The Ideas Report For Serious Investors

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By Ravi Nagarajan

This is the fourth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

It is impossible to escape the daily barrage of terrible news from the Gulf of Mexico.  BP is obviously the target of unceasing criticism, much of it well deserved, and the company’s share price has reflected a great deal of uncertainty regarding ultimate liability and the safety of the dividend.  However, investors are also abandoning nearly any company involved in the oil sector regardless of exposure to the spill or to the drilling moratorium in the Gulf of Mexico.  As we pointed out in previous articles on Noble Corporation and National Oilwell Varco, investor panic often creates interesting opportunities for long term investors.

Ensco 102 in The North Sea

Ensco International plc is an offshore contract drilling company that provides services to oil majors and independent oil exploration firms.  The company has historically focused on jackup rigs designed for relatively shallow water but has devoted the majority of capital expenditures in recent years to build up a fleet of semisubmersible rigs capable of deepwater operations.  Ensco has a fleet of 45 mobile offshore drilling units comprised of four semisubmersibles, 40 jackups, and one barge rig.  In addition, the company has one new semisubmersible unit ready for deployment in August and three semisubmersible units scheduled for delivery in 2011 and 2012.

Overview of Business

One of the common filters that many value investors use involves looking for companies trading at or below tangible book value.  In recent days, Ensco traded below tangible book value and the recent rally has increased the market capitalization to slightly above tangible book.  Of course, this statistic is merely “interesting” until we delve deeper into the quality of the assets on the balance sheet as well as the durability of the business.  The exhibit below displays a snapshot of Ensco as of June 11, 2010:

Ensco is geographically diversified with significant revenues originating from its Europe, Africa, and Asia Pacific reporting segments. The chart below shows Ensco’s 2009 revenues broken down by business segment.  Ensco segregates worldwide deepwater operations into a separate segment and has regional segments for shallow water operations using the company’s large jackup fleet.  We can see that shallow water operations comprised 87 percent of revenues in 2009.  Furthermore, shallow water activities outside the Americas accounted for 66 percent of revenues.   Clearly Ensco is not principally a deepwater player in the Gulf of Mexico.

The following exhibit shows some key data from the past five years.  Note that the company does not employ much leverage and has enjoyed healthy margins over this timeframe due to the overall strength in oil prices which has led to healthy rig demand and high dayrates.  However, the company’s return on equity has decreased somewhat due to significant cash balances earning low returns (cash balance was over $1.2 billion as of March 31, 2010).  Additionally, high levels of capital expenditures on semisubmersible deepwater rigs over the past three years have only started to generate meaningful revenue recently as newbuild rigs enter service.

Cash Generation Machine

High oil prices and healthy demand for the company’s services have resulted in Ensco resembling a cash generation machine in recent years.  Much of the cash flow has been devoted to the company’s expansion program which has focused on building up the fleet of semisubmersible rigs capable of operations in very deep waters.  In addition to investing in capex, Ensco has returned cash to shareholders in the form of dividends and share repurchases.  The company recently increased the regular quarterly cash dividend to $0.35/share from $0.025/share.

The exhibit below shows the cash generation capability of Ensco over the past five years along with the use of the cash.  The company expenses regular maintenance on existing rigs.  We have classified a portion of the capital expenditure program as “maintenance capex” to reflect minor upgrades of existing rigs that could arguably not increase rig capabilities.  The vast majority of capex has been identified as rig enhancements or newbuild rigs.

As noted previously, Ensco’s cash balance has increased dramatically and stands at over $1.2 billion as of March 31, 2010.  Since the recently enhanced dividend will consume approximately $200 million per year, management seems to be aware of the negative aspect of continuing to pile up excess cash on the balance sheet.

Segment Details

As the chart above demonstrates, Ensco is well diversified geographically and current revenues are dominated by shallow water operations outside North and South America.  However, management is clearly committed to expanding deepwater operations significantly.  The vast majority of capex over the past three years has been dedicated to the deepwater segment.  The exhibit below shows selected segment data for the past three years.

The importance of deepwater has increased even further in the first quarter of 2010.  Deepwater operations accounted for 29 percent of revenue and 39.8 percent of operating income for the first quarter — a dramatic increase over full year 2009 statistics.  In other words, the large level of capex allocated to the deepwater segment over the past three years is now starting to generate significant revenues and profitability as more semisubmersible units become productive.

U.S. Gulf of Mexico Exposure

Ensco has ten rigs located in the Gulf of Mexico.  Seven jackup rigs are operating in shallow water areas at dayrates ranging from approximately $50,000 to $100,000.  Two semisubmersible rigs are operating in deepwater areas at estimated dayrates of $295,000 and $365,000.  One newbuild semisubmersible rig is contracted to begin operations in August at a dayrate of approximately $480,000.

The exhibit below lists each of Ensco’s rigs located in the Gulf of Mexico based on the company’s May 14 rig status report.  Ensco Investor Relations has indicated that the next fleet status report will be posted on June 15.  The company did not respond to a request for an interim update prior to the June 15 report.

Last week, we pointed out that there was much confusion regarding the Federal Government’s moratorium policy related to shallow water exploration.  As of today, it is still not entirely clear whether the government intends to stand in the way of shallow water operations, although indications are that such exploration will probably continue to be permitted.  Deepwater exploration is obviously another matter.  President Obama continues to insist on the six month moratorium on deepwater exploration but the significant impact on the Gulf Coast economy has caused prominent politicians such as Louisiana Governor Bobby Jindal to argue for lifting the moratorium.

Under a worst case scenario for deepwater, the “force majeure” clauses in Ensco’s contracts may be activated and the company may lose the anticipated revenues from Ensco 8500, 8501, and 8502.  However, the company’s extensive global operations make it highly probable that these rigs will be redeployed elsewhere within a reasonable timeframe.  In a recent conference call, Ensco Chairman and CEO Dan Rabun stated that the Ensco 8500 series is “perfect for Brazil, Gulf of Mexico, and West Africa and Asia”.  Furthermore, since most contracts call for Ensco’s customers to pay “mobilization” costs for rigs, it is possible that the rigs could be redeployed elsewhere without Ensco paying for substantial transportation costs.

How Good is Tangible Book?

Earlier, we stated that one must examine what is in tangible book value before an investor gets too excited about a company that is trading at or below tangible book.  The quality of assets is obviously critical if tangible book is to be considered a margin of safety for the investor.

The critical component of Ensco’s tangible book value is the property and equipment account which is stated at $4.5 billion as of March 31, 2010.  Since a great majority of the company’s tangible book value resides in illiquid offshore drilling rigs, can we feel somewhat confident that the assets are worth what they are stated on the balance sheet?

While it is very difficult to make a definitive assessment, three recent asset sales provide a clue that management is conservative regarding the valuation of rigs.  The company sold Ensco 57 on April 23.  Ensco 57 sold for $47 million while the rig had a net book value of $30 million.  On March 19, the company announced the sale of Ensco 50 and Ensco 51.  These rigs were sold for $95 million and had a net book value of $63 million.  The cumulative gain on sale for the three rigs came to approximately $49 million.  While the sale of three older jackup rigs may not be reflective of overall valuation of the fleet, a positive surprise upon the disposition of assets is a good sign that management might be conservative.

Summary

Ensco plc is a well diversified, high quality company that appears to have been unfairly punished in recent weeks based on “guilt by association”.  When a high profile incident has a major impact on an industry, market participants often sell any company in the industry first and ask questions later.  With a market capitalization only slightly above tangible book value, diversified international operations, and what appears to be manageable exposure to the deepwater Gulf of Mexico, investors should have some downside protection.

The company is not without risk, but the relevant risk is related to the potential for depressed energy prices that reduce demand for the company’s rigs rather than any specific regulatory action related to the Gulf of Mexico.  In the event of a “double dip” recession that reduces worldwide demand for oil, Ensco’s profitability and cash flow would decline along with every other contract drilling company.  However, the long run demand for fossil fuels in the developing world makes the case for a long run decline in oil prices highly doubtful.  Alternative energy sources are decades away from threatening to seriously displace oil and gas as fuels.

In contrast to Noble Corporation which we profiled last week, Ensco has not suffered the same magnitude of decline since late April and the company is more expensive in terms of cash flow or earnings multiples.  The likely reason is that Noble is much more exposed to the Gulf of Mexico deepwater than Ensco, although even Noble is well diversified from a geographical standpoint.  In the event of a favorable outcome for deepwater regulation in the Gulf of Mexico, Noble is likely to have a more rapid recovery.  If the deepwater moratorium continues for a longer period or becomes permanent, Ensco may be the better choice.  Both companies seem to offer a favorable risk/reward profile at current quotations.

Resources:

Ensco plc 2009 10-K
Ensco plc Q1 2010 10-Q
Ensco Q1 2010 Conference Call Transcript (pdf)
Ensco Fleet Status Report as of May 14, 2010 (pdf)
MMS Deepwater Production Summary as of June 7, 2010 (pdf)
Ensco Investor Presentation on June 10, 2010 (pdf)

Disclosure:  No Position in Ensco plc but considering long position.  Long Noble Corporation.

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Start your 30-day FREE trial of Downside Protection Report and receive 10x45 Bargain Hunter for FREE.

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By Greenbackd

Jon Heller at Cheap Stocks has a great post on The Downside of Net/Net Investing- Lazare Kaplan (LKI). Says Jon:

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Whitney Tilson is convinced that BP is simply too cheap to ignore at the current valuation.  Given the steady stream of negative headlines due to the massive Deepwater Horizon oil spill, BP shares are quickly approaching a 45 percent discount to the stock price that prevailed during much of April.  Mr. Tilson makes it clear that BP shares could certainly fall even further in the short run, but he believes that the dividend should be safe.

While Mr. Tilson’s comments regarding BP’s dividend make logical sense, the political pressure on management may soon require a cut regardless of the company’s ability to make payments. Furthermore, the “asbestos-like” qualities of BP’s liability exposure that Mr. Tilson mentions will make total economic exposure unknown for years or decades to come.  BP’s management has also proven remarkably incompetent and politically tone deaf throughout the crisis.  It may make more sense to look elsewhere in the beleaguered oil and gas industry where stock prices have also been hammered rather than to accept the uncertainty at BP.

To learn more about Whitney Tilson’s bullish case for BP, view the video below.

Disclosure:  No Position.

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By Greenbackd

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By Greenbackd

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By Ravi Nagarajan

This is the third in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

As we discussed in our recent article on National Oilwell Varco, the financial markets have been reacting to the Deepwater Horizon disaster by punishing the stock prices of nearly every company associated with oil and gas exploration in the Gulf of Mexico.  In certain cases, the market reaction may be justified by deteriorating fundamentals and in other cases, stocks may be under pressure based on confusion, uncertainty, or merely “guilt by association”.  The current situation in the Gulf of Mexico is a national disaster but is it reasonable to believe that this rich domestic source of oil and gas will not be tapped in the future?  The job of the value investor is to look at these types of situations as opportunities and to identify cases where Mr. Market may have overreacted.

In this article, we will profile Noble Corporation, a company that provides offshore contract drilling, engineering, and production management services to the oil and gas industry.  Noble’s current fleet includes 62 mobile offshore drilling units comprised of 43 jackups, 13 semisubmersibles, 2 submersibles, and 4 drillships.  The company currently has six semisubmersible rigs operating in deepwater locations of the Gulf of Mexico with aggregate contracted dayrates of approximately $2.7 million.

Brief Primer on Rig Types

The terminology associated with offshore drilling can be confusing for those who have not studied the industry in the past.  The following definitions will be helpful in the discussion that follows:

• Semisubmersible Platforms are floating platforms which can be submerged so that a portion of the hull is below water during drilling operations.  The platforms maintain their position over the well either through a fixed mooring system or a dynamic positioning system controlled by computers.  Typically, these platforms require at least 200 feet of water depth and are capable of drilling in depths of up to 12,000 feet.  Semisubmersibles are used for Noble’s deepwater drilling activities in the Gulf of Mexico and elsewhere.  The nearby picture is the Noble Danny Adkins which is currently deployed in over 9,600 feet of water in the Gulf of Mexico.
• Submersible Platforms are designed to be submerged to the drilling position by flooding the hull until it rests on the sea floor while the upper deck remains above water.  These rigs are used in shallow water between 12 and 70 feet.
• Jackup Rigs are self-elevating drilling platforms equipped with legs that are lowered to the ocean floor in order to establish a foundation for support.  The rigs are towed to the location of the well where the legs are lowered based on various techniques.  Jackups can be used in water depths from 8 to 400 feet.
• Drillships are self propelled ships equipped for drilling and are positioned over a well using a dynamic computer controlled positioning system.  Noble’s fleet of drillships can be used in deep water areas although none are deployed in the Gulf of Mexico.

Noble’s U.S. Gulf of Mexico Fleet

The following exhibit shows Noble’s current Gulf of Mexico fleet of six semisubmersible units.  The data sources for the exhibit are Noble’s Fleet Status Report (pdf) dated May 24, 2010 and the Minerals Management Service (MMS) Deepwater Production Summary Report (pdf) dated June 1, 2010.

The exhibit shows the operator, or lessee, of the rig along with the contracted average dayrate and the contract expiration.  All six of these rigs appear to be operating in waters that are deep enough to be included in the recent six month moratorium on deepwater drilling.  The government has mandated a halt to drilling as soon as wells can be placed in a state that is considered safe but it is likely that all of these rigs will soon be idle.

Noble’s contracted drilling backlog, as reported in the company’s latest 10-Q filing, are subject to various termination and modification provisions but the company does not specifically list the termination rights of the operators of the Gulf of Mexico rigs.  In a worst case scenario in which all six of the currently contracted rigs stop producing revenue, the company’s exposure is roughly $2.7 million of lost revenue per day.  However, it is likely that much or all of the cost of the idle rigs through the end of the contracted term will end up the responsibility of the operator rather than Noble.

Obviously, beyond the current contracted terms, Noble would not be able to deploy these rigs in deepwater within the U.S. Gulf of Mexico if the moratorium is extended beyond six months.  Under such circumstances, the company would either have to idle the rigs, move them to shallow water Gulf of Mexico locations, or use them elsewhere (possibly in Gulf waters under Mexican jurisdiction).

Historical Performance and Valuation

The following exhibit shows selected metrics for Noble Corporation for the past decade as provided by Value Line Investment Survey (click on the image for a  larger view):

One of the important points to note is that the company has a relatively low level of long term debt as a percentage of overall capital deployed.  Noble is a capital intensive business but management has not relied excessively on debt to finance capital expenditures.  We can also see steady progress in earnings per share over the past few years along with higher margins and return on equity. Much of the progress in recent years is associated with the impact that higher oil and natural gas prices have had on the exploration plans of oil majors and independent exploration companies.

The following exhibit shows Noble’s free cash flow and expansion capital expenditures over the past five years:

The company has been generating significant free cash flow with increases in each of the past five years.  This cash flow has been deployed mostly toward expansion of the fleet (newbuilds) or enhancements to the existing fleet.  For a company with a current market capitalization of approximately $7 billion, this cash flow track record is clearly impressive.

Geographic Revenue Distribution

The following exhibit shows Noble Corporation’s revenues broken down by region for 2009:

At 22.3 percent of revenues for 2009, the United States is clearly an important market for Noble.  Furthermore, based on the type of rigs involved, the bulk of this revenue is associated with deep water drilling activities.  Based on a $2.7 million aggregate dayrate, the company could be expected to produce nearly $1 billion in revenue assuming that each rig earns revenue without any interruption at currently contracted rates.

On the other hand, it is also clear that Noble has a large amount of revenue originating in a diversified list of countries, including Mexico which was the largest source of 2009 revenues.  It is not unreasonable to believe that many of the rigs currently operating in United States Gulf of Mexico waters could be put to good use nearby in Mexican Gulf waters in the unlikely event that the moratorium extends for several years.  In addition, we should remember that, with the exception of Noble Paul Romano facing a near term contract expiration next month, current contracts in the United States Gulf of Mexico do not expire until March 2011, unless contract cancellation provisions allow customers an early exit.

A Permanent End to Deepwater Drilling — Very Unlikely

While the current outrage over the Deepwater Horizon disaster is a natural reaction, a permanent end to deepwater drilling in the Gulf of Mexico is neither reasonable nor likely based on current production statistics.  According to MMS, deepwater production in Gulf has steadily increased over the past 25 years and now exceeds 80 percent of production on the outer continental shelf.  Based on the MMS data, deepwater drilling produced 569 million barrels of oil in the Gulf in 2009 alone.  According to the U.S. Energy Information Administration, total production of crude oil in the United States for 2009 was 1.9 billion barrels, which means that nearly 30 percent of production can be attributed to deepwater  Gulf of Mexico drilling.  The United States consumed 6.8 billion barrels of oil in 2009, the vast majority attributed to imports.

It is reasonable to believe that the United States government will prohibit oil exploration and production from a source that provides nearly 30 percent of domestic oil production and represents the best area for new discoveries going forward? Does it represent good public policy to reduce domestic consumption even though the United States must import billions of barrels of oil each year from foreign countries, many of which are in regions hostile to American interests?

The much more likely long term scenario is that governments will impose tougher regulation that impacts oil exploration and production based on lessons learned from the current disaster.  There is clearly a risk that government regulatory overreach will cripple deepwater production over a longer period of time.  There is also a risk that other countries could adopt such policies as well.  However, such risks seem remote given the fact that the modern economy still requires oil to function and alternative  energy sources will not make a dent in overall demand for many decades to come.

Summary

Noble Corporation appears to be in a well diversified position from a geographic standpoint and has delivered solid financial results with minimal leverage in recent years.  Free cash flow is impressive relative to the current market capitalization of the company which reflects no premium on reported book value as of March 31, 2010.  The company should be protected to some extent in the near term by contractual terms associated with the six deepwater Gulf of Mexico rigs. Chairman and CEO David Williams has indicated that all contracts have force majeure clauses but whether these clauses will come into effect is not known at this point.

In the long run, it is likely that the United States government will again allow deepwater drilling, albeit with tougher regulation.  In the event that an extended moratorium exceeds the lengths of Noble’s current contracts, the company should be able to eventually redeploy assets in other parts of the world.

Resources:

Noble Corporation 2009 10-K
Noble Corporation Q1 2010 10-Q
Investor Presentation by Chairman/CEO David Williams on May 25, 2010

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. Disclosure: No position in Noble Corporation, but currently considering taking a long position.

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By Greenbackd

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A new European Value Report was released today. The report features the top two monthly investment ideas, as selected by The Manual of Ideas equity research team in Europe.

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In the just-released monthly issue of Downside Protection Report, The Manual of Ideas highlights the research team's top two monthly investment ideas. Each stock is judged to have strong downside protection and above-average upside potential. Here is an excerpt from the editorial commentary:

Last month we wrote that “May could prove to be a good month to ‘go away.’” Indeed. Investors were rattled out of complacency — one might say unexpectedly, but such things are never expected. The S&P 500 Index ended the month down 8%, bringing the benchmark’s YTD performance to an unimpressive -2%.

Where we go from here is impossible to know. Significant problems remain in our world, but this is hardly anything new. Prior generations have dealt with even bigger problems, and the stock market has done just fine over the long term. As a result, we believe investors need to keep their perspective and their “cool.” Timing the market is almost always an exercise in futility.

The only market timing to which we subscribe is the one based on bottom-up idea availability. If ideas with strong downside protection and good upside potential are hard to find, it’s perfectly fine to hold a large cash position. However, when decent businesses are available at a discount to their liquidation values, the time may be right to be fully invested without worrying whether the market will have another leg down. Time has shown that Ben Graham-style investing works. A reason it has continued to work for many decades is that it is hard to do. Humans are not wired to invest in “troubled” companies, even if the troubles are temporary.

Take the massive oil spill in the U.S. Gulf of Mexico and the moratorium that has been put in place as a result. Does anyone really believe that the Gulf of Mexico will suddenly become off limits to oil and gas exploration? Will regulation really become that much more costly and burdensome, despite the best efforts of the energy industry lobby and the fact that once the news cycle moves on, legislators and regulators tend to move on, too? While we’re at it, does anyone really believe that the much-touted shale plays will usher in an era of unlimited supply of natural gas at prices that make it barely economical for companies to explore for gas?

The two companies featured in this issue may present interesting opportunities for investors willing to look beyond the headlines and toward a world that remains starved for energy. Emerging economies continue to demand increasing amounts of oil and gas, while true alternatives remain in their infancy. And with commodities in general looking more attractive vis-à-vis easily printed fiat currency, history may yet play out in way that puts this month's two featured companies among the beneficiaries rather than the victims. Did we mention the two companies are cheap?

Read Downside Protection Report now.

 

Posted by manualofideas at 04:57 PM | Permalink | Comments (0)

By Ravi Nagarajan

This is the second in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

Recent events in the Gulf of Mexico have increased awareness of the risks facing oil exploration companies operating in very deep waters.  Drilling for oil beneath five thousand feet of water entails challenges that test the abilities of exploration companies under the best of circumstances.  We are now witnessing the impotence of industry or government to deal with a well that has been gushing out of control for over a month.  The current moratorium on deepwater drilling in the United States could be adopted by other countries as well and we cannot predict the duration of the moratorium.  In this environment, is any investment in oil exploration or ancillary products and services worthy of consideration?

National Oilwell Varco (NOV) was formed on March 11, 2005 by the merger of Varco International and National-Oilwell.  The company is the fifth largest oil and gas products and services company by revenues.  The company is a supplier of rig technology, petroleum services and supplies, and distribution services.  Customers include oil majors as well as drilling contractors.  National Oilwell Varco has not been mentioned as one of the involved parties in the Deepwater Horizon disaster.

Overview of Business

One of the daunting aspects of investing the oil and gas exploration industry involves the amount of industry jargon that an investor must understand in order to intelligently read financial reports.  The National Oilwell Varco 2009 10-K report includes a glossary of terms (pages 23 to 27) that the reader is encouraged to review.  The business overview section also provides a good understanding of the interaction between firms such as NOV and drilling contractors and exploration firms. We will not attempt to provide an introduction to the industry and terminology to keep this article to a reasonable length.

NOV operates in three segments:

1. Rig Technology. Rig technology involves the design, manufacture, and sale of complete systems for drilling, completion, and servicing of oil and gas wells.  This is NOV’s largest segment by revenues and has the most year to year stability due to the presence of a large backlog given the fact that there is normally significant lead time involved in new exploration projects.  Demand is highly dependent on capital spending plans by customers and overall drilling activity which drives demand for spare parts.
2. Petroleum Services & Supplies. This segment provides consumable goods and services used to drill, complete, and work over existing oil and gas wells and pipelines.  A large number of products are sold such as drill pipe, drilling fluids (“mud”), drill bits, motors, and more.  Demand is correlated to oilfield drilling and workover activity by drilling contractors, independent oil exploration firms, and oil majors.
3. Distribution Services. This segment provides maintenance, repair, and operating supplies to production locations.  NOV has over 200 distribution service centers worldwide and stocks a large line of consumable components.  The NOV “RigStore” concept locates facilities on offshore drilling rigs whereby the company provides the inventory and permits “just in time” purchases by the customer.  This relieves the customer of carrying larger stocks of inventory on the rig.  70 percent of the segment revenues were in the United States and Canada in 2009.

Due to the importance of the number of drilling rigs as well as the influence of oil and gas prices on drilling activity, we present the exhibit below to illustrate industry trends in recent years (along with data on the oil/gas ratio, unrelated to this article, but a subject we have covered from time to time in the past).

As we can see, exploration companies respond to incentives.  As the price of natural gas and oil increased from 2004 to 2008, rig counts increased.  The collapse in prices in 2009 resulted in a decrease to worldwide rig counts.

Historical Performance and Valuation

The following exhibit shows the past five years of performance and valuation data as reported by Value Line.  When looking at the historical record, please be aware that NOV acquired Grant Prideco on December 16, 2007 in a $7.2 billion cash and stock transaction.

We can see that overall sales per share track the active rig count statistic on a directional basis.  In addition, we can see that overall profitability has been enhanced in recent years as high commodity prices created a rush to drill more active wells giving NOV and other firms in the industry the ability to expand margins.

The following exhibit shows NOV’s revenues, operating profit, and operating margins broken down by reporting segment:

It is apparent that Rig Technology is the most consistent segment in terms of delivering high operating margins and is also the largest segment by revenues and operating profits.  Petroleum services and supplies delivers consistent profitability although operating margins were depressed in 2009.  Distribution services predictably offers the lowest margins.

First quarter 2010 results (click here for 10-Q) show that this pattern is basically intact with operating margins for Rig Technology, Petroleum Service & Supplies, and Distribution services at 30.8%, 12.2%, and 3.3% respectively. Overall first quarter revenues were $3,032 million in 2010 which is a decline of 12.9 percent compared to the first quarter of 2009.  Operating profits for Q1 2010 came in at $637 million, down 11.5 percent from Q1 2009.

Geographic Distribution

The following exhibit shows the distribution of sales by geographic location for the past five years.  The United States only accounts for 27 percent of worldwide sales for 2009.  As recently as 2006, sales in the United States were in excess of fifty percent of revenues.

The chart below shows sales by geography broken down for 2009.

Impact of Regulatory Changes

The degree of geographical diversification at NOV provides some comfort against the risk that any one country’s regulatory changes will have an outsize influence on overall results.  However, obviously the United States is a large market and other countries, particularly developed countries, may adopt risk averse policies going forward toward deepwater exploration.

From a regulatory perspective, the clear risk is that new policies will slow or stop deepwater exploration by NOV’s customer base which will have a corresponding effect on demand for the company’s products.  A lesser regulatory risk may involve mandated changes to parts (blowout prevents are an obvious example) that companies such as NOV will have to implement.  While it is likely that any increase in cost will be passed on to the customer, the dynamics of unknown regulatory changes to NOV’s products and the impact on margins cannot be determined.

Backlog Characteristics

As noted previously, NOV’s Rig Technology segment has a significant backlog of orders based on the long planning cycle for new oil exploration.  The company’s backlog grew from $0.9 billion at March 31, 2005 to $11.8 billion at September 30, 2008, but has fallen to $5.4 billion on March 31, 2010.  Most notably, the land rig backlog comprises 13 percent while the offshore backlog comprises 87 percent of total orders as of March 31, 2010.  In general, customers cannot cancel projects for “convenience” and provide substantial down payments.  Only 3.6 percent of the starting backlog balance on September 30, 2008 has been cancelled to date.  Nevertheless, it is obvious that any extended moratorium on deepwater drilling will have a negative impact on NOV’s backlog.

One important point to note regarding the backlog is that 91 percent of the total backlog is related to equipment destined for international markets.  Thus, even though 87 percent of NOV’s backlog is related to offshore projects, the vast majority are for projects outside the jurisdiction of the United States.  As noted previously, other countries may very well adopt a moratorium on deepwater activity as well, so the heavy international bias of the backlog may not offer as much protection as envisioned.

A final point regarding the backlog is that a significant number of jackup rigs (those operating in shallow water) are very old.  According to NOV’s latest 10-Q, 71 percent of the installed base of jackup rigs are more than 25 years old.  Since the moratorium has no impact on jackup rigs operating in shallow waters, this source of business should be unaffected by a deepwater drilling moratorium.

Conclusion

National Oilwell Varco closed on Friday, May 28 at 38.13.  The shares have fallen in sympathy with the overall sector over the past five weeks and traded above $46 as recently as April 26.  The shares are currently trading at under ten times likely earnings for 2010.  The company clearly has enjoyed healthy profit margins over the past five years and while margins and profitability were down due to lower commodity prices in 2009, overall results held up quite well.

The international diversification of NOV’s business and the other factors discussed above seem to indicate that risks specifically related to the Deepwater Horizon disaster should have a muted effect on the company’s future progress.  However, NOV is still exposed to overall commodity prices and industry risks.  If oil and natural gas prices crash to the lows of early 2009, exploration activity is sure to decline significantly and this will be reflected in active rig counts.  This will have a corresponding negative impact on NOV’s results. The most likely scenario for a commodity price crash would be another worldwide recession, perhaps brought about by the current debt crisis in Europe.

In summary, it is not “obvious” that NOV is undervalued at current levels, but it seems reasonable to regard the company’s future fate as  more tied to overall global demand for oil and natural gas and the prices of these commodities rather than to the regulatory risks associated with Deepwater Horizon.  Therefore, future panic associated with Deepwater Horizon may present an opportunity to establish a position in NOV if the shares fall in sympathy with players that are more directly exposed to the disaster.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. Disclosure:  No position in National Oilwell Varco.  Please note that the author is not an expert in the oil supplies and services industry having started research in the field only in the weeks since the Deepwater Horizon incident.  The author owns shares of Contango Oil & Gas, an exploration firm with the majority of operations in shallow Gulf of Mexico waters.

Posted by manualofideas at 04:54 PM | Permalink | Comments (0)

By Ravi Nagarajan

This is the first in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

Few large companies have built up as much brand equity and consumer goodwill as Johnson & Johnson.  The company routinely appears near the top of lists of the most respected American companies and makes products that consumers rely on.  The company’s prompt response to the Tylenol recalls in 1982 made it the subject of numerous case studies on how to properly handle such situations.

Given Johnson & Johnson’s history, allegations of improper behavior related to recent recalls has surprised many investors.  The FDA is considering criminal charges against the company for pursuing a “stealth recall” of Motrin before being pressured into a formal recall in July 2009.

In addition to the recall related trouble, Johnson & Johnson is also exposed to the new health care law’s 2.3 percent revenue tax on medical devices which will go into effect in 2013.  The medical device tax in particular, and health care reform in general, has weighed on the stock price of many companies involved in the industry.  In this article, we will take a brief look at Johnson & Johnson’s history to determine whether there are any rays of sunlight that may break through the stormy clouds currently over the company.

Ten Year History and Current Valuation

A brief look at Johnson & Johnson’s ten year history reveals a company that has consistently delivered growth in earnings per share, dividends, and sales while posting steadily improving margins.  The following table displays selected data found in Value Line’s latest report on Johnson & Johnson (Value Line makes all Dow 30 stocks available free of charge).  Click on the image for a larger view.

What is interesting about Johnson & Johnson is that the market has steadily cut the price to earnings multiple for the stock over the past decade.  This is not unlike the experience of Wal-Mart or Microsoft shareholders over the past decade.  The business has done very well and key metrics keep improving while the stock gets less and less popular over time.

Johnson & Johnson closed at $58.30 on Friday, May 28 which represents a trailing P/E ratio of 12.6.  The forward P/E ratio is slightly under 12 assuming modest earnings growth this year.  With a current dividend of $2.16 per share, Johnson & Johnson provides a 3.7 percent yield.  Over the past decade, dividends have increased at a 13.3 percent annualized rate while the payout ratio has only increased modestly.  With a market capitalization of nearly $161 billion, one would expect growth to slow at some point, and perhaps the market believes that the decline in revenues in 2009 and very modest earnings per share growth means that the slowdown is imminent.

Medical Device Segment

Since we believe that one of the factors depressing the stock price is related to the health care law’s 2.3 percent medical device tax on gross revenues, it is important to dig a bit deeper and look at Johnson & Johnson’s segment information which is reported in annual 10-K reports filed with the SEC.  The tables below show Johnson & Johnson’s revenues, operating profits, and operating margins broken down by segment (click on the image for a larger view):

We can see that medical devices accounts for a significant percentage of Johnson & Johnson’s total revenues (38 percent in 2009) and a greater percentage of operating profits (46 percent in 2009).  In addition, we can see that operating margins are relatively high for medical devices and have been growing higher over time.  In 2009, medical device operating margins were 32.6 percent, the highest of any segment.  Certainly medical devices seem to be an important part of Johnson & Johnson’s business.  The charts that appear below present segment data for 2009 for revenues and operating profits.

Impact of Medical Device Tax

Is it accurate to take the 2.3 percent revenue tax on medical devices and simply multiply it by segment revenues in order to measure the potential impact?  This would not be accurate because the tax only applies to medical devices shipped within the United States.  In addition, the final version of the health care law made the tax deductible for income tax purposes (some versions prior to the final reconciliation process were non-deductible).

The following table shows Johnson & Johnson’s medical device segment revenues broken down by region for the past ten years (click on the chart for a larger view):

We can see international sales have become more important for the medical device segment in recent years and now exceeds the sales volume of domestic shipments.  Less than half of the medical device revenues at Johnson & Johnson would be subject to the tax based on 2009 revenues:

The tax does not take effect immediately, but let us assume that Johnson & Johnson has to pay the 2.3 percent gross revenues tax on the $11,011 million in medical device revenues in 2009.  The tax would amount to approximately $253 million, but we must remember that this figure is deductible for income tax purposes.  Therefore, assuming a 35 percent tax rate, the net tax impact would be approximately $164 million.  With total net profits of $12.9 billion in 2009, the impact of the medical device tax would amount to a reduction of only 1.3 percent of net income.

Assessing the Risks

Let us revisit the two risks to Johnson & Johnson discussed in this article (there are other business risks that an investor may want to consider as well — specifically the risk profile of the pharmaceutical segment which we have not discussed):

1. Impact of the Recent Recalls. From recent accounts of the recall of Motrin, several troubling allegations have emerged regarding Johnson & Johnson employees taking regrettable actions that could lead to serious trouble with the FDA.  At the very least, the behavior would appear to be totally at odds with the company’s behavior in the 1982 recalls and could certainly reduce consumer confidence in Johnson & Johnson in general and the recalled brands specifically.  It is impossible to predict the outcome but the company is at least making the right statements regarding its commitment to taking corrective action on the recall.  Any direct financial penalty would pale in comparison to the consequences of criminal charges.
2. Medical Device Tax. The medical device tax on gross revenues has been controversial and will certainly impact Johnson & Johnson.  However, the overall impact to the bottom line seems muted and implementation of the tax will not take effect until 2013.  At the same time, one must note that the medical device segment is the fastest growing and most profitable segment at Johnson & Johnson and general pressures on health care cost inflation could constrain the company’s ability to pursue price increases going forward.  On the other hand, the aging population and having more people covered under the health reform law could increase unit volumes.

The bottom line is that Johnson & Johnson is now a very unpopular large company from Mr. Market’s perspective.  At a PE ratio of approximately 12 and a dividend yield of 3.7 percent, the stock appears to be cheap given the company’s history of growth as well as the current levels of profitability that clearly demonstrate the presence of a powerful moat in all three business segments.  The company’s market capitalization is now at the point where one can reasonably expect growth to slow in the future, but investors are not paying a price that demands much future growth.

What would Benjamin Graham think about Johnson & Johnson’s valuation today?  We obviously cannot be so presumptuous as to make any definitive statement, but the company’s record over the past ten years combined with a very secure and growing dividend that yields in excess of the ten year Treasury note would probably at least spark his interest in the stock as a potential “relatively unpopular large company” worthy of serious consideration.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. Disclosure:  No position in Johnson & Johnson currently but seriously considering a purchase.

Read the Johnson & Johnson company profile published in a recent monthly issue of Portfolio Manager's Review (download FREE excerpt).
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Posted by manualofideas at 03:40 AM | Permalink | Comments (0)

Apple has overtaken Microsoft to claim the number two spot in the ranking of American companies as measured by market capitalization.  At $222 billion, Apple only trails Exxon Mobil which has a $279 billion market cap.  Microsoft’s market capitalization fell today to $219 billion.  What does this mean and are there any lessons that investors can learn from Apple’s amazing rise over the past decade?

Apple’s Business Success Drove Result

There can be no doubt that Apple’s business success has driven investor enthusiasm and led the market to value the company at a very high level.  When one looks back at Apple’s condition in the late 1990s, few investors at the time would have bet much on the company even existing in 2010 let alone being the second most valuable company by market cap.  The leadership of Steve Jobs in general and the introduction of the iPod and iPhone not only drove Apple’s bottom line results but radically disrupted the hardware, software, music, and telecommunications industries.

Apple’s earnings growth, as we will see in a table later in the article, has been extremely rapid particularly over the past few years as the iPhone gained momentum.  Sales have increased at a rapid clip while net profit margins have expanded.  It is no surprise that investors are excited about future prospects and willing to pay over twenty times 2010 earnings estimates to own the shares (Value Line estimates 2010 earnings at $11.55/share).

Whether a buyer of Apple stock today will be successful in the long run is beyond the  scope of this article, and indeed far beyond the abilities of this author to analyze.  Obviously, based on projecting the past five years of results into the future, nearly any price can be justified today.  However, at some point (which we cannot pretend to know with any certainty), Apple’s growth will slow and investors will suddenly refuse to pay rich multiples of earnings.

Microsoft:  Solid Business Results, Dismal Stock Performance

Microsoft’s story over the past ten years under CEO Steve Ballmer has been one of solid progress in business results and absolutely dismal performance from a stock price perspective.  This can be traced to the fact that investors in the late 1990s and early 2000s were willing to pay very rich multiples of earnings based on Microsoft’s track record up to that point.  Microsoft often traded at multiples of 50 or more during the height of investor euphoria.

Looking at Microsoft’s Value Line data (available free of charge as a Dow 30 member), we can see the rapid earnings growth in the mid to late 1990s that fueled investor enthusiasm and we can also see solid, but slowing growth over the past ten years.  Indeed, the company failed to increase year over year earnings only twice over the past decade.  In addition, a dividend was introduced.  Profit margins declined over the past decade as the company’s business matured and pricing came under pressure (operating system sales for net books are a good example of the pricing headwinds faced in recent years).  Still, at a 24.9 percent net profit margin in 2009, Microsoft clearly remains a great business.

The stock price decline over the past decade is attributed to the fact that investors were willing to pay far less for each dollar of earnings than in the past.  At an average PE ratio of 13.4 in 2009, investors were treating Microsoft as an average company, at best, and possibly as a company that may be in decline going forward.

A table showing key data (all from Value Line) for Apple and Microsoft appears below.

What can we learn from the history of Apple and Microsoft over the past decade?

First, while Apple’s success story is indisputable, it is very difficult to see how a value investor could have justified a purchase of the company’s common stock in the early part of the last decade while insisting on any margin of safety.  The wonderful success Apple has experienced was courtesy of products that hardly anyone could foresee at the time.  Would it have made sense to purchase shares in 2005 or 2006 after the iPod was firmly established and when speculation raged over the iPhone?  Possibly for an investor who firmly believed that the industry was within his circle of competence, but most value investors probably still would have passed.

Second, we can see from Microsoft’s history the dangers of paying a fancy price for a wonderful company based upon expectations that past trends can continue indefinitely.  Despite turning in solid performance over the past ten years from a business perspective, any buyer of Microsoft stock from that era is sitting on losses of fifty percent or more.  It is clear that a value investor would not have purchased Microsoft stock in 1999 or 2000 simply based upon the valuation at the time.  There was no margin of safety.

While this article is not intended to make any statement regarding Apple’s valuation, it would seem prudent for any prospective Apple shareholder to consider Microsoft’s experience over the past ten years and the importance of a margin of safety when making long term investment commitments.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. Disclosures:  No position in Apple or Microsoft.

Posted by manualofideas at 02:27 AM | Permalink | Comments (0)

By Plan Maestro

Mrs PlanMaestro knows her consumer goods and it was the first person I talked with after the recent appearance of Dean Foods in the 52 week lows lists. While I have not made a decision on this opportunity, I thought that the intricacies of the milk industry were fascinating and managed to convince her to write about them. We have the pleasure to publish her first contribution to this blog … and if you like it please say so to have more

The recent share drop has put Dean Foods (DF) on the spot so I would like to comment on the US dairy industry and provide some perspective on the attractiveness of DF’s business.

In short, the US milk industry is going nowhere. USA per capita milk consumption is among the highest in the world reaching around 70 liters per person. In recent years per capita consumption has remained stagnant in the face of more innovative categories (e.g. functional drinks) which have been gaining share of throat.

While there has been some growth coming from yogurt or soy drinks, none of the dairy industry innovations have been successful increasing the range of consumption occasions or cannibalizing other categories. Unless a radical innovation widens the range of consumption occasions and consumer profile (most probably coming from the large beverages companies, rather than the traditional dairy companies), we can only expect milk industry volume to grow at the same pace as the population growth.

What is really striking in this industry is that private label (PL) penetration has reached 70%. This is a very high number compared to any other beverage category. For obvious reasons, penetration is higher in categories with a larger share of volume sold through supermarkets (which is the case for milk). However, the gap in milk is quite astonishing. PL penetration in water is around 30%, in juices around 20%, and in carbonated drinks under 10%.

Even compared to other groceries, milk remains the category with the largest PL penetration (Cereal ~30%, Mayonnaise ~20), even though volume sold in supermarkets is quite similar for all them (above 80% of volume).

While private label penetration is usually driven by heavy discounts, until very recently milk PL prices were almost in parity to branded products. Most of the PL products are now associated with high quality and as supermarkets extend their reach nationally, they are making such brands available cross nation. On the other side, branded milk has remained mostly regional and unable to differentiate significantly from the PL offer (no single brand holds more that 2% of the industry market share). DF, after a series of acquisitions, has managed to consolidate around 18% of the industry’s market share (47% branded and 53% private label production).

It is uncertain to me how the milk industry in the US commoditized much faster than other categories. My guess it was the compounding result of several factors:

1. Available raw material and simple process: The US produces around 15% of global milk. It produces more milk than it consumes and has a competitive raw milk market with one of the lowest worldwide producer price. Access to milk and the relatively low investment requirements to pasteurize milk fostered the development of dairy companies.
2. Fragmented and weak regional brands: The US milk market is a 100% fresh (pasteurized) market, making it difficult for the development of national brands as investments in refrigerated distribution assets for a national brand would be quite high.
3. Walmart effect: The increased relevance of the supermarkets and their cross dock platforms providing a tempting and efficient refrigerated distribution network for local producers to sell milk nationally.
4. Isolated in the low value category: cheese, yogurt and other high margin branded dairy products got captured by few national brands with accumulated marketing expenditures and national coverage (Kraft, Danone, General Mills) reducing the milk producers negotiating power vs. supermarkets.

To sum up, this is a mature industry with an unclear growth perspective with a very high level of commoditization (estimated category operating margin of 5%). For Dean Foods to compete successfully in it, requires being able to differentiate its product offer versus Private Label while being able to widen its operating margin. A deeper look into Dean’s strategy will be developed in a following post.

Posted by manualofideas at 03:57 AM | Permalink | Comments (0)

By Nadav Manham

The Washington Post Company has announced it will sell Newsweek. CEO Donald Graham, who did not go to auctioneer school, said "we don't see a sustained path to profitability for Newsweek." The destruction of Newsweek's profitability, notes the article, is part of a larger trend: TV Guide, Businessweek, and Reader's Digest all met a similar fate.

Meanwhile, the article implies, The Economist and The Week, the latter founded by Felix Dennis (if I remember correctly, it was the only title he kept when he sold off his publishing empire), are profitable, as are popular titles like US Weekly and People. Obvious question: why?

The article gives the standard qualitative answers for the decline of publications like Newsweek: the fragmentation of audiences, the rise of cable and internet news and the speeding up of the news cycle, increasing political polarization, loss of advertising rate base, etc.

My project for myself, however, is to try to answer these questions more quantitatively, the way our BMMT Dream Team would do it. I would construct historical income statements for each of the magazines mentioned, both the failures and the successes, and figure out why specific line items went south and how. The name of the game in evaluating magazines is predicting operating margins (leverage and asset turnover don't mean that much), which means predicting the return on investment of a given investment in expenses. In other words, don't think of income statement expenses as expenses; think of them as capital expenditures, as investments undertaken to produce a return, in the form of revenues. The higher the gap between operating expenses and the revenues they produce, the higher your return on investment.

As always, figuring our the right metrics would be key. My gut feeling is that, for all the talk about dead trees and trucks, printing and distribution costs do not play a huge role in determining which magazines succeed and which ones fail. In fact, I would speculate that the general interest publications--the ones that are failing--pay less per unit to print and distribute because of economies of scale. My sense is that the main cost differentiator is the labor involved in putting the thing together in the first place.

Therefore, my sense is that the relevant metrics for these publications is:

a) circulation revenue per journalist/editor man-hour, and

b) advertising revenue per journalist/editor man-hour.

Figuring out which magazines do well on those two metrics and why is the key to evaluating magazines. Remember, Newsweek is not failing because of lack of revenue: $165.5 million is a lot of money. It's failing because its cost structure is too high for its revenue.

In this framework, a magazine can succeed either by keeping the numerator high or the denominator low. Some educated guesses:

The Week does not gross anywhere near Newsweek's $165.5 million; its subscription price is not high and its advertising pages don't command a premium. But it is so inexpensive to produce that its revenue per man-hour is high enough to produce profitability.

The Economist probably pays its editors and journalists a premium (not a huge one though;  remember they are not allowed to have bylines, so they never acquire brand value of their own. They can't influence policy at their organizations the way, say, Thomas Friedman and Maureen Dowd did when they complained about their op-eds being put behind a paywall), but because of its enviable demographics and its niche audience of business subscribers, those journalists and editors are extremely productive: they combine to produce more revenue per man-hour than any other magazine.

People Magazine and US Weekly are like The Week: they are just extremely cheap to produce relative to the revenue they earn. The labor involved in putting them together is just very productive.

Newsweek is failing because it's stuck in the middle: its subscription price is comparable to that of US Weekly or People, its advertising rates are comparable--but it just costs way more to produce than US Weekly and People. It probably costs about as much per unit to produce as The Economist, but cannot command the same per-unit subscription and advertising revenues as The Economist. Stuck in the middle.

All of this begs two questions:

1) Before the general interest weeklies got stuck in the middle, they were extremely profitable. Why was that? Maybe a topic for another post.

2) Taking Richard Stengel at his word, why has Time Magazine managed to remain profitable even as it's subject to the same forces affecting Newsweek. Maybe there is only enough circulation and ad revenue to go around for one general interest weekly magazine to prosper, and Time is slowly draining it away from Newsweek.

The only problem with my little project is that it's extremely difficult to create an income statement for an individual magazine. The information is very hard to come by. If anyone has any insight into getting this information, please let me know.

The author of this post is Nadav Manham, president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

Posted by manualofideas at 03:36 PM | Permalink | Comments (0)

As investors, we are accustomed to reading rather formal announcements by companies. That's why we wanted to share a refreshingly different read from Oracle's (ORCL) latest earnings release. In it, CEO Larry Ellison states:

"Every quarter we grab huge chunks of market share from SAP (SAP). SAP’s most recent quarter was the best quarter of their year, only down 15%, while Oracle’s application sales were up 21%. But SAP is well ahead of us in the number of CEOs for this year, announcing their third and fourth, while we only had one."

This is Ellison's light-hearted take on the latest SAP executive reshuffle, which resulted in CEO Leo Apotheker being pushed aside in favor of a co-CEO structure between Bill McDermott and Jim Hagemann Snabe. Perhaps more than anything else, Ellison's comments reveal just how personal the rivalries between top global companies can be. Ellison is the founder and largest shareholder of Oracle with 23% of the company, while SAP co-founder and chairman Hasso Plattner is the largest shareholder of SAP. Both men are in their mid-60s and can look back at hugely successful careers as entrepreneurs. At the same time, they remain motivated to this day to have active leadership roles in their companies. What's more, Ellison won the America's Cup in February, besting his sailing rival (and fellow billionare) Ernesto Bertarelli. Just a month earlier, Ellison closed the $7 billion acquisition of Sun Microsystems, a potentially transformative deal for Oracle. It is nothing short of remarkable at which speed some people move in this world. Ellison is one example. Steve Jobs of Apple (AAPL) is certainly another. From an investors' perspective, however, such larger-than-life leaders may be a mixed blessing. Given the risk that they can abruptly leave for one reason or another, we are left wondering what the impact would be on the company and its future prospects.

Oracle is one of the many companies we will profile in the forthcoming monthly issue of Portfolio Manager's Review. To subscribe to Portfolio Manager's Review, please click here.

Disclosure: No positions.

Posted by manualofideas4 at 09:36 AM | Permalink | Comments (0)

Wesco Financial Corporation held its 2010 annual meeting in Pasadena, California on May 5.  Wesco Financial is a 80.1 percent owned subsidiary of Berkshire Hathaway.  While the Berkshire Hathaway annual meeting attracted approximately 37,000 attendees on May 1, the Wesco meeting is a much lower key event.  The main attraction is the opportunity to listen to Charlie Munger’s views on business, the economy, and a variety of other topics.

Will Wesco Become a Wholly Owned Berkshire Subsidiary?

According to a 8-K SEC report filed today, Mr. Munger had the following to say about the possibility of Berkshire eventually acquiring the remaining 19.9 percent interest in Wesco:

At the Company’s Annual Meeting of Shareholders, the Company’s Chairman and Chief Executive Officer, Charles T. Munger, who is also vice-chairman of Berkshire Hathaway Inc. (“Berkshire”), which owns 80.1% of the Company’s outstanding stock, said that it would be logical for the Company to ultimately become wholly owned by Berkshire. Mr. Munger cautioned, however, that such a combination transaction, to the extent it would involve stock consideration, would only make sense if there was an appropriate relationship between the relative values and prices of Berkshire’s stock and the Company’s stock, and that such a relationship does not currently exist. Mr. Munger did not state any particular time frame for such a transaction. No combination transaction of any kind has been proposed or presented to the Company. The Company’s Board of Directors has not discussed or considered any such transaction and neither has Berkshire’s Board of Directors.

This statement is interesting primarily because it contains a reference to the relative valuation between the common stock prices of Wesco and Berkshire and suggests that the companies are currently trading at different levels relative to intrinsic value.

Valuation of Berkshire vs. Wesco

Reflecting on Mr. Munger’s statement, the desire to have both Berkshire and Wesco trade at similar levels relative to their respective intrinsic values makes perfect sense given the desire of management to treat all parties to the transaction fairly.  To the extent that Berkshire stock is used to compensate Wesco shareholders, each side should receive as much intrinsic value as they are giving up.

Does Mr. Munger’s statement tell us anything regarding his view of whether Berkshire or Wesco currently represents the better bargain at current prices?  Examining the price to book value ratio of each company is admittedly a simplistic and crude approach but nonetheless is interesting to consider.

Both Berkshire and Wesco are expected to file first quarter results tomorrow (May 7), but for now, let us consider December 31, 2009 reported book value.  Berkshire had a book value of $84,487 per Class A share while Wesco had a book value of $358 per share.  On May 5, Berkshire closed at $114,950 and Wesco closed at $369.25.  This gave Berkshire a price/book ratio of 1.36 while Wesco’s price/book ratio was lower at 1.03.

Does this mean that Mr. Munger is saying that Berkshire’s share price is overvalued compared to Wesco?  The answer hinges on the following statement that appeared in Mr. Munger’s 2009 letter to Wesco shareholders (a similar statement has appeared in his past letters as well):

We repeat our standard warning. Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality disparity in book value’s intrinsic merits has, in recent years, continued to widen in favor of Berkshire Hathaway.

In Mr. Munger’s opinion, each dollar of book value at Berkshire is worth far more than each dollar of book value at Wesco.  How much more?  He does not give us a specific figure. However, we do know that the current difference in valuation is not acceptable to consider a stock based transaction in which Wesco would become a wholly owned Berkshire subsidiary.

This brings up the question of whether the price/book value gap would have to widen or narrow in order to make Mr. Munger feel that the appropriate relative value exists.  It is highly doubtful that he believes that the price/book value gap would have to narrow given the strong wording that clearly states that Wesco is much less valuable compared to book value relative to Berkshire.  This would lead one to believe that Mr. Munger thinks that Berkshire is undervalued relative to Wesco, even with Wesco trading not far above book value.

Can We Draw Conclusions Regarding Berkshire’s Valuation?

Taking this a step further, can we draw any conclusions regarding Mr. Munger’s thoughts on Berkshire’s intrinsic value relative to its current quotation?  It would seem that Mr. Munger has to consider Wesco to have an intrinsic value of at least book value or he would be compelled to write down the goodwill component of Wesco’s book value accordingly.  If we are correct in concluding that he believes that Berkshire is undervalued relative to Wesco and that he does not believe Wesco is worth less than book value, it then follows that Berkshire must be undervalued at today’s quotation.

Granted, this intellectual exercise makes a number of assumptions and Mr. Munger did not directly say what his views are regarding either Wesco or Berkshire’s current valuation.  However, it is rare enough to read any comments from Mr. Buffett or Mr. Munger that even peripherally address valuation so some attempt to parse the statement’s meaning seems warranted.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author owns shares of Berkshire Hathaway. No direct ownership of Wesco shares.

Posted by manualofideas at 07:41 AM | Permalink | Comments (2)

The Inoculated Investor has posted notes from the Berkshire Hathaway and Markel annual meetings.

Direct links to the notes: Berkshire Hathaway; Markel.

Posted by manualofideas at 07:00 AM | Permalink | Comments (0)

In a warning that was largely ignored at the time but proven correct in subsequent years, Warren Buffett referred to derivatives as “financial weapons of mass destruction” in his 2002 letter to Berkshire Hathaway shareholders.  Critics of Berkshire’s recent involvement in derivatives often like to point out the superficial inconsistency between Mr. Buffett’s earlier warnings and his willingness to enter into derivatives contracts in recent years.  Today’s Wall Street Journal article regarding Berkshire Hathaway’s lobbying efforts related to the financial regulatory reform bill are already raising charges of hypocrisy. Let’s take a brief look at the facts and how the legislation may impact Berkshire Hathaway.

Background

While Warren Buffett has emphasized the dangers of derivatives on many occasions, he entered into a number of derivatives contracts in recent years to take advantage of what he believed were mispriced terms at the inception of each contract.  The derivatives generally fall into two categories:  Equity puts and credit default swaps on individual companies.  The equity puts are long term contracts that require minimal collateral and are not exercisable until contract expiration.  In a previous article, we provided more details regarding the nature of these contracts in an attempt to clear up persistent misunderstandings regarding the issue.  Mr. Buffett’s latest letter to shareholders provides updated information based on developments in 2009

In addition to the derivatives portfolio managed personally by Mr. Buffett, certain Berkshire subsidiaries such as MidAmerican enter into derivatives contracts for hedging purposes.

Derivatives “Float” and Collateral Requirements

At the end of 2009, Berkshire Hathaway held approximately $6.3 billion of “derivatives float” which represents funds received from counterparties that Berkshire can use for investment purposes.  Berkshire’s counterparties are required to make payments at the inception of contracts. According to Note 12 in Berkshire’s 2009 annual report, very minimal collateral requirements exist and even additional credit downgrades would only require a relatively modest increase in collateral:

With limited exceptions, our equity index put option and credit default contracts contain no collateral posting requirements with respect to changes in either the fair value or intrinsic value of the contracts and/or a downgrade of Berkshire’s credit ratings. Under certain conditions, a few contracts require that we post collateral. As of December 31, 2009, our collateral posting requirement under such contracts was $35 million compared to about $550 million at December 31, 2008. As of December 31, 2009, had Berkshire’s credit ratings (currently AA+ from Standard & Poor’s and Aa2 from Moody’s) been downgraded below either A- by Standard & Poor’s or A3 by Moody’s an additional $1.1 billion would have been required to be posted as collateral.

One additional point that is often missed is that Berkshire continues to own the securities posted as collateral and benefits from any returns earned by the collateral.

It is obvious that Berkshire was able to secure very favorable terms from counterparties regarding collateral requirements precisely because the financial strength of Berkshire has never been seriously questioned.

Berkshire Objects to Retroactive Changes to Collateral Requirements

According to the Wall Street Journal article, Berkshire Hathaway is only objecting to efforts in Congress to retroactively apply new collateral requirements to existing contracts:

The provision, sought by Berkshire and pushed by Nebraska Sen. Ben Nelson in the Senate Agriculture Committee, would largely exempt existing derivatives contracts from the proposed rules. Previously, the legislation could have allowed regulators to require that companies such as Nebraska-based Berkshire put aside large sums to cover potential losses. The change thus would aid Berkshire, which has a $63 billion derivatives portfolio, according to Barclays Capital.

Mr. Buffett’s push is especially notable because he has warned of the potential dangers of derivatives, famously branding them “financial weapons of mass destruction.”

The White House has been trying to kill the Berkshire provision on the grounds that it would weaken the government’s ability to regulate the enormous market for derivatives. Berkshire Hathaway argued that it shouldn’t be made to redo existing contracts and that it is already healthy enough to cover its obligations. The battle over the provision shows how lobbying by businesses and lawmakers to insert just a few words into a complex bill can have a major impact on the country’s biggest companies.

The proposed changes to collateral requirements would have widespread impacts and are not targeted specifically to Berkshire.  The current reports regarding Berkshire’s lobbying indicate that the company is seeking a broad based “fix” to prevent the government from forcing retroactive changes to existing contracts rather than a special exemption only for Berkshire.

Bottom Line Impact

While it is impossible to know exactly what the bottom line impact of the proposed legislation would be for Berkshire Hathaway, it is important to note that any additional collateral that Berkshire is forced to post would continue to be owned by Berkshire and would earn income for the company while it is held.  The ultimate gain or loss from the derivatives position would be unchanged with the main difference being that additional collateral would have to be posted for the duration of the contracts, most of which will remain outstanding for many years.

The more significant impact going forward may be to discourage Berkshire from entering into new derivatives contracts if collateral requirements for new contracts become even more onerous.  A reduction in this type of activity may be inevitable in any case because many Berkshire shareholders may only trust Warren Buffett to personally manage these types of risks.  Whether shareholders would be comfortable with a proprietary derivatives strategy run by Mr. Buffett’s successor is far from clear.

From a valuation perspective, it seems most conservative to consider the $6.2 billion proprietary derivatives float to be in “run off” rather than a permanent source of value.  The derivatives positions will likely produce significant profits for Berkshire over the next several years but renewal of such opportunities seems too uncertain to rely on the proprietary derivatives strategy as a source of ongoing value.  In contrast, Berkshire’s much larger $62 billion of insurance float remains a long standing and enduring source of intrinsic value for the company.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides more information regarding the company including a brief section regarding the derivatives portfolio.

Posted by manualofideas at 01:16 PM | Permalink | Comments (0)

Berkshire Hathaway has been attracting more analyst coverage in recent weeks due to the company’s inclusion in the Standard & Poor’s 500 and expanded institutional interest related to factors such as the Burlington Northern Santa Fe acquisition.  Earlier this week, Barclays Capital initiated coverage on Berkshire with a price target of $88 on the Class B shares.  The report makes predictions regarding all aspects of Berkshire’s businesses including forecasts for GEICO’s combined ratio in 2010 and 2011.  The projections specific to GEICO seem excessively negative.

Barclays states the following regarding GEICO’s combined ratio:

GEICO’s combined ratio rose over the past several years reflecting an increasingly competitive auto insurance market.  We expect this result to deteriorate further from 95% in 2009 to 98% in 2010 and 100% in 2011 as loss cost inflation rises. (Page 17)

GEICO has demonstrated a consistent ability to deliver combined ratios well under 100 over the past decade.  We presented the ten year history of GEICO through 2008 in a post in June 2009 and included much more detail regarding performance in our Berkshire Hathaway Briefing Book which includes 2009 data.  While it is true that GEICO’s combined ratio has been rising in recent years, there is no reason to believe that underwriting profitability will disappear by 2011.

One clue regarding early 2010 performance can be found in Progressive’s first quarter results which were released today.  Progressive reported a combined ratio of 90.9 for the first quarter demonstrating continued underwriting profitability.  Over the past decade, there has been a strong correlation between combined ratios at Progressive and GEICO which we also discuss in the Berkshire Hathaway Briefing Book.  While Progressive generated a more favorable combined ratio in 2009 at 91.6 compared to GEICO’s 95.2, there is little reason to believe that GEICO’s combined ratio will rise to 98 in 2010 if Progressive’s Q1 performance is any indication.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.  

Disclosure:  The author owns shares of Berkshire Hathaway. No position in Progressive.

Posted by manualofideas at 05:33 PM | Permalink | Comments (0)

We'll be updating the following list throughout this year's public company annual meeting season:

• Berkshire Hathaway (BRK.A, BRK.B), by Warren Buffett
• Biglari Holdings (BH), by Sardar Biglari
• Coca-Cola (KO), by Muhtar Kent
• Fairfax Financial (FRFHF), by Prem Watsa
• Goldman Sachs (GS), by Lloyd Blankfein
  
• JP Morgan (JPM), by Jamie Dimon
• Leucadia (LUK), by Ian Cumming
• Sears Holdings (SHLD), by Eddie Lampert
  
• Winthrop Realty Trust (FUR), by Michael Ashner

Posted by manualofideas at 09:44 AM | Permalink | Comments (1)

In the just-released monthly issue of Downside Protection Report, editor John Mihaljevic, CFA and The Manual of Ideas research team highlight their latest top two monthly investment ideas. Each stock is judged to have strong downside protection and above-average upside potential.

The first featured idea of the month is a recently public insurance company with a strong niche presence in the attractive agribusiness segment. The company appears grossly mispriced as a result of the recent conversion from a mutual company to a publicly held corporation. Due to the quirky structure of the conversion, investors in the recent IPO not only received a claim on the cash invested in the IPO but also on the company's existing assets and business. This produced an unusual opportunity to buy a well-established, well-run insurer at roughly one-half of tangible book value. Not surprisingly, insiders bought shares in the IPO, and the company has rushed to repurchase stock almost immediately after issuing it in the IPO. The shares are still available in the public market at only a modest premium to the IPO price -- though probably not for long.

The second featured idea is a multi-billion dollar competitive energy company that generates electric power primarily via coal-fired power plants. The shares trade at less than one-half of tangible book value, even without ascribing any value to the company's multi-billion dollar net operating loss carryforwards, which should be available to offset income taxes for several years. The company continues to generate positive free cash flow and has an unlevered balance sheet. The shares trade at 2.4 times estimated 2010 EBITDA and a 15% estimated free cash flow yield.

Read Downside Protection Report now.

 

Posted by manualofideas at 12:09 AM | Permalink | Comments (0)

Kraft Foods Inc. released its annual proxy statement yesterday which serves as timely illustration of the faulty logic that compensation committees regularly use when setting executive pay levels.  As we discussed last month, compensation policies can encourage executives to pursue value destroying mergers.  Kraft CEO Irene Rosenfeld earned $26.3 million in total compensation for 2009 with significant components granted due to “exceptional leadership” that resulted in closing the Cadbury acquisition in February.  This is the same “exceptional leadership” that resulted in Warren Buffett taking a rare public stand against the actions of a manager in which Berkshire Hathaway holds minority positions.  Berkshire Hathaway is Kraft’s largest shareholder.

“Exceptional Leadership” Rewarded

The following excerpt from the proxy pertains to Ms. Rosenfeld’s actions related to the Cadbury acquisition that justified payment of the annual incentive bonus at 130 percent of target:

Led the combination of Kraft Foods and Cadbury, which transformed the portfolio into faster growing categories and geographies.  The Committee assessed Ms. Rosenfeld’s leadership in executing on the formal bid for Cadbury in November 2009 and closing this complex deal in early 2010 as exceptional; and The Committee specifically noted her commitment to financial discipline as evidenced by maintaining our investment grade rating, accretion to cash earnings in the second full year, and our current dividend.

Led the divestitures of businesses that continue to transform the portfolio.  Divested the North American frozen pizza business in the first quarter of 2010 for $3.7 billion; and Divested several slow growth small businesses during 2009 that generated approximately $0.04 of incremental EPS.

As for Ms. Rosenfeld’s base pay, the company notes that her salary is “below the size-adjusted median of the Compensation Survey Group”.  Presumably, Kraft’s larger size in 2010 following the Cadbury acquisition will result in the company being placed into a larger peer group that will lead to higher base salary recommendations in the future which would illustrate the incentives managers have to grow the size of a business regardless of returns on incremental capital.

Pizza Business Divestiture

The bonus justification associated with the divestiture of the pizza business is particularly disingenuous because the claim that the sale raised $3.7 billion completely ignores the tax inefficiencies that Warren Buffett discussed in a CNBC Interview in January:

I feel poorer. (Laughs.) Kraft, in my judgment, well just in the past two weeks there’s been two things that caused me to feel poorer. They sold a very fine pizza business and they said they got 3.7 billion for it. But, because it had practically no tax basis, they really got about 2.5 billion. They sold a business for 2.5 billion that Nestle is willing to pay 3.7 billion. Now can Nestle run it that much better than Kraft? I doubt it. But that business that was sold for 2.5 billion earned 280 million pre-tax last year. But they sold that at less, right around nine times pre-tax earnings in terms of their own figure.

Now they mentioned paying 13 times EBITDA for Cadbury, but they’re paying more than that. For one thing, EBITDA is not the same as earnings. Depreciation is a very real expense. But on top of that, they’ve got a billion-three they’re going to spend of various rearrangements of Cadbury. They’ve got 390 million dollars of deal expenses. They are using their own stock, 260 million shares or something like that, that their own directors say is significantly undervalued. And when they calculate that 13, they’re calculating Kraft at market price, not at what their own directors think the stock is worth. So, the actual multiple, if you look at the value of the Kraft stock, is more like 16 or 17 and they sold earnings at nine times. So, it’s hard to get rich doing that.

It appears that Kraft’s Board of Directors is content to embed misleading information regarding divestitures in the proxy statement in an attempt to justify a very rich pay package for a CEO who presided over significant value destruction leading the company’s largest shareholder to “feel poorer” as a result.  However, one can hardly blame Ms. Rosenfeld for her actions.  She knew that the executive compensation policies would reward this type of action and was only acting according to the incentives that the Board provided.

If shareholders of Kraft are looking for those to blame for the value destruction, they should note the members of the compensation committee at Kraft and vote their proxies accordingly:

The compensation committee members during 2009 were Ajaypal S. Banga, Myra M. Hart, Lois D. Juliber, Mark D. Ketchum, and Deborah C. Wright.

Alternatively, shareholder can vote with their feet by selling their shares.  If the company’s largest shareholder cannot prompt common sense corporate governance, it is doubtful that smaller shareholders could achieve better results.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author owns shares of Berkshire Hathaway which owns approximately 8 percent of Kraft common stock.

Posted by manualofideas at 10:43 PM | Permalink | Comments (0)

A new European Value Report was released this morning. The report features the top two monthly investment ideas, as selected by The Manual of Ideas equity research team in Europe.

The first company owns the largest coal-fired power plant in the U.K., which is responsible for meeting 7% of the U.K.’s electricity needs. With a strong balance sheet and cash generative operations, the company has staying power. The report estimates fair value at £7 per share (midpoint of valuation range), compared to a recent market price of £3.81 per share.

The second featured company is a German printing equipment and services provider with a resilient, high-margin services business. While the downside is protected by tangible book support and cash generation from the services business, a recovery in printing press demand could provide strong upside.

Posted by manualofideas at 09:36 AM | Permalink | Comments (0)

Charlie Munger’s annual letter to shareholders of Wesco Financial Corporation was published last week.  Wesco Financial is a publicly traded company that is 80 percent owned by Berkshire Hathaway.  Charlie Munger is Berkshire Hathaway’s longtime Vice Chairman and also serves as Chairman and President of Wesco Financial.  Mr. Munger’s annual letter does not attract nearly as much attention as Warren Buffett’s letter to Berkshire shareholders (discussed last month) but nonetheless provides notable insights worthy of extended discussion.

Overview

Mr. Munger makes reference to Wesco’s 10-K report which was released in early March and should be reviewed in conjunction with the financial information provided in the letter.  Wesco reported operating income of $54.1 million for 2009 which is down from $77.6 million in the prior year.  While insurance underwriting produced a $7.2 million profit for 2009 compared to a $2.9 million loss in the prior year, investment income dropped to $55.8 million compared to $64.3 million in 2008.

In Wesco’s non-insurance operations, CORT’s business has been “melting away” faster than management can fix it as demonstrated by a $1.4 million loss in 2009 compared to a $15.7 million profit in 2008.  Precision Steel produced a $648,000 loss in 2009 compared to a $842,000 profit in 2008 as its business was “pounded by the Great Recession”.  Another factor leading to lower reported results for 2009 was a $6.2 million after-tax write down of the carrying value of a condominium development that was completed on land adjacent to Wesco’s headquarters in Pasadena.

Insurance

Wesco engages in the reinsurance business through its Wes-FIC subsidiary and provides various types of insurance coverage to the banking industry through its Kansas Bankers subsidiary.

Since the beginning of 2008, Wes-FIC’s business has been dominated by Wesco’s participation in Berkshire Hathaway’s reinsurance contract with Swiss Re.  Wes-FIC has assumed 10 percent of Berkshire’s 20 percent quota-share reinsurance of Swiss Re which means that Wes-FIC has assumed 2 percent of essentially all of Swiss Re’s property-casualty risks incepting over the five year period starting on January 1, 2008.  This business accounted for the vast majority of earned premiums in 2009 and generated $10.4 million in underwriting profits.  In addition to Wes-FIC’s participation in the Swiss Re contract, the business is exposed to various risks associated with the aviation industry.

Kansas Bankers Surety Company is engaged in providing various types of insurance coverage to the banking industry.  As we discussed last year, Kansas Bankers made a decision to exit the deposit guarantee bond business and this process continued in 2009.  As a result of shrinking the deposit guarantee bond business, Kansas Bankers experienced a significant decline in earned premiums and posted a $3.2 million underwriting loss for the year.  Mr. Munger reports that the aggregate face value of outstanding deposit guarantee bonds has declined to $33 million insuring ten institutions which is down sharply from $9.7 billion insuring 1,671 institutions when the exit from this line of business commenced in 2008.

We continue to note that management’s actions have demonstrated an unusual level of underwriting discipline by rejecting risks that are perceived as inadequately priced even at the expense of a painful reduction in premium volume and near term underwriting losses as overhead expenses failed to shrink in line with earned premiums.  This is the type of underwriting discipline that we discuss extensively in our 2010 Berkshire Hathaway Briefing Book and has led to sustained levels of underwriting profitability at National Indemnity and other Berkshire insurance operations over very long periods of time.  There are few businesses that are willing to voluntarily shrink in the short run in order to preserve capital required for opportunities in the future which is one reason many insurers fail to achieve underwriting profits in the long run.

CORT Gets “Hammered”

Mr. Munger pulls no punches when discussing the poor performance at CORT which posted a $1.4 million loss in 2009 compared to a $15.7 million profit in 2008.  While CORT’s revenues only declined to $380 million in 2009 compared to $410 million in 2008, the revenue decline was much more severe when one excludes the impact of acquisitions.  On a “core revenues” basis, CORT experienced nearly a 20 percent decline in 2009.  Mr. Munger expects “disappointing profits” for 2009:

Under Wesco’s ownership, CORT has continuously undertaken to improve its competitive position. With several websites, principally, www.cort.com and www.apartmentsearch. com, professionals in more than 80 domestic metropolitan markets, affiliates servicing more than 50 countries, almost twenty-one thousand apartment communities referring their tenants to CORT, many ancillary services, and its entrée to the business community as a Berkshire Hathaway company, CORT is better positioned than previously to benefit from an economic turnaround if it occurs in due course. Near term, we expect more of the difficult business conditions of the recent past, but we do not expect another operating loss at CORT in 2010. Instead, we expect disappointing profits.

Precision Steel Gets “Pounded”

Precision Steel experienced a significant decline in revenues with $38.4 million for 2009 compared to $60.9 million for 2008.  In terms of pounds sold, Precision Steel is only shipping half the annual volume compared to the number of pounds shipped thirty years ago when the company was acquired by Wesco.  The main factor responsible for this downturn is that Precision Steel’s traditional customers have been moving production outside the United States and management has been unable to compensate for these competitive losses as well as for the impact of the recession:

Apart from the recessionary-caused weakness, the general and ongoing decline in Precision Steel’s physical volume is a serious reverse, not likely to disappear in some “bounce back” effect once the economy recovers.

Straight Talk

Although Mr. Munger’s letter cannot be characterized as upbeat, it is notably more positive than last year’s letter when he referred to the economy as being in the midst of “the worst economic disaster since the Great Depression.”  But at a more general level, it is hard to not appreciate Mr. Munger’s willingness to deliver bad news to shareholders in a direct and candid way.  For every CEO who is willing to do this, there are dozens who prefer to invent reasons and explanations that strain credulity and attempt to shift blame to others.  For another example of a straight forward document that delivers the required information in a candid manner, please read Wesco Financial’s 2010 Proxy Statement which was also released late last week.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author does not directly own shares of Wesco Financial.  The author owns shares of Berkshire Hathaway, 80 percent owner of Wesco, and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Posted by manualofideas at 11:40 AM | Permalink | Comments (0)

By Matt Darrah

My recommendation to buy Tetragon does not follow my typical tenet of buying good companies with management teams who are wise capital allocators at a cheap price, but due to the attractiveness of the Company’s valuation, I believe it represents an attractive investment opportunity.

• Extremely Attractive Valuation: (1) stock price implies a 51% discount to the Company’s fair value based on reasonable assumptions; (2) trades at 3.3x FCF or a 31% FCF yield
• Relatively Strong Portfolio Performance in a Horrible Market for Lenders: (1) loan default rate of 6.5% compared to 9.6% for the overall market; (2) 32% of CLOs failing Junior Par Coverage Tests compared to 38% for the overall market; (3) 12.0% of loans rated CCC+ or below compared to 16.5% for the overall market
• Market Seems to Be Punishing the Stock for an Out of Market Fee Arrangement the Company made with its Investment Manager at the Time of its IPO: (1) while I also don’t like the fee arrangement, Management clearly disclosed the arrangement to shareholders, and I believe I can adequately predict its impact on cash flows; (2) future shareholders unlikely to be harmed from fee structure

Tetragon Stock Price Since IPO (April 2007)

Source: BigCharts.com.

Company Overview

Tetragon Financial Group Limited (“Tetragon”, “Company”, or “TFG”) is an investment company that was publicly listed on the Amsterdam Stock Exchange in 2007 (Euronext Amsterdam: TFG) (OTC: TGONF). The management team formed TFG to invest in the equity tranches of collateralized loan obligations (“CLOs”).

CLOs borrow money and raise equity, and then use those funds to purchase bank loans. The CLO then uses the interest it earns on those bank loans to pay the interest its own debt, and whatever cash flow is left is sent to the equity holders. Basically, CLOs mimic banks, but instead of using
depositors’ capital to buy and originate loans, CLOs borrow money from investors. Typically, a CLO will borrow in multiple “tranches” of debt. The CLO is required to pay back the senior debt tranches first, and these tranches have more rights that protect them from losing money, which come at the expense of more junior tranches and the equity holders. Investors who want to avoid losses and are willing to accept lower rates of return buy the senior most debt tranches. Junior tranches and the equity holders take on more risk, but enjoy higher returns. A sample CLO structure is shown below.

Sample Collateralized Loan Obligation (CLO) Structure

Source: Matt Darrah's investment newsletter, March 25, 2010.

When the loans that the CLO holds perform according to plan, the assets generate enough cash flow to pay the required interest on the CLO’s debt (senior, mezzanine, and subordinated notes) with the remaining cash flow being distributed to the equity holders.

As I said before, investors buying the senior tranches of debt first and foremost want their principal to be safe, and require that various tests are met to protect their cash flows when the loans do not generate the amount of cash flow planned. Two basic tests protect investors in these senior tranches: the overcollateralization test (O/C) and the interest proceeds (I/C) test. The O/C test measures the par value of leveraged loans to liabilities, but deducts certain assets from being used for the purposes of the test. Types of excluded assets primarily include loans that are rated below a certain level by S&P and/or Moody’s. The I/C test evaluates available interest received from the CLO’s assets to make interest payments on the debt issued by the CLO. CLOs are typically designed to first violate the O/C test during times of distress.

When a CLO violates one of these tests, it begins to “trap cash”. Trapping cash means that the CLO stops distributing any cash to the equity and/or other junior debt tranches and begins to pay down senior notes on an accelerated basis. Paying down debt helps bring the CLO back into compliance, as lower debt levels mean that both ratios will improve as the qualified assets in the CLO will have to cover less debt, and there will be less interest burden on the CLO.

During the recent credit crisis, many CLOs violated these tests and thus began trapping cash. Investors who held the equity tranches of these CLOs stopped receiving payments as a result. In response, many of these investors began to trying to fire sell the CLO equity tranches, resulting in lower market prices for such assets.

TFG only invests in the equity tranches of CLOs, and thus has been severely impacted by the credit crisis.

However, TFG has performed better than many of its peers in terms of several key metrics including: (i) Loan Default Rates (% of loans that are not in compliance with their loan agreements), (ii) CLOs tripping an O/C or I/C test, and (ii) % of loans rated at CCC+ or lower by the rating agencies. This strong performance results from management’s selection of seasoned CLO managers who were able to better weather the financial crisis.

Tetragon Portfolio Outperformance vs. Market on Key Metrics

Source: Matt Darrah's investment newsletter, March 25, 2010.

Valuation

Asset-Based Valuation

As of February 28th 2010, TFG held 68 CLO investments that management valued at $707MM. Additionally, the Company held $163MM of cash. Adding the CLOs and the cash together and subtracting out TFG’s $13MM of liabilities results in a total value of $857MM or $6.91 per share.

Four major assumptions determine the value of a CLO: (i) default rate, (ii) recovery rate (% of par that the CLO will receive in final satisfaction of the claims on a defaulted loan), (iii) prepayment rate (% of loans repaid each year), (iv) reinvestment price (% of par the CLO is able to invest money it receives from prepayments), and (v) the discount rate used to value the cash flows resulting from assumptions (i) – (iv).

In my opinion, TFG uses appropriate assumptions to value the portfolio. Below is a summary of these assumptions.

Portfolio Valuation Assumptions Used by Tetragon

Source: Matt Darrah's investment newsletter, March 25, 2010.

The 6.4% default rate approximates the Company’s current default rate, and assumes that will continue for two years. I believe this is unlikely unless there is a severe double dip recession. The default rate averages 2.4% for levered loans, so 2.1% appears to be an adequate assumption after 2011 given the draconian 6.4% assumption in 2011.

In 2009, recovery rates averaged ~40%, compared to the Company’s 55% assumption for 2010 and 2011. I would expect recovery rates to increase more towards their 75% historical levels as the economy improves, and thus I think assuming 55% for 2010 may be too aggressive, but is offset by the fact that recovery rates will likely be higher in 2011. The 71% recovery rate in 2012 and beyond seems reasonable given the historical 75% recovery rate.

Prepayment rates currently average 14.3%, compared to the assumed 7.5%. A higher prepayment rate results in a higher valuation, as TFG is able to buy loans at today’s attractive prices. Prepayments averaged 40% from 1997 – 2009 versus 20% assumed in TFG’s model after 2011. I expect that the 20% prepayment rate can be achieved, as the high yield markets were not available to issuers during part of 2009, and thus the 2009 prepayment rates are understated. Note that many companies issued high yield bonds to repay their bank loans during 2009.

TFG’s assumed reinvestment rate of 87% in ’10 & ’11 seems a little aggressive, but based on conversations with management, I believe that the lower value resulting from reinvesting at current market prices is offset by the higher current prepayment rates discussed above.

Further, the management team is essentially discounting these cash flows at 30% with a special balance sheet reserve called an Accelerated Loss Reserve (“ALR”). I believe a 30% discount rate represents an appropriate required return on risky CLO equity tranches. However, note the market values the Company’s holding at 51% of the value determined by this model, which means the market is implying a much larger discount rate than 30%. Such a large discount rate gives me comfort that even if the assumptions described above are not met, my investment will not be impaired.

Note that while management chooses the assumptions to place in the valuation models, they must use standardized models produced by Wall Street Analytics to value each CLO investment owned, so management cannot manipulate the model beyond the assumptions they place in the model. KPMG audits the valuation and State Street, the fund’s administrator, reviews the valuations too.

Cash Flow Based Valuation

Despite the fact that 42% of TFG’s CLO investments trapped cash at the worst points of 2009, the Company’s investments still generated $109MM of cash net investment income in 2009. This level of cash flow implies that TFG trades at 3.3x 2009 cash flow.

Summary of Cash Flow-Based Valuation Analysis

Source: Matt Darrah's investment newsletter, March 25, 2010.

Bear in mind that the Company has experienced a number of the CLOs that were trapping cash earlier in 2009 start to distribute cash to equity holders again. I believe that this trend will continue as the CLOs repay senior debt tranches to bring themselves back in compliance, and thus the normalized cash flow of this business is likely much higher than 2009 levels.

Positive Trend among Cash-Trapping CLOs

Source: Matt Darrah's investment newsletter, March 25, 2010.

Further, TFG will redeploy repaid loans at much higher interest rates given the current favorable market environment for investing in loans. Note that CLOs get to keep their historically low interest rates on debt tranches that were negotiated in 2007, which is very attractive to the equity holders.

Key Risks

A couple key risks could undermine my investment thesis. I believe they are primarily mitigated by the low valuation outlined above, but I will list other mitigating factors too.

Mark to Model Valuation

TFG uses a model based valuation technique that I cannot independently verify. However, I gain comfort that I am buying these assets at 51% of purported fair market value and 3.3x cash flow (note that the level of cash flow gives me some comfort that the assets are fairly valued).

Management Incentives Not Aligned with Long-Term Shareholders

A third-party asset management company, Polygon Credit, makes investing decisions for TFG, and receives a 1.5% base management fee on assets under management, and 25% of the fair value increase above a nominal hurdle rate each quarter. Unfortunately, the management agreement does not contain a “high water mark” clause. The lack of this clause means that despite the fact that TFG’s assets have been tremendously written down, the Polygon Credit will still able to collect a performance fee when fair market value goes up in a single quarter. To give you an example of how this could be used to harm shareholders, Polygon could write down the assets to $1 by using very draconian assumptions about default, recovery, prepayment, and reinvestment rates, and then collect 25% of any valued it received above $1. Moreover, Polygon could simply continue this revaluation every other quarter to continual pick the shareholders’ pocket.

While I believe that the fee arrangement is outrageous, I don’t believe management is performing such tricks, nor do I believe that they will due to the oversight from their auditors and the lack of a historical tendency to do so. When few buyers existed for CLO equity in Q1 2009, TFG could have easily written the portfolio down to $150MM - $300MM based on the few comparable transactions completed in the market. Instead, the Company recorded the assets at $615MM, which seems much more realistic based on trailing cash flows received by the portfolio.

Further, this conflict does reduce the likelihood that management is inflating its mark to model valuations.

Potential Catalysts

Share buybacks and Dividends

TFG has been buying back shares below asset value at a rate of ~500k shares per month. Since TFG buys the shares below asset value, the purchases enhance the stock’s value. The Company recently declared a $0.03 per share dividend for Q1 2010, which implies an annualized dividend
yield of ~3%.

Recent Acquisitions

TFG recently purchased CLO equity assets with a $39MM cost basis and a strong manager of $2.5Bn of CLO assets for only $3MM. Acquiring assets at these attractive prices appears very accretive, but perhaps more importantly, the acquisition adds a CLO manager to TFG’s cash flow stream. Asset managers are much more stable generators of cash flow, as they collect fees on assets under management instead of being exposed to the volatility of asset values. Given that the Company
owns the majority of the equity in many of its CLO investments, I wouldn’t be surprised if TFG begins replacing underperforming CLO managers with its newly acquired one (who according to management is one of its top CLO managers in terms of performance through the credit crisis), which could provide a new, robust stream of steady cash flows.

The author of this article is Matt Darrah, Chief Investment Officer of MD Capital Management and contributor to The Manual of Ideas. Matt describes his background as follows: "I have been investing since 1998 (age 16) when I saved nearly all my money from working on my winter break from high school, and invested it according to the value investing principles I had read about in Warren Buffett’s shareholder letters and books about value investing. After high school, I attended Southern Methodist University (SMU) in Dallas, Texas, where I graduated summa cum laude with a degree in finance. Post graduation, I worked in investment banking for two years (helping companies raise financing, buy other businesses or sell their businesses) before joining a private equity and debt investment firm, where I have worked for three years. My investing philosophy has been developed through my (i) insatiable reading of books written by and about prominent value investors and their investment philosophy, (ii) 11 years of public market investment experience and (iii) three years of private equity experience, where I have invested and/or manage over $625MM of investments in 6 companies."

Posted by manualofideas at 06:19 PM | Permalink | Comments (0)

Middleburg Financial Corporation is a small bank holding company with primary operations in the western suburbs of Washington D.C.  The bank’s headquarters are in Middleburg, Virginia. Over the past two years, David Sokol has accumulated nearly twenty percent of the bank’s outstanding shares in his personal accounts.  Mr. Sokol is Chairman of MidAmerican Energy Holdings and Chairman and CEO of NetJets, both of which are subsidiaries of Berkshire Hathaway.  Since Mr. Sokol is often mentioned as a potential future CEO of Berkshire Hathaway and would be responsible for allocation of capital, we found it interesting to learn of his significant personal investment in Middleburg Financial and decided to take a closer look.

Middleburg:  The Heart of Virginia Hunt Country

Middleburg is located at the southern edge of Loudoun County, one of the most affluent counties in the United States in terms of median household incomes.  Middleburg Bank’s main market is on the outer periphery of the Washington metropolitan area in the heart of Virginia’s Hunt Country.  Based on personal observations, this is a region characterized by idyllic rural settings mixed with the advance of suburban sprawl during the housing boom.  The region has not been spared the impact of the housing crash but recent trends indicate overall stabilization.  The area has the advantage of being within commuting distance of the Washington job market which has benefited from the growth of the Federal government.

Brief Profile

Middleburg Bank has offered banking products and services to the surrounding area since it was founded in 1924.  The bank operates seven full service financial centers and two limited service facilities.  The bank serves Loudoun, Fairfax, and Fauquier counties and has plans to add a full service financial center in neighboring Prince William County later this year.  Middleburg Bank owns a 57 percent interest in Southern Trust Mortgage, a regional mortgage lender headquartered in Virginia Beach.  Starting in 2008, Middleburg Bank consolidated the operations of Southern Trust in the bank’s financial statements.

Middleburg Investment Group is a non-bank holding company subsidiary which primarily operates in the Richmond, Virginia area under its Middleburg Trust subsidiary.  Middleburg Trust offers investment and wealth management services as well as fee based investment management services for clients.

Financial History

The ten year financial history of Middleburg Financial shows a steady record characterized by attractive returns on equity and assets until 2006.  Starting in 2007, the company ran into trouble and key metrics deteriorated significantly.  The company had to take a $5 million goodwill impairment on its investment in Southern Trust Mortgage during 2007.  During 2008 and 2009, provisions for loan losses increased compared to prior years.  While the bank remained profitable, return on equity declined to the 3 to 4 percent range from low teen levels that prevailed from 2004 to 2006.  A summary of key statistics for the past ten years appears below (click on the image for a larger view):

In January 2009, the company agreed to accept $22 million in TARP funds through an issue of preferred stock.  In December 2009, the company redeemed the preferred stock although the Federal government still holds warrants to purchase 104,101 common shares at a price of $15.85 per share.  So far, the story regarding TARP is probably similar to many other  small banks in the United States.  However, the manner in which the company raised funds to repay the TARP money is where the story gets interesting.

Sokol’s Investments in Middleburg Financial

From our review of S.E.C. filings, David Sokol first reported a position in Middleburg Financial on November 20, 2008 when he reported ownership of 227,000 shares.  On March 31, 2009, Mr. Sokol entered into an agreement with the company to invest $5 million to acquire 454,545 shares at a price of $11 per share.  Between March 31 and June 2, Mr. Sokol increased his ownership again.  This was followed by market purchases in July and early August.  On February 24, 2010, Mr. Sokol purchased an additional 400,000 shares at $12.75 per share.  He now owns 1,375,792 shares, or approximately 19.9 percent of the common stock.

The table below shows a listing of Mr. Sokol’s activities in Middleburg Financial in recent months:

Mr. Sokol is the largest shareholder by far and owns a stake worth approximately $19.3 million based on today’s closing stock price.  In addition to the $5 million raised from Mr. Sokol in March 2009, the bank also issued additional shares in August 2009 resulting in net proceeds of $19.3 million.  These funds were used to repay the TARP funds in December 2009.

What Drove Sokol’s Decision?

There appear to be no records of any public comment by Mr. Sokol regarding his ownership of the company so some element of speculation is required to determine why he became interested in the company.  From a review of the financial statements and through compiling a ten year history, it seems clear that Middleburg Financial enjoyed a strong franchise during the early part of the last decade in which traditional metrics used to value a bank (such as return on assets and return on equity) were very favorable.  The bank was able to grow deposits at a satisfactory rate and maintained solid net interest margins.  For parts of this timeframe, the bank’s common stock traded well in excess of two times book value.

Community banks like Middleburg did not take many of the risks that ended up sinking larger banks.  We can see that the bank has experienced higher loss provisions but has maintained profitability and, after the equity raises, has capital ratios that are far in excess of regulatory standards.  The cost has been significant dilution particularly over the past year.

There does not appear to be any near term catalyst to return the bank to peak profitability.  In the latest 10-K report for the year ending December 31, 2009, management indicates that net interest margins will likely contract in 2010 and it appears that expansion will prevent net non-interest expense from declining.  One positive factor will be the retirement of the preferred stock which depressed net income available to common shareholders during 2009.

In the long run, if the bank can return to a 10% return on equity, it could earn $10 million, or $1.45 per share.  This could result in a stock price of $15 to $20 depending on the multiple that is used.  However, scenarios in which earnings per share approach this level appear to be at least a couple of years away.  On a more favorable note, at a recent price near $14, Middleburg Financial trades only slightly above tangible book value and far below the typical multiples of book value that prevailed during the last decade.

What led to Mr. Sokol’s decision to personally invest such a substantial sum in this bank?  Obviously, we cannot know for sure but a few observations are quite interesting:

1. At the time of his $5 million investment on March 31, 2009, stock markets were at very depressed levels and it would have been possible to purchase any number of other securities at low prices.  For example, an investor could have purchased Wells Fargo at around $14.
2. Berkshire Hathaway was trading around $87,000.  Presumably investing in Berkshire was an alternative.
3. The S&P 500 traded around 800.
4. It is doubtful that an investment of this magnitude in a small illiquid bank would be intended either for a short term investment or in anticipation of a small gain.  The nature of the investment and the level of risk assumed would indicate that high expectations for long term returns existed.

All of these factors lead us to believe that there are forces at work within Middleburg Financial that could result in significant long term value creation that will eventually be reflected in the common stock price.  Watching this situation play out over the next few years will be interesting in terms of trying to gain insight into the capital allocation decisions of a potential future CEO at Berkshire Hathaway.

For a spreadsheet with data on Middleburg Financial along with links to S.E.C. filings, please click on this link.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author does not own shares of Middleburg Financial.

Posted by manualofideas at 04:21 PM | Permalink | Comments (2)

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In a guest post yesterday on the excellent Greenbackd blog, S. Raj Rajagopal made a case for shorting Berkshire Hathaway and followed up later with more details regarding valuation.  Mr. Rajagopal is an MBA student at Cornell and has work experience in the investment field.  It takes a great deal of courage to make a public case for shorting Berkshire given the company’s long history and loyal shareholder base.  We often discuss  psychological tendencies that harm investors and one such tendency is to dismiss opposing points of view without critical examination.  Mr. Rajagopal’s case deserves such examination before rendering a judgment.

“Adoration is not an investment strategy”

Mr. Rajagopal bases much of his initial post not on quantitative evidence but on the premise that adoration for Warren Buffett is not an investment strategy.  On this point he is clearly correct.  It makes no sense to simply purchase Berkshire Hathaway because of Warren Buffett’s track record.  Obviously some buyers of Berkshire stock make their decision purely based on Mr. Buffett’s track record.  However, any sophisticated investor understands that you do not purchase a security simply based on folksiness or admiration for a grandfatherly character. If Mr. Rajagopal intended his short case to be read by professionals, he begins with an obvious straw man argument.

Bailout Obsession

Having presented this initial warning against backward looking thinking, it is ironic that much of the rest of Mr. Rajagopal’s thesis simply looks at the past in an attempt to forecast the future without providing any substantial quantitative evidence.  For example, several slides in the initial presentation are devoted to Mr. Buffett’s investments in companies that were in financial distress in 2008.  Much is made of Mr. Buffett’s letter to Treasury Secretary Hank Paulson offering to help construct an investment fund partly using $100 million of Mr. Buffett’s own personal fortune outside Berkshire Hathaway.  Of course, Mr. Buffett’s offer was never acted upon by Treasury.

Mr. Rajagopal goes on to lambast Berkshire as a “bailout baby” simply because Berkshire took large positions in companies that were in financial distress and then allegedly manipulated the political process to stack the deck in favor of Berkshire.  Mr. Buffett received numerous phone calls throughout the financial crisis with offers to invest in distressed firms at very attractive prices.  Should he have ignored such opportunities?  How is Mr. Buffett a “welfare queen” (why not a “bailout king”?) based on investments in which Berkshire’s capital was clearly at risk of loss and actually helped provide the votes of confidence that stabilized the system?  None of this is clear from the presentation.

Incorrect Reading of Buffett’s Statement on Berkshire Valuation

Mr. Rajagopal completely fails to interpret Mr. Buffett’s recent statements on Berkshire’s valuation and claims that the “Oracle of Omaha says Berkshire is overvalued now”.  This is obviously not the case.  As we pointed out in January, Mr. Buffett actually stated that Berkshire was undervalued at the time based on its historical relationship to book value and in his latest letter to shareholders, Mr. Buffett explains his rationale regarding using stock for the Burlington acquisition in great detail.  Berkshire’s stock price has advanced since the conclusion of the Burlington acquisition but Mr. Buffett has made no further comments to support Mr. Rajagopal’s claim that he believes the stock to be “overvalued now”.

Derivatives:  Ticking Time Bombs?

Mr. Rajagopal directly calls Mr. Buffett a “hypocrite” for warning about derivatives in 2002 and then investing in derivatives for Berkshire’s account.  It does not appear that Mr. Rajagopal has any grasp of the nature of Berkshire’s derivatives exposure and he offers no substantiation whatsoever for referring to the derivatives as ticking time bombs.  We discussed the misunderstandings related to Berkshire’s derivatives over a year ago and suggest that Mr. Rajagopal review the article or numerous others which explain the nature of these instruments in detail.

Filling Buffett and Munger’s Shoes

Mr. Rajagopal notes that male life expectancy in the United States is 74 years but does not point out that this is life expectancy at birth.  Mr. Buffett is 79 years old and has an actuarial life expectancy of over eight years.  Mr. Munger is 86 years old and has an actuarial life expectancy of over five years.

At the top of his slide he has a subtitle reading:  “David ‘who’ Sokol” in an apparent reference to Mr. Sokol being one of the more frequently cited candidates for CEO at Berkshire.  It is unfortunate that Mr. Rajagopal has decided that Mr. Sokol is unworthy and we would suggest a review of Pleased But Not Satisfied as a good starting point for Mr. Rajagopal to educate himself on one of Mr. Buffett’s potential successors.

Mr. Rajagopal seems to also have issues with the Burlington acquisition which we have discussed here frequently over the past three months.  However, he provides no valuation information and simply comes up with an “inevitable conclusion” that Mr. Buffett is seeking to “protect his franchise with a mammoth acquisition” prior to handing over the reins.  We are also told that “volatility” will increase due to S&P 500 inclusion and the stock split which will cause Berkshire to become a “volatile middle aged and mature stock”.

Seriously Flawed Valuation Model

After facing a barrage of criticism regarding his initial case for shorting Berkshire, Mr. Rajagopal produced a follow up post with his valuation model.  Unfortunately, the valuation only reinforces the impression that Mr. Rajagopal does not understand Berkshire Hathaway.  The following problems were noted in the model:

1. Earnings per share are used in the valuation model even though reported earnings per share for Berkshire are inadequate for judging progress in intrinsic value on a year to year basis because of the volatility to earnings caused by the timing of capital gains and losses as well as the mark to market requirements for the derivatives book.  In addition, many of Berkshire’s publicly traded holdings have earnings far in excess of paid dividends and Berkshire’s share of such earnings are not reported in Berkshire’s earnings figures.
2. Projections for earnings per share going forward are based on an average of the past five years in reported earnings growth which is purely backward looking and fails to take into account any of the drivers of reported earnings that have changed in recent years (purchase of high yielding securities such as the Goldman Sachs and GE Preferreds, acquisition of BNSF, etc).
3. Book Value progress each year is apparently calculated by adding starting year book value to earnings for the year which fails to account for any changes in book value associated with unrealized gains in Berkshire’s portfolio of publicly traded securities.
4. The model uses a 9% discount rate even though the “notes” section states that an 8% rate will be used.  This has a material long term impact on the valuation.  Neither the 8% or 9% rate is ever justified.
5. Target ROE is set at 10% “since BRK is so big” which is an inadequate explanation of a key variable used in the valuation.
6. The model produces prices at a discount to book value but no explanation is provided regarding what element of goodwill is impaired or why Berkshire would trade at a discount to book value which would be unprecedented.
7. The model mysteriously produces declining valuations for Berkshire after 2016 even though book value continues to grow.  At 2021, we have an absurd calculation of an $84 valuation along with an estimate of $209 of book value leading us to believe that Mr. Rajagopal believes that Berkshire’s price to book value will shrink to 0.40 over the next ten years.

It is difficult to know what to make of Mr. Rajagopal’s short thesis in light of the obvious flaws in both the original presentation and the follow up valuation model.  It took some courage for Mr. Rajagopal to offer a short case for Berkshire but unfortunately he completely failed to justify his thesis.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Posted by manualofideas at 12:13 PM | Permalink | Comments (0)

Last month, we posted Matt Darrah's cautionary thesis on Bunge (BG) and the month before we published his long case for Corporate Executive Board (EXBD). This month, Matt looks at KHD Humboldt Wedag, which recently announced an intention to split into two companies in order to highlight the value of its key assets. You can read the original announcement, dated January 6th, here, and an update, dated March 4th, here. Upon completing his primary research on KHD, Matt decided to take no action on KHD. In the following write-up, Matt explains why he passed on KHD:

Introduction

This month’s recommendation is an example of a company I considered as a potential stock purchase, but ultimately decided not to buy. This stock may represent a compelling investment opportunity for some, but it doesn’t fit with my investment philosophy, so I decided to pass. Note that I do not believe investors should short sell the stock, as it may appreciate in price.

Company Overview

KHD is an industrial plant engineering and equipment supply company for the cement, coal, and minerals processing industries. Their products and services include plant design, equipment design and development, engineering services, and automation services. KHD operates in India, China, Russia, Germany, the Middle East, Australia, South Africa, and the United States.

Valuation

Most investors who like this stock point to its seemingly attractive valuation. KHD is valued at $419MM based on Wednesday’s stock price of $13.93, but the firm had $402MM of net cash as of September 30, 2009 (latest financial statements). Typically, an investor could look at this information, and say that he or she was purchasing KHD for $17MM ($419MM market capitalization less $402MM of cash). However, in this instance that analysis is incorrect.

When buying a stock, an investor should act as if he or she is buying the whole company. KHD has received ~$149MM of customer prepayments for future work. If an investor were buying the whole company, he or she would insist on keeping the cash necessary to complete requested work and not give the cash to the old owners. This business has historically generated ~6% profit margins (94% cost), so it will need almost all of the $149MM to service the business customers have prepaid. Adding that $149MM to the $419MM market capitalization while subtracting the $402MM of cash results in an investor buying the business for $166MM. I believe normalized cash flow is ~$34MM per year, and thus the Company is trading at a 20% FCF yield. Below I will explain why I do not find this free cash flow yield appealing enough to invest in KHD.

Increased Competitive Pressures

KDH faces increased competitive pressures from companies with capabilities that it does not currently possess. Companies such as Bechtel or Fluor can manage the entire construction of a cement plant, including the design and equipment supply. Increasingly, cement manufacturers use these companies to act as the primary contractors, relegating companies like KHD to a subcontractor role. Based on my calls to those familiar with the industry, companies like KHD are selected directly by clients only in order to reduce cost. Additionally, as a subcontractor, KHD faces price pressures from the primary contractor, as it does not have the direct client relationship. Despite the seemingly compelling free cash flow yield, this concern over competitive pressures leads me to doubt the long term sustainability of the KHD’s cash flow generating ability.

The author of this article is Matt Darrah, Chief Investment Officer of MD Capital Management and contributor to The Manual of Ideas. Matt describes his background as follows: "I have been investing since 1998 (age 16) when I saved nearly all my money from working on my winter break from high school, and invested it according to the value investing principles I had read about in Warren Buffett’s shareholder letters and books about value investing. After high school, I attended Southern Methodist University (SMU) in Dallas, Texas, where I graduated summa cum laude with a degree in finance. Post graduation, I worked in investment banking for two years (helping companies raise financing, buy other businesses or sell their businesses) before joining a private equity and debt investment firm, where I have worked for three years. My investing philosophy has been developed through my (i) insatiable reading of books written by and about prominent value investors and their investment philosophy, (ii) 11 years of public market investment experience and (iii) three years of private equity experience, where I have invested and/or manage over $625MM of investments in 6 companies."

Posted by manualofideas at 02:48 PM | Permalink | Comments (0)

Berkshire Hathaway’s 2010 Proxy Statement was released yesterday and much attention has been devoted to the low compensation provided to Warren Buffett and Charlie Munger.  Mr. Buffett’s total compensation remained at $175,000 which included $100,000 of salary and $75,000 in director’s fees from the Washington Post.  In addition, the company paid $344,490 for Mr. Buffett’s personal security during 2009.  Mr. Munger’s salary remained at $100,000.  Marc Hamburg, Berkshire’s Chief Financial Officer, received $874,750 in total compensation. The $100,000 salary for Mr. Buffett and Mr. Munger has remained constant for 29 years, during which time inflation has eroded over 60 percent of the purchasing power of a dollar.

Appropriate Alignment of Incentives Today …

According to Berkshire Hathaway’s Owner’s Manual, Mr. Buffett has over 98 percent of his net worth in Berkshire while Mr. Munger’s family has over 80 percent invested in the company.  Both men wish to set an example by ensuring that their fortunes move in lockstep with the results for investors:

Charlie and I cannot promise you results. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner. We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when our partners do and in exactly the same proportion. Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours.

As a result of this unique management philosophy and heavy ownership interest, it is hard to see how large salaries would do anything to enhance the alignment of incentives between Berkshire management and shareholders.  Mr. Buffett has stated on many occasions that he would happily pay Berkshire in exchange for running the company.  Berkshire shareholders are the big winners in this arrangement.  Mr. Buffett’s salary in 2009 amounted to approximately 11 cents per Class A share.

However, Berkshire’s Policy May Be Flawed …

When a company establishes a policy on executive compensation, the arrangement needs to codify principles that will apply regardless of who holds the top management position.  Policies should not be set up such that they work when applied to unique situations but fail to work in a broader context. Unfortunately, Berkshire’s overall policy on executive compensation may fall into this category.  Here is the policy statement from the proxy:

The Committee has established a policy that: (i) neither the profitability of Berkshire nor the market value of its stock are to be considered in the compensation of any executive officer; and (ii) all compensation paid to executive officers of Berkshire be deductible under Internal Revenue Code Section 162(m). Under the Committee’s compensation policy, Berkshire does not grant stock options to executive officers. The Committee has delegated to Mr. Buffett the responsibility for setting the compensation of Mr. Hamburg, Berkshire’s Senior Vice President/Chief Financial Officer.

Based on the wording of this policy, it seems like it is intended to apply over the long run, which means it will apply to Mr. Buffett’s successor as Chief Executive Officer.  The policy is indicating that the executive officers cannot be paid in a manner that is based on profitability of Berkshire or the market value of the stock.  Accordingly, stock options are not granted to executive officers.

The obvious question is how the Board intends to align the incentives of the next CEO with the interests of shareholders if they will not take into account company profitability or even the long term share price.  What will the overall compensation philosophy look like and what performance metrics will be used to set salary and bonus compensation?  These are legitimate questions that are not adequately answered in the current policy on executive compensation and require clarification.

The next CEO at Berkshire is very likely going to be someone who is motivated by a desire to follow in Mr. Buffett’s footsteps and to continue his legacy.  Money may not be a driving factor since the successor is almost certain to be independently wealthy already.  However, the next CEO is not going to have nearly as much of an ownership interest in Berkshire compared to Mr. Buffett and therefore it is necessary to formalize a compensation system that provides monetary incentives that are aligned with shareholder interests. Furthermore, this should be done while Mr. Buffett is running the company and can provide his “stamp of approval” since any successor who seeks a change is likely to encounter substantial criticism when proposing any changes to policies that applied under Mr. Buffett.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Posted by manualofideas at 04:25 PM | Permalink | Comments (0)

Toyota (TM) is currently engaged in a recall of certain car models totaling in excess of eight million vehicles worldwide. The recall campaigns address problems related to the accelerator pedal. To put the size of the recall into perspective, Toyota sold 6.7 million vehicles worldwide in the trailing twelve months. While direct recall costs could be in the billions of dollars, lost sales due to brand damage may “cost” far more.

As the majority of recalls have been in the U.S., American media and politicians have weighed in heavily on the company. Amid a lot of noise, we offer three observations:

1) Massive recalls not uncommon in auto industry: At one point or another, nearly every major brand has had to deal with product recalls. Ford, for example, recently completed a series of recalls affecting 10+ million vehicles. General Motors just this week announced it will conduct a safety recall of 1.3 million cars. While this is no consolation to the people directly affected, as investors we are well-advised to consider the big picture. Recalls are a part of the automotive industry. The irony is that the current focus on Toyota likely makes their new cars the safest around.

2) The political factor: It is hard not to consider politics as a major factor shaping the Toyota debate in the U.S. Toyota has nearly doubled U.S. market share from 9% in 2000 to 17% in 2009. This has been largely at the expense of General Motors, Chrysler and Ford (F). With the U.S. government a significant owner of the former two companies, the objectivity of congressional investigations into Toyota may be compromised. Media hype does not help. Neither does the fact that the industry remains in one of its most severe downturns, with GM and Chrysler briefly undergoing bankruptcy procedures last year. The issue, however, is compounded by the fact that Toyota is also a big employer in the U.S. As all politics is ultimately local, it will be interesting to observe congressmen opinions relative to the presence of "domestic" companies versus Toyota in their respective congressional district or state. Although politics always introduces an element of uncertainty, end-customers are likely to be the ultimate arbiters of the future presence of Toyota on the U.S. market.

3) The price of growth: "Quite frankly, I fear the pace at which we have grown may have been too quick." These are the words of Akio Toyoda, Toyota's President and grandson of the company founder, as part of his testimony to House Committee on Oversight and Government Reform. The testimony is an interesting read, as it highlights the response to a major problem by a world-class organization such as Toyota. In the wider context, it is instructive to pause and contemplate the implications for other fast-growing companies. Investors often are willing to pay high multiples for nominal growth without considering the costs of growth. Be it genetically-modified food or asset management, growth at the expense of human health/returns most likely won't generate value in the long-term.

The Manual of Ideas will profile Toyota in addition to 20+ other companies in the forthcoming monthly issue of Portfolio Manager's Review. Subscribe to Portfolio Manager's Review today.

Disclosure: No position.

Posted by manualofideas4 at 09:55 AM | Permalink | Comments (0)

Edward Lampert, Founder of ESL Investments and Chairman of Sears Holdings Corporation, has released his annual letter to shareholders.  Mr. Lampert’s investment style has often been compared to Warren Buffett’s approach particularly when it comes to capital allocation.  While many companies fail to adhere to disciplined capital allocation practices, Sears has taken a more intelligent approach.

Maintenance vs. Expansion Capital Expenditures

Mr. Lampert has been criticized for failing to make the necessary investments to keep Sears and K-Mart stores competitive.  Personal experience and anecdotal evidence does suggest that Sears Holdings retail properties are not necessarily the most modern facilities in many locations.  However, this fact alone does not automatically justify blindly committing funds to expansion or improvements beyond “maintenance” levels of capital expenditures:

I have written previously about what I believed was the reckless expansion of retail space leading to lower profitability for many retailers and to low or negative returns on the investment required to expand space. In other industries, consolidation rather than expansion has led to a more sensible competitive environment and better returns for shareholders. If you examine the level of capital expenditures over the past decade at many large retailers and compare that expenditure to value created, it would not paint a pretty picture.

Additionally, the dramatic declines in capital expenditures over the past couple of years at most large retailers are strong evidence that the level of maintenance capital expenditures for a big box retailer is materially below what many analysts and experts previously believed. Most of the capital spent over the past decade has been largely for store expansion, with some lesser amount required for maintaining existing stores.

The cost of updating or expanding properties must be weighed against the best possible alternative uses for the funds such as improving Sears’ strongest brands like Kenmore and Craftsman or authorizing share repurchases:

While we continued to repurchase shares during the economic crisis because the value was attractive and because we had significantly lower leverage than others in our industry, many of our competitors suspended their repurchase programs to appease credit rating agencies only to resume them again after their share prices recovered significantly.

Mr. Lampert also criticizes ratings agencies for simplistic analyses that automatically favor capital investment to share repurchases ignoring the fact that capital investment at negative rates of return can end up harming bondholders as well as stockholders.

Owner Orientation

While many executives only pay lip service to “shareholder value” and “management alignment with shareholder interests”, Mr. Lampert’s record and ownership interest in Sears Holdings serves to back up his claims.

We do some things differently than others, and we have certain beliefs that differ from theirs. Our culture is owner-oriented, because we have owners who serve on the board that governs the company. We believe that ownership makes a difference, especially when owners have significant financial interests in the company and a long-term perspective. Instead of this raising concern, rating agencies should welcome and value owners with a demonstrated track record of long-term value creation and conservative capital policies, even when some of the capital allocation preferences differ from those that others believe lead to higher long-term credit performance.

This is the type of owner orientation that makes it preferable to repurchase shares rather than plowing funds into capital expenditures at negative rates of return even though doing the latter is more popular within any organization in the short run and also will win the praises of local community leaders at ribbon cutting events.  The problem with companies that pursue popularity rather than intelligent capital allocation is that eventually the day of reckoning will arrive and the music will stop.

Regulation and Politics

Wading into more controversial topics, Mr. Lampert is critical of policies that may over-regulate the economy by placing government bureaucrats in place of private sector capital allocators when it comes to sustaining an economic recovery.  In terms of financial regulation, Mr. Lampert advocates the removal of the implicit “too big to fail” guarantee which would level the playing field.  However, it is unclear how the government can remove the “too big to fail” perception without some form of regulation to constrain financial institutions from reaching the size and interconnectedness that makes government bailouts inevitable.

Capital can quickly reorganize and provide financing for businesses and projects that create value for our society, without the heavy hand of government planning and policy. I disagree with most people calling for a gigantic overhaul of our financial system led by new and “improved” regulations. Instead, begin the process of allowing more competition in financial services and begin the removal of implicit and explicit government guarantees that provide the perception that some are “too big to fail.” While there are those that claim that their institutions are not too big to fail, they surely recognize the significant competitive advantages that come from this perception. Of course they will accept regulations as long as these regulations do not permit additional competition from entities and institutions that do not take insured deposits, do not have access to Federal Reserve funding, and do not have government guarantees associated with their debt offerings. Regulatory capture comes when there is little competition allowed outside regulated entities and a “freezing” of competitors and innovation in an industry.

Mr. Lampert also protest the special treatment given to Amazon.com and other online retailers that are not required to collect sales and use tax in locations where they do not have a physical presence.  It is difficult to argue with the logic behind treating traditional retailers and online retailers in a uniform manner and the observation that current practices will prove unsustainable as more commerce shifts online.

The real story here is that it is not the payment of taxes or the charging of taxes that is at issue. It is the collection of taxes on behalf of local governments from purchasers of goods and services from stores in a locality or for use in such locality. It is the latter fact that is often ignored. A person who buys products from Amazon.com is required by law to pay sales or use tax to their local jurisdiction. In practice, almost nobody does so. The cost and unpopularity of enforcing such laws has allowed customers to avoid paying sales or use taxes, even though they are required in many states and localities. If you buy a work of art or piece of jewelry in NYC, for example, and have it shipped to New Jersey or California, the seller does not collect sales tax on that purchase but the buyer would be required to pay sales or use tax on the purchase where they receive the merchandise and use the merchandise. So, a piece of jewelry shipped to California would require the buyer to pay California sales or use tax.

Mr. Lampert recommends Thomas Sowell’s latest book Intellectuals and Society.  Although I have not kept up with Mr. Sowell’s work in recent years, I consider one of his previous books, The Vision of the Anointed, to be one of the best essays on the mentality that often drives the decisions of those in high positions of power.

Click on this link to read Edward Lampert’s full letter to Shareholders.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author does not own shares of Sears Holdings.

Posted by manualofideas at 01:58 PM | Permalink | Comments (0)

The Birmingham Business Journal has reported that Burlington Northern Santa Fe has purchased a 32 acre facility in Birmingham for $3 million.  The company is in the process of evaluating the facility for future expansion.  The site is a former pet food manufacturing facility and is located next to Burlington Northern’s existing intermodal facility.  The railroad has received requests from area businesses that are interested in expanded rail service.

Burlington Northern was acquired by Berkshire Hathaway in a deal that was finalized on February 12.  The purchase of the railroad was characterized by Berkshire Hathaway Chairman and CEO Warren Buffett as an “all-in wager on the economic future of the United States”.  The purchase price was not without controversy because it appeared to be a full price.  We recently made the case that the purchase may have been motivated by an intention to increase capital expenditures with Berkshire’s backing in order to pursue more rapid expansion.

While a $3 million purchase by Burlington Northern is hardly a large move and was probably planned prior to Berkshire’s offer for the company, the location of the expansion is notable because Birmingham is at the outer periphery of Burlington Northern’s route network.  In addition to Burlington Northern, Norfolk Southern and CSX Transportation have a significant presence in the city.  As one can see from Burlington Northern’s route network pictured below, expansion in Birmingham may lead to other interesting possible expansion activity in the deep South.

Click on the map or on this link for a more detailed set of BNSF Route Maps.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 11:56 AM | Permalink | Comments (0)

Swiss Re announced annual results for 2009 yesterday and declared that the measures taken in 2009 to rebuild the company’s capital base have been very effective.  In a letter to shareholders, Swiss Re Chairman Walter B. Kielholz and CEO Stefan Lippe made the following comments regarding the company’s capital position and intention to redeem the CHF 3 billion investment made by Berkshire Hathaway last year:

The measures we have taken to rebuild our capital base have proven to be very effective. In 2009, our capital position improved steadily quarter by quarter. At year end, estimated excess capital at AA level was more than CHF 9 billion. This means we are on schedule to meet our goal of redeeming the CHF 3 billion convertible perpetual capital instrument (CPCI) issued to Berkshire Hathaway.

We originally discussed the terms of Berkshire’s investment in March shortly after the terms of funding were announced, and revisited the status of the investment in January when J.P. Morgan analysts released a report stating that Swiss Re was on track to redeem the investment by June 2010.

Redemption Comes at a Stiff Price

The terms of the convertible perpetual capital instrument reflect the distress facing Swiss Re at the time the funding was provided.  With a 12% interest rate and the right to convert into common shares at CHF 25 (nearly 50 percent below today’s quotation) after the third anniversary of the investment, Berkshire secured highly favorable terms.

Swiss Re has the right to redeem the instrument, but at a stiff price.  Swiss Re must pay 140% of face value if the company elects to redeem the instrument prior to March 23, 2011 and at 120% of face value thereafter.  Barring a collapse in the price of Swiss Re common stock, is nearly certain that Swiss Re management would want to redeem prior to March 23, 2012 when Berkshire will have the right to convert into common shares.

From the shareholder letter referenced above, it appears that the J.P. Morgan analysts  were correct in forecasting a near term redemption of the instrument although Swiss Re management does not explicitly state the timing of redemption.

Other Business Ties

Berkshire Hathaway and Swiss Re have other business ties beyond the convertible instrument discussed in this article.  Berkshire entered into an agreement with Swiss Re in 2009 for a retroactive reinsurance policy for CHF 2 billion covering substantially all of Swiss Re’s non-life insurance losses for loss events occurring prior to January 1, 2009.  In addition, Berkshire has a 20% quota-share contract with Swiss Re covering substantially all of Swiss Re’s property/casualty risks incepting from January 1, 2008 and running through December 31, 2012.  Berkshire also owned 11,262,000 shares of Swiss Re common stock as of December 31, 2008.

Update:  February 19, 2010 @ 3pm

The Street.com and Reuters are reporting that Swiss Re CFO George Quinn indicated that the company will redeem the preferred convertible security in 2011.  Presumably, Swiss Re would want to wait until at least March 23, 2011 to pay 120% of face value rather than the 140% that would be required for redemption at an earlier date.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Disclosure:  The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 11:54 AM | Permalink | Comments (0)

By Ravi Nagarajan

Note to Readers:  The following essay is part of an introductory section of an upcoming analysis of Berkshire Hathaway to be published by The Rational Walk shortly after the 2009 Berkshire Hathaway Annual Report is released at the end of February.  The full analysis will be available for purchase as premium content with certain excerpts to be provided on The Rational Walk blog free of charge.

For a formatted PDF File of the following essay, please click on this link.

From Cigar Butts to Business Supermodels

There are numerous books and publications that provide detailed accounts of the history of Berkshire Hathaway as well as Warren Buffett’s life and career.  It is also impossible to fully understand Berkshire without studying the life and career of Vice Chairman Charles T. Munger.  A list of resources for those interested in a comprehensive history of the company and its leaders is provided as an appendix to this document (available in the forthcoming full analysis).  This section merely attempts to provide some context regarding the remarkable history of Berkshire Hathaway and Warren Buffett’s investment approach.

Warren Buffett’s Early Investment Philosophy

Warren Buffett’s early investment philosophy was largely based on the principles developed by Benjamin Graham.  Mr. Buffett has stated on many occasions[1] that his view of investing changed dramatically when he first read Mr. Graham’s book, The Intelligent Investor, in early 1950.  Up to that point, Mr. Buffett had read every book on investing available at the Omaha public library but none were as compelling as Mr. Graham’s straight forward approach summarized in the phrase: “Margin of Safety”.

Benjamin Graham’s approach is more fully documented in Security Analysis which, in contrast to The Intelligent Investor, is more targeted toward professional investors.  Mr. Graham’s approach involved examining securities from a quantitative perspective and making purchases only when downside risks are minimized.  This approach rarely involved speaking to management since doing so could adversely influence the analyst’s impartial view of the data.  In particular, Mr. Graham was a proponent of purchasing stocks selling well under “net-net current asset value” arrived at by taking a company’s current assets and subtracting all liabilities.  In such cases, the buyer was paying nothing for the business as a going concern and had some downside protection due to liquid assets far in excess of all liabilities.

Mr. Buffett was able to leverage the “deep value” approach advocated by Benjamin Graham throughout the 1950s.  In the five year period ending in 1961, the Buffett Partnerships trounced the Dow Jones Industrial average with a cumulative return of 251 percent compared to 74.3 percent for the Dow[2].  While Mr. Buffett employed multiple strategies, one approach involved finding companies that fit the “cigar butt” mold, meaning that they had “one puff left” and could be purchased at a deep bargain price.  This approach led Mr. Buffett to begin acquiring shares of Berkshire Hathaway, a struggling New England textile manufacturer, in late 1962. While Berkshire Hathaway was trading well under book value at the time, Mr. Buffett would later say that book value “considerably overstated” intrinsic value[3].

From Cigar Butts to Insurance

Berkshire Hathaway, as it existed in 1963 when the Buffett Partnership became the company’s largest shareholder, was a cheap company from a quantitative perspective but it was not a good company in terms of offering a business that had durable competitive advantages.  In fact, over the next two decades, Berkshire Hathaway continued to invest in the textile mills but would never gain sufficient traction to complete with overseas competitors with lower cost structures.  Textiles are a commodity business and the low price producer has the advantage.  In retrospect, Mr. Buffett’s purchase of Berkshire Hathaway was a mistake[4].

While Berkshire’s textile mills were doomed to eventual failure, a period of profitability[5] appeared in the mid to late 1960s that presented Mr. Buffett with a choice:  He could either reinvest the profits in the textile business or redeploy the funds elsewhere.  Above all else, Mr. Buffett is a master capital allocator.  He could see the troubles brewing in textiles and, despite attempts by Berkshire’s textile managers to obtain capital for new investments, Mr. Buffett chose to deploy the funds elsewhere.

Berkshire’s entry into the insurance business with the purchase of National Indemnity in 1967[6] was a transformational event for the company.  The textile business, despite a temporary period of profitability, required significant capital investments to continue to remain competitive.  In contrast, insurance operations that are well run generate significant cash in the form of “float”.  Float represents funds that are held by an insurance business between the time when policyholders submit payment and when funds are eventually paid out to settle claims.  As long as underwriting practices are sound, float represents a low cost means of funding investments.  By purchasing National Indemnity, Berkshire was on its way to transforming from a textile manufacturer consuming large amounts of capital at low to negative rates of return into an insurance powerhouse generating large amounts of float for investment in other businesses offering better prospects of high returns.

See’s Candies:  The Turning Point

Few Californians can recall a holiday season where See’s Candies were not a prominent part of the festivities.  The brand is so powerful in California and other western states that many consumers would never think of buying a competing product.  See’s Candies is a textbook example of a company with a formidable “moat”.  Such companies have built up brand identity that cannot be replicated by new entrants even with significant capital investments[7].

Berkshire Hathaway Vice Chairman Charles Munger has been widely credited with convincing Warren Buffett that there are certain situations where deviating from Benjamin Graham’s “deep value” approach can be justified.  Mr. Munger has rebutted[8] the notion that his influence was a deciding factor in Mr. Buffett’s overall record, but many accounts[9] of the events surrounding the See’s Candies purchase supports the conclusion that Charlie Munger deserves much credit for shifting Berkshire’s bias from cigar butts selling at a “bargain price” to excellent businesses selling at a “fair price”.

See’s Candies is the perfect example of a business that produces an excellent return on equity year after year but requires very little capital investment in order to sustain the “moat” that makes such returns possible.  When Berkshire purchased See’s Candies for $25 million in 1972, the company only had $8 million of net tangible assets.  However, See’s was earning approximately $2 million after tax at the time[10].   $17 million of the $25 million purchase price could not be accounted for by assets on See’s balance sheet but represented the value represented by intangible “brand equity”.

Over the first twenty years of Berkshire’s ownership of See’s Candies, sales increased from $29 million to $196 million while pre-tax profits grew from $4.2 million to $42.4 million.  However, that is not even the most amazing part of the story.  What is more remarkable is that Berkshire Hathaway only had to reinvest $18 million of retained earnings over that twenty year period while $410 million of cumulative pre-tax earnings were sent back to Berkshire for redeployment in other investments[11].

There have been many other key turning points in the history of Berkshire Hathaway but the decision to pay a “premium price” for See Candies in 1972 may best symbolize the transformation of Mr. Buffett’s approach toward investing.  This is perfectly summarized in Mr. Buffett’s 1992 Letter to Shareholders:

In my early days as a manager I, too, dated a few toads.  They were cheap dates – I’ve never been much of a sport – but my results matched those of acquirers who courted higher-priced toads.  I kissed and they croaked.

After several failures of this type, I finally remembered some useful advice I once got from a golf pro (who, like all pros who have had anything to do with my game, wishes to remain anonymous).  Said the pro:  “Practice doesn’t make perfect; practice makes permanent.”  And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.

Berkshire Hathaway is the company it is today because Mr. Buffett stopped kissing toads like the original Berkshire textile business and started aggressively pursuing supermodels like See’s Candies instead even if they were more “expensive dates”.  As we shall see, Berkshire has no shortage of supermodels today.

[1] For example, see Mr. Buffett’s preface to any recent edition of The Intelligent Investor.
[2] The Buffett Partnership track record is available in many publications.  See, for example, Roger Lowenstein’s Buffett: The Making of an American Capitalist, 1995 Hardcover Edition, Page 69.
[3] See comment in Berkshire Hathaway Owner’s Manual, Page 5.
[4] Mr. Buffett directly stated that buying Berkshire was a mistake in his 1989 letter to shareholders.
[5] See Lowenstein, Page 133.
[6] For a good history of the National Indemnity purchase, see Lowenstein, pages 133 to 135.
[7] For an excellent brief history of See’s Candies, see Max Olson’s paper entitled Quality without Compromise.
[8] See Mr. Munger’s statement in Poor Charlie’s Almanack, Third Edition, “Rebuttal:  Munger on Buffett”
[9] For example, see Alice Schroeder’s account of the See’s Candies purchase in Snowball:  Warren Buffett and the Business of Life, Chapter 34.
[10] See the appendix to Warren Buffett’s 1983 Letter to Shareholders.
[11] See Warren Buffett’s 1991 Letter to Shareholders.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Disclosure: The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 11:18 AM | Permalink | Comments (0)

Toyota’s recalls in recent weeks have attracted a predictable amount of attention given the number of impacted vehicles on the road.  Rarely a day goes by when Toyota’s latest woes are not reported on the front page of The Wall Street Journal and on television news reports.  For a company that has built its reputation on safety and dependability, the recalls are particularly damaging.

Building a Brand

It often takes decades for a company to build brand awareness and this is certainly the case for Toyota vehicles in the United States.  While the company has been in business since 1937, it was not associated with high quality until the 1980s.  In fact, the company’s cars were widely ridiculed during the 1960s and 1970s particularly by Detroit auto executives who considered the United States market to be “owned” by the Big Three.

In recent years, the Toyota Camry has often been the best selling passenger car in the United States.  Consumers who selected the Camry were not buying it for driving excitement but due to Toyota’s reputation for reliability and economy.  I purchased a 2003 Toyota Camry as a commuter car.  The vehicle had all the excitement of a common household appliance such as a toaster but it never let me down. (It should be noted that the 2003 Camry is not part of the recall.  I have since sold the Camry and purchased a Ford Mustang offering more “driving excitement”).

Decades to Build, Days to Destroy

Unfortunately, what can take decades to build up can be destroyed very quickly.  This is particularly true if problems are revealed that destroy the salient qualities of the brand.  In the case of Toyota, a recall related to safety and reliability harm the foundation of the brand.  This is not a peripheral quality issue such as a radio that breaks.  The problems, while very rare, are potentially life threatening.

From this perspective, the problems are not unlike the famous case study involving the Tylenol cyanide poisonings in 1983.  Johnson & Johnson’s response to the incident has been widely praised as the model for crisis management.  Indeed, the company’s prompt actions to prevent tampering in the future may have even strengthened the brand.

Of course, the main difference between the current Toyota recall and the Tylenol incident is that the car recall is likely due to a flaw in either Toyota’s engineering or the engineering of a sub-contractor rather than the result of criminal tampering.  This makes it even more critical for Toyota to take particularly forceful action to deal with the recall.

Toyota needs to rebuild the trust consumers used to have in its products.  Conducting a recall is the bare minimum required to rebuild that trust.  The company should consider taking additional steps to encourage consumers to stick with the brand.  This might include giving away free services to consumers to encourage people to bring in affected vehicles for timely recall repairs.  An extension of the factory warranty would also represent a forceful action.

Brands and Reputation are Fragile

Barron’s published an annual ranking of the world’s most respected companies this weekend.  Toyota ranked #6 on the list but the survey was completed prior to the recent recall announcements.  If the survey was taken again today, there is little doubt that Toyota’s ranking would fall.  However, the extent of that fall is something that management should be able to influence with prompt action.

From an investment perspective, Toyota’s troubles illustrate the importance of selecting management that will protect the value of a brand.  If one is paying for a significant amount of intangible assets when purchasing a business, it is critical to know that managers of the business are committed to protecting those assets.  The power of great brands is indisputable and it is often worth paying for intangible assets that  provide a business with a moat, but only if management can be trusted  to protect the asset.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author does not own shares of Toyota.

Posted by manualofideas at 12:00 AM | Permalink | Comments (0)

Andrew Frye of Bloomberg writes,

Matthew Rose, chief executive officer of railroad Burlington Northern Santa Fe Corp., welcomed Warren Buffett as his company’s new owner while showing analysts and hedge-fund managers the door.

Buffett’s Berkshire Hathaway Inc. completed the buyout yesterday after winning the approval of Burlington Northern investors. The deal, valued at $100 a share, allows Rose to hand out returns of nearly 300 percent, plus dividends, to investors who bought stock the day he was named CEO in 2000. The problem, he said, is that shareholders with that length of commitment are dwindling in number and influence.

"When I started as CEO 10 years ago, the typical investor had a time frame of three to five to seven years," Rose said in an interview. "Year-by-year, that’s gotten shorter."

The increased focus on short-term results, fueled by real- time media and quarterly analyst calls, can be a distraction for a railroad executive who needs to buy locomotives that run for 20 years and put down tracks that last for 40, Rose said.

Read the full Bloomberg article.

Posted by manualofideas at 12:00 AM | Permalink | Comments (0)

Want to know which countries are the major coffee growers? Or who imports the most potash? The interactive agriculture and fertilizer markets map courtesy of Potash Corp. (POT) provides global crop and fertilizer data in a visual and user-friendly way. Launch World Agriculture and Fertilizer Map.

During our research on leading agriculture-related companies including Potash Corp. and Monsanto (MON), we have come across many interesting facts about global agriculture. For example, did you know that the average yield per acre of planted corn is 157 bushels in the U.S. versus 35 in India? But even the developed countries of the European Union are at "just" 105 bushels per corn acre. There are certainly many factors that explain these differences in crop yield including: seed quality, fertilizer application, use of chemicals for weed and insect control, level of mechanization, and, of course, inherent land quality and other natural factors. So how do companies like Potash Corp. and Monsanto fit into all of this? Are they potentially good investments given the anticipated growth of the agriculture industry to meet rising food demand worldwide? We provide investment cases for Potash Corp. and Monsanto in the forthcoming monthly issue of Portfolio Manager's Review.

To get in-depth analysis on Potash Corp. and Monsanto (as well as 20+ additional, non-agriculture stocks), subscribe to Portfolio Manager's Review today.

Disclosure: No positions.

Posted by manualofideas4 at 09:30 AM | Permalink | Comments (0)

Last month, we posted Matt Darrah's investment case for Corporate Executive Board (EXBD). This month, Matt is back with a well-researched and thoughtful piece on farm products company Bunge (BG). Matt argues that the risks of owning Bunge outweigh any potential upside and that investors should be cautious about investing in the company.

Please note that The Manual of Ideas does not advocate short selling, as it is a risky strategy that can backfire and cause significant losses for investors, even if their thesis is proven correct in the long term. As such, we present Darrah's research piece in order to show you the investment risks that can sometimes be uncovered as a result of in-depth fundamental research. The Manual of Ideas has not verified the data and quotations presented in the following write-up and can therefore not vouch for their accuracy.

Executive Summary

• Low Return on Invested Capital: Total invested capital does not produce meaningful amounts of cash flow. BG operates in a highly competitive industry, where it cannot materially differentiate itself.
• Unattractive Valuation: Recent stock price implies less than 4% normalized free cash flow yield. The market seems to be ignoring Bunge’s lack of historical free cash flow generation.
• Numerous Potential Catalysts Could Drive Stock Price Lower: Multiple sources confirm Bunge has large and speculative derivative (future and options) holdings that could result in material losses. Accounting results do not reflect the economic realities of the business, and Wall Street will eventually figure this out. BG recently sold a key division to avoid a liquidity crisis.

Bunge Company Overview

Bunge Limited (“Bunge” or “BG”) engages in the agribusiness, fertilizer, and food business.

Bunge Business Segments (% of 2009 revenue)

Source: Matt Darrah's investment newsletter, January 2010.

Bunge’s Agribusiness segment (73% of 2009 revenue) purchases, stores, transports, processes, and sells agricultural commodities and commodity products. Bunge principally handles and/or processes oilseeds and grains. It primarily deals in soybeans, rapeseed (canola), sunflower seed, wheat, and corn. The division processes those oilseeds and grains into vegetable oils and protein meals, principally for the food and animal feed industries. This segment also processes sugar and corn into bio-fuels. The Agribusiness division’s main competitors are Archer Daniels Midland Co. (ADM), Cargill Incorporated, and Louis Dreyfus Group.

Bunge’s Edible Oil segment (15% of 2009 revenue) uses the soybean, sunflower, and rapeseed (canola) oil produced in its Agribusiness segment for packaged and bulk oils, shortenings, margarines, mayonnaise, and other products derived from the vegetable oil refining process. Bunge owns and/or operates edible oil refining and packaging facilities in North America, South America, Europe, and Asia. It sells retail edible oil products in Brazil under a number of brands, including Soya, which is the leading packaged vegetable oil brand. Bunge possesses the highest market share in the Brazilian margarine market with its brands Delicia and Primor. One brand, Bunge Pro, has become the top foodservice shortening brand in Brazil.

In Europe, Bunge leads the market in consumer packaged vegetable oils, which are sold in various geographies under brand names including Venusz, Floriol, Kujawski, Olek, Unisol, Ideal, and Oleina.

In Asia, Bunge’s primary edible oil product brands include Dalda and Chambal in India, and the Douweijia brand soybean oil in China. In several regions, Bunge also sells packaged edible oil products to grocery store chains for sale under those stores’ private labels. The Edible Oil Segment’s customers include baked goods companies, snack food producers, restaurant chains, foodservice distributors, and other food manufacturers who use vegetable oils and shortenings as inputs in their operations, as well as retail consumers. This division primarily competes with ADM, Cargill, Associated British Foods plc, Stratas Foods (a joint venture between ADM and Associated British Foods plc), Unilever, and Ventura Foods, LLC.

Bunge recently announced that it is selling the bulk of its fertilizer business for $3.5Bn of net proceeds, so I won’t be discussing this division in detail although I will discuss the implications of selling this division later in this report.

Also, given that the milling division only constitutes 3% of Bunge’s sales, I will not be discussing that division in detail.

Low Return on Invested Capital Business

While Bunge has consistently reported net income based on GAAP accounting principles, it has consistently burned cash. Bunge has reported combined net income for the past 3, 5, and 10 years of $2.1Bn, $3.1Bn, and $4.4Bn, respectively. However, free cash flow over those same time periods equaled negative $(708)MM, negative $(1.6)Bn, and negative $(2.5)Bn respectively. Note FCF has only been positive in two of the past ten years. Typically, over long periods of time, GAAP reported earnings should approximate free cash flow. Temporary differences can arise during periods when a company is growing rapidly and spending money on new property, plant, and equipment, or investing in working capital.

These temporary variances should tend to reverse over five and ten year periods. Prolonged differences between free cash flow and net income typically indicate that free cash flow is a more accurate indication of the true earnings power of the firm, which would indicate that Bunge earns less than a 3% return on invested capital. Even assuming that 70% of capital expenditures are growth related (based on management’s guidance), Bunge still generates below a 8% ROIC (see adj. FCF column below).

Bunge's Historical Return on Invested Capital (click to enlarge)

Source: Matt Darrah's investment newsletter, January 2010. 

Further, Bunge operates primarily in businesses with very small to no moats protecting its returns, as the processing of agricultural products does not require any proprietary knowledge, equipment, or processes, nor are any of its brands likely meaningful to consumers, as evidenced by their historically EBIT margins around 5%.

Unattractive Valuation

Based on GAAP earnings, Bunge doesn’t appear to be overvalued. As discussed above, given the large disparities between free cash flow and net income, its valuation should be based on historical free cash flow. Given the past three years of adjusted free cash flow (adjusted for estimated growth CapEx per the methodology described above), Bunge trades at 23x free cash flow. Basing valuation on unadjusted free cash flow (basically assuming management’s guidance on growth CapEx is unreliable), the last three years’ cumulative cash flow is negative.

It is important to note that the valuations metrics do not take into account the sale of the Fertilizer business, as the cash flow generated by the sale of those assets is still undisclosed. However, as I will discuss below, I believe that the sale of the fertilizer business will only serve to reduce Bunge’s free cash flow generating ability.

Valuation Based on Adjusted Net Income and Free Cash Flow (click to enlarge)

Source: Matt Darrah's investment newsletter, January 2010.  

Catalysts

Derivatives

Bunge has indicated that it only uses derivatives to hedge exposure to commodities cost, implying that they will not be impacted by fluctuations in the underlying cost of the commodity. For instance, Bunge may loan a farmer fertilizer and then receive payment of a fixed amount of soybeans once the farmer has harvested his crop. In order to protect itself from price declines prior to the harvest, Bunge would sell short the volume management expects to receive from the farmer. By doing so, if the price of soybeans declines, while Bunge waits for the harvest, the value Bunge receives from the farmer is less, but the Company has gained enough money to offset that loss with its short position.

However, based on interviews with traders familiar with Bunge’s trading operation, a former executive-level Bunge employee, and a knowledgeable former CFO of a competitor, Bunge operates a speculative trading operation. As the (not-disgruntled, in fact very supportive) former employee stated, "there is no way Bunge could make the margins it makes without some speculation." I also spoke with traders (again supportive) who are knowledgeable about Bunge’s trading operations who stated that Bunge is actively trading in futures contracts that do not necessarily conform to a hedging strategy (the traders could tell because the trades didn’t coincide with harvest seasons). Further, the former CFO of a competitor discussed the difficulties of managing such a hedging operation from an internal controls standpoint. Based on his knowledge of Bunge’s CFO’s background, he did not feel Bunge’s CFO adequately understood the potential loss exposure that could be incurred as a result of its derivative operations.

Unrepresentative Accounting

As previously stated, Bunge’s free cash doesn’t approximate their net income over long periods of time.

These types of discrepancies normally indicate that GAAP accounting does not accurately reflect the economics of the underlying business, and it may suggest fraudulent accounting. A former CFO of a competitor said that after pouring through Bunge’s financial statements, he could only come to the conclusion that "the books were cooked."

Additionally, Bunge’s financial disclosures reveal that management consistently does not reserve enough allowance for doubtful accounts on loans that Bunge makes to farmers. Loan contracts are difficult to enforce on farmers in Brazil, and according to interviews I conducted, most CFOs would reserve at least the full amount of any contract in litigation, as the likelihood of recovery is negligible. Further, a typical CFO would reserve above that amount to anticipate future defaults. However, while Bunge as of September 30th, 2009 is litigating ~$235MM of loans, it had only reserved $196MM at that time. Bear in mind that litigation usually is pursued as a last resort in most defaults, so defaults are likely much higher than $235MM.

Further, Bunge experienced two material breaches of internal controls that were disclosed in 2007. One resulted in a $7Bn revenue restatement, while the other resulted in a theft by several employees from its Peruvian division that resulted in a $34MM loss.

Sale of Fertilizer Business

Bunge recently sold its Brazilian fertilizer operations to Vale for $3.5Bn of net proceeds. While management and sell-side analysts have espoused numerous strategic rationales for why this division was sold, I believe the sale occurred because Bunge needed the cash, and this division was the most readily saleable asset. As shown below, Bunge needed to finance its money losing operations and redeem its preferred stock, which matures during 2010, and therefore had to sell assets. Interestingly, many analysts have noted that the division was sold below the replacement value of the assets, which implies Bunge was in a weak negotiating position, possibly the result of the cash need illustrated below.

Liquidity Bridge (click to enlarge)

Source: Matt Darrah's investment newsletter, January 2010.

Interestingly, Bunge had historically thought the fertilizer division was a growth business and spent large amounts of growth CapEx to improve it. The sale "really surprised" a former executive, as "that business generated a lot of cash…and was a nice grower." Note that the business was likely bleeding cash this year given lower fertilizer prices, but Bunge’s largest free cash flow generating year (2008) coincided with a large increase in fertilizer profits.

The author of this article is Matt Darrah, Chief Investment Officer of MD Capital Management and contributor to The Manual of Ideas. Matt describes his background as follows: "I have been investing since 1998 (age 16) when I saved nearly all my money from working on my winter break from high school, and invested it according to the value investing principles I had read about in Warren Buffett’s shareholder letters and books about value investing. After high school, I attended Southern Methodist University (SMU) in Dallas, Texas, where I graduated summa cum laude with a degree in finance. Post graduation, I worked in investment banking for two years (helping companies raise financing, buy other businesses or sell their businesses) before joining a private equity and debt investment firm, where I have worked for three years. My investing philosophy has been developed through my (i) insatiable reading of books written by and about prominent value investors and their investment philosophy, (ii) 11 years of public market investment experience and (iii) three years of private equity experience, where I have invested and/or manage over $625MM of investments in 6 companies."

Posted by manualofideas at 02:53 PM | Permalink | Comments (0)

By Greenbackd

In his Are Japanese equities worth more dead than alive?, SocGen’s Dylan Grice conducted some research into the performance of sub-liquidation value stocks in Japan since the mid 1990s. Grice’s findings are compelling:

My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

In the same article, Grice identifies five Graham net net stocks in Japan with market capitalizations bigger than $1B:

He argues that such stocks may offer value beyond the net current asset value:

The following chart shows the debt to shareholders equity ratios for each of the stocks highlighted as a liquidation candidate above, rebased so that the last year’s number equals 100. It’s clear that these companies have been aggressively delivering in the last decade.

Despite the “Japan has weak shareholder rights” cover story, management seems to be doing the right thing:

But as it happens, most of these companies have also been buying back stock too. So per share book values have been rising steadily throughout the appalling macro climate these companies have found themselves in. Contrary to what I expected to find, these companies that are currently priced at levels making liquidation seem the most profitable option have in fact been steadily creating shareholder wealth.

This is really extraordinary. The currency is a risk that I can’t quantify, but it warrants further investigation.

Posted by manualofideas at 12:22 PM | Permalink | Comments (0)

BUSINESS OVERVIEW
Syms operates retail stores offering discounted merchandise from designer labels for men, women and children. Syms opened the first store in 1959 and currently operates 53 stores, including 23 Filene’s stores acquired in 2009.

COMPANY-OWNED REAL ESTATE

^{Source: Company filings, The Manual of Ideas analysis.}

INVESTMENT HIGHLIGHTS

• Owns real estate associated with 21 of 30 Syms-branded retail stores, with retail space of 1.2 million sq. ft, warehouse/office space of 350k sq. ft (including 19 acres of land) and other space of 391k sq. ft. The PP&E is carried at $96 million but is likely worth substantially more. One owned store is located in NYC, while the others are generally near highways in places with at least one million people.
• Won bankruptcy auction for Filene’s in 2009, adding 23 leased stores and $315 million revenue (based on November 2009 quarter-end annualized revenue). Syms paid $39 million in cash, and also acquired $21 million of inventory, $30 million of store fixtures, and the Filene’s brand. Syms recorded a related $10 million bargain gain.
• Retail concept: Sell brand-name apparel for less. Brands carried by Syms include Burberry, Ralph Lauren, Calvin Klein, and Tommy Hilfiger. Filene’s stores also offer “off-price” branded apparel and are located in similar markets (mostly in Eastern U.S.).
• Received $30 million of insurance proceeds in December related to death of chairman Sy Syms. CEO Marcy Syms (57) has become chairman.
• Pro-forma net cash of $8 million as of November 28, 2009 (includes $30 million insurance windfall).
• Shares trade at 0.6x tangible book value and 0.2x enterprise value to pro forma trailing revenue.

INVESTMENT RISKS & CONCERNS

• Syms-branded same store sales fell 10% in June-November of 2009. Despite revenue pressure, "clean" EBIT was $1+ million in FQ3 on revenue of $135 million, including full Filene’s contribution.
• Controlled by the founding Syms family, which owns 56% of the company. While the passing of Sy Syms may lead to changes down the road, CEO Marcy Syms, who draws a $600,000+ base salary, appears firmly in charge and set to continue.
• Competes against discount stores, specialty apparel stores, department stores and factory outlet stores, with few sources of competitive advantage.
• Low returns on capital. Although the purchase of Filene’s leased stores lowers incremental capital intensity, capital remains tied up in owned property.

MAJOR HOLDERS
Syms family 56 % | Other insiders <1% | Franklin 10% | DFA 8% | Kahn Brothers 3% | Barington 2% | MFP 1%

Disclosure: No positions.

Syms has been featured in recent issues of Downside Protection Report and Portfolio Manager's Review. Subscribers, please log into the members-only website to review additional information and analysis on Syms.

Posted by manualofideas at 12:01 AM | Permalink | Comments (0)

Those of our readers who have followed the evolution of Steak n Shake (SNS) over the past couple of years know that the company has made huge strides in terms of stabilizing operations and creating value for shareholders. Whereas the previous management team almost ran Steak n Shake into the ground, new chairman Sardar Biglari quickly restored the company's fiscal health, ensuring that Steak n Shake will be around for a long time to come. Not least, Steak n Shake's stock price has enjoyed a renaissance of sorts after languishing for years under the old management.

Despite all the positives that Sardar Biglari's involvement has brought to Steak n Shake, the Indianapolis Business Journal (IBJ) has published an article that can hardly be described as anything other than a hatchet job. In the article, Cory Schouten writes:

"Biglari in June persuaded the board to transform Steak n Shake into a holding company for a diverse range of investments and give Biglari sole discretion over asset allocation. The board’s vote essentially allowed the hedge-fund owner to use the publicly traded company as a personal investment vehicle."

"The unanimous vote came after Biglari, the board chairman, managed to push out every board member unwilling to give him dictatorial authority over Steak n Shake despite his relatively modest ownership stake."

"Personal investment vehicle"? "Dictatorial authority"? This language might be more appropriately used to describe the state of Steak n Shake under previous management. Biglari's words -- and, more importantly, actions -- have made it clear that his paramount goal is maximizing long-term value for all Steak n Shake shareholders. Biglari's authority could be described as "dictatorial," but so could every CEO's authority. The question is whether such authority is used for the benefit or detriment of shareholders. In Biglari's case, the business results and stock price of Steak n Shake speak volumes.

The IBJ article also stokes fears about Steak n Shake relocating to Biglari's hometown of San Antonio, Texas, implying that jobs and capital investment might be lost in Indianapolis. We have no problem with a hometown paper looking out for its town, but in this case the IBJ is far off-base. Steak n Shake "The Restaurant Company" will continue to be based in Indianapolis. Meanwhile, Steak n Shake "The Holding Company" will operate out of San Antonio, Texas, likely with a very lean holding company staff.

The inability of organizations such as the IBJ to distinguish between Steak n Shake "The Restaurant Company" and Steak n Shake "The Holding Company" is precisely why Steak n Shake "The Holding Company" will be renamed Biglari Holdings. Listen up, confused IBJ readers: The restaurant business will continue to be called Steak n Shake.

The reader comments posted on the IBJ website show just how destructive it can be in the fast-paced online age when misleading or outright wrong information is spread by a supposedly authoritative voice. Writes IBJ reader Mike,

"This is an unexpected turn of events. I frequent Steak n Shake for many reasons, but mostly b/c of the local headquarters. I for one will not go as often (or ever) if most of the local corporate jobs are moved."

Adds IBJ reader Joe,

"when did we...decide to let sleazeball Iranian refugees (from the Shah's regime no less)purchase/own good 'ol 'Merkan companies and run 'em into the ground...my guess is his family has millions in Swiss bank accounts they've been living off of for years (used to work with one of these Iranian ex-pats years ago and had he was the sleaziest 'businessman' I ever met!)"

Another IBJ reader who calls himself Indy Observer takes a more lighthearted approach to spreading baseless rumors:

"Any truth to the rumor that the Steakburger is being renamed the Big Lari Burger?"

On second thought, that last one could actually catch on. Give it a few decades, by which time Biglari Holdings may well be another stock with a six-figure price tag and tens of thousands of happy shareholders attending each annual meeting. At that time, "Big Lari Burger" just may become a no-brainer name for a burger that will be enjoyed by droves of happy shareholders.

Disclosure: No position.

Posted by manualofideas at 09:04 PM | Permalink | Comments (0)

By Nadav Manham

I just blogged that Pepsi isn't running a Super Bowl ad.  But guess who just did?  Here's what the CEO had to say (here too).

Why would this internet company decide to advertise on T.V.?  The opportunity cost relative to advertising on the internet is not high, as the company already gets a lot of free advertising there.  Plus the Super Bowl audience likely allows the company to reach more internet naifs/future users at lower cost than any other way of spending ad money.

It's also interesting that the product being advertised is in many ways the product that least needs it:  plain old search, which is a monopoly enjoys high market share. 

I really liked the ad; it was minimalist, easy to understand, and moving in a kind of mystical way--"look at the power of search technology to expand your knowledge and change your life."  Does anyone associate Yahoo search or Bing with any of that?  That's one component of the moat.

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere. 

Posted by manualofideas at 11:41 AM | Permalink | Comments (0)

The blog My Investing Notebook has posted Bill Ackman's presentation on Kraft (KFT), dated February 3rd. The slides provide a good overview of the businesses of Kraft and Cadbury. Ackman also shares a valuation analysis of the combined company, not surprisingly suggesting that the stock should earn a strong return over the next couple of years.

While we like the presentation, we would take some of the assertions with a grain of salt, particularly Ackman's claims regarding merger synergies, potential margin expansion, and a "good" price paid for Cadbury.

Somehow investors always seem to believe there is room for margin expansion. Needless to say, margins don't always expand.

The following classic Buffett quotation may ultimately prove prescient with regard to Kraft/Cadbury: "In some mergers there truly are synergies - though often times the acquirer pays too much for them - but at other times the cost and revenue benefits that are projected prove illusory. Of one thing, however, be certain: if a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked."

Posted by manualofideas at 05:49 PM | Permalink | Comments (0)

In the following interview, Bruce Berkowitz of The Fairholme Fund discusses his recent sale of Pfizer, which had been Fairholme's largest holding through most of 2009.

Berkowitz also opines on the issue of tax rates in the pharmaceutical industry and says that effective tax rates have been too low for too long. The implication is that this could change, potentially depressing earnings -- or at least slowing earnings growth -- across the industry.

Finally, Berkowitz suggests that Fairholme is moving away from a defensive posture toward a more offensive stance in terms of picking investments. Underlying the more aggressive posture is Berkowitz's view that the financial crisis is essentially over and that we are now in recovery mode.

Posted by manualofideas at 05:54 PM | Permalink | Comments (0)

Bruce Berkowitz's Fairholme Fund (FAIRX) disclosed a new position in Citigroup in the annual report of The Fairholme Fund for the fiscal year ended November 30, 2009.

Bruce Berkowitz is one of more than 20 superinvestors regularly covered in Portfolio Manager's Review.

Posted by manualofideas at 05:52 PM | Permalink | Comments (0)

Posted by manualofideas at 05:51 PM | Permalink | Comments (0)

The life-size bronze sculpture by Alberto Giacometti sold for £65 million at auction today in London. It took just eight minutes before an anonymous phone bidder placed the winning bid after the sculpture opened for bidding at £12m at Sotheby's (BID) auction house in London.

The sculpture now ranks as one of the most expensive works of art ever sold. For Sotheby's, today's Impressionist and Modern Art auction was a huge success, yielding a total of £147 million versus its pre-sale estimate of £69-102 million (before buyer's premium). Perhaps more than anything else, the auction proves that despite the economic crisis individual wealth is well and alive, if only limited to the few. It also proves the attractiveness of Sotheby's business model, which benefits from a duopolistic industry structure.

Portfolio Manager’s Review picked Sotheby's as one of the top three ideas in the July 2009 issue, which was entitled “Businesses with Pricing Power and Low Capital Intensity.”  Read our Sotheby's investment case.

Learn more about Portfolio Manager’s Review.

Posted by manualofideas4 at 05:32 PM | Permalink | Comments (0)

Procter & Gamble CFO Jon Moeller discusses the company's quarterly results and outlook with CNBC's Becky Quick.

Posted by manualofideas at 11:13 PM | Permalink | Comments (0)

Eli Lilly CEO John Lechleiter discusses the company's earnings and outlook with CNBC's Mike Huckman.

Posted by manualofideas at 11:12 PM | Permalink | Comments (0)

"We will all be losers if governments clamp down on markets too zealously, according to Deutsche Bank CEO Josef Ackermann." (source: CNBC)

Posted by manualofideas at 11:08 PM | Permalink | Comments (0)

Posted by manualofideas at 11:06 PM | Permalink | Comments (0)

"The global slowdown has caused a radical change in the way people buy and use products, but fast-moving consumer goods like Coca-Cola are less impacted by the change, Muhtar Kent, CEO of the Coca-Cola Company, told CNBC Thursday." (source: CNBC)

Posted by manualofideas at 10:59 PM | Permalink | Comments (0)

Morgan Stanley CEO John Mack discusses his firm's new pay structure and more with CNBC's Becky Quick.

Posted by manualofideas at 10:57 PM | Permalink | Comments (0)

The latest issue of European Value Report, published on January 28th, highlights Vodafone (VOD) as a top monthly investment idea. Key excerpts are included below, but first let's look at David Einhorn's thesis on Vodafone, as laid out in Greenlight Capiital's Q4 2009 letter to investors:

"VOD is a U.K. based wireless operator with over 300 million subscribers worldwide and a market capitalization of £73 billion. The Partnerships established their position in VOD at an average cost of £1.38 per share. VOD's core consolidated operations in Europe, Asia, the Middle East, and Africa already generate in excess of an 8% equity free cash flow yield and support a near 6% dividend yield for shareholders. This does not count any value of VOD's most significant asset, a 45% ownership in Verizon Wireless, the #1 US cellular operator. Vodafone does not consolidate Verizon Wireless and, as a result, sell-side analysts seem to ignore its significant value. VOD currently does not receive a dividend from Verizon Wireless which we believe has led to the market implicitly ignoring its value, despite significant growth in revenue, EBITDA, and cash flow. We believe that Verizon Communications (VZ), which owns the other 55%, will need continued access to the cash flow from Verizon Wireless, and will therefore restore the dividend to VOD or work on an extraordinary transaction. Currently Verizon Wireless's cash flow is being used to repay inter-company debt to VZ. However, this debt will be fully repaid by mid-2010, at which point we expect VZ will need to act. We believe that any changes that reveal the value of VOD's Verizon Wireless stake will force the market to re-rate VOD shares. In the meantime, we collect a nice dividend. Ascribing a reasonable valuation to Verizon Wireless and VOD's other unconsolidated assets, we estimate that VOD trades at less than 3x estimated 2010 EBITDA, versus in excess of 5x for the peer group average in Europe."

The following is an overview of Vodafone, excerpted from European Value Report:

Vodafone provides wireless communications services worldwide. The company had 303 million consolidated subscribers and 323 million proportionate subscribers at September 30, 2009. Non-consolidated operations include a 45% stake in Verizon Wireless, and stakes in China Mobile, Bharti Airtel and SFR. Minority interests are mainly attributable to Vodafone Essar and Vodacom.

Selected Operating Data

We start our approach to valuing Vodafone by recognizing the significant value inherent in its Verizon Wireless stake. The first table below shows estimated values of Vodafone’s 45% equity stake in Verizon Wireless based on a range of EBITDA multiples applied to Verizon Wireless’ calendar 2009 EBITDA.

Our next step is to value the rest of Vodafone’s operations. We are guided by a simple observation: the current Vodafone dividend yield of 5.8% is supported by a 6%+ FCF yield based on cash flows excluding Verizon Wireless (to be conservative, we include purchases of network licenses in the calculation of free cash flow and do not reduce cash taxes paid by Vodafone for amounts attributable to Verizon Wireless pass-through tax payments). As these cash flows are diversified geographically and likely to grow over time (>60% of consolidated subscribers are in emerging markets), an investor can make a fair return from these “non-Verizon Wireless” cash flows when buying Vodafone shares at the current price.

In summary we add the estimated value of Vodafone's 45% stake in Verizon Wireless and the estimated equity value of the rest of Vodafone, i.e. the current stock price, to arrive at a fair value for all of Vodafone operations of £1.85 to £2.11.

Summary Valuation Analysis

Disclosure: No positions.

Learn more about European Value Report.

Posted by manualofideas at 11:56 AM | Permalink | Comments (0)

It’s war on the television screen.  On one side you have GEICO’s Gecko and the famously maligned Caveman.  On the other side is Flo, the hyper enthusiastic Progressive sales clerk.  It’s hard to escape these characters during sporting events or prime time as they try to win market share through a combination of amusing brand building characters and claims of lower prices.

Which company is gaining the upper hand?

GEICO is a subsidiary of Berkshire Hathaway and investors can monitor the company’s progress through Berkshire’s quarterly financial statements.  Progressive is a publicly traded company where one can gain greater insights into financial results through monthly financial releases.

Last year, we presented a ten year comparison between GEICO and Progressive to see if any trends could be identified regarding underwriting results or market share.  (Note:  Since underwriting results and investment results should be evaluated separately, we focused only on underwriting results.)

From this study, we could see that over the ten year period GEICO generally had a slightly higher growth rate in premiums earned, a higher loss ratio, and a significantly lower expense ratio.  This led to the observation that GEICO has been able to gain market share in recent years by offering lower premiums (leading to higher loss ratios) while maintaining higher underwriting profitability over the past few years due to tight controls on expenses, as reflected in the lower expense ratio.

2009 Results

GEICO

Since Berkshire Hathaway’s annual report has not been released yet, we only have GEICO’s results through the first nine months of the year based on Berkshire’s Q3 report. GEICO had $10,103 million in net premiums earned, which is up 9% from the first nine months of 2008.  The loss ratio was 77.2 and the expense ratio was 18.3 which results in a combined ratio of 95.5.  Pre-tax underwriting profits for the first nine months of 2009 came in at $459 million.

Progressive

Progressive recently published financial results for December which also includes figures for the full year.  The company reported $14,012.8 million in net premiums earned, which is up almost 3% from 2008.  The loss ratio for the year was 70.7 and the expense ratio was 20.9 for a combined ratio of 91.6.  Pre-tax underwriting profits came in at $1,175.6 million for the year.

For comparative purposes, for the first nine months of the year we can examine Progressive’s results for September.  The company reported $10,293.4 million in net premiums earned, a loss ratio of 70.5, an expense ratio of 21.1, and a combined ratio of 91.6 for the first nine months of 2009.  Pre-tax underwriting profits for the first nine months of 2009 came in at $859.6 million.

GEICO Aims for Market Share

From looking at the data presented above, it would appear that GEICO has made a decision to take a more aggressive stance on pricing which has resulted in increasing market share but at the expense of a higher loss ratio.  For the first three quarters of 2009, GEICO nearly matched Progressive in terms of premiums earned and was growing premiums at a much faster rate than Progressive.

The higher loss ratio would suggest that GEICO is competing on price.  In addition, GEICO’s expense ratio for the first nine months of 2009 was 18.3 compared to 17.9 for 2008 which could indicate a more aggressive advertising strategy.

While we will not know for certain until Berkshire Hathaway publishes the 2009 annual report next month, it looks likely that GEICO may surpass Progressive in terms of net premiums earned for 2009 if the trends established during the first nine months of the year persisted into the fourth quarter.

The price of gaining this market share is a lower level of profitability compared to Progressive, at least in the short run.  However, since insurance is a product that has high switching costs given the hassle involved in changing insurance companies, GEICO may be able to retain the gains in market share even if they become slightly less aggressive on pricing going forward.  Generally, consumers are not going to be motivated to change auto insurance companies unless the savings is more than trivial.

Most Effective Ad Campaign?

So who is more effective:  Flo or the Gecko?  Take our poll and register your opinion.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway. No position in Progressive.

Posted by manualofideas at 12:11 AM | Permalink | Comments (0)

The December issue of Portfolio Manager's Review, entitled "2009 Losers, 2010 Winners?," listed 100 noteworthy losers in 2009, profiled and analyzed 18 companies, and highlighted five companies as the Top 5 ideas among 2009 losers. Included in the Top 5 was hotel owner and operator Lodgian (LGN), which today agreed to be acquired by Lone Star Funds at a 67% premium to an average of recent closing prices.

While we are certainly pleased that our subscribers had an opportunity to profit from this unique idea in a very short period of time, we are also interested in taking a closer look at how this profit opportunity came about. We came across micro cap company Lodgian as a result of one of our value-oriented screens and were quickly intrigued by the non-recourse nature of the company's hotel mortgage debt. Here is what we wrote about Lodgian in the Editor's Commentary of the December issue of Portfolio Manager's Review:

Lodgian (LGN) owns and operates hotel real estate, representing one of the cheapest ways of buying into a portfolio of hotel properties financed by non-recourse debt. The market valuation of Lodgian implies imminent bankruptcy. However, based on the non-recourse nature of the hotel mortgage debt, Lodgian can escape bankruptcy by offloading unprofitable hotels on the lenders—if the latter are unable or unwilling to modify terms to Lodgian’s satisfaction. This creates an opportunity for investors, as enterprise value is low relative to normalized earnings and asset value. A prerequisite to future value creation, however, is successful extension of debt maturities, mainly related to Goldman Sachs and IXIS. We note a potentially active shareholder base including Oaktree and Blackstone. Overall, for investors who do not require much trading liquidity and can wait for real estate and hospitality markets to recover, Lodgian could deliver strong long-term returns.

Notice our focus on "long-term" returns -- while we considered Lodgian too cheap and too attractively financed to ignore, there was simply no catalyst in sight to near-term value realization. Many investment managers, even value-oriented investors, often shy away from companies that do not have a visible catalyst. Unfortunately, at least in the case of Lodgian, this can prove to be a mistake. If a company is dramatically undervalued and has properly incentivized management or a shareholder base that can exert the right kind of influence over management, a value-unlocking event may occur much faster than investors assume.

Another argument that might have been made against investing in Lodgian would have had to do with the state of the real estate market and the hospitality industry. An investor might have said, "I understand Lodgian is dramatically undervalued based on the assets it owns, but it will take a long time for its markets to recover." This is another mistake often made by investors: Simply because certain fundamentals may take a while to recover, it doesn't mean the stock price will take just as long to recover. After all, today's stock prices are meant to reflect all future net cash flows, discounted at an appropriate rate. So, if Lodgian was dirt cheap even after assuming that cash flows won't recover for a while, and even after applying a conservative discount rate, then why wait? Someone -- in this case Lone Star Funds -- may have the guts to buy the asset today, knowing that it is likely to deliver a strong return over a multi-year period. By not acting on a clearly undervalued asset, investors leave themselves open to being "usurped" by someone who arrives to the party late but is more decisive in claiming the obvious bargain on the table.

Click here to read our profile of Lodgian, as presented in the December issue of Portfolio Manager's Review. Read today's Lodgian acquisition announcement.

Download a sample issue of Portfolio Manager's Review. Subscribe and gain immediate access to the latest monthly report, entitled "Top 10 Ideas For 2010."

Posted by manualofideas at 11:46 AM | Permalink | Comments (0)

(Thanks to Value Investing World for the link.)

Posted by manualofideas at 06:51 PM | Permalink | Comments (0)

General Re, a Berkshire Hathaway subsidiary, has reached a $92 million settlement with the federal government which will allow the firm to avoid prosecution for its role in an accounting fraud involving AIG.  The Wall Street Journal reports that the settlement also includes corporate governance changes that will require Berkshire Hathaway’s Chief Financial Officer to attend meetings of General Re’s audit committee and mandates that General Re appoint an independent director.

The terms of the settlement call for General Re to pay $60.5 million toward restitution for investors who suffered losses in the AIG fraud, $12.2 million to settle the charges with the Securities and Exchange Commission, and $19.5 million to the U.S. Postal Inspection service.

Troubled History

Berkshire Hathaway’s acquisition of General Re in 1998 ran into difficulties almost immediately when underwriting standards proved to be inadequate and large losses ensued.  The September 11, 2001 terrorist attacks demonstrated continued underwriting weakness at the company which Warren Buffett discussed in his 2001 annual letter to shareholders.  Berkshire also inherited General Re’s problematic derivatives book which took years to wind down at a significant loss, as described in Mr. Buffett’s 2002 annual letter to shareholders where he famously referred to derivatives as “financial weapons of mass destruction.”  It should be noted that underwriting issues at General Re appear to be fixed based on results in recent years and the company does provide a large amount of float for Mr. Buffett to invest.

Beyond the financial troubles at General Re, the most troubling aspect has been the serious risks to Berkshire’s reputation based on the alleged impropriety surrounding AIG.  A number of General Re executives were implicated in the case and there were some convictions as well.  All companies depend on their reputation to varying degrees, but none as much as Berkshire Hathaway.  Berkshire’s sterling reputation has enriched shareholders over the years by making it possible to acquire companies whose founders weigh such matters very highly.  Now that the AIG matter is settled, Berkshire and General Re can move past this unfortunate chapter.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 05:20 PM | Permalink | Comments (0)

Bill Ackman of Pershing Square went on the air right before Warren Buffett this morning. Quite interesting that Ackman appears to have misread Buffett's views on the Kraft deal for Cadbury. Watch Ackman's comments first and then scroll down to the Buffett interview in our next article. The juxtaposition is fascinating.

Part One of Bill Ackman Interview:

Part Two of Bill Ackman Interview:

Posted by manualofideas at 03:36 PM | Permalink | Comments (0)

If Kraft CEO Irene Rosenfeld was hoping for a public vote of confidence from Warren Buffett, she is surely disappointed this morning.  Perhaps not surprisingly based on his unusual public criticism of Kraft on January 5, Mr. Buffett says that he “feels poorer” in light of Kraft’s richer bid for Cadbury and he disagrees with the decision to shed a highly profitable frozen pizza business to provide funding for the deal.

The statement today in a CNBC interview prior the special meeting of Berkshire Hathaway shareholders clearly refutes yesterday’s Wall Street Journal article which cited an unnamed source within Kraft who indicated that Mr. Buffett was “totally supportive” of the new terms.

Mr. Buffett also comments on a number of topics including the Obama Administration’s proposed bank tax, stating that he does not believe that banks are making “obscene profits” and companies that have already repaid TARP funds should not be forced to effectively pay for bailouts at Fannie Mae and Freddie Mac.

Other topics covered include the Berkshire Hathaway Class B stock split, Wells Fargo’s results, executive compensation, and Ben Bernanke’s prospects for a second term as Federal Reserve Chairman.  In addition, Mr. Buffett is not planning to increase Berkshire’s stake in Posco at this time and indicated that reports yesterday to the contrary may have been due to a misunderstanding with Posco’s CEO due to language translation.

CNBC Interview: Part One

CNBC Interview:  Part Two

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 02:08 PM | Permalink | Comments (0)

Longtime shareholders of Berkshire Hathaway know that Warren Buffett hardly ever comments directly on his assessment of the company’s intrinsic value.  In an interview with Bloomberg at today’s special meeting of shareholders, Mr. Buffett made an exception to his usual silence on the matter when he was asked about issuing shares of Berkshire to pay for part of the Burlington Northern transaction.

The question of whether the bid for Burlington sends any signals regarding Mr. Buffett’s views on Berkshire’s intrinsic value has been discussed here shortly after the transaction announcement in November and again after the proxy statement was released in December.

Here are excerpts from the interview:

You have no problem issuing shares if your stock is fully valued.  I think our stock actually, measured against book value which many people do and is not a crazy way to measure it, it’s at the low end … so I hate issuing shares.  And if I’m paying $100 a share to Burlington shareholders, it’s costing our shareholders more than $100 which I will explain to them in the annual report, because we’re using shares I don’t want to use.

Now, this deal still makes sense in our view.  I mean, we talk about this extensively at the Board.  But we value Berkshire [shares] that we’re giving out at what we think Berkshire is worth.  Unfortunately the Burlington shareholder is going to value it at the market, so we have to give them $100 worth.  Weighing all of that, we like the deal.  But we don’t salivate over it.  I mean, it was close.  We wouldn’t have issued any more shares than we’re doing.

To view the interview, click on the image displayed below or on this link.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 01:23 PM | Permalink | Comments (0)

Posted by manualofideas at 11:56 AM | Permalink | Comments (0)

According to a Bloomberg article, Warren Buffett may be interested in increasing Berkshire Hathaway’s stake in Posco, a South Korean steelmaker. Posco cited Mr. Buffett as saying that he “should have bought more Posco shares when the stock price dropped during the economic crisis.”  According to Bloomberg, Mr. Buffett met with Posco CEO Chung Joon Yang in Omaha yesterday.  Mr. Buffett has not commented on the meeting.

Here is a brief except from the article regarding prospects for Posco this year:

World steel demand will rise 10 percent this year, Posco said last week when it announced a 77 percent jump in fourth- quarter profit and plans to push ahead with $30 billion of overseas expansion. Buffett, 79, may have a paper profit of more than $1.3 billion in his Posco holding, first disclosed in 2007.

“From the point of view of Buffett, there may be few steel stocks to buy in Asia,” said Chang In Whan, president of KTB Asset Management Co. in Seoul, which manages the equivalent of $8.9 billion in assets. “I’m sure Posco will acquire companies this year, which will help it secure growth in size as well as in efficiency.”

Berkshire held 3,947,554 shares of Posco on December 31, 2008 which represented a 5.2% stake in the company.  Berkshire did not report updates on positions in securities traded on foreign exchanges in quarterly 10-Q reports or in 13-F filings during 2009.

The price of Posco stock has increased from 380,000 Won on 12/31/2008 to 604,000 today while the U.S. Dollar has weakened from 1262 Won/USD on 12/31/2008 to 1124.61 Won/USD as of yesterday.  This would indicate that the value of Berkshire’s holdings in Posco has appreciated from $1.191 billion on 12/31/08 to approximately $2.12 billion today.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 06:58 PM | Permalink | Comments (0)

In a recent interview with The Columbus Dispatch, NetJets Chairman and CEO David Sokol predicts that the company will be profitable this year and no further staffing reductions will be required “barring any major shifts in the global economy.”  In November, Mr. Sokol made positive comments about prospects for NetJets in 2010 and stated that a break-even year would be likely. Since taking over at NetJets last August, Mr. Sokol has made a number of management changes and has imposed budget discipline designed to trim costs.  NetJets is a subsidiary of Berkshire Hathaway.

2009 Loss:  $720 million

The Columbus Dispatch article states that NetJets posted a $720 million loss for 2009 with the majority of the loss resulting from aircraft write-downs.  Through the end of the third quarter, NetJets had reported a $531 million pre-tax loss of which $436 million was attributed to asset writedowns and downsizing costs.  NetJets was profitable on an operating basis for the last two months of 2009 according to Mr. Sokol.

Potential Acquisitions

The article also states that Mr. Sokol has been approached by a number of smaller competitors that may be interested in selling their businesses to NetJets.  However, only one potential deal is in the pipeline at this time.  The company is not interested in taking on additional debt for large acquisitions and instead is planning to reduce debt by $300 million in 2010.

The Political Factor

One clear headwind for NetJets going forward involves a growing populist sentiment against private aviation.  No intelligent executive in today’s political climate would dream of taking a private plane to Washington D.C. if called to testify before a Congressional committee.  However, the problem extends beyond symbolism.

Populist sentiment is increasing in general and the fractional aviation industry must do a better job of communicating the tangible economic benefits associated with their product.  It is likely that populist sentiment will recede once the benefits of the current economic recovery are more widely spread through the country.  Until then, this is an additional negative factor for the industry in general.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 12:01 AM | Permalink | Comments (0)

The Financial Times reports that Hershey is getting closer to finalizing the terms of a counter-bid to Kraft’s hostile £10.4 billion bid for Cadbury.  The war of words between Kraft and Cadbury has escalated in recent days as Cadbury’s management ratchets up the rhetoric regarding Kraft’s “conglomerate” model being an unattractive fit for Cadbury.  Warren Buffett’s recent comments regarding Kraft seeking a “blank check” for the purchase only dimmed prospects for the acquisition even further.

The problem for Hershey has been the possibility that an acquisition of Cadbury would require taking on significant debt and could impact the company’s investment grade credit rating.  In order to reduce the amount of debt required, Hershey has authorized Byron Trott to seek private equity investors to participate in the deal.

Mr. Trott is a former Goldman Sachs banker who now runs his own firm.  He is also known as Warren Buffett’s favorite banker.  Berkshire Hathaway reportedly made an investment in Mr. Trott’s new firm when he set it up last year.

It seems highly unlikely that Berkshire Hathaway would participate in the planned equity raise for a Cadbury bid given the company’s investment in Kraft and Mr. Buffett’s high profile comments regarding the transaction.  Nevertheless, for those who enjoy following corporate board room dramas, it looks like we are in for at least a few more chapters before the story on Cadbury’s future is complete.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 12:08 AM | Permalink | Comments (0)

By Nadav Manham

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

Posted by manualofideas at 12:02 AM | Permalink | Comments (0)

By Nadav Manham

More on the AOL Time Warner merger, which this book described as "the con of the century."  Ouch.  Hindsight is 20/20, and it's easy to forget that much conventional wisdom celebrated the merger when it was announced.  But if you examine the facts on the ground at the time in the context of certain unbreakable laws of business economics, as they were known to the participants at the time, it's difficult to escape the conclusion that the AOL Time Warner merger was . . . the con of the century.  Specifically, Time Warner's decision to  give half of itself away in exchange for half of AOL was unjustifiable even in those heady days.

Only two things could have possibly justified Time Warner's decision.  The first is that there were enough merger-related synergies, either marginal revenues that only a merger could bring about and/or marginal cost cuts that only a merger could enable.  The AOL Time Warner crew trumpeted total potential EBITDA synergies of $1 billion, which no one should have believed.  AOL's total EBITDA at the time was $1.8 billion; it was more than a stretch to believe that number could nearly double just by joining the Time Warner family.  If you want to read more, check out "The Curse of the Mogul." 

The second thing is that AOL was actually worth what Time Warner gave up for it.  What was the ex ante probability that that was true? 

    a) Time Warner was technically acquired at a 71% premium to its market price--if you invert the math you can also say that Time Warner bought AOL at a 42% discount to its market price. 

    b) AOL's stock closed at $73.75 on the eve of the merger announcement.  With about 2.61 billion diluted shares outstanding, that means it had a merger-day market cap of $192.5 billion.

   c)  AOL's EBITDA for the FY ended 6/30/2000 was about $1.8 billion.  Give the company the benefit of the doubt and assume that EBITDA is a useful proxy for the cash generating ability of the business--it works out to 26% margins on FY 2000 revenue of $6.886 billion.  That's a good business. 

   d)  $192.5 billion divided by $1.8 billion equals 107.  AOL was trading for 107 times that year's cash flow when it merged.  Time Warner paid a 42% discount, so it paid a multiple of 62 times that years' cash flow for AOL. 

Under what circumstances is it justified to pay 62 times cash flows for a business?  Only when the future cash flows of that business are so high as to justify it.  Did Time Warner have reason to believe this when it decided to give half of itself away?  Consider the following:

   i)  Just on general capitalist principle, it's extremely rare that a large public company ever grows into a cash flow multiple of 62 times.  There is a chart on page 107 of my edition of "Stocks for the Long Run" that shows the "warranted P/E ratio" of each of the legendary Nifty Fifty stocks of 1972, those companies widely considered the best companies in the world.  "Warranted P/E ratio" is defined as: that P/E ratio that would have produced a total return from 1972-1997 equal to the 1972-1999 returns of the S&P as a whole.  In other words, "warranted P/E ratio" answers the question "How much should an investor have paid, as a multiple of that year's earnings, for a stock, given its subsequent earnings growth?"  Of the entire Nifty 50, only three had a warranted P/E ratio above 62 times.  One sold water flavored with sugar, caffeine, and some other stuff listed in a bank vault in Atlanta.  One sold little sticks of tobacco that happened to be addictive.  And the third sold pharmaceutical drugs.  Everyone else came up short.  It's extremely rare for a public company to grow into a cash flow multiple of 62 times.

  ii)  Just on general human nature principle, it's extremely rare that when someone comes to you and offers to sell his company to you for the "bargain price" of 62 times cash flow, that you are in fact getting a bargain.  "Why come to me?  What have I done to deserve such generosity?" is the better response.

 iii)  The only way to be one of the extremely rare companies that can grow into a 62x multiple is to have a really really good moat in a growing industry, and the former is more important than the latter.  That AOL was in a fast-growing industry was true.  That it had a really really good moat was less true.

Let's examine the state of AOL's moat as of January 2000.  Think back to the supply chain that allowed a layperson like me to access this new thing called the internet:

1)  First I turn on my computer.  More than likely this computer was a PC running Microsoft Windows.

2)  I click on the "dial in to AOL" button, which triggers my modem to dial a telephone number and make that noise we all remember.

3)  On my screen appears "Welcome to AOL" and "You've Got Mail!" and off I go.  There are many many web pages owned by AOL, and I spend my entire session on them, looking at AOL-sold advertisements in the process.

Who did I pay along the way?  I paid something to Microsoft when I bought my PC, for access to its operating system.  I paid something every month for the use of the phone line that my modem used.  Then I paid AOL a monthly subscription for its very user-friendly way of accessing the internet, and for its very fun and informative and user-friendly web pages it directed me to.  As a bonus, a bunch of advertisers paid AOL to show their ads on its virtual real estate that I viewed.  These advertisers paid a lot of money to AOL because the internet was new and exciting, and because AOL had all these customers seemingly locked in.  It was a "walled garden," and in fact the AOL Time Warner merger even drew scrutiny from antitrust authorities and experts like Lawrence Lessig because they thought that with the addition of all the Time Warner online content the new company would be even more of a walled garden, favoring its own sites over non-AOL and non-Time Warner sites.

That was how I and many others accessed the new thing called the Internet circa January 2000.  AOL had two moats: it was a toll bridge that charged consumers about $20/month for its user-friendly way of getting on the internet.  And it was a toll bridge that charged advertisers for the privilege of selling stuff to its 23 million subscribers.

Now I have a confession to make.  I've been fibbing a little.  That was not how I accessed this new thing called the internet circa 2000, which, it's important to note, wasn't so new by then.  It was how my mother accessed the internet circa 2000.  I, on the other hand, was a senior in college by then.  Here is how I accessed the internet.  See if it sounds familiar:

1)  First I turned on my computer.  This computer was a PC running Windows, an operating system I paid Microsoft for up front when I bought my computer.   I also paid Microsoft up front for the operating system when I bought a new computer in 2007.  And I'll probably pay them a little when I buy my next computer.  Something tells me you will too.  As this guy might say:  "That's not a moat . . . THAT's a moat."

2)  I didn't need AOL at all to help me access the internet, nor did I need a phone line.  My college had wired my dorm with ethernet, so I just plugged my computer into the ethernet jack.  I didn't click an AOL button either because by that time my Windows operating system had a button that allowed me to open a browser called Internet Explorer.  The browser allowed me to get right on the internet with no problem and no AOL.  And it was free to use--actually it was bundled into the upfront cost of my operating system, but I didn't pay much attention to that at the time.  Microsoft fought something called a "Browser War" for the right to bundle its browser with its operating system.  It won that war: by the time of the AOL Time Warner merger it had a browser market share of 80% and growing, up from approximately zero in 1996. 

3)  When I finally reached the internet, I had very little interest in AOL's websites or email.  I had my own email address by then, and by then there were maybe a billion web sites that were not owned by AOL or Time Warner.  I cared about investing, so I spent a lot of time on Yahoo! Finance.  I cared about my college, so I spent a lot of time on my college's web site.  I cared about fitness, so I spent a lot of time on the web sites of a few gurus who knew how to build web sites from their basements using something called HTML.  I cared a lot about sex, so . . . never mind.  The point is, by the year 2000 you could spend the entire day surfing the internet without ever encountering one AOL web site.  And the growth of non-AOL web sites was expotential.  So exponential, in fact, that a bunch of people were already trying to figure out how to help organize it all.  One team, two Stanford graduate students named Larry and Sergei, had just six months before managed to attract $25 million of venture capital.  And advertisers were paying attention.  With every passing month AOL's advertising real estate diminished as a percentage of the total advertising real estate available.  As far as I was concerned, AOL's moat was non-existent.

Again, hindsight is always 20/20, but Time Warner really had no excuse for assuming AOL's moat would continue:

1)  As a general rule, technology that's easy for college students to use eventually becomes easy for their mothers to use.

2) Time Warner could have and should have known that non-AOL and non-Time Warner advertising real estate was growing exponentially, which would inevitably diminish the value of its own real estate.

3)  Most importantly, and most inexcusably, the seeds of AOL's eventual moat destruction were being sown . . . within Time Warner itself!  Time Warner Cable was hard at work upgrading its systems to allow always-on broadband connectivity to the internet.  It had a new service called Road Runner that was dedicated to providing faster and more reliable online access, a superior product to telephone modems. 

Then as now, a very bad deal.

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

Posted by manualofideas at 12:00 AM | Permalink | Comments (0)

We are pleased to announce a partnership with value investor Matt Darrah of MD Capital Management, whereby The Ideas Report For Serious Investors will occasionally publish Matt's thesis on his best investment ideas. Matt writes a FREE investment newsletter we highly recommend -- email Matt to subscribe.

The following is Matt's recent write-up on Corporate Executive Board (EXBD).

Executive Summary

• Negative Invested Capital Business: (1) The Company operates a subscription business model where customers pay for a full year of a program at the beginning of the year, but the Company is able to pay its suppliers over time. (2) The Company’s extensive historically database of information acts as a barrier to new entrants, and will help the Company maintain its current level of pre-tax cash flow over a long periods of time.
• Management Team Focused on Delivering Value to Shareholders: Management consistently distributes nearly all free cash flow to shareholders through share buybacks and dividends.
• Attractive Valuation: (1) Recent stock price implies a 15% normalized free cash flow yield. (2) The Company’s expected earnings decline in 2010 concerns the Market.
  

Is Corporate Executive Board a Good Company?

Corporate Executive Board Co. (“EXBD” or the “Company”) provides benchmarking data regarding corporate best practices to business executives and professionals worldwide. Approximately 70% of sales are generated in the United States. The Company distributes its information through various case study profiles, executive forums where executives meet to discuss their issues, and benchmarking datasets. For instance, the CFO of a Coca-Cola might subscribe to the CFO Executive Board and/or the Finance Leadership Board. If the CFO wanted to determine the optimal organizational structure for his accounts receivable department, he could review (i) a case study profile of another company that has a top performing AR department, (ii) review EXBD’s organizational structure database, or (iii) discuss with other executives in the network. Customers provide information about their company’s best practices in exchange for receiving the benchmarking data and best practices from other EXBD customers. EXBD was founded in 1979, and is headquartered in Arlington, VA.

Historically, the Company’s customers bought increasing amounts of benchmarking data by subscribing to more programs in order to ensure that their firms were at the forefront of their industries. However, the recent recession forced many executives to reduce expenditures, and thus the Company is expected to experience a 23% revenue decline in 2009. The fact that 25% of the Company’s revenues are generated from customers in the financial services industry exacerbated this decline. Since the Company’s customers pay in advance, EXBD can fairly accurately forecast revenue growth and declines. The primary predictor of future revenue is “Contract Value”, which represents the annualized revenue that results from the current subscriptions in place. As an example, let’s say one of EXBD’s programs has 100 subscribers priced at $40,000 per subscription. The Contract Value would equal $4MM for that particular program. Contract Value has continued to decline throughout 2009, as customers continue to cut cost, but the rate of decline is slowing. This decline in contract value means that 2010 revenues will likely decline again. However, based on the slowing rate of decline and customer calls, I believe that revenue growth will return in 2011, allowing the Company to generate a more typical amount of free cash flow.

The Company obtains the information it publishes from its customers. The fact that EXBD operates the largest network of companies providing benchmarking data to each other provides another barrier to new entrants, as a new competitor would need to replicate the Company’s expansive network, which includes 80% of the Fortune 500 (largest 500 companies in the U.S.). As of December 31, 2008, the Company employed approximately ~2,430 people, none of which belong to unions. The Company spends capital expenditures on replacing/modernizing information technology (few growth related capital expenditures necessary).

The Company has consistently operated with negative capital requirements, as the Company operates a subscription business model where customers pay in advance for a year long service, but pays vendors over longer, commercially standard terms. Further, the Company requires little infrastructure to provide its service, except for information technology.

Below I will discuss the factors that will allow the Company to continue earning at least its current level of free cash flow over long periods of time. Note that the economic slowdown has materially impacted free cash flows, but prior to the recession, free cash flow did not fluctuated much historically.

The corporate best practices benchmarking industry that distributes information like EXBD is characterized by limited price competition and two major firms, Corporate Executive Board and Advisory Board Company. Consulting firms also provide similar benchmarking data, but only when being used for a project. Thus, EXBD’s data is typically used when a consulting project is unnecessary or prior to engaging a consultant to obtain benchmarking data in a more cost effective manner. The market possesses high barriers to entry with no new companies entering the market since the 1979 due to the difficulty of replicating the historical results of surveys conducted to obtain benchmarking data and the extensive networks developed by incumbent industry participants. The Company owns data regarding best practices dating back to 1979 (its inception), which no new entrant can replicate. The Company has developed over 300,000 corporate best practices, 1,500 benchmarking datasets, and 11,500 analytical tools. The Company’s only major competitor focuses on the healthcare segment, so direct competition on price is limited. Historically, the Company has grown by successfully cross selling other EXBD products into an existing customer’s organization. For instance, a customer’s finance department may subscribe to the Finance Leadership Board, and after having success encouraged the marketing department to
subscribe to the Marketing Leadership Council. The Company incurs little additional cost when selling a program to one more incremental customer, because the cost of developing a program is fixed. Thus, every new subscription the Company sells is very profitable. While the Company counts approximately 80% of the Fortune 500 as customers, a very large untapped addressable market of smaller, mid-sized business exists. Thus, not only does the Company possess a moat with regard to its existing customers, but also has strong growth opportunities.

Risks to Cash Flows

The largest risk I am concerned about regarding owning EXBD is that the decline in revenue during 2009 was a not a as a result of the recession, but a secular decline in demand for the Company’s products. Based on calls I made to customers, EXBD’s clients still find the Company’s products valuable, but like most companies during the recession had to make cost cuts, and information resources like EXBD’s products were cut as opposed to additional headcount reductions. As the economy recovers and corporate purse strings loosen, I believe the Company will be able to return to its historical level of free cash flow. However, that will likely take place during 2011.

Does Corporate Executive Board have a Good Management Team?

The EXBD management team is lead by Thomas Monahan. He was promoted to Chief Executive Officer in 2005. Prior to becoming CEO, he was general manager of EXBD. Prior to EXBD, Thomas was a senior consultant at Deloitte and Touche. Thomas has returned substantially all free cash flow to shareholders through dividends and share buybacks during his tenure, as the Company does not require large amounts of capital to grow. Thomas owns $1.2MM worth of EXBD common stock or ~2x his base salary, ensuring that he will continue to keep a shareholder mindset.

Can EXBD be Bought at a Cheap Price?

After examining the past several years’ free cash flow, I believe that normalized pre-tax equity free cash flow is ~$105MM. At Thursday’s closing price of $22.82, EXBD’s market capitalization less net cash and marketable securities is ~$718MM, which means the stock has a 15% pre-tax equity free cash flow yield. If EXBD trades at a 7% pre-tax equity free cash flow yield, which would be appropriate for this high quality business with compelling growth prospects, the stock will rise to ~$46, making the stock a compelling buy at $22.82. Further, the Company has a 1.9% dividend yield at $22.82 per share.

The author of this article is Matt Darrah, Chief Investment Officer of MD Capital Management and contributor to The Manual of Ideas. Matt describes his background as follows: "I have been investing since 1998 (age 16) when I saved nearly all my money from working on my winter break from high school, and invested it according to the value investing principles I had read about in Warren Buffett’s shareholder letters and books about value investing. After high school, I attended Southern Methodist University (SMU) in Dallas, Texas, where I graduated summa cum laude with a degree in finance. Post graduation, I worked in investment banking for two years (helping companies raise financing, buy other businesses or sell their businesses) before joining a private equity and debt investment firm, where I have worked for three years. My investing philosophy has been developed through my (i) insatiable reading of books written by and about prominent value investors and their investment philosophy, (ii) 11 years of public market investment experience and (iii) three years of private equity experience, where I have invested and/or manage over $625MM of investments in 6 companies."

The author of this article may own the securities discussed herein. This article is not a solicitation to buy or sell securities. This article may have been lightly edited for publication on The Ideas Report For Serious Investors. For full terms of use of this website, visit http://manualofideas.com/terms.html