Diamond Foods: On Risk vs. Uncertainty
Diamond Foods is in the middle of the biggest fiasco of its history since going public in July 2005 (and perhaps one of the biggest debacles of the decade). The firm faces an accounting scandal, suicide of a board member, an SEC & DOJ Investigation, restatement of financials, and firing of their CEO & CFO. In light of all this news, the stock has slid from its peak of $96/share down to the present $20-21 range. As a result, I decided to take a closer look.
The Scandal:
- November 1, 2011- Audit Committee to investigate "certain crop payments to walnut growers", Pringles acquisition is postponed until 1st half of 2012, and board member Joe Silveira commits suicide two weeks later on November 15,2011
- December 12, 2011- Audit Committee investigation shouldn't continue past February 2012 & Diamond is late on 10-Q
- December 15, 2011/Jan 12 2012- SEC & DOJ investigation into Diamond's accounting practices
- February 8, 2012- Audit Committee investigation completed, CEO & CFO fired, 2010 & 2011 financial statements need to be restated- there were $80 MM in payments to walnut growers recorded in the wrong periods
- February 15, 2012- Pringles acquisition is canceled, P&G ends up selling Pringles to Kellogg
- March 13, 2012- progress on restating financials but still no deadline provided
- March 21, 2012- forbearance agreement signed with creditors extending until June 18, 2012
- March 21, 2012- Diamond seeks possible minority stake interest from private equity firms- this is concerning because it shows the depth to which Diamond is in trouble with it finances; there are also whispers that they may sell the firm, although the board is more interested in raising funds
Diamond currently is in noncompliance with loan covenants to regularly deliver quarterly and annual financial statements, so this forbearance agreement gives them a grace period until June 18 of this year to get their financial statements in order. In other words, Diamond is basically saying they expect to file their updated financials before June 18. This is good news that I will get to more later.
Beyond The Scandal: Past Acquisitions & Residual Value
Diamond Foods is not just a pure play on walnuts through their Emerald Nuts brand or their retail culinary & in-shell walnut business. They also made 2 acquisitions in the past few years, as shown below:
(2008) Pop Secret from General Mills for $190 MM in cash
AND
(2010) Kettle Foods for $615 MM in cash
While these may not have been great prices for an acquisition (hard to know without real financials), they're a starting point to value Diamond Foods in its present state. Together, Diamond spent a total of $805 MM for the 2 brands, far below the current market value of $455 MM. However, Diamond has debt to take into consideration before attempting a stab at the valuation.
The latest financials (from July 2011) indicate $20 MM in cash and $530 MM in debt. Going by the latest few years of real financials (2008-2009), the firm has operating margins in the range of 6-10%, therefore I think a reasonable amount of debt is somewhere around $200 MM. In this case, Diamond is a pretty leveraged foods company with its $530 MM in debt, but netting out cash & my estimation of "healthy debt", is around $330 MM in net debt. Therefore, from an adjusted enterprise value perspective, you're paying $780 MM for Diamond Foods. This is close to the amount that Diamond paid for its two acquisitions in the past, so you're basically getting the Emerald Nuts & culinary/retail in-shell walnut business for free at today's prices.
Diamond in the Rough? Risk Vs. Uncertainty
One thing that I always focus on in the difference between risk and uncertainty for an investment. In most accounting scandals, the firm faces a high amount of uncertainty over their real numbers, but low risk for its business continuity. In Diamond's case, the opposite is true. Not only do they have uncertainty over their 2010 & 2011 financial statements, they are in trouble with their operating businesses as well. There are numerous reports that Diamond shortchanged their walnut growers and that many of them are defecting from the company, looking to sell their walnuts to other buyers. This is a very real threat to their supply chain and is mentioned many times in Diamond's press releases. It is currently very difficult to judge how widespread this problem is, but judging from the fact that no private equity firms have jumped in to lend to Diamond yet, it shows the level of "business risk" here.
However, Diamond Foods still has operating businesses that aren't destroyed (yet). As mentioned in their press releases, Pop Secret & Kettle Foods are still performing well and the only real impairment to Diamond Foods' business is their relationships with walnut growers. Therefore only part of the business is in an impaired state. Judging from the present stock price, I'd say the odds are in the favor of those long the stock because of the residual value in the subsidiaries. As I discussed above, Pop Secret and Kettle Foods are worth about as much as the current (adjusted) enterprise value, so even with a destroyed nut business, you'll about breakeven on this trade (I'm not calling it an "investment" because there is still a lot of risk surrounding the SEC & DOJ investigations into the company).
So how would I go about trading in this stock? The June 18, 2012 deadline for their financial statements gives a pretty clear picture of when some of this uncertainty should abate. Hopefully, they do file their statements before then and quell a lot of investors' fears. Therefore I'd consider either buying the stock (a small position) or buying some June 16 call options because of the June 18 deadline.
Overall, this is a very scandal-laden, disgusting, almost revolting stock that should keep most investors away until some of the uncertainty is gone. While I normally would avoid such a situation, the depth to which this stock has fallen has me interested. Hopefully Diamond can get their affairs in order and fix the problems they're facing today.
Disclosure: (soon to be) long Diamond
Redflex: Drive Safe!
Despite my constant efforts to find value in plain sight (as can be seen here & here), I tend to find my best ideas by accident or coincidence. For example, I found the subject of this post, Redflex Holdings, through a friend's father who happened to ask me to look into red light traffic cameras. I never thought it would be much of anything (or that there was even a public company in the industry!), but boy, was I wrong. This is a pretty neat story.
Redflex is a traffic safety company focused on the manufacture, installation, and maintenance of red light cameras. The cameras sit at intersections and are programmed to take a picture of any car that runs a red light. Municipalities hire Redflex to come in, install the cameras, and manage the ticket processing. The ticket fines vary considerably, ranging anywhere from $50 to $500.
Since 2003, Redflex has lead the industry in the number of cameras installed and overall size of their business. It has grown very quickly, as can be seen below:
The main risk of this business is legislation- the cameras are unpopular and seen as being used more for raising revenue than public safety. However, Redflex has continued to win the courtroom (there are a lot of lawsuits challenging the cameras' constitutionality) and they don't see much risk of losing.
Here's the presentation I made summing up my research (from Nov 2011):
Redflex Presentation
Full disclosure: Long Redflex
WWE: Entertaining, And Yet, Unsatisfying
At a young age, I thought the WWF was stupid (before the World Wildlife Fund sued over their trademark abbreviation). But later, a friend introduced me to WWE and it was fun to watch sometimes. However, I never really got into the whole concept of nearly-naked men fake wrestling each other. But hey, call me crazy- they have 12 million viewers each week. That's more than I would have guessed. Then again, this whole company had numbers much higher than I would have guessed. Anyway, the reason I'm writing this post is because a friend told me he thought the stock looked interesting. I'm not sure I agree.
What Exactly Do They Do?
WWE is an integrated media & entertainment company that has focused on sports entertainment the past 30 years. At the heart of their business is developing characters in the form of wrestling superstars and having them "compete" in a live arena in front of thousands of people. This is about 70% of their business. They have a number of ways to monetize this:
- Live Ticket Sales- 22-23% of sales
- Televisions Rights- 24-27% of sales (RAW, Smackdown)
- Pay Per View- 15-17% of sales (Wrestlemania)
- Venue Merchandise- 4% of sales (t shirts, hats, etc.)
In addition to live/televised events, the company has a fairly successful consumer products division that collects licensing & royalties mainly on sales of video games (with THC) and toys (with Mattel). The consumer products division also sells home videos of matches or superstar histories.
Surprisingly, WWE continues to come up with creative ways to intermingle their 140 Superstars & Divasand keep the audience entertained. The business has largely posted very consistent operating results the past 10+ years. They have roughly the same number of live events each year and have largely kept with the same strategy. However, lately, the company has been pushing into areas a little too far outside my comfort zone.
Capital Mis-allocation: A Network and Some Movies
Perhaps the most troubling is the idea of launching their own network (as described here on Wiki). And I quote directly from the latest 10-k:
"Relying on our in-house production capabilities at our technologically advanced, high definition, production facility, we produce six hours of original weekly programming, 52 weeks per year." (emphasis added)
It's a big jump from producing 6 hours/week to starting a full network that has 24/7 programming. One of the chief reasons for this is they want to monetize their large library of programming from the past. While it's a nice idea, I struggle to see the point of launching an entire network with just six hours of new content weekly. Another article discusses some of the "filler" ideas, including reality shows profiling the wrestlers when outside the arena. I'm not fully familiar with the demographics of WWE fans (other than it's targeted to 18-34 year olds), but MTV with WWE Superstars doesn't sound like a winner to me. And I'm guessing this whole network is going to cost a lot of money.
The other headache I got when studying these guys was their WWE Studios operating segment, at just 4% of revenues. They've developed a number of feature films, the only one I'm familiar with being The Condemned, which wasn't a bad! However, the results from this segment haven't been very good. If you look closely at the cash flow statement, WWE has spent $94 MM on "feature film production assets", when over the same period, only generated $90 MM in revenue. That's pretty terrible. Management has recognized this and is trying one last strategy before shuttering the film business entirely. I'm hoping they get away from this segment, but we'll see how things play out.
Valuation: Not Quite There
Despite capital mis-allocation in the form of a new network & their film business, WWE has posted solid operating results the past 10 years. The operating earnings (adjusted for impairment charges) have been in the range of $70-85 million and free cash flows have averaged around $50-60 MM each year. As I stated previously, the business is largely mature (there are only so many live events they can hold), so I treated this as a stable, no-growth investment, similar to H&R Block. In addition to their earning power, WWE has no debt and $160 million in cash & investments. Based on how I'd value this, I see this company as being worth somewhere in the range of $600-700 MM, or $8-9 per share. The stock currently trades around $8/share, so it's not cheap enough for me today. It's about fairly valued- I'd be looking for this to come down to $370-410 MM ($5.00-5.50 range) before getting interested. I realize this doesn't seem too likely judging by historical stock prices, but I'm in the game of valuing the fundamentals.
In closure, I struggle to see the viability of a a new network for a company that has remained largely stagnant (albeit consistent) for the past decade. The growth may be difficult to come by and will likely cost a lot. I'm glad they've talked about exiting the feature film business if it doesn't play out well because it has largely been a failure. WWE is not undervalued today, despite trading at multi-year lows.
Commodities & Societal Impacts of Prop Trading
You know, I've been sitting around thinking. When that happens, generally I get pretty pissed off. There's a lot excess in our society and there are certain practices that really get under my skin. It happens that much of this occurs within large institutional banks, as well as the various leveraged investment banks & other financial firms.
A Fundamental Question
Yesterday, I had a conversation with Greg Herman (my roommate whom I mention occasionally, one of the smarter thinkers about investing that I've met) about commodity price manipulation and the financial markets. So my question is this:
Why should we allow for speculative bets to be made on the basic raw materials and various commodities that our society relies on to thrive?
Forget for a moment that we have a large financial system. Just assume there's a large market of milk producers and milk consumers. As producers produce and consumers consume, prices for milk will hit some type of equilibrium and fluctuate based on natural supply/demand shifts.
Now imagine one banker walks into the marketplace that would otherwise be 100% composed of producers & consumers of milk. He starts to either buy up or sell down quantities of milk, but there's something strange going on- he doesn't get the milk delivered to him (turns out he's lactose intolerant); this milk could just as easily be interest rate swaps or bonds or some other security to him (because all he cares about is the price changes in his portfolio), but the difference in terms of societal impact of his trading is enormous.
With that additional buyer/seller, we end up with a layer of "artificial supply/demand" that builds up for milk. If he didn't get involved, it'd still be a perfect little system of producers & consumers. Then, imagine that one banker calls up some of his friends and gets a speculative party going in the milk marketplace (let's say he starts a milk ETF), then there will be a larger percentage of the overall milk marketplace trading the milk itself who isn't using the milk for anything but speculative activity.
Once this starts up, it becomes very difficult to understand what the true competitive prices of some of these commodities are. Businessmen are perhaps rewarded disproportionately (crude oil in 2007) for the manipulation, or they are hurt by it (crude oil in 2008). Of course, there were other factors (OPEC, recession, etc.), but I do not believe anyone is arguing that financial markets provide stability to commodity prices. Prices whipsaw on rumors, rumors about rumors, or even rarer, they whipsaw on facts. This is damaging to participants in the "real economy".
Articles like this especially start to get my blood boiling.
Ben Graham's Take on Speculation
As Ben Graham once put it, "speculation is neither illegal, immoral, or (for most people) fattening to the pocketbook".
I'd like to counter this notion of his of speculation. In the case of commodities and our massive financial markets, commodity speculation is damaging. You end up with more volatile prices that farmers and other simple folk rely on.
Besides, as "investors", we are the savers that help to fuel additional investment in the economy. We speculate on the direction of commodity prices, thus driving a larger % of GDP to the "casino megabanks" and the government, through fees, transaction costs, and taxes on gains. It would be much better for society to support investment in businesses, but instead we're just making derivative-type bets, in which we either make money or we lose money depending on a commodity going up/down. The asset itself doesn't generate any income- you only do well if someone buys it off of you at a higher price. Contrast that with businesses, where you also get a piece of the earning power and can earn a reasonable rate of return.
So, with the intent being to play at the Roulette wheel (50/50 up or down basically), I'd argue it's detrimental to this country. Nobody asked the fundamental question- do we want to allow gambling on commodity prices? Are there possible unintended consequences of allowing commodity speculation? Who is hurt by not allowing speculation? (hint: banks)
I believe there is no economic, social, or other benefit provided for allowing speculators to buy/sell commodities, other than providing additional liquidity to those who actually need the ability to do this. This market would exist for them anyway (through banks), but that doesn't mean they should be allowed to trade in it. Banks should acts as stewards of the marketplace and keep out of it themselves. We should be having a national discussion on these issues.
I say we only allow trading in commodity markets if the investor has an underlying "real economy" interest in the commodity itself.
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As an aside, I've found a number of great investments the past month. I've enjoyed my search so much I haven't written in awhile. My apologies. More is on the way. Stay tuned.
Gencore: The Problem With Small Positions
Nate Tobik, a talented writer over at OddBall Stocks, has dug further into Gencore than I did. He's done us a big favor- in pointing out a possible fraud (or something that at very best, doesn't appear consistent or completely honest), he's helped us avoid losses. For that I'm very grateful.
You can see his post here.
Stages of Investment Learning
My issue at hand is that I'm in a big growth stage of my investment learning. It's tough to know what to focus on.
Part of it is just developing an investment style. Am I the statistics guy who knows that, on average, a company selling at 1/2 of book will do well for me if I diversify into enough similar situations? Do I go the 'Buffett' route and concentrate my portfolio for things I know are fantastic? Should I play the Einhorn game & go long/short in hopes of having market direction not impact my overall performance? I could also practice the Icahn activist approach, whereby something at 3/4 of it's intrinsic value can be unlocked quickly when you buy 10% of the stock & complain enough. Icahn is great, don't get me wrong, but most stocks he picks aren't all that cheap.
These are questions to be asking yourself all the time. I have my investment style. It will likely change (as it has in the past, and especially as I get more money under management), but what I don't have is the encyclopedic mind of different businesses to go with it just yet. I need to get the exposure to how all these industries work so I can spot the cheap ones. I've covered a number of industries, but there is still so much out there.
What This Means For My Gencore Mistake
So for Gencore, a company whose fundamentals appear worth only taking a diversified bet on (mainly because it's not a very good business), it's tough to sit down & spend the long hours. With my portfolio at <$50k, it's tough to spend the due diligence on positions that might end up at 1-2%, making the dollar value around $500-1,000. Sure, maybe I'll double my money and make about $500, but I won't be comparing 10 years of footnotes, company history, media releases, shareholder letters, industry data, etc. just for a position of this size. It's not worth it compared to getting more business learning exposure in new industries.
I'm not lazy. I just am not focusing on it right now.
I'm focused on that recent post I wrote. The one about the 100 companies I've studied this year. Each company got between 1-4 hours of my time (except for the complicated ones, which got much more, such as MDF), I read the full 10-k & accompanying footnotes, latest proxy, a few years of fin'l statements, and went through the latest company news/presentations to see where they are. This gives a very solid picture of the business, where it is positioned in relation to its industry, and you get a feel for different types of management. (I'm now at 105 for the year, still a ways to go to hit the 150 mark & write another post).
After this couple-hour exercise, and if the company looks cheap enough to take a sizeable position, I then really sit down to analyze the heck out of it. But this not for the positions that would end up being small & almost insignificant. That's what Gencore was.
What I'm not doing is combing the footnotes with a magnifying glass for every smaller position. Especially between years. I generally take the company's word on basic accounts (i.e. receivables, revenue recognition, etc.), and assume the CEO isn't trying to ruin my portfolio. There are certain things I absolutely adjust for (and feel as though my intermediate-level accounting skills are pretty good at this), but I don't have the depth of knowledge to spot red flags. And that's when you really start to add value. Most company's books aren't squeaky clean & it really pays to know where they're trying to hide things...
I'm not ignoring this issue forever. Accounting is very much on my radar. It's my major at school. I want to be extremely good at it. And I will be, one day. But for now I'm going to keep looking for exposure to new companies & industries. That's where I feel like I'm really learning these days.
In Closing
So there you have it. I'm going to stay away from these small, diversified bets unless I have the full story down. Time to start concentrating again... and maybe I should name my pet something like "read the footnotes".... it's that important.
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Gencore was absolutely a mistake & Nate's provided us with a service. Be sure to thank him. And not to yell at me too much. I'm still learning.
One thing Nate stuck to was simply chasing the "bear case", that is, asking yourself "what could go wrong here?". I normally do go about this in a minor way, but it hasn't become part of my investment process & that's going to have to change. I'm pledging to start focusing on this for every company I present from here on out. And I appreciate learning this lesson of chasing the bad news & making sure it's worth paying attention to.
100 Companies: Giveaways & Takeaways
Whoo! I've hit the 100 mark for company research this year!
Okay, so this is again the same theme as last time, when I wrote about 'The Good, The Bad, & The Ugly'. I have an ongoing project of researching 1-2 companies/day, spending a few hours going through annual reports, financial statements, company presentations, etc. This is where I collectively discuss some of my findings (in increments of 50 companies). I have some new companies for each group, as well as some parallels to draw. I guess you could call these thoughts my "Giveaways".
*I also have my "Takeaways" below. It helps to reflect on past research & keep track of my latest thought processes.
The Good (highest quality):
- Hansen Natural
This is a fantastic business. It's knocking the lights out. And it very closely resembles Buffett's purchase of Coke in the 80's- it's a pure syrup business (not involved in bottling/packaging, making it a fabulous investment), expanding heavily both domestically & abroad, and only requires 1-2% of sales in capital expenditures to grow 10-15%/year. I have trouble getting a good sense how big their potential market is, but at #2 market share with Monster (and close behind Red Bull), they have a solid product with a long runway of growth ahead of it. Keep an eye on this one- any big dips or disappointed Wall Street investors might give an opportunity to get in on this company. Today's prices make no sense, however (39 times 'earning power'!) - Mead Johnson Nutrition
Boy, is this company on fire. It is just like Hansen Natural- growing very quickly, is an extremely profitable business with low capital needs, and has all geographic & demographic trends in its favor. Also, they're #1 in the world for infant nutrition and #2 for child's nutrition. They compete against a few large players (Nestle, Abbott Labs, Pfizer, Danone) but they hold their own and have actually been growing market share consistently. They sport innovation, a perfect capital structure, the most premium brand in the industry, are huge in China (25% of sales, growing 15-20% or so/year), and very focused only on what they do. The industry is expected to sport 9% annual growth out to 2015, and 2/3 of their business is outside U.S. with 60% of sales in Asia/Latin America. They report in $USD, which gives us another reason to love them- Helicopter Ben (a.k.a. "The Bernank"; Keep on printing baby!) Unfortunately this is the cute girl at the party- all the guys want to dance with her. The stock isn't cheap by a long shot. - National Beverage Co.
I really like this business. They own Faygo and Shasta, the only two major brands in their beverage portfolio (both are sodas if you're not familiar). The founder, Nick Caprella, has stayed with them since the beginning, both in body (CEO/Chairman today) and in spirit (74% ownership of the company). It has very high returns on capital, no debt, a very simple structure, and no pension. It's, quite simply, a cash machine. It's too bad Caprella isn't like Buffett- this would be a great springboard from which to make capital allocation decisions. Maybe I'll try giving him a call with some suggestions! haha. - IBM
There's not much to add to the discussion of IBM. It's a great business. The efficiency of its business, the margins, future growth potential, and overall business positioning makes me think this is one of the better large cap companies in the world. Very interesting read, especially for a guy not involved in tech. I'd highly recommend it. - Illinois Tool Works
This is historically mentioned as a possible "Buffett Play", and frankly, I'm not surprised. While you wouldn't expect a manufacturer of industrial products to be high quality, they have a very nice little niche. As with one of Buffett's subsidiaries, Iscar, which makes industrial cutting tools, most of ITW's products are "consumables", and thus, are repeat purchases. At around 19% return on net assets, 45% return on invested capital (above average in the U.S., very good for an industrial), and very consistent high margins, this one's a winner. They're extremely diversified in terms of products, have a really unique & interesting 80/20 management philosophy (check it out!), and have 58% of their sales overseas. Perhaps Buffett will come knocking if the business trades down. It's expensive today, even for him. - Honorable Mentions: 3M, Carlsberg, Cisco, Home Depot, Lowe's, LVMH, Sherwin Williams, Wal-Mart
The Bad (5 most overvalued):
- Hanes Brands
This is a decent business. I enjoyed reading about their niche category of high-volume, comfortable, low-cost clothing. They don't have to worry about the latest fashions/trends nearly as much as you'd think, and they can focus more on price-to-value propositions. (Perhaps that agnostic mindset towards fashion is why Buffett bought their competitor, Fruit of the Loom, out of bankruptcy). Unfortunately, that debt load hurts. It doesn't kill the business, even in a bad downturn, but it does affect a would-be-shareholder today pretty significantly. At $2.1 B in net debt & $2.55 B in market cap, you're paying something like 23 times my estimation of earning power for the business. They are mostly domestic (88%), and while they do have international expansion opportunities, I don't see them coming any time too soon to impact my valuation. You can do far better elsewhere. - Estee Lauder
Let me just start by saying that I like this company. It's family-controlled, has a great history, and it has largely kept to its cooking. Even despite being off to a great start in its latest fiscal year, the business is priced for over-perfection. Who wants to pay 35 times 'earning power' for a business that is not that heavy in emerging economies (about 33%)? I don't see them deserving of such a high valuation, so I won't be riding the hype train alongside everyone else on Wall Street. Let them eat their cake. One day they'll wake up with some serious heartburn (and thunder thighs). - Treehouse Foods
I write below about them also being low quality, but for purchase price near 18 times current earnings and its indebtedness (4.5 times operating income), I simply cannot find a reason to be a bull here. I don't want to say anything more negative about them in this post- my description below (in the low quality section) is enough for you to understand where I'm coming from. - Hain Celestial Group
As with Treehouse Foods, I write about them below as being low quality, and it also ends up being on my overvalued list because I believe it's of much lower quality than Wall Street does. At 27 times my estimated earning power, this is a possible short candidate. I think I may initiate a small position. Stay tuned. - National Beverage Co.
While I also have listed this in the highest quality category, quality sometimes comes at a high cost. What are you getting today when you buy FIZZ? A business growing alongside U.S. GDP (perhaps slightly higher), which I'd say medium-term should be around 1-3%/year. I'm seeing this business as having low operating leverage, so it has pretty consistent margins (i.e. earnings won't grow much faster than sales). There's no debt, and all the cash is paid out in special dividends. So, you're effectively buying a bond. Especially with that 75% inside ownership- they're going to keep with this no-debt, dividend scenario. At 16X current earning power (by my estimation), you're not getting much value here at all. It's not crazy overvalued, but there's not much upside above the effective 6% earning's yield today.
The Ugly (low quality):
- Jones Soda.
This shouldn't be a surprise to anyone who knows accounting or how competition in the soft drink business is. This is a dog. There's nothing more to say. I almost just shouldn't include this one because it shouldn't count as a public company. It probably won't be soon. - Cott Corp.
Another company in rough shape. While they sport 55% market share in their two largest markets (U.S. & U.K.), this is only for their defined market of "retailer brand beverages". In other words, private label. The branded soda market is, as always, dominated by Coke, Pepsi, and to a lesser extent, Dr. Pepper Snapple & Nestle. Cott tries to squeeze out a living by being low-cost, but they just acquired Cliffstar for $500 MM and the debt load is overbearing. The margins aren't consistent, Wal-Mart just ended their exclusivity contract effective January 2012, and they don't seem able to earn very much above their interest expenses every year. All signs point to no. - Treehouse Foods
As with Ralcorp Holdings in my last broader research post, Treehouse Foods won't be getting any love today. These guys are expensive and have a similar business model- buy up a number of smaller private label food makers & try to squeeze some efficiencies out of them. Private label foods are consolidating, but the question remains, is any value being created? With an average return on gross assets at around 5% for Treehouse (including goodwill- the price overpaid for a business' net assets), I'd say their strategy isn't particularly effective. In aggregate over the past 3 years, they've earned about $270 MM, borrowed $360 MM, issued additional stock of $110 MM, and used it all to spend $850 MM on acquisitions. Tough for me to get excited with that type of move when they already have a pretty substantial debt load. All that money spent and a lousy 5% or so return when the cost of that money is also around 5%. This company is getting no love from me today. Or tomorrow. Probably for awhile. - Dole Food Company
Unfortunately, this is another example of a private equity deal gone awry (more common than you might think). The original investor, in this case David Murdock, bought the whole firm in 2002 & levered this company to the sky. While a big dividend from this for Murdock back then was great, there's little value left to the shareholder today. They're the largest, lowest-cost producer, and have an impressive refrigerated supply chain, but as far as shareholders go, better luck perhaps with Chiquita or Del Monte. That debt hurts. - Hain Celestial Group
This is another like Treehouse Foods or Ralcorp Holdings. They are looking to continue buying up small food businesses (in this case, those that are organic & all natural) and grow in this way. With return on gross assets at 3.8%, and borrowing at 4.5% after tax, they're not creating much (if any) value with their acquisitions. The business itself isn't bad (returns on net assets & invested capital are pretty much average), it's just the way the cash is managed to invest in low-return acquisitions. I wonder if bad capital management is worth shorting... this could be interesting to try out haha.
The Cheap
- Gencore Industries
Subsequently I've seen that Nate at Oddball Stocks is almost certainly correct on this. It's not cheap, but rather is scary. I have a blog post already written about it (but not posted just yet), so I won't go into detail here. But it was one I'd identified as cheap in this search through my next 50 companies, so figured I'd include it here. - Hewlett Packard (current holding)
I also have an article about this written, it's just not posted yet. I'm still studying their competition further, although it is a position of mine. I'm quite happy with where I bought & think it will work out even if the PC business dies. - Constellation Brands
Not cheap enough for me today, but it is somewhat close & I like the management team. - Computer Sciences Corp.
I'm still working on this one and it may become a position, but I need to understand the bear case better before considering it. - To Be Disclosed Soon (current holding)
There is a company I will share shortly. I know, I know, I said that last month but I'm in the middle of finishing & sharing with my inner circles. Feedback internally is helpful before going public with my research.
Takeaways
It seems the stock researching business gets easier over time. After going through so many, you get very quick at finding information, cutting through legalese, develop somewhat of a encyclopedic mind about different businesses, and will become much more comfortable with accounting. I'm by no means able to spot frauds or shady activity, but I can still see when something doesn't make sense. Becoming an expert in accounting (mostly on the manipulation of numbers) is my next project & I'll likely start in 2012.
Also, my valuation methodology & overall investment process continues to evolve. It's not longer able to be boiled down to a few points (unless I decide to simplify it for others), but it is very helpful and all based on common sense. No CAPM or excel models here. Doing research over & over will force you to re-think previously used metrics & adjust for oddities. Every company has a couple, so I'm always re-thinking how I look at analyze these businesses.
The only thing I'm still not very good at is then checking the Street's consensus. It shouldn't be all that difficult, but it's hard for me to bend over backwards to see what they think. I really try to avoid their research reports & mindsets, mainly because they're biased, but I'm going to start forcing myself to follow them. Usually, the analysts are just chasing momentum, or the latest quarterly results, so those "buy" or "sell" ratings are pretty much useless. Sometimes it's fun to watch the cascading ratings driving stocks very high and then back down (a recent example being Netflix), or even down and then back up (Aeropostale is in the process now). It's been fun occasionally to compare the Street's research to mine, but I haven't done it consistently. I'll have to work on this more.
As for the road ahead, I'll continue to explore new companies in different industries, occasionally post my latest research ideas or holdings, and wait to hear from you! Thanks for reading.
Gencore: My Take on a ‘Net Net’
As an aside, I've seen mentions of Gencore in many different value communities online & from people who have contacted me personally about it over the past year or so. I realize this isn't an original idea, but I figure it's interesting to see my take on this company. Now that I think about it, though, the company is so simple that we all probably have the same exact reaction to Gencor. Nonetheless, I have not yet read anyone else's work on Gencore other than the fact they mentioned it to me. So this is all my work, and if there's anyone to laugh at for mistakes, just laugh at me.
Also, I've mentioned a few times (both in email to friends and on this website) that I have some good ideas that I'd be writing about shortly. This isn't one of them. I have those articles just about fully written but I'm not sharing on this blog until I've fully finished my research & initiated positions in the stocks. As far as I know, 2 of the 3 companies aren't followed by anyone online... so hopefully you'll enjoy once they get posted.
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I'm sure many of you have heard: Gencore is a net net! In the United States no less!! Graham must be turning over in his grave; this is something he probably wouldn't have expected in an age with instantaneously widespread information- via the internet- and it has traded below net liquidation value for a little while now. Not too bad!
However, this is not exactly the same scenario that you'd see with many of Graham's net nets. Back in his day, you could pick up a business for less than it's net working capital, and in terms of size, it was in pretty decent proportion to its operating business. Gencore is a different type of net net- buying them today is much more like purchasing a closed end fund below net liquidation value.
On Closed End Funds
It's been a very successful strategy to simply buy up closed end funds when they trade far below net liquidation value, wait until they sell at par, and unload them. Many would call it arbitrage. It's pretty darned close. So I'd tend to agree with them.
This is the case with Gencore today- they very closely resemble a closed ended fund below liquidation value. This is what their current balance sheet looks as of last check:
Current Assets: $106 MM
Total Assets: $114 MM
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Current Liabilities: $10 MM
Total Liabilities: $11 MM
Shareholder's Equity: $103 MM
There's one detail we need to adjust for, however. Gencore has $81 MM in investments (about 60% bonds, 40% equities):
Investments: $81 MM
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Net Current Assets: $25 MM
Net Total Assets: $33 MM
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Net Current Liabilities: $10 MM
Net Total Liabilities: $11 MM
Net Shareholder's Equity: $22 MM
Ah, that's much better. Now you can really get a sense of how big Gencore is as an operating business. While the balance sheet is overstated from the operating business' perspective (i.e. their asphalt plant & combustion system manufacturing business), you can still subtract it out to get the full picture.
From a valuation perspective, I'll simply separate the two assets (the operating business and the investment portfolio) and value each accordingly. Sum of parts analysis works just fine in this case.
Gencore's Operating Business
Gencore is an interesting little company. They make asphalt plants, combustion systems/industrial incinerators, and fluid heat transfer systems for customers who then make asphalt. This heavy equipment is all focused on one thing- the production & repair of highways. So they're very reliant on the federal government.
Gencore has been doing the same thing for a long time now. 1894 is when they first started making asphalt plants and they now have the largest base of asphalt production plants in the U.S. Throughout their annual report, they continually referenced being the lowest-cost producer, as well as possessing capabilities to produce the highest quality asphalt plants in the country. They've also worked with the U.S. to develop standards and it seems to me like a pretty nice setup. I don't know too many kids who grow up wanting to compete in the production of asphalt plants, so I think they're probably okay in terms of future competition.
The real value in this business comes when the federal government decides to open its pocket book & start repairing/updating our highways across the country. We've had some stimulus the last few years from both Obama & Bush, but they stabilized spending in the industry- it was far from a multi-year highway modernization plan. If you do see any mention of a multi-year highway plan, however, this is the first stock to buy! It pays to keep your eyes open.
I saw in one of Gencore's older annual reports that the U.S. has something between 4,000-5,000 asphalt plants, and also that Gencore clears something between $2-4 MM for each plant they sell. It looks to me like GENC's sales for the last decade were anywhere from 20-60 plants/year (although that may be far off). The last 2 years have been especially low for Gencore, but even at their earlier-decade sales figures, they won't be making much money. The business isn't a cash cow- it just stays pretty stable (although isn't always profitable) and reinvests excess cash flow into its investment portfolio.
One last note is that the business has gone into defensive mode. They allowed their balance sheet to shrink (in the form of inventories, accounts receivable, and all other working capital components), have laid off some workers, and are very focused on reducing SG&A. It's nice to see them waiting for a cyclical upswing in government spending (if it ever comes).
Valuation
This is a pretty simple valuation- by far the most simple you'll see me perform:
Value of Investment Portfolio: $81 MM
Value of Operating Business: $11-20 MM*
TOTAL: $90-100 MM
I like to buy at a discount with an adequate margin of safety:
Discount: $55-65 MM
Current Market Cap: $68 MM
It seems Gencore is cheap enough for me to buy today, assuming no other problems. They have no debt, no serious longer-term obligations, and overall are in fantastic financial shape. I don't have any qualms in terms of bankruptcy risk or downside. The downside seems pretty limited. However, I have one last thing to say about risk in my last section to this article.
*The reason I have their operating business marked anywhere from $11-19 MM is simply 0.5-0.9 of book, I figure in this case the operating business is worth less than book value because it has posted operating losses (by my calculation) in 5 of the last 14 years. None of them were catastrophic either- all were pretty much within the same range. In any event, big swings in the value of the operating business (anywhere from $5-30 MM perhaps) doesn't make a huge impact on the ultimate valuation. The investments Gencore owns are clearly worth more than their operating business.
Fiscal Woes & The Human Factor
The two more obvious things I see as risks for this business are the fiscal woes of the federal government and the human factor behind their business.
As I said above, Gencore is heavily reliant on federal government spending on highways. Without it, asphalt isn't needed in nearly such a large supply, and Gencore's customers stop buying asphalt plants. If you haven't picked up a newspaper in the last 4 years, our government is having some serious trouble with its debt burden. And we're not alone- many governments in the world are having trouble with their debts. So, that leaves us in a predicament... With no money to spend at the federal level, we may not see any increases in infrastructure spending for awhile. And that is unfortunate because many people believe our highways aren't up to par these days. We could do with some updated roads. Just as with defense contractors, most businesses connected to highway construction (I'm thinking of the aggregate producers- Vulcan Materials, Martin Marietta- in particular) may have to wait awhile before they can shine again.
The other thing to consider- the people factor- does hold some importance here. The current Chair/CEO, EJ Elliott, has been with the company since 1965, is 81 years old, and effectively controls the company. He owns the B shares that trump your common stock every day in a proxy fight. So whatever he wants, he's likely to get. There hasn't been a dividend, as far as I can see, for quite some time, but that's not stopping him from selling all $81 MM in investments and paying it all out tomorrow. He also is capable of selling the whole company at a bad price. That's not to say that he'll do these things- but it's a real thing to consider. He's done well for Gencore through thick & thin these past 46 years. So I'm not terribly worried. But he does have to be on your radar.
In Closing
And that's all folks. Pretty simple. You're looking at $81 MM of securities, an operating business that could have a cyclical upswing the next time the federal government opens its pocketbook, and an 81-year old controlling stakeholder. Sounds like a closed-end fund to me.
Disclosure: I'll be long this stock starting tomorrow.**
**It's likely to be a very small position & held more in honor of Graham than anything else. I don't mind having another company to follow, and it'll be interesting to see if anything comes from this.
As I've said in previous posts, I'd much prefer to buy a business at a discount to its operating business (i.e. its earnings), but I still will buy something at a discount to its assets given the right opportunity. And I think this is a fairly decent opportunity. The cycle doesn't have to go in my favor to do well here- but it's a nice catalyst to unlock the value if it does happen. I just don't see it happening for awhile... mainly because of how long it may be before the government puts some money towards our roads. My faith & belief in the U.S. Federal Government's ability to allocate resources intelligently is similar to that of Santa. As I grow older, I believe in it less and less...
Proposed Idea: Alternative Maximum Tax
Let's do it: an alternative maximum tax. All governments (i.e. state, federal, municipal, etc.) in the U.S. shouldn't be able to tax more than 50% of your adjusted gross income.
It's only fair when about half of our population effectively pays no federal income tax. The rich should carry the weight and not be vilified for having more than the rest of us.
I say we eliminate long-term capital gains tax shelters of 15%, eliminate corporate taxes, and have all cash transactions involving corporations (M&A, asset dispositions, dividends, and short-term/long-term capital gains, etc.) all be taxed as ordinary income at the individual level. Owners of the corporations (shareholders) will all pay the largest marginal rate in the country, alongside doctors, lawyers, and other businessmen. This "business tax shelter" of long-term capital gains at 15% isn't quite fair. Despite what the Citizens United case may have continued with its ruling, corporations shouldn't continue to be treated as people. Flow-through entities at more proportional & progressive rates would improve our system.
I wonder how not having taxes at the parent company level would affect different industries... no depreciation tax shield because no more taxes... capital intensive industries would not have additional benefits to increased investment in infrastructure. That's not to say more investment in infrastructure wouldn't occur- with more money in the hands of corporations before handing it back to their shareholders, they may end up investing in more projects. Or just hoarding cash. That seems to be the latest reaction to all the government & economic uncertainty.
It all boils down to the government. Someone needs to clear up the uncertainty behind regulation, the tax code, and the future. Their rhetoric will bury this nation. I try not to be political in my commentary, but the current state of affairs from our current President & his staff is not helping.
P.S.We may end up with a similar 'brain drain' the likes of which Eastern Germany saw after WWII. I'd rather not pretend to be a macro economist, but I do know enough about where the U.S. is positioned for the next 5-10 years or so (in relation to our Federal Reserve, federal & state government debt loads, and amount of excess liquidity currently sitting idle in our financial system, among other things). It has interesting implications for a variety of businesses & investors. I've just been trying to come up with a way that could get us out of this mess. So far I haven't found one. And I'm trying hard.
P.P.S. I'm worried for Bruce Berkowitz. And I hope I'm wrong.
Dartboard Valuations: You Can’t Be Serious.
Oh the CAPM... just a fun little theory that cannot actually be proven. Or so they've told me in my classes at school. It's kind of sad when you think about it- all these business majors have been duped into believing stock prices are all derived from the same statistical distribution- just like natural occurrences in the real world (height of people, birth weight of squirrels, dart scores, etc.). Unfortunately, unlike real occurrences in the world, stock price movements stem from shifts in investor expectations (especially with all the highly correlated ETF's and the capital they now possess). Unless you have no emotions, your investment expectations will be significantly influenced by those emotions from time to time. And emotions aren't rational or able to be distributed in a statistically significant manner. Our market is far from "perfectly efficient", a utopia believed to exist in which all information is instantly widely disseminated & "priced in" for todays' stock price.... but this fact is lost on 100% of academics & 90% of investment bankers. Don't blame them though- it's not their fault. They just did as they were told.
ContinuCare's Buyout Valuation: An 8-K Example
So, I figure I'll list something I enjoyed reading earlier today (which spawned this post). What I have below is an excerpt from an 8-K on ContinuCare's merger valuation:
"These calculations were based on the sum of (i) the implied present values of BRAI’s calculation of projected unlevered free cash flows for Continucare’s fiscal years 2012 through 2016, and (ii) the implied present values of the terminal value of Continucare calculated based on terminal value multiples ranging from 7.0 x to 9.0 x, which multiples were derived from the companies included in BRAI’s Comparable Company analysis described above. BRAI, using its professional judgment and experience, calculated the implied present values using the discount rate range of 17.8% to 20.7%. This discount rate range was based upon a weighted average cost of capital calculation for Continucare, as well as for the companies included in BRAI’s Comparable Company analysis described above, and using: a risk-free rate of 4.48%, based on the 30-year Treasury bond yield; a market risk premium of 7.10% multiplied by Betas (a measure of systematic risk) ranging from 0.64 to 1.04; a small company risk premium of 4.80%; a geographic concentration risk premium of 2.00%; and a customer concentration risk premium of 2.00%. This analysis resulted in a range of midpoints of implied present values per share of Continucare common stock of $4.69 to $6.46, as compared to the implied per share value of the merger consideration of $6.25 to $6.45." (emphasis added)
There you have it folks- had you known these "high finance" modeling methods, which only the 'sophisticated' could possibly have come up with ahead of time, Metropolitan Health Network's acquisition of CNU for $6.25-6.45/share makes perfect sense. It's a wonder why the stock traded at $4.27 the day before the merger announcement... No "high finance" individuals must have looked into this one ahead of time...
Sarcasm Explained
For those of you scratching your heads, or who don't normally use the discount rate range of 17.8%-20.7% (who does?), don't worry, you're not alone. I was being "sarcastical" (to quote Robin Williams in Good Will Hunting). It's simply the efforts of a few monkey analysts in our beloved investment banks.
It's very easy to be given the "right price" for something, treat it as the dart, and draw a dartboard around it to indicate a perfect bullseye. According to Barrington Research Associates, the way they typically value companies is an effort from a combination of a top down and bottom up approach. Their top down research, they go on to describe, looks into economic climates, themes, & trends. Their bottom up research is "grass roots" and based on their top down macro research, to figure out which firms will benefit from their economic predictions. However, I think they're just lazy. Who honestly looks at an acquisition after the fact, looks at the purchase price paid, assumes it is reasonable, and formulates a DCF model to justify the current purchase price? Apparently Barrington Research Associates does...
Using very sophisticated models, they assumed that the volatility in previous share prices for CNU were indications of higher risk (and assigned a 7.10% discount rate accordingly), gave the 4.5% rate on treasuries (opportunity cost), and then added in additional discount rates of 4.8% for being a small company, having geographic concentration for 2%, and even a customer concentration of 2%. While this may seem very well thought-out, nobody comes this close (within 3%) to a valuation after-the-fact with a DCF model (notorious for being highly sensitive) unless they already knew the buyout price. Which leads me to wonder why they'd perform this analysis at all... as always, this is a classic example of a company trying to justify their buyout valuation. Not that Metropolitan has to- I actually agree with this buyout price (and how it's being financed, it makes me happy!). I'm just wondering why they bothered publishing this horrid model- usually you just see very optimistic statements from the executives in the conference calls without much to back them up.
In Closing
Just stay away from ridiculous assumptions. Some would say (including me) that assuming all stock prices being correct, all the time, is just silly. Human emotion rules the day traders, and they move the markets... Even if you just read an 8-k like I did- don't assume that Barrington's valuation methodology is any better than your own. Although they're paid for theirs, I know mine is better, and I'm sure you can come up with something that beats their after-the-fact dartboard valuation.
Common sense still rules the world. Don't let your undergraduate finance classes tell you otherwise.
Probing Google
There's a major problem with an anti-trust probe of Google that many are suggesting should (and most likely will) occur soon. After having read today's WSJ article about Expedia, Nextag, and yelp's griping, I'm sitting here fuming.
Feeling A Little Entitled
Please, just ask yourself this fundamental question- is a business entitled to a profit? Think here- a "legal entity" - should it's right to a profit be protected by the government? Perhaps. If it is in the national interest to keep it afloat, maintaining profitability in some of these institutions (large banks, insurers, auto manufacturers, and more recently, Solyndra) is important. But then you get to the question of who decides what is in the national interest. Who's to say what the national interest is? I can't answer that. But I can tell you what isn't against the public's interest.
A company that has revolutionized the access to, distribution of, and ultimate use of information.
For free.
What does it cost a stay at home mom to look up the recipe to foreign cuisine? How about just you, trying to figure out the weather is for what to wear? It doesn't cost you anything. I can "Google it" and be on my way.
"Monopoly" Definition
These companies that testified in the Senate today, including Expedia, Nextag, and yelp, are trying to brand Google as possessing a "monopoly". I have trouble with the way they're throwing around that word, as if it always is a bad thing.
Historically, and I've briefly read on this for a few businesses developing during the time period,government regulation had been very simplistic if existant at all. Companies flourished, we entered a modern industrial age, and widespread business empires started to crop up seemingly out of nowhere. Then along came the Sherman Antitrust Act of 1890, which was the first law to limit monopolies and cartels.
Of course, it didn't have the teeth it initially needed to break up Standard Oil, a process that didn't take place until more than 20 years later after further abuses that come from controlling around 90% of the U.S.'s oil supply. The Sherman Act was put in place to limit unreasonable monopolies and combat artificial raising of prices (whether through selling less at much higher prices or restricting trade)- something Standard Oil was very good at. This was meant to protect the consumer against businesses who used their unfair positioning to take advantage of them.
But that's not what we're looking at here. Wikipedia's article on the Sherman Act also discusses a different form of monopoly than this predatory one: an innocent monopoly. This type of monopoly is an:
"innocent monopoly, or monopoly achieved solely by merit, is perfectly legal, but acts by a monopolist to artificially preserve his status, or nefarious dealings to create a monopoly, are not."
It goes on further to add that the Sherman Act's intent was to protect the competitive landscape & competition, rather than the competitors directly.
I'd first argue that the competition still exists- no one is stopping you or your brother from developing a search engine. Microsoft's "Bing", Yahoo's "Yahoo" (haha), Ask's "Ask Jeeves", "Blekko", and I'm sure a number of others that I'm blanking on all have competing search engines. Bing even teamed up with Yahoo! It just seems that Google attracts more people because their search is better. Their 65% market share in search confirms this.
They strove to make a better product for people than what currently existed, succeeded, attracted everyone, and improved the access to information in today's modern world. From the beginning, it was about quality, the user of the information, and access to the information.
I'd say so far, it seems they have the merit, are acting legally (because search is free), there is competition, and aren't preserving their search status in any way that is against the law.
Search Rankings
So, I hope I've convinced you of my argument that Google's share of the search market hasn't been unfairly won, or that they use it to generate unfair artificial prices. They don't even have prices for the users of the search.
The next step, then, is to look at how search rankings are affecting the "Gripers". Yelp, Nextag, and Expedia all claim to have lost business as Google drives it's users into their own specialized sites, rather than the existing ones. They all share a similar characteristic- they're where people go for specific information rather than first searching through Google. Expedia is for travel, Nextag is for product prices, and Yelp has reviews on different locations (restaurants, bars, shopping). Is Google targeting these? Again, tough for me to say. So what if they are?
These companies, in this case websites, exist simply because they add value to the customer. Just as Google earned this positioning not so long ago from adding value, so too must these firms add value for their businesses to flourish. As a website, they add more value to the customer when they're easier to access, and the access to that information can come in many different ways. Google isn't the internet authority or the internet itself. They just are a website that helps to organize it. Their opinion on how the internet is what everyone is arguing about. It's so powerful that people want this opinion regulated. Google is trusted 65% of the time! That's staggering.
But that's the thing. Google owes it to user. They always have. Not to the websites. They form an 'opinion' on what's most relevant to user based on how the internet should be organized- it's not an exact science but rather just an estimate. Yes, a conflict of interest does exist to display your own product above your competitors, but isn't that like akin to private label goods in the grocery store?
I don't see Kraft filing anti-trust lawsuits against Costco's Kirkland fabulously successful (and delicious) private label food brand. Costco can arrange the shelves as they see fit because they've brought all the products into the store, organized them, and sell to customers who come in the door. It would be a ludicrous lawsuit. But that's how I see this. Google is arranging their shelves, putting their brand above the competitors, and trying to help the consumer along the way.
My message to these gripers: you aren't entitled to your customers. You have to earn them. Just as you aren't entitled to a profit. You have to earn it. This is why those businesses that fail do so because they've not added enough value. Just how I see it. There are also other venues from which to market. And Google isn't restricting any of it.
As an aside, I realize "adding value" is not the differentiating factor for business success all the time, but for longer-term strategies in business competition, adding value is an important one.
The Question
So, they haven't unfairly won their current search market share, nor should the argument that their rankings are stifling competition hold. I don't consider it a stretch to stake my claim, then, that this is an "innocent monopoly" until proven guilty. And the smoking gun isn't in the evidence room just yet.
So, back to my original question for you- is a business entitled to a profit?
The answer is no. At least from the standpoint of the public interest.
I sure hope the Big Brother doesn't screw this up.