Thursday, May 14, 2009

William Waller & Jason Stock-M3 Funds
The U.S. Banking Sector: Chaos & Opportunity

M3 was founded in 2007, and invests (long and short) in small and mid cap names in the US bank and thrift sector. There are 1300 publicly traded banks, and 93% have market caps less than $500 million.  Stock presented his view of the current state of the banking sector:

• Significantly undercapitalized
• Credit quality still deteriorating
• More bank failures
• Unemployment rate will continue to rise
• Commercial real estate is in trouble

Stock believes that there will be in excess of 150 bank failures in 2009.  Still, he and Waller are still finding opportunity on the long side, and look for the following:

• Low Price/Tangible Book
• Excess capital
• Low loan/deposits
• Attractive markets
• Bearish management team
• Share repurchase plan
• Attractive deposit base

One long name Waller and Stock like: First of Long Island (FLIC: $21.00)

• 140% of tangible book
• 11 times LTM earnings
• Excess Capital; 8.5% tangible equity/assets
• 68.5% loan to deposit ratio
• $1billion high quality deposits with 1% cost
• Positive credit quality, just .01% non-performing loans
• Hidden value in branch ownership
• Near-term catalyst- R2000 index addition
• Could be worth twice current price

Scott Klein-Beach Point Capital Management
Opportunities in Stressed and Distressed Credit

Beach Point, which has $3.75 billion in assets, specializes in high yield bonds, distressed debt, and other credit related strategies. With the high yield market currently yielding 15-16%, Klein believes that the distressed market is currently offering opportunities of a lifetime.

Despite the acknowledgement that defaults will continue to rise, Klein sees this as a lagging indicator, and believes that continued forced selling of distressed bonds will create continued opportunity in an extremely inefficient market.

According to Klein, the high yield market has gained an average of 35% in the 2 years following monthly declines of 5% or more. Such declined have only occurred four times, with the latest, and most severe in late 2008.

With the average high yield bond trading at 70 cents on the dollar, with an 8% coupon, Klein sees ample opportunity in this area, even if the worst default scenarios we’ve ever experienced (Great Depression) are repeated.

J. Carlo Cannell – Cannell Capital
Hydrodamalis Gigas

Carlo Cannell always manages to surprise, and this Congress was no different. He brought with him a co-presenter, Karthik Panchanathan, a graduate student in Biology from UCLA who very articulately presented interesting examples of animals that had become extinct, or were on their way there. Before the audience scratched their head in wonder, Cannell very interestingly tied these situations to companies and industries that had followed a similar path.

Who knew that Hydrodamalis Gigas (the presentation title) is actually the scientific name for the Steller Sea Cow, a huge manatee-like animal that went extinct in 1741? Cannell tied the plight of this animal to that of the restaurant business: both had trouble adapting to environmental changes, the Steller Sea Cow faded into oblivion, and so have many restaurant chains.

The main point of Cannell’s presentation was that the laws of nature also apply to Wall Street, and investors would be wise to look for the “cockroaches” of companies - those that can survive nearly any situation. Look for businesses less prone to predators or extinction, says Cannell.

Currently, Cannell finds the following industries attractive: Oil and gas, agriculture, death care, precious metals, energy service.

Whitney Tilson and Glenn Tongue-T2 Partners
An Update on the Mortgage Crisis and a Discussion of Wells Fargo

The conference concluded with Whitney Tilson and Glenn Tongue.

Last year, conference co-founder Tilson and Tongue, his partner at T2, hit the nail squarely on the head with their bleak outlook for the housing and mortgage markets; it was one of those sobering presentations that you hoped would not come to fruition. But it did, and the T2 guys were astonishingly accurate both with their macro views, and list of shorts and longs.

This year they put it in print with their book More Mortgage Meltdown: 6 Ways to Profit in These Bad Times, which was the basis for much of their presentation. If their scenario continues to unfold as suggested, there is much more pain to come in housing land.

The reams of statistics and data they presented seem difficult to dispute, and they put it all in such easy to understand terms that they are well on their way to becoming the de facto experts on the crisis.

All is not lost though; this will not morph into the Great Depression in their view, and they still see opportunities in the markets, both on the long and short side.

Tongue presented the bullish case for Wells Fargo (WFC), which they were short earlier this year. Now they are long WFC:

• Capable of earning $3.35-$4.26/share, $17.1-$20.1 billion net
• Worth $40-$50/share at a multiple of 10-12
• Business has enormous yield spreads
• Buffet bought for his personal account
• The Wachovia portfolio already significantly marked down

Incidentally, waiting for the 10:35 flight back to Philly post Value Investing Congress West has become one of my opportune times to catch up on some reading. Last year, it was David Einhorn’s Fooling Some of the People All of the Time, a VIC giveaway, that I could not put down. This year it was Tilson and Tongue’s just released book (the giveaway at his year’s VIC). With all of the confusion about the genesis of the housing crisis, this book is a must-read.

*The author does not have positions in any of the companies mentioned. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only.

Jonathan Heller, CFA

One of the more interesting revelations in Alice Schroeder’s biography of Warren Buffett, Snowball, is that the Oracle used coattail-riding as a strategy early in his career. For a notably independent thinker, this is surprising. Yet the book also reveals how often Buffett relied on friends and colleagues to collect information on his many investments. In a sense, Buffett had been coattail-riding since the very beginning, learning the craft from Ben Graham at Columbia University and studying his mentor’s every idea, the most successful outcome of which was GEICO.

In Schroeder’s chapter “Spaghetti Western,” Buffett is riding the coattails of Gurdon W. Wattles, who ran a closed-end investment company called Century Investors. Buffett explains:

“He did this chain thing where he would be buying stock in a company at a discount, which would be buying stock in another company at a discount, which would be buying stock in another company at a discount.

[…]

For ten or fifteen years I followed him. He was very Graham-like. Very Graham-like. Nobody paid any attention to him except me. He was sort of my model as to what I hoped to do for a while. It was so understandable and so obvious and such a sure way of making money. Although it didn’t make you huge money necessarily, you knew you were going to make money.

You don’t have to think of everything, you know. It was Isaac Newton who said I’ve seen a little more of the world than others because I stand on the shoulders of giants. There’s nothing wrong with standing on other people’s shoulders.”

Buffett eventually surpassed Wattles in making Russian doll-type investments, all of which ended under the umbrella of Berkshire Hathaway.

Nearly five thousand miles away across the Atlantic, the enigmatic Belgian billionaire Albert Frère has been doing something similar.

Born in the small Belgian town of Fontaine-l’Evêque on February 4, 1926, Frère came into a family of nail and chain merchants. At the age of four his father died of pneumonia, leaving his mother, Madeleine – then 44 years old and devoid of one eye – to take over the family business.

From these humble beginnings, Frère has built a fortune worth over three billion Euros by quietly buying and selling stakes in European companies. His background and the corporate history of his holdings are extremely colorful, and have been chronicled well in a recent Bloomberg profile and a New York Times article. If you read French, you can also try his biography.

At the sprightly age of 83 today, Frère still heads or controls at least three publicly traded investment vehicles: Groupe Bruxelles Lambert (GBL), Pargesa Holding S. A. and Compagnie Nationale à Portefeuille S. A. (CNP). All three have holdings in common, with CNP having the most diverse set of assets. GBL and Pargesa, however, tend to trade at wider discounts to NAV and have very easily ascertainable values, given that their holdings are a handful of publicly traded European stocks.

There is probably no easy explanation for why the web interlocking these and other companies is so complicated, much the same way Wattles’s Century Investors or Buffett’s Blue Chip Stamps came to be after years of deal making. But if you were yearning to find a modern example of the complex holding structure reminiscent of the diagram in Snowball’s pages 412-413, just take a look at page 2 of this PDF on GBL’s website.

Pargesa is particularly easy to understand, however. It holds stakes in six public European companies and publishes NAVs weekly on its website (there are really seven holdings but the seventh, Iberdrola, is so small as to be immaterial). Pargesa’s shares trade on the Swiss Stock Exchange and are quoted in Swiss Francs. If you would like more details on the six main holdings, which range from oil and gas exploration and production to a worldwide leader in the spirits business, you may want to look at GBL’s latest annual report.

On Pargesa’s website you’ll find that the shares sell at a 20% discount to NAV. But knowing this is probably not enough. A disciplined investor will want to know what multiple of free cash flow he’s paying for the underlying businesses.

Here’s a recent diagram of Pargesa’s shareholdings:

Notice how the economic interest Pargesa holds in each company is multiplied by 50% in each case, because of its ownership of half of GBL (with the exception of Imerys).

Using conservative estimates of free cash flow for each of the six holdings, I arrived at a consolidated estimate – in Swiss Francs – of about CHF 8.6 per Pargesa share. Given that they currently trade for about CHF 70.75, the shares are available for just about 8.2x free cash flow. If you believe that a 10% discount rate is an appropriate indifference level between today’s and tomorrow’s cash flows, a multiple of 8.2x implies a perpetual decline of 2.2%. Given the quality of the businesses Frère has invested in, this is unlikely.

Keep in mind the risks: many of the holdings are companies that currently have a lot of debt. Lafarge and Pernod Ricard – both particularly debt-laden – have just issued rights offerings. This is when a company offers its shareholders the right to increase their stake in the business, usually at a discount to the current market price of the shares. This issuance of stock dilutes a shareholder’s ownership by increasing the number of shares outstanding, unless that shareholder participates fully in the rights offering. GBL, being a large shareholder of both Lafarge and Pernod Ricard, bought all the shares to which it had rights, thereby maintaining its economic interest intact.

Like every great investor, Frère has also made mistakes. But this is a good opportunity to ride the coattails of a savvy operator and pay nothing for the privilege.

Marcelo P. Lima is a securities analyst. He may be reached at MPL4@cornell.edu

If you walk into a Tuesday Morning store, you might not be all that impressed.  It’s the epitome of closeout stores, a kind of higher-end Big Lots, or rich-man’s Family Dollar. The merchandise in this case is typically upscale home furnishings, house wares, gift items, some toys, and a very limited selection of sporting goods, to name a few.  But, this retailer, which is not small with more than 840 stores in 47 states as of last June, continues to chug through this recession.  What’s more, the company is a net/net.

It was a net/net 5 weeks ago when it hit a low price of $.51, and it’s still a net/net today, despite the fact that it’s up 319% since then.   The company was profitable on a trailing twelve month basis through December, although that’s likely to change when the company reports final third quarter numbers on April 27.

Yet shares have surged, due in part to a rising market tide, perhaps a light at the end of the economic tunnel, and the fact that Q3 sales dropped a better than expected -6.4%, while same store sales fell 9.5%.  The company, although light on details until the earnings call (other than that sales fell to $167 million from $178.4 million for the quarter; and earnings will be in the -$.15 to-$.17) also announced that trends and customer traffic appear to be improving.

With current assets of $278 million and total liabilities of $118 million, Tuesday morning’s net current asset value of $160 million is far in excess of its $91 million market cap.  Although operating in a treacherous retail environment, the company carries just $2 million in long-term debt.

Of course, retailers that don’t own their real estate, as is Tuesday Morning’s case, typically have operating leases, which don’t show on the books.  Tuesday Morning currently has $190.5 million in operating leases, which can’t and should not be ignored.

But, at its current price of $2.10, Tuesday Morning is trading more or less as a call option on what was once a pretty decent business; a call option on a pickup in the economy and consumer spending. It’s certainly not for the faint of heart, but net/nets, especially retail net/nets usually aren’t.

Tuesday Morning
Ticker: TUES
Price: $2.10
Market Cap: $91 million
Net Current Asset Value (NCAV): $160 million
Mkt Cap/NCAV: .57
P/E: 74 (through December)
Cash: $5.8 million
Debt: $ 2 million
Enterprise Value: $80 million
Locations: 842 (June, 2008)
Price/Book: .37

Jonathan Heller, CFA
Position:  Long TUES

Common stock investing is inherently risky, and those risks cannot be divorced from the rewards that come with them. Often, it isn’t easy to separate the speculative from the investment component of a common stock commitment. On this topic, Ben Graham, author of the classic The Intelligent Investor, has written most clearly:

Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing;  (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

With that caveat, here’s Wellcare Group (WCG), a stock that has a reasonable chance of going higher once its legal problems are resolved and its earnings normalized. As such, it may present an intelligent speculation.

First, a quick background. Wellcare is a healthcare management organization focused on Medicare and Medicaid, government-run entitlement programs for the elderly and low-income population. It has over 2.5 million members enrolled in its programs nationwide, with a large portion of them in Florida.

Its stock hovered around $120 per share when in October 2007 about 200 FBI agents raided its Tampa campus. The stock collapsed to $40, wiping out $3.3bn in shareholder value. The uncertainty was large; there was no official word of what the FBI raid was for, although newspaper reports stated that one of Wellcare’s subsidiaries had overbilled the government by $35m. In this context, the share price collapse was wildly overdone.

A quick resolution of the problem didn’t happen. Instead, the company went “dark,” not filing its quarterly and yearly financial statements and risking stock exchange delisting for its non-compliance. Periodic SEC filings kept shareholders apprised of the slow progress, but it wasn’t until early 2009 that things became clearer. The company finally filed all of its late financial statements and set a shareholder’s meeting – the first since the FBI raid – for July 30.

Wellcare is well capitalized. As of 12/31/2008, it had about $1.2 billion in cash and $153 million in debt. This debt proved to be another Achilles heel for the stock. When the company reported in 2008 that it was in technical default for not having filed its financial statements, the price dropped precipitously yet again. Fairholme Capital, which owns nearly 20% of the stock, bought a majority of the debt, likely in a move to protect its equity investment.

Throughout this misadventure, the stock has swung wildly, hitting a low of $6.12 in November and $6.23 in March of this year. Yet Wellcare’s core business remains sound, generating substantial free cash flows. The exact number for 2008 involves reversing a goodwill write-down and removing a non-recurring $103m in litigation expenses, but a normalized estimate of $4 in free cash flow per share is probably on the conservative side. While there is significant regulatory uncertainty surrounding its Medicare and Medicaid businesses, at the current price of around $13.80, it’s hard to find a way to lose.

Yet all of these uncertainties – particularly those surrounding the FBI investigation – are still large, which is where the speculative component of this investment comes in. There might be a probability of the government’s penalties being larger than expected. The company is also facing various lawsuits related to its illegal activities, including a class-action lawsuit. Defending against these will cost management’s time and shareholders’ cash.

On the other hand, Wellcare may soon begin conducting conference calls with shareholders and analysts, may soon settle with the government by paying a fine, and may ultimately get sold to a larger competitor, such as UnitedHealth Group. After it fired its disgraced former management, the board brought in Charles Berg, formerly a UnitedHealth executive, Oxford Health Plans CEO and “deal guy.”

With these factors in mind, and taking into account Graham’s three points above, Wellcare may seem like an intelligent speculation after all.

Marcelo P. Lima is a securities analyst. He may be reached at MPL4@cornell.edu

Lamar Advertising (LAMR) is an outdoor advertising company with a large network of billboards (over 150,000). Fear that LAMR may default on its senior credit facility or may be unable to meet its obligation on its converts maturing 12/31/10 pushed down the prices of all of company’s securities. This fear drove LAMR’s equity value down over 50% in 4Q08 while its senior subs and converts began trading in the high-60s to low-70s. The fear of default reached a high point during 4Q08 and the company felt compelled to include a supplemental indebtedness schedule in its press release for 3Q08 results to address a “certain amount of misunderstanding and misinterpretation with [LAMR's] credit agreements and [its] outstanding debt.” As described on the 3Q earnings call, “There are three common misunderstandings in the investment community.” Two of these market misunderstandings pertain to whether the company will violate the debt-to-EBITDA covenant in the credit agreement controlling the senior credit facility (the “Credit Agreement”) and whether LAMR will be able to pay its debts as they come due. In the past month, a series of corporate events have transpired that support a scenario that could prove favorable to equity: LAMR survives any violation of the debt-to-EBITDA covenant and is able to pay off the converts, its nearest maturity debt obligations.

As described by management, the number one market misunderstanding “is that our senior credit facility total debt ratio test steps down from 6-to-1 to 5.75-to-1.” The stepdown to 5.75-to-1 from 6.00-to-1 in LAMR’s debt-to-EBITDA (the “Total Debt Ratio”) is listed on page 95 of the original Credit Agreement, dated 09/30/05, controlling the senior credit facility. On the 3Q08 earnings call, management stated the stepdown was “in the original agreement and we amended that ratio to remain at 6 to 1 for the life of the credit agreement . . . It is at 6 to 1 today and will remain 6 to 1 for the life of the loan.” What created this market misunderstanding? While not entirely sure, we’ve noticed that although page 87 of LAMR’s latest 10-K clearly lists three amendments to the Credit Agreement as exhibits 10(g)(2), 10(g)(3), and 10(g)(4), Capital IQ only lists the first amendment among the “Security Holder Rights and Agreements” in LAMR’s “Key Documents” section. This may be a source of market misunderstanding, since it is the third amendment, dated 03/28/07, to the Credit Agreement that states, without qualification, “The Company will not permit the Total Debt Ratio at any time to exceed 6.00 to 1.”

“The second misunderstanding is that [LAMR's] convertible notes . . . are included in total debt for covenant calculation purposes.” What created this market misunderstanding? There’s nothing to indicate that anything beyond the Holdco / Opco, Lamar Advertising / Lamar Media structure is to blame. The Credit Agreement only includes debt at Lamar Media for the Total Debt Ratio covenant. Lamar Advertising is the borrower on the converts due 12/31/10 that aren’t included in indebtedness for the Total Debt Ratio covenant.

The importance of the Total Debt Ratio has become particularly relevant. On 03/19/09, LAMR announced that it was “in the process of seeking an amendment to [its] senior credit facility,” and it was proposing a private placement of senior notes. The offering size of the senior notes was increased on 03/20/09 to $350 MM from $250 MM and offered at 89% of face value with a 9.25% interest rate (for a 12.56% YTM). Following on the stated purpose of the private placement to repurchase some or all of the converts, LAMR made a tender offer, expiring 04/17/09, for the converts at 92. The converts were trading around 75 immediately preceding the tender offer. The new senior notes are at the Lamar Media level and will count towards the Total Debt Ratio. Pro forma, as of 12/31/08, LAMR’s Total Debt Ratio would have been at 5.6-to-1. This has driven the company to seek an amendment.

Although management previously believed a 2009 with revenues down 10% YOY would constitute “the bottom falling out,” they mentioned that they’d never experienced that type of drop and would have to manage the two biggest costs: headcount and lease expense. Management also that stated that they weren’t planning on having to aggressively cut those costs in order to offset a (10%)+ decline in revenue. Now management is forecasting revenue down (15%) for 1Q09, and they’ve already begun drastic cost cuts (see the 4Q earnings call): 10% of the workforce has been cut and lease renegotiations have saved $10 MM on an annualized basis. All in, management estimates a (5%) decrease in opex.

Notwithstanding these significant cost cutting measures, that forecast indicates increased chances that EBITDA decreases swiftly and leads LAMR to violate its Total Debt Ratio covenant. With LAMR having cut back its digital deployment strategy and placed itself squarely in free cash flow generation mode in order to delever, the company’s lenders are likely to be willing to amend the senior credit facility. Management has stated that the bank group has said they’ll work with LAMR on an amendment—while obtaining a higher interest rate and taking in a pound of flesh in fees. JP Morgan is the administrative agent on the senior credit facility and led the purchase of the new senior notes, taking 60% of the issue (see Schedule 1 in the Purchase Agreement).

If an investor gets comfortable with the covenant default/amendment situation and the potential scenarios, a very simple estimate of EBITDA for 2009 of $400 MM and a stated maintenance capex of $15 MM puts LAMR at 10x its depressed 2009 free cash flow, assuming a (15%) decline in revenues for 1Q and (10%) for the balance of 2009 and a (5%) decrease in opex from 2008. Although LAMR is experiencing one of the worst environments it’s ever faced, one which management has never experienced before, it has an irreplaceable network of billboards with an opportunity for attractive incremental returns, beyond 2010, from investment in digital billboards and significant operating leverage through higher occupancy.