CIM -- Michael Farrell & Annaly Capital Management Inc.

At this point CIM has been in existence for just over 1 month. The company has not filled a single financial statement. There have been no conference calls or presentations beyond the IPO road show. The only piece of tangible news out of the company is the first minuscule dividend of $0.025 per share announced last week.

So why is the stock trading at $17.75 while it has an estimated book value of just over $14 per share?

The only explanation is that the market believes the involvement of Michael Farrell and his associates at FIDEC warrants a premium.

While CIM has no operating history, we can certainly use Farrell’s 10 year track record at the publicly traded Annaly Capital Management (NLY) as a guide. NLY has the same structure and business model as CIM with the big difference being that NLY’s assets are of the highest quality while CIM will invest at the lower end of the quality spectrum.

Looking back to 2006 with NLY shares slightly off the lows after being cut almost in half and the great credit orgy reaching its climax, here is the key quote from the 2005 annual letter (published in March 2006)

“As 2005 played out, we prepared our business for the inevitable change in sentiment and shape of yield curve. While other stretched for returns in the form of credit risk, mortgage derivatives, new business models or extra leverage, we stuck to our discipline of using AAA mortgage backed securities. It cost us some earnings …..but I believe this discipline will only be appreciated by investors when viewed through history’s rear view mirror.”

While this scenario benefiting NLY seems “inevitable” today, it certainly was not so in early 2006. This group stuck to their guns despite earnings and share price plummeting while it seemed like everyone else in the mortgage business was printing money.

NLY’s net interest spread – the main source of NLY’s and CIM’s income -- shrunk from 1.51% to 0.53% meaning that all other things being equal NLY would earn $1 in 2005 for every $3 earned in 2004. This happened because the yield curve flattened and this is a risk of being in this business.

One way to deal with a flattening yield curve is to buy less credit worthy assets which have a higher stated yield. The name for this strategy that clients and shareholders never hear is “reaching for yield.” The problem with this approach is while your net interest spread benefits initially, you are exposing your portfolio to bigger problems later if these higher yielding, less creditworthy borrowers start defaulting. Instead of buying, NLY was selling.

In the fourth quarter of 2005, NLY took a substantial loss by selling assets that they felt were unlikely to meet return expectations. Also, they did not buy any of the most recently issued loans made at higher yields but to less creditworthy borrowers. They cleaned housed. They shrunk their book of business just as the environment was at its most euphoric and it seemed like borrowers could refinance or sell their constantly appreciating homes forever.

By now Farrell and his group have been proven right and NLY is now growing and in a position to buy when everyone else is selling. The stock has regained much of what it lost in 2005.

What does all this have to with CIM?

CIM will make money the same exact way as NLY and will be run by the same exact people that manage NLY. The actions this group took in 2005 show that they are willing to sacrifice earnings, share price, and their reputations in the short term to protect and reward shareholders in the long term. This is a rare quality that certainly deserves a premium and should be a key consideration for every potential CIM shareholder.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

CIM -- Business Model

In this last “background” post on CIM, I am going to talk about how CIM actually makes money and the risks of investing in this stock.

How will CIM actually make money?

The company will take the $520M of cash it raised last month in the IPO (this is called equity) and buy real estate backed loans (these are CIM’s assets) that will produce an income stream in the form of interest and principle paid to CIM. It’s a bit confusing, but CIM’s assets are loans made to someone else. So at this point the company’s balance sheet essentially looks like this …….

$520M in assets yielding lets say $25M in income to CIM
($520M in equity raised as part of IPO)

Then CIM will use its assets as collateral to borrow money and will pay X% as interest expense to the lenders. The company will than use this borrowed money to buy more assets hoping that its assets will yield X%+Spread. So now CIM goes from having $520M in assets yielding $25M, to ……

$520M in assets yielding lets say $25M in income to CIM
$5,000M in additional assets yielding $250M in income to CIM
($5,000M in new liabilities which cost CIM $200M in interest expense)
($520M in equity raised as part of IPO)

So, by leveraging its equity CIM goes from earning $25M or 5% return on equity for shareholders to earning $75M ($25M on equity raised in IPO + $50M in difference between interest income on $5B in assets and interest expense on $5B in liabilities used to pay for those assets) and ROE jumps to almost 15%. Since this is a REIT, 90% of the income gets paid to shareholders in form of a dividend so the shares will have a much higher yield than other equities.

This is a very simplistic example but this example give a good example of where the cash will actually come from and how a company with $500M in equity can have 10x the buying power.

Seems easy enough, but what could go wrong?

The first problem is that CIM’s business model is exposed to the yield curve because CIM will borrow using shorter term loans like commercial paper but will buy long term assets with that money like 30 year mortgage loans. There is a mismatch in maturities that creates a big risk of the yield curve flattening. If the yield curve flattens than the difference between costs and revenue will shrink and CIM will earn less money. This is exactly what happened in 2005 and CIM’s parent Annaly Capital Management got whacked as a result, more on this later.

The second problem is that the company will use a lot of leverage, that’s part of the business model, and is sensitive to what is happening in the credit markets beyond the shape of the yield curve.

For example, if the banks CIM borrows money from all wake up one day and say that they want their money back at the same time or the assets that they are holding as collateral are now worth less than they were yesterday, CIM could be in some series trouble. At this point, CIM either has to find someone else to lend them money, issue more stock which dilutes current shareholders, or have a fire sale on its assets to pay off its lenders. This is called a “credit crunch” and is exactly what happened in early August and is happening right now.

The third problem is that the value of the CIM’s assets is uncertain and changes every day while the cost of its liabilities is written in stone. CIM’s assets are loans to others either in the form of actual loans it buys from a major bank that originated them or in the form of a credit security backed by mortgage loans. Since these are long tem loans there is always a risk that borrowers will default and CIM does not get all the interest/principle it expects to get so the actual yield they realize on their assets is lower than expected.

The other risk is that one day the market can simply decide that its assets are worth much less than originally thought but the liabilities CIM owns will stay the same. If this happens there is a mismatch between loans and assets and that mismatch will be made up buy shareholder equity and will kill the stock. This is by the way exactly what is happening with just about any financial institution that owns any mortgage related assets.

So this is why CIM’s business model is a “catch 22” proposition. On one hand its extremely simple – just borrow short at X and lend long at X+Spread—and leverage that trade up 10 times and you are printing money.

On the other hand, CIM is exposed to the yield curve as well as the gyrations in the credit markets which can change overnight. If CIM takes on to much leverage or can’t sell its assets to raise money in a credit crunch, the company can go out of business overnight or suffer a serious impairment to shareholder equity and therefore the stock price. Also, the company may simply overpay for assets and not earn as much as it expected on them.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

CIM -- Investment Structure

As I wrote in the previous post, CIM is essentially a publicly traded hedge fund structured as a mortgage REIT which means they have to pay at least 90% of their income out as dividends every quarter.

For shareholders this structure exhibits two of the most attractive aspects of investing in hedge funds and one very unattractive aspect.

The first attractive aspect is that the group at FIDAC that will be managing Chimera will be paid on a standard hfund 2/20 structure. Particularly, FIDAC will charge 1.75% of book value as a base fee and will take 20% of anything CIM earns beyond LIBOR + 50 bps. The incentive fee makes perfect sense because FIDAC needs to earn a premium to LIBOR (which any shareholder can get themselves) before they start sharing in the bounty. Also with this structure, FIDAC’s interests are directly aligned with shareholders’ interests.

It also appears that all fees that CIM pays to FIDAC will be adjusted downward to exclude any fees paid on Annaly sponsored products that Chimera might buy. This eliminates the possibility of FIDAC double dipping on fees and benefiting NLY shareholders at the expense of CIM shareholders.

The second attractive aspect of CIM’s structure is that FIDAC has “skin in the game” along with other CIM shareholders. As part of the IPO, FIDAC bought 9.8% of CIM’s stock spending roughly $50M dollars of its own money. Technically, it was Annaly that bought the stock but I am using FIDAC and Annaly interchangeably. Having a large chunk of their own money invested along side fund investors is very common with hfunds and is a substantial advantage to shareholders as interest are perfectly aligned.

The only unattractive aspect of this type of structure is one that is unavoidable and not unique to CIM. Whenever investors hand money over to professional asset managers whether it’s to a stock broker, a hfund, a mutual fund, or a vehicle like CIM the asset manager always has higher incentive to take greater risks than warranted by the mandate. The reason for this is simply that the career/financial benefits to a professional asset manger of taking big risks and being right are almost always much greater than the downside of being wrong.

Every professional money manager knows that if they take unnecessary risks and underperform or even blow up they might get fired or will have to shut down their firm. But professionals also know that if they get fired they can go hide out at a trust department or an insurance company somewhere. If they really screw up, they might have to get out of the business for a couple of years. But everyone knows that things will be forgotten in a few years and they will get another chance to manage money.

But if the managers take the big risks and are right ....... they will become superstarts.

For professional money mangers -- like the people that will be managing CIM -- taking big, unessasary risks is like buying a call option on your career. If you are wrong you lose the small premium (maybe your job or some bonus money) but if you are right, you win big. The problem for investors is that while the manager might lose a little they might lose a lot.

The incentive fee and having the manager’s money along side shareholders is there to minimize the negative aspect that can never be completely eliminated. In subsequent posts I will also make the argument that looking at the track record of Annaly provides substantial evidence that this management team will be very good stewards of shareholder’s capital and CIM’s hedge fund like structure is a net benefit to shareholders.


* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

CIM (Chimera) – First Look

I was initially introduced to this company at 3:00 pm on November 16^th, 2007 when I was getting ready for a conference call and overheard one of the CNBC anchors say “Michael Farrell celebrates Chimera IPO by ringing the closing bell at the NYSE.” At that point I have never heard of Chimera but I have certainly heard of Farrell and immediately downloaded Chimera’s S1.

This analysis will be a bit different than those in the past and I will spend less time talking about Chimera and more time talking about Michael Farrell and Annaly Capital Management which is Chimera’s parent and Farrell’s main investment vehicle.

Currently:
Share price: $15.25
Market Value: $564M
Enterprise Value: $520M (this is book value for CIM)
Investment Type: Time Arbitrage

CIM completed its IPO almost exactly 1 month ago on November 15, 2007. Per the filling on the day of the IPO, CIM planned to sell 33.3M shares at $15 per share raising $500M with an additional 5M shares optioned for overallotments. Off the $500M raised, $31.25M would be paid to the investment banks doing the IPO so CIM would received $14.0625 per share in actual proceeds.

Based on the 11/30/07 13D filling, Annaly owns 3.62M shares representing 9.8% of total shares outstanding, a maximum percentage of shares outstanding allowed to be owned by any shareholder under this structure. This implies that the final number of shares sold was 36.94M for a net proceeds after selling expenses of $520M.

CIM is basically a publicly traded hedge fund managed by an asset management group called FIDAC which is led by Michael Farrell (Annaly technically owns FIDAC but the same people that manage FIDAC also manage Annaly). The company is structured as a REIT which means at least 90% of its income will be paid out as dividends and virtually all of its investments will be real estate backed mortgage loans and structured products backed by mortgage loans.

I will spend more time in the next post on the company’s business model and may do a quick primer on the basic accounting of mortgage REITs.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Some real evidence of a slowdown .......

One of the drawbacks of working for a traditional institutional asset management firm with a decent amount of assets under management is that I get a ton of Wall Street research and I am expected to read most of it and regurgitated it to colleagues, clients and prospects.

Needless to say that reading this stuff gets old fast so I get particularly excited when something useful/interesting/contrarian comes across my desk. Here is the most relevant excerpt from a recent morning note from Merrill Lynch …..

"Mr. Rosenberg, I have been reading your economic reports since your arrival at Merrill. Last night I began my evening by tuning into Kudlow on CNBC. The topic was as usual "Will the slowdown in the housing sector send us into a recession?"

With that topic on my mind I ended the evening with a group of High School students meeting with a local cement contractor. He began his career 20 years ago with one truck and a second mortgage for capital. He now has 85 trucks that cost $175,000 each and 100 employees with salaries of $40,000 to $100,000. Business has been good the last 20 years. We began asking questions: How is business going? We have some road contracts but the housing business has almost stopped. Will you be buying any trucks this year? No. Will you be hiring in the next 6 months? No. Is there a cement shortage? 2 years ago there was a shortage but no shortage now. How much fuel do you use each month? 20,000 gallons. How much do you spend on benefits and insurance? About $10,000 per employee. Other questions were asked and my conclusions were these. This small businessman will not be buying any trucks this year. His employees who love to buy their own large 4 wheel drive trucks will not be buying either. Less fuel will be bought. Less cement will be purchased. Less money will go into retirement plans. Less money to insurance providers. The only expense that was going up was the legal expense for liens on contractors not paying.

Looks like the housing recession is affecting more people than I thought."

I believe that this is relevant since it provides more evidence in two particular areas of interest to investors……

1) The housing market slowdown is decreasing the amount being spend by Americans in real time and not just because they can’t tap the equity in their home, and

2) it says something when the most relevant piece of Wall Street research I have seen in some time (and I am not singling out Merrill who to their credit have been sounding this alarm for a while) is contributed by a reader.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Things that make me happy......

Ran across this great line in this Financial Times article. The article is your boiler plate summary of the current problems in the credit markets but this opening line blew me away and really made me happy.

"As the technology bubble imploded, fund managers stopped pretending to know what ethernet routers did and started asking what life would look like if all tech stocks halved in value. The structured credit market has yet to reach this moment of clarity. As is typical when the sky falls in, many specialists, obsessed with complexity, point to the impossibility of generalizing about the weather.


I have a perverse pleasure of seeing investment industry bullshit get exposed to the public. One of the most frustrating for me is the often voiced idea that portfolio managers and their army of analysts at trust departments or a mutual funds know something about advancements in technology or biotechnology.

Also, the tech bubble and the subsequent explosion holds a special place in my heart as I had the experience of being an equity analyst intern in 2000 and 2001 for a manger of a $1 billion tech fund who thought that it was actually his skill that was responsible for the 5 star Morningstar ranking and the doubling in NAV and assets over the previous 2 years.

I was also there when the music stopped and it became painfully apparent that none of us, me least of all, knew anything about ethernet routers. I am glad to see that I am not the only one who feels the current credit meltdown feels exactly the same as the tech bubble popping.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

“Best Case Scenario Valuation” for CPY …….

In the previous post I laid out a valuation framework using what I feel are very bearish assumptions with the conclusion being that buying the stock anywhere between $21 and $34 per share provides for expected rate of return of 15% to 10%.

Today I will silence my inner and ever present skeptic and will try to put some numbers on what the upside looks like assuming some good things happen over the next few years:

BEST CASE SCENARIO assumptions ……

-EBITDA at Sears would stay flat over the next two years (not all that bullish as EBITDA has been growing over the last 2 years)

-immediate incremental improvement in Wal-Mart EBITDA (not all that bullish as EBITDA can be drastically improved by simply closing underperforming stores)

-Wal-Mart would eventually achieve similar margins as Sears and FCF would double (very bullish assumption as the Wal-Mart business serves a lower end consumer at lower average sales price)

-PCA is not sold under this scenario, so the NOL’s that came with the acquisition can be included in the valuation analysis

Under this best case scenario, the CPY shares would trade at $90 per share assuming a 10x EV/FCF multiple. At a 7x EV/FCF multiple the shares would trade at $60 per share.

The best and worst case valuation scenarios I laid out highlight why I am so bullish on CPY over the next 3 years. Based on worst case assumptions, the stock has very little downside of 20% at which point you would be buying the CPY business at 7x free cash flow. However, the upside is up to 200% assuming the company’s management can do with the Wal-Mart business what they did with the Sears business.

As I see it, as an investor in CPY shares for every $1 in downside risk I am getting $9 in upside potential ….and that’s pretty damn attractive.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

“Worst Case Scenario Valuation” for CPY …….

In the previous three posts I discussed the following points:

-reported earnings are substantially lower than operating earnings due to acquisition accounting

-sittings at Sears are still falling at almost a 10% clip and CPY can only raise prices by 5% so this is a serious problem, however EBITDA for Sears is still growing and both gross and sg&a margins are improving YoY

-CPY’s management will be using the Sears blue print for the acquired Wal-Mart business with a realistic chance that this company can generate $80M - $90M in EBITDA in 2010 and has a market value under $200M with $71M in net interest bearing long term debt

-Knightspoint (aka Ramius) increased their stake by 75% as the stock fell ….basically, very smart people who control the company and know the most about it are doubling down

Alright, here comes the fun part – what does valuation look like? In this post I will try to assign a “WORST CASE SCENARIO” price to CPY shares.

Here are my WORST CASE SCENARIO assumptions ……

-by the end of 2009 the PCA acquisition has proved to be a complete failure

-CPY’s management losses focus and the Sears business sees a decline in EBITDA to $40M per year – from $45M over the last 12 months -- so FCF comes in at $26 ($40 - $5 Capex - $9.2M in tax assuming $14M in D&A) in 2009

-there is no improvement in Wal-Mart EBITDA for the next two years (I think this is extremely conservative since they will surely improve EBITDA by just closing underperforming stores)

-CPY is forced to sell the Wal-Mart business at ½ acquisition price of $82.5M + ½ of the money invested in digital equipment which is targeted to be $38M …..non of PCA’s NOL’s are used or valued under this scenario

Under this worst case scenario, over the next 2 years CPY would use most of its FCF for the digital upgrade at Wal-Mart. CPY would than sell the Wal-Mart business at ½ its total investment and be left with just the Sears business which is now earning less due to loss of focus. Here is how the numbers look……

(I know that the picture is hard to read .....if you double click on it it will enlarge....if you want the excel version shoot me an email at offthebeatenpathinvestments@gmail.com)

Unless I am completely missing something, at current price of $25 per share we get to buy a stock that will have an estimated cash yield of 13% even if a lot of things go wrong. At $21 per share the forward cash yield is at 15%. If you are targeting a cash yield of 10% your buy point is $34 per share which is 20%+ above trading price.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Knightspoint is loading up

October 16, 2007 …………From the filling ……..

New total Knightspoint ownership increased to 1.850M total shares or 29%. Knightspoint continues to add to their position as the stock is falling!

September 10, 2007 ………..From the filling ………..

Announced that Knightspoint (through other entities they control) has purchased an additonal 536,750 shares worth $23.1M. The stock was bought between 9/10 and 9/12 at an avg price of $43. This brings their total Knightspoint ownership to 1.598M total shares or 25%.

Here is a Bloomberg GPTR screen that plots insider buys (green arrows) against the stock price.

These insider purchases indicate that the largest investors in the company, who also happen to have the most insider information, control CPY's future and cash flows, and happen to be sophisticated financial buyers just increased their position in the stock by 75% as the stock is falling off a cliff!

Enough said.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Key points from Q2:2007 Conf Call

Here are my notes from the CPY conference call ….

In my previous post, I adjusted EBITDA for the $8.1M in unbooked revenue. It looks like reported eps was $1 per share lower than operating eps …

"Our overall second quarter results were significantly negatively impacted as a result of purchase accounting adjustments associated with our acquisition of PCA, which closed on June 8. The overall acquisition negatively impacted per share results and net earnings by $1 and $6.4 million respectively."

Looks like sittings will continue to decline in the next quarter. Keep in mind that this was stated on August 29th so the quarter is over by now ...

"The preliminary net sales for the Sears Portrait Studio Division for the first four weeks of fiscal 2007 third quarter represent an approximate 5% decline over the comparable period ended August 19, 2006."

Guidance on digital conversion .....

"We plan to convert up to 400 PictureMe Studios to digital technology before the 2007 holiday selling season. The balance of the US studios are planned to be converted prior to 2008 busy season with the conversion of the Canadian and Mexican studios to follow in 2009. Preliminary estimates of capital requirements to complete the PictureMe integration, over $15 million in 2007 and $23 million in 2008."

Below is the most important portion of the conference call because it show how investors and CPY's management are thinking about the PCA acquisition as well as the attractiveness of CPY shares ones the PCA business is fully integrated by the end of 2009 ......

Q: “Quickly on the PictureMe integration, just thinking about the acquired business back of the envelope there is roughly twice as many studios each of which is delivering about half the revenues as SPS, gross margins are a little bit lower but not that much. Is there really any reason given that the per studio CapEx should sort of come down pretty rapidly given that technology curve since you did the same thing at SPS. If there any reason structurally why the ability to extract free cash over time from PictureMe should be at all inhibited related to the experience at SPS?

A (from CPY CEO): Obviously, that was the part of the attraction to us being able to acquire those assets, as we talked about on previous calls may have the ability to significantly leverage our corporate infrastructure here to realize the cost synergies that make this makes sense but in addition we are confident that by installing digital technology, training the PictureMe associates in the digital technology and having access to the unrivalled foot traffic that you do have in the Wal-Mart stores, that what you just described would certainly be our expectation.

Q: And just sort of thinking back to where we are now with SPS in terms of free cash flow, looks like in the trailing 12 months your somewhere between 40 and $45 million of free cash flow out of SPS.

A: Right

Q: If that doesn’t erode too awfully much over the next couple of years, once we get into ‘09 and you are through the CapEx injection into Picture Me. If we start getting similar free cash flow numbers out of those Picture Me studios, we could be talking about 80, $90 million of free cash flow being delivered by the whole company and yet we’re sitting here looking at a market cap under $300 million, which just strikes me as unbelievably attractive."

Here is the best part ........the cash flow projections have not changed but the stock has been cut in half since the conference call to roughly $160M.

What’s the next level after “unbelievably attractive?”

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

CPY Q2:2007 Earnings Analysis

By just about any measure, CPY has been a pig of a stock. I first posted about it on 6/11/07 when the share price was $71. I have bought shares for the Marketocracy Best Ideas portfolio at an average price of $40.75 and the position now makes up 5% of that portfolio. I have bought shares for my personal account at $45, $40, and $30.5. Any way you look at it, this has been a bad investment thus far.

Obviously, at this point the question is do I cut my losses, do I add to my position or do I hold on. The next few posts will concentrate on CPY and I hope that I can come up with a reasonable answer.

First, the latest quarterly earnings analysis …….

The company reported fiscal Q2 earnings on 8/28/07 with this being the first quarter that included 6 weeks of results from the acquired Wal-Mart business. In their fillings, the company is calling the Wal-Mart business “Picture Me” and the legacy Sears business is called “SPS.”

GAAP reported net income in the quarter is NEGATIVE $3.4M vs. +$0.64M last year. However, it looks like the reported GAAP numbers are substantially understated. As I understand it, the company essentially booked 3 weeks worth of revenue from Picture Me--deferring $8.1M worth of revenue--but full 6 weeks worth of expenses.

Below is a breakdown by business line and what actual EBITDA looks like once the $8.1M deferral is added back:

The real bad news is that Sears continuous to see declining sales with sittings down 9.4% while avg price per order was up 4.8% for a net Sears revenue decline of 5.6%.

The good news is that despite the sales decline management is finding more costs to cut and EBITDA is still growing. Sears EBITDA was up $2M in absolute terms. Sears EBITDA margin up to 14.5% from 10.1% in Q2:2006. Margin improvement came from BOTH GROSS AND SG&A MARGINS.

Interest expense increased as the company is now carrying $115M in debt. D&A increased due to the acquisition. The 10Q stated that D&A from the PCA acquisition will be $14M annually.

From a purely financial perspective, I would say this quarter was substantially better than it looks. The Picture Me business will probably continue to distort earnings for another few quarters as CPY’s management starts to upgrade to digital, raise prices, and starts cutting costs – basically they will follow their Sears game plan from a few years ago. Negative sitting continues to be a concern, however average prices per customer are still rising and EBITDA is still growing.

In the next few posts I will highlight key points from the conference call, talk about the massive insider buying activity, and how I am looking at valuation.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

FTAR.ob -- 3Q Earnings Analysis

FTAR announced Q3 : 2007 earnings last week. Here is the quick breakdown of reported earnings

Q3:2007
Rev $148 (down 3.8%)
GP $44.2 (GM up to 29.9% vs. 29.8% last year)
EBITDA $7.2M (down from $7.7M last year, EBITDA margin down to 4.9% vs. 5% last year)

YTD 2007
Rev $455M (down 6%)
EBITDA $32.9M (up from $30.8M)

When I last wrote about the company I stated that

“next quarter I will be watching for the trend in SSS, K-Mart closings, and EBITDA margin improvement”

While it looks like the sales decline is slowing, there is still a sales decline with SSS at Shoemart down 1.8% and store closings of 0.4%. While it is disappointing I can’t say that I am entirely surprised taking into account the warm winter and consumer spending problems at the low end shopper.

The big disappointment for me was the decline in EBITDA margin. FTAR has been able to offset the decline in sales with continued operating improvements but it looks like they finally ran out of places to cut cost. Not even the best mangers can keep swimming against the tide of negative sales growth – looks like this is the first quarter where this has caught up with FTAR.

So …..sales are down, store count is down, warm weather means less need for new shoes, FTAR’s customers have less money in their pockets, and cost cuts are not keeping up with sales declines ……WHO CARES?

FTAR is still going to generate somewhere between $15M and $25M in free cash flow in Q4 of 2007 and another $30M - $60M in free cash flow in 2008. It will sell its headquarters for north of $20M and already has $15M in cash. With K-Mart having to buy all its inventory at book value at the end of 2008, FTAR is worth somewhere between $5 per share (worst case scenario which assumes some very bad developments) and $8 per share (best case scenario that is way bullish).

In the following quarter, my expectation is that sales well be down roughly 5%. The thing I will be watching is how badly EBITDA margins get hit. Will they continue to fall or will management continue to work its magic.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Watching the sun set ......

While I hate classifications like "value investor" and "growth investor" because by definition every investor is a value investor, if I had to put myself one group I would be in the value camp. I don't think its a stretch to say that just about every value investor is keeping an eye on publicly traded homebuilders as they have been decimated and there will undoubtedly be a very attractive investment opportunity.

The question is .....when?

I will not attempt to predict a bottom in the housing market and homebuilder shares ....not now, not ever. What I will do is share a short "anecdotal" list of things I am watching for to let me know that we are closer to the bottom than the top:

1) multiple bankruptcies of the weakest most leveraged players
2) insider purchase activity at the leading players in the industry
3) large net income losses and massive write-downs
4) largest players in the industry trading below $10 per share
5) politicians become "unanimously outraged" at something
6) nutty valuations

While this list is not in any specific order, my experience has been that when the bubble bursts and things really get hairy, the weakest players are the first to go. We got news on Friday that LEV has filled for Chapter 11. Also, the good people at Calculated Risk report that BZH is having a hard time paying some of its sub-contractors -- not technically a bankruptcy but close enough. My guess is that CHCI and TOA are next.

Points #2 - #4 are fairly straight forward. It looks like the chairman of NVR--probably the most attractive publicly traded homebuilder--just bought a bit over $1M in stock on the open market. Also, I know that I have provided zero evidence that a sub $10 stock price is anything but an arbitrary number and has any meaning what so ever but my experience has been that when this happens across an industry it's a good time to start looking and doing some non-arbitrary research.

Point #5 is a bit trickier but I am basically watching for bipartisan agreement that something bad has happened. When politicians can loudly agree on something it means that the problem has fully materialized and the public has experienced all the consequences -- meaning that the problem is old news, has been priced into the market, and savvy investors have started looking ahead. While its hard to state exactly what the government will do regarding the housing implosion there is no shortage of politicians giving their unanimously outraged opinions on the issue. Watching the Bernake testimony this Thursday reinforced the feeling that politicians are unanimously outraged at what has gone on and are itching to do something that can be used as tangible evidence to their constituents that they are outraged and are doing something about this outrageous outrageousness.

Point #6 should not be on this list because there is nothing anecdotal about it. This is the hardest thing to see and requires a lot of non-arbitrary number crunching. I will be doing more work on NVR (and posting it here) and maybe one or two other publicly traded homebuilders to get an idea of what price represents a truly crazy valuation.

Using my list, if one can apply the old adage that "its always darkest before dawn" to the publicly traded homebuilders than we are watching the sun set and its getting noticeably darker outside.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Earnings estimates for BOOT going up .......

Looks like the only analyst that publishes on BOOT finally raised his/her estimates.

Full year 2007 EPS estimate increased to $1.17 from $1.12
Full year 2008 EPS estimate increased to $1.32 from $1.29

Based on my last post on BOOT, I think these are to conservative. One of the most often cited behavioral biases effecting equity investors (and analysts) is under-reaction to new information. One of the reasons I am bullish on BOOT is that I believe that after years of underperformance, investors are not changing their expectations fast enough and the market price does not fully reflect the strong earnings momentum that the company has enjoyed.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

New CEO Appointed and INFS no longer on the selling block

As I have not posted in a while, I am going to catch up on major changes in the companies I analyzed for this blog and are in the Offthebeatenpathinvestments Best Ideas Marketocracy portfolio (and more importantly my own portfolio).

Looks like INFS appointed a new CEO and decided that the acquisition offers it received are not good enough. I am not particularly surprised that no deal went through and I wrote that I expect that much in one my original posts on INFS:

“ ….my feeling is that it would be hard for any CEO to justify buying a money losing operation even if he/she feels there is value to be added. Also, since Caxton is actively involved it’s highly likely that they would be looking for a very high premium – again, something most CEO’s could not justify to their boards, shareholders, or analysts.”

I don’t really have much more to add on this topic so will move on to the new CEO, Robert “Bob” O’Malley. Its amazing what a few hours and Google can turn up!

Here is an article talking about O’Malley’s departure from Tech Data. This article does not give me much confidence in the new CEO of INFS. It's full on “cover your ass” complements and ambiguities but short on any results attributed to O’Malley.

Phrases like this usually make me cringe: “O'Malley was an anchor” ……” He was driving a lot of the initiatives” …..WHAT THE HELL DOES THAT MEAN?

Here is O’Malley’s work history prior to INFS that I pieced together:

3/2005 – 9/2007, Tech Data -- VP of Marketing
10/2002 – 3/2005, UNKNOWN
10/2000 -- 10/2002, Immersion (IMMR) – CEO
6/1999 – 7/2000, Intermac (sub of UNA) -- President
1998 – 4/1999, MicroAge -- CEO of Pinacor
5/1995 -- 1998, MicroAge -- President of MicroAge Data Services
1/1976 – 5/1995, IBM -- Left as President of Desktop PC division

O'Malley's track record gives me even less hope than the praises of his Tech Data colleagues.

O’Malley was effectively fired from Pinacor in 1999 after being the CEO of that company for little over a year. He was actually moved to the Board of Directors but that’s what small companies do to CEO’s whom they want to fire to protect their public and industry reputation.

On his watch, Pinacor lost its biggest customer, Compaq, which accounted for 26% of sales at the time. It should be noted that Compaq fired a lot of distributors as it cut the number from 39 to 4. It should also be noted that Tech Data was a direct Pinacor competitor (they were one of the 4 that Compaq kept) and did end up hiring O’Malley which is somewhat of a sign of confidence. (http://www.crn.com/it-channel/159402582)

Still, Pinacor was one of the biggest in the business at the time and it’s the CEO’s job to protect key relationships.

O’Malley than turned up as President of Intermac and resigned 1 year later to move to Immersion. He lasted 1 year at Immersion. I was not able to find any more info on his employment between Immersion and Tech Data.

As I see it, this guy fashions himself as a CEO but was only able to last at management jobs at IBM and TechData – two behemoths where underperformers can slip through the cracks for years. His did not last more than two years at 3 small technology firms that he was given to run.

From his track record, there is not one shred of evidence that this guy can manage -- much less turnaround -- a small, money losing company that faces an onslaught of competition. Running INFS is a completely different challenge than a cushy marketing job at Tech Data or a management job at the mother ship, IBM.

I can’t believe this guy was actually compared to Michael Dell at one point.

This appointment basically says that either 1) Caxton did not do as much research on O’Malley as I did (which I seriously doubt) or 2) INFS is in so much trouble that O’Malley is the only guy they can find to run the company.

Either case is not an attractive proposition for INFS shareholders.

This appointment is making me seriously rethink my investment in INFS and I am considering cutting my losses.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Thoughts on BOOT article and furniture stocks

A nice article about BOOT from the The Oregonian. Thanks to joeletaxiiii from the yahoo message boards for the link.

The article briefly discusses how BOOT was able to engineer a turnaround over the last few years by getting out of low priced, low margin, commodity like businesses and re-focusing itself on producing super premium products and reinforcing its brand names.

While its nice to see this company get some ink, I discussed most of these points in my initial posting on BOOT. Still, this article did get me thinking about what other industries are prime candidates for reworking their business model and moving upmarket.

One industry and a number of publicly traded members of that industry that seem to be perfect for such a change are U.S. based residential furniture manufacturers. This industry has been decimated by foreign competitors that produce a much lower quality product but price it so cheap that it makes sense for the consumer to replace their shaky tables and squeaky sofas every few years rather than paying a premium for a higher quality product.

However, I believe there will always be a large opportunity for the higher end producers as everyone eventually gets older and wealthier and at some point you simply want to own a quality product that will last a lifetime and you are willing to pay a premium for it.

I think there is a big enough space between the low end and the super super high end parts of the market for some of the U.S. based manufacturers to dominate and produce a sufficient return on capital. A couple of names in this beaten down sector look interesting but require more work are FBN, ETH, and HOFT.


* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

NO ONE CARES ABOUT BOOT!

Here is a question ...if a company reports 30% YoY operating earnings per share growth and no one hears it, did it really happen?

When I last wrote about BOOT I stated that going forward I will be looking for:

“ trends in gross margins and SG&A as % of sales and if revenue is trending above or below the 8% level set by management as the goal.”

I also stated that “if BOOT reports similar sales growth in the seasonally important 3^rd quarter than estimates will surely go up and the stock will have a strong up side move.”

By just about every measure, BOOT reported impressive numbers in their fiscal 3rd quarter. The stock was up as much as 4.5% midday but finished up 1.2% with only 9,100 shares trading hands .... no one cared!

Revenue came in up 12% and ahead of the company’s long term growth target of 8%. Work boots were above average with 20% YoY sales growth and recreational boots came in at slightly below average at 7%.

While the revenue growth is very nice, the real jem is continued margin improvement due to good inventory management. Gross margins came in at 40.1% and up 10bps YoY (the reported GMargins are 39.1% however this includes Dep&Amort expense). Operating expense grew slower than sales at 9.1% causing EBITDA margins to come in at 14.4% and up 70bps from last year’s Q3.

For Q3:3007, GAAP NI was $3.3M and up 30% YoY, eps came in at $0.52 (beating the single analyst estimate by 4c) and up 27% YoY. Operating EPS for the first nine months of 2007 is $0.77 up 28% YoY (actual eps in first nine month of 2006 was $0.67 however that includes a 7c tax benefit).

The balance sheet continues to be pristine with one small black mark. Cash is $4.7M with no debt. Inventory grew slower than sales. The one black mark is that A/R are up roughly 19% YoY vs. sales up 12% -- generally not considered a good sign but there is a lot of quarter-to-quarter noise in those numbers.

Revenue $36.87
GProfit 14.8 (reported GP includes effects of Dep, this number adds back dep)
SG&A 9.5
EBITDA $5.32

L9M EBITDA $8.51
L12M EBITDA $12.6

Q4 EPS estimate $0.45 (this is my estimate, analysts are currently at $0.39 but that is before the earnings announcement so I assume these will be increasing). To get here I assumed 10% revenue growth, small improvement in GMargin and EBITDA margins of 13.7% which is 75bps ahead of last years Q4.

2008 EBITDA Estimate $15.1
2008 EPS Estimate $1.35

So at this point you have BOOT trading at roughly $17.5 with 2008 estimated earnings of $1.35 which gives me a very reasonable forward multiple of 13x 2008 estimates. While all signs point to the company growing operating earnings 30% this year, this growth rate will slow down next year.

Assuming the positive upside momentum continues, I think a fair price to pay is somewhere between $17 to $20. I am not wildly excited paying 13x-15x forward cash earnings but would allocate new money to this stock since you do get a growing company, with premium brand names (ask any avid hunter about Danner boots) with growing margins, and a fortress balance sheet.

Going forward, I will be watching for trends in gross margins and SG&A as % of sales and if revenue is trending above or below the 8% level set by management as the goal. I will also be watching the change in A/R relative to sales.

To answer my own question posted in the beginning of this entry.....It did happen and I hope no one hears it. Continued ignorance about BOOT increases the probability of the stock trading to or below my next buy point at roughly $17.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Lack of posting .....

To the 5 people that are still regularly checking this blog .....thank you and I apologize for the lack of posting. I have been running at a pretty hectic pace lately with a lot of non-work and non-investment related issues taking up my free time.

So it appears that my blog schedule will be much like my personal investment schedule with periods of much productivity (not necessarily buying or selling stocks but researching) interjected with periods of little activity with little news flow from current holdings and little to be excited about in the way of new ideas.

There has been a lot of activity in the stocks I have written about on this blog:

INFS -- reported earnings today 10/30/07 and the stock popped 14%. Did not listen to the CC but my initial read is that things are heading in the right direction and the company could post a profit in the next 2 quarters.

BOOT -- reported earnings today 10/30/07 after market closed. By all indications the company blew away the quarter with something positive in every category. It will be interesting if the stock will move tomorrow considering there are some clear signs that NO ONE CARES about this company. There were only 300 shares traded today coming into the report which is low even for this company.

JCTCF -- reported earnings today 10/30/07 before the market opened. Skimmed over the release and while it looks like results were mixed, the story stays intact with higher margin non-wood products taking larger and larger portion of total sales and profits and still showing positive growth.

FTAR -- this is "the little engine that could" with the stock incrementally moving upward. The company has had zero in the way of newsflow since the last earnings release that I covered here but my guess that sales will be down more than the 9% decline booked last quarter. FTAR is right on the front lines of the recession selling low end footware to the lower end consumer. Plus the whether has been unseasonably warm which effect sales negatively.

CPY -- this is the stock with the most activity since I last posted on it on 6/11/2007. First, the stock is down to $33 from $71 on June 11th -- I bought for my personal account at $45 and $40 and will be looking to buy more. Second, the company completed the PCA acquisition and has started rolling out the digital upgrade. Third, Knightspoint has increased their ownership from 17% to 28% as the stock has fallen. I plan to devote more than a few post in the near future to this stock.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Things that make me happy......

Recently ran across an interesting article talking about the trend of nice restaurants putting a table in the kitchen. Here is a relevant quote

In the United States, the honor of the first restaurant to feature a kitchen table is claimed by Charlie Trotter's restaurant in Chicago.

"The Kitchen Table dining experience is a way to make everything transparent," Trotter said in an e-mail.
"In the old days, seeing inside the kitchen was forbidden. I wanted to do the opposite - stand it on its head - not only see and tour the kitchen but have the opportunity to dine inside the kitchen. We try to elevate and showcase the 'behind the scenes' and the high level of professionalism that exists inside a kitchen."

Trotter's kitchen table, seating four to six, was introduced more than 20 years ago and is now the restaurant's most requested spot.

How is this related to investing? and why does this make me happy?

Well, its this king of thinking that I believe separates the truly great investors and entrepreneurs from the mediocre. To have the ability to go completely against every conventional wisdom and current trend is in my opinion one the most important characteristics that the truly great investors have.

It also makes me happy to know that there are people out there thinking up new ideas and willing to take risks to be successful ......

BOOT -- 2nd Quarter Earning Analysis

When I last wrote about BOOT I stated that going forward I will be looking for:

“trends in gross margins and SG&A as % of sales and if revenue is trending above or below the 8% level set by management as the goal”

BOOT reported on July 30th and while I am in danger of plagiarizing myself it looks like the quarter was mixed but with more positives than negatives.

The blow out was on the top line with total sales up 14.6% and substantially ahead of the 8% set by management as the de facto benchmark. Sales to the work market were up 6% and up 26% to the outdoor market with new products driving sales.

The only black mark was gross margin which came in at 39.2% and was down 60bps YoY due to an inventory write-down. SG&A margins came in better than last year at 33.3% of sales vs. 35.2% of sales in Q2:2006.

EBITDA was up 40% YoY with EPS up 36% when adjusted for an 8c tax related gain in Q2 last year. Looks like analysts don’t expect the strong YoY eps growth to continue in the last two quarter of the year which account for almost 75% of earnings. Despite two consecutive earnings beats analysts did not budge their 2007 estimates which are currently at $1.17 per share.

I bought a tiny 1.5% position in BOOT in the Best Ideas Marketocracy portfolio at $17.13 and at current prices of roughly $20 per share I am not compelled to add more or to sell. While I am very glad to see the stock continue to surprise on the upside I think the shares are fairly valued and don’t provide much margin of safety. If the stock pulls back to $17 per share I will add another 1% to the Best Ideas portfolio and hope that the momentum of the first two quarter carries into the third quarter.

If BOOT reports similar sales growth in the seasonally important 3rd quarter than estimates will surely go up and the stock will have a strong up side move.

Going forward, I will be watching for trends in gross margins and SG&A as % of sales and if revenue is trending above or below the 8% level set by management as the goal.


* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

More pain on the way?

I have been thinking a lot about the speech given by Robert Rodriguez, which was the subject of my previous post. With perfect timing the LA Times ran the following story ominously titled "Foreclosures may spur price drops: On L.A.'s edges, soaring repossessions could set off a downward spiral." (may require a free subscription)

Why shouldn't I just file this story under what I like to call the "new tires effect" which describes a strange phenomenon where I only notice, remember, and take interest in ubiquitous tire commercials exactly 1 week before I get new tires and than promptly forget them after the new tires are installed?

The reason why I think this story is of particular interest and why it dovetails nicely with the speech given by Mr. Rodriguez is because it describes carnage in the real estate market which has not yet occurred and I believe many investors (including myself) may not be factoring into their models for housing related stocks -- home builders, mortgage REITs, mortgage insurers, regional and super-regional spread lenders like WM.

The thing that made this story particularly interesting and different from many of the other "pain in the real estate market" stories that I read almost every day is that the future tense is used as opposed to the present or the past. The authors -- using data from First American which I believe is the same source that Mr. Rodriguez quotes in his speech -- make the point that the cracks are just starting to appear.

The article argues that the marginal ZIP codes in California that should be the first in the nation to experience the real pain have not entered the cycle of spiking repossessions that swell lender's inventories of unsold homes causing them to flood the market which in turn forces individual sellers to lower prices.

Here is an a quote that sums up the tone of the article nicely:

"We're going to have a bear market in housing for a while," said Christopher Cagan, director of research for First American CoreLogic in Santa Ana. "It's going to be bad to be a seller or someone forced to refinance in the impact zone."

Notice that he says that its "GOING" to be bad to be seller which I believe is different from the common perception that right now is the worst time to be a seller and we are now at or close to the bottom of the market and things will turn around before soon.

As I mentioned in my last post, I am taking this opportunity to better educate myself on publicly traded homebuilders. I think homebuilders represent great long term investments since they have a built in growth rate of 6% (3% from population growth and 3% from inflation), their product will never be outsourced, and the industry is still unconsolidated so the top guys can easily grow at 10% to 15% for years to come by taking market share and/or consolidating. However, it seems that the wises thing to do for anyone looking at homebuilders is to adjust their models for the possibility of the real estate market taking longer than a one or two years to recover and adjust their required margin of safety accordingly.

Absence of Fear

As as a portfolio manager I read a lot of market commentary and market research written by other money managers and the elite of Wall Street.

I would say that 99% of "macro" commentary/research that I read falls into one of two categories:

1) this is really good stuff because it reaffirms my opinion, 0r
2) this makes sense but I don't agree with it and the author did not present enough evidence to change my opinion

Once in a while I am lucky enough to come across a piece that looks at a commonly discussed topic and actually provides some original thinking.

A friend forwarded me this text of speech given by Robert Rodriguez to the CFA Society of Chicago. Mr. Rodriguez is the President and CIO of First Pacific Advisors and runs large equity and fixed income mutual funds as well as institutional money. This guy has been managing money longer than I and most of the people currently running money have been alive and has seen many a cycle in his career.

In this speech Mr. Rodriguez covers everything from subprime to private equity to energy prices and as you would expect for a guy holding 40% cash and 20% energy stocks in an equity mutual fund he is pretty bearish.

The great insight for me came in the section titled "Securitization Contamination." All the usual suspects of greed by banks and complacency by rating agencies are there. What I did not realize is that all the MBS models used by rating services assume a ZERO chance of home price DEPRECIATION for anything more than a year or two. To a certain extent this makes sense and based on the recent 50 years of history home prices falling or staying flat in nominal terms for more than a year or two would really be a black swan event.

But is it impossible? Mr. Rodriguez makes the argument that it is in fact possible to envision home prices falling or staying flat in nominal terms for an extended period of time. And if this happens or the market start believing that this can happen than we will really see blood on the streets.

How did this insight change my thinking? For one, I have started educating myself about mortgage REITs and homebuilders by reading annual reports and trying to get my hands around the accounting. Up until this point, I have thought about valuation and margin of safety with the mindset that there will be some pain for a few years but things will revert back to normal by around 2010 give or take 6 months and the strongest players will emerge stronger and with more market share.

Now, I have no choice but to model in the possibility of a serious contraction in mortgage lending and with it a necessary decline in housing starts for a longer period of time than a couple of years. I will have to adjust my margin of safety to assume that what happened in manufactured homes market where lenders backed away after gorging themselves and have not returned after nearly 5 years can happen in the broader housing market.

There is way to much other good stuff in this speech to summarize, so I will strongly encourage that you spend 10 minutes and read the entire thing. But here are a few tastes to get your appetite wet .....


"[we asked] what if HPA [home price appreciation] were to decline 1% to 2% for an extended period of time? They [Fitch's MBS rating group] responded that their models would break down completely."

Here is another great line .....

"when others are having headaches and need Tylenol, on other words, liquidity, we will provide it to them but at a very, very high price"

Keep in mind that many of the people in the audience were the "others" he was reffering to.....Ballsy!

And the coup de grace for anyone thinking that this guys is just a talking head or a pundit trying to capitalize on a correct market call .....

"We are willing to bet our firm and our reputation to be right. This may lead to investor defections, but that is the price one has to be willing to pay to be right."

This guy is the cream of the crop of investment business, both for his investment acumen and willingness to take career risk to do right by his clients. I feel lucky to be able to watch and learn.

FTAR .OB-- 2Q Earnings Analysis

FTAR announced Q2 earnings today and filed the 8K, actually this company does not announce earnings to any of the major news wires.

Before I dive into the earnings analysis here is what I was looking for when I last posted on the company:

"I will be watching for in the next earnings report are the trend in SSS, trend in K-Mart closings, and Gross and EBITDA margins."

I would say that the latest quarter was mixed but with more positives than negatives.

Looks like overall sales were down 9% YoY with SSS at Shoemart (these are the K-Mart stores that make up 98% of revenue) down 8% with Rite-Aid reporting a horrific 14.5% decline. Looks like no Shoemart stores were closed in the quarter which is good news. For the first six months total sales are down 5%.

The company blamed weak Easter and poor April sales...blah, blah, blah. When I initially posted on the company I used a 10% sales decline as the "Worst Case Scenario" assumption. If things continue at this trend we may hit that worst case scenario.

However, the rest of the report was nothing but good news.

Gross margin was up 80bps to 35% in the quarter and up 90bps to 33% for the first 6 months. This is tracking ahead of my "Best Case Scenario" assumption of 50bps improvement in GM.

SG&A expense fell more than revenue declined providing 50bps increase in margins for the quarter. For the the first six month SG&G as % of revenue is at 24.7% for a 30bps improvement. This is improvement is more or less in line with my Best Case scenario assumptions.

The margin improvement provided for positive EBITDA growth of 1% to $23.6 negating the 9% sales decline. EBITDA is basically free cash flow for FTAR since it does not pay taxes, have any debt, or CAPEX.

If the company can continue to offset sales declines with margin improvements, I believe my previous target price range of $3.5 - $7.5 per share is still valid and provides substantially more upside than downside at current price levels. As I mentioned before, the free option on the contract extension with K-Mart becomes less valuable with each passing day and I have personally assigned it a zero dollar value at this point.

Again, next quarter I will be watching for the trend in SSS, K-Mart closings, and EBITDA margin improvement.


* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

JCTCF -- Final Thoughts

I can’t believe it has been a month since I wrote my first post on JCTCF.

In that time the stock is up 12% after hitting an intraday high of $12.10 which represented a 48% upward move. Also, the company reported quarterly earnings that once again confirmed the potential of the non-wood business to drive earnings going forward.

While the strong earnings in the latest quarter are nice to see they do not negate the fact that JCTCF still gets most of it revenue and profits from selling commodity wood products. Revenues and profitability of this business fluctuate wildly and JCTCF is currently facing headwinds from the slowing housing market.

Despite these very real negatives, it seems that the current valuation and the continued growth of the non-wood products business make the stock attractive. The company announced several store wins for its high end dog kennel line and other non-wood products. This is and example of how JCTCF expects to grow its non-wood products, by getting shelf space from its current customers in the DYI market and from new customers. It looks like another sales channel was opened as the company announced today that they will distributing their dog kennels in Europe. http://biz.yahoo.com/prnews/070807/cltu055.html?.v=101

So how do I look at valuation?

Well, I look at valuation the same way I look at the company -- to me JCTCF at this point is the non-wood business and everything else. The problem is that the company does not break out how much of “Lumber, building materials & other” is attributed to wood and non-wood products so we can only come up with ball park figures.

Based on the latest 10Q (filled on 7/11/07), here is the net income for the last 3 quarters breakdown for each business segment:

JCLC ..................... …......…. $1.531M

Greenwood…......………………$0.79M
Seed Processing ….................$0.220M
Industrial Tools.. ……………..$0.01M
Corporate Expenses………….$(0.99)
Total Excluding JCLC ….$0.912


Estimated net income for non-JCLC businesses in fy Q4 = $0.304 ($0.912 / 3)
Estimated net income for JCLC in Q4 $0.461 (assumes JCLC has same net income as in the previous quarter)

Full Year NI for non-JCLC businesses = $1.22M
Apply multiple of 7.5x (half of SPX current multiple) = $9.12M

Full Year NI for JCLC = $1.99M
Apply multiple of 15x = $29.88M

Total Estimated Market Value = $39M
Estimated fair value per share = $16.38 / share
Apply 40% margin of safety = $9.83 / share

Keep in mind that the company filled an S-1 saying that they are willing to sell shares at $13.33 (this is the $20 price adjusted for the 3:2 split). This is in the ballpark with my rough estimated fair value of $16.4.

I think that at current prices the company provides very good value and substantial potential upside from continued growth in the non-wood product segment. This company has no debt and due to large insider ownership by active management I have confidence that it is less likely to do stupid things. I will adding JCTCF as a full position (8%) to the Best Ideas Marketocracy portfolio.

Going forward, I will be watching the growth and profitability of the JCLC business like a hawk. I will also be watching the extent of the deterioration in the Greenwood business.


* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

JCTCF -- “Da Bulls” -- Part II

In the previous post I made the case that the only reason to own shares of JCTCF is due to the company’s growth and high profitability of the company’s non-wood products segment that is hidden within the company’s commodity wood business.

I also believe that there is evidence that management--who are the largest shareholders with 37% of the stock and effectively control an additional 16% owned by the ESOP--thinks that the stock is worth a lot more than the current market value.

Now, we all know that a management team that SAYS their stock is worth more than the current share price is easier to find than a Democratic politician bending over for the labor unions or a Republican paying homage to the religious right ayatollahs.

However, I think in the case of JCTCF there is some tangible evidence that management really does believe that a minority share of their little company is worth more than its current price.

The company re-filled an S-1 form in September 2006 notifying shareholders that they are looking to sell 500,000 shares to the public which if completed would increase shares outstanding by 25%. The shares would be sold at $20 per share which based on pre-split figures represented a roughly 50% premium to market price and 170% premium to book value.

There are a few nuggets in the filling that give me a warm fuzzy feeling. For starters, this is being done on the cheap. This is a self-underwritten offering with the company spending $125,000 which is 1.25% of gross proceeds and substantially less than the 6% or so ibanks charge.

Also, I could not find any evidence that management is going to be selling their own shares as part of this offering. This means that management is not cashing out and is willing to accept 25% dilution in the ownership of the company. I can only think of one reason why they would do this which is that they believe the cash can be successfully reinvested (this must surely be to grow the non-wood business) and they will be better off owning a smaller portion of a much larger pie.

Finally, this stock will be sold only in two states Washington and Oregon and only by Donald Boone (who is the President and CEO and owns 24% of the stock), Michael Nasser (who is the Secretary and owns 13% of the stock), and two other directors. They will personally solicit potential shareholders with the “intended offerees will be friends, family, and business associates of the our Management.” The filling does state that a broker-dealer maybe engaged to sell the shares, but I don’t believe this has been done yet.

What is so important about people asking their friends and family for money? This happens every day.

The important part is that when you have to pick up the phone yourself and call someone you have a personal relationship with and ask them for money you think differently about the offering price and the outcome than you would if you let Mr. iBanker sell to Mr. Fund Manager. When you are selling to people you know and presumably want to keep knowing, you are much more likely to charge them a fair price which leaves a lot of room for upside. You are also much more likely to be careful with the money they give you.

I should note that management has been unsuccessful in getting this offering done since at least 2004. Does this concern me?

I am not happy about it primarily because I am bullish on the company and think a lot of money has been left on the table.

However, I am glad to see that the offering price has been increased to $20 from $7 (see 2004 S-1)

Also, as a current shareholder it gives me confidence to know that management is willing to sell the stock to friends and family at a much higher price than the shares currently trade. I think the only reason they would do that and be willing to accept dilution of their ownership stake is that they truly believe their stock is worth more and they can successfully reinvest the cash.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.