Off The Beaten Path Investments Forum

NPK -- “Da Bulls” Part II

2008-07-28T22:07:00.002-05:00

In the previous post I discussed my calculation that place the downside price target for National Presto (NPK) shares at $45 which is approximately $25 or 35% below today’s closing price of approximately $70 per share.

So what is the upside potential for NPK shares?

If we make an assumption that the company can grow revenue in the small apps business in line with inflation of 3% and stabilize EBITDA margins, the small apps business becomes a “going concern” and the valuation increases substantially to $54 per share.

If you assume that the defense business turns into a “going concern” and has annual free cash flow similar to 2007 and apply a below market average multiple of 10x the defense business value jumps to about $32 per share from the worst case scenario of $5 per share.

If the absorbents business every shows and operating profit or the company can sell it for more than 50% of what it cost to build the factory and buy equipment just a few years ago this also increases the upside for NPK shares.

Simply assuming that this 100 year old company's two main business lines are going concerns with no growth beyond inflation puts the target price close to $100 per share which represents about 40% upside from current levels.

If one is to assume that the company’s small apps business can grow even slightly above inflation or the company uses its cash to continue to build out the defense business or to make an acquisition with decent ROE potential the upside keeps growing substantially beyond $100 per share.

* 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.

NPK -- "Da Bulls" Part I (Corrected)

2008-07-22T20:52:00.003-05:00

I noticed that I made a pretty substantial error in the calculation of per share value for the small apps business posted yesterday.

Instead of subtracting tax expense from free cash flow, I was adding it back and therefore substantially inflating free cash flow estimates. The other change I made is to decrease the amount spent on CAPEX as the small apps business declines in revenue.

These changes produced a substantially lower per share value for the small apps business of $15 which lowered the worst case scenario share price estimate for NPK to $45 from previously estimated $61. Under this new worst case scenario the worst case scenario downside increases to aproximately 30% from the previously posted 8% downside risk.

Instead of reposting with the correct numbers here is the new calculation.

NPK -- “Da Bulls” Part I

2008-07-21T19:53:00.003-05:00

The bull case for National Presto (NPK) is simply that at current levels the downside risk is very small.

To calculate the downside price target I did a sum of parts valuation using VERY conservative assumptions. Under this valuation methodology, NPK is worth only the value of the small apps business plus the liquidation value of the defense and absorbents business plus the cash on the balance sheet.

I assumed 1.6% revenue growth rate and an annual 50 bps decline in EBITDA margins to estimate the value of the small apps business which means that cash flow declines every year until the business is break even and assumed to be worthless. The net present value of estimated cash flows from the small apps business using a 7% discount rate is $30 per share.

In calculating the value of the defense business I assume the worst case scenario under which NPK delivers on its $250 million stated backlog for 2008 with similar margins as in 2007 which would produce $22 million in after tax free cash flow. At the end of 2008 the business is assumed sold at ½ the dollars invested in CAPEX over the most recent 4 years. Under this worst case scenario the defense business is worth $5 per share.

For the absorbents business I simply assume that its dumped on someone else’s lap at ½ CAPEX over the last 4 years which produces a $2 per share business value.

The last two pieces are the working capital from the two liquidated businesses as well as the current cash on hand which combined is estimated to be worth $24 per share.

My detailed calculations can be viewed here.

The sum of parts valuation under these assumptions is $61 per share which is $5 or 8% below the current price of approximately $66 per share. A worst case scenario downside of 8% is substantially smaller than the potential upside under even modest positive assumptions which will be discussed in the next post.

NPK -- “Da Bears”

2008-07-17T23:00:00.001-05:00

As with all the stocks profiled on this blog the laundry list of problems with National Presto (NPK) is long and deep. NPK’s second largest business is facing both short and long term pressures, success of the company’s defense business is based on large government contracts that may not be renewed, the company’s management has invested both time and money into the diapers business with very poor results thus far, and the stock is highly illiquid.

National Presto’s appliance business has experienced 1.6% annual sales growth over the last 8 years with the company constantly stating that it cannot raise prices fast enough.

While the decision in 1999 to outsource manufacturing to China was certainly a positive it means that NPK will be negatively effected if the dollar continues to fall and/or inflation continues to stay high in China. These items have already taken their toll with EBITDA margin falling from a peak of 19.7% in 2005 to 18.7% in 2006 and 15.8% in 2007. With the company unable to raise prices fast enough its likely that operating margins in the appliance business will continue to contract.

There is very little visibility in the defense business. Management has not indicated what percentage of defense revenue comes from the Department of Defense (DoD) and what percentage from other sources (police force, etc.). The company has not provided any indication of whether they expect the Department of Defense (DoD) to expand the $1.3B contract after it is filled.

NPK’s fillings state that it expects to deliver $550M of the $1.3B contract (up from initial award of $300M) and based on my calculation the $550M will be mostly filled by the end of fiscal 2008. If this business is not replaced, company EBITDA will fall by approximately 50%.

There is not much to say about the absorbents business other than it’s a mess, no pun intended.

After combing through old SEC fillings, I calculate that since 2001 NPK has invested $36M in CAPEX for total EBITDA of $8M. The annual rate of return has been 3% and that is without including working capital in the equation. This is a very low margin, highly competitive business that is exposed to severe swings in commodity costs (wood pulp and energy) and NPK is never going to be a cost leader in this industry.

NPK -- First Look

2008-04-10T20:35:00.002-05:00

Current Price: $51
Market Value: $350M
Enterprise Value: $210M
Investment Type: Classic Value

NPK (National Presto) is a designer of small electric appliances and housewares, produces armaments for the U.S. defense department, and absorbent products. Yes, this company makes toasters, bullets, and diapers.

While operating income from the defense segment now accounts for almost 2/3 of total, NPK has been an innovator in the small appliances category for almost 100 years (a very interesting history can be found here).

The last couple of years have been eventful for NPK, to say the least. Most importantly, the company defeated the SEC in appeals court reversing a decision forcing NPK to be classified as an investment company due to NPK’s large cash hoard. Being classified as an investment company means more government oversight and reporting costs. Keep in mind that the original SEC action in 2002 was not due to accusation of destruction of shareholder value or executive wrong doing, rather due to SEC’s jihad on public companies prompted by the still fresh memory of the Enron and Worldcom debacles.

NPK hired and than promptly fired its new auditors 12 months later. According to this press release from the company, it hired one firm to perform the audit and another to perform the tax work. It is common practice to have the same firm do the audit and the tax work so NPK asked for bids and the firm originally hired to do the tax won.

On top of all that, the company’s CFO resigned “to pursue an opportunity as a financial advisor.” While I have no evidence to the contrary, I have a hard time believing someone would willingly resign a high paying executive position to be a cold calling stock broker.

Despite all the “noise,” NPK had an outstanding operating year. Revenues grew 38% (on top of 65% growth in the previous year) and operating income great 50% (after growing 83% the year before). The company ended the 2007 fiscal year with $142M in cash & securities and no long term debt after paying $4.25 per share dividend on 3/2008 and $3.80 per share a year before.

In the posts to follow I will discuss the bullish and bearish aspects of NPK.

The Quintessential Buffet

2008-04-07T18:16:00.002-05:00

I was cleaning out some old emails and ran across this NYT article dated 12/29/07 regarding Buffet’s decision to enter the bond insurance business but published prior to the offer he made to buy the municipal bond business of the troubled monolines.

This article follows the basic boiler plate for Buffet related articles, mentioning that Berkshire is doing well while others are suffering, that buffet has added to his positions in USB and WFC, and talks about new positions in BNI and KMX (it was later released that KMX was bought by Lou Simpson who is the CIO at GEICO and a Superinvestor in his own right).

However, about half way through the piece came this gem of a quote from the maestro himself:

"We had no compulsion at the start of the year to do anything ….. On the other hand, there was no limit to what we could do."

I think most agree that Buffet and a select few other professional investors are simply better at their chosen profession than everyone else, much the same way that Michael Jordan and Tiger Woods are better and will always be better than everyone else.

However, what many don’t realize and this quote again proves is that Buffet is playing a completely different game than everyone else. I feel lucky to be able to watch and learn.

FTAR Makes it Official

2008-04-05T10:18:00.003-05:00

Yesterday morning FTAR filled the long expected 8K stating that the KMart contract will not be extended beyond 12/31/08 which effectively means the company will wind down and cease to exist shortly after the end of this year. KMart will pay $13M for FTAR’s intellectual property (i.e. ThomMcAnn) as well as honoring the post-bankruptcy master agreement which stipulates that KMart will buy all inventory at book value. Also, the company will be terminating retiree benefits and life insurance which will remove $14.7M of long term debt from the balance sheet and result in a one time earnings gain.

This announcement essentially puts in writing what everyone already knows and makes the investment thesis even simpler. I have updated my figures ( for the most recent news and believe that at worst FTAR is worth $7 per share (up 45% from current levels) and at best $8.4 (up 75%).

[**I am still trying to figure out how to post Excel tables in Blogger so I will add my calculations for the $7 and $8.4 price as soon as I get a hang of this. If you have any suggestion on how I can do this other than posting a picture file that is all but unreadable let me know at offthebeatenpathinvestments@gmail.com]

The biggest difference between the worst and best case scenarios is my estimate of 2008 FCF generated by FTAR. In the worst case I assume sales down 10% over 2007 and some margin erosion while in the best case I assume flat YoY sales and slight margin expansion.

There could also be upside if FTAR sells its HQ for higher than book value, if the non-KMart business is worth more than $0, $80M in NOLs are worth more than I expect, and wind-down costs are less than I estimate.

FTAR currently represents 10% of the “Best Ideas Portfolio” (and roughly that much of my own account) and I plan on raising the stocks weight to 15%.

NOOF -- Final

2008-03-30T13:06:00.003-05:00

The key bearish case for NOOF is that the company has no bargaining power against the cable/satellite companies and any above average profit margins will be constantly eroded which means the stock deserves a low multiple. Also, the company is allocating a lot more cash to the very volatile content creation business essentially trying to build a tiny movie studio. Due to the nature of the “content creation” business, movie studios have generally been very poor investments.

The key bullish case is the recent positive earnings news and trading at 7.3x EV/FCF the company continues to look cheap. Also, all indication point that NOOF is the premier name in the business and should continue to win distribution partnership with brand owners like Penthouse.

Based on my estimates of FCF, the $0.50 per share annual dividend is safe. However, there will be nothing left to reinvest in the business which stifles future earnings growth and any future dividend increase.

Keeping in mind that NOOF is hostage to the cable/satellite companies, I have a hard time envisioning any valuation expansion from current levels. Even if growth returns to 10% annually and I assume a multiple of 10x FCF/EV in 3 years, I get an implied 3 year total return of 80%.

While 80% upside over 3 years certainly looks attractive, the downside is also substantial. I think NOOF will continue to face both long term and short term revenue pressure from its other 3 customer who will expect to renegotiate their contract and get the same deal as EchoStar. Any abnormal earnings return will be taken away by the network providers.

Adding to this company specific issue is the fact that traditional media companies will continue to face pressure from online players and while they will adjust their business models I have a hard time seeing much valuation expansion in a more competitive operating environment.

Simply stated, I don’t feel the downside justifies the upside and since I am not willing to buy more shares at this price I have now choice but to take the loss and liquidate my position.

NOOF -- “Da Bulls” (improved earnings + very low valuation)

2008-03-27T01:37:00.001-05:00

The Bull case for the stock is that there has been some positive earnings news recently and the fact that the stock continues to look tantalizingly cheap based on free cash flow.

NOOF has come off the $4 lows on the recent positive earnings news released on Feb. 5. Total sales were up 8% while the market expected a double digit slide experienced in the previous two quarters. EBITDA was up slightly which compares favorably to the 40%+ decline in EBITDA experienced in the previous two quarters.

Looking at the revenue breakdown in detail, one notices that the company’s largest business – Pay TV –is still experiencing double digit revenue declines. The upside came entirely from huge increase in revenue in the Film Production group as the company completed a “producer-for-hire” arrangement which was not there last year.

The CEO, Michael Weiner, stated on the latest conference call that he believes that the YoY revenue decline in Pay TV is over and next quarter will show positive YoY revenue growth. This implies that the company has been able to offset the re-rate with new products which is a very good sign.

The stock also continues to look very cheap despite the huge decline in profitability. Here is how I am looking at free cash flow:

Reported EBITDA $5.43M
Adjust for large one time deliverables in Film Group $(0.4M)
CAPEX $(0.5M)
Tax $(1.8M)
FCF* $3.0M
Annualized FCF* $12M
EV / FCF 7.3x
Cash Yield 14%

*Excludes “Content Amortization” expense and “Cash Investments in Content”. NOOF uses “film accounting” where they capitalize NOT expense the cash costs spent to produce films and than expense it over time in the form of amortization.

There has been some insider purchases recently as 3 different directors bought a combined $50K of NOOF on the open market. It should be noted that one of the largest shareholders, an activist fund called Steele Partners, has been dumping shares recently.

If NOOF can string together a few consecutive quarters of free cash flow growth, the stock would look even cheaper.

* 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.

NOOF -- “Da Bears” (The Hammer Comes Down)

2008-03-22T12:07:00.002-05:00

The Bear case is simply that NOOF has no bargaining power with its distribution partners – the cable and satellite companies – and future earnings will continue to be eroded by tough negotiations with these network owners.

The hammer came down in the first fiscal quarter of 2008 (6/2007) when the company reported that total revenue fell by 21% and decline by 17% in Pay TV segment, the company’s largest and most profitable. On top of the sharp revenue decline, administrative expenses actually INCREASED so EBITDA fell by a staggering 49% and operating eps declined by 47% to $0.08 per share (eps declined slower than EBITDA due to slightly lower depreciation).

The market did not take this news lightly and the stock cratered from approximately $8.50 to $6 in the first two weeks of August.

Why the sharp drop in revenue and earnings?

The company renegotiated its contract with EchoStar and under the new terms they will be receiving less of the revenue split. While not much more about the deal other than the 3 year duration was announced, it appears that EchoStar was able to increase its share of the split by 20%-25%.

Because the company has such high operating leverage—high operating leverage means that a larger portion of each dollar of revenue drops to the bottom line—a 20% decline in revenue caused a much larger decline in operating earnings.

The following quarter (second fiscal 2007) the performance was not much better. Revenue was down 23%, EBITDA fell by 40% and eps was down 40% YoY. On a free cash flow basis, NOOF earned $2.8M from $5.6 generated the previous year.

The recent fundamental and stock performance has clearly highlighted NOOF’s Achilles heel. Despite all indications that NOOF is the premier adult entertainment content distributor in the business, the company has no pricing power with its distributors. Future above average earnings will continually be eroded by cable/satellite operators.

NOOF -- First Signs of Future Problems

2008-03-18T23:21:00.001-05:00

Looking back, the first signs of problems to come appeared in fiscal 2007 (fiscal 2007 ended in 3/2007 calendar) despite the fact that by all indications fiscal 2007 was a great year for NOOF. Total revenues were up 35%, EBITDA increased 19% and the stock had a total return of 26% (3/2006 to 3/2007) and traded above $10 for a little while.

So where is the problem?

Per the 10K, total Pay TV revenue in fy2007 grew by 9.5% while the number of households reached increased by 39%. While you can’t simply assume that total Pay TV revenues and network households are immediately and perfectly correlated but such a huge divergence in reachable households and revenue should have set off warning bells that NOOF has no pricing power.

In the 2007 10K, NOOF stated that network households increased due to addition of new channels to a current platform (good sign) but they also renegotiated a rate split in place since 2000 with that platform provider.

Clearly, one of the bullish aspects regarding NOOF at that time was the valuation. Based on the stock price in June 2007 (when the fy2007 10K was filed) and the last 12 months of free cash flows the stock looked abnormally cheap:

Market Value at $8.5 per share = $209
Enterprise Value = $181
Latest 12M FCF = $22 (EBITDA-Cash Tax-CAPEX)
EV / FCF = 8.2x

When taking into account the fact that NOOF has grown revenues and EBITDA in each of the last 4 years and that average EBIDA margins for the last 4 fiscal years were north of 40%, NOOF seemed like an abnormally cheap stock.

NOOF -- First Look

2008-03-13T21:27:00.004-05:00

Share Price: $4.5
Market Value: $107M
Enterprise Value: $88
Investment Type: Value Investment

New Frontier Media, Inc (NOOF) is one of the largest distributors of adult entertainment (aka porno) through U.S. cable and satellite networks. The company estimates that it can reach almost 140 million households. Recently, NOOF has started creating its own erotic and mainstream content.

The company is made up of several business lines:

1) Pay TV (recently renamed “Transactional TV”) has historically been NOOF’s largest source of revenue and income. This business unit has provided content for cable/satellite operators either in the form of subscription channels or Video-On-Demand (VOD). The company makes money buy paying the content providers and splitting the revenue with the network operators. It’s key to understand that historically NOOF has not created the content, primarily serving as a middle man between the content creator and owner of the distribution network.

2) Film Production is a new business segment for NOOF, created almost exactly two years ago when the company acquired MRG Entertainment. This group creates original erotic content, acts as a representative for content created by others (porno agent), or as a “producer-for-hire” hired by major studios to deliver a movie or TV series. NOOF paid $21.1M for MRG in an all cash transaction in February 2006.

3) The Internet Group does exactly what the name implies – sell porno on the internet—and is the smallest revenue and profit generator for NOOF. NOOF provides the large cable/satellite networks with new channels and selected content and splits the revenue generated based on negotiated rates. Growth comes mostly by adding new channels to current networks.

Historically, NOOF has not created the content or own the network allowing for very little working capital and Capex costs. Due to low investment requirements, the company has produced an average ROE over the last 4 years of 27%. The other side of that coin is that NOOF has very little bargaining power when renegotiating revenue splits with the network providers.

I purchased NOOF in 3 parts between June 2006 and May 2007 for an average cost basis of $9.09. In that time I have received $0.875 in dividends (one of my 3 purchases occurred after the special dividend of $0.60) which brings my costs basis to $8.215. With the stock so much below my initial purchase price I can no longer just hold it, I have to make a decision to either buy more or start liquidating the position.

Thornburg’s Pain will be Chimera’s Gain

2008-03-07T00:44:00.002-06:00

Thornburg Mortgage (TMA) has declined from $3.56 two days ago to $1.65 today. The stock traded at $26 in May 2007. The company is in technical default and it appears to be heading towards an actual default.

Thornburg Mortgage has historically been one of the best managed mortgage REITs in the world. These have always owned AAA rated paper and did not change their stripes in the go-go days of the housing market to boost short term profits. The management is dedicated, transparent and has put their own money on the line by buying in the open market.

There is no better way to describe what is happening to TMA other than a Black Swan event. Make no mistake about it, we are witnessing a dislocation in the credit markets that can be best described as tectonic plates shifting against each other and causing all kind of havoc with TMA caught in the middle.

What is happening to TMA?

The market for non-agency paper is all but closed. Trades that are completed price these mortgages at lower and lower levels. That means that large holders of non-agency paper—like TMA which owned a $36B portfolio of non-agency, AAA rated, ARM loans at the end of the last quarter—have to constantly mark-to-market at lower prices. At some point the portfolio gets marked so low the people lending money to TMA get scared and start asking for some of it back.

This is where things get interesting, since the repo provider can either try to work out a deal with TMA and avoid a forced liquidation or ask for their money back NOW (a.k.a. margin call).

It appears that one or more of TMA’s lenders got spooked. Faced with a margin call, TMA was than forced to sell at the worst possible time which caused further price erosion and decline in the stated value of the rest of their portfolio. JP Morgan may have dealt the fatal blow, putting the company into technical default and triggering a waterfall of other debt covenants. The rating agencies lowered their ratings on the company (not the mortgages they own) further into junk making it impossible for the company to borrow more money.

So how does all this effect CIM?

Well, for every seller forced at gun point to liquidate there is a buyer with cash and time. When TMA and others--and there are many others, just today it was announced that UBS is dumping its Alt-A loans and Citi will be liquidating $45B in mortgages over the next 12 months--are selling CIM will be buying at better spreads than they were even a month ago.

The short term price drop of CIM and other mortgage REITs does not change the thesis I laid out in these posts.

CIM is still managed by some of the smartest people in the business. They are still one of the only buyers in the market and can set their own price. They have only been in operation since November 2007 and still have a very small portfolio that was already bought at the discount. And now CIM is trading at below book value of $14.25.

I have added to my initial position in the “Best Ideas” portfolio as well as my personal accounts. I will continue to add to my position if the stock continues to fall.

INFS -- Comments from the Conference Call

2008-02-19T21:12:00.002-06:00

As I discussed in the previous post, INFS reporting their first operating profit was certainly better news than the alternative. However, while analysts were congratulating the CEO on “a great quarter” there were two statements made that seem extremely disconcerting to me.

First, the CEO enthusiastically pointed out that 80% of the company’s products have been refreshed over the last 2 quarters. New products are the only way a technology company can grow as they replace the old technology that’s quickly falling in price with newer, more expensive products.

So am I the only one concerned that with 80% of the product line upgraded over the last 6 months, ASPs (average selling price) are DOWN 20% year-over-year?

Q4:2007 ASP=$856 94K units shipped
Q3:2007 ASP=$882 85K units shipped
Q2:2007 ASP=$1,022 72K units shipped
Q1:2007 ASP=$853 91K units shipped
Q4:2006 ASP=$1,090 79K units shipped
Q3:2006 ASP=$1,097 74K units
Q2:2006 ASP=$1,162 84K units
Q1:2006 ASP=$1,191 94K units

The second comment that is making me lose sleep at night is the following:

“the projection market is fiercely competitive excluding a few notable segments has been commoditized. … We [InFocus] will be faster to market with new products and better price points.”

My interpretation of this statement is that instead of trying to use its industry relationships and intellectual property to move up-market, INFS is going to try to compete on price. Compete on price against giant Asian manufacturers (Sony, Sharp, Panasonic, etc) with unlimited financial resources, diversified streams of revenue which means they can lose money on projectors for a few years, and cheaper labor pool.

When I look at INFS I see a company that can’t raise ASPs even with brand new products and a company that has decided to pick a fight it has a very small chance of winning. This is why I am not bullish on the long term prospects for my INFS shares.

So why am I still holding on to my position and buying more?

Despite the long term problems, I feel that INFS is trading at least 50% below liquidation value. And that’s just to good of a deal to pass up.

I am not particularly bullish on Las Vegas real estate but if someone offered to sell me a house in Vegas for half of what the cabinets, shingles and tiles inside were worth if sold separately I would jump on that opportunity.

* 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.

INFS -- Operating Income Turns Positive

2008-02-14T22:14:00.002-06:00

Last time I posted on INFS I was pretty critical of the new CEO and stated that I am “seriously rethink[ing] my investment …. and I am considering cutting my losses.”

I still stand by my statements and more I think about the long term prospects for INFS the more I want to push the SELL button. However, the current undervaluation seems so egregious that I am willing to overlook the crumby business and less than inspiring CEO and hold on to my shares.

INFS reported fourth quarter earnings last week and posted an operating profit for the first time since anyone alive can remember. Excluding the $3.7M charge for lease losses on vacated facilities, INFS posted Operating Income of $1.1M or $0.09 per share in the company’s seasonally biggest quarter. Since I did not cover the 3^rd quarter, I will cover both at the same time.

The financials broke down as follows:

Q3:2007 results
Revenue $76M -- down 7% YoY
GProfit 13.8
GMargin 18.2% -- vs. 16.3% in Q2, 10.9% in Q1, 12.7% in Q3:06
EBT $(3.56)
D&A 1.0 -- estimated number since no CF statement yet
EBITDA $(2.56)

Q4:2007 results
Revenue $81M -- down 3% YoY
GProfit 16.5
GMargin 20.4%
EBT $1.1 -- excluded $3.7M lease write-off charge
D&A 1.0 -- estimated number since no CF statement yet
EBITDA $2.1

Operating expenses excluding the lease charge were $15.4M, which was the target set previously by management. Based on comments made on the conference call, investors should not expect any further significant improvements in gross margins and operating expenses.

The balance sheet continues to be a thing of beauty with $84M in cash and zero debt or $2.11 per share in cash. In addition to the cash on hand, INFS still has over $200M in NOL’s.

In this post I calculated that if only half of the NOL’s can be used over the next 10 years they are worth roughly $1.50 per share today. So a stock trading at $1.70 has approximately $3.50 in cash on hand and NOL’s. The company also has an intellectual property portfolio that maybe worth something.

While I am not particularly bullish on the long term prospects for this company I believe that the stock is currently trading substantially below liquidation value. INFS represents 2.75% of the “Best Ideas” portfolio at a cost basis of $2.03 per share. I will be increasing the weighting to 4% of the portfolio.

CIM -- Taking a look under the hood ….

2008-02-09T00:38:00.000-06:00

CIM released their first ever quarterly earnings report a few days ago. It appears that things are moving along and the company is ramping up its portfolio.

The key number from this report is the average spread on assets which is currently 134 bps annualized Here are my ballpark estimates of what earnings power for CIM will be over the next 12 months:

Book Value $539M
Earning Assets @ 8x - 10x leverage -- $4.85B to $5.93B
(book value * leverage factor + book value)
Spread on Assets -- 130 bps
Net Interest Income -- $63M to $77M
Base Management Fee -- $9.4M (book value * 1.75%)
Incentive Fee* -- $7 to $9.8M (assume 3% LIBOR)
Core Earnings -- $47 to $58M
Estimated EPS -- $1.24 to $1.54
Yield at current price of $19 -- 6.5% to 8.1%

*The incentive fee is even more of a moving target than net income estimates because it depends on net income and LIBOR which constantly changes.

Currently, CIM’s portfolio is almost entirely AAA rated mortgage backed securities and they are still building out the portion of their portfolio that will be in the form of securities. The next step will be to build the portfolio of the portfolio consisting of actual loans. The yield on raw loans should be higher and should help push the spread beyond 130 bps.

What is a realistic estimate for Core Earnings going forward?

I think looking at NLY is the first step in answering that question. NLY also reported earnings a few days ago and ended the quarter with spread of 99 bps. NLY is currently priced for that spread to increase.

I think its safe to assume that CIM will earn a higher spread than NLY, they already do. At a spread of 150 bps I get a current yield of 7.5% to 9.5% (P/E of 10x-13x). At 200 bps spread which is not unreasonable I get a yield of 10%-13% (P/E of 8x-10x).

I think at current levels CIM represents an attractive opportunity to earn a decent return on investment. If the stock were to sell off closer to book value of $14.26 the stock would become even more attractive.

I initiated a ½ percent position in the “Best Ideas” portfolio, and I will be raising this position to 2% after this earnings report.

BOOT -- 4th Quarter Earning Analysis

2008-02-04T22:26:00.000-06:00

When BOOT last reported earnings, I wrote that next time 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.”

In that post I also stated that analysts (in BOOT’s case just one analyst) were underestimating the earnings power and I felt the company would report 45c per share in Q4 earnings.

BOOT reported Q4 earning on Januray 29^th of 38c per share which is up 8% YoY however below the 40c per share analyst estimate and my 45c per share estimate.

I am not going to waste time by regurgitating the earnings release which you can read yourself and will just state that the company blamed the unseasonably warm October and November for the 2% decline in outdoor footwear sales and the earnings miss.

The work market continued to chug along with 8% top line growth and both gross and SG&A margins improved on a YoY basis. The large inventory growth vs. sales was blamed entirely on the warm weather with the CEO stating on the conference call that BOOT is not going to take markdowns on this access inventory as its all basic, high turnover outdoor hunting products.

The CEO also hinted on the conference call that the decline in weather in the beginning of the first quarter is helping sell this access inventory. I believe the CEO’s is hinting that almost everything that was not sold in Oct/Nov is being sold in Dec/Jan. It was also announced that the company instituted a 3%-5% price increase across the board on its products in January.

Today, BOOT announced a special $1 per share dividend as well as its regular quarterly dividend to be paid March 18^th.

So, how attractive is the stock today? Here is how the numbers break down at ...

Market Value $89M
Cash on Hand $15M
Enterprise Value $74M

Estimated fcf over next 12 months $7.5M - $7.8M
Current Cash Yield 10% - 10.5%
Current Multiple 9.5x - 10x

If in fact the weather effected Q4 sales, than there should be another few million that will be dislodged from inventory and into cash in Q1 as sales catch up and that will lower the EV/free cash flow multiple to 9x – 9.5x.

At the time of the Q3 report I also wrote that “I think a fair price to pay is somewhere between $17.5 to $20. I am not wildly excited about paying 13x-15x forward cash earnings but would allocate new money to this tock since you do get a growing company with growing margins and a fortress balance sheet.”

I think the recent earnings miss is just a short term bump in the road and I am getting more excited about the long term capital appreciation prospect as the multiple falls below 10x. At this point, you get to buy a company with premium brands, fortress balance sheet with cash being returned to shareholders and you are paying a sub-10x cash flow multiple. Even if the next 12 -24 months are a little bumpy, in the long term BOOT shareholders will benefit from 8%-10% earnings growth as well as multiple expansion from the current sub-10x level.

In the next quarter I will be primarily looking for indication that the misstep in Q4 was due to weather rather than some broad negative trend. As always I will be looking for margin trends and changes in inventory and A/R relative to sales.

2008-01-27T23:11:00.000-06:00

My favorite commercial of all time ......

Am I watching SBUX?

Of coarse I am.

Starbucks is the kind of company I dream of owning but never get to buy because of the valuation. The stock has almost been halfed in the last 2 years but I am still not buying shares. My guess is that Frapaccino's are susceptible to the laws of economics just like any other consumer discretionary item and as the recession plays out there will be more pessimism and a better opportunity to buy the stock.

Buy I will enjoy this commercial while I wait.

CIM – Final Thoughts

2008-01-23T23:49:00.000-06:00

To get to this point I have written 4 long posts on CIM covering just about every aspect of this investment and company in great detail. I can probably summarize all this verbiage by simply saying that CIM represents a pool of capital that will be invested by some of the smartest minds in the business at a time where they will be one of the very few buyers in the market and should be able to produce above average returns on invested capital over a 3 to 5 year period.

At this point there is not much to CIM other than cash and the investments the company has made since going public 2 months ago. For this, investors buying the stock today have to pay more than $4 per share premium to book value or 1.3x book value.

While CIM certainly deserves to trade at a premium to book, I think many investors are overlooking the fact that CIM’s earnings are going to be very volatile and in this kind of market environment I believe the stock is going to move hard and fast around these data points.

I think CIM is going to be a long term winner and I will be adding it to the “Best Ideas” portfolio, however at current prices I am only willing to initiate a very small position in the 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.

Abscense from posting ........

2008-01-07T12:09:00.001-06:00

I have not concluded my post on CIM as I left on vacation last week without writting out a few posts in advance. I don't plan on writting anything the rest of my vacation and will resume when I get back.

In the meantime here is an example of a fairly common occurance when dealing with small/micro cap stocks -- unrelated and uncommon businesses. Attached below is a business description for EEI, a stock I decided to not research further for a reason I don't remember and a company I looked at for a reason I can't now recall. The highlighted part made me chuckle.......

"Ecology and Environment, Inc., an environmental consulting firm, provides professional services worldwide. The company offers a range of environmental consulting services, including environmental planning, management, and regulatory compliance support. It provides engineering design, and operation and maintenance; environmental emergency management; and environmental sustainability. Ecology and Environment, Inc. offers environmental services encompassing audits and impact assessments, surveys, air and water quality management, environmental engineering, environmental infrastructure planning, and industrial hygiene and occupational health studies. ....................In addition, it produces tilapia fish for markets in the Middle East."

* 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 -- Michael Farrell & Annaly Capital Management Inc.

2007-12-26T00:21:00.000-06:00

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.

CIM -- Business Model

2007-12-19T23:47:00.000-06:00

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.

CIM -- Investment Structure

2007-12-17T19:59:00.001-06:00

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

2007-12-16T14:19:00.000-06:00

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.

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

2007-12-11T18:21:00.000-06:00

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.

Things that make me happy......

2007-12-05T21:30:00.000-06:00

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.

“Best Case Scenario Valuation” for CPY …….

2007-12-03T22:16:00.000-06:00

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.

“Worst Case Scenario Valuation” for CPY …….

2007-11-27T20:44:00.000-06:00

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.

Knightspoint is loading up

2007-11-26T17:29:00.000-06:00

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.

Key points from Q2:2007 Conf Call

2007-11-25T22:59:00.000-06:00

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?”

CPY Q2:2007 Earnings Analysis

2007-11-19T18:05:00.000-06:00

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.

FTAR.ob -- 3Q Earnings Analysis

2007-11-15T23:23:00.000-06:00

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 ......

2007-11-11T19:59:00.000-06:00

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.

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

2007-11-05T17:46:00.000-06:00

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.

New CEO Appointed and INFS no longer on the selling block

2007-11-03T21:28:00.002-05:00

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.

Thoughts on BOOT article and furniture stocks

2007-11-02T23:20:00.000-05:00

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!

2007-10-31T17:55:00.000-05:00

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.

Lack of posting .....

2007-10-31T00:11:00.000-05:00

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......

2007-08-19T14:51:00.000-05:00

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

2007-08-15T13:33:00.000-05:00

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?

2007-08-13T22:28:00.000-05:00

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

2007-08-11T16:40:00.000-05:00

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

2007-08-09T21:11:00.000-05:00

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

2007-08-08T08:42:00.000-05:00

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

2007-08-05T23:45:00.000-05:00

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.

JCTCF -- “Da Bulls” -- Part I

2007-08-03T08:07:00.000-05:00

The entire bullish case for JCTCF hinges on the growth of the company’s non-wood products division which is part of the company’s Lumber, Building Materials & Other (JCLC) group. I believe the non-wood products business is a hidden asset and will allow the company to grow the bottom line despite the slowdown in demand for commodity wood products.

There has been several headlines in 2007 that provide a glimpse that things are happening with non-wood products. For example, in January the company announced that it will sell its high-end dog kennels in 900 Petsmart stores. A few weeks later the company announced that they acquired patents and manufacturing rights to a vinyl gate system -- another non-wood product. In February, the company announced that Fred Myer will sell the high end dog kennels in 117 stores.

Here is another positive announcement related to non-wood products in March:

JCTCF “announced that the Company has received initial orders from two large national home centers for the Company's proprietary gate system for wood fences”

That’s a lot of positive headlines that have gone basically unnoticed as the stock is essentially flat year to date. Keep in mind that at the end of 2006 the P/E ratio was at only 12x-13x for a company with ROE north of 15% and almost zero leverage.

Headlines are one thing, but what do the numbers look like?

Here is where things get interesting. EPS for the last nine months (the fiscal ends in August) is $0.57 vs. normalized eps of $0.57 for the same period in fy2007 (the normalization removes a 16c gain in last years figures due to sale of a distribution facility).

So, what’s so great about investing in a company with zero earnings growth? Consider the fact that earnings are still flat while

1) this company sells wood products and the cost of lumber has plummeted. I don’t have exact statistics and JCTCF did not give any numbers in their latest filling but if you were to look at the latest filling from UFPI which I am a shareholder and have mentioned before you would see that lumber prices have fallen by at least 15% year-to-date.

2) its most profitable business segment last year (Greenwood) has experienced a 17% YoY sales decline and profits for that segment are down almost 50%

3) the company made no money in the “industrial tools” business which accounted for 4c of earnings last year at that time

When you consider that all these notable items have been completely offset by the more than doubling of profits in the JCLC segment and that all that increase was driven by non-wood products a different pictures start to emerge.

For the first nine months of the year, sales in JCLC are up only 2% while operating income for the unit is up 140% …..here is the single most important line from the 10Q

“this reflects a sizable increase in specialty metal products that slightly more than offset a sizable decrease in wood products sales. Operating income was up $889,886 [+140% YoY] reflecting the fact that the gross margin on specialty metal products is much higher than on wood products sales.”

I guess I am not sure what else I can say to get my point across.

When you buy shares of JCTCF you are getting a fast growing business segment with a huge potential market that is currently stuck in a middle of a pile of garbage. My bet is that either that garbage will be swept away over the next few years (lumber prices return back to normal levels) revealing the great business segment within. Or the business will continue to grow so much that it will be noticed while still surrounded by garbage.

* 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 Bears”

2007-07-13T07:51:00.000-05:00

I generally try to summarize the bearish case with one sentences, in the case of JCTCF it can be summarized with one work – INCONSISTENCY.

For example, in the last fiscal quarter of 2006 (ending on August 2006) the company reported positive sales growth while YoY eps doubled. Furthermore, for the full fiscal year 2006 operating eps (which is actually lower than reported eps due to a one time gain) was up 115% on YoY basis. Based on the report the company looked like it was well on the way to driving margin improvement in its two biggest businesses and the turnaround was well under way.

However, the following quarter (fiscal 2007:Q1 and calendar November 2006) the company “crapped all over itself” to use a favorite moniker that our trading desk assigns to stocks that drop from $13 to $10 in one day. Revenue fell 15% YoY, operating net income which excludes the positive effect of $150K inventory write-down reversal fell by 56%.

Even worse, JCLC which holds the hidden asset of “non-wood” products and is in my mind the only reason to own this stock actually experienced a 26% decline in operating income and margins in that business unit actually fell. This kind of inconsistency really makes investors question why they should own a tiny, highly illiquid, microcap with management that rarely publicly talks to investors and provides no business updates. The revenue decline is bad enough, but that can be excused by the fact that most of the business is still based on commodity pricing but the decline in margins in JCLC was inexcusable.

In the following quarter, (fiscal 2007:Q2 and calendar February 2007) the company reported another strong quarter -- by my calculations the company registered 38% YoY operating income growth. However, the quarter was “mixed” as revenue fell again by double digit rates and cash flow was negative compared to positive the previous year at this point as inventory drastically increased.

The point is that while there certainly appears to be a turnaround going on at JCTCF and the company is heading in the right direction, the result have been inconsistent.

Also, it can be added to the bearish case that JCTCF still makes most of its revenue and income from commodity products. The revenue decline that has precipitated over the last few quarters—0%, -14%, -15% in the last three most recent quarters—is a perfect example of the danger that faces companies that sell a commodity product, of course JCTCF has been trying to change that.

While I am not spending much time on this – as it should be evident – an investment in JCTCF comes will all the dangers associated with highly illiquid, highly volatile, tiny winy microcaps.

* 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 -- Today's Earnings

2007-07-11T18:24:00.000-05:00

Those of you that have not looked at JCTCF since I posted on the stock a few days ago should take a quick look at todays earnings announcement -- actually you are better off looking at the filed 10Q.

Based on simple YoY eps growth the company reported a very good quarter with "clean" EPS growth of 30%+. However, if you really dig into the 10Q and you know what to look for I think this was a blow out quarter.

If you remember, in my original post I classified JCTCF as a "hidden asset" type of investment. I also stated that the "Lumber, Building Materials & Other" (JCLC) segment which is made up of “wood” and “non-wood” products is really the key to this investment. The hidden asset being the "non-wood" products.

Here is the most important part of today's announcement:

" Sales at JCLC were $8,216,632 for the three months ended May 31, 2007, which was an increase of $1,514,124 or 18% compared to sales of $6,702,508 for the three months ended May 31, 2006. The increase primarily reflects a very significant increase in the sales of specialty metal products along with a moderate increase in wood products sales. Operating income was up $412,598 or 48% based on both the higher level of overall sales and particularly on the fact that the gross margin on the sale of the specialty metal products is much higher than on wood products sales."

While I am very happy to have some confirmation on my original thesis, one quarterly report does not change anything.

As I planned originally, my next post will concentrate on the bear case for the stock. I will than post the bullish case --again, the hidden asset within the company. I will also discuss the valuation and see how it has changed based on the new earnings and the price move over the next few days -- which looks like its going to be substantial.

* 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 -- First Look

2007-07-09T20:29:00.000-05:00

Initially attracted to this stock for the following reasons:
-substantial EBITDA and earnings growth but still low multiple
-recently strong ROE without much leverage
-very thinly traded (roughly 5K shares per day) and very large insider ownership
-extreme stock volatility over last 18 months despite steady earnings growth

Share Price…….$8.17
Market Value …..$20M
Enterprise Value: ….$24M
Investment Type: …..Hidden Assets

Jewett Cameron Trading Co. Ltd (JCTCF) has four business lines with Greenwood and JCLC accounting for 90% of 2006 sales.

Business Lines

Industrial Wood Products (aka Greenwood) essentially sells treated lumber and other wood products to OEMs in the transportation and recreational boating industry. In the latest 10K the company tries to make the case that these are “value added” products with a lot of customization but based on margins and the recent financial performance of this business and management’s comments this is still largely a commodity business. Also, not only is this business a commodity business a large part of the unit sales (34%, 41%, and 39% in 2006, 2005, and 2004 respectively) came from the recreational boating industry which is highly leveraged to the economy.

Lumber, Building Materials & Other (JCLC) is made up of “wood” and “non-wood” products. The wood products are all pure commodity products with the final users being the residential remodeling or DIY market. The products are sold either at the company’s distribution center and home improvement retailers/center. The “non-wood” products are sold primarily by home improvement retailers and include dog kennels, greenhouses, gates, etc. The company has been expanding the number of “non-wood” products in its lineup and has increased the number of stores that sell these products. I will talk at length about this segment of the JCTCF’s business in further posts as I believe it’s the key to the investment thesis.

Seed Processing and Sales (JCSC) is in the business of taking raw seeds and processing them into marketable products to be sold to farmers.

Industrial Tools and Clamps (MSI) imports and distributes pneumatic air tools and industrial clamps. MSI owns the brand names while the manufacturing is done in Asia. In the lastest 10K, the company estimates that the pneumatic air market at $1B in annual sales with many competitors. The industrial clamps market is estimated at $400M in annual sales with fewer competitors and where JCTCF feels they can take market share.

As always, in the following posts I will outline the Bear and Bull cases for the stock and conclude by deciding if this stock will be added to the Best Ideas or Watch List portfolio.

* 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.

Marketocracy Portfolios -- June 2007

2007-07-05T00:53:00.000-05:00

As mentioned earlier I will maintain 2 separate Marketocracy portfolios to provide some type of performance attribution to the readers of this blog. I will publish the holdings/weights of the “Best Ideas Portfolio” on a monthly basis and discuss any new buys/sells. I will not spend much time on the “Watch List Portfolio” as it will simply hold all the stocks analyzed on the blog but not included in the Best Ideas portfolio.

Best Ideas Portfolio
FTAR ($4.20) ….weight = 5% (full position with target weight of 8%)

BOOT ($18.01)…..weight = 2% (based on my post on 6/9/2007 my sell price is $21-$23, and the stock would need to fall to below $15 for me to increase it to a full position and buy more)

CPY ($69.5)……weight =1% (I posted that I feel this stock is worth at least $105 but that is likely to change as PCA’s financials are disclosed over the next few quarters. Applying a margin of safety, I posted that I would dip my toes in the water if the stock hit $65 and initiated a 1% position at that price. If the stock falls to below $55 I will buy another 1% other than that I am on hold until I see what’s under the hood of PCA)

INFS ($2.23)……weight = 1% (I recently posted that I feel that this maybe a case of a “turnaround that never turns” but I believe that below $2.50 the shares trade at a deep discount to acquisition value. I will add another 1% in the Best Ideas portfolio if the stock dips below $2 per share)

Cash 91%

*All stocks purchased in June 2006

Performance
Best Ideas Portfolio…-0.30%
Watch List Portfolio…-0.08%
Russell 2000 ….-1.46%
Core CPI + 10% ….at this point this is not a meaningful measure for comparison purposes

Keep in mind that the two Marketocracy portfolios hold 91% and 85% in cash, respectively.

As I stated initially, I will use cumulative returns since inception until I reach a 3 year track record. After that I will use a 3 year moving average as well as cumulative performance. I would not pay much attention to the returns versus these benchmarks until there is at least an 18 month rack record and there has been at least one 12 month period with the major indexes down 10% or more.

Again, I want to mention that I have long position in all stocks mentioned in this post and have a vested interested in promoting my long positions. The “Best Ideas Portfolio” is NOT A RECOMMENDED PORTFOLIO. The weight of each stock mentioned in the post is substantially different in my personal portfolio and it would be mistake to replicate this portfolio exactly in your investment account. These portfolio are relevant in the context of this blog only.

INFS -- “Final Thoughts”

2007-07-03T10:19:00.000-05:00

In the previous 5 posts I talked at length about the problems faced by INFS as well as the attractive aspects of an investment in the company.

INFS continues to see prices for its products drop by double digit rates due to roughly 30-40 competing projector manufacturers as well as the ascent of LCD/Plasma televisions.

However, INFS is now controlled by a hedge fund which is the firm’s largest shareholder and will be picking the new management team and setting the new policies, the company has a fortress balance sheet, and it appears that the stock is trading at a discount to the combination of tangible liquidation value + non-tangible assets that certainly posses value for an acquirer.

If there is value for the shareholder, why didn’t anyone purchase INFS when it effectively put itself up for sale a few months ago?

I don’t have a definitive answer to this question but 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.

There will be more key data points coming from the company within the next 6 months. The biggest in my opinion will be hiring of the new CEO and CFO by Caxton and the plan that will be outlined to other shareholders to turn the company around. There will also be a new proxy filled and it will be key to see how the two top people at the firm will be incentivised. Will their biggest gains come only if shareholders benefit (mostly long term restricted stock based compensation plan) or will they be awarded with mostly cash salaries and large parachutes?

Another two key data points in the next few quarters will be the trend in Gross Margins and G&A expense. Obviously these are key metrics for any company any time, but in the case of INFS the trends in Gross Margins and G&A expense will make the difference between survival and bankruptcy.

On the last quarterly call the recently departed CFO stated that gross margins took a 360bps SEQUENTIAL hit due to the company clearing out inventory of IN72 projectors and selling a lot more of the lower price point IN24 and IN26 projectors causing sequential volumes to go up 15% while revenue was down 7%. The CFO stated that they “aggressively sold these products” which of course in the real world means: “CRAZY EDDIE HERE, AND EVERYTHING MUST GO. SALE, SALE, SALE!!!!!!!” While aggressive discounting of course kills margins, the positive is that it clears the deck of old products and turns inventory into cash which the company needs right now. While not as clearly, that much was stated by management on the last call.

The company also needs to cut G&A expense immediately. While there is always a degree of uncertainty around new product introductions which management has no control over, expenses are completely under management’s control. The company needs to cut expenses and needs to do it immediately – this is where a new CEO/CFO team can make an immediate impact. Again, on the last conference call guidance was for $14.5M - $15.5M in quarterly G&A as the goal by year end from the current level of $19.2M in Q1:2007. It will be up to new management to cut expenses without cutting R&D. Cutting costs is great, but where to cut with manufacturing and call centers already outsourced?

One place where I think some cuts can be made is in the development/support of the dealer network as well as some general “home office” jobs. As I understand the business model, the company spends a lot of time training and supporting dealers that sell their product. This is a key function of course, but there maybe room to trim the least profitable dealers (which will mean giving up sales) and the people employed to support them (more profits from fewer dealers). This is by no means a given and in my experience the odds are against any new management team faced with this task.

So is INFS going to be added to the Watch List or the Best Ideas portfolio?

Based on my previous post, I think INFS is trading at a substantial discount to what an acquirer would be willing to pay for the company. The company is now run by the largest shareholders and it the company has the balance sheet needed for such a massive turnaround. Therefore I have added a 1% position in INFS to the Best Ideas portfolio. You will recall that my target for this portfolio is to have 10 full positions at roughly 8% each and 10 smaller positions that will hopefully be increased to full positions eventually.

What will I be watching for in the next few quarters?

I will be looking for a sequential bounce in Gross Margins as the company has apparently moved out the old discounted inventory and should see an increase as it starts selling more higher priced products. I don’t think the company is close to hitting the long term targeted GM of 16% to 18%, but not seeing an immediate increase would be a very bad sign.

After new management is hired I will be looking for declining G&A – are they heading towards previously guided $14.5M to $15.5M? What is management doing to cut expenses immediately?

Details of new CEO’s and CFO’s long term compensation – is it long term stock based or mostly cash?

I will also be looking for trends in revenue and average prices in Q3 and especially Q4. The projector industry is seasonal with most of the sales done in Q3 and Q4, with Q4 being by far the most important. Right now the stated plan is to migrate customers to higher margin IN24+ and IN26+ as well as new product launches like the IN10 ultra mobile projector. If after clearing out inventory the company can’t increase Gross Margins and show at least some initial increase in sales, there is no reason to own 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.

INFS -- “Da Bulls” Part III

2007-06-27T18:58:00.000-05:00

The first two bullish posts talked about shareholders controlling the firms destiny and INFS having the balance sheet required for a turnaround. This post will concentrate on valuation.

Since we are in the early innings of the “turnaround” and its impossible (at least for me) to estimate future cash flow, the only relevant way to value this company is by trying to calculate an acquisition value.

Lets see what this pig is worth ……fist lets look at the tangible liquidation value

Cash & Equivalents ……. $78M
Net Receivables …… $35M (reported $47M, discount by 25%)
Inventory …… $18M (reported $36M, discounted by 50%)
Other CA $9M

Current Liabilities……. ($83M)
Other LT Liab ……. ($4M)
Tangible Liquidation Value …$53M or $1.33M per share

Value of Motif* ……. $23M (50% share of 15x 2006 net income of $3.1)
Non-Cancelable Leases….. ($17M)
Revenue from Sub-Leasing** …$8.5M
Intangible Liquidation Value …..$10.2M (total intangible value $14.5M discounted by 30%)

Total Liquidation Value $63.2M or $1.60/sh
Current Market Value $97M or $2.44/sh

*Motif is a 50/50 JV with Motorola. Net income in 2006, 2005, 2004 has been $3.1M, $7.3M, $4.7M respectively (note 12 in 2006 10K).

**INFS currently sub-leases some the properties it liquidated as part of the restructuring. To be conservative, I assumed they could sub-lease their current properties at 50% of what they are paying.

What is not included in this liquidation value but is worth something to an acquirer?

1) by far the biggest thing that is missing from $1.60 liquidation value I calculated above is the over $200M in NOL’s that INFS is currently carrying. The problem is that you can’t just discount the $200M and add it to value of the company because the nature of tax laws give different acquires different abilities to use the NOL’s. On the last conference call, the CFO (who is no longer with the company ) said that much. However, he also said that to the right buyer the NOL’s have real dollar value.

How much could they be worth? Well, lest say the acquirer can only use 50% of the NOL’s over the next 10 years. Discounted at 6%, the PV is $56M or $1.41/share.

2) another exclusion from the above liquidation value is INFS “intellectual property” (patents, R&D department, brand name, etc.) and its reseller network. While its hard for me to assign a specific dollar value to the company’s intellectual property I think it has a value of more than zero. Despite its problems, INFS still has patents and the know how to make high quality projectors and I feel that this technology is worth something to a potential acquirer. They also have years of relationships with resellers and do posses shelf space that has a tangible dollar value to an acquirer.

I am not going to spend a lot of time talking about the “brand name” even though they state (very often) that they have the largest installed base of projectors and leading brand name. I think its pointless to talk about your “brand name” when you have seen ASP’s fall by double digit rates over the last 4 years– obviously your brand name is not very strong.

So what does this all mean?

Well, I think at the current market price of $2.44 per INFS share you are getting $1.60 of tangible liquidation value as wells as $200M+ of NOLs and the company’s intellectual property which I think is worth over $1.50 per share – even if the acquirer can only use half of the NOL’s they are worth $1.40/share by my calculations.

Obviously INFS is a very high risk investment in the early stages of a shareholder led transformation, but at current prices you are paying a discount to acquisition value.

The next post will conclude my analysis of INFS.

INFS -- “Da Bulls” Part II

2007-06-25T21:41:00.000-05:00

The other bullish aspects of an investment in INFS is that the despite the horrible financial performance the company still has a great balance sheet and the valuation seems to be attractive.

Lets looks at the easy part first …..

INFS has $78M in cash on hand based on the latest quarterly results (Q1:2007), no long-term bank debt, and $4M in “other long term debt”. This translates to $74M ($1.86/sh) in free cash that can be used to cover negative cash flow and reinvestment into the business.

Based on 2006 FCF Statement, INFS had negative operating cash flow of $15M and capex of $5.3M for a total cash burn of $20M. Assuming no improvement in operations, INFS has enough cash to remain solvent for over 3 years. Why is this important?

Well …. Having the financial wherewithal to stay solvent until those activist shareholders and/or new management team can work their magic is another must that I look for when investing in turnarounds. The cash hoard and no interest payments gives INFS management some breathing room as they work on turning the company around and gives them the cash to make investments in R&D and/or Capex to effect the turnaround.

Ok, so the board has the same interest as the shareholders and the company is not going to go bankrupt anytime soon. But, does the current valuation provide enough margin of safety to compensate for the huge amount of risk that is involved in investing in a company that is bleeding cash and does not seem to have any apparent “moat” around its business? Or is this a coin toss?

I originally planned on including the valuation in this post, but it is getting long. The third bullish post will go over my calculation of liquidation value for INFS.

INFS -- “Da Bulls” Part I

2007-06-22T12:36:00.000-05:00

The one sentence bullish case for INFS is that the company’s largest shareholder now controls the board of directors and will be handpicking the new management team, the company has the balance sheet needed to turn itself around, and the stock is currently trading at a discount to acquisition value.

As I mentioned in my initial post on INFS, one of the reasons that I am looking at this stock is because Caxton is now the largest shareholder of the company with 11.2% of the shares outstanding and they control the board. Stated another way, going forward the shareholder with the most money at stake will be running the show.

If you read my posts on CPY, you know that I consider such direct aligning of interests between shareholders and the people running the company (board of directors and management as their agents) as a must for profitable turnaround investments. Because of this, I consider piggy-backing onto large institutional investors who are planning to act as activists to facilitate the turnaround as a very attractive strategy.

If you read the original letter written by Caxton when they reported their holding but before they were given their first 2 board seats , their discontent with INFS is pretty generic:

board has no vision
board has no significant shareholders
must have a new business plan that assures profitability or sell the company

So far, Caxton has been able to fix one of the three points. As part of their agreement with the company to call of a proxy fight, Caxton got to name 2 directors in April if INFS was not sold. With the April and June appointments, Caxton has control of the board and there is now representation on the board from a significant shareholder.

Off the four Caxton board members, two have industry experience and the other two are from the financial sector. Robert Ladd was one of the two directors appointed on June 6^th, Ladd runs Laddcap Value Associates which owns 0.6% of INFS shares.

Interestingly, the other director from the financial sector is John Abouchar who according to this article covered INFS as a sell side analyst and was critical of the company. You don’t often get to see sell side guys getting to make changes in the company’s they cover

Its unclear at this point what Caxton will do to regarding the other two points raised in their letter, 1) vision, and 3) new business plan.

According to the previously linked article, Caxton has called for INFS to turn itself into a an intellectual property company as opposed to a manufacturer, call center provider, parts manufacturer, etc. I have only listened to the latest few conference call and the only thing I have ever heard the Caxton guy say is that he is upset about the company performance and as the largest shareholder they are pissed-off. Naturally!

I think the intellectual property route is an attractive one for INFS. This company will never be able to compete with the big boys (Sony, etc.) or the low cost generic manufacturers so spending less time and money on the non-research related business functions would free up time and resources to spend on being a technology innovator. The company has already outsourced all its manufacturing but there are still a lot of non-R&D functions done by the company that I think Caxton and the new CEO will be looking to cut.

As I said in the beginning of the post, I consider having a large shareholder on the board of directors as a must before investing in a turnaround situation.

INFS -- “Da Bears” Part II

2007-06-21T12:51:00.000-05:00

The second major bearish case for INFS is that this company may never again earn a sufficient rate of return for shareholders. The company has been in a perpetual state of restructuring for the last five years with no sustained improvement achieved. For example, in the last 16 quarters the company has recorded 13 negative “one time charges” and this does not include inventory write-offs which are dumped into cost of goods—needless to say that at this point these are no longer one time in nature.

Here is a brief history of restructuring expenses:
2003
$15.7M inventory write-down (COGS)
$6.7M “restructuring charge” -- lease breakage, severance costs, etc.
$26.4M long lived asset impairment charge

2004
Negligible

2005
$27M inventory write-down (COGS)
$11.1M “restructuring charge”
$9.8M long lived asset impairment charge
$5.1M in SMT related losses

2006
$8.4M inventory write-down (COGS)
$5.4M “restructuring charge”
$9.4M regulatory assessment charge due to China customs case
$7M in SMT write-downs and TUN write-off

INFS also took a $7.4M charge in 2006 to write-down value for investments in technology companies that did not work out.

Looking at this restructuring history leads me to think about the following maxim: “turnarounds seldom ever turn.”

Over the last few years management has made other notable mistakes, specifically the failed and unnecessary JV to incubate a 3rd party manufacturer and the export problems with China. I am not going to spend any more time on these as 1) you can read about them in the latest 10K and I can’t add much more insight than that, 2) the management team that was responsible for these mistakes is no longer with INFS, 3) while these missteps have cost shareholders real money, I don’t think these missteps provide any indication about INFS’s core problems and really are one time in nature.

As I see it, the two main reasons not to own shares of INFS is that the company may never earn above average rate of return for an extended period of time due to
1) consumer and business electronics is a cut-throat industry with very little room for any managerial mistakes, and
2) the fact that INFS has been constantly restructuring without any consistent positive results maybe a sign that there is something inherently wrong with the business model that no amount of investment or managerial talent can fix

* 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.

INFS -- “Da Bears” Part I

2007-06-20T12:23:00.000-05:00

Since there is a lot more bad than good to talk about with INFS, I will jump right into the bearish case. The one sentences bearish case for INFS is that the company was grossly mismanaged just as the projector industry experienced a severe inventory glut and competition from LCD/Plasma televisions.

The mismanagement at INFS over the last few years has come in several flavors …..

First, the company’s management simply failed to properly position their business for the continued price compression in the projector industry. You could make the argument that there is not way management could foretell this, even though its part of their job description. Fine ……

The real mistake that INFS made is that it significantly invested in inventory at the worst possible time. Inventory on hand increased from $62M at the end of 2003 to $155M at the end of 2004. Of the $93M increase, $73M came in the form of “finished goods” (see Note #3 of 2004 10K) which is basically finished projectors sitting in the company’s warehouse, collecting dust and depreciating every single day.

Just as the company significantly invested in inventory, ASP (average sales price) continued their sharp declines …. (all data is from the 10K’s)

2006 (vs. 20005)……-15.5%
2005 ……..-17%
2004………-20%
2003………-27%

This has cost the company dearly in the form of severe gross margin compression as INFS had to lower prices and simply write-off a big chunk of inventory in 2005. Gross Margins fell to 8% in 2005 (this includes the $27M inventory write-off) and 15% in 2006.

On its own terms this is bad enough, however this becomes even a bigger problem when you consider the fact that INFS operates in a highly competitive industry and really cannot afford such missteps. Unfortunately, business and consumer electronics is not an industry where dumb management will be overcome by superior industry dynamics.

INFS is facing severe price pressures from Asian electronics companies that can produce projectors cheaper, have diversified product lines so they can withstand some margin compression on projectors, and have superior financial position to withstand an industry shake out.

Also driving ASPs lower is the emergence of LCD and Plasma televisions as a real competitor. I called one and visited another high end home entertainment provider and my sense is that projectors (both home entertainment and fixed business use projectors) still provide a bigger and better picture per dollar spent compared to LCD or Plasma televisions in similar price range. However, LCD and Plasma TVs are simply a hot product right now and provide a good enough picture which means they are stealing sales and projector manufacturers must lower prices to compete with these often cheaper alternatives (as well as other projector manufacturers).

I will continue with other bearish aspects in the next post ……

* 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.

INFS -- First Look

2007-06-13T21:19:00.000-05:00

Initially attracted to the stock for the following reasons
-James Altucher posted on his Daily Blog Watch that Caxton Associates announced that they have accumulated an 8.9% position in the stock and will be acting as an activist shareholder
-$1.96 per share in unrestricted cash & equivalents and no debt, stock price at $2.60
-operating CF as reported on FCF Statement substantially higher than reported GAAP EBITDA and Net Income
-great products, awful financial performance

Currently
Share Price: $2.44
Market Value: $97M
Enterprise Value: $23M
Investment Type: Turnaround Situation

InFocus Corp. (INFS) is a developer of projectors used for business, education, and home entertainment. The company has a spectrum of products retailing from $500 to over $10,000. In the latest annual report the company uses such words as “industry pioneer,” “worldwide leader,” and “premium.” The company also states that they have the largest installed base of projectors compared to anyone in the industry. While all of these statements might be true I have a hard time assigning such praise to a company that has not reported twelve months worth of positive EBITDA since the third quarter of 2002.

INFS was a high flying tech stock in the “good old days” with peak revenue of $887 million in 2000 and EBITA of $97M in that year. Share price in early October 2000 hit an all time high of $56 per share giving the company a market value of $2.3 billion. The big boost to sales in 1999 (sales up 125%) and 2000 (sales up 29% YoY) came from the growth of “ultraportable” and “microportable” projectors that were above 1,000 lumens and could be carried around and attached to laptops. The first ultraportable projectors were introduced in Q1-1999 and by 2000 accounted for almost 80% of sales.

Don’t know what a “lumen” is? Basically, higher lumen count = brither colors http://en.wikipedia.org/wiki/Lumen_(unit)

Oh how the mighty have fallen …..

In the latest fiscal year ended December 2006, the company reported revenue of $375M and EBITDA of negative $29M.

While it’s not hard to understand why revenue fell by a third between 2000 and 2003—business spending dried up and even the best tech firms experienced similar problems—it is imperative to understand why revenue has not recovered with the economy.

In the last six months there has been substantial developments with the company. Caxton has raised their stake to almost 12% of oustanding share. In February 2007, the company allowed Caxton to nominate 2 directors to the board in order to prevent a proxy fight. INFS unsuccessfully put itself up for sale. The CEO retired in May. And on June 6th, Caxton appointed 2 more directors to the board giving it effective control of the company and the ability to hand pick the new CEO.

As always, I will continue with my analysis by laying out a bullish and bearish case and make a final decision on whether to add this stock to the Watch List Portfolio or the Best Ideas Portfolio.

* 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 Q1:2007 Earnings Analysis

2007-06-11T20:58:00.000-05:00

CPY reported first quarter earnings on 6/5/2007. Based on my previous post this is what I was looking for while reading the release:

“…….trend in Sears sitting and sales per customer, difference between CAPEX and reported dep/amor, insider trading by Knightspoint. Obviously any new information regarding PCA …..”

The trend in Sears sitting continues to be negative with sittings down 13% while the trend in sales per customer continues to be positive with sales per customer up 11%. Overall, net sales were down 4% and the fact that the increase in sales per customer is not offsetting sittings decline is a bearish sign. However, I can make a strong case (at least to myself) to own the stock at the right price without growth in Sears sales so this continued sales decline is not monumental.

EPS increased 40% YoY to $0.40 per share with most of the increase due to a mysterious 9c benefit for a “change in vacation policy.” Its unclear to me if we can expect an additional 9c in each of the remaining quarters or is this a one time deal.

It looks like the second quarter is going to experience the same trends in sitting declines. The company reported that for the first 5 weeks of the second quarter sitting are down 10% YoY and total sales are down 4%.

On the PCA front nothing groundbreaking was disclosed. If you listen to the conference call the only thing worth noting is that it looks like management will start working on converting the studios to digital right away. It looks like the expectation is to do some in 2007 and finish up most if not all by 2008. I mentioned this in my earlier post as “a given” but it’s nice to have a confirmation on this anyway.

The only other thing that was mentioned is that management feels they have the capacity in place already to service all of PCA’s digital infrastructure. The implication is that margins are going to improve with addition of PCA. While this is a nice thought, I am waiting to see the numbers to incorporate this into my projections.

Knightspoint did not sell any shares and GAAP dep/amort continues to be substantially higher than maintenance CAPEX.

Overall, this quarter did not provide any info that would cause me to change my opinion on the stock. If the stock falls below $65 per share before any meaningful PCA info is disclosed I am going to start nibbling, otherwise I am taking a wait and see approach.

Things I will be watching for in Q2:2007 remain the trend in Sears sitting and sales per customer, difference between CAPEX and reported dep/amor, insider trading by Knightspoint, new info regarding PCA. Also, I will be looking to see if the vacation policy change will have the same positive effect on Q2 as it did on Q1.

Oh yeh ….. it looks like CPY continues to be underfollowed. Only two people asked question on the conference call despite the big announcements and sharp share price increase in the last 3 months. There maybe an opportunity for us in CPY yet …….

BAMM -- $3 Special Dividend

2007-06-10T15:14:00.000-05:00

BAMM announced a one time, $3 per share cash dividend that will be paid out on 7/5/2007. The dividend will cost BAMM approximately $50.4 million.

First of all, where will the cash for the dividend come from? While there was no cash balance released in the filed 8K, based on historical trends BAMM should have roughly $40 million in cash.

Also, due to the release of Harry Potter next month the company maybe experiencing an unusually high number of prepayments. I called the customer service line (1-800-201-3550) and they told me that if I want to pick up the Harry Potter book on the day of the release I can go into the store and get a voucher but I have to pay for it upfront. I am not sure how big of a cash influx this will create but there is certainly some.

Even if the company can pay out the entire $50 million without borrowing, it will have to borrow at some point in 2008 to fund the build up in inventory for the large Q4 selling season. BAMM has plenty of liquidity to fund the dividend as they have a $100 million credit facility which is 100% available to fund operations.

The bigger question is what does this dividend signal about BAMM’s long term prospects?

I think the dividend announcement reinforces the point I made in an earlier post on BAMM. While I still don’t like the valuation and the industry is facing some serious problems, this announcement shows once again that management is focused on generating value for the shareholder -- and I don’t want to bet against them with a short position.

I think the immediate impact of the dividend will be to increase ROE as book value will fall and this company can certainly service a little debt if they have to borrow to fund the dividend.

In the long term I think nothing changes. The company is still posting negative SSS which means that if they want to post any type of top line growth (even to keep up with inflation) they need to keep investing in more stores which will show diminishing returns every year if SSS trends remain negative. And the stock is still not cheap, including Q1 results BAMM is still trading at 15x earnings.

* 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.

BOOT -- “Final Thoughts”

2007-06-09T12:04:00.000-05:00

Just to recap, BOOT has really turned around their operations over the last 4 years and has seen substantial margin improvement. However, the company continues to have operating margins below the industry medians even after the increase in recent years.

My favorite way to look at valuation for small cap turnaround stocks is
1) ATTEMPT to calculate a price that a larger public competitor would be willing to pay
2) ATTEMPT to calculate a price that I would be willing to pay for the business

I find this to be a good exercise for those stocks that have publicly traded peer groups. This allows me to calculate a rough buy and sell price, but that’s the smaller benefit. The bigger benefit is that it clearly highlights discreptencies between what I think is the right price and what the market thinks is the right price for a group of similar stocks.

I am going to spend a lot of time talking about what BOOT would be worth as an acquisition candidate. However, I want to reiterate that ITS HIGHLY UNLIKELY THAT BOOT WILL BE ACQUIRED.

Why would the CEO agree to sell the company when his family owns half the shares and the board is made up of his father’s friends? While the current management has added a lot of value since they took over in 2000, the fact remains that “shareholder accountability” is nothing more than lip services. The CEO knows that the board will keep paying him a million bucks a year even if BOOT’s operating performance continues to lag the industry.

Enough with the background noise ……. Is this stock going into the Best Ideas Portfolio or is it getting trashed into the Watch List Portfolio?

Using the peer group that I described earlier we can calculate that sales growth for the last 3 years has been 9.7% annually and EBITDA margins were 13.5%. If we make a very naïve assumption that the group will grow at that rate for the next 3 years and maintain the same margins than the industry is trading at following forward valuations

P/FWD 2007 EBITDA …… 9.48x
P/FWD 2008 EBITDA …… 8.65x
P/FWD 2009 EBITDA …… 7.89x

If we assume sales growth of 8% for BOOT over the next 3 years and its takes 3 years for the acquirer to get BOOT’s EBITDA to industry median levels than the valuation looks something like this:

P/FWD 2007 EBITDA …… 8.07x
P/FWD 2008 EBITDA …… 6.83x
P/FWD 2009 EBITDA …… 5.83x

You are looking at discounts of 25% to 35% to industry levels. To get in line with industry valuations that stock would have to be trading at $23 to $21.5 per share. Haircutting that price by 30% to provide for a margin of safety I get a peer group derived buy price of $16 to $15 per share -- which is a bit lower than the current price of $17.10 per share.

So far so good …….But what would I be willing to pay for BOOT?

Since I don’t have $100+ million I will have to borrow the entire sum. Let’s say I can borrow at 7% (I think most of the peer group I use would be rated A to BBB+ so they would be issuing 10 year paper at roughly Treasury yield + 100bps which gets us to about 6.15% but lets be conservative).

Using the same forward 3 year assumptions as under the peer group analysis, I calculate that I can pay $31 per share for BOOT and if my assumptions are correct I will still break even after 3 years. The $31 target price implies 80% total return and 22% annualized over next 3 years. I think the $31 share price is the highest possible price BOOT can be trading at over the next 3 years.

But I don’t want to just break even, I want to earn a satisfactory rate of return. For me to get a 10% rate of return on this investment I would have to pay no more than $20 per share to acquire BOOT. Haircutting that price by 30% to provide for a margin of safety I get a buy price of $14 per share -- which is almost 20% lower than the current price of $17.10 per share.

Its pretty clear that I don’t think that BOOT is wildly under or over valued. I think the stock is trading roughly in line or at a discount to where others in the industry are trading. Unfortunately, it’s not trading low enough to provide me with a large enough margin of safety to initiate a position at this time. I will be adding the stock to the Watch List portfolio and will be waiting for new data or a lower share price.

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.

BOOT -- “Da Bears”

2007-06-05T21:31:00.000-05:00

The one sentence bearish case for BOOT is that outside shareholders are second class citizens without any power to effect changes, that the company is a below average operator, and that the combination of these two factors demands a discounted valuation.

The Schneider family owns roughly 42% of the outstanding shares so the CEO Joseph Schneider can prevent any takeover or management change no matter how bad things get operationally. Also, the entire board of directors except 1 member is pre-March 2005 meaning that they are all buddy’s of the CEO’s late father who died in 2005 but held on to the Chairman’s title until his last days.

Concentrated ownership controlled by one family (in this case they were not the founding family but George Schneider led the management buyout in 1982) does not generally bode well for unlocking the maximum shareholder value. While the current management has certainly done a good job turning the company around, in cases where the CEO has the board under his thumb one always has to wonder how much more could have been done and will be done in the future.

While the compensation structure detailed in the latest proxy is by no means egregious, a few less noticeable details support the point made above. For example, looking over the last two annual proxy statements it looks like the CEO’s total compensation doubled in 2006 versus the previous year. The increase in total comp was almost entirely due to increase in incentive compensation. So, what? After all, the company had a good year.

The interesting thing is that the increased incentive was achieved by changing how calculations are made to decide if management met their goals. The change in calculation was small (revenue growth became 40% of goal vs. 50% the previous year) but it was enough to ensure a higher payout. Also, management is only taking a small part of their total compensation in the form of options or restricted equity. They can basically take the money now as opposed to taking stock linked compensation and only get rewarded if shareholders get rewarded.

The second part of the bearish case is that BOOT is a below average operator in the industry. Measured by both gross and ebitda margins, BOOT is below the industry medians. Also, the company has less revenue, less EBITDA, and virtually identical book value as it did 9 years ago (this is as far as I have data). It’s true that the company has most recently consolidated its business and walked away from less profitable revenue, but the point is that the company has been a below average operator in the industry.

Considering the fact that BOOT is a less efficient operator than its peers combined with a CEO who knows he will keep his job even if he lags the industry, its no wonder that BOOT is trading at a discount valuation to the group. On top off all that, BOOT gets almost all its sales in the U.S. and is highly depended on both U.S. consumer spending and domestic economic growth.

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.

BOOT -- “Da Bulls”

2007-06-05T19:52:00.000-05:00

The one sentence bullish case for BOOT is that the company has undergone a series transformation and has become solidly positive, it still has room for improvement, and it currently sports one of the lowest valuations among its competitors.

Even though I found some prominent warts on this management teams face and will discuss them in the bearish post, its hard not to commend them for the turnaround they have engineered over the last 4 years. Looking at the year end results for 2002, a year in which sales were down 22% and the stock hit an all time low of around $1.70, EBITDA was $2.14 or 2.2% of Sales and pre-one time charges EPS was negative 36c per share.

Since 2002, the level of gross profit and EBITDA has increased in every year. Also, gross margin and EBITDA margin increased in every year compared to the year before. Gross Margin increase by almost 1100bps while EBITDA margin has increased by 800bps. Further more, the company has been able to maintain the level of working capital virtually unchanged since the end of 2002 but it now generates more than 5x EBITDA and net income.

The median Gross Margin for shoes manufacturers (this EXCLUDES retailers like Payless) over the last 12 months is 43% v. 41% for BOOT. The 200bps difference in margins is HUGE for an industry with median EBITDA margin 12.6%. If BOOT can close the gap and it has been making strides in that direction every year since 2002, this will add somewhere between $5M - $6M to after tax net income or $0.80 - $0.95 per share. This would nearly double net income.

Its hard to say if the company will be able to continue to increase gross margin at the same pace. On average, BOOT has added 270bps to gross margin in each of the last 3 years, but that number declined last year and will be harder to maintain as the easy fruit is always picked first. Still, in the fiscal first quarter reported in May 2007 gross margin was up over 100bps relative to the same quarter in 2006 but it’s the last two quarters that are important due to seasonality inherent in the business.

Of course, “below industry margin with a lot of room for improvement” can be rephrased as “inefficient operator,” more on this in the next post ……

Despite the strong price move in the stock recently, BOOT still trades at discounts to the industry medians based on sales, ebitda, and book value. On average, BOOT trades at a 25% discount to the industry despite reporting better sales and ebitda growth than many of its competitors. I am not getting into a detailed valuation discussion at this point as I plan to discuss it in my concluding post on BOOT.

Companies used to calculate industry median valuations and margins: KSWS, WEYS, TBL, RCKY, WWW, DECK, SKX, SHOO

Companies excluded from median valuations despite industry participation: HLYS, CROX, NKE

* 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.

BOOT – First Look

2007-06-04T21:46:00.000-05:00

Initially attracted to the stock for the following reasons
-strong operational improvement from quarter to quarter
-strong momentum in the form of rising earnings estimates, positive price momentum, and earnings surprises
-hidden assets in the form of NOL
-premium brands trading at discount valuation

Currently:
Share Price: $17.2
Market Value: $108M
Enterprise Value: $98M
Investment Type: Long term holding

LaCrosse Footwear (BOOT) has been making boots for over a hundred years. In 1994 the company acquired Danner, Inc an its line up of premium leather boots. Currently the company’s revenue is almost evenly split between the work and outdoor market. The LaCrosse branded boots are sold at lower price points while the Danner boots have a strong brand name and sell at a substantial premium.

Fast forwarding to the most recent past, BOOT has undergone a substantial turnaround and has drastically improved margins. Over the last 5 years the company jettisoned a substantial number of businesses (PVC boots, children boots, mass market apparel, etc.) and has concentrated on its highest margin products.

The turnaround has been pronounced ……

Looking at the 2002 annual report, a year in which the stock hit $1 per share, the company reported 22% decline in sales due to both weakening economy and discontinuation of several business lines and retail outlets. Gross margins were reported at 26.8% (which was actually a 270 bps improvement from the previous year) and EBITDA was a negative $4 million. In 2002 and 2001 the company relocated its headquarters and most of the remaining U.S. manufacturing to Portland, Oregon and shut down a number of plants in Wisconsin (the company was originally founded as a rubber shoe manufacturer based in Wisconsin).

What a difference 4 years makes …..

Looking over the latest 10K, BOOT reported gross margins of 39.2% and EBITDA of positive $8.84 million. Also, based on the latest filling the company manufactures 80% of its products (by sales dollars) outside of the U.S. and has re-positioned itself into a designer and innovator rather than a sub par manufacturer.

* 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.

Marketocracy Portfolios Created

2007-06-01T21:27:00.000-05:00

In order to keep some type of investment performance track record of the stocks analyzed on this blog I have created 2 Marketocracy portfolios that I describe below.

Those of you that are familiar with Marketocracy know that they have some basic holdings rules for portfolios to be in “compliance” and included in their rankings. I don’t plan to follow those rules and any compliance is accidental -- wow, in an environment where I have to get our firm’s compliance department to sign off before I go to the bathroom writing that actually felt liberating.

For those of you not familiar with the Marketocracy service I suggest you check them out at www.marketocracy.com. I think if used properly, people new to investing can learn some valuable lessons and save themselves some investment losses. Keep in mind that I am only referring to their free services, I have never used the premium service and have no idea if its worth the price or not.

I plan to post and discuss performance on a monthly basis. Below is a description of the two portfolios I created …….

“Watch List” portfolio -- this portfolio will hold a position in every stock that has been analyzed in detailed and written up on this blog. I don’t have any performance expectation for this portfolio. The main purpose of this portfolio is to simply remind me to check up on these stocks on a monthly basis. The secondary purpose is to provide me with some clues about how my personal idea generation process and the stocks that attract me compare with picking stock ideas at random -- on average, am I fishing in the more fertile parts of the lake?

“Best Ideas” portfolio -- this portfolio will hold full positions in a maximum of the 10 best ideas from this blog at any given time as well as much smaller positions in a maximum of 10 “watch list” stocks. I plan on using the 80/20 rule to assign position weights, with the best 10 names making up around 80% and the less attractive names making up around 20%. THIS IS NOT A RECOMMENDED INVESTMENT PORTFOLIO. THIS PORTFOLIO IS FOR PERFORMANCE TRACKING PURPOSES ONLY. THIS PORTFOLIO IS ONLY RELAVENT IN THE CONTEXT OF THIS BLOG. MY PERSONAL PORTFOLIO LOOKS SUBSTANTIALLY DIFFERENT. DO NOT REPLICATE THIS PORTFOLIO IN ANY INVESTMENT ACCOUNT. The main purpose of this portfolio is to see if I can identify the best stocks from all those that are analyzed on this blog.

I will use two benchmarks to grade myself:

1) Rate of inflation (as measured by Core CPI) + 10%
2) Russell 2000

I will use cumulative returns since inception until I reach a 3 year track record. After that I will use a 3 year moving average as well as cumulative performance. I would not pay much attention to the returns versus these benchmarks until there is at least an 18 month rack record and there has been at least one 12 month period with the major indexes down 10% or more.

OMF -- Watch List Portfolio
http://www.marketocracy.com/cgi-bin/WebObjects/Portfolio.woa/ps/FundPublicPage/source=FmOgDiEgEgFcOnMlMaKiAbDf

OTB -- Best Ideas Portfolio
http://www.marketocracy.com/cgi-bin/WebObjects/Portfolio.woa/ps/FundPublicPage/source=FmOaDeKbEgFgOoKjMaKiAbDe/maxDays=10000

BAMM – Q1:2007 Earnings

2007-05-31T20:49:00.000-05:00

BAMM reported its fiscal Q1 results on 5/29/07

Here is what I was looking for when reading the press release:

“For a long position, I am looking for continued operating improvements, lack of insider sales, falling stock price (at roughly $12 the stock would trade at roughly half the valuation of the broad market), positive SSS. To make a short trade I am looking for the opposite to happen.” http://offthebeatenpathinvestments.blogspot.com/2007/05/bamm-final-thoughts.html

Looks like the company continues to improve operationally:
GMargin up 40bps YoY
EBITDA Margin up 55bps to 5.84% YoY
EPS up 44% YoY to $0.13 per share, also beat estimates by 1c and it looks like 2007 full year estimates were raised by 5c to $1.20

From the SSS perspective the company continues to struggle with SSS down 50bps.

At current price of $16.44, BAMM trades at roughly 15x of market value. The company has a lower EV than Market value making the valuation seem a little lower at 12x but due to the nature of the business you could not pull the cash out and still run the business.

I continue to think that the current valuation is to high to provide any margin of safety for a company facing negative SSS in an industry with some serious problems, also I can’t forget the massive insider sales the last time the stock had a decent up move (http://offthebeatenpathinvestments.blogspot.com/2007/05/bamm-da-bears.html)

* 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 -- Final Thoughts

2007-05-31T00:41:00.000-05:00

To sum up, the bullish case is that management is shareholder friendly (as they are major shareholders) and they have had a lot of initial success turning the company around. The bearish case is that they are still in the process of a turning around, the recently hired CEO left, and they have recently announced an acquisition that has sent their shares soaring erasing all of the margin of safety.

I think it’s pretty obvious that I like this company and like what management is doing to turn things around, but when I consider all the things that can go wrong I can’t justify the current share price.

For starters, acquisitions are usually a bad deal for shareholders. Big acquisitions, like doubling the revenue of the company are even less likely to work out. Big acquisitions in an industry facing a lot of headwind is usually suicide.

Also, its not clear that management can execute the conversion to digital at PCA as smoothly as they did at CPY (I am taking it as a given that they will try to convert to digital). Yes, they are doing it a second time and will not make the same mistakes. But, they must convert 3x as many stores (PCA’s store count is 3,000 vs. 1,041 for CPY) which are more spread out geographically (PCA has stores in Europe and Mexico as well as Canada and U.S.). There are also many times more employees to re-train and supervise.

Furthermore, I think that the market is assuming that after a few years and the conversion to digital the margins of the two businesses will be identical so cash flow will at least double. I am not going to waste time speculating about this until CPY provides more information but with 3x as many stores and identical revenue this means that per store sales are 1/3 at PCA compared to CPY. I have a hard time seeing how they will be able to squeeze the same margins from each Wal-Mart store at 1/3 sales per store.

Plus, its not a given that CPY’s Sears business is out of the woods yet. They are still seeing sitting fall by double digit rates. They are taking on this huge integration as well as substantial debt load, while they are still turning around their core business. Needless to say that they will have to execute perfectly to meet expectations implied by the current share price and hope that consumer spending does not contract.

What would be the a good entry point given all these concerns? Again I am not going to waste time with this until there is more information but here are some basic calculations:

EBITDA from Sears in 2009 $44
EBITDA from Wal-Mart in 2009: $22 (Wal-Mart at ½ margin of Sears)
Maintenance CAPEX $10M
Interest Expense on $100M $8
Taxes: $0 (assume NOL’s since they are buying PCA out of bankruptcy and should come with losses)
Net Income in 2009: $51M

2009 S&P 500 P/E = 14.1x
Implied Priced = $106 per share

If the stock trades down to $64 per share which is the $106 implied price minus 40% for maring of safety, than I will consider buying even if there is no new information about PCA.

Things I will be watching for next quarter is the trend in Sears sitting and sales per customer, difference between CAPEX and reported dep/amor, insider trading by Knightspoint. Obviously any new information regarding PCA operations and terms of the debt that will pay for PCA will be watched for and will provide additional info.

* 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 -- “Da Bears” Part II

2007-05-30T23:53:00.000-05:00

Up to this point I have purposely ignored the recently announced acquisition of PCA (Portrait Corporation of America) since I was not sure if it should go into the bullish or bearish column.

On May 2nd CPY announced that it has won the right to acquire PCA out of bankruptcy for $100 million in cash which CPY will borrow. This is what ultimately gapped the stock up from $53 to $75. Based on the market reaction, investors believe that the PCA acquisition is going to be an immediate positive and justifies an immediate 40%+ increase in the share price.

Ultimately, I think this is going to be a successful acquisition for CPY and based on their recent execution I am willing to give them the benefit of the doubt to a certain extent. However, the RECENT PRICE MOVE HAS REMOVED ALL OF THE MARGIN OF SAFETY from CPY (the 8k that was filed on May 25th has no operating details about PCA’s business).

Here is why …….

Current Market Value at $78.50 per share: $500M
Last 12 months EBITDA: $44M
Current MkValue to EBITDA: 11.3x
Current MkValue to EBITDA of SPX: 9.9x

Last 12 months NI (replace $17M in Dep with $5M in Capex) = $28M
L12M P/E = 17.6x
S&P 500 L12M P/E = 17.7x (Reuters estimates data)

Based on this naïve valuation, CPY is trading in-line or at a 15% premium to the S&P 500, while my guess is that it should be trading at a discount (more on this later).

What self respecting analyst looks at last years results, you say. Stop leaving in the past man and look into the future, you say. Have a little vision, you say. Ok, lets play with some numbers to get an idea of what the current $78 share price implies about future earnings.

Current S&P 500 forward multiples are …….
2007 S&P 500 P/E = 16.5x
2008 S&P 500 P/E = 15.4x
2009 S&P 500 P/E = 14.1x

At the current price, for CPY to have a 2009 forward multiple similar to the SPX the company must earn $35M in net income. Let’s say you agree with the negative issue I raised in the previous post http://offthebeatenpathinvestments.blogspot.com/2007/05/cpy-da-bears-part-i.html and want apply a 30% margin of safety you are looking at a 2009 fwd multiple of 9.9x which implies net income of $50M.

My biggest problem with CPY at the current price is that I think the lack of information about CPA’s financials combined with the recent success management has had executing the Sears business turnaround has caused an over reaction to this announcement.

The only thing that was disclosed in the fillings dealing with the acquisition is that PCA has $290M in revenues which is almost identical to 2006 revenue at CPY. I think that the initial back of the envelope analysis would imply that in a couple of years management can work their magic and net income double which gets us to $50M and a multiple that is at a 30% discount to the broad market – when I looked at this stock I did exactly these calculations and thought that it was still pretty damn cheap despite the big pop in price.

And they are now the sole provider of photography to the world’s biggest retailer? What’s not to like.

In the next and concluding post on CPY I will try to highlight why this back of the envelope valuation is not enough to justify a purchase and try to put some kind of target price on the 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.

CPY -- “Da Bears” Part I

2007-05-29T22:49:00.000-05:00

Despite the three part bullish case for an investment in CPY there are some real areas of concern. The one sentence bearish case would be that the company is still experiencing double digit sitting declines, the CEO hired in 2005 to lead the company abruptly left in 2006, and the recently announced acquisition represents a large unknown.

No matter how long I look at the improvement in operations over the last few years and how rational and shareholder friendly the board and management action have been, I still can’t seem to ignore the elephant in the room -- that the number of customers walking through the door has been falling at double digit rates for the last two years. In the most recent fourth quarter, which generally represents 35% of annual revenue and 100% or more in annual net income, the company saw seating decline by 12% and in the year before sitting fell 17% (full year sittings in 2006 fell more than in 2005 but the fourth quarter is the only one that matters). Based on announced first quarter revenue guidance, it looks like we can expect more decline in sitting volumes.

I believe the company when they say that the decline in sittings is orchestrated and that the customers they keep are far more profitable than the ones they lose but I still have a hard time seeing how earnings are going to increase at any meaningful rate. Eventually the company’s undesirable customers will run-off meaning that the growth in revenue per customer will fall drastically. I also have a hard time envisioning the customers that do stay accepting yearly price increases at any meaningful rate.

With no wind in their back, to show any semblance of growth this company has to constantly introduce new products and price their products perfectly, essentially they have execute flawlessly -- this is a rare occurrence and I would not bet on it. Without growth there is no multiple expansion.

Another disconcerting aspect of this investment is that the newly higher CEO Paul Rassmusen suddenly left the company. This seems odd in that he would leave a senior position at Kodak, relocated to take the job in mid-2005 and than leave a year later. I would be much less concerned if he left for a ginormous pay package at another company, but based on Google searches I can’t seem to find where he landed. A publicly traded company would have issued a press release. The CEO was immediately replaced by Renato Cataldo who was originally brought in as a consultant during the early days of the re-org and took a position in 2005 as COO. I am not sure exactly how bad of a sign this is since its obvious that the guys at Knightspoint are still making the big decisions, but it is certainly not a positive to have such a high rate of turnover at the top post.

On top of all this, professional photography is still a discretionary item and demand will fluctuate with overall consumer spending. Yes, you are still going to get pictures of the new baby taken to send to grandma but you may only pay for half as many prints if times are tight.

Also, much like FTAR (http://offthebeatenpathinvestments.blogspot.com/search/label/FTAR) the company still only has one customer and has much less control over its destiny. However, that may be changing ……

* 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 – “Da Bulls” Part III

2007-05-28T22:03:00.001-05:00

The first two bullish posts covered the company’s shareholder friendliness as well as the company’s vision for the future. In this post I will cover CPY’s cash generation ability and why I think cash generated is higher than stated GAAP net income.

If the company can maintain its current level of revenue and profitability, CPY’s can generate $44 million in EBITDA.

Revenue $294
EBITDA $44

From here it gets interesting as reported depreciation/amortization was $17 million but CAPEX was only $3 million. The company actually expected to have $5 million of CAPEX in 2007. It’s a little difficult to guess the exact level of CAPEX going forward since the company basically threw out a lot of its old equipment which consisted not only of cameras but the equipment needed to print the pictures and fill the orders. However, it looks like managements guidance for CAPEX is $5 million at least for the next few years. At $5 million of CAPEX and a 40% tax rate applied to this higher cash flow …..

EBITDA $44
CAPEX $5
TAX $15.6
FCF $23.4M or $3.67/sh
Reported GAAP Net Income for 2007: $16M or $2.60/sh

I think my estimate of FCF is actually conservative by about $5M for at least a few years since the company will pay less taxes on the lower net income than what I calculated here.

What about working capital? Interestingly, it seems that unlike the department stores that they do business in which must spend cash upfront on inventory to growth, CPY actually has NEGATIVE working capital. This largely comes from the fact that they carry almost no inventory and very little receivables but they do take deposits upfront from their customers (there are broken out in the 10K but are probably lumped into “other CA” everywhere else).

* 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 – “Da Bulls” Part II

2007-05-28T12:45:00.001-05:00

The second bullish aspect of this stock is that they seem to have a clear business strategy and more importantly have the balance sheet to execute their plans.

As it stands now, two major tiers have emerged in the professional photo industry with the bottom of the group competing solely on price mainly by offering larger/more prints at discounted prices as well as instituting “no session fee” policies. The top of the group is competing more on quality, service, and number of choices but at higher prices.

Reading through the last 2 annual letters to shareholders penned by David Meyer who is the Chairman of the Board as well as the co-founder of the investment firm that led the hostile takeover in 2004, it becomes obvious that the key CPY’s long-term strategy is to be in the top tier by preventing the commoditization of their products. While digital photography has caused some pain for the company, it is now seen as the best way to achieve long term growth and profitability. Pretty ballsy ……

I am not going to quote extensively from the Chairman’s annual letters but they are important to read to understand what the guy calling the shots is thinking, they are also refreshing compared what these letters usually sound like. Here are what I feel are the most notable quotes:

2004 letter: “digital has arrived, and there is no looking back”
2004 letter: “our customers are not inherently price sensitive when it comes to genuine
differentiation”
2005 letter: “despite facing an aggressive promotional environment, we will not
participate in the commoditization of our valuable service”
2005 letter: “I am frequently asked if I am concerned about our sittings declines. The
answer, candidly, is no.”

(link to annual letters: http://phx.corporate-ir.net/phoenix.zhtml?c=103013&p=irol-reportsannual ….. the 2003 letter is missing for some reason)

I think these give a pretty clear indication of what direction management is going to take this company. I did not spend much time reading the letters from the pre-2004 management, but one quote did jump out at me and highlights the 180 degree turn in the direction of this company:

2002 letter: “In 2003 we will continue to focus on the fair price for the value and service
we provide, but we must also recognize that over the long-term, we need to get new Moms to try us.”

To me this is a nice way of saying that we are going to slash prices to get more people through the door and worry about profitability later. Oh yeh, the only operating target offered as a company stated goal for the following year was a revenue target with no mention of profitability.

Looking over the last 2 years operating results, it looks like management is doing what they said they would and is having some initial success. In 2006 and 2005 sitting volume (the number of customers walking through the door) declined 17.7% and 16% compared to the previous year. However, total revenue showed a small positive increase in both years due to a 22.4% and 22.9% increase in sales per customer due to introduction of new digital products and a price increase instituted in 2005. Yes, this company actually increased prices and customers came back!

Looking at the balance sheet, it also looks like the company has the financial wherewithal to fund its long term plans. AFTER spending $32 million buying back stock and roughly $35 million to upgrade its studios to digital the company is still virtually debt free with $27M in free cash and $16M in debt outstanding that will be paid off by 2009 and $23M in long term liabilities for legacy pensions. The company can generate roughly $25M in free cash flow (see next post for calculations), so if things stay as they are the company will have roughly $70-$75M in free cash on the balance sheet and no debt by the end of 2009.

* 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 -- “Da Bulls” Part I

2007-05-27T23:01:00.000-05:00

The one sentence bullish thesis for CPY is that the company is shareholder friendly, management has the foresight and the balance sheet to grow the top line when the number of customers walking through the door is falling, and it looks like GAAP net income understates the company’s true cash flow generation ability.

Alright, lets take these one by one ……

Many company’s get labeled as “shareholder friendly” but it often means that the execs are buying you dinner before they have their way with your company. Things like stock buybacks, management’s vision and execution are NOT shareholder friendliness – this is what management is supposed to do! What is shareholder friendly is to have executive compensation aligned with shareholders.

Reading CPY’s proxy statements over the last 3 years one quickly gets the feeling that management knows exactly what is going to make them richer. For example, lets take the 2005 proxy and look at the Executive Compensation discussion, here is what we will find:

“Under our new performance plan, executives and other participants have the potential to earn significant gains in overall compensation, if pre−established, objective targets are met and exceeded. For fiscal year 2005, the incentive pool from which all awards were drawn (from the Chief Executive Officer on down) was determined on the basis of EBITDA generated by the Company. ….. The Board of Directors resets the EBITDA targets each year to provide performance awards designed to yield corresponding growth in stockholder value. ……..The Company exceeded pre−established performance benchmarks for fiscal year 2005. Accordingly, recipients throughout the organization, including hourly and salaried employees as well as key managers, were recognized and rewarded for their individual contributions. Importantly, a substantial portion of the total awards was paid in restricted shares, thus aligning the interests of our employees with those of stockholders.”

It appears that this board of directors understands the concepts of profitability, inflation, and that if you are not going to compete on price than share the wealth with the people actually servicing your customers.

The now ex-CEO that was hired in 2005 received 50% of his bonus in restricted stock that will not fully vest until 2010. The company states that non of the key execs have received base salary raises in the previous three years which further focuses them on the level of the stock.

Here is another golden nugget from the 2005 proxy:

The employment agreements for these executives [these are the guys that cashed in and also got canned after Knightspoint took over] also provide that following a Change of Control, the executive is entitled to a base salary at least equivalent ….[you know how the rest goes] ……The employment agreements for Mr. Rasmussen [at the time the new CEO] and Dr. Cataldo [at the time the new COO and now the new CEO] do not contain Change of Control provisions.”

Oh yeh, the new CEO and COO don’t get a pension either.

The one negative I found in the proxy is that one board member and co-founder of Knightspoint awarded himself roughly $650,000 in CPY stock for a years worth of work which is embarrassingly small by Wall Street standards but is substantially higher than many of the other execs received. Why did this happen? Despite owning arpox 15% of the company, Knightspoint effectively controls CPY due to the structure of the board of directors. Since 2004, they lowered the number of board seats to 5 from 9 when they took over and of the 5 seats they control 3.

All in all, this is pretty clean and provides a lot of evidence that management is on the side of shareholders. The proxy for 2006 should be coming out within a few weeks and the compensation structure of the newly hired CEO will provide more evidence on how management is incentivised.

* 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 -- First Look

2007-05-27T16:10:00.000-05:00

I initially discovered this company a couple of months ago when doing research on FTAR thinking that if shoe sales can be outsourced by major retailers why not photo studios, electronics departments, optical centers, etc. Unfortunately this company fell into the black hole I call my “watch list” and I forgot about it until I saw it pop up on the daily biggest gainers list as the stock went from roughly $57 to $75 on May 2, 2007.

Initially, I was attracted to the stock for the following reasons:
-operating cash flow on the CF Statement is substantially higher than reported GAAP net income for the last 2 years, despite the lack of large one time charges
-huge swings in CAPEX over the last two years
- dep/amort in 2007 substantially higher than CAPEX
-19% decline in shares outstanding
-solid balance sheet
-appearance of NEGATIVE working capital (is that possible?)

Currently:
Share price: $79
Market Value: $525
Enterprise Value: $536
Investment Type: Turnaround Situation

CPI Corp. (CPY) operates 1,041 professional photo studios in U.S., Canada and Puerto Rico which are located inside Sears stores (actually, 32 stores are free standing but carry the sears name). CPI has been operating photo studios for the last 60 years and has been Sear’s only photo studio operator since 1986.

There are several aspects beyond what is initially evident from the financial statements that are driving the share price. First, the company has gone through a major shake up since 2004. In early 2004, Knightspoint Partners effectively took over the company in a hostile takeover battle and proceeded to replace 6 of the 9 board members, lower the number of board seat to 8, and fire the CEO and his top 2 lieutenants. As a side note, it appears that Knightspoint is a grown up version of Ashton Kutcher. Based on this article from December 2003 it looks like the guy leading the charge was previously a paid advisor to the company when he was and ibanker at CSFB, now this is what I call getting punk’d. http://www.bizjournals.com/stlouis/stories/2003/12/08/story3.html

Second, it appears that professional photo industry in the midst of major upheaval driven by the advent of digital photography. In the last 24 months the company has effectively switched to all digital (there are a few studios in Canada that are still transitioning) which has required a major investment from the company -- more on this later. It also appears that two major tiers have emerged with the bottom of the group competing solely on price and the top of the group competing more on quality, service, and number of choices.

Third, the company announced that it will be acquiring Portrait Corp of America (PCA) out of bankruptcy which operates all the portrait studios located in Wal-Mart stores and up to this point was one of CPY’s biggest competitors. This announcement has major implications for the company that will be discussed in depth in later posts.

To be completely honest, I have done very little analysis up to this point and have basically summarized the major points from the 10K (http://phx.corporate-ir.net/phoenix.zhtml?c=103013&p=irol-sec) . I hope to change this with the next few post …….

* 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 -- Selleing HQ

2007-05-26T20:12:00.000-05:00

It looks like FTAR has put its headquarters up for sale accoriding to a link on Google Finance. I missed this as I almost never use Google Finance.

This story was not reflected on my Reuters station and I am almost certain not reflected by Bloomberg but will have to double check on Tuesday. I just searched the 10Q reported 1 day before this story ran and can find no mention of this. Checked all the 8-ks since the begining of the year, nothing. This seems rather odd and leads me to the following thoughts.........

If the good people at globest.com report that FTAR is selling their HQ and no one hears it, did it really happen? http://www.globest.com/news/903_903/newjersey/160542-1.html

More importantly, the sale of the headquarters will provide 2 key data points that are going to shed substantially more light on my bullish thesis for FTAR. First, I used $16.5M for the value of this building in my liquidation value analysis which translates to $0.80 per share. They may sell it for more or less than I estimate but it will make at least one uncertainty certain.

Second, the terms of the sale will be a huge clue as to what is likely to happen with the K-Mart option. If its a sale leaseback agreement with a long duration I think this is a big clue that there maybe an agreement coming down the pipe. If this is an outright sale with FTAR moving out in late 2008 or early 2009 than I think the K-Mart option goes to way way way way out of the money (from the current level of way way out of the money).

* DISCLOSURE: I or accounts I manage are long FTAR.OB. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Things that make me happy .....

2007-05-26T11:48:00.000-05:00

Took a night off from the usual Friday night "dog and pony show" at the clubs, I suppose it will not kill me or my social life, and caught up on some recent conference calls for Q1.

This is part of Q&A from April with Universal Forest Products (UFPI) management. Since this is a stock I recently initiated a position in I will do a write-up on them before long, but one of the most attractive things about the stock to me is the management team. Here is one of the reasons why I want to let these guys run my business .......

April 17, 2007
Q from analyst: Okay. Finally, obviously, your cash flow is – cash flow numbers in from operations are quite solid. Can you just address share buybacks? Just looking at performance over the last number of years, we’ve been in a depressed market for about 12 months now. Your stock price has pretty much averaged at these levels for the last 12 months. The last time you bought stock was approximately two years ago at a little bit below where we are now. Can you just give me some thoughts there?

A from William Currie, Chairman: If we didn’t have an intercompany policy that stated there’d be no insider trading within 48 hours of our release, we would have been buying shares back this morning. Our focus is – it looks to us like our best return on investment over the near term, we’ll switch our focus from acquisitions to stock buybacks, number one; capital expenditures for our industrial operations, number two; and acquisitions, number three.

Q from analyst: Is there currently an authorization by the Board for stock buybacks?

A from William Currie: Yes.

A from Michael Cole, CFO: Yes, 1.5 million shares [1.5M shares represent almost 8% of current diluted shares outstanding] . So we have plenty of approved.

I will post my analysis of this company soon (eventually) but hearing stuff like this from one of the my management teams makes me happy ......

* DISCLOSURE: I or accounts I supervise are long UFPI. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

FTAR.OB -- Final Thoughts

2007-05-25T00:50:00.000-05:00

In the previous 4 posts I have outlined the bullish and bearish case for FTAR. As a final thought I will spend some time on short term catalysts that have made the stock even more attractive and have caused me to add to my position recently.

First, management has removed a lot of uncertainty by issuing a special (hopefully not) one time dividend that was paid at the end of April ….oh yeah!, daddy needs a new pair of K-Mart shoes. By the way, if you are looking at financial statements subtract roughly $105M from cash on hand, the small shortfall is going to be financed by the line of credit that will be paid of with this years cash flow.

The biggest concern prior to the special dividend announcement was about management’s intention for the boatload of cash on the books and cash being generated. I think this concern has largely been removed and a liquidation scenario with all cash going to shareholders is a real option. FTAR was trading at $6.5 before the announcement of the dividend and adding back the $5 per share now trades at $9.6 so the dividend payout has removed a lot of overhang and moved the shares by 50%.

Also, the new management team has done and outstanding job streamlining the business which has cause EBITDA margin to increase from 4.5% when the company started trading again to 8.1% over the last 12 months (see Bull case Part I for additional margin discussion http://offthebeatenpathinvestments.blogspot.com/2007/05/bamm-da-bulls-part-i.html

Third, while I don’t want to read into the latest quarter to much since it’s the weakest quarter for the company it looks like the company is continue to improve and at an increased pace. As mentioned in the earlier post, SSS finally have a plus sign in front of them and Rite-Aid SSS were up over 4% with store count up slightly.

Gross Margins were up 130 bps YoY (again, this is huge for a company that had EBITDA margins of 8.1% last year), but keep in mind that the first quarter has the lowest sales and lowest margins so even small changes look big. Also, SG&A expense decline again and SG&A as % of sales improved by 50bps. All in all this was a pretty outstanding quarter, if this company had analyst coverage they would have reported a huge earnings beat.

My last point is more anecdotal but there are some things I have noticed in the 4 months I have owned the stock that put a smile on my face. For example, the annual report I received was on cheap black and white paper stapled together rather than an expensive book – this is good! Another example is that the company just announced a great quarter by any measure and they did not even put out a press release so none of the major alert services picked it up -- just a filling and that’s it. In a case like FTAR where they are going to be holding my cash for a while, these are all things that make me sleep better at night.

Things 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.

* DISCLOSURE: I or accounts I supervise are long FTAR.OB. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

FTAR.OB -- “Da Bears”

2007-05-24T23:47:00.000-05:00

Of course FTAR faces the same economic sensitivity problems that any consumer discretionary company faces.

The company may also not be a “long term” holding in that it may not be there after 2008 – but that’s one of the bullish scenarios.

To a certain extent the company does not control its own destiny. They are always going to be dominated by someone else who owns the stores they sell their products in. As department stores and discounters consolidate they will have more clout to get better revenue sharing agreements out of FTAR.

To a certain extent they operate in the commodity business of selling cheap shoes. They do own some brand names but I have never heard of them and would not assign much value to discount brands sold at the “bottom of the pile” retailers.

* DISCLOSURE: I or accounts I supervise are long FTAR.OB. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

FTAR.OB -- “Da Bulls” Part II

2007-05-24T23:35:00.000-05:00

Picking up where I left off in Part I, in addition to the better upside odds than downside FTAR also comes with a FREE call option that expires in the end of 2008.

Per the agreement with K-Mart, FTAR can be fired by their largest client in the end of 2008 which would cause the liquidations scenario I described in Part I. However, if K-Mart decides to extend their relationship FTAR now becomes a going concern generating roughly $20M and $40M in annual free cash flow.

Simply attaching a 10x multiple to that cash flow (which assumes tax expense), adding back the PV of the NOL’s that are now worth more as they will be realized and subtracting the long term liabilities I get a market value of $270 - $450 which equates to $13 - $22 per share. This value excludes some hard assets and other assumptions made under the liquidation scenario ….. but who cares, if I am off by a dollar or two at this level its still a damn good return.

* DISCLOSURE: I or accounts I supervise are long FTAR.OB. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

FTAR.OB -- “Da Bulls” Part I

2007-05-24T23:23:00.000-05:00

Before moving on to the rest of my post, the one sentence bullish thesis is basically that the agreement with K-Mart and the recent actions by management have provided for a limited downside with a fairly good possibility of positive absolute returns as well as a free 1.5 year option that is likely to expire worthless but can turn FTAR into a 3-5 bagger between now and end of 2008.

I am going to do my best to turn my spreadsheet into words but I suggest e-mailing me at offthebeatenpathinvestments@gmail.com and requesting a copy and double checking my figures (and letting me know if I made a mistake). To get to my price range of $3.5 - $7.5 I made some “worst case scenario” and “best case scenario” assumptions. By the way if anyone knows how to post excel spreadsheets into Bloger let me know.

In my Worst Case Scenario I am assuming that
1) sales fall 10% in 2007 and 2008,
2) gross margins decline in 2007 by 100bps from 2006 levels (100bps decline in gross margins is HUGE for a company with EBITDA margins of 8.1% in 2006) and stay the same in 2008, and
3) SG&A expense falls only 3% YoY, basically I am assuming that for a compounded decline of 21% in sales over next 2 years, SG&A only declines 6.1%

Bearish indeed …….
Those of you that actually look at the recent financials will say that a 10% YoY decline in sales does not sound very bearish when you consider recent trends in sales. I will point out that FTAR’s K-Mart business SSS (same store sales) have improved substantially with SSS in 2006 at negative 3.8% and SSS in 2005 at negative 7.5. Also, SSS were actually positive in Q1-2007 with +0.7%, however this is the company’s weakest quarter so it may not represent a trend.

Another reason why I think total and SSS will not be similar to the most recent past (and therefore a 10% decline would represent a Worst Case Scenario) is that K-Mart has gone through a re-org of its own and I am sure Eddie Lampert closes his worst performing stores first just like anyone else. Also, the actual number of FTAR’s K-Mart stores declined by 3 in Q1-2007 on track for 12 closed stores for the full year. In 2006 FTAR lost 29 K-Mart stores and in 2005 they lost 61.

In my Best Case Scenario I am assuming that:
1) total sales stay flat in 2007 and 2008 -- actually this is an assumption that SSS will be positive as its likely that there will be a number of K-Mart stores closed in that time, and
2) Gross margin increase by 50bps in 2007 and 2008 for a compounded increase of 1% over next 2 years, and
3) SG&A expense will fall by 1.5% in 2007 and 2008 for a compounded decline in SG&A expense of 3% on flat sales

While these assumptions are certainly bullish, they are not impossible. For example, on a rolling 12 month basis GM has increased in each of the last five quarters from 31.5% to 32.2% (again a 70bps move is huge for a company with EBITDA margins of 8.1%). Furthermore, SG&A as % of sales has fallen in each quarter from 26.5% to 24.1%.

Under the worst case I get FCF (assuming $2M in capex annually) of $30M and $16M which are worth $40.5 today discounted at 10%. Under the best case I get FCF of $59M and $61M which are worth $103.5 today.

But that’s not all folks, you also get all your inventory taken out at BV (not liquidation fire sale value) which I calculate as being worth $33M discounted at 6%. To get this I simply net A/R + Inventory against A/P and Accrued Expenses and discount.

If you call now, you will also get the estimated value of the non-K Mart business which is growing by the way, the company headquarters that are almost all paid for and the value of the NOL’s that FTAR has. Net out the liabilities as well as my estimate for $10M-$15M in liquidation costs and I get a price range of $3.5 - $7.5 per share.

At current trading price of $4.6 you get downside of 23% for upside of 64%, those are 3 to 1 odds from where I come from.

* DISCLOSURE: I or accounts I supervise are long FTAR.OB. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

FTAR.OB -- First Look

2007-05-22T20:46:00.000-05:00

Initially looked at the stock in February 2007 for several reasons:
-recently emerged from bankruptcy with no debt and approximately ½ of the market value in cash (before the recently announced speical dividend)
-eps is roughly $2/sh while the stock is trading between $6 - $7 per share (before dividend was paid out)
-originally written up on valueinvestorsclub.com

Currently:
Share Price: $4.60
Market Value $96 million
Enterprise Value: $110 million
Investment Type: Special Situation

Footstar (FTAR) operates footwear departments at lower end stores with the company’s K-Mart business representing over 90% of sales -- if you buy shoes at K-Mart’s serviced by FTAR you are buying them from FTAR not K-Mart. Per the latest 10Q (filed in May 2007 http://www.sec.gov/Archives/edgar/data/1011308/000095012307007054/0000950123-07-007054.txt) the company currently services 1,389 K-Mart stores and 857 Rite-Aid stores. The company also operates a wholesale business which consists of owned brand names (Thom McAn, etc.) and generics which are supplied on a wholesale basis to Wal-Mart and Rite-Aid.

At this point FTAR represents a special situation investment with the likely termination date of 12/2008. As part of the recent re-org (in which FTAR paid out 100% of its debt obligation and did not dilute share count) as part of the bankruptcy re-org, FTAR ended up with 100% of Meldisco (previously a JV with K-Mart) but K-Mart is only required to do business with FTAR until the 12/2008. When the contract runs out, K-Mart can end its relationship with FTAR or renew the contract. If K-Mart ends the relationship it has to buy out all of FTAR’s inventory related to its stores at book value – since K-Mart is 90% of FTAR’s business essentially all its inventory is K-Mart related.

The investment opportunity really hinges on inventory buyout in the K-Mart agreement. Based on present value of the estimated cash flow that FTAR will generate until 12/2008 and the value of the non-K-Mart businesses I believe the stock is worth somewhere between $3.5 – $7.5 (more about my calculations in the next post). However, as an investor in FTAR you also get a free option on FTAR signing new agreement with K-Mart at which point FTAR would no longer trade at liquidation level valuation of 2x-3x cash flow and would be worth somewhere betwee $13 - $22 per share (more about my calculations in the next post).

* DISCLOSURE: I or accounts I supervise are long FTAR.OB. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

BAMM -- Final Thoughts

2007-05-21T19:34:00.001-05:00

Based on the last 3 posts, its pretty obvious that I am not planning to buy shares at this point. Just to recap ....... management is unloading shares, the valuation does not look particularly cheap, YoY growth is due to one time gains, SSS are negative, the industry is in a secular decline.

So why not short, management is after all unloading shares into up moves in case that point was not made obvious already?

The main reason I am not getting a short ticket ready is that I don’t want to bet against management at valuations that are no longer in the ridiculous category. It looks like management is making incremental improvements in operations every quarter and are not wasting their cash – that’s usually not a recipe for good short trades.

If the company can continue to improve operations over the next few years this stock can do very well despite the problems with the industry. For example, despite the recent improvement BAMM is still behind Borders (BGP) from an inventory turns perspective. If BAMM can get to BGP’s level of efficiency, the business can throw off somewhere between $100M - $150M in free cash over the next 2-3 years, if they can get half way there they can dislodge $50 - $75M in cold hard cash. This is a huge windfall for a stock with market value of $277M.

The problem is that I don’t know if the low hanging fruit has been picked or if there are still more easy improvements to be made. A secondary concern is the Harry Potter release, who knows how much hysteria this will generate.

What am I looking for to make a trade? For a long position, I am looking for continued operating improvements, lack of insider sales, falling stock price (at roughly $12 the stock would trade at roughly half the valuation of the broad market), positive SSS. To make a short trade I am looking for the opposite to happen.

Overall, my sense is that this stock is trading at a valuation that is a premium for a declining business because management has gained some credibility and effects of Harry Potter are being discounted by the market.

BAMM -- “Da Bulls”

2007-05-21T19:32:00.001-05:00

BAMM’s management has drastically improved operations over the last 3 years and looks like the company is becoming more efficient every quarter. Inventory turnover has increased consistently as inventory levels have grown slower than sales.

The company could have wasted cash on aggressively expanding its store base, instead management reduced debt from a high of $45M to a current level of $7M. At $45M in debt, debt-to-equity was 45% while currently debt-to-capital is at 4%.

The company raised its dividend rate by 60% in fy2007 to 32c per share and raised it again for fy2008 by 12.5% to 36c per share. This is certainly a good sign in management’s confidence in the cash flow generation ability of the business.

The company is coming up on arguably the biggest book sales even in recent memory with the last installment of Harry Potter hitting stores in July. This will be a huge event for the company and due to the strength of the balance sheet BAMM is in better financial position to wring out max number of sales.

BAMM -- “Da Bears”

2007-05-21T19:27:00.000-05:00

I think the single worst thing about BAMM is the signal that management is sending to shareholders by their latest actions. On April 2, 2007 the company reported their fiscal 4th quarter results which showed significant YoY improvement (due to 1 extra week + one time gain), the stock popped from $14.25 to $17.50 and kept going up until it hit $19+change a couple of weeks later.

On April 9th, 5 different insiders unloaded 1.321 million shares at $17.92 which is a huge amount of stock for a company with 8M share float and 16M in total shares outstanding. How should investors read this? Management is basically saying that they are going to unload a lot of shares whenever the stock has a decent move up.

I think there are two main reasons that prospects for the stock look dim at this price.

First, the industry is in secular decline. There is nothing that management can do about this. They can be the best book store operator in the industry, but an industry in decline is a huge headwind to fight against. This is effecting BAMM in the form of same store sales which were down 0.6% in the latest fiscal year and were down 2.4% in their most important fourth quarter. Unless there is some major change in industry fundamentals, investing in BAMM (or other old line book retailers) will be like swimming against the tide.

Second, at the right price an investment in a bad industry might be justified. However, it does not appear that BAMM is particularly cheap. Based on my previous post the company is currently trading at an adjusted FCF/EV of 6% which is a P/FCF of 16x – 17x which is roughly in line with where S&P 500 is trading.

More importantly, based on pretty bullish SSS estimates for FY2008 BAMM doesn’t look particularly cheap. Based on my previous post, the company should generate roughly $19M in operating cash flow (actual free cash flow maybe more/less due to difference between my assumption for maintenance CAPEX and actual CAPEX) which would increase cash on hand to roughly $53M less $7M in long-term debt. This gives a forward FCF/EV of 8.2% or forward EV/FCF of 12x-13x.

Furthermore, the cash yields provided assume that all cash can be taken out of the business and distributed to shareholders. The reality is that this is a very capital intensive business and there is absolutely no way the company can distribute all its cash and maintain similar cash flow. BAMM basically spends down most of its cash on hand by the end of fiscal Q3 (ending in October) in preparation for the big fourth quarter and gets it back at the end of the Q4. Looking at historical working capital requirements it looks like the company can basically pay off its long term debt but the rest of the cash is needed to run the business.

Assuming the working capital needs, a mor realist valuation is 18x-19x trailing and 14x – 15x forward price/fcf.

BAMM -- First Look

2007-05-21T18:33:00.000-05:00

Initially attracted to the stock for the following reasons:
-operates in an industry that everyone knows is in secular decline, when everyone is sure of something there is often an opportunity
-ebitda and eps up 17% and 56% YoY, but stock down from a high of $23.7 in the beginning of the year to a current price of $16.8
-lots of cash and very little debt, cash net debt is $27M or $1.60 per share
-company has made significant operating improvements over the last 4 years

Books-a-Million (BAMM) is a book retailer with stores located in the Southeastern states of the country. The company has 3 retail store concepts with 206 total stores, a wholesaling business, and an internet sales operation (link to latest 10K http://www.booksamillioninc.com/report/index.html)

The stock has grown nicely from $2 in early 2003 to a high of $22.5 in late 2006 and has since sold off to $17. The big move upmove in the stock is largely due to management’s ability to improve operating performance. Based on some rough calculations, the company has been able to pull out $50M-$60M in working capital since the end of fy2003 which has been used to pay off debt, increase the dividend, and increase the company cash stash.

Over the last 10 years the company has grown the top line steadily but faced some operating challenges between 2001-2003.
10yr Revenue CAGR 5.5%
10yr Gross Profit CAGR 6.4%
10yr EBITDA CARG 10.7%
Two things to keep in mind when looking at these growth rates. First, 2007 figures are adjusted to remove a one time gain from “card breakage” (more on this later). Second, all the EBITDA growth has occurred in the last 3 years as EBITDA more than doubled between end of 2004 and end of 2007. Between 1998 and 2004, BAMM was much better in destroying shareholder value than selling books. In the 7 years between 1998 and 2004, EBITDA declined 3.3% in nominal terms and much more so in real terms.

It looks like there is one analyst that covers the company with a 2008 eps estimate of $1.15. Without reading the report, I think he/she is making the assumption for 5% SSS which without any stock buybacks gets me to $1.13 - $1.17 per share in 2008. The only way I can see SSS changing from negative (SSS down 0.6% in fy2007) to positive is due to the last Harry Potter release scheduled for July 2007 and will be reflected in Q2 for fiscal 2008.

Based on adjustments made to 2007 reported numbers (for an extra week, one time gain from card breakage, maintance capex), I get revenue of $504, EBITDA of $38, and FCF of $15 -- the main point to take away is that these numbers are vitually the same as last year despite the reported jump in sales and profit. Using the published $1.15 eps estimate as a guidline and 5% SSS I get revenue of $528, EIBTDA of $43 and FCF of $19.

Based on $16.5 trading price the market value is $277M and if you assume you can pull all the cash out of the business and pay off debt I get and EV of $250, if you add the expected FCF in 2008 I get 2008 EV of $231M. On a traling 12 month basis BAMM is at roughly EV/FCF of 17x (250/15) and based and a forward 12 month EV/FCF of 12x (231/19).