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

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

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

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

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

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

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

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

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

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

Things that make me happy......

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

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


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

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

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

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

“Best Case Scenario Valuation” for CPY …….

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

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

BEST CASE SCENARIO assumptions ……

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

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

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

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

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

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

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

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

“Worst Case Scenario Valuation” for CPY …….

In the previous three posts I discussed the following points:

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

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

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

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

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

Here are my WORST CASE SCENARIO assumptions ……

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

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

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

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

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

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

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

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

Knightspoint is loading up

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

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

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

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

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

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

Enough said.

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

Key points from Q2:2007 Conf Call

Here are my notes from the CPY conference call ….

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

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

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

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

Guidance on digital conversion .....

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

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

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

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

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

A: Right

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

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

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

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

CPY Q2:2007 Earnings Analysis

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

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

First, the latest quarterly earnings analysis …….

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

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

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

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

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

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

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

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

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