NPK -- First Look

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.

* 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.

The Quintessential Buffet

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

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%.

* 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 -- Final

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.

* 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 Bulls” (improved earnings + very low valuation)

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)

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.

* 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 -- First Signs of Future Problems

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.

* 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.