VII_8.30.13

Transcription

VII_8.30.13

ValueInvestor
August 30, 2013
INSIGHT
The Leading Authority on Value Investing
The Bad with the Good
Smart investing often hinges as much on knowing what to avoid than on
what to pursue – especially when the bulls appear to be running the show.
V
alue investors tend to be an agreeable lot, at least up to a point. As
Spencer Davidson, the long-time
CEO of General American Investors, puts it:
“An early mentor of mine used to always say
we were in the rejection business – that we’re
paid to be cynical and that a big part of success in investing is knowing how to say no.
I’m a big believer in that.”
With markets in recent months hitting a
series of new highs, we thought it an opportune time to ask seven top investors to get
in touch with their negative sides and describe generally what worries them in today’s
market and specifically what they’re betting
against. They’re finding risk in such diverse
areas as cell towers, specialty chemicals, consumer lending, medical diagnostics, electric
See page 2
utilities, apparel and donuts.
John Gillespie (l), Kevin O’Brien (r)
Investment Focus: Seek companies with
safety-first balance sheets and relatively
predictable cash flows, with leadership
that is uniquely adept at managing both.
Investor Insight: Risk Aware
Seven top investors describe what
they’re actively avoiding or actually
betting against in a market that has
been hitting new highs.
PAGE 1 »
Uncovering Value: City National
Examining the potential of a bank
that “actually has a sustainable
competitive advantage.” PAGE 22 »
Uncovering Value: SuperInvestors
Where the best investors in the business mined their portfolios for opportunity last quarter.
PAGE 23 »
INVESTMENT HIGHLIGHTS
INVESTMENT SNAPSHOTS
Sticking to what they know – and knowing it exceedingly well – has been a
simple but winning investment formula for John Gillespie and Kevin O’Brien.
Prospector Partners
FEATURES
Investor Insight: Prospector
Prospecting for less-obvious bargains and finding them today in
Symantec, Aspen Insurance, Infinity
P&C and OceanFirst.
PAGE 1 »
Bright Prospector
INVESTOR INSIGHT
Inside this Issue
H
aving set up his Prospector Partners investment firm in sleepy
Guilford, CT, John Gillespie has
never much worried about being out of
touch. “I’d rather we’re visiting companies
or talking to them by phone than swapping
stories with eight other buy-siders over
lunch,” he says.
Now managing $2.4 billion, Gillespie
and his independent streak have produced
excellent results for investors. His flagship
Prospector Partners hedge fund over 16
years has returned a net annualized 9.8%,
vs. 5.5% for the S&P 500.
With a circle of competence geared toward financials, Gillespie and co-manager
Kevin O’Brien see select upside in property
and casualty insurance, big and small banks
See page 14
and computer security.
www.valueinvestorinsight.com
PAGE
American Tower
10
Aspen Insurance
18
City National
22
Exact Sciences
13
Infinity Property and Casualty
17
Kronos Worldwide
3
Krispy Kreme Doughnuts
6
OceanFirst Financial
20
RWE
8
Symantec
19
Vera Bradley
11
World Acceptance
4
Other companies in this issue:
Agrium, Baker Hughes, BYd, Chubb,
Citigroup, Cobalt, digital Realty Trust,
E.ON, Invesco, Joy Global, JPMorgan,
Lakes Entertainment, Legg Mason,
Mosaic, Newmont Mining, Nuance Communications, Owens-Illinois, PNC Financial, Post Holdings, Realogy, Stonemor,
Tesla, Thermo Fisher Scientific
I N V E S T O R I N S I G H T : Uncovering Risk
Investor Insight: Risk Aware
Alexander Roepers, Whitney Tilson, Tucker Golden, Shawn Kravetz, Carson Block, Carlo Cannell and Travis Cocke describe the extremes they’re seeing in today’s market, how they keep complacency at bay and why they’re betting against
Vera Bradley, American Tower, World Acceptance, Exact Sciences, RWE, Krispy Kreme and Kronos Worldwide.
INVESTOR INSIGHT
hard that we put 8% of our hedge fund on
the long side in those two names.
Has your search for overvalued stocks focused on any particular sectors?
Alexander Roepers
Atlantic Investment Management
“The better the story and the recent
results, the more likely the share price
loses connection to fundamental value.”
When the market has been as positive as
it has, does everything in your portfolio
start to look pricey to you?
Alexander Roepers: On the long side
we’re so bottom-up and fundamentally
driven that we’re always trimming positions when they’re reaching a certain level,
in our case around 11x EBIT, which usually equates to around 15x forward earnings. There are clearly more opportunities
to do that in an up market and we’re doing so, but I wouldn’t say everything starts
to look pricey. Baker Hughes [BHI], our
largest position, is up maybe 5% from our
cost and as far as I’m concerned is still sitting on the tarmac, so I would definitely
not scale it back. Owens-Illinois [OI] is up
40% for the year, but it’s still cheap at less
than 10x forward earnings. We can see
plenty of reasons to remain long across
the portfolio.
At the same time, all kinds of companies hit air pockets and suddenly become
interesting from a value perspective even
in a rising market. The recent turmoil in
the global potash market, for example,
hit stocks we heretofore had not touched,
Agrium [AGU] and Mosaic [MOS], so
August 30, 2013
AR: We have found several short ideas
in REITs, particularly those focused on
cloud-computing facilities of some kind.
Our view has been that investors were
overreaching for yield and ignoring the
risks of over-building and commoditization. We’ve shorted Digital Realty Trust
[DLR] twice this year successfully, though
we recently covered as the stock got close
to $50 and seemed a bit oversold.
In every market there are darling story stocks that are touted by promotional
management and lots of bullish analysts.
The better the story and the better the recent results, the more momentum is picked
up and the more likely the share price loses connection to fundamental value.
Your long universe focuses on industrial,
consumer-products and services companies. Is your short universe as narrow?
AR: What we want to avoid on the long
side are companies that lack transparency, are overlevered and are subject to
technological-obsolescence risk. Those
are the types of companies we want to be
short, so we’re willing to consider areas
like technology and banks that we’d never
touch on the long side.
What we’re careful to avoid with shorts
is illiquidity, high borrow rates and anything that is completely voodoo-like in
our view, like biotech or no-revenue Internet plays. Those can detach from reality
in ways that make us very uncomfortable.
Late last year you went from bullish to
bearish on mining-equipment companies
like Joy Global [JOY]. When that happens
would you go so far as to short them?
AR: When we concluded that the mining
capital-spending cycle was likely to be
under pressure, we didn’t necessarily assume the stocks were going to collapse,
only that end-market challenges would
be a significant headwind for some time.
That’s still true, yet the valuations are relatively attractive. I wouldn’t go long, but I
wouldn’t short them either.
Describe the thesis for a company you are
short, titanium-dioxide producer Kronos
Worldwide [KRO].
AR: Kronos is a pure-play producer of
TiO2, which is used in things like paints
and plastics as a whitener or to increase
opacity. This had been a really bad industry for a long time until the aftermath of
the 2008 recession, when so much capacity was taken out of the titanium-dioxide
market that prices spiked as the economy
started to rebound. This resulted in a
beautiful run for Kronos, with EBITDA
in 2012 going over $400 million, nearly
double what it had earned in any year
prior to 2011.
Our basic view is that not only has the
titanium-dioxide supercycle fully played
out, it’s not coming back. Kronos’ shares
are priced as if people are looking through
the valley to a recovery in two to three
years that looks much like the bubble of
the last couple of years. We don’t think
that’s going to happen.
Why?
Stephen Fisch: As in any commodity business, there has been a significant supply response to rising prices, including multiple
low-cost entrants from China and Eastern
Europe. Chinese suppliers have also been
buying technology to compete more aggressively in the higher end of the market
in which Kronos typically plays. Those
responses are likely to make the pricing
Value Investor Insight 2
INVESTMENT SNAPSHOT
Kronos Worldwide
Valuation Metrics
(NYSE: KRO)
(@8/29/13):
Business: Producer of titanium dioxide
pigments used to improve the whiteness,
brightness, opacity and durability of paints,
plastics and other specialty products.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
Share Information
Largest Institutional Owners
14.98
52-Week Range
Dividend Yield
Market Cap
Company
AIG
Bank of NY Mellon
Deprince, Race & Zollo
Vanguard
Advisors Asset Mgmt
12.65 – 20.52
4.0%
$1.74 billion
Financials (TTM):
Revenue
Operating Profit Margin
Net Profit Margin
Russell 2000
47.1
18.7
(@6/30/13):
(@8/29/13):
Price
KRO
n/a
23.4
n/a
$1.81 billion
(-2.8%)
(-3.2%)
% Owned
6.8%
1.3%
1.0%
1.0%
0.7%
Short Interest (as of 7/31/13):
Shares Short/Float
19.2%
KRO PRICE HISTORY
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35
3030
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2525
25
2020
20
1515
15
the market by running facilities at near
capacity, a much higher rate than most
competitors. Given their cost structure,
if they’re looking to provoke a price war
they are not going to come out on top.
The stock is well off its highs and trades
today at around $15. What do you think
it’s reasonably worth?
SF: We think 2011 and 2012 earnings were
an anomaly and that the peak EBITDA of
$200 million prior to 2011 is more representative of the upside going forward.
Commodity companies rarely trade above
6x peak EBITDA on an enterprise value
basis, which in this case would result in a
Kronos share price of around $7.
Even that valuation may be ambitious
Adjgiven
Closethe current state of the market. Rockwood Holdings, which we own,
has been trying without success to sell its
TiO2 business, which is of higher quality
than Kronos’s, for 5-6x 2014 EBITDA.
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2012
2013
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THE BOTTOM LINE
Due to demand and supply responses to a freakishly strong market for titanium-dioxide
products after the 2008 recession, Alexander Roepers doesn’t expect “normal” for the
company going forward to look anything like its recent past. At 6x his estimate of normalized EBITDA on an enterprise value basis, the stock would trade at around $7.
August 30, 2013
SF: You always have to worry about that,
but there are plenty of TiO2-related assets
on the market. In addition to Rockwood,
Huntsman and Du Pont are also looking
to sell, and they all have better businesses.
It’s hard for us to imagine Kronos commanding a price anywhere near where it’s
currently trading.
INVESTOR INSIGHT
Sources: Company reports, other publicly available information
trough longer and lower than optimists on
the company expect.
Beyond that, there has also been a demand response, with customers reducing
the amount of titanium dioxide used in
their products. For instance, PPG Industries, a big manufacturer of paints and
coatings, says it has taken 5% of the TiO2
out of its paints, with another 5% to go.
Makers of garbage bags are leaving them
clear rather than using TiO2 to make
them opaque and white. Now that users
are figuring out how to reduce usage, we
think that’s demand more or less permanently lost.
Is a Kronos buyout a risk?
All of this is particularly troubling for
Kronos because it is one of the highestcost producers in the industry. Its traditional franchise has been with the small
and medium-sized customer who was willing to pay a bit of a premium for better
customer service. After the spike in prices,
even those customers were forced to try
out new, lower-cost suppliers. Again, we
think a number of them will find the alternatives perfectly suitable.
The result of all this so far is that in
the first half of this year Kronos reported
an EBITDA loss of $69 million. They’ve
actually made it worse for themselves and
Whitney Tilson
Kase Capital
“One painful lesson on the short side:
mere absurd overvaluation is not sufficient reason to be short.”
Do you think the market is overvalued?
Whitney Tilson: If you’re talking about
big, high-quality companies like WalMart, Pfizer and General Electric, I
wouldn’t say they’re overvalued or undervalued. In general, though, I consider this
a complacent, picked-over market where
it’s hard to find things to get really excited
about on the long side. On the short side,
just about everywhere I look there are fantastic ideas. The problem is I thought the
same thing a year ago, which has made it
kind of brutal on the short side.
Can you generalize about where you’re
seeing the best short ideas?
WT: All-time-low interest rates have
caused investors to almost desperately
reach for yield, which has set a lot of
what I call dividend traps. One example in
my short portfolio is StoneMor Partners
[STON], which runs cemeteries and funeral homes. The company is chronically
cash-flow negative but has maintained a
10% dividend yield for years, funded primarily by issuing stock at 3x book value
to yield-hungry retail investors. It has elements of a pyramid scheme to it and can
go on for years, until it can’t. Were the
dividend to be cut, it wouldn’t be pretty
for the stock.
Is the presence of a catalyst like a dividend
cut essential in your shorts?
tion in macro catalysts in the U.S. There
are plenty of things that could roil the
markets – Congress failing to raise the
debt ceiling, the housing market slowing
down, rising interest rates – but I don’t
have high conviction around any of that.
That makes the company-specific catalysts
more important than ever.
Describe why installment lender World
Acceptance [WRLD] meets your criteria
for a promising short.
WT: World Acceptance operates around
1,200 offices in 13 U.S. states and Mexico,
through which it makes short-term, unsecured installment loans to mostly low-income and financially unsophisticated customers. The average loan has an original
term of one to two years and a principal
balance of $1,200 to $1,300. The interest
rates are high, often 40%-plus, so people
typically take these loans out only when
they have no alternative, say when the
brakes go out on their car or they’re hit
with a big medical bill.
I should stipulate upfront that the company has been one of the best growth stories in the financial industry over the last
decade. It has great returns on equity and
INVESTMENT SNAPSHOT
World Acceptance
Valuation Metrics
(Nasdaq: WRLD)
(@8/29/13):
Business: Provider of unsecured consumer
installment loans through more than 1,200
company-owned offices located in 13 U.S.
states as well as in Mexico.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
Share Information
86.21
52-Week Range
Dividend Yield
Market Cap
Company
Prescott General Part
Columbia Wanger Asset Mgmt
Fidelity Mgmt & Research
Vanguard
Manufacturers Life Ins
61.00 – 94.99
0.0%
$968.0 million
Financials (TTM):
Revenue
Net Profit Margin
Russell 2000
47.1
18.7
(@6/30/13):
(@8/29/13):
Price
WRLD
10.6
8.4
7.3
$596.1 million
31.0%
17.5%
% Owned
13.8%
12.3%
10.8%
8.4%
4.7%
Shares Short/Float
44.5%
WRLD PRICE HISTORY
100
100
100
Ad
0.0
0.2
0.4
0.6
0.8
1.0
WT: One painful lesson on the short side
has been that mere absurd overvaluation is
not sufficient reason to be short. I have bet
against things like Lululemon or Michael
Kors or Salesforce.com, and even though
they were by any measure ridiculously
and unsustainably overvalued, they also
were riding hot streaks in revenue and/or
earnings and the stocks just kept going up.
Standing in front of a freight train holding up a sign saying “You’re overvalued”
doesn’t keep you from getting run over.
So I need to have conviction in all my
shorts about either a company-specific
catalyst or a macro catalyst. One issue
today is that I don’t have a lot of convicAugust 30, 2013
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2020
2011
2012
2013
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THE BOTTOM LINE
Whitney Tilson believes regulators are likely to rein in abuses across the financial industry, in particular those by the most “predatory” firms like World Acceptance. As new rules
and regulations place restrictions on certain of the company’s common practices and
threaten its bottom line, “it’s likely to be very bad news for the stock,” he says.
assets, low and stable loan losses, didn’t
miss a beat during the financial crisis and
buys back a ton of stock. At first glance
you’re blown away by the financials – and
it’s only trading for 10-11x earnings.
So what’s not to like?
WT: Putting aside the reliance of the business model on charging high interest rates
that – due to limits set on these types of
loans – are effectively outlawed in 37
states, the really predatory elements of
this business come after the initial loan.
The company aggressively sells add-on
credit insurance that is extremely high
priced and generally unnecessary. It refinances three-quarters of its existing loans,
typically adding to the loan balance and
taking another round of fees and insurance charges. Even the way it allocates the
share of each loan payment to principal
and interest – using what’s called the Rule
of 78 – results in higher principal amounts
being rolled over upon re-financing.
Why hasn’t that all blown up in the form
of huge loan losses?
WT: The first answer is that a rolling loan
gathers no loss. My guess is that if World
Acceptance stopped making new loans
and tried to collect its existing loan book,
it would collect maybe 50 cents on the
dollar. But you won’t see that fully as long
as the loans keep getting rolled and minimum payments are being made.
The second answer is that if you read
ProPublica’s investigative report on the
company, it appears it stops at nothing to
harass and intimidate customers into paying. Loan applicants have to provide a list
of references, including relatives and their
employers – not exactly the people you
want to be called when a payment is late.
This is quite a well-known short. Why get
in front of the freight train now?
WT: I’m counting on what I’ll call the revenge of the regulators. Regulators in the
U.S. and elsewhere have a well-deserved
sense of embarrassment over how their
August 30, 2013
negligence contributed to the financial crisis. I think they’re finally waking up and
there are likely to be major steps to rein
in abuses across the financial industry in
particular.
I don’t believe there is going to be a
sudden directive or piece of legislation
that puts World Acceptance out of business overnight. My best analogy would be
what’s happened in the for-profit education industry. The Department of Education recognized a number of abuses that
resulted in students with worthless degrees
being saddled with incredible debts. What
it did was impose a series of rules and regulations that reined in the most outrageous
practices and destroyed a great deal of the
profitability of the business, particularly
for the most egregious abusers. For World
Acceptance, it could be new interest-rate
caps in the states in which it operates. It
could be restrictions on serial refinancing.
It could be better disclosure or restrictions
on the sale of add-on credit insurance.
As any of that makes its way to the bottom line, it’s likely to be very bad news for
the stock. This is actually the type of short
I see playing out over a number of years,
where I’ll be adding to the position as the
challenges to the company increase. There
still should be plenty of time to get in on
the short side.
Given how brutal the shorting environment can be, do you ever think about
just throwing in the towel and going long
only?
WT: I did that very seriously in October
2007 and went so far as to start going
through my short book to plan how I was
going to start covering each of the positions. I looked at things like Allied Capital at $30 and MBIA at $72 and couldn’t
bring myself to cover a single share of any
of them. I thought they were fantastic
shorts even though I’d been taking nothing but pain on them for years and I just
emotionally wanted to be out of that side
of the business.
It turns out that was a great time to be
short. Today I’d say I feel pretty much the
same way.
INVESTOR INSIGHT
Tucker Golden
Solas Capital
“Companies with less-than-pristine
balance sheets are priced as if low-cost
credit will remain abundantly available.”
Before we talk about shorting, what are
you just avoiding in today’s market?
Tucker Golden: One manifestation of the
complacency we see in the market is investors recognizing but then readily dismissing obvious risks. That’s resulted in
companies with less-than-pristine balance
sheets often being priced as if low-cost
credit will remain abundantly available.
Given the heightened risk we see of that
changing quickly, companies too reliant
on access to credit make us leery. If you
look at our top five long positions, net
cash on average is just over 35% of the
total market cap. Under almost any operating scenario these companies won’t need
to depend on the kindness of strangers or
of the credit markets.
Open-ended growth stories would appear
to have particularly captured the market’s
fancy. Is that a fertile area for shorts?
TG: In anything we’re short we want to
understand the business and the range of
potential outcomes. For us that’s usually
too difficult for the more open-ended stories. For example, I may think the valuation of Tesla [TSLA] makes zero sense,
but the bull case is just too hard for us to
completely disprove or to model. In addition, given the opportunity for short-term
traders to squeeze shorts, we try to avoid
anything like this with significant short inValue Investor Insight 5
terest. We have some popular shorts, but
the hurdle is very high and they’re restricted to a significant minority of our capital.
Describe the risk you see today in Krispy
Kreme Doughnuts [KKD].
TG: Krispy Kreme has a fairly well known
and checkered past, which included accounting improprieties several years ago
that did a lot of damage to the brand and
the franchise network. All that is seemingly behind them and the story now is
focused on growth. Between now and January 2017 management is targeting 14%
annual growth in domestic units and 15%
growth in international franchises.
It’s important to understand where and
how the company makes its money. The
95 company-owned stores account for
25% of profits. The 678 franchised stores,
nearly 80% of which are outside the U.S.,
account for another 30% of profits. The
remaining profit comes from a separate division that sells donut-making equipment
and supplies to its store base, again, most
of which consists of overseas franchises.
Despite the non-U.S. focus, management spends a disproportionate amount
of time highlighting the domestic business.
INVESTMENT SNAPSHOT
Krispy Kreme doughnuts
Valuation Metrics
(NYSE: KKD)
(@8/29/13):
Business: Maker and seller of donuts
through a network of company-owned, franchised and third-party stores, roughly 70%
of which are located outside the U.S.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
Share Information
23.23
52-Week Range
Dividend Yield
Market Cap
Company
Vanguard
BlackRock
Morgan Stanley
Cupps Capital
Keeley Asset Mgmt
6.77 – 23.57
0.0%
$1.52 billion
Financials (TTM):
Revenue
Net Profit Margin
Russell 2000
47.1
18.7
(@6/30/13):
(@8/29/13):
Price
KKD
70.4
31.0
27.2
$448.0 million
9.5%
5.1%
% Owned
5.5%
5.0%
3.7%
3.4%
3.1%
Shares Short/Float
3.7%
KKD PRICE HISTORY
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2011
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THE BOTTOM LINE
The company’s aggressive growth plans are likely to be challenged by less-than-stellar
international performance and increased competition in the U.S., says Tucker Golden.
The shares would trade at $10-11 if they were valued more in line with multiples of other
comparably franchised fast-food concepts, he says, “which is perhaps still too generous.”
August 30, 2013
That’s probably because the non-U.S.
business isn’t great. Same-store sales overseas have been negative for every quarter
since at least 2008. There’s a high level of
churn, with 9-10% of the non-U.S. franchised units closing each year. The company’s Middle East franchisee, then a 12.7%
shareholder, sold its entire stake last year
at a high-single-digit stock price and has
been reducing its number of stores. All
of this implies that the company must
push even harder to keep the international growth story intact. To increase units
15% per year would require a gross opening rate in the low- to mid-20% range. We
strongly question whether that’s feasible.
Another big part of the growth story is
the rollout in the U.S. of small-format factory stores equipped with Krispy Kreme’s
latest donut-making technology. What’s
surprising to us here is that the company
discloses in great detail the sales results
of the first pilot store, but these results
aren’t definitively convincing, and at any
rate, it’s far too early to declare victory,
let alone convince franchisees to buy in.
Having approached domestic franchisees,
we’ve been told that they’ve generally been
disinclined to invest in their KKD units.
Another big challenge in the U.S. is increased competition from Dunkin’ Brands
[DNKN], which plans to double its domestic units, with 3,000 of those openings
in regions overlapping heavily with KKD’s
core markets. Development agreements
sold
Dunkin’ franchisees last year imAdjtoClose
ply several hundred openings in KKD territory in the near term.
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How are you valuing the shares, now
trading at around $23?
TG: The stock trades at 23x next 12
months’ estimated EV/EBITDA. Dunkin’
Brands, with much higher frequency of
customer visits, much higher margins, better franchisee relationships and similar –
but in our view more credible – growth
plans, trades at 17x EV/EBITDA. If we
wanted to be generous, at that valuation
Krispy Kreme would be worth $16-17.
If we look at comparably franchised
fast-food concepts, the multiples are in the
10-11x range, which would imply a stock
price of $10-11 for Krispy Kreme. That
strikes us as more reasonable, and perhaps
still too generous.
Are you counting on any catalysts?
TG: As the stock has tripled over the past
year we’ve seen a significant turnover in
the shareholder base to the type of holder
that will be pretty disappointed if there
are shortfalls against the growth targets
either in the U.S. or internationally.
What do you consider the biggest risk?
TG: One of Dunkin’ Donuts’ strengths is
that it gets more than half its total sales
from coffee and other drinks, which are
higher margin and promote frequent visits. Krispy Kreme doesn’t strike us as having the real estate or the product to make
meaningful progress on that front, but
were it to do so that would be a risk.
We’ll admit to loving Krispy Kreme donuts and just two weeks ago had some for
the first time in a long time.
TG: That’s the point, though, “the first
time in a long time.” The average customer visit is monthly, say the person
who buys a box for the office from time
to time. Relative to the expectations here,
that’s not going to be enough.
INVESTOR INSIGHT
Shawn Kravetz
Esplanade Capital
“We’ve never seen this type of single-security volatility in such a relatively calm
overall market.”
August 30, 2013
You’ve said you have to be more creative
to find long ideas in today’s market. What
do you mean?
You’ve said you want to be an expert on
any industry in which you invest. Is that
as true on the short side as the long side.
Shawn Kravetz: There was a fairly long
period after the crisis in which we could
regularly find even well-known large caps
like Lowe’s or Apple trading at valuations
that struck us as surprisingly attractive.
Over the past 12 to 18 months most of
those opportunities seem to have gone
away. What I mean by the need to be more
creative is that we’re still finding plenty of
things to buy, but they tend to be smaller
or more eclectic or messier. When so many
stocks are “working” easily and quickly,
people are less likely to be bothered with
the more complicated idea.
SK: For the most part, yes. In industries we
know well, we start by looking for mirror
images of what we want on the long side,
so things like overvaluation, overly positive sentiment, and management teams
with a record of overpromising and underdelivering. While we love catalysts
on the long side, we require them on the
short side. Valuation shorts are always
extraordinarily tricky, but particularly so
in this kind of market. Look at GameStop
[GME], the videogame retailer. A year ago
when the stock was below $20 there were
plenty of bright short sellers saying it was
another Blockbuster or Borders and it was
going away. But there was no obvious
near-term reason to expect the stock to go
down. Now it’s trading at close to $50.
What’s a representative example?
SK: This is actually one I’ve spoken to you
about before [VII, March 30, 2012], but
Lakes Entertainment [LACO] remains one
of our larger holdings and isn’t your typical rising-earnings, rising-multiple story.
It’s a very small developer and operator of
gaming-related properties and while the
stock has done extremely well, the market still seems slow to ascribe value to the
company’s assets until it becomes obvious.
With Lakes having a variety of assets in
the early stages of value realization, we
consider that an opportunity.
I would add that even though the market overall hasn’t been volatile, single-security volatility is very high. So you have
the stock of Western Union go down more
than 30% one day last October in an otherwise calm market. There was a genuine
earnings and guidance disappointment,
but we bought on the collapse because we
didn’t believe it was a 30% disappointment. Seven to eight months later cooler
heads prevailed and the stock got back to
where it was, by which point we had already taken nice profits.
We’ve never seen this type of thing happen so often in a relatively calm overall
market. Just a few days ago Abercrombie
& Fitch [ANF] shares were down 20%.
Maybe it’s an overreaction and maybe it
isn’t, but it gets our attention.
Why do you expect the stock of German
utility RWE [RWE:GR] to go down?
SK: We have been investing in solar-energy
businesses – both on the long and short
sides – for nine years now. In following
that business we also track the impact
of solar on traditional utility companies,
which thus far in most parts of the world
is small because solar penetration is relatively limited.
That has started to change, particularly
in Europe and particularly in Germany,
where RWE is the largest electricity producer with more than 31 gigawatts of total installed capacity. By the end of 2012
Germany overall had an installed base of
32 gigawatts of solar capacity, roughly
one-fifth of its total installed capacity of
roughly 150 gigawatts. That’s up from
three gigawatts in 2006 and the number is
still growing. It should be 36 gigawatts by
the end of this year.
All that has wrought havoc on the German electricity market. At certain times
on certain days, electricity prices are now
below zero because of all the solar supply on roofs and in fields. With forward
electricity prices in the country down
more than 50% since 2008, a significant
amount of traditional generation capacity
is uneconomic. Given that had provided a
majority of RWE’s profit, net income has
fallen from €3.8 billion in 2010 to €2.5
billion in 2012. Consensus estimates show
a continued decline. The company hasn’t
had positive free cash flow since 2008,
and even management doesn’t expect any
free cash flow until 2015.
What is the company doing?
SK: They’re limited in some cases by onerous long-term power-purchase contracts,
but they’re trying to burn as little cash as
possible, which means shutting down uneconomic capacity. They’re not being irresponsible, but are just playing with a very
weak hand.
Recently at just under €21, the stock has
hardly been a high flyer. How are you
looking at valuation today?
tions, we arrive at an estimated overall
current value of €15 per share, with a notimmaterial chance it could go much lower
if the German electricity business deteriorates even more quickly than we expect.
SK: If you clean up their most recent year’s
financials for a variety of one-time gains
and asset disposals, the company earned
around €8 billion in EBITDA. There’s €13
billion in equity market cap and about
€35 billion in net debt – including German
pension and nuclear liabilities – so the actual EV/EBITDA multiple is about 6x.
With no free cash flow and the business
trajectory the way it is, we’re relying on a
sum-of-the parts analysis. In addition to
German power generation, the company
also has German power-distribution assets
and a variety of generation assets outside
Germany. Being generous in our assump-
What are the catalysts here?
SK: With debt going up and EBITDA going down, we think the current dividend
– paying a 9%-plus yield – is at least
50% too high and is likely to be cut. That
would be a blow to a shareholder base
that is focused on a juicy, predictable
yield. To shore up the balance sheet and
avoid a possible debt downgrade, we also
believe the company is likely to need to
raise capital in the not-distant future.
On top of all that, the solar story keeps
moving along. Germany’s stated target
is to have 50 gigawatts of solar capacity, which we estimate is about four years
away. At 50 gigawatts, solar could represent 100% of the country’s total generating capacity during the sunniest spring
and summer weekends. Every day the picture gets a tiny bit worse for RWE, and
as the evidence accumulates so should the
negativity toward the stock.
INVESTMENT SNAPSHOT
RWE
(Xetra: RWE:GR)
Business: Generation, transmission and
trading of electricity, with primary operations
in Germany, the United Kingdom, Eastern
Europe and the Benelux countries.
Financials (Trailing 6 mo., annualized):
€57.05 billion
10.6%
4.2%
Revenue
Net Profit Margin
Share Information
((@8/29/13, Exchange Rate: $1 = €0.756):
Valuation Metrics
€20.80
Price
(Current Price vs. TTM):
€20.47 – €36.46
9.6%
€12.80 billion
52-Week Range
Dividend Yield
Market Cap
P/E (TTM)
RWE:GR
17.1
S&P 500
17.8
RWE PRICE HISTORY
6060
60
5050
50
Risks?
0.0
0.2
0.4
0.6
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1.0
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3030
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2020
2011
2012
2013
20
SK: It’s possible the government reneges
on its subsidies and guarantees related
to solar. We don’t expect that and even
if there
was a pullback, the damage has
Adj Close
largely been done. The panels are installed
and are still going to generate electricity.
To us this idea is bit like shorting the
U.S. Postal Service. RWE is a high-fixedcost business in which a lot of the operating assets are no longer economically feasible, and every year it’s losing a bit more
of its most profitable business.
Have you acted on this thesis elsewhere?
THE BOTTOM LINE
The company’s traditional source of profits, electricity generation in Germany, is under
withering attack from the increase in solar-power capacity in the country, says Shawn
Kravetz. With debt going up and EBITDA going down, he expects a dividend cut, a capital raise and for the shares to decline at least to his current sum-of-parts value of €15.
August 30, 2013
SK: We’re also short E.ON [EOAN:GR],
which is a junior version of RWE in Germany, though it has a more diversified
portfolio of assets outside of the country.
Solar is going to have a similar impact
on other utilities around the world. It’s not
nearly as imminent elsewhere, but if you
ask me again a year from now, I’d expect
to have added other similar ideas to the
portfolio.
INVESTOR INSIGHT
markets. The expectation within companies and in the analyst community is often that international businesses will track
their domestic experience. In many cases
we don’t believe that is or will be true, and
the result is that international growth potential is over-estimated and the stocks are
overvalued.
You’ve identified cell-tower operator
American Tower [AMT] as a representative example of this. Walk through the
bear case on it.
Carson Block
Muddy Waters Research
“Investors often overly value emergingmarket growth prospects in companies
based in developed markets.”
Are there any themes behind the overpriced opportunities hitting your desk?
Carson Block: One fertile area for ideas
is in lower-quality companies that have
borrowed heavily in a credit environment
that just isn’t sustainable. We’re still in the
early stages of sifting through the most interesting prospects, but over the medium
term we expect a rising interest-rate environment to expose a lot of companies that
were able to use cheap debt as a temporary Band-Aid to cover poor underlying
businesses.
We also still see a lot of froth in anything
related to emerging and frontier markets.
While stocks in many of those markets
have pulled back, investors often overly
value emerging-market growth prospects
in companies based in developed markets.
Public companies have poured shareholder money into emerging markets over the
last several years through acquisitions and
start-up projects and we generally don’t
believe the expectations for those investments come close to discounting the risks
involved – from currency and inflation issues, to fraud and the political whims of
local governments, to just the difficulty of
managing and executing in less-developed
August 30, 2013
CB: Beginning in 2008 American Tower
significantly stepped up its international
expansion efforts, essentially going hard
into nine markets simultaneously. That has
resulted in top-line international growth
that investors seem to love, but when we
dig into the detail of how those operations
are actually performing, we conclude that
a great deal of value is being destroyed. In
our analysis of the IRRs for four countries
– India, Brazil, Ghana, and Germany – we
found in the first three cases that the IRRs
were no better than if the company had
just invested in local-currency government
bonds. In Germany they beat the local
bonds, but have only generated a 4% IRR.
If we compare the carried value on AMT’s
books of those four country investments
with the intrinsic values of those businesses in our country-by-country discountedcash-flow models, we estimate the value
destruction in those countries alone has
been at least $1 billion.
Another risk we see to future results is
that a good portion of AMT’s non-U.S.
business is de facto lending, where AMT
pays an above-market purchase price for
towers in exchange for the carrier agreeing to pay above-market rents. That
makes revenue and EBITDA margins appear higher initially, but when the rents
reset upon expiration or AMT co-locates
new carriers to the towers and has to offer market rents, that will put a damper
on growth. In general, we believe the international markets are not going to have
the growth dynamics that the U.S. market
had, which we don’t believe the company
has been forthright or realistic about.
Another worrying issue related to the
international operations is the fact that the
company isn’t hedging any of its currency
exposure. Unfortunately for shareholders, while the company’s exposures aren’t
hedged, management’s are. Management’s
performance targets are adjusted to neutralize any currency fluctuations.
In addition, different tax regimes outside the U.S. are going to make AMT’s
international cash flow more inaccessible
than investors seem to realize. That will
limit the company’s ability to grow the
dividend, which could be a big issue for
dividend-focused investors.
Are there other areas of concern?
CB: One significant one is that while it’s
clear that more and more wireless data
will be delivered to customers, we believe
a significant portion of that incremental
data won’t be delivered through cellular
towers. The single largest replacement
technology is one that’s been around for
years, Wi-Fi, which will only become more
ubiquitous as carriers and cable companies deploy broader Wi-Fi networks, particularly in densely populated areas where
usage is the highest. If you’re downloading data over a Wi-Fi network, you’re not
connecting through a cellular tower.
There are other technological advances
that threaten cell-tower prospects, including network antennas for the towers that
are becoming smaller and more capable,
and those that can better handle multiple
carriers at a time. Both of those advances
will result in carriers needing less space to
rent on a given tower – obviously problematic for a company like AMT.
What do you think the shares, now at
$69.70, are more reasonably worth?
CB: It amuses us that the key assumptions
of analysts – say on growth rates and costs
of capital – are all over the place, but they
still generate price targets in the same
range. As shorts in the stock, we like that.
We have developed 10-year projections for each region in which AMT operates in order to arrive at an estimate
INVESTOR INSIGHT
INVESTMENT SNAPSHOT
American Tower
Valuation Metrics
(NYSE: AMT)
(@8/29/13):
Business: Develops, owns and operates
more than 55,000 wireless and broadcast
communications towers located in the
United States and 11 foreign countries.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
Share Information
69.69
52-Week Range
Dividend Yield
Market Cap
Company
T. Rowe Price
BlackRock
Vanguard
State Street
67.89 – 85.26
1.5%
$27.53 billion
Financials (TTM):
Revenue
Net Profit Margin
S&P 500
17.8
15.0
(@6/30/13):
(@8/29/13):
Price
AMT
43.6
27.5
18.7
$3.09 billion
40.1%
20.7%
% Owned
7.2%
6.0%
4.8%
4.7%
4.3%
Shares Short/Float
Carlo Cannell
Cannell Capital
“We prefer companies that are fraudulent or broken, but are also active where
there’s just fawning adoration.”
1.6%
AMT PRICE HISTORY
100
100
100
Can you cite any particular sectors that
strike you as undervalued today?
Adj Close
0.0
0.2
0.4
0.6
0.8
1.0
80
80
80
60
60
60
40
40
2011
2012
2013
40
THE BOTTOM LINE
The company’s international expansion efforts that have so enthused the market have actually shown disappointing performance and face continued important headwinds, says
Carson Block. Based on his region-by-region discounted cash flow analysis, he arrives
at a current intrinsic value for the shares of around $45, 35% below the current price.
of the unleveraged free cash flow of the
combined business. [Editors’ Note: Details of the model are available at www.
muddywatersresearch.com.] Based on our
DCF model, we arrive at a share value of
around $45 per share. That uses what we
think is a conservative 9.5% overall discount factor, which is based on our bottom-up view on the appropriate discount
rates for each country.
What’s your time horizon here?
CB: The stock is off 7% since we first published our research on it in mid-July, so we
August 30, 2013
believe investors are already looking at the
company with a more critical eye.
Shorter-term, we consider it a big deal
that we discovered what we believe is a
$250 million discrepancy between what
AMT claims to have paid for a 2011 acquisition of towers in Brazil and the actual selling price. We still haven’t received
a good explanation about this from the
company – if something untoward comes
out on that, it could be a catalyst to the
downside. As for a longer-term catalyst,
most likely it will be the results of the international business chronically coming in
below expectations.
Carlo Cannell: Natural-gas-related companies appear mispriced – particularly
smaller Canadian E&P companies. Also
mispriced are container shippers who
have seen rates plummet. Trading at or in
many cases below scrap value, these are
classic “buy straw hats in the winter” opportunities in my opinion.
How about a sector you consider particularly overvalued?
CC: Software companies delivering solutions through the cloud. What really matters is the intellectual property, less so how
it’s delivered. A pig with lipstick remains
a pig. The new “plumbing” is important
and valuable to both the consumer and
vendor, but we are skeptical of the enormous bump up in valuation that seems to
accompany it.
You once described your search for longs
as “trying to uncover the dullards and assorted investment misfits in the market’s
underbrush that are largely neglected by
the investment community.” How does
that compare with your search for shorts?
CC: We’re looking at two opposite ends of
the spectrum. While for shorts we prefer
companies that are fraudulent or broken,
we’re also active in situations where the
investment community has shown fawning adoration, the opposite of neglect.
Neither of those descriptions would seem
to perfectly fit Vera Bradley [VRA]. What’s
your short case for it?
CC: I beg to differ. The company has
enjoyed a cult-like following and stellar
growth, but we see rot and deceleration.
You probably know the products, bags
and other women’s accessories with bright
floral patterns. It’s a good entrepreneurial
case study, with the two founders, now in
their mid-70s, building the company from
scratch, largely by cultivating independent
shops around the country. Each spring
they hold a Woodstock-like sales event
in Ft. Wayne, IN and more than 50,000
people attend. This is no fraud or fly-bynight company.
But as the company has grown, it has
done what many merchandise companies
do, diversifying away from the channels
in which it previously enjoyed success. It
started opening its own stores. It started
selling to national retailers. It opened outlets. All this was a poke in the eye to the
mom and pops upon which the business
was built, made worse by Vera Bradley
not selling differentiated product into each
channel and often competing on price at
the company-owned stores.
Discord in the sales channel can be a
real issue in a fashion business like this
one, where brands go in and out of favor
and demand is unpredictable. This appears to be coming home to roost at Vera
Bradley, where we’re seeing unfavorable
inventory trends. Days Inventory Outstanding [DIO] has fluctuated between
175 and 232 over the past year, with a
30% year-over-year increase in the latest
quarter. Compare that to Coach, where
the same metric ranged from 39 to 47
days over the past year.
More subjectively, we’ve spent time
hanging out in stores and always ask if
business is as good today as it was a year
ago. We’re learning the products are still
popular, but less so than they were. Retailers don’t want all the product the comAugust 30, 2013
pany is trying to ship them. If demand is
waning, as we believe it is, you’re going
to see increased markdowns and returns.
We also note that the company has
been diversifying into new product categories without much success. There’s a
baby line, eyeglasses and, bizarrely, office products. In our experience companies like this don’t turn things around by
stretching into new markets.
One last thing I’d mention that feeds
into our spider-sense concern is management turnover. The CFO “resigned” in
January and hasn’t been replaced. The
CEO, the son-in-law of one of the found-
ers, announced his “retirement” in May
and there’s no word on his replacement.
That the board hasn’t been more proactive
and responsive to these key departures
makes us wonder what’s going on.
The shares, at $19.40, are near a 52-week
low. How much worse can it get?
CC: I don’t have a precise answer. What
I’ve found is that the better shorts, ironically, tend to be the ones that are weak
and getting weaker. It is the inverse of the
momentum investor who buys stocks hitting their new highs.
INVESTMENT SNAPSHOT
Vera Bradley
Valuation Metrics
(Nasdaq: VRA)
(@8/29/13):
Business: Designs, produces, markets and
sells a range of women’s fashion accessories, including handbags, totes, wallets,
cosmetic cases and luggage.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
Share Information
19.43
52-Week Range
Dividend Yield
Market Cap
Company
Fidelity Mgmt. & Research
Royce & Associates
Kornitzer Capital
Wellington Mgmt
Frontier Capital
19.18 – 31.00
0.0%
$788.9 million
Financials (TTM):
Revenue
Net Profit Margin
Russell 2000
47.1
18.7
(@6/30/13):
(@8/29/13):
Price
VRA
12.0
10.1
6.8
$547.0 million
19.1%
12.0%
% Owned
8.3%
7.8%
4.5%
3.3%
3.0%
Shares Short/Float
82.1%
VRA PRICE HISTORY
6060
60
5050
50
4040
40
3030
30
2020
20
1010
2011
2012
2013
10
THE BOTTOM LINE
Carlo Cannell believes a combination of things – including inventory issues, channel
confusion, management turnover, diversification from the core customer and pressure on
gross margins – indicate that this is a weakened company that is getting weaker. If that’s
right, he says, “the probable outcome for current shareholders is not good.”
Ad
It’s a combination of things – inventory issues, plus channel confusion, plus
management turnover, plus diversification
away from the core customer, plus pressure on gross profit margins – that tell me
this is a weakened company getting weaker. If that’s right, the probable outcome for
current shareholders is not good.
INVESTOR INSIGHT
Travis Cocke
Southpaw Capital
“Nothing seems to matter in this environment as long as there’s top-line momentum or at least the potential of it.”
Why do you think the open-ended consumer growth story appears even more
popular than usual in today’s market?
Travis Cocke: Part of it could be a lack
of robust growth overall, forcing growth
managers – not to mention the dozens of
growth-oriented ETFs – to fawn over anything that has a whiff of growth to it. Part
of it may be that retail investors coming
back into the market love story stocks. It’s
also possible that active managers, who
are underperforming their benchmarks on
average, are chasing high-beta names in
an effort to catch up.
Whatever it is, the result today is that
for consumer brand names with perceived
secular revenue growth, extremely optimistic projections that have a miniscule
probability of materializing are often entirely priced in. There’s very little skepticism about future operational execution
or transitioning from a cash-consuming
growth phase to a cash-generative and
profitable one. Generally speaking, accounting gimmicks, insider selling, lack
August 30, 2013
of cash flow, etc. don’t seem to matter in
this environment as long as there’s top-line
momentum or at least the potential of it.
What’s an illustrative example?
TC: I consider Tesla the quintessential
cult stock. Elon Musk is considered nothing short of a deity in Silicon Valley, filling a void left by Steve Jobs. The ticker
is the most checked quote on Yahoo and
on brokerage websites like eTrade. If you
read the investor forums or watch video
of events such as Teslive, a shareholder
Q&A with Mr. Musk, critics are cursed
and ostracized and you have people getting teary-eyed and proclaiming they had
no hope for the future of humanity and
sustainable life on the planet until Tesla’s
Model S came along. Obviously they’re
unaware that the electric vehicle [EV] has
been around for a while now.
It is quite easy to pick apart the Tesla
bull thesis from almost any angle – that
electric vehicles aren’t so environmentally
friendly, that it’s a niche market, that the
lack of available infrastructure prevents
scalability, that competitors like BMW
spend more on R&D on a trailing basis
than Tesla has in sales on a forward basis
– but none of it seems to matter. I could
critique Tesla’s valuation in a number of
ways, but here’s one comparison you may
not have seen: BYD, the Chinese battery
and auto company in which Berkshire
Hathaway owns a big stake, owns lithium
mines and controls the entire chain of production for its EV batteries. It has a lot of
EV upside potential, a strong foothold in
China and is estimated to earn $900 million in annual EBITDA, vs. Tesla’s most
recent negative $155 million. Isn’t it a bit
surprising that Tesla’s market cap is currently 100% higher?
Another prominent example today
is software-as-a-service companies, for
which people make aggressive revenuegrowth assumptions and then slap Oracle’s margins on them in the out years.
One big problem is that most of these
companies don’t make money today, and
given the increasing competition in almost
every vertical, they have very little chance
of ever coming close to Oracle’s margins.
If they want to generate cash they have to
slow down growth, but if they slow down
growth the stocks would collapse. These
may not blow up all at once, but there’s a
good chance they eventually suffer from
what is known as the “sobering-up effect,” when the mode of thinking shifts
from abstract and optimistic about the
future to contemplating real-world execution problems and inevitable fierce competition. When that happens, a lot of air
could come out of these stocks.
Describe why you’re betting against diagnostics firm Exact Sciences [EXAS].
TC: Exact Sciences is a single-product diagnostic company whose product is yet to
be approved by the FDA and which has
a long history of spectacular commercial
failure. The situation is somewhat like
Tesla in that it has a compelling narrative,
a supposed product breakthrough, a very
large addressable market and an almost
militantly bullish shareholder base.
The sole product is Cologuard, a
non-invasive DNA test that screens for
colorectal cancer. It requires the patient
to collect an entire stool sample and then
mail it to Exact Sciences for lab testing.
The product’s primary advantage is supposed to be in early detection, which is
key in this instance because it takes about
10 years for pre-cancerous polyps to turn
malignant. The company has completed
a 12,700-patient test and expects to have
an FDA panel discussion before the end of
this year and FDA approval by the end of
next year’s first quarter.
The market seems oblivious to the
company’s previous failures. The first two
iterations of the product were marketed
and distributed by LabCorp and were undeniable flops, never generating royalty
revenues for EXAS above six figures in a
single quarter. The big difference this time
around – when the company is going it
alone without a partner – is not so much in
relative efficacy, but that they’re universally expected to receive both FDA approval
and Medicare coverage. Those aren’t immaterial, but past Centers for Medicare &
Medicaid Services’ studies have not found
stool-based DNA tests to be cost effective at any price above about $60, so with
EXAS management guiding for at least a
$300 reimbursement rate, there could be a
serious disappointment relative to pricing
expectations. What hasn’t changed is the
relatively inferior patient user experience
and the unpleasant specimen-collection
process, which we think will remain a real
deterrent to demand.
Even more important to our case is
the fact that the company and its backers
seem to suffer from a severe case of competitor neglect, resulting in what we think
are far-too-optimistic expectations about
market-share gains.
The existing market is largely served
by Fecal Immunochemical Tests [FIT], the
leading provider of which is Quest Diagnostics. The best renditions of these tests,
if administered annually over a 10-year
period as is suggested, show a cumulative
efficacy that is marginally better than that
of Cologuard, at maybe 20% of the cost
over the full cycle.
Beyond that there are newer testing
procedures that are likely to be highly
competitive with FIT and Cologuard. One
is the virtual colonoscopy, which uses a
How are you looking at valuation with
EXAS stock recently trading at $11.70?
INVESTMENT SNAPSHOT
Exact Sciences
Valuation Metrics
(Nasdaq: EXAS)
(@8/29/13):
Business: Development-stage producer
of a non-invasive diagnostic screening
product, called Cologuard, used for the
detection of colorectal cancer.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
Share Information
Price
11.71
52-Week Range
Dividend Yield
Market Cap
Russell 2000
47.1
18.7
Company
Orbimed Adv
JPMorgan Chase
Gilder, Gagnon, Howe
Vanguard
Wasatch Adv
6.93 – 14.70
0.0%
$827.9 million
Financials (TTM):
Revenue
Net Profit Margin
EXAS
n/a
n/a
n/a
(@6/30/13):
(@8/29/13):
$4.1 million
n/a
n/a
CT scanner and computer graphic software to allow a radiologist to “navigate”
the colon. Another is a new technology
from Given Imaging called PillCam Colon, a pill that has a camera on each end
and records and transmits 35 color frames
per second wirelessly to a recording device
for review. Probably most applicable to a
broader market are a number of bloodbased screens that have already hit the
market or are in later-stage development.
If the numbers we’re seeing on their effectiveness hold, these blood tests are likely
to define the future of the industry.
% Owned
6.6%
5.9%
5.5%
5.5%
5.4%
Shares Short/Float
21.7%
EXAS PRICE HISTORY
1515
15
1212
12
99
9
66
6
TC: The company now has almost no revenues, but the sell side is modeling up to
$100 million in revenue per quarter within
a few years and up to $1 billion in annual
revenue by 2020. The beauty of this thesis
is that while I don’t think the bulls’ rosy
projections will come true, even if they do
I think there’s downside to the stock.
Because there’s no EBITDA or even
EBIT in the foreseeable future to value
it on, you have to look at price-to-sales.
Shares of molecular-diagnostics companies – just focusing on the smaller, fastergrowing ones – trade at an average of 3.5x
forward sales. If you put that multiple on
bullish analysts’ 2015 sales projections for
Exact Sciences, the shares would trade at
Adj$7.30
Close per share.
about
In my downside scenario, 2015 sales
come in at less than 50% of analysts’ expectations and the price-to-sales ratio is
2x, which is in line with comparable companies that have disappointed in terms of
revenue growth. With those assumptions,
there’s approximately 80% downside in
the stock over the next two years.
0.0
0.2
0.4
0.6
0.8
1.0
33
2011
2012
2013
3
How does the balance sheet look?
THE BOTTOM LINE
Investors in the company appear oblivious not only to its previous product failures but
also to the extensive competition its next-generation diagnostic test for colon cancer will
face, says Travis Cocke. Applying the peer-group multiple he considers reasonable to
bullish analysts’ 2015 sales projections, he thinks the shares today are 60% overpriced.
August 30, 2013
TC: Operating expenses in 2014 are expected to be around $70 million and are
likely to go up materially in 2015. There’s
just over $150 million in cash on the balance sheet, so if Cologuard is slow on the
uptake, that leaves a short runway. VII
I N V E S T O R I N S I G H T : Prospector Partners
Investor Insight: Prospector Partners
John Gillespie and Kevin O’Brien of Prospector Partners explain why one investment “backwater” regularly commands
their interest, which idea source has gotten more fertile rather than less, the “ride the winners” aspect of their strategy,
and why they believe Infinity Property and Casualty, Aspen Insurance, Symantec and OceanFirst Financial are mispriced.
Your defined circle of competence appears
a bit smaller than most. Explain where
you tend to focus your attention and why.
Kevin O’Brien: We’re generally attracted
to less-cyclical businesses with more predictable cash flows. We run screens to
identify less-levered companies generating
high free cash flow on a trailing 12-month
basis, but quickly weed out cyclical businesses where that free cash flow goes
away in a downturn. Even with a moderate amount of debt, that can cause serious
problems pretty quickly.
We’ve also developed expertise in financial companies where we’re looking
carefully at book value, its potential to
grow, and how much we have to pay for
that. More than half of our long portfolio
today is in property and casualty [P&C]
insurers, banks and asset managers.
John Gillespie: It’s changed a bit since
the financial crisis, but management typically spends most of its time polishing and
massaging the income statement because
that’s what people care about. How do I
set guidance? Am I meeting or beating expectations? So we spend the least amount
of time paying attention to that and focus
instead on the balance sheet and the cash
flow statement, which are harder to manipulate and offer the best opportunity to
uncover financial improvement or decay.
In businesses like insurance and lending, half the balance sheet is a blind pool.
In a bank it’s the loan portfolio and in an
insurance company it’s the reserves. Some
investors back away from that, but our
opportunity is in digging into those blind
pools in detail, often using regulatory filings and other non-GAAP disclosure, to
better understand the values and the risks.
P&C insurance, for example, is more or
less an investing backwater. The accounting is arcane and complicated. There’s a
separate set of regulatory financials you
August 30, 2013
have to be on top of. It’s just not worth
the time and effort for a general portfolio
manager to come up the curve. But getting back to what Kevin said at the beginning, it’s a stable, defensive business that
in the right management hands can generate very solid returns over long periods of
time. For us it’s worth the time and effort.
Your taste in banks appears rather eclectic. Explain that.
John Gillespie, Kevin O’Brien
KO: About two-thirds of our exposure in
banks at any time is in mutual thrift conversions at various stages of aging. People
ask us if these still happen and still work as
investments and the answer to both questions is yes. You have to get in early and
you have to be willing to buy into small
situations, but the process of going from
mutual ownership to stock ownership can
follow a pretty predicable pattern. The
shares are offered at a discount to tangible
book value and management rationalizes expenses and buys in stock over time.
Within three to five years of the conversion, 50% of the companies are sold. We
get to know management well and if they
know the script, we’re interested.
JG: Elsewhere in banking we have a mild
bias against large, complicated banks that
can be hard to get to the bottom of. That’s
actually not as true today, when some big
banks that are still in the shadow of the
financial crisis look more interesting than
garden-variety regional banks whose share
prices are ahead of themselves in terms of
discounting future earnings. In an industry where scale that drives unit costs lower
will be increasingly important, we like
some of the larger-caps such as Citigroup
[C], JPMorgan [JPM] and PNC Financial
[PNC]. With these we’re not that confident we have a fabulous edge on a fundamental basis, but see significant margin of
safety created by the current share prices.
Lifelong Connections
John Gillespie had a laser-focused jobhunting strategy upon graduating from
Bates College in 1980, writing every investment and commercial bank in New
York City in search of a job. “I had a perfect record,” he says, “50 letters, 50 form
responses saying thanks but no thanks.
Plan B was to ask his father for help. Gillespie Sr. was a trust and estate lawyer
whose clients included then GEICO Insurance CEO Jack Byrne, who Warren Buffett once dubbed the “Babe Ruth of insurance.” Gillespie ended up spending nearly
five years at GEICO, first as an analyst and
then working more closely with Byrne, including helping him prepare his quarterly
management report to directors.
After earning a Stanford MBA and spending 11 years at T. Rowe Price, Gillespie by
the mid-1990s was ready to go out on his
own. This time he didn’t hesitate to tap into
his network, placing an early call to Byrne.
“He said I had a great job and was just
restless,” says Gillespie, “which was his
way of testing my conviction. When I came
back a year later, he knew I was serious.”
In 1997, Byrne’s White Mountains Insurance took an interest in Gillespie’s firm,
Prospector Partners, and staked it with an
initial $20 million to manage.
Value investors don’t seem to talk about
asset managers like they once did. Is that
business still fertile ground for ideas?
JG: We still think it’s a great business. It
produces buckets of cash and we find the
high-single-digit, low-double-digit free
cash flow yields on many asset managers’
stocks attractive. There’s also the prospect that at some point bonds become the
asset class nobody can make money in –
we actually think we’re there – and that
prompts something approaching a great
rotation back to stocks from fixed income.
Money flowing out of low-fee bond funds
into higher-margin equity funds would be
a real positive for the industry. In addition, higher interest rates would do away
with the fee waivers on money-market
funds, which would also be significantly
accretive to many management firms.
What asset managers do you consider particularly well positioned?
JG: We own a number of them, but those
with single fund platforms, like Invesco
[IVZ], should be better positioned to capitalize on an eventual rotation back into
stocks. Many firms have different brands
for bond and stock funds, which can make
it a bit trickier when someone wants to
move money from one to the other. A firm
like Invesco doesn’t have that issue.
A company like Legg Mason [LM], which
you also own, does have that issue. What
makes it attractive?
KO: Legg Mason has a strong fixed income versus equity balance, which is
good, though it isn’t on a single platform.
That’s less of an issue for it because it has
so much institutional money on the fixedincome side that those assets are less prone
to move in the first place. More important
to the story here is the performance of its
equity funds, more than 80% of which are
outperforming over 1-, 3- and 5-year periods. Better-performing funds are going to
attract assets and we think Legg Mason’s
ability to do that on the equity side isn’t
well appreciated by the market.
August 30, 2013
Outside of financials, what sectors typically appeal to you?
KO: Everything we do outside of financial
services tends to be driven by the strength
of the franchise, the predictability and
sustainability of free cash flow and how
well management is allocating that free
cash flow. We’re perpetually underweight
in consumer-discretionary and industrial
names, while being overweight in healthcare, consumer staples and the more recurring-revenue areas in technology.
On Management:
We’re intrigued when the
CEO is asking questions. It
indicates everything is on the
table – an excellent sign.
In addition to free-cash-flow screens,
where do you search for good ideas?
JG: Everyone who has done this for a
while probably says this, but a lot of ideas
just come from following what’s happening in industries and at companies that
we’ve owned or covered for a long time.
You develop a sense of what news is important and worth digging into.
We also find that the modern-style
investment conference has gotten much
more productive. When I started Prospector, conferences were mostly a waste of
time, but now you can just skip the general presentations in the ballroom and set
up one-on-ones or otherwise small meetings with management teams in breakout
rooms. We find that more intimate time
with CEOs and CFOs a very productive
source of new ideas.
What are you looking for in those types
of meetings?
KO: As much as we dig into the numbers, there’s always a level of comfort that
comes from meeting people face to face.
We want to understand the incentives
management has and the filters they use to
make decisions. We want to be sure they
benefit when the stock goes up and hurt
when the stock goes down.
We’re actually intrigued when the CEO
is asking questions. Late last year we
were at a conference where we met with
the CEO of PNC Financial and listened
to a presentation given by U.S. Bancorp’s
CEO. Richard Davis of U.S. Bancorp had
a well articulated, finely tuned plan that
is indicative of a well-run company. It’s
also one we think is well understood by
the market and the stock is priced accordingly. PNC’s CEO, William Demchak, was
relatively new to the position and he spent
most of his time asking questions and listening. He wanted to understand the investment community’s perception of the
company, warts and all. Given the egos of
most CEOs, that’s pretty unique. It indicates everything is on the table, which we
think is an excellent sign.
Is that working out so far at PNC?
KO: The stock has done well, but it’s still
early stages. We still believe with the balance sheet and set of assets they have,
there’s plenty of opportunity to create
shareholder value.
How active are you in investing outside of
the U.S.?
JG: We will certainly take advantage of opportunities outside the U.S. in our areas of
expertise, but I have a healthy respect for
the challenge that international investing
represents. In the late 1990s I took over
full control of the T. Rowe Price Growth
Stock Fund, the last piece of which was
the roughly one-third of assets that were
outside the United States. I remember taking a trip to Asia and concluding not only
that our holdings there were overly vulnerable to the property bubble bursting,
but also that sitting in Baltimore put me at
the end of the food chain with no real edge
in these stocks. That’s something I haven’t
forgotten.
Describe generally how you think about
valuation.
JG: If there are different denominations
of value investors, I’d say we’re members
of the private-market-value and free-cashflow-yield congregations more than we
are the low-P/E or pure contrarian ones.
With our blind-pool types of names,
we spend a lot of time essentially turning
the GAAP balance sheet into more of a
statement of current net asset value, and
then we compare that value with prices
that have been paid in relevant third-party
transactions. There’s no single hurdle, but
obviously the higher the current value gap
and the higher the growth in NAV we can
envision, the better.
Not every business needs to be looked
at through the balance sheet. For the insurance broker or money manager or
technology company, we’ll focus more on
free-cash-flow yield. Here the premium is
on understanding the sustainability of the
free cash flow and on having confidence
that management will deploy it wisely.
Here again there’s no single hurdle, but we
typically get interested on the buy side in
at least higher-single-digit free-cash-flow
yields.
KO: One thing I’d add is that in all cases
we’re very cognizant of the downside.
Most equity investors are optimists and
focus on what can go right, but big drawdowns are the primary enemy of longterm compound returns. We always spend
a great deal of time on what can go wrong
and on how much we could lose if it does
go wrong.
We’ve had new analysts come in and
say, “Here’s the relationship you wanted,
this has 120% upside and 60% downside,” and we’ll say that’s a nice ratio, but
the 60% is too high. We’ve certainly made
mistakes where we’ve lost more than 25%
in a given name, but that’s roughly the
maximum amount we want to believe we
can lose.
You’ve said your thinking has evolved
with respect to portfolio concentration.
How so?
JG: For a long time I was comfortable
having half or more of our long portfolio
August 30, 2013
in the top ten names. At one point I remember having three positions in doubledigits at the same time. While I’ve been
lucky and maybe even skillful enough to
never have that come back to bite me, I’ve
concluded that level of concentration is
just too exposed to the Armageddon scenario in one or more of our target sectors.
Today I stick to 5% as a rough positionsize limit.
Your marketing presentation highlights
the “ride the winners” aspect of your
strategy. Explain that.
JG: One of the mistakes I made early on as
a portfolio manager was selling my win-
On riding winners:
As long as the great franchise you bought at a cheapenough price is intact, you’re
likely better off holding on.
ners and doubling down on my losers to
the point where I looked at my portfolio
and couldn’t stand what I owned. That
impressed upon me that if you’ve had the
chance to buy a great franchise at a cheapenough price, as long as that franchise remains intact you’re likely better off holding onto it.
A good example we currently own is
Chubb [CB]. This is one of the few P&C
insurers with franchise lines of business
– in high-end homeowners and directorsand-officers insurance – that have translated into excellent and improving underwriting results and long-term growth
in tangible book value plus dividends of
14% compounded. We were lucky enough
to buy the shares at 1x tangible book value, the company has continued to execute
beautifully, and the valuation and stock
price are up nicely. But at 1.4x book value
today, we still think that’s well below the
2x or so an acquirer would likely pay. Unless something fundamental changes in the
business or the stock price, there’s no good
reason to sell.
Are there areas today in which you’re
finding good reasons to sell?
KO: We’re actually on the way out of several of our consumer-staples positions.
One example is Post Holdings [POST],
which we originally bought when it was
spun off from Ralcorp in 2012. We think
highly of the Chairman and CEO, William
Stiritz, who left Ralcorp to run Post. We
bought at a free-cash-flow yield of 5.5%
on enterprise value, and greater than 10%
on market cap. Since then the company
has made a few acquisitions, which added
some debt and execution risk. As the market gave the company credit for Stiritz’s
capital-allocation skills and the free-cashflow yield got to the mid-4% range on EV,
we decided to move on.
Before diving into two of your favorite
P&C insurance ideas, describe any general
industry trends of note.
JG: Underwriting is improving across the
industry. Management says it’s because
they’re more disciplined, but a cynic might
say it’s because bond yields are so low that
companies need to make more money
from underwriting in order to have any
semblance of a mediocre return.
Capital management has also definitely
improved. Ten years ago almost nobody
talked about share repurchases and now,
while some are much smarter about it
than others, everybody is doing it.
In terms of pricing, it’s hard to give a
single answer because there are dozens of
sub-segments in the industry. Pricing is going up in most lines of business, but important categories like property catastrophe reinsurance are seeing price declines.
One last thing I’d mention is that the
ratings agencies have gotten more hawkish on capital requirements for P&C companies since the financial crisis. So overall, you’re seeing downward pressure on
returns from lower bond yields and higher
capital requirements, while better underwriting and better capital management
have driven returns up. Those trends seem
to be sort of balancing each other out at
the moment.
With that as a backdrop, what’s behind
your specific interest in Infinity Property
and Casualty [IPCC]?
JG: Infinity focuses on low-cost auto insurance targeting urban Hispanic drivers,
with three-quarters of its business in California and Florida. It has strong brand
awareness among its target demographic
and has proven to be a good underwriter
of what can be higher-risk policies. Over
the past ten years its compound annual
growth in tangible book value plus dividends – how we measure P&C companies
– has been about 13%.
We generally like the auto-insurance
business. Legal mandates for coverage result in fairly stable demand, there are typically a large number of small policies, and
the risks are “short-tail,” meaning there’s
a relatively short period between the assumption of risk and the payment of any
claims on it. All that keeps outcomes within a tighter band, which makes the business more attractive. On a more cyclical
basis, cars on the road and miles driven
haven’t yet gotten back to 2008 levels.
As those metrics improve along with the
economy, that should provide somewhat
of a tailwind for auto insurers.
INVESTMENT SNAPSHOT
Infinity Property and Casualty
Valuation Metrics
(Nasdaq: IPCC)
(@8/29/13):
Business: Automobile insurance focused
on non-standard coverage for lower-income
drivers located primarily in urban areas of
the U.S. West, Southwest and Southeast.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
Share Information
62.14
52-Week Range
Dividend Yield
Market Cap
Company
T. Rowe Price
Dimensional Fund Adv
BlackRock
New South Capital
Vanguard
45.29 – 67.56
1.9%
$714.4 million
Financials (TTM):
Revenue
Net Profit Margin
Russell 2000
47.1
18.7
(@6/30/13):
(@8/29/13):
Price
IPCC
25.2
16.8
11.7
$1.32 billion
4.1%
2.2%
% Owned
15.6%
10.0%
8.0%
6.7%
5.5%
Shares Short/Float
1.5%
IPCC PRICE HISTORY
8080
80
7070
70
6060
60
5050
50
The primary play here is that we see
significant opportunity for Infinity to improve its underwriting profitability. It grew
premiums by 14% compounded over the
past three years, which hurt returns because new business in auto insurance is always less profitable than renewal business.
In response, management has been pulling
back on growth and pushing through rate
increases, both of which should result in
higher profitability. We estimate that over
the next two to three years the company
can get its overall combined ratio [which
measures incurred losses and expenses
against premium revenues] to the level it
is in its best markets. That would take the
overall ratio from 97% to 93%.
How would that translate into upside for
the stock, now trading at just over 62?
JG: Every point the combined ratio improves adds about 75 cents of earnings
per share, which if we’re right would take
EPS from an estimated current $3 run rate
to $6 in the next couple of years. Even if
the valuation pulled back a bit from its
current level we’d still earn an excellent
return from today’s price.
How do you judge private market value?
JG: There hasn’t been a lot of M&A
around non-standard insurers since the
crisis, but deals done before the crisis were
in the
Adj 1.9x
Closeto 2.7x tangible book range.
We’re not counting on a deal or on those
multiples coming back anytime soon, but
there’s plenty of room between those historical comps and the 1.1-1.2x multiple
on Infinity’s book value today.
0.0
0.2
0.4
0.6
0.8
1.0
4040
2011
2012
2013
40
THE BOTTOM LINE
The company as it slows the premium growth it experienced over the past three years
is poised to show material improvement in underwriting profitability, says John Gillespie.
With every point in combined-ratio improvement translating into roughly 75 cents in
earnings per share, he believes EPS over the next couple of years could double.
August 30, 2013
How does the story differ for fellow P&C
insurer Aspen Insurance [AHL]?
JG: Aspen is a different animal. It was one
of a number of companies founded in Bermuda after 9/11 with private equity and
hedge fund money to take advantage of an
expected surge in insurance pricing. Management, which is still in place, was lifted
out of a Lloyd’s of London syndicate that
had an excellent long-term record.
The company today has a diversified global book on nearly all fronts. It’s
about half insurance and half reinsurance.
It writes 30% of its business in the U.S.,
30% in London, 15% in Bermuda and
another 25% on a global basis, including
with Lloyd’s. Roughly 60% is in shorttail lines, such as homeowner’s, property
catastrophe excess and auto, while 40%
is long-tail, including workers’ compensation and directors-and-officers liability.
Compound annual growth since inception in tangible book value plus dividends,
at 11%, has been middle-of-the-pack relative to other Bermuda insurers. But the
stock price, at less than 95% of tangible
book value, is at the very bottom of the
pack. A resolution of that discrepancy between performance and valuation is basically the thrust of our investment thesis.
What put the company in the market’s
penalty box?
JG: Aspen a couple of years ago decided
to grow its primary insurance operations,
and those investments have weighed on
the company’s aggregate returns. A new
CFO combined with less-favorable market conditions have led it to cut back on
INVESTMENT SNAPSHOT
Aspen Insurance
Valuation Metrics
(NYSE: AHL)
(@8/29/13):
Business: Bermuda-based holding company offering a diversified range of property
and casualty insurance and reinsurance
coverage in the U.S., Europe, and Asia.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
(@6/30/13):
(@8/29/13):
Company
Greenlight Capital
Vanguard
Sterling Capital
35.94
52-Week Range
Dividend Yield
Market Cap
28.59 – 39.24
2.0%
$2.43 billion
Financials (TTM):
Revenue
Net Profit Margin
Russell 2000
47.1
18.7
Share Information
Price
AHL
12.5
10.0
2.3
$2.35 billion
13.1%
10.6%
% Owned
5.6%
4.9%
4.0%
4.0%
3.3%
Shares Short/Float
1.6%
AHL PRICE HISTORY
4040
40
catastrophe exposures, which will free up
capital to fund share repurchases and also
over time lead to less volatility in performance. We expect both of those dynamics
to bring the valuation at least back to the
middle of the pack where it belongs.
What impact would that have on the share
price, now around $36?
JG: The median Bermuda insurer today
trades at just under 110% of tangible
book. Those that are perceived as more
diversified and less volatile, such as Arch
Capital [ACGL] and Ace Ltd. [ACE],
trade at closer to 140% of book.
At 110% of book, we think Aspen will
have made its way back to the middle of
the sector’s valuation pack. That move,
when book value is compounding at better than 10% per year, would translate
into a nice shareholder return over the
next year or two.
As with Infinity, there isn’t much of an
M&A story right now. Bermuda firms at
one time went for snappy valuations, 1.5x
to 2x tangible book, but most everything
done since then has been on a distressed
basis. There’s a compelling argument to
be made that these companies should consolidate, but it hasn’t been happening.
Switching sectors, describe your investment case for computer security firm Symantec [SYMC].
Adj Close
KO: The company has three main business lines – Consumer, Security and Compliance, and Storage and Server Management – all of which have leading market
positions, large installed bases and significant recurring revenues. These are the
characteristics of technology companies
we tend to favor.
Central to our case here is Stephen Bennett, who took over as CEO a year ago
and has been methodically reorganizing
the company. He had been Chairman of
Symantec’s board since 2011, but his most
recent operating job was as CEO of Intuit
from 2000 to 2007, a period in which its
annual sales grew from $1 billion to $2.7
billion and its operating margins went
0.0
0.2
0.4
0.6
0.8
1.0
3535
35
3030
30
2525
25
2020
2011
2012
2013
20
THE BOTTOM LINE
After higher-than-expected catastrophe losses last year, the company’s stock has been
in the penalty box, says John Gillespie, resulting in a bottom-of-the-pack valuation for a
firm with solidly middle-of-the-pack long-term performance. He expects the resolution of
that discrepancy and continued growth in book value to pay off nicely for shareholders.
August 30, 2013
from virtually zero to about 25%. We
imagine he was as frustrated as we were at
how Symantec was being run, from overpriced and poorly integrated acquisitions
to a disorganized sales force.
A multi-phase transformation is now
underway. The first step was to rebuild
leadership – nearly half of the company’s
146 officers from a year ago are now gone.
A broader headcount-reduction plan was
initiated over the summer, with resulting
savings likely to become more visible by
the end of this year. We expect more efficiencies down the road from longer-term
projects to consolidate overhead in areas
like facilities and IT. He’s also remaking
the sales effort from top to bottom, taking
out excess layers and rebalancing incentives between new business and renewals
to help drive growth. All this is happening
so far with little disruption to the business.
How are secular technology trends impacting the company’s key businesses?
KO: The company’s Norton brand is the
dominant market leader in consumer antivirus and Internet-security software. Its
segment accounts for just over 40% of
total company revenue, with an operating
INVESTMENT SNAPSHOT
Symantec
Valuation Metrics
(Nasdaq: SYMC)
(@8/29/13):
Business: Global provider of software and
systems that are used by individual and
enterprise clients to protect, maintain and
back up all manner of digital information.
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
Share Information
26.05
52-Week Range
Dividend Yield
Market Cap
Company
Dodge & Cox
Invesco
Vanguard
State Street
Primecap Mgmt
17.02 – 27.10
2.3%
$18.20 billion
Financials (TTM):
Revenue
Net Profit Margin
S&P 500
17.8
15.0
(@6/30/13):
(@8/29/13):
Price
SYMC
24.1
12.2
8.8
$6.95 billion
18.3%
11.0%
% Owned
9.1%
5.0%
4.7%
4.1%
4.0%
Shares Short/Float
1.6%
SYMC PRICE HISTORY
3030
30
margin in the mid-30s. The secular challenge here is the decline in PC shipments,
which will take a long time to have a material impact on the global installed base
of Norton software. The company is compensating by rolling out new products,
including those protecting mobile devices.
Overall, we expect this to be a cash-cow
business that is a flattish to modest grower.
Security and Compliance is focused on
protecting large enterprise computer systems from external incursions and data
loss. This is a nicely growing business, now
accounting 20% of sales, where there’s
still a lot of room to improve margins. After losing money the prior year, this unit
earned a 4% margin in the year ended in
March, and 8% in the most recent quarter. The company will have to continue to
innovate on the product side, but there’s
certainly no secular problem with demand
for enterprise-security solutions.
In information management, which
accounts for the remainder of company
revenues, Symantec is a market leader in
the data protection and recovery markets,
ahead of top competitors IBM and EMC.
Operating margins here are in the mid-20s
and this segment has posted mid-singledigit growth in recent quarters, despite
a drag from some legacy server-related
businesses. We will be watching closely
how the evolution of “cloud” services
impacts this business, but we’re confident
Symantec is operating from a position of
strength,
not weakness.
Adj Close
0.0
0.2
0.4
0.6
0.8
1.0
2525
25
2020
20
1515
1010
15
2011
2012
2013
10
THE BOTTOM LINE
The company under an accomplished new CEO is going through a multi-phase transformation that should both reinvigorate the sales effort and significantly reduce costs, says
Kevin O’Brien. At 15x the $2.50 per share he believes the company can earn within the
next couple of years, the shares would increase roughly 45% from today’s level.
August 30, 2013
With the shares at a recent $26, how are
you looking at valuation?
KO: The stock trades at less than 14x
the consensus fiscal 2014 EPS estimate of
around $1.90. On a trailing basis, the free
cash flow yield is in excess of 7% and the
dividend yield is 2.3%.
Steve Bennett’s stated goals are to increase revenues at least 5% annually and
increase operating margins by 200 basis
points in the next two years and 500 basis
points longer term. Given that margins at
comparable firms are currently 1,000 basis points higher, we think he’s left plenty
of room to surprise on the upside.
Without any big leap of faith, we expect earnings within a couple years to be
in the $2.50 per share range, driven primarily by increasing margins. If they deliver that, we could imagine some multiple
expansion from today’s level. At even 15x,
the share price would be around $38.
If all that happens, we think there’s a
good possibility that this will still have
room to run. Bennett has said he wouldn’t
leave until the company is on the right
path. We look at that maybe taking three
to five years, after which the best may be
yet to come.
Why is OceanFirst Financial [OCFC] one
of your favorite small-bank positions?
KO: This is a company I’ve been invested
in more or less since it converted from mutual ownership in 1996. I was at Neuberger Berman then and we’d often get calls
from our compliance department because
OceanFirst was buying back stock so aggressively that our position kept going
above 10%. Since its IPO the company
has bought back 62% of its shares outstanding.
In all respects this a solid, successful
community bank. It has a strong franchise in a small region, three counties in
northern New Jersey along the shoreline,
an hour and change from New York City.
Core deposits are growing and make up
nearly 90% of total deposits. The loan
book is well diversified across residential
and commercial loans. Net loan chargeoffs never exceeded 1% of total loans
during the financial crisis. They did take a
decent-sized reserve for losses after Hurricane Sandy, but given the conservatism of
their underwriting we expect them to take
that down quite a bit over time.
There are two primary aspects to the
story here. One is the prospect of strong
loan growth as rebuilding continues after
the hurricane. The situations aren’t completely analogous, but as insurance and
government money poured into the region, loan growth was 25-30% at some
of the smaller banks whose markets were
in the path of Hurricane Katrina. We’re
not expecting that for OceanFirst, but we
August 30, 2013
don’t think growth in the high single digits
is at all out of the question.
The second item of interest is that the
company’s long-time Chairman and CEO,
John Garbarino, is set to retire in December of next year. We always look in these
situations at what incentives are in place
that might help us handicap what will
happen. In this case, we calculate that if
there is a change of control prior to the
end of 2014, Garbarino will earn in excess of $10 million more than he would if
he just retired. Maybe it’s just me, but it’s
hard to imagine that he’ll just leave that
on the table.
If you’re right, what kind of premium
might an acquirer pay over today’s share
price of $17?
KO: We’ve analyzed not only the comps
but also the specific branch overlap OceanFirst would have with likely acquirers and
the specific guidelines those acquirers have
articulated for any purchases. When we
do all that, we arrive at an expected private market value for the stock of around
$21. With the loan growth and resulting
earnings leverage we think are possible,
that number could easily be materially
higher a year from now.
INVESTMENT SNAPSHOT
OceanFirst Financial
Valuation Metrics
(Nasdaq: OCFC)
(@8/29/13):
Business: Community bank holding
company operating a total of 25 branches
serving New Jersey’s Ocean, Monmouth
and Middlesex counties.
P/E (TTM)
Forward P/E (Est.)
Price/Book Value
Share Information
16.98
52-Week Range
Dividend Yield
Market Cap
Company
Wellington Mgmt
BlackRock
Sandler O’Neill Asset Mgmt
Perkins Inv Mgmt
12.43 – 17.91
2.8%
$290.4 million
Financials (TTM):
Revenue
Net Profit Margin
Russell 2000
47.1
18.7
(@6/30/13):
(@8/29/13):
Price
OCFC
16.0
14.3
1.3
$81.9 million
38.3%
22.5%
% Owned
9.5%
6.0%
3.8%
3.4%
3.1%
Shares Short/Float
1.2%
OCFC PRICE HISTORY
2020
20
0.0
0.2
0.4
0.6
0.8
1.0
0.0
0.2
0.4
0.6
0.8
1.0
1515
1010
15
2011
2012
2013
10
THE BOTTOM LINE
The market doesn’t appear to appreciate the company’s post-Hurricane-Sandy growth
prospects or the incentives in place for it to sell itself some time over the next 18 months,
says Kevin O’Brien. Based on his detailed analysis of likely acquirers and what they
would be willing to pay, he believes the intrinsic share value today is $21 and growing.
Ad
In the meantime the stock pays a 2.8%
dividend and the company will probably
continue to buy back 5-6% of its shares
outstanding each year over the next couple of years. We think that protects us
quite nicely on the downside.
Tell us about a historical or recent mistake
and any lessons learned.
JG: I may be the worst investor in retail
who’s ever been born. Particularly with
more fashion-oriented retail, I’d never pay
enough for the one that was really growing and I’d assume the ones that were
cheap enough were on the way back. My
instincts were just bad and I’d walk into
one value trap after another. You do that
a few times and you figure out that you
should just stop doing it, which I have.
More recently, we turned out to be very
wrong in assuming gold miners like Newmont Mining [NEM] would start better
managing capital allocation and that private market values were far above prevail-
ing share prices. Management’s acumen
in allocating capital turned out to be as
bad as ever, and our private market values reflected transactions that turned out
to be disasters. If that wasn’t bad enough,
we didn’t contemplate adequately the de-
On rising markets:
You can get lulled to sleep
when markets aren’t volatile,
which likely means it’s time
to take chips off the table.
cline in intrinsic values when gold prices
fell sharply. That probably hurt the most,
since we put so much emphasis on the
downside.
At this point stocks like Newmont have
been so washed out that we’re holding on,
though we haven’t bought more. There is
some tangible evidence that management
across the sector is taking out real costs,
which should provide significant earnings
leverage if the price of gold bounces back.
Extended market rises tend to make value
investors nervous. Are you?
JG: I wouldn’t say nervous, but it is harder
to find names we like. Valuations in general strike us as at the high end of fair – not
overvalued, but above the median. Our
view is that as long as you haven’t tipped
into overvalued, you stay long because the
odds you can earn the long-term return
from stocks over a five-year period from
today are pretty good. That’s compelling
against other investment choices.
KO: We are in the process of culling
through our portfolio and looking carefully at everything that’s really worked,
long and short, with an eye toward taking exposures down. You can get lulled to
sleep when markets haven’t been volatile,
which likely means it’s time to take some
chips off the table. VII
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“An outstanding addition to the volumes written on value investing. Not only do the
authors offer their own valuable insights but they have provided in one publication
invaluable insights from some of the most accomplished professionals in the investment
business. I would call this publication a must-read for any serious investor.
”
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“I often judge a book by how many times I get my highlighter out and dog-ear pages.
On that metric, this book is wonderful – simply packed with insight from some of the
best long-term investors. Everyone will learn something from this book.
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Order Your Copy
Learn More
of The Art of Value Investing
About The Art of Value Investing
August 30, 2013
U N C O V E R I N G V A L U E : City National
On Deposit
“By definition, very few of the 7,000 banks in the U.S. actually have a sustainable competitive advantage,” says
White River Capital’s Mark Curnin. Here’s one that he thinks does – and that the market is mispricing.
There is no better indicator of a bank’s
prospects than the quality of its deposit
base. Banks that attract low-cost liabilities tend to generate superior net interest
margins, take fewer lending risks, produce
higher returns on assets and are more resilient when times are tough. “Deposits
are the raw material of the business,” says
Mark Curnin of White River Capital. “If
you have a cost advantage there and know
how to exploit it, you have the rare foundation for competitive advantage.”
It’s also a foundation Curnin considers
undervalued in today’s market. His favorite case in point: $27 billion (assets) City
National Corp. The Los Angeles-based
bank, with strong customer franchises
in entertainment, real estate and professional services, has consistently sported
one of the most attractive deposit profiles
in the industry. Some 60% of its deposits
earn no interest, vs. an industry average
of 25%. While the average bank relies on
higher-cost, less-dependable jumbo CDs
for almost 20% of its deposits, City National’s share is only 3%. Cheap deposits
are a key reason its net interest margin has
in normal times been around 450 basis
points, vs. only 350 for the average bank.
City National’s performance through
the financial crisis indicates other virtues
as well. Its cumulative net chargeoffs for
the five years ending in 2012 were 3.5%
of total loans, one-third the industry average. Chargeoffs in its residential mortgage
portfolio, in a highly distressed local market, peaked at a miniscule 0.16%.
It also has been unafraid to invest in
growth. Through market-share gains, ongoing expansion of its branch network
and four FDIC-assisted acquisitions, total deposits have doubled since 2007. It
is building out capabilities in a variety of
areas, including equipment leasing, franchise finance and technology and healthcare banking. It has expanded both the
breadth and depth of its wealth-management business, which now has some $60
August 30, 2013
billion in assets under management or
administration. Curnin expects all this to
translate into at least high-single-digit annual earnings growth going forward.
What’s it all worth? At today’s price,
the “deposit premium” on City National’s
shares – which Curnin defines as market
cap minus tangible equity, divided by nonjumbo-CD core deposits – is only 9%. At
the 20% level he considers more reasonable, based on precedent transactions and
historic valuations on high-quality de-
posit franchises, he pegs the share value at
nearly $105. That’s just over 13x the $8
per share he believes the bank would earn
from its existing asset base if interest rates
returned to more normal levels.
“Given the interest-rate environment,
excellent deposit franchises like this are
severely undervalued,” says Curnin. “But
they represent a phenomenal amount of
latent earnings power. As that eventually
becomes clear to the market, that should
be very good news for shareholders.” VII
INVESTMENT SNAPSHOT
City National
Valuation Metrics
(NYSE: CYN)
(@8/29/13):
Business: California bank holding company
focused on serving small and mid-sized businesses and high-income professionals.
Share Information (@8/29/13):
Price
(@6/30/13):
46.83 – 71.88
1.4%
$3.59 billion
Company
State Street
Atlanta Capital Mgmt
Financials (TTM):
Revenue
Net Profit Margin
S&P 500
17.8
15.0
66.69
52-Week Range
Dividend Yield
Market Cap
CYN
17.1
16.5
1.5
P/E (TTM)
Forward P/E (Est.)
EV/EBITDA (TTM)
$1.17 billion
32.1%
18.7%
% Owned
8.2%
4.9%
4.6%
Shares Short/Float
9.5%
CYN PRICE HISTORY
8080
80
7070
70
6060
60
5050
50
4040
40
Ad
0.0
0.2
0.4
0.6
0.8
1.0
3030
2011
2012
2013
30
THE BOTTOM LINE
Chronically low interest rates have led the market to severely undervalue the bank’s
unique, high-quality deposit franchise and its attractive growth prospects, says Mark
Curnin. At a more historically reasonable premium to its existing core deposits, he says
the stock would be worth nearly $105, 13x his $8 estimate of normalized EPS.
U N C O V E R I N G V A L U E : SuperInvestor Insight
Heightened Interest
Smart investors often work their way into a position as their knowledge of the company and conviction about the
investment grows. Where did the best investors in the business mine their portfolios for opportunity last quarter?
Given the effort that goes into the
stock-buying decision, you might imagine
that when smart investors are ready, they
buy the full position they want to own.
But very often managers describe taking
an “R&D” position first, continuing their
research in order to build – or overturn –
conviction. “Things can fall through the
cracks unless you force yourself to focus,”
says Eminence Capital’s Ricky Sandler.
“Having capital on the books does that.”
Where are the best investors mining
their own portfolios for opportunity? Below are the 10 largest positions in which
SuperInvestors tracked by SuperInvestor
Insight at least doubled existing stakes
during this year’s second quarter. Thermo
Fisher Scientific tops the list, as Glenview
Capital led five other star investors in increasing bets on the medical-supply giant,
which during the quarter announced it
was buying laboratory-equipment maker
Life Technologies for $13.6 billion.
While energy-related companies Valero
Energy and Cobalt International made the
doubled-down list, their stocks over the
past six months have significantly lagged
the market. Cobalt was founded in 2005
with private-equity backing and a specialization in deepwater oil and gas exploration, often under large salt formations. Its
stock, now $24.60, fell 15% in one day
earlier this month after it announced that
one of its high-expectation projects in the
Gulf of Mexico was a dry hole.
Realogy, in which Lone Pine Capital
sharply increased its stake last quarter, is
still digging itself fully out of the hole it
found itself in after a 2007 LBO saddled it
with debt near the housing-market peak.
The holding company for such realtor franchises as Century 21 and Coldwell Banker
came public again last October, and earlier this month confirmed guidance that it
would earn a full-year profit in 2013 for
the first time since its buyout. The market,
however, appears unenthused. Likely due
in part to LBO-sponsor Apollo Global’s
July announcement that it was selling its
entire remaining stake in the firm, Realogy
SuperInvestor Insight:
Doubling Down
shares at a recent $42.60 are down nearly
25% from their May highs.
Though well known as an activist,
Icahn Capital has thus far shown only
passive – if much heightened – interest in Nuance Communications. Nuance
sells speech-recognition technology used
in healthcare, automobile and consumer
applications, the latter of which includes
powering iPhone’s virtual assistant Siri.
After announcing it had taken its stake in
Nuance to 16% of the shares outstanding,
Icahn Capital’s David Schecter was nothing but complimentary: “As it becomes
more ingrained in consumer behavior to
navigate the phone by voice, as opposed
to touch, we expect that will lead to a significant acceleration of Nuance’s business
model,” he told Forbes. Nuance’s board
appears unconvinced of the benign intentions – earlier this month it adopted a poison pill with a 20%-ownership trigger. VII
The new issue of SuperInvestor Insight appears
next week. For more information, click here.
These are the 10 largest positions in which SuperInvestors at least doubled existing stakes during
this year’s second quarter. Many have yet to shine, as Realogy, Nuance Communications, Valero
Energy, Franklin Resources and Cobalt International are all down at least 15% from their Q2 highs.
Q2 2013
Ticker
Industry
Price@
8/29/13
Low
High
Investor
Prive Vs.
Q2 2013 High
Thermo Fisher Scientific
TMO
Medical Equipment/Supplies
89.17
75.27
89.50
Glenview
(-0.4%)
Nuance Communications
NUAN
Software
18.31
18.05
23.38
Icahn
(-21.7%)
Valero Energy
VLO
Oil Refining
35.80
33.27
45.53
Viking
(-21.4%)
Tim Hortons
THI
Restaurants
54.87
51.86
59.30
Scout
(-7.5%)
Bunge
BG
Agribusiness
75.26
65.74
74.05
Relational
1.6%
Realogy
RLGY
Real Estate Brokerage
42.57
42.23
55.28
Lone Pine
(-23.0%)
CIE
Oil & Gas
24.62
24.65
29.35
Paulson
(-16.1%)
LBTYA
Cable Services
78.59
68.83
79.11
Third Point
(-0.7%)
Franklin Resources
BEN
Investment Management
46.18
44.66
55.99
Highfields
(-17.5%)
Lowe's
LOW
Home-Improvement Retail
46.42
37.09
43.84
Maverick
5.9%
Company
Cobalt International
Liberty Global
Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2013.
August 30, 2013
General Publication Information and Terms of Use
Value Investor Insight and SuperInvestor Insight are published at www.valueinvestorinsight.com (the “Site”) by Value Investor Media, Inc. Use
of this newsletter and its content is governed by the Site Terms of Use described in detail at www.valueinvestorinsight.com/misc/termsofuse.
For your convenience, a summary of certain key policies, disclosures and disclaimers is reproduced below. This summary is meant in no way
to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.
No Investment Advice
This newsletter is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation
would be illegal. This newsletter is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a general or personal
recommendation or take into account the particular investment objectives, financ ial situations, or needs of individual investors. The price
and value of securities referred to in this newsletter will fluctuate. Past performance is not a guide to future performance, future returns are
not guaranteed, and a loss of all of the original capital invested in a security discussed in this newsletter may occur. Certain transactions,
including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors.
Disclaimers
There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth in this
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the information contained in this newsletter, caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering
the content in this newsletter.
Related Persons
Value Investor Media’s officers, directors, employees and/or principals (collectively “Related Persons”) may have positions in and may, from
time to time, make purchases or sales of the securities or other investments discussed or evaluated in this newsletter.
Whitney Tilson, Chairman of Value Investor Media, is also a principal of T2 Partners Management, LP, a registered investment adviser.
T2Partners Management, LP may purchase or sell securities and financial instruments discussed in this newsletter on behalf of certain accounts it manages.
It is the policy of T2 Partners Management, LP and all Related Persons to allow a full trading day to elapse after the publication of this
newsletter before purchases or sales are made of any securities or financial instruments discussed herein as Investment Snapshots.
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Value Investor Media, Inc. receives compensation in connection with the publication of this newsletter only in the form of subscription fees
charged to subscribers and reproduction or re-dissemination fees charged to subscribers or others interested in the newsletter
content.
August 30, 2013

VII_8.30.13

Transcription

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