My February post is available on the Covestor blog. I devote most of the post to explaining why I added a small position in DreamWorks (DWA) to my portfolio in January. In addition, I discuss my preference for being fully invested in stocks at most times as an investment manager. My closing sentence is perhaps a little too strong when I state that investors don't need their investment managers to tell them how much cash to hold. Obviously it is part of the function of a financial planner or general investment adviser to help an investor to decide what portion of his portfolio should be allocated to cash. My contention is merely that the portion of the portfolio allocated to risky assets should at most times be invested in risky assets, not held in reserve in anticipation of a sharp market decline. Since the returns on stocks have historically been and are likely to remain higher than the returns on cash in the long-run, the equity portfolio manager who holds a lot of cash is essentially claiming that he can row faster against the current than his competitors can row with the current. Curiously however, since the 2008-2009 market debacle, a large portion of money managers have apparently become Olympic class rowers.
My Covestor Model
Since August 12th of last year I have been managing a model portfolio on the Covestor platform. Covestor is a registered investment advisor. I am not a registered investment advisor, and legally, my relationship with Covestor is that of data provider. The way that it works is that Covestor's clients choose to "mirror" the trades of one or more of the many model managers on the platform. Some of the model managers are also registered investment advisors, and some, such as myself, are merely data providers. My model, the all-cap value model, can be found here. I have the majority of my family's wealth invested in an account that mirrors the all-cap value model. The model just "went live" on the Covestor website a couple of weeks ago. Each month, Covestor model managers provide commentary on the Covestor blog. My introductory post on the Covestor blog came out this morning and can be found here. I have also given Covestor permission to republish posts from this blog. I expect to continue to post here, but due to my extremely busy schedule there might be some fairly long periods between posts.
It is Now Safe to Buy IRE if You Like the Bank of Ireland
Back in early September, I pointed out how IRE, the NYSE traded ADR for the Bank of Ireland, was grossly misvalued relative to the price that the bank's shares were trading for in Dublin and London (BKIR.L). At that time, the ADR represented four ordinary shares and traded at $1.24 per ADR, while the ordinary shares traded at about 0.088 Euros. At the time the Euro was worth about 1.43 U.S. dollars, so the ADR should have been trading at about 0.088*1.43*4 = $0.5034, or about fifty American cents. This situation persisted for some time because it was impossible to short the ADR or to convert ordinary shares into ADRs. At the time I pointed out that unless the ordinary shares really take off, the ADR was bound to plunge dramatically. This predication turned out to be accurate, but IRE's fall was masked by a one-for-ten reverse stock split. The reverse split didn't alleviate the pain experienced by the ADR holders, but it might have helped the bank to avoid some bad publicity. Fast forwarding to this morning, the bank was trading at 0.089 Euros in London, and the Euro was at 1.3238 per dollar. After the one-for-ten split, the ADR now represents 40 of the ordinary shares, so a fair price for IRE would have been 0.089*1.3238*40 = $4.7127 per share. As I was able to purchase a small number of shares of IRE for $4.73 this morning, it seems that the price of the ADR is once again aligned with the price of the ordinary shares. If you plan on buying the ADR, it is easy to check that prices are still aligned by looking up the price of BKIR.L and the exchange rate for the Euro on Yahoo Finance (assuming you don't have a Bloomberg). Are the shares worth buying in the first place? I still hold to my original case, but the shares represent only a tiny portion of my portfolio. I expect much more bad news and several more bad earnings reports before prosperity returns to Ireland, but I expect it to return and for shareholders in this bank to be well rewarded when it does.
Disclosure: long IRE and IRLBF.PK (Bank of Ireland Shares traded on the pink sheets, which I purchased earlier when IRE was overpriced).
Disclosure: long IRE and IRLBF.PK (Bank of Ireland Shares traded on the pink sheets, which I purchased earlier when IRE was overpriced).
LoJack Corporation (LOJN)
Thesis
LoJack Corp. (LOJN) is a cheap, cash generating business with a strong competitive advantage that has become substantially cheaper due primarily to a series of solvable business disruptions and being removed from the S&P 600 index. The stock price plunged from an all time high of $28.84 on December 2nd, 2005 to $2.86 at the close of trading on November 14th, 2011. The price then fell a further 14.33% to close at $2.45 on November 18th on news that LoJack will be delisted from S&P 600 small cap index and replaced by Marriott Vacations Worldwide Corp at the close of trading on Monday November 21st, 2011. I believe that the stock is dramatically undervalued and that quarterly earnings surprises and renewed strong profitability and cash flow will cause the stock price to rise substantially in the coming year as business conditions normalize, new car sales continue to improve, and new management talent applies itself to the firm's problems and opportunities.
Business Description
LoJack is best known as the leading global provider of systems for recovery of stolen vehicles. The firm has been in operation since 1978 and their technology has resulted in the recovery of over 300,000 vehicles worth over $5 billion. The recovery rate of stolen vehicles equipped with the LoJack system is over 90%. The firm operates in three segments: North America (28 states and the District of Columbia) International (32 nations), and all other. The all other segment includes LoJack SafetyNet, which provides technology for rescuing people with disorders such as Alzheimer's and autism who wander off, and SC-Integrity, which provides technology for the recovery of cargo and other valuable business assets. The firm has a 100% ownership in all business lines except for SC-Integrity, in which it has a 60% interest.
The company reported revenues of $34.5 million in the third quarter ended September 30th, 2011, and $138.3 million in the trailing twelve months. In the third quarter, the North American segment accounted for 70.25% of revenues, International for 27.65%, and All Other for 2.1%. About 87% of North American revenues come through sales of LoJack units by new and used car dealers. While the firm receives some revenues from licensing fees and subscription services in the international segment, the bulk of international revenue (about 95% in fiscal 2010) is also derived from the sale of LoJack units. Overall, management estimates that only about $10 million per year in revenue is recurring. The only international market that LoJack operates directly, instead of through licensees, is Italy, which experienced a 43% year over year revenue increase in the third quarter and is expected to reach profitability in the fourth quarter. SCI and LoJack SafetyNet generate revenue from a mixture of device sales and service fees. The company contracts for the manufacturing of most components but assembles some products in house.
Lojack was firing on all cylinders from 2005-2007, with sales peaking at $222.7 million in 2007. The company was hit hard by the great recession and the accompanying steep drop in auto sales. The firm's sales are cyclical and unit volumes tend to track trends in auto sales. The business is also seasonal, with the first quarter the slowest and the fourth quarter the busiest, due partly to year-end deadlines imposed by insurance companies in foreign markets for drivers to get LoJack units installed. So far this year, LoJack has failed to show signs of turning around with the gradually improving auto market. Management cites three reasons for the firm's difficulties in the first three quarters of 2011. First, there has been an unfavorable change in the model mix of vehicle sales in the U.S., driven partly by shortages resulting from the Japanese earthquake. The models most affected by the earthquake are also the models where buyers are most likely to purchase the LoJack system. The chairman states in the third quarter conference call that experts expect these shortages to ease in the fourth quarter. The second problem relates to uneven timing of orders by quarter from international licensees. Part of this was reportedly due to protracted negotiations with the licensees. Management believes that most, though not all of the drop-off in sales in the second and third quarters from prior year figures will be made up in the fourth quarter of 2011. Third, costly and distracting litigation has hampered performance. The firm incurred $2.3 million in legal fees in the third quarter. Though legal actions are ongoing, the firm has reached a tentative agreement to settle a long running California federal employee claims case for $1.6 million, which is part of the $2.3 million in legal fees mentioned above.
Cyclicality aside, LoJack is strong cash generator. Going back to 1997 and including the trailing twelve months, the firm has only had two years, 2002 and 2009, of negative free cash flow, defined as cash flow from operating activities minus net capital expenditures and cash spent on acquisitions. Free cash flow was -$0.4 million in 2002 and -$11.4 million in 2009. Cash flow from operations was positive every year except 2009, when the firm paid an $18 million legal settlement. Average free cash flow over any period beginning between 1997 and 2007 and ending at the end of the third quarter of 2011 is at least $9.4 million per year, without adjusting for inflation.
Management
It is difficult to judge whether some recent setbacks were more due to bad luck or management missteps. Management and directors get stock options and share awards but collectively hold little stock in the company. In 2009 LoJack paid an $18 million settlement in a dispute with a licensee. Changes in the cellular infrastructure in Canada from analog to digital caught the company off guard, leading to write-offs of $3.3 million, $38.1 million, and $14.4 million in 2007, 2008, and 2009, respectively. The company has now completed the build out in infrastructure that is necessary to integrate LoJack units into their Canadian vehicle recovery system.
On October 17th, the company brought Randy Ortiz on board as CEO. He has 28 years of experience in the auto industry, mostly with Ford and related entities. He brings a "deep working knowledge of dealership operations" to the company. Also on October 17th, LoJack named Donald Peck as the new CFO. Mr. Peck is also a former corporate attorney. To the extent that poor management was responsible for recent underperformance, the addition of these experienced individuals could provide a catalyst for improvement.
Competitive Position
LoJack has a proprietary technology that works on a radio frequency (RF) network. LoJack, in connection with the FBI, operates a single radio frequency that the FCC has set aside for the purpose of tracking and recovering property and people. The LoJack system consists of a registration system controlled by LoJack, a sector activation system and vehicle tracking units operated by law enforcement, and a LoJack unit installed in the vehicle. LoJack supplies the sector activation system and tracking units to law enforcement for free and maintains them. Tracking units are present in law enforcement cars and aircraft. When a car is stolen, the victim calls the local police, and a signal is automatically sent out to the tracking units. In most cases, a unit will be near the location of the stolen vehicle and the vehicle is recovered quickly before significant damage is done.
LoJack is clearly superior to GPS for the purpose of tracking stolen vehicles. Crucially, LoJack is able to locate vehicles that are hidden behind buildings or other obstacles that often frustrate GPS. Second, with GPS, multiple calls have to be made after the theft to fully mobilize law enforcement. Third, the LoJack unit is not visible, making it extremely difficult to remove, while GPS units are typically more conspicuous.
It is hard to envision a rational competitor entering the market to compete with LoJack, at least in markets where LoJack is already established. Since LoJack provides equipment to law enforcement for free, a competitor would probably have to offer to pay law enforcement to convince them to switch over. It would also be difficult to duplicate LoJack's relationship with car dealers. LoJack's performance record is so impressive that potential customers would have to offer a comparable product at a lower price point to compete. But it is difficult to envision a comparable product that doesn't rely on close cooperation from law enforcement that can be sold at a high enough margin to recoup the cost of unseating LoJack's position with law enforcement and auto dealers.
In a 1998 paper, Steve Levitt and Ian Ayres study the economics of LoJack. The economists find that LoJack creates a great deal of social value that the company is unable to capture. Car thefts fall dramatically in areas where LoJack is known to operate. This implies that much of the benefit of the existence of LoJack goes to car owners that do not have LoJack installed, and to insurance companies, especially those that do not offer substantial premium reductions to customers who have LoJack installed. If thieves knew which vehicles were protected by LoJack then LoJack sales would likely increase dramatically as non-LoJack users would be unable to "free-ride." While it seems unlikely that this will happen given that it hasn't happened yet, the consolation to LoJack shareholders is that at least they are investing in a firm that provides social value and is likely to be at least left unmolested, if not encouraged, by government.
The LoJack SafetyNet product for rescuing lost Alzheimer's and autism patients hasn't become a material part of the business yet and is currently only offered in three states (Florida, Pennsylvania, and Massachusetts). However, management reports that the business is making slow progress. In my opinion, this could be a very large market. From LoJack's 2010 10K:
"It is estimated that 5.3 million Americans suffer from Alzheimer’s disease and that there will be between 11 and 16 million Americans affected by 2050. Wandering, the most life-threatening behavior associated with Alzheimer’s disease, affects 59% of such patients, and 45% of the cases where the person is not located within 24 hours end in death. Additionally, Autism afflicts one in every 110 children in the United States and children with Autism are prone to wandering."
Once a product like LoJack SafetyNet becomes widespread it could quickly gain momentum and come to be considered a necessity for Alzheimer's and autism patients. Law enforcement, which is responsible for conducting frequently high-cost searches for missing patients, could be an ally in advocating the adoption of SafetyNet. SafetyNet has the same technical advantage over GPS that LoJack has in stolen vehicle recovery.
Balance Sheet
LoJack has a solid balance sheet, with $53.1 million in cash and short-term investments versus 9.5 million of negotiated debt at the end of the third quarter of 2011. Almost all of the negotiated debt is long-term. The firm has a current ratio of 2.2 and a quick ratio of 2.0. Almost $20 billion of the $38.7 million in current liabilities consists of deferred revenues. The firm recognizes revenues on certain services associated with its supplemental early warning product over the estimated life of the vehicle. If you take out cash, the firm operates with negative working capital. Tangible book value of common equity (less minority interest of $0.232 million) is $31.1 million, resulting in a price to tangible book ratio of about 1.5.
Off-balance sheet, LoJack has 2,375,047 stock options outstanding with a weighted average exercise price of $7.30 and an average life of 4.12 years. There is no defined benefit pension plan and there are no other legacy liabilities.
Overall, the firm is solid financially and has the resources to weather most crises and quickly seize opportunities without relying on outside funding. Excess cash has actually reached a level that management might consider increasing its buyback if business stabilizes and the stock remains undervalued.
(First column is "conservative" scenario, second is "realistic," third is "optimistic." $ figures in millions except for per share data)
Risks
-The stock is relatively illiquid. Average volume was about 37,000 shares per day before the delisting announcement.
-Pending legal claims seem unlikely to lead to large losses but one can never be sure.
-Management fails to execute.
-More bad luck.
Catalysts
-Forced or speculative selling resulting from delisting from the S&P 600 small cap index has pushed the stock price down over 14% since November 15th.
-Stock is revalued to reflect normalized EBITDA and free-cash flow over the cycle instead of the current depressed levels of these variables.
-The buyback is increased. Management indicated that they are open to this option in the third quarter conference call.
-Management also indicated that they might be open to a buyout on favorable terms.
-Everything comes together in an impressive fourth quarter earnings beat: auto sales surprise on the upside in the U.S, most of the foreign sales that weren't realized in the second and third quarters materialize in the fourth quarter, Italy finally becomes profitable, Canada has bottomed out, accrued legal expenses are reversed.
-New management is able to execute on opportunities and avoid unnecessary legal and business problems.
-LoJack SafetyNet gathers momentum and the market recognizes the potential of this growth opportunity.
Disclosure: I am long LoJack Corporation (LOJN) common stock.
LoJack Corp. (LOJN) is a cheap, cash generating business with a strong competitive advantage that has become substantially cheaper due primarily to a series of solvable business disruptions and being removed from the S&P 600 index. The stock price plunged from an all time high of $28.84 on December 2nd, 2005 to $2.86 at the close of trading on November 14th, 2011. The price then fell a further 14.33% to close at $2.45 on November 18th on news that LoJack will be delisted from S&P 600 small cap index and replaced by Marriott Vacations Worldwide Corp at the close of trading on Monday November 21st, 2011. I believe that the stock is dramatically undervalued and that quarterly earnings surprises and renewed strong profitability and cash flow will cause the stock price to rise substantially in the coming year as business conditions normalize, new car sales continue to improve, and new management talent applies itself to the firm's problems and opportunities.
Business Description
LoJack is best known as the leading global provider of systems for recovery of stolen vehicles. The firm has been in operation since 1978 and their technology has resulted in the recovery of over 300,000 vehicles worth over $5 billion. The recovery rate of stolen vehicles equipped with the LoJack system is over 90%. The firm operates in three segments: North America (28 states and the District of Columbia) International (32 nations), and all other. The all other segment includes LoJack SafetyNet, which provides technology for rescuing people with disorders such as Alzheimer's and autism who wander off, and SC-Integrity, which provides technology for the recovery of cargo and other valuable business assets. The firm has a 100% ownership in all business lines except for SC-Integrity, in which it has a 60% interest.
The company reported revenues of $34.5 million in the third quarter ended September 30th, 2011, and $138.3 million in the trailing twelve months. In the third quarter, the North American segment accounted for 70.25% of revenues, International for 27.65%, and All Other for 2.1%. About 87% of North American revenues come through sales of LoJack units by new and used car dealers. While the firm receives some revenues from licensing fees and subscription services in the international segment, the bulk of international revenue (about 95% in fiscal 2010) is also derived from the sale of LoJack units. Overall, management estimates that only about $10 million per year in revenue is recurring. The only international market that LoJack operates directly, instead of through licensees, is Italy, which experienced a 43% year over year revenue increase in the third quarter and is expected to reach profitability in the fourth quarter. SCI and LoJack SafetyNet generate revenue from a mixture of device sales and service fees. The company contracts for the manufacturing of most components but assembles some products in house.
Lojack was firing on all cylinders from 2005-2007, with sales peaking at $222.7 million in 2007. The company was hit hard by the great recession and the accompanying steep drop in auto sales. The firm's sales are cyclical and unit volumes tend to track trends in auto sales. The business is also seasonal, with the first quarter the slowest and the fourth quarter the busiest, due partly to year-end deadlines imposed by insurance companies in foreign markets for drivers to get LoJack units installed. So far this year, LoJack has failed to show signs of turning around with the gradually improving auto market. Management cites three reasons for the firm's difficulties in the first three quarters of 2011. First, there has been an unfavorable change in the model mix of vehicle sales in the U.S., driven partly by shortages resulting from the Japanese earthquake. The models most affected by the earthquake are also the models where buyers are most likely to purchase the LoJack system. The chairman states in the third quarter conference call that experts expect these shortages to ease in the fourth quarter. The second problem relates to uneven timing of orders by quarter from international licensees. Part of this was reportedly due to protracted negotiations with the licensees. Management believes that most, though not all of the drop-off in sales in the second and third quarters from prior year figures will be made up in the fourth quarter of 2011. Third, costly and distracting litigation has hampered performance. The firm incurred $2.3 million in legal fees in the third quarter. Though legal actions are ongoing, the firm has reached a tentative agreement to settle a long running California federal employee claims case for $1.6 million, which is part of the $2.3 million in legal fees mentioned above.
Cyclicality aside, LoJack is strong cash generator. Going back to 1997 and including the trailing twelve months, the firm has only had two years, 2002 and 2009, of negative free cash flow, defined as cash flow from operating activities minus net capital expenditures and cash spent on acquisitions. Free cash flow was -$0.4 million in 2002 and -$11.4 million in 2009. Cash flow from operations was positive every year except 2009, when the firm paid an $18 million legal settlement. Average free cash flow over any period beginning between 1997 and 2007 and ending at the end of the third quarter of 2011 is at least $9.4 million per year, without adjusting for inflation.
Management
It is difficult to judge whether some recent setbacks were more due to bad luck or management missteps. Management and directors get stock options and share awards but collectively hold little stock in the company. In 2009 LoJack paid an $18 million settlement in a dispute with a licensee. Changes in the cellular infrastructure in Canada from analog to digital caught the company off guard, leading to write-offs of $3.3 million, $38.1 million, and $14.4 million in 2007, 2008, and 2009, respectively. The company has now completed the build out in infrastructure that is necessary to integrate LoJack units into their Canadian vehicle recovery system.
On October 17th, the company brought Randy Ortiz on board as CEO. He has 28 years of experience in the auto industry, mostly with Ford and related entities. He brings a "deep working knowledge of dealership operations" to the company. Also on October 17th, LoJack named Donald Peck as the new CFO. Mr. Peck is also a former corporate attorney. To the extent that poor management was responsible for recent underperformance, the addition of these experienced individuals could provide a catalyst for improvement.
Competitive Position
LoJack has a proprietary technology that works on a radio frequency (RF) network. LoJack, in connection with the FBI, operates a single radio frequency that the FCC has set aside for the purpose of tracking and recovering property and people. The LoJack system consists of a registration system controlled by LoJack, a sector activation system and vehicle tracking units operated by law enforcement, and a LoJack unit installed in the vehicle. LoJack supplies the sector activation system and tracking units to law enforcement for free and maintains them. Tracking units are present in law enforcement cars and aircraft. When a car is stolen, the victim calls the local police, and a signal is automatically sent out to the tracking units. In most cases, a unit will be near the location of the stolen vehicle and the vehicle is recovered quickly before significant damage is done.
LoJack is clearly superior to GPS for the purpose of tracking stolen vehicles. Crucially, LoJack is able to locate vehicles that are hidden behind buildings or other obstacles that often frustrate GPS. Second, with GPS, multiple calls have to be made after the theft to fully mobilize law enforcement. Third, the LoJack unit is not visible, making it extremely difficult to remove, while GPS units are typically more conspicuous.
It is hard to envision a rational competitor entering the market to compete with LoJack, at least in markets where LoJack is already established. Since LoJack provides equipment to law enforcement for free, a competitor would probably have to offer to pay law enforcement to convince them to switch over. It would also be difficult to duplicate LoJack's relationship with car dealers. LoJack's performance record is so impressive that potential customers would have to offer a comparable product at a lower price point to compete. But it is difficult to envision a comparable product that doesn't rely on close cooperation from law enforcement that can be sold at a high enough margin to recoup the cost of unseating LoJack's position with law enforcement and auto dealers.
In a 1998 paper, Steve Levitt and Ian Ayres study the economics of LoJack. The economists find that LoJack creates a great deal of social value that the company is unable to capture. Car thefts fall dramatically in areas where LoJack is known to operate. This implies that much of the benefit of the existence of LoJack goes to car owners that do not have LoJack installed, and to insurance companies, especially those that do not offer substantial premium reductions to customers who have LoJack installed. If thieves knew which vehicles were protected by LoJack then LoJack sales would likely increase dramatically as non-LoJack users would be unable to "free-ride." While it seems unlikely that this will happen given that it hasn't happened yet, the consolation to LoJack shareholders is that at least they are investing in a firm that provides social value and is likely to be at least left unmolested, if not encouraged, by government.
The LoJack SafetyNet product for rescuing lost Alzheimer's and autism patients hasn't become a material part of the business yet and is currently only offered in three states (Florida, Pennsylvania, and Massachusetts). However, management reports that the business is making slow progress. In my opinion, this could be a very large market. From LoJack's 2010 10K:
"It is estimated that 5.3 million Americans suffer from Alzheimer’s disease and that there will be between 11 and 16 million Americans affected by 2050. Wandering, the most life-threatening behavior associated with Alzheimer’s disease, affects 59% of such patients, and 45% of the cases where the person is not located within 24 hours end in death. Additionally, Autism afflicts one in every 110 children in the United States and children with Autism are prone to wandering."
Once a product like LoJack SafetyNet becomes widespread it could quickly gain momentum and come to be considered a necessity for Alzheimer's and autism patients. Law enforcement, which is responsible for conducting frequently high-cost searches for missing patients, could be an ally in advocating the adoption of SafetyNet. SafetyNet has the same technical advantage over GPS that LoJack has in stolen vehicle recovery.
Balance Sheet
LoJack has a solid balance sheet, with $53.1 million in cash and short-term investments versus 9.5 million of negotiated debt at the end of the third quarter of 2011. Almost all of the negotiated debt is long-term. The firm has a current ratio of 2.2 and a quick ratio of 2.0. Almost $20 billion of the $38.7 million in current liabilities consists of deferred revenues. The firm recognizes revenues on certain services associated with its supplemental early warning product over the estimated life of the vehicle. If you take out cash, the firm operates with negative working capital. Tangible book value of common equity (less minority interest of $0.232 million) is $31.1 million, resulting in a price to tangible book ratio of about 1.5.
Off-balance sheet, LoJack has 2,375,047 stock options outstanding with a weighted average exercise price of $7.30 and an average life of 4.12 years. There is no defined benefit pension plan and there are no other legacy liabilities.
Overall, the firm is solid financially and has the resources to weather most crises and quickly seize opportunities without relying on outside funding. Excess cash has actually reached a level that management might consider increasing its buyback if business stabilizes and the stock remains undervalued.
Valuation
I value LoJack's common stock by estimating normalized earnings power value and then adjusting for items such as excess cash, minority holdings, and stock options. This method is similar to the method taught by Bruce Greenwald at Columbia, except I discount owner earnings at the cost of equity instead of discounting NOPLAT at the weighted average cost of capital. I estimate real "owner earnings" and use a real discount rate to avoid the necessity of estimating the future inflation rate. I consider three scenarios for normal operating income. In the conservative scenario, normal real sales and the EBITDA margin are set equal to the corresponding values for the trailing twelve months, yielding normal EBITDA of $7.2 million. In a steady state depreciation should be equal to maintenance capital expenditures (MCAPX), which I assume to be equal to the average of estimated MCAPX over the past five years in the conservative scenario. I classify almost all of the CAPX over the trailing five year period as MCAPX. This yields an estimated normal real operating income of $1.639 million for the conservative scenario.
In the quarter 3 conference call, management endorses an estimate for normalized annual EBIDA of $14-$15 million over the cycle, less occasional non-recurring legal costs. Using the lower $14 million figure and subtracting $2 million for legal (this year's roughly $4 million every two years) gives EBITDA of $12 million per year for my "realistic" scenario. This could be arrived at by posting normal real sales of $150 million per year and an EBITDA margin of 8%. The $3 million value for depreciation/MCAPX in the realistic scenario represents estimated 2011 CAPX less investment in the firm's new headquarters building. Estimated normal real operating income in the realistic scenario is $9 million per year. Estimated normal real operating income in the optimistic scenario is arrived at by using 10-year averages for real sales and EBITDA margin and comes to $18.385 million.
(First column is "conservative" scenario, second is "realistic," third is "optimistic." $ figures in millions except for per share data)
| Normal Real Sales: | $138.30 | $150.00 | $185.61 |
| EBITDA Margin: | 5.21% | 8.00% | 11.52% |
| Normal EBITDA: | $7.20 | $12.00 | $21.39 |
| Normal MCAPX/Depreciation: | $5.56 | $3.00 | $3.00 |
| Normal Operating Income: | $1.64 | $9.00 | $18.39 |
| Normal Other Income&Expenses: | $0 | $0 | $0 |
| Estimated Interest Expense: | $0.80 | $0.80 | $0.80 |
| Owner Earnings Before Taxes: | $0.84 | $8.20 | $17.59 |
| Estimated Cash Tax Rate: | 30% | 30% | 30% |
| Estimated Cash Taxes: | $0.25 | $2.46 | $5.28 |
| Owner Earnings: | $0.59 | $5.74 | $12.31 |
| Real Discount Rate: | 9% | 9% | 9% |
| Earnings Power Value: | $6.52 | $63.78 | $136.77 |
| Add Cash and Securities: | $50.10 | $50.10 | $50.10 |
| Subtract Minority Interest: | $0.23 | $0.23 | $0.23 |
| Subtract Moving Costs: | $2.35 | $2.35 | $2.35 |
| Value of Common Stock: | $54.51 | $111.76 | $184.75 |
| Shares Before Option Exercises: | 18.417 | 18.417 | 18.417 |
| Share Value Before Options: | $2.96 | $6.07 | $10.03 |
| PV of Option Proceeds: | $5.57 | $5.57 | $5.57 |
| Value of Common After Options: | $60.07 | $117.33 | $190.39 |
| Shares After Option Exercises: | 20.792 | 20.792 | 20.792 |
| Share Value After Options: | $2.89 | $5.64 | $9.15 |
| Share Value: | $2.89 | $5.64 | $9.15 |
| Estimated Probability: | 30% | 50% | 20% |
Point Estimate of Value Per Share: $5.52
All values below normal operating income are the same in all three scenarios. Miscellaneous income and expenses are expected to average to zero. Estimated interest income is not added because cash and short-term securities are added back to earnings power value. Interest expense is assumed to stay constant at the trailing twelve month value of $0.8 million. I conservatively assume a 30% cash tax rate in perpetuity. To estimate the real discount rate, I add the roughly 1% real yield on the 30-year treasury to the roughly 6.5% current implied equity risk-premium for the S&P 500. I then tack on a 1.5% small-cap premium. Keep in mind that this is a real discount rate and would translate into a rate of about 12% if we allowed for a 3% expected inflation premium.
All of the firm's cash and short-term investments are interest-bearing, but I subtract $3 million from the amount of cash added back to account for the estimated additional taxes that would be due if the firm repatriated the cash it holds in foreign accounts. The firm anticipates incurring $2 million of capital spending and $0.5 million in incremental operating expenses associated with moving to its new headquarters building in the current quarter (as an aside, the firm expects to realize savings by consolidating all operations in one location). As these are not recurring expenditures, I take a one-time deduction of $2.350 million for the incremental CAPX and the after-tax incremental expenses. Lojack had 17.7 million shares outstanding at the end of quarter 3 2011, to which I conservatively add 0.717 million in unvested restricted stock to get a total share count of 18.417 million. Before accounting for stock options, this results in an estimated intrinsic value of $2.89/share in the conservative scenario, $6.07/share in the realistic scenario, and $10.03/share in the optimistic scenario.
The firm has 2.375 million stock options outstanding with an average exercise price of $4.10 and an average time to expiration of 4.12 years. I assume that all options will be exercised at expiration, resulting in an increase in the share count to 20.792 million shares. In this scenario, Lojack would receive proceeds of $9,737,692.70 in 4.12 years. I use a very conservative nominal discount rate of 15% to discount this value back to the present, resulting in an addition to value of $5.568 million. Adding that $5.568 million to the value of common equity before the adjustment and dividing by the new share count results in an estimated per share value of $2.89/share in the conservative scenario, $5.64/share in the realistic scenario, and $9.15/share in the optimistic scenario. Since each of these estimates are below the corresponding estimates before accounting for the stock options, these are my final estimates of per-share value. I'm not sure that there is a great deal of value in formulating a point estimate of value in addition to a range, but if pressed to do so I would estimate the intrinsic value of the stock at $5.52/share.
Note that this valuation does not attribute any value to growth. The option to leverage current assets to take advantage of valuable growth opportunities like LoJack SafetyNet surely has some value, but it is difficult to estimate.
Risks
-The stock is relatively illiquid. Average volume was about 37,000 shares per day before the delisting announcement.
-Pending legal claims seem unlikely to lead to large losses but one can never be sure.
-Management fails to execute.
-More bad luck.
Catalysts
-Forced or speculative selling resulting from delisting from the S&P 600 small cap index has pushed the stock price down over 14% since November 15th.
-Stock is revalued to reflect normalized EBITDA and free-cash flow over the cycle instead of the current depressed levels of these variables.
-The buyback is increased. Management indicated that they are open to this option in the third quarter conference call.
-Management also indicated that they might be open to a buyout on favorable terms.
-Everything comes together in an impressive fourth quarter earnings beat: auto sales surprise on the upside in the U.S, most of the foreign sales that weren't realized in the second and third quarters materialize in the fourth quarter, Italy finally becomes profitable, Canada has bottomed out, accrued legal expenses are reversed.
-New management is able to execute on opportunities and avoid unnecessary legal and business problems.
-LoJack SafetyNet gathers momentum and the market recognizes the potential of this growth opportunity.
Disclosure: I am long LoJack Corporation (LOJN) common stock.
The Howard Hughes Corporation (HHC)
Thesis
At the current price, common stock of real estate developer The Howard Hughes Corporation (HHC) provides investors with a margin of safety against permanent capital loss and genuine option value. The stock's most recent close as I write this was at $47.98, about 86% of tangible book value. This is despite the fact that the firm's high quality real estate assets have been written down to levels that reflect the depressed real estate market of recent years. The sponsors of the firm have assembled a very strong board and management team with outstanding records in the real estate industry and have provided strong incentives for them to perform. Possible reasons for why the stock is undervalued include myopia (the firm is unlikely to show impressive financial results in the short term), the lack of analyst coverage, the difficulty in valuing the firm, and general market volatility.
Business Description
The Howard Hughes Corporation was spun-off from General Growth Properties as General Growth emerged from bankruptcy in November of 2010. HHC was organized for the purpose of exploiting a portfolio of real estate assets that did not meet the yield criteria sought by REIT investors or that would benefit from redevelopment activity that might temporarily depress yields. HHC is organized as a C corporation to allow for maximum flexibility in financing and investment decisions (one relatively small consolidated entity, Victoria Ward Limited, is still operated as a REIT). The firm operates in three segments: Master Planned Communities (MPCs), Operating Assets, and Strategic Developments. All assets are located in the United States. The firm is named for the old Howard Hughes Corp. that owned the Las Vegas land that is now the Sutherlin MPC. General Growth bought the 50% of the unsold land in Sutherlin still held by the Hughes heirs for $230 million in September of 2010. HHC also recently bought out Morgan Stanley's 47.5% economic interest in the Woodlands MPC near Houston for $117.5 million, giving the firm 100% ownership in all four of the Master Planned Communities. The firm's strategy is to sell off the land in the MPCs and to redevelop or reposition the operating assets and strategic developments to maximize long-term shareholder value. The operating assets consist of retail and office properties that are currently generating income, though management is looking to redevelop or reposition most of them. The strategic developments segment consists of properties and rights that are not generating revenues and will require "substantial future development to achieve their highest and best use." One example of the firm's strategic developments is the right to build above the Fashion Show Mall in Las Vegas.
My Argument
My thesis on HHC is that the stock represents a free option on the development of currently depressed high quality real estate by a highly capable and well incentivized management team. To demonstrate why I believe the development options are free, I need to convince you that the value of the firm’s current net assets per share are at least equal to the current stock price. To do this I will make two arguments. First, I will argue that the firm’s current book value less the carrying value of the MPCs is a conservative estimate of the market value of those net assets. Second, I will show that a very conservative discounted cash flow (DCF) valuation of the MPCs yields a value above their carrying value. With the stock trading below book value, these conclusions demonstrate that there is a margin of safety in the stock, even with zero value attributed to strategic developments and options to redevelop the operating assets. Lastly, I will argue that the growth options are extremely valuable.
Why Operating Assets are Worth at Least Book Value
The firm’s operating assets were written down substantially in preparation for General Growth’s emergence from bankruptcy and the HHC spin-off. Bankruptcy courts are known for demanding conservative valuations designed to be of more use to bondholders than equity investors. I believe that HHC’s assets have been written down to a level that assumes that the current depressed conditions are a “new normal” in the real estate market. General Growth recorded $630 million in impairments on HHC assets in 2009 and $80.4 million were recorded on HHC operating assets alone in 2010. Riverwalk Marketplace in New Orleans accounted for $56 million of these impairments and Landmark in Alexandria Virginia accounted for the other $24.4 million.
Landmark, located just outside of Washington, DC, still represents an attractive development opportunity. Riverwalk was just starting to recover from Katrina when the recession hit, but it is still well rented and has a great location overlooking the Mississippi river. The property comes with both unique challenges and unique potential. Riverwalk is one of the properties in which HHC is keeping lease terms short to keep redevelopment options open (management admits this in their recent 10Q), which is generally unattractive to major tenants. This provides a second reason to believe that the operating assets are worth at least book value: the assets have significant untapped pricing power.
Valuing the MPCs
The biggest challenge in valuing HHC is valuing the MPCs. The land can’t be sold all at once, and small changes in assumptions about timing of sales, realized prices, discount rates, and the effects of inflation can result in large differences in valuations. Since I am most interested in estimating the low-end case, I performed a DCF valuation using very conservative assumptions. The results of this valuation appears below. I estimate a total value of $1,479,647,491 for the four MPCs. In order to avoid complications arising from inflation, I use real values for cash flows and discount rates. I conservatively assume that real land prices remain constant at today's depressed levels. While I have done my best to use reasonable, conservative values, in some cases my estimates are likely to well off. This is particularly true of my estimates for some of my land price estimates. See the appendix for a more complete description of my valuation assumptions.
| HHC MPC Values | ||||
| Summerlin | Bridgeland | Woodlands | Maryland | |
| Price/Acre Res. | $400,000 | $273,000 | $357,000 | $400,000 |
| Price/Acre Com. | $400,000 | $273,000 | $455,000 | $400,000 |
| Residential acres: | 5,934 | 3,831 | 917 | 8 |
| Commercial acres: | 890 | 1,226 | 936 | 200 |
| Total saleable acres: | 6,824 | 5,057 | 1,853 | 208 |
| Years to sell out: | 27 | 24 | 10 | 8 |
| Com. Acres Sold Per Year: | 33 | 51 | 94 | 25 |
| Res. Acres Sold Per Year: | 220 | 160 | 92 | 1 |
| Proceeds Comm. Sales/yr: | $13,185,185 | $13,945,750 | $42,606,200 | $10,000,000 |
| Proceeds Resi. Sales/yr: | $87,905,185 | $43,578,763 | $32,726,190 | $380,000 |
| Total Land Proceeds/yr: | $101,090,370 | $57,524,513 | $75,332,390 | $10,380,000 |
| % Cost of Sales Land: | 27.25% | 27.25% | 27.25% | 27.25% |
| Cost of Land Sales/yr: | $27,552,156 | $15,678,292 | $20,531,825 | $2,829,066 |
| Share of MPC Expenses: | 48.94% | 36.27% | 13.29% | 1.49% |
| MPC Expenses Per Year: | $10,562,303 | $7,827,924 | $2,868,428 | $321,346 |
| Pre-tax Income Per Year: | $62,975,912 | $34,018,297 | $51,932,138 | $7,229,588 |
| Tax Rate: | 35.00% | 35.00% | 35.00% | 35.00% |
| Taxes: | $22,041,569 | $11,906,404 | $18,176,248 | $2,530,356 |
| After-tax Income/yr.: | $40,934,343 | $22,111,893 | $33,755,889 | $4,699,232 |
| After-tax CF/yr.: | $68,486,499 | $37,790,185 | $54,287,714 | $7,528,299 |
| Real RF Rate: | 1.02% | 1.02% | 1.02% | 1.02% |
| Risk Premium: | 7.64% | 7.64% | 7.64% | 7.64% |
| Discount Rate: | 8.66% | 8.66% | 8.66% | 8.66% |
| Value of MPC: | $706,851,503 | $376,921,278 | $353,675,166 | $42,199,543 |
Completing the Valuation
Next, I compute the value of common equity by adding the adjusted book value of common equity from the Q2 balance sheet (less the carrying value of the MPCs) to the estimated DCF value of the MPCs and subtracting the $117,500,000 that HHC invested near the beginning of Q3 to buy out Morgan Stanley's interest in the Woodland's MPC. With the completion of that transaction, the share of equity attributable to non-controlling interests on the balance sheet is immaterial. I add outstanding stock options to shares outstanding to get diluted shares, but I do not add warrants, as a warrant liability of $298,493,000 already appears on the balance sheet. This value for the outstanding warrants exceeds the estimate that I obtained using an asset pricing model, so I retained the balance sheet value. Dividing the estimated total equity value of $2,144,928,491 by the 38,621,447 diluted shares results in what I believe to be a very conservative estimated value of $55.47 per common share, which is comfortably above the current stock price. Again, this valuation attributes no value to development options.
Total PV of MPC CFs: | $1,479,647,491 |
Book Value Equity End Q2: | $2,130,919,000 |
Less BV of MPCs: | $1,348,138,000 |
Less Q3 Woodland's Purchase: | $117,500,000 |
Total Value: | $2,144,928,491 |
Diluted Shares: | 38,621,447 |
Per Share Value: | $55.47 |
Upside
HHC's real estate portfolio consists of high quality properties in desirable locations such as the South Street Seaport in Manhattan, Ward Centers in Honolulu, and multiple desirable properties in the Washington D.C. metro area, Las Vegas, and the Houston area. I encourage you to read the 2010 10-K for a complete descriptions of the properties. It is important to note that the HHC's chairman Bill Ackman led the group that sponsored the plan for General Growth to emerge from bankruptcy and simultaneously spin-off HHC. This is important because it eliminates the possibility that General Growth might have loaded HHC with inferior properties. Ackman's Pershing Square Capital, along with Brookfield Asset Management and M.B. Capital Partners all hold large blocks of stock and warrants in HHC.
This write-up is long enough already, so I am not going to attempt to quantify the option value that HHC is likely to realize from its strategic developments and its options to redevelop its operating assets, except to say that I believe that it could be multiples of the current stock price. Some financial analysts use the term "option value" loosely to refer to the possibility that something good might happen in a firm's business at some point in the future. However, in order to profitably take advantage of an option to increase capacity in an industry, a firm must have some way of protecting itself from competition. HHC has a clear competitive advantage in the form of unique assets, namely the contractual rights to develop some very desirable locations. HHC also has the ability to lever up to take advantage of these opportunities. Typically, failure on one project, no matter how disastrous, will not destroy the option value of other projects because most of the debt used in HHC's developments will be non-recourse debt secured only by the assets of the project or joint venture entity. Almost all of HHC's current debt is non-recourse.
HHC's experienced and accomplished management is extremely well incentivized with warrants and stock holdings. The company's CEO, President, and CFO even took the unusual step of purchasing warrants with their own funds, and the warrants are not exercisable until 2016 or 2017. Strike prices for the warrants range from $42.23 to $54.40. The further in the money the warrants get, the more the interests of the warrant holders resemble those of long-term shareholders.
Risks
-The housing market fails to turn around in the next few years (current depressed conditions are in fact a "new normal" in the real estate market).
-Management fails to execute. I have no reason to believe that this will happen, but it can never be ruled out.
Catalysts
-Increased analyst coverage.
-High profile profitable projects capture the attention of investors.
-Inflation fears or actual inflation lead to a run on quality real estate.
-"The big one" hits California; Summerlin West becomes oceanfront property.
(kidding about that last one of course).
Appendix: Why My MPC Valuation is Conservative
Most land prices are based on recent sales recorded in HHC's SEC filings, but some are estimated based on similar listed properties. When possible, the low end of the price range is used. I used management's estimates of the number of years for each MPC to sell out from HHC’s 2010 10K and subtracted one year from each. I then simply assumed that the available commercial and residential acreage will sell out uniformly. That is, I divided remaining residential acreage, accounting for sales through June 30th, 2011, by the number of years to sell out for each MPC. I then did the same for the commercial acreage. This results in projections of 472 residential acres and 203 commercial acres sold per year for the first eight years, before the first MPC sells out. If one only considers projected sales in the first year, this assumption could be classified as mildly aggressive. HHC sold 192 residential acres and 36.6 commercial acres in the six months ended June 30th, 2011. This annualizes to 384 residential and 73.2 commercial acres. However, given the state of the real estate market and the fact that HHC has only recently put its full sales team in place, it is not unrealistic to believe that HHC will reach the projected sales level in a year or two. More importantly, in most scenarios it would be assumed that sales will be heavily front-loaded. Using a front loaded pattern of sales with sales decreasing by 10% per year with otherwise identical assumptions (not shown on this write-up, but I can provide the spreadsheet) results in a total estimated value of $1,866,344,496 for the MPCs, versus the $1,479,647,491 estimated in the table. Cost of sales as a percentage of land sale revenues is estimated by dividing the carrying value of the MPCs by the total nominal amount of projected revenues from land sales. Estimated MPC expenses are taken from the 10Q. The share of MPC expenses for each MPC is based on the pro-rated share of acreage. The statutory tax rate of 35% for U.S. corporations is assumed. The real discount rate is estimated as the real return on 30-year treasury bonds plus the implied risk premium on the stock market estimated on October 1st, 2011 by professor Aswath Damodaran. This last figure should be used with caution, especially when stock prices are high, but in this case I believe that the result is reasonable, though conservative. HHC used a nominal discount rate of 8.5% to estimate the value of the Riverwalk asset for impairment purposes.
Disclosure: I am long the common stock of the Howard Hughes Corporation (HHC).
Buffett Demonstrates How to Do a Stock Buyback
There is nothing terribly complicated or nefarious about stock buybacks, though shareholders are often hurt when they are mistimed or are not executed correctly. The recently announced Berkshire Hathaway buyback demonstrates the right way to do it. I hold the following propositions about stock buybacks to be self-evident (and I hope that you do as well):
1. Buybacks should never be considered unless the stock is undervalued.
Buybacks should be considered when the firm's stock is undervalued and when the present value of investing $1 in the firm's existing operations is greater than the present value of investing the same dollar in discretionary capital expenditures or acquisitions. If the firm's stock is not undervalued, then paying the $1 directly to shareholders in the form of a cash dividend is always preferable to using it to buy back stock.
As Buffett stated at the 2004 Berkshire Hathaway annual meeting: "If the stock is underpriced, buy it back with excess cash; if it’s overvalued, don’t buy a single share."
2. Managers should establish a maximum on the price per share that they will pay to buy back stock, and should not establish a minimum on the amount that they will spend on a buyback.
The Berkshire press release reads: "Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares." This drastically reduces the probability of overpaying for shares. In contrast, countless firms in recent years have announced to great fanfare that they will spend X billions of dollars on buybacks over a period that sometimes stretches for years into the future, without naming a maximum price. This is the only example that I know of in which managers and boards profess to believe that they can fix capital allocation decisions years ahead of time.
3. Management should be upfront with all shareholders about their estimate of the firm's intrinsic value.
I don't understand the heavy philosophical discussions about what management's responsibilities are in this situation. It seems clear to me that management has a duty to look out for the interests of all shareholders, up to the moment that they decide to dispose of their shares. If some shareholders still wish to sell after being apprised of all relevant information, then management has done its duty with respect to those shareholders. Continuing with the Berkshire press release mentioned above:
"In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest."
4. Management must never sell into a buyback.
Enough said, right? Well, incredibly, it happens. Buffett, of course, doesn't trade in Berkshire shares, especially not against his own shareholders.
5. When the financial implications of a proposed buyback for management or board members differs from the implications for a shareholder who plans to retain his shares,....well, they really shouldn't, but if they do then at the very minimum this fact should be widely publicized when the buyback is announced.
I'm not keen on proscribing new regulations, but stock options and bonus compensation based on targets like earnings per share (EPS) clearly create a misalignment of incentives between management and shareholders when it comes to buybacks. Dividends are sometimes a better alternative for shareholders, but management and board members with options might avoid them because dividends reduce option values. Similarly, managers who are compensated on per share measures like EPS will prefer buybacks to dividends because they take shares out of circulation. Berkshire avoids these problems by paying executives salaries and performance bonuses that are not directly tied to specific, "gameable" metrics. Buffett has worked hard to instill a culture that will hopefully allow Berkshire to continue to avoid these types of blatant conflicts of interest long after he steps down.
Disclosure: I am long Berkshire Hathaway common stock (BRK-B).
1. Buybacks should never be considered unless the stock is undervalued.
Buybacks should be considered when the firm's stock is undervalued and when the present value of investing $1 in the firm's existing operations is greater than the present value of investing the same dollar in discretionary capital expenditures or acquisitions. If the firm's stock is not undervalued, then paying the $1 directly to shareholders in the form of a cash dividend is always preferable to using it to buy back stock.
As Buffett stated at the 2004 Berkshire Hathaway annual meeting: "If the stock is underpriced, buy it back with excess cash; if it’s overvalued, don’t buy a single share."
2. Managers should establish a maximum on the price per share that they will pay to buy back stock, and should not establish a minimum on the amount that they will spend on a buyback.
The Berkshire press release reads: "Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares." This drastically reduces the probability of overpaying for shares. In contrast, countless firms in recent years have announced to great fanfare that they will spend X billions of dollars on buybacks over a period that sometimes stretches for years into the future, without naming a maximum price. This is the only example that I know of in which managers and boards profess to believe that they can fix capital allocation decisions years ahead of time.
3. Management should be upfront with all shareholders about their estimate of the firm's intrinsic value.
I don't understand the heavy philosophical discussions about what management's responsibilities are in this situation. It seems clear to me that management has a duty to look out for the interests of all shareholders, up to the moment that they decide to dispose of their shares. If some shareholders still wish to sell after being apprised of all relevant information, then management has done its duty with respect to those shareholders. Continuing with the Berkshire press release mentioned above:
"In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest."
4. Management must never sell into a buyback.
Enough said, right? Well, incredibly, it happens. Buffett, of course, doesn't trade in Berkshire shares, especially not against his own shareholders.
5. When the financial implications of a proposed buyback for management or board members differs from the implications for a shareholder who plans to retain his shares,....well, they really shouldn't, but if they do then at the very minimum this fact should be widely publicized when the buyback is announced.
I'm not keen on proscribing new regulations, but stock options and bonus compensation based on targets like earnings per share (EPS) clearly create a misalignment of incentives between management and shareholders when it comes to buybacks. Dividends are sometimes a better alternative for shareholders, but management and board members with options might avoid them because dividends reduce option values. Similarly, managers who are compensated on per share measures like EPS will prefer buybacks to dividends because they take shares out of circulation. Berkshire avoids these problems by paying executives salaries and performance bonuses that are not directly tied to specific, "gameable" metrics. Buffett has worked hard to instill a culture that will hopefully allow Berkshire to continue to avoid these types of blatant conflicts of interest long after he steps down.
Disclosure: I am long Berkshire Hathaway common stock (BRK-B).
The Governor and Company of the Bank of Ireland
The name is a bit of a mouth full for those of us who are into the "whole brevity thing," so I'm just going to refer to it as "the bank" from here on out. The bank is an interesting situation right now. Let me give you some background information.
Ways to buy the bank:
The ordinary shares trade under the symbol BKIR.L on the London Stock Exchange (LSE) and under the symbol BIR.IR on the Dublin Stock Exchange. As far as I can tell, prices on these two exchanges are consistent with one another. The bid-offer spread has been around 0.086-0.088 Euros for most of this week. There is also an ADR, symbol IRE, which represents four ordinary shares and currently trades at around $1.24 per ADR. In most cases the ADR is the easiest and cheapest way for a U.S. investor to buy into a foreign stock, but in this case buyers of the ADR are paying a huge premium. With the Euro trading at around 1.43 dollars, an ADR representing four ordinary shares should trade at around 0.088*4*1.43 = $0.5034, or about fifty American cents. I have no idea what the ADR buyers are doing, but for their sake I hope that they know what they are doing.
Before you rush out to try to buy the shares in London, convert them to ADR's, and sell them in the open market, you should know that Bank of NY Mellon has suspended conversion of ordinary shares into ADR's. At some point they are likely to reopen conversion, at which point the ADR is likely to get hammered, unless of course the ordinary shares have shot up dramatically. So the obvious solution then is to buy the ordinary shares in London and then sell the ADR short, right? Right, but unsurprisingly, it seems to be impossible to borrow the ADR for shorting. I tried it at both of my brokerages and was told the same thing - there is not enough IRE available to short. Maybe some smart guys have already snapped up all available shares, I don't know. According to Yahoo Finance, there are about 7 million shares short, out of about 1.32 billion shares outstanding. Anyway, if you are interested in the stock from the long side, then clearly the thing to do is to buy it in London, right? Well, I thought so myself, until I found that I faced a limit of 500 shares per transaction, and that the commission on 500 shares at 0.088 euros would be four euros, or almost 10% of the purchase price. I know that high trading costs are the norm with low-priced stocks, but it turned out that there was another option. The bank also trades on the U.S. pink sheets under the symbol IRLBF.pk. I was able to land 40,000 shares of IRLBF.pk at $0.13 per share for my personal account at Fidelity while paying only the standard online commission. I should also note that I wasn't even able to buy IRLBF.pk through my other brokerage because the shares are not DTC eligible.
Why would you want to buy this bank anyway?:
I believe that the fix is in on the Governor and the Company of the Bank of Ireland. The bank, founded in 1783, is the only bank in Ireland that is still in private hands. In July of this year, a group of American and Canadian investors purchased about 35% of the bank's ordinary shares at just over 0.10 Euros per share. This group included the investment vehicle of noted billionaire vulture investor Wilbur Ross, Prem "the Warren Buffett of Canada" Watson's Fairfax Financial Holdings, Fidelity Investments (yes, the same Fidelity that I was able to purchase the shares through), Capital Research, and Kennedy Wilson. This is not a shabby group. If you can get the ordinary shares for 0.10 Euros or better, this is the team that you are on.
Ireland's economy is in bad shape, but it has some strong points. The central government is fully funded at least through 2012 and probably through most of 2013. They are actually growing, though very slowly, and they run trade surpluses both within the euro zone and with the rest of the world. Crucially, Ireland seems to have won the battle to keep their low corporate tax rate. They have a young, well educated, and also highly mobile population. Ireland is the only PIIG nation to have agreed to a harsh regime of internal devaluation. If there is a way out of this jam, I think that they will find it, and as the only English speaking country in the euro zone and the advantages listed above, I think that within a couple of years Ireland could return to the strong growth of the 1990's and early to mid 2000's, less the froth from the property bubble.
What about the fundamentals? There is no doubt that the bank will continue to report losses in the immediate future. The Irish mortgage situation is still a mess. But there are some good signs. The bank has plenty of measured regulatory capital. In addition to its Irish presence, the bank has a relationship with the post office in the UK and owns a bank in Connecticut. The bank is also following the central government in imposing austerity. Debt for equity swaps have been "suggested to" junior bondholders at terms favorable to the bank. The most recent half year report shows "benefit changes" that reduced pension benefit costs by 63 million Euros versus the first half of 2010. The conservative Wilbur Ross estimates that the bank's true book value at about 0.26 Euros per share. The bank's most recent half year operating profits before taxes and impairments was 163 million Euros. Doubling that, subtracting 15% for taxes, and dividing by shares outstanding comes to 0.0523 Euros per share by my calculations. Applying a multiple of 8 would value the shares at 0.4187 Euros per share. To what extent these figures might hold when we are done with the writeoffs is difficult to estimate.
I think that this bank survives even if Ireland leaves or is kicked out of the Eurozone. Of course that event would plunge the stock price to near zero, but I think that the government would recapitalize the bank with the new Irish currency and that it would eventually prosper. In most cases one would expect the common to be wiped out, but I don't think so in this case. I think that the impressive group of investors who came in did so with certain assurances. An Ireland cut loose from Europe would want to jealously guard its reputation with North American investors. In short, I frankly don't think that Wilbur Ross and Prem Watsa came into this situation to be duped. I think that in return for providing funds (which went directly to the Irish government) to help get this bank back in private hands, and understanding that this is a long-term investment that is likely to show poor results for an extended period of time, the Irish government has agreed to do everything possible to protect the group's investment. One thing that they might do be able to do, if I'm not mistaken, to mitigate the risk that the mortgage situation will overwhelm the bank, is to use the Irish "bad bank" NAMA (National Asset Management Agency), to issue government bonds to the bank in exchange for mortgages to the extent necessary to keep the bank solvent.
Disclosures:
I am long the common stock of The Governor and Company of the Bank of Ireland. I purchased the stock through the pink sheets under the symbol IRLBF.pk.
Nothing in this blog post should be construed as investment advice. I am not a registered investment adviser, and I will not accept inquires about investment management services.
Pink sheet stocks and penny stocks are generally riskier and less liquid than listed stocks. Many penny stocks turn out to be frauds. I am just repeating this as public service; as this post is not intended as investment advice, nothing I've said here should lead the reader to investigate the pink sheets or penny stocks.
I do not guarantee the accuracy of any of the information presented in this post. It is quite possible that I have gotten some details wrong. Please email me if you spot any errors of fact.
Ways to buy the bank:
The ordinary shares trade under the symbol BKIR.L on the London Stock Exchange (LSE) and under the symbol BIR.IR on the Dublin Stock Exchange. As far as I can tell, prices on these two exchanges are consistent with one another. The bid-offer spread has been around 0.086-0.088 Euros for most of this week. There is also an ADR, symbol IRE, which represents four ordinary shares and currently trades at around $1.24 per ADR. In most cases the ADR is the easiest and cheapest way for a U.S. investor to buy into a foreign stock, but in this case buyers of the ADR are paying a huge premium. With the Euro trading at around 1.43 dollars, an ADR representing four ordinary shares should trade at around 0.088*4*1.43 = $0.5034, or about fifty American cents. I have no idea what the ADR buyers are doing, but for their sake I hope that they know what they are doing.
Before you rush out to try to buy the shares in London, convert them to ADR's, and sell them in the open market, you should know that Bank of NY Mellon has suspended conversion of ordinary shares into ADR's. At some point they are likely to reopen conversion, at which point the ADR is likely to get hammered, unless of course the ordinary shares have shot up dramatically. So the obvious solution then is to buy the ordinary shares in London and then sell the ADR short, right? Right, but unsurprisingly, it seems to be impossible to borrow the ADR for shorting. I tried it at both of my brokerages and was told the same thing - there is not enough IRE available to short. Maybe some smart guys have already snapped up all available shares, I don't know. According to Yahoo Finance, there are about 7 million shares short, out of about 1.32 billion shares outstanding. Anyway, if you are interested in the stock from the long side, then clearly the thing to do is to buy it in London, right? Well, I thought so myself, until I found that I faced a limit of 500 shares per transaction, and that the commission on 500 shares at 0.088 euros would be four euros, or almost 10% of the purchase price. I know that high trading costs are the norm with low-priced stocks, but it turned out that there was another option. The bank also trades on the U.S. pink sheets under the symbol IRLBF.pk. I was able to land 40,000 shares of IRLBF.pk at $0.13 per share for my personal account at Fidelity while paying only the standard online commission. I should also note that I wasn't even able to buy IRLBF.pk through my other brokerage because the shares are not DTC eligible.
Why would you want to buy this bank anyway?:
I believe that the fix is in on the Governor and the Company of the Bank of Ireland. The bank, founded in 1783, is the only bank in Ireland that is still in private hands. In July of this year, a group of American and Canadian investors purchased about 35% of the bank's ordinary shares at just over 0.10 Euros per share. This group included the investment vehicle of noted billionaire vulture investor Wilbur Ross, Prem "the Warren Buffett of Canada" Watson's Fairfax Financial Holdings, Fidelity Investments (yes, the same Fidelity that I was able to purchase the shares through), Capital Research, and Kennedy Wilson. This is not a shabby group. If you can get the ordinary shares for 0.10 Euros or better, this is the team that you are on.
Ireland's economy is in bad shape, but it has some strong points. The central government is fully funded at least through 2012 and probably through most of 2013. They are actually growing, though very slowly, and they run trade surpluses both within the euro zone and with the rest of the world. Crucially, Ireland seems to have won the battle to keep their low corporate tax rate. They have a young, well educated, and also highly mobile population. Ireland is the only PIIG nation to have agreed to a harsh regime of internal devaluation. If there is a way out of this jam, I think that they will find it, and as the only English speaking country in the euro zone and the advantages listed above, I think that within a couple of years Ireland could return to the strong growth of the 1990's and early to mid 2000's, less the froth from the property bubble.
What about the fundamentals? There is no doubt that the bank will continue to report losses in the immediate future. The Irish mortgage situation is still a mess. But there are some good signs. The bank has plenty of measured regulatory capital. In addition to its Irish presence, the bank has a relationship with the post office in the UK and owns a bank in Connecticut. The bank is also following the central government in imposing austerity. Debt for equity swaps have been "suggested to" junior bondholders at terms favorable to the bank. The most recent half year report shows "benefit changes" that reduced pension benefit costs by 63 million Euros versus the first half of 2010. The conservative Wilbur Ross estimates that the bank's true book value at about 0.26 Euros per share. The bank's most recent half year operating profits before taxes and impairments was 163 million Euros. Doubling that, subtracting 15% for taxes, and dividing by shares outstanding comes to 0.0523 Euros per share by my calculations. Applying a multiple of 8 would value the shares at 0.4187 Euros per share. To what extent these figures might hold when we are done with the writeoffs is difficult to estimate.
I think that this bank survives even if Ireland leaves or is kicked out of the Eurozone. Of course that event would plunge the stock price to near zero, but I think that the government would recapitalize the bank with the new Irish currency and that it would eventually prosper. In most cases one would expect the common to be wiped out, but I don't think so in this case. I think that the impressive group of investors who came in did so with certain assurances. An Ireland cut loose from Europe would want to jealously guard its reputation with North American investors. In short, I frankly don't think that Wilbur Ross and Prem Watsa came into this situation to be duped. I think that in return for providing funds (which went directly to the Irish government) to help get this bank back in private hands, and understanding that this is a long-term investment that is likely to show poor results for an extended period of time, the Irish government has agreed to do everything possible to protect the group's investment. One thing that they might do be able to do, if I'm not mistaken, to mitigate the risk that the mortgage situation will overwhelm the bank, is to use the Irish "bad bank" NAMA (National Asset Management Agency), to issue government bonds to the bank in exchange for mortgages to the extent necessary to keep the bank solvent.
Disclosures:
I am long the common stock of The Governor and Company of the Bank of Ireland. I purchased the stock through the pink sheets under the symbol IRLBF.pk.
Nothing in this blog post should be construed as investment advice. I am not a registered investment adviser, and I will not accept inquires about investment management services.
Pink sheet stocks and penny stocks are generally riskier and less liquid than listed stocks. Many penny stocks turn out to be frauds. I am just repeating this as public service; as this post is not intended as investment advice, nothing I've said here should lead the reader to investigate the pink sheets or penny stocks.
I do not guarantee the accuracy of any of the information presented in this post. It is quite possible that I have gotten some details wrong. Please email me if you spot any errors of fact.
Keynes Was a Value Investor
I recently read the book Keynes and the Market, by Justyn Walsh. My personal view of Keynes is that he was a rare genius, and that if he were alive today, the facts having changed, he would hold a somewhat different set of views on the economy than most of today's self-described Keynsians. That's not to say that he had everything right about the depression, but he consistently took on the hardest problems of his time and always moved the ball down the field. Besides, if the Europeans had listened to Keynes about Versailles, there most likely would not have been a great depression.
Walsh's book is extremely well written and provides a pleasant overview of Keynes' life and career as an economist and government official, in addition to a credible account of his exploits as an investor. Keynes made and lost a couple of fortunes as a speculator trying to guess the mind of the market before turning to what is now described as the value approach. After his conversion, Keynes was able to multiply the 8,000 British pounds in net assets he held in 1929 to more than 500,000 pounds in 1936. Many of his friends, associates, enemies and admirers were stunned to learn the size of his estate on his death in 1946. Keynes' six key investment principles are presented on page 164 of Walsh's book. Some of these are paraphrased but I think that they capture the essence of the principles:
1. Focus on intrinsic value, which is derived from earnings power value (EPV), and not on market trends.
2. Look for investments that have a margin of safety. The book does not mention if it is known whether Keynes studied Ben Graham's early work, but Keyne's clearly looked for stocks that were significantly undervalued.
3. Use independent judgement, even if you have to be contrarian.
4. Limit transactions costs and turnover.
5. Run a concentrated portfolio, focused on what Keyne's called "stunners."
6. Maintain the appropriate temperament by balancing "equanimity and patience" with the ability to act decisively. On this last one, Charlie Munger could not have said it better.
Here is a revealing quote from Keynes:
"It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy."
This quote illustrates some of the practical difficulties in operating like a value investor, which explains why relatively few individuals who control significant pools of money are able to use the value approach, which explains in part why the rewards available from the value approach have not been and are unlikely to ever be competed away.
Walsh's book is extremely well written and provides a pleasant overview of Keynes' life and career as an economist and government official, in addition to a credible account of his exploits as an investor. Keynes made and lost a couple of fortunes as a speculator trying to guess the mind of the market before turning to what is now described as the value approach. After his conversion, Keynes was able to multiply the 8,000 British pounds in net assets he held in 1929 to more than 500,000 pounds in 1936. Many of his friends, associates, enemies and admirers were stunned to learn the size of his estate on his death in 1946. Keynes' six key investment principles are presented on page 164 of Walsh's book. Some of these are paraphrased but I think that they capture the essence of the principles:
1. Focus on intrinsic value, which is derived from earnings power value (EPV), and not on market trends.
2. Look for investments that have a margin of safety. The book does not mention if it is known whether Keynes studied Ben Graham's early work, but Keyne's clearly looked for stocks that were significantly undervalued.
3. Use independent judgement, even if you have to be contrarian.
4. Limit transactions costs and turnover.
5. Run a concentrated portfolio, focused on what Keyne's called "stunners."
6. Maintain the appropriate temperament by balancing "equanimity and patience" with the ability to act decisively. On this last one, Charlie Munger could not have said it better.
Here is a revealing quote from Keynes:
"It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy."
This quote illustrates some of the practical difficulties in operating like a value investor, which explains why relatively few individuals who control significant pools of money are able to use the value approach, which explains in part why the rewards available from the value approach have not been and are unlikely to ever be competed away.
Good Quote from Mohammad El-Arian
-Mohammad El-Arian on CNBC's Squawk Box, 7 a.m. hour, April 14th, 2011.
Debt Downgrade Illustrates the Law of Unintended Consequences
S&P has downgraded U.S. government debt from AAA to AA+. While it is easy to lash out at the rating agency for its faulty ratings on mortgage backed securities that contributed to the recent financial crisis, I think that S&P's downgrade decision was justified. Put yourself in S&P's shoes: if you were evaluating a borrower who was openly threatening to refuse to make timely payments on existing debt, would you feel comfortable assigning that borrower the very highest rating available, even if the borrower clearly had the means to avoid default? It seems likely that this line of thinking influenced the downgrade decision:
But then the law of unintended consequences rears its ugly head with the S&P downgrade. Whether the analysts at S&P really believed that congress would have allowed a default or not, S&P has to take congress at its word. So it turns out that there was a downside after all. Maybe it was still worth it, given the concessions that the tea party managed to win. But I think that the lesson to be learned is that it is often easy to outsmart yourself. Sometimes it is better to stick with your core principles and not try to be too clever. I believe that this becomes more true the further up the ladder of responsibility one goes and the more ambiguity that the decision entails. In this case, many members of congress might have been better off just wrapping themselves in the flag, evoking Hamilton and stating up front that they would never allow the U.S. to default on a debt obligation, and choosing another field to fight the debt battle on.
“More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating,” S&P said.I don't believe that there are more than a hand full of members of congress who would have preferred actually allowing a default to simply agreeing to a "clean" debt limit increase. But the tea party reasoned that they could use the need to raise the debt ceiling as leverage to try to force the spending cuts that they favored. The dynamics of the game that the tea party played are interesting, but I think that their reasoning could be boiled down to the following: if we play this bluff we might get more of what we want than we would get if we didn't play it, and the worst that could happen is that the debt limit is raised at the last minute and nothing is lost. If we let it be known publicly that we would never be responsible for a U.S. default, we waste a good crisis, as Rahm Emanuel said.
But then the law of unintended consequences rears its ugly head with the S&P downgrade. Whether the analysts at S&P really believed that congress would have allowed a default or not, S&P has to take congress at its word. So it turns out that there was a downside after all. Maybe it was still worth it, given the concessions that the tea party managed to win. But I think that the lesson to be learned is that it is often easy to outsmart yourself. Sometimes it is better to stick with your core principles and not try to be too clever. I believe that this becomes more true the further up the ladder of responsibility one goes and the more ambiguity that the decision entails. In this case, many members of congress might have been better off just wrapping themselves in the flag, evoking Hamilton and stating up front that they would never allow the U.S. to default on a debt obligation, and choosing another field to fight the debt battle on.
Incentives and Options at Heely's (HLYS)
Heelys (HLYS) is an interesting stock to look at, though it doesn't fit my usual criteria for quality. The company sells those "wheeled sneakers" that were hot with the Bart Simpson crowd a few years ago. You could call it a busted fad. The bad news is that sales fell from $188.2 million in fiscal 2006 to $30.4 million in fiscal 2010. The good news is that the company still has a lot of the cash that it earned in the good years and raised in its IPO. In fact, the company is one of the few that has a negative enterprise value. Based on the latest balance sheet dated March 31st, 2011, HLYS has $62.6 million in cash and short-term investments. As an aside, HLYS has been redeploying cash into relatively safe short-term investments in recent quarters, which has resulted in the reduction in cash on recent cash flow statements looking more alarming than it actually is. Back to this issue of a negative enterprise value, if they paid off the $700,000 in negotiated liabilities, Heely's would still have $61.9 million left over, versus a market capitalization of $60.66 million (HLYS's balance sheet does not show any preferred equity or minority interest).
We can divide Heelys into two parts: A pile of net cash worth $61.9 million, and a money-losing novelty shoe business. The shoe business has $12.4 million in tangible capital - $11.6 million in spontaneous net working capital plus $0.7 million in plant and equipment. Is HLYS worth more dead or alive? In liquidation, any proceeds from liquidating tangible capital and the firms' patents would represent excess value relative to the current share price, given that net cash is roughly equal to the market cap. The only reason not to liquidate the money losing shoe business is that there is some chance that it could move from the red to the black. Putting up the extra cash required to keep a money losing business alive is similar to exercising a call option (its actually like exercising a perpetual compound call option, but that level of detail is not necessary here). In my opinion, it is often illuminating to think of some financial decision in terms of options, but in this case the important thing is that you understand that in most circumstances it is wrong to value a money losing segment in a multi-segment firm at zero or less than zero. If at any stage the value of the option to keep the business alive falls below liquidation value plus the amount cash that you have to put in (the "exercise price" or "strike price" in options parlance), the firm can liquidate and bring the losses to an end.
This is where it gets interesting. Assume that the option to continue to invest in the shoe business has a very low value, well below liquidation value. I suspect that this is the case now, though I don't know that for a fact. There is always the hope that another Heel's fad could sweep through some part of the world. The majority of the company's sales are overseas, though sales appear to have already peaked in some foreign markets. Regardless, even if the shoe business should be liquidated, the problem is that there is little incentive for management to liquidate it. If I interpret the NASDAQ data and the proxy statement correctly, management's stock holdings are not large relative to salary. While by all indications Heely's management consists of ethical and responsible individuals, I tend to emphasize incentives when trying to predict how management will behave. And it is always plausible in a situation like this that management may act both ethically and in manner consistent with their own economic incentives, if they perceive that their incentives are aligned with shareholder's incentives. It is well known that corporate managers are often overconfident about the prospects of their own business. If HLYS were to liquidate the shoe business, it would be difficult for management to argue against simply liquidating the entire company and distributing the excess cash to the shareholders. That leads us to a conclusion that contradicts the assertion that I made above about how the presence of a money losing segment in a multi-segment firm shouldn't decrease the value of the entire firm. One likely outcome for Heelys is that management will continue to exercise the far out of the money option to keep the shoe business alive indefinitely, while meanwhile enjoying the nice compensation package and prestige associated with being an officer of a public company.
Outside of a resurrection of the shoe business or a liquidation, are there any other possible positive outcomes for HLYS? Generally, using the firm's cash for an acquisition is not considered a favorable outcome for shareholders, as there is a strong tendency for management to overpay. In this case, however, an acquisition might free up management to close the shoe business, because their services would still be needed to run the newly acquired business. If Heelys could avoid overpaying by too much, an acquisition might actually increase value by aligning shareholder and management incentives. It would not surprise me in the least for HLYS to acquire a small private toy or sporting goods related company in the near future.
While I find the HLYS' situation interesting right now, I don't see enough value at the current price to make HLYS a buy. I'm not an expert on the business, but I find the cash burn resulting from the buildup in inventories and receivables in the first quarter of 2011 worrisome, especially given that sales declined both quarter on quarter and versus the first quarter of 2010. The buildup in receivables after the Christmas season is of particular concern because receivables fell sharply following the 2009 holiday season (from Q4 2009 to Q1 2010). We'll learn more when the company reports second quarter results on August 11th.
We can divide Heelys into two parts: A pile of net cash worth $61.9 million, and a money-losing novelty shoe business. The shoe business has $12.4 million in tangible capital - $11.6 million in spontaneous net working capital plus $0.7 million in plant and equipment. Is HLYS worth more dead or alive? In liquidation, any proceeds from liquidating tangible capital and the firms' patents would represent excess value relative to the current share price, given that net cash is roughly equal to the market cap. The only reason not to liquidate the money losing shoe business is that there is some chance that it could move from the red to the black. Putting up the extra cash required to keep a money losing business alive is similar to exercising a call option (its actually like exercising a perpetual compound call option, but that level of detail is not necessary here). In my opinion, it is often illuminating to think of some financial decision in terms of options, but in this case the important thing is that you understand that in most circumstances it is wrong to value a money losing segment in a multi-segment firm at zero or less than zero. If at any stage the value of the option to keep the business alive falls below liquidation value plus the amount cash that you have to put in (the "exercise price" or "strike price" in options parlance), the firm can liquidate and bring the losses to an end.
This is where it gets interesting. Assume that the option to continue to invest in the shoe business has a very low value, well below liquidation value. I suspect that this is the case now, though I don't know that for a fact. There is always the hope that another Heel's fad could sweep through some part of the world. The majority of the company's sales are overseas, though sales appear to have already peaked in some foreign markets. Regardless, even if the shoe business should be liquidated, the problem is that there is little incentive for management to liquidate it. If I interpret the NASDAQ data and the proxy statement correctly, management's stock holdings are not large relative to salary. While by all indications Heely's management consists of ethical and responsible individuals, I tend to emphasize incentives when trying to predict how management will behave. And it is always plausible in a situation like this that management may act both ethically and in manner consistent with their own economic incentives, if they perceive that their incentives are aligned with shareholder's incentives. It is well known that corporate managers are often overconfident about the prospects of their own business. If HLYS were to liquidate the shoe business, it would be difficult for management to argue against simply liquidating the entire company and distributing the excess cash to the shareholders. That leads us to a conclusion that contradicts the assertion that I made above about how the presence of a money losing segment in a multi-segment firm shouldn't decrease the value of the entire firm. One likely outcome for Heelys is that management will continue to exercise the far out of the money option to keep the shoe business alive indefinitely, while meanwhile enjoying the nice compensation package and prestige associated with being an officer of a public company.
Outside of a resurrection of the shoe business or a liquidation, are there any other possible positive outcomes for HLYS? Generally, using the firm's cash for an acquisition is not considered a favorable outcome for shareholders, as there is a strong tendency for management to overpay. In this case, however, an acquisition might free up management to close the shoe business, because their services would still be needed to run the newly acquired business. If Heelys could avoid overpaying by too much, an acquisition might actually increase value by aligning shareholder and management incentives. It would not surprise me in the least for HLYS to acquire a small private toy or sporting goods related company in the near future.
While I find the HLYS' situation interesting right now, I don't see enough value at the current price to make HLYS a buy. I'm not an expert on the business, but I find the cash burn resulting from the buildup in inventories and receivables in the first quarter of 2011 worrisome, especially given that sales declined both quarter on quarter and versus the first quarter of 2010. The buildup in receivables after the Christmas season is of particular concern because receivables fell sharply following the 2009 holiday season (from Q4 2009 to Q1 2010). We'll learn more when the company reports second quarter results on August 11th.