Category Archives: Valuation

Berkshire Buys Lubrizol

So Berkshire has announced its latest acquisition—Lubrizol (LZ).

In its latest 10-K, Lubrizol describes its primary business—lubricant additives (primarily for engine and driveline lubricants):

“We believe we are the market leader in lubricant additives, and we intend to remain the leader by continuing to invest in this business. Our Lubrizol Additives segment’s growth strategy is to continue to optimize our product mix while closely aligning production capacity with product demand. Challenging market forces and conditions continue to influence the Lubrizol Additives segment. A key factor is the low long-term global growth rate for this market, which we believe is in the range of approximately 1% to 2% per year.”

Pre-tax operating income in 2010 was $1B, on $5.4B in revenues—both records for the company. At an estimated purchase price of $9.7B (which assumes $0.7 net long-term debt), Berkshire is paying 10x pre-tax OI. And almost 4x shareholder equity.

Lubrizol’s gross profit percentage for 2010 was 33.1%, which also appears to be an all-time high. (2008 marked the five year low, at 22.3%; 2006 saw 24.6%.)

Lubrizol has earned very good returns on shareholder capital (excluding special items) in recent years. Its average return on shareholder equity for 2010 was 34.4%, also an all-time high.

I will not extend the theme, but the drift is clear: this purchase price is not a bargain for Berkshire, given Lubrizol’s results over the last five years. Any margin of safety then must lie solely in expected (and highly likely, one would presume) future performance. At minimum, I would think, Berkshire must expect revenues and margins to remain close to their 2010 performance, for at least the majority of the next decade.

Berkshire was not willing to offer LZ shareholders the option of Berkshire stock (as in the Burlington deal), so that should indicate Buffett’s thoughts on each’s relative value.

Longer term, LZ’s future revenues and earnings may face risks—if, e.g., 1) improved engine design increases drain intervals, 2) new vehicle purchases slow and stagnant, or 3) input costs (particularly petroleum) increase faster than expected.

Clearly, I’m missing some important piece of this puzzle.

Disclosure: I hold shares of Berkshire Hathaway.

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Seanergy Revisited

Over the last few months, many have asked for an update to our previous analysis of Seanergy Maritime. Since January, much has changed. Seanergy did follow through on its planned capital raise, which brought in $30m, but executed at a much worse price (about 1.2 per share) than we expected. A few days later, their plans to acquire a 2009 Capesize vessel were nixed. Though in May, Seanergy announced its new plans to acquire a 51% ownership interest in Maritime Capital Shipping Limited, of Bermuda (“MCS”) for a purchase price of $33m.  Last week Seanergy announced that the MCS deal had closed.  And the following day, they reported Q1 results.

In light of these changed conditions, anglers want to know—would you still “throw it back” at these prices? Frankly, I would.

On first glance, today’s $1.2 per price may appear cheap. With about 60m shares outstanding, and 1m warrants with strikes near these prices, Mr. Market values Seanergy’s equity at ~$73m.

Yet, following the close of the MCS acquisition (i.e., June 3rd), Seanergy’s total assets (including now a fleet of twenty vessels) are approximately $730 million, its total debt approximately $430.8 million, and cash reserves near $84.5 million. These numbers suggest a book value (ex-goodwill) near $4.6 per share. This discount to book has led Seanergy’s management to conclude that today’s price represents “a great entry point.” And according to management’s recent CC remarks, the Restis family (i.e., Seanergy’s majority shareholders) thinks today’s stock price is cheap as well.

Apparently, angling for this bargain need not be a lonely endeavor.

Though in principle I appreciate the support of fellow anglers, my reasons for casting back here are threefold:

1) Seanergy operates in an industry with very weak business franchises (see Buffett’s discussion here). Barriers to entry (or, at least, capacity expansion) are low, with banks today still lending a substantial portion of the cost for new ship construction. Consequently, new supply looks abundant. As of April 2010, the total world drybulk fleet could carry 475.6m Dwt. 2010 should see an additional 109.5m Dwt increase in global drybulk capacity (that’s 23%). And we’ll see 104.3m Dwt more capacity in 2011, with 74.4m Dwt more in 2012 and beyond (according to Clarkson Research Services). As Seanergy plainly acknowledges, the current dry bulk order book is 60% of the world fleet, and most of this will come online in the next 2.5 years. Though I won’t make any predictions about dry bulk rates for 2011, it’s hard for me to see the global shipping trade increasing at a rate sufficient to soak up this oncoming supply.

2) On a liquidation basis, Seanergy’s (now twenty) ships are likely worth less than their current $430m in total debt, and after accounting for minority interests. Run your own back-of-the-envelope calculations on their aging fleet, but recent amendments to their outstanding credit agreement with Marfin Bank of Greece show that their leash is tethered.

3) Even though their current market cap to EBITDA ratio may appear cheap, the metric ignores their significant debt load, and assumes that today’s corporate debt levels will be available in perpetuity. Better always, in my lights, to value businesses based on their enterprise value to EBITDA (or better yet, enterprise value to “owner earnings”).

Let’s say Seanergy earns 48m-60m EBITDA for 2010. If you bought the whole company at today’s market price of ~$1.2 per share, you’d be paying $72m for the equity (given 60m shares out), taking on the $430m in debt, and getting $85m in cash (as of 6/3/10). Call it $417m in enterprise value. For me, that’s not an attractive price to buy the business as a whole, particularly in an industry where depreciation is real and significant industry headwinds loom ahead.

Disclosure: no position

Three Cheers for Tucows?

Tucows logoIn the past, we’ve profiled a handful of microcap companies (FNET, KSW, LIMC, RMCF), either with discernible competitive advantages, particularly rational management, or an imminent catalyst for unlocking shareholder value.

We continue in that vein today by profiling Tucows, Inc. (TCX), an ICANN-accredited internet domain registrar based in Toronto that manages email services and over nine million web domains. Through its subsidiary Butterscotch.com, it also owns one of the oldest and most popular software download sites on the Internet. At present, its principal shareholders include: Lacuna, LLC, which controls 17.7% of outstanding shares (as of 3/23/09), Diker GP LLC (13.7%), and Fertilemind Capital Fund I, LP (5.7%).

About two-thirds of Tucows’ revenue derives from its wholesale domain registration services, being the third largest ICANN-accredited registrar in the world and the largest publicly traded. And like other domain registry servicers (e.g., Network Solutions, GoDaddy), its business model is characterized by non-refundable, up-front payments, which generate predictable, positive operating cash flows. More specifically, Tucows receives payment for the annual registration fee prior to providing the full cost of the service, yet it is required to book those payments and costs incrementally. Looking at its balance sheet, one sees what—at first glance—may appear to be a highly-levered, capital-intensive business with nearly $97 million in assets and $75 million in liabilities. Yet, the bulk of these assets and liabilities pertain to prepaid fees and deferred revenues for their domain registry business. In truth then, Tucows is a cash-rich and largely unlevered business that fills its checking account faster than its earnings statement would indicate. In a way, its revenue resembles an insurance premium—non-refundable, and paid up-front—and enables Tucows to keep its cost of capital very low and perhaps even negative.

However, it is not only the balance sheet that masks Tucows’ virtues. In 2008, Tucows took initial steps to divest non-strategic assets and concentrate energies on its most profitable businesses. This process has complicated its cash flow statements and masked its significant free cash flow growth. For example, in 2006, depreciation and amortization charges of $3.9 million were less than capital expenditures ($4.6 million); in 2008, depreciation and amortization charges of $4.8 million far exceeded capex ($2.1 million). Because Tucows has significant amortization expenses—deriving from the intangible assets of previous acquisitions (i.e., customer relationships)—it has far more cash coming into the company today than its reported earnings reveal.

Lastly, Tucows has raised more cash in the last year by liquidating its $7.5 million equity stake in Afilias and a portion of its domain name portfolio. In their second quarter results (coming out in mid-August), Tucows will book a $2 million pre-tax gain on a portion of its Afilias stake; an additional $2 million pre-tax gain will also follow later this year.

Perhaps most interesting though is where all that cash is likely to go. In the last year, Tucows has used some cash to pay down its long term debt, repurchased 4.2 million shares (about 6% of those outstanding) in a “Dutch Auction” tender offer in March 2009, and repurchased an additional 1.1 million shares in a second “Dutch Auction” tender offer in July 2009. And to date, Tucows has ample room remaining in its $10 million stock repurchase program. Though the future capital allocation decisions are difficult to predict, the chains of habit are not easily tossed aside.

All told, Tucows strikes me as a relatively low margin business with low (and perhaps negative) capital costs that has deployed its retained earnings profitably for shareholders in recent years. Though GoDaddy is the dominant player in the sector, Tucows has added customers and concentrated its business lines. If Tucows continues to divest its non-strategic assets and contain its costs, I would not be surprised to see them earn more than $7 million this year ($4.5 million from operations and $2.5 from after-tax sale of investments). With a market cap of $29 million (as of 7/30/09), management and the Board should have an opportunity to buy back shares quite cheaply.

That is, unless enterprising investors find it first.

Disclosure: I, or persons whose accounts I manage, own shares of Tucows at the time of this writing.

Valuing Limco-Piedmont

lpTHESIS: Limco-Piedmont Inc. (LIMC), trading at less than 50% of book value and about 55% of net tangible assets, offers both a compelling merger arbitrage opportunity and the potential for long-term gains. However, this opportunity is not viable for larger funds, as Limco has a market capitalization of $33.5 million (as of 5/1/09), and in the last three months, has averaged about 26,000 shares traded per day.

BUSINESS: Limco has two business segments—a MRO (“Maintenance, Repair, and Operations”) service for the aerospace industry, as well as a parts supply service. Their FAA certified repair stations provide aircraft component MRO services for airlines, air cargo carriers, maintenance service centers and the military. In conjunction with their MRO services, they are also an OEM of heat transfer equipment for airplane manufacturers. The parts services division offers inventory management and parts services for approximately 600 commercial, regional and charter airlines and business aircraft owners.

Both segments appear to have relatively similar margins, though the parts customers are less ‘sticky’. With credit tight and likely tightening, one tailwind for Limco’s businesses in the next few years will be those carriers who lengthen their fleets’ useable life, electing to maintain and repair older craft rather than replace them with new.

HISTORY: Limco had its IPO on July 18, 2007. Previously it had been a wholly-owned subsidiary of TAT Technologies (TATTF). The IPO raised about $46.2 million, placing 4.2 million shares at $11 per share. TAT retained a majority stake in Limco, which currently has 13.2 million shares outstanding. As of December 31, 2008, TAT held 61.7% of Limco’s outstanding shares.

BALANCE SHEET: Limco has a fortress balance sheet. As of 12/31/08, they had $21.3 million in cash and equivalents, and short-term investments of $11.3 million, consisting primarily of government and corporate bonds and auction rate tax exempt securities. As you would expect, the auction rate securities are currently illiquid, but only amount to $2.25 million of the short-term investments.

Inventories stood at $19 million at 12/31/08, accounts receivable at $11.8 million, and other accts receivable and prepaid expenses at $1.3 million. Total current assets then were $64.8 million, or $4.91 per share. PPE less depreciation was $6.0 million at year end, for $5.36 total in tangible assets per share. Intangible assets and goodwill totaled $6.2 million, which brings total assets to $76.9 million, or $5.83 per share.

Total current liabilities were $9.483 million, and the only long-term liabilities were deferred taxes of $0.8 million. Total liabilities then were $10.3 million, or 78 cents per share.

INCOME STATEMENT: Limco earned $2.7 million in 2008, or 21 cents per share vs. $5.2 million in 2007, or 47 cents per share. A large portion of 2008’s decline came from two one-time items: 1) $1.4 million in scrap expense, related to a “new program start-up in the OEM division [that] we believe should not be recurring,” and 2) an increase in general and administrative expenses “primarily attributable to approximately $837,000 in one-time SOX and public company costs.” (10-K)

MERGER ARBITRAGE: On April 3, Limco announced that it had entered into a definitive agreement and plan of merger with TAT Technologies for one half share of TAT for each share of Limco. For the week April 13-17, Limco traded between $2.32 and $2.48, and TAT between $5.12 and $5.51. If one were to set the long LIMC/short TATTF trade well, that spread has ranged between 5-20% since the announcement.

However, it is my belief that there is a better than 50% chance that TATTF will have to come back with a higher offer to close this deal, as at least a handful of litigious types have been trying to organize shareholders to block the “unfair price” (e.g., Levi & Korsinsky, LLP). So what’s a fair price?

VALUATION: At the highest end of the range, one could argue for a buyout at the original IPO price of $11 per share. Book value and cash have increased since the IPO, and Limco has added some valuable capital expenditures to generate future earnings power. In effect, $11 per share could represent paying book value of $5.05 per share, plus a 11x multiple of $0.55 per share annual earnings power. Though $0.55 exceeds 2007’s numbers, TAT could realize such earnings fairly easily through the additional cost savings that Limco would gain if it no longer publically reported and filed under Sarbox. For TATTF and other potential buyers, the regulatory cost savings for a company this small will significantly impact its future earnings power.

At the low end of a valuation range, one could value LIMC’s assets in liquidation. A conservative liquidation analysis would value cash and short-term investments at 100%, the auction rate securities at 75%, accts receivable at 75%, inventory at 50%, PPE at 20%, and liabilities at 100%. This would yield a liquidation value of $32.44 million ($30.35 million+$1.69 million+$9.5 million+$1.2 million-$10.3 million), or $2.46 per share.

However, in my lights, the liquidation value of LIMC understates its intrinsic value, given its demonstrated earnings power. Thus, a fair price for Limco as a going concern would likely include paying for their net tangible assets, plus an additional multiple for the earnings power. For a business with high capex costs, the same approach may overstate its value (see, e.g., Buffett’s reflections on overpaying for Berkshire Hathaway though it traded below its net tangible assets). Yet, Limco’s capex in 2007 was $2.9 million, and $1.7 million in 2008; both of which included some one-time items. Maintenance capex for Limco is likely close to its $1 million depreciation expense over the last three years.

With net tangible assets of $60.5 million, or $4.58 per share, and a 5x multiple of what I estimate to be their average annual free cash flow of $4 million, you get a value of $80.5 million, or $6.10 per share.

Of these three values, the last I find most reasonable, and representative of what a knowledgeable buyer should be willing to pay for the whole business.

Were shareholders able to get a better price, the upside could be substantial. Even an offer of $4 per share (still below net tangible assets) would represent more than 50% upside at these prices. Yet, even without a better offer, the long/short arbitrage should return 5-20%. In the event that the merger does not close, Limco at these levels offers a significant margin of safety to my estimate of its private party value.

Disclosure: I, or persons whose accounts I manage, own shares of Limco-Piedmont at the time of this writing.

Moody’s Intrinsic Value

moodys-logo2008 was a tough year for Moody’s Corporation, with free cash flow (FCF) levels falling to 2003 levels, or $450 million. In our previous analysis, we argued that Moody’s economic moat has shrunk over the last couple of years, as its credit ratings for structured finance products proved unreliable for predicting distress and default risk. So far though, Moody’s credit ratings for municipal and corporate debt have been reliable. The question for today—what price would Moody’s Corporation command from a private buyer in light of recent events?

In the past, we have introduced Seth Klarman’s three methods for valuing a business—by determining its liquidation value, the net present value (NPV) of its future cash flows, or its value relative to similar businesses trading in the public markets. Since Moody’s has a negative book value and has no comparable standalone competitors in the public markets (Standard & Poors is embedded within The McGraw Hill Companies), the NPV approach here is appropriate. And with the help of Morningstar’s FCF data, a NPV analysis is not a difficult exercise.

Since 2001, Moody’s has grown its FCF from $291.5 million to $450 million (FY 2008). As many know, in order to value future cash flows, an investor must make a reasonable estimate what they will be. In Moody’s case, estimates could vary widely, as its FCF in 2007 was $802 million. If we use past growth rates of FCF to estimate Moody’s future, we will get very different growth rates using the FCF data from 2002-2007 vs. those from 2001-2008. The former period shows a FCF growth of 20.4%, and the latter 6.4%.

For today’s analysis, I will use the latter—a 6.4% FCF growth rate—as it likely better approximates Moody’s business prospects over the next decade. Following upon a period of robust growth in its structured products ratings division—a division whose revenue has now fallen by half YOY—it is hard to imagine Wall Street’s structured products returning to their previous levels in the near future, much less to grow at their past rate.

Assuming then that Moody’s will grow its FCF from 2008’s $450 million at 6.4% per year for the next decade, and then assuming that it will continue to grow at 3% for the following decade, Moody’s should throw off $16.3 billion over the next two decades for its owners. If we discount those cash flows at 9% (an estimate of average stock market returns over the long-term), the NPV of those sixteen billions should be $6.578 billion. However, if today’s buyer offered $6.578 billion, he would be assuming a business with nearly a billion dollars in negative book value. Knocking $994 million off the expected purchase price would value Moody’s equity and future cash flows at $5.583 billion. With 235.2 million shares outstanding, the prospective buyer should be willing to pay $23.74 per share for Moody’s.

Of course, at $23.74, the buyer’s assumptions better be correct, because he’s paying fair value for the business and its earnings power. For investors like Warren Buffett, paying fair value typically does not offer a sufficient margin of safety; to warrant investment dollars, Buffett wants to buy dollars for fifty cents. Here a 50% margin of safety would suggest that the investor only purchase Moody’s below $11.87 per share. As of Tuesday’s close (4/7/09), Moody’s traded close to its intrinsic value, at $22.20 per share.

Disclosure: No position

Buffett’s Berkshire Letter from 1978

buffett1978 saw Menachem Begin and Anwar Sadat sign the Camp David Accords between Israel and Egypt. Resorts International (now Resorts Hotel and Casino Atlantic City) became the first casino on the East Coast. And Norman Rockwell took this year to be his last.

Over at Berkshire Hathaway, Warren and Company generated operating earnings on shareholder equity (exclusive of capital gains) of 19.4%–within a fraction of their 1972 record. Mr. Buffett of course dallied with his typical modesty, attributing the gains to his operating managers and a “bonanza period for the insurance industry.”

In this year, Berkshire breaks out each of their four business lines for special scrutiny—textiles, insurance, banking, and retailing.

As in 1977, textiles returned meager capital, given the cost of past investment; with $17 million invested, $1.3 million returned. Buffett sounds a bit exasperated as he recounts management’s attempts to improve the business: “obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc.” Yet, suit liners are difficult to differentiate, and too many are willing to produce them. And so, “the textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage.”

In insurance, the “bonanza period” from 1976-1978 generated an abundance of float for Buffett to put to work, but not all was bliss. Over at National Indemnity, they had been struggling with losses in their California Worker’s Compensation division. Frank DeNardo was tasked with finding a solution in the spring of 1978, and the solution he found was writing 75% fewer policies. For those looking for a lesson in insurance underwriting, take this case study as your first lesson. When business is soft and premiums low, follow DeNardo and write fewer policies. Of course, the required discipline is extremely rare; how many insurance companies do you know that are willing to tolerate 25% of last year’s business volume? I suspect none.

Lastly, Buffett gives his shareholders insight into how he conceives of equity investments. By year’s end 1978, Berkshire Hathaway’s insurance companies held nearly one million shares of SAFECO, another publically traded insurance giant. To some, this purchase may seem odd; why not just compete with SAFECO straight up and steal their market share?

As Buffett notes, “SAFECO is a much better insurance operation than our own…, is better than one we could develop and, similarly, is far better than any in which we might negotiate purchase of a controlling interest. Yet our purchase of SAFECO was made at substantially under book value. We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions. And there is no way to start a new operation – with necessarily uncertain prospects – at less than 100 cents on the dollar. Of course, with a minor interest we do not have the right to direct or even influence management policies of SAFECO. But why should we wish to do this? The record would indicate that they do a better job of managing their operations than we could do ourselves. While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management. Because, quite clearly, if one controlled a company run as well as SAFECO, the proper policy also would be to sit back and let management do its job.”

I would contend that such a statement is unprecedented in the recent history of American capitalism. Have you ever heard a manager say that a competitor provides a superior product, and that it is a more prudent use of capital to buy the competitor’s company in the stock market than to spend capital in an attempt to unseat them? To be this impartial and rational is remarkable, and sets a high bar for others to follow. One over which very few can jump.

In closing, I leave you one more Buffettism worth a smirk–“Our experience has been that the manager of an already high-cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.” So remember, being “resourceful” is not necessarily a compliment.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

[This post continues our series on Warren Buffett’s letters to Berkshire Hathaway shareholders.  Part I is here.]

Valuing Target

target-logo-copy1Friday we compared some big box retailers and argued that Target must serve up its wares with some secret sauce, for it has relatively strong margins. However interesting, if we are to assess Target as a business owner, our analysis should quickly move to its assets and earnings power.

First, the assets. At the close of their fiscal year—January 31, 2009, Target had 44.1 billion in total assets versus 10.5 billion in current liabilities and 19.9 billion in non-current liabilities; shareholder equity then stood at 13.7 billion. Yet, some have argued that Target’s balance sheet currently understates the value of two important assets—their remaining stake in their credit card business, and their real estate property. For example, William Ackman, founder and fund manager at Pershing Square Capital Management, has recently been agitating Target’s management to spin off some of its real estate into a REIT-like structure, with the assumption that the two parts valued separately would demand a higher price than the current aggregate. So what are these two important assets worth?

In 2008, Target sold half of its credit card business to JP Morgan for $3.6 billion; today the remaining half may not fetch the same price, but it is unlikely that it would be worth less than $2 billion. Pershing, in its public presentation on Target, values the remaining credit card receivables at $4.4 billion. A strict average would put a price of about $3.3 billion on the credit card business.

As for the real estate, estimates range widely. In Pershing’s public presentation of its REIT plan on Oct. 29, 2008, they highlight that the gross book value of Target’s owned real estate is $25.2 billion, and its replacement value near $39.1 billion. Were the REIT spun off, Pershing estimates that it would carry an equity value of $29 billion within twelve months (see the Nov 19, 2008 follow-up presentation). Again, a strict average of these three estimates would price the real estate at $31.1 billion.

Of course, there still remains the question of Target’s value as an operating retailer. Any valuation estimate would require some sales and earnings assumptions, but if we take their trailing 5 year average EBIT at $4.5 billion and give it a 6x multiple, we could conservatively value Target’s operating business at $27 billion. In sum, these three parts should carry a fair value of $61.4 billion to a private owner. As of Friday’s close (3/27/09), the market valued the entire company at $25.7 billion.

So, what’s the market missing? If Target is currently valued at less than 50% of its intrinsic value, shouldn’t bargain hunters be snapping up shares?

In my lights, the answer is cash flow. Looking at Morningstar’s numbers, one can see that Target’s free cash flow is quite low, given the wealth of assets that they must use to generate that cash. In fact, it has only broken a billion in FCF once, in 2006. For Target, almost all of its cash flow has been poured back into its business, with capital expenditures consuming at least 75% of its cash flow on an annual basis, for at least the last decade. And the crucial question for the shareholder must be, how long will this endure?

At some point, Target’s FCF does not find its most profitable home in future expansion. Hopefully that point is in the future, but it may be already past. Once Target has built enough stores, future stores will cannibalize the elders. And at that point, capital expenditures will need to come down, and the excess cash flow redirected into more productive endeavors. This is the crucial capital allocation test for retailers; can they transition their strategy prudently? Given Target’s current share price, a good number seem to doubt that they can.

Disclosure: No position