Two Improbable Statements Before Breakfast

I ran across two stunning statements this morning in a press release from Contango Oil & Gas Company. The release announced that Contango had revised its oil and gas reserve estimates down by 48.5 Bcfe, to 300 Bcfe.

Regarding the revised estimates, Ken Peak, Contango’s Chairman and CEO, remarked:

“The downward reserve revision is an enormous personal disappointment. I know full well the complexities and numerous uncertainties of reserve estimation, especially early on in a field’s production history. Moreover, the impact of a downward revision is particularly acute when all the Company’s reserves are in essence concentrated in one reservoir. I have full confidence that our reserve estimates were prepared in a careful, conscientious manner and fully consistent with SEC and SPE guidelines. Nonetheless, it is right that the economic pain of this downward revision be shared, therefore, neither myself nor any Contango employee will receive a bonus or stock options for the fiscal year ending June 30, 2010.” (my emphasis added)

Lest the reader miss the economic impact of that statement, be it known that $2.47m of Peak’s $2.64m 2009 compensation derived from options and bonus pay. That’s an extreme pay cut–one of the largest self-inflicted I’ve ever seen (in terms of percentage).

Peak concluded with some commentary on the Gulf oil spill and its impact on Contango:

“The question on many minds these days is the impact of the Gulf of Mexico oil spill on the industry and in our case, Contango specifically. Obviously no one knows, but I will venture an opinion since it goes to the core of our business model and future. I am certain we will face increased regulatory and permitting costs and scrutiny. I believe we can deal with these challenges. I am certain we will face an increased emphasis on safety, and in particular, redundancy in “fail safes”. I welcome these new standards, but believe everything we are currently doing already meets a very high threshold of safety adherence. Hopefully, it is recognized and understood that no human endeavor is ever, and can never be made to be, absolutely, totally and flawlessly 100% fail safe.

“There are two areas that give me great concern. The first is the concept of unlimited environmental liability for a spill, or a limit so high that a debt-free company with an approximate $1.0 billion market cap like Contango is in essence, asked to “bet the Company” every time we drill a well. The move in recent days by some in Congress to retroactively change the law regarding environmental liability does not give me great confidence in our government. Nor do comments about “boots on throats”. The second area that causes great concern is the thought of going to jail for a judgment error or equipment failure – especially if the MMS approved the procedures that were being followed.

“There is at the moment, an enormous amount of understandable emotion and anger together with political populism spewing forth along with the Gulf of Mexico spill, but I believe, and hope, that once the spill is contained, that serious reflection and thought will be brought to bear on how the nation, coastal states in particular, and the livelihood of tens of thousands who depend on a vibrant offshore exploration industry, can beneficially coexist. Contango’s capital expenditure plans, even before this spill, were to “wait out” the upcoming hurricane season, so no adjustment to our capital expenditure plans is required.”

I’ll restrain any tendency to wax philosophical about contemporary political discourse and its relation to a nation’s moral fiber. Indeed pertinent facts still remain hidden from public view. What stands clear–the tone of our conversation today will shape the arc of an industry’s future.

Disclosure: no position

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Buffett’s Berkshire Letter for 1987

1987 was the year the stock market jumped off the cliff. We use the cliché rather flippantly, but perhaps no metaphor better captures a 20.4% single day drop in the S&P 500. Despite the theatrics, the S&P 500 essentially closed the year where it had started, at 247.

Over at Berkshire, net worth gained $464 million in 1987, or 19.5%. Since taking over, Buffett and Munger’s creation has grown book value per share from $19.46 to $2,477.47, or at a rate of 23.1% compounded annually. Unlike past letters, Buffett doesn’t manage down expectations of future returns; perhaps now he’s proven to himself his consistency.

One of the first items on this year’s agenda are the margins and return on equity (ROE) of Berkshire’s seven non-financial subsidiaries–Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See’s Candies, and World Book. In 1987, these seven combined to produce $180 million in EBIT while only employing $178 million in equity capital and virtually no debt. Thinking about it another way “if these seven business units had operated as a single company, their 1987 after-tax earnings would have been approximately $100 million – a return of about 57% on equity capital.” Indeed, quite impressive numbers, even for someone with Buffett’s standards.

How is it that Berkshire’s businesses require such meager portions of capital? As Buffett observes, “the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.” Stated simply, almost every business change requires capital. In a business or industry always in metamorphosis, substantial portions will be consistently consumed. Think here of the ravenous adolescent.

Since the mid-1970s, Buffett has clearly preferred businesses with small appetites, but is his preference generalizable? A Fortune study from 1987 thinks so, for they found “only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: during the decade, 24 of the 25 outperformed the S&P 500.” Where the pace of business and industry change is slow, capital can accumulate and moats develop.

After giving his annual briefing of Berkshire’s non-financial operations, Buffett gives his mind to analyzing their insurance businesses. Insurance, by and large, offers a commodity product, and the industry offers few barriers to entry. By penning a promise, virtually anyone can collect premiums. Like other commodity businesses, price will often be the primary determinant in the purchase decision.

Yet Buffett reminds his owners that “at Berkshire, we work to escape the industry’s commodity economics in two ways. First, we differentiate our product by our financial strength, which exceeds that of all others in the
industry. This strength, however, is limited in its usefulness. It means nothing in the personal insurance field: The buyer of an auto or homeowners policy is going to get his claim paid even if his insurer fails (as many have)… Periodically, however, buyers remember Ben Franklin’s observation that it is hard for an empty sack to stand upright and recognize their need to buy promises only from insurers that have enduring financial strength. It is then that we have a major competitive advantage.”

The second competitive advantage for Berkshire’s insurance business is their “total indifference to volume that we maintain. In 1989, we will be perfectly willing to write five times as much business as we write in 1988 – or only one-fifth as much. We hope, of course, that conditions will allow us large volume. But we cannot control market prices. If they are unsatisfactory, we will simply do very little business. No other major insurer acts with equal restraint.”

Lastly, Buffett’s 1987 assessment of CEOs’ capital allocation was particularly interesting, especially in light of our recent posts on assessing management [see here]. His basic observation is that “the heads of many companies are not skilled in capital allocation.” Yet, shareholders shouldn’t be surprised, for “most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.” The required new skill set “is not easily mastered,” but absolutely and overridingly critical for business success, for “after ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

Of course, today’s technocratic mindset would encourage the CEO who lacks capital-allocation skills to run and hire some pristinely-dressed and well-connected management consultants or investment bankers. Unfortunately, “Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.”

There is much more of interest here—comments on Mr. Market’s mania and depression, Buffett’s buy and hold philosophy, and inflation. But for the aspiring capitalist, the above themes are most important—buy simple businesses, in industries with little change, those with economic moats—if possible, and managed by skilled capital allocators. Oh, and be sure to pay the right price.

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

Candid Management and Widening Moats

[This article first featured on the DIV-Net on April 28, 2009]

Spring is the season for annual reports, and many executives use the occasion to spin a few tales about business in the year past. Though ostensibly these are letters from management to the boss—that is, the owners—far too many seem to take their storytelling lessons from the habits of evasive, guilty teenagers. On rare occasions one finds an honest, clear assessment of the year’s work, and such candor is impossible to miss. For the investor, the spring season is one for assessing the pen of management, in order to discern trustworthy and honest stewards of capital.

Of course, candor from management has almost become an endangered species in recent years. Rittenhouse Rankings Inc. has followed this trend with its annual CEO Candor Scores, and in 2007, found that in shareholder letters “confusing and misleading statements or “dangerous fog,” increased 66 percent… up from 39 percent five years ago.” Instead of providing an impartial and clear analysis of successes and failures, more and more executives speak their Orwellian language, using “words to describe ‘the truth we want to exist,’ rather than facts.” And the point here is not merely pedantic, for Rittenhouse Rankings argue that “high candor scores and rankings reveal high quality leadership, cohesive corporate cultures, more reliable accounting and superior financial performance.”

One CEO known for his candor is Wells Fargo’s John Stumpf.

In his most recent letter to shareholders, Stumpf makes good on his reputation. Though Wells Fargo acquired Wachovia in one of the largest banking acquisitions in the last year, Stumpf does not trumpet their size, for “where [Wells ranks] in asset size alone is meaningless to us… In fact, to our customers, bigness can be a barrier. I’ve yet to hear of a customer walking into one of our banks and saying, “I want to bank here because you’re so … big!”.”

For Stumpf, Wells’ annual success should be determined by two metrics—revenue v. expenses, and return on equity. Regarding the first, Wells’ revenue grew six percent in 2008, while expenses declined one percent—“the best such revenue/expense ratio among our large peers, and the one we consider the best long-term measure of a company’s efficiency.” And on the second, Wells’ return on equity was 4.79 cents for every dollar of shareholder equity, best among their peers for the year. By the numbers, Wells did more with less than the year before, and it had better returns on shareholder capital than peers. Even in a difficult macroeconomic environment, someone had to be the best. For the large American banks, 2008 was the year of Wells.

As an investor, Stumpf’s candor is refreshing, but his focus arguably more important. Rather than telling a lengthy and jargon-laden tale of Wells’ growth or enigmatic synergies, Stumpf reveals his concentration on managing his owners’ capital productively, and optimizing aspects of Wells’ business that he can control. Increasing the loan portfolio may not be a productive use of capital: only if it can be done at adequate margins, and without excessive expense. Rather than spinning a grand story of how our economy went wrong, Stumpf keeps his eye on his business and intelligent opportunities for growth in the year ahead. Though these two tasks need not be exclusive, experience shows that too many bankers love to indulge in forecasting and professoring.

In our assessment of economic moats, managerial ability, more than almost any other factor, directly correlates with the width of a business’ moat. Like Andrew Grove, the best managers are capable of rebuilding a protective moat with a new product, even as past competitive advantages deteriorate. Like Warren Buffett, the best managers are capable of redirecting the life blood for building moats—capital—to the best castles with the ablest builders. Like John Stumpf, the best managers are capable of concentrating their gaze on matters they can control, and each day use capital a little better than the day before.

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

Buffett’s Favorite Manager

In reading through Warren Buffett’s letter to Berkshire shareholders from 1985, he makes the bold claim that “ [the management of Capital Cities] is the best of any publicly-owned company in the country.” In Buffett’s mind are Tom Murphy and Dan Burke, and in Murphy’s case, he presided over Capital Cities’ growth from one television station to a $20 billion dollar company that ultimately merged with Disney in 1995. By Murphy’s estimation, his tenure returned $10000 to owners for every $1 originally invested; can one even imagine a 10,000 bagger today?

In 2000, Tom Murphy sat down with a Director of Media Development at Harvard Business School for this interview. Describing his start as slipping into “a little crapshoot up in Albany, New York,” largely thanks to a story told by Murphy’s father, Murphy came under the wing of an excellent mentor Frank Smith. After some initial struggles and some capital shortfalls, Capital Cities went on an almost unprecedented acquisition spree, ultimately taking it afield, into newspapers, cable, and radio.

If today’s investor is looking for the next Tom Murphy, what attributes should he seek? For one, Murphy encouraged and sustained a “barebones culture,” as CapCities’ early years provided meager capital. To keep operations “tight,” Murphy hired the smartest and most diligent he could find, not necessarily those with the most experience. And he gave his chosen few plenty of responsibility, so that he never had any more employees than necessary.

From the beginning, Murphy “always ran the company, for better or for worse, as if [he] owned 100 percent of it.” And the principle ran deep, as “we really thought about our stockholders. We ran the company to do the best job for our stockholders. We never ran it to get big. We ran it, if we could, to get our stockholders rich.”

Looking back though, Murphy attributes the majority of his success to being well placed at the beginning stages of a great and growing industry. As he notes, “there’s no substitute for being in good businesses, and there are not many of them. If you go into business, the most important thing is to do something you like. That’s the most important thing, but it’s even better if you can do that and pick a business that really has a future… Today, the cable business is a pretty good business. It’s probably better than the broadcast industry, although the broadcasting business has been pretty good in the past several decades too.”

Simple principles, to be sure, but difficult to argue with his results.

Searching for Rational Management

Through the rambling course we’ve taken on this blog, we’ve highlighted a few businesses with wide economic moats. Some offer products that satisfy basic and enduring needs; others sell a commodity product—like insurance or suit liners—but with the lowest cost structure in the industry.  Elsewhere, we seen wide moat businesses with a network advantage that makes their service difficult to replicate—like Craigslist or eBay.

However, I am increasingly persuaded that the caliber and experience of management is the most important criterion for determining the width of an economic moat. Given today’s rapid pace of innovation and competition, even the best businesses will require excellent strategic decision-making and creative problem-solving to survive and thrive. As we saw in Only the Paranoid Survive, competitive forces could have sunk Intel had Andrew Grove not boldly broken their old habits. If such crisis points arrive even more frequently for business managers of our future, a strong case can be made that strong management is the best tool for widening a business’ moat.

To say as much is largely uncontroversial. The real crux is: what are the characteristics of strong management, and what tools can an investor use to reliably find them? For Warren Buffett, strong management concentrates its focus on daily increasing a business’ intrinsic value. From an expense standpoint, that means using each retained dollar in projects that provide an adequate return. It means growing revenues, but only when the projected profits far exceed other available alternatives (which may include buying shares of competitors in the public markets). It means returning capital to shareholders—in the form of share buybacks or dividends—when adequate returns cannot be found internally. The rational manager repurchases shares only when its price resides far below its intrinsic value.

With recent stock market declines, I had hoped to use this opportunity to filter out those management teams who buy high and pause repurchases when prices fall.  But few management teams have taken advantage of the recent declines. And perhaps even more interesting, April saw insiders’ stock sales outnumber purchases by more than 8 to 1! Though some interpret these sales as tax related, call me unpersuaded.  For one, management insiders are often higher net worth individuals, a group that regularly files for tax extensions, so as to not pay until at least October. And second, tax losses are really most valuable when paired with offsetting gains. To justify the level of insider selling we’ve seen, the tax losses would have to be paired with some very long term capital gains, as anyone who has bought and held the market over the last decade would have few gains. Without such capital gains, such selling is excessive for the mere $3000 claim.

Needless to say, I’ve been rather surprised by these findings (consider me naïve). Not only are many companies slowing their share repurchases, many managers seem to be tossing their ownership stakes aside. So the final question is—are they being rational or irrational? Today’s optimist believes that the stock market offers abundant bargains, and would chastise these crazed sellers for their depressive and irrational behavior. The pessimist though sees rationality in these insider sales, for what has fallen down can fall again, and again. Though I’d like to be an optimist, sitting on the other side of 8 to 1 odds can be a bit uncomfortable.

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

Rocky Mountain Chocolate Factory

Lately I’ve been sleuthing for rational capital management. Impressed by FortuNet’s cash distribution, disappointed by Moody’s stagnant buyback plan, and annoyed by KSW’s passivity, it is clear to me that rational management can be found in unlikely places, and that even the most virtuous can settle into vice (which in this case is sloth—sitting lazily on shareholders’ cash).

Reader Sam highlighted Rocky Mountain Chocolate Factory (RMCF)—a franchiser and confectionary manufacturer with 334 stores (as of 2/29/08)—as an interesting wide moat business whose current market price resembles what Warren Buffett paid for See’s Candies, on a number of important metrics. And a quick glance at the recent 10-Ks and Qs depicts a management who has a habit of returning excess cash to shareholders—via dividends and share repurchases. In fact, on its $5.64 share price (as of 4/22/08), RMCF offers a 10 cent quarterly dividend, bringing the stock’s yield to over 7%.

Though the share repurchases seem to have stopped since February 2008 (filings reveal no share repurchases from March 2008-November 2008), management was an aggressive purchaser in better times. And their 10-K reveals their record:

“between January 9, 2008 and February 8, 2008, the Company repurchased 391,600 shares at an average price of $11.94. Between August 15, 2007 and August 28, 2007, the Company repurchased 16,000 shares at an average price of $15.96 per share. Between March 1, 2007 and May 15, 2007 the Company repurchased 76,335 shares at an average price of $13.12 per share. Between May 1, 2006 and February 28, 2007 the Company repurchased 253,141 shares at an average price of $12.94 per share. Between March 24, 2006 and April 28, 2006 the Company repurchased 74,249 shares at an average price of $14.90 per share. Between October 7, 2005 and February 3, 2006 the Company repurchased 185,429 Company shares at an average price of $14.6 3 per share. Between April 18 and April 20, 2005, the Company repurchased 18,529 Company shares at an average price of $13.28 per share.”

All told, that amounts to over 1 million repurchased shares in a three year period, or about 14% of outstanding shares.

Over that same period, RMCF also paid out significant quarterly dividends. Combined with its share repurchases, shareholders basically saw 100% of RMCF’s FCF returned to them.  Perhaps shareholders should rename them the Rocky Mountain Cash Factory.  In fact, it would be hard to ask for much more as an owner; one would only wish that the school that teaches such value creation would open its enrollment to a few more students.

Perhaps in future posts, we’ll look more carefully at RMCF’s financials, and do a comparison with Buffett’s purchase of See’s Candies. But trading less than 9x FCF, and with a management that has demonstrated sound capital management, it certainly warrants that closer look.

Disclosure: I, or persons whose accounts I manage, own shares of Rocky Mountain Chocolate Factory at the time of this posting.

Rational Management at FortuNet

Truly rational capital management too rarely resides in the executive suites of publically traded businesses.  More often, a myopic focus fixes on growing the empire by acquiring more assets, all while ignoring the owners’ interests—the productive use of retained earnings.  Or, perhaps worse, abdicated vision instills an aura of lethargy.

Of course I say as much knowing that I risk branding myself a crank. However, anomalies occasionally surface; when one catches glimpses of such glory, praise should abound. And today, the laurels should go to the Board and managers of FortuNet, Inc.

FortuNet, Inc. is a small, established manufacturer of multi-game and multi-player server-based gaming platforms, based out of Las Vegas, NV. With 50 employees, a market cap of $32.24 million, 11.04 million shares outstanding, and a price of $2.92, FortuNet is not going to turn many heads on the NASDAQ Global Market. Investors though would do well to take a look, since the company recently announced (and shareholders recently approved) that it will be paying a special cash dividend of $2.50 per share on May 4th, to shareholders of record on April 24th.

FortuNet had its IPO in January 2006, which brought net proceeds of $23.7 million. And since that offering, the company has struggled to find ways to put that capital to productive use. Some went to dividends, some to buybacks, but the end of fiscal year 2008 saw FortuNet’s bank accounts swollen with nearly $26.5 million in cash and short-term investments. This at a time when the market valued the entire company at less than $20 million. Of course, FortuNet is not the only microcap whose share price has been hammered in recent months; many—like KSW—have cash balances at their bank that exceed their market capitalization. However, unlike FortuNet, most of these companies are content to sit on their cash and count their pennies; or, even worse, dole it out on overpriced and impulsive acquisitions.

Since FortuNet’s announcement, its market price has soared from its lows. However, even at yesterday’s prices, the market effectively only values FortuNet’s business at about $4.64 million, or 42 cents per share ($2.92 less the upcoming dividend). And this for a business that earned 25 cents per share in 2008.

At these prices, I find FNET a compelling value, whose price and upcoming dividend offers a substantial margin of safety, particularly if the cash distribution is received in a tax-advantaged account (because the distribution may be taxed in a taxable account). After paying out the $27.6 million ($2.5 on 11.04 million shares) on May 4th, FNET will have a book value of about $16 million, or $1.45 per share. And it’s worth bearing in mind that FNET has shown positive FCF over each of the last six years (the only for which Morningstar data is available).

All told, I find FNET’s Board and management worthy of praise, for doing the right thing for its owners, even at the cost of reducing the amount of assets available for them to play with. It requires abundant honesty and candor to openly admit that productive uses for retained cash are too few and too risky. Human nature entices the powerful and capable to overestimate their abilities, and too often the result is irrational capital management. Kudos to FNET; may your fortune match your deeds.

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