Monday, December 1, 2008
For the 3rd quarter revenue fell 10% pushing the company into a loss of $.1 million. Backlog continues to point towards declining sales. Total backlog is down 29%, comprising of a decrease of 35% domestically and a decrease of 25% internationally. K-Swiss is heading for a loss of $10-35 cents per share in the forth quarter. During the conference call manegment said that they are expecting a loss in 09 that could possibly burn through 10-20% of their cash. Separately K-Swiss announced during the past month that they will pay a special $2 dividend to shareholders on December 24th. This is a very positive sigh because on an enterprise value basis K-Swiss trades for less the 2 times my estimate of earnings a few years down the road. The CEO and CFO are two of the most candid managers out there, the decisions being made by the company show their philosophy of not thinking short term. I’m hoping the stock gets cheaper in the near term as I’m ready to buy a lot more. K-Swiss should easily be able to earn $60-90 million in net income when the economy improves. K-Swiss is currently trading for $400 million with nearly $300 million in cash. My estimate of intrinsic value $1250.5-$1478 million
Read my investment thesis on K-Swiss here
FCA is suffering from a downturn in the coal car cycle after the cycle peaked in 06 and customers over ordered. The poor economy also has a large negative effects on FCA. The 3rd quarter results were good but with the threat of a recession it is premature to say that the bottom of the coal car cycle has been reached. For the quarter sales were $238 million compared to $162 million in the same quarter last year and for the 9 months ended sales were $474 million compared to $680 last year. Net income declined to $7.4 million from $8.7 last year for the quarter. For the 9 months period the net loss was $3.7 million compared to a net income of $43 million last year. Orders during the quarter were 2329 compared to 1400 last year. Backlog at quarter end was 4401 units. FCA delivered 3082 railcars in the quarter compared to 2072 in the 3rd quarter last year. For the 9 months ended FCA delivered 6695 railcars compared to 8677 last year. FCA was hurt by material cost increases and large costs to close the Johnstown facility. To date the cost of closing the facility was $51 million and the remaining costs are small. FCA is trading for $258 million with $128 million in cash. My estimate of FCA’s normalized free cash flow is $36 million. FCA’s enterprise value is $130 million. My estimate of intrinsic value is $40-60 per share.
Read my last post on FCA here
American Eagle Outfitters
For the third quarter American Eagle had net income of 30 cents which includes a 9 cent writeoff of investments in auction rate securities. That compares to earnings of 45 cents last year. Sales were up 1%. Third quarter same store sale were down 7%. Operating margin was $95 million compared to $151 million or 12.6% vs. 20.3% in the same period last year. Results in the 3rd quarter 2008 include a $19.9 million impairment on the value of auction rate securities. Net income was $43 million vs. $99 million. The bright spot was AE Direct where sales increased 35% in the quarter. American Eagle has a market cap of $1.9 billion. Cash and investments total $616 million resulting in an enterprise value of $1.3 billion. Operating margins have averaged around 20% in the past compared to 12.6% in the last quarter. Even with operating margins around half of what they have averaged historically, American Eagle will be able to generate around $180 million in earnings a year. In addition American Eagle is an enduring brand with a lot of growth ahead with the new ventures such as aerie, Martin and Osa, AE Direct and 77 kids. A conservative estimate of intrinsic value is 2-3 times the current price.
Read my investment thesis American Eagle
Nicholas Financial reported earnings of $792 thousand down from $2.6 million in the 3rd quarter last year. Revenue increased from $12.6 million to $13.5 million as the company continued to write new contacts. The new contracts are extremely profitable as NICK’s competitors retreat from the market. This pushed net finance receivables up to $210 million from $189 million in the quarter last year. The provision for credit losses was $5.1 million up from $1.6 last year in the quarter. This pushed the net portfolio yield down to 2.5%. The provision for credit losses is 9.86% so a 30% increase in the reserve would cause losses. The factor that most effects NICK is the unemployment rate. Management expects the charge off rate to worsen slightly in the fourth quarter. The strong point though is NICK’s reserve for credit losses that stands at over $23 million. This compares to charge offs over the last 6 months of $11 million. So the reserve is at a very healthy level. Nicholas Financial is trading for $25 million with $83 million in book value.
Read my investment thesis on Nicholas Financial
For the 3rd quarter Pinnacle reported revenue of $220 million vs. $203 for the same period last year. Operating margin improved to 9% from 7.3% last year. Operating income was $20 million compared to $15 million last year. Pinnacle has $64 million in cash and $127 million in auction rate securities. For the 9 month period operating income was $29 million vs. $43 million but the 2008 period contains a $13.8 million impairment on the value of the goodwill related to Colgan. Pinnacle currently has seven addition aircraft in it’s fleet that are being flown temporarily for Delta. Pinnacle has lead all regionals in operating performance for the past 22 out of 33 months. Colgan’s operations are beginning to turn around as its contracts with the government were rebid during the quarter. Management expects that Colgan will be profitable in 09. Also all the Q-400's are operational. Operationally Pinnacle is doing alright. The over supply of 50 seaters in operation is hurting them. They continue to generate a healthy amount of cash and a $30 million tax refund will be received in the first quarter.
Mohnish Pabrai began selling his stake in Pinnacle a few months back. No matter what, airlines are problem businesses. I now regret my investment in Pinnacle. My mistake was that I focused on PNCL as not really an airline company and I didn't consider the macro factors. I assumed that the contracts were solid. But when the customer is making all the money and the operator has the control, there is going to be problems. What Delta did was also caused by the over supply of 50 seaters in the market today. It doesn't make sense that the airlines would tolerate the regionals making so much money when economic conditions have caused them to be losing a ton on the other side of the deal. But the contracts do allow the parents to swap the 50 seaters for larger planes on a one for one basis. The result is yet to be seen but clearly Pinnacle has been impaired. But, PNCL has $200m in investments and 3rd quarter results were not bad. A healthy level of FCF is being generated. In my last post on Pinnacle I considered the worse case scenario and estimated a liquidation value. Given the price Pinnacle is trading at I’m holding.
Read my other posts on Pinnacle here
Sunday, November 30, 2008
Footstar runs the footwear departments in 1,383 Kmart and 833 Rite Aid stores. In March 2004, due to poor acquisitions, accounting problems and then liquidity issues, Footstar went into bankruptcy. In February 2006, the company emerged and paid creditors in full. While in bankruptcy in 2005 after years of litigation the contract with Kmart was amended. Originally set to expire on December 31, 2012, the contract now expires on December 31, 2008. After the contract expires Footstar will liquidate.
On April 30th 2008 Footstar paid a $5 taxable dividend. On April 3rd 2008 Footstar sold substantially all of its intellectual property to Kmart for $13 million. On June 30th 2008 Footstar paid a further $1 dividend.
When the contract expires at the end of the year, Kmart will purchase the inventory related to its stores excluding unsalable or damaged inventory for book value. Any seasonal (4 months past season) will be purchased for 40% of cost. Footstar has already reserved $2.4 million for seasonal inventory. Any unsalable or damaged inventory will not be purchased.
The other asset remaining is Footstar’s headquarters building located in Mahwah, NJ and is listed for $19.5 million. Mike Lynch told me that they have had interest in the property but nothing has materialized.
K-mart agreed to hire substantially all store and district managers. Footstar eliminated 3 executive positions and notified 218 employees of termination. The severance cost related to these employees is $8.5 million plus $2 million in benefit costs, with $3.6 million already accrued, $6.9 million in remaining severance is not yet expensed. It is my understanding that this accounts for all of the severance. I spoke to Mike Lynch whose is CFO. This is what he said "All employees are accounted for at this juncture, but it is possible that additional severance/retention measures could still be put in place depending upon the circumstances."
The last item that needs to be accounted for is Footstar’s second half 08 operating earnings. Considering income taxes is virtually nil due to deferred tax assets, operating earnings is the best metric to use. Operating income was $28.4 million for the first half. But, this includes a gain of $22.3 million for the reduced severance after Kmart agreed to hire all store and district managers. A charge of $2.4 million for the seasonal inventory and $3.6 million in severence related to the portion that has already been expensed. Neting out these items gives operating earnings of $12.1 million compared to $21.5 million or the first half last year. The factors effecting second half earnings will be lower operating expenses due to lower headcount and weaker retail environment. In the first half Kmart recorded same store sales declines of 6% compared to Footstar’s decline of 10.6%. Operating earnings declined 40% in the first half. Operating earnings was $32 million in the 2nd half of 07. My best case and worse case 2nd half 08 operating earnings estimate is $19-$25 million.
Here is a chart showing the balance sheet at June 28, 2008 adjusted to the expected liquidation value:
My estimate of second half cash flow could prove to be way off especially given the current situation in the economy. My estimate is fairly conservative but the results remain yet to be seen. But keep in mind that even without the 2nd half cash flow tangible equity is $82 million compared to a market cap of $60 million.
Sunday, November 2, 2008
K-Swiss, Inc engages in the design, development, and marketing of athletic footwear for sports use, fitness activities, and casual wear. It also markets apparel and accessories under the K-Swiss the brand name. In 2001 K-Swiss acquired Royal Elastics.
K-Swiss was founded in 1966 by two brothers dissatisfied with the tennis shoes in the market. The two Swiss brothers developed the K-Swiss Classic. In 1986 Steven Nichols then the president of the Children’s shoe division at Stride Aide recognized the timeliness of the shoe and tried to convince his bosses to buy the company. They refused and Nichols left the company and formed an investor group that acquired K-Swiss for $20 million. At the time K-Swiss was basically in bankruptcy. In 1990 K-Swiss went public. Nichols has grown the company from sales of $20 million in 1986 to $410 million in 2007. The K-Swiss Classic still represents two-thirds of sales with only slight changes to the shoe from the original in 1966. The Classic has since developed into a casual shoe. In the mid nineties Warren Buffett offered to buy the company but Nichols refused to sell. He said that he greatly admires Buffett but that Buffett offered no premium for the company. Nichols owns 22% of the company and insiders control 25%, Third Avenue owns 12%.
The shoe sold today is virtually indistinguishable from the original Classic sold in 1966. The Classic is popular with teens. Nichols has a very different strategy then most shoe companies. The extremely long durability of the Classic shoe is a competitive advantage. The product development costs are drastically lower then its competitors who are constantly introducing new models. The shoe’s distributors also are benefitted because the shoe doesn’t need to be marked down when new models are constantly introduced. K-Swiss is the most profitable vendor for the stores it distributes shoes to. K-Swiss is very selective with the venders they will supply to. K-Swiss avoids saturating the market with the Classic because that degrades the image of the brand. For the past 10 years gross margins have averaged 45% compared to 42% at Nike, 41% at Sketchers and 39% at Steven Madden. Operating margins have averaged 17% compared to 11% at Nike, 7% at Sketchers, 8% at Steven Madden. The 10 year average ROIC and ROE is 22% and 25%.
K-Swiss is currently getting hit on two fronts. They are out of style and facing a consumer spending slowdown. In addition the popularity of Crocs, canvass shoes and flip flops has disrupted the market. In 2006 with the stock soaring Nichols started telling shareholders that their product and marketing was not satisfactory. He said this before Wall Street realized it. Sales slowed in 2007, falling 18%, domestic sales were down 37% and international revenue was up 14%. Net income plunged 50% in 2007. For the first half of 08 domestic sales fell 33% and international fell 17%. Nichols response to this situation has been to pull back on supply and even cut off some of the vendors. He said this resuscitates the brand and allows the company to come back stronger. He maintains spending on marketing and product development.
Nichols has done this four or five times in the past with success. Around ‘94 K-Swiss was hit by softening demand. Nichols hired new marketing people who introduced the Classic Limited Edition. That drove sales up until the next slump which occurred in 2000. K-Swiss pulled back on the limited edition and focused on the original. Sales grew until 2006 when once again K-Swiss is facing softening demand. Pulling back on supply in bad times also serves to prevent large markdown activity. This further hurts sales in the short run. But it's an intelligent long term strategy. Many of K-Swiss’s competitors have introduced cheaper shoes to try to boost sales in the short run and save a quarter. Nichols said during the 4th quarter conference call that he thinks the opposite. Instead of trying to save the quarter, K-Swiss thinks long term. "We do almost no short term things. Everything we do has a long term mentality to it." In the first quarter conference call he said "We think our problems are self manufactured. We didn’t move our product and marketing ahead to a point where our brand was in demand." Total backlog for the 2nd half of the year is down 32%. Manegment estimates that 3rd quarter EPS will be $0-(-$.15) and full year revenue of $300-$320 million and EPS between $.5 and $.65.
In the past year or so new marketing people have been hired. A remastered K-Swiss Classic is set to be introduced in mid 2009. K-Swiss has also made a foray into running and Free Running shoes. K-Swiss has been dominant in tennis but tennis shoes represent only 6% of the athletic shoe market, running shoes represent 30%. So far the reception they’re getting at running shops has been good. Also, K-Swiss has signed on athletes such as Anna Kournacova and others, something that they haven’t done before. Nichols said they are still working on improving the marketing, which has become stale.
Steven Nichols and George Powlick are two of the most candid and honest managers out there. Insiders own a large amount of stock and have a long history of making shareholder friendly decisions. The shareholder letters and conference calls are some of the best I’ve come across. The honesty, candor and long term focus of the manegment comes out strong. During the last conference call Nichols said that 97% of the reason for K-Swiss’s current problems is his fault. Since 1996 management has repurchased 25.5 million share at an average price of $6.55 bringing the shares outstanding from 53.16 million on December 31, 1995 to 34.7 million today. I encourage readers to look at the last three conference calls and the three articles I linked to:
Three articles worth reading
and the last three conference calls:
During the second quarter K-Swiss acquired a 57% interest in Palladium for $8.4 million with the option to acquire the remaining 43% for a pre-determined multiple of EBITDA in 2012. Palladium is a French shoe company that looks a lot like K-Swiss did when Nichols took it over in 87. Palladium started making a military hiking boot for the French government in 1947 and the company still sells the same shoe today with the same manufacturing systems as they used in 1947. Nichols said the shoe, called the Pampa, is timeless like the Classic but like K-Swiss in 87, Palladium has been mis-managed. The manufacturing process is out of date, the shoe is uncomfortable, to heavy, to expensive and doesn’t fit well. K-Swiss can change all these things and still keep the shoe’s timeless look. K-Swiss will also be able to use Palladium’s distribution and sales force to increase sales in Europe.
K-Swiss product is distributed in 66 countries but K-Swiss has only begun to tap the potential of the brand internationally. International revenues have gone from $67 million in 2003 to $208 million in 2007. Before the slowdown during the past 2 years, international revenue had been growing at 50% plus a year. Revenue from Europe was $143 million in 2007 up from $17 million in 2002. Sales come primarily from Germany, Benelux and the U.K. The company has struggled in Italy, France and Spain. K-Swiss is only in about half the markets in Europe and Nichols expects that the other half will become more meaningful in the years ahead. There are signs of success in some of those countries. The company introduced the Free Running line of shoes across Europe and the most successful country was Italy where it was extremely well received. Palladium should also help boost sales in Europe because K-Swiss will also be able to use Palladium’s distribution and sales force to increase sales in Europe. Other international represents the rest. Sales are also very strong in Asia (South Korea, Japan, China, Taiwan), Mexico, Canada, etc. Sales in for this segment have gone from $25 million in 2002 to $65 million in 2007. In South Korea there are 200 K-Swiss concept stores managed by a distributor. In China a distributor opened 12 stores in 2007. K-Swiss clearly has a vast untapped market in these countries.
Net Income for the last five years are as follows (2003-2007): $50.1 million, $71.3 million, $75.2 million, $76.9 million and $39.1 million in 07. K-Swiss has a market cap of $421. K-Swiss has no debt and $295 million in cash. For the worst case I’ll assume European and other international sales stay where they are at $150 million and $65 million respectively and domestic sales of $300 million down from $400 million in 04 and up from $200 million in 07. For the worse case total sales are $515 million. At a 20% operating margin, operating income would be $105 million. For the best case international sales at $250 million up from $208 in 2007 and domestic sales of $400 million. Total sales would be $650 million under my best case scenario and operating income would be $130 million. Applying a multiple of 14X on operating income after tax and adding cash, yields an intrinsic value of $1250.5-$1478 million or $36-$42.6 per share.
The author has an investment in K-Swiss.
Monday, August 11, 2008
My original thesis for investing in Freightcar America from July, 07: http://alexbossert.blogspot.com/search/label/Freightcar%20America
August, 07 update:
Freightcar America (FCA) released earnings on Monday and sending shares down 23%. They missed analyst estimates by 32 cents, reporting a loss of 8 cents a share compared to estimates of 24 cents. FCA had its IPO in early 05 at $19 per share and in 06 the stock was at $78 at the peak of the secular boom in coal car orders. But since 06 the company has been hit by inevitable slowdown that was sure to follow. Investors are focusing on falling orders and the disappearing backlog as they look ahead to a possible recession that could further hurt results. But coal car orders will bottom out and return to normal. At $28 FCA has nearly $13 per share in cash and management is actively looking to put it to work either with a possible acquisition or international opportunities. There are signs that the coal car market is bottoming out and that orders will pick up in 09. The export of coal out of the U.S. is booming. Coal cars will need to continue to travel longer distances to eastern ports as the mining of coal deposits in the Appalachian region declines and the activity in the Powder River Basin in Wyoming and Montana increases. 75 coal-fired power plants are expected to begin construction in the next 6 years. 52 of the 75 are currently in the construction phase. FCA’s 80% plus market share in the North American coal car market is protected by high switching costs and 100 plus years of market share and technological dominance. Only one company, Trinity Industries competes with FCA in the coal car market. Foreign companies are prevented from importing cars because of very high shipping costs and familiarity with the market. FCA is conservatively worth $40 to $61 per share.
Earnings for the first and second quarter
For the first quarter FCA had an operating loss of $16.3 million which includes an $18.3 million charge as a result of the May 6th arbitration ruling with the United Steel Workers over the closure of the Johnstown Pennsylvania Plant. FCA announced the closure of the plant in December 07 because of its high manufacturing costs. FCA will have no more impairments related to the United Steel Workers lawsuit. With the lawsuit concluded the Johnstown plant will be closed when the courts approve the settlement. This will allow FCA to move manufacturing to its two remaining low cost facilities and reduce operating costs. Without the settlement net income would have been about $1.5 million.
Second quarter earnings came in at a loss of $900 thousand. As raw materials prices continued to increase, specifically steel and aluminum, some of the company’s fixed price contracts in backlog were no longer profitable. Most of these cars will be delivered during 08. A contingency reserve of $2.7 million after tax was recorded in the second quarter to reflect the unprofitable contracts. Since May the company has quoted variable price contracts to customers and thus the reserve likely represents the total cost of unprofitable contracts. Also, part of the drop in the second quarter 08 backlog was due to a cancelled order of 970 units. All management would say about this is that it is due to one customer and one order.
The coal industry is booming driven by growth in export demand for coal world wide and the large number of coal-fired power plants currently scheduled to come online. U.S. and Canadian coal loadings in the first and second quarter were up 2.8% and 2% respectively while commodity car loadings overall were flat and down 1.6%, respectively from the same period last year.
Coal export activity is booming. Coal export activity was up 19.2% in 2007 vs. 06 and up 67% in the second quarter 08 compared to the same period last year. For the first half of 08 export tonnage for coal was up 57% from the first half of 07 and managements expects that it will continue at this rate through 08. On July 24 Union Pacific CEO Jim Young said in a Reuters article that "Global demand for U.S. coal should stay strong for at least 2-3 years.....Everything we hear suggests that coal will continue to be strong at least in the mid-term horizon." According to a July edition of Railway Age a trade magazine, Norfolk Southern is exporting 20 million tons of coal annually up from 12 million tons just a few years ago due to world wide demand. Norfolk Southern’s coal revenue is up 34% in the second quarter. Wick Moorman, Norfolk’s CEO said "The problems were encountering are on the supply side. The mining companies can barely keep up with demand." FCA’s CEO Chris Ragot said "Demand for export coal has significantly increased as global supplies tighten." The increase in foreign demand is being driven by industrialization and attendant demand for coal fired electricity generation in the developing world including India and China.
Coal inventories are declining. Currently coal inventories are high in the electric power industry however recent data shows that inventories at eastern utilities is falling because of increasing domestic and international demand. Ragot said that inventories will continue to decline.
In addition to the increasing use of coal internationally, there is a large number of coal-fired power plants coming online in the next few years. In the next six years 75 coal fired power plants are expected to come online. These 75 plants will require about 40,000 new coal cars. Of these 75, 52 are currently under construction, near construction or permitted for construction. These 52 plants are expected to add 27,000 mega watts of capacity and will require about 20,000 coal cars. 29 of these 52 are under construction at this time which will add 16,500 mega watts of coal-fired capacity.
Coal will be an increasing large source of the power needs of the U.S. and internationally. The U.S. is referred to as the Saudi Arabia of coal. We have more in terms of energy units in coal reserves than Saudi Arabia has oil. The U.S. has 250 years of coal reserves at the rate we’re using it now. Clean coal technology will continue to advance. The Energy Department is working on what’s called the FutureGen Project, a project to built a carbon sequestering plant. A demonstration plant with carbon sequestering technology is expected to be built by 2015. In addition China is set to build its first clean coal plant in 09 and Germany has coal plants in the middle of major cities with zero emissions. Compare that to nuclear plant takes 10-20 years to commission, I believe coal will continue to serve a large part of the power needs of the U.S. and the world.
An Obama victory in November could be trouble for the industry. Although Obama supports clean coal and coal to liquid if they can emit 20% less carbon over their life cycle then traditional fuels. He is strongly opposed to traditional coal plants and would use whatever means necessary to stop new plants from being built, including a ban on new traditional coal facilities. McCain would be more favorable for the coal industry. He supports coal power for electric utilities. But, he wants to find cleaner ways to use coal. Clearly, both candidates see the need for development of clean coal technology.
How long will it take before coal car orders pick up?
If coal export volume is booming and plants are beginning to come online the why hasn’t FCA’s orders and production picked up? It’s because the amount of coal activity doesn’t overlap demand for railcars. With the oversupply of cars in 05 and 06 the downturn was inevitable. In 05 and 06 the replacement rate spiked above 3% and some of the surplus of coal cars were put into storage.
The cycle in rail car orders from peak to trough is seven years in duration. In 1998 total industry wide rail car deliveries peaked at 75,704 and bottomed out in 02 at 17, 736. Over the same time FCA production went from 9,000 to 4,067. Then industry wide railcar deliveries peaked again, peaking in 06 at 75,729, 07 deliveries were 63,156 and deliveries for 08 are expected to be around 56,000. FCA’s deliveries in 06 and 07 were 18,764 and 10,282. Orders in peaked in 05 at 22,363, in 06 orders were 7,350, and in 07 orders fell further to 6,366. Backlog has declined from 20,729 units in 05, 9,315 units in 06, 5,399 in 07 to 4,917 on June 30th. Clearly the rate at which orders and backlog is headed doesn’t bode well for FCA. FCA is hit even more at the bottom of the cycle because selling prices decline, currently price declines are in the high single digits. Investors are focusing on the plummeting backlog and looking to worse sales next year.
There are signs that orders will pick up again soon. Strong export activity and the number of new coal plants under construction will soon lead to a pickup in orders. In the first quarter conference call FCA’s CFO Kevin Bagby said "It appears as though we’re at or near bottom. It’s difficult to pick that point but there does appear to be some improvement going forward at this point." In the second quarter conference call he said that he expects order activity to pick up in 09. The reason orders should be headed upwards include, a decreasing number of coal cars in storage, many new utilities coming online, increased coal car loadings and increased domestic and international demand. During the first quarter FCA idled one of its plants but in the second quarter due to a pickup in orders the plant was reopened. In the last five weeks there’s been orders placed for 1130 units and management said this is encouraging. In addition they said that they are benefiting from a return in order activity and they expect that to continue for the rest of the year with 95% of the units currently in backlog being delivered over the next two quarters.
In addition to the positive fundamentals for coal and the likely pickup in orders come 09, FCA is also diversifying its operations by developing non coal rail cars and an active exploration of international opportunities. In January FCA announced a joint venture with Titagarh Wagons Limited of Kolkata Indian to use FCA’s designs to develop freight cars for the Indian market. In second quarter release management said that the joint venture is progressing on schedule with production to start next year. FCA sent over some of their engineering staff to assess market conditions and so far things are going very well. Also, FCA signed a licensing agreement with a rail car manufacturer in Brazil and they manufacture coal-carrying rail cars for export to Latin America and have manufactured inter modal rail cars for export to the Middle East. We should expect more international opportunities to come. The CEO said during 1st quarter conference call that "we expect to begin working with additional overseas partners in coming years".
FCA is also trying to diversify its revenue base by introducing new rail car types including, an autorack car and a new design for its open top hopper for aggregates and taconite. In addition, FCA entered the leasing business in the first quarter. FCA has historically shied away from leasing because they would be competing with their own customers. But in the short run it makes sense to maintain production and market share. FCA has $46 million in "leased assets held for sale" on its balance sheet. Also, FCA closed on its first refurbishment order in the first quarter and currently has 200 cars in backlog related to refurbishment contracts. This should be a good avenue to increase business and even out the cyclical nature of the company’s orders and at the same time provide better margins.
I believe the sell off is way over blown. The time to invest in a cyclical company like FCA is when orders and falling and everyone’s looking to even a worse future. Soon orders will begin to pick up and investors will see the light at the other end of the tunnel. Coal will continue to have very positive fundamentals in the U.S. and abroad. The joint venture in India is the wild card with no risk because FCA provides the expertise (car designs and operating experience) and no capital. Titagarh will provide the capital. The expansion into different rail car types and the new refurbishing and leasing business will further benefit FCA. FCA is also working to cut costs at every level of the company and the closure of the Johnstown plant will further reduce operating costs. Coal cars will need to travel longer distances to eastern ports as the mining of coal deposits in the Appalachian region declines and the activity in the Powder River Basin in Wyoming and Montana increases. With $162 million in cash FCA can sustain a few bad years and with that cash they could buy back more stock or make an acquisition which they have recently said they are exploring.
There are 250,000 coal cars in North America. The replacement rate is around 3% and growth in coal use can be conservatively estimated to be 1%. FCA will continue to control 80% of the market. In addition, about 15% of FCA’s revenue comes from non coal cars. Based on these assumptions we can expect FCA’s order rate to be about 9,200 cars per year on average. Based on results from prior years, FCF per car is between $2,800 to $4,000. This equates to FCF of $25.8- $37 million not including interest income. This compares to an average FCF over the last 7 year cycle of $36 million per year. With a 12-15x enterprise value/ FCF and $162 million in cash, FCA is worth between $40 and $61 per share. Think of it another way, in the last 7 year cycle FCA had an average FCF of $36 million a year, and now FCA is expanding into different rail cars types and the refurbishment/rebuilt market, more gigawatts of coal fired power plant capacity will begin construction in 09 then was build in the last 7 years and FCA has $162 million in cash from the 05 IPO. It is highly unlikely that FCA will earn less than it did in the last coal car cycle.
Saturday, June 21, 2008
The retail industry is getting hit hard as investors anticipate a recession. American Eagle’s stock is down nearly 50% in the past year and a half. The disappointing negative same store sales figures for the first few months of the year sent the stock tumbling. January same store sales were down 12%, February’s same store sales were down 4% and in March they were down 12%. For the first quarter same store sales declined 6%, net income was down 44% and operating margin declined from 18.9% to 10.1%. Abercrombie and Fitch, AE’s main competitor had negative same store sales figures but AE was hit harder than most of its competitors. The disappointing first quarter figures were driven by sales decreases in the girls side and a mistake in styling in the denim business, which is AE’s backbone representing around 20% of sales. AE was forced to take markdowns on denim and girls merchandise during the quarter, taking a hit to margins. Insider purchases have been significant over the year. Jay Shottenstein the founder and chairman has purchased $24 million in stock over the past year and his family owns 15% of the stock.
American Eagle is retailer selling mid priced casual clothes targeted to 15-22 year olds through its 942 American Eagle stores in the U.S. and Canada. In 2006 they launched the sub brand “aerie” targeting 15-25 year old girls and has since opened 55 aerie stores. In 2007 a new concept was launched “MARTIN + OSA” targeting 25-40 year olds. There are currently 21 MARTIN + OSA stores.
American Eagle has been a phenomenal company over the years based on margins, returns on equity and other metrics. Average ROE over the past 10 years has been 28%. With new stores on average producing a return on equity of 65% in 2007. Operating margins have been on average 16% over the last 10 years, which is one of the best in the entire apparel industry which averages 4%
American Eagle’s two largest competitors are Abercrombie and Fitch and Aeropostal. Other competitors include The Buckle, Gap, Hot Topic, J. Crew, Limited Brands, Pacific Sunwear of California, Quicksilver, Talbots and Wet Seal. One thing that distinguishes AE from its two largest competitors is price. Abercrombie & Fitch’s merchandise is much more expensive then AE’s. Abercrombie & Fitch’s average unit retail price is $35 compared to American Eagle’s $20. Aeropostal on the other hand is generally slightly cheaper than AE. I compared jeans, tees and polos from American Eagle to near identical merchandise at Aeropostal, Abercrombie & Fitch and their sub brand Hollister. I found that prices at American Eagle and Hollister were very similar. Prices at Abercrombie and Fitch were almost always around 50% more than American Eagle. At Aeropostal prices were nearly always the cheapest of the four. I also read the latest quarterly and annual reports from Aeropostal and Abercrombie & Fitch. I feel that AE has superior qualities to both of these companies:
First, Abercrombie & Fitch’s prices are much higher than AE’s and both contain very similar merchandise. For example a pair of jeans at Abercrombie runs around $80-$90 while a pair at AE and Hollister runs $50-$60 and at Aeropostal it’s $30-$50. The merchandise is nearly the same between these four retailers. Abercrombie relies much more on the intellectual appeal of their brand to convince customers to pay 50% more for very similar merchandise. Therefore I think Abercrombie is much more susceptible to economic conditions, consumer spending and fashion trends. I personally get all my cloths from AE and fund no reason to spend $90 for a pair of jeans that are very similar to what AE has to offer.
Also, despite the significantly higher prices at Abercrombie, AE’s margins are very comparable. Over a ten year period, AE’s average operating margin was 16% compared to 19% at Abercrombie and 10-12% at Aeropostal. But more recently in the last four years AE’s operating margins were better than Abercrombie’s. Aeropostal’s recent good performance is mainly due to people turning to the cheaper alternative during a consumer spending slowdown.
Finally, insiders at both Abercrombie & Fitch and Aeropostal have been dumping stock recently. At Abercrombie many insiders have been selling large amounts of stock. Including the chairman, Michael Jeffries who has sold nearly $100 million in stock in the past six months or about half his holdings. Jeffries is scheduled to receive $68 million in equity compensation this year as part of his “career share award.” Insiders have also been dumping stock in Aeropostal as well. But, over the past year the chairman of American Eagle Jay Shottenstein has purchased over $24 million in stock and many other insiders have been accumulating stock.
There are currently 868 AE stores in the U.S. and 75 in Canada. The ultimate goal is to have between 1,000-1,200 AE stores in the U.S. and 80 AE stores in Canada. New AE stores are being opened at the rate of 40-50 per year giving AE 5-8 years of growth of its flagship AE stores. Also sales at AE Direct, American Eagle’s website, are growing at 30%+ per year and Jim O’Donnell American Eagle’s CEO said in a recent investor presentation that AE Direct should achieve sales of $500 million by 2010 up from $200 last year. American Eagle expects to open 40 new stores in 08 and to remodel 40-50 more stores. Overall square footage in 2007 grew 12% and will grow an estimated 10% in 2008.
During Fiscal 2006, American Eagle launched its new girls intimates brand, “aerie.” targeting girls aged 15-25. “The aerie collection is available in aerie stores, predominantly all American Eagle stores and at aerie.com. The collection includes bras, undies, camis, hoodies, robes, boxers, sweats, leggings, fitness apparel, and personal care for the AE girl. Designed to be sweetly sexy, comfortable and cozy, the aerie brand offers AE customers a new way to express their personal style everyday, from the dormroom to the coffee shop to the classroom” (2007 10-K). The aerie stores have been very successful so far with 55 aerie stores already opened and 80 more planned for 08. aerie seems like a natural extension of the girls section of the American Eagle stores given the synergies and brand recognition already established. Despite that AE stores get 60% of their sales from girls, the addition of an aerie store in proximity to an AE store doesn’t cannibalize sales away from the original store’s sales. Many other retailers have opened stand alone girls intimate stores targeted to the teenage girl. Abercrombie is starting the new concept Gilly Hicks targeted to teenage girls. Victoria’s Secret started the sub-brand Pink in 2004 and last year Pink achieved sales of $900 million. American Eagle’s CEO said that he thinks aerie will eventually achieve sales of $1 billion with over 500 stores possible.
The Company also introduced MARTIN + OSA during Fiscal 2006, a concept targeting 28 to 40 year-old women and men, which offers refined casual clothing and accessories. At first M + O appeared to be struggling badly and in 2007 Jim O’ Donnell said he was optimistic but he would close the stores if it didn’t return to profitability. More recently the stores have improved with same store sales increasing over 50% but the brand is still losing money, about 15-17 cents in annual earnings per year. For the first quarter the CEO said he is pleased by the performance of the new concept. The CEO said on the conference call that the brand is doing better with store traffic increasing. Also the brand has specific goals it has to make otherwise they will consider closing the stores. The CEO expects M + O to be profitable by the 4th quarter this year. Either way it will be good for shareholders; if the stores are closed 15-17 cents in losses per year are eliminated or if the brand becomes successful it will be a new avenue for growth. There are currently 21 MARTIN + OSA stores with 15 more planned for 08.
Last year AE announced a new concept 77 Kids, which will sell apparel for kids aged 0-10. The new concept is currently being developed with the website going up this year and stores are planned for 2010. It’s hard to forecast what will happen. It appears as though this is a pet project of the CEO’s. Jim O’Donnell helped start Gap kids and turned it into a $400 million business in six years before coming to AE..
American Eagle is down over 50% in the last year and a half. With a market capitalization of $3.3 billion, American Eagle’s trading at 8 times last year’s earnings. With $338 million in cash and $367 in investments, enterprise value divided by EBITDA is an appropriate way to value American Eagle. Cash and investments are equal to $3.50 per share. Earnings for 2008 will come in lower than 07 but, when the retail environment improves in a few years American Eagle will be worth much more than it’s trading for currently. First, the company has repurchase plan with up to 41 million shares available for repurchase. With cash on hand 22 million shares could be repurchased or over 10% of the stock. The share count has decreased by 23 million shares since 07. Options issuances continue to be large as they are in this industry with about 12 million shares available for issuance. On average option dilution has been about 1-1.5% per year. Second if either MARTIN + OSA will return to profitability or the stores are closed. The loss from M + O held earnings down by about 16 cents or $36 million last year nearly 10% of net income. With a market capitalization of $3.3 billion net of $370 million in cash and short term investments and $75 million in notes, American Eagle is trading for an enterprise value of $3 billion. Based on 2007 figures American Eagle is trading for an enterprise value/ EBITDA ratio of 4.2. Looking at any valuation metric, AE is significantly cheaper than its competitors. Cash flow from operations has been strong with $480.4, $749.3 and$464.3 million generated in 05, 06 and 07 respectively. With capital expenditures north of $200 million a year, free cash flow generation has been $398.9, $523.3 and $213.9 for 05, 06 and 07 respectively. I think AE is worth twice what it’s trading for and the value will be unlocked once the retail environment improves, share repurchases boost EPS and aerie and MARTIN + OSA begin to make meaningful additions to AE results.
Wednesday, June 11, 2008
Of all the articles/speeches/interviews of value investment managers this is one of the best speeches I’ve ever watched. Klarman discusses how he made over 5 times his money investing in Enron debt, what his investment principles are, his thoughts on the investment manegment industry, why he doesn't go short and why he uses derivitives.
This speech is not posted any where else on the internet. Here is my summary:
Thoughts on Investment Manegment Industry
- The investment Manegment industry is not set up to achieve market beating returns. Instead they are incentivized to get big and act like asset gatherers. At the same time there is little incentive to take risk and deviate from the mean because if they strike out and underperform for even a short period clients will be lost quickly. It’s an enforced mediocrity (if you want to get big just do what everyone else is doing and settle for average results).
- Klarman said he would rather hold treasury bills then invest in many of the hedge funds out there. If stocks do 10% going forward and a hedge fund that charges 2 and 20 takes 3% of your money in fees you’ve only got 7% left, plus it’s leveraged, holds illiquid securities, etc. He would much rather get 4.5% risk free.
- Tweedy Brown is today’s manifestation of Benjamin Graham
- Value investing is risk aversion
- Baupost charges a 1 percent management fee plus 20 percent of profits.
How Baupost Invests
- Rule #1: Don’t lose money. Rule #2: Never forgot Rule #1.
- Baupost always looks for catalysts in its investments. If you find a stock trading for 50% of what you think it’s worth you want there to be something that will trigger it to reach fair value.
- Baupost will always sell an investment as soon as it near their estimate of fair value. Baupost has analysts focused around the type of opportunity; Baupost has a spinoff analyst, index fund deletion analyst, post bankruptcy analyst, distressed debt analyst and an analyst looking at companies that are depressed because of a bad earnings announcement).
- Baupost invest in: Both public and private distressed debt, Real estate (Baupost has done over 200 real estate deals including biding on RTC auctions), U.S. and foreign equities, LBO’s and Derivatives.
- The portfolio is 45% cash, 20% equities, around 17% distressed debt, 11% real estate, 7% private investments (distressed debt, small LBO’s, financial restructurings), 6% in South Korean equities and a small % in hedges.
- Baupost looks at every merger, rights offering, privatization of government business, spin off, major share repurchase, dutch auction tender, thrift conversions or anything else that could cause mispricings.
- Post bankruptcy situations are a good place to look for bargains because people avoid them and don’t understand them. A lot of good things can happen in bankruptcy such as terminate overpriced contracts or leases, shed extraneous business units or, deal with union problems or settle contingent liabilities; all under the protection of bankruptcy court. Then all the debt holders have equity and they will want to sell.
- Baupost opened over 1,000 savings accounts across the country to take advantage of thrift conversions
- Baupost doesn’t go short because unlike going long when you can take advantage of a drop in the value of an undervalued security by just buying more, if your short even though you may be right that it’s worth less then the trading price you can still go broke. It’s way more risky and you can lose infinity. Think tech stocks if you shorted them in 97, 98 or even 99 you would have been killed. It works for a while and then the market goes berserk and you get killed.
- Baupost uses hedges to reduce risk. For example they use derivatives to hedge the interest rate risk in their real estate holdings. They hold credit default swaps on the government debt of countries they have investments in (S. Korea). They also hold credit default swaps in a bunch of European countries not necessarily because they have holdings there but because it reduces risk and they were very cheap ($60, 000 a year for $100 million in insurance).
- Baupost does best when there is high uncertainty and little information. When they research a company they do what ever they can to find information; they talk to every one to get information including, manegment, industry people, former executives, customers, suppliers, they sometimes hire consultants and talk to analysts on buy and sell side.
- They constantly reassess to find new information, if they’ve overlooked something or if something has changed.
- Employees own second largest position in Baupost.
Baupost’s 3 investment principles:
1. Focus on risk before return. This is why Baupost has so much cash, currently 45% of the fund is in cash. If they could find undervalued investments they would put all their money to work tomorrow. If they had to they would have no problem holding 100% cash. People fail to have sell discipline because they can’t hold cash.
2. Focus on absolute returns. Institutions focus on relative returns but Baupost doesn’t because Klarman can’t imagine writing a letter to clients saying "we performed well during the year, the market was down 25% and we were down only 20%" also clients will pull money out at the wrong time and it has a strong psychological effect.
3. Only focuses on bottom up investing. He has views on the macro but doesn’t think he has an edge in that type of investing. Klarman said that it’s really hard to turn a macro idea into an investment.
Klarman's 5 fold investment in Enron debt
- Baupost invested in Enron’s senior debt and he said that would be an example of his favorite type of investment. The situation had a lot of complexity, hard to analyze, a lot of litigation, uncertainty and no one wanted to be associated with anything Enron creating a huge mispricing. Baupost bought the debt for 10-15 cents on the dollar. It comes down to assessing assets minus liabilities. After a few years most of Enron’s assets were cash $16-18 billion but the liabilities were extremely complicated, with over 1,000 subsidiaries. Baupost had one analyst focus solely on Enron for over 4 years and try to figure out its liabilities and how much they would get back on the bonds. Baupost believed that the people liquidating Enron were low balling what they would get back on the bonds. The people liquidating Enron were very pessimistic and they originally estimated that the bonds would get back 17 cents on the dollar at the same time the debt traded for 14-15 cents, Baupost estimated that the debt would recover 30-40 cents and as of now they believe it will be more then 50 cents.
- Investments like Enron debt are possible because the market doesn’t assess risk correctly by relying on volatility (beta).
More about Seth Klarman:
Business Week: The $700 Used Book
Seth Klarman at MIT October 20th, 2007
Baupost's Portfolio Holdings
Great Article About Klarman: Manager Frets Over the Market, but Still Outdoes It
Friday, May 16, 2008
Boone discusses how his hedge fund lost 90% of its value and then made it back. Boone actually has a plan that could solve our dependence on foreign oil.
Monday, May 5, 2008
Fat Pitch Financials: Ultimate 2008 Berkshire Hathaway Annual Meeting Guide
Reflections on Value Investing: 2008 Berkshire Hathaway Shareholder Meeting: Detailed Notes
CNBC: LIVE BLOG ARCHIVE: Warren Buffett News Conference
Omaha World Herald: Notes and highlights from meeting
Berkshire also just released earnings for the first quarter:
Berkshire Hathaway First Quarter 10Q
Thursday, April 24, 2008
Excerpts from the Forbes interview:
But we are in a recession right now, won't these companies suffer
There is a difference between what gets hurt and what stock prices go
down. People don't understand that concept. Typically, in a recession, when
are in the worst environments, the companies most negatively impacted
ones that actually do the best in the stock market.
Because they do poorly before the recession. Everyone knows it will be
for retail in a recession. So they kill retail stocks before they get
recession. Once they're in it, people start to look out to the other
the speculation shifts to this question: When is the recovery?
That is when you
see cyclical kind of companies bottom out. That has
happened in every single
prior economic cycle. I think it's impossible for
housing stocks to get killed
any worse. Banks and finance companies have
gotten killed. Credit card companies
have already taken provisions so their
earnings and stock prices have gotten
killed. People expect the worst in the
credit card business.
Another Interview from December 31, 2007 Via Barrons:
Monday, April 21, 2008
The Dhandho Investor: The Low - Risk Value Method to High Returns.
Smart Money: What stocks do you like now?
Mohnish Pabrai: Pinnacle Airlines. Depending on
things work out, it's anywhere from a double to five or six times return in
the next two or three years.
SM: An airline?
MP: It's a regional jet
company. The large airlines,
like Northwest and Delta, outsource the small planes to Pinnacle. Many of the
reasons why airlines are so terrible — load factors, price wars — don't
The revenue is the same whether there is one passenger or the plane
is full and
whether Northwest charges $200 or $2,000 round-trip. The
long-term, usually 10 years, and will hold up in the event of
a merger. So you
can estimate what their cash flows will be many years into
What's the investment case?
MP: Pinnacle has more than $10 a share in cash
balance sheet. In the next few years, free cash flow will be $3 to $6 a
share, depending on how much more business they get. With a simple 10 or 15
multiple on those numbers, you end up with $30.
SM: Why are the shares so
MP: One overhang is that they have a past-due contract with
But not a lot of Wall Street analysts follow Pinnacle, and the
is changing. The evolution away from hub-and-spoke and
toward more nonstop
flights is driving demand for their services. When you
connect one small city to
another directly, you aren't going to run a jumbo
or a 737.
Thursday, April 17, 2008
Saturday, February 23, 2008
NICK reported very good results for the 3rd quarter ended December 31. Net income for the 3 months ended was $2.23 million compared to $2.77 million for the comparable period last year. For the nine months ended NICK made $7.6 million compared to $8.6 in the period last year. Net income was lower due to an increase in the provision for losses. The provision for losses increased to 3.7% of average finance receivables, for the nine months ended compared to 2.24% in the period last year. For the three months ended the provision rose to 5.1%. The net charge of rate increased to 9.5% for the three months ended compared to 7.4% in the period last year. Note that new dealer discounts also offset credit losses. The reserve for credit losses remains very strong at $19.3 million at December 31st compared to $19.9 million last year. NICK’s pre-tax yield as a % of average finance receivables remained healthy at 7.5% for the three months ended compared to 10.3% for the period last year.
NICK’s assets remained strong enough for them to sign a credit line increase from $110 million to $115 million on November 14. NICK’s losses as a percentage of liquidation increased from 6.91% for the nine months ended to 8.77% for the period last year. The Company anticipates losses as a percentage of liquidation will be in the 8-12% range during the remainder of the current fiscal year. I think NICK’s pre-tax yield will stay at around the 7% level for the 4th quarter and the rest of next year. Based on that NICK will earn about $10 million in 2007 and around $9 million in 2008.
Once charge offs return to normal in 2009, at the earliest, and pre-tax margins return to around 10.5% NICK will be earning $12.5 million without considering any growth in their receivables base. NICK is also trading for slightly under 90% of book value. With a multiple of 12x (1.9x book) NICK is worth between $15 per share vs. a current price of $6.9.
I am still waiting on Freightcar America’s 10K to be released. When it is released I will post and update on their earnings.