Footstar

Footstar is a liquidation play with tangible equity of $82.1 million ($3.84 per share) and an expected liquidation value of at least $96 million ($4.5 per share). This compares to the current stock price of $2.8. I see a very low chance of getting less then the current stock price with the upside being a 40% return in less then a year.


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.

Liquidation


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:

Risks

The largest risk is that management will not liquidate in an expedient manner. Footstar will file a plan of liquidation in early 09. But the sale of the headquarters building could delay the liquidation. Also, some have raised the issue that the last two dividends were not tax efficient and that they should have been set as liquidating dividends and not taxable. The OutPoint Group waged a proxy fight earlier this year attempting to name two candidates to the board. The Outpoint group owns 3% of the company. They and raised such issues as the excessive compensation for the top executives, the CEO’s total compensation was $3.5 million last year and the CFO made $700,00. Directors are paid between $110-$160 thousand year. Footstar reimbursed the chairman $160,000 for his failed bid for the company in 2006.

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.

K-Swiss

This is my analysis of K-Swiss:

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

http://www.allbusiness.com/retail-trade/miscellaneous-retail-miscellaneous/4470121-1.html

http://biz.yahoo.com/bizwk/hotgrowth_article2.html

http://www.allbusiness.com/north-america/united-states-california/277941-1.html

and the last three conference calls:

http://seekingalpha.com/article/66240-k-swiss-inc-q4-2007-earnings-call-transcript

http://seekingalpha.com/article/74724-k-swiss-inc-q1-2008-earnings-call-transcript

http://seekingalpha.com/article/89195-k-swiss-inc-q2-2008-earnings-call-transcript

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.

Freightcar America Down 23% after Releasing 2nd Quarter Earnings

For Back ground Information please read my prior posts on RAIL:

My original thesis for investing in Freightcar America from July, 07: http://alexbossert.blogspot.com/search/label/Freightcar%20America

August, 07 update:
http://alexbossert.blogspot.com/2007/08/update-on-freightcar-america-inc


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.

Industry Fundamentals
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.

Diversification Initiatives
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.

Valuation

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.

American Eagle Outfitters

Background:

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.

Business:

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%

Competition:

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.

Operations:

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..

Valuation:

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.

Seth Klarman Speech April 20th 2006 at Columbia Business School

A friend sent me a video of a speech given by Seth Klarman at the Columbia Business School. Klarman’s hedge fund the Baupost Group has done over 20% a year since he founded the firm in 1983 with only one down year. Also, Seth Klarman’s book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor is also one of the best books I’ve read on value investing. It’s currently out of print and selling for about $1,600 but I got a copy through my library’s intra library loan program.

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

T. Boone Pickens Interview at Milken Institute Global Conference

Billionaire energy investor Boone Pickens, founder and chairman of BP Capital LLC, speaks at the Milken Institute Global Conference in Los Angeles about the outlook for oil, U.S. energy policy, and alternative energy including wind and solar power.

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.

Watch the video here

Then read these two articles:

Natural-gas powered cars

and

T. Boone Pickens Drills into Wind Power

Berkshire Hathaway Annual Meeting

I was able to attend the Berkshire Hathaway Annual Meeting for the third year. Below are links to notes and resources other sites have posted on the meeting:



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

Richard Pzena Interview: Doubling Down in Financials

Anything Richard Pzena has to say is a must read. Pzena was interviewed by Forbes magazine yesterday and shared his thoughts on his current investments and the financial industry in general. Pzena believes many of his financial investments are trading for less then 5 times their normal earnings power. Pzena's current picks are : Alacatel-Lucent, Freddie Mac, Citigroup, Allstate, Capital One Financial, Torchmark, Fannie Mae, Bank of America, Johnson & Johnson, Whirlpool,

Excerpts from the Forbes interview:

But we are in a recession right now, won't these companies suffer
more?

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
you
are in the worst environments, the companies most negatively impacted
are the
ones that actually do the best in the stock market.

Why?

Because they do poorly before the recession. Everyone knows it will be
bad
for retail in a recession. So they kill retail stocks before they get
into a
recession. Once they're in it, people start to look out to the other
side. All
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.

Full Interview Via Forbes

Pzena Investment Management: First Quarter Commentary

Another Interview from December 31, 2007 Via Barrons:

Opportunity Amid the Ruins

Mohnish Pabrai Interview

Mohnish Pabrai started the Pabrai funds in 1999 and has since had returns of 25% a year on average net to investors. I have been following Pabrai since I read an article about him in Forbes Magazine in 2004. I recommend the article , in it Pabrai talks about his investment in Frontline. In the interview published today by Smart Money Pabrai talks about one of my largest holdings Pinnacle Airlines.

Smart Money: What stocks do you like now?

Mohnish Pabrai: Pinnacle Airlines. Depending on
how
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
matter.
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
contracts are
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
the future.

SM:
What's the investment case?

MP: Pinnacle has more than $10 a share in cash
on the
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
cheap?

MP: One overhang is that they have a past-due contract with
pilots.
But not a lot of Wall Street analysts follow Pinnacle, and the
business itself
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.

Full Interview Via Smart Money

I also highly recommend Pabrai's book The Dhandho Investor: The Low - Risk Value Method to High Returns.

Subscribe to Alex Bossert's Thoughts on Value Investing

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Earnings Update

Nicholas Financial

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.

Yellow BRK'er Party Information Details (Friday, May 2, 2008)

My Friend Shai Dardashti asked me to pass this on to all of you:


Yellow BRK'er Party Information:

2008 Meet & Greet Happy Hour

Date: Friday, May 2, 2008Time: 4:00 pm - 7:00 pm Place: DoubleTree Hotel, Omaha

Berkshire Hathaway shareholders from all online communities are welcome.

If you feel most comfortable wearing a suit, go for it. With that said, it's Omaha; please feel under no such obligation. This is a casual atmosphere, with light snacks available. It's a "happy hour" type of gathering - not a formal dinner or anything of that sort.

The DoubleTree is located on 16th and Dodge. There may be some street parking, otherwise, one can use the parking garage with an entrance from the South at 16th & Dodge street, just east of the First National Bank.

To RSVP: http://www.yellowbrkers.com/

---
Directions to venue:http://tinyurl.com/ystqqb

About Yellow BRK'ers:http://tinyurl.com/2fqajh

---
2008 Official Berkshire Hathaway Annual Meeting Press Release:http://www.berkshirehathaway.com/meet01/2008meetpre.pdf

The Black Swan By Nassim Nicholas Taleb

The Black Swan deals with how we interpret random events. A Black Swan is an event that is 1) unpredictable, 2) has an extreme impact and 3) we try to make explanations for its occurrence after the fact. Taleb states that almost everything around us has been brought about by Black Swans: Fads, epidemics, fashion, ideas and art genres.

John Bogle’s Thoughts on the Black Swan: Black Monday and Black Swans

"We produce thirty year projections for social security deficits and oil prices without even realizing that we can’t predict these for the next summer."

How can a Beta measure risk when the securities price is determined by factors that have no correlation with past events. We come up with pretty theory’s that will tell us what will happen in the future or what securities price should be, without realizing that much of what happens in the future is totally unpredictable and small deviations can mushroom into very large differences over time.

We focus on a small section of what we see and generalize from it to the unseen. This is called confirmation bias in psychology. We look for patterns in random information. The narrative fallacy states that we have a limited ability to look at a series of facts without weaving an explanation into it. Expressing facts as a pattern makes it easier to remember and we naturally do it.

We can always find evidence that will validate our thoughts. In science a hypothesis is made and the scientist looks for ways to prove it wrong. We will become smarter by coming up with a conjecture and then looking for disconfirming evidence.

What we can learn from it

Avoid dependance on large scale predictions (macro economic, analyst estimates, growth rates far into the future etc.)

People are ashamed of losses so they look for investments with low volatility but don’t realize that it still contains an equal chance of large losses.

Look for positive Black Swans (those where the surprises will be positive and the downside is limited). -Same as Mohnish Pabrai’s low risk high reward strategy (heads I win tails I don’t lose anything)

Understand that we don’t know what we don’t know.

Avoid the majority of forecasters

The Piotroski screening method

Many studies have shown that low P/B stocks outperform high P/B stocks.
Roger Ibbotson, Professor in the Practice of Finance at Yale School of Management and President of Ibbotson Associates, Inc., a consulting firm specializing in economics, investments and finance, in Decile Portfolios of the New York Stock Exchange, 1967 - 1984, Working Paper, Yale School of Management, 1986, studied the relationship between stock price as a percentage of book value and investment returns. He split all the stocks traded on the NYSE into ten deciles. Decile one contained the bottom tenth of the stocks with the lowest P/B ratios and decile 10 contained the top tenth of the stocks with the highest P/B ratios. The test was run once a year for 18 years and decile one returned 14.4% and decile 10 returned 6%.

Piotroski took the idea that a large portfolio of the lowest P/B stocks would outperform the market and added to it. Piotroski knew that many of these stocks were financially distressed and would turn out to be duds and that they deserved to be trading far below book value.

So he developed nine criteria that when combined with a large number of low P/B stocks, would help eliminate the financially distressed companies and would keep the strong ones. He reports that his screen produced a return of 23%.

Here are his criteria that he applies to the low P/B stocks:


Operating cash flow: Piotroski considers cash flow the real earnings gauge. Passes if full-year cash flow is positive.

Return on assets: Piotroski wants to see increasing profitability. Passes if full-year ROA exceeds prior-year ROA.

Quality of earnings: Cash flow usually exceeds net income because income is typically reduced by non-cash charges such as depreciation. If it's not Piotroski says that's a
bad signal about future profitability and returns. Passes if full-year operating cash flow exceeds net income.

Long-term debt vs. assets: Piotroski prefers companies that are cutting debt. Passes if the full-year ratio of long-term debt to assets is down from year-ago.

Current ratio: Piotroski sees CR as a way to gauge if liquidity is improving which is a good signal about the companies ability to service its debt. Passes if the CR increases from the prior year.

Shares outstanding: Piotroski penalizes companies that sell stock to raise cash.
"Financially distressed firms that raise external capital could be signaling their inability to
generate sufficient internal funds to service future obligations." Passes if the current number of shares outstanding is no greater than the year-ago figure.

Gross margin: Increasing gross margins often signal that a company's costs are decreasing or product selling prices are increasing. Passes if full-year GM exceeds the prior-year GM.

Asset turnover:
"An improvement in asset turnover signifies greater productivity from the asset base. Such an improvement can arise from more efficient operations (fewer assets generating the same levels of sales) or an increase in sales (which could also signify improved market conditions for the firm’s products)." Passes if current year asset turnover ratio is greater then last year's asset turnover ratio.


Link:

Value Investing: The Use of Historical Financial Statement Information
to Separate Winners from Losers By Joseph Piotroski

An Interview with Richard Pzena

The Heilbrunn Center for Graham & Dodd Investing did an excellent job interviewing Richard Pzena. The interview is from December 2006. Joel Greenblatt calls him the smartest man he knows and I totally agree. This is something worth reading.

Link to Interview

Nicholas Financial Inc. (NICK)

Business:

NICK purchases sub prime automobile loans from car dealers in the south eastern U.S. through its branch office network. The company also makes direct loans to current or former customers. Direct loans made up about 7% of loans originated during 2006.

NICK has 47 branch offices, 19 are in Florida. Before opening a branch office NICK will study the market to determine if its strict underwriting criteria will be successful in that market. The branch officer will attempt to establish relationships with local automobile dealers. Their goal is to have each new branch contributing $300K in pre-tax income within 3 years. It takes 12 months for a new branch to earn a monthly profit and about 18 months to recoup start-up costs.

-

NICK’s branch network allows it to establish relationships with clients. The office network requires more employees and higher expenses but the company has much better relations with borrowers. The result is delinquency rates that are incredibly low about 2% on average.
-

The current CEO Peter Vosotas founded the company in 1985. It is obvious that he has impeccable morals. In an industry where quality is sacrificed for quantity and next quarters earnings are more important then next year’s, it is really amazing to see a company like NICK.

-

See the chart below for historical growth and profitability metrics.

Strict Underwriting Discipline

"When yields on loans look temptingly high, we always try to remember that the return of your money is more important than the return on your money." - Inside cover of 2007 annual report

"The Company will not sacrifice credit quality, its purchasing criteria or prudent business practices in order to meet the competition." - Page 10 of 2007 10-K

NICK’s discipline is obvious, they are the only sub prime auto. lender that holds the loans on its books and doesn’t securitize them. The branch manager’s bonuses are tied to the performance of the loans that they made.

Competitors use credit scores as the main indicator of credit risk, allowing their central offices to process large volumes of loan applications and approvals to keep costs low. Nicholas feels credit scoring alone isn’t the most accurate indicator of individual borrowers risk. Two clients with identical credit ratings can offer much different risk levels. Nicholas administers phone interviews with each client. NICK places a high value on impressions made during the interview process. Nicholas primarily measures risk through factors other than raw credit scores, such as income level, stability, type of vehicle and previous credit history.

-

"We try to finance people who may have had trouble because of a divorce, medical problems or job loss, as opposed to 'credit criminals,'' said CFO Ralph Finkenbrink.

-

Amazingly, Nicholas turns down 85% of potential clients. NICK’s unusual credit review process allows it to purchase loans that most competitors wouldn’t touch but actually offer a better credit risk.

-

NICK is also amazingly strict when it comes to delinquent borrowers. The company will call the borrower the first day the loan becomes delinquent. Once, a deadbeat skipped town and the collections officer at the local branch office went to the home of the borrower and dug through the trash until he found the address of the borrowers parents. NICK installed a surveillance camera outside the home and repossessed the vehicle. All for $1,000. Historically the Company has recovered approximately 10-15% of deficiencies from such customers.
-

Financials

NICK purchases its loans at a discount to the loan amount usually 1-15% with the average being 8.5%. It accounts for this discount as a reserve for credit losses. Then when the loan is nearly paid off it accretes the portion of this reserve not charged off, to income. This could be a strong case for understating net income. Recently however, with the increase in delinquencies the amount accreted has dropped and this has negatively affected earnings.

-

NICK has done very well over the long run. During the weaker parts of the credit cycle NICK simply slowed its branch openings and waited it out while weaker competitors went bankrupt. The poor credit market we are in will benefit NICK in the long run.

Here is some historical info on NICK:

Click here for a larger version

The Investment Opportunity

Obviously, the issues in the credit market are negatively affecting NICK’s results and its stock price. But, unlike other sub prime lenders NICK didn’t make risky loans or leverage up. NICK currently has a debt to equity ratio of 1.3 which is amazingly conservative. For the first quarter of this year NICK earned 2.8 million compared to 3 million in the first quarter of 2006. The reason was a 48% increase in reserves for credit loses and lower accretion of discounts. NICK’s pre-tax yield as a percent of finance receivable was about 10%. So, in other words, of the 24.2% average interest rate that NICK’s customers pay on their loans, NICK’s pre tax earnings on that are 10% of the net finance receivable. NICK can withstand a lot if its operating margin is still at 38%. There is a nil chance that NICK will run into any serious problems because of the current credit market. Unlike their competitors they don’t have to worry about margin calls on their debt. And because of their conservative lending they will be the one that benefits from their competitors recent mistakes.

-

"There's always opportunity when there's distress and carnage," said chief financial officer Ralph Finkenbrink. "You've just got to figure out where it is. It hasn't happened yet, but we expect there will be availability from companies exiting the business or just putting portfolios up for sale."

If we take the average net portfolio yield over the last 11 years, which is interest income - interest expense and provisions for credit losses as a percent of net finance receivables, which is 20.5%. Then subtract 10.5% for expenses and subtract a 38% tax rate and the result is net income of 6.2% of net finance receivables. 6.2% multiplied by 184 million (net finance receivables) =’s net income of 11.4 Million. So this is a company trading for less then 8 times earnings that will benefit from the current credit crisis, has management that has proven that they do what’s best for shareholders and with a growth rate that should continue at over 20% a year as it has for the last 5 years.

-

The author has an investment in Nicholas Financial.

Update on Freightcar America Inc.

Usually when I research a company I look for trade journals in the relevant industry. I currently subscribe to Railway Age. I have learned a lot about the railroad industry from this magazine. I received the latest copy via email today. I found something that is relevant to my recent purchase of RAIL:

EPA sees continued "solid" freight car demand

"Despite a slowing momentum in orders during the current traffic downturn, Economic Planning Associates in a newly revised forecast says there are signs that "demand for rail cars will remain on solid footing for a number of years to come." EPA cited "replacement pressures and technological advances as well as legislative measures" as reasons for optimism. EPA expects builders to deliver 66,500 cars this year and 63,000 in 2008. Meanwhile, actual figures from the Railway Car Institute Committee of the Railway Supply Institute said builders delivered 16,643 new freight cars in the second quarter, down from 19,466 in the corresponding period last year. New orders were placed in the first quarter for 11,595 cars, compared with 19,190 in the 2006 quarter. The backlog of new cars on order but undelivered slipped to 73,921 on July 1, compared with 85,692 on July 1, 2006 . First-quarter 2007 orders included 4,236 tank cars, 2,706 open top hoppers, 2,200 inter modal platforms, 831 non-inter modal flat cars, 632 covered hoppers, and 500 boxcars."

The figure above are for rail cars in general not specifically coal cars. Nonetheless, coal car figures generally follow total rail car figures.
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A recent Fortune article titled Going nuclear discussed the merits of nuclear power. As many as 150 coal power plants were in the planning stages as of this summer. But, political opposition has caused many of the utilities to abandon plans for new coal power plants. Despite this many of the plants did get approval and are currently being built or are in the planning stages. Just like nuclear power, coal is being questioned because of its negative environmental effects. Nuclear power has many of the same issues as well. Utilities and scientists are working on ways to decrease the amount of CO2 emissions that coal power plants generate. The amount of coal deposits in the U.S. has oftentimes been compared to the amount of oil in Saudi Arabia. I continue to believe that coal will fill a larger part of our energy needs in the future.

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In my first post on RAIL I calculated that the company will be able to earn 67 million in normalized earnings. Another interesting way to think about this situation is to calculate what the company has to earn to maintain the current price.

Market cap is 533 million - 200 million in cash = enterprise value of 333 million. So, if RAIL earned just $33 million and traded at only 10 times earnings the current price would be maintained. So, therefore if I am extremely off on my calculations and RAIL makes half of what I calculated it will make, I will break even. In other words, I have a strong margin of safety if I am wrong on my calculations or something negative happens to the company.

Interesting Psychology Resources

I am convinced that if an investor has a basic understanding of psychology they will be better investors. The following is a number of the best psychology resources that I have read recently.

Stanford Prison Experiment: "A Simulation Study of the Psychology of Imprisonment Conducted at Stanford University: What happens when you put good people in an evil place? Does humanity win over evil, or does evil triumph? These are some of the questions we posed in this dramatic simulation of prison life conducted in the summer of 1971 at Stanford University."

Born Suckers: The greatest Wall Street danger of all: you. by By Henry Blodget
"Human beings, it turns out, are wired to make dumb investing mistakes. What's more, we are wired not to learn from them, but to make them again and again. If there is consolation, it is that it's not our fault. We are born suckers."

Influence: The Psychology of Persuasion by Robert B. Cialdini

Psychology of Intelligence Analysis

THE PSYCHOLOGY OF HUMAN MISJUDGMENT by Charlie Munger


The Expert Mind
"Studies of the mental processes of chess grandmasters have revealed clues to how people become experts in other fields as well."

Companies in my watch list are falling, falling, falling

Every day I glance at the daily 52 week low list. This is a good way to find companies that are undervalued. I noticed the companies listed below come up on this list recently. Most are quality companies. I have researched a few in the past but I will take another look because they have fell substantially in price.


Maui Land & Pineapple Co: MLP has prime acreage in Hawaii. It's down 25% in the past few months.

Moody's Corporation: Down over 60% during the past few months. Growing concern on Wall Street over the ratings MCO made on sub prime debt has pushed shares lower.

Wal-Mart Stores Inc: Down around 13 percent this past month. WMT is expanding into India. The company also announced that they will be repurchasing shares.

American Eagle Outfitters: Down over 30% in 6 months. I'm a strong believer in this brand.

USA Mobility, Inc: Down nearly 35% the past month. Held by many value managers.

CryptoLogic Limited: CRYP's stock price has suffered recently because of the ban on internet gambling in the United States. Mohnish Pabrai acquired shares at around $25 and CRYP is trading at $21 currently.

M&T Bank Corporation: Down around 20% in 6 months. Berkshire Hathaway has owned shares for a long time.

Lexmark International, Inc: Down 40% in 6 months. Berkshire Hathaway owns shares.

Sears Holdings Corporation: Eddie Lampert's company is down nearly 30% in 6 months.

Tyco Electronics Ltd: TEL just spun off from Tyco. It's down 15% since it first started trading about a month ago.

AutoNation, Inc: AN is down about 20% in 6 months.

Bank of America Corporation: Down about 10% in 6 months. Berkshire Hathaway recently disclosed it owned shares.

Walter Industries, Inc: Recently spun off Mueller Water Products. Down about 10% since it spun-off MWA.

Mueller Water Products, Inc: Down about 15% in a month. Recent spin-off from WLT as mentioned above.

USG Inc: Down 33% in 6 months. I recently researched this company. At the time it was trading at about $45 and now its at $36. I really like the company and if it falls further I will most likely make an investment.

Nicholas Financial, Inc: Down around 20% in 6 months.

Reverse Engineering of Warren Buffett’s December 1999 Investment in First Industrial Realty Trust

On December 3, 1999 Warren Buffett auctioned his 20 year-old wallet to benefit charity. Inside was a stock tip. A few weeks later the winner of the auction, John Morgan released the name of the company on the stock tip. It was First Industrial Realty Trust. I am analyzing the company as if it was December 3, 1999. The company was trading at $25 that day giving it a market cap of $941 million.
The Business

First Industrial Realty Trust, Inc. operates as a real estate investment trust (REIT). As of September 30, 1999, the Company owned 950 properties located in 25 states, containing approximately 65.2 million square feet. This makes First Industrial one of the largest industrial property owners in the country. As a REIT the company is not subject to federal income tax, provided it distributes 90% of its taxable income to its shareholders every year.

The Industry

The industrial reit sector has some very interesting characteristics. Industrial properties include distribution centers, warehouses, service centers, light-manufacturing facilities, research and development facilities and small office space for sales and administrative functions. Compared to other reit sectors, industrial reits maintain longer relationships with tenets because of the nature of the properties. Tenets renew leases at a rate greater then 80% and vacancy rates are very low usually around 7%, according to the book Investing in Reits by Ralph Block. The sector is much less prone to overbuilding because most properties are "built to suit" for specific customers and it takes considerably less time to construct and lease an industrial property so there is a much faster reaction time when demand weakens. Because of these factors, the ownership of industrial reits provides for consistent and high returns. Also, because industrial reits are less cyclical then other reits they are relatively recession resistant. Another advantage of industrial reits is unlike office, apartment or retail sectors, this sector has less of a need for ongoing capital expenditures to keep the building in good repair. Despite the interesting characteristics of industrial reits I doubt the reason Buffett bought was necessarily because of these characteristics. I think the reason was mostly because it was just extremely cheap.
The reit industry was doing fine in December 1999 but, share prices continued to fall. Investors ignored reits as they focused on the tech sector even though reits continued to report growing earnings. According to NAREIT, the price of all equity reits from January 1st 1998 to November 30th 1999 fell nearly 40%. Also, as stocks were trading at somewhere around 40 times earnings, reits were trading for only 8 times FFO! Currently reits are trading at 15 times FFO. Reits were yielding 9% at the time and now they yield just 4%.

The Numbers

For the year ended 1998 First Industrial had FFO of $133 million and was trading for $941 million. Giving the company a price to FFO of 7. Also, the company was trading at 88% of book value as of September 30, 1999. The company had a dividend yield of nearly 10%. Two months from now the company will report that for the year ended 1999 the company had FFO of 151 million giving the company a price to FFO of 6! After reading the 1998 annual report and the three 10Qs leading up to December 1999 I can detect no problems the company is going through. First Industrial wasn’t the only reit that Buffett invested in at the time. MGI Properties, Tanger Factory Outlet, Town and Country Trust, Baker Fentress & Co., Aegis realty, JDN Realty, PMC Capital, HRPT Properties Trust, Burnham Pacific Properties and Laser Mortgage Management all were held in Buffett’s personal portfolio around 1999. I will probably research some of these companies at some time in the future.

How it turned out

Buffett said at the 2004 Berkshire annual meeting that he sold off all his reit investments. So, I’ll assume he sold First Industrial at around the same time. He ended up doubling his money in 4 years. This proves that those with their eyes open can still find undervalued stocks in today’s market.

My Personal Portfolio: Freightcar America Inc

The Business

The company is the leading North American manufacturer of coal-carrying rail cars. They manufactured 81% of the coal carrying rail cars delivered over the three years ended December 31, 2006 in the North American market. The company has been producing rail cars for over 100 years.

The majority of the company's business is to it's top 10 customers. These included many of the major railroad shippers (Norfolk Southern, BNSF, Canadian Pacific, CSX and Union Pacific), financing companies and the remainder are major utilities. The company maintains long range customer relationships with these companies and the chances of one of their customers moving their business to a competitor is low because of the high costs of switching manufacturers.

Coal-carrying rail cars need to be replaced about once every 25 years so most shippers buy infrequently. Combine that with the fact that the company has only about 10 customers that make up about 70% of its sales and you get a company with very choppy earnings.


The company's prospectus from 2005 has good information to help investors learn about the industry.


A Company facing a temporary obstacle

The company delivered 18,764 coal cars last year compared to 13,031 in 2005 and 7,484 in 2004. As you can see the company had a huge spike in deliveries last year and that corresponded to a huge gain in earnings. There are two reasons for the large number of deliveries last year: First, this is a very cyclical industry and it happens to be a time when the industry is doing well. Second, many of their large customers made very large purchases.

Since their customers loaded up last year, the company's deliveries will be considerably lower this year compared to last year's record. Investors dumping the shares in anticipation have caused the share price to fall below intrinsic value. At the end of the first quarter backlog of unfilled orders was at 6,006 compared to 17,794 in the comparable period last year. Earnings and car deliveries for the first quarter were about the same as last year. But, the results in the coming quarters will be much lower then last year.


Why it's cheap

The company's results will suffer for the next few quarters but they will return back to normal soon. The companies results have varied widely from year to year in the past so last year's spike is nothing new. What would make most sense is this situation is to calculate normalized earnings. Normalized earnings is an average earnings figure that helps the investor to see past Freightcar's lumpy results.

First I'll start with a normalized order rate which includes the replacement rate of current fleets and the growth factor. There are 250k coal cars in the North America. Coal cars have a useful life of about 25 years. So that yields a replacement rate of 4%. Besides replacement, there is also a growth component for the normalized order rate. Energy demand in the US is expected to grow by about 2% a year and much of this will be met by coal. So with the growth factor of 2% and the replacement rate of 4%, 6% of the total coal car fleet or 15,000 coal cars will need to be manufactured every year. Since the company will most likely maintain its 80% market share, 12,000 of those cars will be produced by the company. Also, historically 15% of the company's orders were from non coal-cars. That would add 2,000 cars to the company's yearly production. In all, the company's normalized order rate is 14,000 rail cars. This will be used to calculate normalized earnings.

The replacement rate and growth factor assumptions are very conservative and I believe that for reasons mentioned in the catalyst section below that they will be a few percentage points higher. But nonetheless the company is cheap anyway and because of my extremely basic knowledge of the industry, it's probably intelligent to err on the conservative side.

In 2005 the company delivered 13,031 cars. The margins will most likely be similar if the the company delivers 14,000 cars, so this can be the basis for calculating the company's normalized earnings. The company earned 45 million in 2005 but that includes 11 million in interest expense and all this debt has since been paid off. So 11 million will be added to this figure which yields earnings of 56 million. 150 million in cash has since been added to the balance sheet and if the cash returns 5% that would add 7.5 million to earnings. Now we're at 64 million in earnings. Since the company delivered 13 thousand cars in 2005 and not the 14 thousand figure that were looking for it's safe to assume that with this extra 1,000 cars and the added efficiencies that have been realized since 2005 Freightcar America should be easily able to make 67 million a year in normalized earnings. With a market cap of 610 million the company trades at about 9 times normalized earnings. But, there are still a few significant pluses that haven't been added in.


The Catalysts

1. Mohnish Pabrai invested in the company.

2. There will be a surge in the number of coal power plants scheduled to open beginning around the first quarter 2009. The utilities that own these plants will begin to order cars for these plants about 6-9 months before they are scheduled to open. Thus we’d expect to see a surge in new coal car shipments beginning in the second half of 2008. Here is a article in the Washington Post about this boom in plant construction. The article focuses around MidAmerican Energy's activities and David Sokol is quoted often.

The Washington Post:

"At this bend in the Missouri River, with Omaha visible in the distance, the new MidAmerican plant is the leading edge of what many people are calling the "coal rush." Due to start up this spring, it will probably be the next coal-fired generating station to come online in the United States. A dozen more are under construction, and about 40 others are likely to start up within five years -- the biggest wave of coal plant construction since the 1970s."

3. The current fleets of coal cars are at the higher end of their useful lives. The average age of the 250,000 coal cars in North America is about 17 years old and coal cars typically need to be replaced at 25 years of age. Shippers looking to replace older fleets will be a significant plus for Freightcar America. This is already the case with Norfolk Southern. They announced last year that they will replace their 33,000 coal cars over the next ten years.

4. The company has a significant cash hoard. Over 30% of their market cap is cash. The company could expand their share repurchase program, increase dividend, make an acquisition or expand their operations overseas.

5. The company is repurchasing shares. They repurchased 1/8 of the shares outstanding in the first quarter. They can repurchase a further 1/8 of shares with the current program.

6. The company returned nearly 100% on capital last year. If my calculation of normalized earnings is used the company returns about 60% on capital (after taxes are added back in). Because of this the company is on the magic formula list. The company has no debt on its balance sheet!

Note: The author has an investment in Freightcar America.

My personal portfolio: Arbitrage investment -Tribune Company

Current Price----- $29.5
Merger price------ $34
Potential return-- 15%
Annualized return- 36% assuming the transaction is completed by the end of the year

The transaction comprises of two steps first, the tender offer, which has already been completed and second, the merger in which the shares will be purchased for $34 per share. The transaction is expected to be completed by the fourth quarter. If the Merger does not close by January 1, 2008, this amount will be increased at an annualized rate of 8% from January 1, 2008 to the closing.

The preliminary proxy is out but completion of the deal rests on FCC approval and then when the definitive proxy is out, the shareholder vote. The reason for the wide spread is probably caused by the declining operating results at Tribune. It looks like Sam Zell (the acquirer) and the company are to far into the deal for them to easily walk away from the table. The merger looks fine but the risk is that if the merger is canceled the stock could fall because of the softening operating results at Tribune.

Note: The author has an investment in Tribune.