Tuesday, 29 May 2012

Are We in Another Dot Com Bubble?

The immediate slide in Facebook's share price since its much-hyped IPO begs the question: Are we in the midst of a second Dot Com bubble?  There is no widespread tech-driven mania, as there was in the late-1990s.  In those heady days, virtually any company with a ".com" at the end of its name went to the sky.  Indeed, several companies changed their name by adding that very suffix (or similar ones) only to see their stock price soar instantly.  Businesses based on questionable (or worse) premises commanded multi-billion dollar market values, such as Pets.com, the infamous online seller of cat food and dog kibble.  The internet has been a feature of mainstream life in most parts of the world for 15 years or so.  Though it has been every bit as revolutionary for society as expected, it's now understood that it's not a license to print money for anybody and everybody that uses it.
However, among social networking stocks, in some "cloud" computing companies, and scattered here and there in the tech space, valuations are sometimes approaching the nose-bleed heights of the late-1990s.  As noted at length in an earlier article, Facebook's IPO price assumed very strong growth rates over a prolonged period of time.  Related stock Zynga, which provides many of the games that Facebook addicts enjoy, currently sells at a price that values the company at $4.5 billion.  Granted, the company has nearly $1.8 billion in cash and investments, and sales grew 90% from 2010 to 2011.  However, sales growth slowed significantly in the first quarter of 2012 compared to the year-ago period.  Most importantly, the company incurred a large loss of $404 million in 2011, and an $85 million deficit in Q1 2012.
LinkedIn, the widely-used professional networking site, has a stock price of nearly $100, valuing the company at over $10 billion.  Sales growth has been impressive over the past few years, more than doubling to $522 million in 2011, and doubling again in the first quarter of 2012 compared to the same period a year earlier.  Earnings, however, remain virtually non-existent.  Indeed, income stood at $11.9 million in 2011, down from $15.4 million in 2010, and grew to a not-so-impressive $4.9 million in the first quarter of 2012.  Given that sales have galloped forward, it's worrisome that earnings haven't done the same.  Whatever the company earns this year, its multiple is likely a three-figure one at today's stock price.
When bargain-hunting investors scan P/E ratios, the only thing worse than a high multiple is an "NA," which denotes a company that doesn't generate earnings at all.  In the "cloud" space, Salesforce.com's 2011 performance put the company in the unprofitable "Not Applicable" category.  As are many other tech firms, the company is posting impressive sales growth.  Between fiscal 2008 and 2012, revenue grew by 32% per year, and that figure grew by 38% in the first quarter of this year compared to last year's first quarter.  However, none of this growth is making its way to the bottom line.  In fact, the company is forecasting a loss of 0.45 to 0.48 cents for fiscal 2013.  By contrast, the shares trade at around $145, which values the company at about $20 billion.
Groupon went public last year at a price that valued the company at nearly $17 billion, before the company had established profitability.  The stock has fallen sharply, from around $26 at IPO to under $12 today.  Even tech bellwether Amazon.com, a familiar company with a straightforward business model, commands a very high multiple.  The company believes that establishing a market presence today will lead to profits down the road, and it views sub-par profits in the near-term as a kind of investment.  The strategy, in fairness, has worked for the company over time, and it's undeniably dominant in many areas.  However, investors ought to be skeptical of some of Amazon's cutting edge peers, who have taken the same relaxed stance on current profitability: after all, there's no guarantee that tomorrow will be better than today.

For coverage financial bubbles read my review of John Kenneth Galbraith's A Short History of Financial Euphoria

Disclosure: The author did not own any positions, long or short, in any of the companies mentioned at the time this article was published.
Sources: Official filings that can be found on the respective companies' websites.
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Monday, 28 May 2012

Book Review - A Short History of Financial Euphoria, by John Kenneth Galbraith

In the 1993 revised edition of A Short History of Financial Euphoria, John Kenneth Galbraith, one of the twentieth century's leading economists, concedes, "Recurrent speculative insanity and the associated financial deprivation and larger devastation are, I am persuaded, inherent in the system" (viii).  Fresh in his memory are Michael Milken, the "speculative orgy" (ix) in real estate in the 1980s accompanied by the S & L crisis, and the Salomon Brothers disaster.
These were only the most recent examples in an age-old pattern that has involved not just real estate, banks and junk bonds, but securities of all kinds, bank notes, art, tulip bulbs, joint-stock companies, and so on.  However similar to past instances - including the "Tulipomania" in the 1630s, the South Sea bubble in the 18th century, and the "roaring" 1920s - these episodes "always evoke surprise, wonder and enthusiasm anew" (11).
Galbraith doesn't just offer a laundry list of manic episodes, but identifies the characteristics they all have in common.  Though he knows that few will heed his warnings, Galbraith hopes to spare at least some people from the devastating consequences of financial manias and the ensuing crash, which in the past has taken the form of disgrace, impoverishment, exile, suicide, and imprisonment.
Psychology is a powerful element of speculative manias.  People benefiting from an inflating bubble chafe at any criticism.  Partly this is financial, but people also prefer to believe that they are getting rich due to their own superior talent or intelligence.  Others will reinforce such views in a capitalist economy, where wealth is often considered synonymous with brains and ability, not a result of dumb luck.  Money plus ego is a powerful combination.  Lucky naysayers will be merely ignored or dismissed; unlucky ones will be attacked, accused of envy, stupidity, or worse.
People often believe that there is "something new in the world" (18), some exception to the usual rules that will allow prices to continue rising quickly indefinitely.  The tulip bulb mania in the 1630s was particularly bewildering, since it was nothing but a flower that had long been grown in the Mediterranean.  However, they were new to Europe in the early 1600s, and people were more attracted to the blooms the rarer and stranger they were. 
Very often leverage is a cause and aggravating factor in a mania.  In the South Sea Bubble, for example, the company of the same name incurred large leverage owed by the British government in exchange for a monopoly on trade in certain areas.  In the years preceding the Great Depression, investors were able to borrow at a 10-to-1 ratio on margin, though only at a very high interest rate.  Debt played a large part in corporate takeovers and leveraged buyouts in the 1980s.
Frequently, financial "innovation" contributes to bubble, often involving "the creation of debt secured in greater or lesser adequacy by real assets" (19).  The joint-stock company had in fact been around for centuries by the time the South Sea company was formed, but memories are short and fuzzy in the financial industry, and investors believed that a creative new instrument would lead them to enormous wealth.  The "discovery" of junk bonds, high risk bonds accompanied by a high-yield, led to a bubble in that area the 1980s.
Government as Backstop
The state often ends up as the "recourse of last resort" (34) in the aftermath of mania turned to panic.  Insuring deposits, limiting bank leverage, creating regulatory regimes, enacting Keynesian economic stimulus, placing curbs on the use of margin, bailing out failed businesses - most or all of these forms of government intervention were in response to financial manias.
It's striking and heartbreaking how right Galbraith was, not only in his analysis, but in his knowledge that few will heed his warning, and certainly not enough to preempt future bubbles.  The ink was hardly dry in his book before the Dot Com bubble of the late-1990s began to inflate, because the revolutionary arrival of the internet made standard economic rules look old and analog (novelty); derivatives worth hundreds of trillions of dollars, more than all the assets in the world, built up before the 2008 crash (leverage); collecting and repackaging mortgages and selling them as securities relieved banks of the pesky burden of assessing borrowers (innovation).  The peculiar psychology that always helps to cause and reinforce bubble was present in these recent cases, just as it was in innumerable past instances.  Governments and central banks, as ever, were forced to avert worldwide disaster by massive intervention of all kinds.
Galbraith’s target audience is the odd stray investor, banker, or real estate developer that may be ambivalent in the face of a developing mania; he’s too realistic to believe that one book alone can wrestle with such powerful forces all working in the same direction.  By reading this short, useful book, you, dear reader, may yet avoid the next bubble and its inevitable aftermath.

Source: Galbraith, John Kenneth. A Short History of Financial Euphoria. New York: Viking Penguin, 1993.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Friday, 25 May 2012

Facebook - A Business Analysis

Last week, Facebook launched its long-awaited IPO.  Unlike many hi-tech IPOs, investors were not treated to an instant, satisfying gain in the stock price.  Making matters worse, the NASDAQ stock exchange suffered technical difficulties in the first few hours of trading.  Some investors were not sure if they owned stock or not, making it impossible to sell before the stock fell from $38 or so to around $33 at present.  Lawsuits, not surprisingly, abound. 
But buying a stock immediately after it goes public and hoping to sell it weeks, days or even hours later for a handsome gain, is speculation, not investing.  It is virtually impossible to accurately predict the short-term gyrations of a stock over time (to perform better than chance over many repetitions, at least).  The mere fact that other, similar IPOs led to an immediate bonanza offered no assurance that Facebook would too.  The only reliable way to make money investing is to buy a stock that is cheap compared to the future earnings of the business.  Let's do what many investors did not: analyze Facebook's business and financials.
The Business
With 900+ million active users for a company founded in 2004, Facebook has been a staggering success.  The company has a clear competitive advantage: "network effects" mean most new users of a social network will join Facebook, since that's where all their friends, family, co-workers, teammates, long-lost loves, dimly remembered classmates, and others will be found.  From there, people have a chance to share photos, ideas, news, and all-important updates about the status of their dating life, morning coffee and many other deep thoughts.  Businesses, non-profits and many other organizations and institutions are also part of the Facebook community - more than just a website, Facebook functions much like a parallel internet.  There are similar networks that have a significant regional following, such as Google's Orcut in Brazil and India, and there are niche competitors in other areas, including LinkedIn in professional networking, but Facebook is likely to remain the dominant "general use" site of its kind for years to come. 
From a business perspective, Facebook isn't selling services to users, its selling users to marketers.  The sheer size of Facebook's user base, plus the rich array of information that people expose about themselves, gives advertisers and application developers a gold mine of data used to pitch their offerings.  There was a day when advertisers offered commercials to groups as large and generally defined as, say, men between the ages of 18-35, a big, baggy category that is laughably crude by Facebook's standards.  This business model operates on an "if-you-build-it-they-will-come" basis, and as long as Facebook has hundreds of millions - soon to be billions - of users humming with activity, advertisers will come.
Tech stocks are typically difficult to value, given their fast-changing nature.  However, just as Microsoft and Ebay have had long-term success thanks to "network effects," Facebook has likely "locked in" users for a prolonged period of time.  It does not resemble a bio-tech startup with a newly conceived, highly uncertain way of treating cancer, for example.  At least for the foreseeable future, there's a good chance that Facebook will remain a household hobby.
At today's prices, though, shareholders are assuming that the company will not only generate stable and steadily growing earnings, they are assuming very robust growth over a prolonged period of time.  In 2011, Facebook generated EPS of 0.43.  At the current $33, the stock trades at an eye-watering 77 times earnings (as a reference point, the average stock has historically traded for around 15 times earnings).  While a company growing quickly, with a solid competitive position and high returns on capital may justify a premium multiple, 77x is off-the-charts.
Growth, alas, has already begun to slow markedly.  2011 sales grew 88% over 2010, and net income advanced by a less sizzling 65%.  In the first quarter of 2012, however, sales growth slowed to 45% and earnings were down slightly from the same period a year ago, albeit partly due to abnormally high taxes.  The slowdown in growth is not likely a short-term blip, either.  As popular as the site is, it no longer has room for exponential growth.   Though the cyber-world is virtual and borderless, the real world is not infinite, and even Facebook can't escape its finite horizons. 
With a worldwide population of about 7 billion, 13% of every man, woman and child on the planet are Facebook addicts.  Whether it ultimately attracts 1.5, 2 or even 3 billion users, the number won't reach 4 billion or more (the company is not permitted to operate in China, cutting 1.3 billion potential users from Facebook's addressable market).  Admittedly, there is room to grow earnings per user: assuming that Facebook draws in $5.5 billion in sales in 2012, and averages 1 billion users, the company will bring in just over $5 per user for the year, a figure that presumably has ample room to increase.  In its prospectus, though, the company concedes that its rate of revenue growth will likely decline in the future, meaning that slowing user growth will not be completely offset by increased advertising sales.
It seems safe to bet that users and revenue will increase, but at a much slower rate than in the past.  Assuming that sales grow 45% in 2012, 33% in 2013, 25% in 2014, 20% in 2015, and 15% the next year, revenues would reach $12.3 billion by the end of 2016.  Assuming operating margins of 45% and a tax rate of 35%, net income would be $3.6 billion, or $1.69 per share.  Since growth will have slowed significantly by then, investors shouldn't expect a multiple of more than 20x earnings, which would be around $34 per share.  Even adding today's approximate net cash of $4 per share only increases the figure to $38, the very same number, incidentally, that shareholders paid at IPO.
In short, even assuming very strong sales growth and wide margins, the company's stock may hardly budge from today's levels.  Since it's foolish to assume such high growth, and it's doubly unwise to invest without a margin of safety, conservative investors would be wise to pass on Facebook at today's share price.

Source: IPO Prospectus which can be found on the company's website.

Here's my article exploring whether there's a more general bubble in tech stocks.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Wednesday, 23 May 2012

Leucadia National - A Mini Berkshire Hathaway?

Leucadia National (LUK) is sometimes referred to as a "mini Berkshire Hathaway," and indeed the two businesses share many important qualities in common.  Leucadia is among the very few companies with a track record nearly as long and glorious as Warren Buffett's investment vehicle.  Berkshire's (BRK.A) per share increase in book value from 1965-2011 was 19.8% per annum; LUK's performance by the same standard was 18.5% from 1979-2011, despite a large one-time dividend in 1999 that significantly reduced book value.
Aging Masters
Both institutions owe much of their past success to the superb two-man teams than run them.  Berkshire's Warren Buffett and Charlie Munger are the greatest and most influential investing combination of all time; though not famous, Leucadia's Ian Cumming and Joseph Steinberg have an investing record that isn't far behind.  All four super-investors share a similar philosophy: they search for well-run businesses with a solid competitive position, a high return on capital, selling for a reasonable price.  Not surprisingly, Berkshire and Leucadia have similar corporate structures, with each owning a collection of publically traded stocks, as well as wholly-owned subsidiaries that generate cash for the parent company. 
The two companies share a similar style, as well.  They both feature no-frills websites, neither employs an investor relations staff, nor do they host quarterly conference calls with analysts.  This is not to suggest an aloof attitude toward shareholders, though; in fact, just the opposite.  The leaders of both companies craft lengthy, informative letters to shareholders each year, outlining for investors their broad philosophies, as well as significant business developments.  Though Berkshire's annual meeting is an over-the-top capitalist carnival, Buffett and Munger do answer shareholders’ questions for many hours.  Leucadia's managers field questions just the same, though their meeting is a completely low-key affair. 
Unfortunately, these aging legends won't be around much longer.  Though neither has ever expressed an interest in retirement, Buffett is 81, Munger, 88.  While young and sprightly by comparison, the end is now in sight for Leucadia's Chairman Ian Cumming.  At the end of the 2011 letter to shareholders, he quietly announced that he will not work past the end of his current contract, which expires in June, 2015, around the time of his 75th birthday.  There was no word from the President, whose contract expires on the same date, though he is 68 years old.
Bigger, Stronger and Slower or Smaller, Less Strong and Quicker
Given the giants in charge, Berkshire's loss of talent will be greater, but their successor will at least inherit a formidable infrastructure of wholly owned subsidiaries that throw off cash to the parent company.  In the past, Berkshire's value rested largely on its stock portfolio, but over the last decade, the company has focused on buying businesses outright.  In the 2010 annual report, Buffett estimated Berkshire's "normal" earnings power at $12 billion after tax, a figure that must now be well in excess of $13 billion.  The downside of such size is, well, size.  With a $200 billion or so market cap, Berkshire is simply too large to grow quickly.  A nimble elephant, after all, is still an elephant.
Leucadia has a much smaller and less attractive array of wholly-owned businesses.  Berkshire is a cash flow machine, but Leucadia's ragtag collection of operating businesses - including a timber company, a vineyard, and a supplier of plastic netting - has generated only modest profits relative to the size of the parent company.  This may change before the existing management retires, though.  The company recently made its largest ever acquisition, paying $868 million for 79% of National Beef Packing, which commands a 14% share of the US-fed beef market.  Better still, Leucadia paid a price that values the business at just four times 2011 operating cash flow of $273 million.  On the plus side, with a market cap of just $5 billion, Leucadia remains small and nimble enough to grow quickly.
To Buy or Not to Buy
Though they're difficult to value, both companies appear cheap.  Historically, Berkshire has tended to trade at a 50-70% above book value, though that premium has narrowed considerably in recent years, likely due to fears about what happens after Buffett is gone.  The company recently initiated a share repurchase program, pledging to buy back stock only if it fell below 110% of book value.  In the few months since the announcement was made, the shares have rarely fallen below that threshold.  But it is barely above it at present, suggesting a cheap stock.
In the past, Leucadia's stock has deviated wildly from book value, sometimes trading for less than half of equity, other times more than twice book.  It currently trades at around the value of its equity.  There is no similar "floor" underneath Leucadia's stock, either in the form of historical precedent or a firm commitment to buy back stock when it falls below a certain metric.  However, given the company's proven ability to grow book value over time, buying in at today's prices likely represents a sound investment.
Leave it to the pros, or do-it-yourself?
When studying investment holding companies, active investors will naturally be tempted to pick and choose the best ideas for themselves.  Indeed, copycat investors have long coat-tailed Warren Buffett by buying into the same stocks that he does, after his investments have been made public.  But a "do-it-yourself" Buffett portfolio is not a proxy for Berkshire, since it can’t reproduce the massive amount of free "float" provided by the company's insurance operations, nor the large and growing cash flows from 70-odd operating businesses.  However, investors could more readily create a "make-your-own" version of Leucadia, since much of its value is currently tied up in the stock of Jefferies, Mueller Industries and Inmet Mining.  Most investors would be wise, though, to leave it to the masters, even if they won’t be around forever.

Sources: Berkshire Hathaway annual reports, 2011; Leucadia National 2011 annual report, 2012 first quarter filing
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Saturday, 19 May 2012

IBM - Investment Analysis

Warren Buffett sat out the Dot Com Bubble of the late 1990s, just as he had refused to partake in a similar mania in the 1960s, because fast-changing technology companies are inherently difficult to predict, prices were sky-high and, besides, he's a self-described "luddite."  The value of a business lies mostly in the earnings that it will generate over time, and a wildly unpredictable future makes it too difficult to reliably value a business.  Long time Buffett followers were surprised, then, when the technophobic investor announced a $10.9 billion stake in IBM.  For as long as anybody can remember, paradoxically, the company has been leading the world into the mysterious future.  What was the Oracle of Omaha thinking?
Though the company is indeed one of the world's most innovative, its business model, Buffett explained, is slow-moving and "sticky."  That is, the company's "switching costs" are high.  When the IT manager of an institution contracts IBM, the business's hardware, software, systems and staff become intimately entwined with Big Blue.  The costs of untangling - in time, money and risk - are high.  It's neither quick nor easy to move to a competitor's system: staff may need retraining, hardware may need to be replaced, and data could be corrupted, lost or stolen.  It's a hassle.  Besides, competitors have the same will and ability to hold on tightly to clients.  For IBM, however, it creates a solid, predictable revenue stream, and an installed base to add new products and services onto.
IBM not only retains existing customers, the firm pursues new business very aggressively.  Deep Blue checkmated grandmaster Gary Kasparov, Watson outwitted even Jeopardy's foremost contestants - and each dramatic "machine-over-man" encounter gave IBM the opportunity to demonstrate both its technical prowess and its canny salesmanship.  When there's new business to be awarded, IBM will get its share.
The historical financials show not a capricious, shape-shifting hi-tech business, but a steadily growing earnings machine.


From 2003-2011 earnings grew at a compound annual rate of 12% per year, EPS was even higher, at nearly 17%, due to share repurchases, and return on equity improved from high to radically high (the average North American business returns 10%-12% on equity).
There's reason to expect the foreseeable future to be nearly as attractive as the recent past.  Buffett approvingly cited the company's ambitious 5-year "road maps," which it consistently delivers on.  Between 2010 and 2015, IBM has pledged to return $70 billion to shareholders via dividends and buybacks make $20 billion of acquisitions and reach at least $20 per share in earnings.  Given that less than a quarter of revenues currently come from the fast-growth BRIC markets, and the company's move away from low-margin hardware sales to high-margin software and services offerings, it's all but guaranteed that the company keeps its promises. 
Assuming a 17.5x multiple times 2015 earnings of $20 per share, plus another $15-17 in remaining dividend payments, an investor that buys the stock at its current sub-$200 price stands to gain around 20% per year over in IBM over the next three and a half years.  Not only is there virtually no business risk, there is very little financial risk given the company's steady results, its low-capital business model, and its sound financial position.  Since the company is a large-scale, long-term buyer of its own shares, there’s at least a soft floor under its share price, though the lower it goes, the happier patient investors will be, since their per share economic interest in the company will increase.  On the whole, the company has significant upside and very little downside.

Sources: 2011, 2010, 2005 annual reports, available at the company's website.
Disclosure: The author had no position in IBM at the time this article was published.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Thursday, 17 May 2012

Book Review - The Dhandho Investor, by Mohnish Pabrai

"What does "dhandho" mean?"  That's likely the first question book browsers ask when their eye catches the spine of Mohnish Pabrai's The Dhandho InvestorThe ethnic group that the word belongs to defines it as a low risk, high return investment, which contradicts the conventional wisdom that outsized returns can only be had at the cost of high risk. As Pabrai likes to say, "Heads, I win; tails I don't lose much."
Many investors have helped affirm Pabrai's motto: the Patels, a people from India that account for just 1 in 500 Americans, but own half of all US motels; Richard Branson, who started serving an ignored niche in the airline industry, while risking little capital by leasing an unused plane; Lakshmi Mittal, who restored dying steel mills to profitability, but paid very little for them; or Warren Buffett, who amassed jaw-dropping returns, while taking on very little risk.  The "high-risk-high-reward" concept has been proven wrong. 
Pabrai is heavily influenced by Buffett and Charlie Munger.  As they do, he encourages investors to buy simple, predictable businesses.  Moreover, worthwhile businesses have a competitive advantage and resulting high returns on capital.  These gems, however, must be bought on the cheap.  Strangely enough, temporary market inefficiencies will give patient investors opportunities to buy gold for the price of brass.  But golden opportunities are rare enough that when they do arise, investors must bet heavily. 
Though Pabrai doesn't break much new ground in this book, he puts more emphasis on certain points than many other investors do.  For example, he broadens the term "arbitrage" from a narrow fixation on price differences, and uses it as a metaphor for investing in general.  What's a competitive advantage, after all, if not a form of arbitrage?  If one company is able to offer lower costs than competitors, it will draw in more customers; over time, though, high-cost producers will perish, and remaining ones will become leaner, narrowing the gap between the market leader and the also-rans.  Fortunately for investors, though, many "moats" last for decades.  Pabrai analyzes GEICO, owned by Buffett's Berkshire Hathaway, which has enjoyed a low-cost "arbitrage" spread for decades, and is likely to do so for decades to come.
One of the high points of the book is Pabrai's discussion of the difference between risk and uncertainty, a crucial distinction that many investors fail to make.  Risk is the potential for capital loss, while uncertainty is a wide range of possible outcomes.  Confusing uncertainty for risk frequently leads to underpriced securities - investors wise to the difference stand to make a lot of money. 
Along with case studies of Level 3 and Frontline, he candidly discusses his investment in Stewart Enterprises, a company that "rolled up" hundreds of locally-owned, mom-and-pop funeral homes, but amassed too much debt in the process.  Worried about the potential of default, the market pummeled the stock.  Pabrai wasn't fazed.  He calmly assessed the company's major alternatives: reselling some locations to their original owners, refinancing, or restructuring via bankruptcy were the most likely options.  Then he assigned a probability to each, and estimated the share price that would result from each option.  He decided that the bankruptcy would leave enough of the business intact to break even, and the other two options would give him a large profit.  Uncertainty was high, but the risk of loss was low.
Pabrai doesn't just vaguely advise investors to bet heavily when the odds are in their favor, he points them specifically to the Kelly Formula as a guideline for how much to wager given certain odds.  Much of the value of the Kelly Formula is that it encourages investors to consider a range of possible outcomes and attach probabilities.  It carries risks, though: it suggests precision, where only approximations can be made, and it suffers from the same "Garbage-in-garbage-out" weakness that many formulas do.  Pabrai recognizes the drawbacks to the Kelly Formula, and he devotes 10% of assets to each investment. (The book was published in 2007.  Pabrai got walloped in the Great Recession, as nearly all investors did, and now runs a somewhat more diversified portfolio).
Most investors agree that selling is an imprecise art.  With the help of the epic poem the Mahabharata, Pabrai offers some wise advice.  First, allow at least two to three years for the story to play out, unless it has become undeniably clear that the investment was a mistake.  Stocks often decline after investors buy them, even when the business is succeeding.  Jittery investors frequently panic and sell, only to watch the stock appreciate later.  In more serious cases, the business itself may stumble.  But all businesses face challenges, and investors must be patient and wait for improvement.  Pabrai did just that with USAP, a specialty steel maker: his investment fell by nearly two-thirds before roaring back and doubling from his initial purchase price.
Many investors offer a recipe for success that's long on theory, but scant on practical advice for finding undervalued stocks.  Pabrai, however, offers helpful suggestions about how to hunt for value: scan Value Line for battered stocks, consult www.portfolioreports.com and www.gurufocus.com for the holdings of prominent value investors, visit Joel Greenblatt's www.valueinvestors.com, www.magicformulainvesting.com and read his book The Little Book that Beats the Market.  Don't be afraid to clone or copycat, Pabrai urges.
Pabrai is an excellent investor.  From 1999 to 2007, he returned 28% a year, though that number has fallen since the Great Recession.  The Dhandho Investor is a success.  He wisely sticks closely to Buffett and Munger, but has the judgment to borrow from others, too.  His book, however, isn't just an collection of other people's ideas, despite his cheerful admission to copying others.  He cites several examples that don't typically make it into case studies, but also draws on more familiar ones.  He reinterprets basic ideas and gives them much more explanatory power.  Short, clear, fun and wise - this book is a must read for any serious investor.
(1) Pabrai, Mohnish. The Dhandho Investor. Hoboken: John Wiley and Sons, 2007.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Wednesday, 16 May 2012

Wage Stickiness and Greece

Imagine that you've been working for the same employer for a decade.  Over that time you've met all expectations, and have been rewarded for your loyal efforts with regular raises and several promotions.  You've built friendships, brought your family to corporate outings, and the like.  Then something changes.  A recession hits, and your formerly faithful employer offers you a regrettable lesson in Economics 101, from the chapter on supply and demand.
When a retailer orders more shirts, chocolate bars or cars than customers want, they must clear them by lowering prices, putting supply and demand back in balance.  Economic turmoil has left many people without work, leading to an excess supply of labor.  The unemployed are willing to lower their wage demands, reasoning that a lower paying job is better than none at all.  You're offered a choice: accept a wage cut of 35% or forfeit your job to someone who will.  How do you react?
If you're like nearly all workers, you're hurt, confused, indignant.  It's simply not fair.  After all, why should you be punished for economic forces beyond your control?  In fact, the responses to such demands are so strongly, so instinctively negative that employers rarely make them.  They know - or at least fear - that employees who feel betrayed have great power to harm their employer: spurned workers can be unmotivated, unproductive - or worse.  Since workers are the face of their employer's business, and are responsible for producing safe/reliable/quality goods and services, morale must be maintained.
On the surface, this may seem like an unnecessary dose of common sense, but it's actually known officially as Keynesian wage stickiness, a rare and powerful exception to the usual rules of supply and demand.  This is why there are few "clearance sales" in the labor market, and part of the reason unemployment exists.  It's all about fairness.  Indeed, careful analysis has shown that wages are often set above the rate that employers could get away with paying, and that workers understand that they are lucky to have a job during times of high unemployment (1).  This is not some stale detail from economic theory; it very much applies to real-world economics, including the current troubles in Greece. 
Workers in Greece lucky enough to have a job feel exactly as expected: they're not responsible for the over-borrowing of past governments, the corruption of society or the plight of their employers.  This is partly why Europe's current policy for restoring Greek competitiveness has failed.  Slow, grinding deflation has created a depression in the labor market - unemployment is above 20%, and over 50% for youth - but wages have hardly fallen.  (Even if wage cuts could easily be enacted, it would worsen the near-term economic problems, given the Greek government's inability to offset a fall in private demand by increasing public spending).  Many economists believe wages must fall by at least 20% to restore the Greek economy's competitiveness.  This would take years, but Greece's social and political fabric is already fraying.
There are two viable options for restoring Greek competitiveness.  The "in-the-Euro Zone" option is to promote significant inflation in the richer northern European countries - notably Germany - which reduces relative prices in the struggling southern nations.  This can be accomplished by monetary policy, or increased fiscal spending in the north.  Given the ECB's mandate to keep inflation at just below 2%, and Germany's unyielding resistance to elevated inflation or quantitative easing, fiscal measures hold more promise.  German wage growth has been deliberately kept below inflation for the past decade, leaving room for an increase, which would increase the price of their exports.  Thankfully, there’s been progress recently, as one of the country's largest unions won a pay increase of up to 6.5% by the end of 2013.  In addition, finance minister Wolfgang Schaeuble defended other unions trying to bargain for significant pay hikes (2).
The second, scarier option would see Greece exit the Euro Zone and reintroduce the drachma.  Though there would be turmoil following such a move, the new currency would immediately fall sharply against the Euro, restoring competitiveness and renewing growth.  Perhaps because Greece has no equivalent to Germany's ultra-competitive mittlestand, there is a view that Greece exports nothing, and thus stands to gain little growth via currency depreciation.  But Greece does "export" a lot of services, especially in shipping and tourism.  In fact, exports of goods and services are nearly 25% of GDP. 
Judging from the recent flight of deposits from Grecian banks, this option is becoming increasingly likely.  We may know for sure after June's elections.  What we know already, though, is that the demand for fairness ensures that the current policy of deflation will not work.  Yet another time-tested lesson from John Maynard Keynes that we've had to relearn the hard way.
(1) Akerlof, George A. and Schiller, Robert. Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism. Princeton: Princeton University Press, 2009, (pp 97-106).
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Monday, 14 May 2012

ARC Document Services - First Quarter 2012 Update

ARC Document Services (ARC) recently reported results for Q1 2012.  The commercial construction market remains soft, resulting in a 3% drop in overall revenue, despite a 10% increase in FM/MPS.  Gross margins contracted slightly, as well.  On the positive side, operating cash flows increased year-on-year, capex fell slightly despite new investments in growth, and ARC continues to trim net debt.  The company reaffirmed guidance for operating cash flow, which is expected to range from $40-50 million.
Overall, the quarter was in line with expectations, though the softness in the commercial construction market may have surprised some.  The company will continue to rationalize assets, keep costs low, open new markets and continue paying down debt.  As the market strengthens in the years to come, the company is well positioned for very profitable growth.

Here is my original thesis on ARC.

Source: First quarter 2012 press release
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Saturday, 12 May 2012

ARC Document Services - Investment Analysis

Business Description

ARC Document Services' (ARC) primary business is providing document management services, document distribution and logistics, and print services to the architectural, engineering and construction industries. The company provides "blueprints," the drawings that are the universal "language" used in all aspects of the construction process, used by developers, architects, contractors, sub-contractors, suppliers etc. (up to 200 different types of trades are involved from start to finish on a large construction project, and many use these drawings).

Documents change constantly as a project progresses, and the changes must be tracked accurately, quickly and confidentially. The documents are generally larger than 11" by 17" and require specialized printing and finishing, and a deep understanding of construction work flows. Indeed, thousands of documents may be printed over the course of a single large project, a major feat of logistics and organization. ARC also houses company-owned equipment in customers' offices as part of their Facilities Management services, and in some cases customers outsource their entire printing and document management operation to ARC. In addition, ARC offers document management and printing services outside the construction industry, including to the retail, aerospace, entertainment, and health-care industries, mostly in the areas of advertising and promotion.

Competitive Position

ARC spent the last decade consolidating the industry and has established a dominant market position in a fragmented industry. Indeed, ARC has over 200 locations, eight times as many as their nearest rival. Most of ARC's stores are in the U.S., where they operate over 200 cities in 43 states. In addition, they have a presence in Canada, U.K., India and China.

Most competitors are privately owned, "mom-and-pop" shops that operate one or two locations, and generate less than $7 million in revenue per store. The prolonged economic slump, which has hit the commercial construction market particularly hard, has decimated many weaker players. Whereas in the past ARC trumped the competition by buying it, in recent years it has gained share as rivals have folded. The company may pay several thousand dollars to buy a customer list from a defunct competitor, rather than committing hundreds of thousands, or millions, of dollars to buy the entire business. Besides small, strategic "tuck-in" purchases, the company doesn't expect to make significant acquisitions in the future.

Scale gives them several competitive advantages: 1) A large geographical footprint that enables ARC to take on regional, national and global contracts that smaller competitors cannot; 2) As the industry moves to offer more digital services, ARC can spread research and development spending across many locations, but most competitors cannot (ARC has spent over $100 million in the past decade on technology innovation); 3) Economies of scale make ARC one of the lowest cost producers in the industry; 4) A large installed base of the company's equipment in customer offices ensures repeat business - "stickiness" - and studies show that such customers tend to use more services than they otherwise would.


The company enjoys high margins and a variable cost business model (55% of costs are variable), allowing it to produce significant free cash flows, even in a weak economy. In addition, maintenance capital expenditure requirements are modest, averaging about 1.6% of sales, or $7-10 million per year. Though ARC will invest a small amount of added capital to grow, overall capital expenditures should not exceed $15 million annually. The company believes it can double sales from the existing footprint - by adding a second and third shift - and doesn't expect to pursue a significant acquisition program in the future. This means that happy shareholders are likely to benefit from dividends and share buybacks in the future, though not until the company has further paid down debt.

                      2011 2010 2009 2008 2007 2006 2005 2004

Sales             423   442    502  701    688    592   494   444

EBITDA*       67     75      107   173    177    148   110   91

EBITDA Margin* 15.8% 16.9% 21.2% 24.7% 25.7% 25.0% 22.2% 20.5%

FCF** 34 45 90 118 93 91 60 55

*adjusted for unusual items

**defined here as operating cash flows, less capex


CEO "Suri" Suriyakumar has been with the company since 1989. He was President and COO from 1991 until 2001, when he became the CEO. The leadership team is experienced, having navigated through several business cycles and a range of economic, financial and political challenges. In addition, management owns 19% of the company, and are paid only modestly on an annual basis, aligning their incentives with shareholders'. The CEO is honest, energetic and capable. He has assessed the current tough market soberly, resized the business accordingly and has never pretended that a robust recovery was upon us. It must be admitted, though, that the company amassed too much leverage in the pursuit of acquisitions in the past.


The company can realistically hope to generate as much free cash flow at the top of the next cycle as it did at the top of the last one. After all, the US economy will likely have expanded by 15-20% overall, the company has taken significant market share from competitors, and it has expanded into adjacent, high-margin markets. Furthermore, at the top of the last cycle, the company had a very substantial debt load, with large related interest payments (around $25 million per year). However, within the next few years the company will likely pay down most or all of its debt, so interest payments will be negligible in a few years.

Assuming FCF peaks at around $120 million, and a multiple of 12x, the company's market value would stand at $1320/45 million shares = $32. Moreover, once debt is paid down, the company's FCF will be available for tuck-in acquisitions, dividends and buybacks, adding further value for shareholders. From today's $5-6 share price, the investment is a screaming, table-pounding buy.


ARC's markets typically lag behind the general economy by 12-18 months. Since this recovery is slower than most, it is possible that the company won't see a return to significant growth until 2013 or 2014. In the meantime, however, ARC is gaining market share, as smaller competitors close or are acquired, paying down debt, and investing in improvements to technologies. Having rationalized their store base in the past few years, the company has a much leaner cost structure, and will realize significant FCF as it returns to growth.


ARC has a significant amount of debt and high interest payments.

The company has grown mostly by acquisition in the past (140 locations since 1997). If further tuck-in opportunities do not arise, they may have trouble growing beyond past results.

Over 30% of sales are in a single state (California).

About 70% of sales are to commercial construction customers, which has been a weak market and may not pick up for some time.


Financial filings and presentations that can be found on the company's website: http://www.e-arc.com/

There's ongoing commentary on ARC: Here is an update on the first quarter of 2012

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog