North American Value Investing: December 2012

Saturday 29 December 2012

Poseidon Concepts - Value or Value Trap?

The average company trades for about 15 times earnings. What if I told you about a company that was trading not for 10 times earnings, not for 7 times earnings, but for 4 times earnings? Oh, and that's 4 times quarterly earnings - just over 1 times dividends. Sound too good to be true? It's kind of true - but, alas, it's also sort of too good to be true. The dividend in question was recently suspended, and the quarterly earnings, unfortunately were not from the most recent quarter, or, perhaps, for any quarter in the foreseeable future. Let me explain.

The company in question is Poseidon Concepts. Spun out of Open Range Energy last year, Poseidon experienced astronomical growth by offering oil and gas companies a simple, but very efficient, alternative to storing water used for drilling. Employing a device not unlike an above ground pool, Poseidon’s novel concept was not only cheaper, it was quicker and less environmentally risky than the standard methods then being used. In an impossibly short period of time, Poseidon had a foothold in most major North American plays.

The high point came in this year's first and second quarters - the same quarters mentioned above - when earnings per share were $0.38 in each period, and funds from operations were $0.49 and $0.48, respectively. Until only this past week, the company paid a dividend of $0.09 per month, or $1.08 per year, within reach of the current share price, which has fallen by a gut-wrenching 90%-plus from its high. What a difference a quarter makes. By the third quarter, Poseidon's net income had fallen to just $0.10, in part due to a $9 million charge for bad debts that the company is unlikely to collect on.

What happened? It appears the company was hit on two fronts. Not only has demand been weak industry-wide, increased competition pushed down margins, too. Indeed, some firms in the industry have been forced to offer discounts of up to 75%, a sure sign of a commodity-type offering. Though the company holds a patent on its main product - which is responsible for the bulk of its business - it doesn't appear that it will prevent competitors from offering similar items. And there was never any doubt that the high margins and returns on capital that Poseidon has enjoyed would invite salivating rivals. To be sure, the company is rightly trying to use their installed base of storage tanks as a foundation from which to sell added products and services, but it remains to be seen if they will be successful in a fast-changing market.

Clearly, there have also been some troubles specific to Poseidon, as well. For one, it appears that the recent wild growth was faster than management could handle. Indeed, at the end of the third quarter, receivables were $126 million, compared to revenue in the first nine months of the year of $148 million. On such a large base of uncollected cash, further write-downs could be immense. At the end of the third quarter, $36 million of Poseidon's receivables were past due, a worrisome figure, particularly after having written off $9 million altogether. Though receivables in the oil and gas services industry are regarded as difficult to collect on, competitors have not suffered nearly to the extent that Poseidon has. Painful as it must have been, however, the newly arranged board has made the right decision to suspend the dividend, which will give them much more liquidity, buying precious time to - hopefully - right the ship. In addition, at the end of the third quarter, $44 million remained undrawn on the company's credit facility, which doesn't come due until June of 2014.

The changes at the top are unusual. Scott Dawson, former CEO of Open Range Energy and current Chairman of Poseidon will step into the CEO role immediately. Lyle Michaluk will move from the CEO role into the CFO role, which is unusual in such cases - after all, most ousted CEOs are not offered another senior executive position, nor would they ordinarily be interested in accepting one. Similarly, Cliff Weibe will assume the role of Chief Technology Officer, having until recently served as the Chief Operating Officer. Both men, as well as one other director, have resigned from the board. On a positive note, if there was reason to suspect any major ethical breaches or wrongdoing, it's virtually impossible that any of the above officers would have been offered alternative positions. Based on the facts available, it seems reasonable to conclude that the company simply grew too fast for the management team, and the company's processes and system of controls, to handle. In the third quarter report, the company, to its credit, admitted to weaknesses in internal controls, specifically a lack of accounting expertise, and pledged to remedy to problem as soon as possible.

Is the stock a buy at today's dramatically reduced price? It's impossible to know - which means, "No." Wise investors only commit hard-earned capital if the odds of permanent impairment are low - for now, the picture is simply too fuzzy to rule out that possibility. As Warren Buffett has often said, the first rule of investing is "Don't lose money," and the second rule is "Don't forget the first rule." Many bottom-feeding investors may be tempted to scavenge on Poseidon's shares, knowing that if the story works out they could enjoy a radically high return. But if they look down first they will likely find that they're not protected by a margin of safety, and ignoring the risk while dreaming about the upside is foolish. If things turn for the better in the months to come, there will likely be an opportunity to buy shares at a higher, but still bargain price, with the confidence that any mortal danger the company may now be facing has passed.

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Thursday 27 December 2012

Valuing the New Leucadia National

It's difficult to value companies like Leucadia National, which has elements of a conglomerate, a hedge fund and a private equity firm all at the same time. Wholly owned operating businesses in a range of industries, common stock positions, royalty streams - Leucadia has used a wide net when fishing for value opportunities. In the past, shareholders tended to use book value as a rough proxy for intrinsic value, with the stock price moving roughly in tandem with shareholder's equity over long periods of time. However, there have also been long stretches when the share price has traded significantly above and below book value.

The recently announced merger with Jefferies, combined with the 2011 purchase of National Beef, means that the operating business component of Leucadia's value has expanded markedly, and the approach to valuing the company must be revisited. The appropriate way to value the company is probably to attach a multiple to operating earnings and add it to book value. Upon the announcement of the merger, Leucadia estimated its combined business will have a book value of $9.3 billion, or $24.69 per share (including the dilutive effect of shares issued in the merger transaction). Net to Leucadia, its four largest operating businesses - Jefferies, National Beef, Berkadia and Garcadia - currently produce roughly $480 million in combined after-tax earnings. A 12x multiple would make this earnings stream worth around $5.8 billion or about $15 per share. Leucadia, then, may be worth around $40 per share, significantly higher than it currently trades for.

Whatever the method Leucadia's managers themselves use to value their business, they must agree that the business is undervalued - after all, they recently initiated a share repurchase program. Wise investors will consider allocating some of their own wealth alongside one of the finest collections of investing talent in the world.

Leucadia National and Jefferies to Merge - An Analysis

Several weeks ago, an admirable case study in the history of value investing came to an end - at least the long and satisfying first part did. Leucadia National, long stewarded by the two-man team of Ian Cumming and Joseph Steinberg, merged with Jefferies, a leading mid-sized investment bank. Technically, Leucadia swallowed Jefferies - at least the 71% that it hadn't already digested - but in some ways it feels like the reverse. After all, not only will Jefferies become the anchor company in Leucadia's collection of businesses, Jefferies' chief executive Richard Handler will become CEO of Leucadia, as well as remaining at the helm of his own firm. Ian Cumming will retire from his day-to-day role, while remaining a director, though Steinberg and the rest of Leucadia's senior management will remain on board.

Why the change? Clearly, succession played a large part in the move. Leucadia's aging masters weren't going to be around forever, after all. In fact, Cumming had already signaled his intention to retire by declining to extend his contract past 2015. Steinberg, however, will remain with Leucadia, both as Chairman and as an active executive, and has (to this writer's knowledge) not made public when he plans to move on. Evidently, the opportunity to hand over the CEO role to a young and able manager with many years ahead of him was one that Cumming and Steinberg couldn't pass up. Leucadia shareholders can take comfort in the fact that they've worked with Handler and his team for many years. Indeed, they've enjoyed a personal relationship for more than 20 years, and an active business relationship for more than a decade. Handler, for his part, regards Cumming and Steinberg as valued mentors. Given that Leucadia's wholly owned operating businesses are run at the company level, and most of the company's senior managers will remain, Handler should be able to manage his newly expanded role.

How will the two businesses fit together? Many mergers are sold on the basis of "synergies" that often fail to materialize, but Handler actively downplayed this motivation. However, there are several areas where this merger could make 1+1 equal more than 2. First, the deal flow that Jefferies is involved in will unearth opportunities for Leucadia that would otherwise not be available. In fact, this has already happened in the past - Leucadia's investment in Fortescue, for example - thanks to the longstanding relationship between the respective companies and management teams. Second, Leucadia has a large net operating loss, an asset that it can't quickly capitalize on without more operating earnings. The new company, however, is expected to fully utilize the NOL over the next several years, which will turn it from a theoretical balance sheet item into cold, hard cash. Finally, being part of a large and strong company such as Leucadia may allow Jefferies to escape the vicissitudes of the market, such as the one it suffered from in 2011, where the company looked to be in mortal danger for a short period of time, despite being fundamentally sound. For a smaller investment bank, the mere perception that it's suffering financial distress, however false, can quickly create that very reality. This will be less likely to happen as a part of Leucadia, though not impossible.

While Leucadia will look very different in the future than it has in the past, the company has always been evolving, never staying the same for very long. (Surprisingly, Handler stated only that he hoped that Jefferies will remain a part of Leucadia for the long-term, whereas many shareholders might have assumed that the two companies would be permanently married; this is a notable difference from Berkshire Hathaway, to which Leucadia has often been compared, which makes a promise of forever when it acquires a business). What has remained constant, though, is a superb management team with the knowledge and temperament to take advantage of opportunities to create value for shareholders, in whatever form they arise. Only time will tell if Handler is up to the challenge, but the ongoing presence of most of Leucadia's top brass is likely to mean a continuity of values, philosophy and process, even if the Leucadia's next chapter has a few unexpected plot twists in the future.

Glacier Media - 2012 Q3 Update

After accounting for one-time items, and the seasonality of the assets acquired last year from Postmedia, Glacier Media posted solid results in the third quarter. The company's focus on local newspapers, as well as business and trade publications that consumers are willing to pay for, means that it's largely able to escape the pressures suffered by larger papers that compete infinite alternatives, many of them free of charge. Still, the soft national advertising market in Canada has some effect on Glacier Media, as it has all year.

Glacier has a glowing opportunity to create value for shareholders over the next few years, even in the absence of any new acquisitions. With $131 million, or $1.47 per share in net debt ($27 million of it's non-recourse), management can add significant value simply by paying it down. In addition, the company intends to repurchase shares, and increase the dividend over time. In fact, management offered a fairly strong hint that a dividend increase is forthcoming, noting that the topic will be addressed in early 2013.

At today's payout level of $0.06 per year, Glacier Media's stock offers investors a dividend yield of about 3.5%, significantly higher than the market's average yield, which has long stood at about 2%. If the dividend were increased even to $0.08 per annum, the yield would jump to 4.5% at the current share price. Given the general wariness about newspapers and similar content, it's possible that Glacier Media will behave more like a trust than a stock, with significant income, but less than dramatic share price performance. No matter: for a company that throws off $0.40 or so in free cash flow, there's ample room to increase the dividend; shareholders that reinvest the dividend will do well over time. And eventually stellar performance will surely mean some upward movement in the stock price, too.

My original analysis of Glacier Media is here.

Sunday 16 December 2012

Berkshire Hathaway's Amended Stock Buyback

Suddenly, Berkshire Hathaway recently announced an increase in the ceiling price for its share repurchase program, from a maximum of 110% of book value to 120%. Though sudden, the move is not a shock: Warren Buffett has said in the past that he could live with a somewhat higher figure than the original 110%. The announcement included the disclosure that the company had repurchased about $1.2 billion worth of stock from the estate of a long-time shareholder, as well.

There's reason to suspect that Buffett values Berkshire by attaching a multiple to normalized earnings, and adding that figure to book value. In his 2010 Letter to Shareholders, Buffett estimated that "normal" earnings power was about $12 billion after-tax, assuming no extraordinary insurance losses or other outlying charges; that number is probably closer to $14 billion now. Assuming a 12x multiple, Berkshire's earnings are worth $168 billion, or about $102 000 per share, and its book value currently stands at around $115 000/share, giving the company an "intrinsic value" of around $217 000 per share. Thus, at the present stock price, the company is selling for about 61 cents on the dollar.

Given Berkshire's sheer size, its universe of potential investments is a rather small one, and at minimum this move opens another avenue in Buffett's hunt for places invest - specifically, by doubling down on Berkshire's current collection of assets. In the past, Buffett seemed to regard share repurchases as a mild form of admitting defeat, but given the present gulf between price and value, he's clearly more enthusiastic. The first buyback announcement had the effect of putting a floor under Berkshire's stock price, a floor that was mostly above the 110% threshold, meaning the company was able to repurchase only very few shares. The latest announcement appears to have had a similar effect, and it remains to be seen if the company will be able to act in a major way or not. If it can, Buffett has created a low-risk, easy way to create meaningful value for shareholders.