The Fearful Investor

Two Out Three Aint Bad

I always liked that Meat Loaf song...but that's not the point.

So far this year, we missed most of the big downdraft and a bit less of the big rally, to leave our composite of client accounts about

Things We're Not Buying: Comcast

For years I've thought that I wanted to buy Comcast -- dependable revenue stream, semi-monopoly, great margins, but it's never been cheap (10x free cash flow, or less).

Now that Comcast has actually fallen to 10x free cash flow, I'm not so sure I want it anymore. Big competition is coming from the Telcos -- Verizon is marketing is FioS service heavily in Philadelphia area. And customers are cutting back on premium services such as the Soprano-less HBO.

Then, there's agency costs, which tries to value the risk associated with management's ability to re-invest profits at high returns. Management has stated that they'll continue to reduce debt and buyback stock as well as maintain a robust capital expenditure program. This all seems prudent. But, you never know what they'll do from a strategic standpoint.

Maybe I'm wrongly tainted by the negative attitudes about the market, or maybe I'm properly concerned about the economic malaise affecting Comcasts customers and emboldening its competition to step up its efforts. Either way, I'm passing.

Why Bottom Fishing May Take A Longer Line

We've made money for our clients in the past in basically one way: find inexpensive companies in strong industries. Inexpensive companies are easy to find, strong industries are not.

Microsoft is plenty cheap at about a 10% free cash flow yield, but the revenue trend is undoubtedly down. Remember when infrastructure spending was going to boost all the machinery stocks? The 22,000 being let go by Caterpillar are wondering the same thing.

When an industry is going well, revenues go up, margins go up and multiples go up in a virtuous cycle. We are now witnessing the opposite.

Has the market discounted the worst? Hard to say. But, if estimates aren't low enough, stocks will follow estimates lower. Take Microsoft again. Consensus estimates for Fiscal 2010 (ending June 2010) are for about $2.00/share. I think those numbers could be 25% lower. Sure, the company will generate boatloads of cash, but (a) what returns will they get with it? and, (b) what is the future trend of their revenues?

Before everyone gets all excited about the market bottoming, let's also entertain the possibility that delevering, lower revenues and lower margins may not be so good for the stock market. One day, the bottom callers will be right,the question is how much will they have left when we get there?

Prop Up The Losers And The Winners Lose, Too!

In November, I attended the Loews' Analyst Day, where the management of publicly-traded CNA Insurance, announced that pricing in the property & casualty insurance business is suffering partially because AIG is aggressively price-cutting to keep existing clients. So, AIG implodes due to its poor investment risk management, the government supports them and the effect is deflation which hurts the rest of the property and casualty industry, who presumably pursued a sounder investment policy.

The government and the FDIC is trying to support the housing market by offering loan modifications for delinquent borrowers. If you can pay your mortgage, no help for you... Good behavior punished for the greater good of fewer foreclosures and a supported housing market...

Yesterday, GMAC raises $5 billion from the U.S. Treasury to enable the company to recapitalize itself and offer aggressive new loan terms for new car buyers. So the U.S. Treasury supports the underperformers (GM, and likely Chrysler & Ford to follow) to compete against the other car manufacturers, who've been gaining share by offering vehicles that consumers want.

Following this logic, completely hypothetically, if FedEx got a bailout, UPS would suffer, and if Circuit City got a bailout, Best Buy would suffer. While I'm guessing we're closer to the end of the bailout-phase of this downturn, it's fair to say if you see one coming to another industry, sell the winner in that industry, because they're sure to suffer, too.

Stock Market Roulette

Deflation or inflation? What's your bet? I think that investing these days has become a binary game, where either deflation takes us into a sustained recession or monetary and fiscal stimulus incite runaway inflation. The visual image I see is a bucket with a big hole underneath a tap spurting water. Will the bucket empty or overflow? Who knows. I'm not into gambling, so we've grown cash postions and only invested new money in investments that ought to pay in either outcome.

How Hedge Fund Tumult Affects You

In order for the stock market to rise, there must be more buyers than sellers. For now, I project sellers will outnumber buyers for the upcoming year. Let's review the players.

The Sellers

I believe that hedge funds will continue to be net sellers over the coming year and thereby hurt investment returns over the next year. Where hedge funds have been incremental buyers of investments in the past as they have raised money and made money that had to be reinvested, they are now and are likely to continue to be incremental sellers going forward, due to withdrawn money and investment losses. As many hedge funds are suspending withdrawals (i.e. DE Shaw, Farallon and Fortress), this selling pressure is being mitigated somewhat and will spread over a longer period as sellers who want to get out today will have to wait until next year or later.

What hedge funds do is important because they invest over $1.4 trillion in assets and if they are selling instead of buying, it will hurt prices of things we own or are looking to invest in.  Adding to the selling pressure, poorly performing funds are shutting down completely causing further sales pressure and more will shut down after year end, when they know the extent of this years losses and understand that the big incentive fees they've collected in the past, will only be attainable after 50% gains to recoup 2008 losses. Furthermore, funds that have suspended withdrawals will have a hard time attracting new money as they don't want to add money to a fund that is shrinking.

The Buyers

Now, there are buyers, too. U.S. 3-month treasury bills are yielding 0% because there's lots of cash on the sidelines. There certainly are hedge funds that have large cash balances looking for investment opportunities. I believe the bulk of the sidelined cash is with indivdual investors who are, for the most part, unlikely to be early investors in a market upswing after the negative returs this year.

Surely, there will be indivdual investments that rise, and perhaps the government can print enough money that some of it will leak back into risky assets (such as stocks), but I'm not excited about investing until I "see the whites of the eyes" of more buyers than sellers.

Dell Headfakes Investors; Stock Down 12%

CEO Michael Dell teed-up last night's strong revenue performance with an interview with Business Week in late July touting the traction Dell is seeing in the marketplace with its new strategy. He omitted the fact that this growth would not be accompanied by increased profitability. Forget growing margins, margins actually fell on rising revenue. Why pump up investors/analysts only to report subpar numbers?

Making matters worse, the gross margin shortfall was blamed on (1) revenue recognition issues, (2) "self-inflicted" overly aggressive pricing, and (3) strategic pricing initiatives to take share in Europe.
Taken individually:
1) The revenue recognition issues could have been guided to in prior quarters. Why would management have been surprised by this? The tone of this call reminded me of recent GE quarterly conference calls, where under-performance was confidently explained, with little explanation of why this wasn't anticipated or warned about the possibility of happening.
2) The implication of the overly-aggressive pricing comment, is that someone made sales at prices they shouldn't have. How could this happen? I'm hoping/guessing that since inventories went down sequentially for the first time in a while, that perhaps, the company cleared out some soon-to-be-obsolete product and low prices to prepare the pipeline for the rollout of new products. If it is, in fact, due to overly-aggressive selling, what is the sales approval process that allowed this?
3) I'm OK with the idea of strategic pricing to take share. But, if, as Michael Dell said on the call, that competitive pressures were no larger than usual, Dell took a serious margin hit to take share in commercial accounts in Europe!

Furthermore, management continues to tout a $3 billion savings number, while not revealing how far along the company is in the process, or how much of the savings will fall to the bottom line. Management wants investors to trust that what doesn't fall to the bottom line will be invested judiciously. Recent performance leaves us uncertain about this.

My clients and I are long-time Dell investors. In a tough economy, it's important to find companies that can grow regardless. Last night's results show that Dell fits the bill. We're excited about the steady revenue gains being achieved through rapid overseas growth, a push into retail stores, and new products/services. As the company has repeatedly guided investors, the road to success will be indirect, but I just wish that the message were less so.

My Take On Loews Corp.

I just had this published on RealMoney.com today...

Back at the beginning of the quarter, I wrote about Loews Corp. (LTR). The thesis was to buy the Tisch family investment expertise and their portfolio of investments at a 20-25% discount to the sum of the parts and enjoy the ride in their investments -- the public ones (Diamond Offshore (DO), CNA Financial (CNA), Boardwalk Pipeline Partners (BWP) and Carolina Group), the private ones (principally HighMount, a natural gas producer; the GP of the Boardwalk Pipeline Partnership; and Loews Hotels), and the ones to come from the billions of uninvested cash at the holding company level.

The stock is up more than 20% since then, but the discount remains about 25%.

Since the beginning of the quarter, several events have benefited Loews shareholders:

• Through the Lorillard (LO) spinout, completed Tuesday, Loews was able to effect an exchange of its 37% Lorillard equity position into about 93.5 million shares of Loews stock, or about 18% of the outstanding shares. I expect these shares to be retired.
• Natural gas prices are up 25% to more that $12.60 per thousand cubic feet (mcf). Loews spent $4 billion in July 2007 to buy HighMount Energy -- a natural gas producer with 2.5 trillion cubic feet (Tcf) of reserves -- from Dominion Resources (D) back when natural gas prices were about $6 per mcf.
• Diamond Offshore continues to benefit from still-rising oil prices and scarcity of deepwater drilling vessels.

My math works like this:

Based on current prices, Loews holdings in Diamond Offshore, CNA and Boardwalk Pipeline equal $18.1 billion. Conservatively valuing HighMount's 2.5 Tcf of reserves at $2.75/mcf adds $6.9 billion. Add $500 million for the value of Loews Hotels real estate, including the massive hotel in the middle of South Beach in Miami. Add $940 million for the valuation of Boardwalk Pipeline Partners GP (assumes a 6% yield on a public vehicle in three years that generates about $75 million of GP distributions). Add $1.95 billion net cash after the Lorillard spinoff and you get about $28.4 billion. At $49.19, Loews has a market cap of $21.5 billion, or about a 25% discount to the sum of the parts, and the parts are in pretty strong businesses.

Possible catalysts include

1. more buybacks,
2. a possible public offering of HighMount,
3. increased cash flow at Boardwalk Pipeline Partners associated with ongoing capital projects coming online, and
4. a return of CNA to book value (about 20% up from here to March 31 stated book value) when many other insurance companies trade at a premium to book value.

With the reduction of shares, the Tisch family ownership is up to 21% from the high teens. Based on their investment history, discount to the sum of the parts and the potential catalysts, I and my clients have decided to tag along. I'd love to hear your thoughts ...

Be a Contrarian on Avid Technology

Wall Street analysts have given up on Avid Technology (4 neutral ratings, 3 sells, including two Focus Sells!). I think that times are about to change. Avid (AVID $23.11 on 5/15/08) is the worldwide leader in providing enterprise software for video broadcasting, and audio and video editing and production. Avid also has a consumer video production and editing business.  

Having been a Wall Street analyst, I understand where they're coming from. The company has missed projections and generally underperformed for years, making any analyst look silly for recommending it. No client would listen to a bullish recommendation from them anyways.

Here are the facts - you decide:
Market Cap: $855MM
Enterprise Value: $705MM
2007 revenues: $930MM up 2% from 2006 levels
2007 Free Cash Flow: about $52MM
Trailing Free Cash Flow Yield: 7.4% (52/705)

- Avid is in a good market. As broadcasters switch from videotapes to digital editing and production, new equipment will be required from inside the stations, to remote trucks, to cameras. The trend to HDTV requires new equipment and software, too. These are inevitable changes which will take place over years creating steady business for the technology providers.
- As a market leader in all three of its divisions, they should garner a premium valuation should this turnaround work, or sell off a piece or two along the way. Large-cap companies including Thomson, Harris Interactive and Oracle are potential buyers, not to mention private-equity players.
- New CEO, Gary Greenfield, has a track record as a turnaround CEO, most recently in the public market as CEO of Peregrine Systems after the company ousted prior fraudulent management. Investors who bought Peregrine debt upon his arrival did very well. Ken Sexton, joined Avid as Chief Accounting Officer, and has worked with Greenfield at Peregrine as well as brief stint at WebMethods leading up their acquisition by Software AG
- Management has indicated that large restructuring initiatives will be announced in July, that should drive Q4 operating margins to the 10-15% range, in our estimation. Not a reach for a large software company.
- Company has bought back over 4 million shares year-to-date, reducing sharecount over 10% to 37 million shares.
- New CEO and all new management incentive compensation is tied to incremental return on capital gains and stock price. CEO stock options strike at $23.36/share, so he is incented from here.
- Wall Street ratings are almost uniformly negative - with 3 sell ratings and 4 neutral ratings. What's more Avid finds itself on TWO "focus sell" lists - at JP Morgan and Kaufman Brothers. The thesis of these sell ratings are poor recent performance and lack of clarity on turnaround plans. I believe a call to any of the analysts with sell ratings will show that none of them have done any rigorous research. They are simply assuming bad results will continue.
- Blum Capital filed an amended 13D filing announcing its intention to raise its stake in Avid to over 25% of the company, from the high teens during Q1. With a representative on the board of directors, one should probably consider this aggressive insider buying.

Here's the punchline:
Assuming that a restructuring allows Avid to reach 12% margins next year on $930 million in revenues (no revenue growth assumed) yields $110MM in operating profits. Put a 12x multiple on that gets you to $1.34B enterprise value add $100MM in cash (which assumes $50MM cash restructuring expense) and you have $1.44B market cap, which is $36/share. Assume that Avid participates in market growth and the numbers get bigger.

I own Avid. My clients own Avid. 

 

Always Wading Into The Pool

At my day job, running Hurley Capital, a value-oriented money manager, our goal is to keep up with the market in good times and protect our capital in bad times. Achieving this goal requires research and discipline. By research, I mean finding investments that have enough underlying value to sustain themselves during down markets, while having the cash-flow growth opportunities to keep pace with the market in up markets. Discipline means investing assets over time to avoid the natural (and unprofitable) tendency to invest only  when the market sentiment is high and selling when it's low.

Prospective clients often ask where the market is going in the next year to decide whether or not to invest. Per above, my answer always is, "Since we're investing over time, you shouldn't be overly concerned about the next few months. Furthermore, we're investing defensively. Let's ease in." This approach has worked for our clients (and ourselves - since we are invested alongside them) since we started Hurley Capital in 2003 and we're hopeful to keep up the good work going forward.

How are we 'easing in' now? You can look at all of current composite client holdings on our Q1 Investor Letter.