The Fearful Investor

Yahoo For Yahoo!

Here's a quick write-up I wrote for my quarterly newsletter that was sent out yesterday...

Yahoo! is perceived by many to be in the same bucket as AOL -- yesterday's internet companies, quickly leaving the scene to the 'real innovators' like Google, Facebook and Twitter. While AOL is, in fact, a declining business thanks to it's legacy as a dial-up portal, Yahoo! is a media aggregator with #1 sites in:

• homepages (ahead of Google and Facebook),
• e-mail (bigger than Gmail and Hotmail combined),
• finance,
• news (ahead of NY Times and CNN.com), and,
• sports (ahead of ESPN).  

We think new management is right to re-position company as an online media company focused on providing advertising solutions for Global 2000 companies. When the market realizes that the competition is other advertising outlets in all channels beyond Google and the internet (billboard, radio, TV, etc.), and that online media companies are gaining share and can be quite profitable, Yahoo's valuation should benefit. In order for the re-positioning plan to work, Yahoo! must:

• Have compelling content and link to compelling content, which will enable stable to growing market share,
• Provide targeted and successful advertising options - the pinpoint demographics for Sony to advertise their 3D HDTVs before football season or for Pfizer to advertise Lipitor, and,
• Keep up with innovation by providing mobile solutions that maintain and build usage of Yahoo! sites and services

Yahoo! currently trades at a trailing free cash flow yield of about 9%, when adjusting for the cash and publicly traded assets. With the current recovery in advertising spending and the ongoing migration of ad spending from offline to online, we think that the investment should do OK in a bad economy and quite well in a good one.

In a longer write-up, I'd add:

1. Yahoo's Chinese assets, through their ownership in Alibaba have potential for growth should fast-growing Taobao or Alipay go public. Yahoo! spiked when Alibaba.com went public, and I'd expect the same out of another Alibaba group IPO.
2. Yahoo! management is holding their 2nd analyst day in 7 months in May. I'd expect the path to higher margins and cash flow should be clearer to all then.
3. Most media companies are leveraged (see News Corp., CBS, all the Liberty companies, et. al.). Yahoo, with $3/share in cash, is anything but leveraged. Over time, I think you'll see leverage here...
   

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 abouttwo percent in front of the S&P 500 year to date.

We've been looking for investments that will do well in two out of three likely investment scenarios:

- A strong economy
- A flat economy, or,
- A weak economy

Basically, we're looking for defensive investments with an upside kicker. To see what whe chose in June, see our most recent client newsletter.

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.

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.

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. 

 

The Good & The Bad On Arkansas Best

I, and my clients, have been short ABFS since last spring and am reviewing it as I think about covering it. There's been lots of interest in deep-cyclicals (see transportation, retail, housing-related) since the Fed's newfound urgency to slash short-term rates. While we're certainly closer to the light at the end of the tunnel for ABFS, recent market action smacks more of bottom-fishing than of fundamental improvement.  See Pros  & Cons below:

The good news is:
- trucking volumes were up in Nov07 and Dec07.
- company is much closer to trough than peak valuations ('08 PE of 10.1x vs 5yr average of 11.6x and  10-yr avg. of 9.8x)
- interest rate cuts ought to boost the domestic economy, eventually
The bad news is:
- buying out of pension fund with various unions ought to add about $800MM to debt on the company balance sheet
- domestic personal income growth has been anemic for years, with asset gains (read HELOCs) providing much of the fuel for consumption gains. there is no sign of income growth and sure signs of asset losses.
- If ABFS returns to $160MM of operating CF, cap ex stays flat at $80MM, and new debt service on $800MM is 48MM (@ 6%) or $29MM tax-adjusted, free cash flow will be about $51MM -- which is just a 5.21% Free Cash Flow yield. That doesn't seem cheap to me.

In summary, while the next few years for ABFS may be better than the last year, extrapolating a rebound appears somewhat premature to me. That said, $15-18 is probably the lowest ABFS will go as bad news is released and I'm pretty close to covering this successful short.

Follow Up On A Prior Investment: Annaly Capital Management

In my Q107 Investor Letter, posted on my website (hurleycapital.com), I talked about why we bought Annaly Capital. Herewith is a paragraph I've just deleted from my upcoming Q307 Investor Letter about the circumstances surrounding our sale of Annaly in August:

As described in our First Quarter 2007 Investor Letter, we thought Annaly Capital would be a great investment to take advantage of difficulty in the housing and mortgage markets and potentially a lower short-term interest rate. Annaly is the most conservative player in the mortgage investing space, investing exclusively in government-backed AAA-rated mortgages using leverage of 9-11x their equity on hand. As the turmoil in the mortgage market unfolded, all mortgages and mortgage products of ALL credit qualities were marked down. Like The Three Little Pigs, first the subprime players fell, then Thornburg Mortgage, who invests in only AAA mortgages, though no government-backed lost 1/3 of its book value and our judgment was while it was unlikely that the big, bad, wolf would blow down Annaly’s brick house, the risk (Thornburg is still down 50% from its June 2007 levels) outweighed the reward (20-30%) by enough to warrant exiting the investment at a small loss. While Annaly’s stock has recovered to its springtime highs, we’re in the risk mitigation business and believe the decision was an appropriate execution of our investment mandate

FedEx Hits Truckers While They're Down

Yesterday morning FedEx (FDX) announced a 25% reduction in fuel surcharges on its less-than-truckload (LTL) and freight services. Clearly FedEx sees this as a great opportunity to use their growing international business to grab market share by taking advantage of a weak domestic trucking market to further squeeze their competition, including Arkansas Best (ABFS), Conway (CNW), and Yellow Roadway (YRCW). With many truckers continuing to see year-over-year volume reductions, price reductions kick out another leg of the profitability stool for these companies. On many first quarter earnings calls, the saving grace for LTL truckload providers was a stable price environment despite reduced volumes. Managements trumpeted how consolidation in the LTL industry has made pricing more rational among competitors and profitability should therefore remain stable. To make matters worse for investors in these truckers, they are still trading at premium P/E multiples (while the denominator - earnings - are at risk).

As discussed in my April 27th post, one of the keys in my investment process is to invest in industries with the wind behind their back and truckers have the wind squarely in their face. For industries with the wind in their face, while the primary risk is the expected bad results, the really important secondary risk  is the unexpected even worse developments -- such as increased competition or further fundamental deterioration.

My managed account clients and I are short Arkansas Best Corp.

Passing on McClatchy

Less than 6.5x EV/EBITDA. Now that sounds interesting!
That's how I started my work today on McClatchy (Ticker: MNI), a $1.6B newspaper company, that is most famous for buying Knight-Ridder and selling off some of the newspapers. McClatchy owns a bunch of regional newspapers from the Fresno Bee, to the Wichita Eagle to the Miami Herald. My few hours of work came up with a list of good news & bad news:
Good News:
- Local papers have a steady audience and may be the best way for advertisers to access local markets. This positioning appears to be quite defensible and enduring.
- Recent partnership with Yahoo! will enable MNI to further monetize online and print adspace.
- Online advertising is growing and will continue to grow.
- Recent downturns in Auto & Real Estate ad spending is cyclical (more than structural) and will at some point rebound.
- Low valuation.
- Poor investor sentiment toward space.
- Management is intending to use all free cash flow from operations ($150-200MM/year) to reduce debt incurred in Knight-Ridder deal (over $2B)
- Cost cutting is central to ongoing business to preserve margins.
- No one appears too interested in starting competing newspapers.

Bad News:
- Print advertising is in a structural decline. Who knows for how much longer.
- Circulation also appears to be in a structural decline. Who knows for how much longer.
- Job advertising is moving online and appears unlikely to come back meaningfully
- National advertisers are moving more advertising online. This appears structural, too!
- The next generation doesn't appear to be too interested in reading the paper.

Now, there will be a time when the good news begins to outweigh the bad, where online ad sales begin to counterbalance the losses in print ads and some of the cyclical auto/real estate ad spending returns. But, you're guess is as good as mine as to when that happens. Since I'd need a reasoned opinion on when that might happen to think about investing in MNI, I'm going to pass.

I like to think of investing as the Home Run Derby. You don't need to swing at every pitch. No one is calling balls and strikes. Take your time. Find a good pitch and try to get some good wood on it. Good luck and feel free to email me.