Fructivore Investments

Those of you who watch Jim Cramer, of whom Seth Klarman said that he is a symptom of everything that is wrong with the financial world nowadays, will recall that last week he expressed approval of the safety of Windstream’s dividend. He also mentioned Fairpoint Communications (FRP), after qualifying his remarks with the fact that they have little in common apart from them both being rural telecom companies—their financial positions are completely the opposite. Fairpoint Communications has recently announced that they are defaulting on their credit facility, and that their larger creditors have agreed not to force them into bankruptcy until the 30^th.

Fairpoint recently acquired Verizon’s land lines in New England for $2.3 billion, which it turns out was a few hundred million too much, thus demonstrating the value investing principle that there are no good or bad investments, only good or bad prices. After all, anything can be at least liquidated, and with a bankruptcy in the works that is looking like a distinct possibility. Since that time, declining revenues have sunk their income, causing them to suspend their dividends in 2008 and now, it seems, to suspend their interest payments as well.

According to rumors, Windstream is a potential buyer of Fairpoint’s distressed debt, alongside several players in distressed debt. This is perfectly reasonable; inside or outside of bankruptcy, the creditors take the assets of the defaulted debtor, and Windstream certainly could do more with the assets than a distressed debt fund on Wall Street. If they acquire a powerful position in Fairpoint’s distressed debt, this will give them a suitable platform in the Chapter 11 negotiations to arrange transfer of some or all of Fairpoint’s assets to them. It is not unusual in a bankruptcy to create a situation where there will be cash and securities in the reorganized corporation available, with creditors able to choose between the two of them. So, Windstream would perhaps be able to take more securities and less cash. And, since the market for distressed debt tends to be illiquid and the valuations necessarily conservative and more geared to liquidation rather than going-concern values, distressed investing generally produces high returns to go along with the analytical and legal work involved.

Even outside an actual Chapter 11, bankruptcy is still a specter that hovers over the entire process of negotiating a debt workout. Such a workout still results in selling off profitable divisions and arranging debt-to-equity conversions to provide partial relief to satisfy creditors. Just look at AIG. In fact, in a significant proportion of bankruptcy cases, the debtor has already acquired a sufficient number of votes from the creditors of each voting class, thus making the actual bankruptcy process largely a formality, as with GM’s. So, inside or out of formal bankruptcy, Windstream has the same angle.

I should point out, though, that in the last reported quarter, high speed subscribers in the regions Fairpoint purchased from Verizon declined by 3.3%. The company attributes much of this to “cutover related issues;” in other words, they were too busy integrating their systems after the merger to actually sell their products. This is understandable, but since Windstream and every other telephone company is trying to combat loss of land lines by expanding their premium services, this is disturbing news. Their operating income, although it exists (positive operating income now or eventually is a minimum requirement for saving a company with bankruptcy as opposed to killing it), is very low, just a hair over 1% return on assets, so hopefully there is room for improvement.

Obviously, it is too early to say anything, and the rumor of Windstream even buying the debt has not been confirmed, but since Windstream has embarked on two opportunistic acquisitions already in the last year, it would be a positive development for them to be feasting on Fairpoint’s corpse alongside the other vultures. As for ourselves, we like low-hanging fruit and have no objection if some fruit gets blown off the branch by a strong economic headwind. So, if the rumor is true this is another positive for Windstream, although they might want to recall that acquiring more than they can chew is what killed Fairpoint to begin with.

And if you’re wondering about the Star Trek picture, I kept typing “Farpoint” instead of “Fairpoint,” and I couldn’t find an image that suggests a bankrupt phone company anyway.

Some of you may recognize our old friend the yield hog from the Windstream article, but we should ask ourselves what a dividend signifies. For bonds, yields are typically all we get, but for stocks? True, a big dividend yield will amortize our margin balance if we choose to buy on margin, but as Seth Klarman puts it, margin is unnecessary for the value investor, and indeed is often counterproductive.

But, if the firm does not distribute its free cash flow in the form of dividends or some other way, that money is still sitting inside the firm and still belongs to the shareholders. Of course, Ben Graham’s quick and dirty valuation formula valued dividends at three times undistributed earnings, but in his day dividends were viewed as an integral part of the return from equity investment, whereas now they are viewed as a distraction from the corporation’s management trying to build their empire.

In theory a corporation should only hang onto its excess cash if they can produce higher returns by keeping it than its shareholders can produce by receiving it and investing it themselves. Cash has fairly low returns, so building up cash just to keep it built up on the balance sheet should be viewed as robbing the shareholders. Benjamin Graham actually tried to engineer a hostile takeover to get a firm to disgorge its unnecessary investment holdings.

Breitburn Energy Partners LP (BBEP) suspended its dividend last year on the grounds of enhancing liquidity, and predictably the price of the shares tanked. As with Linn Energy, apparently Breitburn was viewed a dividend factory rather than a corporate empire type. But, also like Linn Energy, it seems to be a convincing one. In fact, they have adopted the same hedging strategy running for years into the future, so a buyer is betting on their competence as a natural gas and oil producer rather than on the movements of oil and gas prices. Using the technique of doubling current earnings they will earn $200 million this fiscal year, giving the company a P/E ratio of 2.5, or 5 based on last year’s pre-tax full year earnings. They have been increasing the pace of their operations, though. In fact, if Breitburn had not eliminated its dividend they would be yielding almost 20% at current prices. Now, rather than piling up their cash, they are paying down debt (ironically, piling up cash would be the most liquidity-enhancing move of all). Going by their books, they have cut their liabilities considerably since they started preserving money. However, the interest rate they pay currently is about a fourth what their cost of equity is as determined by their PE ratio so if they wanted to fix cost of capital instead of liquidity they are going about it the wrong way.

So, if you liked a productive, hedged producer like LINN, and are willing to forego a dividend until Breitburn’s managers decide that they are sufficiently liquid, Breitburn should be the ideal stock.

According to the news, the FDIC’s insurance fund is in danger of being totally drained. The article’s author speaks of several strategies that can be used to shore it up, which is borrowing money from banks, from the government, or by levying a special fee on banks. The article portrays all of these as risky and unnatural options. Borrowing money from banks that can afford to lend it is called a bad idea because it diverts money from the private sector. Borrowing money from the government is bad because it looks like another bailout. And raising the money by a special bank fee weakens banks that cannot afford to be weakened right now.

As to borrowing the money from healthy banks, any effect on the private sector from removing the money would be dwarfed by the fallout from the massive bank run if an investor actually suffered a loss due to the bankruptcy of the FDIC. Of course, since the bankruptcy of the FDIC fund is not seriously an option this is not going to occur. However, it seems to be unreasonable for the FDIC to have to pay interest to one bank on behalf of the depositors of another. Using the Treasury’s line of credit would make more sense, although it does look like another bailout to the banking industry, and banks themselves are not looking forward to higher fees down the road to repay interest and principal.

Of course, these would be the banks that are the problem in the first place, and who do not seem to be aware of the concept of insurance. Obviously, a sound system of insurance requires risk-based pricing, so as risks go up an insurance company has to increase its premiums accordingly in order to remain solvent. And it seems to me that if a bank cannot handle an occasional disruptive, unforeseen expense like this, it would be better off in receivership. After all, there are plenty of wealthy banks that are capable of taking them on.

Great Southern Bancorp (GSBC) for example, has taken on two failed banks this year. Although the economic situation has impacted their results they have been able to squeeze out some profits, and on the whole I believe them to be in an excellent financial condition. However, I’m not exactly pleased about their handling of loan loss reserves. Capital One deals with reserves in the aggregate, which, considering their size, they have to do. As recently as 3^rd quarter 2008, GSBC reported non-performing commercial loans singly, as befits a small town bank. However, since their transfers to loan losses normally run only a few million per quarter, a cluster of bad loans can produce a huge mess in unforeseen expense. In 1^st quarter 2008, they lost a great deal of money (for them) by loaning a large sum to bail out a fellow bank that subsequently went under, and not very much later they lost another small fortune on Fannie and Freddie preferred stock. Since these experiences they seem to have learned to wait until after the receivership/bailout to commit capital to banks. If their earnings return to normal they would have a P/E ratio of 10 or 11 which is suitable for a normal bank, although the TARP money they accepted forbids them from raising their dividend.

So, if you want a bank, rather than gamble on the recovery of an unwieldy large bank that needs the special attention of the Treasury, consider a small one that is busy eating smaller ones.

As you may recall, I commented on the dangers of being a yield hog, which is a constant temptation for those of us who seek investments that produce high and sustainable cash flows. Sustainable but not high is not good enough, and high but not sustainable is even worse, because when the cash flow runs out all the other yield hogs will dump the security in question, depressing its price even below fair value. Not surprisingly, just running a stock screener to rank all stocks by yield is inadequate, but it nonetheless can produce candidates that are worthy of further investigation.

Calumet Specialty Products (CLMT) is an investment partnership that produces various petroleum products. It currently pays a dividend of 12.3%, and has a P/E ratio of 10.68, so it is almost covered. However, their earnings seem to have been fairly variable over the years and sales have been dropping from their heights, so this is probably not a good source of sustainable cash flow, although their dividends have been covered by operating cash flow, if not net earnings, for three of the last four quarters.

However, you wouldn’t deduce any of the dividend coverage issues from the partnership agreement. Unlike investing in stocks, where the status of the shareholder is tolerably well known, in partnerships the terms of the partnership agreement must be considered individually before investing. Like LINE’s agreement, they are required to distribute all available cash. However, Calumet’s agreement further requires the distribution of 45 cents per partnership unit every quarter, subject to their credit limit. Furthermore, as the available cash exceeds 45 cents, the general partner takes a larger and larger share of the distribution, from 2% for 49 and a half cents up to 50% of the marginal cash when the distribution exceeds 67 and a half cents. So, where corporate managers are often accused of keeping dividends too low in order to expand the size of their empire, the general partner here could potentially be accused of deliberately starving the company by increasing its own incentive distributions. Of course, there are rules as to what is “available cash,” but there has to be some discretion available.

At any rate, a policy that requires the payment of dividends even when the cash is not earned and has to be borrowed is generally a recipe for disaster. In the 80s companies borrowed money and distributed it to shareholders in an attempt to frighten off the takeover artists, which was a questionable strategic move, but Calumet’s policy isn’t even strategic. It puts them dependent on raising additional capital, either from their lenders or from the public (they did make new offerings of equity in 2007 and 2006). And, since they are under an obligation to pay the 45 cents to the new equity as well, the possibility of a Madoff-like ending (although fraud would not be involved) cannot be ignored. As Benjamin Graham stated in response to a Supreme Court ruling denying relief to holders of preferred stock with noncumulative dividends, it is only what the parties agreed to, and a court cannot just rewrite a contract.

So, if you are looking for a high and sustainable dividend, I suggest looking elsewhere for the moment. Given the number of potential investments out there, compromising our standards of safety for a specific one is unwise.

I suppose the ideal solution for me would be to align this blog with a subscription newsletter. Telling you what to buy would be free, but telling you when to sell would cost you. Since that strikes me as a little mercenary, I’m telling you all that I’m out of CMO.

If you’ll recall, I recommended CMO because the low interest rates have produced a huge financing spread for their mortgage portfolio, and I did warn that if interest rates went up, CMO’s dividend would lag. Although interest rates presently show hardly any signs of going up, what has gone up is CMO’s price; it hit 14.60 today. The company’s book value per share is in the neighborhood of $11.50, and the face value of their debt per share is about $3.50 lower. Although the mortgages are probably entitled to a premium over face value while trading because of the government explicitly guaranteeing them,  interest is paid on the face value, and principal repayments are also made at face value.

Now, interest rates are going to rise eventually, and when that happens CMO’s fat dividend will diminish, or depending on the speed of the rate change, may even disappear, at which point the yield-hungry investors will look elsewhere, collapsing the price back down to book value or even face value. At any rate, the dividends that CMO is likely to generate until then are probably equal to or exceeded by the current premium over book value, so there is no real purpose in holding on any longer to collect a dividend that is already priced in.

Benjamin Graham wrote in Security Analysis that a great deal of financial analysis involves recasting financial reports to get a full sense of a firm’s baseline ability to produce earnings. A lot of the process involves removing nonrecurring or irrelevant events from a single year’s results, as we did with LINE’s profits on its derivatives. Over a longer period of analysis, like five or ten years, we leave the nonrecurring events in or perhaps even distribute them on average over the period. Nonrecurring events still tell us how unlucky or unskilled management is over time, and even though for a single year’s earnings we may forgive a large nonrecurring writeoff all at once, a writeoff is still money gone, and there is a limit to forgiveness.

Much of this fiddling with nonrecurrent events is the fault of accounting rules anyway. When it comes to goodwill, writeoffs take on an unusual character. Goodwill represents the purchase price paid to acquire a company that is in excess of the assets of that company. It represents the excess returns available from buying an established company instead of just replicating it, or, if you believe Damodaran, some of it comes from the “growth assets” of a company – the assets it will one day acquire to produce its growth and future excess returns. A lot of analysts advocate ignoring goodwill entirely, when it first shows up as an asset and when it is inevitably written down when conditions deteriorate. After all, if there are excess returns in a business they will show up in the income statement anyway, so counting both the excess returns and the goodwill looks like double counting. Goodwill nowadays, instead of being linearly written down over time, is now written down whenever, in the opinion of accountants, the excess returns it generated are no longer there. Since this essentially trades one accounting fiction for another, I can’t say that it’s solved the problem of dealing with intangibles, but it does make the data more frequently subject to large, discrete abnormalities.

ConocoPhillips (COP) is an integrated oil producer and refiner that wrote down $25 billion of goodwill last year, plus more than $7 billion for their interest in a joint venture, on the grounds that with the price of oil and the economy down, returns on their business and its recent acquisitions are going to suffer. With our policy of ignoring goodwill, we might say that without the writedowns they earned $15 billion last year, and earned $12 billion the year before that and $15 ½ the year before that. And since the market cap is less than $70 billion, even looking at the worst case their PE ratio was less than 6.

However, as I’ve stated, goodwill writeoffs have to go somewhere, or to be precise they have to come somewhere since the company paid for that goodwill. This year, earnings have been running far behind what the previous years’ performance suggests they would have been, only $2 billion in the first two quarters when last year they were $9 ½. I should point out that unlike Linn Energy in the last post, COP does not hedge its commodity exposure , which is understandable because COP’s production is orders of magnitude larger and the integrated nature of its  business theoretically leaves them less exposed to price changes, as with Rayonier.

We can reconcile the irrelevance of goodwill with the fact that the company has run into a wall by considering return on equity, since equity is where goodwill writeoffs come from. If we double this year’s earnings, and divide it by the book value of equity at the end of last year, we get 7.8%, which looks pretty reasonable, although since COP trades at a moderate premium to book value that is not the return on a purchase at this price. If we put the writeoffs back in and look at last year’s return on equity, though, we get 16.9%. The year before, 13.6%, and the year before that, 19.1%. So, although the goodwill writeoff made more sense than leaving the goodwill in, it hasn’t accomplished what the rules intended it to, which was reconciling earnings power with asset values.

I’m not sure how much of this is temporary and can be blamed on the recession, but it seems simplistic to me that goodwill can always be ignored. Since it represents extra money paid for an acquisition, and since its being written off represents overpayment, I think the more conservative solution is only to look at it in a negative fashion; not counting it as an asset but definitely counting it as a writeoff, at least for a multi-year analysis. And if COP is representative, jumping in after a big writeoff is dangerous. And identifying where the low-hanging fruit isn’t is just as important as identifying where it is.

A stock screener is a useful toy for an investor. In most markets bargains cannot be found by checking stocks at random, and a good screen is a good way to narrow the field. However, a screen is only a first step; a poster at a forum I visit (the same one who referred me to Linn Energy, actually) complained that the first thing new investors do once they finish a copy of Graham’s The Intelligent Investor is run a screen for stocks with a PE ratio under 10, pick out a few names they recognize, and that is their portfolio. There is a certain logic in this plan, since the annual return from the market indexes is said to have been between 9 and 11% depending on who you ask, and without projecting growth a PE ratio of 10 at least gets you what you pay for. And a PE ratio significantly less than 10 looks very appetizing.

However, the trouble with screeners is that they can produce some perfectly ridiculous results. For example, Linn Energy LLP (LINE) has a PE ratio of 1.39 right now. Obviously, this means that you can buy it and get your money back within a year and a half, and still own the stock, right? Well, although the value investor acts under the theory that the market occasionally gets things wrong, rare is the occasion indeed when it gets things crazy (although it does happen). It’s much more likely that the “real” P/E ratio is different. And yet, with a yield of over 11%, LINE is worth a second look. Just because the data make no sense doesn’t mean that the market can’t still be wrong.

LINE is an oil and gas producer, and the bizarre PE ratio comes from the fact that, like many producers, they use derivatives to hedge their exposure to the price of oil and natural gas. However, accounting rules require them to record the changes in value of their derivatives during each earnings period, but they are not permitted to record the counterbalancing change in the oil and gas they hold. Since LINE holds three to five years’ worth of production of these derivatives, any hiccup in the price of oil or natural gas will affect those derivatives by several times what their current results will be affected by. So, ironically, the derivatives that are supposed to make their operations more stable make their reported earnings quite unstable.

In 2008, if you remove the unrealized portion of the derivative gains from their results, their income from operations drops from $825 million to $141 million (much of this income appeared in the most recent two quarters, hence the bizarre PE ratio).  This is an issue considering they paid out $287 million in distributions in that year. YTD 2009, removing the unrealized losses moves their results from a $147 million loss to a $138 million income from continuing operations, and they distributed $145 million to date. The terms of the partnership require them to distribute all excess cash, hence the high payout ratio. At least for the last six months depreciation has equalled cash spent on investing activities, and before then they were still in the capital-raising phase, which clouds the picture.

I don’t know that I see much capacity for near-term growth; virtually all of their projected production is hedged at prices well above current prices; about $7.50-8.50 for natural gas when the current price is less than $5. For oil, half of it is locked in at $90/barrel, or higher. Because of the collars and locked in prices, they don’t benefit if prices go up, just as they’ve avoided suffering as prices have come down. And if they develop a new field, they’d have to lock in the current prices, not the historical ones they had when prices were higher.

What concerns me, though, is stability of operations. WIN, our other high yield candidate, has a long history of producing enough cash flow to cover their distributions, while LINE doesn’t have a long history at all. Even adjusting for derivatives, I’m not sure that its earnings will be stable at this level; utilities have a reputation for stable operations and LINE claims to develop long-lived fields, but that doesn’t tell us how they will do once they have to reset their hedges. If they do keep their earnings stable, for 2008 earnings as adjusted by me they’d have a PE ratio of 18.23, and for doubling 2009 YTD earnings, 9.31, which is not bad. It’s an earnings yield of 10.74% which would almost cover their dividend, and if their depreciation and amortization are not commensurate with future capital costs the dividend may well be covered. Normally one would want to see higher dividend coverage so the company doesn’t have to sell debt or equity to keep up the dividend, and indeed LINE has been raising additional capital by selling new partnership units, which would be unnecessary if they would drop the policy of distributing all available cash. So, if you think they’re going to be stable at this level, they probably would be worth considering for investment. But their PE ratio is certainly not 1.39.

John Maynard Keynes described speculation as essentially trying to guess what other people are going to guess, and doing it better than they guess how you’re going to guess. I think this also describes macro-level investing, i.e. allocating capital based on economic data. As I stated in my last article, focusing on a decent cash flow avoids many of the problems that come from market correlation, leaving you with only the strength of your own analysis to worry about. However, the New York Times has given us a macro indicator that even the most cynical and suspicious of us can get behind. And it’s not even in their business section.

It is, in fact, the New York Times Bestseller List. In a classic investment comedy book, Rothchild’s A Fool and His Money, the author found a newsletter that went through the bestseller lists, and found that the optimum strategy was to peruse the lists for finance and investment books and then do the exact opposite of what the books recommend:

“In the early 1920s Edgar Lawrence Smith wrote…Common Stocks as a Long Term Investment. This book was ignored during the entire period when it would have been a good idea to buy stocks. Suddenly it became a best-seller in 1929…During the entire period from 1932 to 1967…not a single investment book became a best-seller…until Adam Smith’s Money Game was published in 1968, after which the stock market promptly topped out and collapsed. In 1974 Harry Browne’s You Can Profit from a Monetary Crisis…turned half the reading public into gold hoarders, and was followed by a severe decline in the price of gold. Gold didn’t rise again until there were no gold books on the best-seller list…Then it hit $800 an ounce. In the early 1980s, several national bestsellers (most notably Howard Ruff’s How to Prosper During the Coming Bad Years) predicted high inflation forever…a sure sign that inflation had abated. Later in the decade, Jerome Smith’s wildly popular book The Coming Currency Collapse, a terrifying rationale for the total collapse of the US dollar, sold out several editions just as the dollar began its remarkable three-year bull market. Megatrends, a summer favorite in 1983, predicted the triumph of high technology and pronounced the smokestack industries dead. Along…came a genuine depression in the microchip and computer industries and a huge drop in the value of technology stocks, while smokestack industries revived.”

The book was published in 1988, but a sequel would bear up this conclusion. During the dot-com era, Dow 36,000 was published in 1999. The next year the Dow hit 11,750 and then fell to 7286, hit an all-time high of 14164 in 2007, and it looks right now like 36000 is decades of inflation away. And, who could not have predicted the death of the real estate market from the popularity of the Rich Dad series? In 2007 one of Amazon.com’s bestselling books was Bogle’s Little Book of Common Sense Investing, which advised focusing solely on index funds, right before the indexes collapsed, prompting a swarm of articles  about a negative return over ten years (although counting from a bubble to a collapse is kind of cheating).

Right now the New York Times list is devoid of financial books, which is tentatively a good sign for the financial public. Although Rothchild and his newsletter deemed it significant that books on a given subject were not on the list, I think the presence of a book is more important than its absence. #19 this week, however, is Fareed Zakaria’s The Post-American World, about the rise of China and India and the global middle class. It is more optimistic than the title would suggest (and why not? It was first published in April 2008 when the world was better stocked with optimism).

As an aside, China has pegged its currency to the United States dollar for a number of years, in order to perpetuate the trade deficit and build up a substantial pile of Treasury holdings. We ran the price of oil up to $140 a barrel just to shake them off, and now they have the flaming nerve to complain about inflation and suggest that the world needs a new reserve currency. Interestingly, that article also talks about China seeking to switch from export dependency to internal consumption. The trouble is that China’s rapid growth built half of an economy, with the United States and its other importers providing the other half. Since demand creates supply, but supply does not create demand, it’s fairly clear who got the right half. So, for everyone worried about the decline of America’s economic influence, rest assured that when we go down we can still take the rest of the world with us. And, if the New York Times indicator works true to form, the global middle class is doomed anyway.

If you have been reading the financial news since about last May, journalists have been disturbingly preoccupied with the level of the indexes, and have been calling for, say, the S & P to correct from 900, as it sailed merrily past 1000 just to spite them. One imagines that they’ve been going for the stopped clock being right twice a day approach, and after yesterday, (Sept. 1), it seems very much as if they got their wish, at least for the moment.

Should a value investor care about the level of the broader market? Benjamin Graham himself counseled us that when the market is overvalued, even safe investments can be caught in the retreating tide. Warren Buffet, for his part, told his investment partnership in 1969 that nothing he knew how to do would make money in the present environment, so he was liquidating the partnership.

Obviously, when the market is in a depressed mood bargains are more likely to be available, but the central tenet of value investing is that a security’s price and value behave like a comet orbiting a star; they’re locked together as if by gravity but only on rare occasions are they close. However, it is the nature of all financial assets that they turn into cash sooner or later; for bonds, it’s not only sooner but according to schedule, for stocks, often but not always later because they are constantly selling, buying, and shuffling around assets.

If an asset produces cash, now or later, it is worth the cash it produces, and if it does not produce the expected amount of cash it gets written down when that becomes apparent. No matter what happens, cash is always worth cash (although Damodaran, in Damodaran on Valuation, cited some studies to show that this is usually but not always the case). That said, our desire for high current and potential cash flow will insulate us from temporary disruptions in the market, and if our time horizon is shorter than the duration of these disruption, we should be invested in something other than securities.

This cash flow is why CMO, one of my earlier recommendations, has a floor built in to it. With the government explicitly guaranteeing all of its holdings, there is a frozen limit below which its price cannot go (which happens to be about $2 a share below its current price), and that is the present value of the cash it can produce, either from the mortgagors or from the government. If the price does drop below that limit, we can buy it literally without a second thought. Or even a first one.

So, is this yesterday’s action the start of a new leg down for the market, a correction, an event that enough people think is a correction that it will become a self-fulfilling prophecy, or just a coincidence? I don’t know, and whatever the answer is I’m not worried.

I was on vacation last week, but I’m back and I brought Compass Minerals (CMP) with me.

Compass Minerals operates a number of salt mines, and sells rock salt for road de-icing and more refined salt for industrial purposes and consumption by humans and animals. They also produce potash fertilizers. Compass claims to be one of the lowest cost salt providers in the nation, and in the last three years has produced excellent earnings growth, although last year’s high earnings may have something to do with the high price of salt last year.

Their PE ratio is 9 ½, which to me implies that the recent growth they have experienced is not built into the share price. However, it does assume that the recent growth is here to stay. This is a bold assumption since rock salt purchases will be constrained by lowered municipal budgets and fertilizer purchases by diminished demand, but when the economy returns to normalcy as it most likely will eventually, Compass will remain a low-cost provider in an excellent competitive position. They also claim to be diversifying into consumer and industrial salt. Between 2006 when they shipped 8000 tons of salt, and 2008 when they shipped 12000 tons, their cost of production increased from $180 million to $318 million, making a ratio of 1.5:1 for volume and 1.77:1 for costs. This suggests that most of their costs are incremental, which seems to me to be a good thing for a mining company.

They have also been deleveraging their balance sheet, which is most likely a good idea in this environment. On paper, they have $836 million in assets and $692 million in debt, and in prior years their debt has exceeded their asset value. However, this $836 million in assets produced $274 million in operating income and $144 million in 2007 (compare Rayonier, which produced $223 million in operating income based on $2 billion in assets), so there is an argument that Compass’ book value understates the productive capacity of its holdings (or perhaps Rayonier’s is overstated). Certainly the market thinks so; Compass’ market cap is $1.7 billion against $144 million in book equity.

Compass’ capital expenditures have recently exceeded depreciation charges, but they are well covered by operating cash flow. However, apart from last year’s excellent results, operating cash flows  less capital expenditures have covered dividends less than twice, even with Compass’ modest dividend, currently yielding 2.7%. But, if they can keep their current position in the market (on their last 10-K they estimated that the areas they service consume 21 million tons of salt in a year, of which they sold 12 million tons last year), their pricing advantage should carry them through.

At any rate, Compass is a well-positioned company at a reasonable price, and salt is cheap and useful enough not to have many replacements, so Compass Minerals is definitely worth considering.