Alaska Communications – Junk Bonds of the Last Frontier

August 21, 2014

UPDATE: Since this article was written, Alaska Communications sold its remaining wireless assets to GCI and used the money to pay off a great deal of its bank debt, which made these bonds much safer and moved the price to 100. So, buying these bonds when the article was written would have worked out nicely, but at par they’re no bargain. /UPDATE

As you may know, one of my favorite asset classes is high yield bonds, as this market has a small natural constituency and a tendency towards inefficiency, and one of the tenets of value investing is to look for the unpopular and neglected. To this end, I sometimes just run a screen for bonds with high yields and go down the results until I find something interesting.

84091081_pThis time, I got as far as the A’s.  Alaska Communication Systems is a highly leveraged provider of phone services in Alaska, which has recently engaged in a joint venture with its largest competitor to form a wireless entity that is intended to ward off an expansion into its territory by Verizon. I’ve found in the past that rural telephone companies spit out remarkably attractive cash flows in the past as they transition from providing basic services to high-speed Internet and business services, and Alaska Communication System is attempting the same transformation. As one may expect, though, the company has been reliant on federal subsidies to provide connectivity to high-cost customers, and apparently these funds have been struck by the dreaded Sequester. But the rate of decline in Alaska’s cash flows seems to be moderating, and the company is entitled to a preferential up-front cash distribution from its wireless joint venture that will take some of the pressure off from its creditors.

The bonds in question are $120 million of a 6.25% convertible issue due 2018, which sits in line behind $320 million in bank debt. The bonds currently trade at around 81.50, for a yield to maturity of 12.6%. I believe that the company will be capable of meeting its debt burdens, and if not, there is enough cash flow to carry these bonds through the unlikely event of bankruptcy.

As I stated before, Alaska Communications is, like most rural phone companies, moving from basic connectivity to high speed Internet and business services. The company reports that the transition is proceeding adequately, particularly with regard to business services. Also, the company points out that Alaska’s economy is highly dependent on oil, and I think with the high prices of oil expected to persist indefinitely, the forward march of exploration and extraction technology tend to bode well for the business atmosphere in the near future.  The company also owns an underwater fiber optic cable between Alaska and its holdings in Washington and Oregon through which to provide Internet connectivity.

Alaska Communications formed a joint venture in June of 2013 called the Alaska Wireless Network, or AWN, with its direct competitor, GCI. The deal seemed to be highly favorable to Alaska, given that GCI is roughly four times the size of Alaska Communications. Alaska Communications transferred all of its wireless assets to AWN, as well as agreeing to provide it with all of its wireless subsidies. In exchange, Alaska Communications is 33% owner of AWN, and is entitled to a preferential distribution of $50 million for 2014 and 2015, and $45 million for 2016 and 2017, if AWN has the free cash flow to pay it. As of the first two quarters of 2014, this distribution has exceeded Alaska’s 33% earnings share by over $7 million. However, because AWN is not consolidated with Alaska’s financial statements, there is on paper a notable decline in sales.

I often find it interesting to see what other people think of my ideas, and a good source of information, at least for the views of the well-informed public, is at To my surprise, the consensus among the writers there was that even the equity of Alaska Communications is a worthy investment. I find that view unjustifiably optimistic, as I shall discuss further below, but I should point out that as these bonds are convertible, they carry some slight exposure to the price of that equity as well.

Turning now to the figures, in 2013 sales were $349 million, and operating expenses as reported were $96 million. However, operating expenses included an offsetting $204 million in capital gains from forming the AWN venture, as well as $1.3 million in impairments, and stock-based compensation of $2.9 million, which  of course the creditors of the company don’t need to care about. The company incurred $42 million in depreciation and amortization and $48 million in capital expenditures, producing operating cash flows of $47.8 million. Also, the company reported depreciation and amortization of debt discounts and debt issuance costs of $6.9 million. This amount is a noncash expense, and normally is additional cash flow available for paying down debts. However, the company has incurred $3-4 million in both 2012 and 2011 for debt issuance, and as the company’s credit facility falls due to be renegotiated in 2016, and the bonds in question in 2018, we creditors should be aware that there will be issuance costs lurking in the wings.  Also, the amortization of debt discount is a genuine expense, since the company is bound to repay the full amount of its bonds, not the discounted amount.

So, sticking with this $47.8 million, with the caveat that there might be a few million more for a more optimistic analyst to find, we have to look at the company’s debt obligations. The company’s credit facility, which is senior to our bonds, had a balance at the close of 2013 of $346 million and bears an interest rate of LIBOR plus 4.75%, or 6.25%, whichever is greater. The company is also required to make $13.2 million in principal payments in 2014 and $14.7 million in 2015, and as the company has only $5 million in excess cash as of its second quarter 2014 balance sheet, the principal repayment should be considered a claim against cash flow. So, 6.25% of $346 million is $21.6 million, plus the repayment obligation, leads to $34.8 million in prior claims on the company’s cash flow. Thus, the credit facility has an interest coverage ratio of 2.21 times, and a fixed charge coverage of 1.37 times.

This leaves $13 million available for the bonds and our equity holders. These bonds also bear an interest rate of 6.25%, resulting in $7.5 million in interest charges for the entire $120 million issue, and these bonds bear a fixed charge coverage of 1.13 times, and an interest coverage of 1.64 times not counting the principal repayment obligation. I should point out also that the $45 or $50 million in preferred distributions from AWN already exceeds AWN’s required interest and principal repayments. In 2012, sales were $368 million and operating cash flows came to $54 million, and in 2011 sales were $349 million and operating cash flows were $75 million, so at least the decline in operating cash flows is moderating. Also, the current stringency in the federal budget that has frozen the high-cost accessibility subsidies at their 2011 levels may be having an effect, but it can reduce cash flows once but not twice, at least if we can avoid further austerity from our elected officials.

For the first half of 2014, sales were $159 million as compared to $189 million for the first half of 2013. Operating expenses as reported were $140 million as compared to $152 million, producing operating earnings of $19 million as compared to $37 million. In the first half of 2014 capital expenditures exceeded depreciation by $0.6 million, while in the first half of 2013 depreciation exceeded capital expenditures by $10.5 million. Furthermore, equity-based compensation was $1.2 million in 2014 and $1.8 million in 2013. This works out to $19.6 million in 2014 versus $49.3 million in 2013. Furthermore, Alaska Communications received an additional $7.3 million as part of its $50 million in preferred distributions from AWN, of which $25 million has been distributed year to date, so the actual operating cash flow for this quarter is $26.9 million. I am curious that Alaska’s free cash flow for the first two quarters of 2013 exceeded its free cash flow for the entire year, but some of that is attributable to higher capital expenditures in the latter half of 2013.

I would also point out that the company has paid down $18.7 million in long-term debt in the first half of 2014, which includes the early repayment of the $13.2 required principal payment and an extra $5 million voluntary repayment. If, as it seems, the company is directing all of its excess cash flow towards debt repayment, then those who are calling the equity of this company attractive are unduly optimistic, as it will be many years in the future before the cash flows of the company can be considered distributable to them.

So, what “should” these bonds be worth? Well, Aswath Damodaran, author of some excellent books on valuation, has computed the credit spread corresponding to particular credit ratings and interest coverage ratios. His figures are available at

The interest coverage ratios are particularly useful for bank debt or unrated bonds like these. According to his table, the bank debt, counting the required principal repayments, would carry a B rating and a 6.5% spread, while our bonds would be rated CC and carry a 9.5% spread. Taking the 2 year and estimating the 4 year Treasury rates from the Treasury website, the bank debt should carry roughly a 7% interest rate and our bonds roughly 10.8%. Since these bonds, as I stated, trade with a yield of 12.5-12.6%, there is a premium over even their theoretical value. Also, these bonds are technically convertible into shares at a price of $10.28, but the company currently trades for $1.80 and, as I’ve stated, are a long way from receiving any distributable cash flow. Still, I was pessimistic about the stock of Western Refining reaching the conversion price some years ago when I was discussing its bonds, and I was pleasantly surprised.

The sticking point in all this is the fact that the bank debt is due to be refinanced in 2016, before the maturity date of our bonds, and how well or badly that will go depends on how robust Alaska Communications’s cash flows are and how much principal the company has managed to pay down. I think the voluntary additional principal repayments are a good move to make Alaska seem like a responsible borrower and so if things go well the refinancing process would not produce a problem for bondholders as long as cash flows have not deteriorated and interest rates have not increased substantially. Also, as I have stated, the preferred distribution from AWN which the company will receive through 2017 already exceeds the company’s fixed charges, so that money is at least a source of interest and additional principal payments as long as it lasts.

Therefore, I can recommend the Alaska Communication Systems 6.25% bonds due 2018 at their current price as a candidate for portfolio inclusion for those investors who are interested in and have the stomach for high yield investing. Also, you may find, as I did, that brokerages have some difficulty finding these bonds to sell you.

Disclosure: At the time of this writing author owned the bonds referred to in this article.

Image is:

Snow-Covered Telephone Wires, 1938
Photograph by Ansel Adams
Collection Center for Creative Photography
© The Ansel Adams Publishing Rights Trust


Richardson Electronics – A Net-Net Worth Liquidating

July 17, 2014

One of the more famous places to look for value is the net-net company, which has a market capitalization that is less than it could be liquidated for, meaning that the company could never earn another cent and investors would still get more than they paid for. Surprisingly, even in the age of the database such companies still exist here and there. Nowadays, however, many of these companies have money-losing operations that will suck up the excess liquidation value before the shareholders can get to it, so the criteria for purchase should further be limited to firms that have a free cash flow that is positive, or at least zero.

KT88 TubesOne such company is Richardson Electronics, an internationally leading distributor of vacuum tubes, which you may recognize as a technology that was replaced by the transistor about fifty or sixty years ago. Nonetheless, vacuum tubes still have their uses, as they are more resilient to electromagnetic pulses and are useful in some high energy, high frequency operations such as broadcasting, but on the whole the tube remains a specialized market. Richardson also produces customized display units for products such as medical devices. The source of Richardson’s excess asset position is from a large asset sale in 2011, which has left the company with a lot of cash that it has been slowly deploying into share repurchases as well as a few small acquisitions of other tube companies.

The balance sheet, where all the action is, shows $130.5 million in cash and investments, $1.8 million in noncurrent investments, $20 million in receivables, and $35 million in inventories, total $189.3 million. The company also owns a 242,000 square foot headquarters on a 96-acre lot in La Fox, Illinois, which is probably worth a non-trivial amount of money but I don’t include it as part of the net-net value. The company shows liabilities of $26.4 million, leaving $162.9 million in net asset value. The company has 11.8 million class A shares outstanding and 2.2 million class B shares. The class A shares are publicly traded; the class B shares have ten votes each and are not publicly traded, but are entitled to 90% of the dividends on the class A shares. In fact, most of them are in the hands of Mr. Richardson, the CEO.

If we assume that the class B shares are entitled to a premium of, say, 30%, over the class A shares because of their voting control, we have a total of 14.683 million effective shares. If no premium is applied, the total is 14.026 million. Dividing these figures into the net asset position of $162.9 million, we have a per-share value of $11.10 applying the premium, or $11.62 without it. As the company’s share price as of this writing is $10.31, this represents a discount to liquidation value of 7.66% or 12.71%, respectively. I would add the caveat, though, that inventory obsolescence is a problem in the tube business, so it might be prudent not to take these discounts as set in stone.

As is wisely stated by Aswath Damodaran in his book, The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses, the decision of whether to apply a control premium depends on how good a job management is doing. If the entrenched management is running the company as well as any other outside manager could be expected to, then there is no control premium. If, however, the current management in place is incompetent or looting the place though excessive compensation, then the value of control can be significant because the minority shareholders would be better off with the ability to throw them out. For legal reasons I will not state an opinion on Mr. Richardson’s competence, but I am pleased that the company is engaging in share repurchases, since spending a dollar to purchase more than a dollar’s worth of liquidated assets earns the company at least 7.66% without actually having to do anything. On the other hand, given the company’s almost nonexistent free cash flow, I think tying up $162 million in assets to produce it is a little excessive, so I would submit that the repurchases should be accelerated at least until the discount is erased.

In terms of free cash flow from operations, in fiscal year 2013 (ended in June), net sales were $141 million and operating income was $11 thousand (note, thousand, not million). Also, capital expenditures exceeded depreciation by $583 thousand, so the company’s free cash flow would have been negative that year if not for the interest income, which I am not taking into account because the bulk of them are non-operating assets that again should be returned to the shareholders via repurchases. For the first 9 months of fiscal year 2014, net sales were $103 million as compared to $106 million in the same period for the previous year, which is in line with the ongoing trend at Richardson. The operating loss over that period was $229 thousand, although the company did allocate $800 thousand for evaluating potential acquisitions to operating expenses. This compares to $1.6 million in operating earnings for the same period in the previous year. And, again, capital expenditures exceeded depreciation over this period, this time by $1 million, making for another period of negative free cash flow.

So, where does that leave us? It’s fairly clear from the slightly negative free cash flow that tubes is not the place to be right now, but the drain the company’s operations is producing on its asset position is for the moment almost negligible at roughly $1 million a year. Therefore, it would be prudent to purchase the company to take advantage of its discount to its liquidating value, but to watch the discount like a hawk. Also, as inventory obsolescence is a risk factor in the tube business (but not so much for the customized displays as the company makes them to order), it might be advisable not to wring out the last penny of the discount either.

I should also point out that Richardson will release its 4th quarter and fiscal year 2014 earnings very soon, on July 24th. Forecasting what those results will be in any great detail would be a fool’s errand, but here is my forecast. Free cash flow will, barring a miracle, be disappointing relative to the amount of capital tied up in the business, and there may or may not be share repurchases; there were none in the third quarter, but Richardson’s share price has been lower on average in the fourth quarter.

So, with the above caveats in mind, I can recommend Richardson as a candidate for portfolio inclusion, if you believe as I do that purchasing at a discount to liquidation value is a viable strategy.

Disclosure: At the time of this writing, I was long shares of Richardson Electronics.


Crawford & Co. – A good bet for when everything else goes wrong

June 23, 2014

I am often struck by the fact that, when it comes to companies, size is no guarantee of quality. By which I mean that generally speaking I have no bias in favor of large or small cap companies, and frequently I see a symbiosis of small companies serving the large ones like the pilot fish serving a shark. One of my earlier recommendations was CSG Systems, a company with a market cap at the time of less than $600 million that provided billing and account management services to such giants as Comcast and Dish Network, among others. And now I see Crawford & Co. (CRD-A and CRD-B, more on that later), a company with a market cap of less than $600 million that provides claims management services for all manner of players in the insurance industry as well as logistics for large bankruptcies and class actions.

Carcharhinus_longimanus_1Crawford, despite its size, is a global company providing claims management in both hemispheres. Its Americas segment, which covers the entire western hemisphere, deals with property, automotive, casualty, and product liability, as well as maintaining a network of contractors in the United States. Its Europe, Middle East, Africa, and Asia-Pacific covers similar operations in those regions. Both of these divisions were about 30% of sales in 2013. It also operates a division called Broadspire, which provides a broad range service for self-insured and commercially-ensured entities in handling workers’ compensation and medical claims, which was approximately 20% of sales in 2013. And its final division is the legal settlement administration, which administers class actions and certain large bankruptcies. This last division represented the remaining 20% of sales in 2013. However, much of this activity was the result of the Deepwater Horizon spill, and Crawford expects that earnings from this will taper off throughout 2014.

In fact, because Crawford has a global presence, any disaster that leads to complicated insurance claims is probably a good thing for the company. Crawford’s 10-K filings for the last couple of years read like a litany of everything that has gone wrong with the world lately. They mention the Deepwater Horizon spill, superstorm Sandy, the floods in Thailand, the Australian brush fires, etc., all of which were apparently sufficient to move the needle in one or more of Crawford’s divisions and it is apparently with a tinge of regret that management reports that these major disasters did not recur.

Crawford has two classes of publicly-traded common stock. The class A shares are not entitled to a vote, but the board of directors is authorized but technically not required to pay higher dividends on them than the class B shares. The class B shares are entitled to a vote, but 52% of these shares are owned by a member of Crawford’s board of directors, who by an extraordinary coincidence is named Jesse Crawford. There are 30.3 million class A shares outstanding with a price of $8.31 as of this writing, and 24.7 million class B shares with a price of $10.67, for a total market cap of $515 million.

Crawford’s balance sheet indicates $48.5 million in cash and equivalents, and total current assets total $365 million set against $318 million in liabilities, so virtually all the cash might be considered excess. On the other hand, Crawford also faces a pension shortfall of $97 million, or about $63 million after taxes. Pension shortfalls are a prior claim over the common shareholders, so netting out the excess cash and the pension shortfall, we have an effective market cap of $530 million to serve as the denominator when calculating free cash flow yield.

In 2013, total revenues for Crawford were $1.253 billion. Operating earnings for the Americas segment were $19 million, $32 million in the non-Americas segment, $8 million in the Broadspire segment, and $47 million in the legal settlement administration segment, total $106 million in operating earnings. Subtracting corporate-level expenses, operating earnings across the entire company came to $87.5 million. Interest expenses in 2013 were $6.4 million, leaving $81.1 million in pre-tax earnings. Taxes paid in 2013 were $29.8 million, or 36.7% of operating earnings, leaving $51.3 million, and there was an additional $3 million in excess depreciation, producing free cash flow of $54.3 million, for a yield of 9.68%, which is pretty attractive.

In 2012, total revenues for Crawford were $1.266 billion. Operating earnings for the Americas segment were $12 million, $48 million in the non-Americas segment, the Broadspire segment’s earnings rounded to $0 million, and $60 million in the legal settlement administration segment, total $120 million in operating earnings. Subtracting corporate-level expenses but excluding some nonrecurring items, operating earnings across the entire company came to $101 million. Interest expenses in 2012 were $8.6 million, leaving $92 million in pre-tax earnings. Taxes paid in 2012 were $34 million, or 36.6% of operating earnings, leaving $58 million in free cash flow. Excess depreciation this year was de minimis.

In 2011, total revenues for Crawford were $1.211 billion. Operating earnings for the Americas segment were $20 million, $28 million in the non-Americas segment, an operating loss of $11 million in the Broadspire segment, and $51 million in the legal settlement administration segment, total $88 million in operating earnings. Subtracting corporate-level expenses, operating earnings across the entire company came to $72.5 million. Interest expenses in 2011 were $16 million, leaving $56.5 million in pre-tax earnings. Taxes paid in 2011 were $13 million, or 23% of operating earnings, leaving $43.5 million in free cash flow. Excess depreciation this year was $2 million, producing $45.5 million in free cash flow.

In 2010, total revenues for Crawford were $1.111 billion. Operating earnings for the Americas segment were $21 million, $25 million in the non-Americas segment, an operating loss of $12 million in Broadspire, and $48 million in the legal settlement administration segment, total $82 million in operating earnings. Subtracting corporate-level expenses, operating earnings across the entire company came to $69 million. Interest expenses in 2010 were $15 million, leaving $54 million in pre-tax earnings. Taxes paid in 2010 were $10 million, or 18.5% of operating earnings, leaving $44 million in free cash flow. Excess depreciation this year was de minimis.

So, casting an eye over these figures, we see that Broadspire seems to be getting its feet under it, turning a $12 million loss into an $8 million profit, and management claims that the restructuring and refocusing effort at Broadspire should continue to show results. On the other hand, barring another large class-action on the level of the Deepwater Horizon spill, the legal settlement administration division will produce significantly reduced earnings in the next few years, so we can expect future free cash flows to decline unless, for example, the Keystone pipeline gets built and then leaks all along its length. If Broadspire can hold the line with its earnings, Crawford’s cash flows should be adequate but not too exciting for potential holders, plus there is effectively a built-in call option on any future natural disasters. Also, with global climate change still not solvved, we probably have no end of storms, drought-induced wildfires, and floods to look forward to, so we may not even have to wait for something as large as another oil spill catastrophe. With these caveats in mind, I can recommend Crawford & Company as a candidate for portfolio inclusion.

The next question, then, is which class of shares to purchase. Although normally one would expect the voting privilege of the class B shares to give them a premium over the class A shares in price, it should be recalled that Jesse Crawford has majority control of the entire company and so these voting rights are to an extent illusory. As such, it is the class A shares, which the board can pay, and has paid, higher dividends on, that should be purchased, given the current large gap between the two. In fact, the only reason for anyone to offer such a high price for the class B shares is in the hope of prying them out of Jesse Crawford’s hands. But surely they must realize that he will never give up his majority stake so easily.


Make Yourself Immune to Interest Rates

April 7, 2014

I am one of the no doubt very few people in the world who enjoy watching the Federal Reserve Chair testifying before Congress. Among the issues presented in the latest round from Chair Yellen was the difficulty of old people coping with the low interest rate environment in living off their investment income. The Chair, while acknowledging these concerns, could naturally offer no comprehensive solution, partly because her mandates cover unemployment and price stability, not increasing the supply of old-people-appropriate investments, and partly because it’s not her job to offer portfolio management advice anyway.

220px-Janet_Yellen_official_portraitThe source of this criticism frequently seems to be the conservative side of Congress, which has often been suspicious by nature of the Federal Reserve and which has been stymied in its efforts to undermine the institution’s policies by the U.S. economy’s stubborn refusal to collapse into hyperinflation. Having lost, for the moment at least, the argument that the Fed is incapable of managing both inflation and unemployment, thus justifying the removal of one of these mandates, the conservative argument seems to be making up a new mandate, high yields on safe investments, apparently acting on the theory that if the Fed cannot handle two mandates it certainly needs three of them.

Politics aside, though, it does seem unsatisfactory that old savers, or at least their desire to live off of interest income, should be collateral damage of the Fed’s policies, and the solution of taking on more risk is unpalatable even if the portfolio size and life expectancies of some retirees could justify it. And although value investing is effective for bonds as well as stocks–much of Ben Graham’s Security Analysis deals with bonds and many famous value investors have made a reputation and a fortune in fixed income–there is no readily apparent solution to low interest rates, particularly if the broader market is also reaching for yield, based on observed low and declining spreads between Treasury and high yield bonds. Not much can be done about low interest rates now.

But there is something that could have been done before now. As we all know, bond prices and yields move in opposite directions, a principle so well-known to fixed income investors that I don’t even need to cite it (oh, all right, The Handbook of Fixed Income Securities, Eighth Edition). Furthermore, we have ways of modeling exactly how far prices will move in response to a given change in yields, so that with the right choice of bonds we can insulate our future income against the actions of the Fed, or even in a pre-quantitative-easing world, of people other than the Fed as well.

The method is as follows. The value a bondholder derives from a bond comes from three factors. These are the market price, the interest the bond pays, and the proceeds of reinvesting the interest payments. If interest rates increase, it stands to reason that the market price will decline but the reinvestment income will increase, thus offsetting the decline in the market price. Likewise, if interest rates decrease, the price of the bond will rise but the reinvestment income will fall. But the question that concerns us is when the change in the market price and the change in reinvestment income will cancel each other, thus leaving us in the same position we were if interest rates had not changed at all. This method is called bond immunization.

immunization2And it turns out that not only do those changes offset each other, but in theory they do so in quite an elegant manner. For a single bond, and for a single parallel shift in the yield curve (i.e. all relevant interest rates move by the same absolute amount), then the changes to market price and reinvestment income will exactly offset each other at a single point, regardless of which direction or how large the interest rate move is. That point is the duration of the bond. The duration, by the way, is the weighted average of a bond’s cash flows multiplied by the time until they are received, and also measures by what percentage a bond’s price will change in response to a change in interest rates. *

The point of this discovery is that if we are capable of predicting our future retirement expenses for a given year, we simply purchase bonds with a future value equal to those expenses and with the same duration as the year in question. This can be done for multiple years as long as durations are available, and at that point we arrive in the blurry and indistinct future that would be best met with equities. At any rate, the lower interest rates become, the longer bond durations become, so this method is even more usable in the current environment. This immunization technique is commonly used among those mythical creatures known as defined-benefit pension funds, and there is no reason the same logic does not apply to individual investors.

Well, when I say “no reason,” I am neglecting taxes. Also, interest rates have an irritating tendency to move in nonparallel shifts, which is to say that short-term and long-term interest rates sometimes shift by different amounts. But the biggest pain is that bond durations tend to drift over time, rather than decline perfectly in line with the approach of the year they were keyed to. The consequence of these factors is that a bond portfolio cannot be immunized and then ignored; it has to be rebalanced. However, all portfolios need to be rebalanced, so I don’t think this is a valid objection. The fact that there is a tradeoff between predictability of outcomes and not incurring transaction costs is known to anyone who has anything to do with hedging, see Nassim Taleb’s Dynamic Hedging: Managing Vanilla and Exotic Options.

It may be objected that this strategy is not strictly living off of one’s income, since half the time our bond prices will instantly go up and no matter what happens making these moves years in advance of the year in which we need the money means fiddling with our account balances anyway. But the goal in retirement investing shouldn’t be never to touch the principal; it should be to never outlive it. If we have more principal than otherwise through adopting this immunization strategy, and we have to draw it down in the target year, that is the strategy working as intended. And, really, if we never intend to touch our principal what is the point of having it?

In general terms, those who refuse on principle to invade their principal, and the conservative Congressmen at Chair Yellen’s hearing, are missing the point. They are analyzing assets in a vacuum, rather than taking into account the liabilities those assets are intended to meet. This is at best a suboptimal method and at worst one that leads to inadequate income, since interest rates are what they are and unless we happen to be Chair Yellen, we have no control over them but can only position ourselves in advance to respond to changes in them. And, since bond immunization works when interest rates rise as well as fall, the current concerns about the impact of the present tapering of quantitative easing suggests this strategy as much as the cutting interest rates and quantitative easing itself did.

It may further be objected that this strategy is complicated, requires a great deal of attention, and often requires a large portfolio to make the additional transaction costs worth the trouble. These objections are certainly valid, but bond immunization can be approximated, which would be better than nothing. And at any rate it is a little galling to me to see Congressmen and old people themselves up in arms because they are apparently unaware that such a strategy exists.

* Image modified from one appearing at


NASB – Banking on a Return to Normalcy

February 5, 2014

Banks are sometimes difficult to get a handle on; the Citigroup 10-K for fiscal year 2007 was over 200 pages long and you could have read every word of it and not found a line reading “Oh, by the way, we’re doomed.” But not every bank is a too-big-to-fail megabank that dabbles in derivatives; the vast majority, by number if not by total assets, are regional banks that go about the ordinary, everyday business of taking in deposits, lending money, and selling those loans to a securitization entity (sorry, some things do change).

NASB Inc. is such a bank, and is worth looking at. It combined a conservative style with a high return on assets, and last year managed a negative provision for loan losses (which is a rare and impressive feat). Now that the taper is on and things are slowly returning to normal, it can reverse its deleveraging plan and get back to the good old days. And in 2007 they might not even have been doomed.

For my full thoughts on the matter, visit


Cott Corporation (COT) – I think not.

December 27, 2013

Like many investors, I’ve always liked used basic company statistics as a screen to identify companies worthy of more in-depth investigation. I readily admit that there are many qualitative aspects to a company that are unlikely to show up in the figures, but on the other hand, a corporation is a device that turns cash into (hopefully) more cash, and so qualitative aspects are important only to the extent that they can be expected to show up in the numbers eventually, and when it comes to stock purchases, a false positive (buying a stock that shouldn’t have been bought) strikes me as more painful than a false negative (not buying a stock that should have been bought), and at any rate, I don’t always have the patience to heed Warren Buffett’s advice to just “start with the A’s”.

However, a screener is only the first step. Although the goal of screening is to identify a company with a high free cash flow yield, the subsequent analysis and digging into the SEC filings and other useful sources is to determine whether the historical performance is likely to be repeated or whether the same is doubtful, because many companies have low multiples for a reason.
open blank soda can6636619Such a company, unfortunately, is Cott Corporation, which produces private-label sodas and other beverages. Although its free cash flow yield based on historical performance is a robust 10% when excess cash is taken into account, the company’s competitive position and the movement against sugared beverages cause me concern as to whether these cash flows will be likely to repeat themselves in future, and the performance during the current fiscal year seems to suggest that things are already beginning to unravel. I know it is a common weakness of analysts that we cannot see two points without drawing a line through them, nor three points without drawing a curve as well, but again, false positives…

Cott corporation’s produces soft drinks, juices and juice products, flavored waters, energy drinks, sports drinks, teas, and some alcoholic beverages as well. It operates in the private-label, or store-brand markets, and has operations in the United States, Canada, and the United Kingdom. The company is the largest private-label producer in the United States and the United Kingdom. Lately the firm been trying to diversify away from carbonated beverages, reducing them from 50.4% of total sales in 2010 to 39.1% in 2012, a goal that has been partially accomplished through acquisitions.

Naturally, much of Cott’s business is concentrated among the large grocery store chains that can sponsor a store brand, with over 10% of its sales coming from Wal-Mart alone. The company uses long-term supply contracts, but apparently its ability to pass increasing costs on to its customers, as the company also relies on futures contracts for aluminum, corn, and sugar, as well as forward contracts for plastics and other ingredients when available.

The company’s market cap as of this writing is $760 million, and based on its latest balance sheet there was $126 million in cash and its noncash current assets exceed its current liabilities, indicating that the cash can be treated as excess. Thus, the market value of Cott’s operating assets is $634 million.

On the free cash flow side, in 2012 sales were $2.251 billion, gross profit was $290 million for a gross margin of 12.9%. Operating income as reported was $110 million, depreciation was $101 million and capital expenditure $75 million, resulting in operating cash flow of $136 million. Interest expense was $56 million, leaving $80 million, which after estimated taxes of 15% (Cott is headquartered in Canada where corporate taxes are lower than in the United States), free cash flow was $68 million, and subtracting $4 million for noncontrolling interests gives free cash flow to shareholders of $64 million. This works out to a free cash flow yield of just above 10%.

In 2011, sales were $2.337 billion, and gross profit $277 million for a gross margin of $11.8%. Operating income as reported was $101 million, depreciation was $99 million and capital expenditures $55 million, plus $2 million in noncash impairments, producing operating cash flow of $147 million. Interest expense was $57 million, leaving $90 million, which is $77 million after estimated taxes. After subtracting noncontrolling interests of $4 million, we have free cash flow to shareholders of $73 million.

In 2010, sales were $1.803 billion, gross profit of $266 million and gross margin of 14.8%. Free cash flow to common shareholders was $64 million.

Cott claims that in 2012 it exited certain low-margin businesses, which lowered sales but expanded margins. It also explains the increased capital expenditure as being part of a vertical integration program. In 2010, Cott acquired a private-label juice company for $500 million, which explains the jump in sales between 2010 and 2011.

As I stated before, the cash flow situation at Cott seems to be unraveling somewhat already as 2013 goes on. During the first three quarters of 2013, sales were $1.612 billion versus $1.773 in 2012, gross profit $198 million versus $229 million and gross margins 12.3% versus 13.2%. Operating income was $74 million versus $93 million, and ultimately free cash flow to shareholders was $49 million versus $58 million. The fourth quarter is typically not a large contributor to earnings, as one expects during winter from a company that sells nice cold drinks.

Normally, I would warn against making too much of the results of a single quarter or year, as the information content of those results often does not explain the wild swings in prices that accompany their release. But what the results do make clear is that Cott Corporation’s margins are unstable, and this will be the case even if Cott does manage to reverse the current decline in earnings. These unstable margins are a telling symptom of Cott’s unenviable competitive position. More than half of its earnings come from only 10% of its customers, and 10% of its sales come from Wal-Mart alone, and anecdotally being a Wal-Mart supplier is said to be a highly frustrating experience. Furthermore, as stated above Cott has difficulty in transmitting changes in input costs to its customers, hence the push towards vertical integration in 2012.

Furthermore, although the company is looking to expand its range of offerings, the largest category of sales are still private-label sodas, which are currently under attack as the cause of obesity, even outside of New York City. Furthermore, sodas are a low-margin business anyway; in 2012, although they represented only 41% of Cott’s sales volume, they were 63% of its physical volume. And unfortunately for Cott, the market for private-label sodas is naturally constrained because of the presence of the leading brands, which are in a position to suck up a great deal of any rebound in the popularity of soda. As Ross Johnson, then-CEO of Nabisco and a fellow Canadian, said years ago in Barbarians at the Gate, he had to sell off Canada Dry because even if the company could walk on water, Pepsi and Coca-Cola are waiting on the other side.

For these reasons, despite the apparently attractive yields of Cott Corporation, I cannot recommend it as a candidate for portfolio inclusion.


Food Stamps and the Price of the Minimum Amount of Food in 1935 England and Today

October 15, 2013
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Catchy title, no?

Anyway, between the government shutdown and the debt crisis, I’ve found looking at investments rather dispiriting, as the ensuing chaos in the markets would override even the soundest of analysis. So, I’ve been keeping my head down by catching up on my reading at least until this all blows over.

One of the things that has been affected since even before the shutdown was the deep cuts to food stamps in a bill passed by the House, and of course with the shutdown and debt ceiling debates still unresolved, the existing federal food benefit programs are also hanging over the abyss.

dates-300x285But this put me in mind of George Orwell’s The Road to Wigan Pier, where the author visits a mining town in the north of England to comment on the dirt and poverty there, and also the nature of public assistance, which in the Depression-era 1935 was a non-trivial subject. One issue that concerned him was a “disgusting” public debate over how small an unemployed person’s food budget had to be without actually causing them to die of malnutrition. One dietitian put it at five shillings, ninepence, while a more generous one had five shillings, nine and a half pence. But it also led to some snooty letters to the editor about how four shillings should be more than sufficient, including a sample menu.

So, out of my own interest, I thought I would see how well this weekly food budget withstands the test of time, and how it compares with the food stamps allowance of today, using my local Safeway as a source.

George Orwell’s original list was

3 wholemeal loaves, 1 shilling
1/2 lb. margarine, 2 1/2 p
1/2 lb. dripping (beef fat), 3 p
1 lb. cheese, 7 p
1 lb. onions, 1 1/2 p
1 lb. carrots, 1 1/2 p
1 lb. broken biscuits, 4 p
2 lb. dates, 6 p
1 tin evaporated milk, 5 p
10 oranges, 5 p

As he says, if one were challenged to extract as much nutrition as possible from four shillings, this would be about it. He also points out that none of these ingredients require cooking (or refrigeration, although in the ’30s that was probably typical), and that trying to live on this regime for any length of time would practically drive one to suicide.

But if we modern people wanted to live on lard-and-raw-onion sandwiches (which were actually a thing, mentioned in The Jungle by Upton Sinclair as the lunch of an impoverished family of meat packers) and the occasional orange for dessert, the prices would be as follows:

3 loaves of bread $3-4.50,
1/2 lb. margarine: $1-1.16
1/2 lb. lard: $1.50
1 lb. cheese: $3-4
1 lb. onions $1.50
1 lb. carrots $1
1 lb. private-label vanilla wafers or animal crackers, $3.25
2 lb. bananas $1.50
1 box of evaporated milk $4.50 for 3 quarts’ worth.
5 lb. of oranges $8.

Total: $28.55-31.21.

I have made some substitutions, obviously. The range of prices in this list deals with whether one gets the club card discount. I have substituted lard for dripping because cow fat is not commonly sold retail. I’m not aware that one can specifically buy broken cookies, so I went with a close analogue. As for the bananas, dates may have been a staple in 1935 but in California they seem to be a luxury item at $8 a pound, while bananas are 69-79 cents a pound depending on the time of year.  Also, I don’t know how much evaporated milk is in a tin, and I suppose that some savings could probably be made in the orange department too, but too many substitutions would defeat the purpose of the comparison. I believe that most of the above foods, apart from the wafers/animal crackers, are not subject to sales tax.

According to the Internet, the average food stamp allowance in California is $149 a month, or $34.38 per average week. Looking up at the total, this food budget does allow for the above menu with an amazing $3-6 a week to spare, although in all fairness one should probably find a way to squeeze in a multivitamin ($9 for 100 pills).

The next question is how well this menu holds up against inflation, and there are two ways of doing it. The first way is to use the British inflation rate since 1935 and then converting it into dollars, and the second way is to convert into dollars in 1935 and to use the American inflation rates. Under the first method, 4 shillings in 1935 are worth 12.04 pounds today, which works out to $19.26. Under the second method, 4 shillings in 1935 were worth almost exactly a dollar, and a dollar in 1935 is worth $17.07 today. In both cases, the inflation-adjusted amount is below the present cost of the food.

I have to say that this result surprises me; I would have expected that advances in food production technology and the Green Revolution in fertilizers would have lowered the overall cost of food, but then again it is commonly criticized that more and more of the cost of food nowadays is the cost of transporting it to the market (especially true of bananas). Still, we in the modern era have the means to grow more food, store it for longer periods without spoiling, and have in the United States a superabundance of food, and yet we are less generous than the British were in the ’30s.

But what concerns me as well is that this menu was proposed not by a dietitian, but by a letter to the editor, which Orwell points out, may not have been genuine because no one could live on such a diet for a significant length of time without going insane. The actual dietitian’s minimum was nearly 50% higher than this weekly expenditure. And yet, based on the current food stamp allowance, which, recall, is itself in imminent danger of being cut off, the proposed menu barely fits at all. In a nation that exports literally millions of tons of food, I am surprised to hear that supplies of food to those on public assistance are lower than they were in the depths of a Depression despite 80 years of progress.


Skywest – Buy It For Its Cash Holdings, Keep It For Its Airline Business

September 19, 2013

Skywest (SKYW), a provider of regional flight services mainly to United Continental and Delta Airlines , has a balance sheet that I would describe as very interesting. The company literally has enough cash and securities on hand to buy back more than 80% of its shares. Skywest has a market cap of $793 million as of this writing, and its latest balance sheet shows $646 million in cash and marketable securities, which at first approximation implies that one could buy the company for its securities portfolio and get its entire future earnings stream for $150 million, which is less than the company earned in its last full year. In other words, removing Skywest’s excess cash and securities from the equation and valuing only the operating assets of the company gives us a P/E ratio of approximately one.

Unfortunately, that’s not quite how it works. Equity holders are at the end of a long list of prior claimants on a company’s assets, and Skywest has a significant amount of bank debt and also leases many of its planes. Therefore, the question becomes how likely it is that these liabilities will be met by Skywest’s future cash flows, so that the shareholders’ residual claim on the cash and securities is unlikely to be preempted.

As stated in Value Investing: From Graham to Buffett and Beyond, there are three sources of value for a company that roughly correspond to the past, the present, and the future. The balance sheet, where all of Skywest’s cash and securities exist, represents the past. The company’s earnings power as represented by its income statement is the present, and the company’s future growth prospects represents the future. The purpose of making this distinction is the varying degrees of reliability that the three sources have. The balance sheet is, barring accounting irregularities, reliable, although some figures need adjusting to reflect the realities of business. The recent income statements represent the present in that, although they require some insight as to whether the company can repeat the performance, the company has nonetheless established its present ability to produce these earnings and can to a degree be counted on to continue to produce them. The growth factor, representing the future, is the least reliable, first of all because the anticipated growth may not materialize, and second because, even if the growth does materialize, it is possible that the cost of the capital required to create the growth will equal or exceed the growth itself. The lesson, then, is to confine our investments to where the value proposition has the greatest reliability, ideally on the strength of the balance sheet alone. However, as those opportunities are rare nowadays, we should rely on the balance sheet and the current earnings power.

Turning back to Skywest, I believe that the levels of cash on the balance sheet are mostly safe over the long term. Skywest is cash flow positive from an operational standpoint, and although it has significant debt repayment obligations in future years, I find it plausible that the company will be able to roll over its debts. Furthermore, Skywest derives over 90% of its revenue from fixed-rate contracts, whereby its contracting partners, which are major airlines like United and Delta, pay the company a flat rate per flight-hour, modified by incentive bonuses or penalties. Furthermore, its partners reimburse Skywest for the cost of fuel and other expenses. This insulates Skywest from the two largest sources in earnings volatility that affect airlines: ticket prices and volumes and fuel prices. As a result, margins for Skywest can be expected to be more stable than those of most airlines, thus lowering the risk of substantial negative operating cash flows for a long period.

delta-pckSkywest runs approximately 4000 flights per day for short-haul flights between smaller regional airports and the major hubs, in airplanes that typically have a seating capacity of 70 or less. The terms of their contracts allow Skywest to use the airline codes and plane decals of its contracting partners. Skywest’s partners also handle the booking and, as stated above, reimburse Skywest for fuel and some other expenses, sometimes including wear and tear on planes. Nearly 2/3 of Skywest’s flights arise from a contract with United, and nearly 1/3 with Delta, with the balance made up by US Airways, American, and Alaska. Skywest’s contracts with these airlines typically run for five or more years.

Turning now to the figures, sales in 2012 were $3.534 billion, and reported operating earnings was $166 million. Depreciation and amortization were $252 million and net capital expenditures were $58 million, producing operating cash flows of $360 million. Net interest expense was $69 million, leaving $291 million in pre-tax cash flow, or $257 million after estimated income taxes at a 35% rate.

In 2011 sales were $3.655 billion, operating cash flow was $116 million, and estimated after-tax cash flow was $53 million. In 2010 sales were $2.765 billion, operating cash flow was $270 million, and estimated after-tax cash flow was $149 million.
After-tax free cash flow assumes a 35% income tax rate and that excess depreciation is not taxable. It is also calculated before net debt repayments.

The first half of 2013 is shaping up well. Operating earnings are comparable to those of the first half of 2012, although capital expenditures have increased to be more in line with historical levels. However, I should add that Skywest has recently been expanding its capacity, disposing of some of the smaller and more marginally profitable aircraft in its fleet and taking on larger ones, and also increasing its total number of flight hours by 3-6% on a year-over-year basis, so at least some of the additional capital expenditures for 2013 as compared to 2012 may be considered growth capital, i.e. expenditures intended to increase earnings power rather than simply to maintain it.

Thus far, sales in 2013 were $1.643 billion versus $1.858 billion for 2012, capital expenditures were $85 million versus $40 million, operating cash flows were $103 million versus $155 million, and estimated after-tax free cash flow was $58 million as compared to $109 million. Again, after-tax free cash flow assumes a 35% income tax rate and that excess depreciation is not taxable. It is also calculated before net debt repayments.

I should also point out that Skywest’s accounting policy is to record its fuel reimbursements as revenue, so although operating earnings are unaffected, this policy has an affect on the comparability of sales over differing periods.

I alluded earlier to the fact that Skywest leases many of its airplanes. Rental payments for Skywest come to roughly $330 million per year. Furthermore, the terms of Skywest’s loans requires them to make principal repayments of roughly $180 million per year for the next four or five years. However, maintaining this debt payment schedule would reduce Skywest’s level of long-term debt to barely a fifth of its historical level, and as debt repayments tend to produce a corresponding increase in borrowing capacity it should be entirely possible for Skywest to roll over its debts at least in part. Also, based on my research, Skywest’s level of total fixed charge coverage is comparable to those of its competitors, most of which do not enjoy the stability of margins that Skywest gains from its fixed-fee contracts.

Furthermore, although most airline companies maintain a large holding of cash and securities in order to maintain a cushion against the cyclicality of the airline industry, Skywest is unique among airlines in that its portfolio represents such a large percentage (over 80%) of its current market cap, and this despite its fixed-fee contracts providing significant insulation from the effects of cyclicality as well.

So, if Skywest’s performance remains on its current course, the company’s cash flow generation should be sufficient to leave its portfolio of cash and securities at its current level, while any future expansion of the company is also the shareholders’ to enjoy. At the same time, the portfolio should provide substantial protection from any downside moves as so much of the company’s value comes from financial assets already in place rather than uncertain future cash flows. Therefore, I can strongly recommend Skywest as a candidate for portfolio inclusion.


ACCO Brands – An attractive investment once adjustments are made

July 14, 2013

Whenever I’m in a store it always strikes me that every product on sale there, even the small and unusual ones, are produced by some fairly large and serious corporations that employ thousands of people and do millions in business.

office-supplies1One such company is ACCO Brands Corp., which makes office supplies, laminators, shredders, and notebooks and day planners. The company owns the Swingline brand and, following a merger last year, Mead as well. Half the company’s sales are outside the United States, and its largest customer is Staples at 13% of total sales. The company offers a prospective free cash flow yield of 11.8%, which is very attractive.

The Mead acquisition has created a great deal of complication in Acco’s financial statements, and in order to understand them a great deal of nonrecurring matters. The acquisition required a bridging loan, various restructuring expenses and investment banking fees, and a writeoff of capitalized debt issuance costs (As an aside, has any company ever had someone offer to buy its debt issuance costs? Then why capitalize them?). On the other hand, the Mead acquisition also allowed the company to reverse the prior writeoff of net operating losses. The strategic use of mergers to make use of tax loss carryforwards is a simple but highly effective corporate strategy, but it also gave Acco a negative income tax rate in 2012. As a result, to get at Acco’s long term earnings power it is necessary to ferret out both these nonrecurring expenses and this income tax bonus.

In 2012, sales were $1786 million and gross profits as reported were $533 million. Operating income as reported was $139 million. However, merger-related expenses were $23 million and Acco also took $24 million in restructuring. Furthermore, depreciation and amortization totaled $42 million, while the company made $30 million in capital expenditures. As a result, operating cash flow, apart from changes in working capital, came to $198 million. Reported interest expense was $89 million, but this includes $16.4 million in merger financing and $3.6 million in accelerated amortization of debt issuance costs, so long-term interest expense was closer to $69 million. (Actually, the company’s refinancing lowered its average interest rate and the company paid down $200 million in debt over the course of 2012, so the company’s future interest rate is likely to be even lower). This leaves $129 million in pre-tax cash flow to shareholders, which, applying a 35% tax rate, comes to $84 million. The company also had $7 million in earnings from a joint venture, bringing its long-term estimated earnings power to $91 million. Based on the current market cap of $773 million, this is a free cash flow yield of 11.8%.

In 2011 sales were $1318 million, operating income was $115 million and operating cash flow $128 million. Interest expense was $77 million, leaving $51 million in pretax cash flow, or $33 million after taxes, plus $9 million in earnings from the joint venture.

The company reports that its increased sales and gross profits in 2012 were entirely the result of the merger, and apart from this both sales and gross profits declined, owing to weaknesses in Europe and an ongoing shift away from paper day planning products in favor of electronic calendar applications and so forth. Acco is not above whittling away its less profitable lines of business, having sold off an Australian manufactuer of binding products in 2011 and making some smaller asset sales on an ongoing basis. As a result, we can expect further restructuring expenses–the company expects $25 million in restructuring charges in 2013, of which $10 have already occurred–and so it may be optimistic to treat restructuring expenses as nonrecurring, but to the extent they are associated with discontinued operations or severance, it is not per se inappropriate to do so.

For the first quarter of 2013, Acco reported a net loss, although taking restructuring and amortization of intangibles into account the loss was negligible. The company’s operations are seasonal, with the bulk of profits arriving in the second and third quarters, so this outcome is not a great concern. During the first quarter 2013 conference call, the company announced that it was anticipating $150 million in free cash flow for the year, which would be a yield of 19.5%, although the company’s method of calculating free cash flow might not jibe with mine.

At any rate, Acco Brands offers a substantial free cash flow and office and school supplies are to an extent always in demand. Therefore, I can recommend this stock as a portfolio candidate.


CF Industries: Strong Margins Taking Advantage of low Natural Gas Prices

December 2, 2012

CF Industries is the leading North American producer of nitrogen fertilizer. By a miracle of nature, this fertilizer is made out of natural gas and air. Owing to the very low prices of natural gas, coupled with the high acreage of corn expected to be planted in the near future, CF Industries enjoys excellent margins and a free cash flow yield of over 13%. The company also has some facility to protect its margins, as natural gas can be hedged easily.