Collapsing Oil and Avoiding its Ripple Effects

February 2, 2016

A chaotic January of 2016 is over, and given the dramatic downside excursion in the equity and oil markets, even committed value investors could be forgiven for wavering. Even though prices are somewhat above their nadirs, the frequent swings of several percent a day in the oil markets and stock indexes give the impression of market participants who have no idea what is going on but feel the need to join in anyway.

Now, my specialty is not in macro forecasting, as value investors pride ourselves on having a bottom-up approach. However, bottom-up doesn’t mean bottom-and-then-stop; and furthermore, the ability to handle hypothetical economic developments helps any market participant handle actual developments, even if detailed macroeconomic projections are more trouble than they are worth. Awareness of the current economic and financial situation and how it may validate or invalidate our views of a company’s earnings power is certainly a good thing.

oil-prices1-300x225The market’s current source of bad news, of course, is the collapse in the price of oil. Always keep an eye on the bad news; good news can take care of itself. I don’t claim to know the “correct” price of oil–remember, my view is that detailed macroeconomic projections are more trouble than they’re worth–but I can look at the effect of this dramatic decline on the broader markets.

First off, I hope this puts another nail in the coffin of the view that hyperinflation is lurking just around the corner and the only cure is growth-crippling austerity. Part of the collapse of the oil prices is to do with a stronger dollar, as the Federal Reserve has been largely unsuccessful in its efforts to create higher inflation expectations and recently made an unnecessary interest rate hike presumably in order to stop those annoying questions during Congressional hearings. If anything, the problem facing our monetary policy is the risk of deflation.

The other cause of oil’s strength is the supply glut brought on by the fracking boom meeting a determined Saudi Arabia. The chief difficulty facing the frackers is that apparently oil extraction is a capital-intensive industry, and in recent years they have taken advantage of low interest rates to fund their production with high yield debt. Some of them also may have had the foresight to hedge their future production by shorting oil and gas in the forwards and futures markets, which they are bound to deliver on whatever the price. Thus, there are two reasons why the frackers go on producing oil even if it is uneconomic to do so: if they have hedges in place they don’t care about the current price, and if they don’t have hedges in place they still need all the cash they can get to pay their debts down as fast as they can.

Bringing about such a situation may have been the original intent of Saudi Arabia, as a move to eliminate the United States fracking industry the way the Japanese were accused of doing to the consumer electronics industry in the 1980s. If so, their strategy is flawed, as fracking technology can be made uneconomical for a time but it can’t be un-invented, and oil doesn’t need a brand identity the way consumer products would. The destabilizing effects on other oil-producing nations may not be so minor, but they are outside my field of expertise.

As an aside, the obsession with United States energy indepedence on the part of some of pour presidential candidates seems at present an equally counterproductive strategy, given that Saudi Arabia’s cost of oil production is said to be about $10 per barrel, while in the United States it is $36 on average according to At first approximation, then, true energy independence could cost up to $26 a barrel for every barrel of oil no longer imported, which at an estimated 9 million barrels per day, would cost $87 billion dollars a year. Perhaps if oil were much higher I would see more strategic value in it, but directly taking on a determined supplier whose cost of production is less than one third of ours is not what I would expect from the party of businessmen.

At any rate, the drop in the price of oil and the frackers trying to drill their way out from under their leverage will only exacerbate the oil glut in the short term. It seems the recent levels of fracking investment and leverage could only be justified based on the assumption that oil prices would remain high forever, which has already invited comparisons to the subprime crisis. On the plus side, oil is unlike housing, in the sense that it doesn’t stick around for decades after it’s been drilled, and so eventually some bankruptcies and production shutdowns should resolve the problem eventually. I’ve seen estimates ranging from the second half of 2016 to 2017, and again I have no opinion on when it will happen.

What concerns me, though, is not the effects that are confined to the oil sector, but those that might spread through to the broader economy. As I stated above, the oil companies financed their operations by issuing debt that is in many cases beyond their present ability to repay, at least within the lifespan of their hedges. If I were a corporate strategist, and knowing as I do that the production curve for fracking is highly front-loaded, with the majority of production occurring in the first year of a multi-year project, and certainly within the lifespan of available hedges, then I would suggest a more project-financing-based approach, where the production of a set of wells, pre-sold through the forward markets, would pay off the principal and interest of all the investments required to develop them. Perhaps fracking production cannot be projected with sufficient accuracy before the wells are actually drilled, but there has to be some solution between what I propose and the current mess. Perhaps with oil above $60 a barrel no one bothered to look for it.

This overhang of debt, though, is sending shockwaves through the high yield market already, and a wave of bankruptcies will make things worse. Moreover, not all of this debt is in the form of junk bonds; a significant portion of it is in the form of bank debt, and now the analogy to the subprime crisis can be revived. Banks have been as hungry for yield as any other fixed income investor, and they are now looking forward to writeoffs.

The risk is that the banks will have to make up for these loan losses by diverting money from their other lines of business like lending to the non-oil portions of the economy, as well as finding themselves in the position of holding uneconomical oil assets the way they were holding unproductive real estate in 2008, all of which costs them a great deal more regulatory capital than performing loans would. JP Morgan, for example, claims that its loans were backed by physical assets, but these physical assets are oil fields that are not economical to develop at $30 a barrel, and oil drilling equipment that the market doesn’t currently need because the oil fields where they would be deployed are not economical to develop at $30 a barrel. And even if the banks’ ability to lend is not greatly hampered by responding to bad debts from frackers, their desire to lend may well be.

So, where does that leave us investors? Obviously we should avoid oil, anything that extracts oil, and anyone who primarily lends money to either of them. Furthermore, any products that are energy-intensive to produce should be viewed with caution as their historical results may not be reliable and it is not a given that they can keep the difference in oil prices for themselves rather than pass it on to their customers. Also, given the strong dollar and deflationary environment, it might be advisable to tread carefully with any company that makes “things,” at least things without a substantial labor component. It might also be advisable, given the possible mess in the high yield markets, to avoid companies that are going to need to borrow a lot of money in the near future. This leaves us with service companies and financial companies that have no exposure to petroleum, and there are probably any number of them that have been unfairly punished by the market’s retreat.

Happy hunting.


The Focused Credit Mutual Fund Collapse: Liquidity, and Contagion Risk

December 27, 2015

Those of us who watch Federal Reserve Chair Janet Yellen’s hearings before Congress will often hear complaints from the majority that the Dodd-Frank regulations are overreaching in that the Treasury has the power to designate non-bank financial entities, including mutual funds, as being systemically important. However, the recent collapse of the Third Avenue Focused Credit Fund, a junk bond fund focusing on the kind of distressed junk bonds that are one of my favorite asset classes, shows that an institution does not need to hold assets in the hundreds of billions of dollars in order to wreak havoc as it fails. This fund, which a year ago had only $3 billion in assets, was down to less than $800 million owing to losses and redemptions, was forced to suspend redemptions in order to liquidate in an orderly fashion, and its forced liquidation has spread shock waves through the entire high yield market, although they seem to have been contained.

I should state that I am generally a fan of additional financial regulation, and I am concerned that the complaining about designating nonbanks as systemically important is motivated by trying to force a wedge into a crack of Dodd-Frank with the goal of dismantling the entire law.

Anyway, Going-down-2-300x300the trouble here is that Third Avenue’s junk bond fund encountered arose from its ran afoul of one of a mutual fund’s main selling points, that the fund owners can redeem their investments at any time on one day’s notice, which, if many of them do at the same time, will require the fund to liquidate assets to raise the cash. In the case of most mutual funds (or in the case of markets being efficient), this is not a problem, but Third Avenue focuses on distressed bonds which are generally illiquid.

The causes for this illiquidity essentially boil down to the natural constituency of the asset class. Distressed debt, by definition, is corporate debt where default by the issuer is more than a theoretical possibility. The distressed debt marketplace, it seems to me, is a small and fairly specialized niche of the fixed income market, populated by some very price-conscious experts commonly described as “vultures.”

The ideal owner of distressed debt, then, is one who does not worry about cash flow interruptions, who has the analytical ability to compute what a company would look like and be worth after a restructuring or bankruptcy, and who is not a slavish observer of daily or quarterly price reports, since the price of these assets both fluctuate wildly and depart from true value. These characteristics would commonly be found in a private equity fund, in a hedge fund with limited redemption rights, or possibly in an endowment or in an eccentric millionaire. They would not normally be found in a typical mutual fund shareholder.

I think much of Third Avenue’s liquidation mess is the natural consequence of reaching for yield, climbing down the credit quality ladder until eventually one falls off the bottom rung. From a value investing perspective, it is what happens when buyers focus on the naive indicators of returns, like yields, rather than on true value. The wise investor would prefer a demonstrably undervalued asset with no yield than a demonstrably overvalued asset no matter how high the stated yield is. This lesson was pointed out originally by Benjamin Graham and reiterated in many places, especially The Only Guide to Alternative Investments You’ll Ever Need: As individual assets, junk bonds can be attractive, but as an asset class they are not.

This liquidity problem is compounded by the cascade of redemptions that Third Avenue has already experienced over its recent history. If the fund has to sell assets to meet redemption calls, and does not wish to give up too much in spreads in order to meet them, then logically it will sell its more liquid assets first and keep holding the less liquid ones, which will eventually leave it holding only illiquid assets and being forced into its present predicament.

Moving beyond the troubles of this particular fund, I am concerned about the issue of contagion. Contagion played a role in the financial crisis, as banks that sponsored synthetic mortgage backed securities products through special-purpose entities faced the distasteful choice of either propping up these entities by diverting money from their other lines of business like lending money to the real economy, or by letting these products be liquidated in a falling market, thus making the defects of these products obvious to the financial community as a whole. The parallels between these banks and what Focused Credit went through are obvious, and as with Focused Credit, the banks tried the first approach, and when it failed, were forced to try the latter.

Now, in an efficient market, the last reported price is the only true and correct price, forever and ever, amen, but the market seems to have been more or less aware of the situation and has managed to shrug it off. As a result of Focused Credit’s collapse, high yield ETFs declined by a total of nearly 3% on Monday and Tuesday of the week of the announcement, although they have staged a recovery. The New York Times claims to have identified the missing ingredient that separates the Third Avenue Focused Credit situation from the typical market crash: no leverage.

However, leverage as such is not the issue; any situation involving a forced sale can become a problem in the market. Excessive leverage is one source of forced sales, but the right of mutual fund owners to redeem their assets at any time is one source of leverage. An angry phone call from a boss or a client demanding to know what you’re doing holding these assets while they’re collapsing in value is another. And for that reason, any collapse in prices, no matter what the asset or leverage in question, is theoretically capable of setting off a contagion if it is severe enough.

As another window on this subject, I will look at it in terms of options theory. Ever since options were invented, people have been trying to put them into situations where they don’t entirely belong. For example, one model in the CFA curriculum is that a company that borrows money is short a put option on itself, with a strike price equal to the amount of borrowing. This model is somewhat complicated in that the option premium is difficult to define and the Chapter 11 bankruptcy process tends to complicate the payout method, but as Charlie Munger says, wise investors should be fluent in as many models of reality as as there are, in case one of them comes in handy one day.

At any rate, Focused Credit was effectively short a put option on its own assets, or specifically the liquidity spread between the price under “normal” conditions and the fire sale conditions that arise from having to sell on a day’s notice. Relatively illiquid assets like high yield bonds already trade with a liquidity discount intended to cover this gap, but as market conditions change, this liquidity premium can become inadequate. And unfortunately, there is no market instrument that tracks liquidity in a particular sector of the market, making hedging this risk impossible. Dynamic Hedging: Managing Vanilla and Exotic Options, the book Nassim Taleb wrote before becoming famous, is a lengthy text dealing with mathematics and financial philosophy, but its key lesson is that no market participant should ever be short an unhedged option, because sooner or later they will find themselves on the wrong end of the market.

The bitterest irony, though, is that in the case of Focused Credit, the counterparty of this liquidity option is the other holders of the mutual fund, who chose to exercise it by selling early before the crisis hit. Basic game theory requires an investor who is aware of a potential liquidity problem to get out as soon as the prospect of a liquidity crisis is raised; it is no different from standing near the exit of a building in case of fire. The decision by Focused Credit to suspend distributions and liquidate in an orderly fashion cut off this process, a move which was reasonable but almost unheard of in the mutual fund industry. But at any rate, investors who genuinely cannot be forced out of their positions can happily sit like a dragon and suck up a liquidity premium they never will need. Anyone else should avoid a situation where other people can sell out first and leave them holding the bag.


Park-Ohio: An Undervalued Niche Manufacturer With Well-Chosen Acquisitions

November 9, 2015

Park-Ohio Holdings Corp. is a niche manufacturer and logistics servicer for other, larger manufacturers. It offers a large free cash flow yield of 9.4%, and has been expanding sales through well-chosen bolt-on acquisitions. Read more at


Frontier Communications? You Might Prefer the Preferred Stock

June 25, 2015

Long-time readers will know that rural telecom companies have been a particular favorite of mine. Although these companies’ core residential landline business is in decline as mobile phones become the primary phone line among an ever-increasing proportion of the U.S. population, rural telephone companies can respond by lowering capital expenditures accordingly and refocusing their offerings to embrace broadband, comprehensive business services, and fiber optic television. As a result, they have frequently shown themselves to be capable of spinning off a great deal of free cash flow even as overall sales are declining. Furthermore, these companies tend to come with unusually high dividend yields, for people who care about that sort of thing.

As a group, though, rural telecoms have shown disappointing results in the first half of 2015. Perhaps this is to be expected; I first became interested in them in the first half of 2009, when stocks were depressed and interest rates had been recently cut to zero and were likely to remain there. But as of now, in June 2015, the market is at its highs and the Federal Reserve is totally definitely planning to probably raise interest rates any time now, just you wait. Rising interest rates can present a problem for these companies, as they tend to operate under heavy debt loads. Still, this pullback makes me wonder if some of the companies have dropped back into the zone of being attractively priced.

Frontier Communications presents an interesting challenge in this regard. It has recently entered a contract to purchase some of Verizon’s landline assets, which follows two other significant but smaller landline acquisitions from AT & T and Verizon in the last few years. This larger purchase was announced February of 2015 and is expected to close in the first half of 2016, pending regulator approval. The purchase will nearly double the size of Frontier’s balance sheet, and in order to pay for it, the company has issued a new series of preferred stock, as well as a block of common stock, and apparently intends to finance the balance through taking on a great deal of debt. For reasons I will discuss later, I think the preferred stock is where the action should be for prospective purchasers.

Although the new acquisition will no doubt fundamentally alter the earnings power of Frontier, I still think it is appropriate to look at the earning power of Frontier’s existing assets. For one reason, I generally assume as a first approximation that most acquisitions do no better than earn the cost of the capital used to make them, which per Damodaran’s Investment Fables: Exposing the Myths of “Can’t Miss” Investment Strategies might even be optimistic treatment. For another reason, based on what information Frontier has disclosed about this acquisition, I think this particular acquisition will, when viewed conservatively, do little more than pay for itself, as I shall explore later.

In 2014, Frontier’s sales were $4.77 billion and reported operating income was $820 million. Depreciation was $1.14 billion and capital expenditures, not including the cost of integrating the large purchase from AT & T this year, were $572 million, leaving $567 million in excess depreciation and an overall operating cash flow to the firm of $1.39 billion. Interest expense that year was $696 million, and taxes were $30 million, although based on Frontier’s reported income about $57 million would have been more typical. This works out to free cash flow to equity of $634 million, which is a yield of roughly 12.5% not counting the stock issued to pay for the acquisition.

I have chosen not to count the capital expenditures required to integrate the AT & T purchase and the pending Verizon purchase because first, they are presumably one-time expenses that do not have anything to do with Frontier’s ongoing earnings power, and second, logically speaking they should be considered part of the purchase price of the acquisition anyway.

In 2013, sales were $4.76 billion, reported operating income was $966 million (not counting the sale of a partnership interest (which was included in Frontier’s reported operating results despite not being operating). Depreciation was $1.17 billion and capital expenditures were $635 million, producing operating cash flow of $1.51 billion. Interest was $667 million and taxes were $47 million, producing free cash flow of $787 million. Much of the decline in free cash flows between 2013 and 2014 can be attributed to operating expenditures resulting from integration the AT & T purchase, although there is still a gap of about $50 million, which can be attributed to the low-to-mid single-digit percentage declines in Frontier’s customer base, which was masked by the acquisition itself.

In 2012, though, sales were $5.01 billion, reported operating income was $987 million, depreciation was $1.27 billion and capital expenditures were $748 million, producing operating cash flow of $1.51 billion again. Interest expense was $688 million and taxes were $76 million, resulting in free cash flow of $742 million.

The reported earnings for the first quarter of 2015 were apparently disappointing to the market. Sales were $1.37 billion as compared to $1.15 billion for the same quarter last year. Operating income was $163 million as compared to $226, and operating cash flow $334 million as compared to $380, not counting integration expenses. Interest expense was $245 million as compared to $171 million, and taxes were $-30 million as compared to $17 million, producing free cash flow of $119 million as compared to $192 million for the first quarter of 2014. However, integration operating expenses for Frontier’s various acquisitions were $57 million as compared to $11 million last quarter, and removing these expenses, net of taxes, would improve that $119 million to $156 million, which is broadly consistent with the free cash flow that Frontier generated over the full year 2014. So, the earnings may have been disappointing but they were hardly disastrous, and they still represent a free cash flow yield of 12.3%.

The pending Verizon acquisition, as I stated before, will roughly double the size of the company. The Verizon landline assets to be purchased cover 3.7 million voice connections, 2.2 million broadband subscriptions, and 1.2 million FiOS (fiber optic) television connections, while the pre-acquisition company has 3.5 million voice connections, 2.4 million broadband subscriptions, and 0.6 million FiOS subscribers. Although it would be nice if we could just double Frontier’s existing figures and go home, we have to consider the possibility the assets Frontier is purchasing may be of better or worse quality than Frontier’s assets in place, or that the alteration to the capital structure caused by this purchase changes the free cash flow situation, as indeed it does.

Our first clue is the purchase price. Frontier’s current assets have a value of roughly $14.5 billion, based on a market cap of roughly $5 billion and the $9.5 billion face value of Frontier’s long term debt. The purchase price of the Verizon assets is $10.5 billion, and Frontier is projecting an additional $450 million in integration capital and operating expenses. In other words, Frontier is acquiring 3.7 million new customers for $11 billion, while the market is currently estimating the value of its current 3.5 million customers at $14.5 billion.

Because this acquisition is of a portion of Verizon’s assets, not a standalone company, there are no audited financial statements  and we are forced to rely on Frontier’s disclosures about the deal, which are naturally going to be self-serving.

At any rate, Frontier claims that the deal will improve free cash flow by 35% in the first year after the merger is completed. Frontier calculates free cash flow differently from how I do, because their figure for 2014 was $793 million rather than my $634 million, so 35% of that is $277 million or $222 million, depending on whose calculation you use. To this free cash flow to equity must be added about $675-775 million in additional interest payments on the $8.5 billion in debt Frontier will be taking on to finance this acquisition, producing a range of free cash flow to the firm (which is the amount of money the firm has available to distribute to all of its capital assets, whether in the form of interest, dividends/share repurchases, or undistributed earnings) of between $900 million and $1.05 billion, depending on whose estimates you use. The free cash flow to the firm to Frontier’s assets in place, recall, was about $1.4 billion for fiscal year 2014.

So, the purchased assets are projected to produce $1 billion in free cash flow to the firm for a purchase price of $11 billion (counting integration costs), while the existing assets produce a free cash flow to firm of about $1.4 billion for an enterprise value of $14.5 billion. In either case, then, the free cash flow yield is just a hair under 10%, so at least as a first approximation the assets purchased from Verizon seem to be of the same quality as Frontier’s existing assets.

As I said above, Frontier is intending to take on $8.5 billion in debt to purchase Verizon’s wireline assets, but on top of that the company has issued roughly $2 billion in equity, consisting largely of preferred stock but with some common stock added as well. For reasons I will go into, I believe the preferred stock is an attractive method to participate in Frontier, as compared to the common stock.

Preferred stock generally ranks alongside high yield bonds as a generally unattractive asset class, as it typically represents equity-like risk without the equity-like unlimited upside. This point has been hammered home in both Security Analysis and The Only Guide to Alternative Investments You’ll Ever Need. Preferred stock has the added disadvantage that, unlike with junk bonds, the company is at liberty to suspend its dividends without being forced into bankruptcy (although the company’s actual creditors will definitely take note).

Frontier’s preferred stock issue consists of $1.925 billion of preferred stock that pays a dividend of 11.125%. This preferred stock trades under the symbol FTRPR and is currently priced at just above its face value of $100 per share.

These preferred shares have the typical features of preferred stock, meaning that the dividend is cumulative, i.e. if Frontier declines to pay a dividend on the preferred stock it is theoretically required to make it up in subsequent quarters, and that unless the dividends on the preferred stock are current, the common stock will not receive a dividend either. Since Frontier’s management is aware that most people invest in it for its 8% dividend yield, it is equally aware that missing a preferred dividend would be shooting itself in the foot. However, Frontier disturbingly reserves the right to pay the dividend in common shares rather than in cash, and this action would not cut off the right to dividends on the common stock. However, paying a dividend in common shares would also probably be a sign of weakness that Frontier’s management would be reluctant to make lightly. But, if they do, look out below.

The key provision that separates this preferred stock from the vanilla preferred stock, though, is the mandatory conversion privilege. At the end of June of 2018, this preferred stock will automatically convert to common shares of Frontier at a rate depending on Frontier’s common stock price at the time. If Frontier is at $5 or below, each $100 preferred share will convert into 20 shares of common stock. If Frontier is between $5 and $5.875, each preferred share will convert into a number of shares equal to $100 divided by the share price. And if Frontier is above $5.875, the preferred shares will convert into 17.01213 common shares (equal to 100/5.875) no matter how high the price is. Thus, the holders of these preferred shares are allowed to participate in the upside of the common shares under certain circumstances. As of Wednesday, June 2015, the time of this writing, Frontier is at $5.065.

In order to properly evaluate this preferred stock, then, it would be helpful to look at option theory, because the holder of these preferred stock is essentially short a $5 put and long a $5.875 call that expire at the end of June, 2018. In between those two points the exposure to the price of the common stock is purely linear. In order to evaluate these options I will be using the Black-Scholes, not because it produces necessarily accurate results (in fact, its results almost never even match the market prices of different options on the same stock), but because its defects are well-understood by options traders, who can react accordingly, as stated wisely in Nassim Taleb’s Dynamic Hedging: Managing Vanilla and Exotic Options

As a starting point, the January 2016 $5 put has a market price of 62.5 cents, and the January 2016 $6 call has a price of 20 cents. Using my Black-Scholes calculator on Excel (which works essentially like everyone else’s Black-Scholes calculator on Excel, so I needn’t go into detail), I find that changing the strike price of to $5.875 produces an implied value of 23 cents. Then, extending the options’ lifespan to the end of June 2018, I get a value of $1.33 for the put and 93.6 cents for the call. Furthermore, the delta of the put is -.3856 and the call is .5181, which will come up later.

As an aside about my methods, the price one uses in the Black-Scholes model should technically be the forward price, i.e. the expected price stock will have at expiration. Normally, this technicality is ignored, since the forward price is simply the current price compounded at the risk-free rate and adjusted for expected dividends, and at typical interest rates in Western countries and for typical option lifespans, the difference between the forward and the current price is negligible.

However, when looking three years into the future, the price of a stock is going to be dominated by earnings and cash flows, not risk-free compounding and dividends. Although Frontier is likely to pay out its 8% dividends for three years, it is also likely to make the capital investments necessary to maintain its earnings power to produce the money that pays the dividends . Therefore,  assume for purposes of these calculations that the best guess for the forward price of Frontier is the current price of Frontier, without adjusting for dividends. There are other reasons for making this assumption that I will speak of later.

Returning to the value of the preferred stock, the above options prices are based on a 100-share contract, but the preferred stock converts into 20 shares at $5 or below and 17.02 shares at 5.85 or above. Thus, each share of preferred stock is short $26.6 worth of puts and long $15.92 worth of calls. This further implies that the value of the preferred stock without these two options would be $110.68 ($100 + $26.6 – $15.92) and offer a dividend yield of 10.16%.

The reason I calculated the deltas above is to determine how closely the preferred stock will track the price movements of the common stock. The dollar delta of the short put is $7.73, and for the long call it is $8.82, total $16.55. In other words, at the current price if the common stock moves up by $1, each $100 share of the preferred stock would be expected to appreciate by $16.55 as a result of these options.  At current prices, $100 of common stock is 19.74 shares, so if it appreciates by $1 the gain would be simply $19.74. So at this moment, despite the fact that any appreciation of the common stock before $5.875 a share is not reflected in the conversion amount, the preferred still captures 83.8% of the price movements of the common stock.

As I said, I have other reasons for assuming that the future price of Frontier is likely to be its current price. The first one is that this asset purchase is not likely to increase the value of Frontier’s existing equity in the short term. I calculated above that based on Frontier’s own disclosures the conservative estimate of increased free cash flows to equity is $222 million in the first year. However, the company has issued $1.925 billion in preferred stock at 11.125%, and the dividends required on that amount are $214 million, and the $80 million or so in common stock, bearing a dividend yield of roughly 8%, will suck up the rest. It is true that Frontier is projecting an additional $175 million in annual synergies by the third year after the merger, i.e. 2019, but the company is more likely to use that additional money to pay down its substantially increased debt load, rather than let it flow to shareholders. Also, as Damodaran concludes from examining many studies in his Investment Fables, synergy is difficult to count on anyway.

The second reason the future price is likely to stay between the two option prices is because of the dilutive effects of the conversion itself. Unlike ordinary options, which are basically side bets that don’t affect the performance of the underlying stock, these preferred shares, when converted, will become additional shares of the common stock, and since there are about $2 billion in preferred shares and $5.1 billion in common shares, the effect of converting at a favorable or unfavorable level will be significant. If the shares are significantly below $5 at the time of conversion, the common shares will have received $2 billion in financing for a price significantly below $2 billion in common shares, but if the price is significantly above $5.875, the preferred shareholders will receive much more than $2 billion for their equity purchase. As a result, it is easy to see that the price will have a much harder time moving beyond $5 or $5.875, because each such move will produce negative feedback from the dilution effect.

And that is the key provision, in my view, that makes the preferred shares a superior bet to the common. As stated above, at current share prices the preferred shares are projected to gain 183.8% of the common price movements anyway (although it is the nature of options that this is unstable and will require recalculating as time passes or the price of the common stock moves).

Furthermore, because they have a mandatory conversion, their upside is also going to be subject to the braking force the common stock will receive to the upside. Therefore, the income-oriented investors who tend to follow rural telecoms in the first place would be better off having the preferred stock, which has a higher dividend yield and largely similar price behavior properties. Also, because the common shares of Frontier are currently at the bottom end of their likely price range, and the preferred are expected to gain roughly 183.8% of the current price movements (at least at the current price range; that percentage will likely decline as the price rises), the preferred shares are actually more responsive than the common shares to Frontier’s upside at current prices.

So, there are three reasons why I think the price of Frontier is likely to stay flat over the foreseeable future. The first is because the Verizon acquisition seems to be for assets of no better quality than the existing Frontier assets. The second is that if the assets prove to be of better quality due to synergy, the cash flows resulting from that synergy will go to pay down debt, not to the equity holders directly. The third is because the structure of the preferred stock enforces a price range for the common shares of $5 to $5.875, which Frontier is at the low end of, and any upward movement in the common stock at these prices will help the preferred stock more than the common. Therefore, those investors who are considering going long in Frontier would probably be better off with the higher-yielding preferred shares.


Aspect Software: Press 1 to Purchase Attractive Junk Bonds

June 6, 2015

Update: Yes, the company has declared bankruptcy and the bonds, being junior to the bank debt, have been damaged done badly, having been converted to rights to purchase up to $90 million in equity. I confess I got this one wrong, but I’m not going to cover over my mistakes by deleting this post.

As I’ve said before, high yield debt, or junk bonds tend to be among my favorite assets. Not my favorite asset class, mind you, just my favorite assets. As an asset class, high yield debt straddles the line between debt and equity, combining the capped appreciation potential of the former with the latter’s inability to diversify an existing equity portfolio the way investment-grade debt would. This conclusion, as stated in The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad, and the Ugly (which is a good introduction for the non-professional wealth manager), was the fruit of a number of fairly lengthy and impressive studies that managed to conclude essentially what Benjamin Graham figured out in the 1930s from ordinary common sense.

However, value investors look at assets individually, not as asset classes, and the returns available from an underpriced debt instrument can rival those of an underpriced equity. True, a bond can rise only so far before the issuer calls it, but a stock can only rise so far before it ceases to be underpriced as well, and on an annualized basis the returns can be quite impressive, particularly if the bond price appreciates to fair value rapidly.

Call-CentersAspect Software is a privately held company with publicly traded bonds. According to the company’s filings with the SEC, the company sells fully-integrated customer interaction management solutions, including workforce optimization and back office products, using cloud, hosted, and hybrid development options, so that contact centers and back offices align their employees, processes, and touch points to deliver remarkable customer experiences, and integrating customer self-service, contact center operations, workforce optimization and back office workflow solutions into existing enterprise technology investments to remove communication and workflow barriers and/or create more productive business processes. Or, in English, they sell software and IT for call centers.

The company is currently migrating its systems from a traditional hardware-intensive setup to cloud-based solutions. The company claims that this move will allow it to lure a broader base of customers which may be reluctant to make a larger capital commitment. Also, the company provides support for web-based or app-based live help and e-mail and SMS-based systems.

Aspect Software claims that about 2/3 of its business is recurring, as switching providerscauses a significant disruption in operations and a consequent decline in customer satisfaction, which tends to outweigh the potential benefits of a new provider. Because their client base is therefore a “captive audience,” stability of revenues is enhanced, which is an attractive feature that also played a role in my recommendation of CSG Systems, and that went very well (Past performance is not necessarily indicative of future results).

Aspect Software’s capital structure, like most issuers of junk bonds, consists of a substantial bank debt that has priority in security over the bonds, which are more readily available to the public. Again, the company is privately held, but the 10-K is riddled with suggestions that there are plans to go public at a future date, such as the granting of stock options to employees. The bank debt balance is about $440 million, and it bears interest at the greater of 7% LIBOR plus 5.25%. This debt falls due to be refinanced in May of 2016.

The bonds that concern us have $320 million in face value, pay 10.625% interest annually and fall due in May of 2017. Recently the bonds have traded at a price of around 96, making a yield to maturity of approximately 13%. The bonds have traded as low as 90.25 within the last 30 days. Over their lifetimes the bonds have frequently traded at a premium to par and even to the call price.

Turning to Aspect Software’s financials, in 2014 the company had sales of $445 million and reported operating income of $62 million. Depreciation and amortization came to $23 million and capital expenditures were $13 million, producing operating cash flow of $72 million. Income taxes are negative because the company has net operating loss carryforwards and significant noncash charges that make it unprofitable in accounting terms. The company’s cash interest requirements that year were $68 million, which produces an interest coverage ratio of 1.04. Although that coverage ratio is far, far away from investment grade, Aswath Damodaran states that in the current high yield market such a bond is normally entitled to a mere 8% premium over a comparable Treasury. This bond, at a 13% yield, offers a premium of over 12%. In 2013 sales were $437 million and operating cash flow was $73 million, and in 2012 sales were $443 million and operating cash flow was $103 million. Much of the decline in operating cash flow was the result of a large excess depreciation and amortization allowance, since Aspect started investing in its cloud offerings in 2013, which required a higher level of capital expenditures.

The first quarter of 2015 showed some improvements. Sales declined slightly, but the company was able to save in cost of revenue and in general and administrative expenses, improving operating cash flow to $24.8 million versus $16.5 million for the first quarter of last year.

Taking $72 million as the company’s earnings generation power, the $440 million in debt that is senior to the bonds will consume about $31 million in interest payments. If we collapse the bonds and the equity (not an unfair assumption considering the face that the residual value of the equity is likely to be minimal), we would find that $41 million of cash flow against $320 million in bonds is a multiple of just under 8x. This strikes me as rather conservative, if the company’s claims about their high degree of repeat business and the cloud-based solution requiring less resources on everyone’s part hold true. In fact, the company’s publicly traded competitor, Interactive Intelligence, has a price to sales ratio more than twice as based on its entire capital structure, and it has negative free cash flow (although it is free of long-term debt).

Therefore, I think a 13% yield is sufficient compensation for the risk, as even in the event of a bankruptcy the bonds should retain nearly all of their value as the company is showing no signs of declining business. Thus, I can recommend Aspect Software’s bonds as a candidate for portfolio inclusion for investors who can find room for high yield debt in their portfolios. I would add a caveat, though, that the bank debt falls due to be refinanced before the bonds do, and depending on how well that process goes, this refinancing could be an important positive or negative catalyst for these bonds


Back from the Warren Buffett Convention!

May 6, 2015


You’ll never guess where I’ve been. Yes, the Berkshire Hathaway annual shareholders’ meeting in Omaha. And here’s how it went.

The meat of the meeting occurs on Saturday, where Warren Buffett and his co-chairman, Charlie Munger, spend hours fielding questions from the financial press and from lucky audience members. I would have asked, but most naturally my questions would run dangerously  close to the forbidden topic of what Berkshire is buying. All other topics are fair game.

The doors to the CenturyLink convention center in Omaha opened at a nice jet-laggy 7 A.M., which was about the time my group of three arrived at the end of the line, and we still barely managed to find adjacent seats. The crowd of about 40,000 was a record, and even though there were overflow rooms in the hotel near the center, it still seemed as if the shareholders’ meeting has become bigger than Omaha. At the very least, some manner of assigned seating would probably be in order in future meetings.

IMG_20150502_074624_072The first question invited Berkshire Hathaway to respond to a critical article about the allegedly predatory practices of Berkshire’s prefabricated housing subsidiary, Clayton Homes, and also its strategic partnership with well-known takeover artist and heartless downsizer, 3G Capital. As for the first charge, Buffett replied that the prefabricated homes market tends to target the lower end of the credit spectrum anyway, that its profit margins were not in fact out of line with the rest of the market, and that the company was not an aggressive securitizer and so it actually suffered when its customers went broke. As for the downsizing argument, Mr. Buffett made the point that Berkshire Hathaway has never suggested that a company should intentionally overstaff itself and that Berkshire Hathaway would just as happily shed its useless employees if it knew that it had any. In my view this sidestepped the question of whether 3G and Berkshire have different definitions of useless, but more importantly, because of the slides he had to support the defense of Clayton Homes, he had to explain after lunch than the firm was sticking with the tradition of not getting the questions in advance; it just happened that he was expecting that question and came prepared.

I’m not going to go through all the questions, but there were a few highlights. One question was whether, in this time of diabetes and healthy diets, Coke would retain its popularity. Warren and Charlie pointedly took a piece of from their box of See’s peanut brittle, and replied that Coke’s value came from its unassailable brand, and that Warren personally derived about a fourth of his caloric intake from sugar and that, in all fairness, the people shopping at Whole Foods are usually not smiling. I agree that in general a strong brand offers pricing power, which offers protection against competition and some adverse future developments, and it never hurts to be assured of being a larger piece of a smaller market.

On the topic of the current high levels of market valuation, he was asked if we should be worried that the total US market cap/GDP ratio was 1.25x, a level last reached in 1999, and that corporate profits/GDP was 10.5%, whereas its historical range was 4-6.5%. He said the second one is a thorny problem of income distribution that goes beyond stock multiples, and the first one is a predictable consequence of low interest rates. In his response to another question along these lines, the two chairmen did express surprise that all the government intervention since 2007 has not resulted in inflation, but in face it does, a lot of Berkshire Hathaway’s subsidiaries are capable of keeping up with inflation, although the company’s $60 billion in cash reserves might start to look better if they were invested in something.

The issue of tax reform came up, and Mr. Buffett expressed his optimism that Senators Hatch and Wyden would be able to come up with a deal that addresses the high corporate tax rates and the issue of offshoring. Mr. Munger added his complaint about California’s unusually high state capital gains tax rate, which he said was chasing rich people away. This comment drew a great deal of applause. Of course, an audience of Berkshire Hathaway shareholders is not going to be receptive to the idea that their taxes are too darn low, but someone with Charlie Munger’s intelligence must be aware that the problem with California’s tax system is Proposition 13, which caps the annual growth of property taxes at a rate that has until recently been below the rate of inflation, a problem that accumulates exponentially over the years and which is also in my view the problem with California’s public education system. Warren Buffett did circle back by saying that if the federal government is going to spend 20% of its GDP, which it has roughly done for the last several decades, then it has to raise about 19% of the GDP in taxes, one way or another, with the extra 1% capable of coming from economic growth. As with many statements from Warren Buffett, this one is simple and broadly uncontroversial math, but has the rare quality of being expressed in one clear sentence.

As for insurance, Berkshire Hathaway’s favorite division, Buffett was asked if Berkshire’s phenomenal performance in this sector could be repeated. He did cite three lucky turns in his life, two of which were acquisitions and the third, which came before either of them, was finding a mentor in the insurance industry who taught him the secret that in the time between when an insurance company collects a premium and when it pays a claim, the money is the insurance company’s to play with, a practice that has served Berkshire Hathaway incredibly well over the years. In response to another question, about reinsurance, Warren Buffett replied that the reinsurance market was overpopulated wiht capital at the moment because some silly person reminded the world’s portfolio managers that natural disasters are not correlated with the stock market and the general economy, and in the mainstream financial world “not correlated” is more important than “not unprofitable.” Probably a useful thing to remember when examining reinsurers generally.

Another key point was the question of share repurchases, which came up in a tangent in a response about how to deal with activist investors (the secret, unsurprisingly, is to run your company so well that there is nothing for them to do and have no tax-efficient breakup value either). Warren Buffett answered that most companies engage in share repurchases at the worst times, when a company’s shares are overpriced. But he might have revealed more than he intended when he added that he would consider repurchasing Berkshire Hathaway at 120% of book, but certainly not 200% of book. This range might be too wide to trade, considering Berkshire Hathaway’s price/book ratio of 140%, but if the price moves towards either of those extremes the alert investor can trade accordingly.

Still, despite the early hour I did greatly enjoy the shareholder meeting experience, and I even picked up a souvenir T-shirt at the trade floor downstairs.
Not that I’ve ever been accused of false modesty, of course.


Black Box – Worth a second look

September 24, 2014
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As some of you may recall, a couple of years ago I recommended Black Box Corporation, a company that mainly performs IT installations and maintenance for companies and government entities that don’t have the resources to handle such a project in-house. Well, unfortunately the company encountered a decline in sales and margins owing to weakness in capital expenditures and the sequester affecting many of its government clients, and so the price action has been disappointing.

However, there are indications that the decline in sales and margins are moderating, and the shares still produce a substantial free cash flow that meets our 10% rule of thumb. Moreover, it appears that management sees no alternative than to deploy its free cash flow into repurchases, and given the company’s high interest coverage, there may even be scope for the company to swap debt for equity by borrowing money to fund further repurchases or even special dividends.

For more, see


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.