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.


Owens-Illinois: An Attractive Global Glass Company

July 22, 2012

Owens-Illinoisis is the leading global manufacturer of glass packaging, with a high free cash flow yield and the ability to pass its inflation costs through to its customers. I highly recommend it.

For my full view on the company, see


Cablevision: Reasonably Priced with Substantial Free Cash Flow

July 6, 2012

I have long been attracted to companies with a high level of free cash flow, and I have found that telephone companies have been a fruitful place to look, as the companies combine a cash flow orientation with a recurrent source of income. And I think cable companies may have similar investment characteristics. There is something to be said for a company that requires an affirmative action from its customers in order to stop receiving service. After all, when I cancelled my cable service it was because I realized that it had been months since I actually watched TV.

My attention was recently drawn to Cablevision (CVC), a company with about 3.25 million customers in the New York City area. The company also offers high speed Internet and VoIP. The company has also recently acquired Bresnan Cable, a firm which supplies several regions in the foothills of the Rocky Mountains. This acquisition was funded through the issuance of debt and improved the 2011 results significantly as compared to 2010. The company’s debt load, although significant, gives every impression of being manageable. Cablevision’s New York operations showed flat or very slight growth as well in 2011.

Cablevision also owns non-cable operations such as a newspaper company, a chain of movie theaters, and a high school sports network. In my opinion these other assets should be divested, as the newspaper company is paying an interest rate of 10%, while the management admitted in their latest conference call that the movie theater chain had a negative EBITDA once the contributions to corporate-level expenses were taken into account. Since a positive EBITDA is just about the lowest hurdle a company should be capable of clearing, the grounds for disposal seem pretty clear.

There is speculation is that Cablevision is trying to position itself to be acquired, and the company has in the last two years spun off Madison Square Garden, Inc., and AMC Networks, a collection of cable channels. Some observes believe that the reasons for the spinoffs were in order to make Cablevision a pure cable company that would be a better “strategic fit.” However, this rumor has been floating around for some months now, and in my view the possibility of a takeover should be a bonus, not the sole reason for investing. However, the company also owns more than 21 million shares of Comcast, which it claims to have received as the result of various transactions. The company has fully hedged this position with futures, but one wonders if the shares serve a strategic purpose.

I should point out before addressing the figures that the company has two series of shares outstanding. There are 217 million class A shares outstanding that are publicly traded and entitled to one vote, and 54 million class B shares that are held by the controlling family and entitled to ten votes. The class B shares are not publicly traded, but may be converted into class A shares on a 1:1 basis.

The company has about $5.2 billion in bank debt, which bears interest rates of a little over 3% on a weighted average basis, not counting the newspaper’s debt I referred to above. However, these debts come with an extension fee of between 2 and 2.5% per year. There are is also $5.4 billion in notes  that have an average interest rate of roughly 8%. However, in the previous year the company refinanced some of its notes at 6.75%. The company’s overall interest rate on its long term debt would be 6.9% based on its first quarter 2012 interest expense, and so it is not evident that the market is punishing Cablevision for its high debt load.

In 2011, sales were $6.7 billion, operating income was $1.23 billion, depreciation was $1.02 billion, and capital expenditures were $814 million, producing $1.43 billion in operating cash flow. Interest expense was $757 million, leaving $683 million in pretax cash flow, or $410 million in estimated after-tax free cash flow, with a tax rate of 40%. All figures are calculated without taking into account changes in working capital

In 2010, sales were $6.2 billion, operating income was $1.19 billion, depreciation was $887 million and capital expenditures were $823 million, producing $1.24 billion in operating cash flow. Interest expense was $711 million, leaving $530 million in pretax estimated free cash flow, or $318 million. I should point out here that this was the year of the Bresnan acquisition, but the company estimates that even setting aside the acquisition, revenues were up 1.2% and operating income was up 2.1%. It is also noteable that the interest coverage ratio based on operating income has barely moved despite the debt-funded acquisition, while free cash flows have improved considerably.

In 2009, sales were $5.9 billion, operating income was $1.06 billion, depreciation was $916 million, capital expenditures were $737 million, producing $1.23 in operating cash flow. Interest expense was $673 million, leaving $562 million in pre-tax cash flow, or $337 million after taxes.

However, in the first quarter of 2012 sales were $1.66 billion, as compared to $1.65 billion in the first quarter of 2011, operating income of $250 as compared to $298, depreciation of $253 versus $243, capital expenditures of $216 versus $131, producing $287 in operating cash flow versus $412. Interest expense was $182 million versus $191 million, producing $105 million in pretax cash flow, or $63 million after estimated taxes versus $221 and $133 million, respectively.

Cablevision’s has explained the decline in operating income as being  largely due to increased operating expenses, specifically $25 million in programming costs, $15 million in operations and network-related costs owing to increased network and customer premises maintenance expenses, and $6.5 million in VoIP-related matters, of which $3 million was an arguably nonrecurring settlement with the New York sales tax authorities. These three factors add up to $46.5 million and make up virtually all the gap in operating income between $250 million and $298 million in the first quarter last year. I should also point out that programming costs are generally charged on a per-subscriber basis, so these are variable costs that can be passed on to customers.

As for the increase in capital expenditures, Cablevision’s management explained during its first quarter 2012 conference call that the purpose of the expenditures was to make key network upgrades and to support their networked DVR system, and that some of the expenditures were for future projects that had been accelerated. However, they also stated that the increased capital spending will probably continue through 2012, although they did not state at what level. I am hopeful that the newly efficient network should reduce operating expenses in future years. In the conference call management also revealed that the company had not thus far announced a rate increase in 2012, which allowed the company to slightly increase its subscriber count but which left revenue relatively flat. So it is not clear to what extent a future rate increase would hamper Cablevision’s customer retention efforts.

The company offers a dividend yield of 4.5% based on current prices and has raised the dividend twice in the last two years by a total of 50%. Cablevision also disclosed in its conference call that it could have further increased the dividend this year, but declined to do so. Even so, management has increased its repurchase authorization and repurchased an additional $49 million, or roughly 1.4% of outstanding shares, in the first quarter. As I’ve said, I’m not that convinced about the wisdom of buybacks as a means of creating value.

So, in terms of valuation, Cablevision is, as I said, controlled by the class B shares. The customary method of handling this is to assign these shares a control premium, which normally ranges between 20 and 50%. I think 30% is a useful estimate. Thus, the 54 million class B shares should count as 70 million in computing relative share weights. Therefore, the remaining 214 million class A shares should have an effective claim of 75.3% of the company.

If I had to estimate the company’s earnings power based on free cash flows, I would  assume that in the near future the company would at least make some attempt to pass on the increased programming costs on to the customers and that the rate increase may have been deferred this year but should occur eventually. Also, I am convinced that at least some of the incremental capital expenditures were based on the acceleration of future projects and so the current expenditure level is higher than would ordinarily be required to maintain Cablevision’s earnings power. As a result, we could split the difference between 2011 and 2012 so far, and estimate the company’s earnings power at roughly $400 million in free cash flow per year. But even as I write this paragraph, I am aware that sound value investing should not rest on too any assumptions, and that a key difference between a value investment and an attractive speculation is the lack of conditional statements. So I do not deny that this stock may not qualify as a pure value play at current prices.

Even so, $400 million per year, capitalized at 10x, would support a value of $4 billion, or $3.01 billion to the class A shares based on the control premium. Based on the current price of $13.25, the current market value of the class A shares is $2.84 billion. So there is a slight upside based on the current earnings power, and a future rate increase would serve to increase that upside.

Therefore, I can say that Cablevision, although perhaps not a pure value play, is a fairly-priced company that offers a reasonably substantial prospect of significant free cash flow generation, and should be a candidate for portfolio inclusion, especially if the share price should fall further.


Dell’s Dividend: Why Now?

June 19, 2012

As you may know, a few weeks ago Dell reported remarkably disappointing earnings of 43 cents a share on a comparable basis versus 55 cents in the year-ago quarter, which caused the price to decline sharply. In my view, taking DELL’s substantial cash position into account and even allowing these bad results to be indicative of the future, the company remains dramatically underpriced. Even so, the most disturbing development of the quarter was the negative cash flow from operations, which has not occurred at DELL since the third quarter of 2008, although based on the last few years the first quarter seems to be Dell’s weakest in terms of operating cash flow. Furthermore, the cause of the negative cash flow comes primarily from investments in working capital, which I tend not to place a great of weight on.  Another contributing factor to the decline was a $100 million increase in research and development, which some finance professionals believe straddles the line between expenses and capital investments anyway.

However, last week the company also announced that it was instituting a modest dividend, perhaps intended to supplement or replace the billions in share buybacks the company has accomplished over the recent decade. In fact, Dell has repurchased at least $2 billion in stock in every year since 2001 apart from 2008 and 2009, with a peak repurchase of over $7.2 billion in 2006, and totaling $30.6 billion in net repurchases (repurchases minus issuances) between 2001 and 2012. This figure is significantly greater than Dell’s current market cap.

However, these repurchases have not had their desired effect on the share price, which is nowhere near as high as it was when the repurchasing began. When the dividend was announced, the price received a small boost which seems to have evaporated in subsequent market action. Perhaps this serves to expand the shareholder constituency, as some market participants are restricted to dividend-paying stocks, but those constituents are in the minority and probably would not represent much in the way of marginal buying given Dell’s current unpopularity in the market. This leads us to wonder why Dell should choose now to initiate a dividend.

The conventional wisdom pertaining to dividends is that in addition to returning excess money to shareholders, they also provide information to the investment universe. A regular dividend is something that the company is usually willing to defend even in the event of a downturn, and indicates that a company has a baseline level of earning power that investors can rely on. On the other hand, a company with profitable investment opportunities would be better served reinvesting its cash flow into growth projects, and so a dividend suggests that the company has definitely moved beyond the growth phase and into the mature phase, where growth is likely to be limited to the overall growth of the sector and ultimately the GDP of the target markets. Of course, anyone familiar with Dell would not be surprised by this revelation; Dell’s return on assets according to Yahoo finance is a little over 6% (although setting aside the large cash balance would improve it to about 9%), and its reinvestment rate is lower than its depreciation rate and much lower than its free cash flow. By contrast, share buybacks have the perception of being temporary and perhaps indicative that the company’s free cash flow is nonrecurring (although many, if not most companies nowadays do at least repurchase the shares that are granted through stock options).

Dell has joined Cisco as being a company that has repurchased vast amounts of stock while its share price has declined. However, the question is whether this is a defect in the theory of share repurchases. Basic financial theory holds that a company is worth the money it has plus the present value of the money it will have (positive or negative). In this sense, a share buyback would have the same effect as a dividend; it reduces the value of the remainder of the company by the size of the buyback, and the effect on the share price depends on the price/book ratio and other factors. Aswath Damodaran, author of Damodaran on Valuation: Security Analysis for Investment and Corporate Finance, a useful toolkit of standard valuation techniques, adds the further complication that the market may not value the cash of a company at its face value. He writes that if the market believes that the cash is just sitting there waiting to be wasted by management, shareholders will value it at a discount, making a repurchase (or dividend, presumably) a good move, while if the cash is a strategic asset that will be deployed in value-creating expansion projects, the cash will be overvalued and therefore returning it to shareholders is a decision that would be punished.

In Dell’s case, according to the latest 10-K filing 80-90% of the company’s cash is held outside of the United Stated, presumably to save on repatriation taxes. I have the impression that the market places very little value on it at all, at least unless a repatriation tax holiday is declared. This view may be irrational, considering that the US corporate tax rate is unlikely to rise, so at least 65% of that overseas cash can be counted on.

However, for those of us who reject the efficient market hypothesis there is the additional twist of the value effect of share repurchases. The decision of how to return money to shareholders should depend on whether the stock is cheap or expensive. If the stock is cheap, a repurchase would theoretically benefit the remaining shareholders more. Effectively the company is repurchasing assets that has a market cost of capital of 16% or more (based on the P/E ratio of 6, and that is before adjusting for cash) when the justified cost of capital is far lower. If, however, a stock is fairly priced, management would be better served, or at least equally served, by employing dividends. And of course if the stock is overpriced, management’s best move is to arrange a stock-for-stock merger, as with AOL-Time Warner.

So, from that perspective, and given my view that Dell is underpriced, now is a bad time to divert $500 million, which is about what the proposed dividend will come to in a year, from the repurchasing budget to the dividend budget. If anything, repurchasing would be more effective now at the current price than a higher one. I still think Dell is underpriced even if the decline in earnings is persistent, and this dividend decision won’t push me into selling it, but I still think that now is not the time for a dividend.

Disclosure: At the time of this writing, author owned shares of DELL.


Harland Clarke Bonds – A High Yield Opportunity

March 9, 2012

M & F Worldwide is a company that has come across my screens many times in the past, but I never could bring myself to write about it. The company was taken private last September by the well-known takeover artist Ron Perelman, and unfortunately for me, I’m not on record as saying it is an attractive opportunity. However, I recently discovered that the bonds of the company’s main subsidiary, Harland Clarke, represent a similarly attractive opportunity.

There are two series of bonds outstanding, one that pays LIBOR plus 4.75%, or 6% whichever is higher, and an ordinary fixed rate bond that pays 9.5%. The floating rate bond currently sells for 68.50, while the fixed rate is at 80.25, with a yield to maturity of 18.5%, a current yield of 12%, and a yield assuming no reinvestment of 14.9%. Both bond series fall due in 2015. About $300 million of each series of bonds were issued, but thanks to buybacks there are $202 million of the floating rate bonds and $271 million of the fixed rate bonds outstanding.

These bonds rank in priority behind a $1.7 billion credit facility which falls due in 2014, and which will have to be renegotiated then. The credit facility currently has an interest rate of LIBOR plus 2.5%, or the prime rate plus 1.5%, or the federal funds rate plus 2%, whichever is lowest. Obviously, based on the current bond yields the interest rate is likely to come up in 2014, and the uncertainty surrounding this is no doubt a contributor to the high yields on the bonds.

Harland Clarke is the main operating asset of M & F Worldwide, the other, much smaller piece being a producer of licorice flavoring for tobacco. Harland Clarke mainly produces checks and business forms and stationery. The company also operates a financial solutions segment that facilitates financial applications and online transactions, as well as Scantron products and an associated suite of educational testing and grade management applications. The latter two segments each contributed 17% to total sales in fiscal year 2011. Obviously, the printing industry is in a decline and undergoing consolidation, as I have stated in my other articles about RR Donnelley and Deluxe Corp, and this fact is no doubt another influence on the high yield. However, although the businesses are declining they are spinning off a lot of free cash flow along the way. Harland Clarke has been focusing more on expanding its lines of business through complementary acquisitions, unlike RR Donnelley, which is focusing on consolidation.

The acquisition price that Ron Perelman paid, which implied a value of roughly $450 million for the entire company, is dwarfed by the roughly $2.25 billion in debt, but the involvement of a talented takeover artist is a vote of confidence in the company’s future. Furthermore, at current valuation levels even assigning a normal interest rate to the company’s debt, interest would be adequately covered.

Turning now to the figures, in fiscal year 2010, sales were $1.671 billion, reported operating income was $297 million, asset impairments were $3 million, and excess depreciation was $126 million, producing operating cash flow of $426 million. Interest expense that year was $116 million, but even if interest was a more realistic $200 million it would be covered more than twice.

In 2009, sales were $1.712 million, operating income was $250 million, asset impairments were $44 million, excess depreciation was $137 million, producing operating cash flow of $421 million.

In 2008, sales were $1.795 million, operating income was $265 million, asset impairments were $2 million, excess depreciation was $124 million, producing operating cash flow of $391 million.

2011 is somewhat weaker than 2010; setting aside a change in contingent liabilities which is probably nonrecurring, the first three quarters of 2011 produced free cash flow of $278 million, which would be $371 million on a full year basis, as compared to $329 million for the first three quarters of 2010. However, $24.3 million of this diminution of income was the result of acquisition costs, including deferral of revenue.

The company has also taken restructuring charges, which normally one would treat as nonrecurring, but the business has been in restructuring mode for years and probably will continue to be for the foreseeable future, so I would not be inclined to treat them as nonrecurring or even noncore.

One mode of analysis is to start with the bankruptcy and work our way backwards, an approach suggested in many guides to distressed debt investing, including Distress Investing: Principles and Technique by veteran bankruptcy investor Martin Whitman. So, if we allow $350 million in cash flow per year, and rewrite the capital structure to provide an interest coverage ratio of 3, this gives us roughly $120 million per year in interest payments. Capitalize that at 9% and you get $1.33 billion in supported debt. The remaining $230 million, after estimated taxes, produces $138 million per year. Capitalized at a multiple of 8x, this is an additional $1.1 billion, so there is a total of $2.43 billion even under these conservative assumptions. Assuming, quite reasonably, that the secured credit facility must be fully satisfied before the bonds must be paid, that still leaves $710 million in value to satisfy a pair of bond issues that collectively sell for $357 million.

Even if we assume that the senior credit facility would want to take all debt and no equity, $1.72 billion charging 10% in interest would cost $172 million a year. Subtract that from $350 million in pretax free cash flow to firm leaves $178 million, or $107 million before estimated taxes. Capitalize that at 6x (for the lower interest coverage) and that still leaves $642 million, again stacking up nicely against the current price of the bonds.

The question, though, is whether that Chapter 11-style restructuring will be reached, and the key  question in that determination would be the involvement of Ron Perelman. As I’ve said, the involvement of an experienced takeover expert is a vote of confidence in the company’s future, and in fact he is unlikely to risk his equity investment through risking bankruptcy. In fact, he has ridden to the rescue of Revlon, one of his major investees, in fairly recent history by lending it the money to pay off the principal of its loans as they fall due. Of course, the interest rate he charged was exorbitant, but from the perspective of a creditor who has been paid back, that is of no concern. On the other hand, the last reported balance sheet of Harland Clarke showed $205 million on the balance sheet, and Perelman may have designs on it, although there are probably covenants in place protecting it. On the whole, though, I can say that Perelman’s involvement is positive or at least neutral.

As a result, I can say that despite the declining volume of check printing, the bonds of Harland Clarke are in a stronger position than their current prices would imply. As a result I can recommend them as a candidate for consideration for high yield debt buyers.


Investment Technology Group: An Intriguing Broker-Dealer with Plenty of Excess Cash

February 26, 2012

Investment Technology Group (ITG) is in an interesting situation; the company primarily operates a trading platform and provides brokerage services, as well as providing investment research. As you may know, trading volumes have been low for the last few years, never having reclaimed the peak levels of 2008. This has naturally affected ITG’s earnings and share price, both of which have declined precipitously. However, ITG has a substantial amount of cash on hand, and that, combined with their current earnings power, makes them an intriguing candidate. Also, the view among analysts is that ITG is going to turn the corner and return to a modest growth situation, but even if this proves not to be the case (and I am generally suspicious of analysts on the whole), ITG should do well if it merely holds the line on its current earnings.

Investment Technology Group’s primary business is as a broker-dealer and operator of a trading platform, as well as providing original research and trade optimization and processing services to clients. More than 85% of the company’s revenue comes from non-recurring sources like commissions, but the company has been attempting to broaden its offerings to the more repeat-customer oriented field of research. To this end, it has acquired two research firms in the last couple of years. The company has a presence in the United States, Canada, Europe, Australia, and Hong Kong. Its electronic trading networks cover equities, futures, and options, and allow clients to trade with anonymity and without revealing their own orders, and also to scan multiple networks for uncommitted orders. These traits are highly valued in trading large blocks of shares or illiquid stocks.

As a result of continuing low volumes, Investment Technology Group has engaged in significant restructuring over the last few years. Consolidation and curtailment of their operations has enabled them to draw down significant amounts of working capital in 2010. As it is stated in Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance, a useful book on important details of cash flow accounting, one expects working capital to expand alongside a growing business and recede with declining ones. The restructuring has consolidated some locations and removed the company’s physical operations in Japan entirely, among other things, and also freed up cash to devote to acquisitions and share repurchases.

Over the last few years the company has been deploying its cash flow first to pay down its long-term debt and, recently in 2010 to repurchase stock. It is reasonable for a company that relies on volumes in the financial markets to deleverage itself as much as possible, although the firm has added about $30 million in long term debt in 2011, in addition to the acquisitions mentioned above. It is, strategically speaking, a defensible decision to diversify the company’s revenue sources, and furthermore subscription research is probably more recurrent than trading commissions as a source of revenue. However, I do have issues with the prices paid; the latest acquisition was for $38.5 million for a firm which is reported to have $15 million in sales and a pre-tax margin of 25%. Assuming taxes of 40%, this is an after-tax return of $2.25 million per year, or a yield of 5.894%, which is lower than ITG’s earnings yield even before taking excess cash into account. As a result, I would have preferred that extra money to go to buybacks.

Turning now to the figures, the extent of ITG’s excess cash is an important question. The company has $381 million in total cash on its balance sheet, of which $25.5 million is on deposit with clearinghouses and $71.5 million is restricted in some other ways. This leaves $281 million of unencumbered cash. The company’s other current assets are exceeded by its current liabilities in the amount of $121 million, so there is, under our customary test, $160 million in excess cash. However, as a broker-dealer the company is subject to regulatory capital requirements which, across its total operations, come to $210 million. The company’s actual regulatory capital is $365 million, and this $155 million excess has remained fairly constant over the years. Obviously, it would be unwise for ITG to dispose of its entire excess, but the company tries to close its positions one way or another by the end of trading, so its only real exposure is to its clients’ credit quality. As a result, I think the bulk of this excess regulatory capital can be considered excess cash, particularly as the two calculation methods tally so closely at present. Furthermore, the company has generally met its operating capital needs with cash flow from operations, and has paid for its acquisitions in cash, thus bolstering the hypothesis of a large amount of excess cash. Furthermore, the company has a line of credit to address other short-term capital needs. The company’s current market cap of $470 million can thus be reduced to $315 million to produce the denominator of the free cash flow yield calculation.

In terms of earnings, as of this writing the company has released its full year results but not its 10-K that would contain an audited cash flow statement, but based on cursory examination capital expenditures has equaled depreciation and amortization. Sales were $572 million, reported operating income was -$204 million but impairments, restructuring charges, and acquisition costs were $257 million, producing operating cash flow of $53 million. Interest expense that year was $2 million, producing pretax free cash flow of $51 million, or $31 million after estimated taxes of 40%. This is a free cash flow yield of 10%, which is an adequate return on investment especially in today’s environment, if not an exciting one.

In 2010, sales were $571 million, operating income was $50 million, impairments, restructuring, and acquisition charges were $12 million, and excess depreciation was $9 million, producing operating cash flow of $71 million. Interest expense was $1 million, resulting in pretax cash flow of $70 million, or $42 million after estimated taxes. The company was also able to draw down working capital significantly during this year.

In 2009, sales were $633 million, operating income was $79 million, restructuring charges were $25 million, and excess depreciation was $3 million, producing operating cash flows of $107 million. Interest expense was $3 million, leaving $104 million in pretax cash flow to equity, or $62 million after estimated taxes.

In 2008, before the extent of the downturn was fully known, sales were $763 million, operating income was $202 million, and capital expenditures exceeded depreciation by $13 million, producing operating cash flow of $189 million. Interest expense that year was $7 million, producing pretax cash flow to equity of $182 million, or $109 million after estimated taxes.

On a forward-looking basis, as I said before, it seems to be the general view among analysts that the downtrend in the company’s earnings has run its course and that prospective earnings will be marginally higher. Although I generally dislike indulging analysts, I will note that sales, if not margins, were flat in 2011 as compared to 2010.

I am concerned that share-based compensation has increased from $10.4 million in 2008 to $18 million in 2010, and $13.8 million for the first three quarters of 2011, even as incomes have declined. Furthermore, as I said above the company has overpaid for acquisitions relative to the constructive yield on share repurchases. However, the company does have 4.9 million shares, or over $50 million’s worth at current prices, in repurchase authority left, so if the company stocks to that plan I think ITG shareholders will benefit.

As a result, I can say that although Investment Technology Group may not be a traditional value stock, it offers a reasonable earnings yield and should be considered a candidate for portfolio inclusion, particularly for investors who feel optimistic about a recovery in market volumes.


Cracking open John B. Sanfilippo & Son, Inc.

January 28, 2012
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I have a soft spot in my heart for companies that are out-of-the-way, meaning that no one thinks about what they do. CSG Systems, for example, does nothing but handle the billing paperwork for other companies. And John B Sanfilippo & Son, Inc. (JBSS), is a producer of nut products. Owing to high levels of excess depreciation, the company has excellent free cash flow performance. I will note, however, that capital expenditures have been significantly below historical levels (which is tautologically true, otherwise there would be no excess depreciation), which could affect future sales. Even so, the company’s explanation for the dropoff is its recent consolidation of its four Chicago area facilities into one large facility as the result of a restructuring plan, and sales have been more or less flat after the restructuring, as have operating expenses not including depreciation, as a percentage of sales. However, the savings in capital expenditure cannot be overlooked.

John B San Fillippo & Son is a vertically integrated nut company, which controls the production process from purchasing nuts from growers to the end user; they do not actually own nut plantations. Their products include peanut products, tree nut products including pine nuts, and also a line of trail mixes, dried fruit, and sunflower and sesame products. In 2010 the company acquired Orchard Valley Harvest, a producer of nuts and dried fruits, which expanded their presence to the produce aisle, but the wisdom of that acquisition remains to be seen. They produce a variety of nut products; plain, roasted, flavored, and sugared. There is significant customer concentration, with about 20% of their sales going to Wal-Mart and about 12% more going to Target.

John B Sanfilippo’s biggest issue is gross margins; there is no futures market for nuts, even peanuts, and so the company is forced to buy its inputs in the spot market. In fact, gross margins slipped in fiscal year 2011, which ends in June, as compared to 2010 because the company was slow to enact price increases and was actually forced by unexpected orders to purchase nuts at a higher price than they could be sold for, an occurrence which I hope the company will not repeat. The company claims that it is encountering difficulty as consumer preferences are shifting towards lower-priced private label products rather than branded products that offer higher margins.

Turning now to the figures, in fiscal year 2011 sales were $674 million, gross profit margin was 12.5%, operating income net of goodwill impairments was $15.9 million, excess depreciation was $11.8 million, producing operating cash flow of $27.7 million. Interest expense was $7.5 million, leaving $20.2 million in pretax cash flow, or $12.6 million after estimated 38% tax rates. Set against the current market cap of $106 million as of this writing this is a free cash flow yield of 11.9%. The cash conversion cycle based on the beginning of the year data was 92.1 days. I am aware that it is customary to incorporate figures over the course of a year when calculating the cash conversion cycle, but for comparative purposes the beginning of year figures should be adequate.

In 2010, sales were $562 million, gross profit margin was 16.9%, operating income was $29.7 million, and excess depreciation was $7.3 million, producing operating cash flow of $37 million. Interest expense was $6.8 million, producing pretax cash flow of $30.2 million, or $18.7 after estimated taxes. The cash conversion cycle based on the beginning of year figures was 87.3 days.

In 2009, sales were $554 million, gross profit margin was 13.1%, operating income was $15.6 million, excess depreciation was $10 million, producing operating cash flow of $25.6 million. Interest expense was $8.9 million, which produces $16.7 million in pretax free cash flow, or $10.3 million after estimated taxes. The cash conversion cycle was 99.8 days.

I should point out that excess depreciation is not taxable, which would increase estimated free cash flows by an $4.5 million in 2011, $2.8 million in 2010, and $3.8 million in 2009. We may also expect it to improve free cash flows in the near future as well until depreciation falls back in line with the new level of capital assets. However, if we are using these the recent figures as a guide to the firm’s long-term earnings power it may be more appropriate to treat excess depreciation as taxable and calculate the present value of the excess depreciation as a one-time benefit. I would estimate this present value to be at least $10 or $15 million.

The company also owns an office building that was acquired along with the new Chicago area location which currently stands 75% vacant and produces rental income of roughly $1.5 million per year. This building is carried on the balance sheet at $30 million, which appears to be a reasonable price based on its square footage, although the company noted in its 2011 10-K that the building may require additional capital expenditures in order to attract tenants. At any rate, either adding tenants or divesting the building would probably strengthen Sanfilippo’s performance.

Based on these figures as presented, it would seem that John B Sanfilippo is an attractive company, and I would agree that on the whole it has a number of advantageous points. However, I am concerned about the company’s ability to control its margins. As I stated above, the company was forced to answer a large unexpected order by by purchasing nuts on the spot market at prices equal to or higher than the final sale price, and of course the company admitted to being slow to roll out a price increase, both of which cut into gross margins as compared to the previous year. Even if we grant that these were temporary aberrations that are hopefully not to be repeated, the company reports that consumer preferences are shifting to cheaper private-label products as opposed to brand-name products, and although Sanfilippo has a private label business, margins are lower than in the branded sector. Also, the Chinese seem to have developed a considerable appetite for American nuts, which further tightens the supply.

It is, of course, possible that John B. Sanfilippo will ride through these concerns; after all, the situation described above has been true in 2010 and 2011 and the company still produced what seems to be an adequate return even with filling the unexpected, unprofitable order and the lateness of the price hike. However, I will still say that the ability of the firm to earn an adequate margin in future seems to be more questionable than I would like to see. As a result I cannot recommend John B Sanfilippo as a value investment, but I can recommend it as an attractive speculation for those readers who are interested in one.


Lexmark – Excellent free cash flow yield and buybacks

January 17, 2012
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Lexmark, the well-known printer company, presently offers a robust free cash flow yield of roughly 15%, and also has a vast cushion of cash and investments representing more than a third of its market cap. Although a lot of that money is in overseas subsidiaries, whatever isn’t is being wisely used to buy back shares at these attractively low prices.

For my full opinion, see


Recency Bias and Cyclical Companies, and also Assessing International Paper’s Restructuring

January 8, 2012

In my last article discussing Black Box, part of my positive opinion of the company was its performance in 2009. This led me to consider how far back into a company’s earnings history we should go. Ben Graham in his Security Analysis recommends at least a decade, but that runs into the situation that a company now may not be the same company it was ten years ago. However, it would be equally a mistake to take last year’s earnings as representative of a company’s earnings power. Behavioralists call that the recency bias, the tendency to overweight the most recent information, and I attribute much of this bias to the fact that financial websites tend to report only the current figures (current book value, P/E based on most recent 4 quarters of earnings, etc.), and to get historical data you have to do more digging. Not that I mind digging, of course.

The effect is particularly disturbing with cyclical companies. Nothing is more dangerous than valuing a cyclical company at the peak of its cycle. Consider the US Gypsum takeover of 1987; the company received a leveraged buyout offer from a takeover artist, and the Board knew immediately from reading the offer that they were valuing the company at its cyclical peak, as though it was a noncyclical company that could always go on earning at that level. The Board had no choice but to issue a counteroffer with slightly less leverage involved, but sadly even maneuver this was unable to prevent a subsequent bankruptcy.

The trouble is there is a balance that has to be struck. Go back too far and you start incorporating data that is not directly comparable because the company was different at the time, but go back not far enough and you risk missing a cyclical issue. Some businesses have a reputation for cyclicality (US Gypsum, for example, which made drywall and is therefore exposed to the cyclical construction industry).

Obviously for these companies you have to look back into history to determine the average level of earnings and profit margins. And yet, even cyclical companies can change over time. By way of illustration, I give you International Paper (IP), the leading manufacturer of corrugated cardboard in the United States, as well as printing paper, packaging, and other things to do with paper and pulp. The firm’s current market cap is $13.5 billion, or $10.8 billion net of excess cash. The company owns 20 paper and packaging mills, 144 converting and packaging plants, 19 recycleries, 3 bag making facilities, about a third of which are located outside the United States. The company also owns some land in Brazil and has a joint venture in Russia to both harvest wood and process it into paper.

Our interest in this company comes from its massive restructuring in the last few years. In 2010 for example, the company incurred over $300 million in restructuring charges, and in 2009 the figure was more than $1 billion. Clearly, there is a lot of restructuring going on, and the impact of restructuring on the company’s prospective earnings power cannot be set aside, as you will see from the figures. However, the improved economic situation as between 2009 and now, coupled with the fact that this is a cyclical company in general, gives me concern about how effective this restructuring is.

In presenting these figures, I am treating various restructuring expenses as nonrecurring if they are one-time expenses such as severance, or noncash expenses such as writing off an accelerated depreciation allowance. However, expenses relating to the direct cost of closures I am leaving in because the firm can close and open plants even outside of the context of a restructuring, and with nearly 200 facilities that should be considered simply a cost of doing business.

In 2010, sales were $25.2 billion, operating income as reported were $1430 million, the excess of capital expenditures over depreciation $681 million, certain restructuring charges $280 million, producing operating cash flow of $2391. Interest expense that year was $608 million, leaving pretax cash flow of $1783. After estimated taxes at a 35% rate and adding back in earnings from the joint venture, we have free cash flow to shareholders of $1223 million.

2011 seems to be continuing this trend.  For the first three quarters  sales were $19.7 billion, operating income as adjusted for impairments $1261 million, certain restructuring charges $32 million, excess depreciation $286 million, which leaves $1579 million in operating income.  Interest expense was $403 million, which leaves $1176 in pretax cash flow. After estimated taxes and joint venture earnings we have $914 million, which would be $1219 on an annualized basis.

Compare these results to those of 2009: sales of $23.4 billion, reported operating income $1199 million, certain impairment charges $1154 million, excess depreciation $938 million, producing operating cash flows of $3291 million. However, $2100 million of this amount was the infamous black liquor tax credit, so actual operating income was only $1191 million. Interest expense in this year was $669 million, leaving $522 million before taxes, or $290 million afterwards.

And in 2008, sales were $24.8 billion, reported operating income as adjusted for impairments was $624 million, excess depreciation was $345 million, producing a total of $1097 million. Interest expense that year was $492 million, leaving $605 million in pretax cash flow, or $442 million in after-tax free cash flow. This was also the year in which the company acquired Weyerhaeuser’s packaging business.

Now, if we were naïve enough never to have heard of cyclicality we would assume that the improved performance of 2010 and 2011 relative to the years before were the result of the restructuring, which has apparently been effective because the company’s free cash flow yield  after excess cash is deducted is 11.3%. However, because this is a cyclical company we know that it would be unwise to use these earnings as a baseline of the company’s earnings power.

This presents the difficulty that we cannot evaluate the effectiveness of International Paper’s restructuring in the first place, at least without waiting for another severe recession. We could, however, compare it to how the company was doing the last time it was at the same point in the business cycle, which would probably be around 2002. Again, it is a different company than it was in 2002, but the comparison is better than nothing.

Way back in 2002, sales were $25 billion, operating income as reported was $1154 million, excess depreciation was $582 million (not counting an additional $535 million in divestitures—curiously, International Paper was going through a restructuring then too), leaving operating income of $1736 million. Interest expense that year was $783 million, leaving $953 million, or $620 million after estimated taxes.  So, comparing 2002 and 2012, we see that sales and operating profits have remained roughly flat, and the difference in net income is the result of lower interest expenses. And, since long term debt at the end of 2002 was $13 billion and International Paper’s current long term debt is $7.8 billion, we see that the improvements in free cash flow are largely the result of paying down debt, as International Paper’s interest rates are in fact slightly higher than in 2002. So, we can conclude that the  restructuring at International Paper was effective only at retaining existing earnings power, not improving the company’s prospects.

As a value investor, what should we take away from this? One sensible approach is to average a company’s performance across the entire length of a business cycle and use that as an estimate of earnings power. However, cyclical companies tend to be priced according to where they are in the cycle even if the market knows they are cyclical—even Ben Graham observed that ice companies tend to do better in the summer than the winter. It is also possible to assess profit margins across the cycle and apply them to the current level of sales, as I did above.

However, the wise value investor would do better to avoid risk than to make sure that the risk is compensated. As a result, the most conservative rule would be to avoid investing in a cyclical company unless its free cash flow yield based on the current price would be adequate even at the bottom of the cycle. Domtar, a company I have written up previously, is in just such a situation. Even in 2009, free cash flows were $274 million, not including the tax benefits of excess depreciation, and the company’s current market cap after excess cash is taken into account is $2.75 billion, meaning that free cash flow yields in this bad year were a robust 10%, and of course returns at a better time in the cycle would be quite compelling.

My point is not simply “buy Domtar instead of International Paper,” but to make sure that we use a genuinely representative sample of earnings when trying to compute a firm’s earnings power. As I said in my last article, to paraphrase Hugh Hendry, a good alternate form of stress testing is asking what happened in 2009.