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.


Black Box – Robust free cash flows

January 2, 2012
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Black Box Corporation (BBOX) is a provider of network infrastructure services, which embraces design, sourcing, installation, and maintenance of network. Roughly 60% of the company’s income is from voice communications, but the data infrastructure portion has been slowly increasing and represents 23% of income based on the latest two quarters. The company also has a technology product division that sells technology products and support services and warranties on these products.

Black Box offers a free cash flow yield of 12.3%, which is attractive. Moreover, the cash flow yields have been robust, with earnings even in the 2009 period offering a free cash flow yield of nearly 10%. Black Box has also been acquiring smaller private competitors, having accomplished at least nine acquisitions in the last four years. As the acquisitions are of private companies I have no means of making an independent assessment of the acquisitions, but they seem to be at least paying for themselves.

Black Box’s clients include government departments as well as businesses of all size. 88% of the company’s total revenues come from inside the United States. However, a significant portion of the company’s revenue comes from new installations, so it is necessary for the firm to continually find new customers.

Turning now to the figures, Black Box’s current market cap based on current prices is $497 million. For the 2011 fiscal year, which ends in March, sales were $1068 million, operating income was $91 million, and depreciation and amortization in excess of capital expenditures was $13 million, producing operating cash flow of $104 million. Interest expense was $5 million, producing pretax free cash flow of $99 million, which results in free cash flow of $61 million after an estimated 38% tax rate. As stated above, this results in a free cash flow yield of 12.3%.

In fiscal year 2010, sales were $961 million, operating income was $63, excess depreciation was $21 million, producing operating cash flow of $84 million. Interest expense was $9 million, producing pretax cash flow to equity of $75 million, or $47 million after estimated taxes.

In fiscal year 2009, sales were $1 billion, operating income was $80 million, excess depreciation was $18 million, producing operating income of $98 million. Interest expense was $10 million, producing pretax cash flow to equity of $88 million, or $55 million after estimated taxes.

The first two quarters of fiscal year 2012 are consistent with these results. Sales were $556 million, operating income was $39 million, excess depreciation $5 million, producing operating cash flow of $44 million. Interest expense is $2 million, producing pretax cash flow to equity of $42 million, or $26 million after taxes, or $52 million on a full year basis. The free cash flow figure for the same period last year was $31 million. The difference is largely attributable to decreased margins, as sales are up slightly, but the free cash flow yield is still above 10%.

Now, what drew my attention to Black Box may be seen in its fiscal year 2010 results. This was the year that embraced the bulk of the 2009 recession, and this company, although it is active in the business infrastructure market, not only produced a profit but produced a profit that would almost be an adequate 10% free cash flow based on current prices. This gives me confidence that there is robustness in the company’s earnings power. As Hugh Hendry said, when commenting on one round or another of stress testing of European banks, “There is another form of stress testing, and that is what happened in late 2008-2009.” And in this case, what happened seemed to be not particularly troubling.

I do also reserve a criticism for what the company does with its cash flow. Apart from the acquisitions previously mentioned the company has been using its free cash flow to pay down debt, which is not really that necessary based on interest coverage. There have been no buybacks in the last few years, and the firm pays a fairly small dividend that yields roughly 1% at current prices.

As a result, I would describe Black Box as an interesting candidate for portfolio inclusion, particularly in the event that overall capital expenditures increase or a significant pullback in price.


Community Health Solutions (CYH) – Side Effects include Risk

December 14, 2011

As you may know, I generally adopt a fairly quantitative process when looking for potential investments, at least at the screening stage. I first consider an excess cash position if there is one, both because it provides a source of primary liquidity and also because it often can be considered separately from the company’s operating assets and is free to be distributed to shareholders if management does not think of a clever way to waste it. I then compare the market value of the company’s operating assets to its free cash flow to equity and look for a nice fat yield. Of course, I also consider the free cash flow yield based on the actual market cap, because as I said managements have a tendency to regard excess cash as part of their empire, not something to be dissipated by returning it to the shareholders just because it technically belongs to them.

Of course, this is only the first step in the screening process; one must also consider the business’s competitive and economic context to determine the sustainability of existing cash flows. Value investors usually prefer to take the bottom-up approach, but there is no reason for ignoring the “-up.” And, of course, a coequal part of this analysis is the business’s capital structure and degree of leverage. As Marty Whitman, value investor and talented distressed investor, points out in his most interesting and perhaps controversialValue Investing, A Balanced Approach, value investors do not see risk in the abstract, the way modern portfolio theory thinks of risk as identical to volatility. Risk always has an adjective attached: default risk, revenue risk, margin risk, regulatory risk, lawsuit risk, etc. Note if you will that most if not all of these risks are attached to the company, not the market.

By way of illustration, I present you with Community Health Systems Inc., a company which shows up as very enticing on my screen, but which fails as a candidate for portfolio inclusion upon further analysis.

Community Health Systems (CYH) owns and operates more than 130 hospitals and a few care facilities in the United States, primarily in rural areas or in communities where they are likely to be the only hospital. The company has engaged in several acquisitions over the years, and apart from the above criteria the firm’s main targets, according to its own SEC filings, are nonprofit or municipal hospitals. I suppose in a time of municipal budget cuts, many counties and cities will be open to having the expense of running a hospital relieved from them. So, we have two points in CYH’s favor: it passes the initial screen for free cash flow yield on operating assets, and it is preying on sick and wounded hospitals, which is probably good for business, even if it may not be so good for society as a whole.

I believe also that these acquisitions, as they involve an entire hospital and not pieces of a hospital’s capital assets, are not necessary for the company to carry on operations at its existing hospitals. Therefore, these discretionary acquisitions should not generally be counted as capital expenditures for purposes of calculating free cash flow.

Turning to the specific figures, Community Health has $2.8 billion in current assets including $266 million in cash, and $1.7 billion in current liabilities, which means that all $266 million is excess cash and not necessary for the immediate operation of the business, particularly as the firm is cash flow positive overall. Subtracted from the market cap of $1.48 billion, this produces a value of the company’s operating assets of $1.21 billion.

On the free cash flow side, in 2010 sales were $13 billion, operating income was $1114 million, capital expenditures exceeded depreciation by $57 million, producing operating cash flow of $1057 million. Interest expense was $653 million, leaving $404 million in pretax cash flow to equity, which is $263 million after estimated taxes at a 35% rate. Subtracting noncontrolling interest charges of $68 million, we are left with $195 million in free cash flow to equity. This is a yield on the market value of operating assets of 16.1%, and 13.2% basic free cash flow yield.

In 2009 sales were $12.1 billion, operating income was $1069 billion, capital expenditures in excess of depreciation were $11 million, producing operating cash flow of $1058 billion. Interest expense was $653 million, leaving $405 million, or $263 after taxes. After noncontrolling interest deductions of $63 million, we have $200 million in free cash flow.

In 2008, sales were $10.9 billion, operating income was $972 mil, excess capital expenditure  was $182 million, producing operating cash flow of $790 million. Interest expense was $659 million, leaving $131 million in pretax cash flows, or $85 after estimated taxes. Remove the minority interest deduction of $34 and we are left with $51 million in free cash flow.

If you want to spot the flaw in investing in Community Health from a value perspective, look carefully at the 2008 results. Operating cash flow was $970 million, but cash flows after interest were $131 million. Community Health is dangerously overlevered; against its market cap of $1.48 billion there is $8.8 billion in long-term debt. More disturbingly, unlike Supervalu where the managers are throwing all the cash they can spare into paying down this debt, Community Health seems to be just fine with the situation. In fact, the firm has been engaging in share buybacks recently, although they did recently exchange $1 billion in 8.875% bonds for a new $1 billion in 8% bonds, which I suppose helps, but it is not the aggressive pace of paying down debt that I would like to see. And even if the firm were bending all their free cash flow towards paying this debt down, it would take years for them to make a significant dent.

Even though running the only hospital in a region gives the company decent insulation against competition, competition is not the only risk a business faces. It is possible for Community Health’s  earnings to be imperiled, particularly in the face of the fact that medical costs cannot keep increasing faster than inflation forever, and the calls for reducing Medicare reimbursements, which constitute a little over a quarter of Community Health’s revenue, are growing ever more numerous.

As such, I find it thoroughly impossible to recommend Community Health as a candidate for portfolio inclusion despite its good numbers and strong competitive position. Perhaps a massive debt for equity swap would change my mind, as would a Chapter 11 which would essentially amount to the same thing. But as things stand, value investing for me is about avoiding risk, not about being compensated for taking it, and so even the high free cash flow yield cannot move me towards investing in Community Health in its present form.

PS: I should also point out that Community Health’s 12-month high has been $42.50 against a current share price of $16.66, and of course that makes me think of the company as a short candidate–at least at $42.50, if not now. But the high degree of leverage in the company’s operations means that a small change in revenues or margins will be magnified greatly in actual earnings. Therefore, especially at these low prices and multiples, the company’s stock is likely to behave more like an option than a stock, and it is is never wise to have a naked short on an option.


UFP Technologies – Opportunities come in Small Packaging Companies

December 8, 2011

Hello all. Some of you may have noticed that I have not been posing as much as I normally do, and the reason for that is that I have been studying for the CFA examination. The test was last week, so I now find myself again at your disposal. I thought I would kick things off with a discussion of an interesting small cap called UFP Technologies, which I was referred to by a reader, Adib Motiwala of Motiwala Capital.

UFP Technologies is a small manufacturer of packaging for both bulk and fragile products, which it makes out of foam, plastics, and recycled fiber. Some time ago the company determined that the same technology to make packaging could also be repurposed to make actual components. The component trade now composes the majority of UFP’s net income, approximately 60% of the company’s total revenue for 2011 year to date. All of UFP’s physical locations are in the United States. The company’s revenue is somewhat concentrated, with four customers representing over 30% of all sales for 2010.

As a company that supplies packaging for businesses, and also produces components for other businesses, including the medical and automotive fields, the company’s results might well be considered cyclical. However, when the company’s current excess cash position is taken into account, UFP has produced a free cash flow yield that would almost be satisfactory even in 2008 and 2009. Furthermore, the company took advantage of the prices prevailing in 2008 and 2009 to make several attractive acquisitions which for the moment seem to be doing well. The company claims that further acquisition and joint ventures are integral to its current strategy, but it has not made any major acquisitions in 2010 or 2011, and in fact it divested one of its existing packaging factories in 2011.

Turning now to the figures, in terms of excess cash UFP has cash and equivalents of $30.7 million, receivables and inventory totaling $24.1 million, and current liabilities totaling $12.4 million. Current liabilities are therefore fully covered by noncash current assets and thus the entire cash holding may be considered excess. Based on the current market cap of $98 million, we thus have a value of $67.3 million for the market value of UFP’s  operations.

In terms of free cash flow, in 2010 sales were $121 million, operating income was $14.4 million, depreciation and amortization minus capital expenditures was -$0.1 million, producing $14.3 million in operating cash flow (not counting changes in working capital). Interest expense was $0.1 million, leaving $14.2 million in pretax free cash flow, or $9.2 million after estimated taxes of 35%. I should point out that UFP reports its interest expense net of interest income, and therefore I am using the company’s reported cash paid for interest to estimate total interest expenses for all periods. I believe this figure also to be reported on a net basis, so these figures may include interest income on cash that I have already separated as excess, but owing to the current low interest rates the effect should be fairly small. Based on the $67.3 million market value of UFP’s operations, this represents a free cash flow yield of 13.7%.

In 2009 sales were $99 million, operating income was $8.2 million, and excess depreciation was $1 million, which produces $9.2 million in operating cash flow. Interest expense was $0.2 million, producing $9 million in pretax free cash flow, or $5.8 million after taxes.

In 2008, sales were $110 million, operating income was $8.4 million, plus excess depreciation of $0.2 million, producing operating income of $8.6 million. Interest expense was $0.4 million, producing pretax free cash flow to equity of $8.2 million, or $5.3 million after estimated taxes.

As I said before, the free cash flows in 2008 and 2009 do not quite hit the 10% free cash flow yield on the market value of operating assets that many participants, including myself, consider a decent rule of thumb for an asset to be fairly valued. However, as these figures come from a fairly severe recession, and the UFP seems to have expanded its capacity through some acquisitions that it does not seem to have overpaid for, I believe that UFP is fairly robust at current prices.

2011, for which we have three quarters of 10-Q’s released, is shaping up fairly well. Sales are $96 million versus $89 million for the same period last year, but these figures include the automobile panel contract that has now expired. Capital expenditures for 2011 year to date have exceeded depreciation by $0.6 million, but UFP has also sold one of its packaging plants for $1.2 million. Operating cash flows are $10.9 million versus $11 million for the first three quarters of 2010. Cash interest paid was less than $0.1 million year to date, versus $0.1 million for the same period last year, producing free cash flows of $7.1 million for each period, not taking into the account the proceeds of the divestment of the packaging plant.

The company’s debt as a portion of its capital structure is almost negligible, with interest payments covered by operating cash flows many, many times. Furthermore, UFP has a credit facility with $16.7 million available on it. Therefore, the firm has plenty of leeway to return cash to its shareholders, and it is even possible, although the company has given no indication that it is likely, for the firm to expand its use of leverage for the further benefit of its shareholders.

I should point out, however, that UFP has a significant number of stock options outstanding, totaling  nearly 1/10th of the current shares outstanding and with a weighted average exercise price of $4.81, less than a third of the current price. The options that matured in 2011 were settled in stock rather than cash.

Based on a 10x multiple of 2010’s free cash flow to equity of $9.2 million, plus the excess cash figure of $30.7 million, we have an estimated equity value of $122.7 million. After taking the dilutive effect of options into account, this would translate to a share price of $17.56, a modest premium over the current price of $15.01. Thus, this stock is an interesting candidate for portfolio inclusion particularly in the event of any future drop in price.


River Rock’s Exchange Offer has Arrived

November 3, 2011

I said in my comments for my previous article about the River Rock Entertainment Authority bonds that I would have an update when there was something to update people about. I think the default and exchange offer qualifies

River Rock has filed with the SEC a forbearance agreement that has the votes of over 60% of existing bondholders, as well as the basic shape of an exchange offer. In my previous article I expressed some concern that an exchange offer was becoming the new plan, and not just the backup plan. My concerns were eased when the company was showing progress in a refinancing deal, but now that time has run out on that deal I’m glad to see a plan all the same.

As has been pointed out, the terms of the proposed exchange are as follows: Each holder will receive $1000 in principal in new senior notes for every $1000 worth of old notes, plus accrued interest, plus his or her prorated share of the amount of cash on River Rock’s balance sheet that exceeds $13.7 million. However, this cash distribution will count against the principal value of the notes. The new terms require the company to use 90% of its excess cash flow if EBITDA is above $50 million, and 100% if below that figure, to repurchase the bonds. However, I believe this will be on the individual bond level and not prorated. EBITDA in the trailing four quarters was $55 million, and looking back at the last three fiscal years this figure has remained stable at around $54 million.

The distribution of excess cash interests me; had things worked out differently I would have suggested throwing it at River Rock’s investment banks as a sweetener of any underwriting deal. However, the use of the cash to sweeten an exchange offer does not surprise me. I have been considering the assets available for creditors to seize in the event of a lawsuit, and that cash is pretty much it. Despite the waiver of sovereign immunity, only an Indian tribe can run and Indian casino, and the land under the casino is also held in trust. Thus, the only assets that would be realistically available to creditors would be from garnishing the casino’s bank accounts, and by draining its coffers in this manner the casino is offering a disincentive to holdouts. As detailed in Moyer’s Distressed Debt Analysis, a useful guide to distress and bankruptcy investing, finding some means of punishing holdouts in order to incentivize them to transfer is a common practice among debt workouts.

In terms of the early redemption of these bonds, I have mentioned the possibility of amortization in conversations with some readers. Certainly such an action would bring confidence to the lending community, particularly with the possibility of the Graton casino opening within the next few years. And of course with the expansion put on indefinite hold the casino doesn’t really have much else to do with its money. I would be very interested in the redemption mechanics; whether the company chooses the bonds randomly or simply repurchases from the large institutional holders, leaving us retail holders at the end of the line (I assume most of my readers are retail holders (or perhaps contemplating becoming a retail holder)).

On the whole, then, I think the proposed refinancing deal will work out well for us bondholders. I am actually surprised that a refinancing deal along these lines, perhaps with a separate amortizing and a standard bullet issue, could not have been accomplished. As I’ve always said, and as has been pointed out in the comments, there is ample cash flow to support the existing debt structure with money to spare. As such, I think that the the failure of River Rock and its banks to get a refinancing accomplished is not merely an unfortunate surprise; it is inexplicable, even considering the short time frame.

I think part of the problem could be a constituency issue based in the decision to issue part of the debt as municipal bonds. The core constituency of the existing bonds is high yield investors; even setting aside the sovereignty issue the casino has a fixed charge coverage ratio of only about 2.5. The high yield community, I’ve noticed, seems to give financial analysis much more scope, and thinks of due diligence as something other than simply a process to avoid getting sued. That is why, as I’ve said before, we don’t need a rating from the ratings agencies to tell us what is going on. The municipal bond community, on the other hand, would be more likely to adopt a defensive, ratings-based approach and less willing to take a flier on an unusual issue. But on the other hand, Credit Suisse had apparently been trying to place an ordinary high yield issue for some time before the idea of the Build American bonds was adopted, and of course there no doubt is a large (and growing) group of specialists in distressed municipal debt.

At any rate, I remain optimistic about this refinancing in terms of recovering my principle at some point. However, I am not happy about the the lower interest rate, which contradicts the plan proposed in my last article. Furthermore, the early redemption might work against us if the situation at River Rock improves or the interest rate in the high yield markets decline, thus depriving us of earning what could be an above-market rate. As I stated before, I believe that accepting the exchange offer will be preferrable to rejecting it. As valuehound, the well-known commenter on my previous post pointed out, it is the cash flows and economics of the situation that will drive this deal and should be our main concern, and those are adequate to support this issue.

Disclosure: At the time of this writing, the author owned River Rock Entertainment Authority bonds.


Conversations with the River Rock Entertainment Authority

September 11, 2011

Update: There is a new article pertaining to the default and proposed exchange offer here.

As I’m sure most of you know, the River Rock Entertainment Authority has $200 million in bonds coming due at the beginning of November of this year, and although the company has expressed confidence that a refinancing will occur, time is growing short and a definitive announcement has not been made. If you didn’t know that, you do now.

These facts have understandably weighed on the market price of the bonds, particularly as no Indian casino has ever tested the bankruptcy courts and the customary bankruptcy remedies would be unavailable even if they had.

The latest conference call contained little in the way of new information, but in response to a question River Rock management did answer that they had an “underwriter” that was shopping the deal around. As I said at the time, the engagement of a specific investment bank is an early step in the refinancing process, but the fact that they have found one is a positive concrete development.

Last week, I was informed via email that a reader of my articles and a member of the investing website was in a position to pass on information from a conversation between another member and a senior employee of River Rock. In this conversation, the employee identified the underwriters as BofA-Merrill Lynch and Credit Suisse. This struck me as unusual; those are after all very large investment banks–both of them in the “bulge bracket”–and I am surprised that they are taking such an interest in our little casino. CIBC, the investment bank that handled the offering of the bonds originally, is less than a third the size, based on assets, of Credit Suisse, the smaller of the two new banks. This employee also agreed with most of us that River Rock has sufficient cash flows to obtain a refinancing, and that many of the issues are “political,” a topic I will address later.

Curiously, this employee did also mention that he feels that 51% of bondholders would be likely to approve an extension of the maturity date. Obviously I don’t know what manner of canvassing River Rock has done on this matter, but I am concerned that his volunteering of this information could imply that an extension is the new plan, rather than the backup plan.

Following this conversation, this reader then telephoned this same employee for further information. Mostly the conversation contained the same information, but a few interesting highlights did emerge. First was an idea from Merrill Lynch about taking advantage of the Build America bonds program, as much of the borrowing went towards building infrastructure (although the employee may have been thinking of a different stimulus program, based on what I’ve found Googling for the Build America bonds). He also clarified that the political issues mentioned above pertained to the casino’s discussions with Sonoma County, which have now been resolved now that the land on which the road is to be built has been purchased.

As for a possible tender or extension offer, the employee stated that the extension proposal would have a definite maturity, as the bondholding community is understandably wary of an open-ended commitment, and that it would be possible to sweeten the deal with a small increase in coupons. He also added that any definite plan to deal with the upcoming maturity would be disclosed via an 8-K filing, most likely before the November deadline.

The employee also reiterated that River Rock’s cash flows are excellent and in fact the casino’s financial ratios are the best in the country. This is probably a true statement at least for certain financial ratios; River Rock offers better free cash flow coverage of interest than, say, the Mohegan Tribal Gaming Authority, which I have discussed elsewhere on this site.

So, those were the key points of the conversation, and here are my thoughts. I am intrigued about the use of stimulus programs; it would make a refinancing deal more marketable, and a subsidy on part of the borrowing would make the interest coverage on the remaining part, which would consist of ordinary high yield debt, look much better on an interest coverage basis. However, qualifying for the program presumably adds an extra quantum of time to the refinancing process.

One thing that is conspicuously absent in this conversation, I notice, is the possibility of a bridging loan. If Merrill Lynch or Credit Suisse are genuine underwriters, meaning that they will assume the risk of having to keep unsold bonds, this is an expression of their confidence in the value of the new bonds. As such, they might be willing, for an appropriate interest rate and fee, to lend River Rock the money it needs to pay off the old bonds against the proceeds of the sale of the new bonds. Obviously, the new bond deal would have to be pretty definite at that point, but it is a presumably viable option and I am surprised not to hear it discussed.

The main takeaway from this conversation and the current situation, though, is that we bondholders are certainly at the point where we must consider the shape of the extension offer. Certainly the bond prices already indicate that this possibility has been priced in. First off, I am convinced that the issue is one of time and not ultimately one of solvency; River Rock does have sufficient cash flows to support the debt in my opinion, and I do think that an extension at a slightly higher interest rate would not significantly increase the risk of a permanent loss of value.  I would probably vote in favor of an extension with my own bonds if November 1 passes with no refinancing and I haven’t closed my position before then. I would say that the extension, if it proceeds along the lines described above, is certainly preferrable to forcing the company into default, which would certainly hamper any refinancing deal in process, and even taking an optimistic view of the River Rock Entertainment Authority’s waiver of sovereign immunity, there are nowhere near enough seizable assets to satisfy the bond issue.

So, the situation is certainly not ideal for River Rock’s bondholders, but the continuation of interest in an extension offer would make the offer more palatable, and River Rock’s cash flows are still clearly capable of supporting the refinancing, which still may happen on time but I would not rely on it. Naturally I am worried about the future course of bond prices if an extension offer is made, but based on River Rock’s financials I am not greatly concerned about an ultimate impairment in value.

I would like to once again express my gratitude towards the Valueforum member who communicated these conversations to me, and I hope that this signals a trend of River Rock’s management being more forthcoming.

Disclosure: At the time this article was written, Geoffrey Rocca owned bonds of River Rock Entertainment Authority.


DST Systems – Value from a Hidden Portfolio

September 1, 2011

I’ve been meaning to mention this, but my latest article at seekingalpha (and third editors’ pick in a row) deals with DST Systems, a company that provides IT and automation services for the mutual fund industry, among other clients, has a portfolio of stock and private equity investments that is worth a little under half of its current market cap. And yet from the earnings multiples, it’s as though most of that portfolio doesn’t exist. For details, please see.


Windstream to overpay for PAETEC

August 23, 2011

I have been indisposed recently, but I will be ready to resume m usual schedule of posting in the near future. But before then I have some old news that needs addressing, and that is Windstream’s planned merger with PAETEC.

Whenever there is a merger announced, at least one and usually more than one plaintiff’s firm will announce an investigation into a possible breach of fiduciary duty of the board of the target company. In the case of this merger, there were about ten such announcements. Most of these suits are pointless and never go anywhere, and boards of directors have come to regard them as a cost of doing business. But one rarely if ever sees any investigation of the acquiring firm. No one seems to bother to investigate them, despite the historical evidence that shows that a majority of mergers fails to add value.

So, after a long wait, I have decided that I will investigate them–not in preparation of a lawsuit, just to assess the wisdom of a merger. And what I have found is that this merger has all the signs of one of those mergers that fail to add value. Specifically, it places a great deal of pressure on synergy to produce value. Synergy is notorious for often being a thing that the M & A industry makes up to justify a merger that cannot stand on its own merits.

The specifics of the deal are that Windstream will take on $1.4 billion of PAETEC’s debt and issue roughly $900 million in stock, plus $100 million in merger and integration expenses. In exchange, Windstream anticipates synergies of $100 million from operations and capital expenditure savings of $10 million, and  tax benefit of $250 million based on PAETEC’s reported operating losses. PAETEC itself has produced $130 million in operating cash flows last year. Although this year PAETEC is on course to generate a figure closer to $160 million, this figure cannot be isolated as the result of organic growth or savings; PAETEC is also a serial acquirer, having acquired a large business itself in 2010.

So, subtracting out the $150 million from the tax benefit and the merger and integration costs, we have a $2.15 billion price tag. Starting with the generous $160 million figure as an estimate for PAETEC’s operating cash flow, we first consider the cost of debt. $1.4 billion in debt assumed by Windstream at, say, 8% consumes $112 million right away and resolves part of the price tag. The remaining $48 million becomes about $32 million after taxes. This amount, capitalized at 10x, produces a value of $320 million. Set against the $750 million in the remaining purchase price we have a gap of $430 million. Now, $110 million in operating synergies also reduces to a bit over $70 million after taxes. So, it would seem that PAETEC has to produce 61% of its projected synergies (although the merger announcement adds that it estimates that it will take a full three years to ramp up the synergizing, which lowers its present value, obviously).

According to Damodaran in his Investment Fables, a study performed by KPMG concluded that synergies associated with cost reductions, as this merger is, tends to be more effective than synergies based on new product development or sharing R & D. This is a plus, but the study seemed to confine itself to reducing headcounts. At any rate, such mergers have a 66% success rate, as opposed to 25-33% on the R & D category. So, converting this figure into an expectancy, we find that there is a 5% margin of safety on this merger based on the above 61% synergy performance requirement; 5% of $730 million, or $36.5 million dollars on an acquisition of $2.3 billion. Not the clear creator of value that I would like to see.

Windstream may have been caught in the panic on Wall Street this August, and its share price suffered accordingly, but I am concerned that another source of its price drops was the possibility that the market shares my view of the dubious wisdom of the merger. It has not motivated me to sell, but I will be  observing the company’s performance in future.

Disclosure: I am long Windstream at the time of this writing (yes, I am including this disclosure now).


Standard & Poor’s downgrades the US – I say, downgrade S & P

August 5, 2011

I was hoping to have a nice relaxing end to a difficult week, but Standard and Poor’s has officially downgraded the United States’ credit rating to AA+. And of course, they did it when the markets are closed for the weekend just to ensure that we’ll all be good and stressed for Monday.

Obviously, one is left to wonder how this happened? After all, the government’s finances may be strained, but unlike, say Greece, we in the U.S. are not so poor that we’ve had to sell the printing press. Demand for Treasuries remains high, the Federal Reserve stands ready to serve as the quantitative easer of last resort, and in essence the United States cannot default unless it wants to. And, as was recounted in Frank Partnoy’s FIASCO, ratings agencies see their jobs as rating the risk of default, not any other risk such as inflation. He recounts the example of a structured note that Morgan Stanley created that had an embedded put on the peso, meaning that if the peso fell below a trigger level the note holders would effectively be paid back in pesos instead of dollars. And yet the collateral and the cash flows supporting the bonds were as solid as the Bank of Mexico, so this issue gained a AAA rating and retained it as the peso fell right through the trigger level and kept going.

Normally, I try to avoid getting political, but this downgrade is a reflection on politics, not economics and so I have no choice. A close reading of the Standard and Poor’s full announcement is in accord with these views. As I said, the U.S. cannot default unless it wants to, and it seems that the grounds for the downgrade is that the U.S. might want to — at least, it might want to more than it wants the two sides to set aside their partisan warfare. The first sentence of the rationale section reads “we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicates that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.” It continues “the political brinksmanship of recent months highlights what we see as America’s governance and policymaking becomes less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default has become political bargaining chips in the debate over fiscal policy.” In other words, the default risk does not arise from our economy, but our politics. The deficits and the debt levels concern Standard and Poor’s, but they do so less than the political impasse that makes them impossible to address.

Although S & P labors to make clear that it “takes no position on the mix of spending and revenue measures…appropriate for putting the U.S.’s finances on a sustainable footing,” I suspect that this might be a run for political cover, as they will certainly need it come Monday. What I believe to be a major centerpiece of this ratings cut appears later in the report: “[O]ur revised base case scenario assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place.” In other words, they contend that a certain contentious political faction whose name begins with an R will find some way of extending these tax cuts to hold hostage some necessary expenditure, just as they did in 2010 over extending unemployment benefits. And this is on top of the “calculation error” that the administration cited when challenging the S & P report.

Now, I have never been a fan of the Bush tax cuts. The ostensible purpose of them was to return a projected surplus to the American taxpayer. The sequel of events shows that such a move was unnecessary; two unfunded wars, a major expansion of Medicare, and a general failure to produce sustainable economic growth did an adequate job of mopping up the surplus. In fact, I think the only good thing about the Bush tax cuts was the expiration date. Even so, the debt ceiling crisis gave both parties the strength to do what had to be done to prevent a default. The deal that was reached enjoyed votes in favor from both sides in Congress. Likewise, I think the next time the Bush tax cuts fall due to expire there will be enough urgency left in the system to allow it to happen. After all, even with the deficit cutting measures and the bipartisan panel that went into the current debt ceiling deal (of course, I should point out that Congress is itself a bipartisan panel and normally it can’t agree on what day of the week it is), the deficit will still be big enough to cause concern. As such, I hope, and I think it is likely, that enough members of Congress will yield to economic reality to give the Bush tax cuts a dignified burial.

Even Grover Norquist, architect of the “no higher taxes” pledge that virtually all Republican representatives have signed, has said that the expiration of the Bush tax cuts will not violate the pledge. And if even the crusader of the anti-tax movement is willing to offer that concession, there must be something in it. And Nouriel Roubini described the U.S. situation as “manageable” because unlike most other advanced countries, we have plenty of room to raise taxes. Taxes as a percentage of GDP are much lower than in, say, most of the countries of Europe, and are also much lower than the historical average. And, as I have pointed out before, there is virtually zero correlation between tax levels and real economic growth, at least at the levels of taxation that have prevailed through recent U.S. history.

That said, this ratings downgrade is ultimately a small thing that looks like a big thing (unlike the debt ceiling deal, which was a big thing that looked like a big thing). The Federal Reserve has already come out with a notice that it will not affect risk capital decisions, and as long as Fitch and especially Moody’s do not pile on to avoid feeling left out, the impact of this decision should be muted apart from what I predict to be an interesting next week.

So, one is left to wonder why S & P did it. Perhaps they are of a political mind, hoping to get some resolution by pressing the issue. Perhaps they want to be the first ones who called the downgrade if the situation in Congress degenerates further. Perhaps they have no ulterior motives and are genuinely concerned about the current political situation.

The bigger question, though, is whether we should care. I doubt it is a good thing that our financial system has evolved to the point that one unelected, unappointed, unscreened analyst has the power to cause so much chaos despite the fact that he has done nothing more than dropping one letter. I think the better approach for market participants is to learn to ignore ratings agencies. If ratings agencies ever had a purpose, they abandoned it around when they decided to rate subprime securities that didn’t even have a full business cycle of data to work with, and now that they have downgraded a riskless debt that both parties are willing to set aside their deeply held beliefs in order to prevent the default of, Standard and Poor’s has hammered what should be the final nail into its eventual irrelevance.

A credit rating is not a magic talisman. As my readers well know, I have recommended several junk bonds on this website before, and at no time did I require a ratings agency’s stamp of CCC on it to let me know what I was taking on. I can do my own research, and a ratings agency’s opinion is always second — and a distant second — to my own opinion. And now that S & P have taken this action, I feel justified in this method. I still consider the debt of the U.S. Treasury safer than the debts of Automated Data Processing, Exxon, Johnson & Johnson, and Microsoft, because none of those four owns a printing press. And yet S & P would have us believe that the opposite is true, because those four companies are now rated higher than the Treasury. And yet everyone still knows, having seen last week, that no member of Congress will genuinely risk a default because secretly or openly they all know that a U.S. default will make Lehman Bros. look like a papercut.

So, I think it is time to move on from credit ratings. They are interesting, easy to understand, but they are ultimately not useful, and tend to retard analysis rather than encourage it. During the Goldman Sachs hearings in May of 2010, the senators made much of an email suggesting that Goldman Sachs, in peddling its subprime deals, should focus on “ratings-based buyers,” rather than the hedge funds that are sophisticated enough to know what’s going on. And anything that is attractive to a lack of financial sophistication is unattractive to me.

I fear, at least for next Monday, that my views on ratings agencies may not be taken up by the broader market. The two most important people in the United States are President Obama and Ben Bernanke, and not necessarily in that order. But if we continue to be thralls to the ratings agency system, the third most important person in the United States will be Raymond McDaniel. Who, you may well ask, is Raymond McDaniel? Why, he is the CEO of Moody’s, who can approve or veto a matching ratings cut.

So, this ratings downgrade may push the political system into taking some necessary deficit reduction action, and I hope it will put revenue raises back on the table. But in terms of actionable information, I find that it contains none at all. I only hope that market participants next week and thereafter agree with me.


CSG Systems – Servicer to the Greats

July 28, 2011

There are many routes to becoming a successful company. The standard one is to provide a desirable product to customers at a profitable price. However, another highly effective approach is to provide an essential service to other companies that are engaged in the above action. CSG Systems International (CSGS) has adopted the latter approach, by handling the customer care and billing services for a number of cable and direct broadcast satellite markets, including such giants as Comcast and Dish Network. Last year, the company also acquired Intec, a U.K. based firm that primarily services the telecommunications industry.

What drew my attention to CSG Systems, though, is its high earings power relative to its price. Setting aside certain nonrecurring events, the company has an impressive earnings yield of over 16% based on 2010 earnings, once its excess cash position has been taken into account.

CSG’s four largest clients are Comcast (24% of 2010 sales), Dish Network (18%), Time Warner (12%), and Charter (10%), although with the Intec acquisition these percentages are expected to decline over time. CSG has historically been successful in renewing contracts, and last year extended its contract with Dish Network in part through 2017. Even so, the degree of concentration of customers is a risk factor that should not be ignored. The Comcast contract in particular expires at the end of 2012. The Comcast contract was last extended in 2008 for four years. The contract with Time Warner expires in March 2013, and the contract with Charter Communications expires at the end of 2014.

Turning now to the figures, I mentioned earlier that the company has an excess cash position. I calculate excess cash as total cash and investments minus the extent to which current liabilities are uncovered by noncash current assets. According to its latest balance sheet, CSG Systems has $167 million in cash and investments, $195 million in tangible current assets (consisting of accounts receivable and income taxes receivable), and $209 million in current liabilities. As a result, the company has $153 million in excess cash. Subtracting that figure from CSG’s market cap of $585 million as of this writing, we get a figure of $432 million for the market value of the company’s operating assets.

In terms of earnings, I spoke earlier of certain nonrecurring expenses that I will be adjusting for. These would be $12 million in charges relating to the acquisition of Intec, and $20.5 million relating to the company switching its data center to a new provider. The data center switch also produced $15.5 million in expenses in 2009.

So, in 2010, revenues were $549 million, operating earnings were $74 million, but reversing the above nonrecurring charges and taking into account a $14 million foreign currency loss brings the figure to $93 million. The company also incurred $23 million in excess depreciation. This produces a total free cash flow from operations of $116 million. Interest expense that year was $7 million (although CSG Systems did issue a significant amount of debt relating to the Intec purchase, so future interest expenses will be higher). This produces pretax free cash flows of $109 million, which, at a 35% tax rate, produces an after-tax cash flow of $71 million. Based on the above figure of $432 million for the market value of the company’s capital assets, that produces a free cash flow yield of 16.4%, which I consider very attractive.

I should note that this figure differs from the company’s reported earnings for 2010 primarily owing to the noncash amortization of the company’s convertible bond issue, a loss taken on bond repurchases, the company’s interest income, and of course the nonrecurring expenses previously mentioned. However, it is what I consider to be a more reasonable estimate of the company’s sustainable earnings power.
The first quarter of 2011 is shaping up well. Sales were $183 million, operating income was $24 million, excess depreciation and amortization was $10 million, producing $34 million in operating cash flow. Interest expense were $4.3 million, leaving $29.5 million in pre-tax free cash flow, or $19 million in after-tax free cash flow. Obviously, one should not make too much of a single quarter’s earnings, but CSG Systems is not a seasonal company and this figure is at least consistent with (higher than, actually) the company’s historical ability to generate free cash flows.

In terms of debt, the company has outstanding $197.5 million in term loans at LIBOR plus 3.75% due 2015, $150 million in 3% convertible loans due 2017, and $25.2 million in 2.5% convertible loans due 2024. The conversion price for the 2017 loans is $24.45 and for the 2024 loans it is $26.77. As we have seen, interest is covered by cash flows nearly eight times based on the first quarter of 2011’s results and therefore the debt looks fairly safe. The price of CSG Systems as of this writing is $17.88. However, if we apply a 10x multiple to the company’s earnings, and estimate earnings power at $70 million based on the 2010 figures, we get a value for the firm of $853 million ($700 million for the earnings power plus $153 million in excess cash). Based on the 32.9 million fully diluted shares, this translates to a price of $25.89, so there may be some dilution from at least the 2017 bonds.

CSG Systems reports second quarter 2011 earnings on August 2. Analysts are estimating that earnings will be 55 cents, marginally better than last year’s second quarter earnings of 53 cents. I will not comment on analyst estimates, but it is probably worth keeping track of the date.

So, with CSG Systems we have a company with strong earnings power that has the stability of long-term contracts behind it. The customer concentration is a risk factor, although the Intec acquisition has diversified the company’s revenue sources. As long as the company is capable of renewing its major contracts I anticipate that is earnings power will continue, and as it trades at a remarkably low multiple to free cash flow, I can strongly recommend CSG Systems as a candidate for portfolio inclusion.