Fructivore Investments

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 1/10^th 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.

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.

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 ValueForum.com 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.

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.

http://seekingalpha.com/article/290409-dst-systems-hidden-portfolio-assets-make-a-compelling-opportunity

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).

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.

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.

I have to say that I’m surprised how quickly things happen. My comments on the Real Mex bonds, which have been up for barely two days, seem sort of quaint now that the major ratings agencies have issued a cut on the grounds that the company has announced missing an interest payment. As I stated in my previous commentary, I was more or less sure that there would be default, bankruptcy, and restructuring, but I was not sure about the timing. Of course, my idea that there would be the “sweetener” of some extra coupons before the big D (default) is now out the window.

At any rate, the company’s historical free cash flow to the firm, if it can be maintained through this process (and companies in bankruptcy often surprise people with how well they can accomplish this feat), is likely to support the ultimate value of the bonds, and of course the cash interest . However, as things stand this value will probably be realized after a bankruptcy/restructuring workout and not before, and as I said before the price action in the meantime will be difficult to predict.

Much as I enjoy the opportunity to test my hypotheses, I am surprised to see a chance to test this one so soon. I will add that the bonds were trading at around par a little over a week ago, so it’s not just me who was surprised.

UPDATE: On the night of July 20, 2011 the company informed the major ratings agencies that it did in fact miss the latest interest payment on the bonds. As I stated below, the cash flows to the company are sufficient to support the ultimate value of the bonds, but now that value is likely to be realized after a bankruptcy process. I did predict that default/restructuring/bankruptcy was more or less inevitable for these bonds, but I am surprised that it happened so soon. Obviously, that bit about the possible “sweetener” of some extra coupons in the article below no longer applies.

As my readers may recall, I have been interested in high yield debt as well as equity. However, opportunities in this area have been somewhat lacking in the current market as compared to, say, April of 2009, and I have been finding enough equity opportunities to keep me busy. Nonetheless, I find high yield opportunities to be quite enjoyable and suited to my investing style, and I would hate to abandon my favorite asset class.

One interesting opportunity I have found is the bonds of Real Mex, a private company that operates a flock of casual Mexican dining restaurants mainly in California. The company owns a total of 181 restaurants, most of which consist of the three restaurant chains of El Torito, Chevy’s, and Acapulco, which are the largest chains of Mexican full service casual dining in California. The company’s free cash flow to the firm has been declining, but for now the interest of the bonds in question is covered. However, it is likely that Real Mex would benefit from a bankruptcy or financial restructuring, and these bonds would be expected to hold their value in either event. Robustness to bankruptcy is essential to a high yield investor, and indeed to any bond investor, if they would admit it.

The bonds in question are $130 million in senior secured bonds due January 1, 2013. The bonds have the distinctly unsubtle coupon of 14%–normally one might expect a high yield to come from a significant discount to par, but in this case the bonds themselves have the high yield on their face. Actually, at present the bonds also do trade at a discount, and based on the current price level of 92.50 the yield to maturity is 20.2%. Real Mex is required to use any money that the bond indenture defines as “excess cash flow” to offer to repurchase these bonds, but there was no such cash flow available in 2010.

These bonds rank behind a revolving credit facility and letter of credit agreement; the credit facility has a maximum availability of $15 million and as of the latest quarterly filing there was $4.6 million drawn on it. The letter of credit facility is apparently unused, has a maximum draw of $25 million, and has $8.4 million available on it as of the latest quarterly filing. This credit facility falls due in July of 2012, and bears a variable rate plus a fixed margin, which as of the latest filing totaled 9.25%.

Real Mex’s other major debt consists of an unsecured debt owed, at least in part, to the company’s owners. This debt bears an interest rate of 16.5%, but it is payable partly in kind. As this debt is unsecured, it ranks lower in priority than these bonds.

The large interest payments are presently covered by free cash flow to the firm, as I shall calculate below. Sales and free cash flows are declining, but the rate of decline appears to be slowing. However, the large interest requirements are consuming the bulk of the company’s free cash flow, making it difficult for the company to chip away at its debt burden. As such, I am skeptical of the company’s ability to refinance this bond issue, or perhaps even the credit facility if there is a large balance on it when it falls due. However, the existence and persistence of positive free cash flow on the company level would suggest the viability of a bankruptcy or other restructuring.

Turning to the figures, in 2010 sales were $478 million, reported operating income net of impairments was $6.5 million, plus excess depreciation of $18.3 million produces a total of $24.9 million in free cash flows to the firm. Interest accrued that year was $28.8 million, but $4.6 million of that was paid in kind, and interest actually paid that year, according to the statement of cash flows, was $19.4 million.

In 2009, sales were $501 million, operating earnings net of special items were $0.7 million, and excess depreciation, neglecting a massive debt discount amortization, was $27.1 million, producing a total of $27.8 million. Interest expense that year was stated at $46 million, but $25 million of that amount was the debt amortization referred to above, and $1 million was paid in kind. Actual interest paid that year was $15.7 million according to the statement of cash flows.

In 2008 sales were $550 million, operating earnings net of impairments were $9.7 million and there was excess depreciation and amortization of $4.4 million, producing free cash flow to the firm of $14 million million. Interest accrued during that period was $20.5 million, but actual interest paid according to the statement of cash flows was $17.8 million. The first quarter of 2011 is indicating further diminution in earnings, with sales of $116 million as compared to $120 million for the same quarter last period, and $5.6 million in free cash flows to firm rather than $7.9 million in the same quarter last year.

So, the interest on the bonds in question is $18.2 million per year, and on the credit facility, if fully drawn, there would be an additional $1.4 million, plus whatever might be drawn on the letters of credit, although there may be some restrictions on drawing the full amount. At any rate, the current level of cash flows covers the potential interest requirements by approximately once, which is hardly a margin of safety, and which brings into question the possibility of refinancing no matter what interest rate is offered.

However, if we assume that, say, $20 million is a reasonable estimate of the firm’s free cash flow in future, we can assess the value of a restructured firm. The beauty about contemplating a Chapter 11 is that we are permitted to play with the capital structure to render it more reasonable. Allowing for an interest coverage ratio of a more reasonable 3x, that would allow Real Mex to allocate $6.66 million to interest. At a more reasonable interest rate of 9%, this would allow for a bond issue of $74 million. The remaining free cash flow, after, say, 40% in taxes, would leave $8 million in free cash flow to equity, which, if capitalized at 10x, produces an equity value of $80 million. Thus, it would be reasonable to assume that the entire value of the firm would be $154 million. This compares favorably with the current value of the bonds, $120 million, plus the maximum of $15 million in borrowings on the line of credit (letters of credit are used to finance large purchases and not for general business purposes, so I assume they are unlikely to be significant).

As a result, the holders of the bonds may receive some more coupons, which would be an attractive sweetener, with a current coupon of 15.1%, as I do not believe the main crisis for the company will arise until the bonds come due for refinancing. Even so, the main feature of these bonds is that in the event of bankruptcy or a similar workout, the existing bondholders are likely to accede to the ownership of the bulk of the securities the reorganized company, whether in the form of debt or equity. And as I have calculated,  the value of the reorganized company stands a good chance of ending up being greater than the current price of the bonds. Of course, that is at the endpoint of a bankruptcy that may be protracted, but it is nonetheless an exciting opportunity that serves to increase the safety of these bonds beyond what the 20% yield would imply. Even so, there may be a long period of market chaos, low prices, and illiquidity to ride out, although a prepackaged bankruptcy, which takes only a few months, is also a possibility. I should also note that Real Mex’s current owners acquired it as the result of a previous equity-for-debt swap in November of 2008, although since the financial world was coming to an end around then, this occurrence should not be surprising.

These bonds offer a 20% yield in the event that they are refinanced and ultimately paid off, and have as their source of safety the fact that even in bankruptcy the bonds will ultimately retain their value. Accordingly, enterprising fixed income investors who are not afraid to stare down a Chapter 11 will find these bonds an attractive candidate. And, of course, any further reduction in price in the near future will make them more attractive.

Acxiom, a company that is very difficult to pronounce, is a large marketing consulting firm, with a specialty in data mining. The firm uses customer data gathered from clients, and its own proprietary database, to develop a multi-channel marketing strategy (e-mail, web advertising, mobile advertising, and direct mail, among others) for clients. Acxiom claims to have the largest single-owner consumer database in the United States, which it believes to cover almost all households in the United States, and the company also has a presence in Europe, China, Australia and New Zealand, and Brazil. In other words, these are the people who spy on your shopping preferences for targeted marketing campaigns.

In Acxiom’s latest 10-K, it claims that most of its client base is Fortune 1000 companies in the financial services, insurance, information services, direct marketing, media, retail, consumer, technology, automotive, health care, travel, and communications industries. The company normally works under contracts of at least two years, and claims to have a high retention rate, although what constitutes “high” is unstated.

Acxiom claims to be a market leader in the United States, and competes against other large companies as well as smaller firms that have a more limited range of services. The competitive landscape in Europe is similar. In Australia much of the competition is local, and in Brazil the company has no direct competitors, but it would seem that some local competitors are cropping up and other international firms may be encoraching as well. The company has been engaging in numerous mergers with some of its smaller competitors, and it admits in its own filings (which are in full view of the Department of Justice and America’s small army of antitrust lawyers) that it is concerned about several of its single-service competitors banding together to provide an array of services that might compete with Acxiom itself.

Turning to the figures, Acxiom has a significant amount of excess cash on the balance sheet. The company has $207 million in cash and equivalents, and a total of $391 million in tangible current assets. Current liabilities total $229 million, which leaves a difference of $162 million, which is the amount of excess cash. This, when applied to a market cap of $1.04 billion, leaves $880 million as the market value of the company’s productive assets.

In terms of earnings, sales were $1160 million and reported operating income (net of a goodwill impairment) of $111 million. The excess of depreciation over capital expenditures (including capitalized software costs and data purchases) comes to $69 million, producing operating cash flow of $180 million. Interest expense comes to $23 million, which leaves pre-tax cash flows of $157 million. The company’s tax rates have been hovering around 40% for the last few years, and if we apply that, we have a free cash flow to equity of $94 million. This gives us a price/free cash flow ratio of 9.36.

I should point out that fiscal year 2009 and 2008’s earnings (Acxiom’s fiscal year ends in March) include restructuring charges of roughly $30 million and $40 million respectively. I should point out that the above calculation treats excess depreciation as taxable, while it is untaxable under the tax code. If it received the correct tax treatment, 2011’s earnings would have increased by $28 million. However, as we see, the amount of excess depreciation has been declining over time, and the present value of future excess depreciation may not be very large.

The source of the excess depreciation is Acxiom’s acquisitive nature; the company’s historical capital expenditures apart from acquisitions are inadequate. Normally, I assume that acquisitions neither add value, nor take it away (apart from investment banking fees). However, companies that use acquisitions to accomplish capital expenditures that they would ordinarily make outright can complicate this, by giving us a reason to treat mergers as capital expenditures. However, if Acxiom is engaging in mergers to contain the competition, they may find it unnecessary to replace the target company’s assets at the same rate that they depreciate. Furthermore, the goal in this valuation is trying to arrive at Acxiom’s sustainable earnings power, and although future acquisitions may be part of Acxiom’s business strategy, I cannot project the frequency and size of the company’s future deals. As such, the best I can do is present the data as I always have, with the above caveats.

So, we see from the above that, at least for the present year, Acxiom has stabilized after a series of earnings decline. Obviously, with discretionary income under pressure, the profit opportunities for a marketing company can similarly be limited, hence the overall decline in sales and profits. However, with the restructuring, profit margins seem to remain stable. Analysts are projecting a modest increase in sales and earnings in the coming couple of years (of course, that is what analysts do), and if the company has stabilized at this price, the company offers a robust yield on the market value of its capital assets.

However, the issue of Acxiom’s stabilization is not a given, considering the continued pressure on the consumer, even in Australia, China, and Brazil, which are generally considered to be showing stronger growth than in the US and Europe where the rest of Acxiom’s operations are. Accordingly, although this company is an enticing speculation, and would also be attractive if the price were to decline significantly. Even so, under the circumstances I cannot describe it as a pure value play.