Fructivore Investments

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.

The comparisons between Wall Street and a casino predate the current financial situation by decades. I, of course, have an interest in casinos of all kinds, as shown by my approval of various Indian casino bonds. And now, I have found an enticing opportunity in a casino supplier.

Gaming Partners International (GPIC) is the largest supplier of casino products. Its biggest product by far is casino chips, which represent roughly 2/3 of total sales. The company’s premier product line is chips embedded with RFID devices to enable easy counting and tracking, and of course to identify counterfeit or stolen chips with ease. Gaming Partners is the exclusive licensee of the major technology behind these chips, although the patent does expire in 2015. The company also holds several other patents pertaining to chip production.

The firm’s other product lines include quality playing cards, casino furniture and table layouts, dice, and accessory products like card shufflers and, interestingly enough, a device that can be integrated into casino tables that blows the smell of customers away from dealers (a vital service, as most casinos allow smoking).

The company reports that its future growth opportunities may be constrained, as new casino openings, which require a large consignment of chips, are likely to diminish in these uncertain times, and of course casinos are, like anyone, attempting to stretch out the lifespan of their current capital allocations. It is unfortunate, then, that playing cards, which have a lifespan of twenty-four hours, or dice, which have a lifespan of only eight, do not represent a larger proportion of the company’s total sales than the 8% and 4% respective proportions that they do now. However, in the first quarter of 2011 the company achieved very attractive results from a large contract from the Galaxy Macau casino, which opened in May of this year.

Turning now to the figures, Gaming Partners’ balance sheet is highly attractive. Out of a market cap of $59 million, the company boasts $30.7 million in cash and securities. The company’s noncash assets total $16.3 million. The current liabilities include $7.1 million in debts that fell due in June and a further $6.7 million in accrued liabilities, mainly salary. Taking these away from the cash position leaves $16.9 million. The other current liabilities consist of $2.8 million in accounts payable and $3.2 million in customer deposits (meaning that the Gaming Partners already has the money and now has to perform on its contracts to recognize the income). At any rate, these current liabilities are well covered by noncash current assets, meaning that the remaining $16.9 million in cash and securities may be considered excess. This means that the market value of Gaming Partners’s capital assets is $42 million.

In terms of income, Gaming Partners’ sales for fiscal year 2010 were $59.9 million. Reported operating income was $6.4 million, and excess depreciation was $1 million, producing operating cash flow of $7.3 million (due to rounding). After interest expense of $23 thousand, we are left with $7.3 million in pretax free cash flows to equity, or $4.8 million after estimated taxes of 35%. This represents a free cash flow yield on capital assets of 11.4%. Of course, it should be noted that this calculation treats the excess depreciation as taxable when legally it is not. This would serve to raise the free cash flow for the year by $0.3 million.

In 2009, sales were $49.5 million, and operating income (net of a goodwill impairment) was $2.8 million. Excess depreciation was $1.4 million, producing operating cash flow of $4.1 million. After interest expenses of $102 thousand, we have $4 million in pretax cash flow, or $2.6 million after taxes.

In 2008, sales were $60.5 million, operating income (net of impairments) was $5.5 million, excess depreciation was $1.1 million, producing operating cash flow of $6.6 million. After interest of $137 thousand, we have pretax cash flow of $6.4 million, or $4.2 million after taxes.

In 2007, sales were $58.8 million, operating income was $0.9 million, and in this year capital expenditures exceeded depreciation by $0.2 million, producing operating cash flows of $0.7 million. After interest of $190 thousand, the company produced $0.5 million in pretax income, or $0.3 million in after tax income.

In 2006, sales were $74 million, and operating income was $8.5 million. Capital expenditures were high this year, exceeding depreciation charges by $2.8 million, producing operating cash flow of $5.7 million. Interest expense came to $175 thousand, leaving $5.5 million in pretax cash flow, or $3.6 million in free cash flow.

It does seem that Gaming Partners has been able to reduce its capital expenditures in accordance with the current level of business. Furthermore, the $7.1 million in current debts I mentioned above constitutes the last major piece of debt that the company has outstanding, and SEC filings do not suggest any intention to issue new debt. There is a further complication in the form of expiring patents and licenses, although I should point out that the company initially valued its intellectual property at only $915 thousand, so it may be that the company’s profitability may spring from other advantages than the patents.

At any rate, if the current level of capital expenditures can be maintained, or would increase only in response to increased demand, Gaming Partners offers a free cash flow yield that makes it an attractive candidate for portfolio inclusion.

In my last article at seekingalpha.com on the dramatically low price of Best Buy (BBY), it was pointed out to me by a commenter that I have a nonstandard definition of operating cash flow. Specifically, when calculating a company’s operating cash flow, and consequently free cash flow, I ignore changes in working capital as a source or sink of cash.

I do not recall consciously choosing to ignore this category of the cash flow statement. Obviously ignoring versus not ignoring it can produce significant divergence in a company’s free cash flow. But, having had this tendency pointed out to me, I naturally examined the literature and my own investment philosophy to determine whether my view of changes in working capital is reasonable. I concluded that changes in working capital can often, but not always, be set aside.

The first reason why changes in working capital can be set aside is that my goal in performing a valuation is to arrive at a reasonably conservative estimate of a company’s earnings power, and changes in working capital are often temporary. An increase in inventory in one quarter can be offset by the sale of inventory in the next quarter, and payables incurred in one year may be paid off in the next. In consequence, we have not lost the cash invested into working capital in the first period, but only the interest on it. By according too much attention to changes in working capital, the earnings power of a company is made to look more volatile than it is. Of course, Ben Graham’s advice in his Security Analysis is to perform a multi-year analysis rather than placing undue emphasis on the performance of a single year or single quarter. This may resolve this matter without recourse to more complicated modes of analysis.

Even without taking reversibility of working capital changes into account, some categories of changes in working capital are inherently nonrecurring. Changes in working capital in one year are often in no way tied to the changes that occurred last year, or will occur next year. If, say, a retailer makes a deal with its suppliers that it can buy inventory on 90 days’ credit instead of 60 days’, this will produce a dramatic influx of cash in the form of increased payables. However, it would be unwise to infer from this that in the next accounting period, the company will be able to expand its payables to 120 days. Therefore, this source of cash flow would be ignored in calculating a company’s long term earnings power (although it would be taken into account in calculating a firm’s excess cash, obviously).

The second reason I choose to set aside changes in working capital is that working capital is not consumed in the manner that fixed capital is. If, for example, a business invests $3 million in a piece of machinery that has a lifespan of three years, then at the expiration of three years the business is left with a pile of scrap metal. If, however, a business invests $3 million in inventory and receivables, and spends three years selling inventory, collecting receivables, paying down payables, and (hopefully) having cash left over, then at the end of the three years it should have $3 million in working capital, apart from the usual vagaries of obsolete inventory, bad debts, and so on. Working capital, then, if managed correctly, does not wear out. That is why there is generally no depreciation allowance given for it. And, as I said above, an increase in working capital in one year does not imply that there will necessarily be a similar increase in working capital in any future years. This is not true for fixed capital, which requires continuous replenishment. That is why I count excess depreciation as a source of cash flow, and capital spending in excess of depreciation as a cash sink.

This brings me to my third reason to set aside changes in working capital: the distinction between maintenance and growth capital. Ben Graham reminds us that a company’s earnings are only true profits if the expenditures necessary to maintain the company’s earnings power have been made; otherwise a company is merely liquidating itself in slow motion. I have always been skeptical of projecting a company’s growth rate; I attempt to find companies that would be attractively priced even if there is no growth at all, or even shrinkage. This conservatism leads me to assume that all fixed capital investments are required to maintain the current level of earnings power, not to produce growth in future periods.

However, the argument for this assumption is weaker in the case of working capital. Despite the theoretical nonrecurrence of changes in working capital, it would be unrealistic to expect a business with $500 million in sales to have the same level of working capital as it did when sales were $50 million. As a result, we would expect such a company to have made significant investments in working capital over the years, which would constitute a cash sink in the accounting periods leading up to it. This cannot be explained away as being potentially reversible in future periods; even if there is volatility in levels of working capital from the beginning to the end of this process, there is still an inevitable upward drift.

However, as we are told in Mulford & Comiskey’s Creative Cash Flow Reporting, a valuable resource that focuses on ferreting out a company’s sustainable cash flow from its earnings and cash flow statements, a company’s working capital is expected to rise and fall alongside the size of a company’s business. Therefore, ceteris paribus it will be increasing for growing companies, flat for stable companies, and declining for shrinking companies. In other words, investments in, and drawdowns of, working capital would be generally associated with increases and decreases in a firm’s level of activity. I.e. investment in working capital is growth capital.

This conclusion, which I think is the strongest defense of setting aside changes in working capital, also allows us to zero in on the key vulnerability of my approach. If there is an increase in working capital that is not associated with an increase in a business’s level of operations, but is instead due to lower margins, decreasing efficiency, and so forth, then ignoring changes in working capital can lead an investor into making fatal mistakes. However, I would say that more often than not this occurrence can be identified by examination of a company’s financial statements, in areas such as profit margins and movements in incremental sales versus incremental working capital although the latter should probably be smoothed over a number of years.

As a result, I can say that my approach towards setting side changes in working capital when calculating a business’s free cash flow, although nonstandard, does not generally introduce fatal inaccuracies in my estimates of future earnings power. Provided that a company does not invest in additional working capital inefficiently, investments in working capital would generally fall under the category of nonrecurring, or growth capital, both of which would fall out of our estimation of theoretical long term earnings power. And having performed this investigation in my investment methods, I have found a significant investment metric, incremental sales versus incremental working capital, to examine in greater details in future valuations when changes in working capital have been significant.

They do say that value opportunities are usually found in small, out of the way places. I have found this to be true, but sometimes even large companies we’ve all heard of can hold significant value. Best Buy has a free cash flow yield of roughly 15.8% as of this writing, once its excess cash and investments are taken into account, and free cash flow has been remarkably stable over the last few years. The company is looking to streamline operations and push out its Best Buy Mobile stores, which do only mobile products and services and which are based on a model that seems to be producing positive results in the UK. Hopefully this will offset any loss in revenue from the traditional entertainment and consumer electronics sections.

For my full opinion on Best Buy, please visit

http://seekingalpha.com/article/274950-best-buy-great-cash-flow-solid-earnings-inexplicably-low-valuation

AMCON Distributing Co. is a wholesale distributor of consumer products, which constitutes the bulk of its business, and also runs fourteen health food stores. The wholesale segment is the 9th largest in the country and provides mainly tobacco products, but also candy, beverages, paper products, health & beauty, frozen foods, and institutional food services. It has five distribution centers in Illinois, Missouri, Nebraska, and both Dakotas and serves mainly convenience stores.

Cigarettes represent roughly 72% of AMCON’s wholesale revenues. In its financial reports the firm claims to have efficient operations and economies of scale, but I’m not sure I see a moat. The current free cash flow yield to common shareholders as normally calculated is an amazing 20.5%, although there is a convertible preferred issue with a conversion price that is well below the current price, and the resulting dilution must be taken into account. Even so, I calculate that AMCON is trading at a large discount to its fair value. Furthermore, operating trends at AMCON are positive, although I would not care to project these current trends as a guide to the future. Sales have increased 11.5% for full year 2010 as compared to 2009, and although gross margins slipped, free cash flow margins remained flat owing to lower interest expenses. Furthermore, inventory turns increased and the cash conversion cycle shortened.

Turning to the figures, in 2010 sales were $1011 million, reported operating income was $15.5 million, capital expenditures in excess of depreciation were $.5 million, producing operating cash flow of $15 million. Interest expense was $1.5 million, leaving pre-tax income of $13.5 million and after-tax income of $8.9 million. Deducting $.3 million in preferred dividends leaves free cash flow to common shareholders of $8.6

Furthermore, inventory turns improved and the cash conversion cycle shortened, based on balance sheet figures at the end of fiscal years 2008 and 2009. In 2009 there were 24.3 inventory turns, and in 2010 there were 29.3. The cash conversion cycle in 2010 was 17.8 days, while in 2009 it was 20.7 days, although inventory levels at the close of 2008 did appear somewhat high.

2011 is shaping up well as well. Sales were $462 million as compared to $474 million for the first two quarters last year. However, margins were slightly improved, although perhaps not by a significant amount. Operating income was $6.3 million versus $6.2 last year; excess capital expenditures were $.1 million as compared to $.4 last year, so operating cash flow rounds to $6.3 million versus $5.8 million last year. Interest expense was $.6 million versus $.8 million last year, leaving $5.6 million in pretax income, versus $5.1 million last year. After estimated taxes, we have $3.5 million now, and $3.1 million same time last year. After preferred stock accruals, we are at $3.3 million in free cash flow to common, versus $3 million for the same period last year, which is encouraging.

AMCON has also been chipping away at its debt at a fast rate, having reduced debt from $38 million at the end of 2008 to $20 million as of the latest 10-q. However, debt levels are presently higher owing to the recent acquisition of the distribution assets of LP Shanks for $16.4 million.

In terms of the convertible preferred shares I mentioned earlier, there are two issues of preferred shares, the first consisting of 82481 shares that convert at $30.31, for a total of $2.5 million, and 81135 more that convert at $24.65, for a total of $2 million. Both issues have a dividend payout of between 6 and 7 percent. As the company now trades at $71.40, and still appears cheap based on an earnings multiple of roughly 5x, the conversion premium must be taken into account.

If we apply a multiple of 10x, which I think is a reasonable multiple for this company, we would have a market cap of $86 million. If we neglect the preferred stocks, $86 million divided among 590 thousand outstanding shares would produce a price of $147. However, if the shares are converted, the total shares outstanding increases to roughly 770 thousand, and the price target goes to $115. Despite the high conversion value, the preferreds are still redeemable at a small premium over face value at the option of the Company. However, the two series of preferred shares are respectively owned by Chris Atayan, the CEO, and an unidentified financial institution that placed Mr. Atayan on the Board of Directors, so it is not likely that outside shareholders will benefit from the redemption privilege.

I have to reserve my final thought for liquidity. The daily volume of this stock is roughly 1500 shares. Many days there are only one or two trades, and there are days where the company does not trade at all. This is not uncommon for micro-cap stocks, but I have taken the position, in discussing other microcaps, that liquidity is not as important to the long-term investor, because as Ben Graham noted in Security Analysis, such an investor should rarely have to sell in a hurry. Besides, the events of 2008 have shown that liquidity is often an illusion anyway. Damodaran, in his useful toolkit Damodaran on Valuation, does make it clear that there is a yield premium for illiquidity observed in the market. But, as value investors, who have the patience to wait for our prices, we can follow the advice of Ben Graham and not worry about the liquidity that we have little need for, and thus collect a premium that has no effect on our activities and costs us nothing.

Therefore, I can say that Amcon is trading at a significant discount to reasonable valuation, even taking the convertible preferred stock into account. A such, I can recommend it as a portfolio candidate for investors who can tolerate illiquidity.

It may be Stockholm syndrome, but I do think some of the criticism of Goldman Sachs regarding its subprime deals is overblown. I don’t deny that there have been apparent violations of the securities laws in terms of disclosures, but the central issue that upset Senator Levin and Matt Taibbi so much has not seemed to be the disclosure violations, which have the air of “technicalities” about them. Their major criticism seems to be that Goldman Sachs was selling synthetic mortgage CDOs despite the fact that the firm was perfectly aware that the securities would inevitably blow up. However, I think this is the least troubling aspect of Goldman Sachs’s subprime dealings, and not even worth making a rule against.

Senator Levin’s constant refrain in the Congressional hearings on Goldman Sachs’s last year was that Goldman Sachs was selling securities that it was secretly betting against. Specifically, he charged that the bank issued synthetic CDOs to clients without disclosing that Goldman Sachs was retaining a short position on the subprime mortgage market because it believed the securities to be a time bomb that it wanted off its books as soon as possible.

I do not find this a disturbing revelation in any way. As a value investor, and really, as any kind of investor, I consider it the fundamental prerogative of any market participants to make the bets they believe will produce a profit. Nor do I consider it necessary, or even productive, for market participants to have to disclose their investment thesis to the counterparties. The basic model of financial markets is (more or less) willing buyers and willing sellers coming together and trading at a price they have agreed on. This freedom to take positions is central to the functioning of financial markets (and that is why I found it so troubling that former SEC chairman Cox decided to outlaw short selling in financial stocks during the subprime crisis).

Here, Goldman Sachs is being criticized for having a view on the subprime market, which happened to be a correct one, and for keeping that view to itself in constructing these subprime deals. However, Goldman Sachs’s view was only that: a view, an opinion. The people who bought these deals had access to the same information that Goldman Sachs did, and reached the opposite conclusion, or at least concluded that the interest received in the deal compensated them for the risk. The key point, in my view, is that a participant’s opinion alone does not affect the future performance of the deal, and therefore there is no need to disclose it. After all, I don’t disclose my investment thesis to the people I buy stock from (and in fact I couldn’t because the impersonal nature of brokerages and exchanges means that I don’t even know who they are).

However, buying and selling stocks on the secondary market is perhaps not the same as being a bank that sponsors a synthetic CDO. The latter is required to disclose the material facts relating to the issue. The question, then, is whether Goldman Sachs’s opinion of the subprime market, which it has chosen to express by wanting to be short, is a material fact. The question of what is a material fact is specific to the circumstances. The general formulation is that a material fact is any fact where there is a substantial likelihood that the fact, if disclosed, would assume actual significance in the purchaser’s decision to buy or not.

As I stated above, the mere market view of Goldman Sachs is an opinion, not a fact. This opinion alone cannot affect the future performance of the deal, or allow the firm to reap profits from the purchaser in a manner that has not been previously disclosed. As a result, even if the existence of Goldman Sachs’s opinion is considered a fact, it would not qualify as a material one.

But Goldman Sachs did more than develop an opinion and keep quiet about it. Goldman Sachs sought to express that opinion with a short. The Hudson and Timberwolf deals seem to be, in essence, an attempt by Goldman Sachs to clear the credit risk of its long positions in subprime mortgages by transferring the risk to whoever would be persuaded to take it on. Now, of course Goldman Sachs could offloaded the risks with credit default swaps without creating a synthetic CDO, as the market at the time was not completely frozen. But the successful issuance of a synthetic CDO has the same risk transference effect but also allows for management fees.

A synthetic CDO is made of a basket of credit default swaps whereby the buyers of the deal receive a fixed payment in exchange for guaranteeing the underlying securities against default. In the event of default, they are required to pay the difference between the defaulted value and the face value. Obviously, as with all derivatives, a credit default swap requires a counterparty to take the other side of the deal.

In other words, any parties to a derivative knows that somewhere out there on Wall Street there is someone who stands to make all the money that they will lose, and vice versa. And, in fact, in the case of the infamous Hudson and Timberwolf deals, the buyers knew who that party was: it was Goldman Sachs. The standard structure of a credit default swap, according to the standard fixed income reference guide, the very useful Handbook of Fixed Income Securities, is that the bank that sponsors the deal is the protection buyer, and this arrangement was disclosed in the Hudson and Timberwolf offering documents. Thus, the purchasers of these deals knew that Goldman Sachs was short. As for the reasons that Goldman Sachs wanted to be short, or if it had seen the need to take any steps to offset the short position, that brings us back into opinion-land.

I do not mean to suggest that Goldman Sachs was completely blameless in these deals; it described the Hudson deal as not a balance sheet transaction when it was a textbook balance sheet transaction, an attempt to transfer credit risk assets that Goldman held. It also described the Hudson assets as being sourced “from the Street,” which the company lamely defended by pointing out that Goldman Sachs was part of the Street. And of course there was the Abacus deal, where the plan’s asset manager was described as independent when in fact he was being advised by John Paulson.

What depresses me about the whole synthetic CDO business is not so much that Goldman Sachs has such cynical but talented salesmen, but that the buyers of these complicated instruments seem to have learned nothing . I may be lacking in sympathy for the buyers of these deals because any student of recent history could have seen this game being played over and over. In Frank Partnoy’s book Fiasco: The Inside Story of a Wall Street Trader, which details the author’s experiences in structured finance at Morgan Stanley and which should be required reading for anyone who still has any lingering trust of Wall Street, he describes the same situation, the gaming of the ratings agencies’ ratings, the buyers who were less sophisticated than their sellers and were either unwilling or unable to make an independent assessment of the offering documents and who were willing to assume, for example, that particular AAA structured note paid a yield spread over a vanilla security of a similar credit rating because the issuers and underwriters were incompetent, not because the issue had an embedded short option position on the Mexican peso.

Of course, when I say people have learned nothing, I don’t mean literally nothing. The people who have now acquired firsthand knowledge of the dangers of leverage and shorting volatility are the ones who have been escorted from Wall Street in disgrace (imagine being the one who recommended buying the Abacus deal in a job interview). I recall reading somewhere that the majority of people working on Wall Street now were not even present during the dot-com collapse. Perhaps Nassim Taleb is right; the best qualification in this world is grey hair.

At any rate, the enduring rule that has come from subprime mortgage securities debacle (and the structured finance debacle, and the junk bond debacle, and the Latin American debt debacle) is caveat emptor. (And the second rule, obviously, is not to play with borrowed money). It seems to me that all the disclosure laws and ratings agency opinions in the world cannot serve to erase the necessity of adopting a skeptical, defensive attitude towards any financial products and the people who sell them. If market participants would remember that, we would have no reason to excoriate Goldman Sachs for doing what we all wish we had the sense to do.