Fructivore Investments

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.

Those of you who have been following my articles on the River Rock casino bonds will recall that they fall due for refinancing in November of this year, and that this refinancing process has been delayed because the casino is negotiating its agreement with Sonoma County. If you haven’t been following my articles, that should pretty much bring you up to date.

The agreement with Sonoma County required River Rock to build an emergency access road, and also to pay to the county $75 million by 2020 in order to address the increased usage of county resources caused by a planned expansion of the casino. Now that the expansion has been put on indefinite hold, it would seem that the county requiring the full $75 million would place an undue burden on River Rock’s finances and also be unfair.

The River Rock Entertainment Authority has renegotiated the agreement, cutting the required payments from $5 million per year, increasing by four percent annually, to a flat $3.5 million per year. However,  if the expansion does open River Rock will have to make such additional payments as to bring the total payment (including the $10.3 million already paid) to $75 million, and at any rate the full $75 million must be paid by 2020, subject to future negotiation. Furthermore, the Authority also secured an agreement to build the road on an alternate site, which is now in escrow, and which allows for a 20% grade instead of a 10% grade, a change which the casino estimates will save up to $15 million.

So, now that the $75 million obligation has been deferred, which reduces its present value, and the road savings plan is looking more definite, it would appear that River Rock is a more attractive prospect from the perspective of a bond buyer. Based on last year’s free cash flow figures, and treating the $3.5 million annual payment as a fixed charge, the casino has a fixed charge coverage ratio of 2.5x, as compared to 2.3x before the renegotiation, which is a more attractive situation. Also, the River Rock Entertainment Authority has $43 million in cash on its balance sheet, which, if the new road plan goes through, would be more available as a source of liquidity or simply to pay back part of the bonds. As result, it should be easier for River Rock to refinance.

The market seems to greet this renegotiation with approval; prices have improved to around 92 from generally 88 before the announcement (as a reminder, the bonds were at 84 when I recommended them). River Rock now has a clear route to refinancing (and not too soon, I should note, as refinancing bonds seems to be a months-long process). I still find this issue attractive and find it highly unlikely that there should be no refinancing.

Cal-Maine Foods (CALM) is one of the largest egg producers in the United States, with a market cap of roughly $675 million. Of this, $213 million is represented by excess cash and short term investments, and the free cash flow yield on the balance is roughly 16%, or 15% when considering average profit margins over the last five years.  Although egg prices are highly sensitive to supply, Cal-Maine has been expanding specialty eggs as a portion of gross sales. Specialty are organic, cage-free, etc., and more importantly are both less sensitive to supply and offer higher profit margins.

Please my full opinion on Cal-Maine at

http://seekingalpha.com/article/271363-cal-maine-foods-profit-opportunity-in-the-egg-business

I was sick last week, but I have returned and I brought a promising microcap company called Servotronics (SVT) with me.

Servotronics is a small company; daily volume averages only about 1200 shares, but it offers excellent figures. It operates in two sectors, one of which is, obviously, making servos such as torque motors, electromagnetic actuators, and valves for use in the aerospace and missile industries. 21% of Servotronics’s servo sales in 2010 were made, directly or indirectly, to the US government. Servotronics’s other sector is the cutlery business, from cooking knives to utility knives to machetes and bayonets. 21% of Servotronic’s 2010 sales of cutlery were also to the US government, although this is down from 28% in 2009.

The balance sheet of Servotronics is attractive; almost in a net-net situation. The company has a market cap of $18.8 million and has $4.4 million in cash, $5.4 million in receivables, and $11 million in inventory, total $21 million, set against $7.2 million in total liabilities. At any rate, because noncash current assets cover current liabilities (in fact, they cover total liabilities), the cash on the balance sheet can be considered excess.

In terms of earnings, in 2010 sales were $32 million, reported operating income was $3.1 million, excess depreciation was $160 thousand, producing operating cash flow of $3.3 million. After interest expense of $74 thousand, and taxes of 35%, we have free cash flow to equity of $2.1 million. Based on the current market cap this is a free cash flow yield of 11.1% before excess cash is taken into account, or 14.6% when the excess cash is taken into account. The company has very low interest rates because the bulk of its long-term debt, $3.1 million, consists of Industrial Development Revenue Bonds issued through a government agency and carrying an interest rate of .54%. Given Servotronics’s sensibly modest use of debt, I do not anticipate the situation will worsen when the bonds fall due in 2014.

In 2009, sales were $33 million, reported operating income was $2.6 million, excess depreciation was $118 thousand, producing operating cash flow of $2.7 million. After interest expense of $84 thousand and taxes, the company produced $1.7 million in free cash flow.

In 2008, sales were $34 million, reported operating income was $4.7 million, excess depreciation was $42 thousand, producing operating cash flow of $4.8 million. Interest expense was $178 thousand, and after taxes we have a free cash flow of $3 million.

In 2007, sales were $31 million, reported operating income was $3.5 million, excess depreciation was $66 thousand, producing operating cash flow of $3.6 million. After interest expense of $255 thousand, and taxes, we have free cash flow of $2.1 million.

As we see, then, the earnings history of Servotronics is reasonably stable, which gives us confidence that the free cash flow figures are a reliable indicator of a company’s future earnings power. Servotronics also pays a modest annual dividend of 1.6%.

I do need to address, however, the liquidity aspect. Obviously, it would be unwise to use market orders instead of limit orders, but even so, market participants place an importance on liquidity and may insist on a higher return from microcaps like this one. Damodaran, in his useful Damodaran on Valuation, estimates that this premium could reach 30% or more, although many of his examples are drawn from private equity firms, where the market is nonexistent, rather than the stock market where the market is simply thin.

As for this matter, I would first remind us all that liquidity is often an illusion, as we discovered with auction rate securities in 2008, and furthermore, I am reminded of what Ben Graham said about liquidity in his Security Analysis, that it is the sine qua non of speculators, while investors, who if they follow sensible financial policies will hardly ever be forced by circumstances or margin calls into liquidating in a hurry, should find liquidity of secondary concern to value. Even so, the bid-ask spread for Servotronics, from what I’ve observed, can be 1-3% of the share price, which can be a difficult hit even when spread over a long holding period.

At any rate, I find Servotronics to produce stable earnings that are ample relative to the company’s price, and with a little caution and trading skill, one could easily build a position that can produce satisfactory returns.

I recently examined Revlon (REV), a makeup company which has had a spotty and debt-laden history but which has turned the situation around in the last four years, assisted by substantial overseas growth. Although the firm is still dealing with the debt that Ron Perelman saddled it with during its LBO, it offers a free cash flow yield of more than 10% when its tax loss carryforwards are taken into account, and Ron Perelman seems to stand ready to serve as an (expensive) lender of last resort.

For my full views on Revlon, please visit

http://seekingalpha.com/article/266582-revlon-positive-operating-trends-and-a-low-valuation

It was announced yesterday that Smart Modular Technologies (SMOD) would be taken over by a private equity firm for $645 million, or $9.25 per share. When I recommended it here on January 3, the price was $5.94. Not bad for a few months’ wait, I think.

As you may know, my favorite metric for evaluation a company is its ability to generate free cash flows. However, it is dangerous to focus entirely on that issue to the exclusion of other important aspects of a company. I will explore this issue by examining Lodgenet (LNET), a company with free cash flow through the roof, but with certain offsetting characteristics that make it an unattractive prospect to me.

Lodgenet’s business is providing media and connectivity on demand in hotels, and they are also expanding into hospitals. The majority of the company’s revenue comes from guest on-demand movies, including what are described in the SEC filings artfully describe as “independent films, most of which are non-rated and intended for mature audiences”. Lodgnenet also provides ordinary cable programming and broadband Internet service, which it supplements with advertisements.

The company’s numbers are phenomenal; in 2010 the firm’s free cash flows were $50 million, although because much of that comes from excess depreciation, the firm’s earnings power would be about $32 million if excess depreciation was taxed. Lodgenet has 10% preferred stock outstanding, which has a prior claim of nearly $6 million per year, and I shall have more to say about the preferred stock later. Even so, the company’s market cap is only $90 million, so depending on which tax treatment is chosen, the company has a free cash flow yield of 30.3% under the high tax scenario, or 48.9% under the low tax scenario. In other words, in a little over three years, based on current earnings power, Lodgenet would earn a purchaser enough in free cash flow to pay off the shares.

But could it, really? I am concerned that this may be too good to be true. Lodgenet’s sales have been declining for some time, and the firm has a massive debt position that raises concerns about interest coverage and covenant compliance. The preferred stock that I mentioned was issued in June of 2009 in order to equitize a portion of Lodgenet’s debt (as well as provide some anti-takeover provisions) and there was a stock offering in 2010 that had the same effect, although the firm claims that part of the proceeds were used for capital spending as well. In the first quarter of 2011 Lodgenet also refinanced its debt agreement, expanding its permitted leverage ratio from 3.5 to 4 and reducing its interest coverage ratio from 3x to 2.25x in exchange for an increase in interest rates, which are estimated to be 6.5% (5% plus LIBOR, or plus 1.5%, whichever is higher) on a forward-looking basis, apart from a brief spike next quarter before Lodgenet’s swaps expire.

Furthermore, 2010’s capital expenditures, at $22 million, are well below the five-year average levels of $47 million. Now, as is stated in Benjamin Graham’s Security Analysis, a company can only be said to have earned money if it has made sufficient capital expenditures to maintain its earnings power. Damodaran, in his useful toolkit Damodaran on Valuation, reminds us that there can be a distinction drawn between maintenance and growth capital expenditures, with the latter having a sort of optionality attached to it. However, most corporations do not divide the two types of capital expenditures in their reports, and even if they did, the companies have a vested interest in making the growth category as large as possible, both because it makes free cash flows look better and because investors like growth. And of course, it is a distinction without a difference in many cases, as the money is spent either way. Therefore, the wise approach is to take the conservative view that all capital spending is maintenance capital spending.

However, owing to the declines in Lodgenet’s sales and operating cash flows, we do not have this luxury of choice; it is clear that levels of capital spending are below replacement levels, as the lower than average capital expenditures for the last few years may indicate, as would the lowered amounts of actual hotel rooms serviced (1.8 million as of the first quarter 2011 as compared to 1.98 million in 2008). It may be that, like Mac-Gray, Lodgenet is shedding its lower-margin clients, and indeed Lodgenet is focusing on expanding its high-definition offerings, but that too may require more capital than current spending would indicate.

So, enough of dancing around the figures; let us examine them. In 2010 sales were $452 million and reported operating earnings were $23 million.  Depreciation was $83 million and capital expenditures were $22 million. This produces excess depreciation of $61 million, which makes operating cash flow $84 million. Interest expense that year was $34 million, leaving pretax cash flow of $50 million, or $32 million after estimated taxes. Taking out $5 million for preferred stock dividends leaves $27 million in estimated free cash flow to common shareholders.

In 2009, sales were $463 million and reported operating earnings were $22 million. Depreciation was $100 million and capital expenditures were $21 million. This produces excess depreciation was $79 million, which makes operating cash flow $91 million. Interest expense that year was $38 million, leaving $53 million in pretax cash flow, or $36 million after taxes. Taking out $6 million in preferred stock dividends (they did not actually incur this expense, but for purposes of calculating future earnings power we should take it into account), we have $30 million in estimated free cash flow to common shareholders.

In 2008, sales were $534 million and reported operating earnings, apart from a goodwill impairment charge, were $6 million. Depreciation was $124 million and capital expenditures were $64 million. This produces excess depreciation of $66 million, which makes operating  cash flow $66 million. Interest expense that year was $42 million, leaving $24 million in pretax cash flows, or $16 million after estimated taxes. After the preferred stock dividend, this leaves $10 million in after-tax free cash flows.

In 2007, sales were $486 million and reported operating earnings were $-4 million. Depreciation was $116 million and capital expenditures were $79 million (not including acquisitions made that year). This leaves excess depreciation of $43 million, producing operating cash flows of $39 million. Interest expense that year was $41 million. Of course, this was the company’s first year operating on such a large scale, and also the year in which they borrowed the money to pay for the acquisitions that is now causing the firm so much trouble.

As we see, much of the improvements in 2009 and 2010 in terms of free cash flow are owing to the lower capital expenditures in these years as compared to 2008 and 2007. In fact, if capital expenditures were at the five-year average levels from 2006-2010, which is $47 million, there would be hardly any free cash flow to shareholders, apart from the tax benefit of excess depreciation. It may be that Lodgenet’s business calls for a large initial investment and then lower maintenance expenditures, but considering the short lifespan of Lodgenet’s capital assets (the company took $75 million in depreciation charges in 2010 on $206 million in property and equipment from 2009’s closing balance sheet, producing a weighted average life of 2.75 years), I would not bet on it. Lodgenet has been using its free cash flow to common shareholders, including the tax benefit from the excess depreciation, more or less exclusively to pay down debt.

The company released its first quarter 2011 earnings last night (which is why this article wasn’t published two days ago). We can see more of the same trends at work; sales were $107 million, down from 118 million for first quarter 2010. Reported operating earnings were $6.9 million, depreciation was  $19.6 million and capital expenditures were $4.6 million, producing cash flow from operations of $21.9 million, as compared to $24.2 million for first quarter 2010. Interest charges were $7.7 million, as compared to $8.7 million for first quarter 2010, leaving $14.2 million in pretax cash flows, or $9.2 million afterwards. Taking out $1.4 million in preferred stock dividends leaves $7.8 million in free cash flow to common shareholders. The comparable figure for first quarter 2010 is $8.7 million. I am hesitant to draw too many conclusions from these results, particularly as capital expenditure levels can vary over the year and the firm spent only $4.6 million on capital expenditures while management suggested in its earnings call that capital expenditures for the full year of 2011 would be in the $25-30 million range–which itself is higher than in 2010 and 2009, further biting into free cash flow.

So, on top of the diminution in earnings, I find that we are once again confronting our paradox of valuation, that a company in the process of deleveraging can increase its value based on free cash flow  over a given period by less than the amount it actually earns in the same period. Here, it is clear that debt is a problem at Lodgenet, as shown by the two equitization moves and the necessity of renegotiating the debt. As of the company’s last report, its long-term debt stood at $360 million, with the firm able to devote an estimated $50 million per year towards paying it down ($29 million in free cash flows as estimated, plus $21 million in estimated tax benefits from excess depreciation). Lodgenet claims, and not without justification, that the amended credit agreement has bought the company some breathing room, but with cash flows on the decline and capital expenditures at below replacement levels anyway, it is not apparent to me that the debt issue is safe.

So, is Lodgenet ultimately a value investment? I should say no. The difficulty is that although I can see that capital expenditures are below maintenance levels, I do not therefore know what the correct level of capital expenditures would be, making it impossible for me to calculate free cash flow. As a result, I cannot estimate how many years it may be necessary for Lodgenet to devote substantially all of its free cash flow towards debt repayment (the new credit agreement requires 75% of excess cash flow to be directed to that purpose for the lifetime of the agreement), which renders the free cash flow multiple approach impossible (as funds required to be used to pay down debt are definitely not “free). Nor am I satisfied that the debt of Lodgenet, even with the new credit agreement, is safe from default, or more likely, from having to make further concessions in a renegotiation.

Therefore, despite the apparently attractive free cash flow yields of this company, there are far too many unknowns present for me to be able to say that there exists a definite margin of safety or a low probability of ultimately losing money, and I would advise passing on Lodgenet at present. Even though purchasers of this company can (and most likely will, now that I’ve spoken against it) reap  great rewards from this firm, I do not feel there is anywhere close to enough assurance of the same.

I have often found compelling values in rural telephone companies, such as Windstream and Qwest (now acquired by CenturyLink, as they throw off large amounts of free cash flows and are kind enough to produce dividends. My latest discovery in this area is Consolidated Communications (CNSL), which pays 8.4% and which has a free cash flow yield of 11.4% after excess cash is taken into account, based on last year’s results. Unlike Windstream and Qwest, Consolidated uses wireless partnerships to offset loss of traditional customers, as well as high speed Internet, which adds a further level of stability.

I have also reexamined my views of excess depreciation and amortization: Although it is wise to run the calculations first treating the excess depreciation as taxable, and to place significant weight on that calculation, it may be helpful as well to make a reasonable, conservative projection of the actual present value of the tax benefits associated with excess depreciation. Of course, as with all projections, this one is unlikely to be ultimately accurate and one should avoid using only this measure to justify an investment, but the projection must still be of interest to investors.

For my full views on Consolidated Communications, please visit http://seekingalpha.com/article/264006-consolidated-communications-a-strong-candidate-for-dividend-investors

Since my last foray into the paper industry with Boise Inc., I thought it would be appropriate to review the rest of the sector. After some searching, I have settled on Domtar (UFS).  Domtar is the largest producer of uncoated freesheet paper in North America, and also a producer of wood pulp, with operations in several locations in the United States and Canada. The company was formed in 2006 to purchase Weyerhaeuser’s fine papers division, which transaction was consummated in May of 2007. Obviously, the timing of the deal was not the best, as the firm has had to recognize significant goodwill and asset impairments since that event. However, these impairments are noncash expenses, and Domtar has produced an attractive record of free cash flows since the acquisition, with free cash flow yields of above 11% even during the difficult 2008-2009 period. Also, the company has on its balance sheet over $500 million in excess cash, out of a market cap of $3.85 billion.

Furthermore, Domtar has not shied away, as many acquirers do, from the usually necessary process of whittling down of unneeded or underperforming assets following an acquisition. In fact they have shut down several underperforming paper mills in Mississippi, in Saskatchewan, Ontario, and Quebec, and in California. The company has also repurposed its plant in North Carolina to produce purely fluff pulp in response to market demand. Finally, the firm has sold off its wood and lumber products business since the acquisition. In fact, as recently as last week Domtar announced the closing down of a papermaking line at its plant in Arkansas.

As a result, the company has been able to maintain a high level of free cash flows throughout the 2008-2009 period despite a lowering of demand, and 2010 was a dramatically impressive year for Domtar, with free cash flows of $583 million, equal to almost 1/6 of the firm’s entire market cap. However, this may be the result of a fortunate confluence of circumstances, where sales prices increased without the cost of inputs catching up and therefore the 2010 results are perhaps atypical. Domtar has recently been using its impressive free cash flow to pay down its debts, having paid back $917 million in 2010 and $400 million in 2009.

Turning to the figures, I would first like to address the excess cash level. A common measure of a firm’s excess cash is the total cash and investment on the books, minus the extent to which current liabilities exceed current noncash assets. (Of course, cash being described as “excess” does not mean that a company could instantly declare a special dividend of all of its excess cash without its liquidity suffering; it merely means that a purchaser of a company’s stock is allocating part of his or her purchase price to cash that is not encumbered by any pressing need. Therefore, the purchaser may be said to “claw back” that amount from the purchase price, while the remainder is allocated to the actual capital assets of the business. A business that is strongly cash flow positive (and as a value investor, those are the only kinds of business I like investing in) may be expected to produce the cash to address its noncurrent liabilities out of its future earnings, and the extent to which the company’s prospects indicate that they can do it governs whether the excess cash as calculated is really excess, which in Domtar’s case I believe it is. This analysis also requires a determination that a company’s debts are manageable, which again is true in Domtar’s case; interest is covered over four times in each of the last four years surveyed).

For Domtar, based on its latest balance sheet, the firm has $530 million in cash and $1.47 billion in noncash current assets (of which $1.25 billion consist of receivables and inventories, rather than the more nebulous categories of “deferred taxes” and “other”), set against $725 million in current liabilities. As a result, noncash current assets exceed noncash liabilities and therefore all $530   million in cash may be considered excess. Taking $530 million off of the market cap of $3.85 billion leaves $3.32 billion representing the market value of Domtar’s capital assets.

In terms of earnings, in 2010, Domtar’s sales were $5.85 billion and operating earnings as reported came to $603 million. However, because of noncash impairments resulting from plant closures, and other closure- and restructuring-related costs, $77 million in expenses should be considered noncash and/or nonrecurring. This produces $680 million in income from operations, which, after interest expenses of $97 million, leaves $583 million in pretax earnings, or $379 million applying a 35% tax. (In fact, Domtar reaped a tax windfall in 2010 and 2009 for operating loss carryforwards and a tax credit for black liquor, a byproduct of producing paper pulp that makes an excellent fuel and which qualified for an alternative fuel subsidy from the US government in 2009. However, the subsidy has expired, and for purposes of forecasting Domtar’s earnings power, it would be preferrable to apply the statutory, rather than the historical, tax rate).

Furthermore, as with many companies, Domtar has an additional source of free cash flow in that its depreciation charges of $395 million have exceeded its capital expenditures of $153 million. This leaves $242 million of additional cash flow to Domtar’s owners, producing total free cash flows to equity of $583 million. This represents a free cash flow yield of 17.6% based on the $3.32 billion market value of Domtar’s operating assets. This source of free cash flow is presently untaxed, although eventually the gap between depreciation and capital expenditures may be expected to resolve itself at which point this will no longer be the case. However, Domtar is still in the process of whittling away at its underperforming assets to increase its competitiveness and therefore the current levels of capital expenditures may be considered reasonable for longer-term estimates. Therefore, at the current rate of capital expenditures the gap will take many years to close, during which time the excess depreciation will continue to be tax-free.

For 2009, sales were $5.47 billion and reported operating earnings were $615 million. However, this was the year of the black liquor tax credit, which contributed $497 million in nonrecurring extra income, which was offset by $125 million in impairment and restructuring charges. Therefore, actual operating earnings were $243 million, before interest expenses of $121, leaving $122 million in pretax earnings, or $79 million after taxes. Excess depreciation that year came to $299 million, producing free cash flow of $378 million.

For 2008, sales were $6.39 billion and reported operating earnings were $-437 million, but this year included noncash and/or nonrecurring impairments and restructuring charges of $751 million, producing actual operating earnings of $314 million, before interest expenses of $132 million, leaving $182 million in pretax earnings, or $118 million after taxes. Excess depreciation in that year was $300 million, producing free cash flow of $418 million.

Domtar’s acquisition of Weyerhaeuser’s fine papers division occurred in May of 2007, but the firm was kind enough to include pro forma earnings in its 2008 10-K. For 2007, sales were $5.95 million, reported operating earnings were $270 million, before $31 million in noncash or nonrecurring events, producing actual operating earnings of $301 million. Interest expense that year was $142 million, leaving $159 million in pretax earnings, or $103 million after earnings. Excess depreciation that year came to $355 million, producing $458 million in free cash flow.

In 2006, Domtar’s business was still inside Weyerhaeuser, and curiously the financial reports do not allocate any interest expense to it. At any rate, sales were $3.31 billion and reported operating earnings were $-556 million, before noncash or nonrecurring impairments and other items of $701 million, leaving $145 million in actual operating earnings, or $94 million after taxes. Excess depreciation came to $247 million, producing $341 million in free cash flow.

So, what can we take away from these figures? The paper industry is a cyclical industry, and, according to Damodaran in his useful toolkit, The Dark Side of Valuation, it would be unwise to base our valuation on the most recent year even if it was not an unusually good one, but to look at the performance over a broad cycle. Unfortunately our data do not cover an entire business cycle. However, I would say that 2010 was a very good year, with sales increasing 7% and cost of sales actually declining 1%, according to the firm’s 10-K, a situation that may not continue through 2011 and thereafter in an environment of rising costs. By contrast, 2009 was no doubt a period of unusually weak demand owing to the financial crisis and its aftermath (although in 2009 the firm still produced $378 million in free cash flow, which, when set against the $3.32 billion price the market is setting on Domtar’s capital assets, is still a free cash flow yield of 11.4%).

If I had to pick a single figure for Domtar’s earnings power, I would say that it lies between those two extremes. At any rate, if we average the 2007-2010 free cash flows we get $459 million per year, which, set against the $3.32 billion market cap after removing excess cash, produces a yield of 13.8%, which I find very attractive.

I conclude, then, that Domtar has strong earnings power and as long as its management can continue to adjust to changing economic conditions by adapting its productive capacity, it should continue to produce high levels of free cash flows for its owners. As such, I can recommend as a portfolio candidate.