Fructivore Investments

I have discussed United Online several times on this site, and noted that it has apparently attractive dividends and free cash flows, but that the loss of a post-transaction marketing program has affected their free cash flows in such a way that a prudent investor should wait and see how they regain their traction.

As it happens, my concerns were somewhat exaggerated, as the free cash flows for United Online have been hovering around $17 or $17.5 million per quarter pretty much ever since the post-transaction program was suspended, even though dial-up revenues and revenues from United Online’s classmates.com property have declined and capital expenditures have increased somewhat as the result of classmates.com rebranding itself into memorylane.com, a general nostalgia site. As a result, the company has a price/free cash flow yield of an impressive 13.8% which seems sustainable at least for the moment, although the success of the rebranding is still up in the air.

For my full opinion on United Online, please see

http://seekingalpha.com/article/256076-united-online-strong-free-cash-flow-makes-for-an-attractive-valuation

It is only natural that the stock market, having doubled since the March 2009 low, would seem to be running a little short on bargains. And I have a sense, based on purely anecdotal observations, that optimism in the market has reached a local peak in that companies have been punished by the market for putting out respectable, even expectation-beating quarterly earnings. And, of course, then, something in Libya happens and hundreds of billions of dollars of paper wealth have to disappear.

But I have to take the position that whatever is going on in the broader markets, there must be a few bargains out there to go along with all the new overinflated short candidates. One such stock is RR Donnelley (RRD), the largest printer in the country. The printing industry, of course, is under economic pressure, as fewer people are interested in advertising and catalogues, and also under secular pressure from the decline in print directories and the rise of e-books (although the firm claims that their book printing volumes have not been affected by them yet). As a result, RR Donnelley’s sales and free cash flows have declined over a few years. But what has declined more is their share price, moving them into bargain territory. The company, whose debt position is sound and which is rolling up smaller printers in order to reduce what they call “overcapacity” in the sector, now offers a free cash flow yield of 13.3%, when its sales and free cash flow are showing signs of stabilizing. They also offer a generous dividend yield of 5.5%.

My full opinion of RR Donnelley may be found here.

http://seekingalpha.com/article/254219-r-r-donnelly-strong-free-cash-flow-attractive-valuation

I heartily recommend this company as a candidate for portfolio inclusion.

One of the great debates among fundamental investors, whether they are value investors or whether they should be value investors, is the question of bottom-up or top-down. The top-down approach involves examining the economic outlook, the state of the financial markets, and the trends among the sectors, in order to determine the best stocks in the best sectors, taking into account the markets and the economy. The proponents of this view look upon this method as providing three additional checks on the right decision. The bottom-up investors describe it instead as three more ways to make a mistake. Furthermore, what if the economy points one way and the market points another, as is often the case? What if the sector is richly priced but an individual stock has been left behind? Most value investors definitely fall into the bottom-up category, and so do I.

However, I have considered my habit of finding companies that come in pairs, and as such I am willing to concede that if a particular stock is attractive, then other similar stocks are at least worthy of consideration. I suppose you could call it the mountain climbing approach: bottom to top to bottom. In that vein, I thought I would examine Sinclair Broadcasting Group (SBGI), which, like Belo Corp, is a geographically diverse television broadcaster that has  suffered from large noncash impairments and is now seeing stabilization in its operations that is allowing it to deleverage.

Sinclair Broadcasting owns 58 stations in 35 markets, most of which are network affiliates. The company has also chosen to diversify into various other ventures, such as a television broadcasting equipment company, a security alarm service provider, a sign maker, and some real estate speculations. Damodaran, in his Damodaran on Valuation, concludes that the market tends to punish diversified companies and that investors are more or less capable of diversifying on their own, particularly where, as here, there is hardly any possibility of vertical integration. As a result, the market was cheered when the company announced recently that they would be divesting some of its noncore assets, as well as reinstating its dividend. Their bonds, though rated firmly in the junk area, trade roughly at par. Their debts are still ample, and I can see them devoting much of their free cash flow towards paying them down in future, dividend or no.

Apart from large goodwill writeoffs, they have been profitable for the last five years, and revenues have recovered since the 2008 and 2009 slump, assisted by political advertising.  Sinclair’s current market cap is $1.04 billion, which, as I shall calculate later, is approximately 13 times their annual free cash flows, which I would not consider cheap, particularly as those cash flows may be earmarked for debt repayment and as such, under a curious paradox of valuation methods, may not be considered free.

The following is my estimate of their free cash flows. Like many companies in the current economy, Sinclair Group has been able to produce some excess depreciation. Their free cash flows have been remarkably stable despite the economic volatility. As for their 2010 year to date figures, the company has reported that 2010 was an excellent period, buoyed by the Super Bowl, a rebound in automotive advertisements, and an unusually vitriolic election season. However, they have not published the full set of financial statements, and also such a good quarter may serve to distort rather than inform our investment views, so I have not included it.

*ASC 470-20 requires companies that issue convertible debts that may be settled in cash, of which Sinclair Group has three separate convertible issues,  to record the value of the convertible debt in two pieces, the debt component based on the value of a similar nonconvertible debt, and the equity component being the remainder of the face value of the bonds. This equity component must be amortized over the life of the convertible bonds, and most companies record this amortization as an interest expense. I have already made my views on this accounting rule clear: This rule obscures, rather than clarifies, financial statements, requires companies to record an expense that does not exist to amortize an asset that never existed, and does not even appropriately value the conversion privilege, which should be assessed using option pricing, because of its linear assumptions and complete disregard of price movements; the conversion price of the bonds is above 20 and the current share price of Sinclair Group is a mere 12 and change.

At any rate, I expect full year 2010 results apart from the unusually good political advertising season to be somewhere in the mid to high 70 million in free cash flows. If we call it 77, that is a free cash flow multiple of 13.5x, or a yield of 7.4%. As I stated, the company has also announced the resumption of its 48 cent per year dividend, which will consume $38.5 million per year, leaving $40 million per year to pay down debts with. Considering that Sinclair Group has over $1.1 billion in debts, and their interest coverage is somewhat worrisome at roughly 2x, they may be working at debt repayment for some time.

So, where does that leave us? Sinclair Broadcasting has a fairly robust operation and a debt level that is high but manageable, and has shown recent improvement in its operation–not that the wise value investor would project any kind of trend from these improvements. However, the price to free cash flow yield for the company is too high, in my view, especially considering that some of their free cash flow is to be used to pay down debt, which has a comparatively low after-tax return. Other than that, it is in much the same situation as our attractive-looking Belo Corp,  and if there is a significant pullback in prices (unlikely in the current market but still possible if some of the optimism is bled out), it should constitute a very attractive purchase. But as things stand, the price is too high.

I have over the last few months been forming the conclusion that Cisco offers an attractive potential return situation based on its earnings yield from operations. The company, with a market cap of $105 billion, is sitting on $35 billion in excess bonds because the CEO is unwilling to repatriate its overseas profits under the current tax scheme. Take those away, and we find that Cisco’s core operations produce some very juicy returns.

Last night, Cisco reported reasonable earnings and announced that its future growth is not at an end. Regular readers will know what I think about future growth, but Cisco is reasonably priced without it and a screaming buy with it. The market inexplicably punished Cisco with a 13% decline in share prices today, which I would describe as nothing short of a gift for new purchasers.

I have my full views on Cisco on my seekingalpha page at http://seekingalpha.com/article/252139-cisco-looking-beyond-results-from-a-single-quarter. Do please come by.

Future economic historians may refer to the period beginning in 2009 and continuing for some years into the future as the era of deleveraging, at least for everyone except the U.S. government. I have often voiced the opinion on this site that companies that are in compliance with the times by voluntarily paying down debt early are an attractive prospect. This has informed my recommendations of Belo Corporation, Entercom, and even Chiquita Brands. However, as with many things in the stock market, the benefit of deleveraging depends on the valuation model we use. A good review of equity valuation models is contained in Damodaran’s useful toolkit, Damodaran on Valuation. Although value investing adds certain nuances based on stability of cash flows, credit quality, and other qualitative factors, a basic knowledge of valuation according to orthodox practice cannot fail to be useful to value investors, even if only for the reason that other market participants use it.

The simplest method of valuation is the dividend discount model, where the future dividends of a company are discounted to a present value based on whatever required return on equity the investor chooses. Although this method does rightly focus people’s minds on cash returns, this method has several defects. First, it requires investors to project the future course of dividend payments, and investors are perennially incapable of seeing into the future. Second, particularly in the current era of low dividend yields, it often transpires that even a mature company does not pay out anywhere near as much in dividends as it can.

This led to the modern approach of valuing companies based on free cash flow yields. Free cash flow, of course, is the money that a company can afford to pay out of its cash flow after making due provision for maintaining its earnings power. The logic behind the use of free cash flow analysis is that a company is valued based on its potential dividends rather than its actual dividends, and moves us closer to the concept of profit in the economic sense.

However, the confluence of the two models often creates paradoxical results. I will demonstrate this paradox by simplifying the numbers and capital structure of Belo Corp. The company is capitalized with about $1 billion of debt at a yield of 7%, and produces $70 million a year in free cash flow. If we allow that a 10x multiple is a reasonably conservative valuation, we would expect the equity of the company to be worth $700 million. However, the company, although its debt situation is reasonably stable and sustainable, chooses to devote all of its free cash flow to paying down debt

A year later the company would save itself $5 million in interest, which comes to about $3 million after taxes. If we keep the multiple at its conservative level, we will find that the value for the new company becomes $730 million dollars. The paradox lies in that we have clearly earned $70 million dollars in free cash flow over the year and should be $70 million better off, but we have a company at the end of the year that has no more cash than it did at the beginning of the year and is worth only $30 million more.

Now, even Damodaran, although he does not go into great detail, acknowledges that free cash flow does not include debt repayments , but logically, how can this cash flow not be “free” when management could simply roll their debts over as they fall due and keep the money.Even so, management’s decision to pay down debt does move us back into the more primitive world of dividend discounts, because using the money to buy back debt is the equivalent of canceling a dividend for that year, so the view that $30 million, rather than $70 million, is our “true” earnings may be have some logical support. And applying the dividend discount model consistently, we can conclude that $730 million is the correct value only if management decides not to pay down debt next year, and it just as naturally follows that $700 million was the correct value only if management decided not pay down debt this year.

This puts the dividend-discount investor in the always-uncomfortable position of trying to see in the future, and guessing at what point the capricious opinion of management will decide that a given amount of debt paid down is enough, calculating the free cash flow value on that date, and discounting that figure to present value. As investors are, again, incapable of predicting the future accurately, this makes these companies very difficult to identify as inexpensive.

Free cash flow is meant to calculate an investor’s returns on an economic basis, but the trouble is that the company is using the money that is required to produce here a 10% return on an investment in order to effectively “invest” in the company’s own debts, which action here produces a return of 4.2% on an after-tax basis, rather than giving the money to the shareholders or at least keeping it for their potential future benefit, to allow them to seek higher returns on their own. This difference between 4.2% and 10% is presumably where the missing $40 million went. True, shareholder equity increases by the full $70 million, the liquidation value of the equity is improved by the full $70 million, but on a going-concern basis the liquidation event is assumed to occur many years in the indefinite future—and in fact, the paying down of debt may be exactly what pushes the liquidation date out further. I do not know the resolution to this situation.

If conservativeness in valuation methods means anything, it counsels us to use the lower calculated value whenever there is one, particularly if the decisions of management are viewed as forcing shareholders to invest in the company’s debts. And yet, the efficacy of free cash flow analysis has a long pedigree, and it may be that the company derives benefits from paying down debt in terms of the diminished perceptions in the market of the possibility of financial distress. Of course, prudent value investors assure themselves first of all that financial distress is highly unlikely, but the broader market may take more convincing, and there may be a multiple expansion that could be attractive to the more trader-oriented types. As it stands, though, I can only conclude that companies that are deleveraging ought to be held to a more stringent than normal standard for what constitutes a compellingly low valuation.

Hello, everyone. I have written an article about Belo Corporation, a television broadcaster that owns major network affiliates in several markets. It currently trades at an attractive multiple to its free cash flow, and is deleveraging at a rapid pace in order to address its debt situation, an endeavor which I believe will be successful.

The article is available at http://seekingalpha.com/article/249885-belo-corp-television-stock-stabilizing-at-an-attractive-price, as part of my participation in the Seeking Alpha premium authors program. I hope you will all read it there.

My habit of finding companies that come in pairs is running true to form, although I think this could be the longest period between matching up the pairs. More than a year ago, I profiled Rayonier, a timber company that produces forest products and that got to take advantage of the black liquor tax credit, and now I have found Boise Inc. (BZ), a paper manufacturer that also got to take advantage of the black liquor tax credit.

Boise Inc. is the third largest North American manufacturer of uncoated freesheet paper products. They make make paper cut to office size, and also produce paper suitable for use in envelopes or business forms or commercial printing, as well as labels. They also manufacture newsprint and corrugating medium for cardboard as well as other flexible packaging products. Most interesting, I think, is that they have a supply contract with OfficeMax, whereby OfficeMax will buy all the office paper that they can produce, in exchange for them offering a more stable pricing regime than the open market can provide. This arrangement, which falls due for renegotiation in 2012, accounts for 1/4 of Boise Inc.’s total office paper sales. Of course, the demand for paper and forms depends to a significant degree on the overall level of economic activity, and indeed the firm was forced to close down one of its facilities in 2008. Also there is a movement towards paperless offices and electronic forms, which the company sees as a source of long-term pressure. On the other hand, there is no such thing as electronic cardboard.

Boise Inc. also sells transport services to other users when they have the available capacity. I mention this not because it contributes a great deal to their bottom line–revenue from this field amounts to about $60 million a year out of $2 billion in total revenues–but because I like to see companies willing to pursue every avenue of potential profit. It reminds me of Compass Minerals leasing out a disused salt mine shaft to a records storage company.

Turning now to the figures, the black liquor tax credit that the company earned in 2009 is no longer available and should not be taken into account in examining their future results. Removing that amount, plus removing the gains and losses they made from refinancing their debt in 2009, they had $142 million in operating earnings. Adding back in $131 million in depreciation and subtracting $77 million in capital expenditures produces estimated operating cash flow of $196 million. Interest paid in 2009 was $83 million, producing an interest coverage ratio of 2.36x, which leaves $113 million in estimated pretax cash flow, which after, say, 40% in state and federal taxes comes to $67.8 million in estimated free cash flow.

2010 showed even better results, although as Boise Inc. considers itself a cyclical company they may have derived some of this improved performance from a confluence of excellent conditions, as business activity improved somewhat over 2009 while cost of inputs did not. Sales increased by 6% and operating expenses by less than 2%.  At any rate, for the first three quarters of 2010 (the fourth quarter report is due in a few weeks), we have $134 million in operating income. Add in 103 million in depreciation and take out 67 million in capital expenditures and we have operating cash flow of $170 million, as compared to $130 million for the same figure for the first three quarters of 2009. The firm paid $48 million in interest over the same period, producing an interest coverage ratio of 3.54x, leaving pretax cash flow of $122 million. If we multiply this figure by 4/3 to fill out the year and subtract 40% for taxes we get $97.6 million in estimated free cash flow for 2010. Based on current prices, we have a price/free cash flow ratio of 7, which I think is attractive.

In 2008, Boise Inc. did not do so well; they had operating earnings of $40 million and negative reported earnings and estimated free cash flow, owing in part to restructuring costs. In 2007, the predecessor company still produced about $90 million in estimated free cash flow.

Unfortunately, the calculated price/free cash flow ratio does not tell the whole story. Boise Inc. has outstanding 42 million shares worth of warrants at a price of $7.50. The company now has 80.5 million shares outstanding at a price of $8.51. I would say, taking one thing with another, that a free cash flow multiple of 9x would not be unreasonable for Boise Inc., and based on estimated free cash flow of $97.6 million for the year, the warrantless company is worth $878 million, or $10.91 per share. The warrants, if exercised, would add $316 million in cash, so if all the warrants are exercised the company will be worth $1.194 billion and have 122.5 million shares outstanding, which translates to a price target of $9.74. This stacks up attractively against the current price of $8.51.

Turning to the balance sheet, significant debt levels do exist at this company, with $1.96 billion in total assets weighed against $750 million in long-term debt, $327 million in current liabilities and $227 million in “other.” As calculated above, though, interest is well-covered based on 2010 earnings, and indeed their 9% bonds due 2017 now trade at a premium price of 111 with a credit rating of BB, fairly high on the subinvestment grade levels. Long term debt levels have declined by $35 million since the beginning of 2010, and $226 million in 2009, thanks no doubt to the black liquor tax credit. I will also note that in the first three quarters of 2009, the company has built up an additional $100 million dollars in cash holdings. Now, many companies have been building up cash, but since Boise Inc. pays no dividend and produces enough cash to be able to afford one, I would be very interested to know what the firm’s plans are for that money, particularly with those warrants expiring in June of this year and ripe to be bought back.

As a final note Boise Inc.’s financial statements are very lengthy and detailed. Clearly this is a firm that takes the disclosure requirements seriously. On the whole, I find that Boise Inc. is an attractive paper company at current prices, and definitely a candidate for portfolio inclusion.

At the beginning of this week I posted a review of some of my recommendations, citing Chiquita Brands (CQB) as an attractive purchase that never went anywhere, and Coinstar (CSTR) as a compelling short idea that had dramatically gone against me on a wave of optimism.

Imagine my surprise to see Chiquita Brands up over 12% for the week with no news I can think of, and Coinstar down after hours by about 25% on the announcement that next year’s earnings will be lower than previously projected. I find it a telling commentary on growth stock mentality when millions of dollars can vanish literally overnight because a wild guess has been lowered.

It makes me think that I should post reviews more often.

Many of you may have no doubt noticed that my approach to investing is largely quantitative, concerned with free cash flow yields, interest coverage ratios, the gap between depreciation and capital expenditure, net working capital position, and other financial vital statistics. This should not be surprising; I take the position that corporations are machines that turn cash into (hopefully) more cash, and as a result these basic company-specific figures mean more to me than the penumbras and emanations of economic and sector analyses that characterize the top-down approach of non-value investors.

The emphasis on a company’s facts and figures also serves to give us a good sense of what to look for in a company.  We can identify a potential investment, or at least eliminate an unsuitable one on the basis of the numbers. Fortunately, there are a number of sources that track the financial details of a company in obsessive detail and allow searching. It is, of course, indispensible to follow the advice of Ben Graham in his vital Security Analysis, and go through the accounting in searching detail in order to determine whether the reported numbers are representative of reality or have to be adjusted for nonrecurring events, noncash writeoffs, or nonexistent interest expenses due to convertible debt. But we can at least narrow down our list of candidates if we look for the right numbers, and for that we need the right screener.

The Yahoo! Finance Java-based stock screener (not the basic HTML one) is a good choice, allowing screening for a large family of variables, including dividend yields, return on equity, and the ever-popular P/E ratio. However, the P/E ratio does not tell the whole story, owing to gaps between depreciation and capital expenditures, nonrecurring events, the fallout of an economic crisis, or just simple application of accounting rules. Linn Energy, for example, had a P/E ratio of 1.39 owing to its oil price hedges, because it had to report the income from its hedges but not the offsetting losses in its future production that the hedges were hedging. However, Yahoo’s screener does not have an entry for free cash flow yields; the closest it gets is a screen for entity value to free cash flow ratios, and that measure is often distorted by an unusual cash flow structure. Also, it’s not immediately clear how they compute the entity value or free cash flow, because I have found some missing entries. However, the screener does have the advantage of letting you define your own cutoff points for the screen. If you wanted to know which companies had, say, a price/sales ratio of exactly between .93 and .95, Yahoo! will help.

For net-net companies, Ben Graham’s other favorites, an ordinary screener will not do, because the price/book ratio alone is not specific enough, and combining it with other measures such as the current assets to current liabilities ratio or total debt/equity is likely to produce an endless list of false positives and negatives. Fortunately, someone has assembled a screen that uses data pulled from Yahoo! to identify these companies directly. I have found some issues with Yahoo!’s own data being wrong, which occasionally affects the screen as well, but as I never invest without reading at least a 10-K and the latest 10-Q if applicable, these errors are always caught in time. The author of the screen has also added certain other calculations such as the Piotroski score, which is an estimate of what I would call “fundamental momentum.” I find this a useful screen for identifying potential opportunities on the balance sheet, and it definitely has the advantage of being free.

I have recently discovered a third screen at finviz.com that actually will screen for price/free cash flow, a thing I have been searching for for some time. However, it does not allow you to set your own limits, and with theirs you have the choice of looking for a multiple of five or ten. Perhaps 5x catches ltoo few and 10x catches too many, but there are additions to the screen that can be added, and I think it is best to cast a wide net, as the vital work of actually finding suitable investments from the screen results is the lengthier (and more fun) part.

However, I have not found a screen that can do what I really want it to do, and that is to center on historical data. I like to look for companies that not only have a high cash flow yield at present, which could be a fluke, but which also have been able to sustain reasonably high earnings in the past, which gives me greater confidence. In fact, many value investors are guided by what they call the Graham-Dodd P/E ratios, which average earnings over ten years. as I tend to be skeptical about growth, and the usefulness of projecting it, I like the concept. However, it is also the case that a company now is almost always not the same as it was ten years ago, so perhaps taking an exponential average, or even calculating an average profit margin over ten years and applying it to current sales might be in order, as suggested by Damodaran in his useful toolbox, The Dark Side of Valuation, as a method for dealing with cyclical companies.

I have also started to see the logic of companies that are aggressively paying down debt. After the financial crisis, many people began to see that liquidity is a thing that can dry up, and beyond that, at any given time there are always companies in the market that need debt reduction. Furthermore, many economists have noted that consumers and corporations have been reducing their debt levels faster than the federal government has been expanding its (and, if you’re a Keynesian, that is the very reason why the government has to keep expanding its debts). But whatever one’s feelings about economics, there are sound reasons why companies should deleverage in uncertain times, and it is wise to get on the right side of the trade. After all, cutting debts certainly improves future earnings power, and as companies with high debts often produce lower profits and nearly always trade at lower multiples, the tax advantages of debt, and the multiple expansion that comes from a distressed debt situation resolving makes the return from paying down high debts a very attractive use of free cash flow. To that end, I want a screener that can track debt repayments and overall debt/equity levels over a period of years, so that I can dig into the reports and know if the company is following a wise strategy.

At any rate, I haven’t found any screener like that online, at least for free. I suppose a screener with all the features I have in mind would be useful enough, if it exists, that its designers can charge for it. So, I shall have to make do with what I can, and keep an eye open for new tools.