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Archive for the ‘Value Investment’ Category

What does a falling P/E ratio mean?

Posted in About, Stocks, Value Investment, tagged on September 10, 2010| 9 Comments »

While the WSJ is prepared to consign the PE ratio to the dustbin (see The Decline of the P/E Ratio and Is It Time to Scrap the Fusty Old P/E Ratio?) Barry Ritholtz is one of the few actually asking the question, “What does a falling P/E ratio mean?”

Ritholz focuses on the expansion and contraction of the PE ratio as indicative of bull or bear markets:

We can define Bull and Bear markets over the past 100 years in terms of P/E expansion and contraction. I always show the chart below when I give speeches (from Crestmont Research, my annotations in blue) to emphasize the impact of crowd psychology on valautions.

Consider the message of this chart. It strongly suggests (at least to me) the following:

Bull markets are periods of P/E expansion. During Bulls, investors are willing to pay increasingly more for each dollar of earnings;

Bear markets are periods of P/E contraction. Investors demand more earnings for each dollar of share price they are willing to pay.

Hence, a falling P/E ratio is not indicia of its lack of utility. Nor is it proof of “Fustyness.” Rather, it suggests that crowd is still feeling burned by the recent collapse in prices and increase in volatility.

Here’s the chart:

I think Ritholz’s analysis is excellent as far as it goes, but I think it misses part of the story. The “E” in the PE ratio is also subject to expansion and contraction over the course of the business cycle. Earnings are still normalizing from a period of massive expansion. While the single-year market PE might be at 15.8, which is a little over the long-term average of 15, on a cyclically-adjusted basis, the PE ratio is over 20, which is historically expensive:

Click to View

Assuming that this time is not different, earnings will contract as they regress to the long-term mean, and the market PE ratio will contract along with earnings.

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Guest post update: Sham Gad on Paragon Technologies (OTCBB: PGNT)

Posted in Activist Investors, Value Investment, tagged , on September 7, 2010| Leave a Comment »

Sham Gad has provided an update on his earlier guest post on Paragon Technologies (OTCBB: PGNT), which Daniel Rudewicz of Furlong Samex also covered in January. Sham is the managing partner of Gad Capital Management, a value-focused investment firm modeled after the Buffett Partnerships based in Athens, Georgia. Gad is also the author of the recently released,  ”The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett.” He earned his BBA and MBA at the University of Georgia. Here’s the update:

Gad Capital Initiates Proxy Contest for Control of Paragon Technologies

Today, Gad Capital iniated a proxy contest to nominate a new board of directors for Paragon Technologies at the company’s annual meeting on December 15, 2010.

The board Gad Capital has nominated, including himself, consists of:

Jack Jacobs, age 65, has been a principal of The Fitzroy Group, Ltd., a firm that specializes in the development of residential real estate in London and invests both for its own account and in joint ventures with other institutions, for the past five years. He has held the McDermott Chair of Politics at West Point since 2005 and has served as an NBC military analyst since 2002. Mr. Jacobs was a co-founder and Chief Operating Officer of AutoFinance Group Inc., one of the firms to pioneer the securitization of debt instruments, from 1988 to 1989; the firm was subsequently sold to KeyBank. He was a Managing Director of Bankers Trust Corporation, a diversified financial institution and investment bank, where he ran foreign exchange options worldwide and was a partner in the institutional hedge fund business. He retired in 1996 to pursue investments.

Mr. Jacobs’ military career included two tours of duty in Vietnam where he was among the most highly decorated soldiers earning three Bronze Stars, two Silver Stars and the Medal of Honor, the nation’s highest combat decoration. He retired from active military duty as a Colonel in 1987. Since January 2007, Mr. Jacobs has served as a member of the Board of Directors of Xedar Corporation, a public company; since June 2006, he has been a director of Visual Management Systems, a private company; and since 2009 to the present, he has been a director of Premier Exhibitions(Nasdaq: PRXI).

Michael Levin, age 48, is an independent investor and advisor with substantial expertise in corporate governance and corporate finance, with significant experience in U.S. public companies as a finance executive and independent management consultant. Mr. Levin is currently the Chief Financial Officer of AbaStar MDx, a start-up medical diagnostics company. Mr. Levin has served as a Risk Executive Nicor, natural gas utility from 2003-2006. He was the Chief Risk and Credit Officer, CNH Capital, farm and construction equipment manufacturer from 2002-2003. Prior to that was a corporate finance and risk consultant with global management consulting firm BearingPoint and global accounting firm Deloitte & Touche. Mr. Levin holds a B.A. and M.A. from the University of Chicago.

Samuel Weiser, age 50, served as a member and Chief Operating Officer of Sellers Capital LLC, an investment management firm from 2007-2010. From 2005-2007, he was a Managing Director responsible for the Hedge Fund Consulting Group within Citigroup’s Inc. Global Prime Brokerage Division. From 2002 to April 2005, he was the President and Chief Executive Officer of Foxdale Management, LLC, a consulting firm founded by Mr. Weiser that provided operational consulting to hedge funds and litigation support services in hedge fund related securities disputes. Mr. Weiser also served as Chairman of the Managed Funds Association, a lobbying organization for the hedge fund industry, from 2001 to 2003. Mr. Weiser is also a former partner in Ernest and Young. He received his B.A in Economics from Colby College and a M.Sc. in Accounting from George Washington University.

Paragon Technologies, a material handlings systems compnay based in Easton, PA, curren sports a market cap of $3.7 million, $5.4 million in cash, and over $5 milion in tangible net equity.

Interested shareholders should contact Gad Capital at shamgad@gmail.com.

No position.

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Quick Idea: Cal Dive International Inc. (NYSE:DVR)

Posted in Stocks, Value Investment, tagged on September 3, 2010| 3 Comments »

Cal Dive International Inc. (NYSE:DVR) is an interesting play on the offshore oil and gas service industry. It was trading through a cyclical and seasonal low before the Macondo well blowout. The blowout has had a significant impact on the offshore oil and natural gas industry, and saw DVR suffer one of its worst quarters in several years. As a result, DVR’s stock price has recently dropped to a new 52-week low. With Earl and several other hurricanes bearing down on the US, and the offshore oil and gas industry close to long-term lows, DVR looks like a bargain to me.

About DVR

DVR is a marine contractor providing manned diving, pipelay and pipe burial, platform installation and platform salvage services to a diverse customer base in the offshore oil and natural gas industry. It has operations in the Gulf of Mexico Outer Continental Shelf, the Northeastern U.S., Latin America, Southeast Asia, China, Australia, the Middle East, India and the Mediterranean. It owns and operates a diverse fleet of 29 vessels, including 19 surface and saturation diving support vessels, six pipelay/pipebury barges, one dedicated pipebury barge, one combination derrick/pipelay barge and two derrick barges.

Prior to December 2006, DVR was a wholly-owned by Helix Energy Solutions Group, Inc..  In December 2006, Helix transferred to DVR all of the assets and liabilities of its shallow water marine contracting business, including 23 surface and diving support vessels capable of operating in water depths of up to 1,000 feet and three shallow water pipelay vessels. DVR, through an initial public offering, became a separate company. Helix now owns less than 1% of DVR’s common stock.

Hurricanes, winter and energy prices

DVR is cyclical. It does well when oil and gas drillers drill. It’s also seasonal. The first quarter of the year is typically a slower period due to winter in the Gulf of Mexico. DVR’s 2010 “off-season” was particularly poor. Customer spending levels were significantly less during the first half of 2010 compared to the first half of 2009. The decline in demand for DVR’s services in the first half of 2010 was due to a reduction in hurricane repair work, the lag effect of decreased offshore drilling in 2009, and uncertainty regarding energy prices, specifically natural gas prices for Gulf of Mexico customers. Demand for DVR’s services generally lags behind successful drilling activity by a period of six to 18 months. Vessel utilization for its saturation diving vessels and construction barges – its two most profitable asset classes – declined significantly during 2010 as compared to the same period in 2009 (from the June 30 10Q):

The onset of the global recession in the fall of 2008 and the resulting decrease in worldwide demand for hydrocarbons caused many oil and natural gas companies to curtail capital spending for exploration and development. Despite this financial market and economic environment, we experienced steady demand for our services during the first three quarters of 2009. This demand was driven in part by the need for inspection, repair and salvage of damaged platforms and infrastructure following hurricanes Gustav and Ike, which passed through the Gulf of Mexico in the third quarter 2008, and increased domestic and international new construction activities, the capital budgets for many of which had already been committed prior to the end of 2008. However, demand for our services during the fourth quarter of 2009 and the first six months of 2010 was reduced for the following main reasons:

· reduced urgency by customers in completing the remaining hurricane repair and salvage work in the Gulf of Mexico;

· reduced new construction work due to significantly less drilling activity in 2009 and the first half of 2010; and

· fewer large integrated construction projects utilizing multiple vessels planned for 2010 as compared to the projects that were ongoing during the first six months of 2009.

Although there is some evidence that the worldwide economy is emerging from recession and we began to see signs of recovery in the market as we moved into the improved weather months, we still expect challenging market conditions for the remainder of 2010 compared to 2009. The Macondo well accident has significantly and adversely disrupted oil and gas exploration activities in the Gulf of Mexico and there is increased uncertainty in the market and regulatory environment for our industry which will likely have a negative effect on our customer’s spending levels for some time. The duration that this disruption will continue is currently unknown. Generally, we believe the long-term outlook for our business remains favorable in both domestic and international markets as capital spending will be required to replenish oil and natural gas production, which should drive long-term demand for our services.

Vessel utilization

Vessel utilization is a key metric. From the June 30 10Q:

We believe vessel utilization is one of the most important performance measurements for our business.  Utilization provides a good indication of demand for our vessels and, as a result, the contract rates we may charge for our services.  As a marine contractor, our vessel utilization is typically lower during the winter and early spring due to weather conditions in the Gulf of Mexico.  Accordingly, we attempt to schedule our drydock inspections and routine and preventive maintenance programs during this period.  The seasonal trend for vessel utilization can be disrupted by hurricanes, which have the ability to cause severe offshore damage and generate significant demand for our services from oil and natural gas companies to restore shut-in production.  This production restoration focus has led to increased demand for our services for prolonged periods following hurricanes, as was the case in the first half of 2009 following hurricanes Gustav and Ike in 2008.  Beginning in the fourth quarter of 2009, and reflected in our results for the first half of 2010, we once again returned to more customary seasonal conditions in the Gulf of Mexico.  The effect of this return to customary seasonal conditions on our utilization in these already historically slow periods was exacerbated by particularly weak demand for our services in the first half of 2010, resulting in a 27% decrease in vessel utilization across the entire fleet for the first half of 2010 as compared to the same period of 2009.

A small  increase in vessel utilization will see a huge increase in revenues, profitability and cash flow.

Valuation

DVR’s $4.63 close yesterday gives it a market capitalization of $436M and an enterprize value of around $574M (long-term debt net of cash is $138M). DVR’s most recent quarter was a difficult one. Free cash flow turned negative for the first quarter since the same quarter in 2008. Through very difficult business conditions, DVR has still managed to generate over $100M in FCF over the last twelve months, which means it trades on a EV/FCF ratio of 5.7, and a P/CF ratio of 2.8.

Conclusion

This post is intended only to be a quick look at DVR. The key points are thus:

  • DVR was trading through a cyclical and seasonal low before the Macondo well blowout turned what would have been a bad quarter into a disastrous quarter.
  • The stock has been unduly punished, and now trades at a EV/FCF ratio of 5.7, and a P/CF ratio of 2.8, which is cheap, especially so given the difficult trading conditions it is presently enduring.
  • A small improvement in vessel utilization will have an outsized impact on revenues, profitability and cash flow.

Hat tip Mariusz Skonieczny.

Long DVR.

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Alternative metrics to the Shiller PE10

Posted in About, Value Investment, tagged on September 2, 2010| 1 Comment »

My post on the Shiller PE10 ratio calculated using Shadowstats’ alternate to the BLS CPI generated some great discussion about the various flaws in the market-level PE and PE10 – using BLS CPI or Shadowstats’ CPI – ratios. Brett Arends’s WSJ.com ROI blog has a timely post Why Stocks Still Aren’t Cheap examining other measures of stock market valuation. Says Arends:

There’s no one perfect guide to whether the market is cheap or not, but here are a few measures that may give you pause.

Take the so-called “Cyclically-Adjusted Price-to-Earnings” ratio, which compares share prices, not simply with one year’s profits, but with average earnings across an economic cycle of about 10 years. (This CAPE is often known as the “Shiller PE” after Yale economics professor Robert Shiller, one of its leading proponents.)

The CAPE has been a pretty good guide for investors over a very long period of time. It told you, correctly, to get out of stocks in the late 1920s, the mid-1960s, and the bubble a decade ago. It told you to buy aggressively after the second world war, and in the “death of equities” period of the 1970s and early eighties.

Over the past century or so, the stock market has, on average, been about 16 times cyclically-adjusted earnings. Today, it’s about 20 times. Make of it what you will. But it’s not cheap.

Or take the lesser-known “Tobin’s q.” A calculation, named for the late economist James Tobin, that compares stock prices with the replacement cost of company assets. It has a very similar track record to the Shiller PE.

The q on the market is about 1 today, says economic consultant Andrew Smithers. The historic average is just 0.64. By this measure, the market would have to fall a third just to reach its average. Again: This is cheap?

Or take another measure, “price to sales.” This compares stock prices to corporate revenues, rather than earnings. The rationale is that sales tend to be less volatile from year to year. This data, from FactSet, goes back to 1984. By this measure, shares certainly look a lot cheaper than they were in 2000 or 2007. But they are still much higher than they were before the bubble began in 1995. Ominously, they are higher today than they were just before the crash of 1987.

Still hungry for more? Consider another measure, “enterprise value to EBITDA.” This compares the value of all company stocks and debts with earnings before interest, taxes, depreciation and amortization–a key measure of operating cashflow. Many companies recently have been levering themselves up, borrowing more in the bond market. But all shares and bonds must, ultimately, be supported by cashflows. By this measure, share prices are still way above levels seen prior to the last 13 years.

Finally, you could try comparing the market value of equities with total U.S. gross domestic product. Once again, that’s been a reasonable guide to some of the great buying and selling opportunities of the past. Data from Ned Davis Research show that U.S. stocks are valued at about 85% of GDP today. The historic average, says Ned Davis Research, has been about 60%.

None of these measures is conclusive. None is perfect on its own. And, critically, none is any kind of guide to short-term movements. The market could jump 1,000 points next year just as easily as it could fall 1,000 points.

The four charts in the article are worth viewing.

Jeff Miller weighs in at A Dash of Insight with a critique of the Shiller PE10 as an alternative to forward earnings estimates:

There is a constant drumbeat of criticism about market valuation using forward earnings. The most common criticism, that estimates are too optimistic, is open to challenge. If the estimates are too high, why is the beat rate consistently in the 65% range?

…

The fans of the Shiller 10-year past earnings method take pride in having solid data. Then they make a wild guess about whether the trend will continue. Those praising this method point to a few notable successes, mostly times when P/E ratios were very low since interest rates were very high.

Those interested in forward earnings are taking the aggregate work of dozens of specialists. If you think they are a little high, you can feel free to add an error range. If you do so, you should look at past data — especially that of recent years.

…

These points are blindingly obvious, yet widely ignored.

Here is an offer for anyone who thinks that using ten years of past data is the best method: Send me an email and I’ll show you how to enter a nice football pool. The smart money will welcome you and Dr. Shiller.

I prefer Arends’s conclusion:

One should usually give stocks some benefit of the doubt. After all, over the long term they have produced better returns on average than other assets. From that it follows that they have generally been undervalued in the past.

So maybe today stocks are very expensive. Or maybe they’re just no great bargain. But it is almost impossible to argue that they are very cheap. If this were a great contrarian moment to buy stocks, they’d be very cheap.

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McDonald’s Corporation (NYSE:MCD) field trip report from 1965

Posted in About, Value Investment, tagged , on August 31, 2010| 1 Comment »

Michael Bigger’s Bigger Capital blog has a great “field trip” report on McDonald’s Corporation (NYSE:MCD) from 1965. You could have picked up MCD then for a split-adjusted $0.06 per share, giving you a twelve-hundredfold return to date. Says Michael:

A good friend of mine, a talented research analyst, covered McDonald’s (MCD) in the sixties. One of his field reports is posted below. My friend liked the company and bought the stock at a price of $.06 (post split). He still holds a major portion of his original stake. The investment has returned more than one thousand times.

The lesson of this story is that you will most likely stumble upon one or two great companies like MCD in your lifetime. If that happens and your insight leads you to buy the stock, hold on to it for a long period of time. Don’t get shaken out of your position.

Indeed.

Read the report.

No position.

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Graham / Shiller PE10 calculated using Shadowstats’ CPI

Posted in About, Stocks, Value Investment, tagged , on August 27, 2010| 13 Comments »

Saturna Capital has an interesting take on the calculation of the Graham / Shiller PE10, otherwise known as the Cyclically Adjusted Price Earnings ratio (CAPE). Saturna argues that The Market May Be Cheaper Than It Looks because the Consumer Price Index (CPI) provided by the Bureau of Labor Statistics (BLS) understates the true rate of inflation, a key input to the CAPE calculation:

Potentially Understated Inflation

Given that inflation estimates play an influential role in the calculation of the P/E10, it is important to investigate the assumptions behind the calculation of inflation. Traditionally, inflation is measured using the Consumer Price Index (CPI) provided by the Bureau of Labor Statistics (BLS). The CPI estimates inflation by measuring fluctuations in the average price of a basket of consumer goods and services that is deemed to be typical of the average urban consumer. However, due to a variety of reasons, largely political, the methodology used to calculate CPI has undergone many changes in the past 10 to 20 years. One of the most controversial changes was to alter the composition of the basket to reflect changes in consumer behavior over time.

In doing so, the BLS hoped to remove biases that cause the CPI to overstate the true inflation rate. Former chairman of the Federal Reserve Alan Greenspan advocated this alternative methodology, arguing that if the price of steak went up, consumers would choose to eat more hamburger meat instead.² He therefore concluded that unless hamburger meat replaced steak in the basket, inflation would be overstated because consumers were not actually spending more money. Skeptics view these changes as government manipulation, the purpose of which is to understate the true inflation rate, as well as the wage and other rate increases indexed to it (think Social Security).

Saturna uses an alternative measure of inflation: the Shadow Government Statistics’ (SGS) Alternate CPI:

Over time this recalibration of the CPI has produced lower inflation estimates than the “old school” method. In fact, the discrepancy has become rather large… Unlike Mr. Greenspan, however, we prefer steak to hamburger meat. Accordingly, we tend to believe the truth lies somewhere in between the BLS’s CPI and the Shadow Government Statistics’ (SGS) Alternate CPI.

The implications for CAPE using Shadow Government CPI are as follows:

The wide gap between the government-sanctioned CPI and the Shadow Government CPI presents a competing set of assumptions about how to measure the effect of rising prices on the average consumer and the market as a whole. The relevance to investment analysts is that higher inflation figures can have a dramatic impact on the current P/E10 ratio. For example, if inflation is assumed to be 5% annually, $1 in nominal earnings from 10 years ago would be worth approximately $1.63 in today’s dollars. At 10% annually, $1 in nominal earnings from 10 years ago would be worth about $2.59 today. Using a higher inflation estimate therefore increases average real earnings over the 10-year period, and thus lowers the P/E10 ratio. If we assume the SGS figures are correct, then the current P/E10 based on the average closing price during the month of June is about 14x (see chart below). This ratio is much lower than the current P/E10 of near 20x using traditional CPI figures.

Click to View

Read the article.

Hat tip Ben Bortner.

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Vitaliy Katsenelson on Medtronic Inc. (NYSE:MDT)

Posted in About, Value Investment, tagged , on August 26, 2010| 1 Comment »

Vitaliy Katsenelson’s Contrarian Edge has a great post on Medtronic Inc. (NYSE:MDT) (Barron’s is wrong on Medtronic). Katsenelson’s post is a rebuttal to a Barron’s article, Should Medtronic Investors Lose Heart?, in which the author argues that MDT is a sick man. His post is a superb line-by-line refutation of Barron’s thesis:

“The stock looks cheap, trading at about 8.2 times expected forward earnings, but the company’s 10% long-term-earnings growth rate is below the industry average…

At 8.2 times earnings, the market prices in zero growth. If any growth is produced, even half of its “below-industry-average” growth, the stock will not be trading at 8.2 times earnings, but at a much higher valuation. Ironically, today’s low valuation gives MDT earnings a yield of 12%. If MDT remains at this valuation for a long time, it can buy back 12% of the company year after year, and this in itself would result in 12% earnings growth.

“… and it carries a fair amount of debt….

The amount of debt seems high at first, at $10.5 billion; but the company has $3.9 billion in cash and short-term investments, thus net debt is closer to $6.6 billion. MDT generates $3.4 billion of free cash flows – it can pay off ALL of its net debt in less than two years. Also, don’t confuse MDT with low-quality, highly cyclical stocks that were in vogue in the first half of 2010. This is a company that maintained a return on capital of over 20% for decades – an indication of a significant moat. Its revenues are extremely predictable, cash flows are very stable, and thus debt levels are very reasonable. Medtronic’s stock was punished with a 10% decline for lowering its guidance by an astonishingly minor 2%.

“The stock is also a historical underperformer, turning in losses year-to-date, as well as in the last one-, two-, and five-year periods that are greater than its peers in the Dow Jones U.S. Medical Equipment Index and the overall market….

This argument fails to draw a distinction between fundamental performance and stock performance. Over the last ten years, MDT grew both sales and earnings per share at 14% a year. It increased dividends 17% a year. These are not the vital signs of an “underperformer.” As the article pointed out, MDT’s stock has gone nowhere over the past decade – that is true, but not because MDT was mismanaged or failed to grow, but rather because at the turn of the last century MDT was trading at almost 50 times earnings. Medtronic is a typical sideways-market stock: it was severely overvalued at the end of the secular bull market, thus its earnings and cash flows grew while P/Es contracted. This happened to a battalion of stocks, from Wal-Mart to J&J to Pepsico. In fact when I hear the statement that a stock has “not gone anywhere,” I immediately start looking at the stock to see if it is a buy.

Read the article.

No position.

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Darwin’s darlings in practice: Accretive uses “Take Private” tactic

Posted in About, Catalysts, Stocks, Value Investment, tagged , on August 25, 2010| 3 Comments »

One of my favorite strategies is the Endangered Species / Darwin’s Darlings strategy I discussed in some detail earlier this year (see Hunting endangered species and Endangered Species 2001). The strategy is based on a Spring 1999 Piper Jaffray research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy. The premise of the report was that undervalued small capitalization stocks (those with a market capitalization between $50M and $250M) lacked a competitive auction for their shares and required the emergence of a catalyst in the form of a merger or buy-out to close the value gap.

The NYTimes.com has an article, Accretive Uses “Take Private” Tactic In Equities, discussing hedge fund Accretive Capital Partners, which uses a strategy described thus:

Accretive Capital’s strategy is to buy long-only stakes in small- and micro-cap stocks that [founder Rick] Fearon believes would be attractive “take private” companies. The benefits of being public just don’t add up for such companies, he said.

Years ago when Fearon was a principal at private equity firm Allied Capital, he was struck by the wide gap in value the public and private equity markets assigned companies.

In private equity, companies were valued at six to seven times their cash flow, while public companies, especially the smallest businesses, were valued at almost half that, he said.

Fearon believes that market inefficiency, where prices often fail to reflect a company’s intrinsic value, and the $400 billion or so that pension funds and endowments currently have committed to private equity, will help spur returns.

Fearon is fishing in waters where, because the market capitalization of the smallest companies is less than $100 million, Wall Street research fails to adequately cover their operations. In addition to helping create an inefficient market, it has eroded the benefits of being a public company.

With an undervalued stock, stock options are never in the money, erasing the use of stock as a motivator for management and employees; cash becomes preferable to stock for acquisitions, and management holds on to undervalued shares.

“Management teams that have a strategy of A, B, C and D for creating shareholder value may in the back of their minds be thinking, ‘Well, maybe strategy E is the take private transaction, or we sell the company to a strategic buyer, because we’re not recognizing any of the benefits of being public,'” Fearon said.

In essence, the strategy is Endangered Species / Darwin’s Darlings. How has Accretive Capital performed?

Accretive Capital has been involved in 19 take-private transactions, or about one-third of the positions it has closed over the past decade.

Fearon has managed to take the $2 million in capital he started with from mostly high-net worth friends and family to about $20 million on his own. His fund plunged in 2008, but returned 132 percent last year and is up about 20 percent as of July.

Assuming no additional outside capital, turning $2M into $20M in ten years is a compound return of around 25%, which is impressive. [Update: As Charles points out in the comments, the article clearly says he’s returned 4x, not 10x, which is a compound return of around 15%, which is still impressive in a flat market, but not as amazing as 25%.]

Says Fearon of the investment landscape right now:

“We’re not lacking investment ideas or opportunities, our primary restraint is capital right now.”

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Guest post: Adam Sues of Value Uncovered on AMCON Distributing Co. (AMEX:DIT)

Posted in Value Investment, tagged on August 16, 2010| 3 Comments »

Adam Sues, author of Value Uncovered, has provided a guest post on AMCON Distributing Co. (AMEX:DIT). Adam describes himself thus:

I’ve always enjoyed reading about the stock market and started studying in earnest in 2007 right before the whole financial world crashed.  I sold a few positions at a loss (a mistake) but managed to pick up some great names at bargain prices.  Over the past two years, I’ve started to study the principles of value investing and special situations, molding my philosophy after famous investors like Warren Buffett and Benjamin Graham.

Here’s his take on DIT:

AMCON Distributing (DIT)

AMCON Distributing Company (DIT) is just the type of business upon which many value investors focus: a micro-cap stock in a boring industry that the market has largely ignored.

With a market cap of only $33M, AMCON is incredibly producing almost $1B in sales, an outstanding number for such a small company.

Company Background

DIT has been around since 1986, and is currently the 8th largest convenience store distributor in the United States.

Distribution

The company currently operates 4,200 retail outlets, consisting of grocery stores, liquor stores, tobacco shops, and convenience stores across the Central and Rocky Mountain region of the country, selling over 14,000 different products.

The company’s products would be familiar to any normal citizen who has spent time in a corner store – cigarettes, tobacco products, candy, groceries, paper products, and frozen foods, among others.

Stores are serviced by 5 large distribution hubs totaling approx. 487,000 square feet, and are stocked by major suppliers including Phillip Morris, RJ Reynolds, and Proctor & Gamble.

Retail – Health Foods

The second business segment consists of retail health food stores operating under the name Chamberlin’s Market & Café and Akin’s Natural Foods Market. These stores focus on high-quality, organic, & specialty foods.  Both store brands have been around since 1935, with 13 stores between them. Overall, AMCON has exposure to two completely different segments of the market – low-end, commodity type distribution and high-end organic food purchases.

While distribution still makes up for the vast majority of revenues, the retail health food concept is sweeping across the country and could provide a future engine for company growth (just witness the explosion of organic food advertisements and sustainable food awareness campaigns over the past few years).

The company has enjoyed record financial performance over the past two years under the leadership of its Chairman & CEO – Christopher H. Atayan.  AMCON is a remarkable turnaround story.

Financials

AMCON’s industry is highly competitive and low margin business.  Gross margins have averaged 7.3% over the past 10 years, with little variance.  Net margins are very tight, averaging 0.2%, although the trend has been increasing.

Breaking down the business segments, margins on the retail side are much better, with gross margins in the 42% range compared to 6.1% on the wholesale side. Despite the wide range of products, the company is heavily dependent on the sale of cigarettes.  In 2009, approx. 71% of company revenue came from sales of these products, although only 27% of gross profits.

Sales growth has been steady, but slow, at approx. 3% per year.  The company has been able to raise revenue due to price increases, new store openings, and strategic acquisitions.

Most recently, the company owned a new retail store in Oklahoma and expanded its distribution network by purchasing the assets of another distributor:

“On October 30, 2009, the Company acquired the convenience store distribution assets of Discount Distributors from its parent Harps Food Stores, Inc. (“Harps”). Discount Distributors is a wholesale distributor to convenience stores in Arkansas, Oklahoma, and Missouri with annual sales of approximately $59.8 million”

Positives

Improved Financial Health:

AMCON is the type of business that turns over a ton of inventory (almost 25x per year).  Combine this fact with a low margin business, and the company must fund most of their operations through debt financing – there is little cash on the balance sheet.

Management has taken steps to improve the financial health of the business.  Long-term debt has shrunk from $58.2m in 2005 to 27.7M last year.  At the same time, shareholder equity has increased from $-0.2M to $23.8M.

Interest coverage has increased to 9.5, putting the company on much better financial footing.

Turnaround Story:

Since the arrival of Mr. Atayan, the company’s current CEO and Chairman, AMCON has undergone an amazing turnaround.  A few years ago, AMCON was in rough shape:

“The business had negative availability of $2 million on its bank lines, it was being sued in four separate jurisdictions, it was being delisted by the American Stock Exchange, it was behind on taxes, it was losing business, and it was more than $65 million in debt.”

The company sold off non-essential businesses and turned two consecutive record years in 2008 and 2009.

Management:

Insiders own 44.1% of outstanding shares, including 37.5% by the CEO and Chairman, Christopher Atayan.  Mr. Atayan bought out the company’s original founder, William Wright, purchasing over 200k shares last year.

The company re-instituted a cash dividend in 2008, and has more than doubled the quarterly payment to $0.18 during one of the toughest economic times in recent memory.

Last year, AMCON’s board also announced a share repurchase program for up to 50,000 shares, or 9% of outstanding.

Negatives

Regulatory Challenges:

Although the company has worked to diversify its business, it still relies heavily on the distribution of cigarettes.  Cigarette sale and distribution is a highly regulated affair, and overall use has declined due to social stigma and education on the health risks of smoking.

In June 2009, the FDA was granted even greater powers for regulating the sale and distribution of cigarettes.  The agency almost immediately banned the sale of certain flavored cigarettes, and then substantially increased the federal excise tax on cigarette sales.

Increased prices put continued pressure on sales – to date, AMCON has been able to pass along the higher prices to its customers but it remains a big risk for the company.

Competition:

The company is part of a very competitive industry, and the low profit margins do not leave much room for error.  An inventory miscalculation or fuel price increase could severely impact the business.

AMCON currently depends on a $55M credit agreement with Bank of America.  Average borrowings for last year were $31.2M – the company obviously depends on this line of credit.

The current agreement matures in June 2011, and the outcome of that negotiation will have a substantial impact to the business.

On the retail side, the company’s retail stores face intense competition not only from stand alone health stores, but also major grocery chains who are trying to capitalize on the health movement as well.

Stock Float:

DIT is a micro-cap stock, with a market cap of approx. $34M.  The stock is also very illiquid and suffers from a tiny float.  The company only has 577k share outstanding – with the high levels of insider ownership, float is only 350k.

According to Lowfloat.com, DIT is actually one of the top 3 lowest float stocks trading on any of the major exchanges.

Average 3 month volume is only 1000 shares so picking up large blocks of shares is difficult.  Many institutions will pass on the stock because of these challenges, allowing individual investors to benefit.

Valuation

The stock touched a low of $14 back in November 2008, before shooting upwards to $78 in December 2009 – not a bad return for one year.

Current P/E ratio sits at 4.8 – higher than 2008 (2.4) but lower than 2006/2007 (6.2), the first two years of the turnaround.

DIT’s 2010 EPS should come in around $15-17 – applying a normal P/E of 6 to these EPS numbers results in a share price of $90-$102.

Conclusion

Through the first three quarters of the company’s fiscal year, revenues, operating income, and FCF are all higher than 2009, setting the company up for another record year.

With regards to buying a significant personal stake in the company, Mr Atayan had this to say:

“This is a significant personal investment for my family and reflects my confidence in the management team of our company and the strong relationships we have with our vendors and customers.”

With this type of conviction – not only his professional livelihood and reputation, but putting his family’s stake behind the words as well – I have no doubt that Atayan is committed to making the company succeed.

Based on recent performance, he is off to a good start.

No position.

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Guest Post: Sham Gad on Paragon Technologies (OTCBB: PGNT)

Posted in About, Stocks, Value Investment, tagged , on August 12, 2010| 5 Comments »

Sham Gad has provided the following guest post on Paragon Technologies (OTCBB: PGNT), which Daniel Rudewicz of Furlong Samex also covered in January. Sham is the managing partner of Gad Capital Management, a value-focused investment firm modeled after the Buffett Partnerships based in Athens, Georgia. Gad is also the author of the recently released,  “The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett.” He earned his BBA and MBA at the University of Georgia.

Paragon Technologies: Catalyst to Unlock Shareholder Value

Paragon Technologies (OTCBB: PGNT) is a $3.7 million market cap company with $5.5 million in cash and $5.2 million in equity. It’s operating subsidiary, SI Systems, has a 50 year history as a quality provider of material handling systems for many of the world’s top corporations. Unfortunately over the past decade, current management has not succeeded in growing this company. Since 2001, sales have been on a steady decline and the company has generated positive operating income in only 3 of those years. Clearly management can not hide behind the veil of economic turmoil.

A Strategic Alternative

It’s obvious why value oriented investors may be attracted to Paragon. Shares trade for $2.40, there is $3.60 in cash per share, and tangible book value of $3.40 a share. As you can see, the vast majority of book value is cash, not inventory or other hard to sell assets. Yet this cash margin of safety has been eroding for the past couple of years as SI Systems deteriorating operations have consumed cash. Left unchecked, what cash cushion remains today will likely disappear under the current status quo. Since year end 2009, cash per share has declined from $4.15 to $3.60.

In the meantime, current management continues to sit still waiting for one of two things to happen:

1. A pick up in new material handling systems orders; or

2. A sale of the company

As I discuss below, here is why shareholders can not wait for this to happen.

New Order Demand

While there is no doubt that the recession has had a profound effect on the new order volume of Paragon, the company counts names like Caterpillar, Harley Davidson, and Honda Motor as previous customers. Clearly the company has (or at least had) the infrastructure to support Fortune 500 companies. These industrial giants expend hundreds of millions if not billions of dollars annually on cap ex. A mere basis point allocation of this cap ex would significantly impact Paragon which today does less than $10 million in annual sales. Yet somehow the company has not been able to find a way to achieve new orders for years. If you accept management’s argument that new orders lag an economic recovery, then any realistic uptick in new order won’t occur until 2012 based on the current economic data. With SG&A expenses now accounting for 50% of sales, I don’t think this company has the luxury of time.

Sale of the Company

This one is quite simple, yet management seems perplexed. Based on my conversations with the CEO, the only offers being made value the company for its cash. While I will agree that the industrial operations are indeed worth something, any buyer today is buying those operations generating losses not profits. So management waits, refusing cash offers, while allowing the cash to decline. According to the CEO, the company has been trying to sell itself for a couple of years. The offers back then were materially higher than today, yet management continues to wait it out.

An Elegant Solution

While management waits for better days, the only thing they have done is reduce expenses here and there. While I will be the first to applaud this effort, its clear those actions alone are no longer enough. More so, despite the reductions, the company overhead looks bloated given its size today. As the company’s largest shareholder, I have proposed the following 4 point solution in my efforts to salvage this company and unlock shareholder value. In one way or another I have discussed these alternatives with management that I would like to aggressively explore as a member of its Board:

1. Addressing the company’s current compensation package – until the company demonstrates substantial operational improvement, compensation needs to be reflective of the current reality. As of the most recent quarterly filing, SG&A expenses constituted over 50% of sales.

2. Review and analyze efforts to sell the company – for over a year, management has indicated its preference for selling Paragon. I want to work with the Board to ensure that all avenues are explored in order to determine if an attractive sale price exists.

3. Immediately work towards bringing SI Systems back to operational break even – Paragon has had positive operating income in only 3 of the past 10 years. Moreover, it’s only because of asset disposals that the company has been able to increase cash on the balance sheet. Clearly something needs to be done at the operating level.

4. Examine alternative strategies with the balance sheet – The current investment legitimacy and marketability of this company squarely hinges on the cash on the balance sheet. Over the past 2 years this has declined as the operating business has not been a provider of cash, but a user of it. Any future value of Paragon is significantly influenced by the amount of cash on the balance sheet. I believe current management has spent the past year or more looking for a buyer. If today’s economic reality is such that no buyer exists at a mutually attractive price, then the Board has a fiduciary duty to, at a basic minimum, explore alternative options which may include utilizing the cash to make investments unrelated to the current operations of Paragon. By not doing so, they are effectively allowing the cash to deteriorate, while they wait for a potential buyer to appear. Unfortunately, as each week, month, and quarter passes by, the cash declines bringing any potential sale price down with it.

Clearly this company is need of change. While the current Board may sincerely be working in the best interest of shareholders, they have not delivered over the past several years. More importantly, the fact that they refuse to consider alternative solutions suggests a lack of fiduciary responsibility. While economic turmoil has clearly been a weighing factor, one can not continue to hide behind such conditions permanently. I welcome any and all emails and question.

Disclosure: Long PGNT

Shareholders in PGNT may send any inquiries to shamgad@gmail.com.

No position.

Paragon Technologies: Catalyst to Unlock Shareholder Value

Paragon Technologies (OTCBB: PGNT) is a $3.7 million market cap company with $5.5 million in cash and $5.2 million in equity. It’s operating subsidiary, SI Systems, has a 50 year history as a quality provider of material handling systems for many of the world’s top corporations. Unfortunately over the past decade, current management has not succeeded in growing this company. Since 2001, sales have been on a steady decline and the company has generated positive operating income in only 3 of those years. Clearly management can not hide behind the veil of economic turmoil.
A Strategic Alternative
It’s obvious why value oriented investors may be attracted to Paragon. Shares trade for $2.40, there is $3.60 in cash per share, and tangible book value of $3.40 a share. As you can see, the vast majority of book value is cash, not inventory or other hard to sell assets. Yet this cash margin of safety has been eroding for the past couple of years as SI Systems deteriorating operations have consumed cash. Left unchecked, what cash cushion remains today will likely disappear under the current status quo. Since year end 2009, cash per share has declined from $4.15 to $3.60.
In the meantime, current management continues to sit still waiting for one of two things to happen:
1. A pick up in new material handling systems orders; or
2. A sale of the company
As I discuss below, here is why shareholders can not wait for this to happen.
New Order Demand
While there is no doubt that the recession has had a profound effect on the new order volume of Paragon, the company counts names like Caterpillar, Harley Davidson, and Honda Motor as previous customers. Clearly the company has (or at least had) the infrastructure to support Fortune 500 companies. These industrial giants expend hundreds of millions if not billions of dollars annually on cap ex. A mere basis point allocation of this cap ex would significantly impact Paragon which today does less than $10 million in annual sales. Yet somehow the company has not been able to find a way to achieve new orders for years. If you accept management’s argument that new orders lag an economic recovery, then any realistic uptick in new order won’t occur until 2012 based on the current economic data. With SG&A expenses now accounting for 50% of sales, I don’t think this company has the luxury of time.
Sale of the Company
This one is quite simple, yet management seems perplexed. Based on my conversations with the CEO, the only offers being made value the company for its cash. While I will agree that the industrial operations are indeed worth something, any buyer today is buying those operations generating losses not profits. So management waits, refusing cash offers, while allowing the cash to decline. According to the CEO, the company has been trying to sell itself for a couple of years. The offers back then were materially higher than today, yet management continues to wait it out.
An Elegant Solution
While management waits for better days, the only thing they have done is reduce expenses here and there. While I will be the first to applaud this effort, its clear those actions alone are no longer enough. More so, despite the reductions, the company overhead looks bloated given its size today. As the company’s largest shareholder, I have proposed the following 4 point solution in my efforts to salvage this company and unlock shareholder value. In one way or another I have discussed these alternatives with management that I would like to aggressively explore as a member of its Board:
1. Addressing the company’s current compensation package – until the company demonstrates substantial operational improvement, compensation needs to be reflective of the current reality.  As of the most recent quarterly filing, SG&A expenses constituted over 50% of sales.
2. Review and analyze efforts to sell the company – for over a year, management has indicated its preference for selling Paragon. I want to work with the Board to ensure that all avenues are explored in order to determine if an attractive sale price exists.
3. Immediately work towards bringing SI Systems back to operational break even – Paragon has had positive operating income in only 3 of the past 10 years. Moreover, it’s only because of asset disposals that the company has been able to increase cash on the balance sheet. Clearly something needs to be done at the operating level.

4. Examine alternative strategies with the balance sheet – The current investment legitimacy and marketability of this company squarely hinges on the cash on the balance sheet. Over the past 2 years this has declined as the operating business has not been a provider of cash, but a user of it. Any future value of Paragon is significantly influenced by the amount of cash on the balance sheet. I believe current management has spent the past year or more looking for a buyer.  If today’s economic reality is such that no buyer exists at a mutually attractive price, then the Board has a fiduciary duty to, at a basic minimum, explore alternative options which may include utilizing the cash to make investments unrelated to the current operations of Paragon. By not doing so, they are effectively allowing the cash to deteriorate, while they wait for a potential buyer to appear. Unfortunately, as each week, month, and quarter passes by, the cash declines bringing any potential sale price down with it.

Clearly this company is need of change. While the current Board may sincerely be working in the best interest of shareholders, they have not delivered over the past several years. More importantly, the fact that they refuse to consider alternative solutions suggests a lack of fiduciary responsibility. While economic turmoil has clearly been a weighing factor, one can not continue to hide behind such conditions permanently. I welcome any and all emails and question.

Disclosure: Long PGNT


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