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Wednesday, February 10, 2010

Which Way from Here? An Investment Strategy for All Markets + Stock Ideas

As discussed in our slide/video presentation posted the other week, we've been through the psychological ringer over the past two years. We've moved from shock and awe, to realization and, now -- in our view -- acceptance:

While we believe economic data suggests stability, plenty of challenges remain and mixed signals emerge each day, with various media outlets sometimes taking different angles on the very same news piece. For example:
  • BBC on 1/18/10: “IMF head in 'double-dip' global economy warning” (link here)
  • AP on 1/18/10: “IMF chief: global recovery stronger than expected” (link here)
Despite certain concerns, the market's monster rally from the bottom last year made "easy money" possible in many stocks across virtually all sectors for those with the fortitude to take advantage of opportunities. In our presentation, we mentioned four retail companies where stocks have tripled or quadrupled off of the bottom: Whole Foods (WFMI), Tiffany (TIF), William Sonoma (WSM), and Limited Brands (LTD).

We didn't purchase these companies, but did purchase a handful of REITs and other companies such as Harry Winston Diamond Corporation (HWD) that had similar performance. Of course, we also purchased American Oriental Bioengineering (AOB) and Bidz.com (BIDZ), which are flat to down from our average costs. Importantly, we acknowledge that we had no idea that the REITs and HWD would perform so strongly within six to nine months after our purchases -- we only believed we were buying cheap assets that no one wanted with a margin of safety. We continue to hold the REITs and Harry Winston, as well as AOB and BIDZ.

Of course, many keep worrying that now is "time to go to cash" and/or aggressively focus on the short side for the "inevitable" market crash. After all, the ever increasing debtor status of the U.S. and certain other developed markets, plus global imbalances and a "bubble in China", must lead to a correction, right?

We don't know. In fact, as noted in our presentation, near-term forecasting is a fool's game. What we do know is that certain businesses can be acquired on the cheap with very favorable risk/reward profiles for those willing to wait a bit (i.e. not next month or even next year, but maybe several years from now). Then again, like some of the top performers last year, maybe the Market will propel certain businesses back to more reasonable levels sooner rather than later.

Our strategy, as detailed in our presentation is the following: Think and Invest Like an Owner with a Long-Term View
  • Short-term is uncertain but long-term is highly correlated to earnings power
  • When evaluating businesses, ask these questions:
  1. Does the business have a strong financial position?
  2. What would happen if the business went away tomorrow? Would anyone care?
  3. Is management capable and motivated? Is disclosure full and adequate?
  4. Will the business be bigger, better, stronger if five years?
  5. Can the business be acquired with a margin of safety?
  6. Price is extremely important
On the last point, we like how the Fairholme Fund’s Bruce Berkowitz puts it: “Investing is all about what you pay and what you get”, which is a variation of advice from Ben Graham and Warren Buffett.

In our presentation, we highlighted three companies we believe meet our criteria: 1-800-Flowers.com (FLWS), Seaspan (SSW), and Weight Watchers (WTW):
  • While 1-800-Flowers.com is highly discretionary, several durable competitive advantages support long-term cash generation and the business can be acquired with a current year free cash yield to equity of more than 20%. This valuation appears incredible and unlikely to last over as the capital light business model will enable management to use excess cash to repay debt, grow the business, repurchase shares, and potentially pay a dividend. Interestly, Provide Commerce (e.g. ProFlowers) was generating annual revenue of approximately $220 million and cash earnings of approximately $14 million (6% margin) when Liberty Media (LINTA) acquired the business for $477 million in fall 2005 (2.2x sales and 34x cash earnings). We estimate that Provide might be generating $300 million in annual sales today versus 1-800-Flowers.com's floral segment sales of around $380 million (our FY10 estimate). FLWS is currently offered by the market at an enterprise value and price to sales of approximately 0.20x.
  • Per our prior posts, the container shipping sector faces significant excess supply, yet Seaspan’s 68 vessel fleet (43 operating, 25 to be delivered) are fully committed to long-term charters with COSCO of China and K-Line of Japan, which creates built-in growth over the next several years. We see the company as a means to participate in long-term global growth with diverse, creditworthy cash flow stream - high quality counterparties, 90% Chinese and Japanese. While the company does require some additional equity ($180 - $240 million per company) to finance new-builds, distributable cash flow is expected to triple to >$300 million per year with a full fleet in 2012 (perhaps $3.00 per fully diluted share, depending upon share count). During this period, annual revenue should more than double to $680 million with EBITDA growing to more than $500 million. So, we can purchase SSW today at approximately three to four times anticipated distributable cash flow in 2012.
  • Consistently high margins/ROIC and excess cash flow indicate that Weight Watchers operates a high quality business model with durable franchise characteristics. Over the past ten years, revenue increased an estimated 3.2x to $1.41 billion, operating income increased an estimated 4.1x to $398 million (28.3% margin), and free cash flow increased an estimated 5.2x to $248 million (18% of revenue). We see potential for dividend increases over medium term as debt is reduced, which might lead to higher valuation multiples. Historic median multiples imply ~100% upside from current levels and, even acknowledging that growth may be less than prior years, discounted historic multiples still imply substantial upside. The business can be acquired today at an approximate 10% free cash flow yield. We first mentioned Weight Watchers last December.
Finally, let's throw in one more for good measure: under-followed micro-cap Sonic Foundry (SOFO) that, based on our research, offers the best Webcasting solution available and has a growing installed base of happy customers. Looking around today, Webcasting should only become more important across virtually all sectors. Sonic Foundry grew revenue 19% Y/Y in FY09 (end September) is poised to deliver accelerated revenue growth in FY10 with positive earnings and cash flow. Yet, the company is offered at approximately one times sales and possibly a mid-single digit P/E multiple on forward earnings for the year beginning this summer.

Let's close with one more point: the best time to purchase businesses is when no one wants them. For a variety of reasons (some obvious), no one wants 1-800-Flowers.com at present -- but that doesn't mean it's not a fantastic purchase at current levels. Seaspan and Weight Watchers are also out of favor, but are not quite as unloved as 1-800-Flowers today. We'll share more tomorrow on this topic. Please stay tuned.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO, FLWS, SSW, WTW, AOB, BIDZ, HWD.
© 2010 Jeffrey Walkenhorst
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5 comments:

  1. Jeff,

    Have you looked ever at LPSN or DSCM? You mention how webcasting will become more important, agree. DSCM may not have met your cash flow before, but they just had an inflection point type quarter. On LPSN something as easy as chat has become very valuable and LPSN is the 800 pound gorilla here and I think meets your cash flow criteria.

    Best,
    Jim

    ReplyDelete
  2. Hello Jim, thanks for your comment. I've loosely looked at both companies over time and previously (briefly) commented on DSCM in one of my BIDZ posts. While both LPSN and DSCM appear to have differentiated market positions that may enable sustainable long-term growth and/or be attractive to a potential suitor, current valuations do not represent incredible bargains.

    LPSN is trading at 21x the midpoint of adjusted 2010 EPS guidance (31c) with an EV/TTM sales of ~2.6x (per Yahoo! Finance). Although not egregious, too expensive for me. I prefer SOFO at potentially 7x forward earnings (for year beginning this summer) with an EV/sales just north of one times.

    Likewise, DSCM is all about scaling sales volume over fixed cost structure to expand margins and finally generate free cash flow. Such operating leverage may now be arriving as impressive revenue growth continues (defensive business through cycles, which is a positive) and margins improve, yet much forward growth appears priced into the current valuation. The forward P/E on consensus 2010E earnings is 29x with an EV/sales of 0.74x. Note that behemoth CVS trades at only 11x forward earnings and an EV/sales of 0.57x (drugstore + PBM segment) -- completely different growth profiles, but I include for a point of reference. Also, DSCM's free cash flow generation is negative on annualized historic basis and I'm uncertain what sort of cash the business will generate this year. Forecasting is tricky. Do you have any expectations? FCF may be positive going forward, yet even an aggressive 2010 assumption would leave us with a small expected FCF yield given the company's market cap and enterprise value of around $300 million. In this case, I prefer FLWS, which offers us a 25% current FCF yield and significant operating leverage whenever the economy rebounds (even with a slight/slow recovery). FLWS is discretionary and may not have the top-line growth of DSCM, but current FCF generation is meaningful and should allow repayment of all debt within two years with excess cash then accumulating on the balance sheet, which I like. I also still favor unloved BIDZ, although retail conditions remain especially challenging in the low- to mid-range jewelry market.

    Br,
    JW

    ReplyDelete
  3. PS - one correction - DSCM states that it did deliver positive FCF for the TTM period and 2008 (not negative as I indicated above), per recent release -

    http://investor.drugstore.com/releasedetail.cfm?ReleaseID=443918

    "Free cash flow more than doubled to $1.4 million for the trailing twelve months, compared with $680,000 for the trailing twelve months ended December 28, 2008."

    BUT, calculations can vary..... I generally use cash flow from operations less capex. Looking at the 2008 10-K, we see CFO of $9.9 million less capex of $13.2 million = negative FCF of $3.3 million. Maybe DSCM is using normalized capex. No time to evaluate further now.

    http://www.sec.gov/Archives/edgar/data/1086467/000119312509053917/d10k.htm

    ReplyDelete
  4. Thanks, Jeff. Appreciate the comments.

    On DSCM, the estimated unlevered free cash flow for 2010 was $6 million, it is now $12 million. I expect this number to go up a little from here. The Medco deal seems to be for real. Having said all this, on EV/EBITDA basis, which is how I like to value these guys, I think a TP of $4 is a possibility this year. Not a big upside dollar wise, but healthy nonetheless. One other thing, if someone was to buy these guys, like an AMZN, the cost synergies would be so high and the EBITDA number could easily double. Which gets you to alot higher than $4. In have been around long enough to not to hold my breath for that. :)

    Thanks again.

    Jim

    ReplyDelete
  5. Hi Jim,
    It's always a good idea to consider what a rational buyer might be willing to pay for a company. I usually like to use EBIT valuations, after D&A that is related to capex to run/maintain/grow the business.

    For DSCM, I think consensus revenue for 2010 is around $500 million with a 4% EBITDA margin for EBITDA of $20 million. D&A last year was nearly $13 million. Assuming similar D&A, we're left with 2010E EBIT of $7 million (1.4% margin). This means DSCM's current EV to 2010E EBIT is 41x, which is clearly rich.

    BUT, let's look out two to three years. Maybe revenue is $700 million (who knows?) and let's generously assume EBIT margin expansion of 200 basis points for a margin of 3.4%. Applying this to $700 million gets us EBIT of $24 million. DSCM is valued at 12x this non-discounted figure (8% yield), which arguably could be rich or fair depending upon perspective. If, instead, the EBIT margin moves to the mid single digits, then shares might be cheap today. However, betting on this involves significantly more risk than buying a company trading at a low current-year multiple.

    Food for thought.

    JW

    ReplyDelete

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