NOTES ON THE WESCO FINANCIAL ANNUAL MEETING
Thanks to Dah Hui Lau at http://dahhuilaudavid.blogspot.com/
May 6, 2009, Pasadena, California
The meeting was called to order promptly at 2:00 p.m. and carried on at a leisurely pace until ad-journment at 2:04 p.m. The question-and-answer session then commenced. However, in a style he later characterized as “Socratic solitaire,” Charlie Munger both asked and answered the first several questions.
SOCRATIC SOLITAIRE
How serious is the present mess?
“Deadly serious.” “You can’t tell what happens when people get disappointed enough of a dysfunctional civilization.” The Depression led to Hitler. The government has been right to react vigorously.
What caused the mess?
It was an example of a lolapalooza effect: the result of a confluence of causes acting in the same direction.
• Abusive practices in consumer credit, namely extending credit to people who couldn’t handle it, knowing they couldn’t handle it. Sometimes you have to resist sinking to the level of your competitors. But fomenting bad practices often becomes its own punishment. “If you do things that are immoral and stupid, there’s likely to be a whirlwind” that sweeps you away.
• The “scum of the earth” in mortgage credit who “rejoiced in rooking” their borrowers.
• “We had Wall Street go crazy,” pursuing any way of earning money short of armed robbery. In Merrill Lynch’s last purchase of a mortgage outfit, they knowingly bought “a bunch of sleazy crooks,” thinking that if it makes money, who cares that they’re crooks.
• Poor regulation and legislation. Some of the legislators genuinely thought they were being pro-social in helping poor people buy houses, but they weren’t; you need sound credit just as you need sound engineering. Some of the problem was Democrats pushing Fannie and Freddie to lend, some of it was “Republicans who overdosed on Ayn Rand” and thought unrestrained free enterprise was as good for the finance industry as for the restaurant industry.
• The repo system of credit allowed this: “one of the best ways to create excess credit ever invented.” Credit default swaps that let you profit if someone else fails are a terrible idea; in buying life insurance, you’re wisely required to have an insurable interest. Mark-to-model accounting on derivatives let both sides show a profit; “the accounting was phoney because all the customers wanted it phoney.” But Charlie’s never met an accountant who’s ashamed of his profession. People like Greenspan made what was going on respectable by endorsing it, but “it isn’t like free enterprise in restaurants”—more like legalized armed robbery. In the end, “We had to save a lot of these people whether we liked it or not.” To nationalize Fannie
and Freddie and then lower interest rates so good borrowers could buy houses was “very smart government.” In the old days, regulators kept silent about banks until they had to act, then announced a fait accompli; “put me down as dubious” about the public stress-testing. Charlie probably won’t like what Wells Fargo is made to do. Warren and Charlie think more highly of Wells Fargo than others do because of their low cost of funds. Charlie’s willing to put up with less than perfection from the government; on the whole, “it’s working out fairly well,” and “a lot of it has been done beautifully.”
What are the long-term consequences for Wesco?
“Practically none.” Wesco’s holdings will go back up, and indeed some of them have already gone
back up quite a bit. Its businesses will take advantage of the recession, Carnegie-style, to strengthen their positions.
What has the government done wrong?
• Ethanol is stupid. The use of fossil water and loss of topsoil isn’t accounted for, you barely get out more energy than you put in, and driving up the cost of food for the poor is “monstrously stupid.” But ethanol appears to be waning.
• Cap-and-trade is an “insane idea.” The Chinese aren’t going to decrease their emissions. But cap-and-trade might fade away too. What we should worry about is using up hydrocarbons too fast; they have uses, as in fertilizer manufacture, where we have no substitutes. Solar is the way to go; we don’t want everybody, North Korea included, having atomic power plants. Solar, a smart grid, and battery cars. Charlie thinks solar will come down in cost by 50%, but it’s worth switching even if it doesn’t; he agrees with Freeman Dyson that somewhat increasing the cost of energy wouldn’t be a big deal. “We should listen more to Freeman Dyson and less to Al Gore”; one knows how to think and the other doesn’t. China stands to gain from solar too; they’re choking on the emissions from the brown coal their power plants burn. Israel gets half its water from desalination driven by electricity. Cheap power could benefit the Arab nations too, and decrease tensions. “To me these are just ABC. Every bright high-school student in
the room should be nodding his head. . . but I’m not sure that’s the effect.” We could handle a rise in sea level; look at Holland. “Nervous Nellies” see trouble ahead, but we should see plenty. We do need to override obstructive local governments to get the smart grid built. We need more
of the Chinese approach. One of India’s problems is that it has too much due process.
How fast will improvement come?
Japan went all-out with stimulus and lowered interest rates to zero, yet they got stasis instead of a return to 4% growth. That would be terrible in this country, where there’s less social cohesion. “Japan is a very interesting and threatening example,” but Charlie doesn’t know how our case will play out. Japan wasted much of its stimulus filling every pothole three times and leveling every street. We should build that smart grid. Here’s Charlie talking economics, never having taken an economics class in his life. “I’m not apologizing,”and not impressed with academic economics.
What about stock prices?
Charlie’s agnostic on what they’ll do but would be willing to buy at current prices. Coca-Cola is worth what it’s selling for, and so is Wells Fargo. He wouldn’t expect miracles from them, but it’s generally a bad idea to expect miracles anyway. If you wait for a bottom, it’s often too late to buy by the time you know you’ve seen it. Charlie’s pretty fully invested himself. This might be a mistake, but that’s his thinking, and “you’re entitled to know, because you’re cultists.”
What kind of reregulation should come to the financial industry?
An investment bank that is too big to fail shouldn’t be allowed to be anything but a fairly boring
business, making markets, underwriting offerings, and so on. It used to be that way. Partners didn’t make much money. They were conservative people, they actually owned the business, and they’d seen the Thirties. It’s “crazy” to let bright young men buy what they want in the repo market with enormous leverage. Gambling on high leverage ought to be banned. We don’t need options exchanges or credit default swaps. A man doesn’t deserve high pay for ballooning a balance sheet at a tiny spread. “Any idiot could do it. In fact, many have.” We don’t need a world where large numbers of very bright people are trying to get rich by outsmarting each other. Charlie admires Obama for saying he’ll reduce the power of New York, but isn’t sure he’ll have the guts to do as much as Charlie would like done. It’s “not pretty” to make your money by being a better card player than other people, whom you lure into the game.
Buying Berkshire vs. buying Wesco?
“As always,” Berkshire is a better buy at current prices. Wesco gets bid up “because you people are cultists,” but if Charlie were buying today, he’d buy Berkshire. Berkshire is becoming a bigger and better known thing all the time; Wesco is just a byway, and it’s only an independent company by accident.
PRESS QUESTIONS
(Harper’s Magazine) If you were Secretary of the Treasury?
“They’ve been doing pretty well.” Paulson deserves credit, as do the current Secretary and Summers. They’re very able and will do a good job, though constrained by politics: sometimes you know what should be done but can’t do it for political reasons. Considering what they are facing, Treasury has done a good job.
(Motley Fool) If you were Obama, what would you incent?
Charlie would reduce the incentives to go to Wall Street. He’d the markets less deep and liquid, more inefficient. He’d promote the smart grid and do away with the ability of every state and hamlet to block it. He’d promote electric cars. As for Detroit, it’s an “example of a problem where, if you argued for the solution that had a chance of working, they’d bat you over the head and remove you.” Toyota has tough challenges; what hope is there for Detroit? Wringing out everything through bankruptcy and emerging with a single domestic company would have a 40% chance of working. What they’re actually doing has 0% chance except by constantly adding money. It wouldn’t be the end of the world if domestic auto manufacturing died out. It happened in England. Rochester used to prosper on the strength of Xerox and Kodak, and Buffalo has dwindled but is still a pretty nice place. This sort of change, some falling while others rise, is natural. “If someone my age can cheerfully die,” we can put up with the declining communities.
(Kathy Kristof) Many individual investors are disillusioned, seeing both Wall Street and Main Street businessas corrupt, and have sworn off stocks. Are they right to feel that way?
Individuals should maximize their Social Security benefit. That isn’t going away. After that, to expect a lot from stocks, bonds, or whatever is sort of irrational. The best way to achieve felicity is to aim low. Warren’s standard advice, low-cost index funds, is perfectly good for most people, and certainly better than trusting the average stockbroker. (The stockbrokers in the room are different, but “they’re not normal.”) It’s in the nature of markets to go down sometimes. Some people in this room can earn twice the normal return, and Charlie has himself, but he can’t teach everyone how to.
(Gurufocus.com) How do we avoid losses like last year’s? Or can we?
It can’t be done. “If you aren’t suffering a little right now, you haven’t lived a life that’s right.”
(Paul Larson, Morningstar) Book recommendations?
Outliers, by Malcolm Gladwell. “There’s a reason it’s a bestseller.” “I tend not to read self-help investment books. It’s kind of like soap operas: I figure I know all the plots.”
FLOOR QUESTIONS
How to hedge against inflation?
Charlie can remember the 2-cent stamp, the 40-cent-per-hour minimum wage replacing the 25-cent wage. Inflation didn’t ruin the investment climate over his lifetime. When the mass of people can vote, you have to expect inflation. It was a miracle that we had no inflation from 1860 to 1910. But is Berkshire shorting Treasuries or buying TIPS? Berkshire is “aware” that inflation is “the way of the world,” and we do what we can. But we bought a lot of utility bonds paying 9 and 10%. That’s not good if you have inflation, but it’s better than government bonds paying 3%. We don’t have a one-size-fits-all solution.
How can Berkshire invest in Goldman Sachs while inveighing against Wall Street behavior and excessive executive compensation?
The merits outweighed the defects.
What effect will problems in commercial real estate have on GE Capital?
“They will lose some money.”
Isdell and Kent seem much more successful at Coca-Cola than their immediate predecessors, yet it’s the same
company. Why?
The current CEO is “exceptionally gifted.” You can expect good results when a gifted CEO runs a
good company.
What will the business model look like for banks like Wells Fargo going forward?
They’re well situated and have bright prospects. More regulation wouldn’t be a surprise.
Can one teach executive leadership?
Some people are more teachable than others, just as some dogs are. Capitalism keeps filtering out the people who don’t do well and replacing them with people who do better.
What qualities do you look for in a leader?
Trustworthiness; good judgment. Warren’s right that an IQ of 130 is enough (though Berkshire wouldn’t be nearly what it is today if Warren’s own IQ was 130). Overreaching is the problem, and is encouraged by salesmen.
How do the long-term prospects for the investment climates in India and China compare?
If you’re asking whether Wang Chuanfu of BYD will do well, he’ll do “amazingly well.”
Why is growth emphasized? Are there limits to growth? Yes, of course. The material world is finite.
Berkshire’s invested a lot in railroads, but freight volumes are down, and a smart grid with solar and wind would be bad for coal hauling. What would change your views on railroads?
Burlington Northern would still be hauling freight. Railroads have competitive advantages over trucks. They look pretty foolproof; they’d be more foolproof if there isn’t a shift away from coal.
How long would it take to design a smart grid?
Charlie doesn’t know. We’ll need regulatory streamlining to get it built, but it’s perfectly doable.
(Whitney Tilson) Newspaper reports made the Berkshire meeting sound like a gloom-fest, and I wondered whether I’d been at the same meeting. How do you see opportunities today and their effects five years ahead?
Sure we have opportunities, and a smart grid would be good for Berkshire. The guys running Berkshire’s utility business are very good; for one thing, they get along with regulators by giving them what they’d want if they were regulators. There’s “considerable opportunity” for Berkshire to be bigger in utilities.
Human misjudgment?
Like sunshine, it will always be part of the world. At Berkshire, there’s less of it than elsewhere, and his provides an advantage. The best chapter in Outliers is the one about the guy with the 200 IQ who was a total failure in life.
Will there be oil to meet demand in the next five years?
We’re near peak oil, whether the peak is just behind or just ahead. On the other hand, there’s a lot of new gas, and that’s surprised everybody. The world will adapt to whatever the price of oil is, “because it has to.” Oil at $200 a barrel wouldn’t crater America. We’d change our ways and adapt.
What questions are you asking yourself? What should we be worrying about?
There are bad things to worry about. If Charlie were asked the odds of atomic weapons being used in the next 30 years, he’d put them “pretty high.” But you work on things you can change, and “suck up your gut” about the rest. Japan is still a decent place despite 0% growth, though it might not work out the same here; being monoethnic helps them.
What do you think about insuring, or buying, municipal bonds?
Charlie doesn’t want Berkshire insuring an endless amount of municipal bonds. A lot of politicians might yield to the temptation to throw their troubles on some insurer instead of on their taxpayers.
It sounded, at the Berkshire meeting, as though $100 million per year on advertising was maintenance cap-ex for GEICO, and the other $700 million on advertising should be thought of as growth cap-ex. Is that right?
Yes.
Have you read Snowball?
Yes. It’s an interesting book, covering a life in such detail. By and large it’s reasonably accurate, though any book that thick will have errors. And she made a lot of money.
What do you think of reverse mortgages?
They make sense, but they involve big commissions and dealing with frail old people, so Charlie is leery of them, as of anything sold on high commission to the old. Berkshire’s an example, in some ways like a university without walls.
Could we someday have documentation of decision processes released, even if long after the fact?
Berkshire’s example hasn’t had much influence. Charlie compared it to a surgeon he knew of who did a very difficult procedure. Other surgeons admired him but didn’t dare imitate him. Charlie likes Ben Franklin’s idea of not paying government officeholders and would like to see it extended to corporate directors. A fee of $250 thousand is a lot of money to, say, an university professor, and he’s going to do what it takes to stay on the board, and try to get on more boards. But university trustees serve without pay, and directing a public company is a similar public service. “You can argue that Walmart is more important than Harvard” in its cultural and economic impact. Being a director is interesting; why should you need to pay?
Will the coming inflation be like that of the Seventies?
Inflation coming is a good bet, but there’s not necessarily a good way to bet on it. TIPS have drawbacks. Real estate can drop in price, as we’ve seen. Keep your expectations reasonable.
Charlie told the story of a man who owned his house clear and had $1 million invested, letting him live in his house on the dividends. His broker talked him into selling puts on Silicon Valley bubble stocks. He lost his money and his house and took a restaurant job, all from trying to get more when he already had enough.
When will deflation stop and inflation start?
Omaha had no real estate boom and hasn’t had a bust; if you want a house in Omaha now, buy it.
Every market is different. Pasadena real estate is expensive, but it’s a well run city, and if Charlie wanted a house in Pasadena for his family to live in, he’d probably buy. “Now, I might buy it at foreclosure. . ..”
Why did China cease to lead in science 500 years ago?
A dumb, self-satisfied emperor and Confucian bureaucrats “like French Literature at Yale.”
Do you see something special about China?
Charlie likes Confucian values, especially the respect for elderly males. They have a strong work ethic. They’re family-minded. When Wang Chuanfu needed $300 thousand to start BYD, a cousin provided it to him. (That was the best investment the cousin ever made.) Their leaders are engineers: “That’s my kind of Communist.”
Is AIG still underpricing risk? Will the disruption in insurance create opportunities for Berkshire?
Scandal has been bad for AIG’s business. They’ve been “very unlucky.” They’ll survive but have a difficult hand to play. It could happen to Berkshire, or anybody else, if they make dumb decisions.
What’s the future of finance education, giving recent overwhelming evidence that diversification, for example, doesn’t work?
Charlie doesn’t think much of finance professors. Some of them try to turn finance into physics, but it can’t be done. He can’t tell you how to get a good academic finance education.
How can an individual shareholder, who can’t meet management, judge trustworthiness?
There’s no one answer. If you go to Mass. General and say you want to learn to read bone-tumor slides well, they can’t teach you. “No one’s any good at it who hasn’t been doing it for eight years.”
Are corporate lawyers’ fees too high?
Yes. On the other hand, if you can get into a good law school, you’re surrounded by bright people, half from the opposite sex. It’s a good place to meet a mate. And lots of people go to law school without intending to practice. But law in big firms has been too prosperous. Charlie has a lawyer friend who suggested that his firm cull one customer per year, on principle. Charlie thinks it’s a good idea, but the friend’s colleagues shot it down. Charlie’s big early success in business was firing lots of his customers, the ones who didn’t want to let the firm make any money.
What’s the future of the two newspapers you own?
The ordinary daily paper will perish or perhaps become something like public broadcasting, subsidized by one or two big backers.
What do you think about California tax-free bonds?
We have a crazy legislature, gerrymandered to contain only “certified nuts” from the left and the right who naturally hate each other. Charlie doesn’t know how it will play out. You can’t assume good will win. Sometimes evil wins.
Warren has said a weak dollar isn’t enough to resolve the U.S. trade deficit. How might it resolve?
Sometimes the completely unexpected happens. Who could have foreseen Margaret Thatcher and her sweeping changes after 20 years of Labour? “Warren is more pessimistic than I am.” Warren thinks China will tire of sending us goods in exchange for bits of paper. Charlier thinks China is gaining enormously, and the loss of purchasing power on their bits of paper is a small price to pay. The gains don’t show up in the equations of economists, but that means the equations are wrong. Getting good at manufacturing is a form of wealth.
Unrelated to the Wesco Meeting, here is a very good interview of Charlie Munger done recently by Stanford Law School.
Tuesday, May 12, 2009
Sunday, May 10, 2009
Berkshire Hathaway and Wesco Annual Meeting Links
I attended the Berkshire Hathaway Annual Meeting for the Fourth time in a row this year. Overall this year was definitely the best so far. The new structure of the meeting resulted in much better questions and all the poor questions were weeded out by the three journalists: Andrew Ross Sorkin, Becky Quick and Carol Loomis.
I have a compilation of links about the annual meeting:
Notes From Past Annual Meetings:
Whitney Tilson's Notes From Berkshire and Wesco Meetings (1998-2008)
Notes From the 2009 Annual Meeting:
In My Opinion the Best Notes I've Seen are From Ben Claremon at InoculatedInvestor.com
Notes From the Blog ValueHuntr
Notes From Buffettolgist.com
Morningstar's Notes
Interviews:
Charlie Munger on CNBC
Charlie Munger on PBS
An Article on Charlie Munger in the WSJ
Warren Buffett on CNBC: U.S. Economy Slow, Getting Slower...But Will Churn Eventually
Warren Buffett on the Squawk Box
Warren Buffett is up on Banks (CNBC)
Warren Buffett on CNBC: Maybe I've Lost my Touch, But I Beat the Market
Warren Buffett on CNBC: I Apply My Own Stress Tests to Wells Fargo
Wesco Meeting:
The Best Notes I've Seen From the Wesco Meeting
Notes From GuruFocus.com
I have a compilation of links about the annual meeting:
Notes From Past Annual Meetings:
Whitney Tilson's Notes From Berkshire and Wesco Meetings (1998-2008)
Notes From the 2009 Annual Meeting:
In My Opinion the Best Notes I've Seen are From Ben Claremon at InoculatedInvestor.com
Notes From the Blog ValueHuntr
Notes From Buffettolgist.com
Morningstar's Notes
Interviews:
Charlie Munger on CNBC
Charlie Munger on PBS
An Article on Charlie Munger in the WSJ
Warren Buffett on CNBC: U.S. Economy Slow, Getting Slower...But Will Churn Eventually
Warren Buffett on the Squawk Box
Warren Buffett is up on Banks (CNBC)
Warren Buffett on CNBC: Maybe I've Lost my Touch, But I Beat the Market
Warren Buffett on CNBC: I Apply My Own Stress Tests to Wells Fargo
Wesco Meeting:
The Best Notes I've Seen From the Wesco Meeting
Notes From GuruFocus.com
Monday, March 16, 2009
Horsehead Holdings
Business:
Horsehead Holding Corp. is a producer of zinc and zinc-based products with production and recycling operations at six facilities in five states. The company along with its predecessors has been operating in the Zinc industry for over 150 years.
Horsehead is currently trading for $145 million with $123 million in cash on the balance sheet and no debt. Book value currently stands at $358 million. The net current asset value is $150 million.
The company filed for bankruptcy in 2002 due to record low zinc prices, production inefficiencies, high operational costs, and legacy environmental costs associated with prior owners. Sun Capital purchased the company out of bankruptcy and the company went public in 2007 at $18 per share.
They are the largest refiner of zinc oxide and prime western (PW) zinc metal, in North America. The Company is the largest recycler of electric arc furnace (EAF) dust, a hazardous waste produced by the steel mini-mill manufacturing process.
Horsehead operates five hazardous waste recycling facilities for the recovery of zinc from electric arc furnace (EAF) dust and other zinc feedstocks. The five recycling facilities recycle the EAF dust into a zinc intermediate called CZO, which is shipped to their Monaca, Pennsylvania, facility for further processing into zinc metal and zinc oxide. The company’s processing capacity is 565,000 tons of feedstocks which will be processed into 150,000 tons of finished products. They own all of their facilities. Its products are used in a variety of applications, including in the galvanizing of fabricated steel products and as components in rubber tires, alkaline batteries, paint, chemicals and pharmaceuticals. The Company also owns and operates on its premises a 110 megawatt coal-fired power plant that provides it with a source of electricity and allows the Company to sell approximately one-fifth of its capacity on the open market.
EAF Dust recycling
The company is the largest recycler of EAF dust, a hazardous material produced in the steel mini mill process. For every ton of steel produced in the mills 30-40 pounds of EAF dust is generated as a byproduct. This dust contains about 20% zinc. About one million tons of EAF dust is produced in the U.S. every year. The full capacity of their seven kilns plus the flame reactor in Beaumont is 565,000 tons of zinc feedstocks and they are looking to expand that further.
The EAF dust collection market started in 1988 when EPA classified EAF dust as a hazardous waste. Horsehead’s predecessor company, New Jersey Zinc, was among the 55-60 different technologies that were developed to address the regulatory issue. However, none succeeded on commercial basis, except very few ones such as Horsehead’s. Horsehead’s ability to recycle EAF dust and use it as a feedstock for its Monaca smelter gives them a competitive advantage over traditional producers of zinc. The company has a lower breakeven point because instead of paying for its raw materials or mining for zinc, it receives a service fee from the steel mini mills to recycle their EAF dust. Acquiring their raw material at a negative cost gives Horsehead a competitive advantage over their competitors. Horsehead has the only zinc smelter in North America that can produce zinc metal and zinc oxide using 100% recycled zinc feedstocks. In addition their recycling process has been designated by the EPA as a “Best Demonstrated Available Technology” for the processing of EAF dust. In addition, EAF dust recycling operations provide them with a reliable, cost-effective source of recycled zinc without relying on third-party sellers
Horsehead gets about 50% of its EAF dust from Nucor steel. Many of their facilities are situated near Nucor’s plants. Most of Horsehead’s suppliers of EAF dust have been with them since the business started in the 80’s. The company recycles EAF dust for 7 of the 10 largest EAF producers.
Currently, 60% of their feedstocks come from EAF dust. There are significant new opportunities for Horsehead to increase the amount of its feed stocks that come from EAF dust. Since the EAF dust is acquired at negative cost, every increase in the use of EAF dust lowers their overall costs and increases margins. Currently about 1/3 of EAF dust production in the U.S. is deposited in landfills. The steel mini mill share of U.S. steel market has doubled over last 10 years and is expected to increase to 70% of the market by 2017 up from less than 60% today. The steel mini mill market is expected to continue to grow 2-3% a year with new projects under construction currently. Horsehead has many opportunities to increase the portion of their feedstocks that come from EAF dust.
Horsehead management has continually stated that they are looking to increase their EAF processing capabilities. In January of 08 they placed a second kiln into production at their Rockwood, Tennessee facility. This kiln will add 90,000 -100,000 tons to Horsehead’s feedstock capacity per year resulting in approximately 14,500 tons of additional finished zinc product. A new recycling facility is currently under construction in Barnwell, South Carolina near a Nucor Steel facility. The new facility will be able to process 160,000 tons of feedstocks per year and is expected to be complete in the latter half of 09. Management expects production of zinc will increase to 175,000 tons from around 150,000 tons per year currently due to these new projects.
Competitors
Horsehead is the only proven recycler of EAF dust and has no direct competitors. The competition comes from domestic recyclers of zinc secondary’s and miners. U.S. Zinc is a recycler of zinc secondary’s with the ability to produce 75,000 tons of zinc oxide per year. But, U.S. Zinc lacks the integrated processing and smelting capabilities that Horsehead has. The high price of zinc in recent years has attracted attention to the industry. Zinc Ox is currently constructing a plant in Ohio with output of 90,000 tons of zinc metal from dust sourced from a company called Envirosafe and Turkey. In addition, Steel Dust Recycling is currently constructing a plant to recycle EAF dust in Alabama and The Heritage Group has announced its intention to build an EAF dust processing facility in Arkansas. All of these facilities are years away from startup but could pose a risk to Horsehead.
Horsehead competes with landfills for EAF dust. But steel mills have many reasons to go to Horsehead instead. The mills that the company purchases its EAF dust from benefit from less exposure to potential environmental liabilities arising from disposing the hazardous dust in a land fill.
Over 75% of the zinc used in the U.S. is imported. Horsehead benefits from its close proximity to end users and lower costs of transportation verse foreign producers.
Operations
Horsehead sells its finished products based on a slight premium to the prior month London Metals Exchange (LME) price for zinc. The LME price dipped just below 50 cents per pound in 2003 and rose to a high of just of over $2 per pound in December of 2006. But since then the price has fallen to just below 60 cents per pound. The company has been working to reduce costs and their cash flow breakeven level is currently around 50 cents. In 2006 the company made $54.5 million which includes a $16 million management fee to Sun Capital. Excluding this fee, the company made $65 million in 2006 and $90.7 million in 2007. Net income for 2008 fell to $39.4 million due to the decline in the price of zinc and a decline in shipments, offset by a large gain due to hedging.
The future LME price of zinc will be affected by idled or closed zinc mining and smelting capacity growth in steel consumption and falling inventories. The current inventories of zinc have risen from the all time lows of a few years ago but are still well below historical average. Inventories have begun to fall as zinc mines and smelter capacity has been removed due to the low price of zinc. In 07, 11.3 million tons of zinc was consumed worldwide. This is expected to increase by 4-5% a year to 13.6 million in 2012. Meanwhile the supply of zinc is likely to be tight, when the economy improves. Brunswick, the world’s fourth largest zinc mine owned by Xstrata, produced 2% of the world’s zinc last year, is expected to be depleted by the end of 2010. It is likely that a decrease in capacity and curtailed capacity additions will cause the price of zinc to rise from the current historically low levels. Also, any stimulus such as the U.S.’s and China’s that includes infrastructure spending will increase demand for zinc.
In the 4th quarter cash provided by operations was $65.5 million. This includes $64 million in cash received from puts on the price of zinc which were sold in the 4th quarter. Sales of finished product were at an average zinc contained price of $.79 in the quarter. When the price of zinc declines the company is also affected by a lag in cost because the feed stocks going through the income statement were purchased back when prices were higher. When prices for zinc stabilize, costs will decrease further. Management expects that cash from operations will be negative for the first half of 09. But, cost cutting measures and an increase in the use of EAF dust instead of other feed stocks have pushed the breakeven point down to around $.50 per pound. Horsehead made $70 million on put options in 08 and they currently have puts for 90,000 tons of zinc at $.5 per pound through 09 to protect them if prices fall further.
Because of the large decline in the price of zinc the company has taken many actions to reduce costs and conserve cash. During the 4th quarter the company has: reduced output at the Monaca facility, suspended production of zinc oxide made from higher cost feed sources, took at extended outage at the recycling operations over the holidays, implemented a reduction in workforce, renegotiated feed prices and cut smelter output by 17%.
Untapped Value in Iron Byproduct
Horsehead’s operations produce about 350,000 tons of iron rich material that they sell into the aggregate market each year. This iron rich material contains about 175,000 tons of iron that the company believes they could sell for much more than they are getting currently. The company sells this material for about $1 per ton. The company believes they could sell the iron portion for $50- $75 per ton. The company successfully tested higher value applications for the iron rich material in the fourth quarter and expects to place its first order during the first quarter of 2009. The value of this byproduct could be worth $9-$13 million per year.
Undervalued
The company is the largest recycler of EAF dust in the world with no direct competitors. Horsehead's ability to recycle EAF dust gives them a competitive advantage over traditional miners and smelters of zinc. Horsehead is working to increase the portion of their feedstocks that are EAF dust and increase processing capacity. Horsehead also benefits from its close proximity to end users in the U.S. In addition, Horsehead has the potential to make a lot of money on the iron byproduct produced from their operations. Horsehead's stock has collapsed due to the decline in the price of Zinc. But, with their competitive advantages and large cash hoard, Horsehead can survive the recession. Horsehead is currently trading for $145 million with $123 million in cash on the balance sheet and no debt. Book value currently stands at $358 million and net current asset value is $150 million. The company made $65 million in 2006, $90.7 million in 2007 and $39.4 million in 2008. I believe Horsehead is very undervalued.
Horsehead Holding Corp. is a producer of zinc and zinc-based products with production and recycling operations at six facilities in five states. The company along with its predecessors has been operating in the Zinc industry for over 150 years.
Horsehead is currently trading for $145 million with $123 million in cash on the balance sheet and no debt. Book value currently stands at $358 million. The net current asset value is $150 million.
The company filed for bankruptcy in 2002 due to record low zinc prices, production inefficiencies, high operational costs, and legacy environmental costs associated with prior owners. Sun Capital purchased the company out of bankruptcy and the company went public in 2007 at $18 per share.
They are the largest refiner of zinc oxide and prime western (PW) zinc metal, in North America. The Company is the largest recycler of electric arc furnace (EAF) dust, a hazardous waste produced by the steel mini-mill manufacturing process.
Horsehead operates five hazardous waste recycling facilities for the recovery of zinc from electric arc furnace (EAF) dust and other zinc feedstocks. The five recycling facilities recycle the EAF dust into a zinc intermediate called CZO, which is shipped to their Monaca, Pennsylvania, facility for further processing into zinc metal and zinc oxide. The company’s processing capacity is 565,000 tons of feedstocks which will be processed into 150,000 tons of finished products. They own all of their facilities. Its products are used in a variety of applications, including in the galvanizing of fabricated steel products and as components in rubber tires, alkaline batteries, paint, chemicals and pharmaceuticals. The Company also owns and operates on its premises a 110 megawatt coal-fired power plant that provides it with a source of electricity and allows the Company to sell approximately one-fifth of its capacity on the open market.
EAF Dust recycling
The company is the largest recycler of EAF dust, a hazardous material produced in the steel mini mill process. For every ton of steel produced in the mills 30-40 pounds of EAF dust is generated as a byproduct. This dust contains about 20% zinc. About one million tons of EAF dust is produced in the U.S. every year. The full capacity of their seven kilns plus the flame reactor in Beaumont is 565,000 tons of zinc feedstocks and they are looking to expand that further.
The EAF dust collection market started in 1988 when EPA classified EAF dust as a hazardous waste. Horsehead’s predecessor company, New Jersey Zinc, was among the 55-60 different technologies that were developed to address the regulatory issue. However, none succeeded on commercial basis, except very few ones such as Horsehead’s. Horsehead’s ability to recycle EAF dust and use it as a feedstock for its Monaca smelter gives them a competitive advantage over traditional producers of zinc. The company has a lower breakeven point because instead of paying for its raw materials or mining for zinc, it receives a service fee from the steel mini mills to recycle their EAF dust. Acquiring their raw material at a negative cost gives Horsehead a competitive advantage over their competitors. Horsehead has the only zinc smelter in North America that can produce zinc metal and zinc oxide using 100% recycled zinc feedstocks. In addition their recycling process has been designated by the EPA as a “Best Demonstrated Available Technology” for the processing of EAF dust. In addition, EAF dust recycling operations provide them with a reliable, cost-effective source of recycled zinc without relying on third-party sellers
Horsehead gets about 50% of its EAF dust from Nucor steel. Many of their facilities are situated near Nucor’s plants. Most of Horsehead’s suppliers of EAF dust have been with them since the business started in the 80’s. The company recycles EAF dust for 7 of the 10 largest EAF producers.
Currently, 60% of their feedstocks come from EAF dust. There are significant new opportunities for Horsehead to increase the amount of its feed stocks that come from EAF dust. Since the EAF dust is acquired at negative cost, every increase in the use of EAF dust lowers their overall costs and increases margins. Currently about 1/3 of EAF dust production in the U.S. is deposited in landfills. The steel mini mill share of U.S. steel market has doubled over last 10 years and is expected to increase to 70% of the market by 2017 up from less than 60% today. The steel mini mill market is expected to continue to grow 2-3% a year with new projects under construction currently. Horsehead has many opportunities to increase the portion of their feedstocks that come from EAF dust.
Horsehead management has continually stated that they are looking to increase their EAF processing capabilities. In January of 08 they placed a second kiln into production at their Rockwood, Tennessee facility. This kiln will add 90,000 -100,000 tons to Horsehead’s feedstock capacity per year resulting in approximately 14,500 tons of additional finished zinc product. A new recycling facility is currently under construction in Barnwell, South Carolina near a Nucor Steel facility. The new facility will be able to process 160,000 tons of feedstocks per year and is expected to be complete in the latter half of 09. Management expects production of zinc will increase to 175,000 tons from around 150,000 tons per year currently due to these new projects.
Competitors
Horsehead is the only proven recycler of EAF dust and has no direct competitors. The competition comes from domestic recyclers of zinc secondary’s and miners. U.S. Zinc is a recycler of zinc secondary’s with the ability to produce 75,000 tons of zinc oxide per year. But, U.S. Zinc lacks the integrated processing and smelting capabilities that Horsehead has. The high price of zinc in recent years has attracted attention to the industry. Zinc Ox is currently constructing a plant in Ohio with output of 90,000 tons of zinc metal from dust sourced from a company called Envirosafe and Turkey. In addition, Steel Dust Recycling is currently constructing a plant to recycle EAF dust in Alabama and The Heritage Group has announced its intention to build an EAF dust processing facility in Arkansas. All of these facilities are years away from startup but could pose a risk to Horsehead.
Horsehead competes with landfills for EAF dust. But steel mills have many reasons to go to Horsehead instead. The mills that the company purchases its EAF dust from benefit from less exposure to potential environmental liabilities arising from disposing the hazardous dust in a land fill.
Over 75% of the zinc used in the U.S. is imported. Horsehead benefits from its close proximity to end users and lower costs of transportation verse foreign producers.
Operations
Horsehead sells its finished products based on a slight premium to the prior month London Metals Exchange (LME) price for zinc. The LME price dipped just below 50 cents per pound in 2003 and rose to a high of just of over $2 per pound in December of 2006. But since then the price has fallen to just below 60 cents per pound. The company has been working to reduce costs and their cash flow breakeven level is currently around 50 cents. In 2006 the company made $54.5 million which includes a $16 million management fee to Sun Capital. Excluding this fee, the company made $65 million in 2006 and $90.7 million in 2007. Net income for 2008 fell to $39.4 million due to the decline in the price of zinc and a decline in shipments, offset by a large gain due to hedging.
The future LME price of zinc will be affected by idled or closed zinc mining and smelting capacity growth in steel consumption and falling inventories. The current inventories of zinc have risen from the all time lows of a few years ago but are still well below historical average. Inventories have begun to fall as zinc mines and smelter capacity has been removed due to the low price of zinc. In 07, 11.3 million tons of zinc was consumed worldwide. This is expected to increase by 4-5% a year to 13.6 million in 2012. Meanwhile the supply of zinc is likely to be tight, when the economy improves. Brunswick, the world’s fourth largest zinc mine owned by Xstrata, produced 2% of the world’s zinc last year, is expected to be depleted by the end of 2010. It is likely that a decrease in capacity and curtailed capacity additions will cause the price of zinc to rise from the current historically low levels. Also, any stimulus such as the U.S.’s and China’s that includes infrastructure spending will increase demand for zinc.
In the 4th quarter cash provided by operations was $65.5 million. This includes $64 million in cash received from puts on the price of zinc which were sold in the 4th quarter. Sales of finished product were at an average zinc contained price of $.79 in the quarter. When the price of zinc declines the company is also affected by a lag in cost because the feed stocks going through the income statement were purchased back when prices were higher. When prices for zinc stabilize, costs will decrease further. Management expects that cash from operations will be negative for the first half of 09. But, cost cutting measures and an increase in the use of EAF dust instead of other feed stocks have pushed the breakeven point down to around $.50 per pound. Horsehead made $70 million on put options in 08 and they currently have puts for 90,000 tons of zinc at $.5 per pound through 09 to protect them if prices fall further.
Because of the large decline in the price of zinc the company has taken many actions to reduce costs and conserve cash. During the 4th quarter the company has: reduced output at the Monaca facility, suspended production of zinc oxide made from higher cost feed sources, took at extended outage at the recycling operations over the holidays, implemented a reduction in workforce, renegotiated feed prices and cut smelter output by 17%.
Untapped Value in Iron Byproduct
Horsehead’s operations produce about 350,000 tons of iron rich material that they sell into the aggregate market each year. This iron rich material contains about 175,000 tons of iron that the company believes they could sell for much more than they are getting currently. The company sells this material for about $1 per ton. The company believes they could sell the iron portion for $50- $75 per ton. The company successfully tested higher value applications for the iron rich material in the fourth quarter and expects to place its first order during the first quarter of 2009. The value of this byproduct could be worth $9-$13 million per year.
Undervalued
The company is the largest recycler of EAF dust in the world with no direct competitors. Horsehead's ability to recycle EAF dust gives them a competitive advantage over traditional miners and smelters of zinc. Horsehead is working to increase the portion of their feedstocks that are EAF dust and increase processing capacity. Horsehead also benefits from its close proximity to end users in the U.S. In addition, Horsehead has the potential to make a lot of money on the iron byproduct produced from their operations. Horsehead's stock has collapsed due to the decline in the price of Zinc. But, with their competitive advantages and large cash hoard, Horsehead can survive the recession. Horsehead is currently trading for $145 million with $123 million in cash on the balance sheet and no debt. Book value currently stands at $358 million and net current asset value is $150 million. The company made $65 million in 2006, $90.7 million in 2007 and $39.4 million in 2008. I believe Horsehead is very undervalued.
Sunday, March 15, 2009
Sold Footstar
In late November I purchased shares in Footstar at $2.8 per share. In January I received a $1 dividend as part of the company’s liquidation. In the 4th quarter the company received $53 million from Kmart for the remaining inventory and reduced the market price of their headquarters building to $12 million from $19 million. The current carrying value on the balance sheet is $6.2 million. In addition, 4th quarter earnings came in at the high end of my estimate at $25 million.
Last week I sold my shares for $2.63. In 3 months I made a 30% return on my investment in Footstar. I purchased Footstar because I believed that the company would be able to distribute at least $4.5 per share as part of their liquidation. After accounting for the recent dividend and the operating results for the 4th quarter which were better than I had estimated they would be, the company estimates it will distribute $2.65-$3.45 per share to shareholders. There is still a 30% upside from the current price using the best case. But, the sale of the headquarters building could take time especially in this environment. If the best and worse cases are averaged shareholders would end up with a 15% return on their money. With the opportunities available in the market today I’ve decided to sell my shares in Footstar.
Last week I sold my shares for $2.63. In 3 months I made a 30% return on my investment in Footstar. I purchased Footstar because I believed that the company would be able to distribute at least $4.5 per share as part of their liquidation. After accounting for the recent dividend and the operating results for the 4th quarter which were better than I had estimated they would be, the company estimates it will distribute $2.65-$3.45 per share to shareholders. There is still a 30% upside from the current price using the best case. But, the sale of the headquarters building could take time especially in this environment. If the best and worse cases are averaged shareholders would end up with a 15% return on their money. With the opportunities available in the market today I’ve decided to sell my shares in Footstar.
Monday, December 1, 2008
Third Quarter Earnings
Here is an update on the investments in my portfolio and my thoughts on third quarter earnings.
K-Swiss:
For the 3rd quarter revenue fell 10% pushing the company into a loss of $.1 million. Backlog continues to point towards declining sales. Total backlog is down 29%, comprising of a decrease of 35% domestically and a decrease of 25% internationally. K-Swiss is heading for a loss of $10-35 cents per share in the forth quarter. During the conference call manegment said that they are expecting a loss in 09 that could possibly burn through 10-20% of their cash. Separately K-Swiss announced during the past month that they will pay a special $2 dividend to shareholders on December 24th. This is a very positive sigh because on an enterprise value basis K-Swiss trades for less the 2 times my estimate of earnings a few years down the road. The CEO and CFO are two of the most candid managers out there, the decisions being made by the company show their philosophy of not thinking short term. I’m hoping the stock gets cheaper in the near term as I’m ready to buy a lot more. K-Swiss should easily be able to earn $60-90 million in net income when the economy improves. K-Swiss is currently trading for $400 million with nearly $300 million in cash. My estimate of intrinsic value $1250.5-$1478 million
Read my investment thesis on K-Swiss here
Freightcar America:
FCA is suffering from a downturn in the coal car cycle after the cycle peaked in 06 and customers over ordered. The poor economy also has a large negative effects on FCA. The 3rd quarter results were good but with the threat of a recession it is premature to say that the bottom of the coal car cycle has been reached. For the quarter sales were $238 million compared to $162 million in the same quarter last year and for the 9 months ended sales were $474 million compared to $680 last year. Net income declined to $7.4 million from $8.7 last year for the quarter. For the 9 months period the net loss was $3.7 million compared to a net income of $43 million last year. Orders during the quarter were 2329 compared to 1400 last year. Backlog at quarter end was 4401 units. FCA delivered 3082 railcars in the quarter compared to 2072 in the 3rd quarter last year. For the 9 months ended FCA delivered 6695 railcars compared to 8677 last year. FCA was hurt by material cost increases and large costs to close the Johnstown facility. To date the cost of closing the facility was $51 million and the remaining costs are small. FCA is trading for $258 million with $128 million in cash. My estimate of FCA’s normalized free cash flow is $36 million. FCA’s enterprise value is $130 million. My estimate of intrinsic value is $40-60 per share.
Read my last post on FCA here
American Eagle Outfitters
For the third quarter American Eagle had net income of 30 cents which includes a 9 cent writeoff of investments in auction rate securities. That compares to earnings of 45 cents last year. Sales were up 1%. Third quarter same store sale were down 7%. Operating margin was $95 million compared to $151 million or 12.6% vs. 20.3% in the same period last year. Results in the 3rd quarter 2008 include a $19.9 million impairment on the value of auction rate securities. Net income was $43 million vs. $99 million. The bright spot was AE Direct where sales increased 35% in the quarter. American Eagle has a market cap of $1.9 billion. Cash and investments total $616 million resulting in an enterprise value of $1.3 billion. Operating margins have averaged around 20% in the past compared to 12.6% in the last quarter. Even with operating margins around half of what they have averaged historically, American Eagle will be able to generate around $180 million in earnings a year. In addition American Eagle is an enduring brand with a lot of growth ahead with the new ventures such as aerie, Martin and Osa, AE Direct and 77 kids. A conservative estimate of intrinsic value is 2-3 times the current price.
Read my investment thesis American Eagle
Nicholas Financial
Nicholas Financial reported earnings of $792 thousand down from $2.6 million in the 3rd quarter last year. Revenue increased from $12.6 million to $13.5 million as the company continued to write new contacts. The new contracts are extremely profitable as NICK’s competitors retreat from the market. This pushed net finance receivables up to $210 million from $189 million in the quarter last year. The provision for credit losses was $5.1 million up from $1.6 last year in the quarter. This pushed the net portfolio yield down to 2.5%. The provision for credit losses is 9.86% so a 30% increase in the reserve would cause losses. The factor that most effects NICK is the unemployment rate. Management expects the charge off rate to worsen slightly in the fourth quarter. The strong point though is NICK’s reserve for credit losses that stands at over $23 million. This compares to charge offs over the last 6 months of $11 million. So the reserve is at a very healthy level. Nicholas Financial is trading for $25 million with $83 million in book value.
Read my investment thesis on Nicholas Financial
Pinnacle Airlines:
For the 3rd quarter Pinnacle reported revenue of $220 million vs. $203 for the same period last year. Operating margin improved to 9% from 7.3% last year. Operating income was $20 million compared to $15 million last year. Pinnacle has $64 million in cash and $127 million in auction rate securities. For the 9 month period operating income was $29 million vs. $43 million but the 2008 period contains a $13.8 million impairment on the value of the goodwill related to Colgan. Pinnacle currently has seven addition aircraft in it’s fleet that are being flown temporarily for Delta. Pinnacle has lead all regionals in operating performance for the past 22 out of 33 months. Colgan’s operations are beginning to turn around as its contracts with the government were rebid during the quarter. Management expects that Colgan will be profitable in 09. Also all the Q-400's are operational. Operationally Pinnacle is doing alright. The over supply of 50 seaters in operation is hurting them. They continue to generate a healthy amount of cash and a $30 million tax refund will be received in the first quarter.
Mohnish Pabrai began selling his stake in Pinnacle a few months back. No matter what, airlines are problem businesses. I now regret my investment in Pinnacle. My mistake was that I focused on PNCL as not really an airline company and I didn't consider the macro factors. I assumed that the contracts were solid. But when the customer is making all the money and the operator has the control, there is going to be problems. What Delta did was also caused by the over supply of 50 seaters in the market today. It doesn't make sense that the airlines would tolerate the regionals making so much money when economic conditions have caused them to be losing a ton on the other side of the deal. But the contracts do allow the parents to swap the 50 seaters for larger planes on a one for one basis. The result is yet to be seen but clearly Pinnacle has been impaired. But, PNCL has $200m in investments and 3rd quarter results were not bad. A healthy level of FCF is being generated. In my last post on Pinnacle I considered the worse case scenario and estimated a liquidation value. Given the price Pinnacle is trading at I’m holding.
Read my other posts on Pinnacle here
K-Swiss:
For the 3rd quarter revenue fell 10% pushing the company into a loss of $.1 million. Backlog continues to point towards declining sales. Total backlog is down 29%, comprising of a decrease of 35% domestically and a decrease of 25% internationally. K-Swiss is heading for a loss of $10-35 cents per share in the forth quarter. During the conference call manegment said that they are expecting a loss in 09 that could possibly burn through 10-20% of their cash. Separately K-Swiss announced during the past month that they will pay a special $2 dividend to shareholders on December 24th. This is a very positive sigh because on an enterprise value basis K-Swiss trades for less the 2 times my estimate of earnings a few years down the road. The CEO and CFO are two of the most candid managers out there, the decisions being made by the company show their philosophy of not thinking short term. I’m hoping the stock gets cheaper in the near term as I’m ready to buy a lot more. K-Swiss should easily be able to earn $60-90 million in net income when the economy improves. K-Swiss is currently trading for $400 million with nearly $300 million in cash. My estimate of intrinsic value $1250.5-$1478 million
Read my investment thesis on K-Swiss here
Freightcar America:
FCA is suffering from a downturn in the coal car cycle after the cycle peaked in 06 and customers over ordered. The poor economy also has a large negative effects on FCA. The 3rd quarter results were good but with the threat of a recession it is premature to say that the bottom of the coal car cycle has been reached. For the quarter sales were $238 million compared to $162 million in the same quarter last year and for the 9 months ended sales were $474 million compared to $680 last year. Net income declined to $7.4 million from $8.7 last year for the quarter. For the 9 months period the net loss was $3.7 million compared to a net income of $43 million last year. Orders during the quarter were 2329 compared to 1400 last year. Backlog at quarter end was 4401 units. FCA delivered 3082 railcars in the quarter compared to 2072 in the 3rd quarter last year. For the 9 months ended FCA delivered 6695 railcars compared to 8677 last year. FCA was hurt by material cost increases and large costs to close the Johnstown facility. To date the cost of closing the facility was $51 million and the remaining costs are small. FCA is trading for $258 million with $128 million in cash. My estimate of FCA’s normalized free cash flow is $36 million. FCA’s enterprise value is $130 million. My estimate of intrinsic value is $40-60 per share.
Read my last post on FCA here
American Eagle Outfitters
For the third quarter American Eagle had net income of 30 cents which includes a 9 cent writeoff of investments in auction rate securities. That compares to earnings of 45 cents last year. Sales were up 1%. Third quarter same store sale were down 7%. Operating margin was $95 million compared to $151 million or 12.6% vs. 20.3% in the same period last year. Results in the 3rd quarter 2008 include a $19.9 million impairment on the value of auction rate securities. Net income was $43 million vs. $99 million. The bright spot was AE Direct where sales increased 35% in the quarter. American Eagle has a market cap of $1.9 billion. Cash and investments total $616 million resulting in an enterprise value of $1.3 billion. Operating margins have averaged around 20% in the past compared to 12.6% in the last quarter. Even with operating margins around half of what they have averaged historically, American Eagle will be able to generate around $180 million in earnings a year. In addition American Eagle is an enduring brand with a lot of growth ahead with the new ventures such as aerie, Martin and Osa, AE Direct and 77 kids. A conservative estimate of intrinsic value is 2-3 times the current price.
Read my investment thesis American Eagle
Nicholas Financial
Nicholas Financial reported earnings of $792 thousand down from $2.6 million in the 3rd quarter last year. Revenue increased from $12.6 million to $13.5 million as the company continued to write new contacts. The new contracts are extremely profitable as NICK’s competitors retreat from the market. This pushed net finance receivables up to $210 million from $189 million in the quarter last year. The provision for credit losses was $5.1 million up from $1.6 last year in the quarter. This pushed the net portfolio yield down to 2.5%. The provision for credit losses is 9.86% so a 30% increase in the reserve would cause losses. The factor that most effects NICK is the unemployment rate. Management expects the charge off rate to worsen slightly in the fourth quarter. The strong point though is NICK’s reserve for credit losses that stands at over $23 million. This compares to charge offs over the last 6 months of $11 million. So the reserve is at a very healthy level. Nicholas Financial is trading for $25 million with $83 million in book value.
Read my investment thesis on Nicholas Financial
Pinnacle Airlines:
For the 3rd quarter Pinnacle reported revenue of $220 million vs. $203 for the same period last year. Operating margin improved to 9% from 7.3% last year. Operating income was $20 million compared to $15 million last year. Pinnacle has $64 million in cash and $127 million in auction rate securities. For the 9 month period operating income was $29 million vs. $43 million but the 2008 period contains a $13.8 million impairment on the value of the goodwill related to Colgan. Pinnacle currently has seven addition aircraft in it’s fleet that are being flown temporarily for Delta. Pinnacle has lead all regionals in operating performance for the past 22 out of 33 months. Colgan’s operations are beginning to turn around as its contracts with the government were rebid during the quarter. Management expects that Colgan will be profitable in 09. Also all the Q-400's are operational. Operationally Pinnacle is doing alright. The over supply of 50 seaters in operation is hurting them. They continue to generate a healthy amount of cash and a $30 million tax refund will be received in the first quarter.
Mohnish Pabrai began selling his stake in Pinnacle a few months back. No matter what, airlines are problem businesses. I now regret my investment in Pinnacle. My mistake was that I focused on PNCL as not really an airline company and I didn't consider the macro factors. I assumed that the contracts were solid. But when the customer is making all the money and the operator has the control, there is going to be problems. What Delta did was also caused by the over supply of 50 seaters in the market today. It doesn't make sense that the airlines would tolerate the regionals making so much money when economic conditions have caused them to be losing a ton on the other side of the deal. But the contracts do allow the parents to swap the 50 seaters for larger planes on a one for one basis. The result is yet to be seen but clearly Pinnacle has been impaired. But, PNCL has $200m in investments and 3rd quarter results were not bad. A healthy level of FCF is being generated. In my last post on Pinnacle I considered the worse case scenario and estimated a liquidation value. Given the price Pinnacle is trading at I’m holding.
Read my other posts on Pinnacle here
Sunday, November 30, 2008
Footstar
Footstar is a liquidation play with tangible equity of $82.1 million ($3.84 per share) and an expected liquidation value of at least $96 million ($4.5 per share). This compares to the current stock price of $2.8. I see a very low chance of getting less then the current stock price with the upside being a 40% return in less then a year.
Footstar runs the footwear departments in 1,383 Kmart and 833 Rite Aid stores. In March 2004, due to poor acquisitions, accounting problems and then liquidity issues, Footstar went into bankruptcy. In February 2006, the company emerged and paid creditors in full. While in bankruptcy in 2005 after years of litigation the contract with Kmart was amended. Originally set to expire on December 31, 2012, the contract now expires on December 31, 2008. After the contract expires Footstar will liquidate.
Liquidation
On April 30th 2008 Footstar paid a $5 taxable dividend. On April 3rd 2008 Footstar sold substantially all of its intellectual property to Kmart for $13 million. On June 30th 2008 Footstar paid a further $1 dividend.
When the contract expires at the end of the year, Kmart will purchase the inventory related to its stores excluding unsalable or damaged inventory for book value. Any seasonal (4 months past season) will be purchased for 40% of cost. Footstar has already reserved $2.4 million for seasonal inventory. Any unsalable or damaged inventory will not be purchased.
The other asset remaining is Footstar’s headquarters building located in Mahwah, NJ and is listed for $19.5 million. Mike Lynch told me that they have had interest in the property but nothing has materialized.
K-mart agreed to hire substantially all store and district managers. Footstar eliminated 3 executive positions and notified 218 employees of termination. The severance cost related to these employees is $8.5 million plus $2 million in benefit costs, with $3.6 million already accrued, $6.9 million in remaining severance is not yet expensed. It is my understanding that this accounts for all of the severance. I spoke to Mike Lynch whose is CFO. This is what he said "All employees are accounted for at this juncture, but it is possible that additional severance/retention measures could still be put in place depending upon the circumstances."
The last item that needs to be accounted for is Footstar’s second half 08 operating earnings. Considering income taxes is virtually nil due to deferred tax assets, operating earnings is the best metric to use. Operating income was $28.4 million for the first half. But, this includes a gain of $22.3 million for the reduced severance after Kmart agreed to hire all store and district managers. A charge of $2.4 million for the seasonal inventory and $3.6 million in severence related to the portion that has already been expensed. Neting out these items gives operating earnings of $12.1 million compared to $21.5 million or the first half last year. The factors effecting second half earnings will be lower operating expenses due to lower headcount and weaker retail environment. In the first half Kmart recorded same store sales declines of 6% compared to Footstar’s decline of 10.6%. Operating earnings declined 40% in the first half. Operating earnings was $32 million in the 2nd half of 07. My best case and worse case 2nd half 08 operating earnings estimate is $19-$25 million.
Here is a chart showing the balance sheet at June 28, 2008 adjusted to the expected liquidation value:
My estimate of second half cash flow could prove to be way off especially given the current situation in the economy. My estimate is fairly conservative but the results remain yet to be seen. But keep in mind that even without the 2nd half cash flow tangible equity is $82 million compared to a market cap of $60 million.
Footstar runs the footwear departments in 1,383 Kmart and 833 Rite Aid stores. In March 2004, due to poor acquisitions, accounting problems and then liquidity issues, Footstar went into bankruptcy. In February 2006, the company emerged and paid creditors in full. While in bankruptcy in 2005 after years of litigation the contract with Kmart was amended. Originally set to expire on December 31, 2012, the contract now expires on December 31, 2008. After the contract expires Footstar will liquidate.
Liquidation
On April 30th 2008 Footstar paid a $5 taxable dividend. On April 3rd 2008 Footstar sold substantially all of its intellectual property to Kmart for $13 million. On June 30th 2008 Footstar paid a further $1 dividend.
When the contract expires at the end of the year, Kmart will purchase the inventory related to its stores excluding unsalable or damaged inventory for book value. Any seasonal (4 months past season) will be purchased for 40% of cost. Footstar has already reserved $2.4 million for seasonal inventory. Any unsalable or damaged inventory will not be purchased.
The other asset remaining is Footstar’s headquarters building located in Mahwah, NJ and is listed for $19.5 million. Mike Lynch told me that they have had interest in the property but nothing has materialized.
K-mart agreed to hire substantially all store and district managers. Footstar eliminated 3 executive positions and notified 218 employees of termination. The severance cost related to these employees is $8.5 million plus $2 million in benefit costs, with $3.6 million already accrued, $6.9 million in remaining severance is not yet expensed. It is my understanding that this accounts for all of the severance. I spoke to Mike Lynch whose is CFO. This is what he said "All employees are accounted for at this juncture, but it is possible that additional severance/retention measures could still be put in place depending upon the circumstances."
The last item that needs to be accounted for is Footstar’s second half 08 operating earnings. Considering income taxes is virtually nil due to deferred tax assets, operating earnings is the best metric to use. Operating income was $28.4 million for the first half. But, this includes a gain of $22.3 million for the reduced severance after Kmart agreed to hire all store and district managers. A charge of $2.4 million for the seasonal inventory and $3.6 million in severence related to the portion that has already been expensed. Neting out these items gives operating earnings of $12.1 million compared to $21.5 million or the first half last year. The factors effecting second half earnings will be lower operating expenses due to lower headcount and weaker retail environment. In the first half Kmart recorded same store sales declines of 6% compared to Footstar’s decline of 10.6%. Operating earnings declined 40% in the first half. Operating earnings was $32 million in the 2nd half of 07. My best case and worse case 2nd half 08 operating earnings estimate is $19-$25 million.
Here is a chart showing the balance sheet at June 28, 2008 adjusted to the expected liquidation value:
Risks
The largest risk is that management will not liquidate in an expedient manner. Footstar will file a plan of liquidation in early 09. But the sale of the headquarters building could delay the liquidation. Also, some have raised the issue that the last two dividends were not tax efficient and that they should have been set as liquidating dividends and not taxable. The OutPoint Group waged a proxy fight earlier this year attempting to name two candidates to the board. The Outpoint group owns 3% of the company. They and raised such issues as the excessive compensation for the top executives, the CEO’s total compensation was $3.5 million last year and the CFO made $700,00. Directors are paid between $110-$160 thousand year. Footstar reimbursed the chairman $160,000 for his failed bid for the company in 2006.
My estimate of second half cash flow could prove to be way off especially given the current situation in the economy. My estimate is fairly conservative but the results remain yet to be seen. But keep in mind that even without the 2nd half cash flow tangible equity is $82 million compared to a market cap of $60 million.
Sunday, November 2, 2008
K-Swiss
This is my analysis of K-Swiss:
K-Swiss, Inc engages in the design, development, and marketing of athletic footwear for sports use, fitness activities, and casual wear. It also markets apparel and accessories under the K-Swiss the brand name. In 2001 K-Swiss acquired Royal Elastics.
K-Swiss was founded in 1966 by two brothers dissatisfied with the tennis shoes in the market. The two Swiss brothers developed the K-Swiss Classic. In 1986 Steven Nichols then the president of the Children’s shoe division at Stride Aide recognized the timeliness of the shoe and tried to convince his bosses to buy the company. They refused and Nichols left the company and formed an investor group that acquired K-Swiss for $20 million. At the time K-Swiss was basically in bankruptcy. In 1990 K-Swiss went public. Nichols has grown the company from sales of $20 million in 1986 to $410 million in 2007. The K-Swiss Classic still represents two-thirds of sales with only slight changes to the shoe from the original in 1966. The Classic has since developed into a casual shoe. In the mid nineties Warren Buffett offered to buy the company but Nichols refused to sell. He said that he greatly admires Buffett but that Buffett offered no premium for the company. Nichols owns 22% of the company and insiders control 25%, Third Avenue owns 12%.
The shoe sold today is virtually indistinguishable from the original Classic sold in 1966. The Classic is popular with teens. Nichols has a very different strategy then most shoe companies. The extremely long durability of the Classic shoe is a competitive advantage. The product development costs are drastically lower then its competitors who are constantly introducing new models. The shoe’s distributors also are benefitted because the shoe doesn’t need to be marked down when new models are constantly introduced. K-Swiss is the most profitable vendor for the stores it distributes shoes to. K-Swiss is very selective with the venders they will supply to. K-Swiss avoids saturating the market with the Classic because that degrades the image of the brand. For the past 10 years gross margins have averaged 45% compared to 42% at Nike, 41% at Sketchers and 39% at Steven Madden. Operating margins have averaged 17% compared to 11% at Nike, 7% at Sketchers, 8% at Steven Madden. The 10 year average ROIC and ROE is 22% and 25%.
K-Swiss is currently getting hit on two fronts. They are out of style and facing a consumer spending slowdown. In addition the popularity of Crocs, canvass shoes and flip flops has disrupted the market. In 2006 with the stock soaring Nichols started telling shareholders that their product and marketing was not satisfactory. He said this before Wall Street realized it. Sales slowed in 2007, falling 18%, domestic sales were down 37% and international revenue was up 14%. Net income plunged 50% in 2007. For the first half of 08 domestic sales fell 33% and international fell 17%. Nichols response to this situation has been to pull back on supply and even cut off some of the vendors. He said this resuscitates the brand and allows the company to come back stronger. He maintains spending on marketing and product development.
Nichols has done this four or five times in the past with success. Around ‘94 K-Swiss was hit by softening demand. Nichols hired new marketing people who introduced the Classic Limited Edition. That drove sales up until the next slump which occurred in 2000. K-Swiss pulled back on the limited edition and focused on the original. Sales grew until 2006 when once again K-Swiss is facing softening demand. Pulling back on supply in bad times also serves to prevent large markdown activity. This further hurts sales in the short run. But it's an intelligent long term strategy. Many of K-Swiss’s competitors have introduced cheaper shoes to try to boost sales in the short run and save a quarter. Nichols said during the 4th quarter conference call that he thinks the opposite. Instead of trying to save the quarter, K-Swiss thinks long term. "We do almost no short term things. Everything we do has a long term mentality to it." In the first quarter conference call he said "We think our problems are self manufactured. We didn’t move our product and marketing ahead to a point where our brand was in demand." Total backlog for the 2nd half of the year is down 32%. Manegment estimates that 3rd quarter EPS will be $0-(-$.15) and full year revenue of $300-$320 million and EPS between $.5 and $.65.
In the past year or so new marketing people have been hired. A remastered K-Swiss Classic is set to be introduced in mid 2009. K-Swiss has also made a foray into running and Free Running shoes. K-Swiss has been dominant in tennis but tennis shoes represent only 6% of the athletic shoe market, running shoes represent 30%. So far the reception they’re getting at running shops has been good. Also, K-Swiss has signed on athletes such as Anna Kournacova and others, something that they haven’t done before. Nichols said they are still working on improving the marketing, which has become stale.
Steven Nichols and George Powlick are two of the most candid and honest managers out there. Insiders own a large amount of stock and have a long history of making shareholder friendly decisions. The shareholder letters and conference calls are some of the best I’ve come across. The honesty, candor and long term focus of the manegment comes out strong. During the last conference call Nichols said that 97% of the reason for K-Swiss’s current problems is his fault. Since 1996 management has repurchased 25.5 million share at an average price of $6.55 bringing the shares outstanding from 53.16 million on December 31, 1995 to 34.7 million today. I encourage readers to look at the last three conference calls and the three articles I linked to:
Three articles worth reading
http://www.allbusiness.com/retail-trade/miscellaneous-retail-miscellaneous/4470121-1.html
http://biz.yahoo.com/bizwk/hotgrowth_article2.html
http://www.allbusiness.com/north-america/united-states-california/277941-1.html
and the last three conference calls:
http://seekingalpha.com/article/66240-k-swiss-inc-q4-2007-earnings-call-transcript
http://seekingalpha.com/article/74724-k-swiss-inc-q1-2008-earnings-call-transcript
http://seekingalpha.com/article/89195-k-swiss-inc-q2-2008-earnings-call-transcript
During the second quarter K-Swiss acquired a 57% interest in Palladium for $8.4 million with the option to acquire the remaining 43% for a pre-determined multiple of EBITDA in 2012. Palladium is a French shoe company that looks a lot like K-Swiss did when Nichols took it over in 87. Palladium started making a military hiking boot for the French government in 1947 and the company still sells the same shoe today with the same manufacturing systems as they used in 1947. Nichols said the shoe, called the Pampa, is timeless like the Classic but like K-Swiss in 87, Palladium has been mis-managed. The manufacturing process is out of date, the shoe is uncomfortable, to heavy, to expensive and doesn’t fit well. K-Swiss can change all these things and still keep the shoe’s timeless look. K-Swiss will also be able to use Palladium’s distribution and sales force to increase sales in Europe.
K-Swiss product is distributed in 66 countries but K-Swiss has only begun to tap the potential of the brand internationally. International revenues have gone from $67 million in 2003 to $208 million in 2007. Before the slowdown during the past 2 years, international revenue had been growing at 50% plus a year. Revenue from Europe was $143 million in 2007 up from $17 million in 2002. Sales come primarily from Germany, Benelux and the U.K. The company has struggled in Italy, France and Spain. K-Swiss is only in about half the markets in Europe and Nichols expects that the other half will become more meaningful in the years ahead. There are signs of success in some of those countries. The company introduced the Free Running line of shoes across Europe and the most successful country was Italy where it was extremely well received. Palladium should also help boost sales in Europe because K-Swiss will also be able to use Palladium’s distribution and sales force to increase sales in Europe. Other international represents the rest. Sales are also very strong in Asia (South Korea, Japan, China, Taiwan), Mexico, Canada, etc. Sales in for this segment have gone from $25 million in 2002 to $65 million in 2007. In South Korea there are 200 K-Swiss concept stores managed by a distributor. In China a distributor opened 12 stores in 2007. K-Swiss clearly has a vast untapped market in these countries.
Net Income for the last five years are as follows (2003-2007): $50.1 million, $71.3 million, $75.2 million, $76.9 million and $39.1 million in 07. K-Swiss has a market cap of $421. K-Swiss has no debt and $295 million in cash. For the worst case I’ll assume European and other international sales stay where they are at $150 million and $65 million respectively and domestic sales of $300 million down from $400 million in 04 and up from $200 million in 07. For the worse case total sales are $515 million. At a 20% operating margin, operating income would be $105 million. For the best case international sales at $250 million up from $208 in 2007 and domestic sales of $400 million. Total sales would be $650 million under my best case scenario and operating income would be $130 million. Applying a multiple of 14X on operating income after tax and adding cash, yields an intrinsic value of $1250.5-$1478 million or $36-$42.6 per share.
The author has an investment in K-Swiss.
K-Swiss, Inc engages in the design, development, and marketing of athletic footwear for sports use, fitness activities, and casual wear. It also markets apparel and accessories under the K-Swiss the brand name. In 2001 K-Swiss acquired Royal Elastics.
K-Swiss was founded in 1966 by two brothers dissatisfied with the tennis shoes in the market. The two Swiss brothers developed the K-Swiss Classic. In 1986 Steven Nichols then the president of the Children’s shoe division at Stride Aide recognized the timeliness of the shoe and tried to convince his bosses to buy the company. They refused and Nichols left the company and formed an investor group that acquired K-Swiss for $20 million. At the time K-Swiss was basically in bankruptcy. In 1990 K-Swiss went public. Nichols has grown the company from sales of $20 million in 1986 to $410 million in 2007. The K-Swiss Classic still represents two-thirds of sales with only slight changes to the shoe from the original in 1966. The Classic has since developed into a casual shoe. In the mid nineties Warren Buffett offered to buy the company but Nichols refused to sell. He said that he greatly admires Buffett but that Buffett offered no premium for the company. Nichols owns 22% of the company and insiders control 25%, Third Avenue owns 12%.
The shoe sold today is virtually indistinguishable from the original Classic sold in 1966. The Classic is popular with teens. Nichols has a very different strategy then most shoe companies. The extremely long durability of the Classic shoe is a competitive advantage. The product development costs are drastically lower then its competitors who are constantly introducing new models. The shoe’s distributors also are benefitted because the shoe doesn’t need to be marked down when new models are constantly introduced. K-Swiss is the most profitable vendor for the stores it distributes shoes to. K-Swiss is very selective with the venders they will supply to. K-Swiss avoids saturating the market with the Classic because that degrades the image of the brand. For the past 10 years gross margins have averaged 45% compared to 42% at Nike, 41% at Sketchers and 39% at Steven Madden. Operating margins have averaged 17% compared to 11% at Nike, 7% at Sketchers, 8% at Steven Madden. The 10 year average ROIC and ROE is 22% and 25%.
K-Swiss is currently getting hit on two fronts. They are out of style and facing a consumer spending slowdown. In addition the popularity of Crocs, canvass shoes and flip flops has disrupted the market. In 2006 with the stock soaring Nichols started telling shareholders that their product and marketing was not satisfactory. He said this before Wall Street realized it. Sales slowed in 2007, falling 18%, domestic sales were down 37% and international revenue was up 14%. Net income plunged 50% in 2007. For the first half of 08 domestic sales fell 33% and international fell 17%. Nichols response to this situation has been to pull back on supply and even cut off some of the vendors. He said this resuscitates the brand and allows the company to come back stronger. He maintains spending on marketing and product development.
Nichols has done this four or five times in the past with success. Around ‘94 K-Swiss was hit by softening demand. Nichols hired new marketing people who introduced the Classic Limited Edition. That drove sales up until the next slump which occurred in 2000. K-Swiss pulled back on the limited edition and focused on the original. Sales grew until 2006 when once again K-Swiss is facing softening demand. Pulling back on supply in bad times also serves to prevent large markdown activity. This further hurts sales in the short run. But it's an intelligent long term strategy. Many of K-Swiss’s competitors have introduced cheaper shoes to try to boost sales in the short run and save a quarter. Nichols said during the 4th quarter conference call that he thinks the opposite. Instead of trying to save the quarter, K-Swiss thinks long term. "We do almost no short term things. Everything we do has a long term mentality to it." In the first quarter conference call he said "We think our problems are self manufactured. We didn’t move our product and marketing ahead to a point where our brand was in demand." Total backlog for the 2nd half of the year is down 32%. Manegment estimates that 3rd quarter EPS will be $0-(-$.15) and full year revenue of $300-$320 million and EPS between $.5 and $.65.
In the past year or so new marketing people have been hired. A remastered K-Swiss Classic is set to be introduced in mid 2009. K-Swiss has also made a foray into running and Free Running shoes. K-Swiss has been dominant in tennis but tennis shoes represent only 6% of the athletic shoe market, running shoes represent 30%. So far the reception they’re getting at running shops has been good. Also, K-Swiss has signed on athletes such as Anna Kournacova and others, something that they haven’t done before. Nichols said they are still working on improving the marketing, which has become stale.
Steven Nichols and George Powlick are two of the most candid and honest managers out there. Insiders own a large amount of stock and have a long history of making shareholder friendly decisions. The shareholder letters and conference calls are some of the best I’ve come across. The honesty, candor and long term focus of the manegment comes out strong. During the last conference call Nichols said that 97% of the reason for K-Swiss’s current problems is his fault. Since 1996 management has repurchased 25.5 million share at an average price of $6.55 bringing the shares outstanding from 53.16 million on December 31, 1995 to 34.7 million today. I encourage readers to look at the last three conference calls and the three articles I linked to:
Three articles worth reading
http://www.allbusiness.com/retail-trade/miscellaneous-retail-miscellaneous/4470121-1.html
http://biz.yahoo.com/bizwk/hotgrowth_article2.html
http://www.allbusiness.com/north-america/united-states-california/277941-1.html
and the last three conference calls:
http://seekingalpha.com/article/66240-k-swiss-inc-q4-2007-earnings-call-transcript
http://seekingalpha.com/article/74724-k-swiss-inc-q1-2008-earnings-call-transcript
http://seekingalpha.com/article/89195-k-swiss-inc-q2-2008-earnings-call-transcript
During the second quarter K-Swiss acquired a 57% interest in Palladium for $8.4 million with the option to acquire the remaining 43% for a pre-determined multiple of EBITDA in 2012. Palladium is a French shoe company that looks a lot like K-Swiss did when Nichols took it over in 87. Palladium started making a military hiking boot for the French government in 1947 and the company still sells the same shoe today with the same manufacturing systems as they used in 1947. Nichols said the shoe, called the Pampa, is timeless like the Classic but like K-Swiss in 87, Palladium has been mis-managed. The manufacturing process is out of date, the shoe is uncomfortable, to heavy, to expensive and doesn’t fit well. K-Swiss can change all these things and still keep the shoe’s timeless look. K-Swiss will also be able to use Palladium’s distribution and sales force to increase sales in Europe.
K-Swiss product is distributed in 66 countries but K-Swiss has only begun to tap the potential of the brand internationally. International revenues have gone from $67 million in 2003 to $208 million in 2007. Before the slowdown during the past 2 years, international revenue had been growing at 50% plus a year. Revenue from Europe was $143 million in 2007 up from $17 million in 2002. Sales come primarily from Germany, Benelux and the U.K. The company has struggled in Italy, France and Spain. K-Swiss is only in about half the markets in Europe and Nichols expects that the other half will become more meaningful in the years ahead. There are signs of success in some of those countries. The company introduced the Free Running line of shoes across Europe and the most successful country was Italy where it was extremely well received. Palladium should also help boost sales in Europe because K-Swiss will also be able to use Palladium’s distribution and sales force to increase sales in Europe. Other international represents the rest. Sales are also very strong in Asia (South Korea, Japan, China, Taiwan), Mexico, Canada, etc. Sales in for this segment have gone from $25 million in 2002 to $65 million in 2007. In South Korea there are 200 K-Swiss concept stores managed by a distributor. In China a distributor opened 12 stores in 2007. K-Swiss clearly has a vast untapped market in these countries.
Net Income for the last five years are as follows (2003-2007): $50.1 million, $71.3 million, $75.2 million, $76.9 million and $39.1 million in 07. K-Swiss has a market cap of $421. K-Swiss has no debt and $295 million in cash. For the worst case I’ll assume European and other international sales stay where they are at $150 million and $65 million respectively and domestic sales of $300 million down from $400 million in 04 and up from $200 million in 07. For the worse case total sales are $515 million. At a 20% operating margin, operating income would be $105 million. For the best case international sales at $250 million up from $208 in 2007 and domestic sales of $400 million. Total sales would be $650 million under my best case scenario and operating income would be $130 million. Applying a multiple of 14X on operating income after tax and adding cash, yields an intrinsic value of $1250.5-$1478 million or $36-$42.6 per share.
The author has an investment in K-Swiss.
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