Farewell- It’s Been Fun

That’s my attempt at waving goodbye in a picture, take it or leave it I guess haha. Figured my readers may be interested in what I look like, although I’d hope it doesn’t matter for what I’m writing or how you interpret it.

My roommate’s father recommended to me, at the beginning of this past school year, to start an investment blog because it would help me meet people. I almost didn’t take his advice, but I’m glad I did. Writing in a public forum and getting feedback on my ideas has been invaluable.

It’s been an interesting journey the past 9 months or so. About 5 of you reached out and we’ve shared research notes, becoming friends, or at least colleagues/acquaintances. And, I’m glad to write, we are still collaborating today; this was the greatest thing I’ve gotten from the blog.

About 20 of you kept me on my toes at one point or another for my analysis; for this I’m grateful, it helps point out flaws in my thinking (nobody is perfect, I’m definitely still learning).

And with that, I guess it’s goodbye….

Just kidding! I’m launching a new site with a friend I met at IU, one of the most talented people I’ve met at the school, and we’re collaborating on a small LLC together in which we pooled our capital. I provide the in-depth research and valuation; he keeps very aware of emerging trends in the market and has been a trader for the past few years. He knows the options, futures, and international markets, as well as the dynamics behind some of these transactions (how they’re filled, shorting, option pricing). So, with every position we take (almost all of which is long-term stock holdings), we both consider it with different backgrounds and attempt to take advantage of option pricing when the situation warrants it.

The new website is:

theSTreport.com (Schneck-Thomas Report)

My first post is on Reading International, a cinema operator mixed with a real estate developer. I will warn you, it’s quite long, even for me. You can see my post here:

http://thestreport.com/2011/06/reading-intl-a-monopolistic-popcorn-stand/

Thank you for all your support, criticism, curiosity, humor, hard work, and above all, for reading my work. It’s been awesome and I plan on continuing it. I’ll leave this blog up for my past posts and to reference from time to time, but I don’t think I have a reason to post on here again- everything new will go on theSTreport.

Being a businessman, I figured you’d like this as well- a small part of the decision to start a new site was the ad revenue. Not to mention owning my own domain name; it appears much more serious/professional for your own website as an investor just getting started (or so I hope).

Posted in Uncategorized | Tagged , | Leave a comment

Noble Corp: Still Misunderstood & Worth a Serious Look

“I don’t know that you’re ever going to find a CEO who believes his valuation is correct.” ~David Williams

Noble Corporation held an analyst day Wednesday in Singapore and put up their presentation on their website. It’s about 3 hours, so while I’d recommend you listen to it, I think you should pull up a comfortable chair.

Above was David Williams’ quote after being asked a question on where he thinks Noble should be valued. He had been commenting numerous times on the comparison between Noble’s valuation and Ensco’s, and an analyst finally asked about it. It’s clear he still believes Noble deserves a higher valuation from today’s prices… In any event, Ensco has much more visibility in earning power the next year or two because less of their business was affected by the Gulf of Mexico and their rigs didn’t have any downtime, whereas Noble lost 30% of their business during the moratorium. I believe that’s why Einhorn favored them following the Macondo spill (his fund’s biggest position for awhile) and why he wasn’t as big a fan of Noble, even though the companies are very comparable long-term and Noble has been much cheaper all the way since the BP spill. If you compare fleets, they’re virtually identical (this assumes Ensco/Pride merger already took place and newbuilds as part of the current fleet).

Noble vs. Ensco:

  • 27 floaters vs. 27 floaters
  • 45 jackups vs. 49 jackups

While it is true that Noble’s fleet is slightly older, their floater fleet (which is more profitable than jackups) has better specs across the board. Noble’s management went into granular detail about the two fleets during the presentation & I think you should hear it for yourself on the earnings call.

Age is a serious issue for customers, along with specifications, when it comes to these offshore drilling rigs. Ensco flaunts a graph of avg. fleet age in their latest investor presentation, but they don’t adjust it to be an earnings-weighted average fleet age. As a result, it shows Ensco being 7 years old on average, while Noble shows up at 19 years. However, Noble relies much less upon their older rigs for earning power. Their incoming globetrotters, bully’s, and HHI rigs will constitute a large chunk of earning power, as well as the Jim Day and some of their newer semi-subs and high-spec jackups. The old jackups are what skews the average fleet age, and despite this, many more will get tenders the next few months, according to Noble’s management Wednesday. In any event, it’s best to visualize the 4 classes of jackups that Roger Hunt separated out below. It speaks to the disparity between older & newer jackups and the demand for both today:

As you can see, utilization and dayrates are significantly affected by when a rig was built. The newer ones are getting poached first off the market and then it trickles down- this speaks largely to those drillers aggressively investing in their futures, not only at the jackup but also the floater level. It’s why Ensco & Noble are my two favorites for the industry. I just think they should be valued about the same, perhaps giving Noble a small premium once their earning power is more clear in a 2013 (when many of their newbuild rigs will be delivered). Today, Ensco/Pride trades at $15.5 B, whereas Noble’s at $10.7 B. This 50% disparity is completely unreasonable, but then again, that’s what happens I guess when a situation is difficult to analyze.

So, I want to go back through some of the numbers so you can assess it for yourself. Here are the figures of importance (click for larger picture):

Some things to note are that the op. cash flows are adjusted for working capital changes, maintenance capex is a combination of “other capital expenditures” and “major maintenance capital expenditures”, the operating margins don’t include depreciation/amortization or other non-cash charges, ROA/ROE is based on returns of my definition of “owner earnings” (my op. cash flows less my maintenance capex), and the working capital subtracts out cash.

As you can see, the fleet size hasn’t changed materially over the last decade. What has changed is the profitability per rig, and that has a lot to do with disposing of non-core rigs and building newer high-spec rigs. Return on equity & return on assets are very high, especially for the industry, and a lot of that has to do with the rig selection they’ve made the past five years. 2010 was substantially lower due to the moratorium in the GOM, and this is not going to continue as a good number of permits have been issued already. If you focus on my definition of owner earnings, you’ll see they peaked in 2009 at $1.45 B. Since then, there was the Frontier acquisition and a number of newbuilds being announced as well. Below I’ve listed Noble’s presentation on their floater fleet expansion through 2014:

As I noted before, deepwater floater rigs are much more profitable than their jackup counterparts, and this expansion from 12/13 rigs up to 27 show Noble’s significant growth through the past 2 years. At $1.4 B in 2009 and having 13 floater rigs, having 26 floaters in 2013 will end up much higher, at least approaching $2 B in annual owner earnings in 2013. I realize I don’t have the figures for floater vs. jackup profitability and it’s difficult to assess just how much earning power has been added through the Frontier acquisition, as well as through their newbuild program, but I believe the business will be in very solid shape moving forward with these high-spec rigs.

Moving on, it’s hard for me to quantify all the industry knowledge I’ve obtained the past year from reading so much, but I do know that demand for offshore rigs is as strong as ever and is picking up in various parts of the world. Noble has always stuck to not building any new rigs “on speculation”, meaning they need a firm contract in place before ordering one of these $500+ MM rigs because Noble is the most conservative in the industry. To see them order a few extremely high-spec, expensive rigs on speculation shows me that they have confidence in future demand for offshore drilling.

For example, Noble has a near-exclusive relationship with Shell as their main offshore provider (80+% of drilling), and Shell is filing for permits now to drill 10+ wells off Alaska’s shores. This is a huge development that looks likely to be approved and Noble’s Discoverer will be the first one up there, along with Shell’s Kulluk rig that Noble will operate for them. Shell has already invested over $3.5 B up there in various projects to allow them to drill in Alaska. Another example was Noble’s management discussing strong demand in the North Sea for the latest high-spec jackups, the JU3000N’s, which the customers are now getting up to speed on their new capabilities.

I believe Noble has the best rig selection team in the world as well. David Williams has given numerous examples through the last 2 years of their team going around the world to look at every secondhand rig, each shipyard to work with them on specifications & price, and looking at their existing fleet for possible refurbishments. He said at the presentation Wednesday that the refurbishment & purchasing secondhand rigs has run its course, and that customers are now looking for newer, high-spec rigs for much of their drilling needs. This speaks very well to those companies in this industry with newer rigs being built or currently in place (Noble, Ensco/Pride, Seadrill), and not so well to those who don’t replenish their existing fleets (Diamond especially). I showed the jackup table that Noble provided earlier; it’s another indication that newer fleets will win in the long-run for this industry.

Closing remarks:

I feel I got a very solid picture of today’s situation in offshore drilling after this long presentation. Management views these tough times as a trough in the drilling cycle and the industry is investing in the next generation high-spec rigs (except for Diamond, who plans on dying slowly by not building any new rigs). Also, finally emerging from this Gulf of Mexico mess will contribute significant industry tailwinds. In addition, management reiterated the $70/barrel that allows offshore drilling to be profitable, and they saw 2010 as a very rough year for them, with much optimism for the next few years.

Overall, Noble has some uncertainty as to 2013/2014 earning power moving forward, but it’s easy to see today’s situation as being significantly misunderstood. With a fleet with better specs than Ensco/Pride’s and being almost identical in terms of size, a 50% discount to Encso/Pride’s valuation is unreasonable and, at the very least, gives today’s investor a significant margin of safety for the future. With a belief in at least $2 B owner earnings in 2013, shareholders can pick it up at a 19% yield to long-term earning power. I continue to believe in this company and it remains as one of my largest holdings, as well as my favorite moving forward.

Also, did I mention? T. Boone Pickens now has Noble as his largest position for his BP fund this latest quarter (more than doubling his position from last quarter from $11 MM to $30 MM)… in my mind this is no coincidence. He sees what I’m seeing and believes in Noble’s current valuation. I think this is the best purchase at today’s prices, except maybe Aeropostale, and shareholders should be very excited for the next 3+ years.

If I were an analyst working for a bank, my recommendation would be “Strongest Buy Possible”. Take a close look into the industry, I think you’ll do well at today’s prices in Noble.

Posted in Noble Corp, Stock Updates | Tagged , | 3 Comments

Aeropostale: I spoke too soon.

From some of the commentary on my previous article, I have found some serious resistance to some of my thoughts. Comments included:

  • Overly optimistic future expectations and earning power estimates
  • Ignoring idea of value destruction by management
  • Wrongly believing past results are indicative of future growth

Rather than comment individually, I figure I’d write another article, addressing these concerns with some thoughts.

First, I want to thank you guys for keeping me honest- it’s helpful to have criticism and allow me to reassess my thinking. It’s also interesting to see the stock drop even further and to have me question my analysis/do some soul-searching here.

I’ve gone back and done what I should have previously- listened to last 2 quarters of conference calls to make sure management’s views lined up with my own. My thoughts are as follows:

2010 Q4 earnings call:

  • First indication of inventory & merchandise problems
  • Men’s comps flat, Women’s down 4% (down 3% for quarter comparable sales)
  • Talked about increased costs in 1st half of 2011 of 3-5%, and 10-15% for 2nd half of 2011; going to try to pass along to customers
  • Overly optimistic/serious tone, looking forward to fall season already

2011 Q1 earnings call:

  • Men’s up 2%, Women’s down 10%, issue was their knitted tops which is one of Aero’s staple products
  • “Clearly disappointing” results, somber & apologetic tones
  • February was good, March & April were affected more severely than expected
  • Main problems were merchandise, didn’t have women’s assortment that customers wanted
  • Having challenging inventory clearance, overhang from Q4 inventory and now Q1 is overhanging to Q2- not having Q2 results like they’d want/expect
  • Still sees significant cost inflation for back half of 2011
  • Very specific merchandise issues in comparing good sellers to bad sellers; using words like “crystal clear”, “absolutely”, and “confident” about the changes that need to be made, getting back to roots
  • If they didn’t know the problems, it would be a serious problem, but they know exactly what to change and really believe they can fix the problems

From listening to both conference calls, I get the sense from Q4 that management just started to see problems but wasn’t waking up to them yet (they had said in Q1 that February was strong and things turned in March/April, this call was March 10).

So, Q2 is suffering still from the Q1 inventory overhang and they’re clearing it through as quickly as possible. In both the Q4 and Q1, they were very optimistic about the fall & back half of the year. I think that is the inflection point. We may very well see then if the problem is a brand issue (which management vehemently denies/disagrees with) or a shorter-term merchandise issue. I’m not worried in just listening to management, and although they’re very optimistic all the time, they really seem to be getting back to roots from Q1.

So, this will hit margins this year. Fortunately, Q1/Q2 are the less-important quarters for the business, comprising 17-20% of sales each quarter the last few years. So, I want to update my thoughts on earning power.

First, you must realize I didn’t subtracting capital expenditures when analyzing the business for the original article. While they are remodeling stores as part of the expense, it costs much less to remodel a store than it does to open a new one, and these new store openings are still driving growth. Don’t focus on the last two quarters as an indication that growth isn’t working- it just happens that existing stores have had some issues in selling less than they previously did, whereas new store growth kept sales flat the past few quarters. I would say capital expenditures for store remodels are likely in the range of $10-20 MM, so I’ll take that off my initial earning power estimation.

In addition to this $10-20 MM being taken off, I will point out historical earning power vs. what can perhaps be expected for the future:

As you can see, gross margins have been as low as they were in Q1 (29.1%) last in 2003, where they were 29.5%. While I do not expect that margin for the full year, I do expect it for Q2. As a result about 40% of 2011 sales will be at 29.5% GM’s and it is unclear as to what to expect for Q3/Q4. With SG&A at 21% of sales (management said to expect flat SG&A for the year), this indicates an 8.5% operating margin for the first half of the year. On sales of $2.5 B (my approximation, one commentator believes closer to $2.4 B but with more store openings I think $2.5 is pretty accurate), this would lead to $85 MM in operating earnings for the first half of 2011.

One note to the above paragraph, because I’m sure someone will check & see there is only a 5.8% op. margin for Q1 2011, is that SG&A is a relatively fixed expense, and sales are lower in Q1/Q2 than in Q3/Q4. This gives a larger SG&A as a percent of sales in quarters 1 & 2 vs. the back half of the year. I’m assuming a fixed percentage of sales for the full year, rather than a monetary amount for each quarter separately to make the analysis simpler.

If you want to go by management’s confidence in getting back to it’s roots and clearly identifying the problematic merchandise, then you will agree with my margin expectations for the 2nd half of the year. It seems that in 2003, when there was a GM of 29.5% for the year, the operating margin was 9.4%. If it were to increase to 31% for the year, you’d expect closer to 10% operating margins, which is what I’m going to expect. That would mean the remaining 60% of sales that come in Q3/Q4 would need GM’s around 32.5%. I think that’s perfectly reasonable considering management’s commitment to improving results in the 2nd half of the year. Therefore, I expect operating margins at 10%, indicating operating earnings at $250 MM.

Cash flows, adjusted for working capital, typically come in some $60 MM below operating earnings, so I’d expect close to $190 MM in 2011 owner earnings. As discussed above, there’s the $10-20 MM also in store remodeling to be subtracted, so owner earnings for 2011 will come in perhaps at $175 MM, a far cry from my original article at $300 MM where I believed it was conservative. My apologies.

As for this merchandise issue, I’d consider it a shorter-term problem that management believes they can fix. Therefore, just as with Noble Corporation (my favorite holding currently) where earning power is depressed shorter-term, the current earnings should not provide the only basis for valuation. I believe once these problems are fixed with merchandising, earning power will return to mid-cycle levels around 12-13%. Paired with that are the margin-increasing licensing agreements abroad and P.S. store growth. Therefore, although 2011 earning power should have 10% operating margins, I’m going to value it at 12% operating margins once the merchandise problems are fixed.

At $2.5 B in 2011 sales, this indicates $300 MM in operating earnings, or $250 MM in op. cash flows adjusted for WC changes, meaning $240 MM in owner earnings. At $1.4 B (77 MM shares outstanding at $18.25/share), this indicates an 17% earnings yield for a growing business with potential margin upside if problems abate. I will say I think this business is worth somewhere between $2.75-$3.25 B, again if current problems are merchandise-related and not brand-related, which is a far cry from today’s prices.

Shareholders should focus on the next earnings call and see what management is seeing from their first month in the back to school season. If things are going as planned, we could see a turnaround in the 2nd half of the year. If problems are still arising and there is additional inventory overhang, owners should start to worry. For now, I’m happy owning the stock and welcome additional share repurchases (4.2 MM this past quarter).

Posted in Aeropostale, Stock Updates | 3 Comments

Buckle vs. Aeropostale: A Comparison

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I had planned on posting this a few days ago, but don’t think that the drop in Buckle’s stock affected this decision- if anything, I wish it was posted beforehand because it makes me look like I’m validating my research by Buckle’s 12% drop today.

For those few of you who follow my blog, you’ll know I previously wrote an article about Buckle in August talking about the company. The business is solid, it was undervalued, and I liked what I was seeing. Since, it has run up 75% or so. This is not a bragging moment- I sold out before it ended up above $40 and think it’s somewhat crazy how high the stock has gone in such a short time. It was frustrating for me because my sale was pretty close to when they announced a special dividend & it shot up 30% or so in about a month. I had predicted a special dividend in September, as they had done the previous two years, but they waited a little longer this year. It was their main way of returning excess cash to shareholders and I figured it was coming again in the same month… maybe they were on vacation, who knows…

Compare that now to Aeropostale. I found a similar valuation with them in October when I wrote an article discussing my decision to invest. In a subsequent 7-month time frame, the stock has come down about 15% and I’m scratching my head. So here I’m thinking: am I wrong, or is everyone else just crazy? That’s what I’m here to analyze.

Buckle hasn’t opened any new stores since my article, and has actually closed three. Apparently my original vision of 800-1200 stores may not have been accurate (currently 420), but then again, they do expect 12 new stores in 2011. This is far lower than their avg. growth of 20 stores/year, but I’m not too worried for them. They have one of the best store location selections of any retailer and you can read about it in their ann’l report, or just visit a nearby mall & see what I’m talking about. With 43.5% director ownership, you know every action they make is still in the best interest of the shareholder. So, my views of the business have changed little since the original article. Adjusted for working capital changes, their earning power was:

  • 2010: $180 MM
  • 2009: $157 MM
  • 2008: $133 MM

This growth trend will continue, although stated previously, perhaps at a slightly lower rate. So, in buying Buckle today, what are you getting?

  • 420 stores
  • $100 MM reserve cash
  • $180 MM earning power growing at perhaps 3-6% per year (if store growth continues at current pace)

At a current valuation of $2 B, you’re effectively getting a 9% owner earning’s yield with some growth in front of you. Not bad, but also not near a price I’d be interested. My original purchase was much closer to $1.1 B and that was a much better time to invest.

Now, let’s compare that to Aeropostale. Unlike Buckle, who returns excess cash in the form of dividends, Aeropostale buys back as much stock as possible. Here are the latest figures for shares outstanding:

  • 80,723,152- May 2011 Proxy
  • 81,776,929- March 2011 10-k
  • 87,968,635- December 2010 10-q
  • 92,445,136- September 2010 10-q
  • 93,523,697- June 2010 10-q
  • 94,207,445- March 2010 10-q

I think I’ve made my point. You’ll notice between December & March, Aeropostale bought back 7% of shares outstanding. This was done without additional cash on the balance sheet & all from operating earnings- what other companies do you know that do this without explicitly stating an aggressive repurchase program or borrowing money to recap? I’d like to hear about them if you can find one.

So, although the stock has fallen from $24/share to $21/share, a 12.5% drop, the market cap has fallen from $2.25 B down to $1.7 B, a 24.5% drop.

So, what has happened to the business to deserve such a valuation decline? Some good, some bad, but nothing close to what Wall Street seems to believe in terms of how bad things really are. Here are some goodies since my last article:

  • 15 new U.S. Aero stores (now up to 906)
  • 7 new Aero stores in Canada (now up to 59)
  • 8 new P.S. From Aeropostale stores (now up to 47)
  • 5 new license stores in the U.A.E.  (now up to 10)
  • New licensing agreement for 25 new licensee stores the next 5 years in Singapore, Malaysia, and Indonesia

I said there was some bad; the items above are the good stuff. Now, brace yourself, here comes the bad news:

  • Same store sales have declined last few quarters or stayed flat (figures below)
  • Margins are taking a hit from a highly promotional teen environment
  • Sales/square foot likely coming down this year (figures below)
  • Management hired Barclays to block a takeover offer

As you can see above, the last few quarters have hardly been something to get excited over. However, did anyone stop to check sales/square foot the past decade to see what happens if same store sales decline 7% for the year?

As you can see, during the recent recessionary period, Aeropostale added on a considerable amount of efficiency to their stores. The business has increased in productivity every year since 2003, the year of the IPO, and their sales/square foot are the highest in the industry. What I believe happened during the recession was Aeropostale added some customers that I would consider “non-core”, whose parents were struggling with tough times & went to the more discount stores to buy clothing for their children. Lately, these “non-core” customers have been defecting back to the stores they used to shop at, namely Abercrombie & Fitch, American Eagle, Buckle, etc… and as a result, Aero’s figures have come down. While I expect their sales/square foot to drop back to perhaps the $600 or as low as the $550 level in normal times, this is still above all their competitors and is hardly reason for concern. And yet, Wall Street has worried with recent news events from Aeropostale the business is dying or that they’re running into serious margin problems.

However, their margins peaked in fiscal 2010 at 17.2% operating and 10.3% net. Fiscal 2011 was a slight drop to 16.1% operating and 9.6% net. Even if they came down to the worst year in the last decade, at 13.1% operating and  7% net (which I view as highly unlikely), the business would still earn $325 MM operating and $175 MM net on sales of $2.5 B (a reasonable estimate).

The only really frustrating negative is management not accepting the previous takeover offer and hiring Barclays to advise them on how not to be bought out. I guess they want to receive more options on Aero’s stock and ride the gravy train… at less than 5% inside ownership, I feel as though a lawsuit should be filed. In any event, the business will eventually print enough money to overcome these frustrating management antics.

So, to summarize the bad, the margins aren’t a major issue because they’re pretty high and the store efficiency argument about declining same store sales doesn’t have any economic reality. They’re well-positioned with their business and I have little concerns about either. Oh, and did I mention? Throughout this entire period of declining same store sales, they’re still posting increased sales because of the additional stores that they’ve built. They’re outgrowing the declines in efficiency for now, and because I don’t expect them to continue declining indefinitely, I think the business is perfectly fine.

Here’s earning power adjusted for working capital changes the past 3 years (fiscal years):

  • 2011: $317 MM
  • 2010: $284 MM
  • 2009: $207 MM

Now, on to what you’re getting today at Aeropostale:

  • 965 Aeropostale stores (906 U.S., 59 Canada)
  • 47 P.S. From Aeropostale Stores
  • 10 current U.A.E. licensed stores
  • 25 future licensee stores in Singapore, Malaysia, and Indonesia
  • $265 MM cash balance
  • $300 MM conservative earning power
  • Growing perhaps 5-10% moving forward
  • Aggressive share repurchases (tax efficient)

So, at a valuation of $1.7 B, you’re getting an owner earning’s yield of 17.5%. If I were to be more aggressive on earning power, I could argue closer to perhaps $325 MM, giving us closer to a 19% yield. There’s also some flow-through from working capital changes for the next year or two to be expected that should increase that further up to 20% or so.

So, would you rather have 965 stores from Aeropostale at $1.7 B or 420 stores from Buckle at $2 B? For me, the answer is simple. I think Wall Street is wrong and I no longer own Buckle. Aeropostale is now my largest position.

Posted in Aeropostale, Buckle Inc., Stock Updates | Tagged , , , | 6 Comments

Best Buy: Not Cheap Enough

For those who know me, I’ve been talking about Best Buy for a little while but my research kept getting interrupted by finals. This trip to the Berkshire Hathaway Shareholder Meeting gave me the time to finish my research & determine if it was worth an investment. Sorry for the delay in getting through all of this.

I found Best Buy through one of my talented friends, Greg Herman. Not that there was much to find; it’s a pretty well-known business in the U.S. & I only took a look because Greg claimed it looked pretty cheap. He was right, it does look cheap, but not cheap enough at today’s prices for my standards.

Best Buy was founded in 1966, but the company didn’t resemble it’s modern self until they began mass-merchandising consumer electronics in 1983. Richard Schulze, one of the original founders, still holds a 17% stake in the business and has been with them for all 45 years. He is the current Chairman, although he has Brian Dunn in the CEO role. I think this is the best board structure to have; a large inside ownership by a non-CEO who will keep the management team honest and shareholders’ interests close to heart (it’s why I like CNU’s board a lot). Other than some botched acquisitions the past 5 years which I’ll discuss later, he’s done a good job allocating capital to do well for his shareholders. Also, there are many insider transactions between Schulze, his family members, and the company. Normally I would take issue with it, but it doesn’t bother me much due to his large insider stake & the relatively small size of the transactions ($2 MM in leases/year, some legal fees, a few family members being hired as compared to almost $2 B/year in value creation).  In any event, keeping a close eye on Schulze is a good idea for the future; while some are worried that Best Buy may lose its relevancy to Amazon or others, Schulze continues to hold his large (almost $2 B) stake. If we see heavy insider selling, as with Netflix‘s founder Reed Hastings, it may be a serious cause for concern.

As with all retailers, it’s important to remain cognizant of the product mix and where the growth has come from in the past so you can determine if its sustainable or not. Here are Best Buy’s product segments:

  • Consumer electronics- video & audio products (TV’s, GPS, cameras/camcorders, e-Readers, DVD & Blu-Ray players, MP3 players, home theater audio, musical instruments, and automobile audio systems)
  • Home office- computers, tablets, monitors, mobile phones, hard drives, networking equipment. (includes Best Buy Mobile concept)
  • Entertainment- video gaming hardware & software, DVD’s, Blu-Rays, CD’s, computer software
  • Appliances- major appliances & small electronic components
  • Services- warranties, computer-related services, product repair, delivery & installation of home theater audio
  • Other- snacks & beverages

And here are the past 5 years so you can visualize the changes (this is for consolidated international & domestic operations with a weighted average based on revenue figures):

As you can see above, the product mix has shifted away from consumer electronics and moved more into mobile phone sales (Home Office). This is to be expected, seeing as they have opened 177 Best Buy Mobile stores in the U.S. and acquired a 50% interest in 2,440 CarPhone Warehouse stores in Europe over the last 5 years. As I learned from studying RadioShack in detail (sorry for not posting, wasn’t worth a solid investment), mobile phone sales contribute to lower margins and higher working capital needs mainly through receivables from wireless carriers. Also, in Best Buy, the comparable store sales have flatlined; it’s either a function of its current environment of skittish customers or mobile phones not increasing their same store sales at all. In either case, margins are down slightly and the business has only grown through adding additional stores; very little, if any growth came from increases in store efficiency, even with this shift in their product mix. While I would not call this a recipe for success, they aren’t failing either. The business remains remarkably consistent (comparable to Wal-Mart) and I don’t have too many worries about their current operations. If you look over their financials, it’s as if the business didn’t see any affects from the recession in the U.S.

However, unlike their current operations in the U.S., their international expansion has cost shareholders. Much of their value creation went to a so-far-unsuccessful European acquisition in 50% of CarPhone Warehouse’s retail operations. In looking over the numbers, I’m not pleased in the slightest. Margins are extremely low at about 1%, returns on capital are terrible, and they may have been better off buying something like RadioShack or just paying a larger dividend. I realize why they want to expand abroad; their model works like a charm in the U.S. (consistent 5% op. margins, 20+% returns on equity the past 2 decades). However, other than Canada, they really just don’t have the talent to expand abroad right now. I don’t blame Schulze or anyone else; they just know their home country better than foreign ones. So far, they opened 8 Best Buys in China which are all since closed because they didn’t work, 71 in Canada, and 6 in Europe (I’m guessing in the U.K.). To gain a foothold in China better, they bought up Five Star and have been expanding it across China aggressively with this concept. It hasn’t made a material impact on their financials so far, so I’m not going to pay it much attention. Canada seems to be their best market & I feel good about expansion there at about 10% per year. All things considered, their international expansion is disorganized, not the powerhouse we’re seeing in the U.S. markets, and has the chance to do serious harm to shareholders by destroying the value created in the U.S. It’s a good thing this low-margin business in the international markets is only 25% of their business; otherwise you’d see much lower company margins overall.

So, with the U.S. business being extremely successful & consistent, the international expansion inconsistent & costly, and overall capital allocation outside the international expansion pretty good, what is the business worth? Their operating cash flows/year are $2 B after normalizing working capital changes and their maintenance capex averages out at about $200 MM/year. Their growth capex is at about $225 MM/year, but it’s contributing value in some markets so I won’t subtract that to calculate owner earnings. Overall, I’d call it an even $1.8 B/year in owner earnings today with the potential for future growth if the international expansion succeeds. As for now, I won’t be betting on that because the last 5 years have been pretty bad overall in that category. Because I’m worried about cash flow investment into these markets, I’ll demand an 18% yield to owner earnings. This is no complex formula; just what seems right to me today based on everything I’ve read. Therefore, I’m willing to buy Best Buy today for $10 B. Best Buy’s current market valuation is $12 B or so, so the stock still needs to come down 17% to hit my purchase price, currently calculated at about $26/share. There you have it folks- buy it at $26 and you’ll do well. I’m hoping Best Buy screws up one more time to send the stock just a bit lower…

For those of you know me, you know I’m as stubborn as Charlie Munger would be if you tried to put him in a nursing home when it comes to valuation. If it doesn’t meet my criteria, I won’t consider it. As with H&R Block, where I missed out on a quick 70% gain after having understood their business quite well and not buying, I do not feel Best Buy meets my criteria right now. I will say this- buyers today will very likely do well & get something like 10-12% annualized unless more international expansion is screwed up, but I’m not in the game for investing without a better margin of safety and more upside. I plan on keeping a close eye on Best Buy in the future and seeing if they ever do hire some international talent; if so, I’ll be on board immediately at prices like we see right now. Until then, on to the next one…

If it seems this is a little lacking, it’s because I focused on the main points. I have extensive research done & am sharing just the important points.

Posted in Best Buy, Investment Write-Ups | Tagged | Leave a comment

Why I’m Short Netflix

Yes, yet another value investor has taken the short side against the overpriced Netflix. Why will he make money? Because it’s not just the lofty valuation. The business is falling apart and Wall Street seems to just be taking notice now.
(Disclosure: been short Netflix now for 3 weeks, plan on holding for awhile)

Okay, so the first item to note is the large amounts of insider selling (look at aggregate amount of buys & sales the last year at top right):

There was more than $200 MM sold, with not a single purchase, in the last 12 months for Netflix. Netflix co-founder, Reed Hastings, seems like he was selling just about $1 MM every week. Now, it’s not always the case that insider selling means the company is headed for trouble, but it sure isn’t the greatest vote of confidence…

Next is the growth in subscribers and growth in revenues. It seems reasonable to expect more competition in the future from the likes of Amazon, DirecTV (through Blockbuster), Hulu, Megavideo & others.. I started to think that maybe the figures would be unsustainable for the growth in subscribers vs. the growth in costs. Here are the figures:

# of subscribers (and percentage that are free subscribers):

  • 2005: 4,179 (3.7% are free)
  • 2006: 6,316 (2.6% are free)
  • 2007: 7,479 (2.0% are free)
  • 2008: 9,390 (2.4% are free)
  • 2009: 12,268 (3.1% are free)
  • 2010: 20,010 (8.7% are free)

So, maybe Netflix is reaching a little too hard now to get additional subscribers. It’s the number they’ve always touted in annual reports- that growth rate in subscribers- that gets Wall Street very excited. However, when looking at revenue per subscriber (not even profitability), it is a little troubling:

Revenues vs. Revenues per subscriber:

  • 2005: $682 MM vs. $163
  • 2006: $997 MM vs. $158
  • 2007: $1,205 MM vs. $161
  • 2008: $1,364 MM vs. $145
  • 2009: $1,670 MM vs. $136
  • 2010: $2,163 MM vs. $108 (has come 50% last 5 years)

So, with a massive increase in subscribers while some getting less out of them on a per-subscriber basis, I was curious how much the increase in revenues lagged the increases in subscribers… It shows how much Wall Street has been duped into thinking subscriber growth directly translates to growth in value of the company:

Percent Increase in Subscribers vs. Percent Increase in Revenues:

  • 2006: 51% vs. 46% (virtually equal)
  • 2007: 18% vs. 21% (virtually equal)
  • 2008: 26% vs. 13% (slight 10% differential)
  • 2009: 31% vs. 22% (slight 10% differential)
  • 2010: 63% vs. 30% (massive 30% differential)

Now, while the company has been growing in the double digits the past 5 years, it seems their revenues aren’t keeping up with subscriber growth & I’m not sure it’s sustainable to assume everyone’s going to keep signing onto Netflix at the same price…

Anyway, with that small seed of doubt planted in your mind, here’s the fun part- the costs and how they’ve changed in the last 5 years.

I’ve listed the forward 1-year library content costs vs. Cost of Subscriptions on Income Statement for that year. (so, for 2009, the $91 MM is an estimate from 2008 on library content costs, whereas the $909 MM is listed on the Income Statement as total subscriber costs):

  • 2005: $8.7 MM vs. $394 MM (2.2% of subscription costs)
  • 2006: $15 MM vs. $532 MM (2.8% of subscription costs)
  • 2007: $21 MM vs. $664 MM (3.1% of subscription costs)
  • 2008: $49 MM vs. $761 MM (6.4% of subscription costs)
  • 2009: $91 MM vs. $909 MM (10% of subscription costs)
  • 2010: $235 MM vs. $1,150 MM (20.5% of subscription costs)
  • 2011: $531 MM vs. ???

As I said above, the 1st number is an estimate for the upcoming year, whereas the second is the “cost of sales” for that year. So, with more than a double from 2010 in estimated content costs, I’m expecting this to start taking a serious toll on margins. From what I’ve read, it seems Netflix signed the original contracts back when the content providers didn’t really understand the value of what they were giving up. They maybe figured Netflix wouldn’t end up with 20+ million subscribers, or that cable TV & DVD sales would get hit really hard by them. Either way, the content providers have all the power here and are looking to make up for large amounts of lost revenue.

So, with no end in sight to these increasing costs, there are some ridiculous prices they’re paying up for. One is the content on Mad Men at nearly $1 MM/episode. Next is the $100 MM or more that Netflix is paying on the Kevin Spacey series called House of Cards. Both of those announced after these results in the 10-k, and we should expect even higher than $531 MM on next year’s ann’l report. I do believe this will dominate the expenses on the income statement the next year or two at least.

So, the growth in revenues is decelerating, while the growth of costs is accelerating at a massive pace.. surely this is a good short if the stock is at a reasonable valuation even, so what are the current valuation metrics?

Op. Cash flows vs. Operating Earnings:

  • 2006: $248 MM vs. $65 MM
  • 2007: $277 MM vs. $91 MM
  • 2008: $284 MM vs. $122 MM
  • 2009: $325 MM vs. $192 MM
  • 2010: $276 MM vs. $283 MM

The major differences between the two here are about $100-150 MM/year in additions to content library costs. Its all offset in the cash flow statement for what was incurred vs. what was paid in cash already. It seems 2010 was a year they paid back a lot of the cash to the content owners if you look closely at the cash flow statement. From a valuation standpoint, it’s much easier to do shorthand with the op. earnings than op. cash flows minus the content library costs, so just focus on op. earnings. They are at $283 MM in 2010, likely headed lower in future, and at $12.4 B, it’s trading at 2.3% yield to earnings. Sadly enough, shareholders won’t even get 2.3% moving forward- a large chunk of those earnings are going to end up going back to the content providers. I’m expecting a major sell-off for Netflix once Wall Street understands this… quite interesting.

So, with options prices too high to buy a put, I decided to do my first naked short. I made it a small position, but still made it large enough that I’d make a little once the stock collapses. In my mind, it’s not a question of “if” but “when” the music stops. I’m okay with waiting- I think Wall Street will catch on quickly once costs head higher & Reed Hastings sells even more of his stake.

Posted in Netflix, Short Sale | 3 Comments

Japan- Opportunity for the Careful

Many investors I admire are starting to focus all their energies on Japan, and for good reason. Never before have I encountered such bizarre circumstances regarding the economics of an entire country worth of businesses. It seems the profit motive in Japan is almost non-existent… I’ll come to that later. One blog I follow closely has written at length about Japan’s many great value investments (see here and here and here). I suspect Geoff is looking mostly into net nets that have historical profitability & I believe I’ve found many of these net nets he’s considering.

However, I won’t consider investing in most of them, as exciting as it would be to own some of the famous “Graham net nets”. The problem is that Japan isn’t the United States, at least in terms of returns on capital. Japan has probably the worst returns on capital I’ve ever seen. Virtually every business is shrinking & pre-tax returns on assets seem to be stuck around 3%. That is a horrible way of doing business (it has to do with their culture, as well as their economic & deflationary environment). For a funny little side note, take a look at this diagram of Japan’s corporate governance from Sharp. Unbelievable how bureaucratic it looks, and from what others are writing, it seems this is common practice for corporate governance for Japan. No wonder they aren’t earning any money.

So unlike the U.S. where businesses suffering hardship can come out of a slump and stock prices jump accordingly, Japanese net nets are almost all suffering businesses that can’t grow their businesses out of it. The returns on capital are simply too low. Now, it would be a different story entirely if I had the money to buy out some of these net nets & extract the “last cigar puff” for myself, but at my current size, it makes more sense to me to try & find those businesses with good returns on capital & trading at extremely low prices. Luckily, I’ve found three so far, the average price to “owner’s earnings” is at about 3, and all are sufficiently capitalized (one has western brand names, much like a Coca-Cola bottler operating in another country, only it’s a different company). Although, as I’ve been told but haven’t had the fortune of watching personally, net nets are “supposed to shoot up” much more in a bull market when compared to the more stable companies, I’d say why not buy a security that is near-guaranteed to return to me many cash flows over the next 5 years so as to give me above 20-25% annualized? It requires more scrutiny to find companies like that, but the rewards are worth the extra work. Japan appears cheap at first glance if you look only at balance sheets, but long-term returns to be expected of companies like that are suspect. My argument against most Japanese investment ideas is those returns on capital; if Japanese equities don’t rise as a whole market in the next few years, the economy continues shrinking along with the value of their currency, and the company shrinks alongside its stock price, you may be holding a company worth considerably less in a few years when (and if) Japan’s economy fixes itself. The counter-argument would be that maybe those assets will be liquidated & paid out to shareholders, but it’s not what I want to be betting on.

A similar proponent of what I’m thinking is in this article here. Also, if you start the Buffett video at 10:15, you can see what his thoughts regarding Japan are. Over a longer time horizon, those marginally profitable net nets won’t do much for an investor, even if purchased at 50% of net working capital or lower.

Unfortunately, I’m not going to have full disclosure on what I’m looking through right now (as it takes a lot of work), but I will share once my positions are established. I will also share a list of profitable net nets for those of you who don’t buy my return on capital argument. Who knows, maybe I’ll be wrong on this one… I’m just looking to learn from the experience & fine tune my investment ideas. It is quite interesting & I’ll be in touch. My new account is being set up currently for international markets, so by next week I’ll be fully invested & have a post or two for you about Japan.

So if you do consider Japan, please be careful of this return on capital problem.

Posted in Commentary, Japan | Leave a comment