Alex Bossert's Thoughts on Value Investing

Update On Convera

AlexBossert@gmail.com (Alex Bossert) — Fri, 26 Feb 2010 04:01:00 +0000

I’ve had a few comments about my lack of posts on this blog recently. I’m having a very busy senior year in high school and I feel that with my more limited free time, I have for investing, I’d rather spend it reading and researching than posting more frequently. I feel no need to fill your email with useless posts and I will post once every two or three weeks on what I feel is most important. I think it makes sense to post few but very high quality posts.

I’m honored that my site has over 210 subscribers and over 33,000 page views. If you would like to subscribe and receive email updates when I post, please subscribe by clicking here. I’ve also enjoyed getting to know many of you. I’ve received emails from readers from all around the world. I really enjoy your feedback or questions at Alexbossert[at]Gmail[dot]com.

Update on Convera:

I sold CNVR two months ago because I no longer thought the transaction would play out as I originally wrote in my write up. The transaction was likely to take longer than expected and the cash burn was more than I expected in the 10Q filled in December. The 10Q in December also had different language as it relates to the distributions than the proxy statements. The most recent 10Q troubled me because it didn’t mention the two $2M distributions, which account for about $0.07 of value in the liquidation. They were still included in the original plan of liquidation and therefore by reference in latest 10Q. The distributions were likely to be less and stock was still trading at the same price as I bought at, so I sold.

As it turns out, the company distributed 10 cents per share February 8^th.Convera is trading for 8 cents right now and in the original proxy, management estimated that the company would pay out an additional 7.4 cents from here. So if you pay 8 cents now you might get 7.4 cents back and some shares in a potentially worthless company. So it’s not near buying range right now.

Companies in liquidation has been an area of the investment world that really interests me. A good example of of a liquidation play is my investment in Footstar. You can read everything I've written on the company here. Footstar worked out really well and with Convera, I just broke even on my investment. I would also say that it’s much less appealing to own liquidation plays after the first few major liquidating dividends. That is when it starts to take a really long time and management has the incentive to sit and collect their salaries.

Portfolio Update and Results for 2009

AlexBossert@gmail.com (Alex Bossert) — Sun, 10 Jan 2010 04:48:00 +0000

Here is where my portfolio stood at year end:

Boss Holdings 9%
BYD Co 10%
Clear Choice Health Plans 6%
Cogo 25%
Nicholas Financial 25%
Convera 8%
Cash 16%

For the year 2009 my portfolio had a 160% return. Obviously this year was incredible and it’s unlikely to be repeated. My portfolio’s results over a 3 to 5 year span will be more reflective of how good of an investor I am and I shouldn’t be judged on one year alone. I had a nice surprise at the end of the year when Clear Choice Health Plans announced it was being acquired for a 167% premium. My portfolio did well because of the investments made around a year ago. Investments I made such as Nicholas Financial, Horsehead Holdings, Footstar, BYD and Clear Choice Health Plans were made when other investors were pricing many of these companies as if they were going out of business. In all of the names I mentioned above, the intrinsic values of these companies wasn’t impaired in the recession but were trading for 50-90% less than they were trading for only one year earlier.

A quick update of what I’ve been up to. I’m currently a senior in High School. I haven’t figured out where I want to go to college yet but I will be hearing back from schools I’ve applied to soon. This past summer I interned at a hedge fund in New York City. I was also featured in the book Of Permanent Value: The Story of Warren Buffett by Andy Kilpatrick.

I hope my blog is both interesting and profitable to readers. As always if anyone has any comments feel free to email me Alexbossert@gmail.com. I’d love to hear your feedback.

Error In Yesterdays Subscriber Feed

AlexBossert@gmail.com (Alex Bossert) — Thu, 31 Dec 2009 16:44:00 +0000

If you received the post yesterday titled "Earnings Update" from two years ago, it was sent by mistake. Sorry for the inconvenience.

Happy new year to subscribers and readers of Alex Bossert's Thoughts on Value Investing.

Convera Corp.

AlexBossert@gmail.com (Alex Bossert) — Sat, 05 Dec 2009 18:58:00 +0000

Convera is a liquidation play. Convera is trading for $.22 and the company estimates investors will receive $.26 per share in cash in the next 12 months and an additional $.11- $.19 after intellectual property is sold. The trading volume on Convera shares is small with around 150,000 shares traded a day.

According to Yahoo Finance, Convera’s business consists of “vertical search services to trade publishers in the United States and the United Kingdom. The company provides hosted white-label search technology and services, which enable publishers to generate Web traffic and online revenues by creating customized search applications. Its search platform helps publishers to combine site search, their proprietary content and an editorially vetted best of the Web into a vertical search application that provides an authoritative and comprehensive search experience for specialist audiences. Convera Corporation’s vertical search service comprises a suite of various components, including Web Search Platform that incorporates multimedia search of Adobe Systems Portable Document Format, image files, and other data formats; Convera Ad Service that allows publishers to manage and pursue search-based advertising revenues for their vertical search Web sites; and Publisher Control Panel, a self-service application that provides the publisher with the ability to control and tailor the Convera Web Search Platform and the Convera Ad Service for each vertical search site from a single interface. It also offers Converanet, an online search directory portal that contains various search engines in a single Web site. In addition, the company provides various professional services consisting of Web site customization; search engine optimization, marketing services, and training; and advertising sales kit development and training.”

Liquidation Time table:

Majority shareholders have already approved the liquidation:

According to the proxy statement: “Holders of our Class A Common Stock which represented a majority of the voting power of our outstanding capital stock as of the Record Date, have executed a written consent in favor of the actions described above and have delivered it to us on September 22, 2009, the Consent Date. Therefore, no other consents will be solicited in connection with this Information Statement.”

The Certificate of Dissolution hasn’t yet been filled:

“We anticipate that we will first take corporate action with respect to the Plan of Dissolution in accordance with our stockholder approval by filing the Certificate of Dissolution with the Secretary of State of the State of Delaware not less than twenty (20) days after the mailing of this Information Statement to our stockholders.”

The first cash distribution will take place shortly after the certificate of dissolution is filled with the state of Delaware.

Distributions:

The liquidating distributions consist of two parts. First, Convera will distribute a cash component worth $.26 per share. Second, after the certificate of dissolution is filled, Convera will merge its remaining intellectual property with VSW recieving a 33% ownership stake in VSW. Convera will sell its 33% interest in VSW or distribute it to shareholders. The company says the value of its ownership interest in VSW will be $.11 - $.19 per share.

Cash Component:

According to the proxy statement:

“In connection with the Merger, our stockholders will receive cash, plus a pro-rata share of an aggregate of one-third of the common stock of VSW. Our management estimates that our residual cash, after transfer of all of the operating assets and $3,000,000 in cash at closing of the Merger, drawn-down portion of the $1,000,000 line of credit, and various wind-down activities, will be approximately $14,000,000. We plan to distribute $10,000,000 shortly after the closing of the Merger, with the remaining $4,000,000 to be distributed in $2,000,000 increments at six months and 12 months after the closing of the Merger, subject to possible holdbacks for potential liabilities and on-going expenses deemed necessary by our board of directors in its sole discretion.”

The present value of this cash distribution, assuming a discount rate of 10%, is estimated at $0.26 per share. The calculation was performed as follows:

Value of intellectual property:

“Following the filing of our Certificate of Dissolution, we expect to consummate the merger of B2BNetSearch, Inc. and Convera Technologies, LLC, each a wholly-owned Delaware subsidiary of Convera, with VSW 2, Inc., the Delaware parent company of Firstlight Online Limited, a company in the business of online advertising sales and marketing incorporated as a company limited by shares in the United Kingdom (“Firstlight”), pursuant to, and subject to the terms and conditions of, an Agreement and Plan of Merger dated May 29, 2009, as amended and restated on September 22, 2009 (the “Merger Agreement”). As a result of the Merger, Convera will own 33.3% of the total outstanding capital stock of Vertical Search Works, Inc., a Delaware corporation and the indirect parent company of VSW 2 (“VSW”)."

“Both our CEO, Patrick Condo, and CFO, Matthew Jones, will join VSW after the effectiveness of the Merger. Mr. Condo has entered into a transition agreement with us and we intend to enter into a transition agreement with Mr. Jones. Additionally, it is the intention of the parties that Messrs. Condo and Jones enter into employment agreements with VSW.”

“In accordance with such agreement, we will pay Mr. Condo, among other benefits, an aggregate amount of $480,000 in cash in a lump sum on the 30th day after the closing of the Merger, provided that Mr. Condo has signed and delivered a general release in favor of us and the release has become effective.”

“Hempstead assessed the value indication associated with a one-third equity interest in VSW based upon the discounted cash flows methodology. Specifically, under a discounted cash flows methodology, the value of a company’s stock is determined by discounting to present value the expected returns that accrue to holders of such equity. Projected cash flows for VSW were based upon projected financial data prepared by our management. Estimated cash flows to equity holders were discounted to present value based upon a range of discount rates, from 25% to 35%. This range of discount rates is reflective of the required rates of return on later-stage venture capital investments."

The resultant value indications for the VSW component of the transaction, on a per-Convera share basis, are as follows:

The valuation placed on the 33% interest in VSW is $.11 - $.19 per share. Convera’s estimate of the value for the cash and valuation of VSW stock to be received in liquidation are within a range of $0.37 to $0.45 per share.

Herb Allen:

Herbert A. Allen has been a director of the Company since the effective date of the Combination on December 21, 2000 and was a director of Excalibur since June 2000. He has been President, Chief Executive Officer, Managing Director and a director of Allen & Company Incorporated, a privately-held investment firm, for more than the past five years. He is a member of the Board of Directors of The Coca-Cola Company. He is the father of Herbert A. Allen III.

The Allen family and Allen and Co. control over 61% of the company. Since Herb Allen is friends with Warren Buffett, I’d assume he is honest and trustworthy. He is also a very well connected person, knows a lot of power players, and with his own money on the line its good that the person in control has an interest in making sure the liquidation is completed quickly and efficiently. Both Herb Allen and his son are on the board of directors of Convera.

Conclusion:

Convera shareholders will receive the following as part of the liquidation:

1) $10m or $.187 per share upon closing of the merger
2) $2m or $.037 per share 6 months after the closing
3) another $2m 12 months after the closing plus 33% of VSW, estimated to be worth $.11- .19 per share.

At a purchase price of $.22, I’m being paid an 18% return to hold a free option on the value of VSW. The value of VSW is unknown but all the upside is free. One of the major risks in a liquidation play is executives have an incentive to delay the liquidation process and continue collecting their salaries. In this case, the executives are being hired by VSW so they don’t have to worry about losing their jobs. In addition the CEO, Patrick Condo will receive $480,000 30 days after the closing of the merger. Executives, especially the CEO have an incentive to move the liquidation process along quickly. Also, Herb Allen controls over 61% of Convera and he and his son are on the board. I like the fact that he’s friends with Warren Buffett and he will insure that the liquidation process moves along quickly because $8 million of his money is on the line.

The author owns shares in Convera.

Sold Horsehead Holdings

AlexBossert@gmail.com (Alex Bossert) — Tue, 13 Oct 2009 14:59:00 +0000

I purchased shares in Horsehead Holdings back in March at $4.23 per share and I recently sold my investment at $11. I made at 160% return on my money in 6 months. I invested in Horsehead because it was trading for $150 million with $123 million in cash and a net current asset value of $150 million. I was buying at 40% of book value and the replacement value of the facilities is over one billion dollars. Not only was Horsehead incredibly cheap but it was a great company to. It’s the lowest cost producer of zinc in the world and the only company that can use 100% recycled feedstocks in its facilities. Horsehead’s competitive advantage in the zinc market is further benefited because its facilities are next to steal mini mills with long term contracts for the delivery of feedstocks. It would be extremely hard for a competitor to come in and hurt the company’s supply of low cost EAF dust. No other company has been able to develop recycling techniques comparable to those of Horsehead. Horsehead has a large moat in the zinc market. I also recognized the potential for higher economical uses of the iron by product that could be worth up to $13 million per year. In addition, the company continues to increase the percentage of feedstocks derived from EAF dust. 66% of the company’s feedtsocks are EAF dust and for every percent increase, margins expand.

Revenue decreased 64% in the first half of 09 because of lower realized prices for zinc and a decrease in shipments. Net income was negative $24 million vs. a profit of $24 million in the same period last year. The decrease was due to lower prices of zinc and less production. The company idled some capacity but fixed costs are still high. EAF dust fees were also substantially lower. A $22 million charge occurred due to hedging activities.

The company resumed operations at its Rockwood, Tenn., recycling facility in August. The company said it expects to restart one of two kilns at the Rockwood plant in mid-September. It had idled the facility as a result of the economic downturn.

In September Horsehead issued 9.1 million shares in a secondary offering at $10.50 per share less discounts and commissions of $0.525 per share and received $80 million in cash. “The Company intends to use the net proceeds from the offering for general corporate purposes, which may include capital expenditures, acquisitions, working capital, investments and the repayment of indebtedness.” After the offering there are 44.364 million diluted shares outstanding. Horsehead currently has $160 million in cash when the proceeds are factored in and a market capitalization of $500 million.

The secondary offering changes the dynamics for my investment in Horsehead. The market cap of the company is now around $500 million. The price of zinc has averaged about 90% of the cost of production. Unlike oil or many other commodities, zinc is so plentiful in the world that the price of zinc is based on the cost of production and has averaged around 90% of production. Predicting the price of zinc is impossible but looking at historical prices and the cost to produce zinc it doesn’t look like their will be any large upside from here. I have no competency in zinc prices and the price of zinc meant little to my investment in Horsehead. I invested because it was the lowest cost producer of zinc and it was trading below net current asset value. Horsehaed is no longer cheap and based on historical earnings it appears fairly valued.

Alex Bossert Featured in "Of Permanent Value: The Story Of Warren Buffett" By Andy Kilpatrick

AlexBossert@gmail.com (Alex Bossert) — Thu, 01 Oct 2009 20:16:00 +0000

Last year I was lucky enough to be featured in a chapter of the 2009 edition of Andy Kilpatrick’s book “Of Permanent Value: The Story of Warren Buffett.” I was in chapter 205, page 1169-70. The chapter was titled “The Story Of Alex Bossert, Age 17.” Andy Kilpatrick is good friends with Warren Buffett and has been updating the book every year. The book is sold directly at the annual meeting every year.

Next year’s edition will be out in April and has a chapter on me and my friend Eric Schleien. Chapter 215 is titled: “The Alex Bossert Story, Age 18.” The chapter is on page 1215.

“Of Permanent Value” is considered by many to be the most extensive book about Warren Buffett and value investing.

You can view Andy Kilpatricks web site here.

You can purchase his book on Amazon by clicking here.

Click here to read the chapter that will appear in the 2010 edition of the book.

There is one factual error about Eric Schleien. He is currently going to school at the University of Buffalo. This will be corrected by April.

Pabrai Funds Annual Meeting Notes 2009: Huntington Beach California

AlexBossert@gmail.com (Alex Bossert) — Tue, 29 Sep 2009 03:03:00 +0000

I attended Mohnish Pabrai’s annual meeting in Huntington Beach California last Saturday. I thought Mohnish did an awesome job as usual. I’ve been lucky enough to get to know Mohnish over the past few years and I grateful that he is so willing to share his ideas with others. Mohnish is both a friend and mentor. I admire his investing abilities and I also find him to be a very genuine person who like Buffett, is always having a good time and cracking jokes.

Here are my notes on the Pabrai Funds 2009 Annual Meeting in Huntington Beach California:

Presentation:

The formal presentation began with Mohnish discussing his checklist. He came up with the idea after reading an article in the New Yorker by Atul Gawande about checklists in medicine. He mentioned a few of the items on the checklist. Is the business simple to understand? Does the investment have a margin of Safety? Does the business have a moat? Mohnish went on to say that he has analyzed many of Buffett’s and other value investor’s mistakes as well as his own and added the mistakes to his checklist.

Mohnish cleaned house in the fourth quarter of last year. He sold many of the poor performers and weaker names and invested in natural resource companies and banks. He added 10 new positions in the 4th quarter of last year. The portfolio is now much stronger as a result. Mohnish's funds are up around 110% since the begining of the year.

He has also learned a lot from Seth Klarman about diversification. The old structure was geared towards 10 names with 10% of the fund allocated to each. Now, Mohnish has adopted a 3, 5 or 10 method whereby most positions will be 3 or 5% or the portfolio and if the seven moons line up he will allocate 10% to the investment. Mohnish said this should lead to better results.

Mohnish then discussed a few mistakes he has made. Compucredit is a subprime lender that was trading at 5x earnings and growing rapidly. The investment was sold at a 72% loss. The company has a win lose dynamic where is the company does well it is because they are preying on lower income customers.

Sears Holdings is another mistake. The funds lost 60% in Sears. Retailers are tough businesses. Mohnish is unhappy with himself for investing in this particularly because he wrote a chapter in his book Mosaic about why retailers are tough businesses. The thesis was that Lampert was very smart and would redeploy assets in better things. Sears also has below market leases and some very valuable brands. If it didn’t work out the real estate would be sold. But the problem is that 324,000 employees are between the investors and the assets. Sears cannot compete with Wal Mart.

An investment that worked out late last year was Level 3 bonds. Mohnish purchased the 3.5% 2012 convertible notes around November 4th for an average price of $432. The bonds have a $1,000 face value. He sold for $680. The bond markets were tremendously depressed during the crisis.

Questions:

Q: One of the first questions came from someone who wasn’t happy with Mohnish’s performance last year. From peak to trough the funds were down 70%. This person said that was inexcusable. He also wanted to know why Mohnish doesn’t pay attention to the macro view? To avoid the huge losses last year Mohnish could have raised a large cash position?

A: Mohnish said that for the most part investors were blindsided. Also, he can’t go short and can’t take on leverage. Even if he focused on the macro view, it would have been very difficult to have forecasted what happened last year. He does have some appreciation for the macro view though. But, its much easier to focus on situations where the probabilities are easier to handicap. Mohnish will benefit from inflation because of the natural resource investments he has. Going forward the changes for the funds will be more diversification, a little more emphasis on the macro view and higher cash positions. He is currently a net seller of stocks.

Q: Due to the events last year do you still wait for 3 years for your investments to reach intrinsic value?

A: Mohnish said he is still patient with investments and will wait 3 years for a particular investment to reach intrinsic value. The majority of the gains in the portfolio are long term gains. He will try to minimize taxes. He would never place a stop loss order.

Q: Would you invest in Chinese companies?

A: He said most lay outside his circle of competence. But he has made investments for the partnership in India. He also has one Chinese investment. When making foreign investments he would focus on the ethos of management. There are many great companies but its hard to make investments from foreign companies while being based in the US.

Q: Would you invest in Gold?

A: No. Gold is too hard to value. It has luster value but the intrinsic value is unclear. He has investments in gold through some of the companies he owns. He wants to invest in productive commodities and then find the lowest cost producer. Then he would be interested.

Q: Would you invest in warrants, options or short stocks?

A: Won’t look at anything except possibly covered calls. He has experimented in his personal portfolio and so far only lost money. To invest he would have to go through an amendment process with investors.

Q: How does the Kelly criteria fit with the 3, 5, 10, portfolio allocation method?

A: Pabrai told Munger about his diversification ideas and Munger interrupted him and said that he is going in the opposite direction then him. Pabrai said that since he’s running other people’s money he has to be risk averse. Berkshire has had way more than 20 holdings for a long period of time and done very well. Some large bets have gone wrong. The Kelly Criteria works if the inputs are correct. In some instances he placed the wrong inputs in the formula. Some of his large bets went wrong. He did the formula wrong. He’s moving to a greater cash position like Klarman. When stocks are cheap such as earlier this year he puts the cash to work and now he is a net seller. So over time the cash position will build up as ideas become less plentiful and then cash will decrease when investment opportunities become more plentiful.

Q: Do you use the checklist for portfolio strategy? For example, is there an item on the list that says that you won’t invest a lot in just one industry?

A: The checklist is company specific. The portfolio structure comes before the checklist comes into play. He wouldn’t put a large portion of the partnership in one industry. There will always be at least one issue on the checklist for even a good idea. If you exclude leverage 80% of investments are ruled out. There is always at least one issue. 10 of the questions on the checklist are on leverage, 5 on management. Such as; does management have a large stake in the company? The checklist puts the tradeoffs in front of you. Another checklist item is; does the company have union issues?

Q: An entrepreneur asked Mohnish for some advice on running a business.

A: Focus on what you’re passionate about. Find what you’re interested in and good at. Then hopefully people you know well will give you money.

Q: Did Mohnish had any confidence issues in the 4th quarter of last year?

A: Mohnish said he had no confidence issues but he was watching redemptions closely. He saw the most incredible opportunities he’s ever seen. He was very excited about the investments that were being made. He said that he looked for investments in businesses that had moats and products that were essential.

Q: Why is Mohnish closing the fund to new investors at one billion in assets?

A: He wants to focus on smaller companies. If he had a billion dollars, with 5% allocation he would put $50 million into each investment. To stay under the 5% threshold he would need under a billion in capital.

Q: Someone asked if he could explain his Pinnacle Airlines mistake?

A: Based on value metrics it was very cheap. It totally fails the checklist. There is no win/win dynamic in the business ecosystem. Pinnacle would rake in money as the carriers lose a lot of money.

Q: Could you discuss the lunch with Warren and Charlie?

A: The lunch was worth every penny. 54 different topics were addressed. Buffett said that if he could have lunch with anyone it would be Isaac Newton and then he stopped and said no it would be Sophia Loren. Mohnish told Warren that Harina really enjoyed the lunch but her real love in life is Charlie. Buffett then arranged a meeting with Charlie. He found Charlie to be gracious, like having lunch with your grandfather. Mohnish asked Charlie how he handled his fund’s poor performance in 73 and 74. Most of it is family confidential. Warren told his kids that the most important decision they make is who they decide to marry.

Q: Any book recommendations?

A: The Black Swan was good but could have been written in only ten pages. Atul Gawande’s article in the New Yorker about checklists is a must read. That’s the article that sparked Mohnish’s idea to create his checklist. Also, Atul has written two books, Better and Complications. Mohnish highly recommends both. Mohnish also mentioned the book, The Miracle: The Epic Story of Asia's Quest for Wealth by business journalist Michael Schuman.

Q: Why were there so many redemptions?

A: Last year 15% of the fund’s assets left. Mohnish feels bad because these people were not able to let the investments play out and lost out on a lot of upside. The reason was partly hardship redemptions and fear of equities. Some investors went completely to cash. Some sold everything and went completely into cash. Investors like to do the opposite of what they should. They invest after stocks have done well and sell after they have done poorly. Mohnish received the most new money in 05-07) and the most was taken out just before the best gains in the history of the fund.

Q: Was he forced to change his methods and ideas or was it voluntary?

A: It wasn’t a change rather it was an evolution. Munger says to be a continuous learning machine. But, underlying principles always stand.

Link to Pabrai Funds 2009 Annual Meeting notes from Chicago

Nicholas Financial Update

AlexBossert@gmail.com (Alex Bossert) — Fri, 21 Aug 2009 17:11:00 +0000

Nicholas Financial had a good first quarter because of a drop in loan losses. Nicholas is able to make highly profitable loans as a lot of competition is hurt. The company has only a fraction of the debt to equity ratio of its peers but because of its unique lending strategy and its able to make an ROE of 20%+ in a normalized environment. I believe the company is worth at least $12 per share.

For more background information on Nicholas and my original write up click here

All my posts related to Nicholas click here

Nicholas Financial reported net income of $2.3 million for the three months ended June 30, compared to net income of $2.1 million last quarter and $1.6 million in the first quarter of 2008. Revenue for the just-ended quarter was $13.7 million, compared to $13.1 million a year earlier. Things are beginning to improve for Nicholas as loan losses, operating expenses and the cost of borrowed funds fell in the quarter. Net income rose 34%.

The biggest issue I see is the company needing to increase its credit line and renewing it in November of next year. This shouldn’t be an issue because they extended their credit line last year without a problem. The credit line is for $115 million and they have $104 million drawn down. The line of credit has one key covenant, which is that the pre-interest-expense, pre-tax income must be 1.25x interest expense at the end of each month. They're at 3.8x as of this quarter. The company should have no problem there.

The economic indicator that best correlates to Nicholas’s charge off rate is the unemployment rate. The pre-tax margin for the quarter was 6.34% and the provision for credit losses was 6.16%. Credit losses would have to double from here to bring Nicholas into the red, a very unlikely scenario, given that the provision for credit losses fell from 6.26% of average credit receivables to 6.16% in the current quarter. Net charge offs fell from 8.94% in the fourth quarter to 7.72% in the 1st quarter. Management anticipates losses absorbed as a percentage of liquidation will be in the 11%-16% range during the remainder of the current fiscal year. Losses as a percent of liquidation were 11% in the 1st quarter.

The loans the company is making are getting more profitable as their competition has diminished during the credit crisis. The average discount of new loans purchased has risen to 9.29% from 8.87% a year ago. At the same time the new loans are becoming more profitable they are also being made with more stringent credit standards:

The primary changes include; raising the minimum income required by the debtor to qualify for loan approval, reducing the maximum dollar amount that can be advanced for certain loan applications, and the maximum dollar amount that can be approved by a branch manager on certain approvals.

- First quarter 10Q

The average pre-tax yield over the course of the company’s history is around 9%. So when that level is reached again and it is likely that it will be at 9% or higher given that the loans being made now are of higher quality, due to lack of competition. With $216 million in net finance receivables at a 9% pre-tax margin, net income would be $12.5 million. At the same time the company is growing at more than 10% per year. With a multiple of 10x earnings Nicholas is worth $125 million or $12 per share.

Each of the 50 branches is budgeted (size of branch, number of employees and location) to handle up to 1,000 accounts and up to $7.5 million in outstanding finance receivables, net of unearned interest. To date ten of the branches have reached this capacity. The goal is to get all the branches to this level. If all the branches were operating at this optimum level the company would have $375 million in net finance receivables verses $216 currently. One issue for the company has been attracting qualified branch managers who are able to run a small business and at the same time be street smart and tough enough to collect from non paying customers. In the CEO’s letter to shareholders he said:

As a result of the spike in the unemployment rate, especially within financial services, we are now attracting a much higher number of quality job candidates than we have in the past. In many instances their company has either gone out of business or made considerable cut backs leaving them out of work or fearful of future layoffs. This recent change in the recruiting environment has allowed us to staff our company with several well-qualified people, making us stronger than ever. We believe this opportunity will help us to expand our Company, while our competitors pull back or in some cases, abandon our markets.

- Chairman’s Letter to shareholders 2009

During the recession management stopped all expansion to keep the balance sheet strong. Management is more confident with their current results so they have two more branches scheduled to open in the near future. This expansion will include new branch locations in Akron, Ohio and in Gastonia, North Carolina, which will bring the number of branch locations to 50 in 12 states. Also, the company mentioned, for the second time, that it is interested in an acquisition: The company “remains open to acquisitions should an opportunity present itself.” In ten years net worth has grown from $11 million to $88 million. Clearly the company has room to grow.
Nicholas is currently trading for $70 million with $88 million in shareholders equity. I believe the company is worth $125 million and I added to my position a few months ago at $5. Company insiders also thought the company was cheap and have been adding to their already large holdings.

Wesco Financial Annual Meeting Notes

AlexBossert@gmail.com (Alex Bossert) — Wed, 13 May 2009 03:28:00 +0000

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.

Berkshire Hathaway and Wesco Annual Meeting Links

AlexBossert@gmail.com (Alex Bossert) — Sun, 10 May 2009 17:49:00 +0000

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

Horsehead Holdings

AlexBossert@gmail.com (Alex Bossert) — Tue, 17 Mar 2009 01:23:00 +0000

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.

Sold Footstar

AlexBossert@gmail.com (Alex Bossert) — Sun, 15 Mar 2009 17:44:00 +0000

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.

Third Quarter Earnings

AlexBossert@gmail.com (Alex Bossert) — Mon, 01 Dec 2008 21:06:00 +0000

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

Footstar

AlexBossert@gmail.com (Alex Bossert) — Sun, 30 Nov 2008 17:13:00 +0000

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:

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.

K-Swiss

AlexBossert@gmail.com (Alex Bossert) — Mon, 03 Nov 2008 01:26:00 +0000

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.

Freightcar America Down 23% after Releasing 2nd Quarter Earnings

AlexBossert@gmail.com (Alex Bossert) — Tue, 12 Aug 2008 02:12:00 +0000

For Back ground Information please read my prior posts on RAIL:

My origonal thesis for investing in Freightcar America from July, 07: http://alexbossert.blogspot.com/search/label/Freightcar%20America

August, 07 update:
http://alexbossert.blogspot.com/2007/08/update-on-freightcar-america-inc

Freightcar America (FCA) released earnings on Monday and sending shares down 23%. They missed analyst estimates by 32 cents, reporting a loss of 8 cents a share compared to estimates of 24 cents. FCA had its IPO in early 05 at $19 per share and in 06 the stock was at $78 at the peak of the secular boom in coal car orders. But since 06 the company has been hit by inevitable slowdown that was sure to follow. Investors are focusing on falling orders and the disappearing backlog as they look ahead to a possible recession that could further hurt results. But coal car orders will bottom out and return to normal. At $28 FCA has nearly $13 per share in cash and management is actively looking to put it to work either with a possible acquisition or international opportunities. There are signs that the coal car market is bottoming out and that orders will pick up in 09. The export of coal out of the U.S. is booming. Coal cars will need to continue to travel longer distances to eastern ports as the mining of coal deposits in the Appalachian region declines and the activity in the Powder River Basin in Wyoming and Montana increases. 75 coal-fired power plants are expected to begin construction in the next 6 years. 52 of the 75 are currently in the construction phase. FCA’s 80% plus market share in the North American coal car market is protected by high switching costs and 100 plus years of market share and technological dominance. Only one company, Trinity Industries competes with FCA in the coal car market. Foreign companies are prevented from importing cars because of very high shipping costs and familiarity with the market. FCA is conservatively worth $40 to $61 per share.

Earnings for the first and second quarter

For the first quarter FCA had an operating loss of $16.3 million which includes an $18.3 million charge as a result of the May 6th arbitration ruling with the United Steel Workers over the closure of the Johnstown Pennsylvania Plant. FCA announced the closure of the plant in December 07 because of its high manufacturing costs. FCA will have no more impairments related to the United Steel Workers lawsuit. With the lawsuit concluded the Johnstown plant will be closed when the courts approve the settlement. This will allow FCA to move manufacturing to its two remaining low cost facilities and reduce operating costs. Without the settlement net income would have been about $1.5 million.

Second quarter earnings came in at a loss of $900 thousand. As raw materials prices continued to increase, specifically steel and aluminum, some of the company’s fixed price contracts in backlog were no longer profitable. Most of these cars will be delivered during 08. A contingency reserve of $2.7 million after tax was recorded in the second quarter to reflect the unprofitable contracts. Since May the company has quoted variable price contracts to customers and thus the reserve likely represents the total cost of unprofitable contracts. Also, part of the drop in the second quarter 08 backlog was due to a cancelled order of 970 units. All manegment would say about this is that it is due to one customer and one order.

Industry Fundamentals

The coal industry is booming driven by growth in export demand for coal world wide and the large number of coal-fired power plants currently scheduled to come online. U.S. and Canadian coal loadings in the first and second quarter were up 2.8% and 2% respectively while commodity car loadings overall were flat and down 1.6%, respectively from the same period last year.

Coal export activity is booming. Coal export activity was up 19.2% in 2007 vs. 06 and up 67% in the second quarter 08 compared to the same period last year. For the first half of 08 export tonnage for coal was up 57% from the first half of 07 and managements expects that it will continue at this rate through 08. On July 24 Union Pacific CEO Jim Young said in a Reuters article that "Global demand for U.S. coal should stay strong for at least 2-3 years.....Everything we hear suggests that coal will continue to be strong at least in the mid-term horizon." According to a July edition of Railway Age a trade magazine, Norfolk Southern is exporting 20 million tons of coal annually up from 12 million tons just a few years ago due to world wide demand. Norfolk Southern’s coal revenue is up 34% in the second quarter. Wick Moorman Norfolk’s CEO said "The problems were encountering are on the supply side. The mining companies can barely keep up with demand." FCA’s CEO Chris Ragot said "Demand for export coal has significantly increased as global supplies tighten." The increase in foreign demand is being driven by industrialization and attendant demand for coal fired electricity generation in the developing world including India and China.

Coal inventories are declining. Currently coal inventories are high in the electric power industry however recent data shows that inventories at eastern utilities is falling because of increasing domestic and international demand. Ragot said that inventories will continue to decline.

In addition to the increasing use of coal internationally, there is a large number of coal-fired power plants coming online in the next few years. In the next six years 75 coal fired power plants are expected to come online. These 75 plants will require about 40,000 new coal cars. Of these 75, 52 are currently under construction, near construction or permitted for construction. These 52 plants are expected to add 27,000 mega watts of capacity and will require about 20,000 coal cars. 29 of these 52 are under construction at this time which will add 16,500 mega watts of coal-fired capacity.

Coal will be an increasing large source of the power needs of the U.S. and internationally. The U.S. is referred to as the Saudi Arabia of coal. We have more in terms of energy units in coal reserves than Saudi Arabia has oil. The U.S. has 250 years of coal reserves at the rate we’re using it now. Clean coal technology will continue to advance. The Energy Department is working on what’s called the FutureGen Project, a project to built a carbon sequestering plant. A demonstration plant with carbon sequestering technology is expected to be built by 2015. In addition China is set to build its first clean coal plant in 09 and Germany has coal plants in the middle of major cities with zero emissions. Compare that to nuclear plant takes 10-20 years to commission, I believe coal will continue to serve a large part of the power needs of the U.S. and the world.

An Obama victory in November could be trouble for the industry. Although Obama supports clean coal and coal to liquid if they can emit 20% less carbon over their life cycle then traditional fuels. He is strongly opposed to traditional coal plants and would use whatever means necessary to stop new plants from being built, including a ban on new traditional coal facilities. McCain would be more favorable for the coal industry. He supports coal power for electric utilities. But, he wants to find cleaner ways to use coal. Clearly, both candidates see the need for development of clean coal technology.

How long will it take before coal car orders pick up?

If coal export volume is booming and plants are beginning to come online the why hasn’t FCA’s orders and production picked up? It’s because the amount of coal activity doesn’t overlap demand for railcars. With the oversupply of cars in 05 and 06 the downturn was inevitable. In 05 and 06 the replacement rate spiked above 3% and some of the surplus of coal cars were put into storage.

The cycle in rail car orders from peak to trough is seven years in duration. In 1998 total industry wide rail car deliveries peaked at 75,704 and bottomed out in 02 at 17, 736. Over the same time FCA production went from 9,000 to 4,067. Then industry wide railcar deliveries peaked again, peaking in 06 at 75,729, 07 deliveries were 63,156 and deliveries for 08 are expected to be around 56,000. FCA’s deliveries in 06 and 07 were 18,764 and 10,282. Orders in peaked in 05 at 22,363, in 06 orders were 7,350, and in 07 orders fell further to 6,366. Backlog has declined from 20,729 units in 05, 9,315 units in 06, 5,399 in 07 to 4,917 on June 30th. Clearly the rate at which orders and backlog is headed doesn’t bode well for FCA. FCA is hit even more at the bottom of the cycle because selling prices decline, currently price declines are in the high single digits. Investors are focusing on the plummeting backlog and looking to worse sales next year.

There are signs that orders will pick up again soon. Strong export activity and the number of new coal plants under construction will soon lead to a pickup in orders. In the first quarter conference call FCA’s CFO Kevin Bagby said "It appears as though we’re at or near bottom. It’s difficult to pick that point but there does appear to be some improvement going forward at this point." In the second quarter conference call he said that he expects order activity to pick up in 09. The reason torders should be headed upwards include, a decreasing number of coal cars in storage, many new utilities coming online, increased coal car loadings and increased domestic and international demand. During the first quarter FCA idled one of its plants but in the second quarter due to a pickup in orders the plant was reopened. In the last five weeks there’s been orders placed for 1130 units and management said this is encouraging. In addition they said that they are benefitting from a return in order activity and they expect that to continue for the rest of the year with 95% of the units currently in backlog being delivered over the next two quarters.

Diversification Initiatives

In addition to the positive fundamentals for coal and the likely pickup in orders come 09, FCA is also diversifying its operations by developing non coal railcars and an active exploration of international opportunities. In January FCA announced a joint venture with Titagarh Wagons Limited of Kolkata Indian to use FCA’s designs to develop freight cars for the Indian market. In second quarter release management said that the joint venture is progressing on schedule with production to start next year. FCA sent over some of their engineering staff to assess market conditions and so far things are going very well. Also, FCA signed a licensing agreement with a railcar manufacturer in Brazil and they manufacture coal-carrying railcars for export to Latin America and have manufactured intermodal railcars for export to the Middle East. We should expect more international opportunities to come. The CEO said during 1st quarter conference call that "we expect to begin working with additional overseas partners in coming years".

FCA is also trying to diversify its revenue base by introducing new rail car types including, an autorack car and a new design for its open top hopper for aggregates and taconite. In addition, FCA entered the leasing business in the first quarter. FCA has historically shied away from leasing because they would be competing with their own customers. But in the short run it makes sense to maintain production and market share. FCA has $46 million in "leased assets held for sale" on its balance sheet. Also, FCA closed on its first refurbishment order in the first quarter and currently has 200 cars in backlog related to refurbishment contracts. This should be a good avenue to increase business and even out the cyclical nature of the company’s orders and at the same time provide better margins.

Valuation

I believe the sell off is way over blown. The time to invest in a cyclical company like FCA is when orders and falling and everyone’s looking to even a worse future. Soon orders will begin to pick up and investors will see the light at the other end of the tunnel. Coal will continue to have very positive fundamentals in the U.S. and abroad. The joint venture in India is the wildcard with no risk because FCA provides the expertise (car designs and operating experience) and no capital. Titagarh will provide the capital. The expansion into different rail car types and the new refurbishing and leasing business will further benefit FCA. FCA is also working to cut costs at every level of the company and the closure of the Johnstown plant will further reduce operating costs. Coal cars will need to travel longer distances to eastern ports as the mining of coal deposits in the Appalachian region declines and the activity in the Powder River Basin in Wyoming and Montana increases. With $162 million in cash FCA can sustain a few bad years and with that cash they could buy back more stock or make an acquisition which they have recently said they are exploring.

There are 250,000 coal cars in North America. The replacement rate is around 3% and growth in coal use can be conservatively estimated to be 1%. FCA will continue to control 80% of the market. In addition, about 15% of FCA’s revenue comes from non coal cars. Based on these assumptions we can expect FCA’s order rate to be about 9,200 cars per year on average. Based on results from prior years, FCF per car is between $2,800 to $4,000. This equates to FCF of $25.8- $37 million not including interest income. This compares to an average FCF over the last 7 year cycle of $36 million per year. With a 12-15x enterprise value/ FCF and $162 million in cash, FCA is worth between $40 and $61 per share. Think of it another way, in the last 7 year cycle FCA had an average FCF of $36 million a year, and now FCA is expanding into different rail cars types and the refurbishment/rebuilt market, more giga watts of coal fired power plant capacity will begin construction in 09 then was build in the last 7 years and FCA has $162 million in cash from the 05 IPO. It is highly unlikely that FCA will earn less than it did in the last coal car cycle.

Pinnacle Airlines to Continue Flying for Delta

AlexBossert@gmail.com (Alex Bossert) — Wed, 23 Jul 2008 20:16:00 +0000

If you remember back to my last post on Pinnacle, I wrote about the ramifications of Delta attempting to cancel their contract with Pinnacle. On Friday Pinnacle announced that they have resolved the conflict with Delta and the contract will continue on the same terms. In my prior post I said that Delta is desperate to get out of the contracts it had with the regionals and I predicted that Delta wouldn't be able to cancel the contract it has with Pinnacle. My reasons were, Mesa was able to get a court injunction to stop Delta from canceling their contract earlier last May for a similar operating issue to Pinnacle's, also the operating issues were caused by factors out of Pinnacle's control (a very bad winter weather pattern for airlines and unrealistic scheduling imposed by Delta).

As part of the agreement reached with Delta Pinnacle will take delivery of the remaining 7 CRJ-900 five months later then originally planned. This won't effect Pinnacle much because the manufacturer will deliver the plans later to correspond to the change. I think that the uncertainty surrounding the Delta contract over the past month continues to cloud Pinnacle even though the issues are resolved. With the significant free cash flow that will be coming in from the new contracts, I think Pinnacle is very undervalued.

American Eagle Outfitters

AlexBossert@gmail.com (Alex Bossert) — Sun, 22 Jun 2008 03:41:00 +0000

Background:

The retail industry is getting hit hard as investors anticipate a recession. American Eagle’s stock is down nearly 50% in the past year and a half. The disappointing negative same store sales figures for the first few months of the year sent the stock tumbling. January same store sales were down 12%, February’s same store sales were down 4% and in March they were down 12%. For the first quarter same store sales declined 6%, net income was down 44% and operating margin declined from 18.9% to 10.1%. Abercrombie and Fitch, AE’s main competitor had negative same store sales figures but AE was hit harder than most of its competitors. The disappointing first quarter figures were driven by sales decreases in the girls side and a mistake in styling in the denim business, which is AE’s backbone representing around 20% of sales. AE was forced to take markdowns on denim and girls merchandise during the quarter, taking a hit to margins. Insider purchases have been significant over the year. Jay Shottenstein the founder and chairman has purchased $24 million in stock over the past year and his family owns 15% of the stock.

Business:

American Eagle is retailer selling mid priced casual clothes targeted to 15-22 year olds through its 942 American Eagle stores in the U.S. and Canada. In 2006 they launched the sub brand “aerie” targeting 15-25 year old girls and has since opened 55 aerie stores. In 2007 a new concept was launched “MARTIN + OSA” targeting 25-40 year olds. There are currently 21 MARTIN + OSA stores.

American Eagle has been a phenomenal company over the years based on margins, returns on equity and other metrics. Average ROE over the past 10 years has been 28%. With new stores on average producing a return on equity of 65% in 2007. Operating margins have been on average 16% over the last 10 years, which is one of the best in the entire apparel industry which averages 4%

Competition:

American Eagle’s two largest competitors are Abercrombie and Fitch and Aeropostal. Other competitors include The Buckle, Gap, Hot Topic, J. Crew, Limited Brands, Pacific Sunwear of California, Quicksilver, Talbots and Wet Seal. One thing that distinguishes AE from its two largest competitors is price. Abercrombie & Fitch’s merchandise is much more expensive then AE’s. Abercrombie & Fitch’s average unit retail price is $35 compared to American Eagle’s $20. Aeropostal on the other hand is generally slightly cheaper than AE. I compared jeans, tees and polos from American Eagle to near identical merchandise at Aeropostal, Abercrombie & Fitch and their sub brand Hollister. I found that prices at American Eagle and Hollister were very similar. Prices at Abercrombie and Fitch were almost always around 50% more than American Eagle. At Aeropostal prices were nearly always the cheapest of the four. I also read the latest quarterly and annual reports from Aeropostal and Abercrombie & Fitch. I feel that AE has superior qualities to both of these companies:

First, Abercrombie & Fitch’s prices are much higher than AE’s and both contain very similar merchandise. For example a pair of jeans at Abercrombie runs around $80-$90 while a pair at AE and Hollister runs $50-$60 and at Aeropostal it’s $30-$50. The merchandise is nearly the same between these four retailers. Abercrombie relies much more on the intellectual appeal of their brand to convince customers to pay 50% more for very similar merchandise. Therefore I think Abercrombie is much more susceptible to economic conditions, consumer spending and fashion trends. I personally get all my cloths from AE and fund no reason to spend $90 for a pair of jeans that are very similar to what AE has to offer.

Also, despite the significantly higher prices at Abercrombie, AE’s margins are very comparable. Over a ten year period, AE’s average operating margin was 16% compared to 19% at Abercrombie and 10-12% at Aeropostal. But more recently in the last four years AE’s operating margins were better than Abercrombie’s. Aeropostal’s recent good performance is mainly due to people turning to the cheaper alternative during a consumer spending slowdown.

Finally, insiders at both Abercrombie & Fitch and Aeropostal have been dumping stock recently. At Abercrombie many insiders have been selling large amounts of stock. Including the chairman, Michael Jeffries who has sold nearly $100 million in stock in the past six months or about half his holdings. Jeffries is scheduled to receive $68 million in equity compensation this year as part of his “career share award.” Insiders have also been dumping stock in Aeropostal as well. But, over the past year the chairman of American Eagle Jay Shottenstein has purchased over $24 million in stock and many other insiders have been accumulating stock.

Operations:

There are currently 868 AE stores in the U.S. and 75 in Canada. The ultimate goal is to have between 1,000-1,200 AE stores in the U.S. and 80 AE stores in Canada. New AE stores are being opened at the rate of 40-50 per year giving AE 5-8 years of growth of its flagship AE stores. Also sales at AE Direct, American Eagle’s website, are growing at 30%+ per year and Jim O’Donnell American Eagle’s CEO said in a recent investor presentation that AE Direct should achieve sales of $500 million by 2010 up from $200 last year. American Eagle expects to open 40 new stores in 08 and to remodel 40-50 more stores. Overall square footage in 2007 grew 12% and will grow an estimated 10% in 2008.

During Fiscal 2006, American Eagle launched its new girls intimates brand, “aerie.” targeting girls aged 15-25. “The aerie collection is available in aerie stores, predominantly all American Eagle stores and at aerie.com. The collection includes bras, undies, camis, hoodies, robes, boxers, sweats, leggings, fitness apparel, and personal care for the AE girl. Designed to be sweetly sexy, comfortable and cozy, the aerie brand offers AE customers a new way to express their personal style everyday, from the dormroom to the coffee shop to the classroom” (2007 10-K). The aerie stores have been very successful so far with 55 aerie stores already opened and 80 more planned for 08. aerie seems like a natural extension of the girls section of the American Eagle stores given the synergies and brand recognition already established. Despite that AE stores get 60% of their sales from girls, the addition of an aerie store in proximity to an AE store doesn’t cannibalize sales away from the original store’s sales. Many other retailers have opened stand alone girls intimate stores targeted to the teenage girl. Abercrombie is starting the new concept Gilly Hicks targeted to teenage girls. Victoria’s Secret started the sub-brand Pink in 2004 and last year Pink achieved sales of $900 million. American Eagle’s CEO said that he thinks aerie will eventually achieve sales of $1 billion with over 500 stores possible.

The Company also introduced MARTIN + OSA during Fiscal 2006, a concept targeting 28 to 40 year-old women and men, which offers refined casual clothing and accessories. At first M + O appeared to be struggling badly and in 2007 Jim O’ Donnell said he was optimistic but he would close the stores if it didn’t return to profitability. More recently the stores have improved with same store sales increasing over 50% but the brand is still losing money, about 15-17 cents in annual earnings per year. For the first quarter the CEO said he is pleased by the performance of the new concept. The CEO said on the conference call that the brand is doing better with store traffic increasing. Also the brand has specific goals it has to make otherwise they will consider closing the stores. The CEO expects M + O to be profitable by the 4th quarter this year. Either way it will be good for shareholders; if the stores are closed 15-17 cents in losses per year are eliminated or if the brand becomes successful it will be a new avenue for growth. There are currently 21 MARTIN + OSA stores with 15 more planned for 08.

Last year AE announced a new concept 77 Kids, which will sell apparel for kids aged 0-10. The new concept is currently being developed with the website going up this year and stores are planned for 2010. It’s hard to forecast what will happen. It appears as though this is a pet project of the CEO’s. Jim O’Donnell helped start Gap kids and turned it into a $400 million business in six years before coming to AE..

Valuation:

American Eagle is down over 50% in the last year and a half. With a market capitalization of $3.3 billion, American Eagle’s trading at 8 times last year’s earnings. With $338 million in cash and $367 in investments, enterprise value divided by EBITDA is an appropriate way to value American Eagle. Cash and investments are equal to $3.50 per share. Earnings for 2008 will come in lower than 07 but, when the retail environment improves in a few years American Eagle will be worth much more than it’s trading for currently. First, the company has repurchase plan with up to 41 million shares available for repurchase. With cash on hand 22 million shares could be repurchased or over 10% of the stock. The share count has decreased by 23 million shares since 07. Options issuances continue to be large as they are in this industry with about 12 million shares available for issuance. On average option dilution has been about 1-1.5% per year. Second if either MARTIN + OSA will return to profitability or the stores are closed. The loss from M + O held earnings down by about 16 cents or $36 million last year nearly 10% of net income. With a market capitalization of $3.3 billion net of $370 million in cash and short term investments and $75 million in notes, American Eagle is trading for an enterprise value of $3 billion. Based on 2007 figures American Eagle is trading for an enterprise value/ EBITDA ratio of 4.2. Looking at any valuation metric, AE is significantly cheaper than its competitors. Cash flow from operations has been strong with $480.4, $749.3 and$464.3 million generated in 05, 06 and 07 respectively. With capital expenditures north of $200 million a year, free cash flow generation has been $398.9, $523.3 and $213.9 for 05, 06 and 07 respectively. I think AE is worth twice what it’s trading for and the value will be unlocked once the retail environment improves, share repurchases boost EPS and aerie and MARTIN + OSA begin to make meaningful additions to AE results.

Update on Pinnacle Airlines

AlexBossert@gmail.com (Alex Bossert) — Fri, 13 Jun 2008 14:29:00 +0000

Backround

On April 17, 2007 Pinnacle and Delta signed an airline services agreement for which Pinnacle would fly 16 CRJ-900 jets for Delta. The CRJ-900s began being delivered to Pinnacle in December of 2007. Currently they have 9 of 16 planes in operation. On June 10th Pinnacle announced that Delta wants to exit the contract citing poor on time performance. Pinnacle will have to take the planes out of service by July 31. I have a few observations to make about this development:

Delta doing whatever it can to get out of contracts

With the increasing gas prices the airline industry is in a crisis and the major airlines are looking everywhere for places to cut costs. One way would be to cut the contracts with their regional carriers if they are unprofitable. Attempting to cut the contracts with the regionals is unsustainable for the major airlines because regionals fly passengers cheaper then the major carriers could (lower wages and pension obligations), the major’s want to focus on larger planes that drive more revenue and passengers transfer to and from longer routes via regional airlines. I believe Delta is so desperate that they are attempting to cut the contracts with their regional carriers. I believe this is what they are doing because they tried to cut their contract with Mesa Airlines’s subsidiary Freedom Airlines earlier last month but that attempt was thwarted when Mesa won a federal court injunction and was able to keep flying.

Delta has said it has the right to terminate the contract with Mesa’s subsidiary Freedom Airlines because Freedom did not maintain at least a 95 percent completion rate for three months within a six-month period late last year and early this year. Delta obviously wants out of these contracts if they are willing to cite both Mesa and Pinnacle for minor and temporary operating issues that both carriers don’t have any control over.

Pinnacle’s legal rights

Pinnacle’s CEO said Pinnacle plans to "pursue appropriate remedies." Under the ASA either party can terminate the contract if one of the parties breaches any of the requirements listed in the ASA. This is the item in the ASA that Delta claims that Pinnacle breached "(vi) Operator fails to achieve any of the Operational Performance Standards set forth on with respect to the Delta Connection Flights during any two consecutive months or three months during any consecutive six month period;" Delta said "Pinnacle's operational performance has fallen below minimum levels required under the contract." In the last call and in the 10Q Pinnacle Manegment said that they are no where near the minimum operating requirements which doesn’t make sense based on what Delta is saying.

Here is what Pinnacle said in the press release: "Delta contends that Pinnacle did not meet minimum arrival-time performance requirements for a period since flights began late last year. However, many factors affecting on-time performance are beyond Pinnacle’s control, said Phil Trenary, Pinnacle Airlines Corp.’s president and chief executive officer. The operational schedule created by Delta is a key factor affecting on-time performance, he said. Under the capacity purchase agreement, Delta is required to collaborate with Pinnacle to create a mutually acceptable operating schedule. Delta has created Pinnacle’s operational schedule since the beginning of operations in December 2007".

"From the very beginning of our Delta Connection operations, we expressed our concern that the flight schedules Delta created were unrealistic. Our position was affirmed when recent schedule changes by Delta allowed immediate improvement in our on-time performance, well above the agreed minimum standard and above most other Delta Connection carriers."
"We believe that the attempt by Delta to terminate this contract is wrongful, and we intend to pursue appropriate remedies," Trenary said

That is why Pinnacle kept reaffirming that it was no where near the minimum operating requirements. If Mesa was able to stop Delta from canceling the contract for completion rate then I think Pinnacle will have a strong argument in court cased on what Pinnacle said above. They will be able to argue that the poor performance was due to one of the worst spring and winter weather patterns for airlines in decades, which is obviously out of their control and that Delta scheduled unrealistic routes while not collaborating with Pinnacle on routes, so in effect Delta broke the ASA as well. Once Delta made scheduling changes the on time performance improved immediately, was above the minimum and was better then many of Delta’s other carriers which shows it wasn’t Pinnacle’s fault.

How will the loss of Delta effect Pinnacle?

First off, how much in free cash flow will Pinnacle lose? Going back to my original analysis, I concluded that Pinnacle should be able to generate $70-90 million in FCF in 2009. The amount of 2009 FCF that will be lost if the CRJ-900s are taken out of service is $14.1 million, hardly a life sentence. If the $14.1 is subtracted from my $70 million estimate, Pinnacle should still generate at least $55.9 million in FCF. Since Colgan is having some trouble, if you want to be very pessimistic you could subtract that to and it still leaves just over $50 million in FCF for 2009. Under Pinnacle’s purchae agreement for the CRJ-900s, Bombardiar won’t deliver the planes unless the contract with Delta is in full force. So, after July 31 Pinnacle will look to put these planes into service with another carrier. If they can’t they are stuck with $36 million a year in principal and interest on the planes. Pinnacle will still have plenty of cash and FCF to cover this. This is not what investors should be worried about though.

If the Delta contract were to be canceled a default under one of Pinnacle’s credit facilities would occur. It is just the debt that is related to the purchase of the CRJ-900's and the pre delivery deposits. The amount of debt that could default is $200 million. Pinnacle has $76 million in cash and $126 million in illiquid auction rate securities. Pinnacle will have serious trouble coming up with $200 million. The ARS could be sold for a loss of just under $10 million but Pinnacle has $60 million borrowed against them eliminating Pinnacle’s chance at coming up with the $200 million. If Wells Fargo wanted to they may be able to force Pinnacle into bankruptcy. But, Pinnacle will be able to show that they could meet the interest payments even if they are unable to put the CRJ-900s into service with another carrier. Also in bankrutcy Pinnacle would lose its other contracts and that would be bad for Wells Fargo. Why would Wells Fargo want to push Pinnacle into bankruptcy if Pinnacle would be able to make the interest payments. The possibility of a Pinnacle bankruptcy cannot be overlooked though.

The worst case scenario would be a Pinnacle bankruptcy. To get there Pinnacle would have to fail to get a court injunction against Delta and then Wells Fargo would have to deliver the default to Pinnacle. I have reasons that I went through above that show why Pinnacle has a good chance of getting a court injunction against Delta and if that doesn’t work, reasons why Wells Fargo wouldn’t want to push Pinnacle into bankruptcy. But I’m not even close to ruling out the worst case scenario. To get a possible liquidation figure I took book value + deferred revenue-intangibles-goodwill-debt issuance costs-deferred income taxes and came up with $155 million or about $8.61 per share. But a good chunk of the assets are in aircraft that are basically brand new. If the aircraft are sold for 10% less then they’re on the books for that would bring my liquidation figure to $120 million or $6.60 per share. This is still $50 million above today’s trading price but of course there would probably be more write downs in bankruptcy and a lot expenses also.

I will continue to hold my shares because in looking at the possibilities of what might play out, the worst case is bankruptcy and in that case it’s probably not worth much less that what it’s trading for. I do think the odds of bankruptcy are low. I see a good possibility that Pinnacle is able to continue operating and in that situation Pinnacle is worth way more then it’s trading for. It will mot likely come down to what oil prices do. If they continue to rise then that increases the risk that Pinnacle’s other customers will want to get out of the contracts. If Pinnacle continues to operate they should be able to do about $50 million a year in FCF.

Seth Klarman Speech April 20th 2006 at Columbia Business School

AlexBossert@gmail.com (Alex Bossert) — Wed, 11 Jun 2008 20:49:00 +0000

A friend sent me a video of a speech given by Seth Klarman at the Columbia Business School. Klarman’s hedge fund the Baupost Group has done over 20% a year since he founded the firm in 1983 with only one down year. Also, Seth Klarman’s book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor is also one of the best books I’ve read on value investing. It’s currently out of print and selling for about $1,600 but I got a copy through my library’s intra library loan program.

Of all the articles/speeches/interviews of value investment managers this is one of the best speeches I’ve ever watched. Klarman discusses how he made over 5 times his money investing in Enron debt, what his investment principles are, his thoughts on the investment manegment industry, why he doesn't go short and why he uses derivitives.

This speech is not posted any where else on the internet. Here is my summary:

Thoughts on Investment Manegment Industry

The investment Manegment industry is not set up to achieve market beating returns. Instead they are incentivized to get big and act like asset gatherers. At the same time there is little incentive to take risk and deviate from the mean because if they strike out and underperform for even a short period clients will be lost quickly. It’s an enforced mediocrity (if you want to get big just do what everyone else is doing and settle for average results).

Klarman said he would rather hold treasury bills then invest in many of the hedge funds out there. If stocks do 10% going forward and a hedge fund that charges 2 and 20 takes 3% of your money in fees you’ve only got 7% left, plus it’s leveraged, holds illiquid securities, etc. He would much rather get 4.5% risk free.

Tweedy Brown is today’s manifestation of Benjamin Graham
Value investing is risk aversion

Baupost charges a 1 percent management fee plus 20 percent of profits.

How Baupost Invests

Rule #1: Don’t lose money. Rule #2: Never forgot Rule #1.
Baupost always looks for catalysts in its investments. If you find a stock trading for 50% of what you think it’s worth you want there to be something that will trigger it to reach fair value.

Baupost will always sell an investment as soon as it near their estimate of fair value. Baupost has analysts focused around the type of opportunity; Baupost has a spinoff analyst, index fund deletion analyst, post bankruptcy analyst, distressed debt analyst and an analyst looking at companies that are depressed because of a bad earnings announcement).

Baupost invest in: Both public and private distressed debt, Real estate (Baupost has done over 200 real estate deals including biding on RTC auctions), U.S. and foreign equities, LBO’s and Derivatives.

The portfolio is 45% cash, 20% equities, around 17% distressed debt, 11% real estate, 7% private investments (distressed debt, small LBO’s, financial restructurings), 6% in South Korean equities and a small % in hedges.

Baupost looks at every merger, rights offering, privatization of government business, spin off, major share repurchase, dutch auction tender, thrift conversions or anything else that could cause mispricings.

Post bankruptcy situations are a good place to look for bargains because people avoid them and don’t understand them. A lot of good things can happen in bankruptcy such as terminate overpriced contracts or leases, shed extraneous business units or, deal with union problems or settle contingent liabilities; all under the protection of bankruptcy court. Then all the debt holders have equity and they will want to sell.

Baupost opened over 1,000 savings accounts across the country to take advantage of thrift conversions

Baupost doesn’t go short because unlike going long when you can take advantage of a drop in the value of an undervalued security by just buying more, if your short even though you may be right that it’s worth less then the trading price you can still go broke. It’s way more risky and you can lose infinity. Think tech stocks if you shorted them in 97, 98 or even 99 you would have been killed. It works for a while and then the market goes berserk and you get killed.

Baupost uses hedges to reduce risk. For example they use derivatives to hedge the interest rate risk in their real estate holdings. They hold credit default swaps on the government debt of countries they have investments in (S. Korea). They also hold credit default swaps in a bunch of European countries not necessarily because they have holdings there but because it reduces risk and they were very cheap ($60, 000 a year for $100 million in insurance).

Baupost does best when there is high uncertainty and little information. When they research a company they do what ever they can to find information; they talk to every one to get information including, manegment, industry people, former executives, customers, suppliers, they sometimes hire consultants and talk to analysts on buy and sell side.
They constantly reassess to find new information, if they’ve overlooked something or if something has changed.

Employees own second largest position in Baupost.

Baupost’s 3 investment principles:

1. Focus on risk before return. This is why Baupost has so much cash, currently 45% of the fund is in cash. If they could find undervalued investments they would put all their money to work tomorrow. If they had to they would have no problem holding 100% cash. People fail to have sell discipline because they can’t hold cash.

2. Focus on absolute returns. Institutions focus on relative returns but Baupost doesn’t because Klarman can’t imagine writing a letter to clients saying "we performed well during the year, the market was down 25% and we were down only 20%" also clients will pull money out at the wrong time and it has a strong psychological effect.

3. Only focuses on bottom up investing. He has views on the macro but doesn’t think he has an edge in that type of investing. Klarman said that it’s really hard to turn a macro idea into an investment.

Klarman's 5 fold investment in Enron debt

Baupost invested in Enron’s senior debt and he said that would be an example of his favorite type of investment. The situation had a lot of complexity, hard to analyze, a lot of litigation, uncertainty and no one wanted to be associated with anything Enron creating a huge mispricing. Baupost bought the debt for 10-15 cents on the dollar. It comes down to assessing assets minus liabilities. After a few years most of Enron’s assets were cash $16-18 billion but the liabilities were extremely complicated, with over 1,000 subsidiaries. Baupost had one analyst focus solely on Enron for over 4 years and try to figure out its liabilities and how much they would get back on the bonds. Baupost believed that the people liquidating Enron were low balling what they would get back on the bonds. The people liquidating Enron were very pessimistic and they originally estimated that the bonds would get back 17 cents on the dollar at the same time the debt traded for 14-15 cents, Baupost estimated that the debt would recover 30-40 cents and as of now they believe it will be more then 50 cents.

Investments like Enron debt are possible because the market doesn’t assess risk correctly by relying on volatility (beta).

More about Seth Klarman:

Business Week: The $700 Used Book

Seth Klarman at MIT October 20th, 2007

Baupost's Portfolio Holdings

Great Article About Klarman: Manager Frets Over the Market, but Still Outdoes It

Pinnacle Airlines First Quarter Earnings Update

AlexBossert@gmail.com (Alex Bossert) — Mon, 26 May 2008 01:56:00 +0000

PNCL reported earnings of $2.7 million for the first quarter compared to $9.4 million for the first quarter last year. Several factors have caused PNCL’s bad earnings during the first quarter. They appear to be primary temporary in nature and PNCL should deliver 2009 free cash of between $70- $100 million. These temporary factors have caused PNCL’s stock price to decline nearly 50% from November and at the same time the long term has changed little. PNCL currently has over $4.50 per share in cash plus another $7 per share in auction rate securities and since the first quarter 07, nearly 25% of the stock has been repurchased. If the deferred revenue is added to book value and goodwill and intangibles are subtracted, adjusted book value is $13.81 per share. Pinnacle is trading for less then 50% of adjusted book value. I plan to buy more shares on Tuesday.

To avoid confusion I will call the parent company PNCL and the two subsidiaries (Pinnacle ) and (Colgan). Consolidated operating income was $6.7 million compared to $12.8 million last year which resulted in an operating margin of 3.3% and 7.1% respectively.

PNCL’s subsidiary, Pinnacle, had operating income of $17.7 million up from $15.4 million in 07. Pinnacle’s operating margin was 11.5% for the quarter vs. 10.7% in 07. In the call management stated that this year was the worst winter weather pattern in the history of the company. Penalties caused by the delays cost Pinnacle $2.5 million and management said that the delays cost Pinnacle another $2 million in lost revenue and other costs.

The Colgan operations had an operating loss of $4.9 million vs. break even in 07. Since Colgan’s contracts are "revenue pro-rata", they are effected by fuel prices. The 54% increase in fuel prices cost Colgan $4.2 million more then last year. Also Colgan’s operations are seasonal with the first and fourth quarters being the worst. Management expects Colgan to be at a loss for the year. Significant cost cutting initiatives are planned to return Colgan to profitability. These initiatives include rebidding the Essential Air Services flights, relocating nine markets from Pittsburgh to Washington Dulles, relocating maintenance hubs to eliminate ferry flights, implementation of fuel saving initiatives, simplifying the maintenance structure, and eliminating the unprofitable Beech 1900 fleet. Management stated in the call that if these initiatives don’t return Colgan to profitability then they will take measures to reduce of eliminate the "revenue pro-rata" contracts and attempt to get the planes into capacity purchase agreements. If Colgan were to exit the current contracts it would incur large one time costs.

Pinnacle had operating income of $17.7 million, Colgan reported an operating loss of $4.9 million and PNCL had overhead expenses of $6.1 million. Overall operating income was $6.7 million down from $12.8 million last year. To summarize, the results were affected by the poor results at Colgan which was primarly the results of fuel prices ($4.2 million), penalties due to weather ($2.5 million) and lost revenue due to delays ($2 million).

Five CRJ-900's entered service in the first quarter as part of Pinnacle’s contract with Delta. Ten more CRJ-900's will be delivered by January 2009 and Delta has the option to add up to seven more. Six Q-400's entered service during the quarter as part of Colgan’s contract with Continental. Nine more Q400's are scheduled to be delivered by the third quarter of 08, eight more in 09 and two in 2010 for a total of 19 by 2010. Continental has the option to add up to 20 more Q400's. The Q400's use 28% less fuel then a comparatively sized regional jet.

Disclosure: I own Pinnacle.

T. Boone Pickens Interview at Milken Institute Global Conference

AlexBossert@gmail.com (Alex Bossert) — Sat, 17 May 2008 03:44:00 +0000

Billionaire energy investor Boone Pickens, founder and chairman of BP Capital LLC, speaks at the Milken Institute Global Conference in Los Angeles about the outlook for oil, U.S. energy policy, and alternative energy including wind and solar power.

Boone discusses how his hedge fund lost 90% of its value and then made it back. Boone actually has a plan that could solve our dependence on foreign oil.

Watch the video here

Then read these two articles:

Natural-gas powered cars

and

T. Boone Pickens Drills into Wind Power

Berkshire Hathaway Annual Meeting

AlexBossert@gmail.com (Alex Bossert) — Mon, 05 May 2008 23:17:00 +0000

I was able to attend the Berkshire Hathaway Annual Meeting for the third year. Below are links to notes and resources other sites have posted on the meeting:

Fat Pitch Financials: Ultimate 2008 Berkshire Hathaway Annual Meeting Guide

Reflections on Value Investing: 2008 Berkshire Hathaway Shareholder Meeting: Detailed Notes

CNBC: LIVE BLOG ARCHIVE: Warren Buffett News Conference

Omaha World Herald: Notes and highlights from meeting

Berkshire also just released earnings for the first quarter:
Berkshire Hathaway First Quarter 10Q

Richard Pzena Interview: Doubling Down in Financials

AlexBossert@gmail.com (Alex Bossert) — Fri, 25 Apr 2008 00:15:00 +0000

Anything Richard Pzena has to say is a must read. Pzena was interviewed by Forbes magazine yesterday and shared his thoughts on his current investments and the financial industry in general. Pzena believes many of his financial investments are trading for less then 5 times their normal earnings power. Pzena's current picks are : Alacatel-Lucent, Freddie Mac, Citigroup, Allstate, Capital One Financial, Torchmark, Fannie Mae, Bank of America, Johnson & Johnson, Whirlpool,

Excerpts from the Forbes interview:

But we are in a recession right now, won't these companies suffer
more?

There is a difference between what gets hurt and what stock prices go
down. People don't understand that concept. Typically, in a recession, when
you
are in the worst environments, the companies most negatively impacted
are the
ones that actually do the best in the stock market.

Why?

Because they do poorly before the recession. Everyone knows it will be
bad
for retail in a recession. So they kill retail stocks before they get
into a
recession. Once they're in it, people start to look out to the other
side. All
the speculation shifts to this question: When is the recovery?
That is when you
see cyclical kind of companies bottom out. That has
happened in every single
prior economic cycle. I think it's impossible for
housing stocks to get killed
any worse. Banks and finance companies have
gotten killed. Credit card companies
have already taken provisions so their
earnings and stock prices have gotten
killed. People expect the worst in the
credit card business.

Full Interview Via Forbes

Pzena Investment Management: First Quarter Commentary

Another Interview from December 31, 2007 Via Barrons:

Opportunity Amid the Ruins

Mohnish Pabrai Interview

AlexBossert@gmail.com (Alex Bossert) — Mon, 21 Apr 2008 23:42:00 +0000

Mohnish Pabrai started the Pabrai funds in 1999 and has since had returns of 25% a year on average net to investors. I have been following Pabrai since I read an article about him in Forbes Magazine in 2004. I recommend the article , in it Pabrai talks about his investment in Frontline. In the interview published today by Smart Money Pabrai talks about one of my largest holdings Pinnacle Airlines.

Smart Money: What stocks do you like now?

Mohnish Pabrai: Pinnacle Airlines. Depending on
how
things work out, it's anywhere from a double to five or six times return in
the next two or three years.
SM: An airline?
MP: It's a regional jet
company. The large airlines,
like Northwest and Delta, outsource the small planes to Pinnacle. Many of the
reasons why airlines are so terrible — load factors, price wars — don't
matter.
The revenue is the same whether there is one passenger or the plane
is full and
whether Northwest charges $200 or $2,000 round-trip. The
contracts are
long-term, usually 10 years, and will hold up in the event of
a merger. So you
can estimate what their cash flows will be many years into
the future.
SM:
What's the investment case?
MP: Pinnacle has more than $10 a share in cash
on the
balance sheet. In the next few years, free cash flow will be $3 to $6 a
share, depending on how much more business they get. With a simple 10 or 15
multiple on those numbers, you end up with $30.
SM: Why are the shares so
cheap?
MP: One overhang is that they have a past-due contract with
pilots.
But not a lot of Wall Street analysts follow Pinnacle, and the
business itself
is changing. The evolution away from hub-and-spoke and
toward more nonstop
flights is driving demand for their services. When you
connect one small city to
another directly, you aren't going to run a jumbo
or a 737.

Full Interview Via Smart Money

I also highly recommend Pabrai's book The Dhandho Investor: The Low - Risk Value Method to High Returns.