The Elephant Fund

Oh, Expedia…I think she's still worth the trouble. Here are a few quick thoughts why.

Thesis tested, again

Priced attractively given recent guidance

"Each Stockholder EXPEZ warrant entitles its owner to purchase 0.969375 shares of Expedia common stock at an exercise price equal to $11.56 per warrant. The exercise price must be paid in cash. Each Stockholder EXPEZ Warrant may be exercised on any business day on or prior to February 4, 2009."

Unfortunately, warrants are not the same as call options and have to be valued differently. I don’t know how to value warrants explicitly, but I found a useful model online. The price curve implies a value of $5,05 – 6,35.



Seeing that the online model was close to the Black Scholes value, I rounded my estimate to $5,50. EXPEZ has recently been trading around $4,40.


Outlook

I can’t tell you where we head from here; I see few near-term catalysts. Any short-selling here would be unwise given that EXPE has real assets that produce cash and have the potential to surprise the market as much to the upside (Nov. 2005) as to the downside.

I’d love to know what Bill Miller and Legg Mason are doing with their shares these days. If MMs continue to unload, I’d expect continued weakness in the near-term. Following two earnings misses, most buyers have left the building.

Good luck,

RMA

# posted by RMA @ 08:12 2 comments

Still stinging from EXPE's impressive-(ly bad) Q1, I've been investigating various pain treatment options. Sure, your OTC analgesic might relieve the afternoon headache or Jack & Coke hangover, but stock market pains sometimes need a little extra... like an implantable morphine pump.

Fortunately, the good people at PainCare Holdings (AMEX: PRZ) offer just that. PRZ is a healthcare services company specializing in the treatment of pain. They offer pain management care (to treat chronic or acute pain), minimally invasive outpatient spine surgery, and orthopedic rehabilitation. The Pain Management field is increasingly becoming an important component of patient care and PRZ is a fast-growing provider of these services.

PRZ is attempting to roll-up the Pain Management industry by acquiring high-performing practices, expanding their service offerings, and increasing practice revenues and operating profits by 25-50%. To be clear, the consolidation strategy aims at capturing revenue synergies, not leveraging the cost base to achieve a scale advantage. Given that physician salaries comprise most of the cost bar, I believe PRZ sees limited opportunity on the cost front.

Preliminary results have proved successful. Since 2003, PRZ has increased revenues and operating profits by more than 400% to 69M and 15M, respectively.

BUT, of course there's a 'but':





Just a few weeks ago, the SEC took issue with PRZ's treatment of some non-cash, accounting charges and the stock plummeted by more than 50%. The revisions are an absolute mess and incredibly difficult to weed through. However, I honestly believe they are the nature of the beast and not Management's attempt at disguising the truth. They are all non-cash, non-operating and deal with the accounting treatment for cash-less stock options, debentures, PIPEs, & warrant financing instruments, and intangible asset amortization. The Company has been working hard to revise the financials and is expected to submit their 2005 10K by June 2nd. Most of these issues will persist through Q2 2006.

So, here's the investment thesis.

• Treatment volume will increase: 75M * (1 + 30%) * 'X' Higher incident rate
• Healthcare costs will increase (a given, I think)

Management has successfully executed... and ....Management has unique experience in...
Reviewing the 10K, management biographies indicate a wealth of experience in Healthcare, Industry roll-ups, Pain management, and Mergers & acquisitions.



In addition, PRZ has brought on board a six-person deal team to integrate each practice as it comes online. The acquisition process is methodical and well-tested with more than 20 acquisitions completed to date.

• Clear business definition: PRZ has acquired and continues to acquire high performing Pain Management, Spinal Surgery, or Orthopedic rehabilitation practices. These businesses rank highly on both customer and cost sharing.
• Attractive targets are abundant: American Academy of Pain Management has 6.600 members. Assuming 3 members per practice and that only the top 25% are high-performing (e.g. 80% gross margins, 25% cash operating margins), there are at least 550 potential targets.
• Merger terms are replicable: Almost every PRZ acquisition has been identical. PRZ pays 5x operating earnings with 50/50 cash/equity consideration with earnout agreements spaced from one to three years.
• Consolidation captures synergies: Organic revenue and operating earnings growth for acquired practices trends between 20 and 50% in the first two years after acquisition.

• I think the stock has shown a lot of weakness as persons familiar with PIPE transactions may have anticipated the SEC announcement and shorted the stock ahead of time.
• Investors often shudder after missteps by small-cap companies causing share prices to overreact.
• The non-cash accounting losses are ironically exacerbated by the appreciation of PRZ shares during those time periods (e.g. share price goes up, derivative instrument losses increase as well). As the share price has dropped precipitously in Q1 2006, PRZ is going to announce a monster (great) Q1 that might attract a lot of momentum investors providing the catalyst for the share price to gap upwards.

# posted by RMA @ 06:25 4 comments

Would you buy a dollar for 50 cents? How about a brewery on sale for liquidation prices?

Redhook Ale Brewery (HOOK) makes beer, and good beer at that. Their most popular brews include their own Redhook ESB and India Pale Ale as well as Widmer Hefeweizen (a contract brew for Widmer Brothers).

Yet, great products don't always make great companies. For the last five years, HOOK has been stuck in the proverbial 1st (more accurately, reverse) gear while earning net profit margins of negative 3-5% and experiencing a 4% annual sales dollar decline. HOOK's lackluster financial performance has coincided with an almost 90% cumulative decline in share price since it peaked in the late 90s. Has this been warranted?

Maybe, maybe not. While there are a number of explanations for sales decline and profit performance (sales team restructurings, new distributor agreements, brewing capacity utilization), I'd like to fast-forward to the valuation. I'll let you do your own reading of the company's 10K -- I've already done mine.

At a first glance, Yahoo says that HOOK is currently trading at ~50% of book value. In other words, you or I could buy $60M worth of assets for $30M. I often like to take a closer look at the balance sheet to see what's really under the hood. Below, I've detailed how I would estimate the reproduction cost of the assets.



I see no reason to adjust the current accounts and the only adjustment for fixed assets is to take into account the land appreciation of the Washington facility. Assuming 4% annual appreciation (covers inflation and minimal asset value increases), I estimate BV at $73,5M or $9 per share.

• What would an industrial buyer pay for similar assets?
• What could be a catalyst for the stock to converge on BV?

As for the first data point we don't have to look very far (2005 HOOK 10K). As a matter of fact, as part of a distribution agreement between HOOK and BUD, BUD assumed a 33,6% position in HOOK common stock. Moreover, BUD valued the interest at $8 a share (or 100% premium to today's price).



Given BUD's economic interest in HOOK, I feel pretty comfortable with my an $8-9 intrinsic value estimate for HOOK shares. Now, what could catch Mr. Market's attention to realize that price?

If HOOK could just muster up some profitability, I think investors would reward the stock. And, I think Management is working towards this goal. Since 2001, EBITDA margins have improved 300 basis points to 6,8% and HOOK turned free cash flow breakeven-to-positive in 2005.

Management has offloaded most sales & marketing responsibilities (while conceding gross margin) through the use of distributors (e.g. BUD, Craft Brands) and seems to be improving plant utilization through contract brewing agreements (e.g. Widmer Brothers). Those actions have reduced COGS / unit and improved EBITDA margins. In addition, they re-launched the brand in 2005 and preliminary results are positive.

To summarize:

• HOOK is cheap, really cheap.
• Budweiser, the King of Beers, thinks HOOK is worth $8 a share.
• Profits are improving, albeit slowly.

# posted by RMA @ 13:14 3 comments

Have poultry shares hit bottom or is this merely the calm before the storm?

Unfortunately, I don't know; but, I think these shares are attractive now and could become even more attractive with a little patience. In particular, I think CGL-A, GKIS, IBA, PPC, and SAFM merit a closer look.

They’re businesses that I understand

The companies mentioned above are a sampling of the leading US poultry disassemblers. To varying degrees, they essentially all do the same thing: raise, slaughter, and package fresh and frozen chicken. The primary players and their respective market shares are as follows:

IBA operates exclusively in Mexico and consequently doesn't report US production.

They have favorable long-term prospects (kind of)

As far as I can tell, most people like chicken and will most likely continue consuming into the future. If you don't believe me, both the American and Mexican governments track domestic chicken consumption relative to other proteins. They've concluded the following:

• Since 1980, US Chicken consumption has increased at a 2.4% CAGR while Beef and Pork have declined slightly and Turkey has increased 1.7%.
• In Mexico, since 1977, chicken consumption has grown at a 5.3% CAGR and is projected to increase at a heady clip of 6.5% through 2010.

Don't get me wrong, this is not a growth story. However, the sky isn't falling either. I would be foolish to ignore the short-term prospects given the threat of a worldwide avian flu pandemic. However, if you're still reading, I'm sure you've drawn your own conclusions on the avian flu threat/pandemic/burlesque...

I think poultry investors are very scared of the uncertainty that lies ahead. I see an opportunity. Warren Buffet once said:

"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."

Here is what I see in the poultry market:

Like Warren, private equity players often get greedy when others are fearful. I think that an investment in one of these companies could be an interesting PE idea:

• Invest in the trough
• Wait for the multiple expansion
• Pay down some of the debt
• Grow EBITDA
• Sell after the rebound

Later, I’ll walk through my intrinsic value estimate: a LBO valuation of these firms. In fact, the key driver in this investment decision is the valuation. The industry isn’t particularly attractive. Nonetheless, I'd like to comment on the competitive position of these companies as it might affect which horse we pick.

In a commodity business (like this one), relative cost position is key. Given that processors have less influence on the end-product pricing, competitive advantage (and the ability to generate higher returns) comes in the form of being the lowest-cost producer. Contrary to intuition, protein disassembly is not a scale industry. The highest operating margin is held by one of the smallest players (in order from biggest to smallest):

SAFM is the low-cost producer both on an operating margin basis as well as cost / lb.:

I trust the management

Walking through SEC filings as well as Investor Relations postings, you’ll see that this industry has some of the highest levels of disclosure around. In addition, Insiders (mostly founders) remain heavily invested in their companies (TSN, SAFM, PPC, CGL-A). I think transparent filings and high insider ownership suggest that management and investor incentives are aligned.

Did I mention the valuations were a steal?

CGL-A

CGL-A opened today at $6.75, implying a capitalization of $32M. Okay, it’s small; BUT, at that valuation, it’s trading at .66x net asset value (Assets – Liabilities). Even PPC paid BV when it bought CAG’s operations for a song.

IBA

Again, a net asset value comparison suggests that IBA is trading at .75x NAV ($876M / $1,175M). BTW, $300M of that is cash in the bank. In other words, Mkt. Cap / EV = 1.5x.

With both companies, I believe the gap below net asset value + intangibles which aren’t recorded on the balance sheet (supplier relations, customer lists and relationships, brand equity, etc.) creates a sufficient margin of safety. However, for both companies, there isn’t much liquidity and given their unique statuses (micro-cap and a Mexican company, respectively), a catalyst to realizing intrinsic value might appear later than sooner.

SAFM

This one is a little tricky. Using current valuations and earnings as a starting point doesn't make a lot of sense since everything is likely to look decidedly negative. After reviewing SAFM’s historical 10K’s, I propose taking FY2005 as the basis for our valuation (2004 was exceptionally strong and a lot has changed since 2003).

Let’s start with a picture of normalized earnings. In 2005, SAFM achieved a 11.3% EBIT margin on revenues of roughly $1B. For the sake of conservatism, let’s assume 10%.

An analyst at J. P. Morgan recently commented that SAFM has historically traded in a range of 3-7x EV/EBITDA, averaging around 5x. I estimate that a weighted average of that multiple (weighted by the amount of time trading at a specific multiple) over that time period is most likely in the 5.2-5.7x range.

Based on normalized earnings alone, SAFM might be worth:

Currently, SAFM trades at $23 (.74x normalized earnings): a 35% margin of safety.

Let’s look at it a different way. SAFM currently has a very conservative capital structure with minimal debt: D/E = .06x.

• What if SAFM were to re-organize its capital structure?
• Better yet, what if SAFM were taken private by a PE shop or otherwise?
• What would be the private market value?

First, we’ll re-capitalize SAFM assuming the use of typical LBO debt instruments:

Summing everything, SAFM total interest bearing debt becomes $511M, or D/E of 1.5x. I think an average of cost of debt of 9% would be acceptable, making annual interest payments of $46M or a normalized EBIT / interest coverage ratio of 2.2x. After interest and taxes, SAFM could then pay down some of its debt:

So, what is the maximum that a PE shop would pay today for SAFM while targeting a 30-40% IRR? I think that a PE shop would pay as much as $32 / share.

PE shops make money in three ways: using leverage, waiting for multiple expansion, and executing operational improvements. I’ve oversimplified the investment model, but here are three potential scenarios:

Erring on the side of conservatism, my intrinsic value estimate is $32.

To summarize:

• Everyone likes chicken and will continue consuming long after you and I pass on.
• High levels of insider ownership align management with investors.
• Valuations are attractive to both retail and PE buyers.
• Everybody wins.

Even though SAFM is attractive at current prices $22-23, I think it could become even more attractive with a little patience. Given current poultry prices, the current quarter is likely to be a disaster and could present an attractive buying opportunity as speculators run scared. In addition, if avian flu follows historical migratory patterns, it will most likely hit the US and these shares will tank. If that were to happen, I would then be more greedy than fearful.

I will consider a small position at the current price and then build my position if the price falls.

Good luck, RMA.

# posted by RMA @ 09:18 6 comments

It’s been some time since my last posting which unfortunately shows how hectic my schedule has been of late. In contrast to my ambitious start (3 postings in 5 days), I’ve realized that updating this blog with valued content will at best be a semi-monthly endeavor.

After waiting almost two months for a work visa, I’ve recently moved to Madrid to begin a new assignment that will take me through the end of September. So far, Madrid has been great (think: sangria, tapas, and mid-day siestas). I live on the northern side of the city (Nuevos Ministerios) which lacks the charm of Madrid’s more historic parte vieja, but I’m conveniently just a 5 minute walk from the office.

Pasamos a hablar de inversiones. Before my next analysis, I wanted to provide some context on my performance and portfolio theory. The latter is very much a work in process and I expect to do a significant amount of spring cleaning as I take on a more ‘focused’ approach.

The first quarter has come to a close and my actively managed portfolio is up 14.3% YTD.

Holdings as of 3/31/06, listed in no particular order:

I actively manage a little more than 2/3 of my investment portfolio while the balance is invested in a mix of cash and domestic & international equity index funds offered through my firm’s 401k plan. I haven’t invested enough time to determine the optimal allocation between active & passive as well as current & tax-deferred investments. Instinctually, I feel that diversifying my tax liability between traditional brokerage and tax-deferred investment accounts is the correct answer. Correspondingly, I actively manage the brokerage account and passively manage my 401k contributions.

I hold little cash and no debt or derivative securities. As to the benefits of an all equity investment plan, I recommend you pick up a copy of Jeremy Siegel’s Stocks for the Long Run. Jeremy is a Wharton finance professor who has completed extensive security research showing that stocks have historically outperformed all other asset classes given a long-term investment horizon (~20 years).

Hasta el próximo, RMA.

# posted by RMA @ 06:50 0 comments

If their catchy commercials hadn’t caught your attention, maybe EXPE’s recent rise and fall did – It certainly has mine. Actually, I originally caught interest in Expedia about 5 months ago as I watched its stock price deteriorate from $24 to around $19 following its spin-off from IACI.


I initiated a long position at $20.34 after seeing no material change in the company’s operating prospects and discounting pre-existing ‘synergies’ from the IACI ownership. After all, if synergies did exist, the ‘whole’ should have been greater than the ‘sum of parts’ and IACI would have retained EXPE. From a business definition perspective, EXPE and IACI ranked poorly on both customer and cost sharing. The spin-off was the right move and it presented an attractive buying opportunity. For reasons more eloquently described by Bruce Greenwald in his book Value Investing, spin-offs often represent interesting investments:

“Spin-offs are a wonderful opportunity for investors who are not constrained by questions of corporate size. Because many of the shares are sold for reasons unrelated to the company’s prospects, there are bound to be gems tossed away by the large funds for whom a small company stock, though perhaps a jewel, is still a nuisance” (23).

• Online travel represents 10% of WW travel spend and is no where near fully-saturated
• The Expedia franchise remains intact with a 1.8x RMS and 28% EBITDA margin
• Management has laid out a competent plan for profitable growth from the core
• At $18 and change, the stock is priced attractively relative to comparables analysis as well as intrinsic value estimates
  

# posted by RMA @ 23:39 5 comments