The Elephant Fund

Mr. Market causing you pain? (2 of 2)

2006-06-16T13:03:00.000-05:00

As promised, here’s a follow-up to our PainCare discussion.

In part 1 of 2, I laid out an investment thesis with five points to prove, leaving the last two for further research: Financing benefits equity holders and PainCare is priced attractively.

Proving the last two points has been difficult, to the say the least. The aggressive acquisition model inherently brings with it a lot of moving parts; however, adding in financial re-statements and recent equity restructurings makes this exercise even more daunting. In that context, I’ve elected a more back-of-the-envelope approach. Any output is, as a result, more speculative.

Financing benefits equity holders

Debt levels are manageable… and… Cash flow covers earnouts

In 2006, a number of convertible and straight debt as well as performance earnouts will come due for PRZ. One of my biggest doubts has been whether PRZ will have enough cash in the tank to fund these liabilities while adhering to debt covenants. In fact, even PRZ has raised this concern. In their discussion of risk factors, Management says:

“We may need to negotiate a waiver letter with respect to our credit facility…
If we are forced to repay our debentures and notes in cash, we may not have
enough cash to fund our operations.”

To ease this fear, I conducted a quick cash analysis comparing the expected sources and uses of cash for 2006. Most inputs were available from the recent 10K; however, I had to estimate the 2006 Earnout payment.

I’ve estimated the 2006 earnout payment value using a quick & dirty approach. Instead of researching every contingent payment, from every acquisition, from every 8K, I’ve made my own estimate. I believe that CY’s earnout payment is correlated with the PY’s growth in the Goodwill account. Since earnout payments are deferred cash distributions of the Goodwill recorded at the time of acquisition, this seems rational. Thus, I’ve estimated the 2006 earnout payment as the 2005 growth in the Goodwill account times an adjustment factor.

In addition to the 2006 earnout payment, I’ve made some broad assumptions on a few variables (e.g. assumed same interest rate on all debt, 10% organic growth, same-sized credit facility waiver fees, cash operating income), however I think they are reasonable.

Assuming that PRZ will continue to be in violation of its debt covenant (e.g. minimum EBITDA levels) and that the share price doesn’t rise above $1,90 (the price at which the convertible debt converts, the net cash position is $4,4M – enough to run the business. However, if the share price recovers, the convertibles would most likely convert, freeing up an additional $8,5M in cash.

A large caveat to this analysis would be that this ignores the timing of all cash flows.

Nonetheless, I’m comfortable enough to say that Debt levels are manageable and Cash flow covers earnouts.

Dilution is acceptable

I’ll start off by saying: “I have no idea how many shares are outstanding.” PRZ has been so busy swapping out warrants for restricted shares, vesting stock options, and issuing contingent performance share awards that I can’t reliably determine how many fully-diluted shares are outstanding. But, I’ll try nonetheless.

In the 2005 10K, Management reported ~50M shares outstanding. Yet, a few weeks ago, the CFO told analysts in a conference call that he estimated the 2006 year-end, fully-diluted, outstanding share count between 65-70M. I’ll take the most conservative estimate and assume 70M.

With 70M shares outstanding, 2006 fully-diluted EPS falls within Management forecast of $0,20 – 0,22.

PainCare is priced attractively

As a starting point, I always like to look at a company’s earnings power value (EPV) assuming a no growth scenario. Effectively, the EPV is a perpetuity function, assuming current earnings forever. I calculate the no growth EPV by looking at last year’s distributable cash earnings less net debt divided by fully-diluted shares outstanding. I also make an adjustment for maintenance CapEx.

Here is the no growth EPV for PRZ.

Taking last year’s earnings, PRZ trades at a little more than half of the no growth EPV of $1,96. Yet, we know that Management expects to grow the business 20-30% annually over the next few years. I believe they can accomplish this, earning returns above their cost of capital, and thus creating value.

So what?

I am cautious about making a significant investment. However, I will dabble.

Frankly, the investment decision depends on a number of factors outside my circle of competence: the potential for numerous debt covenant violations (e.g. market cap, EBITDA, FCF), the delay in financial statements submissions, the complex financing instruments. Although, I think a flexible and patient investor could be well rewarded.

For better or for worse, it's been an interesting exercise.

Good luck,

RMA

Third time's the charm

2006-05-27T08:12:00.000-05:00

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

Shares are fully valued assuming no growth scenario; assume growth as the margin of safety.
Favorable cash flow cycle gives EXPE an attractive FCF yield of 10-11%.
The Company is well capitalized with ample cash and positive net debt.

Growth adds value to the enterprise and opportunities are abundant

A back of the envelope ROIC calculation (excludes ~$2.7B of goodwill for original Expedia purchase from MSFT) implies returns above WACC; thus, a franchise exists and EXPE can profitably grow within that franchise.
International markets are relatively young and growing quickly.
Expedia Corporate Travel is gaining momentum; I continue to believe that travel procurement outsourcing provides significant cost savings to companies.
TripAdvisor is a unique asset: the only online travel community, trip reviews increased from 1M to 4M in 2005, potential for increased monetization

Short-term, ‘quick hits’ are underway

Expedia announced a 20M share buyback.
Project Apollo is fully scoped and workstreams are pursuing cost savings.
Sales & Marketing strategies are being re-thought: more targeted, clearer Expedia value proposition.
Loyalty program to be launched in 2H06.

Action taken

Having said that, I recently sold my EXPE shares for a loss. Then, I bought EXPEZ warrants. I reduced my total dollar investment (which was mistakenly too high as percentage of total assets) and purchased control over more shares than I previously held.

The instrument:

"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."

I’m not familiar with warrant valuation and pricing, but I stumbled upon something that seemed a little peculiar:

At a first glance, it seems that EXPEZ warrants have taken an unfair beating over the last several months. So, I took a stab at valuing them.

Note: I know very little about option pricing. I've completed this exercise to reality-check my decision.

First, I valued the warrants assuming a Black-Scholes call option valuation. My model valued the warrants at $5,62.

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

Mr. Market causing you pain? (1 of 2)

2006-05-24T06:25:00.000-05:00

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.

Industry has favorable long-run prospects

Addressable market is sizeable and growing
Google tells me that each year 75M (or 1/4 of) Americans complain of chronic or acute pain and spend $100B on treatment annually. Common sense tells me that most of these complaints are from baby-boomers and the elderly.

The US Census says that the 45 - 84 age segment is likely to grow by 30% by 2010. As aging baby-boomers are generally perceived as more active than previous generations (interviews with my parents confirmed this, n=2), I would expect many of them to suffer from arthritis, back pain, and chronic joint symptoms.

Let's assume:

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

Driven by volume and price increases, the overall market for pain management has very strong growth prospects.

As this relates to PRZ, Pain Management is just one piece of the puzzle. The market opportunity becomes even more attractive when you consider the trends in spinal surgeries. Deutsche Bank estimates that the market for spinal replacement parts will grow at a 23% annual CAGR through 2007. Spinal replacement parts require professional installation; and, PRZ provides these services.

Margins are stable
PRZ margins are mostly driven by pricing and doctors' salaries. Currently, PRZ practices achieve an ~80% gross margin and ~20-30% cash operating margin. All acquired practices have fit this profile and PRZ as a whole reports similar results.

Even as competition increases, I would expect pricing to hold constant over the near to medium term. I don't know of any "2 for 1" deals on percutaneous disectomies. Remember, we're talking about multi-syllabic medical devices and spinal surgeries, not car insurance.

As for doctors' salaries, they are controlled by PRZ Corporate and are locked in through employment agreements signed at the time of acquisition.

Management is competent

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.

Growth increases firm value

Acquisition strategy is viable
So far, PRZ has kept a sharp focus on their acquisition profile. I believe the acquisition strategy is viable for the following reasons:

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.

Execution has delivered value
Management has publicly-stated that PRZ will only engage in transactions that are accretive to fully diluted EPS. Since the SEC ruling, this metric has been difficult to track, but my educated estimate is that fully-diluted EPS increased from $0,05 to $0,20 from 2003 to 2005.

Another way of answering the value question, is reviewing ROIC - WACC evolution. Once again, this is difficult without the revised 10K, but my best guess (note: this is not an educated estimate) is that ROIC minus WACC has fallen from -4,5% to 0,0%.

As for the rest...to be continued

As indicated in the title, this is "1 of 2". Without reviewing the most recent financials, I can't truthfully prove that "Financing benefits equity holders" or that "PainCare is attractively priced". These are two very important points given that PRZ has a very aggressive acquisition strategy that relies heavily on convertible debt financings and stock issuance. My biggest fear is that PRZ could dilute away all shareholder value or might not have enough fuel in the tank to cover debt repayment.

Nonetheless, my 30 second answer is postive. Management has forecasted pro forma, fully-diluted earnings for 2006 at $0,20 - $0,22 with no further acquisitions. Assuming $1,50 as the current share price, PRZ trades at a PE of ~7,5x. I cannot reliably estimate intrinsic value, but I would speculate that it sits above $2,00 per share.

Finally, I think PRZ is interesting to speculate on not only because of the proof points outlined above but also:

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.

I look forward to taking a closer look at the revised 2005 10K and 2006 Q1 10Q.

Good luck,

RMA

Is Redhook Ale skunky beer?

2006-05-09T13:14:00.000-05:00

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.

I think stocks trading at a discount to reproduction cost are great finds; however, I need more to go on before buying. I like to identify two supporting data points:

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.

Good luck,

RMA

Fried Chicken?

2006-04-05T09:18:00.000-05:00

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:

Tyson (TSN)	21.6%
Pilgrim's Pride (PPC)	16.3%
Goldkist (GKIS)	9.0%
Perdue Farms	5.8%
Sanderson Farms (SAFM)	4.4%
Wayne Farms	4.4%
Mountaire Farms	3.7%
Foster Farms	2.5%
Cagle's (CGL-A)	.9%
All others	9.8%

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):

TSN	7.0%
PPC	7.9%
GKIS	-1.1%
SAFM	11.3%
CGL-A	6.4%

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

	Rev. per lb.	COGS per lb.
TSN	$1.06	$0.93
PPC	$0.85	$0.60
GKIS	$0.52	$0.60
SAFM	$0.64	$0.52
CGL-A	$0.71	$0.62

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%.

EBIT	$100M
+ DA	$24.7M
EBITDA	$124.7M

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:

EBITDA	$124.7
EV/EBITDA multiple	5.2x
Enterprise value =	$648.4M
Less net debt	$18.5M
= Equity value	$629.9M
Divided by fully diluted shares of	20.137M
= $ / share	$31.28

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:

Working capital revolver	80% * (A/R + Inventory)	$115M
Senior term loan	65% * PPE	$345M
Subordinated debt	Based on EBIT/Interest	$30M
Current debt	SAFM 10-Q	$21M

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:

EBIT	$100M
- I	$46M
= PBT	$54M
- T (35%)	$19M
= NOPAT	$35M

Principal payment	$30M

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:

	Leverage	Leverage + Multiple expansion	Leverage + Multiple + Earnings
Purchase multiple (EV/EBITDA)	5.3x	5.3x	5.3x
Implied buyout $/Share	$31.98	$31.98	$31.98

Year 0 purchase price	$663	$663	$663
Year 0 permissible debt	$511	$511	$511
Year 0 Equity investment	$152	$152	$152

EBITDA growth (CAGR)	0.0%	0.0%	7.0%
Annual principal payment	$30	$30	$30

Year 5 EBITDA	$125	$125	$175
Year 5 debt total	$361	$361	$361

Exit multiple (EV/EBITDA)	5.3x	6.0x	6.0x
Year 5 EV	$663	$750	$1,052
Year 5 Equity investment	$302	$389	$691

IRR	14.8%	20.8%	35.5%

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.

Holiday in Spain

2006-04-02T06:50:00.000-05:00

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:

EXPE	TPX
KND	FDP
INTC	TCLP
MCD	MGI
SFCC

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.

Plenty of runway ahead

2006-03-13T23:39:00.000-06:00

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).

After holding on from $20 to $26, and now down to $18, I’ve had to re-evaluate my position. Am I still bullish on EXPE?

Yes, and to show you my thought process I’ll walk through the basic ‘focused’ approach that I discussed in my March 12th posting.

EXPE comprises a portfolio of leading online travel agencies that include Expedia.com, Hotels.com, Hotwire.com, TripAdvisor.com, and Expedia Corporate Travel. You might be surprised to learn that of the ~$900B WW travel market (business & leisure), online store fronts account for only 10% of gross bookings. Even by conservatively estimating that online travel will reach full market penetration at 40% of total bookings (I think the end-game saturation point is much higher), there is plenty of headroom for growth in the sector and I believe that the industry's long term prospects are very attractive.

In online travel, scale matters and EXPE has a lot of it. A straight-forward way of looking at the benefits of scale is by comparing relative market shares (RMS: market leader's share / closest competitor's share, all other company's share divided by the market leader) and their associated returns (ROS, EBITDA %, etc.). EXPE commands a dominant RMS of 1.8x as compared to its closest competitors Cendant Online Travel (Cendant: Orbitz, Cheaptickets,com, Gullivers, eBookers), .6x, and Travelocity (Sabre-Holdings: Travelocity and lastminute.com), .5x. RMS goes a long way to explain why EXPE earns 28% EBITDA margins as compared with 13% and 6% for Cendant and Travelocity, respectively. A further analysis of ROIC could prove interesting; however, I’m uncertain how to treat EXPE's large Goodwill account as it makes up ~75% of assets. I think including all of Goodwill would understate EXPE's true economic return; however, comletely excluding Goodwill overstates the figure. Regardless, EXPE's strong RMS is a valuable asset and they have acquired it early.

But, is EXPE’s RMS sustainable? Is its franchise (read: competitive advantage) intact? Yes. Interestingly enough, EXPE has fueled its 27% 2003-05 CAGR in gross bookings through organic expansion while competitors have relied on acquisitions (Travelocity purchased lastminute.com and Cendant purchased its entire online platform: Orbitz, Gulliver’s, and eBookers). EXPE invaded Europe with a 77% 2003-05 CAGR in gross bookings thanks to the importation of US best practices: technology, content procurement, and sales & marketing.

In addition to a solid technology platform and strong market share, EXPE’s management team seems competent (from what I, as an independent, retail investor can discern) and possesses an impressive understanding of what drives value in online travel . I encourage you to review to their 2005 Q4 earnings call as well their March 6th Allen & Co. presentation, both available at http://investors.expediainc.com. The CEO effectively lays out how EXPE will seek out profitable growth from the core by pursuing geograhic adjacenices (e.g. continental Europe, Japan, and China), business adjacencies (e.g. Hotels.com, TripAdvisor, Hotwire, and Corporate Travel), and improving customer retention and loyalty (e.g. CRM systems and the Expedia Best Price Guarantee).

Valuation makes up the last, yet most important, piece of my investment decision. Initially, on an EV/FCF and EV/EBITDA basis, EXPE feels cheap at 8.9x and 10.7x, respectively. PCLN is the only pure-play online agency of which I’m aware, and she trades at 15.6x EV/EBITDA. Beyond comparables analysis, estimating a simplified earnings power value (EPV) produces equally interesting results. For the time being, let’s assume that EXPE achieves no ongoing growth and FCF remains stagnant at $706M (EXPE's reported FCF of $798M net of stock option expense of $92M). How much would we pay for this annuity? How about: $702M / 10%? A 10% discount rate would yield a per share value of $20.58. Again, $20.58 values EXPE’s US, European (the world’s largest travel market), and Asian growth (Expedia’s 51% stake in elong.net, China’s #2 online travel agent and the launch of Expedia.co.jp) squarely at $0. I believe EXPE's intrinsic value sits significantly higher than $21 and that $2/share (Annuity value minus current price) plus the international growth opportunity is an adequate margin of safety.

To summarize:

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

I like EXPE and I’ll be adding to my position this week. Until next time, good luck, RMA.

My approach to investing

2006-03-12T20:32:00.000-06:00

Before getting started, I wanted to post something on how I think about investing. If I had to describe my investment style, it would most closely resemble a value-based approach before any other. However, an important caveat is that I believe an investment style evolves as the investor gains experience... hopefully for the better.

I try my best to pursue a focused approach; however, I find myself tempted by less-researched, more speculative plays. Ben Graham said that "Investment is most intelligent when it is most businesslike." I am still working towards that goal.

My interest in more speculative (less researched) work arises from the accepted truth that investing is more art than science. A more precise approach does not necessarily guarantee more accuracy. With any speculative idea, I will name it as such. More often that not, my speculative ideas are stocks that we can flat out call cheap with minimal research (e.g. Graham's net-nets and other ideas that I call 'ambulance chasers' [credit for the 'ambulance chaser' moniker unfortunately goes to a good friend of mine, WHH]).

As for the 'focused approach', I've largely based it off what Buffet was frequently described as his method: "(1) Businesses that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively" (1978 letter to investors). Where Warren has been light on specifics, I've filled in detail based on my professional experience as well as my own research into methods & models used by other value investors. I'll save you the lengthy description here and instead leave you with the graphic below. It is my best attempt at summarizing my approach. I will do my best to highlight how I apply it when I discuss forthcoming investment ideas.

In the meantime, I hope that you find it valuable. Good luck, RMA.

A little about myself

2006-03-09T18:37:00.000-06:00

I consider myself a beginning investor (~4 years) and have created this blog as much for you as for me. By writing a blog, I force myself to synthesize and codify my ideas. In the end, I think this makes for stronger and more defensible investment theses. I hope that we can share/debate/refute ideas. I believe there are many ways to make money in the market and I pursue only one of them. The strategies I pursue most closely ascribe to the school of value investing (Graham, Buffet, Lampert, Greenwald etc.); however, I do speculate and make investments in non-value plays.

As for the rest, I'm currently a management consultant and study investments in my free time. In part, I'm penning this blog to document a track record as I anticipate pursuing opportunities in money management in the near-to-medium term. My education is a mix of romance languages and your bread & butter business sciences. I have two degrees, a B.S. in Finance and Accounting and a B.A. in French and Spanish.