Fructivore Investments

I read in the news today that on the second anniversary of TARP, the government has earned 8.2% on its investments in banks and insurance companies, which comes to about 4% a year. The article claims that many investors expected the deal to have losses running into the billions, which I suppose is true, but I’m not sure that these results vindicate the program. After all, in order to know how well it went we have to compare it to private bailouts.

Consider the CIT group bailout; in July of 2009, after the government announced that it would not receive a second round of TARP financing, it was forced to look for salvation elsewhere. It found it in a group of bondholders that included Seth Klarman, noted value investor, and the terms were much better for the lenders than 4%. They required an interest rate of LIBOR + 10%, or 13%, whichever is greater, plus a security interest amounting to 5 times the amount of any borrowing, plus a dizzying array of fees: 5% for any amounts lent, 1% per year for any amounts not lent, and 2% exit fee. Although CIT group was unsuccessful in avoiding bankruptcy, the loan company made out all right; because of their security interest they would receive every penny of principal owing to them including interest after the bankruptcy filing.

For another example, in September 2008, Warren Buffett purchased from Goldman Sachs $5 billion in preferred stock that yields 10% per year, plus warrants–stock options, basically–to purchase $5 billion in Goldman Sachs common stock at a price of $115 a share. Goldman Sachs currently trades at $157 per share. Of course, that deal was put into place before anyone knew that TARP would pass, but in those two years Warren Buffett has made $1 billion in dividends plus about $1.8 billion in intrinsic value of the warrants. That’s a return of 24.9% per annum over roughly the same period that TARP has produced 4%.

Of course, these deals are the cream of the crop when it comes to bailouts, but when I look at them I still can’t help feeling a little shortchanged when it comes to TARP.

As anyone who holds Seagate (STX) knows, or at least has had the opportunity to investigate upon seeing the price jumping by 16% overnight, there has been news of a buyout offer from TPG Capital and Kohlberg Kravis Roberts to take Seagate private at a price of $7.5 billion, or about $15.88. So, this naturally gives us holders of Seagate the dilemma of taking our profits now or seeing how this will turn out.

Now, this offer is below the 52-week high of $21.58, and furthermore, I calculated earlier that the firm is in a position to generate roughly $1 billion in cash per year, so a price of $7.5 billion produces a multiple of 7.5x, which seems low. $21.58 is a multiple of about 10.2x, which strikes me as more reasonable. Although hard drives are commoditized and theoretically under pressure from solid state drives, if most investors require a 10% return on their money a multiple of 7.5 implies some pretty substantial declines in future earnings power. However, it cannot be denied that the market has not been able to sustain a higher multiple for Seagate, and private equity/buyout firms require returns substantially upwards of 10%. So, which market do we rely on?

In considering this question, I am reminded of Marty Whitman’s book, Value Investing: A Balanced Approach. whitman’s book argues that value investing has moved beyond Graham & Dodd fundamentalism, which I find a highly controversial point. I think he sort of cherry picks the parts of Security Analysis he chooses to disagree with, but his theory of value investing is that traditional approaches to investment are solely concerned with the outside passive minority investor market, where individuals and institutions trade small pieces of the company back and forth. Although basing valuations on this market is a useful skill, Whitman’s thesis is that there are other markets that the complete value investor has to be aware of.

For example, he talks about how Benjamin Graham advises bond investors to assure themselves that all of a company’s bonds satisfy high standards of safety, and then buying the highest yielding one, which is typically the subordinate issue. However, Graham elsewhere states that a deterioration in the company’s performance can cause a troubling decline in value. Whitman, though, completes the thought by concluding that the decline in value matters in the bond traders’ market but perhaps not in the holds-bonds-to-maturity market, who are less likely than the bond traders to use leverage and therefore can sometimes afford to ignore market prices. And, if the deterioration should become severe, the relevant market is the post-Chapter 11-workout market, where the senior, rather than the subordinate, issues are likely to be the more desirable purchase, and, if even in bankruptcy the senior debts will receive 100% of their claim plus accrued interest, the prices in the actual bond market don’t matter. This is quite the postmodern approach, taking into account a market that doesn’t exist yet.

Relevant to the situation with Seagate, though, is the difference between the outside passive minority stock market and the buyout market. In the time of Benjamin Graham, of course, a leveraged buyout was not in anyone’s vocabulary and the perception was that an investor could purchase an undervalued stock and take all the time in the world to wait for the stock to reach fair value, at which point it could be sold, invariably to another investor. However, the introduction of the leveraged buyout (or the merger, liquidation, etc.) can cut this process short, so investors’ exit strategies must include the possibility of taking what they can get. Fortunately, buyouts typically (but not always) come at a substantial premium to the current market price, but unfortunately the market price can still be below the “fair” price, so an investor can still be left without full value.

I do recommend Whitman’s book, as it gives a unique and intriguing perspective on the art of value investing, and contains such witty commentary that only an investing veteran could produce, such as (paraphrased) “Predicting future earnings per share is a job that any competent analyst can do (although accuracy is a different matter). But turning that into a future price requires predicting future P/E ratios, and that is something that can only be done by an expert in abnormal psychology.” And “Among the disadvantages of running a public company, #1 is the exposure to a swarm of litigious idiots, i.e. public shareholders.”

So, where does that leave us with the Seagate decision? On the one hand, the buyout value does appear low, so it might be worth hanging on to in case the offer is rejected or, ideally, a bidding war breaks out, in which case hanging on to the stock would be wise. On the other hand, the buyout negotiations might fall through, as a previous buyout for $7 billion did, and the price might fall and be a long time in recovering. On the third hand, it is customary in buyout negotiations for the Board to insist that the acquirer bump up the price somewhat, so that in the inevitable shareholder derivative suit they can claim that they did serve the interests of the shareholders by demanding a better price, so the $7.5 billion could conceivably go up even absent another bidder.

So, again, what should we do? Well, not having any prophetic abilities, I don’t actually know what we should do, but I can tell you what I have done, which is selling off half of my position. I won’t turn up my nose at a quick profit, but I am also willing to wait for a slow one, at least for now, as I believe Seagate to still be worth upwards of $7.5 billion in both the stock and the buyout markets.

I observed before that the stocks I like come in pairs, and having found Entercomm, a radio broadcaster that went through a difficult 2008 and 2009 and whose operations now seem to have stabilized but at an attractive price. I believe that with Saga Communications (SGA) I have found a paired company.

Saga is a smaller company, with a market cap of only $87 million and an average daily volume of only 6000 shares (most days there are only a few trades, some days there are none at all, but the volume is definitely skewed to the upside). The lack of liquidity of this stock may make it unsuitable for many investors, because some care and trading skill may be required to build a position or, more importantly, to exit it if the market becomes volatile. However, the patient long-term investor who can ride out any volatility spikes may expect to be rewarded.

As with Entercomm, Saga Communications had a difficult 2008 and 2009, which resulted in them incurring significant asset impairments. This caused them to book a GAAP loss for the two years. Revenues were lower in 2008 and 2009 than in 2007, indeed, but the impairments themselves were a noncash expense. If we reverse these transactions as nonrecurring, the company’s operating income went from $27.9 million in 2007 to $24.7 in 2008 to $18.7 million in 2009, although fortunately the firm’s operating expenses scale down somewhat alongside their revenue. They have been paying down their debt at a fairly rapid pace, $30 million in 2009 and an additional $8 million year to date. This paying down of debt, plus the fact that their loans are variable rate, has served to reduce their interest requirements from $8.9 million in 2007 to $7.2 million in 2008 to $4.9 million in 2009. Their interest coverage ratio, then, has never dropped below three times. I should also point out that their depreciation expenses have run a few million dollars below their capital expenditures, which is normally a source of free cash flow. However, their current capital expenditures are below historical levels, so it may be better not to count on the additional cash flow. After deducting interest and applying a 35% tax rate, we have earnings of $12.35 million for 2007, $11.37 million in 2008, and $8.97 million in 2009.

For the first two quarters of 2010, advertising revenues have recovered somewhat and are about 5% above where they were for the first two quarters of 2009, and whatever cost containment the firm has been putting into play has been continuing, as their operating expenses are lower than in 2009. The net effect is that they have $11.4 million in operating income, as compared to $6.3 million last year. Interest expense came to $3 million, and removing that and 35% for taxes produces $5.5 million in earnings, or $10.9 million on an annualized basis, which is a fairly attractive earnings yield of 12.5%. Furthermore, the firm states that the first quarter brings in the lowest advertising revenue, so the full year’s results may be a little better.

Under the term of Saga’s credit agreement, the available balance on their line of credit is reduced by $2.5 million each quarter. I’m not sure if I should count this figure against free cash flow or not. On the one hand, it is money that must be set aside for the benefit of creditors rather than shareholders, but on the other hand it seems pretty clear that the firm should be paying down its debts aggressively anyway, since the credit agreement comes up for refinancing in 2012, and at any rate earnings belong to the shareholder no matter what the company subsequently does with them. The firm estimates that its excess cash flow, as defined in the credit agreement, will come to $8.3 million for the year. Presumably, the company has an incentive to define excess cash flow to be less than the full amount of earnings, but it is comforting to see that the company is not projecting a diminution of revenue that would result in an inadequate earnings yield.

The risk, of course, is that come 2012, or earlier if they start encroaching on their covenants, they may have to refinance their debt at a higher interest rate. However, they are generating an adequate return on their money, they have over $200 million in book assets against $96 million in long term debt, which is being paid down. Therefore, it seems to me that the risk of interest rates becoming high enough to put the company and its earnings ratio at risk is a remote one.

As a result, I can recommend Saga Communications as a medium/long term investment for anyone who can deal with the low level of liquidity. Just be careful getting in or out.

I have been greatly interested in junk bonds over my investment career, as they offer some potentially very attractive returns and often without correlation to the broader bond or equity markets. However, I have found that because junk bonds are considered as an asset class best left to the professionals, the literature available on them is small compared to the size of the asset class (particularly since the asset class grows during difficult economic times). Fortunately, though, in Leveraged Financial Markets, edited by William Maxwell & Mark Shenkman, we who are unafraid to build our own high yield portfolios have found a valuable resource. Whether we want to construct a full high yield portfolio, or just if we take my approach of buying single issues opportunistically, the book has much to assist us.

The book’s editors take the Frank Fabozzi approach, whereby instead of writing the book themselves, they solicited articles from experts in the particular field: the section on debt covenants was written by a partner at Cravath Swaine & Moore, a premier New York law firm, and other sections likewise written by experts in their fields.

One of the key pieces of advice is that it is impossible to make a portfolio that beats the target index under all circumstances. Certain types of bonds will do better in a recession, and other types of securities will do better in a neutral or growth situation, and because of the liquidity in the bond markets it is impossible to switch one’s approach without incurring greater costs than the profits from the new approach. This is common sense, but it puts me in mind of my own value investing approach. The goal of an investor, professional or personal, should not be to beat an index; it should be to finish up with more money than we start with, without taking undue risks. And, as I stated above, those of us who invest for ourselves have our choice of asset classes and can act opportunistically, as opposed to someone constrained to run a junk bond portfolio, have the advantage in this situation.

In terms of actual analysis, they provide some very useful advice, the most important of which is to adopt a highly fundamentals-based approach and above all not to rely on credit ratings. Even before ratings agencies had to back away from the ratings they issued because of the tsunami of CMO defaults, they have taken great pains to remind users that, although a BBB credit is better than BB, they cannot translate a rating to a default probability. Although the book refers us to a number of services that perform statistical analyses to identify defaults before they happen, my preferred approach is to find junk bonds that are actually robust to defaults. At any rate, the authors also remind us of concerns broader than default risk of a single issue, such as the health of the sector and also the level of liquidity in the market. At any rate, the key advice of the book is to analyze credits yourself, rather than rely on a credit rating agency to do it. This is vital advice; my favorite credit rating seems to be CCC+, and although most CCC+ bonds I can still reject as unsuitable, I would throw away a whole family of B rated bonds to find a CCC that offered the right risk/reward situation. The authors also remind us that a high yield cannot compensate for unpalatable risk; a junk bond investor cannot afford to assume that his or her portfolio holdings insure each other.

I have to say that my faorite part, though, was the discussion of covenants, and not just because it was written by a lawyer. Covenants are not even mentioned in Graham’s Security Analysis, since prior to the 80s deep consideration was deemed unnecessary because only creditworthy companies were expected to issue debts anyway. And, of course, before the junk bond crash of the early 90s no one quite grasped their importance. Afterwards, the bond community decided that it was necessary to take covenants beyond their historical course. As the book details, junk bond covenants are now greatly detailed, including restrictions on use of loan proceeds, restrictions on issuing new debt and even interest coverage ratios, in order to protect holders from small problems becoming large problems leading to bankruptcy. In fact, my short recommendation on SBA Communications was largely based on the possible impending breach of their covenants.

In short, anyone who is interested in junk debt, or even companies that issue it, would do well to have a resource like this one at their disposal.

I have been interested in short ideas lately, and the last two I identified, Red Hat Inc. and Concur Technologies, were demonstrably overpriced and already showing signs of running out of growth. However, there was no catalyst lurking in the wings that had the potential to throw a wrench into the market’s optimism. However, with SBA Communications (SBAC) I think I’ve found a company which, in addition to slowing growth, is also staggering under a large and growing burden of debt. If their debt covenants are breached–and they are already under pressure–it could definitely serve as the desired catalyst.

SBA Communications owns or leases a number of wireless communications towers, and leases space on them to wireless service providers. Their revenues have been increasing, but they have been continually expanding their portfolio of towers through the issuance of debt. Because of the large amounts of depreciation that their business generates, they have no actual earnings. Their free cash flow, although positive, is showing slowing growth. Wireless traffic in the United States is also on the rise, which would explain the optimism surrounding this company, but the debt of this company appears to me to be approaching a dangerous level.

The company’s earnings figures are complicated first because depreciation is much greater than capital expenditures, which is a common enough occurrence. But the true earnings power of the company is also occluded by noncash interest expense and gains and losses from bond redemptions. Not only has the company had to resort to increasing debt levels in the first place, but it has also had to get creative in the form of its debts; they have three outstanding convertible issues as well as a securitization-type structure whereby they have transferred some of their tower holdings into a special purpose vehicle and securitized the income from them.

I have spoken before of how certain convertible bonds produce non-cash interest expenses; accounting rule ASC 470-20 now requires them to be divided into a debt component, as determined by the estimated value of a non-convertible bond paying the same coupon, and an equity component consisting of the value of the conversion privilege. The equity component is considered paid-in capital and is amortized over the lifetime of the convertible instruments. I have said previously that, instead of increasing the clarity and information content to the user of financial statements, this rule decreases it. The borrower is not on the hook for only the debt value of the instrument when it is issued; it is on the hook for the full amount, and the company is forced to recognize interest payments that do not exist to amortize paid in capital that never existed. The phantom interest distorts the earnings calculation, and a user who is unfamiliar with the application would easily be induced to undervalue a target company. Furthermore, the amounts are not updated alongside stock price and volatility, and linear amortization also does not correctly model the behavior of options. In SBA’s case, the application of this accounting method actually reduces the stated amount of their liabilities from $2.549 billion to $2.386 billion.

Fortunately, I am somewhat conversant with ASC 470-20 (and SBA lists the nonexisting interest separately on their income statement anyway). So, we can calculate their free cash flows once we adjust for this noncash interest and depreciation and capital expenditures. We should also adjust for the nonrecurring profits and losses from their continuous extinguishment and reissuance of debt. In SBA’s case this is often a significant amount: in the last three full fiscal years they have issued $2.57 billion in debt (not counting $182 million in warrants and $375 million in options to reduce the effect of the conversion features, which it seems to me would defeat the purpose of issuing convertible debt) and paid back $1.42 billion in several transactions.

In fiscal year 2007, free cash flow after all the above adjustments was $87.540 million; in fiscal year 2008, $122.078 million; in fiscal year 2009, $140.573 million, and year to date 2010, $70.911 million as compared to $77.402 million for the first half of 2009. The serial growth, then, is 39.5% for 2008, 15.2% for 2009, and -8.4% year to date. If we annualize the year to date cash flows, we get a price/free cash flow ratio of 32.6, which seems high for a company with a slowing growth trajectory. Revenues increased 16.4% between 2008 and 2007, 17.0% between 2009 and 2008, and 11.5% for the first half of 2010 as compared to 2009, so there is an apparent slowdown there too.

Now, the price/free cash flow ratios for our other shorts were somewhat higher; Concur Technologies was 102, and Red Hat’s was 67. However, neither of those companies are hampered by a large and increasing burden of debt. SBA, on the other hand, has a very weak interest coverage ratio: 1.94x times in 2007, 2.16x in 2008, 2.07x in 2009, and 1.95x year to date, which is typically consistent with a credit rating in the B- area. The company’s current credit rating is apparently BB-, but according to Etrade that hasn’t been updated since July 2009. The face amount of their long-term debts is $3.06 billion, but they are carried on the balance sheet at $2.81 billion (owing mainly to the convertible discount above), plus other miscellaneous debts, produces a total liability of over $3.14 billion, set against $3.43 billion in book assets. Of course, the high levels of depreciation has made the stated asset values unreliable, but it is still not an attractive picture.

But what leapt out at me was SBA’s credit facility, which requires that they have on an annualized basis, a debt/EBITDA of less than 5x, an EBITDA/cash interest of greater than 2x, and a debt/adjusted EBITDA of less than 8.9x. The company claims to be in full compliance with these provisions, but it occurs to me that they may be cutting it close. I have already calculated an interest coverage ratio of less than 2, and their actual debt/EBITDA on a year to date annualized basis is 10.77. Presumably, this apparent breach is cured by the securitization arrangement; the revenues and income from the securitized towers are consolidated for reporting purposes but not for the purposes of the credit facility, as they are in a special purpose vehicle and are nonrecourse anyway.

Unfortunately, we do not know what amount of revenues and cash flow are offsetting the interest requirements of these towers, but the firm claims that they meet the required 1.3x coverage of the securitization agreement. The debts issued by the securitization entity have a weighted average coupon of 4.6%, which, out of $1.23 billion in face value, is $56.58 million, or $14.1 million per quarter. Multiply by $1.3, and we get $18.4 million per quarter that is the minimum “reserve” from cash flows to comply with the terms.

So, carve out $1.23 billion in debts, $14.1 million in interest payments, and $18.4 million in securitization entity cash flows, and we are left with parent-level quarterly cash flows of roughly $58.8 million, interest payments of roughly $23.3 million, and total debt of $1.91 billion. This represents interest coverage of 2.5x and debt/EBITDA ratio of 8.1x. So it is pretty clear that the SBA is bumping up on the edge of their covenants. I should point out that the company has no borrowings on its credit facilities at this time. (I am also aware that the way I’ve written this test, the greater the share of securitization income, the lower the cash flows of the parent company are, but since the majority of the securitization’s cash flows are pledged to the debtors anyway, not very much of the income can be counted in favor of the parent company, at least until the notes are paid down somewhat).

So, although it seems that the market is willing to accept SBA Communications with an overall interest coverage ratio of 2, it would also appear that the company’s growth is decelerating and any actual diminution in the company’s current earnings would put them in a difficult situation covenant-wise. Furthermore, even if wireless traffic does expand, SBA may not be in a position to take advantage of the expansion without the ability to acquire more capital freely as necessary. This, coupled with decelerating growth, suggests to me that SBA is an attractive short candidate.

I have previously expressed an optimistic view on American Greetings (AM), based on its attractive price/free cash flow. Last Wednesday, American Greetings announced earnings that were substantially down from one year ago, and the stock was punished by nearly 10%, although it has recovered somewhat since then. Now, Ben Graham reminds us not to place too much weight on the results of a single quarter or even a single year; nonetheless, nonetheless, it may still be worthwhile to examine the results of a quarter for signs that the company can no longer produce the desired performance. If, however, the company can continue to produce results, the market’s overreaction may create profitable opportunities.

American Greetings reported a decline in revenues of 3.8%, or about $13.6 million; however, it explains this away as the result of the sale of their party goods division, without which sales would have declined by a mere 1%, which I think of as a trivial difference. More significant is the decline in reported earnings from $23.1 million to $8.5 million. Prior to the announced results, American Greetings had a market capitalization of over $800 million, so if we take the $8.5 million as fully representative of their earnings power, annualize it, and then apply a multiple of 10x, we get $340 million. This is a slight gap.

American Greetings’ management first cites that these earnings contain $5.2 million in expenses to integrate two recent acquisitions, while last year’s earnings for the quarter were increased by $7.9 million in insurance benefits. I consider both of these to be nonrecurring. Removing them serves to considerably narrow the gap between the two years. A second issue is that the firm’s tax rate for the latest quarter was the unusually high figure of 49.9%. If we remove the integration costs and apply a kosher 35% tax rate, we get $14.4 million, which is much closer (although it is still not the $20 million that would produce our $800 million market capitalization).

However, we are leaving out on our favorite adjustment, that of subtracting capital expenditures and adding back in depreciation. This measure improves estimated free cash flow to approximately $17 million, which is very close to our target. American Greetings’ management also understands the importance of free cash flow; their metric they cite in the announcement and earnings call is cash flow from operations minus capital expenditures, and they claim that they have produced $75 million out of their target $120 million for the year. Much of that amount comes from changes in working capital and is therefore not likely to be recurring, but for the first half of the year, earnings as modified above plus depreciation minus capital expenditures still comes in at $51 million, which is actually an improvement over last year.

So, although I would have liked the $17 million estimated free cash flow for the quarter to have been closer to the $20 million I had in mind, it is clear that overall performance has not degraded. So, absent further declines, American Greetings is still attractively priced, and the 10% drop seems to me to be more the effect of market participants seeing a large GAAP earnings decline and not digging any further into the numbers.

As I stated last week, I have taken the view of James Montier that a low price/sales ratio is an unreliable indicator of cheap stocks, since it ignores profit margins and capital structure. I have similarly adopted his view that an astronomically high price/sales ratio is a reliable indicator of overpriced stocks, because at a certain point there is no capital structure or profit margin that will justify the current price. Furthermore, the degree of growth required to justify a company at that price would be almost impossible to realize. And it seems to me that with Red Hat Inc. (RHT), we have a company in such a situation.

Red Hat Inc. provides software support services for open-source Linux programs in the enterprise space, including product delivery, problem resolution, ongoing corrections, enhancement and corrections, new versions, and compatibility issues, as well as providing training. Their best-known product is the Red Hat Enterprise Linux operating system, and they also include a virtualization platform (which may explain some of the optimism surrounding the company; VMware trades at a similarly high valuation), as well as middleware tools. All their products are open-source rather than proprietary; their revenue, apart from training, comes from the support they provide, which is sold on a subscription basis.

The business model is an attractive one and seems to be effective, no doubt, but Red Hat’s valuation seems to come straight from 1999; they have a price/sales ratio of 9.96 and a P/E ratio of 85. Those figures have recently increased by a 10% reaction to the firm’s 2nd quarter earnings announcement that sales increased 20% year over year and operating earnings increased 23% over the same period. In the current economic environment, such a level of growth is indeed impressive, and the open source model is enhanced by an army of tinkerers inside and outside the company. All of that makes for a good story, true, but as Damodaran reminds us in The Dark Side of Valuation, prudent investing calls for all stories to be translated into numbers.

Ultimately, reported earnings were down from a year ago, which the company blames on amortization and stock-based compensation. Now, as it appears that Red Hat’s stock is very expensive, the company is probably better off paying its staff in stock rather than cash. However, from the perspective of a shareholder, dilution is still dilution, and so their removal of stock-based compensation to arrive at their pro-forma earnings seems a little like cheating to me.

Turning to the amortization, however, I prefer to eliminate depreciation and amortization and replace it with capital expenditures in order to get closer to determining free cash flow for the period. From that perspective, Red Hat claimed total depreciation and amortization of $11.7 million, and total capital expenditures of $9.7 million last quarter, which would increase quarterly earnings to $25.7 million. The comparable figure for last quarter would be $32.7 million, after making an adjustment of $3.7 million for the same reason.

However, considerable further adjustments have to be made to strip out the Red Hat’s non-operating income and expense and to address the issue of deferred revenues in order to enable a real history of earnings growth. It is a somewhat labor-intensive process, but necessary in my opinion, to arrive at figures that most readily permit year-over-year comparisons and to arrive at a calculation of what the owners of the company are actually getting out of it (and therefore what the shorts would have to cough up).

The first necessary adjustment is often to separate a company’s core operations from their non-operating income and expenses. In Red Hat’s case these adjustment are significant, because Red Hat has a vast portfolio of cash and securities that composes the bulk of its balance sheet. It also has currency translation issues as the firm does business in multiple regions. As interest rates are lower this year than last, it would be reasonable to eliminate interest, gains on trading in securities, and currency translation, to make the two periods comparable.

Now, it may be objected that I want to take out interest and trading profits because I’m approaching this situation from the short side and as a result I want to make the figures look as bad as possible. However, I would reply that even if the company may be entitled to a high multiple, their cash and investable securities are not. Their portfolio certainly doesn’t become magical because they own it. So, if we separate the $1.05 billion in cash and securities on Red Hat’s balance sheet, and treat it separately from the remaining $6.66 billion price, we get closer to looking at the value of Red Hat’s core operations.

This means lowering the 2nd quarter fiscal year 2011 earnings by $2.3 million, and the 2010 earnings by 5.7 million, to reflect interest, trading, and currency translation income. I should also note that 2010’s 2nd quarter tax rates were unrealistically low and should be adjusted. Taking $2.3 million out of pretax earnings and applying a standard 35% tax rate, 2011’s 2nd quarter “core” earnings were $22.2 million, and after a similar adjustment to 2010’s earnings we see “core” earnings of $17.9 million. Adding back in the difference between depreciation and expenditure calculated above, we get “core” free cash flow estimates of $24.2 million for 2nd quarter 2011, and $21.6 million for 2nd quarter 2010. So, at the end of this laborious process we have found that their core operational earnings growth is 12% over last year.

If we apply a similar adjustment process (eliminating interest and other income, applying a standard 35% tax rate, and adding back in depreciation but removing capital expenditures) across the last three years’ results, we find 2010’s full year “core” results were $81.8 million, 2009’s were $62.4 million, and 2008’s were $27.3 million (although capital expenditures that year seem unusually high).  So the growth is there, but it’s slowing (12% as compared to the year-ago quarter, down from 31.1% 2010 as compared to 2009 and 128% as compared to 2008, which, again, may be distorted by capital expenditures).

Turning now to the deferred revenue issue, Red Hat produces cash flow greater than its earnings because it sells year-long or multi-year subscriptions. The firm recognizes the revenue over the lifetime of the contract but on the whole likes to be paid a significant amount up-front. The cash that the subscribers pay in advance shows up on the cash flow statement and the balance sheet (offset by a liability for deferred revenue, of course), but it would be most unwise to consider it “free money.” Not only do those payments have to be earned by Red Hat providing the direct costs of the services that were subscribed, which costs money, but also they should bear their fair share of the cost of running the company, including administration, marketing and research and development. The deferred revenues should also bear their fair share of taxes, since the revenue most definitely will be taxed when it is recognized.

If we prorate these expenses between revenues recognized and deferred revenues, we can compute the effective operating margins for their core operations, and if we then apply these margins to deferred revenues we will be pretty close to calculating the company’s core free cash flow, which is what is needed to perform a sensible valuation in the first place.

In fiscal year 2008, the core after-tax operating margin including deferred revenues was 16.4% and accordingly we add 16.4% of their deferred revenues to their 2008 core earnings, producing a total estimated core free cash flow from operations of $42.2 million. In fiscal year 2009 the margin was 17.2% and adding back in that amount of deferred revenues gives us estimated core free cash flow of $79.3 million, and in fiscal year 2010 the margin was 16.5%, so adding back in that proportion of deferred revenue we get $95.4 million. This gives us growth rates of 73% between 2008 and 2009, and 20.4% between 2009 and 2010. Performing a similar calculation for 2nd quarter of 2011, we get core margins of 14%, giving us core free cash flow of $26.1 million, as compared to a margin of 14.5% and core free cash flow of $23.1 for 2nd quarter 2010. This gives us 13% growth, in line with what we calculated above. Fortunately the margins are stable enough not to produce a major distortionate effect.

I will also note that deferred revenues have been declining on the statement of cash flows since fiscal year 2008, which is indicative of deceleration of the growth rate of subscriptions.

Now, growth rates comparing one period to another give us the situation relative to how it was, but if we want to decide if a company is ultimately overvalued or not we have to use absolute measures, and our calculation of core free cash flow serves us well here. We already have the figure for the 2nd quarter of 2011, and calculating it for the prior  three quarters we have current core free cash flow of $99.8 million. When set against the $6.66 billion price the market is putting on Red Hat’s core operations, we have a P/E ratio of 66.7. So it is clear that the market is pricing in a high level of future growth.

How high, exactly? Well, let us use the H-model I have previously discussed. The H Model assumes that a company will grow at a high rate that will decay in a linear fashion to a stable growth rate (most companies show growth decay in a faster than linear fashion, actually). In The Dark Side of Valuation, Damodaran calculates that even starting from the IPO, median growth levels decay exponentially until by year 6 the company’s growth rate is indistinguishable from the other companies in its sector. So, six years is a good starting assumption.

The H model, in case you were wondering, is price = e*(1 + g)/(K-g) +e*H(G – g)/(K – g), where

e = current earnings
g = long-term stable growth rate
G = initial high growth rate
K = required return on equity investments
H = half the number of years until stable growth rate is reached.

Let us make some optimistic assumptions about Red Hat’s future growth. The initial growth rate is set at 30%, much higher than it is now. If 6% is the long term growth rate of Red Hat’s target market (generous but not unreasonable, as it takes into account both inflation and actual growth), and using the six year assumption and a required return of 10%, we get a total value for the core cash flows of the firm of $4.4 billion, far below the $6.66 billion price tag. In order for the company to grow into its valuation, then, either the initial growth rate has to be set at around 60%, or the high growth period has to last for 13 years instead of 6, neither of which I find particularly likely considering that growth is already showing signs of slowing.

I do not know what the reason for the optimism regarding Red Hat Inc.’s share price; there is always surely some residual love of technology at work in the investment community, and also perhaps people are looking at the gross margin of the subscription business, which is over 93% last quarter. However, the subscription business cannot be capable of limitless growth, particularly without the marketing, administrative, and research and development expenses necessary to support an expansion. Therefore, I find it highly unlikely that this company can produce the kind of growth necessary to justify its valuation. And so, although the company is operationally stable and does not seem to have any catalyst that would instigate a price drop, I can see ample grounds for considering it a short candidate.

Montier, in his Value Investing, made a spirited defense of value investing by demonstrating, not only that it works in a normal market, but also, based on the history of Japan, that it works effectively in a lost decade scenario. I find this significant because it strikes me that the United States faces a significant probability of facing such a scenario. Sadly, Montier couldn’t prove that value investing worked in a Great Depression scenario, which would make me feel better. But at any rate, a value strategy, he calculated, produced 3% annual returns in a period with very low inflation, when buy and hold returned -4% over the same period. But a long value/short strategy beat the pants off of both of them: 12%.

His book also contained advice about how to find a good short candidate. He expressed skepticism in the price/sales ratio, which he considers a transparent attempt to move up the income statement until something looks good. Perhaps the best that can be said about price/sales ratio is that it ignores both profit margins and capital structure. For example, Bon-Ton department stores has a price/sales ratio of 0.05, but since virtually all of its earnings are eaten up by interest, the stock is still highly unattractive.

But even if a low price/sales ratio does not necessarily indicate an attractive buy, an astronomically high price/sales ratio might well indicate an attractive short. Montier’s book includes a quote from Sun Microsystem’s own CEO to the effect that his firm was too expensive at a price/sales ratio of 10. The CEO stated that this lofty valuation assumes that his company purchases no raw materials or capital, that his staff works for free, and that despite his company not buying anything or paying anyone, it pays no taxes.

In this vein, I am pleased to present Concur Technologies (CNQR) as a short selling candidate. I hope I shan’t be accused of piling on, but the apparent level of optimism around this stock seems to have surpassed unrealistic and moved on to fanatical. The company has a price/sales ratio of 9.4 and a P/E ratio of 117. True, they have produced five year earnings growth of 33% per this article at Motley Fool, but the question then becomes how many years they can sustain that level of earnings growth, and how many years they have to sustain it in order to justify their current valuation.

Fortunately, Damodaran, in Damodaran on Valuation, has given us a formula for evaluating companies that are currently growing at faster than stable rates. The H Model described in his book assumes that a company that is now growing at a high rate will see its growth rate decay in a linear fashion to a stable growth rate. It may be objected that most growth companies do not actually show a linear decay in earnings growth rate, and I must say that I agree with that sentiment: growth usually decays in a faster than linear manner. In The Dark Side of Valuation, Damodaran calculates that even starting from the IPO, median growth levels decay exponentially until by year 6 the company’s growth rate is indistinguishable from the other companies in its sector.

The H model, in case you were wondering, is price = e*(1 + g)/(K-g) +e*H(G – g)/(K – g), where

e = current earnings
g = long-term stable growth rate
G = initial high growth rate
K = required return on equity investments
H = half the number of years until stable growth rate is reached.

It’s not the most sophisticated formula, but it does give you a rough idea of what the market is expecting, and is not calculation-intensive enough to be inconvenient.

So, Concur’s current earnings per share are 44 cents, but they did record a significant noncash interest expense of $2.5 million relating to their convertible debt, so if we put that back in the earnings improve to 49 cents. Let us further assume that the high growth rate of 33% holds true, and that the long-term growth rate is 6%. This is not unreasonable since it includes inflation as well as economic growth. It is optimistic, but when we consider short candidates we want to make optimistic assumptions, just as when we want to value longs we want to make conservative assumptions.

Assume further that the high growth period will last six more years, and that we have a required return on equity investments of 10%. This gives us $22.91, which is less than half of the current share price.

Now, as I said, the H model gives us an idea of what the market is expecting, so let us solve for what the market actually is expecting. If the market accepts 33% as the high growth rate, for example, how long is the market expecting the company to go before it drops to stable growth? Using the H formula, we find that the market expects the high growth period to last 23 years, which, considering that 6 or less is more common, strikes me as somewhat unlikely. It assumes that even nine years from now they will still be producing 20% growth.

Or, we could assume that the six years is correct, but that the company is entitled to a higher high growth rate. Keeping everything else constant and using a six year assumption, we find that the market is expecting earnings growth rates of 109%, meaning that the firm will double its earnings growth next year, nearly double them again the year after that, make a further increase of almost 3/4 the year thereafter, and so forth. I find this outcome also highly unlikely.

If we take a hybrid assumption of 50% for the high growth rate and 10 years of excess growth, we still get only $39.44, about 23% below the current share price. So, even results that most companies would kill for would not be good enough to justify buying Concur at its current price.

But perhaps there is something about Concur that makes it so interesting. Its primary line of business is automating tracking and reimbursement of employee spending on matters such as business travel. Increased automation of these processes decreases both time expended and error rates, as it tends to cut down on businesses using the manila-envelope-full-of-receipts method of filing. However, it does not appear to me that they have any sort of defense from the competition; expense management software is not so unique, and even if their software-as-a-service model allows them more flexible pricing given the needs of their customers, their competition could take advantage of the same service.

Furthermore, and perhaps more disturbing given the hyper-growth thesis that the market currently holds for Concur, their growth seems to have hit a ceiling.  Between 2007 and 2008, sales nearly doubled and profits more than doubled. Between 2008 and 2009, sales increased by over 15%, from $206 million to $239 million, and net income increased by a little under 50%, from $17.2 million to $25.7 million. However, 2010 year to date, sales have increased an additional 18%, and yet income to date, even putting back the noncash interest expense, has in fact declined slightly as compared to last year.

Furthermore, one aspect of the company that gives me further concern on the long side is that more than half of the company’s assets, $550 million out of $950 million total, consists of cash and short term investments. It seems to me that a bona fide growth company should be able to find a better use for its money than just sitting on it. The company’s return on non-cash assets is a robust but not too outsized 7%, so if all their cash was in fact converted into usable assets earnings would theoretically more than double. So, the fact that this has not occurred would only be because the firm has not yet found the customers to allow it. And even if it did occur, this trick would double earnings once but not twice.

As a final aside, I will note that the firm has outstanding $285 million in outstanding convertible bonds, an additional 5.4 million shares, or roughly 10% of total shares outstanding, that are bumping against the conversion price. Curiously, the firm purchased roughly 5 million shares worth of call options on itself to offset the effect of the bonds converting, and the $60 million in options premiums sort of defeats the purpose of saving money by issuing convertible debt, or so it seems to me.

The only thing missing from making Concur into the perfect short is a catalyst. The company’s interest requirements are covered by about nine times, so there is no apparent risk of distress. The only real problem with this company is the price, and, sadly for shorts, overvaluation can persist for some time. However, given the massive levels of growth required to make the current share price have any semblance of logic, it strikes me as unlikely that the company can pull it off, particularly if competition starts sniffing around. And so, I would conclude that Concur Technology is an attractive short candidate.

Now that the BP well has been finally containmed, it is only natural that market participants have come to expect a great deal of the shrinkage in valuation of Gulf oil producers to reverse itself to some degree. Certainly there will be new regulations, and perhaps more onerous inspection standards, but on the whole it seems that people are expecting some return to normalcy in Gulf extraction operations.

However, even if it is likely that many Gulf oil extractors will rebound up to, or even above, the price levels prevailing before April 20th, not all of them deserve that rebound. Some of them were in fact overpriced to begin with.

Stone Energy (SGY) is an example: on April 20th, the day the oil rig exploded, their stock closed at 18.42.  It dropped to a low of 10.30, and as of September 13th, closed at 12.44. Normally one would consider this company as primed for considerable appreciation now that the oil spill is contained and the Gulf is attempting to move on.

However, a closer look at Stone Energy’s free cash flow suggests otherwise. Stone Energy currently trades at a reasonable, if not robust, P/E ratio of 14.18, but the free cash flow picture tells a different story.

Free cash flow is the amount of a company’s earnings that it can actually distribute without affecting its earnings power. The notion of free cash flow as a thing separate from accounting earnings goes back to Benjamin Graham, who reminds us that the “true” profits of a business can only be calculated after deducting whatever expenditures allow the business to maintain its earnings power. Sometimes depreciation is a proxy for these expenditures, but in many cases, capital expenditures on a forward-looking basis have nothing to do with a backwards-looking measure like depreciation. As a result, a convenient estimate for free cash flow for a given period is earnings plus depreciation minus capital expenditures.

I am aware that not all capital expenditures are intended to replace used-up earnings power, and that for many companies, some or most of capital expenditures are intended to expand earnings power rather than simply maintain it. However, no company ever differentiates maintenance capital expenditures from growth expenditures in its financial reports. However, the conservatism necessary for investing in general, and especially for oil extraction companies, which by their nature invest in assets with finite lives and thus are constantly in need of replacement assets, it is advisable to treat all capital expenditures as maintenance expenditures unless there is a very good reason not to.

Stone Energy’s projected capital budget in 2010 is $400 million, of which $170 million has been spent to date. In 2009, the figure was $320 million, in 2008 the figure came to $450 million, and in 2007, 230 million, not counting an acquisition in 2008 that was paid for mainly in stock. So it would seem that the figure of $400 million is not of an outsize proportion that could be dismissed as nonrecurring.

Year to date, Stone Energy has reported earnings of $56 million and depreciation of $124 million, not appreciably better than results of the first two quarters last year (not counting a nonrecurring impairment that I shall have more to speak of later). Taking out the $170 million in capital expenditures year to date, this gives us free cash flow year to date of zero. This represents an improvement over last year’s estimated free cash flow of minus $36 million for the first two quarters, but still nothing that would justify a great deal of optimism, particularly with capital investments estimated to come in $60 million higher over the latter half of the year.

For the full year 2009, free cash flow was $60 million (neglecting the large impairment and the tax writeoffs that it produced). In 2008, estimated free cash flow as adjusted was $175 million, and in 2007, free cash flow was $252 million.

Much of this diminution in earnings is the result of the dramatic fall in oil prices from their 2008 peak, which was also the cause of a writeoff of $466 million in goodwill and $1.814 billion in property values. Although the impairments are themselves a noncash expense, it is clear that their effects on earnings power have not been exaggerated.

So, even though Stone Energy may see a recovery in its share prices as a result of a broad recovery in Gulf oil produdcers’ prices, it does not appear that the current free cash flow levels would support it. It would be more prudent to look elsewhere for a more sustainable recovery from the BP-caused lows.

Since my last foray into the taxation arena, where I examined the (most probably nonexistent) link between tax collections and growth, proved so interesting, even though it was a purely statistical analysis and nothing to do with tax policy as such, I thought I would make a modest proposal in some actual tax policy directions. As I have had occasion to state in the past, I’m not a macroeconomist, but that never stops anyone else from discussing macroeconomic issues, and it won’t stop me. I have two ideas, one “modest,” and one real.

It has been estimated that every dollar cut from the IRS’s enforcement budget winds up costing the government four dollars in revenues. And so it seems to me that if the IRS’s auditing staff were expanded by 10 or 20 or 40 thousand people, or even more, we could simultaneously lower unemployment and cut the deficit. As such, it is a win-win situation–apart from the fact that it would possibly be the least popular thing this administration could do.

However, one idea that I think is more promising is the elimination of the tax deduction for amortization of goodwill. As you know, goodwill is created when a firm pays more than the value of the assets in an acquisition; it is the difference between the purchase price and the asset value. For many firms, particularly serial acquirers, this can add up to a significant amount. Under current tax law, goodwill amortizes over 15 years.

I suppose the purpose originally was to treat intangible assets the same way as tangible assets, which also depreciate over time. However, as I have had occasion to state before, goodwill is not a “real” asset the way intellectual property or trademarks or brand name recognition are real assets. It cannot be licensed, sold, nor its value otherwise tapped, apart from through the tax deduction itself. Many value investors advocate ignoring goodwill, both on the balance sheet and when it is impaired on the income statement. Our reasons for doing so are quite simple: goodwill represents the theoretical excess earnings power arising from acquiring a company rather than just replicating its assets. If that earning power persists, it will be reflected in the calculation of income and return on assets, and if that earnings power drops, it will also be reflected. Therefore, we do not require goodwill or its amortization to tell us what we already know.

The trouble with amortization of goodwill is that it effectively results in taxpayers subsidizing a merger. This paper found a statistically significant increase in goodwill paid for acquisitions after the tax laws changed to allow goodwill amortization.  Whatever amount of goodwill is created by a merger, the taxable income of the merged corporation will be reduced by 1/15th of that amount every year for the next 15 years, with the rest of us taxpayers picking up the tab. The corporate tax rate in the United States is currently 35%, and considering the massive amounts of goodwill bouncing around the system, the total amount of amortization deductions easily reaches into the tens of billions per year.

Of particular concern is when two firms get into a bidding war over an acquisition target, where prices can be bid up to giddy heights far removed from tangible valuation. In contentious auctions, it is often the case that the winner of the auction is actually the one who comes in second, because he or she has convinced a competitor, the actual winner, to pay too much. However, as the price being bid up generally results in an increase in the goodwill portion of the total price paid for the acquisition, the taxpayer is in effect subsidizing fully 35% of the bid increases.

Furthermore, let us consider that mergers and acquisitions have a history that is mixed at best. Damodaran, in his Investment Fables, tells us that researchers examined a set of mergers between 1972 and 1983, with an eye to two questions: 1, Did the return on the amount invested in the acquisition exceed the acquirer’s cost of capital, and 2, Did the acquisitions help the acquirer outperform the competition. 28 of 58 mergers sampled failed both tests, and 6 more failed at least one. Furthermore, many acquisitions are reversed within short time periods; one study places the figure at 44% of the total with a short lead time, and cited that the most common grounds for reversal were that the acquirer overpaid or that the operations of the firms did not mesh. Over longer periods the divestiture rate has approached 50%. We can all understand the virtue in subsidizing success–if mergers are successful a firm’s taxable income will increase, with the result that the deductible amortization  may be offset in part, in whole, or even in excess, assuming that the additional profits could only have been unlocked by the merger itself. But, if mergers have high odds of not producing the anticipated synergy, taxpayers are essentially subsidizing failure.

This is offensive enough in a normal environment, but it is particularly troublesome in the current environment, where firms are accused of piling up assets and either engaging in or preparing for mergers rather than spending that money on internal investment and hiring. Banks fell under considerable criticism for using their TARP money to acquire weaker competitors back in 2008 and 2009.

In summary, the elimination of the amortization of goodwill would remove the incentive for companies to invest their resources in ill-starred and overpriced mergers, and allow them to focus on building better companies, not merely bigger companies. It would also provide significant deficit reduction at a time when the nation is in great need of it.