Fructivore Investments

I am recommending stock in Entercom Communications Corp (ETM), on the grounds that they are considerably undervalued. Of course, I wish I had issued this recommendation last week when they closed at $5.29 per share, but even now that they are at $7.30 per share, the company is still compellingly undervalued.

Entercom claims to be “one of the five largest radio broadcasting companies” in the United States, which I take to mean that they are the fifth largest. Like so many companies, they recognized large impairments of their intangible assets in 2008 and 2009, which made earnings look absolutely horrible for those two years. However, such impairments are a noncash expense, and based on the firm’s actual free cash flow, Entercom produced, and continues to produce, a very attractive return based on the current share price.

In 2008, for example, the firm booked an operating loss of $710 million. However, $835 million of that loss was due to a large impairment; without that, the firm would have produced operating income of $125 million. After removing $45 million in interest, and applying a 35% tax rate, we get $52 million in sustainable earnings. For 2009, when advertising revenue had dropped somewhat from 2008, the firm reported operating income of $11 million, but that was after an additional $68 million noncash impairment, and as adjusted the firm produced $79 million in operating income. After removing $31 million in interest (much of Entercom’s financing is from variable rate debt) and applying a 35% tax rate, we get $31 million in sustainable earnings. For the first two quarters of 2010, advertising revenues have rebounded a bit as compared to the first half of 2009, producing operating income of $41 million, and no impairments at all, finally. After $14 million in interest, and applying a 35% tax rate again, we get earnings on a sustainable basis of $17.5 million, or $35 million projected for the entire year. Since the company at the current price has a market cap of $260 million, this produces a P/E ratio of 7.5.

If, however, we use our site’s favorite proxy for free cash flow, the situation improves further, since in 2008 Entercom took a depreciation and amortization allowance of $20.5 million, but made capital expenditures of only $8.5 million. In 2009, their depreciation allowance was $16.5 million, but they made only $2.5 million in capital expenditures. And in 2010 year to date, depreciation ran $6.5 million, but capital expenditures have run only $1.5 million. So, it would seem, if current levels of capital expenditure are deemed adequate, that the firm has an additional $10 million in free cash flows at least, which would give it projected 2010 annual free cash flow of $45 million, and a price/free cash flow ratio of 5.75.

Furthermore, Entercom, according to its latest 10-K, had a net operating loss carryforward of $48 million as of December 2009, which should serve to shelter their income from taxes for all of 2010 and possibly part of 2011 as well. This would save the company $16.8 million dollars.

I will admit that Entercom’s balance sheet is looking more than a little anemic; the stated value of their assets, owing to the massive impairments, is $913 million, and they have $777 million in total liabilities, producing shareholders’ equity of $136 million. However, I believe that these impairments were overstated, because I find it hard to believe that $136 million in assets (actually, 114 million at the end of year 2009), can produce free cash flows of $45 million; that’s a return on equity of roughly 33 percent which strikes me as unusually high. Furthermore, in terms of interest coverage, the company seems to be doing adequately: 2.75x in 2008, 2.5x in 2009, and 2.9x year to date 2010. This figure approaches the 3x coverage that I use as a rule of thumb to allow debt to appear reasonably safe. As I stated, though, much of Entercom’s debts are variable rate. On the plus side, Entercom has interest rate derivatives to prevent them from rising interest rates in the notional amount of $475 million, roughly 2/3 of their total long term debt. On the plus side, Entercom has been paying down their debt at a fairly rapid pace, $76 million in 2009 and $35 million in 2010 to date. And, realistically, given the current environment I don’t see interest rates rising by much any time soon.

So, despite the 38% run-up in a week that I missed (I’m sorry), I think that Entercom is still dramatically undervalued.

As I seem to be in a mood to find junk bonds lately, I am pleased to present you with the bonds of the Mohegan Tribal Gaming Authority. The Mohegan Tribe operates a massive casino in Connecticut, one of only two casinos in New England, as well as several other ventures.

The company has been attempting to open casinos on other Indian reservations in the recent few years, but owing to certain regulatory difficulties, both proposed casinos have been put on hold. Coupled with the drop in revenues from the economic slowdown, which seem to be leveling out, the ability of the Mohegan Authority to service its debts has come into question. Although their operating incomes have never actually failed to cover their interest requirements of roughly $100 million per year, they certainly have come close, as I shall state below.

The Mohegan Authority’s financial statements require two species of adjustment. The first is the one I customarily make, which is adding back depreciation and removing capital expenditures in order to reach a convenient proxy for free cash flow to the firm. In Mohegan’s case, though, the numerous projects they embarked on, including the drive to open two other casinos, a major expansion to their existing casino (now on hold), and the purchase of a WNBA franchise, has served to give their capital investments a remarkably uneven quality from year to year. As a result, I can find no better course than to average out their capital expenditures for a considerable number of years, which comes to about $70 million in capital spending per year. It may be that given the apparent regulatory opposition to expanding casino gambling as well as the economic slowdown, the company may be in a position to ratchet down their future capital expenditures. This would increase free cash flow, but with so many projects on hold indefinitely, we may expect to see (noncash) writeoffs in future as well, which may drag on the price of the bonds.

The financial statements also require another adjustment, and this one is company-specific. The Mohegan Authority made a deal with a developer in 1998 that requires them to hand over 5% of their revenues until 2014. The company records their projected payments under this deal as a liability. In my view, this figure should not be treated as a liability, since the only way for the liability to accrue is for the company to do business and so it should simply be treated as an operating expense. In fact, the current treatment leads to the paradoxical effect that the company’s liability goes up the better the company does. Accordingly, when calculating operating income to arrive at interest coverage, the projected change in this liability, which is separate from amounts actually paid under the agreement, should also be stripped out.

So, adding back in the change in the liability (which can be negative, as it was in 2008 and 2009), adding back in depreciation, and removing $70 million from operating income to account for capital expenditures (or a prorated amount for the 3 quarters of fiscal year 2010), we get the following figures for available operating income:

2004: 180
2005: 192
2006: 208
2007: 232
2008: 123
2009: 126
2010 ytd: 159

I would like to focus on the last three years, because two of them were very low years, and the current year may give us some insight into where the company stands now. The Mohegan Authority has several classes of long-term debt, including $527 million in bank loans, $193 million in privately placed 11.5% senior notes, $250 million of 6.125% senior notes due 2013, and a family of subordinated notes with $475 million outstanding. Adding back in payables and miscellaneous liabilities and removing the liability for their deal with the developer, the Mohegan authority has total debt of approximately $1.9 billion, set against $2.27 billion in assets, most of them long-term and/or intangible.

In terms of interest coverage, the total interest paid year to date, apart from amortizations and other noncash items, comes to $82 million so far this year. This represents an interest coverage ratio of nearly 2x, and typically the summer is prime gambling season at the Mohegan Authority, so the full year results may show even more improvement. However, in 2008 and 2009, interest paid was $96 million and $102.4 million, resulting in interest coverage ratios of 1.28x and 1.24x. However, the senior bond, has a coverage ratio of 3.5x in even the worst years when one strips out the interest of all bonds subordinate to itself.

So the question becomes which class of debt to buy; the 6.125% senior notes or one of the subordinated notes. Both classes of debt are rated CCC+, which seems to be a favorite rating around here; Bon-Ton’s bonds and WNR’s convertible bonds are also CCC+, and it may be that the ratings agencies reserve this rating for bonds that could conceivably justify a rating in the B’s, but don’t want to go out on a limb by actually giving them one. Especially now that the subprime debacle has naturally made them worried about handing out ratings that are too high.

The 6.125% senior notes due 2013 currently trade at a 79.50, has a current yield of 7.7% and a yield to maturity of 16.6%, which would be a respectable return for anyone. Among the three issues of subordinate debt, the 8% notes due 2012 trade at 79, currently yield 10.25% and offer a yield to maturity of 25.8%; the 7.125% notes due 2014 trade at 60, currently yield 12.18% and offer a yield to maturity of 23.9%, and the 6.875% notes due 2015 trade at about 55, offer a current yield of 12 and a yield to maturity of 24% (my bond screener says that there is a bid/ask spread of 8 on these bonds, so I’m just averaging the two).

I am of two minds when it comes to the relative safety of the senior versus subordinate bonds. Benjamin Graham, in his excellent Security Analysis , advocated satisfying oneself that all of the bonds of a company are safe and then buying the highest yielding one, but that was his advice for generally investment-grade debt. On the other hand, as stated in Stephen Moyer’s vitally useful guide to distressed and bankruptcy investing, Distressed Debt Analysis, seniority really comes into play in a bankruptcy. However, I am not sure how a bankruptcy would affect an Indian casino, because under the law only a tribe may own an interest in an Indian casino, so the usual outcome of a class of bondholders becoming the new stockholders is unavailable. Even so, any workout would result in the senior debtholders taking much less of a haircut.

That said, with the lower capital requirements from stalled expansion projects, I don’t think that bankruptcy is anywhere near imminent, although the Mohegan Authority does seem to have to roll over their debts at higher yields. So the 8% subordinate bond due April 2012 would seem attractive at first glance, with a yield of 25% and a short time horizon (only 19 months). But if you find yourself asking “What could possibly happen in 19 months?”, ask yourself what happened in the 19 months starting in April of 2007. Given the currently tenuous situation, I do think the more defensive approach of the 6.125% senior notes, with their current yield of 7.7% and a yield to maturity of 16.6%, offer an excellent return. One can always move down the seniority ladder when and if the situation at the Mohegan Tribal Gaming Authority improves.

PS: I am aware that certain followers of socially responsible investing would prefer not to receive income from activities such as gambling. I take the position that since investments purchased in the secondary market do not result in any cash actually going to the company in question, then receiving the income from the bonds does not equate to supporting gambling. In fact, there would be a certain poetic irony if, say, Gamblers Anonymous invested its spare cash in the securities of casino operators so it could direct the casinos’ own profits against them (or from a more cynical standpoint, it’s hedging its bets). Or, if I may coin the expression, It is not what goeth into a man’s pockets that defiles him, but what cometh out of a man’s pockets that defiles him.

I noticed on Yahoo! finance a couple of days ago that Paul Otellini, CEO of Intel, publicly complained that, owing to high taxes and regulatory uncertainty, innovation and growth in the US would be stifled and, of course, Obama is to blame.

Of course, this would be the same Intel that paid AMD a $1.25 billion settlement over antitrust violations, settled claim with the FTC a couple of weeks ago over its anticompetitive activities, and is still fighting off a $1.45 billion claim in Europe. Of course, antitrust laws have been on the books for more than a century (and were invented by Republicans), so if the CEO hasn’t quite got the hang of complying with them after all this time, then his complaints come off as a case of sour grapes to me.

He did also state that we have to look forward to “an inevitable erosion and shift of wealth.” Now, it is only natural for a business to want less regulation, and of course it is natural for everyone to want to pay less taxes. But these comments got me thinking of how strong the relationship is between taxation and growth, particularly now that the Bush tax cuts are due to expire.

The job of an economist, it has been said, is to take something that works in practice and make it work in theory. The author of that statement may have intended it as a satire, but it is actually a remarkably accurate description. And in theory, too high a level of taxation on production forces economic participants to direct more and more of the nontaxed remainder of their economic activity towards immediate consumption rather than the building up of capital, and also makes certain marginal uses of capital economically unattractive, causing its owners to leave it idle or consume it. And without capital there can be no growth.

So, that is the hypothesis that economists and CEOs have set up for us: more taxes = less growth. Fortunately, we have a way to test this hypothesis, as the government, thanks in part to the taxes it collects, has given us a wealth of data on historical GDP levels, and also of taxes collected as a portion of GDP. With these two pieces of data, we can test the hypothesis.

If, as it is stated, more taxes = less growth, then we should see lower growth in a period where taxes as a portion of GDP are high, and higher growth in a period where taxes as a portion of GDP are low, and using the elementary statistical analysis technique of regression, we can calculate the r-squared, the coefficient of determination, which will tell us how accurately the data fit the theory. An r-squared close to 1 means that there is perfect correlation, and an r-squared close to 0 means that there is no correlation.

The most basic mode of analysis is to compare the taxes collected in a given year with GDP growth that year. Using a linear regression function and taking data since 1963 (a year I chose more or less arbitrarily) up until 2007, it gave me the formula of y = 13.73 – .56x, , where y is GDP growth and x is the level of taxation as a portion of GDP. Now at first glance the hypothesis is correct; every 1% increase in taxation as a percentage of GDP results in GDP growth that year dropping by .56%. However, would you care to know what the r-squared was? .07. Remember how I said that an r-squared close to 0 suggest complete randomness? So in theory, tax levels explain 7% of GDP growth (the other 93% are explained by something else), but with an r-squared that low, I am forced to question the validity of the expression itself.

But since I have the data I may as well play with it. After all, very often one only knows one’s tax liability after it’s too late to change it, and one just has to adjust in future periods accordingly. So it would perhaps be more fair to look at the taxes collected in one year and the effect on growth for the next year. Here I get a more dramatic looking equation, y = 16.49 -.72x, but again my coefficient of determination is only .11, meaning, depending on interpretation, that my equation has an 11% explanatory power, or that there’s only an 11% chance that I’ve discovered anything at all.

But while I’m at it, I recall that capital and consumption decisions are often made with more than a year of time horizon. From that perspective, it would probably be more enlightening to compare taxes collected in one year with GDP growth over the next three years. This time I get y = 6.59 -.19x, and my r-squared is only .02. So in fact what logic suggests would be a clearer relationship is actually the more tenuous one, as the r-squared suggests that the odds are very good that the relationship is nonexistent.

And finally, I am reminded that capital is a thing that accumulates over time based on previous consumption and savings decisions, so in the interest of thoroughness as well as symmetry, I compared average taxation as a percentage of GDP over the last three years to average GDP growth over the next three years, and I was amazed at what I found. y = 4.34 + .09x, indicating that paradoxically, higher tax collections over a three-year period actually lead to higher growth over the next three years. It made no sense to me, until I consulted the r-squared figure, which was .003, meaning pretty much conclusively that there was no detectable correlation at all.

And just to finish out the available set of comparisons, calculating the effect of three-year average tax collections on growth in the subsequent year produces an r-squared of .016, no better than most of the other experiments and also far below a level of significance necessary to conclude that a correlation exists.

So, the upshot of this fairly basic analysis is that no matter how you slice the data, it seems that tax levels (at least the tax levels that have prevailed in the US since 1963) have an undetectable effect on GDP growth, if indeed they have any at all, and that therefore GDP growth must come from other factors.

I am aware that since the data for taxes as a portion of GDP has only one decimal, it is entirely possible that I have two GDP growth figures for a single level of tax, so this method could be criticized that if one line has to go through two points on the same point on the x axis, it is inevitable that it can only be close to one of them. However, I would counter these critics by asking why, if tax levels have a strong explanatory power, would the two growth points be far away from each other in the first place.

It may further be objected that taxes and GDP growth are a chaotic and nonlinear system, and so the use of a linear regression would not be reasonably calculated to produce a good fit. But a cursory visual examination of the raw data indicates that there is no obvious cluster, and using the other regression tools available in Excel produce no improvement.

So, it seems, based on this simple analysis, that cutting taxes as a portion of GDP has a poor record in producing near-term growth, and so the perennial push to make further tax cuts in order to juice economic growth would appear misguided. But on the plus side, the impending expiration of the Bush tax cut is equally unlikely to strangle an economic recovery, as many people have feared.

I find that the stocks I like seem to come in pairs. I liked oil and gas producers Linn Energy and Breitburn; I liked phone companies Windstream and Qwest, and now in the contract manufacturing sectors, I liked Keytronic and now I like Amkor Technology (AMKR).

Amkor produces semiconductor packaging for other manufacturers, and also performs testing services. Most of their operations are in Asia. Based on today’s prices, I would estimate their P/E ratio at a little over 7. I shall go into more detail on that later.

On the downside, Amkor has significant debt; $2.7 billion in total assets and $2.2 billion in liabilities, producing a price/book ratio of around 2. Although they have significant R & D expenditures, and, following Damodaran, in Damodaran on Valuation, I have advocated capitalizing these, their interest coverage is still hovering around a little over 2x, firmly in junk status, although their credit rating was recently raised a notch to BB-.

Furthermore, some of that debt is convertible at various prices, ranging from $14.59 per share to $250 million in notes at $3.02 per share (the price as of Monday’s close is $5.61). As a result, there is a significant gap between normal and fully diluted earnings. The $3.02 convertible notes do deserve further attention; they were sold to the company’s chairman in April 2009, and the conversion price is actually lower than the price of the stock was at any time during the month. Most convertible notes are issued with a conversion price that is at a significant premium to the current stock price. Now, I know that April 2009 was still a time of economic crisis and was only a month after the market hit bottom, and as a result financing was hard to come by, but even so this level of blatant self-dealing should be a black mark against the firm.

Amkor is a cyclical company, and as a result sales for 2009 were no higher than they were in 2005. However, apart from a goodwill writeoff in 2008, the firm has been profitable every year since 2006. The recent improvement in the semiconductor device market has given the firm some improvement in their results as compared to last year. Turning now to earnings, in 2009 they reported earnings of $156 million, but because of operating losses, instead of paying taxes it worked out that the government actually owed them. If their tax liability had been normal, they would have earned only $80 million that year. They took $300 million in depreciation and amortization, and made $235 million in investments, producing free cash flow of $155 million. In 2008 the figure was $275 million, and in 2007, about $220 million.

Year to date 2010, they have reported earnings of $104 million, which is again propped up by tax effects so the correct figure would be about $67 million. Depreciation year to date has been $154 million, and capital expenditures $143 million, producing free cash flow of about $78 million, or $156 million on a full year basis. The firm also disclosed in their SEC filings that they typically see better results in the last two quarters of the year, and also that they intended to front-load a significant amount of capital expenditures for the year, so it is possible that the full year’s results will be even better. Furthermore, they have $300 million in net operating loss carryforwards to burn through as well.

I think the main drag on Amkor’s valuation is their significant debt levels, and although they have not made significant movement towards paying their debts down lately, which I would have preferred them to do, they have at least been refinancing at lower rates. During the last quarter, they borrowed what amounts to $133 million at a variable rate, currently 4.5%, to be paid down by 2013, to replace $125 million of 9 1/4% notes due 2016 (I assume some of the difference went to loan costs and the rest they kept). They also issued $345 million of 7 3/8% notes due 2018 (which they intend to replace with publicly traded notes by the end of the year, otherwise they will be liable for more interest), to replace their existing notes due 2011 and 2013. These transactions cost them $17.8 million, which is theoretically nonrecurring, but since the company has a large variety of debt outstanding and therefore has to engage in these operations frequently, and also since 2009’s results include a $16.8 million gain from similar transactions, I would not say that these costs are nonrecurring enough to eliminate from consideration. Pity they won’t give the notes convertible at $3.02 this kind of refinancing treatment.

As an aside, I will note that their 10-K is a thing of beauty. Very clear writing and a lot of easily digestible subheadings.

In the final analysis, I do think that the company is offering a very good return on investment and is capable of managing its debt load.

I have a certain weakness in my heart for junk bonds. Junk bonds, of course, are bonds with a sub-investment grade credit rating, and they can range from just barely on the cusp of investment grade to the point where the purchaser would have to be crazy to consider them. As Ben Graham wrote, an ordinary bond investor should never buy them, and speculators prefer a more speculative medium, and yet there are millions (now hundreds of billions or trillions) of them out there and someone has to own them.

And better still, some people can’t own them. Many institutions are limited to investment-grade holdings, so a cut in ratings means that they have to sell them. Any situation where investors refuse to buy a security for any reason other than its investment merits creates a fruitful hunting ground.

Of course, picking individual bonds is no easier than picking individual stocks, and given that the potential upside for a bond is limited to getting principal and interest while the potential upside for stock is theoretically unlimited, many people have called it less rewarding. However, the upside of bonds can be very large indeed if they sell at a discount, and the upside of stocks is effectively limited, at least for value investors, because a stock can only go up so far before it becomes too speculatively priced to consider. Even so, this limits us to bonds that are priced below par. A bond below par with a near maturity date is an advantageous situation, since the bond must be paid off at par or default, and as the time nears the uncertainty of eventual payoff lessens and such bonds creep towards par as if by magic–assuming that the company is capable of paying off the debt, typically by a new bond issuance.

Since a lot of such bonds are issued by marginal companies, it is only natural that these companies would use whatever methods they can to reduce their interest obligations. One of the most common methods is by issuing convertible bonds, whereby the bondholder can convert the bond into a given number of shares of stock that normally represents a price well above the market price. Basically, it acts like a long-lived call option.

Convertible bonds have been around for decades, and they in fact predate the options pricing models that let us figure out what they’re worth. Of course, a convertible trading at below par is probably trading at below par because the company that issued it has gone through some misfortunes since then, so the possibility of actually converting is not really much of an issue in the bonds’ valuation.

However, the accounting profession is never content unless it is making a simple thing complicated. For most classes of convertible bonds, accounting standards codification 470-20 requires them to divide the bonds between the debt on the balance sheet itself between the debt and the option component. This means that if a company borrows $300 million of convertible debt due in five years, and based on comparing interest rates, similar nonconvertible bonds would sell for $250 million, then the company would record a liability of $250 million, and every year take $10 million in additional interest costs to bring the liability back up to $300 million by the time the debt is due.

This is a useless complication that is completely inconsistent with everything most people know about accounting. It obfuscates the facts rather than makes them clear. The obligation to repay the extra $50 million doesn’t accrue in 5 years; it accrues immediately when the debt is issued (particularly since anyone familiar with options knows that it’s typically better to sell the option than exercise it, so anyone with a convertible bond that’s worth converting would probably rather write a call/buy a put and keep the bond, rather than actually convert it). The effect of this rule means that the company’s liabilities are constantly understated on the balance sheet, and that the firm has to record a noncash interest expense every year to amortize a discount that never existed in the first place.

I look upon this rule as a symptom of a disease that Marty Whitman diagnosed during the debate about expensing stock options: the assumption that financial statements should be geared only to equity holders. Stock options are an expense to equity holders because they result in dilution, but creditors don’t care if equity holders are diluted to nothing as long as they get paid. Here, too, a creditor looking at the fictitious financial statements required by 470-20 would conclude that a firm with convertible debt has much fewer liabilities and a much higher interest expense than the actual situation would suggest. Creditors other than the holders of the convertible bonds care primarily about interest coverage, and imposing a large noncash interest charge makes them feel unduly nervous. The holders of of the convertible bonds themselves couldn’t even figure out from the balance sheet what is the aggregate size of the bond issue they own. Only the equity holders would actually care about the dilution caused by converting.

As a final insult to reality, the allocation between debt and options is fixed when the bond is issued, so if the price of the company collapses the debt doesn’t automatically move closer to its full value despite the fact that conversion is highly unlikely. Without updating the figures in real time, the option premium contained in the convertible bonds tells no one reading the financial statement about the actual odds of dilution, which is what this rule was intended to accomplish.

I found out about this senseless rule while I was reading about Energy Control Devices’ bonds, which I ultimately decided against because, although the bonds are presently backed by substantial current assets, the firm itself has no operating income. Investing in such a firm basically involves placing a bet whether the firm is going to run out of money before the bonds fall due, and that sort of analysis is too reliant on foresight.

But I am considering the 2014 Western Refining (WNR) 5.75s, which sell at about 76, representing a yield to maturity of about 14% and a current yield of about 7.67%. The conversion price is around $10.80 per share, more than twice the current share price, so the possibility of conversion hardly seems to be an issue. The bonds’ credit rating is CCC+, which is the best of the bottom tier.

These convertible bonds are designated the senior bonds, but the other classes of bonds have security and guaranty provisions, so they are actually probably the junior debt. Western Refining’s total interest requirement year to date has been $61 million. Operating earnings year to date are $37 million, plus $69 million in depreciation, and $37 million in capital expenditures. Furthermore, the firm has listed $23 million in maintenance expenditures year to date. According to its financial statements, various classes of maintenance activities have a schedule of roughly 2-6 years between actions. Looking back at their history, we find that in the last five full years they have spent more than $23 million only once, and on average over that period maintenance expenditures were $16.5 million. If we assume that the company has spent an outsized amount on maintenance, and instead applied the average amount of maintenance expenditures over the years, we find that there is theoretically another $14 million in cash flows available to meet interest. This produces a theoretical operating cash flow of about $85 million to meet their interest requirements, and an interest coverage ratio of 1.25, which is consistent with a CCC or a CC rating.

Also, their working capital has expanded recently, resulting in a cash burn rate that would normally be disturbing for interest coverage issues. However, let us recall that Western Refining is an oil refinery, and the end of the last quarter coincided with the early phase of the summer driving season. Furthermore, the large amount of maintenance they did year to date has resulted in several weeks of a shutdown in production, which makes the year to date results unusually low.

Now, the fact that they are a refinery may also give investors some confidence; refining services will be in demand as long as oil is in use, and it may allow them to survive with lower interest rate coverage levels than a typical company that produces more discretionary products. However, refiners do not enjoy the advantage of a local monopoly the way utilities do, and because they are not thus insulated from competition, they are in a more precarious situation, hence the discount from par for their bonds. Western Refining also owns a chain of gas stations and a fleet of fuel distributors.

Operating income has in fact been on the decline for the last few years, which the company attributes to narrowing spreads between light and heavy crude, and the continued economic slowdown. Although the United States hasn’t built a new refinery in 30 years, Western Refining has in fact ceased operations at one of their unprofitable refineries, a move that the CEO claims will save them money. They have also raised the specter of asset impairments in their outlook, which is a noncash charge but makes the reported earnings drop dramatically for the quarter in which it happens.

Now, one of the things that recommended Bon-Ton stores to me was the possibility that the bondholders would do fine in a bankruptcy. I am not convinced that this is the case with Western Refining, as the convertible bonds are behind a number of secured and trade creditors in terms of priority. The firm has a total of about $2 billion in debt outstanding, and as I’ve calculated the firm has only $85 million in free cash flow to the firm. Doubling that to round out the year and capitalizing it at 10x creates a value of only $1.7 billion, although considering the difficulty of building new refineries in this country they may be entitled to a higher multiple. At any rate, it does not appear that they are as bankruptcy-robust as Bon-Ton, and considering the low interest rate coverage that is an issue that cannot be ignored.

Even so, the company has over $600 million available in borrowing capacity,  a large figure considering the firm has $2.8 billion in assets and the market cap of the equity is only $400 million. Furthermore, apart from a nonrecurring writeoff of goodwill and other impairments they have operated at a profit for the last five years. Accordingly, I have confidence that the interest on the convertible bonds is safe, at least as far as junk bonds go, and the likelihood of them being paid off at par is sufficient inducement to make these bonds attractive to any people interested in high yield debt.

The below post was a foray into the world of macroeconomics, a matter which I have no formal and little informal education in but I nonetheless feel perfectly qualified to give my opinion, just like everyone else. Now I would like to talk about issues in valuing United Online, a matter with which I have much more fluency.

I have recommended United Online (UNTD) here in the past, and I do still like their FTD online property, and I think their dialup business is capable of spinning off quite a bit of free cash flow before it ceases operations. (I am fairly indifferent to classmates.com).  By traditional valuation metrics, the stock is still underpriced, but I have noticed that their free cash flows are declining quarter by quarter, presumably as the result of the loss of some after-sale marketing programs. I think the company will eventually find a new equilibrium, but on the other hand, I wouldn’t care to place a bet on what level of free cash flow that equilibrium will be.

Last quarter, they reported net income of $14 million, depreciation of $14 million, and capital expenditures of $10 million, producing free cash flows of $18 million. If we use this figure as the basis for their full year outlook and capitalize it at a rate of 10x, we get a market cap of $720 million, which is a good 50% above the current market cap. However, the quarter before last, free cash flow was $21 million, and the quarter before then $23 million, and the quarter before that, $26 million. Fortunately, as the result of their disappointing earnings announcement and not-optimistic outlook, the company’s market cap dropped by roughly $90 million, so it seems that the market is more or less instinctively walking the price down until the company regains cash flow stability, so hopefully those of us who are waiting for that moment will not see the apparent bargain price pulled away from us prematurely.

I should also point out that for whatever reason, the company includes stock-based compensation alongside depreciation and amortization. I agree that much like the other two, stock-based compensation is a non-cash expense, and if I were one of United Online’s creditors I would support that designation. However, stock-based compensation still dilutes the equity holders, and since United Online is probably undervalued I dislike seeing so much stock being given away all the more. Stock-based compensation ran them $40m last year, $36m the year before, $19m the year before that, and nearly $15m year to date. I will say that such compensation has allowed the firm to pay down its debts (almost $30 million more last quarter alone), and although interest expense is highly manageable at approximately 1/4th free cash flow to the firm, I do like to see debt being paid down in this environment.

The bottom line in terms of recommendations is that United Online is apparently underpriced on a free cash flow yield basis, but until they can get their declining free cash flows under control, I would probably not consider investing in them without a much larger discount. In terms of book value, they’re not particularly impressive either. I believe that such an occasion, as indicated by a quarter or two of flat or increasing free cash flows, is not long in coming, and I hope that the market will not walk the price away from us bargain hunters in the meantime.

I should make it clear at the outset of this article that I’m not an economist. But, like many people who begin their speeches with those words, I won’t let it affect what I have to say.

I have made it clear in the past that I take a sanguine view of the possibility of inflation, since the massive deflation across all asset classes (stocks, real estate, many debt instruments and some commodities), amounting to tens of trillions of dollars, in my view massively outweighs even the cutting of interest rates to nothing and the large deficits anticipated over the next ten years. However, there is an equally convincing reason to think that hyperinflation will not be a problem: Because everyone thinks it will.

As I mentioned in my article about the New York Times indicator, whenever a particular stock market or macroeconomic view is popular enough that a book about it makes the best seller list, it’s time to get out. And what did I see in an article in Fortune.com early last week? An article about how hyperinflation won’t die, and the words  “Adam Fergusson’s When Money Dies: the Nightmare of the Weimar Collapse was recently offered at $1,705.63. A rushed paperback UK edition of Fergusson’s book has held onto the number one spot for business books on Amazon UK for more than twenty-six days and is now climbing Amazon’s US rankings.” I think that’s a good enough hit for the New York Times indicator.

Just ask Hugh Hendry, a macroeconomic hedge fund manager with a dreamy accent and an enormous brain. He reports that he has never seen such a crowded trade as the absolute certainty of hyperinflation. In my view, the fact that a trade is so crowded is reason enough to consider not just declining to jump aboard the bandwagon, but actually taking the other side of it. And there is nothing so dangerous as absolute certainty. Hendry himself is actually willing to hold the long term government bonds.

Of course, in that same interview, Hendry said that quantitative easing has a mixed record in history and he is definitely afraid of deflation, since despite the willingness of the US government to ease and to engage in deficit spending, the private sector is still not playing ball. The trouble is that in a normal environment, it pays to take risks that no one else is willing to take, but in a deflationary environment this is often not the case. It doesn’t pay to stick your neck out by investing and expanding capital and payrolls; it pays to go into turtle mode and stock up on government bonds and cash. Now, I have seen a recent uptick of articles about deflation, but no books. Furthermore, I can see the case for deflation a lot better than for hyperinflation.

As hyperinflation is contraindicated by the New York Times indicator and the numbers involved, it is pretty clear that deflation is the real risk we’re facing, and it is a pretty severe risk for any economy but especially a highly leveraged one like ours (did I mention that I like companies that are paying their debts down while they can?). As I said, I have seen a spate of deflation articles recently, but nothing I would call a crowded trade, apart from the continued bull market in US government bonds despite the unusually low interest rates. But deflation certainly worries me more than the remote possibility of excessive inflation. So maybe “cheer up” isn’t really the right sentiment.

I hope that the hyperinflation fearmongers and the gold people (who are also selling books and articles and gold coins over the radio) realize that the steps we have taken so far are not enough to create hyperinflation or possibly not even enough to prevent deflation, and that the stimulus and easing we have had so far was in fact not a bad idea, but instead just too small of an idea. Ireland embraced austerity early; it was one of the first countries in Europe to do so, and it remains mired in the same recessionary spiral as Greece is and the rest of Europe may not be able to avoid. China embraced a massive stimulus and is growing right now, assuming that China’s reported figures are credible. Commentators have said that we need to get the fiscal house in order before we get hit by the next cyclical recession and consequent erosion in the tax base, but I say that we actually can’t even begin the next cycle until we’re done with this one, and right now it doesn’t look like we’re even close.

Let me paint you a worst-case scenario (well, not the worst-case, but a pretty bad case, anyway). The US is right now treading a middle ground, with no deficit cutting but no further large-scale stimulus packages in the works (extending unemployment benefits props up demand, but can’t really create it). I hope it doesn’t require Europe to blow up from austerity before the US decides that avoiding deflation is worth what it costs. But if it does, we can always print a ton of money and buy the remnants of Europe’s capital assets with it.

I’m sure that’s what China would do.

Benjamin Graham gave two useful pieces of advice that are applicable during earnings season. First, don’t pay too much attention to the results of a single quarter. Second, when paying too much attention to the results of a single quarter, make sure that you strip out the nonrecurring events in order to get a better picture of actual earnings power.

So, last week two stocks I’ve recommended here have reported quarterly earnings (as have several others, but I’m focusing on these two). The first is Chiquita Brands (CQB), and the second is Linn Energy (LINE).

Chiquita Brands reported earnings of $1.40 a share apart from a nonrecurring profit, the sale of some of its interest in a fruit drink concern to Danone. This caused the share price to rise to over $14 a share, producing a 10x multiple of this quarter’s earnings alone. Of course, this is typically Chiquita’s biggest quarter, so I don’t think that too much should be made of this.

However, this is still notable because Chiquita Brands also moderated its full year earnings forecast to $80-90 million in comparable earnings, down from the $100-120 million they claimed last quarter. Normally such an event would dampen market enthusiasm, but considering the European debt crisis reached the critical phase during last quarter, and the Euro dropped briefly to below 1.20, this came as no surprise. Furthermore, this forecast is based on the the assumption that the euro will stay at around 1.26. It is in fact 1.30 as of this writing, and may increase further now that the Europeans are fetishizing austerity.

Now, as I mentioned before, I have very sanguine views of inflation and so I don’t think it is vitally important to close the deficit gap very soon, particularly with such an anemic looking recovery. This applies doubly so in Europe, where the social safety net is much larger and so austerity actually has some meaning. So, this un-Keynesian move by Europe will possibly slow or even shrink the European economy, make their exports more expensive, and possibly result in the occasional riot. But, it is more likely than not that it will cause the Euro to go up against the dollar, which is good for Chiquita Brands.

Of course, Chiquita is now reaping the benefits of the change to a formerly unequal tariff regime, which based on current volumes will save them $30 million a year, rising to $60 million when the next phase of the tariff adjustments occur by 2017 or 2019. Being able to compete with banana growers from regions not subject to the tariff might even allow them to increase their volume in future, particularly in the face of overall banana price declines. Of course, the wise value investor does not indulge in rosy projections of the future, but based on their current showing alone Chiquita is still nicely positioned. If earnings for the year are $80 million their current P/E is 8.25, and at $90 million, 7.33.

Chiquita also managed to pay down another $20 million in debt this quarter, and depreciation and amortization has run to $29 million year to date, with capital expenditures at only $16 million year to date, so that appears to be an extra $26m in annualized free cash flow. But I should note that historically capital expenditures have run higher than depreciation.

During their earnings call, Chiquita also mentioned that they wanted to buy back another $40-$50 million in debt before they would feel comfortable with share buybacks or other ways to return cash to investors. Of course, that’s several quarters of free cash flow away, and a lot can happen in several quarters, so I wouldn’t put too much stock in it. But the better their interest coverage becomes, the more likely it is that they can refinance their high-interest borrowings, which would also produce a substantial benefit to shareholders.

On the whole, then, I am very pleased with Chiquita’s performance and despite the advance in share price, I think Chiquita is still underpriced.

Linn Energy (LINE), the other company I wanted to discuss, has a more opaque set of figures, and this may be due to the fact that their derivatives strategy is more integral to their business. But on the other hand, Warren Buffett has stated that if a company wants you to understand its financial statements, you will understand them, and if a company doesn’t want you to understand its financial statements, you won’t understand them. I will warn you, the following post is full of accounting.

Chief among my complaints is the fact that their latest 10-Q doesn’t include a three month cash flow statement, requiring you to open last quarter’s 10-Q and subtract. At any rate, their net income is flat at $60 million for the quarter, well under their latest distribution of roughly $80 million, but of course it is cash flow that drives the yield.

They are kind enough to separate their “core” operations from their derivatives trades, and net income plus depreciation and amortization for the three months did in fact come to about $120 million. From their derivatives activities, they reported $90 million in derivatives profits for the quarter, but only $80 million of that was cash received. As I’ve stated before, they hedge their production several years in advance, so a small movement in oil and gas prices can produce a significant divergence in derivatives income. Actually, the price of oil has certainly been more stable than in 2008 and 2009, but since the prices that Linn Energy locked in for oil is well above the current market price, the large amount of cash from their derivatives is somewhat anomalous, although derivatives income plus sales should not be.

On the next line, they reported a loss of nearly $75 million on cancelled derivatives, which after a little digging in the report I discovered to be $1.2 billion in pay-fixed, receive-floating interest rate swaps. I found this entry curious; the only exposure that Linn Energy had to rising interest rates was on its line of credit, which had an outstanding balance of $900 million at the end of the first quarter and $600 million at the end of the second. Linn Energy had restructured its debt recently to pay for a large acquisition, so clearing out the swaps makes sense, and at any rate I believe that these swaps at the very least are a nonrecurring event.

The final line on the derivatives section of the cash flow statement is premiums paid for derivatives. As I said, Linn Energy engages in careful hedging of the prices of oil and natural gas many years into the future as part of its core strategy, so spending large amounts on derivatives–a total of $91 million year to date–is somewhat to be expected. But Linn Energy spent approximately $90 million on derivatives for the whole of 2009, so although this category may be recurring, the total amount spent by only the second quarter may be anomalously high.

So, where does that leave us in assessing Linn Energy’s sustainable cash flow? First of all, those losses on interest rate swaps are a nonrecurring event, but I also take the position that they are not really an operations expense. As near as I can tell, they were entered into to hedge interest rate exposure on their line of credit, and therefore, they should properly be imputed to the financing cash flows section. As for the derivatives, we might say that since they spent $90 million for all of last year (although previous years involved larger amounts), that the company may have just decided to purchase a year’s worth of derivatives all at once, and if we spread them over a year we find that only $22.5 million should be imputed to this quarter. Taking that into account, we have operating cash flows of $90 million for the quarter, just about enough to cover their distribution. Of course, since the purpose of a company in Linn’s space is to distribute all the cash it can spare, this is not of great concern in terms of coverage.

In fact, we might even be persuaded to take a more generous view of that $90 million in derivatives purchases, since on the next sections of the balance sheet we find that Linn Energy made nearly $600 million in acquisitions for the quarter and nearly $800 million year to date. Obviously, these acquisitions have future production that has to be hedged, so it is likely that some of these hedges are for the future production of the acquisitions, and so there is an argument for classifying the purchases of such derivatives as a use of investing cash flow, thus improving the operating cash flow even further. However, these hedges are part of Linn’s operational strategy, and are intended to reduce their exposure to the price of oil and natural gas rather than speculate on it, and at any rate the amount of the adjustment is difficult to determine, so I think the correct and conservative approach is to leave the derivatives purchase under the operations category and just to make a mental note that things might be better than they appear.

(If I sound unusually pedantic about the source and allocation of cash flow, it’s because I’ve been reading a book called, funnily enough, Creative Cash Flow Reporting, by Mulford and Comiskey. The title is somewhat misleading, as the authors are very much opposed to creative reporting. But so far it’s a good book and I recommend it).

Turning again to the acquisitions, a typical cash flow watcher would be somewhat concerned that depreciation and amortization year to date have come to less than $125 million, while acquisitions have come to nearly $775 million. Surely, they say, this is a sign of vastly negative free cash flow. Normally they would be correct, but Linn Energy financed these new acquisitions by issuing equity and debt securities rather than reinvested earnings (which is just as well because their policy leaves them no retained earnings to reinvest).

I’m not quite sure how to interpret the debt financing of acquisitions. Based on the $90 million in cash flow from operations I calculated above, their interest is covered three times, which appears safe enough, but there is a wrinkle involved with borrowing against oil fields and other finite assets. When an asset is subject to depletion, it is customary to set aside additional income from the asset in order to pay down principal, because borrowing $700 million on an oil field, extracting ten years’ worth of oil from it, and then expecting to roll over the full $700 million when it falls due, is nothing short of ridiculous. This is why most lenders against such assets require a “sinking fund” provision that requires the borrower to pay down portions of the principal over the life of the loan (generally there is no actual “fund” involved; the company just buys back the bonds according to the agreed-upon schedule, so “fund” is a verb and “sinking” is an adverb). It is curious that Linn Energy’s lenders for this current acquisition did not insist on such a fund. True, they have all of Linn Energy’s assets to sue for, not just the current field, but all of Linn Energy’s properties have the same finite character. Here, Linn Energy will have to decide for itself what amount to set aside for principal, and this amount will definitely have to be higher than nothing.

Now, finding all of this out took a bit of digging through the quarterly report and a number of supplemental 8-K reports, but I think it was worth it to conclude that on a conservative basis, Linn Energy is earnings its distribution and not too much else. Recalling the Warren Buffet quote above, Linn Energy promoted in its announcement of quarterly results, its “adjusted EBITDA,” which is of course, non-GAAP. I’ll never understand why equity investors care about EBITDA, since all of I and all of T are taken out before they see anything, and whatever amount of D and A has to be replaced gets to be replaced by them as well. Even bond investors, for whom EBITDA was originally invented, have to worry about D and A. At any rate, adjusted EBITDA, not surprisingly, was nearly twice my estimate of $90 million in sustainable cash flow for the quarter.

So, where does that leave us from an investing decision standpoint? Linn Energy is earning its distribution, which at 8.4% is both attractive looking and tax-deferred (as with other pass-through tax entities, distributions are not taxed but lower the holder’s basis), and Linn Energy’s hedging strategy mitigates the risk from energy prices. And they are seeing excellent results from their new acquisitions. On the other hand, their current hedges are at a higher-than-market price, and in the next couple of years they step down. Of course, any new acquisitions made by Linn Energy will also be based on the market price, but as it stands I don’t know that I see the possibility of any major improvements in Linn’s position and wouldn’t care to speculate on it, so my basic view is that for Linn’s distribution, what you see is what you get. And if the price goes up much further, what you get isn’t that huge, so I would sell if it goes up much further.

For once I can mention a company that most of you may have heard of. Seagate Technology (STX) is the world’s largest hard drive maker, producing a wide range of standard hard drives and since December of 2009 has also been producing a line of solid state drives, although they were a late entrant to the market. Of course, for enterprise or most consumer electronics, the spinny magnetic disk isn’t going anywhere anytime soon.

But what makes Seagate pop up on everyone’s radar these days is, of course, their P/E ratio of 4 and a quarter, which is almost inconceivable in a company this large (market cap of $6 billion and annual sales of about $12 billion) and this well followed. My  initial instinct is that their earnings were distorted by nonrecurring gains, but I found that not to be the case. But I did find that the company had substantial tax benefits accrued and therefore has paid a negligible amount for income taxes year to date, but that only pushes the P/E up to about 7. I can’t explain why such a large company should be the subject of this degree of market neglect (and large competitor Western Digital is also trading a low P/E), but I couldn’t explain the mania for subprime mortgage derivatives either, and the wise value investor just takes cheapness as he or she finds it.

I didn’t find any major nonrecurring events in fiscal year 2010 (Seagate’s fiscal year ends in June), but of course in fiscal year 2009 , like nearly every company with significant goodwill on the books, they wrote theirs off in its entirety. I’ve stated previously that goodwill writeoffs are a noncash expense, and of course goodwill on the balance sheet is a phantom asset, so it can safely be ignored in the majority of situations. Even ignoring the goodwill writeoff, they reported a loss in fiscal year 2009 as sales declined by 23%, but sales for this year seem to have rebounded at least to 2007 levels.

In terms of earnings and cash flows, the company’s free cash flow has been roughly equivalent to earnings, as depreciation and capital expenditures have tracked each other pretty well over the last few years. It was even nearly positive in fiscal year 2009 owing to a decline in capital expenditures ($600 million as opposed to $900 million), and the low level of capital expenditures seems to be continuing for the first three quarters of 2010 (less than $400 million year to date). Earnings year to date have been $1.2 billion, and depreciation $600 million, so the year’s free cash flow to date is $1.4 billion, which is nearly $1.9 billion on an annual basis, creating a current price/free cash flow from operations ratio of less than 3.5. Even if capital expenditures return to historical levels, free cash flow would come to $1.4 or $1.5 billion. This produces, again a price/free cash flow from operations of around 4.5, a definitely attractive situation.

Of course, price/free cash flow from operations is calculated before interest and taxes, and taking those into account we have a projected long term price/free cash flow ratio of approximately 7, which is still notably low for a company of this size, market presence, and stability.

Turning to the balance sheet, most notable is the very top entry: over $2 billion in cash, and $200 million more in short term investments. This is almost 1/3 of the market cap. Midway through fiscal year 2009, Seagate suspended its modest dividend, and despite its impressive cash flow, it has also ceased to engage in shareholder buybacks, which totaled $1.3 billion in fiscal years 2008 and 2007. It may be unseemly to want a cash return on investment from a high technology firm, but I think nowadays hard drives are commoditized enough to be able to support dividend payments, and the rate of cash accumulation on the balance sheet is fairly good evidence for my view.

Seagate claims that they suspended the dividend for liquidity reasons, and on paper their liabilities do come to 65% of their assets, but their interest coverage ratio for 2010 to date is approximately 10x based on earnings alone, suggesting to me that they have more than adequate liquidity. Curiously, their credit rating is a mere BB+, the best of the sub-investment grade ratings, and since a coverage ratio of 10x is more consistent with an AA rating, I think it is the apparent low level of asset coverage that gives the ratings agencies concern.

However, the apparent low level of asset coverage and high debt should be analyzed in view of Damodaran’s suggestion of a “research asset.” Research and development produce benefits that are considered by accountants to be too nebulous to capitalize (or lend money against), so they must be expensed. However, R & D produces a definite benefit to the company, and in the hard drive business it is a practical necessity. Seagate has spent approximately $900 million on R & D every year for the last three full fiscal years, and is on track to do so in fiscal year 2010 as well. As R & D has been a large and growing category of “expense” for Seagate I can’t say that amortization of this theoretical research asset is faster than its accrual, so it would definitely not be a source of free cash flow. But it should occupy a significant space on the balance sheet; it would certainly explain why a company with $1.5 billion in shareholder’s equity can produce projected earnings of roughly $1 billion a year.

I will add that I don’t like their “anti-dilution” policy of buying back shares to offset the effect of stock grants and options exercises; it assures that they buy back stock after it goes up, not before.

On the whole, though, I expect that Seagate’s strong operations backed up by a demonstrated willingness to invest in capital and product development, should allow it to retain its market positions and generate the projected cash flows that indicate it to be a very attractively priced opportunity.