Fructivore Investments

I have had occasion to suggest Capstead Mortgage as an attractive purchase partially based on attractive economics created by historically low interest rates, and partially based on the number of difficulties in evaluating most other investment firms that are not encountered with this one. Capstead Mortgage purchases adjustable rate mortgages on a leveraged basis and holds them in order to profit on the interest differential between the mortgages and their own cost of funds. The fact that all their mortgages are adjustable rate insulates them from most interest rate volatility, and the fact that the mortgages are all GNMA, Fannie, or Freddie securities insulates them from the possibility of default, as the government is explicitly guaranteeing them for the foreseeable future–taxpayers are understandably irate that their tax money is going to bail out these institutions but by buying companies that hold their debts they can easily recover what they lost and more. At any rate, actual impairments of value for CMO are highly improbable and the only issue is making sure that the share price is right.

In that vein, I had occasion to point out around the date of the “flash crash” that the real issue was not simply Capstead Mortgage’s book value, but instead the actual principal amount of mortgages held. It is natural to assume that a default-free and largely interest-rate-risk free security would trade at a premium to its principal value. However, when mortgages prepay, or suffer of defaults which are treated as prepayments, that premium disappears and the mortgage holder is left only with the return of principal. As a result, purchasing CMO at a price that is too high exposes the purchaser to risk of losses even if the business itself is not risky at all. The day after I expressed this view, the flash crash occurred and CMO was briefly pushed even below this principal value, creating a literal no-brainer buy situation. The equity interest in the principal value of the mortgages based on their last report was $10.04 a share, although the situation is complicated by preferred stock with a liquidation preference, so the ultimate worst case scenario price is actually $7.81 per share. And I don’t expect the premium to shrink to zero, even if I don’t think it should be relied on too much.

So what are my grounds for recommending selling before earnings, which are due on July 28th? Well, as I said, although interest rate spreads are the source of Capstead Mortgage’s profitability, book value is the source of its safety, and the current price of almost $12 a share represents a considerable premium over the principal value of the loans, which no doubt represents the premium over the principal value of the mortgage securities owned. In their first quarter earnings announcement, Capstead Mortgage pointed out that defaults were running high and that Fannie and Freddie were engaging in a buyout of seriously delinquent loans, which causes higher than normal amortization of premiums. Furthermore, in this uncertain environment the firm could not justify repurchasing all of the repaid principal, thus lowering the leverage and theoretically the profitability of the firm. This is no doubt a major influence in causing them to reduce their dividend last quarter from 50 cents a share to 36.

So, it occurs to me that there may be some confusion in the minds of the investing public about the distinction between book value and principal value. At prepayment rates prevailing in the 1st quarter, over 7% of the premium existing after last quarter’s earnings, or about 30 cents a share, will have evaporated due to prepayments alone, and perhaps more of that will have evaporated by the actions of the market now that Fannie and Freddie’s actions have made prepayments more likely. To those of us who track principal value this is of little consequence, since principal has just been turned into cash (and not always back into principal, as stated above), but if the market is focused solely on book value it may lead to a wave of selling as the apparent book value diminishes.

Of course, it may not be the case that the market will react so badly, as the situation with Capstead Mortgage may already be priced in, but I would just as soon not take the risk. And at any rate, holding stock of an investment company that represents too big of a premium over its principal value is a risky move whether or not it is earnings season. Therefore, I will be looking for an opportune selling time definitely before the 28th.

A couple months ago I saw a car driving along the freeway with a windmill in its roof, merrily milling the wind along as the car was zipping towards San Francisco. Of course, the car was some manner of hybrid. Although I commend the car owner for its efforts, I do not commend him for his knowledge of thermodynamics; even if the engine and the windmill both operated at the impossible level of 100% efficiency, the windmill is only recovering the energy spent to overcome the wind resistance created by the windmill itself, and when you factor in the fact that windmills weigh more than 0 pounds, it’s kind a loser all round. Of course, if the windmill could be put up and taken down so it could be used only when the car is not moving, or, better still, had an automatic elevator that would retract it into the roof of the car unless the driver was braking, in accordance with the theory of hybrids, then having a windmill in your car would make sense. I guess every good idea starts out as a bad idea that needs work.

Speaking of which, there is a bill afoot to make hybrid cars make noise, as a car running on electric motors generally makes very little. The reason for this regulation is that pedestrians who are accustomed to “stop, look, and listen” can still be run down by a silent hybrid around a blind corner. Now, the lawyer in me remembers the legal adage “For every wrong there is a remedy,” or to be more precise, “for every wrong there is a lawyer.” It follows that if pedestrians are getting injured despite complying with every rule of common sense, then the real problem is the negligence of the hybrid drivers who are going too fast to stop for a pedestrian who can see but not hear them. Imposing higher insurance requirements and/or instituting a public awareness campaign seems to me a better idea than fitting a perfectly good car with an annoying noisemaker.

So, what’s put me in a car mood lately? Fuel Systems Inc. (FSYS). Their primary line of business is devices to adjust the pressure and concentration of fuel for vehicles that run on natural gas or propane. Given the current interest in building such vehicles, spearheaded by T. Boone Pickens, takeover artist and natural gas magnate, they are in an excellent position and are considering beginning operations in the US. Many of their operations have recently been performed in Italy, where a government subsidy that has recently expired has given them considerable sales growth. Now, for alternative energy, chasing government subsidies around the world is par for the course, but natural gas vehicles do have the advantage of viability.

In terms of energy content, 5000 cubic feet of natural gas is considered equal to one barrel of oil, but because of storage and transport issues and the fact that more “stuff” can be refined out of oil, one barrel of oil has traditionally traded at about 6000 cubic feet of gas. However, a few years ago this relationship was severed by the discovery of shale cracking technology, which increases the number of places that natural gas may be extracted from. Natural gas reserves instantly became much larger, and prices fell dramatically. Of course, some say that this is an arbitrage that should eventually be corrected and either the price of natural gas will go up and oil will come down to reflect “energy content parity,” if I may coin the term, and actually the widespread introduction of natural gas vehicles might be just the catalyst to do it. Natural gas is also kinder to the environment, since pure methane contains no C-C bonds and therefore contributes less carbon dioxide per unit of energy extracted than oil does. Did I mention that Linn Energy and Breitburn produce both oil and natural gas?

Returning to the company, its numbers are fairly respectable; a P/E ratio of 10, hardly any long-term debt, and a balance sheet that is heavily weighted towards current assets. Unfortunately, the price/book ratio is somewhat high, but return on assets has been 12% recently, and return on equity around 20%, well above average for a firm that is technically a growth company. Of course, a now-expired subsidy has much to do with creating those excellent figures, but a company announcement at the end of 2009 suggested that in a post-subsidy world, the firm could look forward to $400-450 million in sales and a margin of 12-14%, which at current prices would preserve a P/E ratio of 10. As this is a firm that is investing in research and development and capital expansion, as well as some strategic acquisitions, depreciation has been running behind capital expenditures and thus free cash flow is lower than earnings.

Of course,  government subsidies, either getting them or not getting them, will have a significant impact on the future course of the company, and as a result perhaps a pure value investor may view this as far too reliant on an unpredictable future, but if the company’s projections are close to accurate the firm would still produce a respectable but not outsize return on investment without them. And I do think that natural gas vehicles will be increasing in popularity; they are a viable technology and based on a relatively cheap and abundant resource.

Tech Data (TECD) is a distributor of electronics in the US and European  areas. Its role is to sell a mix of primarily IT products from original  manufacturers and entities identified as “value-added resellers” and to  perform various related ancillary services, and it is one of the largest such distributors in the world. Approximately 30% of their sales come from HP.

It is unusual, perhaps, to find a value opportunity in the largest of anything, as value stocks tend to be overlooked, but the company’s market cap is a “mere” $1.94 billion, still below the radar of the largest institutions. More interesting for our purposes, nearly all of that value is represented by tangible assets: $900 million in cash, $2.5 billion in receivables, $1.8 billion in inventory, against $3.5 billion in liabilities, total $1.7 billion in tangible assets. This leaves a gap of about $240 million, which is just over a year’s free cash flow. The value of these tangible assets is safeguarded by agreements with some clients to return unsellable goods or to receive compensation in the event of the seller offering discounts or rebates. It seems therefore safe to conclude that much of the money invested into the firm will still be there.

In terms of investment returns, the company has a present P/E ratio of 10.12, a respectable figure for any company without a great deal of obvious growth potential. Moreover, in terms of free cash flow, the situation is  even more attractive; the firm’s depreciation has been running ahead of its  capital expenditures by more than $40 million a year for the last three years, and also the firm records $10 million in noncash interest expense for the last few years owing to its convertible debt.  However, last year’s earnings were complicated by an unusually low tax rate. At any rate, adding back in these two noncash expenses and applying a normal tax rate produces a price/ free cash flow ratio of 9.24, an attractive prospect when combined with the safety of principle above.

(I will explain the convertible debt noncash expense as an aside. Damodaran reminds us that convertible debt should be treated as straight debt plus the value of the conversion option, and the FASB seems finally to have concurred in this view.  It requires companies to estimate the current discount of a nonconvertible bond yielding what the bond actually yields to a bond that pays market interest rates, and to amortize that discount over the lifetime of the bond. The conversion price is $54 a share, more than 50% above the company’s current price, but any rate the amortizing discount is not a real cash outlay, since the company actually received par for the bonds, not the discounted value.)

As the firm is a distributor, and does not make anything themselves, it should come as no surprise that it operates in a fairly competitive sector with fairly thin margins; their gross margin is 5.2% and their net margin is 0.8%, a situation that is replicated at least in their largest competitor, Ingram Micro (IM). In such a situation, it is clear that competitiveness comes from keeping capital requirements as low as possible, and Tech Data has managed to lower their long term debt since 2007 and also has just concluded a $100 million share buyback and announced another.

As stated above, the company does much of their business in the United States and Europe. They have engaged in several strategic acquisitions in the last few years. It is no doubt a concern that they are so exposed to Europe (between 50 and 60% of their total sales) in a time where the euro is weakening, but as they are resellers, and their inventory turnover period is only 26 days, whatever they lose by selling their inventory in euros is regained the next time they buy inventory. This, coupled with  judicious use of currency derivatives, has historically kept their foreign  exchange losses to a negligible amount.

I am aware that Ingram Micro, their largest competitor, is in much the same situation; their P/E ratio is within half a percent, and most of their other relevant characteristics (net profit margins, sales/assets, etc.), deviate from Tech Data’s by what amounts to a rounding error. However, Tech Data’s sales/inventory is 12.96, while Ingram Micro’s is 11.08, reflective of higher turnover rates. As I stated, with margins as tight as in this business the ability to do more with less is highly valuable (and I will point out that Ingram’s depreciation is equal to its capital expenditures, while Tech Data’s is higher) so although the two firms are so similar I would still give the edge to Tech Data. True, Ingram Micro is more geographically diverse, having made inroads into Latin America and Asia, but I’m not sure how much of that advantage will hold up in the face of competition for those areas either from Tech Data or from third parties.

At any rate, Tech Data offers excellent safety of principal and an enviable free cash flow, and should definitely be considered for portfolio inclusion.

Orient Paper (ONP) seems to have much in common with my other Chinese ideas: A high historical growth rate; a P/E ratio of 9 at current prices, a decent balance sheet, a Byzantine corporate history involving an offshore holding company and this time not even lumbered with a set of unusually high receivables; and being still in the capital building phase; and of course their cash flows are solely in yuan. Return on assets hovers around 20%, and return on equity around 25%, but since the price/book ratio is not particularly promising, and much of their value is made up of property, plant & equipment, returns to shareholders are, as above, still hovering around 11%. Of course, a paper manufacturer needs machinery, but from a defensive standpoint, current assets are preferrable to a large proportion of property, plant & equipment because of the possibility of obsolescence.

Their current product mix is corrugating paper, midgrade offset printing paper, and digital photo printing paper, which are made using recycled paper. They claim to have a competitive advantage of being in very close proximity to their suppliers, as their factory is reasonably close to Beijing and Tianjin, both large cities that consume a lot of paper and run a recycling program.  Their inventory turnover rate in 2009 has been 21 days, which, applied to their first quarter 2010 inventory levels, suggests sales in the next four quarters of approximately $130 million, which at their current margins would produce a forward P/E ratio of 6. Of course, I view such naive projectionism with suspicion, but it is still a tantalizing data point. Digital photo paper, which they have only been producing for one quarter, seems to be a high margin business – gross profit of 66% of total sales if the first quarter’s results are typical. The company also claims to have purchased a larger assembly line to produce a higher volume of corrugating paper, which is being installed over the course of the next couple of quarters. In all, a good picture of a plucky, growing company.

Now, the perceptive reader will note that I used the word “claim” twice in the above paragraph. This is because a certain outfit by the name of Muddy Waters Research issued a report about a week and a half ago suggesting that the company is engaging in a scheme of massive fraud and misappropriation. The company issued approximately $27 million in stock earlier this year to purchase the new cardboard line, but the report claims that the entity that sold them the machines has no device that can produce at the capacity claimed by Orient Paper, and that this money has disappeared. The report also claims to have a filing with the Chinese authorities that Orient Paper’s sales are a small fraction of what they reported, and that they visited the factory in January of this year and found it in a state of dilapidation, without any trucks moving in and out the massive supplies of raw materials and finished paper that the company would have to buy and sell every day. They also claim that the company has turned over their largest customers too many times to produce the kind of sales growth they have. Muddy Waters announced that they had a short position at the time of the report’s release, which must have made them a great deal of money since prices declined from about $9 a share to about $4 and change at one point, although they have now recovered to $7.

The company is not taking this lying down, of course. One of the company’s defenders, and a long holder of the stock, claims that Muddy Waters originally visited them with a view to write a positive report in exchange for hundreds of thousands of dollars in cash and securities, a claim that Muddy Waters denies. Furthermore, the company has issued a comprehensive press release, first noting that Muddy Waters has the report of the Chinese authorities of a company with a similar name, and has produced a faint scanned copy of their own filing that shows the claimed revenue accurately. Muddy Waters has not, to my knowledge, published a copy of the document they obtained. Furthermore, the company claims that they receive deliveries of raw materials early in the morning, and their customers generally pick up their purchases either early in the morning or late in the afternoon, whereas the authors of the report visited in the middle of the day – a glib explanation if false, but perfectly reasonable if true. As for the dilapidation of the factory, one of the company’s defenders claims to have visited the same factory and found it to be untrue.

As for the large customer turnover, Orient Paper claims that their product mix shifted between the 2008 and 2009 annual reports; they used to create high quality offset printing paper that is not made with entirely recycled material, but the soaring price of wood pulp caused them to move to recycled feedstock and produce instead what they called medium quality printing paper, which of course is of interest to different customers.

As for the misappropriation of $27 million, the company claims that Muddy Waters’ contact with the equipment manufacturer must have been mistaken. Muddy Waters claims that the manufacturer’s largest line can produce only 150,000 tons of paper a year and costs $4.4 million, but Orient Paper claims this to be a ridiculous figure, and that they wish they could get hold of this mythical machine, because at their profit margins they could pay off the cost of acquiring it in less than a year. The company claims that the line they actually purchased is a custom job for $27 million and capable of producing 360,000 tons of paper a year (at their current margins it would pay for itself in a little over two years, but they claim it will produce a denser paper that should sell for higher prices (at a cost of more raw materials, obviously)), and that they provided the contract in their SEC filings previously, which provides that payment will be made at various stages of the completion of the installation.

As I hear this story I am reminded of a book called Sold Short by Manuel Asensio, who found a similar fraud, if fraud there be. A company claimed to be able to extract bitumen from Canadian oil stands without using the caustic materials that prevailed  in the established process. Having raised $70 million in capital, the company made a great show of building a factory, and hiring the fitters, plumbers, and factory technicians to fill it up, but when the hype died down they fired most of them, intending to keep on only as many people as would allow them to build a single machine that would produce one barrel of bitumen, which would justify them in their search for the next round of financing. He estimates that they spent $40 million in an effort to make it look like they spent $70, and wondered how much more work it really would have been to have actually built a factory and rolled the dice. It’s an inspiring story, and perhaps it inspired Muddy Waters to make this bold accusation in what is apparently their first public report.

So, where does that leave us who are considering an investment? Ultimately, the sad fact is that the typical investor, no matter how boundless their financial genius, is more or less powerless against fraud. Ben Graham, in Security Analysis, reminds us that bonds are largely homogenized (by credit rating, maturity, embedded options, covenants, etc.), and thus if you reject one bond in favor of a similar one, you will feel no regret. However, with stocks rejecting the right one is often as painful as buying the wrong one. And yet, if there is any indication of fraud, especially with Madoff burning freshly in the public’s mind, the defensive investor might be best served by avoiding risk on this one, at least until the smoke clears. After all, short of traveling to China to check, taking either a long or short position based on the reports of Muddy Waters, who has a big short position, or the company’s defenders at thestreet.com, who are long, seems to verge on rolling the dice. Muddy Waters certainly tells an incredible story, but I suppose most accusations of fraud sound incredible, and there are several Chinese companies (as well as several American ones), that have engaged in such fraud in the past.

However, amid this uncertainty there is a perfectly good way to play this situation, as the uncertainty is entirely binary. Either Muddy Waters is right and the company is worthless, or Muddy Waters is wrong and the company is worth at least the $9 it was trading at before they issued their report. There is nothing in between. And Orient Paper has options trading on it. A long straddle, buying both puts and calls at the nearest strike price of $7.50, was invented by options players for exactly this type of situation.

Either way, someone is getting sued over this. You don’t need an analyst to tell you that.

No doubt all of you have noticed that China has recently unpegged their currency to the US dollar, preferring to key it instead to a basket of foreign currencies. Of course, having a fully floating yuan is pegging it to a basket of foreign currencies; it’s just that the peg is to every currency in the world at whatever weight the international market allows. At any rate, this has caused the yuan to become slightly stronger, although the Chinese government is still in control of all currency exchanges and is keeping volatility clamped down, but it is a positive development for those of us who like domestically-focused Chinese stocks, as the same amount of yuan now translates to more dollars.

China has said all along that they will not be bullied by complaining foreigners, and that if they unpegged their currency it would be to serve their own interests. And this unpegging may indeed have nothing to do with Western agitation and everything to do with China’s needs. We are told that the Chinese economy is expanding and some policymakers are becoming more domestically focused, and this means that China needs concrete, steel, copper, coal, petroleum, and all manner of things, which will be consumed internally rather than be worked up and re-exported. These things are, of course, much cheaper to buy with a strong currency than a weak one. Unfortunately, since the dollar and other currencies become weaker as the yuan becomes stronger, we in the US may find them to cost more, although our own exports will become more competitive as well. In any case, those of us who own companies that have cash flows in yuan should make out very well.

Speaking of which, HQ Sustainable announced Friday that they intend to spin off their marine health and bio-products line, representing about 1/4 of the firm’s total sales but more than half of its gross profits, into a separate company, although the board claims that it will retain 65% ownership. This segment has been the recipient of the bulk of the firm’s marketing expenditures, and much of the firm’s allocations to bad debt reserves has gone to the fish farm business last quarter, although the health products division received most of the reserve increases last year. It has not escaped my notice that many domestic Chinese firms have high and increasing receivables, so it is reasonable that bad debt reserve allocations will be higher than historical levels. I’m not sure if receivables reserve against chargeoffs can be viewed as nonrecurring; on the one hand a weak global economy will mean that chargeoffs are higher than they would be on a normal footing, but with higher levels of receivables come higher levels of reserves naturally, so I’m not convinced that these chargeoffs are nonrecurring enough to be ignored.

As I stated in my last article, the market tends to punish conglomerates of unrelated businesses, on the grounds that diversification for its own sake is generally practiced on the portfolio level and it is superfluous to practice it within a company. The market reacted positively to this spinoff, and the stock went up 10% on Friday, although it gave that back up entirely on Monday. I do like spinoffs, although with the company theoretically giving up 35% of an entirely domestically-focused business the cash flows in yuan may be going to another party. Furthermore, since I view the entire company as dramatically undervalued I worry that the spinoff will result in the firm giving away the new shares too cheaply, thus paradoxically destroying value in a move intended to enhance value. However, if the sales go well, the firm will receive the premium associated with the spinoff and retain control and a large interest in an entity that has its premium unlocked, and 35% of that premium will be in cash.

On balance, then, I think that both China’s liberalization of the yuan and the HQS spinoff  are positive developments for the strategy proposed on this blog.

Investors nowadays have an unhealthy obsession with growth (and by nowadays, I mean since about 1870). I,  for my part, have no objection to growth, but as I have stated, I don’t like overpaying for growth, which usually simplifies to “I don’t like paying for growth.”

But if growth is king, and people are willing to pay daft multiples for it, and even invent a mode of  analysis called “real options” in order to justify even higher multiples (the real options concept is interesting in theory, but attempts to quantify it break down because unlike actual options, real options do not have the rigor imposed by the arbitrage elimination requirement), then a company that has anti-growth is a sort of pathetic phantom of Wall Street, doomed to wander in darkness eternally. But, as Ben Graham said of junk bonds, they exist in large quantities and someone has to own them. And sometimes, that someone should be us.

Deluxe Corporation (DLX) has been in operation for a number of years as a check printer, and checks still constitute over 60% of their income. In addition to generic checks, they also produce, either directly or through banks, checks with licensed characters or associated with causes, such as Disney, Garfield, or the National Arbor Day Foundation. They also sell checks directly to consumers as well as through financial institutions.

Since electronic payments have been increasing in popularity, and and the lowered  pace of economic activity recently has led to fewer transactions in general, their main line of business has been declining by several percentage points annually, and their total revenues have fallen from $1.59 billion in 2007 to $1.34 billion in 2009, although curiously their profit margins have gone up a bit thanks to aggressive cost cutting and control. Furthermore, the bankruptcy and consolidation of financial institutions due to the recent banking crisis have had a tendency to cost them clients, force them into a tricky  negotiating position when a bank that is one of their clients merges with a bank that isn’t, and also forced them to be more flexible in pricing when their contracts are up for renewal, since in banking nowadays every penny must count.

The firm also prints a number of customized forms for businesses, which they claim are often designed against the type of accounting and other records software commonly used by small business, as well as other printed items such as business cards and promotional materials. But with fewer businesses comes fewer forms, and of course form designing software is not so difficult to find these days, so that line is also under pressure. The firm is attempting to expand the range of business services it offers, such as web hosting, logo design, payroll management, and so on, primarily by making small opportunistic acquisitions. For financial institutions they also offer fraud protection and some record keeping and consulting services.

It is laudable that they are trying to become a one-stop shop for small business services (generally speaking, businesses have had bad results diversifying for its own sake (that can be left to stockholders themselves on a portfolio level), but if it is done pursuant to a sensible marketing plan it is at least defensible), but I do not believe at this time that the sectors they are expanding into offer them a great deal of potential for product differentiation. Their CEO was formerly the VP of “retail solutions” at NCR, which may explain the interest in product line expansion–not that I find that trying to get into the CEO’s head to be a fruitful exercise from a value added perspective.

So, that’s the bad news, and as you can see it’s pretty bad. But the next question becomes whether this bad news is priced into the company, and I’m going to say that it largely is. Even if a company is in terminal decline, it may be able to remain profitable and spit out a lot of cash along the way, as, for example,  Qwest and Windstream have despite the decline in use of of land lines in the United States. The firm has a market cap of $1.03 billion, and last year produced GAAP earnings of about $99 million.

However, this figure needs to be adjusted, both up and down, for nonrecurring events. It should be noted that cost of goods sold plus selling, general, and administrative expense, has declined from a total of $1.318 billion in 2007 to $1.117 billion in 2009, and the CEO claims he still has $65 million in costs to cut, although of course, like all costs, these are no doubt linked to revenue-generating activities and cannot be regarded as free money. But at any rate, 2009’s earnings are hampered by $32 million in restructuring charges and asset impairment charges, which are noncash and/or nonrecurring, but which are offset by a $10 million gain on early debt extinguishment, so their real earnings are a bit higher at $121 million. Their real P/E ratio is thus about 8.5. If a 10% return is standard, this suggests that the market is pricing in a terminal decline in earnings of about 1.7%, which is not quite the 4-6% decline in check volume the firm has seen historically since around the 90s but it does show us the theoretical size of the gap  that Deluxe has to fill, and the gap appears to me to be manageably small.

I believe that checks will always be in use by some people, as some people do like tangible records of transactions and not everyone likes either sending or receiving electronic routing information for single transactions, and there is substantial infrastructure built up around them as well as the tendency towards “stickiness” in payment methodologies, so it seems to me that the 4-6% decline may at some point level off. Also, it should be noted that Deluxe is hardly the only check printer exposed to this problem, so there may be opportunities for consolidation among check companies in future, and really I would like to see the CEO focus on that more than, or at least as well as, expanding their product offerings.

The wise value investor, however, does not console himself with rosy projections of the future, so these considerations may produce a bonus down the road but they should definitely not be relied on. But it appears that the firm has produced a reasonable profit margin despite a recession, and it has the free cash flow to pay down debt early. Furthermore, the first quarter of 2010 is promising, actually $5 or 6 million, or about 20% higher, than the first quarter of 2009 on my estimate of a comparable basis, and which translates to full year earnings of about $1.3 million, which produces a P/E ratio of 7.7. The firm and its analysts both expect the fall in revenues to arrest itself by 2011, but of course, they are paid to be optimistic. Depreciation and amortization of intangibles have exceeded capital expenditures, but on the other hand the company’s strategy does seem to involve future acquisitions so this should not be looked on as a source of free cash flow.

The firm’s balance sheet is not particularly robust, loaded as it is with goodwill and intangibles, but on the other hand it is not unusual for a balance sheet to look a little empty when capital expenditures are depreciated and not replaced, or for an acquisitive firm to carry a lot of goodwill. Non-replaced depreciation is the source of a lot of declining companies’ ability to spin off excess cash flow, and Deluxe has closed down 9 facilities since its cost cutting began. The firm’s interest requirements were covered five times in 2009, and fully 6.5 times in the first quarter of 2010, so it does not appear that the decline in business is likely to produce financial distress at this time, and it is the specter of financial distress that often causes the low valuations of declining companies to turn out to be perfectly accurate. The firm pays a 5.1% dividend which I believe to be more than adequately covered.

In sum, at current prices I believe that the investor in Deluxe Corporation is getting at least what he or she paid for, and the possibility of Deluxe arresting the decline at some future point would make this a reasoanbly attractive opportunity at this price and even more attractive should the price decline further.

As you may recall, I recommended Chiquita Brands a couple of months ago, and since then it has gone down from 15.17 to 13.58 today, or down about 10%. So, not really my best work, I suppose, but an economic crisis in Europe, where Chiquita Brands performs 40% of  its operations, would naturally dampen enthusiasm for the share price. However, Chiquita did reiterate its $100-120 million estimate for next year’s earnings during their latest conference call, which at current prices translates to a P/E ratio of 5, although to be fair that projection was before the sovereign debt panic and the Euro hitting 1.2o. But, even if the company misses that estimate by a full 50% an investor at these prices would acquire a kosher 10% return on his or her money.

This view was echoed in an interview published by The Wall Street Transcript, where Scott Mushkin, a senior research analyst at Jeffries & Company, concluded that, based on current prices, “you are getting the company for the value of the salads business, and so you’re getting the banana business for free right now,” and that the euro situation has largely been priced into the company.

http://finance.yahoo.com/news/Chiquita-Brands-International-twst-2469784650.html?x=0&.v=1

Now, value investors are noted for being able to operate independently of Wall Street opinion, but it is still gratifying to me to receive some confirmation.

Furthermore, Chiquita has been paying down debt at a fairly rapid rate, as total liabilities shrank $160 million in 2009 and $240 million in 2008, which is acting to improve their interest coverage ratio, which improves their credit rating and cost of borrowing and also enhances the safety of equity holders. They are also benefiting from Europe’s liberalizing of their banana tariff scheme.

And, as a final recommendation of Chiquita Brands, on June 3rd the company’s CEO, Fernando Aguirre, announced that he had acquired 40,905 shares of Chiquita Brands, and the transaction code on the announcement was “P”. “P” is what you want to see; it stands for “purchase”, as opposed to a grant from the company or some other method of acquisition. “P” means that the CEO purchased the stock with his own money. And as Peter Lynch noted:”  There are many reasons why insiders sell, but only one reason insiders buy.”

I am frequently surprised by the places where I find promising looking stocks, but really I shouldn’t be. Value can theoretically be found in any sector, although the newer and developing sectors are unlikely to hold much in the way of reliably underpriced stocks, since there is so much unpredictability in the future course of sector developments. Very often highly fragmented sectors resolve themselves into an oligopoly, with all the other firms either bankrupt or acquired by the winners, and without any indication of which companies will eventually land on top, it is often better to look for a more established industry. And what could be more established in American society than greeting cards?

Anyway, last Mother’s Day I recall being struck by the price of greeting cards these days. I didn’t look into it immediately, but I was flipping through the Value Line Investment Survey, as I sometimes do, and I ran across a promising company called American Greetings Corp (AM), which is the largest publicly traded greeting card company in the US. They also do a line of gift wrap and other products, and presently control the Strawberry Shortcake and Care Bears properties, although I should mention they were attempting to sell their interests in these properties before the economic collapse. These deals seem to have fallen apart, spawning a couple of lawsuits in their wake, one of which has been settled fairly recently.

In terms of numbers, it has a P/E ratio of about 10, and earnings have remained fairly robust over the last few years, although in 2009 they took a large goodwill writeoff. They also recently sold off their retail operations, while retaining the rights to supply these stores, which should lower their operating expenditures in future. The firm has recently engaged in several acquisitions, which seem to have gone well so far, but it does mean that their spending on new capital acquisitions has often exceeded their depreciation and amortization charges, although this trend was reversed last year.

One of their more impressive acquisitions, at least to me, was buying out Recycled Paper Greetings by purchasing their bonds at a large discount and then taking control of the company as a result of Chapter 11 proceedings, a bold move but one out of Moyer’s most excellent Distressed Debt Investing.

In the last three years, the firm has managed to buy back over $250 million in stock, which is nearly 1/3 of the current market cap. In terms of balance sheet, the firm has a price/book ratio of 1.35, but because they use LIFO inventory, which tends to understate inventory value, so the real situation might be a bit better. However, their balance sheet does indicate more than $400 million of “other,” and one hopes to see something a little less opaque.

I’m not sure that I see much growth potential in the company, barring an acquisition (although the company’s management seems to show the right degree of opportunism in acquisitions), but the firm’s income is stable, reliable, and above all, large enough to produce an adequate return on an investment, and as such it seems like a reliable long term holding. And I don’t see the greeting card becoming obsolete anytime soon.

It has been observed by me, and possibly other people, that free cash flow, more than earnings, is a correct measure of an equity investor’s true returns (free cash flow is earnings plus depreciation minus capital expenditures). The logic behind this goes back to Benjamin Graham’s notion of calculating true earnings; he said that before a corporation should be deemed to have earned money, it has to maintain its own earnings power. Depreciation is a convenient proxy for loss of earnings power, but the linear decline of depreciation does not take into account the definitely nonlinear rate that most  capital assets wear out and there is definitely some degree of kurtosis in the data, as large capital expenditures tend to be made all at once. Of course, the free cash flow approach does not deal with the real problem of sudden obsolescence, but neither does the linear depreciation model.

It therefore follows that if the cost of maintaining the old earnings power of the capital has gone up, owing to, perhaps, more stringent environmental regulation, an increase in the cost of materials in making the machines, etc., then the old depreciation figures do not fully reflect the cost of replacing the capital in order to replicate earnings power. Likewise, if technological progress has made the capital assets cheaper, as often happens, then depreciation comes to be overstated.

However, there is a difference between capital expenditures intended to maintain earnings power and those intended to expand the business. This is the difficulty in valuing the domestically-focused Chinese firms that have interested me in the past, as has been observed by American Lorain‘s own CFO, who cited as an excuse for his firm’s negative free cash flow, “this past year we have been building out the factory lines for the expansion into the convenience food segment.” Unfortunately, few firms are willing to provide information sufficient to divide maintenance capital from expansion capital, which is baffling since American Lorain itself can state the problem in a single sentence.

So, when we have a company like Qwest that has maintained its earnings at roughly the current level for the last few years despite the fact that depreciation has exceeded capital expenditures, we may conclude that the firm, owing to lower replacement costs, historical overinvestment, or a changing strategic focus, does not need to replace the full amount of its depreciated capital in order to maintain earnings power, and thus its free cash flow is really free.

But, does free cash flow apply only to depreciation and amortization? What about other noncash expenses, like the depletion of mines and oilfields? After due consideration, I have had to conclude that depletion is not free cash flow. The point of free cash flow is that it is distributable, but depletion is meant to indiate the loss of reserves from a given property. Even if the firm earns an excellent profits on its resource extraction, if it distributes the depletion allowance as well it will have nothing to acquire new properties when the old ones are exhausted.

Therefore, in assessing whether a firm’s distributable income is actually free cash flow, watch out for excess depreciation coupled with loss of earnings power, or distributed depletion allowances in any event.

I suppose that my loyal readers are tired of hearing me going on about cheap Chinese stocks, but value investors have to go where the value is. Some Chinese stocks, small and overlooked, seem to show up on my screens more often than I would expect considering the China cult, and although HQ Sustainable Maritime (HQS) doesn’t have quite the built-in bet on China’s floating its currency, it has some compensating factors. At any rate, recent events have made China floating its currency a little less likely.

I suppose the currency situation merits a digression. The basic thesis of the Chinese currency bet, as I’ve stated, is that China’s currency is being kept artificially weak so that they can boost their export trade, and that international pressure is on them to let their currency float. Unpegging China’s currency to the dollar will mean it takes fewer yuan to produce the same number of dollars, so an American receiver of Chinese cash flows will benefit. However, because of the Europe situation, the dollar, and consequently the yuan, are already stronger, without China having to unpeg a thing. Since China’s economy is so export-based, the internal pressure not to unpeg the yuan, or even to further weaken it, will be fairly intense and therefore the possibility of a floating yuan has been made more remote. Still, I guess we could always run the price of oil up to $140/barrel to shake them off again.

Anyway, HQ Sustainable Maritime Industries raises tilapia and other seafood for export to Europe, Japan, and the US, and they also make health products out of shark cartilage and other marine materials for the domestic Chinese market. Approximately 2/3 of their income is from exporting tilapia, and 1/3 from their health products, which means that they have some exposure to a floating yuan. They also have a P/E ratio of about 9, which considering the higher equity risk premium in China, is reasonable but not screamingly cheap, although they are looking forward to future growth.

But HQ Maritime has the advantage on its balance sheet of being a net-net stock on an unadjusted basis; as of this writing the market cap is $80 million, and the company has $38 million in cash, $57 million in receivables, and $2 million in inventory against $8 million in liabilities, totaling $91 million in current assets. However, those receivables ought to be discounted for the possibility of uncollectability, particularly since receivables have been increasing dramatically over the last year. It is also not clear how the firm has $23 million in quarterly sales from $2 million in inventory; they may be pulling the GM trick in reverse (GM always paid their dealers bonuses the day after the end of the quarter to make their cash balances look bigger, so perhaps HQ makes a huge push to sell their inventory before the end of the quarter to perform a similar form of window dressing). Or it could be the natural effect of last in, first out inventory accounting coupled with a high turnover rate, I suppose Even so, the balance sheet is fairly attractive.

The firm also has 100,000 shares of preferred stock that is largely in the hands of the firm’s management. The preferred stock is convertible into half as many shares of common stock, so from a purely accounting standpoint it knocks about $275 thousand off the price. However, the preferred stock is entitled to 1000 votes per share, giving the holders of the preferreds unassailable control of the company. This arrangement is not unusual outside of the first world, or among certain new companies, and although it sounds less than ideal, Damodaran reminds us that the value of control depends on how well the company is run; if management is generally competent the minority shareholders do not suffer because the management is entrenched because throwing management out and then running the company exactly the same way produces no change in the company’s value. However, it must be admitted that the management seems to be more willing to make convertible debt offerings and other dilutive financing arrangements.

On balance, and assuming that the accounting for receivables and inventory is reliable, it seems to me that HQ Sustainable Maritime is a desirable company, reasonably priced under pessimistic assumptions, and with both growth potential and partial exposure to a floating yuan in its favor.