Fructivore Investments

A new year is upon us, and with it, a new set of investing opportunities. Actually, most of them are the same opportunities that existed last year, but the prices have changed and that makes all the difference. Actually, I have been noticing lately that I have been finding fewer attractive opportunities, as a result of a continuing stock market advance. I have been selling certain positions, including Linn Energy and Qwest, and not replacing them. I would rather incur opportunity costs than risk losing money by lowering my standards.

However there remain some opportunities out there on an absolute as well as a relative basis. One of them is Smart Modular Technologies (SMOD). Smart Technologies makes memory modules, particularly DRAM, and also makes solid state products including hard drives and embedded flash devices. They also perform design work to facilitate integration of their products into their clients’ products, and provide other services such as supply chain management and other services relating to their products. Their current operating focus seems to be moving into Brazil.

The company’s operating figures paint an attractive picture, with a P/E ratio of 7.3 and a market cap of $373 million. HP, Cisco, and Dell have collectively accounted for roughly half of their sales. Obviously, as they provide for the consumer and enterprise markets, their sales have been fairly volatile, having increased 59% for fiscal year 2010 as compared with 2009, while 2009 sales decreased 34% from 2008. Volatility in DRAM prices also produces a great deal of volatility in sales, and as Smart has recently announced a continuing drop in DRAM prices that is affecting them and all their competitors, which is weighing on their future prospects.

As Smart has cyclical operations, it is difficult to think of a particular year as representative of overall earnings power. As a result, it may be more appropriate to examine what their overall margins have been over the last few years. Gross profit margins were 17.4% in 2006, 17.7% in 2007, 17.9% in 2008, 20.4% in 2009, and 23.6% in 2010. In terms of operating expenses, lately R & D has been up from $15 million in 2006 to $25 million last year. The last five years have also included various nonrecurring or noncash events such as goodwill impairments and restructuring charges. If we remove them, as well as general and administrative costs, we have operating margins of 7.7% in 2006, 8.7% in 2007, 5.9% in 2008, 3.3% in 2009, and 11.5% in 2010, and an average level of 7.4%. Interest has been covered amply in every year, and as Smart Technologies operates in a number of taxing jurisdictions their tax rates have frequently deviated from a kosher 35%. Based on projected sales of roughly $700 million, this produces projected operating earnings of roughly $52 million, which, after roughly $5 million in interest payments and taking out a third for taxes, we have theoretical income of roughly $32 million.

Now, I don’t mean to project that Smart Technologies will actually have net income of $32 million next year, or any year, for that matter, but that is, I think, a fair estimate of their earnings power based on the current situation. Furthermore, given that their five year history includes 2008 and 2009, there could be an argument that the five year averages are lower than their true earnings power, and as a result we could perhaps justify some optimism. At any rate, $32 million set against a $373 million market cap is an earnings yield of 8.6%, which is reasonable, if not particularly attractive. Also, depreciation has been more or less tracking capital expenditures, so there is no additional source of free cash flow.

What makes this company intriguing, though, is its strong balance sheet that is heavily tilted towards current assets. Based on their recent results, they have $93 million in cash and $179 million in receivables, as well as $103 million in inventory, total $375 million. Total assets come to $482 million, and they have $163 million in total liabilities, of which $81 million is accounts payable. This high level of cash and receivables should give buyers confidence that the existing value is safe. Although their inventory, or at least the DRAM part of it, is somewhat volatile and could be subject to write-downs, the fact remains that current assets minus total liabilities comes to $212 million, more than half of the current market cap.

As I stated before, they have recently been focusing their operations on Brazil, and indeed non-US sales represent more than 70% of their total sales. This may be an attractive trait for investors who wish to avoid exposure to the dollar.

The results for the first quarter of fiscal year 2011, which ends in August, are in line with 2010’s excellent results, with nearly $8 million in reported earnings, or $32 million per year. They claim that there was an infrequent and nonrecurring expenditure of $7.5 million for a “technology access charge” for technologies they will be using in their development of solid state products. Now, this amount may be nonrecurring in that they probably do not intend to incur this particular expense again, but it may be recurring in that they will incur technology licensing fees in future. At any rate, this expenditure is directed towards developing more solid state products. Now, on the whole, companies that run diversified lines of business for the sake of diversification alone tend to have their schizophrenia punished by Wall Street, and my holding of Seagate may indicate that I am skeptical that solid state is the inevitable wave of the future–and if it is, it is still hard to tell who will ultimately be the victor. However, it may be in Smart’s interest to lower its exposure to the volatile DRAM prices that caused it to lower its estimates for the year. At any rate, first quarter results do confirm my existing assessment of Smart’s earnings power.

As a result, I can say that Smart is a well-positioned, safe, and reasonably high yielding company with a solid position, and therefore should be considered for portfolio inclusion.

I find very often that I seem to be the one who is interested in the investments I’m interested in. Certainly that is true of the River Rock and Mohegan casino bonds, where I seem to be the only person on the Internet who has even considered their investing attributes. So, when I find people actually looking at the kinds of things I look at, I feel a combination of gratification that my views are common, and concern that perhaps my investing thesis is too popular and has already been priced in.

Recently there has been a spate of articles about Supervalu (SVU), a supermarket chain and grocery wholesaler that has been going through some difficult times lately, partly as the result of an acquisition of Albertson’s that imposed a high level of debt (you may recall that Damodaran demonstrated in his useful Investment Fables that more than half of all mergers fail to add value), and partly because of an overall decline in sales. Although some of this can be attributed to the slow economy, the decline has fallen lower and lasted longer than many of Supervalu’s competitors.

The effect of these results on their stock price has been dramatic.  The company has a P/E ratio of 4.67 after adjusting for a goodwill writeoff, and their free cash flow picture is even more attractive. But on the other hand, they have a high debt burden that they are whittling away at but which is causing some concern about interest coverage issues, the decline in sales has of course led to a decline in profits, and presumably there is a limit to how low they can cut capital expenditures.

Supervalu saw a decline of about 10% of sales between fiscal year 2009 and 2010, but as some of its stores have been closed or sold off, same-store sales have declined by about 6.7%. Setting aside a goodwill writeoff, reported operating earnings have declined from $1.4 billion in 2009 to $1.2 billion in 2010, a decline of about 15%, which follows a similar proportionate decline from 2008.

Supervalu’s interest requirements of $576 million that year were thus covered by earnings a little over twice, but the company also has $150 million in operating leases, and at least some fraction of that should be considered interest rather than an operating expense for calculating coverage of fixed charges. This would lower the fixed charge coverage ratio. Offsetting this inclusion was a depreciation and amortization charge of $950 million but only $680 million in capital expenditures in fiscal year 2010. This level of capital expenditures is lower than the historical averages, but as the company is closing stores and reexamining its operations I think we can take reduction in capital expenditures as a somewhat permanent feature. This amount improves the interest coverage by another .5x, and it ultimately produces pretax cash flow to equity of approximately $900 million, or about $600 million after taxes, for 2010. This money, plus any proceeds of divestment, are available for paying down debt, and this what Supervalu has been doing–$900 million in 2009 and an additional $360 million year to date 2011.

Speaking of fiscal year 2011, year to date sales are down a bit less than 10% over last year, and operating income is down about 15% again, $504 million as compared to $607 million last year. There is an additional $188 million in excess depreciation as compared to $119 million last year, as Supervalu has apparently ratcheted down capital expenditures further. So, free cash flow to the firm is reduced by less than sales, at $692 million year to date this year and $726 million year to date last year. However, year to date capital expenditures dropped by 21% as compared to last year, and I am not sure how much capital expenditures can be cut without seriously affecting long-term earnings power, or whether the firm’s management has any better awareness than mine. At any rate, interest year to date is $303 million, producing interest coverage of 2.28x and pretax free cash flow to equity of $389 million, or roughly $260 million after taxes. On a full-year basis this translates to $520 million in free cash flow to equity and a price/free cash flow ratio of 3.61.

It is clear the the market is anticipating future declines in free cash flow, as shown by the market prices of Supervalu’s debt. As a result of the Albertson acquisition and certain other capital structure issues, they have a large number of debt issues outstanding. The notes due in 2012 sell at above par and a yield to maturity of 6.1%. However, the notes due in 2014 sell at below par with a coupon of 7.5% and a yield to maturity of 8.6%, and the notes due 2016 also sell at below par with a coupon of 8% and a yield to maturity of about 9%. In all, nearly half of Supervalu’s $6.6 billion in debts falls due within the next four years or so, and with free cash flow declining it is not clear that Supervalu can pay down this debt out of their cash flow, and may be forced to tap their credit facility, which will have $1.128 billion available in borrowing capacity, or rolling the debt forward at what current market sentiment suggests would be a higher interest rate. They could also provide for debt repayments out of asset sales, an area that the firm is also exploring. However with the aggressive repayment of debt that Supervalu is pursuing, in the space of a few years assuming that nothing derails the plan, Supervalu’s debt could be whittled down to a more manageable level.

The company claimed in its most recent earnings call that there were signs that same-store sales declines were decelerating. However, to assume that the 3.61 price/free cash flow ratio is at all meaningful, we must assume that management is ultimately capable of arresting the decline not only in same-store sales, but in total revenues, which would require their divestitures and store closings to run their course, and also of avoiding any disruptive credit issues like a bad refinancing or having to renegotiate their debt covenants. Even so, if the 3.61 price/free cash flow ratio is a permanent feature, we can calculate that the market is pricing a permanent decline in free cash flow to the firm of 17.7% a year, as a firm’s earnings yield assuming a stable growth (or shrinking) profile should equal the required return on equity (10%) minus the company’s growth rate (here negative).  I find this outcome is unlikely considering that the decline in free cash flows is already slower than that.

The real risk that concerns seems to be is that future developments will push the firm into distress and liquidation. As Damodaran reminds us in the chapter on declining companies in his useful toolkit, The Dark Side of Valuation, which contains advice for valuing companies in various states of their life cycle including the distress situation, it doesn’t matter how pessimistically we discount for earnings in year 5 if the company risks liquidation in year 2. Although the debt situation is stable, the decline in earnings has not been arrested and anyone purchasing Supervalu is probably going to have to assume that revenues and earnings will flatten and possibly even recover at some point in the future.

The prudent value investor does not rely on future projections that such an event will or will not occur, but as long as the company can continue its rapid pace of paying down debt, the company’s situation seems to be improving with each passing quarter. The company’s cash flows will definitely support the current levels of equity and debt, although interest coverage is lower than one would normally like to see. As a result, I can say that Supervalu is an attractive candidate for portfolio inclusion as it has a large upside and is still selling at a price far below the decline in earnings. However, as investing in this company requires a certain optimism, or at least not-pessimism about the future, there is a speculative element introduced that prevents this firm from being a pure value investment.

Behavioural Investing by James Montier is a weighty book with much to tell us about an aspect of investing that has long been overlooked. Behavioral investing, of course, is basically determining why market participants do not act in a manner consistent with the fancy equations of the financial economists, as they frequently don’t. Of course, overreliance on these equations was a major contributor to the subprime crisis and the blowing up of any number of individual market participants even in good times.

Now, no one would describe his or her investing style as “behavioral,” but all fundamentals-based investing styles are ultimately behavioral in that they believe that the market is generally incapable of pricing certain companies properly. Growth investing assumes that markets underprice growth (a ridiculous view; if there’s anything markets overprice, it’s growth), and value investing assumes that markets misprice everything, but especially lack of growth. Montier himself follows a value approach, which gives his book a pleasing smugness that we value investors are accustomed to.

Much of the book contains details of psychological experiments, many of which have nothing to do with finance or markets but that reveal useful information about human psychological biases. Most important is the conclusion, borne out by experiment after experiment, that giving people more information tends to make them more confident about their conclusions but almost never more accurate. Those of us who don’t have a department full of equities researchers should be comforted by that view. Furthermore, people tend to confuse confidence with ability, which makes, say, talking to management a dangerous distraction.

He also has experiments dealing with market professionals that showed that the slightest bit of uncertainty inevitably produces bubbles. He described a game with a hypothetical “stock” that had equal probabilities of paying one of four dividends for a number of rounds, with the company being liquidated at the last dividend. Obviously, it is possible to calculate the expected value of each dividend and play the game accordingly, but he found that only graduate economics student actually played the game that way. First year business students managed to create a bubble that peaked at over 30 times the correct value, a result that was only beaten by CEOs, who created a peak at over 50 times the correct value. Think about that the next time the CEO of your favorite company announces an acquisition.

The meat of the book, though, deals with how these psychological biases and other typical market behaviors affect market performance, and in here there is much useful data to be found. He takes on the statistic that most mutual funds fail to beat the market by showing that most mutual funds have become passive indexers with a portfolio with over a hundred stocks that, coincidentally, belong to their target index. Such companies, he demonstrates, will automatically fail to beat the index by roughly the amount of their management fees, as expected. However, mutual funds that actually try to pick stocks have a tendency to earn their fees and more. He also includes an article showing that companies that are being sold by institutions do better than companies being bought by institutions, as institutions are more likely to sell companies with value characteristics like poor liquidity and low historical growth.  All of these are amply supported by historical data.

One of his interesting points is that value investing can be looked at as “time arbitrage.” I know that in a world dominated by the efficient market hypothesis, successful value investors should not exist, so one wonders if the concept of arbitrage is the only way their existence can be justified to the efficient marketeers. However, he also found that time is the friend of value investors but the enemy of growth investors. At any rate, a major behavioral bias is that market participants have no patience either for short-term losses or waiting for profits, and that people are not instinctively capable of sorting out complex cause and effect. A shabby stock that has a compelling story attached to it is much more attractive than a compelling value stock without one. Also, he found that fund managers who have done well, with three years of outperformance that has catapulted them to a better job, tend to show no outperformance afterwards, while fund managers who have been fired for incompetence tend to beat the market after they find a new job. Clearly, this is a demonstrated inability to deal with probabilities and to assume that something as complex and difficult as the markets is a deterministic process.

At any rate, the list of biases is long and difficult to categorize, since he stated in the outset that the book was written for an audience of professionals who may not have the time to sit down and follow the complicated threads of an argument through an entire book, so the chapters are brief and pretty much always self-contained essays. Of course, Charlie Munger says that he has never known anyone successful in a field that requires broad knowledge who does not read pretty much all the time, so one would expect these professionals to make time. But as behavioral investing is a broad and discursive field of study, the book probably benefits from keeping topics separate and not attempting to create a unified theory.

In all, I would say that the book is a useful guide to identifying biases that we bring to the markets and to exploit the biases of others. I should point out that many (but not all) of these mistakes can be summed up as failure to employ value investing, but that could just be a confirmation bias on my part. Montier’s Behavioural Investing would be a useful addition to any investor’s library.

Some people think the reason for value investing’s unpopularity is that it’s pretty boring. No excited conversations with analysts, no being wined and dined by management, no building of gleaming, elegant, projections going years into the future; just you and your calculated value to compare to market prices. However, this approach led me to buy Windstream (WIN), which I originally picked up in May and June of 2009 when the market was recovering, at an average price of about $8.60, and with the current price of $14 I’m sitting on about a 60% gain plus having taken down an 11.5% yield for the last year and a half. I don’t actually consider that boring, but I am reliably informed that these results aren’t typical, although there’s no reason why they shouldn’t be.

But I’m not writing this just to brag; the fact that Windstream is now at the highest price it’s been for some time and I need to consider whether I should get out or not. Certainly Windstream offers one of the highest dividends in the market that I view as stable and sustainable and so the question might be asked if I get out of Windstream what would I put my money into instead? However, there is no shame in holding cash until a better opportunity comes along, and a stock should cheap on its own merits and not simply as compared to something else.

Now, a high dividend payment is indicative of earnings stability, as the market tends to punish the prices of companies that cut their dividends (although counterexamples can be found in 2008), and managers are aware of this. However, I view high and sustainable free cash flow as a sine qua non of an equity investment, not a bonus, and so I would be unwilling to attach a premium to it.

The free cash flow picture of Windstream is complicated in that they have gone through many acquisitions of smaller companies recently, most of which have been privately held and therefore have no publicly available financial statements, and the summarized financial data do not give sufficient information to calculate free cash flow, regardless of synergy. The new and undigested acquisitions may have something to contribute to earnings, and certainly give rise to integration costs that should be viewed as nonrecurring.

So, in 2007, free cash flow net of nonrecurring costs were $610 million. In 2008, the figure was $604 million. In 2009 it came to $594.7, and in 2010 year to date it comes to $503 million, which is $670 million on an annualized basis. Of course, Windstream has issued a number of shares to pay for its acquisitions, so free cash flow per share has not necessarily improved.

Currently, there are 483.5 million shares of Windstream outstanding at a price of $14 each, producing a market cap of $6.77 billion. This is a multiple of almost exactly 10x current free cash flows. Ten times earnings I consider a fair price, not necessarily a cheap price to pay, particularly as I am skeptical about most growth opportunities to the point that I generally try to avoid projecting any growth at all in order to justify a purchase. Of course, in this low interest rate environment a high free cash flow yield like Windstream’s might justify a higher multiple, but such a view easily sets off a slippery slope.

So, I am not inclined to sell Windstream yet, but I would consider selling if the price moves significantly higher.

It appears that Seagate (STX) will not be taken over after all, as it has rebuffed its
buyers for not meeting their price. The stock price seems to have taken this
development in stride, dropoping only 3.25% today. However, the market’s incurable
impatience had already caused the price to drift down from the $15 level it had
reached after the buyout was announced. But the question remains of what to do now.

It would not surprise me if the price fell even lower, particularly as there seems to
be a gloomy sentiment hanging over the market. Actually, Seagate is headquartered in
Ireland, which doesn’t seem to have entered the public’s consideration but one never
how the investing public’s mind will choose to connect the dots in future. At any
rate, I do not feel that this event is a setback, as my investment thesis for Seagate
never centered on its being a buying candidate. I simply identified a company with a
free cash flow yield of about $1 billion per share, with an extra billion in cash on
the books, selling for what was at the time about $5 and a quarter billion.

At this time, the first quarter 2011 cash flows were below the historical trends, as
capital investments and operating expenses were both higher than the historical
results. I do not feel that a single quarter’s results affect the analysis that much,
but I think some monitoring of the situation is in order. But leaving that aside, the
company is still selling for $6.34 billion, which is a P/E ratio of 6.3. And, as
their levels of cash on hand are roughly $1 billion over their historical level, the
prospective yield is even higher.

On the other hand, the market seems to have decided that solid state drives are the
wave of the future and that anything that is not solid state is doomed. Of course,
Seagate has some solid state products. Moreover, it seems to be the trend of all
storage devices to inevitably become cheaper, so it may be that a conservative
earnings multiple would be lower than for most companies. Even so, I think that six
is too low for one of the two leaders in the hard drive industry.

The firm did announce a $2 billion share buyback, presumably in order to soften the
blow. As the stock is apparently underpriced, it is probably as well for the company
to buy back shares while they are cheap. Even so, I think of share buybacks as a lazy
step for management, who can think of nothing to invest their money in but who for
whatever reason are unwilling to commit to a dividend. Still, the high and fairly
stable cash flows of Seagate are attractive to me, and I am definitely not going to
sell based on this announcement.

Netsuite is a company that produces an integrated suite of business applications for medium sized businesses. Within this core area they also produce industry-specific applications, and also a platform that allows for customer-driven development. The company was born in 1998 and seems to have brought some of that era’s valuation with it, as the company has a price/sales ratio of 8.75 and a price/free cash flow ratio of about 170. Revenue growth has been very impressive, increasing from $17.7 million in 2004 to $166.5 million in 2009. However, this growth has not yet produced any tangible benefit to the shareholders, and one wonders when the shareholders will run out of patience.

The company has an impressive rate of sales growth, but this revenue growth has not translated into increased earnings. To be precise, this revenue growth hasn’t translated into earnings, period. As James Montier noted in his excellent Value Investing, a low price/sales ratio doesn’t necessarily mean a cheap stock, as the metric does not take into account capital structure or profit margins.However, a high price/sales ratio is a sufficient indicator of an expensive stock, since no capital structure or realistic margins will produce the earnings necessary to justify the price. At 8.75, Netsuite’s price/sales ratio is one of the highest to be found in the U.S. market.

Turning to the earnings picture, it is normally helpful to use a proxy for free cash flow, which is earnings plus depreciation minus capital expenditures. Looking at this measure, we find that Netsuite actually isn’t producing any free cash flow. In 2007, Netsuite reported earnings of -$23.9 million, took $3.4 million in depreciation and amortization, and made $4.6 million in capital expenditures, resulting in free cash flow of -$25.1 million. In 2008, Netsuite reported earnings of -$15.9 million, took $6.9 million in depreciation and amortization, and made $7.3 million in capital expenditure, producing total free cash flow of –$15.5 million. In 2009, reported earnings were -$23.3 million, plus $10.7 million in amortization and depreciation and minus $6.1 million in capital expenditures, producing estimated free cash flow of -$18.7 million. Year to date 2010, the figures are no better despite the continuing trend of sales growth. Reported earnings for the first three quarters are -$21 million, plus $9.3 million in depreciation and amortization, minus $4.7 million in capital investments, total -$16.1 million, which would be -$21.4 million on an annualized basis.

Of course, it should be noted that much of the reported earnings losses spring from the fact that Netsuite is very good at handing out stock-based compensation. Given the high share price of Netsuite it is probably good for the company to hand out stock instead of cash, but from a shareholder’s perspective dilution is still dilution. If we set that aside, and add back in all the stock-based compensation, we find that in 2007 the company would still have earned -$7 million in 2007, -$4 million in 2008, $2 million in 2009, and $7 million year to date in 2010–equity-based compensation, at $23 million year to date, is more than 50% higher than it was last year at this time. It is not immediately clear to me what is the benefit to the shareholders from handing out stock-based compensation at a higher rate than the cash generation that the management is being compensated for, but that is the Board’s decision and they show no signs of changing it. At any rate, even if we neglect dilution, $7 million in cash flow is about $9.3 million on an annualized basis, and weighed against the company’s current market cap of $1.61 billion gives us a price/cash flow ratio of 173, a figure that strikes me as rather high.

I suppose that Netsuite’s sales growth may eventually produce better returns, and perhaps even positive earnings. Also, perhaps the last three years have been bad times for businesses to make major new investments (not that Netsuite’s 2005 and 2006 figures have shown positive earnings, either).  But it seems to me that Netsuite’s current valuations can only be justified by wildly hopeful expectations.

And as to this rosy future, I will also note that in the 2009 10-K the company noted that “As a result of continuing losses, management has determined that it is more likely than not that the Company will not realize the benefits of its domestic deferred tax assets and therefore has recorded a valuation allowance to reduce the carrying value of these deferred tax assets to zero.” As the company discloses elsewhere in the same document, the operating loss carryforwards expire between 2018 and 2029. This means that, as they are fully written off, the company is saying that it cannot be more than 50% sure that it will achieve profitability under the Tax Code even by 2018 or later. Obviously, these projections are subject to revision, but this should be a sobering thought for those who are optimistic.

As a result, then, I can say with confidence that Netsuite is not presently generating anywhere near the results they need in order to justify their current market price, and I can recommend them for consideration as a short selling candidate.

Hugh Hendry, the hedge fund manager and inflation skeptic whose views I have always found informative and interesting, sat on a panel at a conference last February called the Russia Forum. I finally found footage of the full panel. On the whole, he was his usual opinionated self, but he did shed some light on the China situation. Although the remarks are months old, I think his views are entirely applicable today.

The panel, chaired by Marc Faber, consisted of himself, Nassim Taleb (author of Fooled by Randomness and The Black Swan), Michael Gomez of Pimco, David North of General Investment Management, and Michael Powers of Investec, were asked whether or not China is a bubble. Nassim Taleb, in his usual style, said that if people were looking for the “hot” growing country to invest in in 1900, they would have picked Argentina before the United States and so things are really only obvious in hindsight. Hugh Hendry, more willing to put his sense of pattern recognition where his mouth is, answered a definite yes.

His grounds were that a nation that is simultaneously a large foreign creditor and running a trade surplus comes to a bad end unless one or the other of those things changes. It creates a massive asset bubble that ultimately leads to a deflationary depression. China is in that situation now, he says. Japan was in that same situation in 1990, and, strange though it is to think of the United States as a creditor nation, it was in that same situation in 1929.

Of course, correlation does not imply causation and this could all be an interesting coincidence, but the proposed mechanism makes it a plausible hypothesis. Obviously a nation that is a large foreign creditor and that has a large trade surplus winds up with a huge amount of cash bouncing around its economy beyond what it requires domestically. This creates a pressure on the extra money that should push it back out into the world, as the people of the country spend it on foreign goods and services. Ultimately, this turns the trade surplus into a trade deficit fairly rapidly. If, however, this natural process is obstructed by economic forces or explicit government policy, that money has nowhere to go except into pumping up domestic asset prices.

Although it is further back in history than Hendry would go, Spain and Portugal had a similar problem. Adam Smith records that because of their possession of the very productive gold and silver mines of their American empires, massive amounts of money flowed in. However, mercantilist ideas of the time equated the wealth of a nation with the amount of gold and silver in it, and so the countries banned or imposed an export duty on the two metals. As a result, Smith writes that Spain and Portugal were “the two most beggarly countries in Europe.” Adam Smith likens this process to building a dam; if you dam a river without altering its course in any way, the water will eventually overflow the dam and keep flowing exactly as it did before; there will just be created a lake of liquidity deep enough to drown in.

In the United States, Hendry claims that the gold standard prevented that money from going abroad (and much of Europe at the time had little for the US to purchase), a situation that a modern floating exchange rate would prevent. China, of course, does not have a floating exchange rate. In fact, not only does China use a fixed rate, but it actually forces its exporters to surrender their foreign currency in exchange for yuan at the government’s official rate. That money ultimately winds up in the hands of China’s central bank, which adds it to the bottomless pot of foreign reserves. The alternative, as I stated, is that the exporters could use that money to purchase foreign goods and services that they might actually enjoy. Hendry provocatively describes this policy as turning Chinese citizens into worker ants, and it results in the Chinese working for less than they’re worth, and forced into overpriced real estate, all to feed the current account surplus. He seems to think of it as a financial imperial ambition where China is placing financial global influence over economic stability.

Evidence suggests, though, that this ambition of China is rapidly becoming more trouble than it’s worth. China has (very slowly) been trying to allow the yuan to appreciate, and last August also began to allow exporters to keep some of their  foreign currency holdings offshore, where they would not have to be converted. Be that as it may, asset bubbles are called bubbles, rather than balloons, for a reason. With balloons, the air can be let out in a gradual and controlled process, but bubbles only burst.

Given the fact that China’s is inevitably doomed if they continue their policy, I still don’t know how to respond to Obama’s call for China to liberalize its exchange rate policy. It may be part of a Sir Humphrey-type grand strategy, where Obama is calling for China to liberalize its exchange rate in the hopes that it will force them to dig in their heels and not do it. On the one hand, the principle of self-determination must mean that China has a fundamental right to destroy its economy however it pleases. Furthermore, it would be nice to see one of the United States’ rivals for global supremacy to suffer a setback, and it might result in some recovery of manufacturing in the United States. But on the other hand, recessions have messy unforeseen consequences, and I’m not sure that China would handle widespread civil unrest very well.

Either way, I recall that in the 80s people were worried that Japan had somehow managed to repeal the ordinary laws of economics, when all they had really done was set the stage for a lost decade. One would have thought our own experience with bubbles would have left us more alert for other peoples’.

As you may have noticed, the stock market has been doing very well over the last few months, and even my staid old telecoms have been caught in the updraft despite (or perhaps because of) the high dividend payouts. As the entire market now seems to be looking for yields now that cash and most fixed income (not my junk bond recommendations) have anemic yields, and the general trend seems to be for companies to do something with their excess cash other than making capital investments (Qwest has been eagerly buying back its debt), the recent advance in Qwest is unsurprising. Now, many of the talking heads have begun to question whether the rally is stalled and we should all get out (a sure sign that the rally is likely to continue). However, in my view the value of Qwest and CenturyLink have crossed a key valuation threshold.

As I said in my last article about how CenturyLink (then CenturyTel) was buying Qwest for less than its fair value, I calculate Qwest (Q) to be worth about $13 billion based on applying a multiplier of 10x to its average five-year free cash flows to equity of $1.33 million. CenturyLink’s five-year average flows are complicated due to a recent spate of mergers, but I would think that $800 million, or an $8 billion value for the pre-merger company, is not out of the question. The companies estimate that they will gain about $500 million in synergy from the deal, which, capitalized at a multiplier of 10x again, comes to $5 billion. So, $13 billion + $8 billion + $5 billion comes to $26 billion. The combined market caps of Qwest and CenturyLink are now $24.9 billion, within spitting distance of this price.

Now, it is not unusual for a company to swing from below fair value to above it, and so I may see a higher price for Qwest in future. But as a value investor, I am satisfied with buying below fair value and selling at fair value, because at that point there is no advantage in continuing to hold an investment. Furthermore, the case for $5 billion of that value is from synergy, which represents a dangerous assumption.

As was shown in Damodaran’s Investment Fables, an important book that examines the true historical performances and other concerns about various investment strategies, mergers have a mixed record when it comes to enhancing value. The book cites a study that assessed mergers along two lines: 1, Did the return on the amount invested in the merger exceed the acquirer’s cost of capital?, and 2, Did the combined company outperform the competition? Of the 58 mergers studied, 34 failed at least one test and 28 failed both of them. Furthermore, Damodaran concluded that firms that acquire  companies of a similar size has a worse record than firms that acquire smaller firms. In the case of the CenturyLink/Qwest merger, the target, Qwest, is actually bigger than the acquirer by most fundamental measurements. However, the book also claimed that firms that merge to gain economies of scale have statistically greater success than firms that merge to keep their growth streak going in order to impress analysts, which is to be expected. At any rate, it appears that actually realizing synergy from a merger is more difficult than managements and investment banks would have us believe. Therefore, conservatism demands not counting the full value of the synergy (or perhaps even not any value at all) to the combined company.

I cannot say for certain that this current price ($6.93 as of today’s close) is the best price I can get for Qwest (there is, after all, a $1 billion discrepancy between the market cap of Qwest and CenturyLink that will theoretically have to be resolved as the companies are merging roughly as equals), but I can say that it is about the highest price I feel comfortable in getting. As is suggested in Marty Whitman’s Value Investing: A Balanced Approach, sometimes the merger and acquisition market overtakes the ordinary investor market, and we have to take what we can get. In this case, then, the current price of Qwest is about as good as we can get without running the risk of overvaluation and the possible risk of loss that comes with it.

I am pleased to report that my habit of finding investment opportunities that come in pairs is running true to form. I recently recommended the bonds of the Mohegan Tribal Gaming Authority, and now I can follow it up with the bonds of the River Rock Entertainment Authority, which runs a casino in Sonoma County, California, which offer reasonable safety and an unbelievably high yield.

The bonds currently trade at around 84, with a coupon of 9.75%, current yield of 11.7%, and fall due in November of 2011, offering a yield to maturity of roughly 30%. The bonds’ credit rating is B+, ostensibly an improvement from the CCC+ debt that I normally seem to find. The bonds are River Rock’s only long term debt, which prevents us from worrying about issues of subordination or secured versus unsecured. As stated in Steven Moier’s Distressed Debt Analysis, a vitally useful book for investors in junk debt, if there is only one bond issue it is automatically senior and secured.

The issue size is $200 million, and at current prices has a market value of $170 million. The question, then, for the bond investors, is simply whether the entire casino is worth less than the value of these bonds. As we shall see, the financial statements of River Rock indicate that this question is ludicrous.

Revenues at the casino have been on the decline as the economic troubles have been underway, but seem to have stabilized. The casino’s operations have not only covered their interest requirements by a significant margin, but have also allowed the generation of a substantial profit.

In 2007, income was $139 million, operating expenses net of depreciation were $88 million (including an $11 million “credit enhancement fee” to their developer, an obligation that has since been extinguished), producing operating income of $51 million. The gap between depreciation and capital expenditures was $3 million, creating estimated free cash flow of $54 million. Their interest requirement of $21 million was thus covered 2.57x, a safe margin considering the rating of the bonds.

In 2008, income was $140 million, operating expenses net of depreciation were $76 million (the fee owed the developer is conspicuously absent), producing operating income of $64 million. The gap between depreciation and capital expenditures was $4 million, producing operating income of $68 million, which covered their interest requirement by 3.3x. This level of interest coverage is may actually be found in the lower levels of investment-grade debt.

In 2009, income was $124 million, operating expenses net of depreciation were $70 million, producing operating income of $54 million. The gap between depreciation and capital expenditures was $4 million again, producing estimated free cash flow of $58 million. Their interest requirements were covered 2.76x despite what was apparently a difficult year.

In 2010 year to date, income was $65 million for the first two quarters, with operating expenses of $35 million, producing operating earnings of $30 million. Plus a $1 million gap between depreciation and capital expenditures, we have $31 million in operating incomes, with interest covered 2.95x.

You can see what I mean by the absurdity of the question of whether the entire casino is worth less than the bonds. In its worst year, the casino could boast $58 million in free cash flow to the firm. The value of its debt, $200 million, then, is less than four times its yearly free cash flow, a remarkably safe proposition. (By way of comparison, Bon-Ton department stores bonds, another junk bond I liked, had a debt/free cash flow ratio of about 10 when I bought it).

So, then, what is the source of the market’s skepticism? Most value investors have given up on determining why the market does what it does, but identifying the factors is still worth considering. First of all, there is a proposal to build a new casino between River Rock’s current location and the San Francisco Bay Area. River Rock reports that this casino is still in the planning and permitting stage, but if it is ultimately approved and built, it would perhaps affect River Rock’s profitability in a few years’ time. This fact might make it difficult for River Rock to refinance its bonds in November of 2011. Furthermore, River Rock reported in its 2009 10-K that its plans to renovate and expand have been put on hold for want of financing, which no doubt is weighing on the market perceptions as well. Also,  the casino transfers at least $11 million to the Tribe every year, and these payments, although they rank below the bonds in priority, might well be regarded as sacrosanct. However, this distribution is well covered by the casino’s operations after interest.

I think the main reason, though, is that the balance sheet is apparently not in good shape, containing a large entry for “construction in progress” and showing hardly any equity at all even taking the construction in progress into account. However, earnings power should guide the balance sheet, not the other way round. The casino also has $35 million in cash on the books, so it may be that River Rock will not have to roll over the full amount.

Moreover, in the unlikely event that River Rock were unable to refinance these bonds, the market would be in uncharted territory, as no Indian casino has ever tested the bankruptcy courts. Obviously, the traditional workout of the bond holders stepping up to become new equity holders is unavailable because only an Indian tribe can hold an interest in an Indian casino. However, the alternative of foreclosure and liquidation is not feasible, because the property is useful only as a casino, really, and given its current profitability there would be no reason to pursue this course. So, as no stakeholder in the casino has any reason to see its operations terminated, even in the unlikely event that the debt could not be rolled over, a workout would ultimately be fairly painless.

So, based on the above figures I can state that River Rock gives every appearance of being able to handle the interest on its current bonds and give assurance to the new debtholders when the time to roll the issue over comes that they can service their debts. As a result, I think the large discount and consequent high yield to maturity are a market anomaly that will likely be corrected, to the profit of everyone who buys at the current price.

I was involved in a conversation recently about short selling, where the old adage was trotted out that a stock can rise to infinity but only drop to zero, which is said to illustrate that short selling is more risky than investing on the long side. Although this is technically true, its impact on the risks of shorting has perhaps been overstated. Obviously, stocks can make large moves in short time periods where there is not enough liquidity to allow a graceful exit, but that applies to downside moves as well as upside. The real issue comes from the possible  asymmetry. As a result, a good short candidate should not have that asymmetry in place, and so a lot of short selling horror stories may come from stocks that were poor short selling candidates to begin with.

The example that was raised to me was a small biotech company that announced over the weekend that it had cured cancer. The announcement turned out to have been a gross exaggeration, but anyone short in that position would have had a very bad day. Likewise, shorting low-priced stocks (below $2, $3, or sometimes even $5 or higher) also run the risk of asymmetry. The reason for this effect is that startup companies or many low priced stocks tend to be have like call options, or bets on whether the company will achieve profitability before it runs out of financing. Of course, such bets are often losers, but shorting such a stock is putting oneself in the position of being short an option rather than a stock, and without even taking in an option premium. So, rather than shorting a low priced stock for pennies and hanging on for the bankruptcy, it would be preferable to short a high priced stock that the market has unjustifiably run away with.

In that vein, I am pleased to offer Crown Castle Industries (CCI). Like SBA Communications, it is a cell phone tower company, and again like SBA Communications it is under a heavy burden of debt and generating a free cash flow that is inadequate to justify its $12.36 billion market cap.

I will first deal with the free cash flow issue. As I have stated, a decent proxy for free cash flow is reported earnings plus depreciation minus capital expenditures. In Crown Castle’s case, reported earnings have been negative, although they have lately been approaching zero but for nonrecurring or arguably nonrecurring events. As they seem to be constantly refinancing their debts, they have reported refinancing losses which I am willing to treat as not related to their core operations. In the last few reporting periods, Crown Castle has also reported losses due to ineffective interest rate swaps. Although this is technically part of their financing strategy and should be treated as recurring, the firm has been reducing the size of their interest rate swap positions and so I could justify treating it as nonrecurring.

So, taking out noncore or noncash items, in 2007 they reported earnings of -$222 million, after $540 million in depreciation, $24 million in amortization of financing costs, $66 million in writedown charges, $75 million in impairments, $25 million in acquisition integration costs, and $300 million in capital expenditures (and $494 million paid for an acquisition, which I’m not counting), producing total estimated free cash flow of $208 million. However, $94 million off that $208 million consists of tax benefits, which, as they do not technically have any taxable income, becomes a net operating loss carryforward. Because they still have no reported profits, the company may not realize the value of their carryforwards for some time, and it actually does not represent immediate cash flow. In that same year, the company incurred interest expenses of $325 million, producing an interest coverage from free cash flow to the firm of 1.64x.

In 2008, the figures were -$49 in reported earnings plus $526 depreciation & amortization, $25 million in amortization, $17 million in writedowns, $56 million in impairments, $2 million in acquisition costs, minus $451 million in capital expenditures, producing $126 in estimated free cash flow, of which  $104 million is tax benefits. Interest paid that year was $330, producing interest coverage of 1.38x.

In 2009 the company was able to ratchet back its capital expenditures somewhat. The figures were -$114 reported earnings plus $530 million in depreciation, $91 million in losses from refinancing, $61 million in amortization, $19 million in writedowns, minus only $173 million in capital expenditures, producing free cash flow of $414 million, of which $76 million was tax benefits. Interest paid that year was $332 million, producing coverage of 2.25x.

Year to date 2010, they reported earnings of -$217 million (owing to a large loss on interest rate swaps), plus $267 million in depreciation, $66 million in losses on debt refinancing, $37 million in amortization, $4 million in writedowns, plus $187 million on the swaps themselves, minus $91 million in capital expenditures, producing estimated free cash flow of $253 million, of which $15 million is tax benefits. The same figures for the first two quarters of last year were $207 million in free cash flow of which $56 million was tax benefits. Most interesting to me, though, is the fact that in the same period, interest expense rose from $146 million last year to date to $208 million this year to date. Interest year to date is covered 2.22x, and the remaining cash flows produce a price/free cash flow of about 30. This strikes me as high for a company with such debts, particularly one with slowing growth.

Now, I did notice an interesting point in one of their filings, that their maintenance capital expenditures were only $10 million a year. I have noted before that, as stated in the useful Damodaran on Valuation only maintenance capital should count against free cash flow, because growth capital can be suspended at any time (presumably at the expense of the growth it would create). However, it is not clear that management is aware that they are in a financially precarious situation and so they may go on gleefully expanding their capital into oblivion. Furthermore, it strikes me that $10 million may be their current maintenance requirement, but that figure may go up dramatically. If many of their towers are of fairly recent vintage, it may be some time before wear and tear start to take its toll, but when it does capital requirements may increase in a hurry.

Sales have been increasing at a fairly steady 10% for the last few years. Operating income plus depreciation and nonrecurring events moved from $665 million in 2007 to $838 million in 2008 to $983 million in 2009 to $534 million for the first half of 2010, or $1068 million on an annual basis. This indicates to me a slowing rate of growth. Even assuming that interest takes precedence over capital expenditures, interest coverage has moved from 2.05x in 2007 to 2.54x in 2008 to 2.96x in 2009 but dropping back down to 2.62x for the first half of 2010 owing to higher interest requirements. It may be claimed that cell phone towers are in the nature of a utility company and can bear a lower interest coverage ratio, but the increased interest expense for 2010 suggests to me that some of their lenders are starting to become worried. The company announced that subsequent to their latest figures they issued $1.55 billion in debts to replace $1.33 billion in tower revenue notes (albeit at an interest rate 1.2% lower), which, like SBAC’s, are held in a securitization-type arrangement.

Crown Castle may be a bit further from breaching its covenants than SBA Communications, but it is not out of the question. The covenants in their credit agreement require that their adjusted EBITDA/total debt must be less than 7.5, and that their EBITDA/interest must be at least two. I don’t know what “adjustments” they are making, but they report that their adjusted EBITDA/total debt is 5.7 and their interest coverage is 2.7x, which is a little higher than I calculate it. Curiously, according to Etrade, its bonds trade at a premium despite yielding only 5% for the 2015 bonds and about 5.9% for the 2019 bonds, and a credit rating of B-. This is only anecdotal, but I’ve noticed that all the bonds I like are rated CCC+, suggesting that the credit agencies might consider them worth of a higher rating but aren’t willing to stick their neck out by pushing them up. I think the same reasoning could apply to a B- rating on the downside. At any rate, though, their calculation and mine is before Crown Castle’s capital expenditures, which take another bite out of actual cash flows.

So, it is my considered opinion that Crown Castle is in a bind. Its growth is slowing, requiring it to make high capital expenditures in order to grow into its current share price. However, it is bumping near the ceiling of its debt capacity, and funding capital expansion out of its own cash flows reduces free cash flow to shareholders. As a result it looks as though Crown Capital is too overextended one way or another to justify its valuation, making it a potentially attractive short.