Post Holdings (POST)

OK, so nobody is going to believe me again.  People will think I am just sitting here watching TV and then when I hear something interesting, I look stuff up and make a post about it.  Well, there's nothing wrong with that but that's only part of the story.

I was looking at POST in the past few days for a number of reasons.  I know you are tired of hearing this, but POST is run by an outsider CEO, William Stiritz.  Of course, I knew this and you knew this.  POST was obviously worth a very close look as:

• It's an outsider CEO company and
• It's a spinoff and has the classic signs that Greenblatt talks about in his Genius book (segment suffering from 'benign neglect' for years, ripe for some focused (and incentivized)  improvements via spin-off).

So this is a perfect candidate for a post here (and for a position in any value investor's portfolio). 

What got me to look at this in the past few days was Stiritz making headlines.  He took a big stake in Herbalife (HLF) and said he wants to help do something to get Ackman off their back.  He filed a widely reported 13-D with this note:

Item 4. Purpose of Transaction.

The Reporting Person has analyzed the Company and concluded that it has a sound business model, a strong distribution system and a positive outlook for long-term growth opportunities. The Reporting Person believes that the Company’s market capitalization is undervalued at this time. The Reporting Person plans to interact with Company management to offer them, for their consideration, his views, advice and counsel for ways of promoting and furthering the Company’s shareholder interests. The Reporting Person’s views, advice and counsel may address a wide variety of matters, including ways to further leverage the Company’s strong distribution system, potential financing and/or recapitalization strategies, potential stock repurchase programs, and potential strategies for confronting the speculative short position that currently exists in the Company’s stock and its attendant negative publicity campaign. The Reporting Person may, from time to time (i) acquire additional Shares and/or other equity, debt, or other securities of the Company, (ii) dispose of any or all of his Shares or any other such Company securities, and (iii) engage in hedging or similar transactions with respect to the Shares.

This is fascinating on its own, this ongoing drama; sort of a battle of the titans. 

He owns 6.5 million shares ot HLF which is a stake of $460 million; that's huge.  Stiritz owns 370,000 shares of POST and has options on 1.55 million shares (at a $31.25/share strike price) for a total stake (if options exercised) of $90 million.  That shows you how strongly he feels about HLF.  The POST stake seems a little small, but this is not a founder/owner-type situation and ownership stakes tend to be small in those cases so it's not too much of an issue.

So anyway, that was the trigger for me to pull up some information on POST.  I have been going through the financials (not much since this is a new entity) when CNBC had on a Tiger cub fund manager named Nehal Chopra.

Tiger Ratan Capital
So Nehal Chopra is a Tiger cub; her fund was seeded by Tiger Management (Julian Robertson).  Again, Julian Robertson is a legendary hedge fund manager, but importantly (for us value investors), he is a hard core fundamentals-based value manager.  Robertson and his cubs are known for very deep research.  They won't invest until they do extensive work on the companies and especially their management. 

So of course, I turned around today to watch when I heard this Tiger cub talk about POST.  First of all, Tiger Ratan Capital focuses on corporate change which often causes dislocations and mispricings.  They seek to double money in three years.

Ralston 2.0
For POST, her comment was that the cereal business is a very stable business but at POST has been undermanaged for years, and after the spin-off they are fixing it up.  The most exciting part of POST is the CEO, Bill Stiritz, who at Ralston returned 21%/year for 21 years (that's even higher than the +20%/year for 19 years in the Outsiders book.  See the table in the post). 

She feels that POST is Ralston 2.0 (the only problem is that Stiritz is 78 years old, so we may or may not get another 21 years).

So a fund manager talking about a stock is no big deal, usually, even if it's a stock you like.  You just say, well, OK...

Charter Communications (CHTR) and Valeant Pharmaceutical (VRX)
But what was very interesting to me was that she went on to mention two of her other favorites; Charter Communications (CHTR) and Valeant Pharmaceutical (VRX).   I mentioned CHTR here and do like the stock and what Malone/Rutledge are doing.  Chopra said that CHTR looks good even without a Time Warner Cable deal.  Their capex should come down going forward and they have a lot of free cash flow.

For VRX, she explained the business model; that other small pharmaceuticals spend a lot of money on R&D but in aggregate their return on investment (in R&D) is negative.  So VRX doesn't do that and just buys companies with successful products.

I haven't done a post on VRX, but it was mentioned in the comment section of one of my posts and it
is a big Sequoia position and is sort of an outsider CEO-type situation.

So needless to say, we seem to have similar taste! 

Of course with a manager like this we have to take a look at what else they own.  Here's a link to the recent 13F:  

Tiger Ratan Capital holdings as of September 2013


Back to POST
Anyway, back to POST.  It's a spin-off from early 2012 so in the world of spin-off investing, it's still pretty fresh.  It has all the things that you want; an incentivized, competent management, a business that has been neglected for a long time in a stable industry etc.

Plus we already know about Bill Stiritz.  These things alone make POST very interesting.

But what is exciting about POST is the new businesses that they are investing in.  They have made some acquisitions this year and will close one next year.

Their Attune Foods business (which includes the Hearthside businesses they bought) gives them exposure to organic, non-GMO cereals and snacks and private label granola business.  Natural and organic cereals have a high single-digit growth rates.  And the acquisition is cash accretive in 2014.

Premier Nutrition acquisition represents a three-fold opportunity (according to the 4Q2013 conference call):

1. Access to double-digit growth of sports nutrition and weight loss category.
2. It's POST's first out-of-the-bowl eating experience with Premier line of shakes and bars.
3. Platform from which to initiate roll-up opportunity as industry consolidates.

This is also cash accretive in 2014.  Premier also gives POST knowledge of science of protein.

The Dakota Growers (pasta) acquisition expands the private label business and is also cash accretive in 2014.  Dakota also creates an attractive strategic growth platform (through acquisitions).

So all of these acquisitions seem to have in common higher organic growth rates, platform for future growth through acquisitions while being cash accretive.   That's good!

Valuation
OK, so let's just take a quick look at this.  First of all, POST doesn't look so good on conventional measures like P/E due to the high debt.  There were also a bunch of charges and expenses related to the spin-off and restructuring.

So let's look at what is more important in these situations; EV/EBITDA, free cash flow and things like that.

Fiscal 2013
First of all, they just released their fiscal 2013 results (year ended in September).  Their adjusted EBITDA came in at $216.7 million.   Capex for the first nine months was $18 million, so just annualizing that and assuming $24 million in capex in 2013, that's free cash flow of around $193 million  (capex will be in the 10-K which hasn't been filed yet).

POST closed at around $47/share, so with 33 million shares outstanding, that's $1.6 billion market cap.  They have $1.4 billion in long term debt or $1.0 billion net of cash (which is pretty much going to the purchase of Dakota Growers which will close early 2014).  So that's an enterprise value of around $2.6 billion.

So on fiscal 2013 figures, that comes to 12x EV/EBITDA and 13.5x free cash flow.   That's not expensive at all.  Just plucking easily accessible figures, here are some EV/EBITDA for some comps:

                                   EV/EBITDA (ttm)
Kellogg                      13.3x
General Mills             11.7x
Kraft Foods Group     10.0x
Campbell Soup          11.4x

So just looking at the EV/EBITDA of the past twelve months, the valuation looks pretty normal and within reasonable range.  But then again, we are comparing this to companies with little or no growth, and our assumption is that POST is going to grow rationally and profitably, outsider CEO-like.  In that sense, this 'normal' valuation may in fact be very attractive.

They did offer up guidance for 2014. 

2014 Guidance
Adjusted EBITDA:  $245 - $260 million.
Capex:   $65 - 75 million

Using the midpoint of each would give us $252 million in adjusted EBITDA and $70 million in capex.  That gives us free cash flow of $182 million. 

So the current $2.6 billion enterprise value gives us an EV/EBITDA of 10.3x (this may be fairer as 2013 didn't include full year of 2013 acquisitions but the full balance sheet value was included in EV at September-end).  That's 14.3x free cash flow, though, but still a free cash yield of 7%.  This free cash yield includes all the capex for organic growth, but obviously not growth that will come from acquisitions. 

Conclusion
This is just a quick look at POST, but it looks pretty interesting.  I don't know that you want to compare valuations too much with other food companies that are really big and slow growth.  I would look at POST more as a special situation; as a company in transition run by an outsider CEO.  Plus it's a spin-off play and a relatively fresh one at that as spin-off returns usually are the best a couple of years or more out.

Also, some of the slow-growers in the grocery category are big and find it hard to find incremental growth.  POST may have an advantage there too as they are still pretty small and therefore nimble.

Here are some revenue figures to compare (POST is for the recent year-ended September 2013; others are whatever the most recent full year was):

POST:                  $1 billion
Kellogg:             $14 billion
General Mills:    $18 billion
Kraft:                   $4.5 billion
Cambell Soup:     $8 billion

This is not to say that POST can get to $14 billion or $18 billion in sales.  Not at all.  It's just a lot easier to grow a company with a smaller revenue base.  A $100 million idea will have a much bigger revenue impact on POST than on say, Kellogg.  Obviously this applies to acquisitions too.  An acquisition too small for the other companies may have a reasonable positive impact on POST (larger pond to fish in).

So what's not to like?

• Greenblatt-style spin-off play
• Outsider CEO
• Reasonable valuation (I only say reasonable because I haven't done the work to declare it really cheap)

Exxon Mobil (XOM)

OK, so this is really a strange coincidence.  I was honestly thinking about making a post about Exxon Mobil (XOM) recently. Of course, noone will believe me; they will think I am just posting this because of Buffett.  Well, yes.  I like to post about Buffett's picks because why not?  He is the greatest investor ever.  It would be silly not to take a good look at his picks.  But anyway, again, it's related to that book.  

XOM an Outsider CEO Company?
Yup.  The book, The Outsiders.  And yup again, XOM is mentioned in there.  Like the other outsider CEO companies, XOM really focuses on capital allocation.  They won't just invest for the sake of growth or size.  They want to invest when the returns are there.  If there is no opportunity, they will return cash to investors, and they aren't shy about doing so aggressively.  I think this is sort of first-level / second-level thinking too. 

Thorndike says in the book that many point to production and reserve growth and say XOM has no growth but XOM (like other outsider CEO companies) focuses on return on capital so if they don't see good opportunities to deploy capital, they will repurchase shares instead.

So I was going to take a quick look at XOM to show how 'outsider' this company is.  We all know how great a company it is.  But XOM still seems to be used as sort of an oil price proxy; people get bullish when they forecast higher oil prices and get bearish when they think oil prices will go down or will stay flat.

That's kind of like first-level thinking; determining investment merits of XOM based on crude oil price assumptions. Sure, prices are very important for XOM.   But there is more to it than that as we will see. 

Long Term Chart of XOM

The red line is the S&P 500 index.  I left out Berkshire Hathaway since the price history doesn't go back to 1970.

Inflation Hedge / Crude Oil Price Bet?
This is not to say that Buffett's purchase of XOM is not a bet on oil prices.  He has said more than once that he feels crude oil prices will be much, much higher over time.   Of course he bought ConocoPhillips (with poor timing) and has owned PetroChina in the past (primarily due to valuation gap between PTR and western majors).  He has expressed interest in the oil sands in Canada (having helicoptered over them with Bill Gates a while back; he said he was interested but not at available prices or something like that).

He has also said that with this pump priming by the Fed, inflation is inevitable.  He feels there is no question that what the Fed is doing will lead to inflation down the line.  It goes without saying that he probably thinks that the longer it goes on, the bigger the inflation when it hits.

Having said that, I would be the first to insist that Buffett doesn't really make bets like that based on big picture scenarios.  That really is not his game.  But that doesn't mean it is a zero consideration when looking at investments.

If a business is a good one with good returns on capital, good management and available at a reasonable price, and oh, by the way, it might benefit from higher oil prices and/or inflation, I don't think it is going to bother him.

XOM used to be a big part of Alleghany's (Y) equity portfolio.  They do say that they want to invest in stocks/businesses that is inversely correlated to interest rates (to hedge their big fixed income portfolio).  

 

 This is a snip from Y's 2012 letter to shareholders:

... and from the 2011 letter to shareholders:

Cumming and Steinberg of Leucadia also said that their portfolio (at the time) was geared toward inflation; every position that Leucadia owns would benefit from inflation which to them was inevitable.

This position at Berkshire might have a similar effect to what Alleghany talks about; it offsets the many financial positions Berkshire owns.  But again, that wouldn't be the main reason Buffett would do this.  First and foremost, he is investing in a great business at a fair price (or something like that).  I don't think he sat down and said, "Gee, Berkshire needs an inflation hedge...  Let's buy an oil stock!".  Maybe (well, highly unlikely but who knows) he read the The Outsiders book, slapped his forehead and said, damn, why don't we own a bunch of XOM?!  Duh!  Or maybe he has deeper insight on XOM through the Lubrizol position.


Return on Capital
Anyway,  here is one of the most important things when looking at XOM.  The return on capital across the segments is amazing.  This is not return on equity, but return on capital. 

Return on Capital Employed

So let's take a look at some things I plucked from the XOM annual meeting presentation and annual report.

Shareholder Returns Over Time

The long term return to shareholders has been pretty good.  If stocks were a good inflation hedge since the early 1980s, then XOM was an even better one.  Dividends have far outpaced CPI and the S&P 500 (S&P 500 dividends).

Return on Capital Employed Versus Industry 

The chart on the right shows XOM's returns on capital versus the industry.  This is pretty consistent going back in time too.   This is from a past annual meeting presentation showing rolling average five year ROCE through 2007:

Here's a different way to look at the same stuff:





Return on Incremental Capital
And by the way, let's take a quick look at return on incremental capital.  Average capital employed was $88,342 million in  2002 and $179,094 in 2012 for an increase of $90,752 million.  Net income excluding financing cost was $11,895 million in 2002 and $45,438 million in 2012 for an increase of $33,453 million.  So return on incremental capital was around 37% over the past decade.  There was a large gain on sale in 2012 which makes this number look especially good. Excluding the $8,731 million gain in 2012, earnings would have been $36,707 so return on incremental capital would have been a still pretty good 27%.

Gain on sales are included in the return on capital employed figures going all the way back, so to keep it consistent with the way they present it, I will leave it all in there for the incremental returns below (otherwise you would have to back out all gains in previous years too).

So let's take a look at the same using a three year average instead (which is what should have been done in the first place):

And on this basis, over a ten year period return on incremental capital employed is 31%, so that's pretty good (excluding the 2012 gain would still leave you with 28% return on incremental capital).  I didn't look at the five year period as that includes the XTO acquisition, great recession and the crude oil price spike to $150 so I figured it wouldn't be representative of what XOM is capable of over time.

No Spinoff?
And as if to counter calls for breaking up XOM, they show that XOM integrated is greater than the sum of the parts.  Of course, outsider-type CEOs don't just do what's popular and what investors demand.  They will do what makes sense.  The chart below sort of reminds me of a slide that J.P. Morgan had in one of their presentations too showing the synergies of having asset management and other businesses together.

ROCE in the downstream business is impressive (the 2012 spike includes gain from restructuring):

With low cost / efficient operations:

Their chemical business ROCE is impressive too:

All of this leads to significant cash flow:

Shareholder Friendly
And this is where it gets really good:

Just like outsider CEO companies working hard to increase the per share intrinsic value of their businesses, XOM focuses on per-share interest in production.  If capital is better utilized by repurchasing shares, they will do so.  Conventional management would think more about expanding the empire, increasing reserves or production.  XOM focuses on shareholder value.

This is the longer term look at the combined downstream and chemical ROCE.

What is remarkable about the consistently high returns is that the recent ten years have not only included the great recession, but a wild range of crude oil prices and refining margins.  Crude has been as low as $20-40 to as high as $150 and yet XOM cranks out high returns consistently.

Shareholder Friendliness

This is a table that shows how much XOM has paid in dividends and how much in stock they repurchased.  For example, in 2012, they paid out $10 billion in dividends and bought back $21 billion in stock.  To show what the dividend yield would have been if they paid a dividend instead of repurchased shares, I added the dividends paid and amount of cash spent on shares repurchased and divded by the average shares outstanding to show a sort of adjusted dividend yield.   The column to the right shows the amount compared to the year-end stock price.  You will see that even though the actual dividend yield is in the 2% range, there is a lot more cash being returned to shareholders every year.  This is impressive given that this is not a business in runoff or anything like that.

They recently started separating out share repurchases that are actual distributions to shareholders and repurchases that offset shares issued under benefit plans:



Just for reference, here is some operating information on XOM:

Reserve figures will go up and down according to crude oil prices (higher prices = higher reserves etc).  We see from here that even though earnings and other financial metrics have been improving over time, there hasn't been any growth in production over the past decade.  Their refinery throughput is also down since 2001.  Their reserves are higher and they have been able to replace reserves every year (2010 includes the XTO acquisition).

Conclusion
So, none of this is really new to value investors, but again, many themes seemed to come together in this idea.  And then Buffett discloses a big stake in it, so that's an excuse to make a post.  As I said, I was going to eventually make a post about it anyway (well, let's say it was on my list of post ideas) but the Berkshire purchase made me push it up the queue a little bit.

I will probably overuse this outsider CEO thing and the first-level / second-level thinking, but you know, those are good models to have so I don't mind overdoing it a bit.

Berkshire Hathaway bought a bunch of XOM earlier this year.  It has all of the factors that Buffett seems to like:

• Good management
• High returns on capital
• Shareholder friendliness (share repurchases)
• High moat (technology, scale and integration that allows high returns can be considered moats)

etc.

And merging it with the outsider CEO themes and first-level / second-level thinking:

• Many see XOM as too big to grow; they point to subpar reserve and production growth while others look at XOM as a proxy on oil prices.  This sort of looks like first-level thinking whereas...
• The reality is that XOM is focused not on superficial growth but rational capital allocation so would rather repurchase shares at reasonable prices than spend money to grow reserves/production just to please or impress Wall Street.  Focusing on this outsider-CEO-esque behavior seems more like second-level thinking...
• If opportunities aren't available for reasonable returns (this is not true; there are still opportunities), then XOM will simply just keep repurchasing shares and the per share share of production will continue to go up.  This is the same as Coke, Washington Post, IBM etc.

From a business standpoint, the history of XOM shows that you don't really have to have a strong view on the direction of oil prices to make the assumption that they will continue to do well.

There are a lot of debates going on, like peak oil (or not), alternative sources pushing out carbon-based energy (Gore scenario).  But I think those are extreme scenarios that won't be a factor for many years to come.

I suppose if one has a view on any of those things that are extreme, they may see XOM a bit differently. But that's OK.  I don't have such an extreme view.

XOM did fine with crude oil trading in the $10s and $20s (and lower), did fine at close to $150, and is doing fine now at below $100.  They will probably continue to do well under most moderate scenarios.

But it is interesting that you have a company/stock like this that:

• fits the Buffett model
• fits the outsider CEO model
• and may benefit from higher crude oil prices and inflation

Anyway, I just looked at one aspect of XOM.  There are certainly other issues.  Cost of finding new reserves, what the cost of producing those new reserves are and what the return on investments will be in those projects that will be more expensive and more complicated etc.  But knowing XOM's strict discipline in capital allocation, I do think we can take comfort in the fact that they will invest prudently and not make unwise investments for the sake of size.  Oh yeah, and XTO has yet to prove itself, but time will tell; they are putting up impressive figures despite it.

DaVita HealthCare Partners (DVA)

So Ted Weschler, one of Berkshire Hathaway's (BRK) new investment managers made some news recently.  He bought 3.7 million shares of DaVita HealthCare Partners (DVA) after their dreadful 3Q conference call in which Thiry (DVA's current and long time CEO) said that the outlook for 2014 is worse than they had anticipated, and the hit to earnings can be substantial.  They knew things can be bad in 2014, but they said it may be worse than they thought.

BRK now owns more than 35 million shares.  The most recent buy occurred between $53 - $56/share.  The stock is now trading at over $58, so that's a $2 billion position.

The BRK annual report includes stock holdings with a value of more than $1 billion, so this DVA position will make it into the 2013 annual report.  Just out of curiosity, here's a look at the December 2012 stock holdings:

Stock Holdings of Over $1 Billion

As of December 2012, DTV was the only pick on the list from the new managers (and this one is a Weschler pick too).  The market is up quite a lot and there have been major purchases so this list will look a little different at year end, but it still shows you how big this DVA investment is, relative to BRK, even though it's only 2% or so of the equity portfolio (which was fair valued at $105 billion at the end of the 3Q 2013).

Also quite interesting is that Ted Weschler himself, his daughter and some trusts that he runs own a big position in DVA.  In the November 12 filing, it shows that Weschler has a 2.2 million direct ownership stake in DVA, which comes to $130 million.  That's a pretty big position.

I looked at this before when Buffett hired Weschler (and everyone started dissecting his hedge fund holdings) and I didn't think much of it.  I thought, "different strokes for different folks".   I've looked at dialysis center stocks before and remembered their stocks tanking on Medicare payment cuts (or threats).  The common view (ever since at least the late 1990s) was that this is a business that can be destroyed by a single stroke of the pen in Washington DC.  Why invest in a business that an irrational congress can blow up so easily?

I still held this view when I looked at DVA recently.  But this recent purchase made me scratch my head so I decided to dig a little deeper to see what's going on here.  Weschler is not a reckless gambler/risk-taker.  He is a very rational investor.  So whatever he is doing, he is certainly not betting on the outcome of the impact of the ATRA 2012 (see excerpt below on the American Taxpater Relief Act of 2012), Affordable Care Act and many other factors (you can read a bunch of risk factors in their 10-Qs and 10-Ks).  

Going forward, obviously, Weschler's and Comb's picks will be more interesting to follow than Buffett's (who is limited to looking at only the 50 - 100 largest cap names).   So this is something we Buffett followers have to do: study Ted and Todd's hopefully excellent adventures.

Here's one of the big issues people are worried about that will take effect in 2014 (CMS is Centers for Medicare and Medicaid Services):

Risk that our rates are reduced by CMS. The American Taxpayer Relief Act of 2012 mandates that the Secretary of Health and Human Services (HHS) reduce dialysis payments beginning in January 2014 to reflect the Secretary’s estimate of changes in patient utilization data from 2007 to 2012 for erythropoiesis stimulating agents (ESAs), other drugs and biologicals that would have been paid for separately under the composite rate system, and laboratory services that would have been paid for separately under the composite rate system. The Secretary must also use the most recently available data on average sales prices and changes in prices for drugs and biologicals reflected in the ESRD market basket percentage increase factor. CMS has asked for comment regarding phasing in any reduction over a one year or longer period. In the proposed 2014 ESRD PPS rule published on July 8, 2013, CMS determined that the ESRD Prospective Payment System (PPS) base rate that otherwise would apply in 2014 (inclusive of the market basket update of 2.5%) should be reduced to account for reductions in the use of drugs and biologicals between 2007 and 2012. This cut represents a significant reduction (inclusive of the market basket update of 2.5%) of 9.4% in Medicare payments that is proposed to take effect January 1, 2014 for calendar year 2014. Although the proposed rule is not final, if it is implemented as proposed, it could have a materially adverse effect on our business and financial condition. Any reduction in dialysis payments will negatively impact our revenues, earnings and cash flows.

 

 

So Why DVA?

I'm not going to do a thorough analysis of DVA here.  I just wanted to make some major points that I realized as I took a look at this thing.   And then I realized that DVA has components of two themes that I talk about here. 

First of all, let's see how DVA has done over time.  The current CEO, Kent Thiry, became CEO in October 1999.  DVA (previously called Total Renal Care Holdings) at the time was in bad shape; probably due to bad acquisitions/big merger, too much debt and bad execution.  He really turned the company around. 

Here is the chart of DVA since Thiry took over:

 

DVA Since October 1999

The red line is the S&P 500 index and the green line is BRK.

DVA has returned +25%/year since October 1999 versus +2.0%/year for the S&P 500 index (excluding dividends) and +7.3%/year for BRK.

Here's a more recent look; the last five years:

DVA Last Five Years

Free Cash Flow

(figures adjusted for 2013 stock split)

So this is just some stuff I got from the annual report letter to shareholders section which includes adjusted EPS and free cash flow.  You can't really use operating cash flow less capex here from the cash flow statement as a lot of capex is for opening new dialysis centers (so it's not all maintanence capex).  As you can see, DVA is a huge cash flow generator.

The first nine months of 2013 has also been pretty decent, and cash flow and free cash flow for the last twelve months through September 2013 was $1.62 billion and $1.24 billion respectively.   Using the 9 month average shares outstanding of 215 million shares (close enough), that comes to $5.77 in free cash per share generated in the last twelve months.   With a stock price of $58/share, that's 10x free cash. 

That's pretty cheap.  But of course, it's not so simple.  Thiry did say that 3Q 2013 was exceptionally strong.  And these numbers, although they reflect sequestration, don't reflect the problem shown above that kicks in in 2014, not to mention the substantially lower earnings expected from HCP that they mentioned.

We know that DVA has done incredibly well in the past, but how can we get comfortable (or how does Weschler get comfortable) about DVA going forward?  That's the big question.   Even though there are a lot of trends in favor of DVA (increasing obesity / diabetic rates, demographic trends (including racial composition of population) favor increasing rates of diabetes etc), there are trends that don't, like government funding problems (medicare / medicaid = bust), Affordable Care Act and other cost pressures on health care in general etc.

Howard Mark's Second Level Thinking
So here is where it gets interesting.  I have been guilty of "first level thinking" on this issue for at least a decade. The first level thinker of DVA thinks it's a bad idea because their biggest payor is the U.S. government which is broke (and broken).  If pricing and terms can be set and reset at the whim of congress, who wants to be on the other side of that?  DVA and other health care providers have faced this issue for years.   Private health insurers too, will be a source of increasing pricing pressure (as was discussed in the 3Q conference call).  ACA may make that worse as private health insurers have to lower cost too.

But first, a detour to another situation this reminded me of:

Warren Buffett's Second Level Thinking on Banks
After the crisis, people wondered why Buffett kept investing in banks; isn't the golden age of banking over?  Won't new regulations and lower leverage make banking a low return business?  Won't the return on equity of banks going forward be really low?  With interest spreads shrinking, how will banks make money?  Won't Wells Fargo, one of the biggest, be the hurt most from these trends?

Buffett's response was simple.  He said that in any industry, the one with the lowest cost wins.   No matter what happens in the economy, if you have the lowest cost, you will win.  This is true in any industry.

His point was that all of these negative trends will hurt all banks equally, but if you have the lowest cost, it will hurt you the least.  The high cost players will be run out of business, and the lowest cost player can probably pick up market share.  This is how it has always been in any industry.

This is precisely what seems to be happening in the banking industry now, with market share increasing at Wells Fargo (and Bank of America and JP Morgan too).

Back to DVA
So, getting back to DVA.  DVA is staring at some serious issues going into 2014.  But the key point here is that this is an issue that will face all dialysis (and other healthcare) providers.  Drastic payment reductions will put many small operators out of business.   DVA seems to be a very efficient operator (high margins) with very good patient outcomes (various metrics are disclosed every year in the annual report).

Without going into too much detail, I think we can assume that DVA is one of the most efficient operators out there.

During the 3Q conference call, analysts couldn't understand how Thiry can price and purchase dialysis businesses without a clear insight into how all of these new health care issues will play out in congress (and elsewhere).  And interestingly, he insisted that they don't make purchases or price deals based on short term considerations, but they base it on a view of how things will look six or seven years out (or something to that effect).

The point is that if there are drastic payment reductions, they will simply have to cut costs to accomodate the new structure including closing some centers that don't make economic sense.

And judging from the numerous independent and non-profit operators out there, he feels that many of them won't be able to survive in a scenario of drastic cuts. This would force rationality on the part of the CMS (or else face a lot of problems from patients who may lose access to much needed care when too many centers close).

So basically, the less efficient operators should provide a floor to pricing such that in any scenario, DVA should be able to do well (even though there might be short term reset shocks to revenues / stock price etc.).  

If they do insist on cuts even with the negative impact on many other less efficient operations, this may provide an opportunity for DVA to move in with more efficient and possibly profitable operations.  Or who knows, this may even lead to a big acquisition by DVA (to take a big bite of market share).

Either way, the view must be that over time, say five to seven years, things will settle down to a level of stability and due to DVA's strong competitive position of efficiency and positive patient outcomes, they should come out the other end stronger.  They will be a beneficiary of that (even though I would guess that Thiry would rather not have such a big shock to the system).

Outsider CEO-like
And not to overplay this idea, there is something sort of outsider CEO-like about Thiry.  They grow through acquisitions and focus on capital allocation and free cash flow plus strong execution.  Thiry doesn't own a whole lot of stock, which I find curious. So he doesn't quite fit the owner-operator model.   Given the stock price performance over the past 14 years, I bet he wishes he held on to more stock too.  But who knows what the situation there is. 

Conclusion
So, the fact that there is some pricing pressure (including a big change from CMS in 2014) and uncertainty with respect to the ACA and other changes is a concern for any rational investor.  But to stop thinking there (single biggest payor = U.S. government = bad investment) is first level thinking.

Thiry believes that DVA offers superior service to other dialysis centers, and that HCP (recently merged, non-dialysis health care business) is part of the solution to the health care cost problem.  In this case, when the dust settles they should come out of all of this better off.

I can't imagine a scenario where payments get so low that many operators can no longer survive.  Five to ten years from now, there will be a dialysis business and someone will be doing it profitably (or else the industry would disappear and that's not likely to happen).

There is also a sort of time arbitrage factor at work here; many seem focused on the short term outcome of various changes in the health care industry while others like Weschler focus on the long term outcome (superior management / execution will get the business to a better place regardless of what happens as any adversity will be an opportunity to increase market share).

There are other risks, but for this post I just wanted to focus on this aspect of DVA that I find very interesting as it sort of illustrates the concept of first and second level thinking, how the strong operators with competent management may be able to take advantage of adversity, and the importance of capital allocation and free cash flow generation (which makes it possible for strong operators to exploit opportunities as they arise).

 

What To Do In This Market

After such a huge rally since the great recession, and now after a huge runup this year people are wondering what to do with their money.  Many are afraid that the markets will tank as they are getting bubbly and there will eventually be tapering that will most certainly be devastating to the markets.

But then people like Buffett just keep buying stocks and telling people stocks are the place to be, even recently.  When people ask him about stock prices, he always says that if stock prices go down it would make him happy as he will find more things to buy.  Munger also says that bad times and low stock prices are good; that's how businesses grow.  That's how the rich get richer; they just take advantage of dislocations to expand.  

Someone asked Buffett about IBM; he owns a bunch and the stock price is down.  He says that IBM is buying back a lot of stock so a low stock price is actually good for him as IBM can buy back more stock.  This is something that people have a hard time understanding.  If he owns a bunch of Berkshire Hathaway stock, how could he be happy to see the stock market go down?  If he owns a bunch of IBM, how can he be happy to see the IBM stock price go down after he has already bought a bunch?

I was thinking about all of this stuff and it occured to me that this ties back into the outsider CEO / owner-operated business theme.

Outsider CEOs and owner-operated businesses tend to be good businesses and remember, those outsider CEOs had tremendous track records even through the bad times.   If the best hedge against inflation or bad times is a good business, then outsider CEO businesses must be great hedges.

First, let's just look at the obvious one.

Berkshire Hathaway in the 1970s
I think what many fear is a 1970s like situation; interest rates and inflation flying out of control, stocks going down a lot or staying flat for a long time, stagflation etc.

So let's see how Buffett did during that horrible period.  When I mention Buffett to people, even people on Wall Street, many say that Buffett is just a product of a bull market (if it's that simple, then how come there aren't more Buffetts?).

Here is the book value per share change of Berkshire Hathaway, stock price and change in stock price from 1969 - 1982.  Now remember that 1969 was sort of a peakish year.  You can use 1968, 1970, 1972 or whenever you want, but I think they make a similar point.

Berkshire Hathaway BPS Growth and Stock Price

So from 1969 through 1982, BPS grew +26%/year and the stock price appreciated +25%/year.  And this is between 1969-1982.  There was no bull market here.  There was no boom.  From 1972 - 1982, both BPS and stock price rose +26%/year.   Buffett (as far as I know) didn't own gold, gold stocks, crude oil futures, oil stocks, commodity funds, real estate, timber, alternative investments or anything like that.   A lot of this value was created because of the flat period and low prices.  He was able to pick up stocks and businesses on the cheap and he didn't need a bull market for those values to be realized.

I posted here many times how well the superinvestors of Graham and Doddsville did during this time period too despite a flat market.

OK.  So we can't identify a Warren Buffett or superinvestor ahead of time you say.  Of course if we invested with Buffett early on, it wouldn't have mattered what the market did.

So now let's look at one of the outsider CEOs.

Teledyne in the 1970s
So check this out.  We know that Henry Singleton was a great capital allocator.  But he was not a stock market 'superinvestor'.  He bought and sold businesses, for the most part (they did get into insurance at one point too).

Look at this table closely.  I input some of the data at the back of the book, Distant Force.

Teledyne Performance 1961 - 1989

 

 



This is kind of tricky to look at due to all the transactions, splits, stock dividends and things like that.  The important figure is the far right column which shows the value of 1,000 shares of Teledyne owned in 1966 (in thousands of dollars). 

All of the raw data is from the back of the book, and the blue area are figures I calculated using the raw data.  I just put it there for perspective so it's not perfectly accurate.  For example, book value per share is simply shareholders equity divided by shares outstanding, ROE is net income divided by average shareholders equity (average of beginning and ending equity).  There isn't enough information to make necessary adjustments, so the blue area is for reference only. 

The purple/pink figures for the 1986-1989 EPS is calculated using the net income and shares outstanding as the EPS figures in the book look wrong.  In the book, it shows EPS of $4.07, $6.45, $6.81 and $4.66 for that period which doesn't make sense if the net income and shares outstanding are correct (and those look more in line with the rest of the data).

From the end of 1966 to the end of 1989, a Teledyne shareholder would have gained +19.5%/year.  And look at the valuation as of 1966; 111x p/e and 14.9x book.   But you had to endure a lot of pain to achieve this long term return.  From a peak of $288,000 value in 1966, the value of 1,000 initial shares held would have gone down to $52,000 in 1974.  That's a stunning 82% decline!  That's sort of what you get for paying more than 100x earnings.   Between 1966 and 1974, book value per share of Teledyne actually increased from $5.74/share to $25.96/share; it grew +21%/year during that time.  Net income was positive too all throughout the period indicating that Singleton was creating value throughout this period.

Between 1972 and 1982, Teledyne stock returned +33%/year.   Again, this was sort of a peak-to-low in the stock market; no bull market or strong economy to help. 

Much of Teledyne's return has come from share repurchases.   There's a nice table at the back of the book that shows the many tender offers Teledyne did between 1972 and 1984 at significant premiums to the then trading price of the stock.  The eight tenders in the table show that it repurchased as a percent of the then outstanding number of shares, 27.9%, 6.9%, 17.6%, 10.4%, 19.6%, 18.4%, 21.6% and 42.9% (in 1984).  From 1972 through May 1980, Teledyne repurchased a cumulative 74.5% of their outstanding stock.  In May 1984, they bought back 42.9% of their outstanding stock so the cumulative shares repurchased between 1972 and through May 1984 was an astounding 85.4%!

Buffett often mentions Washington Post as an example of how share repurchases can create value.  His ownership stake has increased over the years simply from share repurchases (he owns the same number of shares but share count decreases with repurchases).

Low Prices Are Good
From these examples, you can see why Buffett is not concered at all with lower prices.  If you have good, honest, competent management, then lower prices is fine as they will focus on value adding acquisitions or share repurchases.  The above shows that you don't need a roaring bull market and booming economy to get good returns.  In fact, the above two examples show people who did better in a flat, horrible economy than most did in the bull market starting in 1982.

This is why I think it's so important to focus on what management is doing rather than on what's going on in the world.  A good manager will do what makes sense in whatever environment.  The question of management is so much more important than what asset class might or might not do better in the future, how much cash to set aside or anything like that.

The natural instinct, though, from looking at the above tables is to try to find a way to avoid sitting through a 50% decline in the stock price (even Berkshire Hathaway went down 50% in the 1970s and in the recent financial crisis too (and in the late 1990s)).  It seems like most people tend to focus on how to avoid the 50% drop rather than the long term value creation of good businesses (which makes a temporary 50% drop in the stock price entirely moot).

Depressed Valuations for an Extended Period
The other thing people worry about is that purchases of businesses made at reasonable prices may trade at depressed levels for a very long time.  What if you pay 20x P/E for a business and it trades at 7x P/E for an extended period of time?  If it trades cheap for a long time and the business is sound and throwing off tons of free cash (again, this is why free cash flow is so important!), then it's not going to matter; value will be increased.

The Teledyne example is a perfect one.  Teledyne would not have done so many tenders if the stock wasn't so cheap.

Let's take a look at the period 1969 through 1979.  According to the table above, Teledyne was trading at 20.6x P/E back in 1969, but was trading at only 7.7x P/E in 1979.    The value of an initial 1,000 shares owned in 1966 grew from $171,000 in 1969 to $890,000 in 1979.  That's an +18%/year return!  And that's with the valuation going from 21x P/E down to less than 8x P/E.

So for the Teledyne shareholder to have done well, it didn't even have to get back up to 10, 15 or 20x P/E.  Going from a reasonable (or high) valuation to a cheap valuation still allowed the shareholder to do well.  And again, that's due to the tenders done throughout the 'cheap' period.

And importantly, a Teledyne investor didn't have to wait until the stock price got cheap in order to do well in the stock.  Of course they would have done better buying at the low, but how many people actually do that?  In many cases people wait for a good opportunity to buy and it never comes, or it comes at a far higher price.

Conclusion
With the market having done so well recently a lot of people seem to be looking for other places to put their money.  They wonder how much in stocks they should own, whether they should get into real estate, gold or other hard assets.  Institutional money is running to alternative assets.

I think the more interesting question is not so much whether or not to own stocks (versus other assets), but which stocks to own.   I think history shows that choosing which stocks to own is more important for returns than choosing which asset class to own, which sort of goes in and out of fashion.  If you own commodities, gold or real estate, they will go up and down with the trends/fashion of the moment (actually, real estate can be managed actively and intelligently). 

I know there are academic reports contradicting this, but my guess is that those studies focus on large institutions and their equity portfolios tend to mimic the major indices so there is probably very little difference in returns based on stock selection.

But if you own a good business such as those run by an outsider-type CEO, the stock price may go up and down in bull and bear markets according to the mood of Mr. Market, but the intrinsic value of the business will keep going up.  And the markets will eventually reflect that increasing value over time.  Even if Mr. Market refuses to acknowledge the value, a good CEO can use that irrationality to enhance value (through aggressive buybacks).

Anyway, this is what Buffett keeps saying and value investors understand this.  But I just wanted to use a specific example to illustrate exactly what he means; to see the mechanics of how this actually happens.  Of course, Teledyne is an extremely successful example so we can't expect to find something that will do as good as the old Teledyne, but I think many companies operating under similar principles can do much better than the market (and certainly better than 'hard' assets and most other investment 'alternatives').

So what do you do in this market?  I guess the conclusion is to keep doing what we should always be doing.  Looking for businesses like the above, and then just hanging on.  Don't do anything different.  Ignore books and people who give advice on what to do in flat markets, inflationary markets, depressions, how to prepare for this or that and things like that.

FRMO Corp. (FRMO)

So I read a book, make a post about it and all sorts of ideas start coming out.  This is another thread that comes out of that and I am going to pull it to see where it goes (thanks to the person who mentioned this in the comment section in the other post).  I don't think there is anything imminently actionable here on FRMO itself, but I spent some time at their website and went through their annual reports and annual meeting transcripts and found it totally fascinating.

Here are the relevant websites:

http://www.frmocorp.com/
http://www.horizonkinetics.com/

FRMO is a strange entity, but basically it owns a stake in Horizon Kinetics (asset manager), has cash and investment assets, revenue sharing stream and things like that.  More on that later.

Horizon Kinetics is an asset manager run by Murray Stahl and Steven Bregman.   Murray Stahl sounds like an outsider's outsider.  Or maybe that's outsider^2.  He loves owner-operator businesses which is similar to the outsider CEOs and he himself is a manager (of funds, FRMO and Horizon Kinetics) who thinks like an outsider.

Check out how "outside" he is in his thinking.  This is a snip from a recent conference call transcript (on the website:  FRMO might have the best investor website ever.  Even better than Berkshire Hathaway and Leucadia; it has the simplicity of each of them, but includes conference call and annual meeting transcripts!)

 

Value Investor Insight (May 31, 2013)
Anyway, at the website there is a great interview with him from Value Investor Insight (May 31, 2013). 
Here are some notes from that interview:

• Stahl quote: "Every perspective I have will sooner or later go stale...  I'm constantly looking for how successful people do things differently."
• Horizon Kinetics manages $8.1 billion; the large cap strategy has returned +11.5%/year net versus 7.6%/year for the S&P 500 index since January 1996.
• Likes owner-operated businesses.  Warren Buffett and John Malone are examples. 
• Leucadia is also an example.  Handler looks good so still owns Leucadia.
• Sears is another example and the story there is not over yet.
• Valuation methodology:  estimate earnings in four or five years, apply reasonable multiple and then discount back at 20%.  If implied discount rate is greater than 20%, will look at closely.

These are some names discussed in detail:

• Brookfield Asset Management (BAM); has owned for a long time, trading below liquidation value, spin-off opportunities 
• Dreamworks (DWA): market not giving credit to film library; market tends to price stock based on most recent movie (hit or not).
• Ascent Capital (ASCMA):  Malone spinoff.  Burglar alarms, fragmented industry, opportunity for accretive acquisitions etc.  Amortization obscures core profitability (at $73.50) trading at 7-8x forward free cash.
• Likes Oaktree Capital Group (OAK): Run by Howard Marks.  Look at PIMCO (AUM $2 trillion) for potential upside of DoubleLine (AUM $60 billion).
• Dundee Corp:  Canadian owner-operator.  Analogous to Brookfield and Leucadia.   Run by Ned Goodwin.  Sum of the parts play.
• Onex Corp:  Listed private equity firm in Canada.  Trading at value of investments; market giving no value to management company (fee revenues streams).

Anyway, you will notice that this manager seems right up my alley.  He likes the same sort of companies that I do for similar reasons.


Owner-Operators
Since we are on an outsider CEO kick now, this is really on-topic to what I've been looking at recently (and another reason why I'm making this post).

Check out the holdings of the Kinetics Paradigm funds.  With $1.2 billion in AUM, I guess it's one of the main funds that Horizon advises:

So check this out.  It is a pretty focused fund (compared to other mutual funds) and there are a bunch of owner-operator and spin-off/special situations stuff.  I'm surprised more people don't talk about Murray Stahl / Horizon.

How has this fund done over the years?

 

All of this and more is available at the Kinetics Mutual Funds website.

So even if you don't invest in mutual funds, at the very least, checking out the holdings here is not a bad idea.

But anyway, back to the topic of owner-operators. 

Stahl talks a lot about the problems of indexing in the annual reports, annual meeting and conference calls.  So I think in an act against this trend, he has created his own index.  He decided to create an index based on owner-operated businesses instead of creating a fund or ETF.  You can read about all the reasons why in his literature, but at the end of the day, he just decided that that's the best way to go; it can be objective (third party to calculate / manage the index) and the cost of creating an index is very low (pencil, paper and a calculator).  Revenues that accrue from licensing will therefore have high returns.

Anyway, this lead to the Wealth Index.

Horizon-Kinetics ISE Wealth Index
This index is based on Stahl's idea that owner-operated businesses tend to outperform over time.  Again, I really recommend people to go read all of the annual reports and read the annual meeting transcpripts at the FRMO website.  He offers investment ideas and things like that too (at the annual meeting).  And it won't take long.  It's not like reading the 10-K of J.P. Morgan for the last ten years or anything like that at all.  In fact, you can read all of that stuff in less time it takes to read a JPM 10-K for a single year.

Anyway, the index is composed of companies run by wealthy people in control positions.

Here is how it has done over time:

Not bad at all for a mechanical index. 

So let's take a look at the inside of this thing.  Here is just a sample list:

So look at that.  Some of our favorite names are in there.  Berkshire Hathaway, Colfax (subject of a recent post), Loews, Liberty Media, Greenlight, Google, Vornado, Sears etc...

If you had an algorithm to pick stocks, you can do worse than this. 

Going off on a tangent for a second; how about taking this index as a basket and then applying the Magic Formula to it, or 'value'-weighting it as Greenblatt suggests?  Then you might get some insane returns. But then again, some of those metrics may not work for the above names.

At the annual meeting (according to the transcript), they said they have a new wealth index for the Japanese market and they are also developing a similar idea based on spin-offs.

There's a whole lot more and I may post more about what I find later.  There is still a bunch of stuff on the website (like research) that I haven't dug into, but from what I've read so far, I bet they would be well worth any serious value investor's time.

FRMO Corp
OK, so finally I get to FRMO.

I'm not going to go through the history here.  Stahl explains it well in the documentation at the website. If I attempt to summarize it, I will probably bungle it and confuse everyone.  So let's just say that all sorts of things happened at FRMO over time, and now the structure may be a little more stable going forward.

I think in the past it used to be really tricky to value this because FRMO had an ownership stake in a private entity (Horizon Kinetics) that didn't disclose much information.  If someone owns 1% of something and you don't know what that something is in terms of financials, you can't value it.

That's still sort of the case, even though we know a little more.  I think Stahl said that more will become public over time.  For example, the revenue share stream became clear starting in the first quarter of the new year because the non-investment related revenue will be pretty much the revenue share from Horizon-Kinetics (they get 4.199% of Horizon's revenues).

They also own 4.95% of Horizon Kinetics itself.   So we have two problems; what is the Horizon revenue sharing stream going to look like, and what is Horizon-Kinetics worth?

I have some ideas about that and I may post something at a later date.

But for now, I have a cheap copout on this.  Since they just did the deal where FRMO's ownership of Horizon Kinetics went up 4.09% to 4.95% we can use that as a valuation benchmark.  The deal was done on May 2013 so it's still fresh, or maybe five months old at most.

[ By the way, I found a typo on page 12 of the 2012 year-end financial statements.  At the bottom of the page, the dates May 31, 2012 and May 31, 2013 should be reversed; Investment in Horizon Kinetics LLC is marked at $10,973,940 as of May 31, 2012 instead of May 31, 2013. ]

Valuation
I don't think there was any mention at the 2013 annual meeting of the valuation of the deal in May when FRMO acquired 4.09% of Horizon-Kinetics, but I think they did it at what they consider fair value.  The last time they did a similar deal (mentioned in the 2012 annual meeting), Stahl said that they priced the deal using other asset managers as comps to avoid a conflict (as Stahl runs both FRMO and Horizon).  I think he said they used 6.3x EBITDA for the earlier deal excluding some stuff on the balance sheet.  That was when AUM and valuations were depressed in the sector, he said.

Assuming they did the same this time in May, then the $11 million valuation on the balance sheet for the Horizon Kinetics stake might not be too far off.  I have no idea what the balance sheet capital is at Horizon Kinetics so this is probably low (in the earlier deal, the balance sheet assets were not included in the valuation so FRMO got it for free).  But if they did the transaction at a fair price using asset manager comps, then the May 31, 2013 valuation might not be a bad benchmark going forward.

As for the revenue share stream, it is also booked at around $10 million.  This is also a 'fresh' mark, so even if it's at cost, it hit the book recently from a fresh valuation.  This value was "determined by an independent valuation" so it may not be as good as the 4.95% ownership stake.

If I recall correctly, I think Stahl said that in the first quarter of this year (no conference call transcript of 1Q14) we will see the revenue stream; basically what is not investment related revenues should be the revenue sharing revenues.   If that is correct, then the revenue stream is $680,000 in the first quarter which annualizes to $2.7 million.   Using a 10% discount rate gets you a value of $27 million for this stream.  Using a 6% discount will get you to $45 million.  Either way, it's a lot larger than $10 million on the book.  This is pretax, but from an earlier post about asset managers, I am comfortable with 10x pretax earnings as a valuation for asset management earnings streams.

As for equity income from the 4.95% ownership, I thought Stahl said that we would see that itemized in the 1Q earnings report, but it looks like the income is clumped together with the investment partnerships as "Income from investment partnerships and limited liability companies".   They have $19 million or so of investment partnerships interests on the balance sheet so we don't know how much of this income is from the investment partnerships and what is from Horizon Kinetics.

So unless I am missing something, we still don't have enough information to get a value for Horizon Kinetics; the best guess is still where they did the transaction in May ($11 million).

What is curious is that both the 4.95% equity stake and 4.199% gross revenue sharing agreement are marked at a very similar level of $10-11 million.  As they mentioned before, a gross revenue sharing agreement is worth more than an equity interest as revenues don't come with costs attached (where an equity holder will get less than revenues due to expenses).

So my tentative conclusion is, let's say the 4.95% equity stake in Horizon is worth what it's on the books for ($11 million) and the revenue sharing agreement is worth much more.  From the above (if the assumption is correct that "Consultancy and advisory fees" is all from this agreement), then it may be worth $17 - $35 million more than the $10 million it's stated at on the balance sheet.   With 43 million shares outstanding, that comes to $0.40- $0.80 per share more than stated book value. 

The rest of book value is cash and investments, which are all marked to market.

So with shareholders equity at $1.93/share as of the end of August 2013, and an additional value of a possible $0.40 - $0.80, that's an adjusted value of $2.33 - $2.73.   But using my 10x pretax value for the revenue share stream, it may be closer to $2.33  (But keep in mind that this revenue stream can grow alot from here).

That makes the current stock price a bit high at $6.90/share.

Let's say that the equity value of Horizon Kinetics is actually very understated, even if they did the May transaction at what they themselves (Stahl) felt was fair value.  As a sanity check, let's assume that the 1Q revenue share income annualized of $2.7 million is more or less normal and they have (now or eventually) 50% operating margins (TROW, PZN and other equity and alternative managers have margins in that area). 

But with the revenue sharing agreement, the operating margin would be 46% (they have to pay out 4% of revenues so 50% - 4%).  Horizon would have annualized revenues of $64 million and at 46% operating margin gets you pretax earnings of $30 million, and 10x that is $300 million.  4.95% of that is $14.9 million, or another $0.09 on the balance sheet ($11 million is already on the balance sheet).  That would give us a total range of $2.42 - $2.82/share as the fair value of FRMO.  There are other adjustments to be made, but this is just a big picture guestimate.

Anyway, this back-of-the-napkin Horizon Kinetics value is probably way off as we don't know what the fee structure details are.  As I mentioned before I'm not a big fan of percentage of AUM as a valuation measure either as that really depends on the underlying assets (equities versus bonds versus liquidity funds), structure (mutual fund-like fixed management fee, institutional/retail, advisory / subadvisory,  hedge fund-type fee with incentives etc...) and other factors.  10x pretax earnings seemed to work well the last time I looked; valuations are probably higher now.

But!
If you read the annual reports and conference calls, you will notice that they have a lot of new projects planned, many with very low marginal cost (hedge funds, more indices and services with swaps which is very interesting to me as I have been involved with derivatives before (I assume they just get the licensing fee and not have anything to do with any actual swap)).  There can be a lot of potential there.  We don't know what the margins are at Horizon, but if new projects stick, they can probably get some pretty good operating leverage that is not reflected in the valuations above.  Licensing fees literally just fall straight to the bottom line and there won't be any AUM associated with that either.

They also said that AUM growth is accelerating (or at least the Horizon revenue growth).

Either way, this stock isn't currently trading at below any "readily ascertainable asset value" but who knows.  I look forward to following this going forward.

By the way, the structure of FRMO has been evolving and equity base is getting bigger so this may not be indicative of future potential, but check out the history of growth in per share value of FRMO over the years from their 2011 letter to shareholders (per share tangible BPS was $1.39 and $1.93 for 2012 and 2013):

Colfax Corporation (CFX)

OK, so this is another extension of the footnote to the book post.  Someone mentioned in the comment section that Colfax (CFX) is the younger analog to Danahar (DHR) and it is owned by some Tiger cubs and BDT Capital, a firm run by Byron Trott (Buffett's investment banker).

Here's the 2013 ownership section from the 2013 proxy:



Of course, what is interesting is that BDT Capital owns such a large percentage.  They did sell some shares in a public offering earlier this year but still own a large stake (or at least they didn't sell their entire position on the offering).  Probably the most important owner is Steven M. Rales; this is the Rales that founded Danahar (DHR).

Blue Ridge Capital, of course, is run by the Tiger cub John Griffin.  Tiger Global and other Tiger cubs own shares too.

Maybe interesting to the Buffett followers (other than Trott's involvement) is that Tom Gayner of Markel has been a board member of CFX since 2008 and Markel has owned a million shares or so since early 2012 (when CFX bought Charter, no not Malone's Charter, the Irish welding company... I know, this can get confusing).  Markel paid $23.04/share and BDT Capital got a bunch of shares at that price too in January 2012, related to the Charter acquisition.

Markel still owns it, and it looks like it's 2% or so of their equity portfolio.

Anyway, let's look at the chart:



CFX IPO'ed at $18/share back in 2008.  That was just when the world was falling apart and it shows in the stock price.  But over time, it has done incredibly well.   By the way, the red line is the S&P 500 index and the green line is Berkshire Hathaway.

History
Anyway, I have never heard of CFX until someone mentioned it the other day here.  CFX was originally started back in the mid 1990s with the backing of the Rales brothers.  As I was looking around the SEC filings, I found an S-1 filing for CFX from back in 1998.   I guess they filed an S-1 and never did the IPO. 

So here's a cut and paste from the August 1998 S-1 filing on the start of CFX:

Philip W. Knisely, with the support of the other Principal Stockholders,
embarked in 1995 to acquire, manage and grow world class industrial
manufacturing companies in the fluid handling and industrial positioning
industries. These industries were targeted due to their size, highly fragmented
nature and the Principal Stockholders' belief that these industries provided
the opportunity for accelerated growth and for improvements in operating
margins.

The Principal Stockholders have significant experience in acquiring and
leading multinational industrial manufacturing companies. Mr. Knisely, the
Company's President and Chief Executive Officer, has experience in managing
global industrial manufacturing operations for more than 15 years, including as
a group president of Emerson Electric Company and president of AMF Industries.
The Rales, who will serve as directors of the Company, are also directors and
principal stockholders of Danaher Corporation ("Danaher"), a New York Stock
Exchange ("NYSE") listed company and a leading manufacturer of tools,
components and process/environmental controls with a market capitalization of
approximately $5.6 billion as of July 31, 1998.

  The Company intends to expand its operations through internal growth and
acquisitions. The Company believes that there is a significant opportunity to
increase the internal growth of the Acquired Companies and of
future acquisitions by implementing the Colfax Business System ("CBS"), a
disciplined strategic planning and execution methodology designed to achieve
world class excellence in customer satisfaction. CBS is a customization of a
system which has its roots in the world-recognized Toyota Production System. A
similar system has been successfully deployed at Danaher for more than 10
years. Management has begun implementing CBS in each of the Acquired Companies
and believes that it has resulted in cost savings that have contributed to an
improvement in the Company's pro forma results of operations, as shown in the
following table:

<TABLE>
<CAPTION>
                                                         UNAUDITED PRO FORMA
                                                           SIX MONTHS ENDED
                                                      JUNE 30, 1997 JULY 3, 1998
                                                      ------------- ------------
                                                        (DOLLARS IN THOUSANDS)
   <S>                                                <C>           <C>
   Net sales.........................................   $272,006      $277,201
   Adjusted operating income(a) .....................     22,155        33,364
   Adjusted operating income margin..................        8.1%         12.0%

And like the other outsider companies, the main growth strategy is:

GROWTH STRATEGY

. INTERNAL GROWTH

  The Company believes that there is significant potential to increase the
  internal growth of the Acquired Companies and of future acquisitions.
  Through the implementation of CBS, the Company will seek to grow internally
  by focusing on customer needs and striving to improve product quality,
  delivery and cost. Specific actions to accomplish these goals include: (i)
  leveraging its established distribution channels; (ii) introducing
  innovative new products and applications; (iii) increasing asset
  utilization; (iv) using advanced information technology; (v) increasing
  sales and marketing efforts; (vi) expanding and diversifying the customer
  segments served; and (vii) expanding the geographic markets served.

. ACQUISITION GROWTH

  The Company believes that the fragmented nature of the industries in which
  it participates presents substantial consolidation and growth opportunities
  for companies with access to capital and the management ability to execute
  a disciplined acquisition and integration program. The Company's
  acquisition growth strategy is to acquire companies in the segments in
  which it participates that (i) have leading brands and strong market
  positions; (ii) will expand its product lines; (iii) have reputations for
  producing high quality products; and (iv) complement or enhance the
  Company's existing worldwide sales and distribution networks. The Company
  also believes that the extensive experience of its management team and the
  Principal Stockholders in acquiring and effectively integrating acquisition
  targets should enable the Company to capitalize on these opportunities. The
  Company intends to take a proactive approach to acquisitions and has
  currently identified approximately 50 potential acquisition targets in each
  of its two business segments located both in and outside the United States,
  although it does not currently have any agreements or understandings with
  respect to the acquisition of any such potential targets.

Their growth strategy is more detailed than this in their 2008 prospectus.  But the above pretty much shows you what the original intent was.

I don't know what happened since 1995 until the late 2000s when we get more information through the public filings.  Knisely no longer runs CFX; at some point it seems he went to work for Danahar (executive VP), retired and now is an advisor to Clayton, Dubilier and Rice (private equity shop).

Anyway, the Rales are still involved as owners and Chairman (like DHR) and that's the important thing.  We are looking for another DHR, right? 

By the way, here's the current CEO.  He's a DHR guy:

Steven E. Simms has been President and Chief Executive Officer since April 2012. He has served as a Director of Colfax since July 2011. Mr. Simms also served as Chairman of the Board of Directors of Apex Tools and is a former Executive Vice President of Danaher Corporation.  Mr. Simms held a variety of leadership roles during his 11-year career at Danaher. He became Executive Vice President in 2000 and served in that role through his retirement in 2007, during which time he was instrumental in Danaher’s international growth and success. He previously served as Vice President–Group Executive from 1998 to 2000 and as an executive in Danaher’s tools and components business from 1996 to 1998. Prior to joining Danaher, Mr. Simms held roles of increasing authority at Black& Decker Corporation, most notably President–European Operations and President–Worldwide Accessories.  Mr. Simms started his career at the Quaker Oats Company where he held a number of brand management roles. He currently serves as a member of the Board of Trustees of The Boys’ Latin School of Maryland and is actively involved in a number of other educational and charitable organizations in the Baltimore area.

He's only been on the job for a little more than a year. 

Anyway, let's take a look at how CFX has done over the years.  I'm too lazy to make a table so I'll just snip stuff from the annuals so you can get a sense of how they've done:

This is from their 2008 annual report; the first annual after their IPO.  Things looked fine.  Sales are up, margins are going up etc.  Adjusted EPS is $1.22, so the IPO was priced at around 15x the current year EPS.  Their margins were going up thanks to CBS (Colfax Business System), and was up to 15.0%.  Hold that thought because we'll need it.  By the way, DHR has operating margins north of 15% (17.3% in 2012).

 

And things sort of start falling apart along with the economy.  This is from the 2009 annual report:

And finally this is the five year financial summary from the 2012 10-K:

So it wasn't smooth sailing through the great recession like some of the other outsider companies.  But look what happened in 2012.  In January, they did a huge deal, obviously.  I guess we can call that a tranformational acquisition since it's so big. That's the Charter acquisition that brought in Markel and BDT.

Now look closely at the operating margin.  Even excluding all that acquisition-related and restructuring charges, operating margin is really low.

Remember, how is CFX going to grow?  Through acquisitions and CBS (Toyota-like improvement system), right?  Yes, organic growth too.  But acquisitions and margin expansion are two big drivers.  So for CFX to make such a huge acquisition and for BDT, Markel and others to support it by providing equity funding for the deal, there must be some huge operational improvement potential at Charter, right? 

So that's the story right there.  Of course, the main, full-time story is that CFX will grow like DHR did and like other outsider companies.  But the story now is this huge deal that they did, and I think it's obvious that they know Charter's business well enough to have confidence that they can really get their margins up. 

Valuation
So let's get to the interesting part.  Yahoo finance says that CFX is trading at 60x ttm P/E and 22x next year's estimate EPS.  CFX is guiding $2.00 or so for December 2013-end full year EPS.  At $56, that's 28x P/E.   I notice that there are people calling to short this overvalued stock based on this P/E.

But with shareholders like the above, we know this can't be right.   We have to look beyond the headline metric to see what is actually going on.

So check this out. This is from their June 2013 investor presention:

So the model for the top line is to outdo GDP by 1-2% on an organic basis and then add to that via acquisitions; something that the Rales have sort of been good at doing historically.

And here's the key for my current back-of-the-napkin analysis:  Margins.  They target mid-teens operating margins.  Let's call that 15%.  This was once achieved by CFX (see above 2008 annual report) and is currently done by DHR, so there is no reason why it can't be done here.  In recent years, there was the financial crisis and then this huge megadeal.  But when they work through this huge deal, there's no reason why they can't get up to 15% operating margins.  Well, yes, things can go wrong.  The economy can fall apart etc.   

Also, like DHR, they will get free cash flow above net income.  There's no reason why they can't do that either. 

By the way, here's what the big deal did to their revenues:

They have higher exposure now to higher growth markets.   This may have backfired in the short term as it seems like former high growth markets are having problems (China, Brazil etc...).  But that's probably a short term cyclical problem, and over time, the growth markets will tend to grow faster than the mature markets.

So let's get to the fun part.  This is going to be really rough work so don't take it too seriously.  I am just going to play with the numbers to get sort of a reality check on valuing CFX. 

What if CFX gets operating margins back to 15%?  What would earnings look like then? 

Here's the 2013 guidance from their 3Q earnings slide:

 



 

You will see that on the low end, they are guiding revenues of $4.1 billion, adjusted net income of $223 million and adjusted EPS of $1.98/share. 

Now let's just adjust the above to a 15% operating margin instead of 10%.  Then the above table would look like this:

Revenues:                              $4,120
Adjusted operating profit:        $618
Interest:                                    ($76)
Taxes  (@27%):                     ($146)
Noncontrolling interest:           ($31)       
                                                 $365

I'll just use 115 million shares (102 million shares outstanding plus 13 million dilutive shares) and we get $3.20 in adjusted EPS.   That's 17.5x P/E ratio if, all else equal, operating margin was 15%.

Wait, but there's more.  CFX seeks to have free cash flow exceed net income.  DHR had free cash above net income for 21 years in a row.  If the Rales are focused, they can get that done here too.  Why not? 

For a quick guestimate, I just looked at depreciation and amortization against capex.  For the first nine months of 2013, D&A was $102 million versus capex of $51 million.  So cash earnings were $51 million higher than net earnings so far this year.  Annualize that and you get around $70 million.

Add the $70 million to the above $365 million and you get $435 million in free cash.   That comes to around $3.80/share.   With a $56 stock price, that's 14.7x cash earnings, or free cash per share.  That's a 6.8% free cash yield.

So think about that.  And as they get their margins up there, sales will probably continue to grow and some of the softer emerging markets will start to come back.  So even without any sales growth, just by doing their Toyota thing, they can get almost a 7% free cash yield...  and then add to that the GDP plus 1-2% growth organically and maybe some potential acquisitions and more margin improvements there and you are talking about some serious potential compounding.

Oh yeah, on the earnings calls, they sort of talk about margins for their segments.  Segment margins and overall company operating margin will differ; segment margins don't include corporate overhead.  

I would think that CFX should get company level operating margins up to 15% at some point, but let's say that they only get their segment margins up to 15%.  In that case, we will have to lop off around $50 million for corporate SGA from the above $365 million.  This would make the above figures around 14% lower. 

Conclusion
I don't know why I keep writing 'conclusion' on these posts when I don't often have one.   I just wanted to take a look at this company as there seemed to be so many reasons why I should;

• it's an outsider-type company with a similar strategy
• and it's actually run by the Rales who have done it before with DHR (or at least Chairman'ed by them)
• has a distinguished shareholder list even though BDT seems to be selling.  Blue Ridge seems to have gotten in in the past year or so, so it's still fresh.  Markel still owns it.

Anyway, my analysis above is admittedly very rough, but I don't think it's a stretch to imagine that CFX can keep improving the operations and get their margins up.   This is what they do and what they are good at.  If they do so and they keep sales growing organically and through further acquisitions, I would not be surprised at all if CFX stock does really well.

Having said that, I've only spent a day or two on this so even though I like a lot of what I see, I can't say I am comfortable with it enough to own the stock (or at least own a big position in it).  Maybe I'll get more comfortable after looking more closely at DHR (and get familiar with the way the Rales operate) and following it in real time for a little.