Reflections of a Cheapstockhunter

Show me the money!!!

The myopic focus that Wall Street places on near-term earnings-per-share (“EPS”) and the resulting price appreciation awarded to companies that “beat” EPS estimates creates a misguided incentive for executives to “manage” reported earnings. Though accounting rules have been tightened, there are still many ways which companies can use aggressive accounting to “beat” EPS targets. Naturally, financial engineering has become an all-too prevalent and sophisticated exercise.

One infamous example of this involved appliance maker, Sunbeam Corporation, which after a string of poor results initiated a restructuring to repair its image with investors. As sales continued to falter, newly hired CEO “Chainsaw Al” Dunlap initiated a scheme to improve results by shipping barbecue grills and air-conditioners to retailers—in December!! With generous rebates and return allowances Sunbeam successfully padded near term sales but the returns from retailers led to ballooning inventory, hurting pricing and leading to disastrous results and the collapse of Sunbeam. This kind of “channel stuffing” is often a warning flag of declining corporate performance and a lower future stock price.

Because, historically, EPS has been the primary measure of a company's performance, accounting rules have evolved that attempt to more precisely match the timing of a firm's revenue and expenses. Earnings are composed of cash flows and accruals. Accrual accounting strives to recognize revenue when it is “earned” and allocate expenses when they are “incurred” regardless of the timing of the actual cash flows. The benefit of accrual accounting is that more appropriately smoothes the operating results of a business. However, because accruals are based on assumptions about the future, corporate managements may be tempted to tweak assumptions in a manner that make the company appear more attractive.

Here are a handful of situations that highlight the importance of monitoring the level and trend of accruals:

1. Manipulation of depreciation and other non-cash expenses
Accounting rules allow managers wide discretion to determine the allotment of “non-cash” costs such as estimating the useful life of an asset. Waste Management was recently penalized by the SEC for "juicing" its earnings by re-estimating the useful life of its garbage trucks, an action which had the effect of lowering its depreciation expense and reporting higher income.

2. Excessive capitalization of items which should be expensed
In 2002 AOL Time Warner was forced to take a charge of $54 billion as a result of the excessive purchase price of AOL and years of aggressive accounting policies that overstated the true economic value of the enterprise. AOL abused the accounting rules allowing certain expenses to be classified as assets and expensed over many years, rather than during the period when they were actually incurred. For example, as AOL was struggling during the late 1990s to show a profit, they extended the assumed useful life of the “starter kits” for dial-up internet service from two years to five years, dramatically lowering their current marketing expenses and increasing their reported income. AOL was grossly overestimating the useful life of these now-obsolete assets and, had they properly reported these expenses, the profits reported from 1997 through 2000 would in fact have been losses.

3. Inventory trends relative to sales
The collapse of Lucent and several of its telecom peers provides an example of where more careful monitoring of inventory trends may have protected investors from significant losses. While Lucent was keeping the Wall Street analysts pacified by consistently exceeding earnings expectations, investors overlooked that the company's inventories were growing at a dizzying pace. Increasing competition, product development missteps, and tempering demand was weighing heavily on Lucent’s cash flow. These factors together with the accelerating levels of accruals caused by the disproportionately higher inventory levels should have served as a warning regarding Lucent’s deteriorating business performance.

4. Accounts receivable (credit-based sales)
Lucent’s situation was exacerbated when the company loosened its credit standards and began offering very favorable financing terms to entice its customers to buy more equipment. The financing game stimulated some artificial demand by “borrowing” sales from future quarters and encouraging marginal customers and distributors to buy more products they otherwise likely wouldn't have purchased. While this stimulated near-term results, the higher-credit risk customers eventually defaulted on payment which contributed to the fall of Lucent’s stock.

While EPS (i.e. “accrual earnings”) is important, these four accounting situations highlight why we focus equal attention to a company’s ability to generate free cash flow (also know as "defensive earnings"). A recent study published by professors from the Universities of Michigan and Pennsylvania identify a phenomenon they call the “Accrual Anomaly”, where excess returns may be available to investors that buy companies with low levels of accruals. The results of their study are both robust and compelling as their model portfolio (long top 25%, short bottom 25%) beat its benchmark in 28 out of 30 years, and outperformed the market by almost 10% per year.

We view studies such as these as reaffirming of our practice of analyzing EPS quality and using earnings quality as a filter to our research process. In each investment we make, we closely evaluate levels of free cash flow trends in defensive earnings relative to accrual earnings, which we believe reduces the risk of earnings blow-ups amongst the names we own. This demand for strong earnings quality, in addition to seeking robust fundamental attributes of profitability, growth and valuation strengthen our portfolio holdings.

Adobe Corp: Riding the Wave of Web 2.0
Given the recent volatility in the market, I have slightly modified my screening process placing a slightly greater emphasis on strong topline growth, earnings consistency & clean balance sheets, the qualities of companies that tend to trade well during times of economic uncertainty. Obviously, I am not the only investor seeking a safe haven in this market, and the redirection of money flow into these stocks has driven their prices and P/E ratios up. Stocks like Proctor & Gamble and Microsoft are at their 52 week highs and trade at P/E multiples much higher than historical averages. Although my investment approach is rooted in value investing, I am willing to pay a premium for stability in this environment. After all, the great Warren Buffet has even been known to pay up for quality during times of turmoil, as evidenced by Berkshire's late 1980's purchases Coca Cola and Gillette.

My search has led me to Adobe Corp. Most everyone that owns a computer in the developed world has at one time or another used Adobe Acrobat(900mm installed base). Adobe utilizes a "reverse razor blade" strategy by distributing free copies of its reader product to PC manufacturers, and generating its profits on sales of its writers, or applications used to create communications in PDF. format. This creates enormous competitive moat for the company and allows it to generate strong returns on its invested capital.

Not only does the company have strong competitive position, but several growth catalysts are emerging that should increase the visibility of earnings growth and likelihood of upward revisions. From an industry perspective, the outlook is bright. Enterprise roll-outs of Vista (Microsoft) and insatiable consumer demand for notebooks is expected to support PC/Notebook shipment growth of over 11%-13% according to Gartner and IDC forecasts. Most of these machines will come pre-installed with Acrobat software. Furthermore, the popularity of web-communities such as myspace and youtube is resulting in exponential growth in the number of websites and the need for creative content solutions.


Internally, the company is intently focused on its recent launch of CS3 (Creative Suite 3), a suite of tools used by creative professionals and consumers that want to use computers to create their own websites, blogs, and share media with family and friends. With the recent acquisition on Macro-media, known for their popular flashplayer technology, the new product offers much greater video functionality for web-developers and should generate significantly higher per unit margins than previous rollouts. Since 2003 the average selling price of ADBE's product mix has grown from about $250 to $400. This trend should continue. Going back 20 years, I found a strong correlation between product launches and accelerating sales trends. Given that CS3 is anticipated to be the most successful launch ever for the company, revenues are poised to follow the historical pattern of post-launch growth. On its most recent conference call Adobe management pointed out that penetration rates among creative professionals are 40% higher than previous releases at this point in the product roll-out cycle (launch + 6 months), due to the products growing popularity and enhanced functionality.


Additionally, new product launches in mobile applications should gain traction in 2008. The number of of "flash enabled" devices sold per year has grown from about 50mm to 250mm in just the last 3 years. Interestingly, most of the developing world (and over 60% of the worlds population) will access the internet for the first time via a mobile device, so the enormous opportunity here is clear. There are indications that the company will launch a mobile product in 2008.

Lastly, the company is making significant strides within the enterprise marketplace through a recently announced partnership with SAP which should dramatically increase the Adobe value proposition within large organizations. Longer term, the company has been beta testing a new html-based architecture known as AIR that will make web content creation much more accessible to the masses. As the operating system continues to look more and more like a home-page, applications such as AIR will be at sweet spot of this technological evolution. At a recent conference management indicated that internally, they think AIR has the potential to do for internet content development what Acrobat did for document management. The company expects numerous product launches based on the AIR technology, as this next generation "razor blade" gains mass acceptance.

Fundamentals & Valuation
The company should earn about $1.85 next year, which means it trades at about 22x earnings at the current price of 42. They do have over $6B in cash & equivalents on the balance sheet, so adjusting for cash we are paying about 19X, not cheap, but not ridiculous either for a company that generates ROE's of 25% and is expected to grow at 16% over next several years. I also like to look at free cash flow, and as expected with any software company, Adobe is a cash machine. The company has well over $1B in cash flow earning power, which is healthy for a company with an net enterprise value of about $18B. Based on my DCF analysis, which assumes consensus growth rates, a discount factor of 10%, and a terminal multiple of 18X, the stock is intrinsically worth about $50 per share, a modest margin of safety.

This isnt a classic value stock, and any execution missteps with the new management team do pose a real risk to the thesis given the premium we are paying. I have met the new management team, and they have been well groomed internally, and largely seem to be thoughtful, shareholder friendly managers. Not a risk free story, but when the market gyrations have you reaching for the Pepto, a stock like Adobe, might let you sleep a little better.

Labels: ADBE, Adobe

The Long Case for Pacer International

Having recently finished reading the book The World is Flat by Thomas Friedman, I have found myself searching how to apply the “globalization paradigm” to my portfolio management process and how to incorporate these trends into a more thoughtful view of the investment landscape. One clear observation I have made is that jobs and growth are headed overseas, so a forward thinking investor ought to position their portfolios to benefit from this inevitable shift of capital. That said, for the enterprising analyst, there are certainly pockets of opportunity within the US markets. One industry that arguably cannot be “outsourced” is transportation, you simply cannot outsource the infrastructure, assets, and human capital involved in delivering goods along American highways, waterways, and railroads. This realization has led me to focus my screening in that sector.

Using a disciplined screening process focused on valuation, return on capital, and growth, I discovered Pacer International, the worlds largest inter-modal transportation company. Pacer is an asset-light transport, meaning that it does not own hard assets, like trains and trucks, but instead, most of its assets are in information technology and deeply entrenched relationships with the railroads and shipping companies. This, by nature, leads to higher returns on capital, and positions them favorably at the end of economic cycle, when the asset heavy players see steep profitability declines as businesses become over-capitalized.

Inter-modal refers to the process of moving a container or trailer via more than one mode. Essentially, Pacers fleet of leased containers are able to be transported via rail or truck, eliminating the need to load and unload the vehicles. PACR also has a patented system known as “double-stacking” which, logically, allows containers to be stacked one on top of the other, enabling more goods to be transported along rail routes.

The value proposition that PACR presents is their economies of scale. PACR has the ability to contract large container volumes at discounted prices, and therefore offer customers more cost effective methods of sending and receiving goods. Smaller, regional chains do not have the buying power to realize such discounts and therefore use Pacers services. Furthermore the company handles the logistics and supply chain functions needed to transport the goods from the factory floor, to the retail level. Imagine a small sporting goods company that sells golf clubs. Golf clubs manufactured in China, will arrive via ship to the port of Los Angeles. PACR will handle getting the products through customs, warehouse the items, and using information technology, load items onto appropriate containers, based on varying levels of demand. From there, the goods will move via Pacer railroad containers to Atlanta, Chicago, New York, etc, and at this point the containers will seamlessly disperse, this time pulled by heavy duty trucks that bring the goods to their final, regional destinations.



The economies of scale, IT infrastructure, and entrenched relationships with suppliers (railroads) and customers (mostly retailers), provide a powerful competitive advantage for Pacer.

In addition to their strong competitive advantages within the inter-modal industry, the following trends should also act as a “wind in the sails” for PACR

1. Cost effectiveness (Fuel Costs) - Higher energy costs and increasingly higher trucking rates driven by labor shortages (do you know any 18 year olds clamoring for a truck-driving career)and regulatory changes have made this mode of transportation significantly more cost effective than Truckload and Less-than-Truckload transportation. For perspective, consider that transporting one ton of goods via rail is 40% cheaper than trucking the same amount of deliveries.

2. Container Imbalances - Asian Imports - An increasing amount of goods coming from Asia is creating an imbalance of containers, increasing the value of the service. Nearly 3 deliveries moves eastward across the US for every delivery that moves westward. Asian shippers do not want their containers traveling across the country only to come back empty. PACR on the other hand can use its extensive network of customers and delivery routes to more effectively utilize the volume.

3. Railroad Improvements - Improving service levels from railroad operators - a major criticism of the stock has been its reliance on habitually unreliable railroad companies. This is changing. The railroads have spent a tremendous amount of capex in recent years to incorporate technology that limits service interruptions and bottlenecks.

From a fundamental perspective, the investment looks compelling as well. PACR is expected to earn 2.00 next year, a 14x multiple, based on its current $28.00 handle. Other non-asset based transports are trading at over 25x, which is a historically wide discount for PACR. Based on a conservative DCF model, assuming 15% growth in free cash flow, and a 12% discount rate, the shares appear over 30% undervalued. The company should earn a 15% return on its capital this year and deliver over 100mm in free cash, about 10% of its market value. Furthermore, the company is expected to grow at a 14% rate, and judging by a recent string of positive earnings surprises, the consensus may be low.


While most of the talking heads on CNBC will probably tell you this is a bad time to invest in cyclical transports, which typically under-perform at the end of an economic cycle, I would disagree. If I had a dollar for every portfolio manager that thought they could accurately predict the economic cycle I would be a rich man, I have yet to find someone who can consistently time these peaks and valleys. A more thoughtful investor however might use all this pessimism to find some bargains to add to their portfolio. PACR offers investors a reasonably priced stock, well positioned in a bottlenecked industry, with some very favorable long term trends that should enable them to sustain healthy growth. In an increasingly “flat” world that’s becoming more and more unpredictable, I’m using these dips to patiently construct a portfolio of well positioned companies in defensible markets, a strategy that should outpace the market over the long run.

Walter Industries: Trading at a wide discount to sum of its parts

Walter Industries is a company that is not well understood by most investors, and I feel, trading at a level significantly below its intrinsic value. Because Walter operates in traditionally “un-sexy” industries and has a relatively poor record of profit generation, this company has flown under the radar screens of most Wall St. analysts and portfolio managers. Even after posting a 300% return in 2005 and growing its market value well into mid-cap land, the stock is still only covered by 2 lesser known brokerage firms.

In my view the company has some assets that most investors may not fully appreciate. Currently Walter operates 3 segments, a homebuilding division that manufactures and provides financing for low priced modular homes sold largely to customers in the Southeast, an industrial segment that makes ductile iron pipe, or the heavy duty pipe used in water distribution systems, and a coal mining division that operates 5 mines in northern Alabama. While the money losing homebuilding has traditionally captured all the headlines, effectively scaring away the “housing bubble” crowd, I am more focused on the value of the industrial and coal businesses.

Lets start with the industrial or water pipe business. Late in 2005 the company acquired privately held Mueller Industries, increasing the contribution of this segment to about 60% of sales and 50% of operating profit. The well publicized “water crisis” resulting from an aging U.S. water infrastructure has driven demand for Walter-Mueller products. Furthermore, Walter-Mueller has a significant competitive advantage in the location of its manufacturing; its New Jersey and California facilities are in close proximity to the areas of the country where infrastructure is needed most the fast growing sunbelt, and the metropolitan areas of New York, Philadelphia, and Boston, where current systems are over 100 years old. In Q4-05 these businesses generated roughly 75mm in EBITDA. If we do a simplified analysis and extrapolate this seasonally weak quarter, this segment has roughly 300mm in annual earning power. Most public companies is this space trade at roughly 8x EBITDA, implying that this segment is worth 2.4Billion

The coal business looks even more interesting. The type of coal that WLT mines is called metallurgical or “met” coal. This is the type of coal used in the steelmaking process, and strong demand, particularly from China is driving the price over the $100 per ton level, nearly 3x the price of its soft, high-sulfur counterpart “steam” coal that is used in power plants. During the most recent quarter WLT was booking average prices of about $99 per ton for their coal, but management was hesitant to comment on 2006 prices as coal contracts are currently in the negotiation process. The total cash costs of extracting this coal are about 52-54 per ton, implying about $48 in EBITDA per ton extracted. The company anticipates mining about 7mm tons in 2006, and production is expected to grow by more than 30% over the next 3 years. If these prices hold, it is feasible that the company could generate $326 in cash flow this year. Applying the coal industry average multiple of 10x, yields a value of this business over 3.2B

Ignoring the homebuilding business, which when coupled with its financing arm is generating a small and growing profit, these two businesses could be worth 5.6 billion. Subtract 1.5B in debt that is attributable to these operations, and we are left with 4.1 billion in value or $100 per share. While the analysis has been simplified, the stock trades at a significant discount (currently $65), and there is plenty of room for error here.

Lastly, there are several catalysts on the horizon. The company plans to break up the divisions eventually so that homebuilding, natural resources, and industrial, can hopefully earn the respect (and multiples!) they deserve. News-flow surrounding new coal contract negotiations could also provide a lift for the shares. Lastly, a high concentration of activist shareholders on the top ten owners list is sure to drive management to create value.