A Ship in the Harbor is Safe...

Robo-snake

Nothing to do with finance, just extremely terrifying:

FNM/FRE

For anyone (like me) who thinks distressed financial companies might be a potential goldmine, but doesn't really know how to begin looking at them, here is an 11-part series that digs into Fannie Mae and Freddie Mac from John Hempton at Bronte Capital:

Part I - Introduction

Part II - The Business & Its Books

Part III - Cumulative Default Curves

Part IV - Modeling Future Losses

Part V - Modeling Future Revenue

Part VI - Putting it Together

Part VII - Sensitivity to Loss Assumptions

Part VIII - Sensitivity to Revenue Assumptions

Part IX - Private Label Securities: The Best of the Worst

Part X - Review

Part XI - The Politics

Behind the Spread - kaChing Interview

For anyone out there interested in following my career as well as my investment ideas, I was interviewed by Hiro Takei from Behind the Spread this weekend.  We spoke about my involvement with kaChing, my background, and my investment strategy.  For anyone not familiar with kaChing, basically I've been managing a fantasy portfolio there for about a year, and they just started allowing investors to open brokerage accounts that mirror my trades.  So far there's about $200k mirroring me!

kaChing has been making waves with their official launch.  Dan Carroll and Andy Rachleff made an appearance on CNBC yesterday.  They were also covered in the New York Times, Blogging Stocks, the Broker News Blog, Business Pundit, Fast Company, Forbes, the Huffington Post, Newspost Online, Reuters, and 9 other news sites...  I'm sure you get the point.

Building a Build-a-Bear Workshop (BBW)

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If you’ve been wishing you could travel back in time to March to buy stocks when they were “obviously” cheap, when investors were looking out over the abyss of unemployment and sinking profits wondering how companies could make ends meet, Build-a-Bear Workshop (BBW) might be that opportunity.  Not that I care what a stock chart looks like, but you can see that this company has been stuck at its March price of $5 for months, and is first gaining momentum now.

Maxine Clark, CEO, founded the company in 1997 and grew BBW from scratch to a company that continues to generate well over $400 million in revenue and generated $30 million in profits in its peak year.  At a market cap of $90 million and an enterprise value of $60 million, the market is effectively assuming this company has no future.  Boiling it down for anyone who doesn’t want to read past the first two paragraphs:  the good news is that even with conservative estimates, BBW should be able to generate enough earnings to justify double the current share price; the bad news is that stores were underperforming before the recession could be blamed and the margins are narrow, making an estimate of value sensitive to our assumptions (to the downside as well as the upside).

Store Economics

Build-a-Bear has a pretty straightforward business.  They open stores, mostly in malls, and sell teddy bears that are assembled on-site in short order for anxiously awaiting 7-year olds.  The experience is part of the fun, and bears are currently being promoted for $30 a piece.  Stores cost around $400k to open, as discussed each year in the annual report, and the net income per store has ranged from $137k in 2005 to only $13k in 2008.  Average NI/store has been $77k.  When I say net income, I mean for BBW as a whole, so this includes corporate administrative expenses (and taxes) that aren’t attributable to any specific store.  Using these numbers, we can calculate an after-tax RoI ranging from 3% to 34% on new stores. 

Because management was kind enough to tell us exactly what the average cost per new store was each year, we can somewhat accurately guess what maintenance CapEx is on a per store basis.  The average over the time period I analyzed was around $80k, but I modeled it as closer to $50k because a) management expects to spend $9k on CapEx (with only one store opening) in 2009 which translates to around $25k/store, and b) some CapEx is from corporate growth.  Of the $9mm of CapEx in 2009, $2mm is being spent on repurposing failed experimental concept stores, indicating that real maintenance CapEx might actually be even lower than $9mm for 245 stores.

Management has repeatedly stated that they believe there’s a market potential for 350 stores in North America, and 70-75 stores in the UK and Ireland.  This compares to 291 stores open in North America, and 54 in the UK, Ireland, and France.  BBW also has franchised stores in other international areas totaling 61 stores out of an estimated market potential for 300.  In terms of owned and operated stores, if management’s estimates are correct, they are currently operating at 81% of carrying capacity.  The weak economy in 2009 might have forced management to put the breaks on a little early, but it looks like this might prevent them from driving off a cliff.  Slower store growth means more FCF will be available for management to return to investors in the form of dividends or share repurchases.  The risk exists, of course, that management will pursue an aggressive acquisition strategy and destroy shareholder value with unprofitable expansion.  However, Clark has a pretty strong track record for not being overly aggressive.  In 2006 BBW purchased The Bear Factory, which provided 40 stores in the UK and Ireland for $40 million.  These stores perfectly fit into the BBW business, and are now effectively Build-a-Bear Workshops.  BBW tested a doll-making concept called “friends 2B made”, eventually operating 9 stores in or around existing BBW stores, and decided this year to scrap the concept.  BBW also owns a 25% minority interest in Ridemakerz worth $7.7million, part of which was paid for in exchange for support services.  Otherwise, investments have all focused on expanding the Build-a-Bear Workshop store base. 

The reason for the low share price is weakness in same store sales.  If we look back a few years, we see that BBW has had same store sales problems for a long time.

 


I’m aware of the downward trend in same store sales, but I’m optimistic that BBW will be able to maintain revenue per store of at least $1,400 for a few reasons:

1) The most obvious explanation for SSS declines is cannibalization.  Growing the store base beyond carrying capacity would increase fixed costs and decrease sales per store.  This is exactly what we’ve observed.  But management always has the option to close stores as leases expire if SSS don’t naturally improve.  Total revenue would decline, but existing stores would have an easier time meeting fixed costs, which would boost the bottom line.  Cannibalization alone shouldn’t prevent BBW from returning to historic levels of profitability, and that’s all investors need to see windfall gains on BBW shares.  Reducing store count is a difficult decision for any management team to make, but I really get the sense that Clark isn't trying to build an empire so much as a profitable business.  If her goal was to build an empire, annual reports wouldn't claim a North American store limit of 350.
 
2) The fad risk is low because customers continue to love the store.  Sales aren’t declining because customers are unsatisfied.  You can spend a few minutes browsing reviews, video reviews, or reviews of the online store to get a sense of how much people love BBW.  I struggled to find negative reviews of any sort.  Even buildabearville.com, the virtual reality companion site, has gotten good reviews and is generating traffic according to alexa.com.

3) Ignoring the recession we’re in as a non-permanent contributing factor to recent sales weakness is a mistake.  I’m not sure exactly how much we can blame on the economy, but I do think that once conditions improve we’ll see BBW recover to some degree with the general economy.  I find it difficult to imagine that 2009 won’t be the low point for sales/store.

Valuation

The simplest back of the envelope way to estimate value is to assume the stores are worth what BBW paid.  At $400k each BBW’s enterprise value should be around $139 million, compared to $65 million today.  This also compares to PP&E of $113 million.

Same store sales is the crux of the problem.  Effectively, an investment decision is a bet on same store sales.  Using a very simple linear regression I tried to estimate what the fixed and variable costs are on a per-store basis.  This allows me to take an educated guess at how profitable store will be at a given the revenue per store, and where the breakeven point is.  The numbers indicate fixed COGS per store (which includes lease expenses and D&A) of $400k, and fixed SG&A per store (which includes payroll, advertising, and corporate expenses) of around $70k.  For a rough comparison, these numbers compare to a lease expense per store of around $141k, so we know we’re at least accounting for the most important fixed cost.

The math shows that $1.2 million in revenue per store translates into an EBIT of -$2.7 million, and $1.3 million in revenue translates into EBIT of $10.8 million.  This confirms what we’ve observed.  BBW generated EBIT of $7.2 with $1.35mm revenue/store.  However, LTM revenue per store is at $1.24mm, which puts us right on the long-run breakeven point. 

Using the same math, we can get an idea for what EPS might look like given the revenue per store:

 


If you believe that 2008 same store sales won’t recover from $1.35mm, then BBW will probably only generate about $0.50/share, and it might actually be worth only $5.  If you think that the economy is partly to blame and stores will eventually begin to generate between $1.4-$1.6mm again, compared to a 7-year average of $1.57, then you’re looking at shares that will be worth between $7-18.  A scenario where BBW generates even lower revenue per store isn’t impossible.  LTM revenue/store is $1.24mm.  But the probability of a recovery and the appreciation shareholders would see outweigh the risk that this is the end for BBW.

In part because of economic weakness, BBW might have an opportunity to renegotiate leases on more favorable terms.  Leases in North America are generally signed for 10-year periods, with the option to cancel granted to both parties every 3-4 and 6-7th year.  International leases seem to have been signed over longer periods of time and under less favorable terms than those in North America.  At the end of 2008, BBW had operating lease obligations of $48.656 million in 2009 (or $141k/store), decreasing by 2.3% in 2010, 8.3% in 2011, and 10% in 2012.  So if this recession is extended and stores continue to underperform, renegotiation (or closing stores) is a possibility.

Model

My model is pretty straightforward.  Sales per store and the store count drive revenue and margins.  I assume that shares are worth 10x 2013 earnings plus the cash balance, and I discount that back each year at 15%.  All the FCF is saved on the balance sheet, no share repurchases or dividends are assumed.  I assume that BBW continues to build new stores at a growth rate of 2%, but the model isn’t sensitive to this.  Using my base case, a growth rate of 0% indicates a PV of $10.25, compared to $11.14 at a store growth rate of 10%. 

Using these assumptions, I can get a sense for what shares might be worth based on the long-term sustainable revenue/store.  My base case scenario is for sales per store of $1.41mm, which is an average weighted more towards recent poor performance.  This yields a current share value of $10.25.  If I use an unweighted average of $1.57, shares are worth $15.85.  I also ran through my model assuming 10% store growth and using a 10% discount rate.  These assumptions could be reasonable given the opportunity for international franchising and the possibility that management will return value to shareholders in the form of a dividend or share repurchases sooner than 2013.  It looks like $5/share is the proper value if we expect $1.25mm/store to be the long-term run rate.  But with more reasonable assumptions, BBW could easily be worth 2-3x the current share price.

Download BBW Excel Model

Disclaimer: I have shares in my kaChing portfolio, and I plan on buying shares for myself if the price doesn't move too far away before I can finish building my kaChing position.

Opening a can of golden worms...

This is an interesting market commentary that I'd like to post here because I've been thinking a lot about the dollar, gold, and where the next economic tsunami will be coming from.  This is coming to us from MarketFolly, a blog I subscribe to and usually find very interesting.

Sprott September Market Commentary

I plan on posting my thoughts on the case against gold in the next month or so.  I realize that there are a lot of reasons to be concerned about the value of the US dollar... but that doesn't necessarily point to gold as the solution.  Inflation is cited as a major concern, but last time I checked, even the experts were conflicted on whether we're facing inflation or deflation, and the TIPS spread isn't abnormal.  Even in the best case scenario for gold, where we have commodity inflation and asset/consumer goods deflation, I don't understand why gold is a better choice than owning shares in an oil/gas producer.  The intrinsic value of gold is 0.  You only buy it to sell to someone else at a higher price.  The intrinsic value of oil is the ability to produce gasoline which gets you from point a to point b.  And if the commercials I see on TV touting gold as an investment aren't proof that gold is in a bubble (or heading towards one), I don't know what is.  That being said, many of the smartest investors are buying gold.  It's hard for me to tell Einhorn he's wrong.  Fortunately I have Buffett on my side.  Here's a link to an interview with Peter Schiff hitting points on both sides of the argument.

Investing Philosophy Part I: Different but Equal

Investors understand that earnings and growth are good, but the relationship between earnings, growth, and value is misunderstood.  The P/E ratio, a universal symbol of value investing, is itself a bastardized form of the Gordon growth model.  The PEG ratio is even worse.  What does matter is how much value the companies we invest in return to us in the future.  Without a crystal ball, we’re forced at least in part to guess what’s ahead by looking in the rear-view mirror.  The least we can do is make sure objects aren’t closer than they appear.  We can only do this by having a logically consistent understanding of investment returns.

A company generates earnings, which are valuable and important, but if we plan to own shares for more than a quarter, what we really care about is what management does with those earnings.  They have four choices, a) hold the cash (or repay debt), b) pay a dividend, c) repurchase shares, or d) reinvest in the business. 

Cash

Holding cash (or repaying debt) shouldn’t create or destroy value.  Foreign exchange traders would disagree, cash held in a foreign currency can fluctuate in value, changing your purchasing power.  Also there’s an optimal capital allocation argument, with the tradeoff being default risk vs. tax shield, and a positive cash balance is like negative leverage.  Cash is also confusing when we start talking about enterprise value vs market cap valuations.  We should be willing to pay more for a business with cash on the balance sheet than an identical business without it, but the tradeoff isn't 1-1, and estimating the true value is a matter of judgment.  But this isn’t my focus today.  As far as we’re concerned, retaining cash should generate (or offset) just enough interest that it’s a breakeven proposition and we're going to focus on the three other forms of return.

Dividends

Dividends are one of the key ways in which an investment returns tangible value to shareholders.  A bond’s coupon payment is equivalent to a dividend.  Even if the bond trades at par value forever (i.e. never appreciates) it still returns value to investors by yielding some percent.  Stock dividends are the same thing.  Some investors don’t like dividends because it forces them to pay tax on the proceeds immediately, but dividends have advantages over other forms of return in that they’re transparent, easy to value (a $5 dividend is worth $5), and they generally send a signal that management believes the current dividend payments are sustainable (although some dividends are one time and some companies have to reduce or cancel periodic dividends).

An example of a company I looked at for the dividend was International Paper (IP), which had a historical dividend yield of 15%.  This allowed me to be highly confident of the upside and focus on the downside risk in the first report I published on my blog. 

Share repurchases

Share repurchases are equivalent to dividend payments.  The company is taking a portion of its cash and distributing it to shareholders.  Shareholders don’t get paid cash, but instead their shares entitle them to a greater portion of future company profits (and therefore future dividends) because the individuals least willing to hold shares relinquished their right to future earnings.  If a company’s net income next year is equal to their income this year, but fewer shares are outstanding, earnings per share will rise.  If a company’s earnings yield is 10%, they earn $1/share on shares that trade for $10.  With 1,000 shares outstanding, they’ve earned $1,000 of net income this year and the enterprise value is $10,000.  If earnings are flat next year, but that $1,000 was used to repurchase shares, the company will earn $1,000/900 shares, or $1.11/share because 100 shares were repurchased last year at $10.  Like magic, the same company selling the same products to the same customers at the same prices was able to grow EPS.

Investors sometimes criticize management for making large share repurchases before a fall in share price on the grounds that management could have repurchased a greater number of shares for the same amount of money if they had waited.  Generally these investors are just sore losers who wish they had thought to sell shares back to management at high prices.  Current shareholders obviously expect the share price to continue rising even if the share price already seems high to others.  From management’s point of view, shareholders believe the stock is worth the price it’s trading at or more, and therefore should be indifferent between dividends or repurchases.  Shareholders can’t be mad at management for repurchasing shares that shareholders themselves believe are fairly or under-valued.  However, large repurchases can signal that management believes shares are grossly undervalued.

One of the things I like most about dividends is that they only flow in one direction.  Management pays investors money.  They never demand that existing shareholders contribute money to continue owning shares.  With share repurchases, management sometimes sells shares, which is effectively a negative dividend.  It’s managements way of a) forcing shareholders to pay for things the company otherwise couldn’t afford like acquisitions, and b) hiding expenses (such as managements incentive pay in the form of stock options).

Incremental Reinvestment (aka growth)

Reinvesting earnings is the final way in which a company can return value to shareholders.  Sources of reinvestment can include CapEx, acquisitions, and R&D. The market often views reinvestment favorably, but it also entails the most risk because management chooses which projects to invest in.  A new project can yield the same, more (because of economies of scale), or less (because of the law of diminishing returns) than the existing business.  There is also a time delay, whereby capital invested today may not generate returns for many years.  A biotech company that earns no income and continually dilutes shareholders while investing heavily in R&D will not appear to be returning value to shareholders, but the technology is growing in value.  These situations require special expertise to analyze.  The important thing to remember is that reinvestment, despite the inherent risks, returns value to shareholders in the same way as share repurchases, by growing EPS.

An example of a company attractive to me for it's growth is the maker Ugg boots, Deckers Outdoor (DECK).  In my analysis, I showed how they have managed to grow the business and a phenomenal rate without significant reinvestment of earnings.  This would indicate to me that a dollar in the hands of DECK is worth more than a dollar in the hands of most other companies.

Conclusion

These are management’s only options.  Combining each of them is the only way to understand what returns investors can expect in the future.  But the most important thing to recognize is that if both share repurchases and growth return value to shareholders by growing EPS, there should be a way to equate them in terms of "value".  If share repurchases are equivalent to dividends in the way management makes a tangible distribution to shareholders, we should also be able to equate repurchases to dividends.  And finally, if we tie it all together, we should find a way to equate growth to dividends, and select the investments that will generate the highest total return.  Over the next few weeks, I’ll build on this to explain how and why investors misuse the P/E ratio and overvalue growth.  I'll also show you some shortcuts to avoid miss-pricing different but equal forms of investment return.

Rob Arnott Interview

Rob Arnott is the Chairman of Research Affiliates, a global leader in innovative investing and asset allocation strategies. The firm manages and licenses over $40 billion. Rob sub advises the Pimco All Asset Fund and also sub advises mutual funds and ETFs for the Schwab Funds, Powershares and Nomura. Research Affiliates did the original research on fundamental indexing and Rob is the author of "The Fundamental Index" (John Wiley & Sons, 2008). He is a former editor of the Financial Analysts Journal.

via kingworldnews.com

My goal for this blog is to focus on original content, but this interview is very worth listening to. Check it out.