A Ship in the Harbor is Safe...

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.

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.

Deckers Outdoor Corp. (DECK)

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Deckers Outdoor Corp. (DECK) has an amazing business.  Since 2001 it’s grown revenue at a CAGR of 33.5% and it continues to grow in 2008.  More importantly, it’s grown EPS at a CAGR of 55.6%.  But what’s probably the most amazing thing about this business is that it’s grown with minimal reinvestment.  A significant portion of FCF has been put in the bank each year, growing cash & investments from $3.9 million in 2002 to $175 million LTM.  This compares to total CFO over the same time period of $212.6 million.  Of course, past performance is no guarantee of future success, but it doesn’t matter because you’re not paying for it.  The stock trades today at 10x earnings.  On an EV basis, it’s about 20% cheaper.

Overview of Business

DECK manages a portfolio of footwear brand names including UGG, famous for their women’s sheepskin winter boots that are so comfortable half the buyers refuse to wear them with socks.  For obvious reasons, fashion aside, UGG lovers have to buy a new pair every season.  DECK also manages the Teva brand name, which provides some counter-seasonality to the UGG brand, and three other smaller brands, Simple, TSUBO, and Ahnu which specialize in environmentally friendly footwear, high-end casual comfort shoes, and trail-running sneakers respectively. 

With 84% of 2008 sales coming from UGG, the obvious concern is that either a) the retail environment will be so harsh for the next few years that UGG will stagnate, or b) UGG is a fad that’s run it’s course.  Fortunately we have Google trends to provide timely global insight into demand. 

So far UGG seems on par with the last two years.  Keep in mind, 2008 looked identical to 2007, but sales grew 67%.  Part of the UGG strategy has been to keep supply below demand each holiday season, and to demand orders from retailers far in advance.  Management might have some insight they’re not willing to share with the public, but quarterly inventory numbers reveal the truth.  2Q09 inventory is up 29% YoY.  Q2 is the only quarter with inventory turnover less than 1x, indicating that this is a key reserve-building time of year for DECK.  As this inventory is backed by orders, these numbers imply that UGG might be one of the few rays of optimism from battered and cautious retailers.  Inventory is a decent measure of future sales as DECK generally only accepts returns for damaged or defective products.  Allowance for estimated returns was 2% of accounts receivable at the end of 2008.

Earnings vs FCF

FCF has generally lagged earnings by less than 10% as DECK builds accounts receivable and inventory faster than ST liabilities.  On a quarterly basis cash flow is far more volatile than earnings while inventory builds up.  Cash flow is usually negative heading into Q4, and LTM cash flow should always be down YoY if management expects higher Christmas season sales.  Therefore, especially before the year-end, investors should focus on the income statement over cash flow as a basis for valuation.

New Stores

One of the reasons for Deckers’ profitability is that it outsources manufacturing to China and sells its goods wholesale to retail chains.  However, in recent years, DECK has begun opening its own stores.  In 2008, same store sales grew by 32.7%, meaning the existing 7 stores generated $24.393 million of revenue.  At average operating margins of around 17%, we see income from operations of $4.147, which is $2.965 million after tax.  In 2008, DECK opened 5 new stores for CapEx of $7.323 (which doesn’t break down into maintenance and growth, so we’ll assume the worst, that this is the total cost of new stores).  If 7 stores earn $2.965, 5 stores should earn $2.118, which indicates an RoIC of 28.9%. And of course this doesn’t take into account the fact that I’m basing my analysis off store profitability in the midst of an economic meltdown.

The obvious argument is that profitability should decline as the business expands, but 5 of the existing 7 stores were located in New Jersey.  I think profitability will at least stay flat for the foreseeable future as DECK expands into new markets and refines store design.  This investment opportunity is a good reason to value DECK on EV rather than market cap.  With $175 million of cash before this year’s earnings season, DECK could grow NI by 51% just investing existing cash in new stores.  This would obviously require additional working capital, but I’m looking at the cash balance after Q2.  At the end of 1Q09, DECK had $230 million to spend.

What’s the holdup?

None.  There’s no lawsuits, no debt, no SEC investigations.  The market is just pessimistic about consumer appetite for spending exacerbated by “conservative” management guidance.  I’m not blind to these concerns, I recognize the credit contraction and unemployment rate are pressuring consumers.  But at 10x earnings, the market seems to think that growth is permanently frozen, ignoring the possibility of an eventual recovery in the US or international expansion.  Looking at the Google trends chart above, we see that of the top 10 cities searching for UGG, only 4 are in the US, with the other 6 in the UK.  At the end of 2008, 16% of sales were international.  For the 6 months ending in June, 33% of sales were international compared to 28% for the same period last year.  In the 3 months ending June, 45% of sales were international, compared to 37% for the prior year.  So while US growth might be a concern (although we’re up 17% domestically for the first half of ’09), international demand seems able to pick up at least some of the slack.  For comparison Nike generated 58% of its revenue overseas in 2009 (fiscal year ends in May) and if NKE grows at 3%/year, it would take DECK 14 years of 30% growth to catch NKE.  Nike is arguably not a great comparison company because they manufacture many things other than footwear, but footwear accounted for 83% of 2009 US sales.  In short, the growth story isn’t dead.

Shrinking demand for the non-UGG brands has weighed on earnings in Q2 and probably won’t help Q3.  But this is a company that primarily makes winter boots.  Teva sales, which have been weak for years, aren’t a good indication of what UGG sales will be.  At the end of Q2, management updated guidance.  Despite the fact that UGG sales had increased 23% YoY for the second quarter (excluding retail sales which were up 100%, but only 8.4% from same store sales), management only expects UGG to be up 9-10% for the year.  They expect EPS to be flat to slightly up for the year, with a 10% improvement in the third quarter and a weak Q4.  These numbers don’t make sense to me, and they apparently didn’t make sense to Todd Slater from Lazard Capital who questioned management during the most recent conference call:

Slater - I was just trying to get my arms around a little bit the conservative nature of the retail assumptions you're making in the fourth quarter, which are obviously impacting your guidance. And you have this, I guess, about a 5% increase baked into your back-half guidance for UGG. I'm just curious, what level of backdoor or reorders are you assuming in this guidance compared to last year?  I'm just wondering, is it down versus last year? Are you being very conservative? Does it represent or reflect what you're seeing in the velocity of that business currently? Because it sounds like you are getting some terrific uptake, not just on the anniversary sale items, but on some of the full-priced product around it. I'm just curious about what assumptions you are making on that reorder business versus.

Ziv (COO) - Well, Todd, as I mentioned, we are assuming a similar level of the minor cancellation levels that we had last year. We're still being conservative vis-a-vis the pre-book. One area that we also take a cautious look at is our e-commerce business. As you know, it has been down in the second quarter. And right now it looks like, in our assumption, it's going to be down for the full year. So it depends how consumers buy and it depends how much they buy from our consumer direct business. That will impact our numbers.

Martinez (CEO) - By the same token, we are also anticipating a better December than we had last year, given the wheels falling off the cart on the economy at the beginning of December, certainly from a retail perspective. So I don't anticipate that happening this year. I think most of the bad news is out, and consumers are over some of that shell-shock. So we should see a smoother level of reorder compared to what happened last year, where everything just kind of fell off the table at the beginning of the month.

Slater - So if you take all that into consideration, July through January, I'm still -- it's not clear to me. Are you expecting the dollar level to be down at this moment, or at least guiding to that type of expectation in the hopes that you at least hit that, if not exceed it? Or can you give us a sense? Because I couldn't tell whether you were saying flat year-over-year or up or down, in terms of expectation for the full period.

Ziv (COO) - For the back half of the year, we're looking at UGG to be about 5% up.

Sltater - Great. Well, I hope your guidance is conservative as it has always been, and best of luck.

Again, I want to stress the fact that I don’t really care what happens in any single quarter, or even in a year.  I think long-term prospects are strong.  But even the short-term pessimistic scenario which analysts find hard to swallow is low or no growth.  No one is expecting sales to decline.  For $80/share investors get a business that generated LTM earnings of $7.82, $13.30 of cash, and another $15.84 of inventory and accounts receivable.  The growth story is far from over, but it’s not necessary at present valuations for investors to realize significant returns. 

Disclaimer: I own shares.

Download DECK

Dolby Laboratories (DLB)

Bonus Report:  This is the last report I wrote before starting this blog.  The numbers are a little outdated, but nothing fundamental has changed.  Most importantly, I've been reviewing DLB recently, and it still looks attractively valued.  Their year ends in September, and I plan on posting an update that digs into the numbers with a re-worked model after the 10K is out.  But in the meantime this is a good background on what DLB does.

3/29/09

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Introduction:
Dolby Laboratories’ (DLB) core business is the development of computer algorithms that code and decode sound files with the goal of maximizing sound quality while minimizing the need for data storage or high information transfer rates.  While the stock has only been publicly traded since 2005, “Dolby” has been a household name for many years.  The next largest competitor, DTS Inc. (DTSI), has one-tenth the revenue and technologically equivalent products as far as most experts are concerned.  On a relative basis, Dolby is the biggest in the industry and advantageously positioned for the future.  In absolute terms, Dolby has been highly profitable and financially transparent.

The technology produced by companies such as DLB and DTSI are incorporated into hardware, software, and media, but do not generate revenue as a function of media sales.  Media consumers benefit from this technology when the media they are consuming and the playback hardware they are utilizing are compatible.  DLB has benefited from consumers upgrading to higher quality home entertainment systems, demanding higher quality audio on secondary media playback devices such as home computers or video-game systems, and making use of portable media devices such as MP3 players or cell-phones.  DLB has also attempted to enter markets for 3D movie theater equipment and technology to improve visual aspects of next-generation high-definition televisions.

Because DLB earns revenue as a function of unit sales reported by the companies that utilize its technology, DLB has no control over sales.  It cannot offer incentives in a bad quarter or run promotional advertisements.  The hands-off nature of its business makes Dolby dependent on the volume and product mix of consumer purchases.  Whether consumers purchase a DVD player from Best Buy or Wal-mart for 7% less, it doesn’t affect DLB.  But consumer downgrades to lower-tech products that license fewer or cheaper technologies from DLB does impact revenue.

DLB classifies revenue into three segments: Licensing, product sales, and services.  Licensing is the most significant portion of revenue (84% LTM) and it has a 97% margin.  In an initiating report from Thomas Weisel published on October 6, 2008, the analyst breaks licensing revenue into personal computers, consumer electronics (home theater systems and DVD players), broadcast TV devices (TVs and set-top boxes), and an “other” category (video game systems and mobile devices).  The report does a great job of detailing what the technology is and how sales are translated into revenue for DLB.  It’s a solid 60 pages before the charts and worth reading if you’re interested.

Licensing Revenue FY07    Market Size    Attach Rate    ASP        Revenue
PC                361        64%        $0.59        $135.50
Consumer Electronics    155        99%        $0.68        $104.80
Broadcast            194        53%        $0.60        $61.90
Other                                $0.69        $42.60

Presently, consumer electronics is the largest contributor to licensing revenue.  The data above shows CE as a smaller segment than the PC market because it excludes Blu-ray sales which were negligible for FY07 and some other segment data for which we have no total market size figures to establish an attach rate from, such as audio receivers.  Actual revenue from the CE segment was $147.1 million in FY07.  The good news is that “Dolby Digital has been selected as a mandatory audio standard and Dolby Digital Plus and Dolby TrueHD have been selected as optional audio standards in the Blu-ray Disc format” according to DLB.  However, analysts don’t expect volume to increase because DLB was already mandatory in red-laser DVD players.  Revenue is expected to grow in this segment as Blu-ray DVD players take market share, but concerns exist about the relationship between higher ASPs at lower volume.

The PC market is an important segment for DLB.  The market size number above includes global PC unit sales for desktop and laptop systems.  Revenue includes licenses to Microsoft for inclusion in two versions of Vista, as well as revenue from integrated software vendors (ISV) and Dolby’s PC entertainment experience (PCEE) license.  This means that some computer units might generate license revenue for DLB more than once despite the fact that licenses are sometimes redundant.  It is possible, for example, for only 100 million of the 361 million computers sold in 2007 to have included DLB technology.  But the attach rate is 64% because some systems were packaged with the same technology twice, both generating revenue.  If ISVs begin to see their margins squeezed, excluding DLB licenses in software designed to work with MSFT’s higher-end operating systems is certainly possible, but in my opinion not probable.  In general, the growth in use of computers as entertainment centers has led analysts to expect continued growth in this segment, eventually overtaking consumer electronics.

The broadcast market in particular is expected to grow in the near-term as TV signals are converted to digital forcing consumers to purchase digital set-top boxes where Dolby is a mandatory technology.  The Advanced Television Systems Committee (ATSC) has made Dolby Digital the mandatory standard, meaning DLB technology is included in every TV and digital converter box in North America and Korea.  France has also adopted DLB as a mandatory standard, although it is not part of ATSC.  Brazil and Japan are requiring the HE-ACC sound format for digital TV signals, which DLB earns revenue from.  And any other country that has adopted TV broadcast standards has included DLB technologies as optional except those operating under the DMB-T/H agreement.  DMB-T/H countries include China, Iraq, Jordan, Syria, Venezuela, Nicaragua, and Cuba.

Long-term, the PC, video-game console, and hand-held markets are expected to grow more quickly than consumer electronics.  Compression technology on these devices is arguably more important as streaming data squeezes every bit of performance out of the software.  Dolby technology has traditionally been credited with greater compression (about 3x more) than competing DTS technology.  However, experts argue that it is unrealistic to believe that the Dolby codec is actually 3x more efficient than the DTS codec, leading to the conclusion that DTS sound quality must be higher.  The argument is reasonable, but there is no evidence that listeners can tell the difference.  Even the notoriously vocal online communities have no opinion.

The product sales segment contributed 11% of revenue with a 47% margin LTM.  This is mostly sales of projection equipment to movie theaters, and is projected to be a very low-growth piece of the business.  A big part of the problem is that Dolby and DTS were standard sound formats on film.  Audio on digitally recorded movies is provided by open standard algorithms that DLB doesn’t own proprietary rights to.   Conversion to digital systems has been very slow because theaters have traditionally been responsible for purchasing/maintaining projectors, while movie production companies have been responsible for producing and distributing film reels with development costs baked in.  As a result, theaters don’t want to make a capital investment to benefit production companies, and growth will remain slow until a new business model is adopted.  Other product sales include broadcasting equipment and encoding software.

Growth in the product sales segment is effectively contingent upon adoption of Dolby’s 3D projection technology, which has not proven to be popular compared to the competitor product RealD.  The main technological disadvantage for DLB compared to RealD is the glasses.  RealD glasses are cheap enough to be disposable, compared to DLB glasses that cost approximately $30 each (after significant reductions in recent months).  The expensive glasses require theater operators to collect glasses after each presentation for cleaning and reuse.  This seems to be a larger concern in the US where movie viewers are more prone to break, steal, or loose the glasses.  However, the DLB system can be projected onto a normal screen (compared to RealD which requires a special silver screen), and “Dolby 3D requires no postproduction color correction and no corrective preprocessing, meaning distributors are able to master and distribute one digital file for both 3D and 2D viewing” according to Lloyd Walmsley from Thomas Weisel.  Overall, the total cost of operation is lower for the Dolby system.  It also seems as though Dolby has produced a 3D technology that could eventually find it self at use in home theaters.  The higher cost and disposability of glasses would be less of a concern, and the post-production simplicity would make it a solid choice for DVD distribution.  Also, the RealD technology relies on polarization of light, which cannot be reproduced on television screens.  A report by Jim Slater from Cinema Technology Magazine describes the Dolby technology:

 “the system doesn’t depend on the use of polarized light, but instead uses a technique based on the wavelength of light. Dolby uses a “wavelength triplet” technique… [in which] the red, green, and blue primary colors used to construct the image in the digital cinema projector are each split into two slightly different shades.  One set of primaries is then used to construct the left eye image, and one for the right.”

Bringing 3D to the home is completely unsubstantiated speculation on my part.  Dolby hasn’t announced any plans or intentions to market 3D technology for home theaters.  I don’t fully understand the technology, but if porting 3D to home theaters is possible, it’s the next logical step for DLB.  This is in contrast to the audio-focused DTSI strategy.

The services segment is the smallest portion of revenue (4.8% of revenue, 59% margin).  Examples include services to media producers who need assistance using the coding technology and theaters trying to maximize sound quality for special events such as movie premiers.

Costs of good sold, SG&A, and R&D have all come down as a percentage of revenue over the past few years.  COGS have decreased mostly as a result of changes in the licensing segment, where DLB no longer pays royalties on patents it owns.  The only cost still accounted for in the revenue segment is D&A of acquired technology.  SG&A and R&D margins have shown nominal but consistent improvement.  With the R&D budget far surpassing the nearest competitors, I would imagine that DLB will have room in the future to expand EBIT margins simply by growing R&D at a slower rate than revenue as continued incremental improvements to COGS become more difficult to achieve.

Acquisitions:
Coding Technologies - $253 million
http://www.codingtechnologies.com/index.htm
Audio compression technology including HE-ACC v.1 and v.2 already in use in the broadcast market as discussed above.  This technology should also apply to mobile and internet applications.

Brightside Technologies - $30.2 million
http://www.bit-tech.net/hardware/2005/10/04/brightside_hdr_edr/1
LED backlighting of LCD screens is Dolby’s foray into visual technology.  Brightside does not have a stand-alone website, but the link above does a good job of explaining the concept behind the technology.

Comparison:
DLB has two good comparison companies that compete in the sound technology licensing business.  DTSI directly competes with DLB in the sound codec market, and is a mandatory standard in Blu-ray DVDs.  On traditional film reels, DTS time stamps were included alongside Dolby Digital sound bytes so that a CD could be synchronized with the movie.  SRS Labs (SRSL) also creates proprietary sound technology to be licensed out, but its technology is designed to simply enhance sound quality.  It is not integral to the code-decode process.

The sound codecs that DLB and DTSI develop are compared across four main technical specifications:
Sample Rate – the number of samples per second, measured in hertz (Hz) taken from a continuous sample to create a discrete representation.  Higher sample rates are associated with higher quality sound.  At constant frequency, a sample rate of only twice the frequency is necessary to reproduce the tone.  However a higher sample rate is necessary to accurately reproduce the sound if we care about amplitude and/or if the frequency is changing.
Bit-Rate – Bits per second (bit/s) is a measurement of the data transfer rate.  Higher bit-rates are associated with higher quality audio, but good compression software can allow an equivalent audio quality at lower bit-rates.  64 kbps of HE-AAC is approximately equivalent to 128 kbps mp3 in terms of sound quality.
Sample Depth – (x-bit) the number of bits of data recorded for each sample.  Higher sample depth is associated with higher audio quality.
Channels – The number of discrete speaker signals that a sound file can reproduce.  2 channels would be standard stereo speakers.  5.1 surround would include, a center, front-left, front-right, rear-left, rear-right, and a subwoofer channel.

Actually comparing technologies based on these specifications is difficult because they often vary as a function of each other.  For example, the DTS-HD Master Audio technology allows for 192 kHz sampling at 24-bit depth in two channel stereo, but only 96 kHz @ 24-bit depth when 8 channels are utilized.  Dolby TrueHD supports 192 kHz @ 24-bit on up to 6 channels, with the same 96 kHz @ 24-bit in 8 channels, but it also supports up to 18 channels.  Eventually it boils down to user satisfaction, and this is probably as much a function of brand image as technical specifications.  From the reviews I’ve read online, there is surprisingly little passion in the comparative discussions, with a consensus that the technologies all perform well and deliver high quality sound.

One technology that is interesting to compare side-by-side is the surround sound headphone technology each company is developing.  I won’t discuss my impression of these because I don’t want to bias your opinion.  In no particular order:

1) http://www.srslabs.com/demos/default.asp#SRSHP
For this one, you need to scroll to the bottom of the page and click on the last demo.  It’s a trailer for Planet of the Apes presented in SRS Headphone.

2) http://www.dts.com/Technology/Surround_Sensation/Surround_Sensation_PC.aspx
A concert with two drummers from DTS Surround Sensation.

3) http://www.dolby.com/consumer/technology/headphone.html
There are a few links at the bottom of this page.  The ‘Dolby Headphone demo’ is definitely worth experiencing; it features a host simply walking around the listener in a circle and then a video clip from a speedway.  The MacBreak clips are also interesting because the hosts are set up in a semi-circle in front of the listener with a crowd and ambient noise coming from behind.

Dolby has also taken steps to differentiate itself from DTS and SRS Labs by venturing into the visual aspects of digital entertainment with the 3D business and research being done to enhance LED backlit LCD screens as discussed above.

Comparative valuation:
                           Current    52-Week
Company Name        Ticker    Price        Hi        Lo        Shares Out.
Dolby Laboratories, Inc.    DLB        $33.15        $53.63        $24.86        115.096
DTS, Inc.            DTSI        $18.73        $35.99        $15.25        18.174
SRS Labs, Inc.        SRSL        $4.81        $7.25        $2.75        15.783

                Market                    Enterprise
Company Name        Cap.        Debt        Cash        Value
Dolby Laboratories, Inc.    $3,827        $9.38        $514.43    $3,322
DTS, Inc.            $340        $     -          $85.50        $255
SRS Labs, Inc.        $76        $    -          $46.72        $29

                 LTM        LTM        LTM        Average P/E
Company Name        P/Sales    EPS        P/E        (Bloomberg)
Dolby Laboratories, Inc.    6.0x        $1.74        19.1x        31.8x
DTS, Inc.            5.8x        $0.60        31.2x        39.8x
SRS Labs, Inc.        4.3x        $0.07        68.7x        50.2x

                Enterprise Value        Market Cap.
                 as a Multiple of        as a Multiple of
Company Name        Revenue    EBIT        NI        FCF
Dolby Laboratories, Inc.    5.2x        11.6x        19.2x        15.3x
DTS, Inc.            4.3x        17.9x        16.6x        44.4x
SRS Labs, Inc.        1.6x        -37.0x        64.9x        16.1x

                EPS Figures (Bloomberg) and Multiples
                 Fiscal Year    Fiscal Yr        Fiscal Yr    Fiscal Yr
Company Name        EPS ('08)    Multiple ('08)    EPS ('09)    Multiple ('09)
Dolby Laboratories, Inc.    $1.79        18.5x            $1.95        17.0x
DTS, Inc.            $0.56        33.4x            $0.71        26.4x
SRS Labs, Inc.        $0.14        34.4x            $0.36        13.4x

                Margin Analysis
Company Name        EBIT        Net Income        R&D
Dolby Laboratories, Inc.    44.8%        31.2%            9.7%
DTS, Inc.            24.2%        34.9%            11.8%
SRS Labs, Inc.        -4.4%        6.6%            19.5%

Earnings for SRSL are low because of what seems to be higher than normal sales and marketing expenses.  Part of the reason for this is that SRSL lost some of its key customers recently, leaving Samsung responsible for 40% of licensing revenue compared to 25% last year.  Cash flow from operations or FCF is a better estimate of present earnings.  Analyst estimates of $0.36/share seems like it would require substantial growth from LTM earnings of $0.07/share.  However, 2007 earnings were $0.32/share.  More importantly, SRSL has $48 million of current assets of which $47 million can be considered cash, against $3.3 million of total liabilities, half of which is deferred revenue.  This puts cash per share at a $2.69, compared to a 52-week low of $2.75.  EV/FCF is only 6.2x.

DTSI is has been focusing exclusively on sound technology since 2007 when it sold the cinema and digital image businesses.  This led to impairment charges that I left out of the earnings numbers above.  Compared to just the licensing revenue of DLB, DTSI is earning 1/10th the revenue.  However, Blu-ray sales are expected to fuel revenue growth for DTSI more so than DLB because DTS was only an optional standard on red-laser DVD players.  More importantly, there is a discrepancy between CFO and NI that doesn’t seem to be coming from the disposition, and I can’t reconcile it without devoting more time than it seems worth at this point.  But regardless of which numbers are most relevant, it’s unlikely that DTSI offers the best value.  DLB is a better company and SRSL is trading near cash.

Tax Assets:
Tax assets have grown significantly in recent years.  In 2008, tax assets were 10% of total assets reported on the balance sheet, and the cost of these tax assets reduced cash flow by 20%.  Note 6 in the most recent K details where the assets are coming from in terms of the difference between reported asset and liability values for financial and tax purposes, but I’m still confused.  It doesn't explain what is causing the difference to arise, or what would reverse it.  DTSI seems to be experiencing a similar trend also without an explanation.  There is no reserve or write-down allowance; DLB (and DTSI) expect to realize their tax assets in the near future.

Other Concerns:
Ray Dolby, the founder, is effectively in control of all the voting shares.  He has done a great job of running the company, but I’m not sure how good of a job his surviving family members will do.  This doesn’t have any impact on my valuation, but it’s a risk to be made aware of.

Macroeconomics:
Looking at the S&P 500, it’s incredible to see how far the market has fallen in a year.  But 52-week highs are a terrible indicator of how much “value” the market has lost and an even worse indicator of how much value the market has left to lose.  Is it value that was lost or is it value that never really existed?  A better indicator of value is the price/(10-year average earnings) index assembled by Robert Shiller, author of “Irrational Exuberance”, the book that predicted both the internet and sub-prime housing bubbles before they popped.  A frequently updated excel file can be downloaded from his website at Yale.  Shiller’s data was current up to August 2008, so I added the January 2nd S&P index price of 932.  This resulted in a current S&P P/E of 15.2x, compared to an average since 1871 of 16.3x and a minimum of 4.8x in December of 1920.

These numbers can be confusing to think about because we’re used to seeing P/E as a function of the LTM earnings.  Earnings should be lower from the 10-year average assuming earnings have been able to grow.  However, in the case where current earnings are lower than the 10-year average, the Shiller index should report a lower multiple than the analysts would see at the time if they were using the standard P/E ratio as a guide.  I also believe that the average P/E ratio should rise over time as the economy depends more heavily upon R&D and other intangibles.  The fact that R&D is expensed instead of capitalized pushes current term earnings down, but the growth rate of earnings up.  In the dividend discount model, these factors should even out and result in an equivalent P/E ratio.  But the dividend discount model doesn’t work with the P/(10-year average E) ratio.

The Shiller numbers give us and idea of a) how much stock market value could ultimately be lost by comparing today’s value to the historic minimum (15.2x vs. 4.8x), and b) how over/under-valued the market might be today in reference to an average historical P/E (15.2x vs. 16.3x) indicating what people are generally willing to pay for earnings and growth.  This doesn’t indicate that companies are destroying or loosing value.  It just indicates that the market could temporarily value earnings, and especially growth, at a lower rate in the near future, despite how much the S&P has already fallen in an absolute sense.  This comparison to history indicates that we’re far from in the clear, and possibly just scratching the surface of undervaluation.

I want to avoid rationalizing the market with expectations that it will reflect a logical valuation anytime soon.  The market might be stuck in a positive feedback cycle where decreasing valuations are causing liquidations, which are causing decreasing valuations.  George Soros’ reflexivity hypothesis enters the picture as another positive feedback cycle pushing prices lower.  As valuations decrease, the cost of capital becomes higher for companies, making capital-intensive operations more difficult or risky to continue, which further decreases valuation.  A strong cash position that can be used to repurchase shares is the only thing a company can do to counteract these two positive feedback cycles.  Companies able to provide liquidity to their own market are protecting their investors from the need for further liquidations and capitalizing on the higher investment returns offered at lower prices.  They’re also less threatened by the reflexivity problem if there is no need to raise capital.  The cash position of DLB combined with its ability to maintain margins without the use of debt is a strength seemingly undervalued in the market right now.

Valuation:
Under normal circumstances it would be difficult to value DLB with growth in EPS at a spectacular arithmetic average of 38.2% over the past 5 years.  Even in Dolby’s 4Q08 that ended September 26th, year over year EBIT for the quarter was up 33% and EPS was up 9.6%.  EPS was up less than EBIT because of an unusually low tax provision four quarters ago.  Earnings are lower than any reasonable measure of cash flow, and the market cap. is higher than the enterprise value, so the most conservative multiple the market can put on DLB is a simple P/E of 19.1x.  This is for a clear market leader with R&D completely expensed, a sizeable cash position, and very transparent financial statements.  If growth was expected to be zero forever, this is a discount rate of 5.2%.  Comparatively, EV/FCF is 13.2.

While I feel that a fair price for investors who can withstand short-term volatility would be higher than 15x earnings, in today’s environment other factors take precedent.  As discussed above, I think a greater emphasis should be placed on dividends or ability and willingness to repurchase shares.  Establishing a price floor is my major concern with DLB.  Without dividends or share repurchases, I think the next best estimate of an absolute price floor must be some function of cash.

In my model and previous discussions of DLB, I have excluded the “Long-term Investments” line item from measures of cash.  As auction-rate securities became less liquid, DLB transferred these items from short-term to long-term investments, increasing long-term investments from $33 million in 2006 to $73 million in 2007, and finally $181 million in 2008.  If counted as cash, this increases total cash to $695 million, raising cash per share to $6.04 and increasing the attractiveness of DLB on an enterprise valuation basis.

Conclusion:
DLB is a leader in its field and economies of scale allow it to maintain both a larger R&D budget and wider margins than the competition.  Cash flow is strong too, with free cash flow (measured simply as CFO-CapEx) slightly leading earnings every year since the initial public offering by about 4%.  Both earnings and cash flow are valid measures of performance with capitalization of R&D the only major adjustment I would consider making.  Since my thesis is that DLB is a good investment, capitalization of R&D has been included in a separate page of my model (which I would be happy to share), but is not used in my valuation because it would raise earnings and CFO.

Analyzed in isolation, DLB satisfies most requirements I could think of for a great investment opportunity.  Margins are wide, the gap between DLB and its closest competitors is wide, financial position is strong, and management is patient with acquisitions.  Revenue may decline in a recession (although it has not yet) as consumers buy less of the hardware that DLB earns licensing revenue from, but DLB is gaining market share as it becomes a mandatory standard in more consumer electronics around the world.  But most importantly, DLB has negligible debt and enough cash to cover all liabilities or SG&A two times over with no effect on margins.  This puts it in an optimal position to employ capital in the most effective ways possible through an economic downturn.

Questions/Comments

This was originally a post, but I want to keep it around permanently.  If anyone has questions, comments, thoughts, ideas, or feedback of any kind, related or unrelated, this is an open request for it. 

Thanks!

jeff

American Church Mortgage Co. (ACMC)

I saw a preacher on the TV with big diamond rings on his hand
He was begging for some money, he said to send us every penny you can
I guess the good Lord's got a mortgage and a payment on a yacht in the Keys
So we better keep sending our hard earned living to those God fearing folks on TV
-Filthy Rich by Big & Rich

American Church & Mortgage is a church-based REIT with some serious fundamental flaws that have caused significant EPS shrinkage over the years.  However, ACMC is a dividend paying REIT, and modeling even the most pessimistic scenarios indicates that ACMC shares are undervalued at $2/share (above recent trading prices).  Dividends over the last twelve months have been about $0.36/share, so for $2/share you’re getting an 18% yield.  At $1.50 you're getting a 25% yield.

1) EPS and the dividend have declined from $0.66 to $0.30 per share over the last ten years because of conflicts of interest.  Myers is the president, treasurer, secretary, and chairman, but he doesn’t take a paycheck from ACMC.  Instead he holds positions at Church Loan Advisors (paid an asset management fee as a function of AUM and loan originations) and American Investors Group (paid an underwriting fee when ACMC raises new debt).  As a result of this arrangement, Myers’ incentive has been to grow the business from an asset base of $13 million in 1999 to $47 million in ‘08 despite consistent shareholder dilution. 

2) ACMC looks cheap compared to book value, but it should be trading at a discount and that discount should grow with the debt to equity ratio.  If a closed-end-fund manager was just able to track an index like the S&P which for argument’s sake we expected to return 8% per year by replicating it, but management still paid itself a fee of say 2% AUM, shares should trade at a 25% discount to book value.  In the case of ACMC, management has consistently underperformed with earnings and dividends falling every year, and they still take a management fee on top of that.  Even if the assets are worth book value (which is in question given the weak economy and ACMC’s reluctance to take writedowns), management is a drag on performance.  In terms of liquidation value... impossible scenario.

3) Management should only raise capital under two scenarios.  If the dividend yield falls below the rate at which management can safely lend they should issue shares.  Debt is a little more complicated.  The deal with Church Loan Advisors is that operating expenses will be refunded to ACMC if they exceed 2% of average invested assets or 25% of revenue.  Therefore, debt should only be issued if ACMC can borrow for a minimum spread of 2% or 75% of the lending rate.  If they lend at 10%, they should not borrow for more than 7.5%.  If they lend at 8%, they should not borrow for more than 6%.  Historically, borrowing has been at a negative after-fee spread and as a result earnings have decreased as leverage increased.  The one who benefits, of course, is Myers.  And these are breakeven points, it doesn’t take into account default risk or the fact that they’re chasing the same number of opportunities with more capital.  To actually create value, the spread would have to be in excess of these limits.

4) The good news is that there’s a limit to how much management can dilute shareholders by increasing leverage.  The company has set a debt to equity limit of 3x compared to around 1x today.  However, ACMC is presently covering interest by only about 1.4x.  I complied a list of nine other REITs yielding over 10% to get a feel for what interest coverage and debt to equity ratios commonly are.  To avoid the effects of recent asset writedowns or poor short-term performance, I looked at 2007 financial statement data.  The average interest coverage ratio was 1.9x with a minimum of 1.1x.  The average D/E was 9.0x, but excluding one outlier brought it down to 3.1x.  So assuming management won’t fuel growth by accepting blatantly negative interest rate spreads, the market should limit access to capital and force management to stop diluting shareholders. 

5) I built some scenarios to test the effect of changes in leverage and interest rate spreads.  If you’re following along in my excel model, scenario 3 is really my baseline.  RoA is 8.5%, interest rates are 7.5%, OpEx is 20% of revenue (below the 25% max explained above), and the company raised $12 million to cover ST-liabilities and maintain the current SE of $20 million.  This scenario is almost identical to 2007.  In scenarios 2 and 4 I lowered and raised the borrowing rate by 1% respectively, yielding a 23% change in EPS.  This shows how sensitive ACMC is to the spread, changing RoA would have the same effect.  In scenario 1 I reduced the assets to the point where ACMC only nets $2 million in revenue and I reduced the debt level to keep SE at $20 million.  The effect of this was $23.5 million in assets (compared to $47.1 million for baseline) and growth in EPS of 14% from baseline.  In scenario 5 I increased debt to the 3x debt/equity limit while holding SE at $20, and grew assets by the same amount.  With total assets of $80 million, EPS was down 20%.  The scariest thing about this scenario is that the interest coverage ratio was only reduced to 1.2x, indicating that there might be more room than implied above for mgmt to continue slowly diluting shareholders.  Scenario 6 looks at ACMC’s ability to grow EPS once leverage hits the ceiling.  By doubling assets, liabilities, and SE, we can double the EPS.  However, we also use cash…which could only then be raised by selling shares.  The net effect is a wash. In conclusion, ACMC is probably more sensitive to short-term changes in the spread, but the long-term effect of leverage is slowly chipping away at the dividend.

Finally, in the absolute worst case scenario #7, I reduced the spread to 0%, and I increased the leverage ratio to 3x.  This resulted in EPS of $0.14.  So at $1.50, shareholders would earn 9.3% 10 years in the future after earning higher dividends for the next few years if management continues on this path.

6) I also modeled how EPS varies with leverage from $0 to $30 million in increments of $5, and surprisingly it’s linear.  At an interest rate of 6.8% (and RoA of 8.5%) EPS isn’t affected by leverage.  At interest rates below 6.8% the real spread turns positive and ACMC benefits from leverage.  For comparison, series C certificates are set to yield between 6.25 and 7.25% depending on the maturity date.  Unfortunately, even at breakeven it’s the shareholders that bear the risk of fluctuating mortgage yields and constant interest expenses. 

Conclusion:  It looks like at a steady run rate in terms of spread and OpEx will probably resemble 2007, but management will probably continue to leverage ACMC up to the 3x debt/equity limit, reducing earnings by another 20%.  With the mortgage portfolio yielding 8.5% and debt costing 7.5%, fully leveraging ACMC would result in EPS (and a dividend) of $0.38/year.  Maintaining the current debt/equity of 1.35x (slightly higher than where we are at the end of Q2, but with short term debt coming due), we can narrow the interest rate spread to 0% and still generate $0.36/share on the unleveraged portion of the mortgage portfolio.  So if the loans under perform, or short-term refinancing comes at a higher rate, we can put a floor under expected earnings of around what we earned LTM.  Again, that represents an 18% yield at $2/share, above where the shares have been trading for the last few weeks.  And of course, this ignores the upside scenario where management uses loan repayments and prepayments to de-leverage the business and rebuild a more sustainable ACMC which might actually be a better captive client for Myers’ investment banking business in the long-run.

Disclosure:  If you haven't already read my disclaimer on the right of this page, read it now.  I own a position in this company, and if shares rise enough, I'll be selling.  This is as micro-cap as a micro-cap company gets.  It's extremely thinly traded, and if you place a simple market order, you might get filled at a ridiculous price.  So please please be very careful!  After this, I think I'll go back to analyzing normal-size companies for a while.

Download ACMC

Dryclean USA (DCU)

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Dryclean USA (DCU) is another micro-cap company worth it’s market cap, and trading at a ridiculous enterprise value.  With earnings that have grown from $300k in 2001 to $600k in 2008, peaking at around $900k in 2007, DCU might seem fairly priced around $7 million.  The earnings yield in the last twelve months is 10%.  However, if we consider that this company has $5.3 million of cash, we're left with an enterprise value of $1.7 million.  The underlying business is therefore yielding a 40% return to investors. 

DCU primarily distributes commercial and industrial laundry and dry cleaning equipment including a proprietary line of dry cleaning machines (98% of revenue).  They also have a small dry clean franchise and store development business (2% of revenue).  Until this past quarter, DCU also operated a broker that matched buyers and sellers of laundromat and dry clean businesses, but this operation was discontinued.  In the first three quarters of 2009, DCU has undergone some major changes in sales mix that aren’t apparent on the surface.  9-month revenues have increased by 20%, but this is the result of commercial laundry equipment sales increasing 75.9%, compared to a reduction of 57.4% in dry cleaning equipment, 40.7% for boiler sales, and 2% for spare parts.  To a small degree, this have a negative impact on margins as it’s moved the mix away from DCU’s proprietary products.  But otherwise, it’s hard to predict what the long-term effect of this will be, if anything.  At the moment it’s really just something to be aware of.

Earnings have been positive at least since 2001.  Cash flow has been more volatile, occasionally turning negative, but on average it’s approximated earnings.  So it doesn’t seem like this company would really need to keep much cash on the balance sheet, especially if they made better use of their unused revolving credit agreement, which expires on October 30, 2009, but is likely to be renewed.  As a function of short-term assets, cash has grown from 5% in 2001 to 36% of assets in 2008, peaking at 48% in 2007.  Again it doesn’t seem as though this company needs as much cash as it has.  The question of whether or not it will be returned to shareholders, or kept on the balance sheet as working capital, is a little more difficult to answer.  Between 2004-2008, DCU maintained a dividend payout rate (on FCF) between 50-100%.  However, dividends in 2009 have been cancelled.  One possible reason for this is that management is concerned about the future and doesn’t want to risk jeopardizing a strong balance sheet.  The other possible explanation is that management is more optimistic about opportunities for reinvestment in the business.

One reason to be optimistic about the opportunity for incremental reinvestment is that RoA, RoE, and after-tax RoIC measures have all steadily improved from 2001-2007, from 3.8%, 6.2%, and 8.4%, to 9.1%, 14.0%, 41.1% respectively.  These metrics dropped to 5.4%, 9.1%, and 19.0% in 2008, but are back up LTM.   Even if we include half the cash balance as working capital, RoIC improved from 8.1% to 19.7% in 2007, and it’s at 16.1% LTM.  Only a fraction of DCU assets are long-term, so it isn’t very likely that they will have large CapEx.  But the cash should more than allow DCU to expand working capital if sales volume warrants it.  We should see some evidence of management’s expectations for growth when the K is released this month.  In 2008, DCU employed 33 workers, 13 in sales and 3 in service.  If we see these numbers grow in 2009, it should be a strong indication that DCU is optimistic about top-line growth.  For reference, LTM revenue is up 13.2% over the prior twelve months.  If employment hasn’t increased, investors will just have to be satisfied knowing that DCU has a strong financial position and the means to eventually resume a large dividend.

At the present $1/share, DCU is fairly priced regardless of capital structure.  LTM EPS is $0.10/share, against an average since 2001 of 9 cents and a peak of 13.  EV/after-tax EBIT is 2.4x, compared to an average of 11.4x since 2001.

I modeled the company out to 2013 based on 3 variables: discount rate, dividend rate, and how much cash we can assume is excess.  Sales growth is modeled as a natural function of last years assets (minus some portion of cash), creating revenue growth of just over 8%/year (compared to a CAGR of 5.3%).  However, EPS growth is only 6%/year (compared to a CAGR of 9.9%) because revenue from fees is modeled as a flat $800k/year.  My base case is a 15% discount rate, 30% dividend payout rate, and 50% of cash is taken out as separate from the business.  In this scenario, I’m getting a present value of $1.20/share.  These assumptions are conservative considering how much cash has grown compared to other assets and what the historical dividend rate has been.  If I decrease the discount rate to 10%, shares are worth $1.49.  If I increase the cash take-out to 100%, the shares are worth $1.52.  And if I increase the dividend payout rate to 60%, the shares are worth $1.24.  So there’s obviously considerable room for upside.  Management could unlock a significant portion of this value simply by paying out the unnecessary cash in a one-time dividend. 

Again the key factors are: cash/share $0.75, EPS of about $0.10, and no severe revenue declines in 2008 or LTM.  The risk tradeoff is really only illiquidity.  Nowhere in this analysis do I take into account the possible effects of further operating improvements that would show up in the RoA, RoE, or RoIC metrics which have all been steadily improving over time.  It would be impossible to take a large position in this company, but a small position should yield nice returns uncorrelated with the market.

Disclosure:  I own shares in this company.  Again, this is the most micro of all micro-caps, and it's extremely illiquid.  I don't even understand why a company this small is publicly traded.  Even with my tiny account, it's taken me about a week to build a position.  Please be careful if you decide to buy as there are special risks... and be patient.

Download the DCU model

CCA Industries (CAW)

Someone in my office forwarded a link to a video of Bruce Greenwald discussing value investing which was summarized with three points:

• Value Investing consists of a basic investing process starting by identifying potential stocks among those are ugly, cheap, obscure, small capitalization, and out of favor.
• What distinguishes value investing is the approach to valuating stocks, which starting with balance sheet. Most people do not, instead they focus on income statement.
• Value investing has been proved beyond doubt to be a better approach to investing. The reason it succeeds is that most people go where the dreams are. Value investors identify where the market is crazy about and looking for opportunities that most investors are turned off about.

A few days earlier I stumbled across CCA Industries (CAW), an ugly, cheap, small cap, and out-of-favor company, and my investment thesis is pretty much based on their balance sheet.  This doesn’t require much analysis, you can determine if you like it in a few hours, and the biggest position you could possibly take is less than $3 million.

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CAW licenses or owns some brand names for consumer goods generally sold in drug stores and supermarkets, including products for hair removal, nail care, shampoo, and sunscreen.  They don’t manufacture, they just warehouse inventory and manage brand names, distribution, and relationships with buyers.  RoIC has bounced around the 50% range as capital requirements are minimal, barely exceeding working capital.  Some of their brands look weak, but keep in mind that if they’re weak today, they’ve been weak for the last 10 years.  Nothing’s changed.

With earnings and FCF over the past 8 years averaging $4.2 million, the business might appear cheap at a market cap of $28 million.  But when we look at the balance sheet, we realize that there is $17 million of cash and investments, bringing the EV down to $10.6 million.  Of course this doesn’t take into account market value appreciation of assets since the most recent quarter ended on May 31, which the model is extremely sensitive to.  For example, a 10% increase in the cash and investments balance pushes the EV down 17% (to $8.8 million).  There is no bankruptcy risk with $17 million of cash and equivalents, a completely unused line of credit for $20 million, and positive LTM FCF of $3 million.

I’m guessing there are three reasons why this stock is so cheap.

• The company is tiny and thinly traded
• The brand names are weak, things you wouldn’t be surprised to see in a dollar store
• Walmart canceled orders for a specific line (of toothpaste) which should reduce revenue by about $6 million (10%)

Even with some pessimistic assumptions, the stock is undervalued.  Starting with depressed LTM revenue and subtracting the Walmart hit, we have a sustainable top line of $50 million.  Assuming no growth forever and margins heavily weighted towards recent poor performance, we get an EBIT of $3.7 million.  Compare this to peak 2007 EBIT of $9.3 million.  These assumptions put CAW trading at 4.4x earnings after tax.

Further assuming that CAW maintains 2008 dividend payouts of $2.9 million (a 10% yield), I modeled a $19.3 million cash and investments balance in 2013.  That balance plus the 2013 dividend plus 10x after tax EBIT yields a 2013 share price of $6.56.  Discounting back to today at 15% per year gives us a minimum share price of $4.51, compared to the market value of $3.95.

There really isn’t much more to know.  Management doesn’t host conference calls, there’s no sell-side coverage (although some old reports are posted on the CCA website).  Seth Hamot, an activist investor from Roark Rearden & Hamot Capital Management, defended common shareholders in a dispute with management over Class A shares in 2007.  Since then, he’s been a member of the board.  If you need to contact him, it might be good to know that Roark and Rearden are fictional Ayn Rand characters.

Disclosure:  I own shares of this company.  It's thinly traded and illiquid, so if you decide to buy shares, make sure you're careful and you know what you're doing!

Download the CAW Excel Model