Back in the days of dinosaurs

Value was so compelling that even a caveman could recognize it.

Moody's writeup from 1951, thanks to Shai Dardashti

So how did Buffett find this company? My guess is that it's the same story then as today, effort. He read everything, three or four newspapers a day, and every page for every stock in Moody's (and later Valueline), until he finally found something this stinking obvious.

So if you like to complain about how few good ideas are out there, compare your effort to Warren's. I'll bet you come up a little short in the comparison.

CEO don't control the stock price, or do they?

I've been wanting to comment on Robert Nardelli's resignation as CEO of Home Depot for some weeks. Actually not the resignation per se, but on one prevalent theme that media commentators have used to explain it. I'll pick on Alan Murray of the Wall Street Journal to start, quoting from his comments on Jan. 4th.

"Some of Mr. Nardelli's numbers were hard to argue with. In six years on the job, he doubled Home Depot's sales and more than doubled its earnings." Mr. Murray then goes on to explain that it was Nardelli's lack of political skills that doomed him more so than performance. To give Mr. Murray credit, he also mentions other performance factors that might have hurt Nardelli as well, including poor stock price returns, and pushing Home Depot into the "low margin wholesale business".

Matt Koppenheffer of the Motley Fool says it more directly. "Had Home Depot's stock price headed up and to the right during Nardelli's term, investors might very well be patting themselves on the back for money well spent on a great executive." Essentially, because the market stubbornly refused to reward Home Depot shareholders for Nardelli's great management, he was forced out, with his only real sin being his arrogance.

Is Home Depot really a better company for Nardelli's efforts? Let's look at the numbers. Nardelli is credited with doubling earnings and sales in six years, a compound annualized growth rate of about 12% per year. But in the single year before Nardelli took over, Home Depot grew sales 26% and earnings almost 50%. At that pace sales would double every three years, not six.

So it's a myth that "Bob Nardelli doubled sales at Home Depot", those sales were doubling whether he was there or not. Sales actually grew much slower under his watch. That's not necessarily bad, Home Depot was growing fast enough that it would soon run into saturation problems. But almost any CEO running Home Depot would have come close to doubling sales, so why credit Bob for that?

And Bob "bought" some of this growth by expanding into areas outside of the Home Depot's greatest area of expertise, retail, into wholesale distribution. You would think this lack of focus could hurt retail execution, and it did. Even worse was Bob's approach to customer service. Nardelli improved margins by hiring less skilled and dedicated employees on the front lines, i.e. by paying less. But those employees were a huge part of the Home Depot brand, which is what made Home Depot successful to begin with. That brand created those high margins, and when Bob reduced that service, he angered his best customers and gave a huge gift to his biggest competitor, Lowes. It's very clear that retail performance, the most important criteria for measuring the CEO of Home Depot, declined under Nardelli's tenure. He as much admitted this when he attempted to stop reporting same store sales in his final year.

Nardelli's decisions made Home Depot's results look better in the short run, but the short run is over. So was Bob fired over anger at his pay package, or his arrogance at the last shareholders meeting? Or was it because Bob's "success" appears to have been a short term house of cards built on buying revenues and under-investment in their core business?

CEO's can't directly control the stock price in the short run. But the key decisions they make can create or destroy large amounts of shareholder value, and will eventually be reflected in the stock price. In Bob's case, I think the stock price has clearly reflected how the market perceives his "contributions".

It's coming. If you haven't signed up for the greatest product ever concieved for managing your investment ideas, now is the time. Just drop me a line at stocknotesinfo@gmail.com, and tell me if you want to test, or just to be notified when we are ready.

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Randy

Arbitrage opportunities at Star Maritime?

Star Maritime (SEA) is a "blank check" company that seems to offer an interesting "risk free" opportunities that I liken almost to an arbitrage. "Blank check" companies are interesting vehicles that have gained a bit of popularity recently. A blank check company is created through an IPO to raise funds for a management team to search for a potential acquisition. The IPO investors receuve not only shares, but typically also warrants that are exercisable if the acquisition is approved. The shareholders also receive some interesting security. Their funds are held in trust, and management is given only a limited time to find an acquisition. If they don't find one by their deadline, or can't get their choice approved by shareholders, the company is forcibly liquidated and the common shareholders get all the trust cash plus interest returned to them. Even if the deal is approved, the company has to buy back the shares of any dissenting shareholders at a redemption price.

And in the case of SEA, the normal blank check arrangement is even more advantageous to shareholders. SEA sold 20M units in it's IPO (a unit being one share and one warrant exercisable at $8) for $10 per unit. But management bought over 1M units at a cost of over $10M, and have agreed to forfeit those shares if the acquisition is not approved (and the underwriters also have to forfeit their fees). And management only has until the end of June to get a deal approved. So how much would a common shareholder receive in a liquidation scenario?

There are two slightly different scenarios, the first is if the acquisition is voted down, all common shareholders (except management) receive the trust proceeds. The second is the deal goes through but you elect to redeem your shares. Let's start with the first.

As of Sept. 30th, there is 192.7M in trust, and by my calculations, 18.9M shares eligible for distributions, or $10.22. The trust is netting about .34% in quarterly interest after tax/expenses, so on July 1st the distribution should be around $10.32.

In the second scenario, you have the right even in an successful vote to redeem your shares for $9.80 (the $10 minus underwriters fees) plus interest, basically a 20 cent per share difference from liquidation. So I estimate a value of about $10.12 on July 1.

SEA announced their deal this week. The common didn't move, it's been trading around $9.90, so essentially you can get either a 2.2% gain if your shares are redeemed ( 5.1% annualized) or if the deal is voted down, you'll get a 4.2% gain (9.9% annualized). Doesn't sound like much does it? But these gains are essentially risk free, so it looks like SEA is offering you a money market rate in the worst case scenario, with a kicker that doubles your returns if the deal is voted down. And if you can get the shares cheaper (I think they may have hit $9.85 briefly on Friday) returns are even better.

But wait, there is still more upside to the common! By holding common shares you get a free "call option" on any price increase in the common until the deal is voted on. For example, if SEA trades at $11 next week, you can sell and reap some nice short term profits. If it drops to $8, you simply wait until redemption to get $10+. You keep all upside, with no downside!

Now the negatives. I'm not super impressed with the deal and so far neither is the market, but there is still plenty of time left until a vote happens where you might be able to profit from upswings in the price. We have the risk that management files for an extension and doesn't get a vote done until late this year or early next. If that happens your annualized returns in these scenarios decline, though interest continues to accumulate and you get a longer "call option" for any possible price spike.

I've been told that 90% of these blank check deals end up getting approved. I don't know how true that is, it sounds extraordinary because the typical deal requires 80%+ shareholder approval. And SEA is a bit special, they only need 67% shareholder approval, but it still sounds like a difficult hill to climb.

So I can imagine what some of you are thinking right now. "Okay, Randy, sounds like an interesting set of circumstances, but the returns aren't that great. I'm a swing for the fences guy, willing to take big risks for big rewards. What have you got for me?".

Okay, you want some real upside mixed with some real danger? Look at warrants, SEA+ (SEA-WT on Yahoo). They are trading around $1.40 (unfortunately up 20 cents over the previous two days). These warrants have a strike price of $8, so they should be worth $1.90 or more. But they aren't there yet due to two factors, first that the warrants will be worthless if the deal is voted down, and even if the deal is approved the stock may decline sharply afterwards. IIf this deal is approved, the warrants should be worth more than the stock price minus $8, because they are essentially very long term (2.5 years) call options. The value of this long life span means that if the deal is approved they should trade substantially above the price imputed by the stock price. For example, if the common trades at $10 post deal, I would not be surprised to see the warrants trade above $2.50. Their only downside is the warrant's maximum value is capped around the mid six dollar range, as the company has a buyback right when the stock price trades above $14.25 for 20 out of 30 days.

And this isn't an investment you can take a large direct position. So this is where the "arbitrage" came into play. To reduce risk, I bought the common in a ratio with the warrants, so if the deal is voted down I would make a little money on the common to offset the warrants going to zero. And if the deal is approved, I win on both.

Unfortunately I bought my warrants at 80 cents pre-deal, but sold them at $1.20 as soon as the deal was announced because I didn't really think through how valuable the long term call the warrants provided was. As usual, the price you pay will determine your long term return, so getting either the common or warrants cheaply will definitely make these opportunities more attractive. Right now I own only the common, and won't buy more warrants unless they drop back below $1.20, but you need to make your own determination of what you think a reasonable entry point would be.

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Nicholas Financial (NICK)

Note: I originally posted a longer version of this write-up on ValueInvestorsClub.com, Nicholas is one of my favorite companies and is currently one of my largest positions.

How much would you pay for a company that’s grown same quarter revenues and earnings for 65 out of it’s last 66 quarters? That’s grown EPS from 12 cents per share to $1.08 per share over the last ten years (23.6% annualized). A quality company with solid financials built solely through organic growth, (no rollup), with at least another decade of strong growth ahead in the U.S. market along. I understand, you’re a bargain type guy, and you don’t like to overpay for anything, even your wife’s engagement present. So how about if Mr. Market puts this hot little number on sale, just for a short time, at a little less than 11 times reported TTM earnings? Not interesting enough? What if earnings may be substantially understated? Nicholas Financial exists in the toughest part of the sub-prime auto lending business, and has a unique “hands on” approach that is responsible for high profitability and low loss rates with very low credit score clients. As opposed to other (mostly larger) lenders that centrally automate their approval and collection systems with a focus on maximizing loan productivity, Nicholas handles all clients through local branch offices, in order to get to know them more closely. This means the Nicholas office is close by when clients need to make payments, new applications, and most importantly, when collections are necessary, which helps reduce losses. Competitors use credit scoring as the main determinant of credit risk, allowing their central offices to cost-effectively process high volumes of loan applications. Nicholas feels credit scoring alone is not the most accurate gauge of individual client risk as two clients with identical credit ratings can offer much different risk levels. Nicholas to measure risk through factors that supplement raw credit scores, such as income level, stability, “life” trend, etc. This allows NICK to “cherry pick” clients who have lower risk than credit scores alone would indicate. Even then, Nicholas turns down 85% of potential clients. One of the most attractive qualities of Nicholas is that they do not securitize their loans. This makes their balance sheet clean and easy to understand, and contributes to their quality of earnings. By not securitizing, they actually take long term ownership of their loans. This provides a strong incentive to underwrite conservatively. Because of this, accounting is also conservative, loan discounts are kept as loss reserves and aren’t recognized until the pool is liquidated or the pool is determined to have excess reserves. Leverage is very low (1.35-1 Debt to Equity). Historically the ratio has been higher but a secondary offering in 2004 substantially increased equity. So the risk in the balance sheet revolves around the quality of loan reserves, and the fact it is borrowing short-term, to loan longer term. Since I believe the reserves are strong, and the balance sheet is so lightly leveraged, I see both risks as limited or manageable. The lower leverage since 2004 has had the effect of lowering ROE, which has declined into the 17% range since the secondary. From a conversation in early 2006, management expects the debt to equity ratio to increase as they grow and add more loans, but to stay under 2.5-1 for the next three years. They feel comfortable with any ratio of 3.5-1 or below. Nicholas’ real competitive threat is irrational pricing in the market. The sub prime financial business has gone through irrational pricing periods, until there is a shakeout and some firms go under. This has not happened since 1996-98 when cheap public money flooded the segment. So far, today’s competitors are more rational about pricing. If pricing turns unreasonable, Nicholas has been disciplined enough in the past to give up bad business rather than lose underwriting discipline. Evidence of this is found in 1997, revenues grew only 10% and profits 20% during a period of irrational price competition. The Opportunity: On Nov 2nd, NICK reported disappointing earnings (by it’s standards) in it’s second quarter. Net income only increased 10% year over year, and was actually down over first quarter (27 cents vs 29 cents). In response, the stock declined to the low $11 range, and only recovered a little bit since. A variety of factors are squeezing their results. Borrowing costs are up a half percent, while loan rates are static. Write-offs and charge-offs have increased. NICK has benefited in the past from a rosy economic climate, and it appears to be in the worsening part of the cycle. Finance receivables have only increased 15% year over year, and operating costs are up slightly proportionately. This leads me to suspect that several recently opened branches aren’t up to speed yet and this may be a drag on quarterly comparisons. The question to ask, has anything material damaged their business? I don’t believe so. The key number for me is that 15% growth in finance receivables. Even 15% per year is still excellent, and justifies a much higher PE ratio than it's currently trading at. There are no real limits to their growth at this stage, with many more states to expand into, as well as more markets in current states. My belief is that we may have to deal with some slower growth in the short run if credit losses are higher, but in the long run earnings will keep up with financial receivables growth. Even if EPS growth over the next ten years averages 15% per year, NICK would deserve a much higher PE ratio than 11, I’d think closer to 20. So right now I believe it’s trading at quite a discount to intrinsic value.