Debt for Equity swap

May 29th, 2008

Companies have many options for financing operating activities, issue debt, issue stock, and using cash flow from operations among other things. One stock I have been following for a while now is E*Trade (NYSE:ETFC), which has been engaging in something called a debt for equity swap recently. I wanted to go into detail why I believe these swaps are good for shareholders.The basic idea behind one of these swaps is to issue equity equaling a debt load to pay off the debt. I am going to construct a simple example to explain the concept below.Consider the following:

Company Acme

  • Revenue of $1,000,000
  • Cost of running business $500,000/yr
  • Original shares outstanding 100000
  • Debt of 10 year $300,000 at 5%
  • Shares trading at $50

Revenue $1,000,000
COGS $ 500,000
Interest Payment $ 15,000

Net Income = $485,000
Earnings per share = $485,000/100000 = $4.85/share

The company issues 6,000 shares at $50 bringing the share count to 106,000 and lowering the earnings per share from $4.85 to $4.57. The share count was increased by 6% and the earnings per share decreased by 6%. Now lets take a look at year two:

Revenue $1,000,000
COGS $ 500,000
Interest Payment $ 0

Net Income = $500,000
Earnings per share = $500,000/106,000 = $4.71/share

The earnings per share increased 3% from the reduction of the debt. This leaves more money in the company for operation, or dividends for shareholders. The company can initiate a share buyback to reduce the dilution from the swap. The company also has discretion about buying back stock, this freedom does not exist with a debt issue. Because of the freedom the company could buy back some of the stock if the price of the issue falls.

Ideally a company should never have to dilute shareholders in some situations it’s much better than being saddled with a big debt load. The debt for equity swap gives a company freedom in their financing activities and can allow a company to gain footing much quicker than issuing debt.

The news item that relates to E*Trade and this post can be found here: link

Disclaimer: I own a very small option position in E*Trade.

Posted in finance, investing | 1 Comment »

Do software companies have moats?

February 25th, 2008

In this post I want to explore the idea of software companies having moats. For our terms I’m going to define an economic moat as an advantage one company has over competitors. A moat can take many forms including

  • product differentiation
  • perceived product differentiation
  • driving costs down
  • locking in customers
  • locking out competitors.

An investor could argue that some software company somewhere qualifies as having a moat under one of those qualities. What I want to consider is do software companies have a moat in general, and if they do what are common aspects of that moat.

I believe that tech companies in general all inherit common characteristics of the industry, and three of those characteristics are, driving costs down, locking in customers, and locking out competitors. Many software companies have perceived product differentiation (Apple and Oracle come to mind), but I don’t believe that’s a widespread trait. I also don’t believe that real product differentiation exists much in the software realm.

So what are the aspects of software companies that give them a moat? I want to discuss each below.

Low Costs: A software firm has fixed assets of possibly an office, and computer equipment, but outside of that, most of the companies assets is stored in the minds of it’s designers, engineers and programmers. People react much better to cost cutting than machines do. An employee is willing to take a pay cut if they believe that at some point in the future their hard work might pay off with stock options. Whereas a company that has fixed machinery can’t decide to only use half the electricity without damaging it’s production pace.

Locking in Customers: For most non-technical users learning a new software package is a big ordeal. Consider that Apple OS X is easier to use, but Microsoft Windows has a much bigger market share. Most users who learned Windows at the office purchased a PC to use Windows at home, even though there were superior choices available.

A second example of this is word processors. Microsoft Office is the word processing package of choice worldwide. There are not many people using WordPerfect, or OpenOffice, even though they provide the same user experience, often at a much lower cost (OpenOffice is free). Office has locked in users with training, and with file formats. To open a Word document a user must be running Office.

Software companies lock in customers much like a bank. They create a switching cost which is the hassle of installing and learning new package so high that users are content to use a product that might not be the best choice available.

Locking out Competitors: This is an area that I feel is opening up, but is still very real. Most software companies create products that conflict with competing products. Try running Oracle on Windows, it doesn’t work well because Microsoft has it’s own database engine SQL Server. The same can be applied almost across the board, Apple locks out competitors unless they use the Apple guidelines for software, Microsoft does the same thing with Windows.

With all the great things going for software companies what could stop them? I have a few value destroyers listed below.

  • Open Source Software – This is a movement where programmers build software components for free for the good of humanity. The software is often equal to the commercial version, and the price most of the time is free. You can’t compete with free.
  • Revenue Recognition – This is a dicey subject not talked about often, but it’s a grey area in the GAAP on how to recognize software revenue if software is a service. This issue is what led NEC from being delisted recently. Improper recognition could make a company seem much more profitable than it is.
  • Unfair expectations – Most investors have not forgotten the DotCom bubble in the 90s, and there are still some of the same expectations floating around. This leads to unfairly high P/E ratios, and share prices that are often high flyers for companies that don’t have much of a profit.

Does the implied economic moat around most software companies create a good investment opportunity? I think this needs to be evaluated on a case by case, as there are definitely great opportunities amongst the industry. What is known is that software companies have a great competitive advantage that is not available in many other industries, and investors should take advantage of good bargins on solid software firms.

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Nice gain on GWR since last post

February 25th, 2008

I posted about Genesee and Wyoming Railroad back in July of 2007.  At that point in time I really liked the management outlook on the company and highlighted the insider purchases.

I kept my eye on GWR for the following few months but never made a purchase.  After looking at the chart today there were some great buying opportunities in the late summer and right at the beginning of the year sell-off.  Purchasing around $26 anywhere from August to early January would have yielded a 20% gain, not too bad for holding a few months.

The catalyst in the move was a better than expected earnings for the end of 2007.  Revenue increased 14%, they also benefited from currency conversio (dollar devaluation).

The reason I took a second look at GWR is I’m looking for a stock to write covered calls against, and GWR might be a great opportunity.  I hope to post a scenario in an upcoming post.

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Bowl America Special Dividend

January 25th, 2008

To any shareholders of Bowl America (AMEX: BWL.A) who were wondering why two dividends were paid out on January 22nd I found the answer in the latest 8-k filed.  The ‘extra’ dividend was a 50th anniversary present to the owners of the company.  I previously wrote about Bowl America and the strong dividend policy.

This is a welcome surprise, and one more sign the Bowl America management is shareholder focused.  Stated in the 8-k  the Board of Directors also increased the quarterly dividend from $.14/share to $.15/share to keep up with inflation.  At the $.60 dividend rate and the current trading price the yield is 3.87%, which is higher than ING Direct after the rate cut.

I have pasted the release below:

Memo from Leslie H. Goldberg, President, dated January 22, 2008,
 mailed to security holders of record January 10, 2008.

January 22, 2008

Dear Fellow Owners:

The enclosed third quarter dividend is being paid earlier than usual this year.
Today is the 50th anniversary of the opening of the Shirley Tenpin Bowl - Bowl
America's first center.  We have, therefore, included a $.10 extra dividend as
sort of a birthday present from us (it really is our money) to us.

Of equal importance, we have increased our regular quarterly dividend to $.15
per share.  If business conditions warrant, this increase will make this year
our 37th consecutive year of increased per share dividends.  Our corporate
objective remains to provide dividends that keep pace with inflation.

We are subject to the same pressures as every retail company.  We are hopeful
that the techniques we have learned in prior cutbacks in consumer discretionary
spending will enable us to continue to deal with the problems that we see today.

HAPPY BIRTHDAY SHIRLEY!

Posted in general, investing | 1 Comment »

Bowl America rolls a strike

December 17th, 2007

This item will be a little different than posts in the past. In this post I wish to talk about, and give my fair value for a company that owns bowling lanes along the east coast, Bowl America.

Bowl America (AMEX: BWL.A) is a closely held company that owns and runs 19 bowling centers in D.C., Baltimore, Richmond, Jacksonville, and Orlando. Bowl American runs 756 lanes across 19 facilities. Bowl America opened their first bowling center in 1958 in the Metro DC area. That facility is still open today. The company was founded by the current CEO and Chairman’s father C. Edward Goldberg.

I first ran into Bowl American through a stock screener on my Fidelity account. As I researched the company and read the presidents letters I fell in love with the company and the opportunity it provides. Bowl American is a pretty standard bowling operation, they generate revenue from three main sources, open bowling, league bowling, and concessions/merchandise. The first thing I liked about this company was the management’s philosophy, the management runs a very shareholder friendly company, and I dare say a shareholder focused company. In reading the president’s letters it’s very clear he is a strong believer in giving back company profits to shareholders in the form of a dividend. The dividend has been increasing for the last 50 years. In the current shareholder letter it’s stated that “…cumulative dividends on that single $2.00 share will exceed $100.” Besides paying a steady increasing dividend the company is run very conservatively, they own each center outright, have no debt on the books, and have a large cash position. Each new bowling center is financed out of their cash position.

Bowl American presents a unique challenge in deriving an intrinsic value. The reason for this is three-fold, the first is the real estate portion of the company is quite large, and most of it is valued on the books at it’s purchase price in the late 50s on up. Most of their properties are held in the Metro DC area, and for anyone who’s been asleep at the wheel a plot of land in DC is worth a little bit more now than it was in 1958. The second is the large securities portfolio the company holds. As of Sept 30th Bowl American had a securities portfolio value of $6,218,625. The third reason is that I don’t believe a classic P/E valuing correctly values the cash this business throws off, because of this I’m going to do a FCF analysis to determine the intrinsic value.

I searched through the latest 10-Q, annual report and last year’s first quarter 10-Q. In the first quarter last year they had an unusually high capital expenditure, they purchased a new bowling alley and recorded it in Q1. Due to this I’m adjusting the 2007 Q1 CapEx from 1,762,974 down to what has historically been the CapEx for that time period 220,000. By adding in the quarter that just ended and subtracting out Q1 last year from the figures in the 10-K I get

$5,957,998 Net Cash Provided by Operating Activities

$795,713 CapEx for fiscal year 2007

I’m using a discount rate of 10% and an annual growth rate of 5% with a FCF of $5,162,285, and 5,135,690 shares outstanding. With this I get a value of $20.10/share. (5162285)/(.1-.05))/5135690 = 20.1035. That’s without dividends subtracted. Adjusting for dividends I get $8.50/share. ((5162285-2978932)/(.1-.05))/5135690 But this is only part of the story, remember they have a large amount of stock on their balance sheet. The Chairman and CEO has mentioned that he is a ‘stock nut’, which could explain the telcom stocks Bowl American holds. In the latest 10-Q there is a listing of share amounts and companies, from this and yahoo finance I can figure out the current value of the holdings. I have a list of the stocks and share amounts below.

  • 3,946 shares of Alltel = 281981.16
  • 45,580 shares of AT&T = 1845990
  • 669 shares of Avaya = 11694.12
  • 2,000 shares of Embarq = 95320
  • 939 shares of Idearc = 15822.15
  • 475 Shares of LSI = 2574.50
  • 9,969 shares of Qwest Communications = 66991.68
  • 40,000 shares of Sprint = 556400
  • 18,784 shares of Verizon = 809590.4
  • 11,865 shares of Vodafone = 427495.95
  • 4,079 shares of Windstream = 53353.32

The total value of the securities portfolio as of the close at 4pm on 12/17/2007 is $4,167,213.

Taking the assumption that the cash and equities totaling $6,497,917.3 will be employed to grow the business at a rate of 5% I get a value of $25.30/share for the securities portion. Adding the securities/cash and the operating FCF together I get a value of $33.80 as the intrinsic value of Bowl America. Currently Bowl America is trading at $15.91 at 4pm on 12/17/2007. Given these figures Bowl American is trading at a discount of 52.9% to it’s intrinsic value.

I’m interested in anyone’s thoughts on this analysis. I’m open to suggestions or corrections in my math and/or assumptions.

Disclaimer: I have held shares of Bowl American since March 07. Also note Bowl American trades on the American Stock Exchange with very low volume, so liquidity can be an issue.

Posted in finance, investing | 9 Comments »

[MFI #3] American Eagle

October 19th, 2007

American Eagle (AEO) is a clothing retailer that markets mainly to teens and college age individuals.

I actually already have purchased a position in AEO before doing my analysis. The reason for this is I live in Pittsburgh where AEO is headquartered, so I’m always reading about the company in the paper and keeping up with current company events. I also know people who have worked there, or are related to employees at AEO. Because of this I essentially already did some of my analysis on the background of the company.

I have always been impressed with AEO. What pushed me over the edge to purchase was the insider purchases recently. Usually with a company when insiders start buying they know the shares are undervalued and it’s time to pick them up cheap.

Debt

There is no debt on their books

Pros

American Eagle Outfitters has a strong brand and strong presense in teen culture. While building a strong brand in teen retailing isn’t impossible it doesn’t happen overnight. I consider AEO’s brand to be a competitive advantage.

$6.22/share in net current assets

Cons

While many teens would consider trendy clothing vital it unfortunatly isn’t the case.  Retail is subject to rising costs in oil, and the consumer credit crunch.  The outside risk factors could weigh on holiday sales, which is traditionally a strong time of the year for them.

Cash Flow

This is a little lower than I’d like.  AEO is not a cash flow rich company, and doesn’t appear that it ever has.   The current P/CF is 12.12 according to Morningstar.


Dividend Policy

There is currenly a $.40/share dividend which is approx 1.68% percent.

Current Share Details

As of 10/18/07 AEO closed at: $23.30

Disclaimer: I currently own a position in AEO 

Posted in finance, investing | 1 Comment »

[MFI #2] Biovail Corp

October 6th, 2007

Biovail Corp [ticker: BVF] is a pharmaceutical company that develops, manufactures, and delivers drugs to the United States and Canada.

Pros:

New CEO in 2004 has shaken things up at the company, eliminating losing divisions and tripling the dividend.

Cons:

Restating earnings from 2006,2005,2004. The restatement has occurred due to weak financial controls. They overstated the amortization expense for a drug they ordered from GlaxoSmithKline. This resulted in a 17.4M net income recognition in 2007. It’s possible the accounting tricks have not stopped.

This is a drug company, in August they were denied FDA approval on one of their drugs which send the stock down 20%, this could happen again with any of the drugs they have in their pipeline.

Biovail is a Canadian company, so currency risk is involved in both their sales, and from the investor standpoint the purchase of their stock and dividends.

Warnings:

The accounting revisions are troubling, there could possibly be more problems.  The auditor as of March 2007 stated that they do not believe internal controls can catch accounting problems.  This statement is extremely troubling.
Due to the nature of the business there could be significant litigation. I am not as worried about this in the near-term. But the news of a possible lawsuit could severely depress the price of the issue.

Cash Flow:

The cash flow is strong, but can be spotty. In the fiscal year 2006 free cash flow was as follows:

  • Q1 – 76,480,000
  • Q2 – 98,116,000
  • Q3 – 78,913,000 (made possible by an asset writes down of 147M, otherwise a loss)
  • Q4 – 228,561,000

Dividend Policy:

There’s a $1.5 dividend per share which is about an 8% yield.

Debt/Equity:

No long term debt

Long Term Growth:

I don’t see anything in the near term impeding Biovail’s growth.

Management:

CEO Dr. Douglas J.P. Squires is a relatively new in the position. He was also recently named interim Chairman.  CEO Squires has taken an active approach in turning the company around.

The CFO who presided over the accounting scandal has left.

Price:

As of 10/4/2007 BVF closed at: $18.45

Posted in investing | 2 Comments »

[MFI #1] KSW Inc

September 27th, 2007

KSW Inc [ticker: KSW] is a company that installs HVAC systems in buildings. If you spend a little bit of time looking at the chart you’ll notice the stock fell from a high of $8.5 to a low of $6.5 at the end of July, it has since recovered to around $7/share.

I will assume much of the sell-off has occurred because investors are panicing over the housing market bust. KSW rises and falls with commercial real estate investment.

Debt/Equity:

No debt on the books

Warnings:

One thing I’m concerned about is the fact that since June the CEO has been dumping stock. There have been 14 form 4’s filed since June 18th. All of the forms include sales. Maybe the CEO needs to pay rent or something, but the frequency and amount are concerning.  On some days the insider selling amounts to 20% of the volume for the day.  This is a big red flag for me.

Pros:

According to this press release the company has $90 million dollars in backlog.

2Q earnings were $.12/share vs $.10 same period last year

Cash of $2.77/sh

Cons:

As noted in the 10-K the company is considering pursuing an acquisition in either the same field, or a different line of business for diversification (diworsification most of the time).

This is a small cap stock (43 million market capitalization), this could result in large bid-ask spreads, or liquidity problems when purchasing or selling.

The $90 million backlog is based on contracts that have been signed that have contingency clauses and allow customers to back out.  I don’t consider this a reliable number.

Dividend Policy:

There is currently a $1.96/sh dividend.  Which at the current price of $6.90 works out to be a 27.8% dividend.  I’m not sure how long this dividend can be sustained at this level.

Long Term Growth:

I think KSW has some nice long term growth prospects.  Commercial real estate didn’t appreciate as much as residential real estate during the current boom.  Also this type of business is very stable over the long term as long as the company is in a good financial position to weather the storm.  I think KSW has enough cash to weather this housing boom if they cut their dividend and do not encounter any delays in their backlog.

Management: 

I don’t really have any information on management except for the insider selling noted above.

Current Share Details:

Price: $6.90

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New series of analysis

September 23rd, 2007

I have been reading and researching something called magic formula investing.  It was introduced to me via Joel Greenblatt in his book “The Little Book that Beats the Market“.  Information about the formula can be found on his site or via Google, I don’t plan on rehashing any of it here.

I have decided to venture into MFI (magic formula investing) by putting some of my own hard earned cash towards it.  Joel recommends purchasing 20-25 stocks from the MFI list in groups of 5-7 quarterly.  This method aims to capture the average of the MFI stocks, and diversifying an investor.  He recommends that if an investor is comfortable with indepth research that it’s possible to yield the same results with only 5-7 stocks in the portfolio.  This is the strategy that I will be using, modified slightly, I will invest in 10 stocks, in two batches of five at a time.

In preparation for my first batch I have been researching the stocks that appear on the MFI top 25 list.  My first screen was looking each up in Morningstar.  Of the 25 stocks 10  are covered by Morningstar’s equity analysts.  There are 3 four star, 2 three star, 1 two star, and 3 one star stocks, one stock is unrated.

My next screen is to run through the SEC filings reading almost everything submitted.  I will be crunching some numbers to determine trends, and possibly extrapolate longer term trends.  In looking at the filings I’m looking for earnings quality, and possibly warnings signs that would make me stay away from the stock.  All of the stocks on the MFI list are there because of high return on capital, and low earnings yield, so determining if the stock is a value or below intrinsic value is a somewhat pointless exercise.

For my MFI series of blog posts I plan on including the following items about each stock I research:

  • debt/equity
  • pros/cons of the business
  • potential timebombs (hopefully some insight as to why the stocks on the list)
  • cash flow
  • dividend policy
  • long term growth potential
  • any insight into management

Each post in this series will start with an [MFI #] in the title.  Keep posted!

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Sun Microsystems Reverse Split

September 5th, 2007

Sun Microsystems recently changed it’s ticker from SUNW to JAVA.  It appears that with the new ticker they’re trying to re-invent their stock price through a reverse split.  The details for the split are found here.

According to the SEC filing the reverse split will increase EPS, reduce shareholder transaction costs, and increase share price.  I agree that all of these will be true, but through a little smoke and mirrors instead of the normal technique of growing the business.

It should be noted that I don’t have an axe to grind with Sun.  I like their software Solaris and Java.  I think they make world class hardware, and I think they have some of the most intelligent people in the IT industry working for them.  What I do have a problem with is pulling tricks with the stock to create an illusion that the company is worth more than it really is.

As of the price today once the reverse split is completed JAVA’s new price will stand around $21/share.  I get the sense that with the ticker change and the higher price due to the split they’re trying to lure new investors into the company and pump the price up.

Note to Sun:  If you want your share price to rise legitimately have your sales force return calls from clients.  License Solaris technologies to other companies.  Introduce a rock bottom server to get new clients in the door.  No more reverse splits will be needed.

Disclaimer: I do not own a position in JAVA, although I do own a Sun server, and have used the Solaris operating system, and the Java programming language. 

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