Long View: ADT

Security: ADT JAN 16 2016 40.00 CALL
Date of first purchase: March 24, 2014

I am buying call options on ADT expiring in 2016 because I think the business is significantly undervalued and the expected value of its LEAPS is attractive. Each option is $1.34 at a strike price of $40. I estimate the business is actually worth $44 to $60 per share. This implies that at ADT’s current market capitalization of $5.3 billion it is being priced at a 36% to 53% discount to its intrinsic value of $8.2 billion to $11.2 billion. This margin of safety should allow generous room for error if in the long run I have incorrectly assessed the true value of ownership.

ADT is North America’s leading provider of home and small business monitored security services. At 139 years old, it is also the largest and most well-known brand in this fragmented and growing industry. It serves roughly 6.5 million customers, which is 22% total market share, roughly six times the size of its next largest competitor. Its residential customers are typically owners of single-family homes, while its small business customers include retailers and small-sale commercial facilities. With 92% of its revenue recurring in nature, it has attractive earnings and operating stability. This is because its new accounts typically have an initial term of three years with automatic renewals for successive 30-day periods. Moreover, ADT’s average customer relationship is seven years, longer than many of its newest competitors have been in the industry. The perceived threat of these new competitors led to a 30% drop in the price of ADT shares since the beginning of 2014.

America’s telecom giants are expanding into the home automation segment of the monitored security alarm industry, bundling new services in this field with existing offerings of broadband, television, and phone connectivity. And in some instances, they are significantly underpricing the automation component of such bundles. Comparing ADT’s results with its competitors’ efforts reveals the threat to be overstated so far. For example, in calendar 2013, cable industry behemoth Time Warner Cable added 32,000 subscribers to its IntelligentHome offering that competes with ADT’s similar Pulse home automation service. In the last three months of 2013, ADT added 231,000 customers overall, 36.5% of whom purchased Pulse. In other words, roughly 84,000 people in three months chose ADT over the 32,000 who chose IntelligentHome in an entire year. Yes, ADT’s new competitors bring with them hefty balance sheets and strong cash flow production. And ADT has recently increased its leverage to repurchase shares, limiting its financial flexibility. However, ADT has no maturities of debt until 2017 and over 75% of its total debt does not mature until after 2021; and with $300 million to $400 million in average free cash flow, ADT has the funds necessary to meet its fixed obligations and competitive capital needs. And management is putting its money where its mouth is. After the company retired 20%of its outstanding stock over the past year, eight different ADT officers and board directors have in aggregate purchased more than $700,000 of stock with their own funds at current prices.

I am thus purchasing ADT’s LEAPS because the margin of safety in the company’s equity greatly favors the probability of gains versus the potential for loss at expiration. The pricing and expiration date of the options should allow ample room for error or adversity if I have wrongly appraised the true worth of owning ADT or if the business’ brand strength and cash generation do not soon outshine recent fears of new competitive threats in its marketplace.

Long View: AIG

Security: AIG JAN 17 2015 40.00 CALL
Date of first purchase: December 4, 2012 

I am buying call options on American International Group (AIG) expiring January 17, 2015, because I think the business is substantially undervalued and the expected value of its LEAPS is very attractive. Each option is $4.26 and the strike price is $40. In my estimation, the intrinsic business value of AIG is likely $60 to $70 per share, or approximately $89 billion to $103 billion for the whole company. This compares to a current stock price of $33.32, or a market capitalization of $49 billion. So with around $100 billion of tangible book value, the entire company is on sale for half its net tangible assets, significantly below its peers and long-term historical levels. This sale price is a 45% discount to the bottom range of its true value. 

It is almost impossible to overstate the extreme terror that gripped securities markets in the fall of 2008 because of the known and unknown dangers lurking in AIG’s balance sheet. After an ill-judged expansion into insuring the most toxic areas of the mortgage and derivatives markets, AIG received a $180 billion bailout from the Federal Reserve and U.S. Treasury. The Treasury has gone from owning 92% of AIG at the time of the bailouts to 77% at the beginning of this year. Through additional share sales this year, the Treasury currently owns 16% and is on the cusp of selling its remaining stake in the next few months. In the time since the bailouts, senior management and directors have been replaced and AIG’s shareholders have suffered substantial losses. The company shed major assets to help repay the government and divested international operations. It floated AIA, the Asian life insurer, and sold its non-U.S. life insurance subsidiary Alico to U.S. rival MetLife. Its businesses have been de-risked and downsized, headcount globally shrinking to 57,000 from 116,000 in 2008. And its balance sheet has been deleveraged, the derivatives book of AIG Financial Products, over $1.8 trillion on a net basis four years ago, shrinking to about $157 billion by June of this year. It is still a substantial player in its core end-markets, though, and about to be the first non-bank designated in the U.S. as a systematically important financial institution. It is similarly difficult to overstate how improbable it was to conventional wisdom on Wall Street that AIG would ever repay the government, let alone earn both the Federal Reserve and U.S. Treasury a profit.

The company’s shares have risen over 40% YTD, spurred on by successively improving quarterly results and the company repurchasing over $13 billion of its shares. Those repurchases increase share price through raising book value per share, a multiple at which insurance companies trade. But what matters to an insurance company, a complex organization even in the most normal of times, is ultimately not the excess value of its assets over its liabilities. It is its ability to earn more on its assets than it must pay on its liabilities, as reflected in its return on equity. And AIG’s mid-single-digit ROE is well below that of peers. The company will refocus on improving its debt coverage ratios in the next year, putting repurchases on the backburner. And it must improve the earning power of its core property casualty and life insurance businesses. It has a substantial surplus of equity and the operational scale to do so, making it likely to achieve average earning power of at least $5 billion per year going forward.

I am thus purchasing AIG’s LEAPS because the significant margin of safety in the company’s equity greatly favors the probability of gains versus the potential for loss at expiration. The pricing and expiration date of the options should allow ample room for error or adversity if I have wrongly appraised the true worth of owning AIG or if the business’s strengths do not soon outshine recollections of a considerably troubling period in its history.

Long View: Dell

Security: Dell Jan 17 2015 10.00 Call
Date of first purchase: October 29, 2012 

I am buying call options on Dell expiring January 17, 2015, because I think the business is substantially undervalued and the expected value of its LEAPS is very attractive. Each option is $1.58 and the strike price is $10. In my estimation, the intrinsic business value of Dell is likely $22 to $28 per share, or approximately $38 billion to $49 billion for the whole company. This compares to a current stock price of $9.24, or a market capitalization of $16 billion. So, with $6.2 billion of net cash and $2.9 billion in average owner earnings since 2007, the entire company is on sale for less than $10 billion, 3.4x its proven earning power. This sale price is a 75% discount to the bottom range of its true value. 

The margin of safety here has grown considerably wider in the past six months. Price competition in the consumer PC business and exogenously weaker demand weighed down the company’s last two quarters. Management then lowered its year-end earnings guidance 40%, a level matching its average earnings but below last year’s record results. Dell’s market price subsequently declined nearly 50%. Two things likely worry the marginal investor: Either the company’s legacy business of selling PCs has become an albatross, or Dell faces a prolonged transition to becoming a higher-margin supplier of end-to-end IT solutions.

The marginal investor is asking a particular question, heavily influenced by his fixations and aversions: Where will Dell trade in the next 12 to 18 months? To answer this question he fetishizes management guidance, known catalysts to changing business conditions, and near-term growth projections that only go upward. To arrive at a “valuation” for the business, he applies a multiple to next year’s earnings expectations, a method anchored to current sentiments and to what multiples investors have applied over time. Above all else, the marginal investor is impatient. He is unwilling to own a business over the next 12 to 18 months if that means experiencing volatility.

What would you need to know before you formed an opinion about becoming an owner of Dell at today’s prices? You would need to know approximately what Dell is worth. That question begets many other lines of inquiry. Notably, Dell’s likely ability to meet its future obligations, how good a job its managers are doing operating the business, and whether its earnings are likely to be higher in 5 to 10 years than they are today. But you do not substitute easier questions that in themselves or their answers overemphasize popular impressions or currently circulating stories. A business analysis of Dell shows that its strategy is laudable and working. Dell is targeting shareholder value creation, instituting a dividend, aggressively repurchasing shares, and focusing on long-term growth in operating earnings and free cash flow. Things are not going as quickly or smoothly as the temperamental investor would endure, but just as a patient, long-term owner would think. Successful business transformations are not without competition, stumbles, or stock price fluctuations.

I am thus purchasing Dell’s LEAPS because the significant margin of safety in the company’s equity greatly favors the probability of gains versus the potential for loss at expiration. The pricing and expiration date of the options should allow ample room for error or adversity if I have wrongly appraised the true worth of owning Dell or if the business’s strengths do not soon outshine an exaggerated focus on its recent hiccups.

Long View: WH Smith

Security: LSE:SMWH
Date of first purchase: August 18, 2010 

I am buying shares of WH Smith plc at $6.35 per share (including commission) because I believe the business is actually worth $9.18 to $10.94 per share. This implies that the intrinsic value of WH Smith is between $1.4 billion and $1.6 billion, despite a current market capitalization of $955 million. Given the company’s $215 million tangible net worth, WH Smith’s intangible assets, such as its operations, market share, and brand, are effectively on sale for $740 million, a 45% discount to the bottom range of their true value. This margin of safety should allow considerable room for error or adversity if in the long run I have wrongly appraised the true value of ownership.

WH Smith is the United Kingdom’s largest neighborhood retailer of magazines, newspapers, books, and stationary supplies. A 218-year old company, it achieved its current stature in British business and culture through locating itself conveniently on virtually all of the country’s high streets and supplying Britons with low-cost print media and impulse products. But over the past two centuries, it has at times strayed from its core (which is both surprising and unsurprising given its longevity). WH Smith has been an owner of music retailers, newspaper distribution operations, and a variety of other dissimilar, low-margin businesses. This lack of focus culminated in the largest loss in the company’s history of $267 million, before current CEO Kate Swan took the helm.  Ms. Swann and her management team simplified the company down to its most profitable businesses. The company now operates in two segments: High Street and Travel. Its High Street segment contains the defensive neighborhood convenience stores on which WH Smith built its reputation. The Travel segment contains small, high-margin outlets located in areas with heavy foot traffic, such as airports, hospitals, workplaces, and bus and train stations. With a renewed focus on the two businesses in which the company has its strongest market positioning, management has been able to reduce costs, improve scale, and increase profitability. In doing so, it has seen a decrease in top-line revenue from $4.5 billion in 2004 to $2.2 billion in 2009 as it has shed or wound down low-margin channels such as DVD and CD sales. This top-line decrease has possibly created fright and confusion among market participants voting on the price of WH Smith shares, especially in light of the British government’s recent austerity measures. However, it is unlikely austerity or its effects will be allowed to persist; moreover, this reduction in sales has actually been intentional and beneficial. WH Smith is today a focused business with a debt-free balance sheet, a net cash position of $72 million, sound working capital management, and more than 2.8 times coverage of its fixed costs. And the company has potential for even greater cash generation and shareholder returns going forward: it has inflation-adjusted, average owner earnings of $109 million per annum over the past five years, pretax earnings of $132 per square foot in its expanding Travel segment, a 4.1% dividend yield, and a record of productive share repurchases.

For these reasons, I am making an investment in WH Smith with the expectation of protecting principal and achieving a modest profit.

Long View: AXP

Security: NYSE:AXP
Date of first purchase: February 24, 2009

I am buying shares of the American Express Company at $12.27 per share (including commission) because I believe the business is actually worth $28 to $33 per share. This implies that at American Express’s current market capitalization of $14Bn, it is being priced at a 57% to 64% discount to its true value of $33Bn to $39Bn.  This margin of safety should allow generous room for error or misfortune if in the long-run my determination of the true value of ownership proves to be incorrect.

Large and rapid layoffs have transformed the credit crises of 2008 from a concern over the liquidity and solvency of corporations to a concern over the debt holdings of consumers and small businesses. Payment companies like American Express have been forced to write-off larger numbers of past due loans, increase loan-loss reserves, and restructure as consumers and businesses worldwide reduce expenses. With no certainty as to what percentage of cardholders will default on their obligations, equity investors in these companies have taken a “sell now, think later” approach to valuation. I don’t blame them. Given the dour headlines flooding the news media, those worried about the near-term liquidity and profitability of payment companies are justified in their pessimism. American Express will most likely have annual income well below its 15-year trailing average over the next few years.

However, in the midst of non-stop dire forecasts regarding consumer spending and defaults, the strengths of the company’s brand, costumer base, and management are being ignored. Unlike its larger competitors (Visa and MasterCard), American Express seeks and serves more affluent customers. It attracts its clientele not through the aggressive lending promotions that the issuing banks of its competitors have long-offered, but through an impressive, long-built reputation. This reputation draws merchants eager to sell to American Express’s higher-spending cardmembers and attracts members eager to reap the rewards of the company’s incomparable loyalty programs. Nowhere is this more evident than in the fact that even after three years of aggressively (too aggressively) increasing its lending, American Express still derives the vast majority of its revenue from membership fees, travel commissions, and the fees it charges merchants for transactions—not from the revolving balances of its cardmembers. The management of American Express has long been more comfortable competing on branding initiatives, merchant relationships, and customer service than on interest rate spreads.

This is not to say that the company benefits from the credit contraction and economic downturn. American Express derives 70% of its revenues from the United States. A consumption-led recession in the American economy will surely hurt the company’s near term earnings. In comparison to the earnings of recent years, forward earnings will pale in comparison. But if the company’s average earnings over the past 15 years provide any index as to what the company may again earn in more normal business conditions, then American Express is poised to return to a market valuation more appropriate to its long-term results. And though there will be government initiatives (some commendable) to reduce consumption as a share of U.S. GDP, consumer and business spending will return to levels that make American Express not only a profitable business but also a stellar one. For these reasons, I am making an investment in American Express with the expectation of protecting principal and achieving a moderate return.

Additional Purchase: March 10, 2009

I bought additional shares of American Express today at $12.05 per share. This purchase increases my total ownership stake in the company, and slightly reduces the average cost of my shares to $12.13 from $12.27 (including commission). 

Long View: RMCF

Security: NASDAQ:RMCF
Date of first purchase: November 11, 2008

I am buying shares of chocolate maker and franchisor Rocky Mountain Chocolate Factory (RMCF) at $6.45 share because I believe the business is actually worth at least $9 to $11 per share. This implies that equity markets are pricing a company at $40MM when it is worth at least $55MM to $65MM. The business is underpriced because of two investor concerns. One is a concern that RMCF may face negative revenue growth, and the other is a concern that RMCF’s profit margins may contract.

RMCF’s earnings in its most recent quarters decreased, which investors likely attributed to two causes: tighter credit markets and decreased discretionary consumer spending. Tighter credit markets decrease the lending available for new and existing franchisees in the near term, which is no small matter. New franchisees are a significant source of high margin revenue for the company and the survival of existing franchisees is crucial to attracting future ones. Additionally, decreased discretionary spending lowers sales for existing franchisees, reducing RMCF’s manufacturing revenue. Making matters worse, a large number of RMCF’s 300 existing franchisees are located in tourist destinations that the recession is sure to hurt.

While these expectations are rational and likely to come about, they are being too heavily weighted in the market price of RMCF's shares at the ignorance of RMCF's strong financial profile and business model.  Rocky Mountain Chocolate Factory currently has no long-term debt, a negligible amount of short-term debt (less than $0.2MM), little capital expenditures (approximately $0.5MM per annum), and strong free cash flow from operations ($3MM to $5MM). Moreover, RMCF's contractual cash obligations (e.g., rental, warehouse, and trucking operating leases) over the next few years are covered by the company's cash flows from operations many times over.

Should the worst arise, and a large number of RMCF's existing franchisees go out of business and no new franchisees emerge, RMCF’s revenue and profit margins will decrease. However, the business will still profit from the confection orders of its surviving franchisees, and when an eventual U.S. economic recovery occurs and small business lending and discretionary consumer spending increase, RMCF's operations and profits will be well-positioned to expand again. For these reasons, I believe a near-term investment in RMCF with a sizable margin of safety will eventually turn a substantial profit.