Sunday, October 29, 2006

Quick Valuation - Apollo Group (APOL)

Apollo Group runs the University of Phoenix and other for-profit higher education institutions. It recently reported 12% lower net income due to higher costs in marketing expenses and retention program costs. The earnings miss, poor retention rates, higher capex, and an options backdating probe has brought these shares down 25% from last month's prices. Is this best-of-breed business worth buying? I'm not 100% sold on the business, but the valuation seems cheap.

I played with a 3-stage DCF valuation to see how bad the growth has to be for the shares to be fairly valued around $35 a share. Using my customary 11% discount rate for companies of this size and the current FCF of $435 million dollars, the company would have to only grow 5% for the next five years and 3% in perpetuity to be worth $35 per share. To put this into perspective, the annual growth rate of the company over the last 5 years has been about 17%. A worst-case scenario of 7%, 5%, 3% staged growth results in the shares being worth $41. A more likely scenario is that the company can grow 10%, 7%, 3%, resulting in an intrinsic value of $49 a share. At current prices, APOL is trading with a 27% margin of safety. There doesn't seem to be much more down-side, but I am wary of the headwinds against the for-profit education establishments.

If the price gets even cheaper from here, I will take a closer look at the company. There are just too many unknowns and risks.

Friday, October 27, 2006

Weekend Links

Morningstar chimes in on Western Union, valuing the company at $32. The company reported earnings this week that beat analysts' estimates, resulting in a jump in the stock.

Eric Schleien has found an interesting natural gas company in FEC Resources. FEC owns 33% of FEP, a British natural gas discovery company with natural gas deposits in the Phillipines. Eric proposes a hedged trade that sounds promising, but most brokers have very expensive OTC trading commissions for this penny stock. MBTrading, my discount broker of choice allows me to trade penny stocks at a fixed $8.95 commission. I have not investigated how much it would cost me to short the FEP shares or if the company is so undervalued that I don't need to do the hedged-side of the trade. Natural gas exploration and extraction is not my area of expertise and I'm a bit wary if these deposits are extractable by such a cash-strapped company. I've set a limit order at $.04.

FatPitchFinancials has more value investing links for your viewing pleasure. George also runs Value Investing News, a Digg like news aggregator.

Quick Valuation - Legg Mason (LM)

Early in the month, Legg Mason warned investors that it would not be able to meet consensus estimates for the most recent quarter. They cited a rotation of assets under management into lower-fee fixed income funds due to market conditions and poor performance by a number of their large cap funds, including the LMVTX fund run by legendary Bill Miller. Miller's 15 year winning streak against the S&P index may finally be over this year. Investors are probably a bit short-sighted to abandon his fund because of this temporary setback. My bet is that Miller is still a great investor and Legg Mason is worthy of a spot on my watchlist.

Legg Mason has grown its free cash flow at a very healthy 27% clip to about $450 million this year in unencumbered cash. My inputs to the DCF are 20%, 10%, and 3% staged growth with a 11% discount rate. There isn't much share dilution, about 3% annual. This gives me an intrinsic value of $110 per share. At current prices, we have a 19% margin of safety. Let's keep watching this one. I'm not very comfortable with the assumed 20% growth over the next 5 years and probably need a larger margin of safety before I buy shares. A 35% margin of safety requirement would set a buy-below price of $71.50. I would wait for a better price.

At this point, I think USG and WU are better bargains than LM. Based on my previous valuations of $30 for WU and $71 for USG, we have a margin of safety of 25% and 28% margin of safety respectively. It's a shame both stocks did not give me enough time to load up. I am debating whether to buy these stocks at current prices. At a later time, I will re-evaluate WU and decide whether or not to make it a full-fledged WCS stock pick at current prices.

Sunday, October 22, 2006

Quick Valuation - Western Union (WU)

Over the weekend I skimmed over the Western Union spinoff information kit with unaudited pro forma financial statements. While looking at the previous 5 years worth of historical cash flow, I noticed that the growth rate in free cash flow (net cash - capex) diverged significantly from the growth rates that I am seeing used in DCF calculations by other bloggers like Mike. Interpolated from these numbers, free cash flow has grown at about 18% over the last 5 years. Since others already consider it cheap at 10% fcf growth rate, this makes WU an interesting investment opportunity. Greenblatt always said to investigate spinoffs as they usually present good investment opportunities.

My current estimate of the intrinsic value of the WU is $30. I used a 2-stage DCF model with growth rates of 10% for the next 10 years and 5% terminal growth. I used a 11% discount rate, justified by the company's enduring brand and global presence. In the worst-case, I can't imagine this company having lower growth rates than 7% for next 5 years, 5% for the following 5 years, and 3% in perpetuity. The intrinsic value in this highly unlikely worst-case configuration of growth rates is $19. Any purchase under $19.50 has a 35% margin of safety from my $30 IV estimate and is fairly valued in the worst-case. Sounds like my kind of odds!

In a future post, I will discuss the merits of the Western Union business. I will discuss why we need not worry about immigration legislation and why we don't have a buggy whip business on our hands.

Full Disclosure: I have a 2/3 full position in this stock. My original shares were spunoff from First Data Corporation (FDC). I have also recently made purchases at $19.40 and at $18.50.

Saturday, October 21, 2006

More findings on USG

Berkshire Hathaway recently announced a $7 billion reinsurance deal with Lloyds of London. As part of the deal, Berkshire Hathaway will take over the float and daily operations of the Equitas division. The main driver of this deal is to acquire a large $8.7 billion dollar float in Equitas's reserves. Warren Buffett is betting that he can generate enough returns from this float to cover all asbestos liabilities. I mention all this because it is a good example of developing one's circle of competence, a trait that Charlie Munger, Buffett's lifelong partner in crime expounds upon. Buffett no doubt used the knowledge he acquired while researching USG to assess this deal.

I recently found an article describing the older FAIR Act, which was tabled by the Senate in early 2005. Apparently, it did not get passed by a very small margin of one vote. This is good news to me as the new FAIR Act may fair better with new updates to address issues brought up by the opposition. Still, I will not add any additional value to my intrinsic value estimate of USG because of this. I'm still looking to buy a large position at $46 and will nibble at $47. Maybe next week =).

I also wanted to note that D. E. Shaw, a highly successful and quantitative hedge fund is the second largest shareholder of USG. It's reassuring to be with such good company when exposed to some litigation risk.

Saturday, October 07, 2006

Worst-case Scenario (WCS) Stock Pick - USG

I was initially drawn to USG by the constant news wires about Warren Buffett purchasing boatloads of this stock. His most recent acquisition of 371,200 shares at $46.10 occurred the day after my own purchase of my starter position at $46.84. It appears he is buying this stock whenever it approaches $46. He now owns about 19% of the company, about $800 million of the 4.24B market cap company. Over the last three months, USG grew from a 1% BRK holding to a 3% holding. I think WEB is onto something here and we may have an opportunity to tag along for the ride.

According to the most recent 10Q, USG emerged from bankruptcy on 6/20. This is good news to the company, but the stock price subsequently dropped by over 60% from its highs. No doubt this was because of the announced rights offering to generate cash for the Proposed Plan to emerge from bankruptcy. It was to offer shares to shareholders at an additional $40 per share in order to raise $1.8 billion. After the rights offering, each share is equivalently worth $80 if we are to believe the correct valuation is the previous $120 valuation.

In the most recent 10K discussing the Proposed Plan to emerge from bankruptcy, USG plans to set up a Section 524(g) asbestos personal injury trust fund from which all litigation payouts will be drawn. USG will initially fund it with an $890 million dollar in cash and then write a contingent note for $3.05 billion of additional funds. The note will be cancelled if the Fair Act of 2005 is passed into law and is not challenged as unconstitutional. The note is payable if the Fair Act is not passed into law. In that case, USG's total payout for asbestos litigation will once again be unclear.

Can USG remain solvent if the $3.05 billion note becomes due? My conclusion is that it can. USG's total obligation is $3.95 billion. It raised $1.8 billion from the rights offering, has $1.577 billion in accumulated cash, is owed $1.1 billion in expected tax refunds, and can raise an additional $1 billion in financing. Subtracting the obligations out leaves $1.57 billion in cash, about enough to finance 5 years of capex (~$1 billion), lease obligations ($227 million), and interest payments (~$20 million). Even in the worst-case, this company will remain solvent.

As the cost leader in the wallboard industry, it has a wide moat. This moat allows the company to generate significant cash flow in good years and bad. The average generated free cash flow for the last 5 years totals about $240 million dollars. The projected growth rate of cash flow is about 15% a year. To be conservative, I will use the average cash flow instead of next year's projected free cash flow as input to a 3-stage DCF calculation. Using an 11% discount rate, a 15% growth assumption for the next 5 years, 7% for the following 5 years, and 3% in perpetuity, the estimated intrinsic value of the company is $71 per share. By starting off with a conservative estimate of free cash flow, I allow myself some leeway in adjusting the growth rates. Using even more conservative estimates for growth of 7%, 5%, and 3%, the instrinsic value is $48. In the worst-case, we have a stock trading at fair value.

Some may say that there are two main catalysts for the price to go up. I argue that even without these catalysts, the stock is undervalued. The first catalyst is continued interest from Warren Buffett. From looking at his recent purchase history, I don't see him buying a larger stake unless the stock drops to under $46. The second catalyst is the passing of the FAIR Act of 2005. I don't see our bipartisan Congress passing such a law, but there is still a chance. Because the stock is worth much more even if the FAIR act is not passed, this catalyst comes free. Besides litigation risk if the Fair Act is not passed, there is the risk of a hard landing if/when housing heads south. As the low cost producer, I don't see USG's business being impacted in the long term.

I recommend buying this stock at $46, a 35% discount to my calculated intrinsic value of $71.

Two other bloggers whom I follow have also written about USG. George from FatPitchFinancials thinks that USG is a fat pitch, while F K Soft at concludes that we have a great business selling at a good price. Please refer to their posts for their detailed analysis.

Full Disclosure: I picked up a 1/3 starter position at $46.84 two weeks ago, but I wish I had bought more. I am looking to invest more under $46, but will pick up more shares at close to $47.

Wednesday, October 04, 2006

Current Portfolio Composition

It's not a good sign when a new blog does not get updated for almost two months after the second post. The lack of momentum in this blog probably foreshadows a quick death, but I'm going to try to breathe some life into this blog over the next few weeks.

To start off, I'm going to disclose my current holdings so that readers may have a frame of reference as to the type of stocks that I am interested in. I haven't made many stock trades since 7/30, so readers aren't missing much from my hiatus. Throughout July and August, I was fully invested. Before a two week vacation in September, I lightened up some of my heavier positions to generate some cash. In hindsight, this proved to be the wrong thing to do but that's OK. It's always good to have some dry gunpowder for future bargains that arise.

MSFT - 24.30%

FAF - 8.81%
DELL - 8.08%
VGTSX - 7.39%
MMM - 6.78%
HD - 6.46%
AEA - 5.37%
OAKMX - 5.12%
BUD - 3.71%
PFE - 3.66%
COP - 2.45%
FDC - 1.66%
RCII - 1.50%
UNH - 1.42%
WU - 1.42%
GPS - 1.40%
ENH - 1.38%
USG - 1.35%
TYC - 1.22%
HDL - 1.09%
JBSS - 1.05%
ACUS - 1.01%
DISCA - 0.93%
DHOM - 0.86%
DRL - 0.83%
EWEB - 0.77%
Total - 100%
Cash equivalent to ~8% of investments.

Readers will notice that I run a somewhat concentrated portfolio, 80% of my money are in my top 10 positions. The majority of my money is concentrated in good companies selling at decent prices. Rounding out my portfolio are a bunch of starter positions in undervalued companies and a bunch of distressed Grahamian cigar-butt-type securities. Over the next 6 months, I want to reduce my number of holdings as keeping up with all these symbols has become unwieldy. I'm considering selling Rent-a-Center (RCII), First Data (FDC), Tyco (TYC), and Gap (GPS).

As for new investments, I am currently most interested in adding to my positions in Advance America Cash Centers (AEA), Western Union (WU), and US Gypsum (USG). USG is new position that I started last week. My next post will include a worst-case scenario analysis of USG and why it's undervalued even in the worst-case.