Warren Buffet accumulated a position in the Washington Post Company in the early 1970’s and his influence on the management style, compensation policies and accounting is apparent. The Washington Post Company (NYSE: WPO) is a conglomerate with assets in education, cable, broadcasting and publishing businesses. The Company, under the leadership of Katherine Graham went public in 1971, primarily with publishing and broadcasting assets. In the 1980’s the company diversified and entered the education and cable businesses, which have grown and become a major part of the Company under the leadership of Donald Graham, who became CEO of the Company in 1991. Today, the education assets account for a majority of WPO's profitability. These assets are at a very high risk because of the increasing default rates.
Kaplan Higher Education
Kaplan was founded by the legendary Stanley Kaplan, and bought by the Washington Post Company in 1984 for $45 million. Kaplan was primarily engaged in the test prep business but over the years it has entered and prospered in the for-profit education business. The higher education division, which is the biggest, now accounts for 38% of Washington Post’s revenues and 62% of its operating income. The company invested heavily in this business during the late 1990’s and finally turned a profit in 2002. On average, the division, organically and through acquisitions, has since, grown revenues at 25%, and importantly, increased operating margins.
The Good
Kaplan’s Higher Education division within the for-profit sector exists to serve the market demand to educate individuals who the traditional schools have failed to satisfy. As the US economy transitions more and more into a service economy, and new employment opportunities require post-secondary schooling, higher education becomes essential for an individual to maintain their living standards. Kaplan and others provide individuals with the convenience of continuing with their present occupation while pursuing further education to enhance their credentials. The option to take courses online has further lit a fire under the growth engine and accelerated Kaplan’s growth. Their success is evident from the increase in market share of for-profit institutions, measured by degrees granted, which has gone from 2.3% in 1997 to nearly 6% in 2006 and rising. Furthermore, enrollments have grown exponentially in 2009 due to unemployment and, consequently, an increased interest in higher education. The growth in revenues in this division has mostly come from: (a) growing enrollments, and (b) tuition increases.
Kaplan Higher Education, through Kaplan University, Kaplan Colleges and Kaplan Career Institute operates in a fragmented industry with many competitors. Kaplan itself has few, if any, competitive advantages, but the industry as a whole is experiencing tailwinds due to pent up demand from the non-traditional student and the convenience of online education. Kaplan and others, however, have a few distinct advantages over traditional schools.
• First, their marketing prowess is unmatched. They advertise extensively. Non-traditional students are often not aware of the student aid available and consequently, are not sure if they can enroll in higher education. Kaplan admissions counselors help students with the paperwork and make the process effortless.
• Second, traditional schools do not have an extensive online offering, while Kaplan has a very advanced online education portal. Online education makes it very convenient for a student to obtain a degree as students can study and attend classes when they want and where they want. Importantly, it takes a lot of time and capital to develop and offer comprehensive, trusted, high quality online curriculum.
• Third, they are more responsive in academic program changes - their program offerings change as market conditions change. The bureaucracy and the public nature of most traditional schools cannot match the agile nature of for-profits.
• Fourth, because Kaplan is geared towards non-traditional students, they understand their customers and their special requirements. If students require extra help in the beginning or added counseling, it will be provided.
• Fifth, although the costs of an online school are comparable to an out of state public school, there can be many cost-saving advantages to attending an online school. With an online education there are no room and board expenses, travel expenses or other ancillary expenses
Kaplan competitively differentiates itself with: (a) a trusted brand name (which is due to test prep), (b) extensive offering, which is illustrated by its ranking as 4th among online universities in the number of degrees offered, (c) quality, where it is ranked in the top 10 among online for-profit universities by various sources, and (d) regional accreditation, which is superior to national accreditation as credits are transferable. Furthermore, Kaplan can and does raise tuition rates along with the budget constrained public schools, which have to raise rates to remain feasible. Psychologically, an expensive education is considered superior and this also helps Kaplan raise rates, but the rates will have to remain competitive with public institutions.
The Bad
The for-profit higher education industry, in which Kaplan Higher Education operates, has little to no barriers to entry. Accreditation, while difficult to obtain organically, can be bought, as evidenced by the sale of Waldorf College in May 2009. It is today a segregated industry. There are many other struggling colleges in the US which, as they capitulate, can be bought to expand or obtain accreditation by for-profits. In addition, the non-profit public and private universities are entering the online education market. Arizona State University (ASU), for example, has lenient admission standards and an extensive offering of online courses; the degree obtained by the online students is not distinguished from students who attend the brick and mortar school. Long term, as more and more traditional schools enter the fray the only students who attend non-profits will be the ones who are unable to get into a traditional school. Then given the admissions standards, how does a degree from Kaplan university fare compared to a degree from an online traditional school? Comparatively, what is the customer’s ROI on education? After talking to two admissions advisors from Kaplan, and after repeated attempts, I could not get any information on placement rates. Kaplan tuition rates are already at the high end of a public out-of-state college rates. Having said that, public schools, being public, will be slow to respond, will probably not be adept at dealing with non-traditional students, and will probably take a long time to widely enter the online education market. Moreover, there will always be a sect of students, those moving up in a small company for example, who will benefit from an education provided by for-profits. So, although there is a place for for-profit institutions, but long term, it is not a place that harbors 25% growth and 15% margins. For-profit institutions in this environment will only prosper based on the quality of their curriculum, placement rates and marketing. They will nevertheless, retain their distinct advantages in vocational programs. However, Kaplan’s presence is mostly in the non-vocational degree programs.
In addition to the increased competition from public and for-profits alike, Kaplan had a weighted average retention rate of less than 70% and a weight average graduation rate of 42% in 2007. This means that in order to just maintain the revenue levels these students have to be replaced, while even more students need to be added to grow. The story is similar among other non-profit institutions. Although the non-traditional student demographic is large, it is still finite. One has to question the long term sustainability of this business model.
And The Ugly
Kaplan and most other for-profit universities exist on the back of government funding. In 2008, Kaplan University derived 85% of its receipts from the Title IV programs. An institution with revenues exceeding 90% for a single fiscal year is subject to enforcement, which leads to ineligibility in participating in Title IV funding. Kaplan has hired additional personnel to manage these risks, and I believe it is a risk they can manage as they can filter students with a very high proportion of Title IV funding.
Also, during 2008, funds received under the Title IV programs accounted for approximately $904 million, or approximately 71%, of total Kaplan Higher Education revenues, and 39% of Kaplan, Inc. revenues. The business overwhelmingly depends on Title IV funding. Starting in 2009, in order to remain eligible for Title IV funding Kaplan has to maintain 3 year cohort default rates (CDR) below 30% (increased from 25% and 2 year) for three consecutive and below 40% for one year. Below is a table presenting the cohort default rate for various Kaplan institutions in 2007.
Name City Retention
Rate (FT) Graduation Rate Enrollment 2 Year Default Rate Trial 3 Year Default Rate
Kaplan University Davenport 66.0 35.0 53,212 13.3 23.2%
Kaplan College Phoenix 77.0 49.0 587 18.0 25.7%
Kaplan College Stockton 97.0 67.0 1,043 14.4 27.5%
Kaplan College Hollywood 92.0 85.0 1,328 17.0 12.2%
Kaplan College San Diego 89.0 74.0 2,239 8.1 15.3%
Kaplan College Salida 86.0 66.0 1,364 14.8 27.7%
Kaplan College Sacramento 79.0 52.0 861 18.8 33.5%
Kaplan College Vista 92.0 69.0 1,686 13.2 23.1%
Kaplan College Panorama 94.0 74.0 520 17.6 28.7%
Kaplan College Merrillville 57.0 20.0 676 17.3 28.6%
Kaplan College Indianapolis 75.0 60.0 1,702 12.5 22.1%
Kaplan College Las Vegas 69.0 48.0 832 21.2 31.5%
Kaplan College Columbus 61.0 30.0 931 22.8 32.8%
Kaplan C. Institute Boston 37.0 68.0 792 15.3 31.6%
Kaplan C. Institute Brooklyn 65.0 65.0 1,105 16.8 37.7%
Kaplan C. Institute Harrisburg 73.0 58.0 916 20.4 35.3%
Kaplan C. Institute Harrisburg 73.0 59.0 916 20.4 35.3%
Kaplan C. Institute Pittsburgh 86.0 34.0 1,827 21.9 37.9%
Kaplan C. Institute Nashville 57.0 47.0 616 7.9 22.2%
Kaplan C. Institute San Antonio 68.0 67.0 1,986 16.4 29.8%
Source: Department of Education and NCES
As we can see from the above, the 3 year CDR’s for some of the institutions are already higher than 30% and many are very close to the 30% mark. Please note that these statistics are from 2007. Here is a table showing the trend in Kaplan CDR’s:
Kaplan University 2 year CDR
Fiscal Year 2005 2,006 2,007
Default rate 5.90% 9.20% 13.30%
Source: NCES
The trend, in this case, is clearly not favorable. With increasing unemployment and general economic malaise, I would expect the CDR’s for 2008 and 2009 to be much higher. Kaplan is in serious risk of losing its Title IV funding under the new rules. Kaplan will have to change its enrolment strategies in the immediate term to recruit students at a lower risk of default. This again shows that growth will (should) taper, there are no signs however, that it is. Moreover, there is only so much Kaplan can do to stem the rise of CDR’s, Kaplan cannot, for example, control the macroeconomic environment. The Department of Education will not impose sanctions based on rates calculated under this new methodology until three consecutive years of rates have been calculated, which is expected to occur in 2014. Furthermore, the company is facing three separate lawsuits related to Title IV funding.
Although the company has a prudent board and an intelligent management, the rise in the rate of CDR’s cannot be ignored. It is quite ironic that such discrepancies occurred under such conservative leadership. Make no mistake, the cable assets in Cable One and Kaplan test prep are very profitable divisions, but when the higher education business accounts for 68% of the operating profit, and is at such high risk, one has to be careful.
Disclosure: No Position
Tuesday, August 17, 2010
Wednesday, May 19, 2010
The world according to Seth Klarman
Mr. Klarman runs Baupost Group, a Boston-based investment firm with about $22 billion under management. He doesn't share his market insights that often, so when he does it's worth listening. Tuesday morning he spoke at a conference for financial industry professionals at the CFA Institute in Boston.In particular, he is looking at the deluge of government interventions to prop up the financial system in the past couple of years and what those may mean down the road. And he is talking about the danger–not a certainty, merely a danger–that governments around the world will trash their currencies in a continuous free-for-all of "handouts and no taxes." The near-$1 trillion bailout in Europe is just the latest worry.
Anyone rushing to throw more money into shares or high-yield bonds today should think twice. And anyone with a lot invested, especially if they are risk averse, might want to think about taking some chips off the table. Mr. Klarman warns that asset prices have risen too far, too fast, and returns from these levels may be poor. "Given the recent run-up, I would worry that we will have another 10 to 12 years of zero or nearly zero returns," he said. His firm is holding a remarkable 30% of its assets in cash.On high-yield bonds, Mr. Klarman's group found terrific bargains during the financial crisis but that window has long since closed. "The rally's been indiscriminate," he said. "On the credit side it's been overblown. Things are now being priced for almost perfection."
Most investors, Mr. Klarman warns, have rushed to embrace risk again as if the financial crisis never happened. "The lessons haven't been learned," he said. "People are back drinking the Kool-Aid again. It's very troubling." By keeping interest rates low and juicing stock markets with liquidity, the government is basically pushing people to speculate, he said. If there were another serious collapse, he said, many investors would be caught out–again.On the macroeconomic outlook, Mr. Klarman is remarkably gloomy–even by the usual standards of conservative value managers. "I'm more worried about the world, broadly, than I have ever been in my career," he says. Governments are spending, borrowing and printing money far too freely. Whereas the Great Depression generation learned to live within their means, the Great Recession generation is taking the easy way out, he says. The Greek bailout is just the latest example.
Inflation looks like the easy way out. "It's not clear that any currency is all that trustworthy," he says. "I worry about paper currencies."He goes further, mistrusting some official data and actions. "We don't know the extent to which we have been manipulated," he says. He believes the official figures–particularly on inflation–are suspect. "We are being lied to."Such sentiments have led to a stampede for gold, of course. But Mr. Klarman repeated cautions he has made before about investing in all commodities, including gold: They generate no cashflow, and so they are extraordinarily tricky to value. Gold has also just hit new highs, he added. That should make value investors–who tend to look for assets that are on sale–very nervous.
Instead, to insure his clients' portfolio against the dangers of runaway inflation he has been using complex derivatives. Baupost, says Mr. Klarman, has been buying "out of the money" put options on long-term government bonds. These are bets that long-term interest rates will eventually rise sharply. Mr. Klarman says he is using the put options to buy cheap insurance in case long-term interest rates go into double-digits. These puts, Klarman said he viewed as "cheap insurance," will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.
He said his firm is finding some bargains in the distressed area of commercial real estate. But he warned these were just in the private market: Publicly traded Real Estate Investment Trusts that invest in commercial real estate have mostly risen too far for his tastes, and offer poor value. "We are highly opportunistic," he says. "I will be buying what other people are selling. I will be buying what is loathed and despised." That today would be Europe, Oil and Gas Services, Large Caps..
Anyone rushing to throw more money into shares or high-yield bonds today should think twice. And anyone with a lot invested, especially if they are risk averse, might want to think about taking some chips off the table. Mr. Klarman warns that asset prices have risen too far, too fast, and returns from these levels may be poor. "Given the recent run-up, I would worry that we will have another 10 to 12 years of zero or nearly zero returns," he said. His firm is holding a remarkable 30% of its assets in cash.On high-yield bonds, Mr. Klarman's group found terrific bargains during the financial crisis but that window has long since closed. "The rally's been indiscriminate," he said. "On the credit side it's been overblown. Things are now being priced for almost perfection."
Most investors, Mr. Klarman warns, have rushed to embrace risk again as if the financial crisis never happened. "The lessons haven't been learned," he said. "People are back drinking the Kool-Aid again. It's very troubling." By keeping interest rates low and juicing stock markets with liquidity, the government is basically pushing people to speculate, he said. If there were another serious collapse, he said, many investors would be caught out–again.On the macroeconomic outlook, Mr. Klarman is remarkably gloomy–even by the usual standards of conservative value managers. "I'm more worried about the world, broadly, than I have ever been in my career," he says. Governments are spending, borrowing and printing money far too freely. Whereas the Great Depression generation learned to live within their means, the Great Recession generation is taking the easy way out, he says. The Greek bailout is just the latest example.
Inflation looks like the easy way out. "It's not clear that any currency is all that trustworthy," he says. "I worry about paper currencies."He goes further, mistrusting some official data and actions. "We don't know the extent to which we have been manipulated," he says. He believes the official figures–particularly on inflation–are suspect. "We are being lied to."Such sentiments have led to a stampede for gold, of course. But Mr. Klarman repeated cautions he has made before about investing in all commodities, including gold: They generate no cashflow, and so they are extraordinarily tricky to value. Gold has also just hit new highs, he added. That should make value investors–who tend to look for assets that are on sale–very nervous.
Instead, to insure his clients' portfolio against the dangers of runaway inflation he has been using complex derivatives. Baupost, says Mr. Klarman, has been buying "out of the money" put options on long-term government bonds. These are bets that long-term interest rates will eventually rise sharply. Mr. Klarman says he is using the put options to buy cheap insurance in case long-term interest rates go into double-digits. These puts, Klarman said he viewed as "cheap insurance," will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.
He said his firm is finding some bargains in the distressed area of commercial real estate. But he warned these were just in the private market: Publicly traded Real Estate Investment Trusts that invest in commercial real estate have mostly risen too far for his tastes, and offer poor value. "We are highly opportunistic," he says. "I will be buying what other people are selling. I will be buying what is loathed and despised." That today would be Europe, Oil and Gas Services, Large Caps..
Saturday, February 6, 2010
Introducing India
I was on a relatively long vacation in India, and although it was supposed to be strictly a vacation, I couldn't help but observe a few things. Now I was not present when the US was growing post WWII, but it seems that it would have been very similar to India's growth at present. In all the talk about China, although justified, India gets ignored. It is much smaller than China but I believe it has a few characteristics that make it very interesting, especially for the enterprising value investor. There are restrictions at present for non nationals, but in time, they will probably be eased.
The private sector in India is growing at a very crisp pace. The problem is that the public sector is not keeping pace. By public sector I mean infrastructure and bureaucracy. Infrasturcture here refers particularity to the roads, rail and electricity; and bureaucracy the slow judicial system, well, thinking about it - all public offices. Indian economy is growing at a 7-8% clip, but the productivity is low, comparatively, because of these issues. When and if the infrastructure is built, the productivity will receive another boost resulting in further growth (think turbo kicking in). Needless to say, corruption also plays a big part in hampering growth and there are no easy solution in sight. Importantly, India has a lot of people! A large number of people coupled with growth means increasing incomes. While this presents a huge social problem, it is good for business. Along with growth, think scale, which leads to increasing margins.
Now, in my opinion, the way a value investor (assuming he/she can invest) benefits, because being an emerging economy, the markets are volatile - something an enterprising value investor can take advantage of! There are many firms which are extensions of international corporations. Nestle India, Novartis India, Crisil (the leading bond rating agency half owned by S&P) would be some examples. Then there are others family majority owned firms where one can invest alongside the controlling family (Tata, Bajaj, Mahindra). These firms, in my opinion, will generally take out many cliche concerns of investing in a 'emerging' economy. I do not pretend to be an expert on India and am learning. The purpose of this post is to introduce India and present some links which I've found useful.
The private sector in India is growing at a very crisp pace. The problem is that the public sector is not keeping pace. By public sector I mean infrastructure and bureaucracy. Infrasturcture here refers particularity to the roads, rail and electricity; and bureaucracy the slow judicial system, well, thinking about it - all public offices. Indian economy is growing at a 7-8% clip, but the productivity is low, comparatively, because of these issues. When and if the infrastructure is built, the productivity will receive another boost resulting in further growth (think turbo kicking in). Needless to say, corruption also plays a big part in hampering growth and there are no easy solution in sight. Importantly, India has a lot of people! A large number of people coupled with growth means increasing incomes. While this presents a huge social problem, it is good for business. Along with growth, think scale, which leads to increasing margins.
Now, in my opinion, the way a value investor (assuming he/she can invest) benefits, because being an emerging economy, the markets are volatile - something an enterprising value investor can take advantage of! There are many firms which are extensions of international corporations. Nestle India, Novartis India, Crisil (the leading bond rating agency half owned by S&P) would be some examples. Then there are others family majority owned firms where one can invest alongside the controlling family (Tata, Bajaj, Mahindra). These firms, in my opinion, will generally take out many cliche concerns of investing in a 'emerging' economy. I do not pretend to be an expert on India and am learning. The purpose of this post is to introduce India and present some links which I've found useful.
- The Economic Times - The prominent business newspaper in India (in English).
- Fundoo Professor - A blog by Sanjay Bakshi, who teaches behavioral finance and operates a fund in India.
- Parag Parikh Financial Advisory - An advisory firm with a blog. Contains many research reports on Indian corporations.
- A Collection of Value Investing blogs in India - ...
Monday, October 12, 2009
Decision Making: Process vs. Outcome
The Safe and Cheap blog was meant not only to be an exercise in Value Investing, but also, and importantly, a journey towards better Decision Making. Although I've often found that the worlds of value investing and good decision making are intertwined, I reckon a separate post on the importance of 'process' is warranted.
The essence of this post is this - Bad process will inevitably produce bad long term outcomes, they might however, produce good short time outcomes. On the other hand a good process, if efficiently executed, will naturally, over time, lead to good long term outcomes. I would like to emphasize long term here as even a good process will unavoidably lead to bouts of bad short term outcomes. It is important to note that, bad short-term outcomes do not necessarily imply a bad process, but the importance of luck in success.
Consider the game of golf (which I love, no..hate, nah..love), which highlights the importance of process than no other. In order to execute a good shot, it is important that you, (a) have a decent swing (backswing, downswing and follow through), (b) a proper grip, (c) a good stance, (d) focus, and importantly, (e) keep your eyes on the ball. Having said that, there might be times when you don't do any of these and hit a good shot, but make no mistake, you will not be able to hit anything close to a 72 when you play a round. This is because over time, this bad process will catch up to you and produce a bad overall, long term (over 18 holes) outcome. A good process however, might lead to a bad shot or two; (1) perhaps because you took your eyes off the ball - a mistake in execution, and/or (2) because wind suddenly starts blowing and herals your ball to a tree (I am sure golf enthusiasts will understand) - the cause usually is a known unknown or an unknown unknown. But overall, you have the chance of hitting a good long term score. The same analysis can be applied to most sports. In professional sports , skill is also a big factor, which essentially comes from the perfection of a process. Likewise, if you regularly drive fast - well you get the point.
But we ain't in the discussing academics business, we in the allocating capital (and making money) business. Retail investors often focus on the historical performance of a mutual fund. A fund with good historical performance numbers usually attracts more capital, while a fund with bad short term performance usually faces withdrawals. Is this warranted? Sometimes it is, and sometimes it's not! We have to analyse the process each manager is following, and then reasonably determine, (a) if the process makes sense, (b) if it will make money, and importantly, (c) what is the downside (and if I am comfortable with that downside). A good manager with a good process may produce bad short results, but over time, the performance of the fund ought to reflect the superior course of action. In keeping with the disclosures, I have never been able to nail down George Soros process of making money (well not fully), and he produced good results and did it over a long period of time (If I was an academic, maybe I'd talk in sigmas). Likewise, in stock selection, it is important to focus on the process, and importantly, the downside risks, than worry about the outcomes. This process, coupled with heaps of discipline, over time, will inevitably lead to good long term results. It is also noteworthy that the inputs to the process are of prime importance. Bad inputs, coupled with a good process, will lead to a bad outcome - Garbage In Garbage Out (GIGO) principle.
In conclusion, all other things being equal, generally:
1) Bad Process, Bad Outcome - Inevitable in the Long Term
2) Bad Process, Good Outcome - Luck (outcomes from known unknowns and unknown unknowns are favorable) - a Short term phenomenon
3) Good Process, Bad Outcome - Luck (outcomes from known unknowns and unknown unknowns are unfavorable) - a Short term phenomenon
4) Good Process, Good Outcome - Inevitable in the Long term
The essence of this post is this - Bad process will inevitably produce bad long term outcomes, they might however, produce good short time outcomes. On the other hand a good process, if efficiently executed, will naturally, over time, lead to good long term outcomes. I would like to emphasize long term here as even a good process will unavoidably lead to bouts of bad short term outcomes. It is important to note that, bad short-term outcomes do not necessarily imply a bad process, but the importance of luck in success.
Consider the game of golf (which I love, no..hate, nah..love), which highlights the importance of process than no other. In order to execute a good shot, it is important that you, (a) have a decent swing (backswing, downswing and follow through), (b) a proper grip, (c) a good stance, (d) focus, and importantly, (e) keep your eyes on the ball. Having said that, there might be times when you don't do any of these and hit a good shot, but make no mistake, you will not be able to hit anything close to a 72 when you play a round. This is because over time, this bad process will catch up to you and produce a bad overall, long term (over 18 holes) outcome. A good process however, might lead to a bad shot or two; (1) perhaps because you took your eyes off the ball - a mistake in execution, and/or (2) because wind suddenly starts blowing and herals your ball to a tree (I am sure golf enthusiasts will understand) - the cause usually is a known unknown or an unknown unknown. But overall, you have the chance of hitting a good long term score. The same analysis can be applied to most sports. In professional sports , skill is also a big factor, which essentially comes from the perfection of a process. Likewise, if you regularly drive fast - well you get the point.
But we ain't in the discussing academics business, we in the allocating capital (and making money) business. Retail investors often focus on the historical performance of a mutual fund. A fund with good historical performance numbers usually attracts more capital, while a fund with bad short term performance usually faces withdrawals. Is this warranted? Sometimes it is, and sometimes it's not! We have to analyse the process each manager is following, and then reasonably determine, (a) if the process makes sense, (b) if it will make money, and importantly, (c) what is the downside (and if I am comfortable with that downside). A good manager with a good process may produce bad short results, but over time, the performance of the fund ought to reflect the superior course of action. In keeping with the disclosures, I have never been able to nail down George Soros process of making money (well not fully), and he produced good results and did it over a long period of time (If I was an academic, maybe I'd talk in sigmas). Likewise, in stock selection, it is important to focus on the process, and importantly, the downside risks, than worry about the outcomes. This process, coupled with heaps of discipline, over time, will inevitably lead to good long term results. It is also noteworthy that the inputs to the process are of prime importance. Bad inputs, coupled with a good process, will lead to a bad outcome - Garbage In Garbage Out (GIGO) principle.
In conclusion, all other things being equal, generally:
1) Bad Process, Bad Outcome - Inevitable in the Long Term
2) Bad Process, Good Outcome - Luck (outcomes from known unknowns and unknown unknowns are favorable) - a Short term phenomenon
3) Good Process, Bad Outcome - Luck (outcomes from known unknowns and unknown unknowns are unfavorable) - a Short term phenomenon
4) Good Process, Good Outcome - Inevitable in the Long term
Wednesday, September 2, 2009
Stock Analysis: Birchcliff Energy
BirchCliff Energy (TSX: BIR) is a junior oil and gas exploration, development and production company. Its objective is to acquire and hold, large working interests in several highly focused producing areas in the Peace River Arch where it can hold operatorship of its assets and control the infrastructure necessary to facilitate the exploitation, development and exploration potential of those areas. Birchcliff produces roughly 70% natural gas and 30% light oil and natural gas liquids (NGLs). It has two major properties:
(1) Montney/Doig - Montney/Doig is an unconventional natural gas resource play consisting of reservoirs in tight sands, siltstones and shales. Birchcliff has 166 net sections of land in the area where 57 sections have been assigned reserves of 314 bcf (57 mboe), assuming 2 wells/section and 2.8 bcf/well. Management (consistent with other firms in the area) believes that 4 horizontal wells can potentially be drilled on each section giving Birchcliff an inventory of around 600 wells with recovery reaching 5 bcf/well.
(2) Worsley - The Worsley oil and natural gas assets in the Peace River Arch area of Alberta was acquired in September, 2007 for total cash consideration of $270 million. The purchase price was equivalent to $17.53/boe of proved plus probable reserves, which after reserve additions has now come down to around $10/boe for 24.6 mboe. The Worsley property provides stable cash flow and commodity diversification when compared to the natural gas assets in the Peace River Arch. Birchcliff owns high Working Interest (WI) lands (>80%) and has been working essentially without partners or farm outs.
The 3 year average for the Finding and Development (F&D) costs excluding future development capital were $8.01/boe and including future development capital were $15.63. This average has been decreasing where the 2008 F&D costs excluding future development capital were $5.17/boe and including future development capital were $14.06/boe and are more indicative of future F&D costs.
Valuation
The valuation of the company is as follows:
Downside
The current Book Value (BV) of Birchcliff is $4.15/share and as per the market price of $6.4/share the company is currently trading at 1.5x BV. This is higher than many E&P in Canada which are trading for < 1x BV. Furthermore, with an Enterprise Value (EV) of $1.024 B and 2008 Cash Flow (CF) of $131 million; the EV/CF ratio for the company is around 7.8 which also is much higher than most of the comparables trading at 3-4x EV/CF.
2009 Cash Flows Assuming Birchcliff produces on average 12,500boe/day in 2009; at the current AECO natural gas price of $4/mcf and oil price of $50/bbl ($32/boe – 67% gas; 33% oil) Birchcliff’s 2009 cash flow would roughly look as follows:
Revenue: 12,500 boe/day*365 days*32 $/boe: $146 million
Royalties: 146 * ~15%: $21.9 million
All Expenses (~$16/boe):$73 million
Cash flow before taxes (Operating cash netback: $11.2/boe): $51.1million
The production could increase and/or fuel prices could increase resulting in higher cash flows, but the $80 million estimated by management for capital expenditures in 2009 is much higher than the current situation dictates and there is a risk of (a) equity dilution (b) increased debt load. Furthermore, assuming higher cash flows in 2010 and 2011, it still might not be enough after capital expenditures to repay the debt with an outstanding current balance of $250 million. Interest payments on the debt load come to around $10 million annually and this is manageable even under stress scenarios.
Upside
In order to analyze the upside it is important to decipher the Montney/Doig natural gas resource play. I have already analyzed unconventional gas resource in a previous post. The gas is there, essentially the challenge is to maximize the flow rate for the lowest cost. Specifically, Birchcliff has 166 net sections of land in the Montney/Doig resource play. AJM consultants have designed resources of 314bcf to 57 net sections assuming two wells per section each producing 2.8 bcf over its lifetime. Net-net there is only engineering risk and very little exploration risk. The management plans on drilling 4 wells per section giving them a total inventory of more than 600 wells, with each costing around $5million. Management also believes (in like with other firms in the area) that each well can produce 5bcf of natural gas over its life as technology improves. Conservatively, assuming on average 1.5-2.5 bcf/well and 600 well locations (certain), Birchcliff can potentially recover 900-1500 bcf or 150-250 mboe of natural gas. This will require a lot of future capital, where each well will cost around $5million and the company will need new processing facilities as production increases leading to additional capital expenditures. Presently, Birchcliff has proved and probable reserves of 98.5 mboe (82.3 net) adding all its properties, where the Worsley light oil pool contributes 24.6 mboe.
Comparables ARC, Encana, Talisman, Crew Energy, Canadian Natural etc. all have lands adjacent to Birchcliff lands in the Montney area, with Talisman’s lands being the closest to the Pouce Coupe area. Bigger firms in the area have been pioneering to economically extract resources from this area. Managements’ estimates of potential resources and technologies in the area are in line with these companies. Duvernay Oil Corp. which has the highest quality land in the Montney region was bought by Shell Canada for $5.9 billion including debt (it was an anomaly). Duvernay quotes gas-in-place of 50 bcf per section, while Birchcliff quotes at 30 bcf per section. Shell paid $38.87/mcf for proved and probable reserves of 152 mboe and received 450,000 acres of land. This purchase price discounted the future expected recoveries in the undeveloped lands. Birchcliff at present has 98.5mboe of reserves and 380,000 acres of undeveloped land.
Finally, – The current EV is equal to $1.024 B. Based on various combinations and comparable deals, we can assume that Birchcliff is worth between $2 B to $5 B for a 2.5x – 4x upside from the present prices. As long as management manages the balance sheet conservatively, Birchcliff should not have a problem attracting a bid in due time. Seymour Schulich a prominent Canadian investor owns 22% of this company and he is more or less waiting for a bid to cash out. Please note that the thesis here is for a takeover only, you are essentially buying a 'option' when you buy the stock. Personally, the 'option' has to be much cheaper than it currently is for me to purchase the stock, but I am posting the analysis nonetheless.
Disclosure: None
Friday, August 28, 2009
Stock Idea: Steinway Musical Instruments
Steinway Musical Instruments (LVB: $12/share) is a renowned manufacturer of pianos and band instruments. The piano segment (60% revenues) operates under the brand names Steinway, Boston, and Essex. The premium Steinway brand has an 85% market share and represents roughly 80% of the revenue in this segment. The band and orchestral segments (40% revenues) operating under Conn-Selmer divisions sell a wide array of other musical instruments and accessories. Steinway is not a growth story. It is however, a distinguished brand which has delivered consistent cash flows and has the added margin of safety in hidden real estate assets - it owns the 57th Street building in Manhattan and a waterfront manufacturing facility in Queens.
Bird in the Hand: The margin of safety in this investment comes from the hidden read estate value and the working capital surplus. As per a press release by the management in Feb, 2006, West 57th street building was purchased in 1999 for $30 million, is carried on the books at $24 million and has a market value of at least $100 million. In addition, the Steinway manufacturing facility in Queens is on the waterfront, has views of Manhattan and is carried on the books for $3 million but is worth around $200 million. Furthermore, the company has $172 million in inventory and there is precedence that it will not be liquidated but sold piece meal. There are other assets on the company’s books that have substantial worth. I would roughly peg the total value of the hidden assets at $200 million or $23/share after tax. The company does not need to own the aforementioned real estate to operate and hence the assets can be monetized without substantial effect on the operations (add: lease expense for factory, subtract: rental income from building).
Bird in the Bush: The company has an enterprise value (EV) of $285 million (including pension underfunding) with a market capitalization of $100 million. Steinway’s revenues have been flat averaging $375-$400 million for many years. The company has consistently had gross margins in the 28-30% range and operating margins normalize at 8.5%. Due to the consistency in operating metrics we can normalize cash flows and determine the valuation. The company on a normalized basis does around $45 million in EBITDA and approximately $20 million in FCFE. At 8x EV/EBITDA the company would be valued at $360 million. Looking at the FCF multiples, at 10x FCFE the equity of Steinway would be worth around $200 million. The stock has a 60-100% upside to $16-20/share just based on the operations. The earnings are depressed right now because of the macroeconomic conditions, I reckon, however that (a) there are so secular forces against the company, and (b) the company has not suffered permanent damage from imports or consumer demand.
In addition, there might be some growth opportunities in countries like China where Steinway is working to establish a presence. Chairman Kyle Kirkland and CEO Dana Messina have majority voting control due to their 100% ownership of class A stock, and therefore have full control of the major strategic decisions faced by the Company. They have made prudent decisions so far and have been fairly compensated, but this does pose a substantial risk. In conclusion, the company seems to be worth around $35-$45/share. This is a classic ‘buy on assets, sell on earnings’ play.
Disclosure: None
Tuesday, June 30, 2009
Hedge fund jobs..
A few posts ago I wrote about the Distressed Debt Investing blog, where Hunter brought some real insights into the process. Hunter's at it again! He's starting a new blog titled 'How to get a Hedge fund job'. Here he will dwell on his own experience and his networks to give reader a comprehensive understanding on what it takes to land Hedge fund jobs. At a time where unemployment is rearing its ugly head, Hunter's blog is a welcome relief. As someone who is looking for a mentor, I hope he comes up with some quality content helping me and people like me in their search!
Subscribe to:
Posts (Atom)