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

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

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

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!

what WB said about inflation..

I fret every time a value guy talks about macroeconomic conditions, but here I am talking about inflation. Swarmed by the talking heads, I went up on the Himalayas (BRK shareholder letters) to get some real advice from the guru (Warren Buffett). 1978-1982 was a time where real inflation actually took place, before the then fed chairman Paul Volcker raised rates to as high as 21.5% (can you imagine that) to reign in inflation. Fortunately, we have WB's 1978-1982 shareholder letters to decipher the time and his strategy (which as always he just lists out!).

While you and I talk about commodities and real estate etc., he was still looking for businesses but with the following characteristics, " Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital." Essentially, business like See's Candy. When talking about commodities, he favors the lowest cost producers. We want to watch the downside, we want to make sure we make money even if inflation does not take hold.

Any fixed income security is likely to produce real term loses in a high inflation environment. He was absolutely against long term bonds, and mostly looked for bonds with conversion rights or distressed securities. When talking about return on capital you have to figure the inflation effects and then the taxation effects. A 10% bond with 8% inflation and taxes would not make any real return! In case of equities, the corporations will be paying taxes on nominal income and not real income. Considering owners can only use real income, this means the corporations would pay taxes on deficits!

I can only say so much and not a fraction as good as WB, so I would highly recommend the Berkshire Hathaway shareholder letters from 1978-1981.

What chu think about TicketMaster?

Past
TicketMaster (TKTM) is the world’s largest live entertainment ticketing and marketing company. The company is a primary and secondary ticketing (thru ticketsnow.com) retailer in the US and over 20 international markets and provides a marketing portal for clients to over 58 million registered users on ticketmaster.com and affiliated websites. TKTM serves as an intermediary between the venues/promoters and their customers to provide the technology systems and distribution functions.

You and I both have had experience with TicketMaster and loathe would be too nice a word to describe the feeling. They make way above the economic rate of returns and have successfully passed price increases to customers - something a monopoly can do. Ticketmaster secures its monopoly by goading the venues into multi-year agreements that empower Ticketmaster to act as their exclusive vendor. So what was a cost center for venues (ticketing) has become a steady source of income. They have been a monopoly ever since the early 1990's and have maintained and increased their position even after the advent of the Internet and increasing number of players. They are very Microsofteqe in their business practices and took/are taking a lot of heat for their monopolistic actions. It was spun off of IAC in mid-2008. In essence, TicketMaster is a toll booth.

In 2008, Tktm had revenues of $1.45B with an ebitda of $225 million for ebitda margins of 16%. The margins have however come down from the mid 20's over the past few years. TKTM is trading at $7.50 for an EV of $1060 million and an EV/EBITDA ratio of 4.7. It traded for as low as $3.50/share in March 2009.

Present
This is where things get convoluted. Live Nation, TicketMaster's biggest client fired TicketMaster and said they'll do their own ticketing (LYV brought 13% of revenue in 2008 for TKTM). Live Nation also intends to poach TKTM's clients. Live Nation operats on razor thin margins but has a large presence in the live entertainment business. TicketMaster then bought a majority interest in Frontline Management and brought Irving Azoff (someone you wanna read about) as CEO. With this TKTM controlled a lot of very high profile artists and became a threat to Live Nation. Live Nation and TicketMaster then decided to merge (50-50 share) and have all the intended approvals except the regulatory approvals (which might be tough to get!).

In this business, the main parts of the puzzle are: (1) Artists (2) Promotors (3) Venues (4) Ticketing and (5) the Fan. Live Nation is the worlds biggest promoter, has control over various venues and artists (because they can pay them more than anybody else, given the scale). TicketMaster has ticketing and venues (thru exclusivity arrangements) and now artists thru Frontline. Combining these two business would vertically integrate an industry and crush the competition, but I don't think a stockholder would complain.

Future?
The files are with the Justice Department and they along with the states are taking a deep hard look at the merger. I'd say there is a 50-50 chance. They do have a case when they say touring is the main source of income for the artists and the record label model is broken with the illegal downloads etc. They might be asked to divest certain assets like ticketsnow.com for the merger to pass.

If the merger does not happen that is where things become uncertain. A couple of scenarios:

1) Live Nation comes back to Tktm for ticketing and they Frontline works with Live Nation, in essence they collude (kinda)- will they be able to pull this off?
2) Live Nation does not come back. TicketMaster decides to go into the live event promotion business (with Frontline managing artists) and these two operate in a duopoly - can they?
3) TicketMaster faces increased competition from Live Nation in the ticketing business. TicketMasters market share decreases - but by how much? Can Live Nation severely damage their moat?

They exposed themselves by announcing a merger. I watched the senate hearing on the TicketMaster/Live Nation merger and it was well worth watching. There is information on the history, business practices, competitors, future etc. etc. Now TKTM is cheap (given market position, margins, ROC), it might get cheaper but given all the uncertainties is it safe? what chu think?

Dimon and the Letter

Most of what I've know has come as a result of 'hop' reading, which essentially means reading something, finding something interesting and hoping on to read about this something interesting. So when Warren Buffett at the AGM recommended Jamie Dimon's letter, I had to read it! Needless to say it is a wonderful letter. I second Tom Brown when he says this is the type of stuff we expect from Warren Buffett (the AGM fills in some holes). It is a must read..

It is becoming apparent that an equity investor doesn't just need a good understanding of the industry but also needs to comprehend the credit markets and value the political risks. WB famously said that even if Alan Greenspan (the then fed chairman) told him what his next move will be, it will not effect how WB invests. This makes sense because as value investors we look for under priced securities with a margin of safety and it is as simple as that. But on the other hand, I reckon, some awareness of the macro conditions is an absolute must and being 'street smart' important. JPM shareholder's letters gives a good summary of past mistakes, present challenges and a recommendation (not just a complain) on future reform.