Category Archives: Analysis

AM Greetings in 2 minutes – Special Situation

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American Greetings makes greeting cards. Conventional wisdom says this is a dying business – the world now revolves around email and Facebook, not old fashioned greeting cards. Revenues mirror this wisdom to an extant – ten years ago the company brought in just shy of $2B which slowly declined until 2010 they brought in ~$1.6B before rebounding to $1.7B in FY11.

While the stock has remained range bound throughout the last several years, large amounts of free cash flow allowed management to quietly buy back 44% of the shares allowing earnings to grow from $1.54/share to 2.64/share over the last 10 years.

These buybacks are evidence of a management team that puts share holder interests first… and they should, because the CEO and COO are brothers Jeffrey and Zev Weiss whose family founded the company and first took it public in 1958. Together with assorted family trusts they control 51% of the voting rights of the company.

Despite being a cash cow the share price has lagged due to the above mentioned “conventional wisdom” and the fact that in recent quarters capital spending has come under question. The most egregious example of this questionable spending is management’s plan to spend up to $200M building a world headquarters building.

The thought of future cash flows being spent on projects with questionable return had the shares trading below $15 before management announced plans to take the company private for $17.18 a share on 9/25.

Wednesday morning a law suit was filed by a share holder to halt the take private proposal because it is greatly under values the company.

With average free cash flow over the past 4 years of ~$3 / share, I would tend to agree.

This is a company in decline, but it is not terminal. Despite the advent of email etc, people will always appreciate the more human touch of an actual hand written card. I think it is fair that a company like this is worth at least 7 or 8x free cash flow, which puts us in the $21-24 range, significantly above management’s $17.18 bid.

At this point the situation begins to look like a reasonable risk reward trade. Considering the psychology of the buyer – 2 guys who want to restore the legacy of their 100 year old family business by taking it private – 2 guys who want to empire / ego build $200M headquarter buildings for a greeting card company without being yelled at by pesky outside shareholders – I think it is reasonable to assume that the downside on an investment at this point is break even. It is of course entirely possible that they just decide to walk away from their bid, but it seems unlikely.

On the upside, I don’t think there is huge potential – like I said above, maybe the company is worth $21-24 / a share, but its difficult for me to imagine that management will boost their bid by 40%. I don’t think they would be bidding at all unless they thought they were getting a deal.

They control 51% of the voting power so they can pretty much tune out the complaints of outside shareholders if they want to – they don’t NEED to take it private to build their fancy headquarters building. That being said, I could see them boosting their bid by a dollar or 2 to the $19 level to bring the company back within the family fold. From today’s prices that would be a bit over an 11% return net of expenses. Not a huge return, but a relatively safe return.

Of course one could also think about juicing those returns by buying calls rather than equity, but again, who knows if they will actually raise their bid? By getting involved with options you risk total capital loss. If they don’t boost their bid or if they pull their bid. If you stick with the equity and they pull their bid you risk owning a company with a strong record of FCF generation and a management team that has a strong history of returning capital to shareholders that has apparently temporarily lost their way.

A Year Later…

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As it has been about a year since i first started to put some effort into tracking my thoughts on investing, I have been spending time thinking about investments I have made over the last year with a critical eye focused on improving my process and results and understanding what I have learned.

The first lesson that really jumps out to me is tied to RSH, which at down 76% from my purchase point as of today has been nothing short of a disaster investment. When I bought this company i was entirely too focused on the past record of high ROEs and a history of returning money to shareholders via buybacks and dividends and not nearly focused enough on the lack of a clear moat, increasing competition, and a shifting business mix toward lower margin products. On several occasions I thought about selling the stock, but my firm’s trading rules prevented me from doing so because we were actively involved in the name at the time. I was also emboldened by the fact that Francis Chou and other buy and hold investors had purchased stock.

I still own the stock because at this point it is a net net… sort of… and to be honest I still have faith in my original thesis that outside of major metropolitan areas where branded stores are common RSH’s all under one roof mobile business model makes sense. I am tempted to sell it just to get rid of it, but at these prices, I would probably buy it even w/o a clear moat. However, the lesson remains the same: FOCUS ON THE MOAT unless you are buying assets at a discount.

The second lesson that jumps out at me is my attraction to falling knife turn around situations such as RSH, KSWS, and EA. Each of these companies is cheap… but that is because they have all encountered serious changes in recent years and their businesses have seriously declined. I have found myself focusing too much on the past and not enough on changing environments. If they are able to just normalize their operations they will all do very well, however, these companies are not suffering from short term earnings misses or the like – they need to adjust their business models to regain their former strength – a process that may take years. There is nothing wrong with this, and I suspect that out of these 3 names two of them (not sure which too) will wind up as successful investments on a longer time line, but on a shorter time line, the falling knife situations are difficult to endure. As such I will have to pay more attention to position sizing and gradually enter positions of this nature rather than just picking spots.

The third lesson is the natural corollary of the second lesson, and that is rather than spending time on turnarounds, I should focus on companies that have a consistent record of 1) growing book value or 2) increasing their earnings power and operate in change resistant industries. More recent investments such as FLIR, WWE, and the cruise lines, are representative of this. Additionally, I recently purchased entry positions in GS and LUK. I am not going to go into my reasoning in depth, but short versions are:

GS – over the last 5 years CAGR of book value has been 10%, and current P/B is basically at the lowest levels since the depths of the crisis in 2008. Clearly the issue here is what does that book value consist of… suffice it to say that I am reasonably certain that the assets on the books now are of higher quality than they were a few years ago. ROE has come down over the last year partially due to declines in trading and banking volumes, but if you compare GS’s ROEs to their competitors ROEs, GS is lagging the group vs. the historical spread. This may be partially due to business mix, but I believe a large part of it is due to management being extra conservative. At some point management will reengage, capital markets will rebound, and the stock will enjoy serious multiple expansion coupled with the growth in book value in the interim period.

LUK – over the last 3 years book value has grown at a CAGR of 12%, and more importantly over the last 30 years book value has grown 20% per year. Without getting into details, this growth has often been choppy due to the vagaries of GAAP, but the longer term record is unimpeachable. Currently the stock trades at a discount to book as the market prices of several of their investments have suffered for various reasons and because the 2 founders are approaching the end of their careers (Ian Cumming has said he will retire in 2015 when he is 75 years old). However, this is a firm that for 30 years has taken the principals of value investing and successfully applied them. Their current investments are under performing (in terms of market price), but these investments were not made for short term reasons and will likely work out in the long run. Additionally, while the founders are clearly masters of their craft, I find it unlikely that they are not surrounded by extremely capable like minded individuals who will carry the flame long after the founding members are gone. As Buffett has said, “with value investing, you either get it in the first five minutes, or you never get it all.” After 30 years of running their business, I am reasonably certain that the folks at LUK have found plenty of people who got it in the first five minutes, and then spent the last 10 or 20 years perfecting their craft. At some point, the long term value of their present holdings will shine through, and in the mean time, new investments will continue to allow book value to grow. When the market applies an average multiple to this success, the investment will be a success.

The point is that these are companies in defensible industries that can grow their intrinsic value over time that are currently trading at cheap prices. The market price may get cheaper before it appreciates, but the core businesses are sound, and at some point in the future will ascribe a higher multiple to these strong businesses. As Buffet said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” However, unlike Buffett, I would be quick to take profits if multiples expanded to their historical average.

That brings me to the next lesson, which is to not be afraid to take profits when they come quickly. In the past year I have seen 4 of my investments go from 30-40% gainers to flat or losing positions without taking any off the table. I have collected dividends in the mean time, but I would be happy to at least have taken 50% of my investment off the table if it ran 33% percent in 3 months or matched some other arbitrary level of return. I am much more comfortable with a longer timeline and thus did not sell, but in a world of sideways markets, I will have to spend more time considering taking profits quickly if they come quickly.

In summary, this exercise has been a success in terms of forcing me to think about investments and document my process so that I can learn from it. Additionally, the many emails from readers have helped me think outside the box. There is much work to be done, and I wish that I was able to dedicate more time and resources to this forum, but it is serving its purpose to date.

QSII 2 minute pass

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Quality Systems develops and markets computer systems designed to automate records keeping, billing, etc etc in doctor’s and dentist’s offices.

The fact that many doctor’s still rely on a system of manila folders rather than an integrated technology solution has provided a strong tailwind over the last decade, with revenue growing from 54.8M in 2002 to 429.8M in 2011. Over that period the company has produced mean ROEs of 27% while maintaining a strong cash position and zero debt.

Share holders were richly rewarded throughout this period of growth and the stock traded at an average PE of 35x.

The stock has traded off ~66% over the last few months following a series of earnings misses. Despite missing street expectations the company is still strongly profitable, and has a pristine balance sheet so I took quick look.

Management explains away the earnings disappointments by pointing to the fact that while many of their sales are made to small private practitioners, they also compete for large sales with hospitals and other large scale medical organizations. These large sales lead to lumpy earnings quarter to quarter. That makes perfect sense… but I have to believe that almost all of the large medical organizations have computerized their records and billing at this point, meaning that if the easy big sales aren’t gone completely, they will be soon. Large sales in the future will depend on convincing a large organization that it is worth migrating all of their information to a new system, and training all of their people on a new system… something that will be very difficult to do.

As for the smaller sales to private practitioners, it seems as if the runway is still long, but without any clare network effects what if any moat the company may have is difficult to identify. There are already several publicly traded competitors, and with limited barriers to entry, new developers can introduce a new system at any time.

With a 9% short interest and the tendency to have lumpy earnings reports it is likely that the stock will spike at some point which may make the stock attractive to some, but I don’t see how this company will grow its intrinsic value effectively in the longer term, making it a poor investment at these prices.

ROC – Mispriced Market Leader?

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CAP STRUCTURE:

COMPANY OVERVIEW

Rockwood Holdings (ROC) is a US based global specialty chemicals company operating 81 facilities in 23 countries across five business segments (recently expanded from 4 as seen below):

1) Specialty Chemicals (37% of 2011 net sales) includes leading global supplier of surface treatments products and solutions for metal processing industries and leading global producer of lithium products.

NOTE: as of Q1 ’12 the company separated surface treatments and lithium. For Q1 ’12 these segments were 20.7% and 12.6% of net sales. Previous annual levels should be updated upon the filing of their next K.

2) Performance Additives (21% of 2011 net sales) includes color pigments for concrete products, paints, and a leading provider of a new generation of alternative timber treatment chemicals, and clay based additives used for coatings, inks, household products and other applications.

3) Titanium Dioxide Pigments (25% of 2011 net sales) operated as a 61% owned JV with Kemira Oyj and includes a leading producer of specialty grade TiO2 produced through the sulfate process, rather than the chloride process, which allows production of both anatase products and rutile products rather than only rutile. Most global production is rutile, but anatase results in less wear and tear on application machinery, and is typically used in synthetic fibers, rather than coatings, inks, plastics etc where rutile is used.

4) Advanced Ceramics (16% of 2011 net sales) a leading global producer for end markets including medical, electronics, industrial, and automotive focusing on niche applications. Almost all advanced ceramics products are made to order based on specific customer requirements.

The company provides products that they believe are generally critical to the success of their customer’s final products, but account for a small portion of the total cost of the final products. No single customer represented more than 2% of sales in 2011.

While the company is economically sensitive, this is somewhat mitigated by the fact that the company has more than 60,000 customers across a variety of end uses as demonstrated by the following breakdown of 2011 net sales by end use markets:



INVESTMENT HIGHLIGHTS / CATALYSTS

1) Demand growth for Lithium is expected to remain strong

The runway for iPhones, tablets, and other consumer products that depend on lithium based batteries remains long as global consumers continue to upgrade their mobile devices. Additional demand comes in the form of portable power tools and other consumer electronic items.

The real step change will come from the eventual adoption of hybrid / battery powered vehicles, with some analysts expecting a 500% increase in demand for lithium associated with vehicles in the coming years.

Today batteries represent ~30% of total lithium demand. Sell side estimates put battery demand at 50% of total demand by 2020. Other uses include ceramics, glass, and lubricants.

Currently, lithium producers enjoy an oligopolistic pricing environment and have been able to consistently raise prices (up 300% since 2000) as demand increases. Of course, global supply is increasing as demand increases, but with a 3-4 year lead time before new mines/plants can become operational, the current pricing structure will remain in place for some time.

Additionally, when new entrants are able to come online, ROC should be able to maintain their status as a low cost producer. Unlike lithium used for ceramics, glass, etc, battery grade lithium must undergo significant refinement through techniques which ROC has been perfecting for years, and new entrants will have to attempt to replicate.

While the trend will likely be for battery grade lithium to drift toward a pure commodity pricing structure over time, I believe ROC will enjoy customer loyalty for some time. For example, historically a major complaint from AAPL users has been related to battery life. This hurdle seems to have been cleared in recent years, but the company is likely aware that customers remain suspicious of battery life, and AAPL will likely want to stick with a known and proven source of high quality lithium.

2) The company has long noted that TiO2 is not a core business, and has engaged a bank to examine strategic options for the TiO2 business.

While management contends that their Ti02 business is adequately specialized to demand a higher multiple than other Ti02 businesses, market perception is that Ti02 is a straight commodity business, and thus less valuable than ROC’s other business lines. On the Q1’12 conference call management announced that they had engaged Lazard to examine strategic alternatives for the business, with the likely outcome being either an IPO or a sale. Regardless, this business is probably worth somewhere around $900M to ROC (4.1x 2012 EBITDA, with minority interest backed out) – money which can be used to pay down debt, or returned to share holders. The pro forma business should command a higher multiple as claims that other product lines enjoy oligopolistic pricing are easier to justify than the Ti02 business.

3) Continued Debt Reduction / Return of Cash to Share Holders

Management has consistently stated that cash use priority would be 1) expanding Li production capacity, 2) paying down debt, and 3) returning cash to share holders. They have been true to their word, aggressively paying down debt, and implementing a dividend (3.3% yield) for the first time in the most recent quarter.

Net Debt/LTM Adjusted EBITDA Source: Presentation at DB Industrials Conference, 6/13/12

4) Motivated Management

Not only is management excellent from an operational standpoint, but they own more than 9% of the company (#2 holder KKR has 2 board seats). Conference calls indicate a clear preference for profit over revenue growth, and margin maintenance against a difficult macro background and rising input cost environment has been impressive. They have consistently stated that priority use of FCF would be to expand the lithium business, pay down debt, and return cash to share holders. Debt has been significantly reduced, and a dividend was instituted for the first time in Q2’12.

RISKS / WHY IT IS CHEAP

1) European Exposure

Approximately 63% of 2011 net sales were denominated in Euros, and current share prices reflect continued macro / European concerns. However, it is important to recognize that while production takes place in Europe (primarily Germany), sales are largely generated via exports, meaning that continued weakening of the Euro may help accelerate sales to some extent.

Additionally, a substantial portion of the company’s total debt is denominated in Euros (448.2 Euros), allowing the company to more easily pay down debt in the event of continued Euro weakness.

Worst case scenario would be a return to the Deutsch Mark, which would likely be the strongest currency in the region, and thus negatively impact exports.

In summary, despite very real Euro related concerns, demand for ROC’s products will continue to rise over time independent of the macro outcome in Europe, and patient investors will be rewarded.

2) The Ti02 Business Is Seen As A Drag By The Investment Community

Ti02 demand remains strong, but input costs are rising faster than producers can raise prices leading to margin squeeze. Additionally, Ti02 is not as specialized as ROC’s other business units, leading to a lower multiple. However, the company intends to divest the Ti02 business. Short term this may lead to dilution, but longer term, it will lead to a stronger pro forma company.

3) Asian / Luxury Exposure

Many of the company’s products are sold into the German luxury auto market, with an eventual destination of Asian buyers. Recent commentary from luxury retailers has indicated a softening in demand from Chinese buyers as the Chinese economy cools and as new government rules meant to reduce bribery in the form of luxury gift giving are set to go into effect.

However, over the course of the global recession luxury sales have proven to be resilient, and I believe luxury auto demand is independent of luxury demand attached to gift giving, which is more likely focused on smaller, less conspicuous items like watches and other fashion accessories than automobiles.

While I believe that continued slowing in China is a likely scenario in the near term, I believe luxury spending will remain robust on a longer time line.

VALUATION

ROC is a business with strong growth in front of it that is currently trading at historically low multiples.

Historical EV/Consensus forward EBITDA, and P/Consensus forward Earnings:

Assuming growth in line with recent performance and multiple expansion to levels in line with historical performance, ROC is currently priced with a large margin of safety, and should significantly outperform indexes over the next 2-3 years.

Given the high quality mix of ROC’s business, and based on comparative multiples for other specialty chemical companies, I believe a 7.5x EBITDA multiple is appropriate, indicating significant mispricing.

On an EPS basis, the mispricing is more pronounced. While like most industrials there is some variability in ROC’s earnings, their record of strong growth, excellent management, and long runway likely deserve at least a 14x multiple.

KICKERS

The company has consistently made it clear that lithium and surface treatments are their primary focus. However, while not central to the thesis, other business lines are well run and should add value on a longer time line. Additionally, ROC would make a nice tuck in acquisition for a larger competitor in the chemical space.

1) ROC is one of the more likely takeover candidates in the chemical industry
2) The performance additives business is tied to construction, and an eventual rebound in the housing market will be a strong tail wind.
3) The advanced ceramics business is tied to solar panels, and has suffered due to uncertain subsidy environment globally. However, longer term increased production of solar panels seems likely.
4) The advanced ceramics business is FDA approved for ceramic hip joints – as metal on metal joints face increasing criticism, and the global population ages, demand for this high margin business should improve.

SUMMARY

While European concerns are weighing on all investor’s minds, ROC is a solid company with an excellent operating history, long runway of growth, and a motivated management team. Patient investors that can look past near term European uncertainty will be rewarded by significant EPS growth and multiple expansion.

CRESY – more

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I briefly discussed CRESY after the Argentine government appropriated YPF. At that time I focused on the market value of the non Argentine assets thinking that in the event of an appropriation of the Argentine assets, share holders would come out just fine based on the value of their non Argentine holdings.

The stock has dropped about 20% since I last looked at, so I am taking another look. To remind you, CRESY is a conglomerate domiciled in Argentina that owns a variety of assets – most of them Argentine real estate. Much of this is through a controlling position in IRSA Inversiones y Representaciones (ADR ticker IRS) which owns shopping malls and hotels, again mostly in Argentina. More interesting to me are CRESY’s agricultural land holdings, which include more than 685,000 hectacres of land split between:

The company fashions itself as a developer of sorts, and buys land with the intention to improve it and re-sell it. For example, using land for corn or soy is more profitable than using land for grazing, so they try to buy land that has been traditionally used for grazing and improve it so that it can be used for agriculture. Given the company’s balance sheet and personnel, they believe they can increase the yield from the land through modern farming techniques and equipment that previous land owners may not have had access too. Basically they are just taking traditional land and applying modern, industrial farming techniques to the land.

This is an asset heavy business, but unlike railroads or cruise lines, the assets (the land) don’t have to be depreciated and replaced. Rather, land typically appreciates over time. However, accounting conventions do not adequately address the upward revaluation of land holdings, meaning that their book value is likely understated by a fair measure. The Brooklyn Investor did a brief writeup on CRESY a few months back and demonstrated that CRESY has effectively grown book value in the past. According to the company’s 3/31/12 6K the book value of the company is 2,192,778,000 pesos, or $488,783,000 USD (according to google’s exchange rate). With current non-diluted ADR shares outstanding of 55,891,537, that is a BV / share of about $8.75 per share vs current ADR prices of around $7.50 / share… a ~14% discount to a likely understated book.

So – what does the book value consist of, how defensible is its value, and should this company trade below book?

According to the recent 20F roughly 64% of the total assets fall under “real estate” and 36% fall under “agriculture/feedlot.” Unfortunately the components of those assets (ie PP&E vs intangibles etc etc – obviously PP&E is what we really care about here) are not split out, but PP&E is about 55% of the total asset base and 21% is “investments” which is not defined, but I believe to be capitalized improvements to PP&E. There is also cash and inventories, but the point is that the vast majority of the balance sheet is hard assets, not intangibles or good will. In fact, the company carries negative goodwill which represents the discount purchase prices they have paid on assets in the past – evidence of skillful capital allocation.

First, the “real estate” business which consists of shopping centers, offices and non shopping rental properties, hotels, and development property held for sale. My big fear here would be that a lot of this property was acquired in the mid 2000s at inflated prices and is now at risk of being written down in the event of a renewed global slow down. However most of the shopping centers were acquired in the 1990s, with a touch more than 25% of the total appraised value of shopping centers having been acquired in 2009-2010. This is somewhat comforting as the company was not on a shopping spree in an overheating market, reducing the likely hood of a write down.

Additionally, the company believes that Argentina is still going through an evolution away from neighborhood shops and towards fully developed malls… sort of like the US in the 50s or 60s. I doubt that any area that has not yet fully embraced a mall culture will reach the amount of malls that the US presently has due to the advent of internet shopping, but the point is that Argentina is not “over-malled” like the US is, and there is still an opportunity to refine and centralize shopping destinations in Argentina – despite internet sales.

Additionally, the properties they buy for development and sale are in under or undeveloped areas of densely populated areas, or on the outskirts of Buenos Aires with convenient access to the city. Again the company is not top ticking the market as these properties often lack even basic infrastructure which the company then puts in before selling the properties. This is basically a play on a continued population / urbanization trend in Argentina.

The hotel and office building businesses are slightly more concerning as they are more attached to premium parts of the market, but again, the company was not on an acquisition binge through the early 2000s. These investments are basically a play on Buenos Aires continuing to develop as an international city for both business and tourism – longer term I think both are likely, however, there is a chance all of the above could be written down in a global slow down.

The agricultural business is less concerning. As stated above, the company buys agricultural lands and increases their yield. In the longer term, I am very positive on South American farm land. The global population is bound to grow, and food demand from a growing global middle class will make total food demand grow exponentially. In order to meet this demand the world needs arable land. In order to grow crops in a price competitive way this land needs to be close to water. South America is really the only place that will be able to meet this need on a kind of large scale.

In the shorter term, if there is a global slow down farm land is unlikely to lose much value. People still need to eat, and farm land should benefit from a flight to safety affect as both an inflation hedge and the source of non discretionary food. That is not to say that CRESY’s stock won’t sell off – it likely will, especially given the high debt load and fears of a freezing credit environment – but I think the value of the actual land is pretty safe.

In summary, I think that the book value of the property and land is reasonably safe from being written down, so I feel comfortable looking at this as a ROE / book value story. Over the last 10 years ROE has averaged 6.4%, and over the last 3 years it has averaged 8.6%.

The ROE numbers are not all that impressive, but there are a few things to think about here. First, assuming our cost of capital is 10%, returns of 6 or 8% can be just fine if you’re buying the assets at a discount, which we would be. Second, the story here isn’t really about the year to year income – its more about the appreciation of land over time. The year to year income will reflect some property sales, but it is more representative of sales of beef, milk, crops, and income from tenants. Third, how has the composition of ROEs changed over the years?

A quick look at 10 years of Dupont break down show that leverage has been the contributor to ROE in recent years which is of course less than ideal.

But is it a problem? More on that later.

FLIR in 2 minutes

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FLIR is the world market leader in thermal imaging. The company was founded in 1978, and designs, manufactures, and markets sensors capable of reading and measuring infrared energy or heat signatures across a variety of applications. The technology is not new, but FLIR has been on the leading edge of expanding its uses and reducing its cost. Whereas once it was limited to “thermagraphers” who owned devices costing tens and even hundreds of thousands of dollars and did contract work for those needing it, the technology is now cheap enough to allow mass adoption. This mass adoption has led to impressive growth at FLIR.

Continue reading →

Special Situation – JAKK

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JAKK is doing a partial tender offer.

Basically, if you own less than 100 shares, the company will buy them from you for $20/share at the end of June. Now of course nothing is ever risk free, but considering JAKK has plenty of cash on hand to self finance this offer, this is about as close as it gets.

I was able to buy 198 (99 in each of 2 accounts) shares at an average price of 18.145 for a cash outlay of $3,593 + $14 in commissions = $3,607.

At the end of June assuming all goes as planned I will receive $3,960 or a return of $353. That is a touch over a 10% return in about a month, or an annualized gain of ~120%.

Small dollars, but big percentages… and who doesn’t like free money?

JNGW – Special Situation Completed

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About a week ago the payout for the JNGW special situation FINALLY went through. The shares were actually delisted back on March 30th, so for the last 6 or 7 weeks I have been left wondering if, when, and how I would be rewarded for my investment. The company rudely didn’t issue a press release with that information. I unsuccessfully called the company on several occasions asking for information on timing and had been left doubting the wisdom in investing in a Chinese special situation.

Thankfully the situation resolved itself for a 16% return.

The time i spent wondering / worrying if I would get my money back reminded me that special situations are not “free money.” Even though the market risk is largely eliminated, you still have to worry about company specific risk such as a management team that absconds with your money. The risk of this happening in the US is pretty low, but in China markets are obviously not as tightly regulated as they are here.

More on Cruise Lines: Tailwinds and Valuation

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In the last post, I made the case for stability in the cruise industry.

Now I’ll talk a bit about tailwinds and valuation.

Sell side analysts talk about occupancy, available passenger days, net yields and several other industry metrics that are likely useful while trying to pinpoint short term earnings potential. However, I am not interested in the cruise lines because of the short term earnings potential. I am interested in them because I think they are stable businesses with little risk of change over the next ten years or so. In the shorter term I really have no idea what will happen with prices. I think the equity is cheap now, but it is certainly at risk of decline due to a global consumer spending slow down, a terrorist attack, an out break of bird flu, an accident at sea, a spike in oil prices, and any other number of factors.

However, the above mentioned risks have always been present, and they will always be present in the future. I really don’t think there is any way to invest around them.

It is worth noting however, that in the past, despite all of the previously mentioned risks which have manifested themselves at various points, the two companies still managed to post 10 year average ROEs of 8.2% (RCL) and 10.9% (CCL). These averages have also been significantly impacted by the last few years of the great recession, suggesting that a true normalized ROE number would be higher, rather than lower.

Of course, historical ROE numbers are useless if you think the future of the industry is at risk, but I don’t. In fact, I think the future of the industry is brighter than its past as there are a number of tailwinds developing. First, and perhaps most obvious, is the aging population in the US. The average age of cruise passengers is over 50 years old, and there is a significant senior segment. Second, historically cruising has been a mostly North American phenomenon, but that is changing. According to RCL’s recent investor presentation, 3.3% of the American & Canadian population are cruise customers, while only 1.1% of Europeans, .2% of Latin Americans, and .1% of the population of the Asia/Pacific region are. That provides a long runway of growth potential as the situation in Europe stabilizes and other regions become more prosperous. Additionally, new destinations are coming online as is evidenced by the fact that in 2007 50% of RCL’s cruises were Caribbean, and in 2012 only 42% were. Furthermore, vessels are becoming more fuel efficient, and capacity growth is slowing as management teams have indicated they will be more focused on strengthening their balance sheets and focusing on ROIC rather than blind expansion as they had been in the past.

All of those tailwinds are great… but I don’t want to pay for them. And at today’s prices, I am not. Today I am paying for the assumption that consumers will never go on cruises the way they used to, ships will crash, and terrorists will attack cruise ships. I am happy to buy that assumption.

RCL is trading for .61x book, and CCL is trading for 1.04 book. With average ROEs of 8.2 and 10.9 respectively, at these prices with a cost of capital or hurdle rate of 10%, intrinsic value of the shares can be estimated at 82% of book for RCL (8.2% / 10% )and 109% of book for CCL (10.9% / 10%). For RCL that implies an intrinsic value of over $32 and for CCL a price around $33. This is obviously a very simple valuation, but in a business whose long term prospects are as stable as i believe the cruise business to be, simple is all you need.

I believe these estimates are conservative for a few reasons. First, book values for cruise lines are understated due to the effects of inflation. The ships are typically deprecated over a 30 year period, but a new build costs significantly more than the carrying value of the old ships. Second, as mentioned, the 10 year average ROE number that I used is likely understated. Third, the previously listed tailwinds should all benefit revenue in the future, meaning even higher ROE. Additionally, it is worth noting that historically P/B for RCL was mostly above 1.5x and for CCL mostly above 2x with the exception of the post 9/11 years and great recession years.

In summary, I don’t know what will happen in the short term, but for an individual investor that does not have to pander to the whims of impatient customers that expect quarterly results the way most institutional managers do, I think that the cruise lines will perform very nicely. At these prices RCL has an almost 25% margin of safety vs a low estimate of intrinsic value, meaning the margin of safety is probably closer to 40%.

Disclosure – establishing a long in RCL and hoping to add more lower.

Cruise Industry at a Glance (RCL / CCL)

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Buffett has often said that when valuing a company he tries to picture what the value line sheet will look like in ten years. The implication is that Buffett is only interested in companies that are resistant to change. Now, I am not suggesting that the cruise lines have the growth prospects of a Buffett company, but I do think that the industry will prove to be resistant to change, which makes it easier to value. In fact, short of Richard Branson or Sirgei Brin succeeding in the commercialization of space travel on a grand scale, I really can’t see how the cruise business will change at all in the future.

The cruise business is a good business with high barriers to entry. Competition within the industry is centered on price and service, and as usual where price is a factor, economies of scale matter. RCL and CCL respectively control 24% and 49% of the worldwide cruise industry through a variety of branded subsidiaries that are meant to appeal to different price points, geographies, and cultures. RCL and CLL are able to leverage one operational framework as well as spread their risks across many boats and clearly benefit from these economies of scale. What this means is that the existing power players could easily move to undercut the prices of new entrants or existing upstarts if a threat developed.

Additionally, cruising is an industry where reputation is important. Feeding, housing, entertaining and otherwise caring for hundreds of people while at sea is an impressive logistical feat. Consumers are likely to go with a name they know and trust – perhaps a friend had a great vacation on XYZ cruise lines – rather than try their luck with an unproven upstart that may be thought of as more likely to have problems at sea a consumer is likely to also go with XYZ cruise line. Because of the above any new entrant would likely need to be branded (example: “W Cruises” brought to you by the W Hotel or something along those lines that implies quality) or really access only a small niche within the broader market.

Further protecting the established norms is the fact that global port capacity is limited, and port operators may be reluctant to deal with new entrants for fear of angering their larger clients. If there is limited dock space, and you are the port operator, would you be more likely to work the port schedule around the new company that operates one or 2 ships that come to port once or twice a month, or with the company that operates a half dozen ships that come to port 10 times a month? The same can be said about the outside vendors that cruise ships partner with to provide “excursions” for their guests. If you are in the business of taking cruise ship passengers on jet ski or horseback rides, you would be more inclined to deal with the companies whose ships come to port most often, making it more difficult for an upstart to provide add on experiences for their guests.

Also a thought, although I’m not sure how relevant it is due to the declining importance of travel agents as a whole, but I would think that people going on cruises would be more likely to use a travel agent than the average traveler due to the fact that cruise customers tend to be older (assuming less likely to book online) and that cruises have multiple moving parts between flights, transport to the dock, the cruise itself, and then add on activities. Travel agents would likely be incented to push cruises from the major operators in some sort of rewards plan.

As for why the cruise lines never priced each other to death airline style, I think there are two main reasons. The first is that the industry is differentiated vertically, meaning that there are high end cruises, low end cruises, and everything in between. On the high end as with many things considered “luxury” pricing cruises higher helps attract a certain clientele. For this well heeled clientele discounting prices is a bad thing. When one has an elitist attitude, a lower price makes the experience more accessible for those in a lower social strata which the elitist does not wish to be associated with, and these customers will gladly pay up to ensure they are only surrounded by people who they view as social equals. On the low end, value conscious consumers book far in advance trying to lock in the best price, allowing the cruise operator to adjust pricing upward based on remaining supply for the next round of buyers. Of course as time until departure gets low prices adjust downward to ensure a full boat.

The second reason is that cruise offerings are differentiated horizontally, meaning that there are many different cruise niches. The obvious here is geography, but other niches such as black tie dinners versus adventure excursions are also plentiful. Additionally, different ships are pitched as different experiences with the net effect being that cruise experiences are not as commoditized as one may first assume.

All of the above is enough to get me interested in taking a look at what the future of the industry may hold, and what valuation currently looks like.

More on that in the coming days.