Wednesday, January 27, 2010

Jackson Hewitt Tax Service: Don't Be Fooled Into Thinking It's In Value Territory

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I stumbled upon Jackson Hewitt Tax Services (JTX) during one of my stock screens and had to investigate since it had an eye-popping 0.41 Price to Book (P/B) ratio. As some might know, I try to find profitable companies trading at a P/B of less than one, with the ideal scenario being that they can have all of their Goodwill and Intangibles written off and still have a P/B of less than one.

First, however, a little information on Jackson Hewitt:

Market Cap: $ 84.58 MM
Enterprise Value: $ 412.21 MM
P/E: 4.02
Forward P/E: 4.82
PEG Ratio: 0.82
P/S: 0.41
P/B: 0.41

And Yahoo! Finance description:

[The company] engages in the computerized preparation of federal, state, and local individual income tax returns in the United States. As of April 30, 2009, its network comprised 5,610 franchised offices and 974 company-owned offices. The company was founded in 1985 and is headquartered in Parsippany, New Jersey.

The Surface of Things

Just looking at the above mentioned numbers, JTX looks pretty attractive. Forward P/E and trailing P/E are both low and do not vary significantly, Price to Sales (P/S) is less than one, PEG is less than one and most importantly to me, P/B is less than one, and to boot, very low.

That all being said, even just glancing over the recent news bulletins for this company, and today's stock movement (down 16.5%), suggest that all is not necessarily well in the Jackson Hewitt household. It seems that the big market moving data piece was that JTX was not going to have enough funds to extend profitable tax return loans to customers.

This hits on two levels. The first is that it indicates a lack of cash and a lack of access to credit markets, both issues that are negative. The second, another negative, is that the business will not have access to a profitable fringe line of their business, especially during the most crowded season for individual tax work.

While negative press is something I think an investor should always be aware of, it shouldn't be the most significant factor in selecting an investment. In fact, I'm of the persuasion that oftentimes negative press can expose large amounts of value for investors to capitalize on. That being said, it's time to look under the hood and check out JTX's balance sheet.

For Want of Cash

I mentioned above that the recent negative press on JTX likely spoke to a lack of cash. This is very quickly confirmed after looking at their most recently filed 10-Q from the quarter ended October 31st, 2009, in which one discovers that they only had $60,000 at the end of the quarter. This is likely due to the net loss of $41.3 MM they reported for the quarter, but is still slightly chilling because they borrowed $85 MM under a revolving credit facility.

Now this isn't immediate grounds for dismissal since they've cut Accounts Receivable by 48% from the prior quarter, a positive sign that they're not just making sales on credit to try and boost revenues. Especially since the tax preparations business has seasonal cyclicality (centering around April 15th, the Christmas for the industry), a loss in a quarter that does not include tax season loses some of its significance.

However, after looking farther down the balance sheet, the Goodwill and Other Intangibles jump, since together these make up 85% of the company's total assets. This is somewhat understandable given that companies such as Jackson Hewitt rely on human capital (their accountants) and branding as a means of running their business. You can't really observe the value of these two items on a balance sheet, so when there's an acquisition, the bulk of the recorded assets is going to come in as goodwill.

That being said, compared to H&R Block (HRB), their biggest competitor, JTX's ratio of Goodwill and Intangibles to Total Assets looks absurdly high. H&R Block's Goodwill and Intangibles only make up 25.5% of their total assets, and they're currently sporting a P/B of 6.81. This leads me to think that JTX's low P/B is more of a warning sign than a value investing trigger.


Further examining JTX's balance sheet, if one were to write off all Goodwill and Intangibles the company would be left with a deficit of $304 MM for Shareholder's Equity. Additionally, for Shareholder's Equity to maintain a positive value (i.e. SE is greater than or equal to one), the combination of Goodwill and Intangibles can only withstand a writedown of 40%. To have a P/B of 1 or less, these same areas could only withstand up to a 24% markdown.

Given this information, I can say that I needn't do more analysis as to JTX's future prospects since these items point me to strongly reject JTX as an investment. While if you're the adventurous type JTX might be an interesting roller coaster, I find the risk-reward payoff unsuitable. In this instance, the P/B is probably a signal to look for the life boats on this Titanic.

In addition, one can almost categorically reject service industry investments such as Jackson Hewitt from my value investing perspective when their operational competitiveness is based primarily on human capital. People are the only assets that have legs, and you can bet if things go in to a bankruptcy scenario they're going to try and get out of there. Further, since this stock is going through a flux and the business model seems to be struggling, I'd bet money that JTX's most talented accountants are trying to jump ship, if they haven't already.

To look at the spreadsheet I used for my analysis, please see below
JTX Analysis

Thursday, January 21, 2010

The Selection Bias in Goldman's Argument Against the Obama Regulation

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The proposed Obama regulations that I'm referring to are the statements that came out today that he would:
"seek to prevent banks that have special access to low-cost Fed funding from operating or investing in hedge funds, private equity funds, or trading purely for their own benefit in a way that’s unrelated to serving customers." [Bloomberg]

While this is sure to be contentious, I think it's important to take a step back and look at what especially discounted Fed funding is intended for. I'm not talking about the funding that the Fed provides during a "business as usual" scenario, but in scenarios such as this recent credit crisis, when the discount window's possible term length was raised to 90 days and interest rates slashed, the goal was presumably to get some emergency liquidity out there to try and unfreeze credit markets and stimulate lending again.

I won't try to quantify the potential for ruin that hedge funds, private equity, and proprietary trading might potentially represent to a bank, although this is certainly possible. If the goal is to stimulate lending, however, having all these components as parts of banks that have the discount window available to them would make it difficult to monitor where these emergency funds might be going once they leave the Fed. While these other activities no doubt have the potential to be economically important, I don't think there would be significant objection that the Fed's primary objective in a crisis, is to funnel funds to firms that are going to use that money to lend and keep credit flowing, might be hindered if these funds are instead going to any number of other activities available to some of the firms that received emergency Fed funding.

This leads to the Goldman comments coming from Chief Financial Officer David Viniar. He argued:
"If people are focused on things that caused, or were real contributors to the crisis, it wasn’t trading...Most trading results were actually pretty good, not just at Goldman Sachs but at most firms and that’s not really where the problems were." [Bloomberg]

Looking at the results of trading from the crisis as a sample of typical trading is a vivid example of selection bias. It seems that Viniar would like us to think that because most trading was profitable during the crisis, it will be profitable in the future and doesn't doesn't pose systemic risk to banks. While on average trading profits might be positive, that says nothing for the skewness and kurtosis of trading profits/losses. By that I mean that proprietary trading could be negatively skewed or with fat tails (positive kurtosis) in the negative end of the distribution.

This is an example of a positively skewed, positive kurtosis, positive mean distribution. While it will be on average positive most of the time, the long negative tail creates the possibility for financial ruin when returns end up in that part of the distribution.

I'm not going to take sides on this issue, since I can see the validity in both. That being said, I think that Vinair's argument regarding proprietary trading is mistaken. For example, while fund managers can on average beat the market by holding a portfolio of the S&P 500 and writing puts (insurance against a fall) on the S&P 500, when it does go bad, it's ruinous. This is the "picking up nickels in front of a steamroller" scenario.

While I don't claim to know the distribution of trading profits or the absolute level of risk these firms are taking on (they might not know either), I can understand why Obama and his administration would want to prevent artificially-lowered interest rates from fueling these types of activities. Especially since it's meant to stimulate lending, allowing firms that have access to the Fed's discount window to engage in hedge funds, private equity and proprietary trading could be a usage of funds not best for unfreezing financial markets.

That being said, Obama needs to be careful when he talks about "curbing excessive risk taking". Lending to small businesses is one of the riskiest types of loan a consumer bank can do, and since stimulating the flow of credit to areas of the economy such as this seems to be an Obama administration priority, curbing risk taking shouldn't be his goal.

Wednesday, January 20, 2010

Will the NY Times' Move to Freemium Make a Difference?

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It has come to my attention that the NY Times, a publication I read on a daily basis, but mostly just their blog DealBook, will in 2011 implement a metered system whereby after a certain number of read articles you will be required to register and therefore pay.

Initially when I read this, my first thought was that it might be easy to circumvent a counter if it's tracking an IP by using a proxy. This would be quite hassle, so it'd probably just lead people to finding other mediums to get their information if paying for content is a problem.

Evaluating the decision leads to the general question of which is greater: ad revenue from a freely available Times, or subscription fees from a limited one. Presumably, dropping the current ads the Times has on its website would be a requisite if they were to switch to a freemium model. I know I'd personally be very upset if I were to subscribe and found the website littered with the same amount of ads.

Moreover, I think the concern becomes whether or not people are willing to dramatically change the sources from which they get information, or whether they'll just pony up the additional cash to keep from changing. The promotion of what might be called "new media", sites such as this blog, is a positive externality of publications like the Wall Street Journal, the Financial Times, and the NY Times going to a freemium model. That being said, they also probably won't get as much link traffic since I certainly would never cite something that not everyone could view.

It's somewhat unfortunate that I won't be able to view the Times with the same wanton freeness I used to. However, I'll have no problem substituting in new sources of information. It does, in my opinion, create an opportunity to contemplate the future of "old media" sources like newspapers. I'll be curious to see if the freemium model works.

How Not to Make a Slideshow

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So this has already been pretty widely covered, however I couldn't not link to it. This slideshow is probably the single worst and most crudely photoshopped thing I've ever seen. I'm a huge fan of Photoshop Disasters, so when you hit the intersection of that and Bloomberg, I'm all over it. Smile for the camera kids!

Don't let my bright smile fool you. I am absolutely petrified. Please, someone for the love of God get me down from here.

Thursday, January 14, 2010

I'll Take Obama's Bank Fee Plan Over the U.K. Banker Tax Any Day

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Yesterday I talked about the choices that faced U.K. banks following the 50% bonus tax levied on them. Today, in light of the news that Obama is going to levy a fee on U.S. banks of over $50 billion in size, I felt it well fitting to discuss this current development.

The fee, which is expected to raise "$90 billion over 10 years", is geared towards trying to pay back the money lost under the TARP bailout system. The apparatus for determining the fee per bank:

The fee would be approximately 15 basis points, or 0.15 of a percentage point, of covered liabilities, or total assets minus Tier 1 capital -- common stock, disclosed reserves, retained earnings -- and excluding FDIC-insured deposits for banks or insurance policy reserves for insurance companies, the official said. [Bloomberg]

In terms of the financial system, I am of the opinion that it will regularly experience shocks of confidence, since by it's nature most financial firms rely on the investor and counterparty's confidence that they will remain a going concern to earn a profit (the FDIC helps). Since I am of the opinion that crisises, especially in vulnerable sectors like financials, are an inevitability due to human nature (i.e. the ability to suspend rational thought once the "panic" button has been depressed), operating under the perspective that this will not be the last bailout of financial institutions is, I believe, a good idea.

I see the Obama plan as doing two positive things: recouping bailout funds from an industry that greatly benefited from its support and will likely need it in the future and providing incentives for firms to decrease in size. These large firms are the ones that pose a systemic threat were they to collapse, so I think means by which to gently encourage shrinkage would be a net positive for the system. Ignoring, of course, the obvious political rhetoric ("when I see reports of massive profits and obscene bonuses at some of the very firms who owe their continued existence to the American people" etc. etc.), which I see as mostly trying to rustle up voter approval in the face of mid-term elections, this plan to me is very solid.

This of course stands in juxtaposition to the U.K. bonus tax plan. One of the things that I found most distasteful about that plan was the perspective that all bonuses, no matter whether or not they were deserved, were evil. I think that's dangerous territory to step in to, because financial firms are not the only ones that pay bonuses. While one might make an argument that financial firms are in a league of their own because of the size of their bonuses, I still feel that it's a slippery slope to be walking on. I see the 50% tax as a populist measure at trying to strike down select human beings.

In contrast, I feel the Obama measure, while assuredly being unpopular at banks, will actually help discourage firms from reaching the TBTF stage. I think that recognizing the frailty of the financial system is paramount to learning from the mistakes of the credit crisis.

I know myself, a current student looking for employ in the financial sector, would be exposed to the operational risks of financials. That's why my retirement and savings plan would be of a much lower risk quotient than the average American to offset my increased employment risk.

Wednesday, January 13, 2010

Was Flipping the Bird to the Treasury a Good Idea for U.K. Banks?

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Referencing of course the ongoing drama involving the City and the British government, RE: a 50% bonus tax. This had the intention of reducing oversized banker bonuses, but recently it has been noted that most banks will simply take the hit of the 50% tax and pay their employees anyways. Evidently, some banks chose to go heavier on deferred stock bonuses, which only incur the much lower capital gains taxes rather than the lofty 50%.

For the budget deficit ridden U.K., which estimates the tax may generate as much as 2 billion pounds, this provides quite a nice little windfall for them. Obviously it's not accomplishing what they hoped it would, but for taxpayers incensed by high flying bonuses for companies they feel they saved from the brink of destruction, it's a decent consolation.

This is of course what the banks have chosen as the short-term fix to what might prove to be a long term problem. As it were, the banks don't have the option to move over night as they please (for the lack of flexibility in office space leases for one thing), so they really could only answer the question "to pay or not to pay".

In terms of extending the time frame out a little farther, banks have much more freedom in terms of choosing where to do business. As I look at it, since they went ahead and took the hit of the bonuses, the tax is going to stay in place as long as people are willing to pay it. So as a bank, you either have to do one of two things: move your office, or hope that enough other people move their offices such that the government drops the tax to retain jobs.

Could it have been different? I'm of the opinion that was the City to have laid low for a little while until the public outcry died out, potentially the tax might have been dropped. But as it were, I don't think there's any incentive to drop the tax since government officials likely figure that they have a captive market, willing to pay the necessary amount as a cost of doing business.

That being said of course, human capital is much more mobile than businesses. So perhaps paying the taxes was the only option they really had to retain top performers.

Monday, January 11, 2010

Mirant Corp (MIR): Is There Significant Value Behind this Coal-Burning Utility?

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As I noted in my write-up for The Pantry (PTRY), my investing strategy focuses on finding value stocks trading at a Price to Book (P/B) of less than one. From these, I try to find seemingly boring and unsexy companies that I think will keep posting positive free cash flows to equity holders long enough for the market to re-evaluate the company, presumably at a P/B of greater than one.

One company that's held my interest for a while now is Mirant Corporation (MIR). Again some basic information:

Market Cap : 2.35B
Enterprise Value: 2.93 B
P/E : 1.99
Forward P/E : 10.23
PEG Ratio : 0.18
P/S : 0.79
P/B : 0.53

Yahoo! Finance description:

"Mirant Corporation produces and sells electricity in the United States. It generates electricity through coal-fired and oil and gas generating facilities. The company'’s operations primarily consist of procuring fuel, dispatching electricity, hedging the production and sale of electricity by its generating facilities, managing fuel oil, and providing logistical support for the operation of its facilities. The company was founded in 1982 and is headquartered in Atlanta, Georgia."

The Crux of It

The main sell for Mirant is that even after taking away intangibles, goodwill, and other non-current assets, the stock still maintains a P/B of less than one. Looking at their balance sheet from their most recent Q3 filings, using today's closing stock price and subtracting the value of intangibles, derivative contracts, deferred income taxes, prepaid rent and other, I get a P/B of 0.87.

From that P/B, Mirant is being priced practically like it's going in to bankruptcy. When all of these values are netted from shareholder's equity as reported on the balance sheet, one essentially arrives at a post-bankruptcy value to shareholders because I would consider these netted assets ones that would only remain valuable to the business were it to remain a going concern. Arguably if the derivative contracts were exchange traded they could probably be easily sold off, however since Mirant noted that they dealt quite significantly in OTC derivatives I subtracted this value to be more conservative.

If Mirant was going in to bankruptcy, I wouldn't want any part of it. I'm not a lawyer or a vulture and don't want to speculate whether there's going to be more than the current share price left over once senior stakeholders have been paid. The company's large cash reserves and a question regarding whether or not Mirant actually has excess cash from their recent Q3 earnings call have lead me to believe, however, that this company is not being priced because of bankruptcy risk. In light of this, it's necessary to look at other possibilities.

So Why the Discount?

Typically, if something sounds too good to be true, it probably is. That being said, with Mirant I think the reason for the dramatic under-pricing is a market perception that companies like Mirant, generating electricity from coal and gas, are carrying unstated environmental liabilities and could potentially get thrown under the bus as the United States' economy moves toward "green" energy.

If you look at Mirant's competitors, this story is supported. The AES Corporation (AES) and Calpine Corp. (CPN) are both trading at P/B values of over one (2.01 and 1.19, respectively), and in both companies' business descriptions they note being involved in one or more alternative energy generating activities, including geothermal and wind. RRI Energy, Inc. (RRI), however, is only trading at an unadjusted P/B of 0.47. The distinguishing difference of RRI? They're not involved in alternative energies, much like Mirant.

Is this discount warranted? Looking at Mirant, they've had to spend $1.67 B, of which they still have $341 MM to go, on capital expenditures due to the Maryland Healthy Air act. They estimate further capital expenditures to bring them up to other environmental standards to be $12 MM in 2009 and $20 M in 2010.

While environmental liabilities will affect companies that are more heavily involved in the dirtier forms of electricity production more than those that are producing partially from alternative means, both companies are still retaining environmental liabilities were states and/or countries to become more adamant about reducing pollution. AES for example, while utilizing wind energy, only generated $28 MM of their Q3 $3.8 B in revenue from it. So while they may be better poised with operational expertise in this industry as it takes off, they're still generating the bulk of their revenues the old fashioned way.

Stability of Cash Flows

Mirant posted operating cash flows of $727 MM for Q3, with total net CFs of $198 MM. This included capital expenditures of $508 MM, well above depreciation charges of $37MM.

One of my concerns with Mirant's CFs was the amount coming from proprietary trading. Being familiar with Enron, several red flags went up when I read about this element of their business in their most recent
10-Q. However, upon noting that realized trading revenues only accounted for $32 MM (7% of total) and even after subtracting unrealized trading losses of $24 MM that the figure would still be positive at $8 MM, I was much calmer.

Looking forward to upcoming charges, Mirant notes projected capital expenditures of $225 MM in 2009 and $441 MM in 2010. These comprise expenditures for the Maryland Healthy Air Act (60% of 2009 and 46% of 2010), other environmental (5% and 5%), maintenance (26% and 26%), construction (4% and 18%) and other (5% and 5%).

As I understand it, a large chunk of this construction expenditure is going to come from building Marsh Landing, a "760 [Megawatt] natural gas-fired peaking" plant near Antioch, CA. From their Q3 earnings call, Mirant notes: "
We expect [Marsh Landing] to begin construction next year, and we expect to have construction completed and go into commercial operation in May 2013". For some perspective, Mirant currently produces 10,112 MW of power, so Marsh Landing would expand production by 7.5%.

In terms of upcoming debt, Mirant has $535 in unsecured LT debt coming due in May 2011 and $374 MM in secured LT debt coming due between 2009 and 2013. Based on their positive net cash flows and large cash reserves ($2.0 B), I don't see Mirant having any issues either retiring the debt or rolling it over, especially as credit markets continue to unfreeze.

In terms of looking at operating revenues for 2010 and beyond, Mirant seems to have a very effective hedging program in place to smooth out volatile commodity movements. Mirant is 86% hedged for 2010 for power prices and 78% for fuel. Looking forward, they're 52% hedged for power and 61% hedged for fuel in 2011, with this hedging level continuing to taper off until effectively reaching zero in 2014. In light of this, I don't see a dramatic threat to Mirant's positive net CFs in the near future.

Outlook for U.S. Energy

While the prospect of the power generating assets of Mirant becoming impaired as environmental standards increase or alternative technologies become cheaper increases the risk of this company, I'm of the persuasion that the United States' need for energy will maintain the necessity for more traditional forms of power generation.

In a slide presentation from Mirant that accompanied their Q3 earnings call, the company included a graph looking at current and predicted reserve margins. For those of you unfamiliar, reserve margin is "the capacity of a producer to generate more energy than the system normally requires".

The earnings call noted:

I point as I have before to the orange line toward the bottom of the page, which is PJM East, which is our most important market. This trend remains and takes into account all that's going on demand side management and other efforts, and it is for anyone who is responsible for making sure that there is an adequate electric supply to meet the needs of the American public, a worrisome situation. This is not how a system should operate. This is not a good trend. It is a good trend for incumbents. It is a good trend in our own narrow self-interest for Mirant, but this is not good for the system.

While this is of course using their proprietary research, I think that when it is combined with other research it suggests that the United States and the world will increasingly need more and more energy, of which for the foreseeable future traditional energy generating techniques will remain a large part.

While I don't profess to be an expert on energy generation or utilities, I do feel that Mirant is priced at such a level as to be a very good investment possibility. Especially facing what I perceive to be an improving macro-economic climate, I strongly feel that Mirant possesses strong potential to be positively revalued by the market.

Disclosure: Long MIR

Too see the spreadsheet I used for my analysis, please see below

Sunday, January 10, 2010

Away For The Weekend

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Hey all, so I've got some friends in town that have been keeping me busy, so I apologize for the lack of new content. I'm working on some analysis for Mirant Corp. (MIR), and I should be able to post Monday evening if you want to check back.

In the meantime, if you've already checked out my recent analysis on The Pantry (PTRY), then check out some of these other stories from around the web:

Virgin acquires banking licence ----- Reuters DealZone

Have a great weekend and I'll hopefully see you next week.

Tuesday, January 5, 2010

The Pantry, Inc. (PTRY): With a P/B of 0.65, Are They a Vision in Value?

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The Pantry, Inc. (PTRY) came up in one of my recent stock screens, and upon further review I decided to dig a little deeper to see if it was as good as it looked just based on the Price to Book (P/B). As a note, my screen is for companies trading below 1 P/B, market cap below $10 billion, average volume above 100,000, stock price above $1, and that they be turning a profit.

Here's some basic info on PTRY, just so you get an idea:

Market Cap : 297.66 MM
Enterprise Value: 1.40 B
P/E : 4.98
Forward P/E : 7.99
PEG Ratio : 0.69
P/S : 0.05
P/B : 0.65

And Yahoo! Finance description: "The Pantry, Inc. operates a convenience store chain in the southeastern United States. Its stores offer a selection of merchandise, gasoline, and ancillary products and services. As of September 24, 2009, it operated 1,673 convenience stores in 11 states under various select banners, including the Kangaroo Express, its primary operating banner. The company also operated 229 quick service restaurants that offer Subway, Quiznos, Hardee’s, Krystal, Church’s, Dairy Queen, Baskin-Robbins, and Bojangles branded food products. The Pantry was founded in 1967 and is headquartered in Cary, North Carolina."

So what piqued my interest about PTRY?

Considering that a P/B of less than one is a condition that I look at a stock, the degree to which it is below one is important. Also, I tend to prefer companies that operate on a simple business model and are relatively asset intensive. The Pantry seems to pass both qualifications, so it's on to the next step.

Let's Break it Down

Before I talk about the operational fundamentals of the company, I'll speak to it from a strictly asset perspective. PTRY owns the real property at 396 of their stores and leases the property at their remaining 1,277 stores. Looking at their balance sheet, assets primarily fall under cash (6.7%), receivables (3.6%), inventory (4.9%) and property plant and equipment (PPE) (55.8%). Goodwill (24.9%) and intangibles (1.2%) from acquiring other chains and stores also make up a large chunk of total assets.

When looking at the raw assets, I think it's important to remember that GAAP requires assets be stated at the lower of cost or market, so unless there is/was an impairment charge or the asset is exchange traded, the book value is the cost at which it was acquired netted of depreciation. I look at goodwill and intangibles as the least reliable assets on the balance sheet, mainly because these (a) aren't tangible assets and (b) could be dramatically overvalued if PTRY paid too much for a particular company (imagine the goodwill that Time Warner recorded when they purchased AOL).

The ideal investment for me is one where you can completely write off the book value of intangibles and goodwill and still have a P/B of less than 1. Unfortunately, PTRY doesn't pose as such an instance, so the next step is how much of an impairment on goodwill and intangibles that they can record and still be at a P/B of 1. I calculated this to be 31.35%, which if you ask me is a pretty safe error margin.

But What About the Company

One of the reasons that I restrict my screen to companies posting a profit is that I don't want to deal with growth companies or to speculate on whether a company can eventually make a profit. I should mention that in this P/B less than 1 environment, I feel that the scruples that need to be placed on the company are less strenuous. I don't feel the need to find a convenience store that's going to outperform other convenience stores. Rather, I simply want to find a company that is going to make all of their debt payments and perform at an adequate level until the market can re-evaluate it at a more favorable value.

In their 10-K, PTRY noted that 35% of their stores are "located in coastal/resort or tourist destinations, areas such as Jacksonville, Orlando/Disney World, Myrtle Beach, Charleston, St. Augustine, Hilton Head and Gulfport/Biloxi", and that 25% are "situated along major interstates and highways". While there's probably some overlap between those two numbers, I was impressed by a cogent and well articulated investing thesis that management presented.

This strong tourism exposure gives PTRY more "cyclicality" (e.g. more tourists during the summer) and helps explain why the stock has been beaten up in a down economy as people have shunned extracurricular spending. While I wasn't a big fan of the "Kangaroo" logo and brand, the company emphasized that they had "re-imaged" 80% of their stores in the past four years to make them well lit, clean and better looking, and that in 2009 they spent $14.8 MM to remodel 110 stores.

Part of my concern was what type of gas was sold at PTRY's stores, since from my personal experience the quality of the gasoline makes a big difference. In their 10-K, PTRY notes that of their stores, "68.9%, were branded under the BP, CITGO, Chevron, Shell, Texaco or ExxonMobil brand names". This assuaged my fears that they were selling mostly trashy gas.

I also was impressed by their IT commitment, which in the convenience store space I see as being useful, but not necessarily essential. PTRY notes in their 10-K: "In fiscal 2010 our technology focus will be on completing our point of sale upgrade and enhancing our ability to capture detailed merchandise movement data. We also anticipate upgrading our merchandise pricing system in fiscal 2010 to enable us to execute a greater number of pricing zones. In November, 2009 we established the position of Chief Information Officer and named Paul M. Lemerise to the role. These investments in information systems infrastructure are a key component of our strategy to optimize store level performance." I feel that this commitment to a "smarter" inventory management and pricing system will lead to better margins and potentially less spoilage of inventory.

Cash Flow Analysis

In FY 2009, PTRY had operating cash flows of $169 MM, CFs from investing of $(166) MM and CFs from financing of $(50.7) MM. This led to net CFs of $(47.7) MM.

Breaking down their operations, it's clear that the gross margins on gasoline are very little (6%), and are more to give you the margins you get from the convenience store (~35% gross margins). The Pantry spent $122.6 MM on additions to property and equipment and and $48.8 MM on acquisitions of businesses net of cash. If PTRY had cut off the acquisitions and toned down the PPE additions, which were still well above the FY 2009 depreciation charge of $109.6 MM, they would have had net positive CFs for 2009.

Looking forward to FY 2010, PTRY is going to have obligations of $129 MM coming due, which includes operating leases, financing leases and long term debt. Interest payments of $35 MM are also slated to be due, but since this is less than the $80 MM they experienced in FY 2009, I didn't think any additional amounts were needed to be taken out for consideration.

If The Pantry were to turn operating CFs in 2010 equal to those in 2009, this would unfortunately only leave $40 MM available for investing activities if PTRY hoped to turn a positive net CF in FY 2010. This seems unreasonable at best. However, if next summer yields a more favorable spending climate (in line with PTRY's seasonal cyclicality), and PTRY is able to grow revenue and/or increase margins, this might be possible.

This is of course presuming that PTRY has the exact same operating CFs for 2010 as they did for 2009, a less than realistic assumption (erring dramatically on the conservative end in my opinion). It does provide an interesting benchmark, and in the current economic climate, with the exception of a double dip recession, and unless they can't create positive value from their acquisitions from 2009, I think it is a very baseline assumption for operating cash flows. In addition, I feel that their cash reserves and untapped revolving credit line provide an additional cushion that should allow them to survive any temporary short term difficulties.


I would give PTRY a buy recommendation. I have a positive macroeconomic perspective for 2010, and I feel that this will positively effect the regions and industries that The Pantry is most exposed to. Management seems to have a very good handle on what must be done, and the excellent degree to which they were forthcoming about the leverage that they had taken on and the risks inherent in their business made me feel that they weren't trying to pull a fast one on investors. With 98% percent of their shares held by institutions, I feel like this is a very good bet.

That being said, I wouldn't say that this is a "buy of the decade". The volatility of crude prices and their exposure to interest rates through $419 MM of floating rate long term debt make them more exposed to risks that they don't have a competitive advantage in taking than I would like. While they noted that a hedging program is in place to protect from interest rate movements, it would be nice to see them develop some sort of program for protecting against sharp movements in crude oil prices.

As electric cars begin to be phased in and American demand for gasoline presumably decreases, I only see competition in this sphere getting more intense. From the best I can tell, their business model seems to be based on selling higher margin convenience items to customers while they're purchasing much lower margin gasoline. While I don't see this business model becoming ineffective in the next 3 to 5 years, I would be concerned about holding on to this investment for too long.

If you want to see the spreadsheet for the analysis that I did, check out the below
PTRY Analysis

Monday, January 4, 2010

How Legitimate is Ben Bernanke's Concern Over a Weak Dollar?

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Or to rephrase: what actions will the Fed potentially take to stop a sell off of USD? A few months ago Bernanke mentioned that they were "monitoring" the dollar's strength. Presumably, this statement was to suggest that the Fed would help protect the dollar if it kept getting slaughtered in Forex markets.

The layman looks at the exchange rate of the dollar as a bearing on the strength of the U.S. economy, and I've anecdotally seen it take on a national-pride role. In more complicated terms, a weakening dollar can either mean changing inflation expectations (toward higher inflation), an exodus from dollar denominated securities and/or U.S. debt, or simply more dollars entering circulation (i.e. "actual" inflation).

When the dollar starts to falter, dollar holders, but especially foreign dollar holders, start to get concerned. Take for example China. A large chunk of their sovereign wealth is denominated in dollars. This works for trade reasons (they do a lot of trade with the United States) and to help ensure confidence in the Yuan, which is unofficially pegged to the dollar. But it has led to public concern on the part of China (specifically PM Wen Jiabao) as to the security of their investments.

On the plus side, when the dollar is weak, exports and manufacturing get a boost. For example, the market moving story today was the Institute for Supply Management’s factory index rising to 55.9 where above 50 indicates expansion (this is the highest the index has been since 2006). After having done research on steel companies, Goldman Sach's conviction buy rating for U.S. Steel Corp. was partially because of a weak dollar environment.

After the market's positive reaction to the manufacturing report, and Bernanke's previous concern that unemployment might erode a U.S. recovery, I would not be surprised if the Fed put dollar strength on the back burner except in extreme cases, in favor of promoting job creation and strength in the manufacturing sector. In light of the U.S.'s forays into car companies (read: Chrysler and GM), a weak dollar climate might be great for taxpayers, too. Because of this, I see the positive manufacturing report as a signal of more to come rather than a one time event (in terms of monetary policy implications).

Too-Big-To-Fail and Psuedo-Government Agencies: Do You Wind Them Up or Wind Them Down?

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It's hard for me not to have some burst blood vessels when stupid actions by people that cause a lot of damage go unpunished.

Socially, I'd say the job is pretty much done. If you were calling the shots at any of the really government entrenched companies (Fannie Mae, Freddie Mac, GMAC, GM, AIG, etc.) or the meh-government entrenched companies (big banks like BofA, Citigroup, and then to a lesser degree any of the other institutions receiving TARP), you probably don't talk about your job history much outside of the house. Whether it be for fear the Barista at Starbucks might not secure the lid on your coffee as she hands it to you (read: throws) or that the townspeople might burn you in effigy in front of your house a lá the KKK, I feel that socially and culturally a lot of decision makers have likely suffered their backlash.

But I feel like there's an "eye-for-an-eye" principle, where if you lose money, you want the person that lost that money for you to lose more. This is more of a gut instinct than a rational, thoughtful consideration. With the financial system, where everyone is fishing from the same lake, it's hard to tell who might have polluted the lake with sketchy fishing tactics, and who is a victim of the polluted lake now and didn't really cause it. Nancy Pelosi would probably say all the major actors (read: banker fat cats) were responsible. I think the right answer is more nuanced (sweeping generalizations, while helpful for making quick decisions like who to get behind in line, rarely work on the national policy level).

When it comes to GMAC, Freddie and Fannie, all recent newsmakers for their profit making difficulties, it's hard not to get upset about the situation that got them to where they are: sucking at the teet of the Federal government. Fannie and Freddie: ok, having the essential guarantee that they would never go under probably led to some moral hazard. My question is whether making this at one point implicit guarantee explicit, along with the commitment to offer unlimited assistance for the next three years, is actually making things any better. Did GMAC need their recent $3.8 billion infusion? Yes. But did the United States need GMAC to receive that $3.8 billion infusion? That's a really difficult question.

Which of the governmentally held companies offer hope at one day/soon making a profit and being resold, and which need to be broken down and the pieces sold off? I might stick AIG and GM in the "hope" category, and GMAC, Fannie and Freddie in the "no hope" section. I think a lot of the changes that have been happening at GM have been very positive, and AIG, presuming it serves more to be a holding company of subsidiaries whose names don't ring of "AIG", is on the right-ish path as well.

But do you give GMAC the ability to go on making new loans when they've established a track record of being terrible at it? I don't think so. I would say you service the loans you've already made, do your best to salvage what you have on your balance sheet, sell off the chunks that people want (Warren Buffet spoke of acquiring a part of ResCap, GMAC's real estate lending division), and then wind it down. Otherwise, my concern is that congressmen, stuck with this black hole, look at it and say: "well, let's promote lending for the common good so I can get something out of it". This would probably be loans to people in serious need at below market levels and people that typically do not fall under the umbrella of "credit worthy".

There is a huge threat that this will happen at Fannie and Freddie, who basically make the mortgage market work. I see the value in Fannie and Freddie underwriting a lot of the mortgages out there, but not if it's in a way that's negative NPV. With governmental agencies, in perpetuity I would see it being very difficult for them to be profit making as they become a more established part of the bureaucracy. For this reason, I think the government and the Treasury Department need to look at their portfolio and say "wind up" or "wind down". Not all bailout companies should be treated equally, since they don't all equally have shots at being profitable. The status quo doesn't work. If it continues, these companies will simply become a part of the sausage making process.

Sunday, January 3, 2010

Oh Great It's Back

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For a time (mainly from June 2008 to June 2009), I ran my blog I had a really great time doing this, but by a combination of the time it took to run it and the cost to do it (not that expensive, but it certainly wasn't free), I decided to let the blog shut down when my web hosting agreement expired.

Thus my blog entered the dark ages, a time when I had no venue to let my pixelated voice echo throughout the empty halls of the internets *suffering*. I decided on a whim to restart the blog on blogger, so this must be...the renaissance?

My goal is to discuss current topics in finance, business and investing, with no specific focus on any one topic. I hope to provide a whimsical yet lucid perspective on the current environment, and my hope is that you will enjoy said voice. With that, I welcome you back to "The Sane Investor".