The 10% FCF yield club

When a company's business is easy to understand, offers a 10% FCF yield, provides steady and predictable profit year-in-year-out without oversize Capex, I get excited. If it can grow its cash flow in line with nominal GDP growth, it can easily offer 15% p.a. return. 15% has been Buffett's hurdle rate throughout his investing life. This is the "good enough" mentality that both Warren Buffett and Ben Graham advocate. If it's good enough for Buffett, it should be good enough for me.

What's interesting here though is I started looking at one company which led my thoughts onto another company which led me onto another one... And I ended up indecisive....

Let's start with Lamar Advertising.

Lamar Advertising

• Company: Lamar Advertising (NASDAQ:LAMR)
• Market Cap: $2.55B
• TTM FCF yield: 9%
• Business: The 3rd largest billboard advertising provider in US
• Moats: Nothing can replace billboards for brand-awareness advertising. Highway Beautification Act (1965) limits the number of billboards that can be built. This is pretty close to Buffett's "toll booth" type of business.
• Positives: A gradual recovering US economy will improve both occupany and rates. LAMR will also be able to refinance some of its debts in the coming years with lower interest rates.
• Negatives: Cyclical business. Very high debt. FCF interest cover is only 2.2x. But the mgmt has been prudently using all of the FCF to pay down its debts in the last 3 years. Yet, there is no gaurantee the mgmt won't do another debt-fueled acquisition in the future.

My biggest hesitation here is the 2.2x interest cover. It is quite a stretch on my comfort level. While LAMR's cashflow was pretty stable through the GFC, considered that its advertising contracts are typically less than a year long, I'm not sure how much shock such a highly levered balance sheet can take. My issue here is safety.

While I was thinking about LAMR's advertising business, I remembered another advertising related company.

Omnicom Group

• Company: Omnicom Group (NASDAQ:OMC)
• Market Cap: $13.2B
• TTM FCF yield: 10%
• Business: Advertising agent
• Moats: Ad agent is a service business.When marketing campaigns get more and more complicated, the value of an Ad agent increases. Its moat resides in its sticky customer relationship. (e.g. Apple has been staying with one agent since Jobs returned. You can't say that for its semi suppliers. Btw, Apple's ad agent belongs to OMC.)
• Positives: Although debt/equity is ~1.0, interest cover is a comfortable 10x. 
• Negatives: This is cyclical business and profit moves in tandem with the economy. OMC has significant exposure in Europe. This is both a plus and minus. When Europe's problems fade, we shall see growth. But it may take years.

Next, I remembered Dun & Bradstreet Corp, which was beaten down badly in May after it released its disappointing FY2012 guidance.


Dun & Bradstreet Corp

• Company: Dun & Bradstreet (NYSE:DNB)
• Market Cap: $3.22B
• TTM FCF yield: 8.75%
• Business: Data provider of business records and credit history
• Moats: When the database you provide is essential to other people to conduct their businesses and when its size gets to a certain critical mass, its economics benefits from a form of network effect and becomes self-sustainable. This is the kind of business an idiot can run.
• Positives: But DNB's mgmt are not idiots. They don't chase unattractive growth for the sake of it. They return cash back to investors in the form of share buybacks.
• Negatives: Business isn't growing in the recent years. Can it really grow in line with the economy?

At this point, I asked myself, why all these troubles? Why don't I just add more to my existing Microsoft position?

Microsoft Corp

• Company: Microsoft Corp (NASDAQ:MSFT)
• Market Cap: $252B
• TTM FCF yield: 11%
• Business: software
• Moats: MSFT has 2 undeniable franchises: Windows and Office. Both are essentially annuity kind of business.
• Positives: Truck load of cash. ROE in the range of 40% without using debt. Growing steadily 8-12% p.a. over many years. On the corporate front, Windows 7 upgrade cycle will accelerate in these 2 years. On the consumer front, Windows 8 sales will provide additional revenues.
• Negatives: Given its size, growing will become harder and harder. Cloud-based computing and mobile computing both threaten MSFT's franchises. There is also the risk the mgmt will destroy value on poor acquisitions.

I'm pretty comfortable MSFT can defend its turf. It may even be able to leverage its dominance into offering more cloud-based solutions and mobile solutions than everyone can imagine.

No matter how I cut it, MSFT looks like a superior investment to the rest. My conviction is high.

Charlie Munger always says diversification is diworsification. My dilemma here is whether I should diversify in order to reduce my exposure to one single company. No matter how high my conviction is, there are always "unknown unknowns". There is also this unhelpful thought urging me to divest: "Earning outstanding returns requires hardwork. If I keep on adding to just the same old position and not spending time to dig deep into other companies, I'm not working hard enough." (I haven't yet done in depth analyses of some of these other companies. If I end up staying with MSFT, this won't be the best use of my brain power and time.)

I'm really interested in your thoughts!

 (Disclosure: Long MSFT)

Value of the century - the Aussie edition

I spent some time last month combing through the bottom end of the ASX market, looking at companies with market cap less than A$300m. I haven't found anything worth investing so far. Then, last night I saw Whopper's post ACGX: value of century? I just couldn't resist and decided to write this up for your amusement.

Details at a glance:

• Company: Richfield International Limited (ASX: RIS)
• Market Cap:A$1.6m
• NACV: A$6.3m, mostly cash!!
• Business: It operates shipping services in Singapore. It used to operate trucking services years ago.
• Profitability: Mildly profitable or break-even most of the years.
• Dividends: Never in the last 8 years.
• Insider ownership: 72% controlled by the directors

So, here you are. A crazy pile of cash. Buying a share of RIS is buying 25 cents dollar. Or, to flip it around, you are getting an instant 4 bagger. While the value isn't as extreme as Whopper's ACGX, RIS is a listed company with audited accounts and regular filings.  

What's the catch?  

I have serious doubt the company exists mainly for the purpose of running a business. It looks more like the directors' tax shelter. It's basically their family's piggy bank. The most likely end-game I can foresee is, when the business dries out, they will shut down the operations and gradually draws down the cash pile as salaries until it reaches zero. Well, there is no certainty. They may declare a surprise special dividend or announce someone tendering for the company. But I won't bet on it.


(Disclosure: No position)

Will PGNT become a mini replica of BRK?

No, Paragon Technologies isn't Berkshire Hathaway. But the current situation shares some interesting aspects of the old BRK when Buffett bought it in 1960s.

PGNT is a $4.3m microcap. It provides conveyor systems for assembly lines and order fulfillment operations. It lost money 7 out of 10 years between 2001-2010. Current share price is ~$2.8 while it has a NCAV of $3.25 which consists mainly of cash.

Normally I would quickly dismiss companies without a track record of making money. However, I noticed Sham Gad, a value investor, was involved. I took a closer look.

Downside protection

Gad was elected to the board in 2010. He subsequently built up his position to 25% throughout 2011. In March this year, he didn't only take over the chairmanship, he also got the 2 directors elected. These are the 2 directors that he originally recommended in the proxy fight back in 2010. So, effectively, Gad has the complete control of the company.

Why is this important? This is important because it puts a very solid floor on our downside. Gad intends to bring the business back to profitability. After he gained a seat at the board, he managed to reduce cost and steer the business to break even in 2011. What will happen if he senses he can't achieve it? As a value investor, he won't have any emotional baggage. He will immediately liquidate the business. The liquidation process may not be smooth. But since the bulk of the assets is in cash, we should get back most of the $2.8 invested. The presence of a value investor collapses the range of possible outcomes to almost a single point if the business fails to deliver. This wouldn't be the case if it were the founder controlling the company.

Valuation

And what is our upside? We should consider this a turnaround and handicap it. I take a stab at this in the spreadsheet below:

(If your rss reader doesn't show the spreadsheet, you need to visit my blog directly.) 





Under the "turned around" scenario, I assume it requires a 1.0x quick ratio to keep the business running. Hence $2.75 cash can be distributed. I assume it can double its revenue, back to the level before GFC. I assume it can earn a generic 5% net margin. And I give it a conservative 8.5 P/E multiple. This gives us a valuation of $7.13 per share.

Next, we need to guess how likely the business can turnaround. Again, this is a wild guess and a pretty aggressive one. But one thing that helps is the recovery of the US economy is on our side. I put down a one-fifth chance. The rest of the calculation in the table is self-explanatory. We end up with an expected return of 42%. You can try to plug in different numbers in different places. But the general risk/reward profile doesn't change much.

(Another thing to be aware of is, the 42% return or the $3.99 value won't exist in the real world. We will either end up with one of the possible scenarios. There is nothing in between. The expected value is only indicative.)

Capital allocation

Why did I make reference to BRK at the start? This has to do with how Gad intends to use the cash in PGNT. I don't believe Gad will actually distribute the cash if the turnaround fails. Gad has lay down his intent in his chairman letter published in March:

Through a disciplined capital allocation process, we will examine ways to utilize the Company's assets to increase the intrinsic value of the Company.

This is how I see it. He will try to keep the business breakeven and plow any operational cashflow back into the business (e.g. in R&D) while waiting for recovery of revenue. At the same time, he will invest the cash pile in any opportunities he can find. If you are familiar with the history of BRK, this is effective what Buffett did to BRK.

Gad is a Buffett disciple. Investing in PGNT will feel like investing in BRK in its old days. You need to be comfortable to be Gad's junior partner to invest in PGNT.

Final thoughts


So, we can look at the investment case this way: At $2.8, we are basically taking a stake in Gad's managed fund and at the same time getting a free option on the PGNT's business.


The asymmetric risk/reward profile here is a classic "tail I win, head I don't lose much" case. This is "high uncertainty, but low risk". I think the market misprices it because everyone focuses on the middle scenario. I imagine many value investors don't dare to dream wildly on the turnaround possibility because this is not usually how one will reason a net-net.

p.s. I have no position because my capital is deployed and locked up in other places.

(Disclosure: No position)

SODI shareholders

If you are a SODI shareholder, please look at this post at Oddball stocks.

(Disclosure: Long SODI)