Gravity Co. LTD (GRVY)

Overview: 

Gravity is a company that creates and markets computer games. The most successful one is Ragnarok. The sequel, Ragnarok II (RO2), has been in the works for quite some time. With the company trading around a conservative liquidation value (cash+ST investments minus total liabilities) of $1.15/ADR (6.948M shares, 4 ADRs to 1 regular share) it could be an enticing buy or a value trap.

Investor Fatigue:

Just about nobody really wants to own a stock. The goal is to buy a company and sell it shortly thereafter. This universal renting of companies causes people and investors to lose patience and interest quickly. Some people are more patient than others. Value investors  tend to be more patient. For example, GRVY has been written up on the Value Investors Club four times total.   

"GRVY continues to trade well under net cash ($2.2 per share) with modestly profitable operations and a significant catalyst on the near-term horizon: launch of Ragnarok Online 2 (RO2) this summer. Company IR has now confirmed to me twice - including today - that RO2 will launch this summer (though there is some risk of further delays)."

That was in 2010. 

"But the catalyst for the stock, the release of the Ragnarok 2 (R2) multi-player online game, is now only months away."

That was in 2007. 

The statement "only months away" was true. RO2 was only about 60 months away from launch in Korea. If the analyst who wrote the article still holds shares, let me know. I'll buy you a beer for being so patient.

I'll do everyone a favor and not claim that RO2 is a catalyst. The continued deterioration of sentiment, poor management a few years back, and limited information means that GRVY often trades below cash. 

I like pessimism though. It creates something to launch off of. Five years of waiting creates a lot of pessimism, below liquidation value pessimism.

Are things really that bad?

Like I stated earlier, I have no idea when RO2 will be released across all countries. I think there have been some interesting developments though over the past 6 months. 

Q3 2012 BUSINESS UPDATES

Ragnarok Online II to be launched in two more markets in the first half of 2013

Gravity is planning to release Ragnarok Online II in North America and the Philippines in the first half of 2013 after its launch in Singapore and Malaysia in December 2012.

Steal Fighter to be launched in Korea in the first quarter of 2013

Gravity will launch Steal Fighter, an action real-time strategy role playing game, in Korea in the first quarter of 2013. Gravity entered into a license agreement with L-Time Games Co., Ltd., the developer of Steal Fighter, to publish the game in Korea in April 2012 and conducted closed beta testing in September 2012. The Company intends to launch the game in the overseas markets after its launch in Korea.

Ragnarok Online – Uprising: Valkyrie to be launched in China and Taiwan

Ragnarok Online – Uprising: Valkyrie, a mobile massively multiplayer online role playing game, will be released in China and Taiwan by the end of 2012. Gravity has entered into license agreements with local licensees in each market and the game will be available on iOS and Android platform. Ragnarok Online – Uprising: Valkyrie hits more than 600,000 cumulative downloads in Korea since its launch in May 2012.

Q2 2012 BUSINESS UPDATES 

Ragnarok Online to be launched in Singapore and Malaysia in the fourth quarter of 2012

Singapore and Malaysia are expected to be the first overseas markets where Ragnarok Online is to be released. 

The Company and AsiaSoft Online Pte. Ltd., the licensee of Ragnarok Online II in Singapore and Malaysia, have agreed to commercially offer the game in these markets in the fourth quarter of 2012.
 

Mr. Hyun Chul Park, CEO of Gravity said, “The performance of Ragnarok Online in Korea is below our expectations. However, I believe that we have overcome most of the technical problems in the early stages and that we are ready to release the game in the overseas markets where the game is eagerly anticipated.”
 

The service language of Ragnarok Online in Singapore and Malaysia will be English. The Company is also planning to launch the English version of the game in some other markets in the near future after localizing the content to tailor the game to local cultural preferences of each market.

Gravity strengthening its presence in the mobile game industry

Gravity has been enhancing its mobile game lineup by releasing more smartphone games with up-to-date technology, based on its flagship title Ragnarok Online. In particular, Ragnarok Online – Uprising: Valkyrie, a mobile massively multiplayer online role playing game for iOS and Android released in Korea is surging in popularity with more than 430,000 cumulative downloads in less than three months since its launch in May 2012. Ragnarok Online – Uprising: Valkyrie is a cross-platform game which allows users to play the game on one server regardless of their operating system.
 

The Company intends to release Ragnarok Online - Uprising: Valkyrie in other markets, such as China and Taiwan, in 2012 and more other smartphone games will be available later in 2012."

Okay, so in Q2 they said that RO2 would be launched with AsiaSoft in Singapore and Malaysia by Q4 2012. 

In Q3 they updated that the launch would take place in December in Singapore and Malaysia. 

Well on December 7, 2012 AsiaSoft is unveiling their next blockbuster free-to-play MMORPG. Looking through all AsiaSoft's nine other MMORPG titles it seems likely that release next week is Ragnarok II.  Maybe not though, we'll see.

I've seen some good reviews for ROII, and there are forums dedicated to when an English version of the mobile Ragnarok will be available. Whether or not this is indicative of future success is unknown to me.

Ragnarok Revenue Tail

Even without the release of RO2, the company is doing alright. They are similar to land line providers: dying, but very slowly. On page 8 of their most recent 20-F, the company claims that users for ROI peaked in the first quarter of 2005. They also supply a lot of information about their users. From an ARPU (Average Revenue Per User) basis, RO makes Farmville look pathetic. 


While ARPU has declined from $744 in 2009 to $313 in 2011, total Average Current Users (ACU) have increased. The largest user increases occurred in Taiwan/Hong Kong, while Japan has declined ~9-14% per year. This isn't good because the average Ragnarok user is worth about 18X more in Japan than in Taiwan. Even so, it's not as if Ragnarok revenues fell off a cliff.

Japan is very important to the long term success of GRVY and the Ragnarok franchise. In the short term Malaysia and Singapore are not that important, at least using backwards numbers. A successful launch could inspire confidence though. 

Perhaps the game is released and it does OK and they release to North America in 2013. If that happens, awesome. We've got a company that should produce positive cash flow. If not, well at least we have a lot of cash and a bunch of user who are still playing the game.

Is it Worth an Investment? 

I believe it is. The key here is that the player base is sticky and a conservative liquidation value has stayed (basically) the same (it was $1.20/ADR in 2010) for the past several years. It seems unlikely that a permanent impairment of capital could take place. 

The company as a whole has been able to expand beyond Ragnarok. Ragnarok was 88% of sales in 2005 and at the end of 2011 only made up 66% of sales. The company saw overall sales increase by 7% for the same period.

It could very well be a value trap and opportunity cost is real. Right now though a company that is trading for its liquidation value, still generating cash (admittedly from an attriting business) and someday may deliver on it's promises seems like a safe bet. I believe this is an asset play for now. If RO2 (or other games) get released more accurate valuations/exit price can be determined. As always, do your own research and come to your own conclusions. Long GRVY.

EVI EnviroStar

This will be a brief post as the story is simple and the investment has largely played out.

I've followed EVI for a couple of quarters but never purchased shares. They had a decent(profitable) business, large insider ownership, and good asset protection. I shoulda, woulda, and coulda bought when the company was trading below $1.30/share, but I didn't. Instead I waited for them to offer a special dividend of $0.60/share(not on purpose). Here's my thought process, all figures are from their respective 10Q.

As of 9/30/2012 there were 7.033M shares outstanding.  They had $10.397M of cash on the books with customer deposits of $4.997M. Net cash therefore is $5.4M or $0.76/share. They will pay out $0.60/share, or $4.2M as a special dividend in December.

Right now they have a tangible book value of $8.387M, paying out the dividend will reduce that to $4.16M, most of it will be working capital. 

So what's a fair value?

They have a four year average of generating $0.58M of free cash flow (net income plus D&A plus non-cash items minus CapEx). Slap a 10X multiple (arbitrary choice) on that and the operating business is worth between $5-$6M, or $0.71-$0.85/share. Sprinkle in BV of $0.59/share ($4.16M of post-dividend BV) and you get a post-dividend value of $1.30-$1.44/share.

With EVI currently at  $1.95, the post dividend share price should be $1.35, meaning we're in fairly valued territory now.

Is there more upside?

Potentially, yes. Backlog has increased to "historic levels" this quarter and I would be willing to bet owner-operators like the Steiner family could allocate capital efficiently. If the price of the shares pops again, I will likely be a seller. Should we hit my initial buy prices in the low $1.60's I would be willing to buy more.

This could be interesting to revisit post-dividend in case the market over-corrects to the downside. Long EVI

ADES Update

Charlie Munger has said that if an investor can't stomach a 50% loss they shouldn't be investing. I'm about half-way there with ADES and Munger's pain threshold. I thought now would be a good time to review the investment and determine future actions. In the efforts of full disclosure, funds I manage are long ADES. I have not backed the truck up though.

What's happened?

Well not much and that is the problem/reason. I think investors were expected a quick acceleration of profits. People are not seeing results and are clearly frustrated. I must admit that I thought things would be moving along faster as well.

Michael Durham highlighted this frustration in the Q3 call:

"But just the optics if you don't look beyond initial quarter what you see is that $3 a ton expense that leads to significant loss this year even though that is creating a $7.57 per ton cash benefit in the future. That doesn't show on this quarter. So if you look at an investor who is only looking at the headline they're going to miss that. So, I think until we get additional monetizations and you see that slip from the big expense to the big segment income and then an earnings the investment community is not going to understand the story."

The key point of frustration came with the company announced results this past quarter and once again it lost money. They failed to monetize two of their plants and several other plants are taking longer than expected. This was seen as a strike against management, and rightfully so. Management has promised to deliver for several quarters now.

The story is still confusing and management is losing credibility. If you listen to the Q3 conference call it's clear that several of the analysts asking questions are confused. And not just about simple things, but about the entire structure of ADES and Clean Coal Solutions(CCS).

Is Mr. Market right?

An investment in ADES is not going to be based on BV, safety of assets or something typical, which I think makes these issues all the more difficult to weather. Is the sell-off due to frustration and only a temporary hiccup, or is the business permanently impaired?

Based on the 12 plants that I have been able to track down and the numbers I have backed into, it doesn't matter if the company gets their RC facilities up today or in 24 months. A company that has an earnings yield of 25-60% is cheap with even the greatest discount over a two year period. There has been no change in the overall numbers, simply the time it will happen. Sixty million tons of RC coal should be processed and management is hunting for larger plants to process even more. So if they fail at 1/2 their plants they'll still process 30M tons. At $1.60/ton flowing through to ADES the company will still see $48M of EBIT.

This assumes that the entire Emissions Control business does nothing. Which is unlikely, they have >$100M of bids out there and were recently awarded a $14M contract for DSI systems and expect to announce several longer term ACI contracts soon.

Yes, coal is terrible and Obama is the coal Antichrist, but 42% of electricity generated in the US depends on it. Hurricane Sandy taught everyone on the East Coast just how valuable base load power is. It's not going away.

So right now this seems to be a time issue, and if the plants are monetized in the next couple of years it really isn't a big deal. The question is, how do we handicap the likelihood (or lack thereof) of monetization?

I don't have an answer for that question. It's a difficult one to answer but I can rely on some of my research to back my belief that monetization of RC facilities will occur.

We learned that the two plants that were supposed to be monetized by now, are not. These plants are actually costing CCS ~$3/ton in operating expenses. If they monetize them that's $18M of cash going into CCS(Q3 '12 Call). So that's the basic math there, approximately $7/ton difference between self-monetizing plants, and getting an outside monetizer(CCS sees over $3/ton go to them instead of booking a tax credit and a operating losses).

So why didn't Goldman or the other partner become the monetizer? We know that GS was expected to monetize these two plants. How?

"In October 2012, GS determined that it would not pursue leases on two particular RC facilities on which it had paid deposits totaling $4.7 million and concurrently gave notice for the return of the related deposits. "  pg 24 10Q Q3 2012

GS wants their money back, right?

"While, as previously noted, GS has given notice for the return of deposits in the amount of $4.7 million, which we are obligated to return by January 30, 2013, we anticipate that this amount may be offset by deposits for additional RC facilities that we expect to receive from GS in the near future." pg 33 10Q Q3 2012(emphasis added)

GS, a 15% owner in the CCS JV, decided not to pursue two facilities. Facilities which only add up to about 2-3 million tons of coal per year(per ADES management on the Q3 call). We know that CCS is pursuing gulf coast lignite (and pulverized) coal burning facilities that consume up to 8M tons of coal per year. Me thinks that GS is waiting for a bigger and better plant.

Another problem is getting a Private Letter Ruling(PLR). I wanted to figure out how much of a hassle these are so I chatted with a gentleman who has approved numerous Section 29 PLRs and at least five (that I was able to find) Section 45 refined coal PLRs.

"We aren't ruling on who benefits. The only question is does it qualify as refined coal?" -PLR reviewer IRS.

The reviewer wouldn't go into great detail but it literally sounded as simple as this: if the process qualifies as refined coal then the PLR will be granted. This has been done already at multiple plants with Arthur Gallagher/Chem-Mod and CCS.

We know that at least 14 plants have RC facilities built out by Helmkamp. I inquired about a facilities operator job at a PRB coal plant in North Dakota. Although I didn't get the job, I can confirm that there are real people on the phones interviewing people. Several environmental directors of utilities also said it works, they like it, and will keep on using it. These things indicate to me that all the facilities are real, working, and actually staffed.

Bottom Line


This looks like a "shoot first, ask questions later" reaction. Listening to the call I was confused too, mostly from the poor questions. It sounded like people have no idea what ADES does as a company. I was surprised that someone asked what kind of technology M-45 uses.With all that said, I also think management has done a poor job explaining how it all works to the community and tends to tell confusing numbers that you have to really dig into.

Overall, the call led me to believe that there are two inefficiencies here. The first is that people don't understand the technology and the structure of the company. That, in turn, leads to the second inefficiency. When things don't perform as expected (i.e. immediately when management says so) the only answer is to get rid of the "failure." I personally don't believe we have to believe in management to see success in this investment. All the wheels are in motion and the success of the projects are not dependent on management.

I think all signs point to good things, if the monetizations occur. I see no reason why they won't occur. Yes, it's taking longer than expected. That's what happens when investment bankers and utilities get together and play Let's Make a Deal. I believe the delay is ultimately for the better though. I believe that GS did not monetize two plants due to a lack of belief or failure, I believe they wanted to be part of better plants with better operating costs. Over the next quarter or two we will see if my belief is correct.

Of course, I could be missing something as well. It is obvious that management was overly optimistic but if the RC facilities aren't monetized the cash flows will never be realized. I have found no information to indicate that the eventual monetization won't occur. For me, this is about patience and reliance on my multiple sources. Long ADES and hoping for continued volatility.

ADA-ES (ADES)

I find it harder and harder to predict macro trends. Perhaps everything will work itself out with time. Perhaps there will be inflation. Perhaps there will be deflation. No matter what happens I want to find an investment that can generate cash flow in any scenario. Right now, I believe that ADA-ES (NASDAQ: ADES) can do just that.

Business

ADES develops technologies and services that companies can use to lower their emissions. They operate in three segments, Refined Coal (RC), Emissions Control (EC), and CO2 capture.

Refined Coal

Thanks to Section 45 (part (7)) the renewable tax credits are extended to Refined Coal as long as there is a reduction of >20% of nitrogen oxide and >40% of either sulfur dioxide or mercury.

ADES designed materials that could work in cyclone reactors to reduce mercury via a halogen bonding. They have since updated it (M-45) to use urea, just like Hug Engineering does in heavy duty diesel trucks. M-45 is designed to work in fluidized bed reactors, which gives ADES a much wider range of coal power plants that they can help.

This is the cash cow. Each facility generates on average $3.3M in operating income. That's based off of 15 facilities and a run rate operating income of $50 million per year. ($50M/15=$3.3M). If we take the $50 million segment income and run a discounted cash flow we can see how undervalued this is.

If only those facilities get up and running the math is simple. 15 facilities will run from 2013 until 2021, 2 will be shut down in 2019 (they opened up two years earlier than the rest ). Therefore for 2013-2019 could see operating cash flow of $50 million. 2020 and 2021 will see operating income of $46 million. For 2012 I've taken my estimate for operating income of the RC segment, which I peg to be around $19 million on a maximum capacity of 30 million tons of coal (Q2 2012 Conference Call).

I believe this is conservative because in the Q1 2012 Earnings call management said "Based on the progress with the first 15 units, we expect that our RC EBIT run rate will exceed $25M per year by the end of the second quarter, and we are comfortable with the guidance that by the end of 2012, expect the RC facilities to be generating pre-tax income of $50M per year.

So I've done a sample model. I believe that operating income could look like this...
2012: $19M ($25M EBIT run rate is 12.5M for H2 2012, plus the $7M for the other two facilities)
2013-2019: $50M
2020-2021: $44M
Discount rate 12%

NPV of operating income is $251M

Remember, they have the right to 28 facilities. The model I've constructed brings the remaining plants up slowly over 2013. I estimate (this is a guess at best) that operating income in 2013 will be around $67 million. What's great here is that barely any more facilities have to be up and running to get a decent value.

If all 28 facilities are up and running I estimate a NPV of $397M, again using a 12% discount rate.

Goldman Sachs bought their 15% JV portion for $60M. ADA-ES owns 42% of this giving ADA-ES roughly a 3X larger stake than Goldman. So Goldman must believe that ADES is worth at least ~$180M.

Using a couple of points of data we can fairly safely say that the RC segment is undervalued. Insurance company Arthur Gallagher (AJG) apparently thinks there is significant value in modified coal with their 42% investment in Chem-Mod. AJG has 29 investments in LLCs that control coal plants.

What does AJG think they will make for income?

In an April 11, 2012 conference call, AJG believed that they could generate $16.5M per quarter in after tax profit from their clean energy investments.

"We’ve put this in a tabular form here, and again what I’ve done in the first two columns is I’ve just recapped that we’ve got 29 plants, that we’ve got 31 to $32 million invested in, and we believe that the earnings that will run through the P&L ultimately can be about $16.5 million per quarter in net after-tax earnings to Gallagher." April 11, 2012 Conference Call

$66M/year isn't too bad for 29 plants. From slide 20 they believe that ultimately Chem-Mod could reach ~150-200 million tons of coal per year, with the 33 qualified plants owned by other investors contributing 100-140 million tons per year.

Therefore, I believe that AJG has directly invested in capacity of 50-60 million tons per year, which is roughly in line with what ADES has. The CFO of ADES told me that they are expecting about 50 million tons per year of RC as their baseload projection. Depending on a couple of factors this could rise up to 70 million tons of RC per year.

On page 47 of their 10Q they believe that 12 of their plants (2009 era plants) could potentially generate ~$4.3M of net after-tax earnings per quarter through 2019. Their 2011 era plants (5 total) are expected to generate $8.0M of net after-tax earnings per quarter through 2021. Annualized this works out to $49.2M....which is pretty close to my math for 15 plants. I will claim this as further confirmation bias.

While it's hard to drill into exact numbers with each plant I don't think it's necessary. A back of the envelope calculation will get you reasonably close and keeps returning you to the same conclusion: RC should generate significant cash flows for ADES.

What happens if coal prices rise or fall substantially?

In my conversation with the CFO it was made quite clear that these amounts will not fluctuate for ADES. While ADES may not have any upside (downside) like a monetizer such as AJG or Goldman has if coal prices go up (or down), they will continue to have predictable cash flows as long as they execute. I think this is very important in today's monetary environment.

One final point worth mentioning about RC is that it controls mercury at no cost to the utility. While not every plant in the country will benefit those that can take advantage of RC, reduce mercury, and save money will likely do so. I can't think of a plausible economic reason not to.

Other Business Segments

There are two other segments to ADES. Enhanced Coal(EC) and Activated Carbon Injection/Dry Sorbent Injection make up Emissions Control (ACI/DSI), and CO2 capture. The later is still a science experiment but is not costing the company money. I spent very little time researching CO2 capture and consider it a free call option.

The other two segments will not generate the absolute cash flows that RC should generate, they still could be significant thanks to the Mercury and Air Toxics Standards(MATS) program.

MATS requires compliance by 2015. Their CFO said that he expects orders to start flowing through next year.

There are several ways to become compliant and each method of compliance will not be a one size fits all solution. While some plants can use scrubbers to become compliant they also will spend $100 million or more for the luxury.

As luck has it, EC ACI, DSI, and EC all offer emissions control for much less money.

DSI is an effective method to reduce emissions and has been used for over 20 years. ADES expects to install over 200 DSI units at $3 million per unit.

ACI is a well known method for reducing mercury. It's so well known that ADES is paying royalties to Norit for the activated carbon it sells. This is a razor/razorblade business that only costs $1 million for equipment and then recurring activated carbon. There are some issues with using activated carbon though so between those problems (explained below) and the royalty payments ADES wants to get away from this. They still expect to sell about 600-700 ACI units over the next three years.

EC requires no capital equipment but results in about $2-$4 million higher fuel costs. Basically EC is a bromine additive applied to the coal (either at the mine or at the plant). Plants will see $1-$4/ton savings by using EC compared to methods like ACI. Some plants will sell their fly ash to cement manufacturers and clean fly ash is worth about $1-$2/ton. ACI does not produce clean fly ash(but there is research being done into making low carbon fly ash).

EC also allows a wider range of coals to be used, so additional savings can be seen by plants choosing to use cheaper and dirtier coals.

ADES has made the bankrupt Arch Coal a believer in EC. Arch made an investment in ADES to get the right to use EC at their mines. Luckily for ADES investors, EC is not limited to just Arch Coal. ADES has the right to offer EC to anyone else. This is good if a plant wants to choose alternative coals but still benefit from EC.

Arch could potentially treat 140 million tons of coal per year, according to the CFO of ADES. At $1/ton to ADES let the imagination run wild.

Valuation

One could slice and dice valuations (as I have) all day long. I'll try to keep this simple.

RC should generate at least $50M in operating income in 2013

Emissions control could see an average of $100 million in revenue per year for the next three years (the CFO repeated that number and walked me through some of the logistics). At 25% operating margins this works out to $25 million in operating income.

I'll assume CO2 capture remains a science project but neither hurts nor helps them.

My base case indicates $75 million in operating income, less $20 million in corporate SG&A (to be conservative, it's currently at a $16 million run rate) and a 10% corporate tax gives you earnings of around $50 million. Not bad for a company with a $240 million market cap.

Slap a 10X multiple on it because of the recurring stable cash flows for a few years and a fair value for the company could be around $500 million. A dollar selling for 48 cents. This is my base case but I think there is a lot more upside. It really doesn't matter, I just wanted to show that it's cheap.

Risk Factors

An investment in ADES is not one for the faint of heart. I can think of many things that could go wrong and will try to spell them out as clearly as possible. Ultimately, I find it difficult to believe that ADES isn't on the verge of generating significant cash flows.

1. If coal does become an economically unfavorable fuel (due to MATS there is the chance that some plants will shut down. For the RC segment this may not be a big deal. AJG spells out the risk of coal demand sinking in a clear manner.

"Page 37 – there’s a lot of questions that happen—what is the likelihood demand of coal? We do run the risk that some of these facilities will want to displace coal with natural gas. They could choose to shut down their utilities—excuse me, shut down these plants. These plants are portable. We can move them to other utilities, so if we have a utility that shuts down, we would pull them out of the housing and connections. That would probably cause a write-off of 2 to $4 million, and we’d move the plant into a different location hopefully at a utility that would continue to burn it.

Page 38 is a graphic where we show here that it’s projected through 2035 that the U.S. demand for coal actually may rise slightly. As total consumption—as total need for electricity increases, coal in this graphic looks like it will be a viable part of the U.S. energy source for a long period of time.

Page 39 shows you they’ve been burning about a billion tons of coal in the U.S. per year for U.S. electrical generation for a long time, and if that happens for the next 10 years, we should be in pretty good shape." April 11, 2012 Clean Energy Conference Call

It's worth mentioning that coal provides 45% of the electricity in the US. Not all coal plants can convert to natural gas, so coal needs to stay economically favorable or the US risks massive energy shortages. 

2. Right now ADES has 8 plants up and running, with another 9 coming online soon. If the additional RC plants don't receive PLRs (Private Letter Rulings) from the IRS

3. I think another risk will be the amount of cash coming in. What will management do with the money if they start generating the amount of cash they expect to? I don't really have a great understanding of the capital allocation abilities of management.

Insider ownership hopefully will stay high and I can only hope that capital allocation follows insider ownership. CEO Michael Durham owns 244K shares, which is roughly 6X his total compensation in 2011. CFO Mark McKinnies owns 86K shares, equaling 4.7X his total compensation. COO Jean Bustard owns shares worth 4.8X her total compensation in 2011. 

For these three executives at least 20% of all their shares are held in a pension account. While I have no idea what their pension fund balances (individual) are, I feel good that this motivates them to act as long term business owners. 

4. Political Risk is high here as well. Perhaps a new administration or Congress decides to totally ax the tax credit. Perhaps the EPA is overruled on MATS and coal plants are deemed economically necessary.  It seems unlikely given that multiple technologies can make plants compliant, most of them are cheap and low CapEx meaning any small increases in price could be passed onto the consumer with relative ease. 

5. Intellectual property risk. We only have to look at the Norit litigation to see the IP risk.

Conclusion

While the future is always unknown, I believe that ADES is on the verge of gushing cash flows. The confirmation from companies like Arthur Gallagher and Goldman Sachs certainly don't hurt for RC. ADES is no one-trick pony though and can help coal plants of different ages and technologies meet new air emission requirements in a cost effective and low capital manner.

An exact fair value is hard to pin but I believe that ADES is too cheap to need an exact value. With insiders aligned to think long-term shareholders may be rewarded for years to come. Further research will be done to contact more coal plant operators and understand PLR. Long ADES

1937 and 1938

I figured I'd collect some newspaper references to show just how unknown the future is. For the past year or so I've been trying to figure out what the second leg down will look like, if it occurs at all.

What we know now:

Stock market hits 195 in March 1937. Hits 100 in April of 1938. Time from peak to bottom was 13 months. So I looked at what happened 2 months prior to March 1937 up to March 1938 to understand the mindset. Index closing levels from here.

I only focused on topics that are relevant today (debt, monetary easing, business sentiment etc). Of course, there was a little uprising occurring in Europe. So like all things, this is not a complete picture. At best it's like comparing a jigsaw piece to the Sistine Chapel. Even if I did have all the pieces it still wouldn't do justice.

Jan 1937

"Business has progressed so far that it could get along very well without further stimulants. Control of the recovery, however, is another story and the new year finds serious attention being devoted to it. The government intends to maintain an easy money policy but apparently will seek to regulate its consequences as is evident for the treasury plan...." pg 10 Jan 2, 1937 Milwaukee Journal

"Hopes Roosevelt will Settle Labor Troubles Sends Stocks Ahead" pg 6 Jan 5 1937 Milwaukee Journal

Feb 1937

"There is here no question of deflation: the problem is to only control inflation.
On the surface at least, the inflationary trend has not gone very far. Certainly it has not in commodities."
page 6, Feb 1, 1937

On Feb 11 there was an offer for $75M of Northern States Power Company 3.5% 30 year bonds.

March 1937

"Oh Me, Oh My, Why Didn't You Buy Some of Those Stocks back then?" pg 7
There were multiple articles about record profits.

April 1937

"Steel Copper Cited as 'Out of Line'" "President Roosevelt told a press conference Friday, that prices of durable goods such as copper and steel are far too high. He added that the time had come for the government to discourage federal expenditures for such goods and to encourage expenditures for consumer goods." Front Page April 2, 1937
"Roosevelt's Comment Takes the Starch Out of Stocks" pg 17 April 2, 1937
"Economy Dispute Flares; Roosevelt Orders Slash in Expenses" pg 2 April 14, 1937
"Optimism Over Business Is Reflected by Buying Orders On Stock Exchange" April 14, 1937 must have been a very confusing day.

May 1937

"Stocks Market Flutters Aimlessly as Volume Goes into a Tailspin"& "More Spending By Government" Government spent $2.3B more than it took in, bringing total debt to $34.9B(roughly in line % wise with recent times). May 3, 1937

June 1937

On June 3, 1937 more reports about the record breaking debt: "The amount of financing was far above all unofficial estimates."
And people loved gold then too.

July 1937

"Congress Cuts US Spending" July 1, 1937 pg8 Milwaukee Journal
"Profit Trend Continues Up" July 1, 1937 pg 8 Milwaukee Journal
http://news.google.com/newspapers?nid=jvrRlaHg2sAC&dat=19370701&printsec=frontpage&hl=en

August 1937 was pretty slow. Low volume was noted and not much action from the couple of papers I saw. It also started the slide from 190 down to the low in March of 1938.

September 1937

"Stock Market Shows Power Although Ticker Tape Goes to Sleep" Sept 2, 1937

October 1937

"Throw Jewels Out Put Meat in Freezer." It seems on Oct 4, 1937 a drought was causing a spike in corn prices.

Nov 1937

"One of the 'unfavorable indications' in the general situation, the report said, is the expected decline in government spending and 'deficit financing.' Government financing has played an important part in the recovery." This was in the article titled "Business Drop will Last Year" on page 8

Dec 1937

"Government Choking Business with Fear, Taxes, Alfred Sloan and Merle Thorpe Say in Speeches" pg 7 Dec 3, 1937
Also on the same page is an article about Social Security funds not being saved but instead being spent on other government uses.

And a headline that I thought was pretty good "Credit Stimulation Program is Halted- The Federal reserve board Friday revealed that it had discontinued last week..its credit stimulus program of buying government securities."

Jan 1938

"Budget Message Points to Further Big Deficits" Front Page

March 1938

"Optimism in Cautious Vein as Street Watches Dividend Cuts and Omissions and Further Unemployment" pg 4 March 2, 1937

Conclusion:

I'll never know the future.

Yellow Media: Cigar Butt Arbitrage

Note: I wrote this up before putting on the trade last week. While the shares have gone up a little the thesis remains the same.

Yellow Media (TSE:YLO) is a small Canadian company that is recapitalizing. YLO hopes to exchange $1.8B worth of debt for new debt, cash, and 82.5% of New Common Shares (NCS). The existing convertible debentures, preferred shares and common shares will be exchanged for 17.5% of NCS and warrants (representing in the aggregate 10% of NCS). They have holders of 30.0% of medium term notes and 23.7% of Senior Unsecured Debt supporting the Recap.

If this goes through the company will be significantly less levered (Net debt of $794M) and save approximately $45M a year in interest alone.

Conversion Rates:

From the Q&A document common shares will be treated as follows:

"Each holder of 100 existing common shares will receive 0.50000 New Common Shares and 0.28571 Warrants that are exchangeable into New Common Shares."

So right now every 100 common shares that are bought will cost $7 and in exchange you'll get 1/2 share and 0.28571 warrant which will exercise at $31.67 (and expire 10 years from the closing of the Recap). Ignoring the value of the warrants, NCS are valued at $14 right now.

The company also had existing preferred shares. Preferred shares 1,2,3 and 5 will receive the following:
"Each holder of 100 existing preferred shares, other than Series 7 preferred shares, will receive 6.25000 New Common Shares and 3.57143 Warrants that are exchangeable into New Common Shares." Cumulative dividends on the existing preferred shares won't be paid."

Today the series 3 (TSE: YLO.C) will cost you $53 to buy 100 shares. After the recap you will receive 6.25 NCS and 3.57143 warrants. YLO.C is pricing the NCS at $8.48 a share($53/6.25), assuming that the warrants are worthless.

Game Theory

There are two scenarios that could play out in my eyes. The recapitalization goes through (1) or it doesn't(2).
(1) If the recap goes through the logical argument is to go long the preferred. Right now the shares of the preferred are priced at a 39% discount to the existing common shares. While it is unknown whether or not the deal will go through it seems likely in my opinion.

As stated previously, management has commitments from note holders of the medium term notes (30%) and Senior Unsecured Debt (23.7%). If this does go through a holder of $1,000 face value medium term notes will get Senior Secured notes($423), subordinated Unsecured Exchangeable Debentures($56 exchangeable at a conversion price of $21.95), NCS (12.001 shares) and cash ($141). The new Senior Secured notes will pay 9% and will be redeemed with 70% of consolidated excess cash flow at par on a pro rata basis. Ignoring the value of the common shares, existing bond holders are getting 62 cents on the dollar.

(2) If the recap doesn't go through it's a whole new ballgame. The worst case scenario is they file for bankruptcy and the common goes to zero. I have no ability to predict what residual value (if any) will exist in the common or preferred so I won't try. The preferred, being higher up in the capital structure, will have more residual value.

So the question is: how do you play the upside potential that this recap has while drastically reducing the downside of a bankruptcy filing?

Go long the preferred and short the common.

While the upside is less, the downside is also capped. By shorting the common you negate the bankruptcy risks and by going long the preferred you get a play on the upside if the recap goes through. The image below shows what we believe will happen if the recap goes through, you buy a 1000 share slug in the preferred and short an equal dollar amount of common.(This has changed obviously due to price fluctuations)

The delta is the number of shares you would receive post recap. While the value of the NCS is not yet known, the imagination can run wild(see next section). By holding the preferred one also gets 35.7 warrants. The value of the warrants has been completely ignored for now.

The downside is the borrowing costs (~3% annual borrow cost currently) and transaction costs. It is hard to imagine a scenario where the preferred get totally screwed but the common survive. Currently convertible debentures holders are crying foul over the recap but they seem to be the only ones left in the dark.

"However, during a conference call on Monday, Yellow Media’s restructuring advisers, BMO Nesbitt Burns and Canaccord Genuity, explained the rationale for treating convertible holders in this manner.

They said that Yellow Media assumed that convertible debenture holders would convert their bonds to common shares, despite an $8 conversion price when the stock was trading around eight cents.

According to lawyers not involved in the deal, the presiding court for this restructuring will likely rely on case law to approve the deal, and case law dictates that debt holders and shareholders must vote on the transaction as separate classes of owners. To make sure shareholders approve, the company must give them reason to vote, and that could be why they’re getting something extra.

Convertible debenture holders, however, have been grouped with holders of the senior debt. Their $200-million pales in comparison to the $1.8-billion owed to senior holders and the banks, so their votes are not going to sway the result."

The convertible holders appear to be retail holders. A significant portion of senior holders have already agreed to the restructuring. Holders who appear to be more sophisticated investors (Bloomberg screen shots). To sum it up...I don't see how holders of convertibles can sway the vote enough.  

What could the NCS be worth?

I believe the downside from this trade is defined. If the recap does not go through I would expect the common to drop for fear of bankruptcy and the preferred to drop but less than the common given the discount already present and the higher residual value in bankruptcy. I anticipate a mark to market downside could be much greater than stated but patience should take care of that. 

For fun, let's assume that the recap goes through. What is a reasonable price for the NCS?

Net debt/LTM EBITDA will be 1.3X, Net Debt is $794M which means EBITDA is $610M. LTM cash interest was $132.7M and taxes were $134.8M(YLO financial filings). The press release for the recap stated that interest expense would be reduced by $45M. So post recap earnings before CapEx are $387.5M. For the past four years CapEx has averaged $52.4M. I'll round up to $60M, so earnings would be $327.5M. Since YLO is a dying business lets say that it's only $300M.

There are going to be 26M shares after the recap plus 3M warrants which are ITM at $31.67. If the NCS are priced 2X earnings or $600M, with 26M shares that's $23/share. Above $21.97/share the Unsecured Exchange Debentures are ITM.

Conclusion:

By going long the preferred and short the common of YLO one is able to significantly reduce the risk present in this recapitalization. Even if bankruptcy is declared a low cost short can be executed, negating most of the downside risk.

On the other side of this arbitrage there appears to be plenty of upside if the recap goes through. Ultimately it is hoped the recap goes through, the shares shorted are covered and the owner of preferred has a significant stake in a company that has little debt and significant upside, even in a business that is dying. Long YLO.PR.C, Short YLO. 

 

Update 9/11/2012

 

The recapitalization went through. I covered 3/4 of my short leaving only a little remaining in case the court order goes against them. I didn't really think the change in the recap made much of a difference. It basically dilutes NCS by ~8%. Nothing really significant.

 

Thus far this has been a profitable trade as I've been able to take advantage of an arbitrage several times. Still long YLO.PR.C and short YLO.

A CONN-fusing company

Business:
Conn's is a retailer. They sell electronics, furniture,  and appliances to the thousands of sub-prime borrowers who walk into their store. About 80% of their sales are financed.

Goal of the analysis: Determine if Conn's is overvalued and a timely short

Amazon is decimating brick and mortar retailers. As expected, the stocks of Best Buy (BBY) and hhgregg (HGG) have been punished and appear to be value traps. I believe that Conn's should be valued similarly, if not worse than those two companies. While analysts will argue that the company is growing quicker than rivals and has an advantage by extending credit to those who can't afford it I think there are problems.

Is CONN growing enough to deserve a premium?

The charts below show revenue and store growth is non-existent at CONN. HGG and BBY have been growing store count and along with that, overall revenue. Conn's store count has dropped from 76 in 2009 down to 65. It does seem that these were less active stores as revenue/store has risen from $9.59M in 2010 to $10.05M in 2012(~2% per year).  

HHG is argued to be snapping up old Circuit City stores. This rumor seems believable based on their store count numbers quickly expanding since 2008. BBY is growing stores and revenue is starting to flatten out, in their 10K they mention that comparable store sales have declined by ~1.7% per year the past two years.

Regardless, CONN is the only one of the bunch that is neither growing store count nor revenue. While they have eliminated stores that are less active (based on Rev/store number) the growth within existing stores is hardly inspiring. Yet this growth commands a 13X forward multiple based on guidance of $1.30 EPS.

This high multiple for a sector in decline seems odd when you consider BBY has a forward multiple of ~6X with guidance for GAAP EPS of $2.85-$3.25. HHG is guiding for GAAP EPS of $0.90-$1.05 for a multiple of ~6.6X.  So why would CONN be valued 2X as high as rivals who may be in a secular decline, but are still quite profitable, growing revenue and store count? 

Does Conn's have a better business model?

Maybe CONN is doing something better than their rivals. Perhaps they sell different products, don't have as many contractual obligations, or get much higher returns through their financing arm.

Besides the subprime financing, BBY and HHG sell cell phones while CONN does not. In FY2012 BBY had 40% of their sales come from "Computing and Mobile phones." Besides appliances (comparable store growth up 10.6% from 2012 to 2011) it's been the only growing segment up 6.0% compared to 2011 in comparable stores.

For HHG 9% of sales came from computing and mobile phones and comparable store sales grew 52.9% YoY. Appliances grew 3.0% YoY in comparable stores. Besides that, all other segments declined but they did mention that mattresses had "strong double digit growth.''(pg 37 2012 10K)

So appliances are growing between 3-10% at the two other retailers. At CONN recent conference calls have emphasized increased furniture and mattress sales. This segment increased 35.2% YoY (pg 8 2012 10K) but only makes up 16.7% of their product sales. The thought is that they can generate higher margins by growing this segment. Retail gross margin has improved 2.2% YoY thanks to an emphasis on furniture and mattresses. I think the obvious thing is that cell phones should not be focused on(see Radioshack).

So there are some differences in the business model. So much in fact, that for 2013 management expects retail gross margin to jump up to 33%, largely thanks to product mix. I still believe that's a lofty goal considering a well established company like La-Z-Boy has 30% gross margins currently and 10 year gross margin average of 26.5%(LZB filings).

Total contractual obligations are always big for retailers as operating leases can be hidden. BBY has total contractual liabilities of $14.2B (pg 54 2012 10K) for a total capitalization (MC+total contractual liabilities-cash) of $19.1B. With a low end earnings of $2.85 and 366.3M total shares net income will be $1.043B. So BBY has a total capitalization to earnings ratio of 18.3X.

HHG has $715M of contractual obligations, no debt and cash of $59M. With a market cap of $227M they have a total capitalization of roughly $880M. Net income will come in at $36M if EPS is $0.95/share. So my calculated total capitalization to earnings ratio for HHG is 24X.

Finally, CONN has $458M of total contractual cash obligations (pg 59 2012 10K), a market cap of $578M and cash of $6M (which isn't excess but I'll just subtract it for simplicity) for a total capitalization of $1030M. With net income of $1.30/share and 32.9M diluted shares (a 1M increase from the quarter before!), my calculated total capitalization to expected earnings ratio is 24.1X.

I could calculate ratio after ratio and paint a million different pictures. At the very least I'm convinced that HHG isn't that cheap due to contractual obligations and neither is CONN. Yet all three are in the same ballpark. What I can try to determine now is the quality of Conn's earnings. Are they avoiding the secular decline in brick and mortar stores from their financing arm?

Conn's Financing and Overall Valuation

This credit segment first caught my eye and still mystifies me. Somehow this company charges 18% interest rates and has net charge-offs of 8.5% on a $634M portfolio balance(pg 23 Q1 2013 10Q). Therefore the maximum amount of money they'll get is 18% of $634M ($114.1M). They also have 3rd party financing that makes ~$25M. Total financing revenue is $138.6M. 

If we back out the expected 8.5% net charge-offs ($53.89M), $24.5M of interest expense (guided to on their Q1 2013 earnings call) and Credit Segment SG&A of $57.8M (pg 42 10K 2012 41.7% of revenues), we have total costs for the portfolio of $136.2M. Adding back the provision for bad debts of $53.6M and the $634M portfolio makes $56M or 8.8%. 

What I find amazing, stunning actually, is that their loss rates are so low. They re-age their loans and currently 11.6% of their loans are re-aged. CONN has figured out something that Visa, MasterCard, Bank of America, Citi, JP Morgan, etc have not figured out. Giving a group of people with an average weighted score of 601 more chances at paying back debt drops charge offs to rates seen in prime borrowers.



According to Lending Club's white paper, FICO bands of 600 or lower will see >19% charge offs. Hmmm, if we add 11.6% plus 8.5% we get 20.1%. I would argue that re-aging simply pushes out the charge-off date. I believe this is confirmed even with secured debt. On home loans with LTV's over 90% (the average down payment for Conn's is 4.5%) foreclosure rates average 25% for FICO 580-599 and 19.5% for 600-619. It's simply amazing that CONN has such low rates of default and in reality, they probably don't.

FY 2012 Valuation

So let's revisit the business again and see if it's making money. The information below is from the 2012 10K and simply reproducing their numbers to fit what I see as free cash flow.

The retail section is pretty straightforward. Retail gross profit for FY 2012 was $191.6M ($653.6M-$455.5M-$6.5M). Total SG&A was $237.9M(I'll assume all SG&A is in retail, by my calculations Credit SG&A minus provision for losses is only about $3-4M). Therefore operating profit for this segment was -$46.3M.

Credit had total revenue of $138.6M, net charge offs of $46.9M, and borrowing costs of $22.5M. Profit for the credit segment was $69.2M.

Other non-operating charges included $7M for store closings and $2M for impairment. These are added back to operating cash flow on the cash flow statement but I believe that to be a mistake. Opening and closing stores, even if they are not operating, still cost a business money. Leases have to be paid and that payment is usually in cash, meaning it's a real cost.

From there I've assumed that a real investor would see D&A ($12.8M), stock comp ($2.3M), and loss from early extinguishment of debt ($11.0M) for total non-cash provisions of $26.1M. Back out $4.3M in CapEx and the company generated $35.7M in what I believe is free cash flow.

With today's market cap right around $578M the investor today gets a FCF yield of 6.1%.

FY 2013 Valuation

But perhaps next year will get better. The stock market is after all, future looking. They hope to open 5-7 more stores in FY 2013. Let's say 6 stores are opened and for simplicity sake, they make 1/2 the revenue that established stores make (50% of 10M).

In FY 2013 if sales grow by 2%(what I've calculated rev/store growth to be over 2 years) and an extra $30M is made 2013 revenues will be $696M. Maybe they become a furniture store for people with credit scores under 605, if so they could see 30% gross profit (in line with La-Z-Boy). So gross profit would be $208.8M. SG&A should rise ~5% due to 10% more stores for half a year so SG&A of $249.8M. So operating profit should come in around -$41M.

The financing segment is tough to predict but lets assume that it too increases by ~10% and the average total outstanding balance gets to $700M, roughly what it was for FY 2011. At 18% interest they'll make $126M plus another $28M (a 10% increase from 2012) from third parties. Total Financing revenue of $154M. Subtracting out 7.5% net charge-offs (7.5%*$700=$52.5M), $24.5M interest (guided on their Q1 2013 call) the financing segment should see operating profit of $77M.

If we add back non-cash of $26.1M to the two segments operating profit of $36M ($77M-$41M) and back out CapEx for the year of $18M (pg 58 10K 2012) FCF for the year is $44.1M. So forward looking an investor today can get a business with a 7.6% FCF yield. I did not subtract impairment or store closing costs as was the case in 2012.

While maintenance CapEx will be less than $18M even if it goes to zero the company makes $62.1M, giving the investor in CONN a 10.7% FCF yield. Definitely not a long but is it really a short? That clue may lie in an assessment of management.

Management

For all that I tried I couldn't find anything terrible on management. They have over-reserved provisions for bad debts in the past five years. Perhaps they use this to massage earnings, I don't know. It still shows conservative accounting for bad debts, which based on their use of re-aging is probably necessary.

If they are massaging earnings (again I don't know if they are) it would be under the direction of a new CEO, Theodore Wright. Theo was previously CFO at Sonic Automotive and left for personal reasons. It certainly wasn't the salary, as his base salary in 2000 was almost the same as his salary now($450,000). He owns over 175K shares and his only open market purchase was April 4, 2011 when the company was trading for $4.83 a share. With the benefit of hindsight it was a well timed purchase. 

His compensation is tied to adjusted operating profit and ignores costs for store closings and severance agreements. Grand total he made $2.9M in 2012. While it certainly would be nice to find something far more devious, I see nothing that's really out of line. It's rare to see a CEO actually really own a significant chunk of shares, especially at a small-cap so I can't really hold it against him. I don't think most executives understand how the market works anyways, but that's a topic for another time.

Why this stays in the "Too Hard" pile

I found myself going down rabbit hole after rabbit hole with this analysis. While the company is not cheap, there is nothing caustic here. I believe there is some flexibility being applied to their accounts receivable portfolio but it seems a stretch to say that anything is materially wrong. Since they no longer have the off balance sheet vehicle it is considerably harder to hide bad loans.

Also, just because CONN is offering credit to lower quality borrowers does not mean they are a ticking time bomb. Payday lenders are incredibly profitable and as long as there aren't interest rate restrictions I believe they will continue to make money. Whether or not 18% is enough to charge is the question. If you forced me to make a call I'd say the portfolio is break even at best over a 10 year cycle. That is just a gut level assumption.

The rise in promotional receivables and decreased down payment could lead to trouble down the road and let's be honest: the brick and mortar store is not profitable. Until I can find something more definitive I will stay on the sidelines. I am often wrong and could be here. No position.

AIG: A megacap behaving like a smallcap

I feel like this story has been presented ad nauseum. So prepare to throw up. Everyone knows about AIG and what an awful company it was. On the flip side, value investors are pouring over it. I think this would qualify as a Michael Burry "ick factor" stock. In fact, I think that everything is overblown and a margin of safety exists that may be greater than any other insurance company out there. More so than even my favorite, Aspen. 

There are four inputs to this: Insurance segment (Chartis/SunAmerica), management, the government, and everything else (all the auxiliary lines of business/wind-downs/IPOs). 


Chartis


Personal and Commercial insurance arm of AIG. They will not win an award for being the best insurance company but they are certainly one of the bigger ones. In Q1 2012 they wrote $8.8B worth of net premiums and had a pre-tax income of $910M. They underwrote to a loss, so investment income was $1.2B for the quarter.

They returned $1B to the parent in Q1 2012 and $1.5B in FY 2011. Management expects Chartis to return between $2.5-4.5B to the parent in 2012. This is off $124.9B of total invested assets as of Q1 2012.

While I'm not overly impressed with their loss ratios it's not a total train wreck considering all the catastrophes the past two years. I give Chartis a "C" for a grade (average for those conditioned to grade inflation).

SunAmerica

This is their retirement and annuity branch. In Q1 2012 it returned $1.6B to the AIG parent. In the Q4 2011 earnings call management expected SunAmerica to return about $2B to the parent. This is off $192.8B of total invested assets as of Q1 2012.

SunAmerica is big, well known, and probably here to stay. With a fair amount of ignorance I would apply a "C" to SunAmerica as well.

Insurance Segment

Combined Chartis and SunAmerica have total invested assets of $317.7B. Backing out debt and reserves and everything else one arrives at a BV of ~$83B. Management expects annual dividends from their operating companies to come in at $4-$6B. This would obviously correspond to an ROE in the mid-single digits. Just like every other insurance company, AIG has "aspirational goals of 10% ROE."

I believe that in today's low rate environment, coupled with the insurance industry surplus this segment is worth 0.9BV or $75B. Perhaps that will improve in the future but for now I'll stick with a bland 0.9 assessment.

Management

In Andrew Sorkin's "Too Big to Fail" I remember when Lehman Brothers, hoping for a liquidity injection, sent Buffett an annual report and other documents. Buffett read them and made a note of anything he didn't understand. Supposedly the report was littered with notes by the time WEB was done reading it. Confusing annual reports are not good.

Financial companies are opaque at best. Reading an annual report should clear and concise.
Reading AIG's most recent annual report was a breath of fresh air. Everything was spelled out. Does this eliminate long tail risk? Of course not. I can only hope that the team hired to clean up the mess created in the crisis will actually clean up the mess. They are experienced insurance executives and they seem committed to returning money back to shareholders. Up to $30B by the end of 2015.  

Everything Else

This will be a gross oversimplification but here goes.

ILFC: Looking at Whitney Tilson's presentation I think it's reasonable to believe that ILFC is worth book value. The S-1 for ILFC shows shareholder equity of $7.6B(pg 44).

Maiden Lane III: AIG received $5.56B on July 12th. They'll now get 33% of the remaining equity Conservative value = $5.56B

AIA Stake: Obviously this will fluctuate with the market. As of March 31, 2012 their remaining interest in AIA was ~$8.2B. With roughly 290M shares held this has declined in value to roughly $7.8B as of 7/16/2012.

I have ignored the other assets, such as United Guaranty, deferred taxes, etc. I think that "Everything Else" is worth $20-$21 billion. It could be worth more and perhaps in a serious market swoon/IPO bust it's worth significantly less. Again, my hope is that this is conservative.

The Government

The Treasury owns 61% of the shares outstanding. With roughly 1 billion shares and a break even price of $28.72 there's a worry that the stock price will be stuck at the break even price as the Treasury unloads shares on the market. Management knows this is the belief widely held.

"Conventional wisdom has been, as long as the treasury has a large position $29 is probably the ceiling for the stock.'' Robert Benmosche Q1 2012 Earnings Call

I have no idea what the end exit strategy for the government will be. Quite frankly, I don't care as long as they exit sometime soon, which is the stated intention.

So why do I believe AIG is a buy?

First, there is a skewed shareholder base. The Treasury owns 61% of the shares, Fairholme owns another 5%. Therefore, 66% of all shares are held by two groups. One group doesn't care that much about selling price. This would be an inefficiency. What fund manager would want to be caught owning AIG while the Treasury also owns shares?

Pretty much just Bruce Berkowitz and friends.

In small cap stocks large ownership stakes sometimes present inefficiencies. In this case we know that the Treasury wants to sell their stake. They are a forced seller. The exact details aren't known but as I've said earlier, we know they are exiting. Once the Treasury exits fund managers around the world can start buying. I believe this makes AIG act like a small cap that has a strange shareholder base.

If we believe that "Everything Else" is worth $21B and the core insurance business of AIG can make $3-$7B a year (3%-8% ROE) today's it's easy to see why Benmosche thinks that they can return $30B to shareholders in the next three years. As the Treasury exits shares should get bought back.

Will things change once the Treasury's stake drops below 50%? Yes I would imagine. Luckily we have the other banks that took TARP funds as a road map. They made it out OK and I think AIG will too.

The second reason I believe AIG is a buy comes from the margin of safety. The company is priced as if no other business segment ("Everything Else") has any value. Today's valuation gives the insurance segment alone a P/BV 0.67 ($58.7B MC $83B BV). I find it absurd that ILFC, ML III, United Guaranty and everything else has zero value. Even if it does you still get SunAmerica and Chartis at a discount.

Is that discount warranted? No, I think there is excellent clarity in conference calls, annual reports and public messages. Thanks to the Joe Cassano PR campaign, AIG is combed over by everyone. Luckily for us, the AIG of today is not the AIG of 2007. Once the government exits and non-core businesses are sold you're left with a large insurance company.

I think it's reasonable to value the insurance companies at $75B (explained earlier as 0.9BV) and "Everything Else" at $20B in value. AIG, in my eyes would be fairly valued at roughly $51 per share(1.875B shares 95B fair value).  

Conclusion

In 2007 AIG was spread out and had it's hand in numerous cookie jars. Many of these jars had mousetraps and as a result AIG suffered. The company is completely different now and poised to return $30B to shareholders in three years.

Buying AIG at a discount today lets investors participate in a clear path to accretive book value growth. As the Treasury exits I believe management will buy back shares. This will grow BV and enhance the upside while reducing the downside of government intervention. This will also lift the stigma associated with owning common shares. Instead of a government backed entity you will have an insurance company selling for about 1/2 book value that generates 3%-8% ROE on an annual basis.

While there are many risks to this investment I believe the clear path forward and the deep discount to conservative book value is a compelling opportunity. Long AIG

Kronos (KRO)

Background:

A lot has been written about titanium dioxide (TiO2)and the run up in prices. High cost suppliers shut down production during the depths of the financial crisis and Tronox went bankrupt. Once the dust settled, prices skyrocketed and now it seems as though there are monthly TiO2 price increases. Dupont, Cristal, Kronos, Tronox, and Rockwood are enjoying massive profits on limited supply and typical demand.

I have reviewed several TiO2 companies and believe that Kronos represents the best opportunity right now. They are one of the few pure plays to TiO2 and have been unduly punished due to the European Crisis. On top of that management thinks like owners.

Business:

Kronos has six TiO2 plants and a total capacity of 533,000 tons/years split 75:25 between chloride and sulfate routes. Two of their plants are in North America and the others are in Europe. They also own and operate an ilemnite (raw material for sulfate TiO2 production) mine in Norway, supplying 10% of the worlds supply of ilmenite (and all of the their sulfate European production).

Management:

Harold Simmons is the Chairman of the Board. Mr. Simmons is a simple man, he loves TiO2 and hates President Obama.

Regardless of his political tendencies, he has been buying shares just about as quickly as he has been donating to conservative Super PACs. If that's not conviction I don't know what is. Directly and indirectly he owns about 95 million shares of Kronos.

Unlike his LBO days, he left Kronos relatively unleveraged ($481.5M in total debt). His conviction, track record in business, and insider buying are a moderately positive sign for the individual investor. There do seem to be multiple related party transactions. I can't say Simmons gets me excited as a leader but his influence hopefully is waning.  

CEO, Steven Watson, has been buying shares often in the open market and owns over 128,000 shares. Mr. Watson was made CEO in 2009 right around the time Tronox went bankrupt. He was with the company "during the last big upsurge" (Q4 2010 conference call) and seems to understand the perils of too much capacity. The scars from the 1990's have clearly impacted Mr. Watson.

Each swoon that beats the stock down results in another round of insider buying. While insider buys are not something to rely on, I think they are a positive sign.

Favorable Economics

Much has been written about TiO2 and how the prices will just keep going up. I have no idea if prices will keep going up. I can make a couple of reasonable assumptions that indicate Kronos will remain an attractive investment for several years.

1. There's almost no real TiO2 capacity coming online. No good ones anyways. Supposedly there are plants coming online in China, I put that in the "I'll believe it when I see it" category. Regardless, there is plenty of technical knowledge involved with TiO2 production, something the Chinese recognize. The incremental improvement by first tier firms will likely only keep up with the expected increase in demand and not surpass it.

There have been no green field announcements and these plants take about four years to build according to Kronos(Q4 2010 Conference Call). Those that choose to invest will need to be sure that they can get adequate returns. Kronos has stated multiple times that a new 150,000 tpa chloride plant will cost upwards of $1B. An investment that takes four years to build will need assurance that pricing will remain strong.

Some estimate that TiO2 demand will reach 6-7.5 million tons per year. The upper range will only occur if all plants come online(expected by 2015 at the earliest). I'd say those estimates are a little aggressive as current worldwide demand stands at roughly 5 million tons per year. I would imagine TiO2 demand would track global GDP growth. If all that capacity comes online and works as expected it may result in lower TiO2 prices.

The take home point here is: capacity will not just pop up overnight. The capacity that is coming is several years away, so I believe pricing for TiO2 will remain strong for at least a couple of years.

2. Feedstock capacity is easy to bring online. Kronos has said so themselves on multiple occasions and it makes sense. Titanium and iron are everywhere, you just need capital to mine it.

Steve Watson talked about feedstock constraints in 1H 2012. This was expected to ease in the second half of 2012. No matter what feedstock ends up costing it doesn't matter, there's no capacity leftover in pigment production and thus far pricing increases have been passed on with ease.

There is feedstock production coming online and a lot of capacity can be brought on quickly. Mines in Madagascar, Mozambique, and other countries are expected to start producing ilmenite in excess of pigment capacity, depending on demand projections. Ilmenite is used in the sulfate production method and thus lower quality and doesn't have the same pricing power as rutile.

As reference, if TiO2 demand hits 6.2 million tons per year feedstock demand will need to be around 7.3 million tonnes per year (Arkitol).

3. The last titanium dioxide cycle was long. Peaking in the early 1990's it destroyed pigment manufacturers until plants were closed permanently. The reason it's such a long cycle is simple, plants take time to build and only a few players have the technical knowledge. Most of the plants that are being built now, whether in China or elsewhere, will take several years to build.

In the late 1980's (the last cycle peak for TiO2) gross profit margins hit 50% and EBITDA margins were in the 45% range (Q4 2010 KRO Earnings Call). I think this is a good proxy for what levels would have to hit before new plant expansion happens. Currently KRO has gross margins of 61.4% (1,194M gross profit in 2011) and EBITDA margins of 30.8% (600M in 2011). 

What's it going to earn and why is it so cheap?

I lack the ability to know exactly what TiO2 pricing is going to be but let's take a base case scenario.

In Q1 2012 the company generated $561M in revenue COGS were $299.8. There have been two price increases that will raise prices by ~10%. If no other price increases occur revenue will be ($561*1.1) times 3 quarters plus $561 for Q1 2012 revenue. Revenue for 2012 will be $2.412B.

Per Kronos conference calls, COGS will rise by 50-60%. If that's the case then COGS will be ($299.8M*160%)* 3 quarters (9 months left in 2012) plus Q1 2012 COGS of $299.8M. COGS for 2012 will be around $1.738B.

Our base case gets us gross profit of $674M. This trickles down to roughly $317M in net income ($195M for SG&A and $25M for interest and $137M for taxes at 30% ). Let's call it $300M because it will take a couple of months for those price increases to hit and SG&A will probably go up. With 115.9 shares outstanding that's EPS of $2.58. With the share price hovering around $16, plus or minus a lot depending on Spain's weekly bond auction/bailout, that puts it 6.2X earnings.

I think that's a little pessimistic though. While a meteoric rise in prices like 2011 is unlikely (40% YoY increases) I feel confident that 1. feedstock costs will moderate and 2. TiO2 prices will increase. How much I don't know.

The central thesis for me here though is that if ore prices go through the roof and pigment pricing stays the same we're looking at a company that still has a good shareholder return. Even if prices decrease and feedstock prices stay elevated you still will get a good return.

For what it's worth, I think that Kronos will generate around $3-4/share in earnings for 2012.  I used 60% ore increases and TiO2 price increases of 10-20% (~11% has already occurred this year at Kronos, Cristal looks like their are leading the industry with more increases, there are some reports that Western European pricing is softening though). Finally I ramped up SG&A $5M and backed out $25M in interest expense.

So I believe I'm buying a business for 5-6X earnings. Some of these estimates are based on talks with contacts in the paint and chemical industry, some are just plain old estimates.

My final point for how cheap it is focuses on replacement cost. Steve Watson has said a couple of times that it would cost around $1B to build a 150,000 tpa chloride plant. Kronos has 400,000 tons of chloride production. The replacement costs of their chloride plants is $2.6B. This makes no allocation for their sulfate production or mine in Norway. All this for a company that can be bought for $1.8B plus some debt.

Depending on the scenario you believe will occur, Kronos is kinda cheap, or stupid cheap. The question is, why?

I think most investors are concerned with the recent bankruptcies, plant closures, and Europe. The bankruptcy concern is dumb because Tronox went bankrupt for legacy environmental issues (which were made impossible to overcome by crappy TiO2 economics). Baupost owns Tronox now so I feel their chance of going back into bankruptcy is slim.

Plant closures happened to the higher cost providers, Kronos has new plants and vertical integration that may help slightly. I didn't factor this is because mining revenues are only a couple of percent of their revenue at best. Also ilmenite pricing hasn't been as strong as rutile and probably will only get weaker as new capacity comes online.

It really seems to trade with Europe though. Oh no Spain needs a bailout?! Sell KRO!!

Yes, a significant amount of their plants are in Europe but they have two large plants in North America and their product could easily get shipped elsewhere. I believe that European fears are unfounded for a commodity like TiO2 and that demand may weaken slightly but will not crater. One cannot just stop using TiO2 (Everybody loves off-colored clear plastic). Short interest is pretty high for this name, at 5.05 days to cover. I wasn't able to find any solid short thesis on Kronos but I would love to see one. This will be an important discovery for the thesis.

I will admit I don't like some of their inter-party transactions. They are not large enough to worry me for now, but I will keep an eye on them. Hopefully Watson continues to plow ahead and run a profitable business leaving Simmons to attend Tea Party rallies.  

Conclusion:

I have spent quite a bit of time looking at this, I originally started researching the different TiO2 players around November. To me the thesis is simple: demand is going to remain relatively stable and there is almost no significant capacity coming online for the next 3+ years. In the meantime the earnings power of these businesses will keep rising. Is this a hold for 10 years? Probably not.

I doubt demand for TiO2 will fall off a cliff but the strength of Kronos' balance sheet and high quality plants lets me sleep at night. This thesis does depend on TiO2 pricing staying constant and perhaps increasing slightly.

Kronos offers a compelling risk/reward due to solid insider management, a supply/demand imbalance and powerful profit generator for several years. It will be crucial to monitor new plants and capital expansions. As with everything, if Europe really goes to hell in a hand basket this bet would probably tank as well. Long KRO

Update 7/10/2012

Iluka had a conference call yesterday saying they were revising down production targets.


"We think, for example, chloride pigment producers, who are clearly important  to us, have reduced their production by somewhere around 25% in the US and in Europe, and their forecast production
similarly, obviously.
Sulphate pigment production is also down, although we think by not as much as margins are
actually better in that segment versus chloride." David Robb Managing Director

So if Kronos lowered production by 25% in the 2nd half they should produce around 200,000 tons this year (I've ignored whether or not it's Cl2 or sulphate for simplicity). Iluka's conference call seemed to believe that it was more inventory control. So it could be a small cyclical downswing or a canary in the coal mine. We'll see.

Dupont and Tronox came out today swinging saying that Iluka's comments weren't indicative of their business and this is an over reaction. Dupont believes 2H 2012 pigment demand to be strong. So who knows, conflicting news in some ways but in other ways it supports my thesis. I believe the most prudent decision is to simply sit and wait for earnings.