RNDY Roundy's

Roundy's is an underappreciated and undervalued grocer in the Midwest. In this beaten down industry Mr. Market believes the threat from Wal-Mart and Target will drive out grocers like Roundy's(RNDY). This, a busted IPO, and dividend cut have left RNDY undervalued. 

Currently the company trades for 5X 2012's FCF¹, although the current yield gives no credit to the expansion taking place in Chicago. New store openings, while a positive long-term development, are masking true cash flows from increased capital expenditures and pre-opening expenses. As these new stores mature and the associated opening costs go away, EBITDA margins will increase and obviously, so will free cash flow.

The current share price assumes that the company will continue to see same-store sales decline causing further shareholder pain like the recent dividend cut. While dividend cuts are normally associated with struggling companies, I believe this was not the case for RNDY. The company can more than adequately cover the dividend, grow out stores and still have cash leftover to pay down debt. Ultimately, the dividend cut will be seen as a prudent capital allocation by a management team that is shareholder friendly.

We can be assured that shareholders are being fairly represented for several reasons. There is a skewed shareholder base with one large PE owner who has owned the company since 2002. Management is world class and has a great history within the industry. We believe that the current expansion represents the CEO's legacy. The combination of owner's pride, prudent capital allocation, and robust cash flows at an attractive valuation make RNDY a compelling investment. If the company can hit their targets I believe that they will generate $1.67/share in FCF in 2014, implying a 22% FCF yield.

Background  

Roundy's (RNDY) is a regional grocer, selling under the Pick 'n Save, Rainbow, Copps, Metro Market, and Mariano's banners. As of 12/29/2012 there were 161 total stores, 93 of which were Pick 'n Save's. RNDY was bought by PE firm Willis Stein in 2002 for $750 million. Willis Stein hired Rob Mariano to head the company and stores increased from 61 to more than 150 by 2007.  After that expansion, Willis Stein tried to sell the company and had "several interested parties."

Willis Stein failed to sell the company for $2.0 billion in 2007 and $1.2 billion in 2011, so an IPO took place in 2012 at $8.50/share, well below expectations. Willis Stein sold 4.5 million shares during the IPO, although they still hold 41% of all shares. Besides the partial shareholder exit, proceeds from the IPO were used to delever the balance sheet and to fund store openings in Chicagoland.

Chicago is a new area of development for RNDY, with their first store opening in 2010. Historically the company has operated in Milwaukee (Pick 'n Save and Metro Market), Madison (Copps), and Minneapolis (Rainbow Foods). Management is no stranger to the area; several members of the helped grow and develop Dominick’s into one of the top grocers in Chicago.

By the end of 2012 RNDY had 8 stores in Chicagoland. The company has high expectations for Mariano's and the Chicago market in general. To free up cash to fund the Chicago expansion the company cut their dividend in November 2012 to free up cash flow. This did not sit well with Mr. Market.  

A Tale of Two Stores (And Four Cities)

On the surface RNDY looks poor with decreasing same-store sales (SSS) and declining EBITDA. These problems are temporary thanks to the Mariano's expansion, changes to the old stores, and management team.  

Mariano's 

Mariano's, named after CEO Bob Mariano, is Roundy's new store offering in Chicagoland. Mariano's sits squarely in-between high end grocers like Whole Foods and lower-cost grocers like Jewel-Osco. Stores average 65,000 square feet and "offer expanded produce sections, unique specialty departments and inviting ambiance," according to their S-1. Pictures can be seen here. To say Mariano's has been a success would be an understatement.

"We continue to be very pleased with the strength of our five Mariano's Fresh Market stores in the Chicago area. The customer response to these stores has been overwhelmingly positive, and that is translating to financial performance well beyond our expectations. Our overall same-store sales for this group of stores at this point only includes two of those stores, opened in the low double-digits range year-over-year, and our new store that opened earlier this year is also already generating positive EBITDA." Bob Mariano Q2 2012 Conference Call

"Our growth banner, Mariano's, continues to generate excitement with each customer in (the) Chicago area. Our current strategy intends to build around 5 stores per year. And as I mentioned earlier, we are increasingly confident that the Chicago market can support more than 30 Mariano's stores." Bob Mariano Q1 2013 Conference Call

The stores are clearly targeting higher income consumers, something that can be seen in the table 1 below. Most of the areas they are penetrating have per capita incomes over $30,000 and while their stores have sprouted up around Chicago there are clearly several other municipalities that have the capacity to add Mariano's. Areas that I believe could support Mariano's, solely based on income and population levels, are in bold.

Table 1. Mariano's Store Locations

Municipality	Population	Median Income	Per Capita Income	Mariano's
		Per family
Aurora	199,672	$60,689	$25,491	Potential
Elgin	108,395	$58,404	$21,112
Joliet	148,402	$55,870	$19,390
Naperville	142,773	$130,164	$48,239	Potential
Arlington Heights	75,101	$100,966	$41,654	Yes
Berwyn	56,657	$55,946	$20,143
Cicero	83,891	$42,235	$14,339
Des Plaines	58,364	$65,806	$24,146	Potential
Evanston	74,486	$102,706	$40,732	Yes
Gary, IL	80,294	$32,247	$16,300
Hammond, IL	80,830	$46,905	$17,747
Hoffman Estates	49,495	$85,301	$26,669	Yes
Kenosha, WI	99,218	$58,484	$23,728
Mount Prospect	54,167	$84,136	$34,002	Potential
Oak Lawn	56,690	$47,585	$23,877
Orland Park	57,016	$77,507	$30,467	Potential
Palatine	68,557	$74,915	$30,049	Yes
Racine, WI	78,860	$51,411	$20,246
Schaumburg	74,227	$84,931	$31,586	Yes
Skokie	64,784	$68,253	$27,136	(2014/2015)
Tinley Park	56,703	$71,858	$25,207	Yes
Waukegan	89,078	$47,341	$17,368
Wheaton	52,894	$108,706	$42,179	Yes
Chicago				Yes(4)
Vernon Hills	25,113	$110,343	$42,205	Yes
Frankfort	17,782	$122,466	$45,285	Yes

Source: Roundy's, US Census

Obviously this expansion has costs including pre-opening expenses (training and inventory) and capital expenditures. Pre-opening expenses are estimated to be between $1.5-$2.5 million per store, based on competitors published figures. Management has stated that capital expenditures are around $5 million. The table below shows the estimated impact for 2011-2014, this does not include store remodels.

Table 2. Estimated Opening and Capital Expenses for Mariano's

	2011	2012	2013	2014
Opening Expense	$(4)	$(10)	$(10)	$(10)
CapEx	$(15)	$(20)	$(25)	$(25)

These costs are well worth it though. Stores were originally expected to do $750,000 per week in sales and according to management this was easily exceeded. Stores are now expected to generate around $50 million in sales per year at 5% EBITDA margins upon maturity.

With an estimated market of 30 stores in Chicago (13 currently open and two more opening soon), management is a little under halfway through. What Mr. Market seems to be doing though is applying the depressed EBITDA into the future, which I believe is incorrect. Based on my model I believe that 2014 will be the year that results start to bear fruit, something management has guided to in their earnings calls. The table below shows an excerpt from my model detailing the growth in EBITDA from the Mariano's stores only.

Table 3. Mariano's EBITDA growth

In Millions	2011	2012	2013	2014
Estimated (5%) EBITDA	$3.2	$9.1	$19.5	$28.3
Opening Expenses	$(4)	$(10)	$(10)	$(10)
Mariano's EBITDA	$(0.8)	$(0.9)	$9.5	$18.3

Source: Discussions with management & Authors calculations

The point with the table above is not to show an exact figure, but to highlight that things have been depressed and as management has stated, should improve in the next couple of years. This seems to be lost on the sell-side who only note the decline in operating margins and same-store sales decline. 

If the plan in Chicago continues as planned and RNDY is able to open 30 stores with annual sales of $45 million (10% below what mature stores are generating now), that is $1.35 billion in sales from their Chicago stores alone. If these stores can continue to generate 5% EBITDA margins that would equal another $67.5 million in EBITDA. This is compared to a company that currently generates $3.89 billion in revenue and $198 million of Adjusted EBITDA in 2012. It should be no surprise that management is applying lessons learned at Mariano's to their other stores.  

Other Stores

The other three markets of Milwaukee, Minneapolis, and Madison are seeing declining SSS due to competition from Target, Wal-Mart, and conventional grocers. In 2012 there were 24 competitive openings, eight of which were super centers. Overall, these competitive openings reduced SSS by 2.7%. Management has guided for a similar impact in 2013.

While this is disconcerting, RNDY initiated some Mariano's concepts at 14 Pick 'n Saves in Milwaukee (M14). This group was compared to a control group of 20 stores in the Milwaukee area. The results of this experiment were positive according to management, M14 saw better comp comparisons and EBITDA "has tracked better in the M14". While there are no hard numbers for M14, investors will get a chance to see the impact on the remainder of the Milwaukee stores. The 69 stores in Milwaukee are expected to see improvement in 2014. 
 
It is important to note that this could ultimately fail. What works in Chicago may not work anywhere else. The bad news is real news, sales are decreasing and competition is coming from large, well-funded companies. However, confidence in this plan is coming straight from the top.  

Management

The grocery sector is incredibly competitive, therefore I feel it is vital to have a management team fully aligned with shareholders with years of experience. I believe this is what separates RNDY from numerous other chains and will ultimately help the company deliver upon its various targets.  

Bob Mariano: CEO
 
Mariano has worked in grocery stores since 1968, starting at Dominick's. He spearheaded the development of the "Fresh Store" for Dominick's. Those efforts made him CEO after which he took the company public and finally sold it to Safeway in 1998. The current demise of Dominick's may indicate how vital Mariano was to the success of the store.

Regardless, Mariano joined Roundy's in 2002 and appears to be on a similar path, growing the store count, bringing innovative changes, and taking the company public for its large PE owner. The newest stores, as mentioned earlier, are named after Mariano. I believe that these stores represent his legacy.  His public words show a tremendous amount of pride in the success of Roundy's and especially Mariano's.

Mariano owns over 1.132 million shares compared to a base salary of $955K in 2012. (14A) 

Darren Karst: CFO

Darren worked with Mariano at Dominick's and left at the same time. He owns over 554,000 shares compared to a base salary of $700K in 2012. (14A)  

Willis Stein

Willis Stein owns 41.5% of shares outstanding. This large share position makes it unlikely that they will do anything deleterious to common shareholders.  The company has tried to sell off their holdings several times with little success. In August of 2012 Willis Stein raised capital to return money to investors who bought stakes in their third fund, the same one that held Roundy's. Willis Stein did not sell their stake and stated that they intend to hold RNDY in a "sub-fund." 

Valuation  

Roundy's trades at a very attractive valuation, one that doesn't account for any growth. In the table below we can see my estimated FCF, based on 46.75 million shares outstanding. Chicago revenue growth is based on talks with management. Ex-Chicago sales decline by 2.3% in 2013, -2% 2014, -1% in 2015, and finally flatline in 2016. This is strictly a guess but seems reasonable given Target will stop expanding soon and there are new initiatives in Milwaukee.

Table 4. Estimated Free Cash Flow

In Millions	2013	2014	2015	2016
Ex-Chicago	$    3,625	$    3,552	$    3,517	$    3,517
Chicago	$       390	$       567	$       736	$    1,030
Total	$    4,014	$    4,119	$    4,253	$    4,547
EBITDA	$    188.7	$    201.8	$    212.7	$    227.4
Interest	$      48.5	$      47.6	$      46.7	$      45.9
CapEx	$      65.5	$      65.5	$      65.5	$      65.5
EBT	$      74.7	$      88.7	$    100.5	$    116.0
Tax Rate	40%	40%	40%	40%
FCF	$      44.8	$      53.2	$      60.3	$      69.6
Mariano's CapEx	$       (25)	$       (25)	$       (25)	$       (25)
Adjusted FCF	$      69.8	$      78.2	$      85.3	$      94.6
Per Share FCF	$1.49	$1.67	$1.82	$2.02

Clearly the company has no problem producing cash and I believe the model above is on the conservative side. The remodel cycle was completed in 2009 and management has stated that true maintenance CapEx is around $25 million. The next remodel cycle shouldn’t start until 2016 if industry averages (7-10 years) are applied.

Even if one assumes that the CapEx ($25 million annually) to open new stores is really just true CapEx for the next refresh cycle, 2014 FCF of $53.2M works out to $1.17/share, a 15.6% yield to today's share price of $7.50.

The cash will be used to pay a dividend of $22.4 million each year ($0.48/share per year). The remainder of the cash will likely be split between store improvements and paying down debt, something management guided to during the Q3 2012, Q4 2012, and Q1 2013 conference calls. The company currently has $72.88 million cash on hand versus $692 million in debt. Their debt is floating rate (L+4.5% with a 1.25% floor) so it seems logical that they pay down some debt. Management has not disclosed how much they plan to pay down but they do have mandatory principle payments. The table below shows the scheduled debt payments. The company will  have no problem paying down debt and a dividend.

Table 5. Scheduled Debt Payments

Year	2013	2014	2015	2016
Principle Payments	$   10.92	$   13.03	$   11.74	$   11.90
Interest @ 7%	$   48.50	$   47.68	$   46.76	$   45.94
Debt by the End of Year	$ 681.08	$ 668.06	$ 656.32	$ 644.42

7% cost of debt assumes non-cash items

There is no exact fair value to RNDY. How much success Mariano's achieves and how quickly sales declines can be reversed will dictate a lot. Regardless, I believe that the company is undervalued and should be valued as a growing company rather than one in decline.

Conservative Approach

If we take 2013 FCF (before Mariano's adjustment), we arrive at FCF per share of $0.96. An 8X multiple, which assumes no growth gives a share value of $7.66, versus today's price of $7.50. In my opinion Mr. Market is pricing in very little growth in Chicago. There are 13 stores that should open by the end of 2013, all of which should generated over $40 million in sales during 2014. The declining sales in other stores (2.7%) will easily be outmatched by the increase in sales from Mariano's.

Optimistic Valuation

Arguably growth CapEx should be excluded and the company should be given some credit for their growth efforts. If we apply a 10X multiple to the 2013 FCF/share number in Table 5, we arrive at a fair value of $14.90/share, roughly double today's price.

If Mr. Market were to value RNDY at $14.90/share the dividend yield would be 3.22%, much closer to other grocers like KR(1.77%), AHONY(3.59%), HTSI (1.29%), VLEGA(2.82%) and SWY (3.48%). 

In-between Approach

Finally, if we assume that all the growth CapEx (for Mariano's) will simply be applied to store remodels in the future (that is, actual CapEx is consistent) then 2014's FCF of $53.2 million should be used. This works out to $1.13/share. Applying a 10X multiple, because cash flows are increasing and debt is decreasing by $10-$14 million per year, gives a fair value of $11.30/share.   

Risks

• Competition proves to be far greater than expected. Wal-Mart, Target, and perhaps Amazon in the future, are not to be taken lightly. I believe that the increase in sales from Mariano's will drive a different customer to their stores. It's unlikely that a customer who wants to hear live piano while grocery shopping will opt for Wal-Mart. The M14 initiatives should help mitigate future threats.

• Mariano's saturates the markets or experiences competition from Whole Foods and Trader Joe's. Mariano's is significantly less expensive than Whole Foods (produce is 70% the price of Whole Foods) so again, the customer should be different. Dominick's is leaving a void in Chicago that will need to be filled, who better than the team that filled that void more than a decade ago?

• Interest rates climb. With floating rate debt of $696.5 million, every 1% increase in LIBOR (over 1.25%) will increase interest expense by $6.96 million. 

Conclusion

Things have not gone as planned for Roundy's but hidden behind all the pessimism is a company trading at an attractive valuation with significant tailwinds. Mr. Market has punished the company and does not understand the potential that this company has as it executes on its Chicago plan, likely the CEO's legacy. 
Other analysts are too focused on what has happened and fail to look forward. 

I believe in five years the dividend cut will be seen as a great use of capital and shareholders will be rewarded as the company is valued as a growing company with good prospects. In the end this may be what Willis Stein sees and this may explain why they aren't dumping their shares. The development of a sub-fund to hold RNDY was likely them trying to keep the position and let things develop. 

Downside is limited because cash flows are robust now, even with competition from national big box stores. While the name could be dead money if the Chicago expansion doesn't grow as quickly as thought, a 6% dividend that is adequately covered(50% payout ratio on trough earnings) will compensate the patient investor. Sentiment changes take time, luckily we are patient investors. 



1. Author estimates that FCF in 2012 was $69 million

Disclaimer: This research report expresses our opinions. Any investment involves substantial risks, including the complete loss of capital. Any forecasts or estimates are for illustrative purpose only. Use of this research is at your own risk and proper due diligence should be done prior to making any investment decision.

This is not an offer to sell or a solicitation of an offer to buy any security. We are not registered as an investment advisor. All expressions of opinion are subject to change without notice and we do not undertake to update or supplement this report or any of the information contained herein. All the information presented is presented "as is," without warranty of any kind. We makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use.

Star Scientific (STSI)

A short primer: I don't short a lot. Right now the portfolio is short ~10%. Combine that with a 10% allocation to consumer loans and the end result is 80% net long. The process for finding shorts though is the exact same as longs. I look for things that don't make sense. If I can ask 1,000 questions and say "this business doesn't seem right''(whether it's under or overvalued) I feel as though I have a winner.

Finding a long that doesn't make sense is fairly straightforward and if you've done your homework averaging down is simply part of the process. On the flip side, shorting brings a whole new level of fun. ZIRP is making it expensive to short and there's the obvious factor of margin calls. I'm sure there has never been an "easy" time to short, but I would imagine today is especially onerous. Regardless, today I present Star Scientific.

Background

I found this idea on VIC (I'll briefly brag that I'm now a member) and the short case has been made by numerous other analysts (see here and here). I think the idea is better now than it was in the past, despite a much lower share price.

Here is the short thesis in a nutshell: the only thing that Star Scientific can sell is their stock. This isn't unusual for Jonnie Williams and team, they've been running sca....unprofitable, shareholder leaching, management-centric "businesses" for several decades. It took some time, but those other ventures eventually went to zero. (Oh yeah, he also can fit you with contact lenses on the cheap, no license needed!)

Anyways, the best piece of news to sell stock was when STSI sued RJ Reynolds for patent infringement. While they successfully received compensation from RJR, it is hard to argue that the $8.4M received was in the best interest of shareholders. We can see the original language in their license agreement from March 16, 2001. (SSI refers to Star and RCT refers to Regent Court Technologies).

8.2 SSI shall promptly notify RCT of any potential infringement of any of
the Patent Rights. In the event that a third party infringes on any of the
Patent Rights, SSI shall have the right but not an obligation to bring legal
action to enforce any such patent, including the right to bring suit in the name
of Star Scientific, Inc. If SSI exercises such right, SSI shall select legal
counsel and pay all legal fees and costs of prosecution of such action. In the
event that SSI shall choose not to take such action, RCT shall have the right,
at its option and at it own expense, to prosecute any action to enjoin such
infringement or to prosecute any claim for damages. The party prosecuting any
such action shall be entitled to retain any funds received as a result of
settlement or judgment of such action. The Parties may also agree to jointly
pursue infringers. After deduction and payment to the Parties of their
respective costs and fees (including without limitation reasonable attorneys'
fees) incurred in prosecuting any such actions, the net funds obtained as a
result of settlement or of judgment of any such jointly prosecuted action shall
be divided in the following manner: 25% of all net funds shall be divided
equally by the Parties and 75% of all the net funds shall be divided between the
Parties in the proportion to the amount of legal fees and costs incurred by the
Parties in the prosecution of such actions. 

STSI got to foot the bill and pay Regent Court Technologies a bunch of money. For Williams and company this has proven very lucrative. 

After "winning" this lawsuit, management decided that safe cigarettes weren't going anywhere. Eight out of 16 patents STSI holds will be expiring by the end of 2016 (pg 12 2012 10K), suing other tobacco companies and waiting a decade won't help them much. Thus, management has decided to shift their strategy again and market anatabine to consumers.

Anatabine

Anatabine is a minor alkaloid of tobacco. From a chemistry perspective it is simple and a synthetic process of isolating the compound has been known as far back as 1965. This was improved upon in 2005 (isolating optically pure substance in a method that should scale well). STSI came along and determined an even better way to synthesize the product. And guess what?

They could make kilos of the stuff and I doubt anyone would care. It has been known for decades that tobacco alkaloids are have some sort of pharmacological effect. These have been studied by other companies, some decades old.

So what does STSI think anatabine will cure in the future? Right now, ANYTHING dealing with inflammation.

Based on the overwhelming lack of evidence from reputable scientific sources I'd say that the company has a very low chance of success. I say this not because I'm an expert in pharmaceuticals, but because I believe, like investing, science is very hard. If it was easy, it's likely that it would have been discovered.

A search at PubMed for anatabine brings back 59 articles. There was only one article that gave details on the anti-inflammatory nature of anatabine. This was written by Daniel Paris from the Roskamp institute. The other articles not written by Roskamp associates were mostly analytical studies. It seems odd that no one, anywhere, has researched this small molecule. Unless of course it had no promise.

It's no secret that small molecule drug makers are finding few sources of new revenue. I would say that anatabine has been tested several times in various library assays for drug potential. Other companies probably think the chance of success is low and now so does STSI. This is despite the recent press releases that talk about medical studies on colitis (IR would not tell me who is actually running the study at UVA) the company seems to think the best chance for success lies elsewhere.

"Initially, marketing of Anatabloc ^® was directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who regularly deal with issues relating to inflammation." pg 6 2012 10K

So the company now believes it will make money from an overpriced, over-marketed, GNC product. There are 3 active ingredients in Anatabloc: vitamin A, vitamin D, and anatabine. Since it's been well established that vitamin A and vitamin D combat inflammation, where's the proof that Anatabloc is any better than multivitamin?

Discussions with physical therapists lead me to believe that in the past year the company was sending copious amounts of marketing material to medical professionals. Nobody bought the product except for one massage therapist who was referenced in a puff piece on STSI's press release page.

He got all of his information about the science from the company (he claimed to understand it but didn't know anything about the molecule when I questioned him). He heard about the company through a client...who was an investor in STSI.

Cash Burn

So what does it take to run a pharmaceutical lab investigating one of the greatest small molecules in the world?

In 2012 spent $4.5M on R&D. All that research obviously required a lot of publicity, which is why STSI spent $6.1M on marketing. Having worked at a venture backed company (chemical based) those numbers do not paint a pretty picture for innovation.

Regardless, the company burned through $17.4M of cash (FCF before working capital) in 2012, roughly in line with my estimated cash burn in 2011 and 2010.  Currently there is $23.1M of cash in the bank. Keeping a staff of scientists and their equipment hunting for the next breakthrough will be tough, especially with all that marketing spend and management incentives.

With a current burn rate of $1.4M ($17.5M/12 months) per month it seems likely that the company will have to:

A. Cut staff. This would drain resources from creating/selling product. Plus this is a very top heavy firm with set contracts and exit agreements. Every $40K tech they fire will only pay for 2 weeks of Williams salary.

B. Cut marketing. This would also drain resources from selling the product. The extra marketing spend (an increase of $3.6M from 2011 to 2012) was likely the only reason they increased sales to $6.188M in 2012 from $1.244M in 2011. I would imagine a lot of this is set too just to remain in GNC fliers.

C. Dilute shareholders.

Based on managements past, (C) seems most likely. Since 2010 share count has risen from 118.3M to 146.99M(8% growth per year). Further dilution is almost guaranteed unless Anatabloc catches fire. I guess there is a chance of this happening even though Anatabloc has been in GNC stores for more than a year now. Tom Dowd, a GNC executive, recently stated that "sales of Anatabloc continue to surpass expectations."

With sales of $6.188M in more than 4,000 GNC locations, GNC must have expected sales to be less than $1,547 per store per year, or 20 bottles/store per year($1,547 divided by $79.99 per bottle).  Since one bottle is only a months supply, there are 1.66 people per store buying Anatabloc(20 bottles/12 months in a year).

I'm being quite generous by saying all sales in 2012 took place in GNC, so the actual sales per store was probably lower. Even if my numbers were off (the wholesale price per bottle is ~$66 for a minimum of six bottles) it doesn't change the fact that barely anyone is buying this product despite endorsements, a national chain roll-out, and all the advertising that they can buy.

Conclusion

Star Scientific is a terrible company that doesn't make any sense. Now that the RJR lawsuit is out of the way it seems unlikely, if not impossible, that the company can grow their profits to match their ridiculous $190M market cap. With only $23M in the bank the company will have to exponentially increase sales to operate at breakeven operating margins.

Since they are already established in GNC I believe we are already seeing the best that they can do. In my opinion, the company is worth, at most, 2X book value(let's pretend that there is some value to the IP). With 146.99M shares outstanding and a book value of $24.98M(12/31/2012) this gives a per share value of $0.33/share compared to the current price of $1.33.

Even if some miraculous medical discovery happens, it will take years before the company is actually able to monetize anything. I believe that the large retail base and abhorrent management team makes this a timely and compelling short.

We are short STSI. This can change at any time.

Doral Financial DRL

Doral Financial (DRL) is a bank with two divisions, Puerto Rico and the USA. The company has had a slew of issues since 2004. The thought process behind examining this bank is simple: it's way to cheap if it's solvent enough to stay in business.

The table below shows just how cheap the company is compared to it's peers in Puerto Rico

Table 1. Silly Ratio Analysis

As the title indicates, the ratio analysis does little beyond tell you that the company is cheap. So let's look at the reasons it is cheap.

History

Like many fantastic organizations in the credit bubble, Doral took a very proactive stance to loan underwriting. By proactive I mean they would issue a loan to anyone with a pulse (and likely a few people without one).

Even better, the company was able to use creative gain-on-sale accounting to inflate income by almost $1 billion. The company also had managers who creatively valued interest-only strips. All this creativity caused the company share price to plummet.

All of this happened before 2005 and here we are in 2013 and the company is still dramatically cheaper than peers, who have all, in theory, improved their metrics. In fact, Doral ongoing struggles were even mentioned (not directly) in the Q4 2012 OFG Conference Call. Becoming a better bank rests on the belief that the newly created subsidiary, Doral Recovery, can manage the high number of non-performing assets and loans.

Doral Recovery

There are three main sections to Doral Financial. Doral Bank, Doral Insurance, and Doral Recovery. The corporate structure can be seen in the well-drawn flow chart below. My wife is an artist, I clearly am not.

Doral Corporate Structure

 

Doral Recovery was created in March of 2013 to manage

"The credit costs related to Puerto Rico TDRs and non-performing assets are the largest drag on our earnings. They need special attention, so we've established a special servicing capability; we call it Doral Recovery. The purpose of Doral Recovery is to isolate, manage, and resolve these assets." -Glen Wakeman Q4 2012 Earnings Call

 This isn't a new strategy, but what exactly are those assets?

Well from their Q4 presentation we can see that there is $699M of residential loans(43% of loans are performing), $525M of CRE, $127M of C&I, $111M of mortgage and Commercial OREO, and $147M of Construction and Land for a total of $1,609M in Recovery. The table below shows how they are performing. 

Doral Recovery Performing Loans

Therefore, there are at least $742M of non-performing loans in Recovery. On page 125/126 of their most recent 10K they list total non-performing assets and loans. Also on page 125 there are $111.9M of OREO NPLs. Grand total there are $894.8M of Non-performing Assets (NPA).

Clearly this is what the market is concerned about, and rightly so. But how much bad news is there?

Impact on Book Value

Book value was $835M at the end of the year. The allowance for loan and lease losses was $135.3M (pg 63 10K). Adding that non-cash figure back we get an pre-allowance BV of $1.011B. 

Let us assume that all non-performing assets are worth exactly zero. 

$1,011M - $894.8M = $116.2M (conservative) BV

That is BV to equity though and there is $352M of preferred shares out there (current liquidation value found on F-3 2012 10K). So in order for common equity to have any value the preferred needs to be made whole. Which means that Mr. Market thinks there is more than $236M ($352M-$116M) of value in those non-performing assets since the common shares are not a zero.

Just two weeks ago FBP announced a sale of loans to Lone Star Funds where they received 38% of their unpaid balance. This was for commercial and construction loans. Below I've shown a brief recovery analysis for Doral's NPA. 

Currently the common is $0.81/share, which implies a market cap of  $104M (128.44 shares outstanding). So Mr. Market believes that those loans will be able to recover $340, or 38%, of the NPA balance ($236M of preferred liquidation to make up and then $104M of common equity).

To me that says the market is pricing this well on the equity side and poorly on the side of the preferred, which are all trading below liquidation value. Next steps include understanding the preferred structure and determining a fair value for Good Bank Vs. Bad Bank.

Miscellaneous Thoughts

-Out of their $4.56B of deposits $2.12B are brokered deposits. I'm not a fan of it being this high.

Yellow Media (TSE:Y) Update

I believe buying Yellow Media(Y), either in the common shares or warrants, is an attractive investment today. Although the company was written up before, I thought I would expand my commentary.

The company has completed their recapitalization. Debt maturity was extended to 2018 and total debt was reduced by 54%. This will result in $45M less interest paid each year. The company is still generating significant free cash flow and even though the main business is dying there may be an overreaction by Mr. Market.

Effects of the Recapitalization

Overall the recap lowered debt by $1.5 billion. The company now has $800M (9.25%) senior secured notes and $107.5M of senior convertibles (8% per year or PIK 12%). All together they will pay $82.6M in interest per year.

Interest expense should drop though because the company has forced debt repayment. As mentioned in their filings, there is a bi-annual cash sweep that will be used to pay down debt. The minimum payment is $100M in 2013, $75M in 2014, and  $50M in 2015 for a minimum payment of $225M over the next three years in some fashion. So it should look something like this:

Interest expense is simply for senior notes. Total interest expense would add back $8.6M each year for the converts.

According to the covenants, this minimum will get paid as long as there's at least $75M in cash on the books. At the end of Q4 2012 they had $106.8M of cash on their books.

It has been mentioned twice (covenants and in the Q3 2012 Call) that there is a 75% excess cash sweep. So the real question is how much cash can the business generate?

Business Analysis

The business is divided into two segments, Print and Online. Obviously Print is not doing so well and is seeing double digit declines on an annual basis. It's tough to peg a firm number on decline rate. I'll try to estimate 2013 free cash flows.

1. In 2012 online revenues were $367.3M, up from $346.1M in 2011 or a 6% increase. Management has guided for growth of roughly 11% per year. It seems reasonable to conclude that with increased focus on the business the company can grow online revenues at least 4% and perhaps 11%.

Scenario 1(low): Revenue in this segment grows 4%. $367M*1.04 = $381.9M
Scenario 2(high): Revenue in this segment grows 11%. $367M*1.11 = $407.3M

2. Print. Ah print. This segment was declined considerably. In 2010 the print segment was doing $1,184M in revenue and it dropped to $740.7M of revenue in 2012. That's a drop of roughly 20% per year. Year over year I calculate that print dropped 24.5%(2011 had print revenues of $982M, this declined $241.3M). As another reference point, a decline of 20% per year is also what DEXO and SPMD forecast (Slide 13).

Scenario 1: Print declines by 35% next year(40% higher than this years decline): $740.7M *65% = $481.5M
Scenario 2: Print declines the same as it did this year (~25%) in the past two years. $740.7M*75%= $555.5M

3. Print revenues are expected to be 50% of total revenues by 2014, according to the Q2 2012 conference call. EBITDA margins are right around 50% and management expects this to go down into the 40's as they transition to online but they do not give a bottom figure. In the 2011 Annual Report (pg 29) Y states "most of our new online placement products contribute margins similar to those of our print products in our local markets."

I think EBITDA will go down but end up being somewhere between 40%-50%. In 2010 and 2009 online revenues were about 30% of revenues and EBITDA was over 54%. It seems reasonable that EBITDA margins will not drop much lower than 40%.

Scenario 1: EBITDA margins plummet to 40%
Scenario 2: EBITDA margins only drop 2% from 2012's average of 51% and end up being 49%.

Therefore in those two scenarios EBITDA will be...

Scenario 1: $381.9M + $481.5M = $863.4M*40% = $345.3M
Scenario 2: $407.3M + $555.5M = $962.8M*49% = $471.7M

(Both of these revenue and EBITDA calculations are below 2013 consensus. My hope is to come up with an independent assessment)

I think EBITDA will be between $345M-$471M. This is compared to a company that has $106M of cash and we know has $800M of long term debt and $87M of outstanding debentures. Enterprise value (assuming a market cap of ~$200M) is right around $1.0B. This implies a forward EV/EBITDA multiple of 2.8X-2.0X.

CapEx was $42.5M for 2012, and $68.8M for 2011.In the Supplemental Disclosure management breaks down CapEx. If we believe that 2012 is accurate due to the closure of Canpages, than CapEx could be around $45M in 2013(rounding up).

Interest is straight forward. They will pay up to $74M on the senior notes per year and $8.6M on the convertibles. Therefore Interest is at most $82.6M and will be less depending on the amount of debt paid off.

Taxes were guided to be $60M in 2013 and $80M in 2014 in the Q4 Supplementary Disclosure.

So cash available to pay down debt is:

Scenario 1: $345.3M-$45M-$82.6M-$60M = $157.7M

Scenario 2: $471.7M-$45M-$82.6M-$60M = $284.1M

75% of the excess cash is well above the minimum $100M required to pay off. Based on Scenario 1, I estimate that by Sept 2013(the second date of debt repayment) total LT debt should be less than $700M, reducing interest expense by $9M per year.

It's cheap, but so what?

The main reason one avoids a dying business is a lack of flexibility and inevitable squandering of capital by management to pursue "growth opportunities." The later is not as much of an issue because the new covenants force management to pay down debt and prevent management from taking on new debt. This should help prevent any large acquisitions. Good thing, if we use the Canpages acquisition as a template, management has proven to be poor capital allocators.

Discussions with IR indicate that there is more flexibility than one would think. Yellow Media does not own printing presses nor is it bound to them (see DEXO). Therefore if a business segment (say Montreal Yellow Pages print distribution) becomes unprofitable, management can shut it down and focus on segments that are still making money.

While there will be a slight lag (and thus a slight drop in EBITDA margins), management has shuttered unprofitable segments. I think the proof of this can be seen in the lower decline in EBITDA margins compared to print revenue declines. 

Downside

It would be sloppy to not address the potential downside here. I think the easiest way to imagine downside is to send the print business to zero and let online growth simply stay the same. I'll have to make a few vague assumptions here but my point doesn't change too much.

If print goes zero and online revenues stay the same, the result is revenues will be ~$360M. Management has told me there are few hard fixed costs. So I will assume that EBITDA margins come in at 40%. Even that is draconian compared to margins that have largely stayed the same.

So EBITDA is $360M*40% = $144M.

Interest would be $74M because the Senior Convertibles have a PIK toggle. If the print business goes to zero I'm willing to bet management would "toggle on."

CapEx would probably be cut to only "Sustaining Capital Expenditures" of ~$20M (this is just the annualized rate of sustaining Capital Expenditures on page 4 of the Supplementary Disclosure for Q3 2012).

So earnings before taxes would be $144M-$17.5M-$74M = $52.5M.  I can't imagine that much of any taxes would be paid. Either way it doesn't matter.

If this happens in the next three years they most likely default because they can't pay the mandatory minimum payments of $100M, $75M, and possibly $50M in 2013, 2014, 2015 respectively. Remember, they need to keep a minimum of $75M of cash in the bank. They've got $106M right now. So if print goes to zero TODAY they may survive for one year, but probably not two, and definitely not three.

Conclusion

It seems unlikely that the print business will go to zero over the next 3-12 months. Given the large number of subscribers (309,000) it's likely that the current rate of attrition can be extrapolated forward. I can only base this on what has happened the past couple of years and what similar companies (DEXO/SPMD) are predicting. Businesses can and often do fail faster than expected.

The million dollar question is: Will online revenues grow enough to transform a dying business with a small online segment into an online advertiser with a small dying print segment? I believe Q4 showed that print is going to die a slow death, one that hopefully can be milked. The company deserves a discount because cash flows may be squandered. At this price my models and research lead me to believe that Yellow Media is very undervalued.

I've also started to dig into DEXO/SPMD. The new company could offer an interesting hedge and/or investment I hope to dig deeper into the newly combined company over the next couple of months.

Blyth BTH

I'm sure many people heard about Bill Ackman's short thesis on HLF. If you haven't, do yourself a favor and check it out. It was phenomenal. I was mesmerized for the entire presentation and what was great was that all his research could have been accomplished by anyone will to work.

Time will tell if he is correct. Ackman, for all his glory, bets big and has failed even bigger in the past. I have zero intention of shorting HLF but I'm enjoying the discussion over the investment. I've examined MLM companies in the past and thought I'd write out a few quick thoughts on Blyth (BTH).

Background

I first discovered the MLM side of BTH at Roddy Boyd's newest webpage Southern Investigative Reporting Foundation(SIRF). I've always respected Boyd and thought his book on AIG was great.

Anyways, SIRF discussed the incredible growth of BTH, a story I won't rehash. There's plenty of internal dealings between ViSalus (the MLM group) and BTH. ViSalus also has it's fair share of odd insider activities. (Their white papers are literally about hearing loss! There's nothing to do with weight loss!) What I think makes BTH interesting is potential overlaps between BTH and HLF stories.

Similarities

1. Incentive to Recruit: On slides 246 and 247 of Ackman's presentation he shows the incentives that exist for promoters at Avon and HLF. The point that I thought was most informative is that Avon only pays you for three levels in a descending manner. Thus, there is no incentive to recruit and recruit.

Some MLMs do not have those limits, thus the incentive is to recruit and not sell. The compensation for ViSalus is designed to recruit very aggressively. If you don't believe me, check out their Summary.

2. Pop and Drop: Ackman shows several countries where HLF entered, saturated the market and dropped. Is ViSalus on the way there?

It is interesting to note that Q3 2012 had 110,000 promoters, down by 3,000 from the second quarter of 2012. The sustainability of the business could be shown over the next quarter or two depending on how many more promoters sign up or leave. This is simply something to watch.

ViSalus is preparing for international expansion in 2013. This could set them up for continued expansion and revenue growth. This too could be a similarity to HLF. 

3. Some similar faces at the top: The Chief Technology Officer and President of Visalus both hail from Herbalife.

Finally, some of the top distributors currently at ViSalus have worked for some....well, not so good MLM companies. I could list about a dozen people/companies that received nice cash bonuses to switch to or from Monavie, Limu, Momentus, ViSalus etc. It's seems to be a carousel.

So with those quick notes I think it's worth mentioning the other part of Blyth, the actual business.

The Decaying Core Business

Boyd hits on this in his article but I thought it was worth expanding. The core business is deteriorating and the only thing keeping BTH afloat is growth from ViSalus. The evidence is pretty clear in their filings.

Looking at last quarter we see that total sales were $269.8M. ViSalus contributed $169.9M (63%) of that. In 2011 BTH reported total revenue of $796.6M and ViSalus contributed $230.2M, meaning core BTH revenue was $566.4M. In the past nine months BTH parent revenue was $848.5M and ViSalus had $497M of revenue putting core revenue at $351.5.

Annualized this 9 month revenue figure works out to 2012 revenue of $468.6M, a one year decline of $97.8M or 17%. In 2009 BTH revenue figures came in at $913M, ViSalus represented only 2% of total sales at that point(Page 4).

So what is the Core Business worth?

To arrive at an estimation I looked back to 2011. My references were pg F-4 of ViSalus S-1A filed 09/17/12 and page 42 of BTH's 2011 10K.

I assumed that everything was consolidated (except for my calculated core profit #) because their ownership was over 57% for most of 2011 and over 71% during the end of 2011. As far as I understand everything up to operating profit is consolidated. My assumptions for interest and taxes should result in something more favorable towards BTH and thus a conservative (for bears) estimate of profit.

Core Revenue: $796.6-$230.186=$566.4M
Core Gross Profit:$473.99-$164.58M=$309.4M
Core SG&A: $424.32 - $129.35M= $294.97M
Core Operating Profit: $14.43M 
Core Interest Expense: $7.15 -$0.26M= $6.89M
Core Tax:$14.708-$9.87M= $4.83M
Core Profit: $2.71M


Even if we assume that sales and expenditures stay the same (extremely unlikely), equity for the core business isn't worth much besides residual asset value. With a current market cap around $258M (~16.6M shares outstanding after the recent buyback times $15.60/share) most of the value is being assigned to ViSalus.

Conclusion

I think that Ackman may have gotten a little ahead of himself here. He could end up correct, but to what degree he is right will dictate the success of this bet. With that said I think he makes some great points and his information is worthwhile.

I believe that ViSalus is similar to HLF and may see a pop and drop due to declining promoter enrollment, a trend that might be confirmed over the next quarter or two. This is not good for BTH due to the $229M payment in 2013(pg 11). This would wipe out all the cash on the balance sheet and leave BTH with a rapidly decaying business and an MLM arm. A significant cash crunch could occur if ViSalus doesn't continue to grow because BTH has ~$100M in bonds due in November 2013.

For now I will hold off and continue to research. Perhaps the best way to learn more is to make a visit to their Regional Event in NJ on the 19th. No position currently.