Friday, August 15, 2014

Newspaper Spinoffs

I did another lunch investment pitch roundtable today, this time the topic was "Impact of Technology on Communication and Stocks".  I was already looking into the recent news/print spinoffs, so I decided to squeeze them into the topic and pitch the whole basket.

Below is my deck with some commentary, outside of News Corp and New Media Investment Group, I've only looked into these spins at a surface level, so some numbers might be completely wrong.  But the sector seems attractive as its bottoming and figuring out the correct corporate structure, digital strategy and industry dynamics to survive.
The first quote from David Carr of the New York Times came from his column "Print Is Down, and Now Out" published on 8/10/14 after the announcement of Gannett's newspaper spin.  His column and this quote sum up the consensus view of the newspaper industry, it's ugly, unwanted, and destined for red ink in the digital age.  However, news and content is still valuable, it just needs to be more tailored to its audience.  A (digital) subscription to The Wall Street Journal is virtually a requirement for anyone in finance or a senior management position in corporate America.  On the other end of the spectrum, community newspapers are the only news source for many small cities and can provide valuable targeted advertising.

As for the spinoff dynamics, most newspapers have been essentially hiding within otherwise growing media conglomerates, by exposing the print business, management will be forced/incentivized to adapt their product to the current marketplace.
There's nothing really new in this slide compared to my post on News Corp nearly a year ago, but REA Group's market value continues to rise, Harlequin was added, and hopefully Amplify is closer to wider acceptance.  One minor complaint, the quarterly conference calls sound like management is telling a story rather than a business update, makes the lack of a clear capital allocation plan even more of a concern.  But it's clearly cheap.
This is another update slide for blog readers, I'm still on the fence about New Media, like the strategy but I remain concerned about the third party management agreement and how that might be bought out or internalized.  Fortress is a savvy shop, and they've executed on the plans they've laid out.  Their quarterly presentations are transparent, a little promotional, but it clearly presents the investment thesis and should net investors high teen returns as they buy local papers cheap and they're rerated in the public markets.
Now we get to recent spins, Tribune Publishing is the riskiest of the bunch, its leveraged and doesn't have the benefit of its real estate assets.  Its papers are primarily large metropolitan newspapers, a segment that's similar to a JCPenney's in the retail space, stuck in the middle without a loyal customer base.  However, its very cheap and has a lot of upside if turned around, parent Tribune Media emerged from bankruptcy about 2 years ago and former creditors (unnatural holders) might be taking advantage of the liquidity of an NYSE listing and selling.
The newspaper spins really picked up in the last two weeks, Gannett announced they were going to spin off the publishing business earlier in the week.  I don't know the exact timing of the filings, but Carl Icahn curiously filed a 13D after the spin was announced, suggesting the spin.  There might be some upside left, but this transaction is well publicized and pretty straightforward.

E.W. Scripps & Journal Communications
The more interesting transaction is the "double spin/double merger" of E.W. Scripps and Journal Communications, where both will combined their TV/radio broadcast divisions and then spinoff their newspaper segments into a new company to be named Journal Media Group.  Both companies would be free of cross-media ownership rules and could therefore pursue acquisitions in markets they were restricted from as combined broadcast and print companies. 

Today the two companies have a combined $1.5B market cap, if you take management's guidance of $200MM EBITDA and use a 9x multiple (low end of comparable broadcast companies due to radio exposure) the "new Scripps" is worth roughly the current market cap and you get the Journal Media Group newspaper business "for free".  It's a complicated transaction that won't close until sometime in 2015, and there are more merger details including a $60MM special dividend to Scripps shareholders, but with more consolidation in both industries likely, it initially appears to be an attractive deal for both future companies.

Each of the recent spins are a little different, but as a group they should outperform the broad market over a 2-3 year time.  I could also see regulations relaxing in this space, newspapers/radio/local TV entities aren't as influential as they once were, encouraging more consolidation.

Disclosure: I own shares of NWSA

Tuesday, August 12, 2014

Mario Gabelli: "Activism - New Catalyst to Surface Value... Good or Bad?" - Notes

I attended an enjoyable luncheon today titled "Activism - New Catalyst to Surface Value... Good or Bad" with Mario Gabelli, Founder, CEO, and PM for the value strategies at GAMCO (GBL), he's as talented of a speaker as he is a value investor.  Here are some short form notes I took and wanted to document:

  • Gabelli manages the Gabelli Asset Fund, a $3.8 billion dollar five star fund with an amazingly low 6% turnover ratio, he mentioned several names that he's held for over 20 years
  • He's a believer in "POSP" or Plain Old Stock Picking, he researches one stock, one industry at a time and doesn't spend a lot of time worrying about economic indicators (showed a cartoon of an analyst flipping a coin) or overvalued sectors like biotech or social media - I particularly liked this point and its how I try to approach investing, it's fun to discuss where we are in the economic cycle, but I don't think there are many people smart enough to consistently exploit it
  • Shareholders own the company; think like an owner
  • In 1988, he posted a "Magna Carta of Shareholder Rights" and still stands by it today:

  • He's fiercely against poison pills and actively works to remove them, compared the poison pill to the Berlin Wall and management trying to keep the shareholders out, entrenching themselves
  • Wants short sellers to disclose their holdings, same with distressed debt buyers attempting to gain control of a company going through a restructuring
  • He looks for companies trading below private market value that have a catalyst in place to close the gap, he's recently added activism to his list of potential catalysts alongside (1) regulatory changes; (2) industry consolidation; (3) death of founder; (4) stock repurchases; (5) sale of a division; and (6) management or capital succession
  • Activism is a net benefit to shareholders
  • Large inflows in recent years at activist funds, lots of OPM (Other People's Money) to play with
  • Be aware of activist fund intentions, the 2&20 fee structure encourages activism, need for a big quick win, good for publicity to raise assets
  • Lots of special situations as a result of activism (spinoffs, splitoffs, mergers, and liquidations), went through a few local Chicago examples like Fortune Brands and Kraft
  • During the Q&A he dropped a quick stock pitch for GATX Corporation (GATX), a railcar lease company that should earn 12 or 13% CAGR over the next decade
  • Also likes content and media companies, been on TV recently discussing Twenty-First Century Fox (FOXA) and others
He's an active alumnus of the Columbia Business School (interviewed in the Fall '11 copy of Graham and Doddsville), good to get a little Dodd/Graham philosophy reminder every now and then.

Friday, August 8, 2014

Exelis and its Spinoff Vectrus

Exelis Inc (XLS) is an aerospace and defense contractor that was originally spun off of ITT Corporation (ITT) on 10/31/2011, and now Exelis is following suit by spinning off its shrinking mission systems business line into a new company called Vectrus (VEC) later this summer or early fall.  This is the classic move to separate the declining business to highlight the attractive remaining business.  Exelis will be more of a pure play aerospace and defense products contractor focused on a few select growth sectors.  Vectrus will be a government services defense contractor with falling revenues, but strong cash generation due to the low capital requirements and a variable cost structure.

Both Exelis and Vectrus will benefit:
  • Exelis benefits by shedding the underinvested services business which is experiencing severe declines in revenue due to budget constraints and the draw down of troops in Afghanistan.  The mission systems business is weighting on the rest of the business and masking the improved growth profile of Exelis's C4ISR segment and other growth initiatives, giving the remaining business a higher multiple.
  • Vectrus is similar to other recent spins in the government services space (Engility Holdings & SAIC), declining revenues in the near term is less of a problem than it appears due to the low fixed costs, most of their costs are variable and attached to specific contracts.
With increased geopolitical tension defense contractors could once again see their revenues pick up from cyclical lows and Exelis represents an attractive event driven way to invest in that theme.
At the time of the Exelis spinoff from ITT, mission systems was the growth business and the rest of the business was flat or declining, times have certainly changed.  Shortly after the spinoff from ITT, defense spending came under a microscope with budget sequestration and the draw down of troops in Afghanistan.  In 2013 Vectrus had $1.5B in revenue with 100% of that coming from the U.S. Federal government, a full 92% from the U.S. Army, and 34% of 2013 came from Afghanistan which is quickly going away.  Revenues are expected to be down 25% in the mission systems business in 2014, with additional downward pressure in 2015.

Vectrus will operate in three main business lines: base operations (majority of the revenue), logistics, and network communications.

Major contracts include (69% of 2013 revenue):
  1. Kuwait Base Operations and Security Support Services (K-BOSSS) contract for Camp Arifjan: Base operations contract for one of the largest bases in the U.S. Military, services include: medical services, postal and maintenance, public works, transportation, and emergency services
  2. Operations, Maintenance and Defense of Army Communications in Southwest Asia and Central Asia (OMDAC-SWACA) contract: Network communications contract expiring in 2018 supporting the O&M of the Army's largest network from locations in the Middle East.
  3. Logistics Civilian Augmentation Program (LOGCAP): Logistics contract where Vectrus is a subcontractor for certain task orders, the subcontracting agreement ends in 2018
  4. Kuwait based Army Prepositioned Stocks-5: Logistics contract storing and supporting a wide range of military equipment and supplies.
Despite the industry headwinds, Vectrus can be an attractive business due to its low working capital requirements, much of their employment base are subcontractors attached to single contracts, as the contracts wind down so does a lot of the expense base.  Operating margins aren't great, at 4.0-4.5%, but with a renewed strategic focus on the business (classic spinoff reasoning) there will likely be some additional restructuring and cost cutting in the months after the spin is completed.

Leading Vectrus will be Ken Hunzeker, he has been the president of the mission systems business going back to the ITT/XLS spin, and is in for a nice raise.  Slightly more interestingly, Lou Giuliano will become the Chairman, he's the former Chairman and CEO of ITT and ran what would become Exelis at ITT for 8 years before becoming the President and COO of ITT in 1998, so he's intimately familiar with the business and the defense industry cycles.

Like many spins, Vectrus will be take out debt in order to pay a dividend back to the parent, here they're targeting 2.5-3.0x EBITDA, or approximately $130-150MM (although that's been a moving target down recently).  Government services businesses generate a lot of cash, I view debt (as long as its reasonable) as a positive here, management will likely be focused on paying down the new term loan and potentially refinancing to a better rate once the company becomes more seasoned.

Vectrus should have EBITDA of $50MM in '15 EBITDA, assuming they max out the debt at the 3x range, and putting a discounted 7x EV/EBITDA multiple on it gives you $200MM in market cap, a small slice of the $3B combined Exelis market cap.  I would imagine there will be some selling once the spin appears in Exelis investor's accounts as it will be a small unwanted orphan (it's worth about $1 per XLS share), so one strategy would be to wait for the spinoff to occur and settle out a bit before snapping up Vectrus shares on the cheap.

Exelis has identified four "Strategic Growth Platforms" in which they want to focus and invest going forward: (1) Critical Networks;  (2) Intelligence, Surveillance and Reconnaissance Systems & Analytics; (3) Electronic Warfare; (4) and Composite Aerostructures.  The Vectrus spin allows Exelis to appear more attractive to investors, post-spin it will have higher margins and a diversified revenue base less focused on the Department of Defense.
While top line revenue is down double digits YoY for the combined Exelis, the majority of the decline is the Vectrus business while the rest of Exelis is mostly flat with growth expectations going forward that should deserve a higher multiple.

Pension Liability
When Exelis was spun off of ITT, many called it a pension plan with a defense business attached to it, and that would have been a fair assessment.  Exelis has made significant progress on the pension (~$1.3 billion unfunded position as of the last 10-Q) and will retain and continue to service it after the spin.  The company has also frozen the pension plan of all future benefit accruals effective December 2016 and expects it to stop needing to make additional contributions to the plan after 2017.

Continued low interest rates have plagued companies with large pension plans because it lowers the discount rate at which a defined benefit plan calculates its future liability.  The lower the discount rate, the more current assets the plan needs to meet the future pension liabilities.  Tucked away in a transportation and student loan bill (MAP-21) was a pension funding relief provision that is likely going to get extended, it will reduce the amount Exelis will be required to contribute to its plans in the next several years from $225MM annually to $150MM.  This gives time for interest rates to normalize (bringing the discount rate up) and may reduce the overall contributions necessary by Exelis.

Post-Spin Cash and Capital Allocation
Vectrus will be paying Exelis a dividend of ~$150MM upon the spinoff giving the parent company amply liquidity when you consider the unused commercial paper program and credit facility with very little net debt.  Exelis anticipates maintaining their current quarterly dividend (2.5% yield), and could return additional capital to shareholders with their share repurchase program.  The flexible balance sheet also allows them additional room to invest in their Strategic Growth Programs and bolt on some smaller acquisitions like they recently did with the Orthogon airport management business.

Exelis Valuation
To value a post spin Exelis I added the $1.3B pension liability to the net debt, along with the $150MM dividend from Vectrus, subtracted out the $50MM in EBITDA that Vectrus is expected to earn in 2015 and then added back the pension contribution to EBITDA.  If Exelis were to be valued at 8x this adjusted EBITDA measure, I come up with a ~$24 price target for the remaining business.  Add the additional $1 for Vectrus, and the combined business is worth $25 per share versus $16.41 at today's prices.

  • Greater than expected headwinds in the Vectrus mission systems business, especially in their major Afghanistan and Iraq contracts.
  • Continued political pressure to reduce military and defense spending, although temporarily out of the headlines, the budget deficit is still substantial and unsustainable. 
  • Exelis has a large unfunded pension liability in comparison to its market cap, if interest rates stay flat or decline it could force Exelis to make additional pension contributions above current projections.  Additionally, Exelis is assuming an 8.25% rate of return (down from 9.00% in 2012) which could turn out high given current elevated asset prices.
  • The spinoff was guided earlier in the year for "Summer 2014", but has now slipped into summer/fall, further slippage or cancellation of the spinoff would reduce the attractiveness of Exelis, but it still remains an undervalued company in its current form.
With the defense industry near a cyclical bottom, the spinoff of the Vectrus mission systems business provides an attractive event driven investment opportunity by creating a higher growth products business and a headwinds facing services business.  I'm initially going with a Joel Greenblatt like call option strategy to enter a postion, the spin will expose value in both the parent and the orphan, but I'm extending it out with a January expiration to allow Vectrus a little time to find a following in the investment community.  Depending on where Vectrus trades after the spinoff, I may pickup some additional shares at that point.

Disclosure: I own XLS calls, anticipate buying VEC shares sometime after the spinoff is completed

Wednesday, July 16, 2014

Quick Post on PHH Corp

The PHH Corporation story is pretty well known at this point.  Before two weeks ago, it operated in two unrelated businesses: mortgage origination/servicing and fleet management leasing.  At the insistence of an activist campaign (which the activist curiously exited last week) the company sold off it's fleet management business to Element Financial Corporation for $821MM net of taxes ($1.4B pretax) to create a purer play on mortgage origination and mortgage servicing rights.

The mortgage origination business is struggling in the current environment, refinances have mostly dried up as those who could refinance already have and the home purchase market has yet to really show signs of strength as consumers are struggling with debt and stagnant wage growth.  The servicing side of the business however should become more valuable as interest rates rise and fewer mortgages are refinanced stretching out the length of time borrowers maintain their mortgage and increasing the servicing fees collected by PHH.  The business is at a cyclical low, layoffs are in the thousands across the industry, sentiment is low, and that creates a potential opportunity when teamed with the sale of the fleet management business.

The market cap of the company is only $1.4B, so the sale of the fleet management business represents a large cash infusion, PHH laid out it's plans in a recent investor presentation:
PHH is planning on repurchasing up to $450 million in stock over the next 4-5 quarters, including $200 million shortly after the 2nd quarter earnings release, or a total of ~32% of the market cap.  PHH's shares trade at 0.75x proforma tangible book value (with the optionality of the mortgage servicing rights value increasing in a rising rate environment) and within a few weeks there will be a large indiscriminate buyer in the market scooping up shares.  Approximately 30% of the shares are short, and 40% of the shares are in the hands of Hotchkis & Wiley, PIMCO, Citadel, and DFA, plus another 10% in index funds, sets itself up for a potential small short squeeze rally.  So in the end, you get a business that's retooling itself for the next stage of its business cycle at a cheap price with a near term catalyst.

Disclosure: Long a small amount of PHH

Saturday, July 5, 2014

CBS Outdoors Americas: Split-Off, Exchange Offer, and a REIT Conversion

Following up on the REIT conversion theme that is ever so popular this year, there's an interesting exchange offer giving CBS shareholders the opportunity to swap CBS shares for CBSO at a 7% discount.  CBS Outdoors Americas (CBSO) is another REIT conversion that split-off of CBS Corporation (CBS.A/CBS) earlier this spring via an IPO of 19% of the company on 3/27/14 (CBS retained the remaining 81% stake).  

CBS Outdoors is a billboard and out of home display advertising company that operates over 350,000 billboards throughout the United States, Canada, and Latin American.  The company generally owns the physical billboard assets but leases the underlying sites from property owners.  Their advertising revenue contracts are usually short term in nature, however billboard advertisements are seen as DVR proof (or as the company puts it "always on") and their popularity has increased in recent with advertisers as print and other forms of advertising have suffered.  The company is focusing its capex efforts on converting select billboards to a digital format which brings in 3-4x the revenue as engagement improves and advertisers can be more targeted (night versus daytime, etc).  It's an established business that's relatively stable, although is subject to the cyclical nature of the economy as advertising dollars ebb and flow.

The main reason for the split-off is so CBS Outdoors can convert their corporate structure to a REIT and eliminate most corporate level taxes.  Unlike some of the other conversions I've been highlighting, CBS Outdoors has already secured the private letter ruling (PLR) from the IRS back in April which is why the pre-REIT discount isn't as significant here.  But because CBS still owns 81% of CBSO, it cannot formally convert to a REIT until after the exchange offer is complete, which it plans to do immediately.  The conversion purging dividend isn't a big issue here, estimated at $500 million, $100 million of that will be in cash (or ~$0.83 per share) and the other $400 million will be in shares, or roughly 12.4 million (+10% to the outstanding) in additional shares.

CBS Outdoors has two pure play display advertising rivals in the US: Lamar Advertising (LAMR) and Clear Channel Outdoor Holdings (CCO).  Lamar is also pursuing a REIT conversion, Clear Channel is a little murkier as it has a complicated private equity structure that makes comparasions more difficult.  They're all valued roughly the same at 11-12.5x forward EBITDA, but that's still a moderate discount to the REIT universe that trades for 15-20x EBITDA.

From an AFFO prespective, CBSO earned approximately $2.00 last year, so proforma for the purging dividend its trading at 15x trailing AFFO.  Not screaming cheap, but still a slight discount to traditional REITs.

I tend to look for opportunities that don't screen well, CBSO doesn't look attractive on a traditional P/E basis (~22x), even though the REIT conversion is well known, it will take some time for REIT investors to become familiar and comfortable with the outdoor sector.  One risk to note is CBSO will not be included in any well followed indexes after the exchange offer is completed which may increase the time it takes to gain acceptance in the REIT sector.

As a way to get an even better valuation, CBS shareholders can exchange their shares for CBSO shares at a 7% discount.  The exchange essentially works as a buyback for the parent CBS as it will retire the shares that are offered in the exchange.  There is an odd lot provision where holders of fewer than 100 shares of CBS will not be subject to proration provided they tender all their shares.  No fractional shares will be issued, and there is an upper exchange limit of 2.1917 CBSO shares for each CBS share.  The offer expires on July 9th, so if you want to participate you need to act quickly.  After the exchange is completed, CBS Outdoors will have the right to keep the CBS name for 90 days before rebranding, and they'll have up to 18 months to rebrand the 350,000 billboards which sounds like quite the endeavor as well.

Overall, CBS Outdoors Americas is a moderately undervalued security that is made more attractive via the exchange offer.  I purchased 99 shares of CBS, to avoid the proration, and have submitted my shares for exchange effective next week.  I don't anticipate making it a long term holding (few weeks to a few months), but I'm comfortable participating in the exchange offer and accepting the market risk given CBSO's relative undervaluation compared to REIT peers.

Disclosure: I own shares of CBS, going to fully exchange for CBSO

Monday, June 30, 2014

Mid Year 2014 Portfolio Review

In my year end 2013 portfolio review,  I planned to do this quarterly, but I don't think I'll have enough commentary or trades to give a full update each quarter.  Going forward, I'll do a portfolio performance review semi-annually.  Onto the results (there were no deposits or withdrawals into the blog portfolio during the period):

The first half of 2014 has been great, just about all of my ideas have been working, but I don't have any visions of this continuing at the current pace.

However, a lot of value investors get too caught up in the macro picture, trying to outsmart the market by holding large cash positions, tweeting links to examples of excess in the market, and attempting to call a market top.  It always sounds clever to be bearish and pessimistic, but it's not productive unless you're trying to build followers.  I'd rather focus on finding a handful of mispriced securities than constantly worrying about when the next market correction is going to happen, it will at some point, but for smallish investors it leads to bad decision making.

Current Portfolio
 Positions Closed

You'll see I disposed of the thrift/mutual bank conversions, I still like the strategy and will continue to highlight conversions I find attractive, but for now I'm going to pass until I increase the size of the portfolio or macro conditions change.  I'm finding too many other opportunities available that don't have 2-3 year opportunity costs like a thrift conversion.  I also work for a large bank and I'm fully aware of the headwinds facing the entire industry, especially those highly weighted towards net interest margin like small community banks.

There are so many spinoffs happening right now it's hard to keep them all straight.  Despite the value creation being fairly well known at this point, spinoffs still outperform as a group.  I'm going to try to identify a few that I find interesting in the back half of the year.  Then exploiting them either by buying a call option if I believe the spinoff is actually the more attractive asset (like OIS/CVEO), or wait until regular trading occurs and buy the spinoff if its the orphaned business that gets sold indiscrimately.  I also like the REIT conversion trend, curious to see if these conversions and tax inversions acquisitions will finally spark some corporate tax reform in Washington.

Position Thoughts/Updates
Howard Hughes Corporation
Lots to like at Howard Hughes Corporation, they're aggressively investing in their "strategic assets" which will make their way into operating asset bucket over the next few years.  At some point in the future, it doesn't make sense to have these stabilized operating properties in a C-Corp structure, so another REIT spinoff could be in the offering once the NOLs are used up.  I like this company as a long term compounder, they have quite a few levers to pull and a capital allocation/shareholder focused management.  At a recent investor presentation, management quipped that an analyst's $200 price target was too low, I would agree.

It's balance sheet has uncovered most of the hidden real estate value due to accounting consolidation rules already creating a quick gain.  The question is what's next?  I like the share repurchase program, but that doesn't really help the fact that they're too small to be a public company, and they're only breaking even on an operating basis.  MuniMae has an incredible amount of NOLs, they should be initiating a rights offering and buying an operating business that throws off taxable income.  It's no longer a screaming buy, but I'm going to hold and let the situation play out more.  However, it's towards the top of the sell list if I need cash for a better idea.

Ultra Petroleum
The Uinta Basin purchase is a nice bridge asset, its going to be cash flow positive right away and gives management and analysts something to focus on while waiting for natural gas to resume its climb up.  There's still a huge spread between natural gas prices in the United States and what it fetches in foreign markets.  Given the recent news about oil exports being allowed for the first time in 40 years, more LNG export terminal approvals might be in the offering as well, long term this spread should narrow.

Disclosure: Table above is my blog/hobby portfolio, its a taxable account, and a relatively small slice of my overall asset allocation which follows a more diversified low-cost index approach.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.

Friday, June 20, 2014

More Thoughts on Civeo Corporation

I gave an investment pitch at a CFA Society of Chicago roundtable today with a "Value investing in a not-so value world" topic theme, my idea was Civeo Corporation, below is the deck I used, been a great winner for me so far via a pre-spin call option that expired today.  I presented a pretty bullish view for the purposes of the pitch, but I think it has decent room to the upside as they pursue a REIT conversion.

Disclosure: I own shares of CVEO, sold my shares of OIS