November 27, 2007

Is Discover a Deal?

From the Fool:

When shares of Motley Fool Inside Value recommendation Discover (NYSE: DFS) traded at $25, I described them as a "solid buy." If shares kept sliding, I warned, I might be forced to pull out my wallet. With Discover now marked down below $17 as investors flee the financial sector, it's a good time to take another look.

The sliding spinoff
Why have Discover's shares performed so poorly? Besides the obvious credit-crunch problems roiling the financial sector, I believe the company's spinoff status is also partly to blame. Like the fortune cookie at the end of a Chinese dinner, spinoffs are often cast aside because they're a free giveaway at the end of dinner, not the main course.

When Morgan Stanley (NYSE: MS) spun off shares of Discover Financial, it was easy for investors to overlook the company. After all, Morgan Stanley is a blue-chip investment bank, while Discover is only the sixth-largest credit card issuer, and the fourth-largest credit card network.

In addition, Morgan Stanley distributed one share of Discover for every two shares of Morgan Stanley investors owned. At the time of the spinoff, Morgan Stanley shares were trading at about $75, and Discover at $30.

Given the 2-for-1 ratio, Morgan Stanley investors would've received $15 worth of Discover stock for every $75 in Morgan Stanley stock they owned, or a mere 20% of the value. As a result, it would've been easy for investors to not even care about their Discover shares, and simply dump them.

As Discover shares kept sliding, it's likely that increasing numbers of disinterested shareholders, handed shares that they never chose to own, joined the selling frenzy.

Credit card comparables
Capital One (NYSE: COF), American Express (NYSE: AXP), and MasterCard (NYSE: MA) currently trade at seven, 14, and 26 times forward earnings estimates. Why the discrepancy between Capital One's multiple and those of its larger rivals? It's largely a matter of credit risk.

MasterCard, as a credit card network, takes a small fee from every transaction and bears virtually no credit risk. Thus, it trades at a rich multiple. American Express' customers are usually the ultra-rich, and the company also owns its own credit card network, in addition to being a credit card issuer. As a result, the company isn't as prone to credit risk. In fact, even if credit losses had doubled last quarter, American Express still would have made a profit.

On the other hand, Capital One, as a credit card issuer that doesn't own its own network, makes most of its money from what it earns in interest payments from credit card holders, minus its cost of funds and credit losses.

Thus, it's much more exposed to credit risk than a credit card network like MasterCard or a network/issuer like American Express. As a result, Capital One has taken a series of credit losses (partly because of a discontinued mortgage segment), and its shares trade at a much lower multiple.

What price Discover?
In that framework, what would be a fair price for Discover? Unlike Capital One, Discover owns its own credit card network, but it lacks the affluent client base of American Express. It also has a much smaller market share than MasterCard. On a relative basis, it should arguably trade at a premium to Capital One, but at a discount to American Express or Mastercard.

At 10 times forward earnings (equating to a 10% earnings yield), Discover seems fairly priced -- attractive, even. Although shares have fallen on consumer credit fears, the average FICO score on new Discover accounts is a respectable 734. So while credit losses will almost certainly increase next year, it seems that Discover has remained disciplined in its credit underwriting.

Although Discover will be fighting headwinds as credit losses increase and the economy swoons, at an estimated 10% earnings yield, it seems to be paying shareholders enough to assume its consumer credit risk. As a result, investors with a two-to-four-year outlook and a stomach for volatility could do very well if they make room in their portfolios for Discover.

November 26, 2007


Outdoor gear superstore concepts like Bass Pro Shops and Cabela's are sorely misunderstood. The large boxes appear overly lavish, complete with themed camping terrain, large aquarium tanks, and museum-like wildlife displays. Shopping is an adventure, yet the chains are positioned reasonably well for a tightfisted future because they provide a lot of entertainment bang in pursuit of the buck.

Sales continue to grow at Cabela's, though earnings dipped slightly this past quarter. With the stock now trading at just 10 times next year's analyst profit target of $1.62 per share in earnings, Cabela's is cheap. It's now better looking prey than some of its snapshot-ready critter replicas.

It is close to its 52 week low.


Cement. Yep, our contest winner is the third-largest cement company in the world. This company, which was recommended by Bill Mann in the June 2007 issue of Motley Fool Global Gains, dominates the Mexican cement market and has operations in more than 50 countries. As fellow Fool Anand Chokkavelu recently noted, Cemex's share price is down more than 35% since the summer, most likely because it was incorrectly tied to the U.S. housing market. Anand argues persuasively that Cemex's exposure to the U.S. market is limited -- indeed, the company is broadly diversified across different markets.

Bill Mann is equally enthusiastic about Cemex, having declared back in June that he expects this "$25 billion market cap company will be worth $50 billion or more within three years."

On MDC Holdings

It's trading for book value, but it boasts $730 million in cash and more than 20% insider ownership, and it's poised to weather the real estate downturn.It is also trading at a 52 week low with a dividend. It is also a MF Hidden Gems pick.

November 21, 2007

American Repographics

The stock I'm highlighting today is so seriously undervalued, I've staked part of my professional reputation (and some cold, hard cash) on it. You see, I recommended American Reprographics (NYSE: ARP) in the November issue of Inside Value, our value investing newsletter. Since no good deed goes unpunished, the firm promptly missed its third-quarter earnings. Shares have tumbled roughly 30% since I recommended it -- but I'm not concerned.

At approximately eight times the size of its nearest competitor, American Reprographics is far and away the dominant firm in the fragmented reprographics industry, reproducing graphics for the architectural, engineering, and construction (AEC) markets. But printing all the documents relating to a construction project is only the first rung on the "value ladder." American Reprographics also provides document management, thanks to a proprietary platform that it licenses to other firms as the industry shifts from analog to digital technology.

The company is determined to press its competitive lead through an aggressive acquisitions program, having already purchased more than 100 smaller reprographers since 1997. American Reprographics now has more than 280 branches in North America; none of its competitors can boast a national footprint.

You say residential, I say commercial
American Reprographics' stock has been pummeled lately, losing more than 50% year to date. This owes partly to investor concerns about the effects of the housing crisis on American Reprographics' franchise. However, it's worth remembering that less than 15% of the firm's revenue is tied to residential construction, with the majority (65%) derived from commercial construction projects. During the third quarter, the company did register a slowdown in the former segment, but the latter remained healthy. Furthermore, the housing downturn is reducing the valuations of smaller rivals, making them more attractive targets for American Reprographics.

The ultimate margin of safety
In a recent interview, First Eagle Funds' star value manager, Jean-Marie Eveillard, noted that the distinction between Benjamin Graham's and Warren Buffett's approach to value lies in their approach to a stock's "margin of safety." Graham defined the margin of safety as the amount by which a stock's intrinsic value exceeded its market price; he would entertain buying any stock where a margin of safety existed. However, Buffett learned that it may be worth paying full value for outstanding businesses, because of their ability to compound shareholder wealth. Steady increases in intrinsic value create their own "margin of safety" by reducing the odds of a permanent loss of capital.

My point? American Reprographics is the best sort of undervalued stock, offering both forms of "margin of safety." Its present intrinsic value is higher than the price at which shares are currently changing hands, and I fully expect that intrinsic value to increase over time, thanks to a disciplined acquisition program and profitable organic growth. American Reprographics' depressed share price is no blue-light special -- it's a clear invitation to buy quality on the cheap this Black Friday.

Still not convinced? Don't overlook the firm's growth opportunities in China, and in catering to other industries. (The firm recently signed a three-year contract with Boeing, potentially worth $45 million.) In addition, management is aligned with outside shareholders through an aggregate 19% ownership stake in the company.

ViroPharma is On Sale

Attention Kmart biotech shoppers: ViroPharma (Nasdaq: VPHM) is on sale in Aisle Four! Value investors searching for the multibagger spice that a drug developer can provide need look no further than ViroPharma.

Most value investors would never go near biotech stocks, which is unsurprising, since most drugmakers are unprofitable and dependent on the FDA and other regulatory agencies to get their products to the market.

Fortunately, ViroPharma already has a drug approved by the FDA. On the back of its lead compound, an antibiotic named Vancocin, ViroPharma had $95 million in operating cash flow last year, and operations have already provided $92 million in the first nine months of 2007. Not bad for a drugmaker with a market capitalization of about $550 million and more than $300 million in net cash and investments on its balance sheet.

I've been a fan of ViroPharma since it was trading at the $14-a-share level. Unfortunately, that was a little too early to get excited about the drugmaker; its hepatitis C drug candidate subsequently offered a few too many side effects in combination with its impressive efficacy.

The side effects of ViroPharma's HCV-796 are disappointing, considering that the drug's efficacy has only been bested by a few other anti-hepatitis C drugs such as Vertex Pharmaceuticals' (Nasdaq: VRTX) telaprevir and Schering-Plough's (NYSE: SGP) boceprevir.

ViroPharma and partner Wyeth (NYSE: WYE) discontinued dosing of HCV-796 -- one of only two clinical-stage drug candidates in ViroPharma's pipeline -- after the unexpected side effects popped up, and they will decide in the coming months whether to continue development of the drug based on how patients perform in long-term follow-up.

Following the negative hep C drug results in August (and some suspicious trading beforehand), shares of ViroPharma have fallen more than 40%. This drop in share price skews the risk/reward balance in favor of owning shares of ViroPharma, even with the possible discontinuation of its hepatitis C treatment and the possibility of generic competition for lead drug Vancocin.

ViroPharma started marketing Vancocin after acquiring it from Eli Lilly (NYSE: LLY) in 2004. Sales of the antibiotic have grown 22% in the first nine months of this year, even though it has been on the market for many years.

Earlier in the year, there were worries about a new competitor to Vancocin coming online as Genzyme (Nasdaq: GENZ) was testing one of its drug candidates against Vancocin. But the Genzyme compound failed to outperform Vancocin in a head-to-head study.

With competition worries out of the way, strong and growing cash flow, and a share price reflecting expectations of nothing but bad times ahead, ViroPharma gets my vote as one of the cheapest value stocks on the market. It won't take much success with ViroPharma for value investors to be rewarded if they snap up shares at this bargain-basement Black Friday price.

If you agree that ViroPharma shares are a deal that can't be passed up, vote outperform for its shares in our CAPS database. CAPS is free to use, and you can see what other investors have to say about ViroPharma as well. We'll tally up the votes and reveal the winner of the Black Friday Bargain Stock contest on Monday. Happy Thanksgiving!

November 20, 2007

A Buyout on Actuate?

I like top growth stock Actuate most for two reasons. First, it is seeing improved results. Q3 earnings rose 83% -- easily besting Wall Street estimates -- and CEO Peter Cittadini is buying shares.

Second, the company is a longtime Microsoft partner and Microsoft is the only major vendor of enterprise software not to have purchased BI expertise. Its Reporting Services software gets good reviews but that's mostly a BI add-on to SQL Server.

Microsoft could bolster SQL Server, and thereby its position as a provider of enterprise software, with a tuck-in acquisition of Actuate for less than $1 billion. Heck, I wouldn't be surprised if deal papers were shuffling around in Redmond right now.

On Blackstone

Steve Schwarzman spoke at the Merrill Lynch conference today, and I think some of what he said about his company, Blackstone, has been overlooked in the wash of John Thain rumors. I picked up a few shares of Blackstone today.

So what did he say that was interesting?

About the business:

He said that the alternative assset industry is a "marvelous place."

And that risk-adjusted returns are way above returns from traditional assets.

Importantly, he noted that institutional penetration is still low -- most big institutional pension plans have only 4 or 5% in alternative investments, and they are looking to increase that allocation.

(Personally, I think this increase in market share for private equity and alternative investments is a huge opportunity for Blackstone -- pension fund managers are going to be in a near panic to hit their numbers as the baby boomers retire, and they'll look longingly at the outsize returns achieved by David Swensen at Yale using allocations of more like 20-30% in various alternative assets like private equity, hedge funds, and real estate ... all areas of significant Blackstone strength).

Schwarzman also opined that Blackstone has been given a significantly lower multiple than traditional money managers, but has more than three times their growth rate.

Beyond that, he took a bit of a stab at the analysts who track the shares and noted that "We are not focused on quarters, we are focused on building value for the long term" -- which of course is something many people say, and I don't know whether Schwarzman is more or less believable in saying that than anyone else. They don't give quarterly earnings guidance, which is certainly one indication that they really believe this.

I like that management and employees are incentivized by the distributions and performance of the Limited Partnership Units. The existing partners, according to Schwarzman, are pushed out to an 8-year vesting schedule, significantly longer than average, which means they will be sitting on big embedded costs over the years that they vest these shares and that those people are very motivated to stick around -- the IPO wasn't a one-day gravy train for them. Those costs of vesting options are what surprised investors a little bit with the high costs during their last earnings release, but of course they have nothing to do with operating earnings.

Blackstone has separately stated that they more or less promise to have an ongoing distribution of 1.20 per year as a minimum through 2009 (close to a 5% yield), and Schwarzman reiterated that they will continue to distribute additional income as they make more. As befits a partnership, the reason for their existence is to funnel excess cash earnings to unitholders.

But what stood out for me in his comments was his hypothetical projection of Blackstone performance -- and of course, since they don't really give guidance this wasn't official guidance, but it was dramatically optimistic in comparison with current results. That specific kind of optimism is somewhat rare from CEOs in these post-SarbOx days, and it makes me wonder whether analysts really are lowballing Blackstone's long term potential right now.

Schwarzman said that the two keys for them will be the size of assets under management, and the rate of return on those assets. That's because they essentially make their money from the management fee, which is charged regardless of their performance, and the carried interest return, which is the percentage of gains that they charge.

Returns have historically been massive in comparison to the overall market, but also quite lumpy -- I think that if they can keep getting their average returns their income should be remarkable. (It's worth noting that many people consider the last five years to have been the "golden era" for private equity, and that those returns might be impossible in the future.)

So it's important to note that Blackstone is still raising record amounts of money, and still finding ways to invest it. Schwarzman said that "People fundamentally missed that we committed to invest 6.9 billion dollars in one quarter in private equity and real estate." That's $6.9 billion that they can start charging fees on.

If they have many future quarters like that, Shwarzman said that from just that one part of their business they could "theoretically make $8 billion in profit in a year."

And as part of that same hypothetical exercise, "estimates that show earnings in the $1-2 billion range could prove to be dramatically wrong."

I don't want to overstate this -- and Schwarzman tried to be quite politic about it, too, in emphasizing that the $8 billion potential assumes that everything goes their way, they get returns in line with their average, and they continue to attract a lot of money. But I am a little surprised at the lack of attention it got -- there was one Reuters story titled "Blackstone CEO sees earnings estimates way too low," but that was all I saw. You can, of course, listen to his presentation yourself if you like through the IR section of the Blackstone website.

They of course can't control their circumstances entirely, but clearly Schwarzman believes that there is potential for really dramatic outsize returns because of the power of carried interest and the massive amounts of money that the world is willing to give Blackstone to invest.

So, the overhangs on Blackstone (and all other private equity firms, at least the public ones) remain -- lumpy earnings, a business that the analysts are going to have a really hard time projecting, and the threat of higher taxation on carried interest (which seems to me to be largely baked in to the stock at the current forward PE ratio of around 13), to say nothing of the possibility that tighter debt terms and higher interest rates might hurt the potential for really massive deals in the near future (though I think Blackstone has said that their average deal is a relatively modest $500 million, which certainly doesn't require massive debt financing when you're talking about investment funds of $20 billion or more).

This seems like a bit of a contrarian buy, as does anything financial these days, but I think the asset managers in general are going to be excellent investments over the next ten years, and as the leading light in a segment of that business that's well positioned to take market share from competitors, especially among the big pension managers that are the engine of private equity funding, I expect very good things from Blackstone over the long run ... and I think the downside is limited if performance of the company remains just average, especially in the near term with the backstop of that 5% dividend.

November 15, 2007

AutoNation Turnaround?

When superior investors buy, I pay attention. That's the case today with AutoNation, which superstar stock picker Eddie Lampert, worth $4.5 billion and ranked 68th on Forbes' latest list of America's richest people, has been buying since at least late October.

But those are only the buys we know about. According to this SEC filing, his hedge fund, ESL Investments, owned roughly 50 million shares of AutoNation before this latest buying spree. Lampert has since raised his stake to 52.3 million shares, or 28.4% of the outstanding shares.

For me, there's only one way to interpret that: Lampert thinks the recent decline in AutoNation shares, fueled in part by subprime fears, is unjustified.

That brings me to Allied Capital. A disappointing third-quarter earnings report proved that its problems with Business Loan Express, which came to light in March, could persist for a while. Investors apparently didn't want to hear that; the stock is down nearly 13% since Halloween.

But here's the thing: 10 different insiders have bought stock in Allied since Friday, including CEO William Walton, who added 50,000 shares at $22.83 apiece, boosting his direct stake by 6%.

November 8, 2007

An Estimate of Sears' Value

Analyst Seth Sigman of Credit Suisse calculated for the first time values on Sears Holdings' (SHLD) [Click to launch this SmartLink] property and brands.

In a report issued Tuesday he estimated values as follows: real estate, $9.5 billion to $11.5 billion; leased stores, $1 billion to $2 billion; distribution centers, $700 million to $1.1 billion; Hoffman Estates headquarters, $200 million to $400 million; private brands, such as Craftsman, Kenmore and DieHard, $3 billion to $5 billion; Lands' End, $2.2 billion to $2.8 billion; and home services business, $2.8 billion to $3.5 billion. Total? $19.4 billion to $26.3 billion.

That is just the value of the land and the brand's, it does not include the results of the retail operations which contributed $2.5 billion last year. Sears current valuation on the market? $18 billion, 7% below even the lowest estimate of just it's real estate & brand value and 46% below the highest.

Currently shares trade at $127 and there are less than 140 million of them outstanding (we will know exactly how many Lampert has repurchased soon but he may have bought 10.4 million back). If we were to value Sears just on the brands and not on it's operations, we get a share price of $137 to $185. We also have to value the operations and that gives us an additional $9.47 a share for the past 12 months giving us a price range of $145 to $194.

The important point is that this valuation include NO premium for either the brands, property or earnings. It is a flat valuation of the parts and a years earnings. What type of valuation do we give the capacity of Lampert to monetize the brands or the property?

Sears is trading at 13 times its current earnings, at the lower end of the retail spectrum. Consider Wal-Mart (WMT) [Click to launch this SmartLink] trades at 15 times, Target (TGT) [Click to launch this SmartLink] 17 and Macy's (M) [Click to launch this SmartLink] 18 times. If we add the value of the property and brands we can effectively double its current share price. The issue for the market currently is that the value of those items will not filter into the stock price until Lampert unlocks that value. If Lampert decide to sell or lease the land he owns, the value of that then filters into the stock price. If he licenses the Craftsman or DieHard brands, that value then filters into the price. Without anyone knowing what his plans are, investors are hesitant to make a leap of faith and assume he may take a certain course.

Thus the "hidden value" in Sears shares... Lampert is smart and will not sit tight forever. My guess is he is buying as much stock as he can at these prices while he can before he moves....

It's alright, I got time...

November 7, 2007


Is a MF Hidden Gems PayDirt selection. They manufacture AFIS and electronic fingerprinting equipment.

November 6, 2007


DDiscover is the smallest of the U.S.-based credit card companies, behind American Express, Visa, and MasterCard (NYSE: MA). Its three key advantages are owning its own network, the high credit quality of its cardholders, and DOJ rulings that cut down restrictive practices of Visa and MasterCard. The share price is down because of concerns that Discover may not get adequate returns on securitizing credit card receivables, along with the predictable drop after a spin-off. By my estimates, though, Discover is trading around 40% below its intrinsic value.

It is a MF Inside Value Recommendation

November 2, 2007

Bill Miller: Financials and Homebuilders Lead the Way

More particularly, just as the right thing to do in 2002 was to buy what everyone was panicked about, I think the greatest gains over the next 5 years will be made in those securities people are panicked about today. For specific names, consult the 52-week new low list."

52 Week low financial? Washington Mutual (WM), Citigroup (C) , Wachovia (WB) , Bank of America (BAC) , Wells Fargo (WFC) Merill Lynch (MER) and every homebuilder.

We have been buying Citigroup, Wachovia and Goldman Sachs since the late summer and financials now make up almost 60% of the portfolio. Like Miller, I am expecting big gains over the next several years out of this group. I also expect some short term pain and hey, no pain no gain, right?