Thursday, February 21, 2013

Hidden Real Estate Value in Gencorp


Recently, Mario Gabelli, a famous investment manager, told CNBC about two stocks that he expects will double in value. One is Gencorp (NYSE: GY), the provider of aerospace and defense products. The other is Legg Mason, the global asset management company. In this article, I will take a closer look at Gencorp to see whether or not we should follow Mario Gabelli into this stock at its current price.
Huge Real Estate Asset
Gencorp operates two main business segments: aerospace and defense, and real estate.
In the aerospace and defense segment, Gencorp is the leading technology-based maker manufacturer of aerospace and defense products for the US government. The company believed that it was the only US supplier of all four propulsion types, including liquid, solid, air breathing and electric for both defense and space applications. The two biggest customers, Raytheon and Lockheed Martin, accounted for 36% and 28%, respectively, of the company's total revenue in 2011.
In the real estate segment, Gencorp owns 12,200 acres of land that were acquired in the early 1950's in Sacramento Metropolitan. Gencorp established Easton in 2009 in order to execute entitlement of 6,000 acres for new development opportunities. In addition, the company is leasing around 303,000 square feet of office space in Sacramento to different third parties, generating revenue of around $6.7 million in fiscal 2011.
The majority of Gencorp’s revenue, $909.7 million, or 99% of the total revenue, was generated from the aerospace and defense segment. The real estate segment only generated around $8.4 million in revenue in 2011.  
Real estate value is not reflected in the book yet
As of November 2012, Gencorp had a negative book value of -$393 million, $162 million in cash, and nearly $250 million in debt. The net property, plant, and equipment on its books was only worth $144 million. The land was valued only at $32.8 million, while the buildings and improvements was valued at nearly $140 million. As property, plant and equipment are recorded at cost, I personally think the book extremely undervalues the market value of Gencorp’s properties. Mario Gabelli liked Gencorp mainly for the company’s huge real estate asset in Sacramento.
Debt Financed Acquisition
In the middle of last year, the company agreed to buy Pratt & Whitney Rocketdyne, a rocket-engine maker, for $550 million from its rival United Technologies (NYSE: UTX).Gencorp is worth around $712.5 million on the market and it has only $162 million in cash. Thus, in order to pay for Rocketdyne, it has to incur much more debt. Recently, the company has confirmed that it would sell $460 million worth of its 7.125% second-priority senior secured notes, maturing in 2021, to finance this purchase. After the senior secure notes sale, its debt load would increase significantly, from $250 million to around $710 million.
Peer Comparison
Compared to its peers, including Alliant Techsystems (NYSE: ATK) and United Technologies, Gencorp had the lowest operating margin at 4%, while the operating margins of Alliant and United Technologies were 10% and 14%, respectively. However, Gencorp is the most expensively valued at 13.6 times EV/EBITDA. Alliant had the cheapest valuation among the three, at 5 times EV/EBITDA, whereas United Technologies is valued at 10.38 times EV multiples.

GY
ATK
UTX
Operating margin (%)
4
10
14
EV/EBITDA
13.62
5
10.38
Dividend yield
N/A
1.6
2.4
United Technologies is paying the highest dividend yield of 2.4%, while Alliant is paying a 1.6% dividend yield. Currently, Gencorp is not paying any dividend.
Foolish Bottom Line
I think Gencorp is an attractive real estate play with its 12,200 acres in the Sacramento metropolitan area. However, it would take some time for the company to fully unlock its potential real estate value. Personally, I think Gencorp could fit well in long-term portfolios of patient investors.

This Global Asset Management Firm is Cheap


In a recent interview with CNBC, Mario Gabelli, a successful investment manager, has talked about two stocks that would double in the near future. One was Gencorp, with its huge hidden real estate value. The other was Legg Mason (NYSE: LM), a global asset management company. In this article, I’ll dig deeper into Legg Mason to determine whether or not we should follow Mario Gabelli into this company.
Business Snapshot
Legg Mason, incorporated in 1981, is the global provider of investment management services to institutional and individual clients, with about 3,000 employees and 31 offices around the world. Legg Mason conducts its business mainly through 12 asset managers, including Batterymarch Financial Management, Brandywine Global Asset Management, Legg Mason Capital Management, Royce & Associates, and Western Asset Management Company.
Legg Mason is considered one of the most diversified asset management firms in the world, with around $654 billion in assets under management (AUM) as of December 2012. The two biggest revenue contributors were Fixed Income (41%) and Equity (41%). The majority of assets was invested in fixed income, accounting for 57% of the total AUM, while Equity and Liquidity represented 22% and 21% of the total AUM, respectively. As the majority of the AUM, 72% of the total AUM, was from institutions, the AUM was considered quite sticky. However, Legg Mason has been facing challenges for several years as investors have been pulling money from its funds. The AUM has decreased from $1 trillion in the beginning of 2008 to $654 billion. In the third quarter of fiscal year 2013, the net outflow was around $7.5 billion. 
High Percentages of AUM Beating Benchmark
In order to evaluate an asset managers’ capabilities, we should look at their performances in a 5-10 year period to see whether or not their results beat the benchmark. In a 10-year period, Legg Mason has had significantly high percentages of its strategy AUM beating the benchmark. 
Source: Legg Mason’s presentation
Legg Mason has had 89%, 84% and 91% of its strategy AUM beating Benchmark at the end of 2010, 2011 and 2012, respectively. As of December 2012, the performance looked great in all four periods of 1 year, 3 years, 5 years and 10 years.
Recently, Legg Mason appointed Joseph Sullivan to be a new CEO. It seems to be a decent move, as Sullivan has spent nearly all of his life working for Legg Mason. Sullivan has been committed to Legg Mason’s turnaround. For instance, he has discussed equity offering for the firm’s executives. Sullivan commented that offering equity to managers would give them real ownership, which could help to recruit and retain executives.
Gabelli Increased His Stake
Gabelli liked Legg Mason, as the firm has kept buying back its stocks. The firm has reduced its number of shares outstanding from 164 million to only 128 million. In addition, it also announced that it would spend two thirds of the cash flow to repurchase more stock. Gabelli said: They’re in the investment business, great cash generator, and they’re solving a lot of their issues.”  On Feb. 8, Gabelli increased his stake in Legg Mason by more than 32%. Thus, he owns more than 4.9 million shares, accounting for more than 3.8% of total shares outstanding. 
Peer Comparison
Currently, Legg Mason is trading at $27.60 per share, with a total market cap of $3.56 billion. Legg Mason is considered the smallest company compared to its other peers, including BlackRock (NYSE: BLK) and Charles Schwab Corporation (NYSE: SCHW). Blackrock is the biggest company, with a total market cap of $41.77 billion, while Charles Schwab is worth $21.4 billion. Among the three, Legg Mason seems to be the cheapest with 12.95x forward earnings and 0.73x book value. At the current trading price of $243.80 per share, BlackRock is valued at nearly 14x forward P/E and 1.69x book value. Charles Schwab has the most expensive valuations, at 19.3x forward earnings and 2.51x book value. BlackRock has a much higher amount of AUM Legg Mason does, at $3.79 trillion in the fourth quarter of 2012. Among the three, Charles Schwab is paying the lowest dividend yield at 1.4%, while the dividend yields of Legg Mason and BlackRock are 1.6% and 2.8%, respectively.
Foolish Bottom Line
Legg Mason seems to be quite cheap in both absolute and relative valuation measures. It is trading at 30% discount to the book value and it has the cheapest valuation among its peers. As the new but experienced CEO commits to turning the business around, I think Legg Mason’s stock price might be driven higher in the near future. 

Is NASDAQ Cheap?


Recently, a famous private equity fund, Carlyle Group, entered discussions withNASDAQ OMX Group (NASDAQ: NDAQ) to discuss taking the exchange company private. However, the deal fell apart because the two parties couldn’t agree with each other on the buyout price. Since the middle of 2012, NASDAQ’s share price has experienced quite a sweet rise, from $22 per share to more than $31 per share. Is NASDAQ a good investment opportunity at its current price? Let’s see.
Business Snapshot
NASDAQ, founded in 1971, is a global exchange group operating several exchanges, including the NASDAQ Stock Market in the US. It has three main business segments: Market Services, Issuer Services, and Market Technology. The majority of its net revenue (less transaction rebates, brokerage, clearance and exchange fees), $1.1 billion, or 66.4%, was generated from the Market Services segment. The Issuer Services ranked second, generating $375 million in revenue, while the net revenue of the Market Technology segment was $184 million in 2012.
Consistent and Growing Cash Flow
What I like about NASDAQ is the consistent and growing cash flow that it has generated in the past 10 years. Since 2002, the operating cash flow has grown from $157 million to nearly $670 million. The free cash flow has also followed the same trend, increasing from $72 million in 2002 to $581 million in 2011. Indeed, I personally think that was what Carlyle was looking for: a growing and consistent cash generator. In addition, NASDAQ seems to have quite a strong balance sheet with a reasonable amount of leverage. As of December 2012, it had $5.2 billion in total equity, nearly $500 million in cash, and $1.93 billion in long-term debt. However, what worries me is the huge goodwill and intangible assets that NASDAQ carried on its balance sheet. At the end of 2012, it had $5.34 billion in goodwill and $1.65 billion in intangible assets. With the huge goodwill and intangibles, NASDAQ is quite vulnerable to write-downs, which would negatively affect its short-term earnings result. Since 2007, NASDAQ has returned a huge amount of cash to shareholders in the form of share buybacks. The amount of treasury stock increased from $8 million in 2007 to more than $1 billion in 2012.
Relatively Undervalued Compared to Peers
At the current trading price of $31 per share, NASDAQ’s total market cap is $5.12 billion. The market is valuing NASDAQ at only 7.28x EV/EBITDA. This valuation could be considered the cheapest compared to its two peers CME Group (NASDAQ: CME) andNYSE Euronext (NYSE: NYX). CME is trading at $58.50 per share, with a total market cap of $19.4 billion. The market is valuing CME at 10.57x EV/EBITDA. NYSE Euronext seems to be the most expensive, with 11.2x EV multiples. NYSE Euronext is trading at nearly $37.60 per share, with a total market cap of $9.13 billion. Among the three, CME seemed to be the most profitable, with a 58% operating margin. NASDAQ ranked second with a 25% operating margin, while the LTM operating margin of NYSE Euronext was 22%.  NASDAQ is paying investors the lowest dividend yield at 1.7% while the dividend yields of CME and NYSE Euronext are 3.1% and 3.2%, respectively.  If NASDAQ were trading at a comparable level to its peers, at around 10x EV/EBITDA, NASDAQ’s enterprise value would be $8.75 billion. Thus, NASDAQ would be worth around $7.5 billion on the market, or around $45.50 per share.
Foolish Bottom Line
NASDAQ had a decent operating margin and employed a reasonable amount of leverage. In addition, it has kept returning cash to investors in the form of share repurchases for the past 5 years. The relative value was estimated to be around $45 per share, or a 45% premium to its current trading price. Indeed, NASDAQ seems to be a good investment for patient investors at its current price. 

Wednesday, February 20, 2013

A Fast Growing McDonald's in Latin America


The Motley Fool has released the top 7 stocks that were recommended by Fool’s analysts for 2013. Out of these 7 stocks, I have talked about two companies, includingTile Shop Holdings, the tile retailer, and Western Refining, an independent crude oil refiner.  In this article, I will cover one more mid-cap stock on that list. It is Arcos Dorados Holdings (NYSE: ARCO), the Argentina-based McDonald’s (NYSE: MCD) master franchisee. Let’s see whether or not we should buy this stock now.
A Leader in Quick Service Restaurant Market
Arcos Dorados is considered the largest operator of McDonald’s restaurants in 20 countries in Latin America, including Argentina, Aruba, Brazil, Chile, Columbia, Peru, etc.  $3.5 billion of the company's sales, or 95.7% of the total revenue, was generated from the company-operated restaurants, whereas the sub-franchise restaurants only generated $153.5 million in revenue in 2011. Arcos Dorados is the leader in the quick service restaurant sector in Latin America. In 2011 McDonald’s had around 1,840 restaurants, with a 9.9% market share. The second largest player, Burger King Worldwide (NYSE: BKW), with more than 1,000 restaurants, and owns a 3.1% market share.
Huge Growth Potential
For the past three years Arcos Dorados has been growing both revenue and net income significantly. The revenue has increased from $2.66 billion in 2009 to $3.66 billion in 2011, while the net income has risen from $80 million to $116 million in the same period. The operating cash flow has also followed the same rising trend, from $148 million in 2009 to $262 million in 2011. Arcos Dorados employed a reasonable amount of debt in its operation. As of September 2012, it had $700 million in total shareholders’ equity, $244 million in cash, and $651 million in long-term debt. Over the past 12 months, Arcos Dorados generated a profit margin of 3.11%, and the return on equity was 17.3%. Interestingly, Arcos Dorados is the exclusive franchise of McDonald’s restaurants. Fool contributor Nathan Parmelee commented that there are more than 14,000 McDonald’s restaurants in the US, a country that has 313 million people. Arcos Dorados had only 1,840 McDonald’s restaurants in 20 Latin American countries, which have the combined population of 500 million. Thus, the potential growth for Arcos Dorados is huge.
High Insider Ownership and Experienced Management Team
What impressed me was the highly experienced management team. All members of the management team have been with the company for between 18 and 24 years. Woods Staton, the Chairman and CEO, has worked for the company for 26 years. German Lemonier, the CFO, and Sergio Alonso, the COO, have been with the company for 20 years. Moreover, the company had a high insider ownership. The biggest shareholder, Los Laureles, owns 38.2% of the total economic interests and 75.5% of the total voting interests in Arcos Dorados. Los Laureles is actually owned by Chairman Woods Staton. In addition, Mr. Staton directly owns 1.8% of total economic interests and 0.7% of the total voting interests in the company. On the combined basis, Staton controlled Arcos Dorados with 40% of total economic interest and 76.3% of the total voting interest.
Reasonable Valuation
At the current trading price of $13 per share, the total market capitalization is $2.72 billion. The market is valuing Arcos Dorados at 13.8x forward earnings, 4x book value. The company is paying investors a 1.8% dividend yield. McDonald’s is a much bigger corporation, with a $94.23 billion market cap. McDonald’s is valued at 14.7x forward P/E and 6.9x book value. It is paying a better dividend yield at 3%. Burger King, with $5.64 billion in market cap, is just a bit bigger than Arcos Dorados. At the current trading price of $16.15 per share, Burger King is valued at 19x forward earnings and 5.1x book value. Its dividend yield is the lowest of the three, at only 02%.
Foolish Bottom Line
Indeed, Arcos Dorados is a fast growing business of McDonald’s in Latin America. With a leadership position in the quick service restaurant market, significantly high insider ownership, and a reasonable valuation, Arcos Dorados could fit well in investors’ growth portfolios.  

Dell Should be Worth at Least $23 Per Share


Michael Dell, the Chairman and CEO of Dell (NASDAQ: DELL), is trying to take the company private for $13.65 per share, with a total transaction value of $24.4 billion. However, Dell’s largest outside shareholder, Southeastern Asset Management, has opposed the buyout deal publicly. Recently, Dell’s second largest outside shareholder, T. Rowe Price Associates, has also joined Southeastern in opposing the deal. Southeastern and T. Rowe Price own 8.5% and nearly 4.4% stakes in Dell, respectively. Both of the funds think that the buyout offer was too low. So what is Dell really worth?
Dell is Worth $23 Per Share With Preferred Stock Distribution
As of October 2012, Dell had nearly $10.2 billion in equity, $11.3 billion in cash, $2.9 billion in long term investments and $9 billion in both short and long-term debt. With 1.74 billion shares outstanding, Dell’s net cash per share was around $3. Analysts expected Dell to earn around $1.67 per share in fiscal year 2014. With the current trading price of $13.80 per share, Dell is valued at around 6.5x forward earnings, net of cash. If we apply David Einhorn’s creative idea of preferred stock distribution to Dell, Dell could issue up to $25 billion, or $14.40 per share in face value of preferred stocks. The value to common equity would be around $5.98 per share at that time. Thus, the potential value of Dell should be the net cash ($3) plus the value to common equity ($5.98) plus the preferred stocks’ face value ($14.40), equals $23.38 per share, a 69.5% premium to the current trading price. 
Southeastern’s “Sum of All Parts” Valuation
In the recent letter to Dell’s Board of Directors, Southeastern has shown that Dell should be worth around $23.72 per share. After deducting structured debt in Dell Financial Services (DFS), Dell’s net cash per share was $3.64. In addition, the book value of DFS was $1.72 per share. Southeastern stated that Michael Dell had used $13.7 billion, or $7.58 per share for acquisitions. With no impairment charge, Southeastern valued Dell’s previous acquisitions at their costs.
In terms of operating segments, Dell’s business was divided into four main segments including Server Business, Support and Deployment, PC Business and Software and Peripherals. As Dell was one of the big companies in X86 players serving “hyperscale” customers, Southeastern thought the Server Business was worth around $8 billion, or $4.44 per share. In addition, Dell’s support and deployment activities were expected to generate at least $1 billion in operating income. With 7x earnings multiples, this segment could be worth at least $7 billion, or $3.89 per share. With the expectation of $1.3 billion in operating profit, the PC Business could be worth $5 billion, or $2.78 per share. The Software and Peripherals might be worth at least $3 billion, or $1.67 per share. Afterwards, Southeastern subtracted $1 per share in unallocated expenses and another $1 per share in "DFS value embedded in segments." That works out to $23.72 per share.

Source: Southeastern’s letter to Dell’s Board of Directors
Peer Comparison
At the current trading price, Dell is valued at 2.4x book value and 4.9x EV/EBITDA whileMicrosoft (NASDAQ: MSFT) has a more expensive valuation at 6.22x EV/EBITDA. Microsoft had a huge net cash balance of $64.8 billion, or $7.70 per share. According to Einhorn, Microsoft’s potential value could also be unlocked via preferred stock distribution. With the expected EPS of $2.85 in 2013, Microsoft could issue up to $155 billion, or $18.35 per share face value of preferred stocks. Using the similar calculation, I think Microsoft should be worth nearly $40 per share.
Hewlett Packard (NYSE: HPQ) is valued the cheapest among the three, at 3.44x EV/EBITDA. Both HP and Dell are considered the victims of the overall decline in global PC sales. HP was hit much harder, due to the recent $8.8 billion impairment charge on its Autonomy acquisition. After the huge write-down, HP’s goodwill and intangible asset isstill a huge number, $35.5 billion, or 5.5% higher than its current total market capitalization. 
Foolish Takeaway
Indeed, a $13.65 per share offer is quite cheap compared to the “sum of all parts” valuation. If Dell followed David Einhorn’s idea to distribute preferred stock to shareholders at not cost, the shareholders’ value would be unlocked and Dell’s share price might reach $23 per share. 

The Cheap Refiner for 2013


Western Refining (NYSE: WNR) was one of the top 7 stocks for 2013 recommended by The Motley Fool’s analysts. Its stock price has increased significantly in the last 3 years, from only $5 per share in the middle of 2010 to nearly $36 per share. Should investors buy Western Refining when it has already reached $36, its 52-week high? Let’s see. 
Business Snapshot
Western Refining is an independent crude oil refiner, operating two refineries with a total capacity of around 151,000 barrels per day. In addition, the company also operates stand-alone refined product distribution terminals and asphalt terminals, with around 210 retail service stations and convenience stores in the US. The majority of Western Refining’s revenue was generated from gasoline sales that accounted for 44.1% of the total sales in 2011. The second biggest revenue contributor was diesel fuel, accounting for 35.1% of the total revenue. Jet fuel represented 12.9% of the total sales while asphalt accounted only 3.6% of total sales.
Western Refining had a diverse customer base, with no single customer accounting for more than 10% of the net sales in 2011. Western Refining’s products were sold via both retail and wholesale channels. In 2011, the wholesale revenue was more than $4.75 billion while the retail segment generated only $940.4 million in revenue. While the wholesale segment generated only $26.6 million in operating income, the operating income of the retail segment was $4.7 million. 
Benefiting from High Brent/WTI Spread
As Western Refining purchased crude oil based on WTI pricing and sold its refined products based on Brent pricing, it has benefited from the widening Brent/WTI spread. The wide Brent/WTI spread also benefited other refiners including Valero (NYSE: VLO)and Tesoro (NYSE: TSO). Since the middle of 2010, Tesoro’s stock price has grown from $11 per share to $54 per share, while Valero has increased from $16 per share to $45.6 per share during the same period. As Western Refining has its operations solely in the US, the company is in the best position to benefit fully from the current high spread.
Consistent Cash Flow and Stronger Balance Sheet
In the past 5 years, Western Refining has consistently generated positive operating cash flow, from $113 million in 2007 to $508 million in 2011. The free cash flow has increased from -$164 million in 2007 to $424 million in 2011. In the same period, the company has managed to pay down the long-term debt, from $1.57 billion to $500 million. Since the end of 2010, Western Refining has reduced the debt/total capitalization ratio, from 61% to only 33%. As of September 2012, Western Refining had $1 billion in total stockholders’ equity, $510 million in cash and $500 million in long-term debt. In addition, it had $270 million in deferred tax liabilities that were considered an interest free loan from the government.
Peer Comparison
With the current trading price of $36 per share, the total market cap is $3.17 billion. The market is valuing Western Refining at only 3.7x EV/EBITDA. Valero is a much bigger company with $25.27 billion in market cap. With the current trading price of $45.65 per share, Valero is valued at 4.53x EV/EBITDA. Tesoro, with $7.44 billion in market cap, is valued at 3.7x EV multiples. Among the three, Western Refining had the highest operating margin of 9%. The operating margin of Valero, 4%, is the lowest while Tesoro had a 5% operating margin.
Foolish Bottom Line
Western Refining looks cheap even after reaching its 52-week high. With the highest operating margin, cheap EV multiples and stronger balance sheet, investors might consider Western Refining for their portfolios in 2013. 

This Bank Might Have 20% Upside


At the 2013 Barron’s Roundtable, Brian Rogers, chairman and chief investment officer of T. Rowe Price, recommended two of his favorite stocks. One was PNC Financial Services (NYSE: PNC), a financial services company. The other was Avon Products, the direct selling company with beauty and fashion-related products. In this article, I will focus on PNC to see whether or not investors should buy this company at its current price.
A Growing and Profitable Financial Services Company
PNC, incorporated in 1983, is considered one of the biggest diversified financial services in the US, with four main business segments: retail banking, corporate banking, asset management services, and residential mortgage. In the full year 2012, PNC had $9.64 billion in net interest income, whereas the noninterest income was nearly $5.88 billion. The net income came in at $3 billion, or $5.30 per share.
In the past three years, PNC has experienced a growing number of customers in all four segments. In the retail banking segment, the new consumer and small business accounts, exclusive of accounts acquired via acquisitions, totaled 254,000. In 2012, the number of new clients in the corporate banking segment and asset management were more than 1,000 and 2,117, respectively. In the residential mortgage segment, total loan originations have reached $15.2 billion, a 33% increase compared to 2011.
The core operating performance could be measured by the growth in net interest income and net interest margin. In 2012, PNC’s core net interest income increased 12% due to the organic loan growth, lower funding costs, and Southeast expansion. In the past 5 years, PNC’s net interest margin has fluctuated in the range of 3% - 4.14%. In 2012, its net interest margin stayed at 3.94%.
Compared to its much bigger peers including Bank of America (NYSE:BAC) and JPMorgan (NYSE: JPM), PNC had the highest net interest margin among the three. In 2012, the net interest margins of Bank of America and JP Morgan were 2.35% and 2.40%, respectively.
PNC is Worth $70 - $75 per Share
Brian Rogers commented that PNC had been up only around 4% last year while other financial stocks were rising significantly. It might be due to its recent purchase of Royal Bank of Canada’s operations in the Southeastern US. Rogers said that he liked to look back to 2008 and 2009 to see how banks had performed through that crisis period. PNC was still quite profitable in those two years. In 2008, PNC’s EPS was $2.10, and it jumped to $4.46 in 2009.
In addition, PNC owned around 21% of Blackrock. According to Rogers, excluding Blackrock, PNC was trading at around 8 times expected earnings while the majority of the banks were trading at 10 times – 12 times earnings. If PNC reached 11 times earnings, Rogers thought the share price would reach $70 - $75 per share.
With a current trading price of $12.20, Bank of America is worth more than $131 billion on the market. The market is valuing Bank of America at 9.4 times forward earnings. JP Morgan is quite cheap with only 8.2 times forward earnings. JP Morgan is trading at $49.45 per share, with a total market cap of $188 billion. Among the three, Bank of America is the cheapest with only 0.6 times price/book valuation. The P/B of PNC and JP Morgan are 0.9 times and 1 times, respectively. As the core business of Bank of America generated 1% ROA and 10% ROE, a 60% discount to book value would represent a 16% annual return on investment.
Foolish Bottom Line
PNC, Bank of America and JP Morgan are generating good returns on assets, decent net interest margins, and trading for equal or less than book value. Personally, I think all three giants could be considered long-term investment opportunities for value investors.

Should We Buy This Specialty Retailer in 2013?


Fool contributor John Reeves wrote about seven stocks in 2013 that Fool analysts recommended for investors. Out of those seven stocks, I pay special attention to four small and mid-cap businesses, including Tile Shop Holdings (NASDAQ: TTS),Western RefiningArcos Dorados Holdings and Lazard. I will take a closer look at each of these four stocks to determine whether or not investors should buy them at their current prices. In this article, I will focus on Tile Shop Holdings.
The Best Comparable Store Sales Growth in the Industry
Tile Shop is a specialty retailer of natural stone tiles and maintenance materials with more than 4,000 products, including ceramic, porcelain, stainless steel, granite, etc. Tile Shop is operating 68 stores in 22 states and three distribution centers in the Midwest and mid-Atlantic US. Tile Shop sourced its products from more than 100 suppliers globally, including 10 suppliers from Asia, which accounted for around 55% of the total purchases. The majority of its net sales were generated from Stone products, accounting for 53% of total net sales. Ceramic products ranked second, representing 29% of the total revenue. In the company’s presentation, it was reported that Tile Shop’s same store sales growth has always been better than that of the industry. In 2011, it experienced 6.4% same store sales growth, while the average same store sales growth of the industry was only 4.1%. 
Source: Tile Shop’s presentation
In the first nine months of 2012, Tile Shop had a 5.5% growth in its same store sales, higher than that of both Lowe’s Companies (NYSE: LOW) and Home Depot (NYSE:HD). The comparable store sales growth of Lowe’s was only 1.2%, while Home Depot experienced a 3.9% rise in its same store sales. Indeed, as Tile Shop purchases its materials directly from a diverse base of global producers, it could provide shoppers with a much wider range of choices compared to Home Depot and Lowe’s. The retailer has also managed to grow its store count significantly. Since 2001, the number of stores has increased from 14 stores in 2001 to 68 stores today, marking an 11-year compoundedannualized growth rate of 16%. In the next several years, Tile Shop is expected to double its store count to 130-140 stores.
High Margin, High Insider Ownership but Richly Valued
Over the last 4 years, Tile Shop has delivered much better adjusted EBITDA margins compared to Home Depot and Lowe’s. While Tile Shop had 28% EBITDA margin, the EBITDA margin of Home Depot and Lowe’s were 12.6% and 10.4%, respectively. Since 2007, Tile Shop has been consistently growing its profits, from $18.5 million in 2007 to $31.4 million in 2011. Over the past 12 months, its net sales reached $174 million and the adjusted EBITDA was $49 million, or 28%of  adjusted EBITDA margin. 
Tile Shop has a high insider ownership. Robert Rucker, the President and CEO, owns a 19.82% stake in the company. Peter Jacullo, Director, had a 12.86% stake in Tile Shop. All executive officers and directors combined hold more than 37% stake in the company. At the current trading price of $17.95 per share, the total market cap is $765.62 million. Tile Shop is quite richly valued, at 17.7x EV/EBITDA. Both Home Depot and Lowe’s are valued a lot cheaper, at 11.8x and 9.75x EV/EBITDA, respectively.
My Foolish Take
With a high insider ownership, a high EBITDA margin, and high comparable store sales growth, Tile Shop seems to be a good stock for investors in the long run. However, because of the expensive valuation, I would rather wait for a price correction before initiating a long position in this company. 

CEOs Are Buying These Stocks (Part II)


In the previous article, I wrote about two companies whose stocks were bought by their own CEOs in February: First Commonwealth Financial and Computer Programs and Systems. In this article, I will cover two more companies with recent CEO purchases, namely Bally Technologies (NYSE: BYI) and Electronic Arts (NASDAQ: EA). Let’s dig deeper to see whether or not those two companies are worth buying at their current prices.
A Global Gaming Company With Double Digit ROIC
Bally Technologies, founded in 1932, is a gaming company that provides advanced technology-based gaming devices, systems, custom mobile applications and interactive applications. The majority of its revenue, $357.4 million, or 41%, was generated from gaming operations. Gaming equipment ranked second with $310.7 million in revenue, or 35% of the total revenue. In fiscal year 2012, its 10 biggest customers represented around 22% of total gaming device sales. For the last 5 years, Bally has managed to deliver double-digit returns on invested capital, in the range of 12.5% - 19%.  It has also generated consistent positive free cash flows. Over the last 12 months, the return on invested capital was 15.21% and the free cash flow was $122 million. However, Bally employed high leverage in its operation. As of December 2012, it had $196 million in total stockholders’ equity, $70 million in cash, and $560 million in debt.
On Feb. 3, Bally’s CEO Ramesh Srinivasan bought 25,000 shares at around $47.48 per share, with a total transaction value of nearly $2.1 million. However, the next day another insider, David Robbins, exercised 100,000 shares at $24.65 per share and sold 60,000 shares at $47.60 per share on the market. Bally is currently trading at $49 per share, with a total market cap of $2 billion. The market is valuing BYI at 8.23x EV/EBITDA. 
A Video Game Publisher With Huge Goodwill
Electronic Arts is a publisher and distributor of game software contents that could be played on video game consoles, personal computers, tablets, and mobile devices. The business is divided into two main segments: Products and Services. In 2012, the product revenue was $3.4 billion, while the service revenue was only $728 million. In the product segment, the majority of revenue, $2.67 billion, or 64.5% of the total revenue, was generated from publishing revenue. In the past 12 months, Electronic Arts earned $0.54 per share, generated $253 million in free cash flow, and delivered a 5.7% in return on invested capital. The company didn’t employ a lot of debt in its operation. As of December 2012, it had nearly $1.96 billion in total stockholders’ equity, $1.5 billion in cash, and nearly $650 million in debt. However, the amount of goodwill and intangible assets, $2 billion, was huge. 
Recently, Electronic Arts’ CEO John Riccitiello bought 31,300 shares at around $15.90 per share, with a total transaction value of nearly $500,000. Electronic Arts is trading at $17.40 per share, with a total market cap of $5.32 billion. The market is valuing Electronic Arts at 10.88x EV/EBITDA. Two of its peers, Activision Blizzard (NASDAQ: ATVI) andNintendo (NASDAQOTH: NTDOY), are valued quite differently on the market. Among the three, Activision Blizzard is the biggest company with a $15.08 billion market cap, while Nintendo is the smallest company with only a $1.5 billion market cap. Nintendo has the most expensive valuation at 83.37x EV/EBITDA, whereas Activision Blizzard has the cheapest valuation at only 6.81x EV/EBITDA. However, Nintendo’s EV multiple is quite misleading, as its EV and EBITDA are negative. Nintendo’s EV is -$10.54 billion, while its EBITDA was -$126.43 million. Among the three, Activision Blizzard seems to be the most profitable company with a 30% operating margin, while the operating margins of Electronic Arts and Nintendo were 4% and -4%, respectively.
Foolish Bottom Line
Electronic Arts and Bally Technologies seem to be a decent bet with their CEO buys. With high return on invested capital, positive free cash flow, and a low EV multiple, Bally Technologies seem to be a better bet than Electronic Arts at its current price.  

Warren Buffett's Tasty Food Deal


Warren Buffett, the most successful and respected investor in the world, has recently pulled the trigger on H. J. Heinz (NYSE: HNZ), one of the largest global makers of ketchup and baby food. His firm Berkshire Hathaway partnered with 3G, a Brazilian private-equity firm, to purchase Heinz at around $72.50 per share, with a total transaction value of $28 billion. The purchase price represented a 20% premium to its Wednesday’s closing price of $60.48 per share. Some might argue that Warren Buffett has overpaid this time, but Buffett said that it was his kind of deal and kind of partner.
Heinz is a Wide Moat Business
Heinz is considered the global leader in the ketchup and baby food businesses, with a global brand portfolio and world-class iconic brands. Over the last 10 years, Heinz has reduced the number of business categories from 6 in 2002 to only 3 in 2012. The three main business categories are Ketchup & Sauces, Meals & Snacks, and Infant/Nutrition. Around 47% of the total sales were generated from the Ketchup & Sauces business, including one of its key brands, Heinz Ketchup. Heinz Ketchup is considered a market leader in several markets, with a 60% market share in the US, 70% in Canada, and around 80% in the UK. For the last 10 years, Heinz has been increasing its global mix successfully. The sales from emerging markets have grown significantly, from 7% in 2002 to nearly 25% in 2012. In the first quarter of fiscal year 2013, Heinz derived two-thirds of its revenue from the international market.
Tasty Deal for Buffett
The Heinz acquisition is not a common buyout deal that Warren Buffett often does. Looking closely into the deal structure, I find that the majority of his investment goes into preferred stocks. Berkshire Hathaway will invest more than $4.5 billion for a 50% stake in the company, and 3G will invest an equal amount for another 50% stake. In addition, Berkshire Hathaway will invest an additional $8 billion in preferred stocks in the company. Thus, out of the $12.5 billion that Buffett invests in the deal, around 64% goes into preferred stock investment. Interestingly, the preferred stocks carry a juicy dividend yield at 9%. Thus, the $8 billion preferred stock will pay Buffett a yearly stable preferred dividend of $720 million.
Is it an Expensive Deal?
At a purchase price of $72.50 per share, the deal values Heinz at nearly 14x trailing EBITDA, a 30% premium to Heinz’s 10-year EBITDA average. It seems to be quite pricey compared to its listed peers, including ConAgra Foods (NYSE: CAG) and Nestle(NASDAQOTH: NSRGY). ConAgra Foods, with a trading price of $33.70 per share, is worth nearly $13.7 billion on the market. The market is valuing ConAgra at 11.45x EV/EBITDA. Among the three, Nestle is the biggest company with a $218.5 billion market cap. It is valued at around 13.5x EV/EBITDA. However, the Heinz deal is not as expensive as Nestle/Pfizer’s baby food deal.  In April 2012, Nestle purchased Pfizer Nutrition, a baby food business from Pfizer for around $11.85 billion, or as much as nearly 20 times EBITDA. In November 2012, ConAgra bought Ralcorp, a leader in the private brand food sector, for around $90 per share, with a total transaction value of $6.8 billion. The deal values Ralcorp at around 11x EV/EBITDA. Thus, the ConAgra/Ralcorp deal seems to be the cheapest. Among the three, ConAgra had the lowest LTM operating margin at 8%. Nestle’s operating margin is the highest at 16%, while the operating margin of Heinz is 14%. 
Foolish Bottom Line
With a 14x EBITDA, the Heinz buyout deal doesn’t seem to be quite expensive. Personally, I think it is a fair deal. As Warren Buffett put it: "It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.  With the market leading position, Heinz has quite a wide moat. It is really a great business that has been purchased at a fair price.

CEOs Are Buying These Stocks (Part I)


Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.”
Peter Lynch 
According to Peter Lynch, investors should follow insiders’ buys closely in order to pick the right investment opportunities. In February, there were four CEOs who bought shares of their own companies, including First Commonwealth Financial Group (NYSE: FCF),Computer Programs and Systems (NASDAQ: CPSI)Bally Technologies andElectronic Arts. In this article, we will look closer at the first two companies to determine whether or not investors should follow these CEOs into their companies.
A Pennsylvanian Bank
First Commonwealth is a provider of consumer and commercial banking services, and trust and wealth management services, with more than 110 community banking offices in Pennsylvania. As of December 2012, the majority of First Commonwealth’s deposits, $2.54 billion, or 55.8% of total deposits, was savings deposits. Time deposits ranked second, with more than $1 billion. The third biggest deposits source was noninterest-bearing demand deposits, at $883 million. The largest loan category was Residential Real Estate, $1.24 billion, or 29.5% of the total loan portfolio. Commercial & Industrial ranked second with $1 billion in loans. In 2012, First Commonwealth generated 3.61% in net interest margin. On Feb. 6, Michael Price, the President and CEO, bought 2,600 shares at around $7.08 per share, with the total transaction value of only $18,408.  At the current trading price of $7.25 per share, the total market cap is $724.3 million. The market is valuing First Commonwealth at 12.3x forward earnings and 1x book value. Currently, the bank is paying a 2.8% dividend yield to shareholders.
Consistently High Return but Not so Cheap
Computer Programs and Systems is a healthcare information technology company for small and mid-size hospitals. The majority of its sales, $73 million, or 40%, was generated from support and maintenance segment. The second biggest revenue contributor was system sales, generating $72.5 million in sales in 2012. For the last 10 years, Computer Programs has been consistently generating a high return on invested capital that has been in the range of 26.36% - 69.70%. Over the past 12 months, the net margin was 15.42%, while the return on invested capital was 46.3%. The high returns have been generated without the help of any leverage.  As of December 2012, Computer Programs had $57.2 million in total stockholders’ equity, $8.9 million in cash, and no debt. At the current trading price of $49.10 per share, Computer Programs is worth $544.15 million on the market. It was valued at 11.76x EV/EBITDA and 8.5x book value. Computer Programs is also a consistent dividend paying company, with a dividend yield of 3.9%. In February, several insiders including the Chairman, the CFO, the CEO, and Senior VP bought 11,800 shares, with the total transaction value of more than $560,000.
One of its peers, WebMD Health Corporation (NASDAQ: WBMD), has a much higher valuation. At the current price of $16.60 per share, WebMD is worth nearly $830 million on the market. It is valued at 16.53x EV/EBITDA and 1.61x book value. However, WebMD generated much less profitability than Computer Programs. While the operating margin of WebMD was 4.93%, Computer Programs had a 23% operating margin. In addition, WebMD used much more leverage than Computer Programs. As of September 2012, WebMD had $510 million in total stockholders’ equity, $970 million in cash, and $800 million in long-term debt. Its debt/equity ratio was 1.6x, while Computer Programs had no debt at all.
Foolish Bottom Line
With the decent dividend yield and consistently high returns on invested capital, Computer Programs is a good stock to own for the long term. First Commonwealth seems to be a good play on the improving residential real estate market. However, both Computer Programs and First Commonwealth had a bit rich valuations. I would rather wait for some price corrections before coming in.  

These Companies Can Unlock Their Potential Value


David Einhorn is getting frustrated with the current capital allocation strategy of Apple(NASDAQ: AAPL). While its share price keeps falling, Apple is still sitting on a huge cash balance and doing nothing to unlock shareholders’ value. Einhorn suggested that Apple should make a much better use of its cash balance by distributing perpetual, high yield preferred stocks to shareholders at no cost. Let’s see what Apple might be potentially worth if it follows Einhorn’s idea.
Apple – 78% Upside Potential
As of December 2012, the company's cash balance was around $137 billion. As Apple had 947.2 million shares outstanding, the cash per share was nearly $145. Analysts estimated that Apple would earn $44.75 per share in fiscal year 2013. At the current trading price of $475 per share, Apple’s total market capitalization is $446 billion. The market is valuing Apple at only 10.6x forward earnings. Net of cash, Apple is valued at only 7.37x forward P/E.
David Einhorn thought that if Apple used around half of its earnings for the preferred stock distribution program with the annual dividend rate of 4%, Apple would be able to issue around $500 billion in face value of preferred stocks, or $528 per share. The annual preferred dividends would be $20 billion, or $21.1 per share. After the preferred dividends are distributed, its adjusted 2013 EPS will be $23.65. Applying the current forward earnings valuation on the adjusted 2013 EPS, the value to common equity would be $174.30 per share. Apple’s total value per share would be the sum of the value tocommon equity ($174.30 per share) plus the value of preferred issues ($528 per share) and its net cash ($145). Thus, Apple’s potential value per share would be around $847 per share. The upside potential would be 78%. 
Dell – A $25 Billion Offer is Low
David Einhorn thought that the same idea might be applied to Apple’s peers as well, including Dell (NASDAQ: DELL) and Microsoft (NASDAQ: MSFT). As of October 2012, Dell had around $5.15 billion in net cash. With the total 1.74 billion shares outstanding, net cash per share was around $3 per share. Dell is expected to earn $1.67 per share in fiscal year 2014. With the current trading price of $13.60 per share, Dell is valued at 8.15x forward earnings. Net of cash, the forward P/E becomes only 6.35x. If we assume that Dell pays half of its earnings in preferred stock dividends with the annual dividend rate of 5%, Dell could issue $25 billion, or $14.40 per share in face value of preferred stocks. The annual preferred distribution would be $1.3 billion, or $0.75 per share. The adjusted EPS in fiscal 2014 would be $0.92. With 6.35x forward earnings, the value to common equity is $5.84 per share. Thus, Dell’s potential value would be $23.24 per share.
Founder Michael Dell is trying to take the company private at around $14 per share, with a total transaction value of nearly $25 billion. However, I personally think the $14 price tag is not fair for Dell, and the deal should be opposed by the largest outside shareholder, Southeastern Asset Management. Compared to the calculation results above, Dell should be fairly valued at around at least $23 per share, 64% higher than the current buyout offer.
Microsoft is Worth $39 Per Share
As of December 2012, Microsoft had $64.8 billion in net cash, or $7.70 per share.  Microsoft is expected to earn $2.85 per share in fiscal year 2013. With the current trading price of $27.55 per share, Microsoft is valued at 7x forward P/E, net of cash. If Microsoft uses half of its earnings to pay preferred dividends with a 5% yield, Microsoft could issue $155 billion, or $18.35 per share in preferred stock face value. With the adjusted EPS of $1.93, the value to common equity would be $13.50 per share. Thus, the total value of Microsoft would be $39.55 per share, a 43.5% upside potential.
Foolish Bottom Line
David Einhorn’s idea of preferred stock distribution is a smart way to quickly unlock the potential value of companies with huge cash balances. Apple, Dell, and Microsoft seem to be quite cheap after the value of the preferred stocks is recognized fully by the market.  
Disclosure : Long Apple

Chuck Royce's New Buys (Part II)


In a previous article I talked about two new buys (Alere and Saga Communications) of famous small-cap investment guru Chuck Royce. In this article, I will cover two more stocks that he just bought in the fourth quarter. One is BankUnited (NYSE: BKU), a bank holding company based in Florida. The other is Geospace Technologies (NASDAQ:GEOS), the manufacturer of instruments and equipment in seismic data processing.
A Conservative Bank With High Interest Margin
BankUnited is a bank holding company with two wholly owned subsidiaries: BankUnited and BankUnited Investment Services. The company has 96 branches in 15 Florida counties.  The majority of BankUnited’s loan was 1-4 single family residential, which accounted for 44.4% of the total loan portfolio. Commercial loans and leases was the second largest loan, accounting for 26.8% of the total loan portfolio as of September 2012. The high level of residential loan could be beneficial to BankUnited with the improvement in the residential housing market. BankUnited's operation seems efficient, as it generated a higher net interest margin while lending quite conservatively. In 2011, the net interest margin was 6.14% and the loan to deposit ratio was only 56.17%.
Chuck Royce bought more than 243,000 shares of BankUnited for around $24 per share, with a total transaction value of more than $5.8 million. I personally think BankUnited is Chuck Royce’s bet on residential housing improvements. At the current price of $27 per share, the total market capitalization is $2.56 billion. The market is valuing BankUnited at 13.4x P/E and 1.5x P/B. The bank is currently paying a 2.7% dividend yield.
High Margin Business but Expensively Valued
Geospace Technologies, incorporated in 1994, is the manufacturer of instruments and equipment used in the processing of seismic data in the oil and gas industry. In 2012, the majority of its revenue, $82.65 million, or 43.1% of the total revenue, was generated from wireless seismic exploration products. The second biggest revenue contributor was traditional seismic exploration products, with $66.85 million in revenue. In 2012, two customers accounted for 16.9% and 11% of its total revenues, respectively. Since 2010, Geospace has experienced good growth in both the top line and the bottom line. Revenue increased from $129 million in 2010 to $192 million in 2012, while EPS rose from $1.14 to $1.37 in the same period. For the last 3 years the return on invested capital has been good, in the range of 10.22% - 17.85%.  Interestingly, although Geospace consistently generated double-digit returns, it did not employ any debt in its operation. As of December 2012, it had nearly $240 million in total stockholders’ equity, $65 million in cash and short-term investments, and no debt.
Chuck Royce purchased more than 68,800 shares for around $72 per share, with the total transaction value of around $5 million. At the current share price of $109.50 per share, the total market cap is $1.41 billion. Geospace is valued quite expensively on the market, with as much as 17.6x EV/EBITDA. One of the company’s peers, ION Geophysical Corporation (NYSE: IO), has a much cheaper valuation. ION is trading at $7.36 per share, with a total market cap of $1.15 billion. The market is valuing ION at only 6.35x EV/EBITDA. In terms of profitability, the operating margin of Geospace was 31%, much higher than ION’s operating margin of 17%. As mentioned above, Geospace generated high returns on a debt-free operation, while ION had a reasonable amount of debt. As of September 2012, it had $470 million in equity, $47 million in cash, and $101 million in long-term debt.
Foolish Take
BankUnited and Geospace seem to be decent businesses. However, those two stocks are not definitely cheap at the moment. Geospace is quite expensive with high EV multiples. I would rather wait for future price corrections before initiating long positions into those stocks.

Chuck Royce's New Buys (Part I)


Chuck Royce, the founder of Royce & Associates, has been quite successful in investing in small cap stocks for more than 40 years. For the last 10 years, the cumulative return of his fund was 159% while the return of S&P500 was only 34.8%. In the fourth quarter, he initiated long positions in four small cap stocks including Alere (NYSE: ALR)Saga Communications (NYSEMKT: SGA)Geospace Technologies and BankUnited. In this article, we will look closer into Alere and Saga Communications first.
A Business With Huge Goodwill and Intangible Assets
Alere is in the business of developing capabilities in near-patient diagnosis, monitoring and health management, with three main business segments: professional diagnostics, health management and consumer diagnostics. The majority of Alere’s revenue, $1.44 billion, or 67.5%, was generated from the professional diagnostics segment. The health management segment ranked second, with nearly $600 million in revenue.
What impressed me was Alere's 10-year consistent growth in both revenue and operating cash flow. Its revenue has grown more than ten times to $2.39 billion, whereas its operating cash flow has increased 20 times to $271 million. However, there were two issues concerning balance sheet strength. First, Alere seemed to be a bit over-leveraged. As of September 2012, it had $2.23 billion in total stockholders’ equity, $303 million in cash, and more than $3.5 billion in long-term debt. Second, the equity was just half of the company's goodwill and intangible assets, which were a whopping $4.95 billion. Thus, it seems that Alere's growth relied heavily on acquisitions. With the huge amount of goodwill and negative tangible book value, Alere is quite vulnerable to huge write-downs in the near future, which would affect its earnings negatively.  
Chuck Royce bought 409,000 of Alere’s shares at around $19 per share, with the total transaction value of more than $7.7 million. At the current trading price of $22.66 per share, the total market capitalization is $1.83 billion. The market is valuing Alere at 8.44x EV/EBITDA. 
Broadcasting Business with Consistent Cash Flow
Saga Communications is a broadcast company with two main business segments: television and radio. It is currently operating five TV stations, four low-power TV stations, five radio information networks, 61 FM and 30 AM radio stations. The majority of Saga’s net operating revenue, $108.9 million, or 85.5%, was generated from the radio segment in 2011. The radio segment generated nearly $30 million in operating income while the TV segment generated only $4.13 million in operating profit.
What I like about Saga are its stable operating cash flows for the past 10 years, in the range of $25 - $30 million. Saga could use its stable cash flow generated to either grow its business or buy back the shares or pay dividends to shareholders. Indeed, Saga paid the special dividend of $1.65 per share to shareholders on November 2012.
Royce purchased nearly 183,000 shares, accounting for around 4.3% stake in Saga. The average purchase price was around $33 per share, with the total transaction value of $6 million. Saga is trading at $47.54 per share, with the total market cap of nearly $260 million. The market is valuing Saga at 8.54x EV/EBITDA.
One of its listed peers, Entercom Communications (NYSE: ETM) has the same EV multiple with Saga’s valuation, at 8.54x. Entercom is trading at nearly $8.10 per share, with the total market cap of $311.65 million. In terms of profitability, Entercom had a slightly higher operating margin, at 25% while the operating margin of Saga was 23%. Compared to Saga, Entercom was much more leveraged. Its debt/equity ratio was 2.2x while Saga’s D/E was around 0.6x. At the same time, Saga’s interest coverage was much higher at 7.2x, whereas the interest coverage of Entercom was 3.1x.
Foolish Bottom Line
Both Alere and Saga have quite reasonable valuations. However, I prefer Saga to Alere. Alere had a huge amount of goodwill that is quite vulnerable to impairment charges. Saga, on the other hand, is a consistent cash generator that is poised for success.

Is Sears Canada a Buy Now?


Recently, Bruce Berkowitz, a “Stock Manager of the Decade,” initiated a long position in Sears Canada. In the fourth quarter he bought more than 6 million shares in the company, with the total transaction worth more than $68 million, accounting for around 1% of his portfolio. Berkowitz also owned 16.94 million shares in the company’s parent, Sears Holdings (NASDAQ: SHLD), which held a 51% stake in Sears Canada. Let’s look closely to see whether or not investors should follow Berkowitz into Sears Canada.
A Spinoff from Sears Holdings
Sears Canada, which was partially spun off from Sears Holdings, is a multi-channel retailer with 122 department stores, 371 specialty stores, 16 floor covering centers, nearly 1,600 catalogue merchandise pick-up locations and 105 Sears travel offices. Sears Canada had two main sales channels: the Retail Channel (Hometown Dealer, Outlet, Corbeil…) and the Direct Channel. In 2011, Sears Canada generated more than $4.6 billion in revenue and $50.3 million in losses. At first glance, Sears Canada didn’t seem to have a lot of debt. As of October 2012, Sears Canada had $1.15 billion in total stockholders’ equity, $227 million in cash and only $37 million in both long and short-term debt. However, the operating lease, $501 million in total, was not included in the long-term debt. At the beginning of 2012, Sears Canada reported that it had around 19.6 million square feet for store locations, including 16.5 million square feet of full line Department stores, and 2.1 million square feet of Sears Home stores. 
Berkowitz is More Interested in the Parent
Berkowitz might receive Sears Canada stocks due to the partial spin off from Sears Holding. After the spin off, Sears Holdings owned 51% of Sears Canada, and Eddie Lampert owned a 27% stake in Sears Canada. Actually, Berkowitz has been quite bullish on its parent, Sears Holdings. With 16.94 million shares, or 13.4% of his total portfolio, Sears Holdings was the second biggest position in his investment portfolio. Regarding Sears Holdings’ investment, Berkowitz mentioned that it was not a retail play but a liquidation play. The liquidation value of Sears Holdings lies in two areas: merchandise inventory and real estate. Berkowitz said that the market was trading at the liquidation value of the retailer’s inventory. For real estate, he conservatively estimated that if the real estate was fully valued on the balance sheet, Sears would be worth as much as $160 per share.
A Big Rival is Coming to Town
In October, it was reported that the US retailer Target (NYSE: TGT) was preparing to enter Canada. Target is one of the big box retailers in the US, operating around 1,778 stores across the US. Target is trading at $63 per share, with a total market cap of $41 billion. The market is valuing Target at 7.82x EV/EBITDA. Canada will be Target’s first expansion outside of the US. It intended to open around 125 – 135 stores in March and April at locations that used to belong to Zellers. Barclays Capital commented that Sears Canada was considered to be the most at-risk among Canadian retailers due to its significant overlapping offerings, at up to 70%. In addition, 37% of Sears Canada’s locations were less than a kilometer away from a Target store.
At the current trading price of $9.60 per share, the total market cap of Sears Canada is $970 million. The market is valuing the company at 9.45x EV/EBITDA. Its parent, Sears Holdings, generated $470 million in LTM EBITDA. With $4.93 billion in market cap, Sears Holdings is valued at 17.7x EV/EBITDA. One of its peers, Canadian Tire Corporation(NASDAQOTH: CDNTF) is worth $6.5 billion in the market. Canadian Tire is valued at a much cheaper valuation, at 8.13x EV/EBITDA. Canadian Tire has a quite strategic retail network in Canada. At least one store of the company is within 15 minutes of 90% of Canadians. The retailer has more than 1,700 outlets in Canada, with a total of 30 million retail square feet.
Commit to Turning Around
Sears Canada has recently announced that it would stick to its three-year turnaround plan as the CEO Calvin McDonald was not satisfied with the company’s performance over the last year and a half. Sears Canada is trying to upgrade service and refocus on several important categories, including mattresses and major appliances. In addition, it has been constantly evaluating its store portfolio. It had closed three big downtown stores in Vancouver, Calgary, and Ottawa. McDonald said, “The business, financially, is still healthy. We have a strong balance sheet, we have no debt. We still have access to a lot of means to drive the transformation.”
Foolish Bottom Line
Sears Canada seems to commit to turning the business around by boosting services and restructuring its retail focus. Investors need to dig deeper to better understand the potential value of Sears Canada’s real estate. Personally, I would rather wait to see any further developments before buying the stock. 
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