North Fork Investors

North Fork Investors 2009 Performance Review

noreply@blogger.com (North Fork Strategy) — Wed, 10 Feb 2010 05:31:00 +0000

We are pleased with our portfolio's performance in our inaugural year, although we are sure most investors feel the same after the tremendous market appreciation since mid-march. We began in February with $100,000 of equity and ended the year at $132,329 (or an increase of 32.33%). This lagged the S&P 500 slightly (which returned 34.86% for the same period), but we achieved this substantial increase with far less risk to our portfolio than a fully-invested index during a period of great uncertainty. At most, we were 54% invested in the market, with the remainder in cash. We also invested (or sold cash-secured puts) in stable, positive cash flow companies with business models generally able to withstand the horrific economic environment. Note that our internal rate of return on our invested portfolio (our long investments, plus the entire amount of cash required upon exercise of any of our naked puts) for the year was 79.69%.

Holding a large cash balance won't necessarily be our investment model going forward - it was a result of our slow, diligent moves into the market as we found bargains. In hindsight, we should have gone "all in" when we started in February 2009, but we're confident our more cautious approach will serve us well going forward. In 2010 we will look to slowly build our portfolio of investments, until we are closer to 75-100% fully invested. Assuming the market continues to appreciate, we'll also look to build a portfolio of shorts of troubled businesses. Below is a brief summary of our current holdings, and the positions we exited in 2009.

Current Holdings:

Greenlight Capital Re, Ltd. (GLRE)

Our first investment was Greenlight Capital Re, Ltd., which we purchased on February 13 for $12.90 per share. In Greenlight we saw the opportunity to piggy-back on the performance of one of the better long-short equity hedge funds, while participating in the compound growth that profitable reinsurance underwriting combined with strong investment returns can generate over time (and no corporate level tax!), all at a purchase price below tangible equity per share. We're pleased with the performance of both the stock and the business thus far. The underwriting team has been hard at work this year, expanding unearned and earned premiums over the previous year (leveraging their balance sheet with zero-cost leverage), and the hedge-fund investments had a stellar year (David Einhorn and his team generated returns of 32.1% for the year). As such, the company has recouped all previous investment losses in 2008 and then some, and the market has taken note. The stock is now trading at what we believe is a fair premium to book value (1.2x-1.3x). Our investment thesis has not changed, and we look forward to holding the stock indefinitely as we believe the company is built around a great business model and management team, and believe that the stock warrants a premium to book value. Going forward, we believe that reinsurance pricing will "harden" as economic growth accelerates, and that Greenlight is well positioned to capture an increase in business and pricing.

Linn Energy, LLC (LINE)

Linn Energy has had a very interesting year. The company's second quarter results were far lower than expected due to extremely low prices for oil and natural gas. Since that point, however, the energy market has rallied along with the entire stock market and Linn has disproportionally participated in these gains. We continue to hold as our initial investment thesis is intact - Linn is a highly hedged company with solid, sustainable cash flows which support the quarterly distribution and ongoing oil/gas property development. We note that Linn management made some excellent decisions over the prior year to put itself in an enviable market position. They successfully completed an equity offering in order to pay down debt, reducing unnecessary risk in an uncertain market, they completed an acquisition of an oil and natural gas field at a favorable price, and the company has seamlessly completed an upper management transition - former COO Mark Elliis was appointed as a successor CEO to founder Michael Linn. Nevertheless, the market's valuation of Linn has expanded quite a bit over the last year, and we are currently reviewing whether or not the fundamentals warrant continued investment.

China Nepstar Chain Drugstore Ltd. (NPD)

Similar to WSP Holdings (discussed below) China Nepstar, an operator of small chain drug stores in China, is a stock we were initially attracted to because of (a) a large cash balance due to a recent IPO at a much higher price, and (b) long term growth potential. We purchased a small position in Nepstar at $3.86 per share in February, received a regular dividend of $.35 per share in May and then a large $1.50 per share special dividend in December. As such, we've already recouped a substantial amount of our initial investment. But notwithstanding these large dividends, Nepstar's stock price has also increased substantially, reaching a high near $7.50 per share in late November. When we purchased the stock, we calculated an enterprise value (market cap less excess cash) of roughly $59M, and an EV/EBITDA ratio of around 2.5x. Now that the company has far less cash (because of the dividends) and because the stock price has increased, the company's enterprise value has risen dramatically (roughly around $300M as of today's date). But Nepstar really doesn't make much money - its still in its growth phase - so the stock now carries a lofty EV/EBITDA multiple. Feeling that the stock's price had become a bit inflated, we sold calls in November struck at $7.50 per share which expire in March. NPD has since come down in price substantially to around $6.00 per share, a more appropriate price (albeit still inflated in our opinion). While we do think the company has the ability to become a market leader in the chain-pharmacy space as the Chinese marketplace continues to develop and modernize, we find the stock's current valuation less than compelling. While we had hoped to hold the stock for a long period of time, we're currently evaluating whether continued investment makes sense.

Ark Restaurants Corp. (ARKR)

In October we purchased a full position in Ark Restaurants Corp, a micro-cap operator of unique restaurants and fast-food concepts in touristy locations (New York, Las Vegas, etc). While we are sure that Ark's stock will not follow the same path as a high-flying tech stock like Adobe, we are excited about the company's consistent cash generation and measured, debt-free growth. Ark's restaurants have performed solidly in a down market, and management has demonstrated a forward-looking and prudent perspective - they've kept headcount up and avoided layoffs at the expense of short term profit while generating long-term goodwill with employees. They also operate the company with a debt-free balance sheet and focused on maintaining a conservative cash position, cutting the dividend in early 2009 (which drove the price of the stock very low) and then reinstating the dividend at a lower rate later in the year. Over the short-term we are excited about the performance of the company's new restaurant at Columbus Circle, Robert @ MAD which has gotten favorable reviews so far. Over the long-term we look forward to an increase in sales at the company's restaurants in Las Vegas and New York as the economy turns. If the company can come close to generating 2006 and 2007 type profit figures at some point over the medium term, we think the investment will be very much worth the wait. In the meantime, we will collect roughly a 7% dividend.

PetMed Express, Inc. (PETS)

As a recent position, most of our thoughts can be summed up in our January 18th post at http://www.northforkinvestors.com. We are excited about owning a market leader in this space, and applaud the company's recently released quarterly results. This is a well managed, scalable, high ROIC business with serious tailwinds. Given its prospects (80% of pet meds are sold by vets for marked up prices), we find its mid-teens earnings multiple more than reasonable.

Additional 2010 Investments

Note that so far in 2010 we (i) sold puts on Microsoft Corporation (MSFT) and (ii) purchased a 1/2 position in Yum Brands, Inc. (YUM) while also selling additional puts on YUM.

Closed Positions:

WSP Holdings Ltd. (WH)

In May we purchased a small position in WSP Holdings, Ltd., a Chinese steel pipe manufacturer, at $3.48 per share. Like China Nepstar, we were initially attracted to the stock because of its historical earnings growth combined with a very large cash balance which was a result of an IPO the year before at a much higher price. This turned out to be a very interesting investment, one which we admittedly could have been smarter about. Soon after our investment, the Company announced a special dividend of $.45 per share, and the market responded favorable (irrationally excited you could say - the company was distributing to shareholders a very large portion of its safety-value cash balance). The stock was quickly driven to the mid 6's. Having collected the special dividend, and participating in this large price appreciation, we should have sold and moved on. We continued to hold believing that the company's pricing power compared to the large steel companies in the industrialized world would lead it to consistent growth. Time will tell over the long term, but in the short term other macro and political factors began to take a toll on the company's business. The company is now facing large tariffs in the North American market, downward pricing pressure resulting from a glut of supply in the Asian markets, and general declining demand. In addition, due to rapid expansion and facility construction, the company's short term debt ballooned. In November we sold our shares of $3.60 per share, feeling that there was far too much uncertainty facing WSP's business to justify continued investment. Including the special dividend, our IRR on this investment was 32.94%.

Adobe Systems, Inc. (ADBE)

In February, we purchased 230 shares of Adobe Systems, Inc. at $17.37 per share, while simultaneously selling puts (hoping to purchase more shares at an even lower price). We subsequently bought back the puts after they declined in price, and sold a second set of later-dated puts at a higher price, again hoping to leg into more adobe shares at prices lower than the market was willing to offer. This second set of puts again expired worthless as Adobe's stock price crept upwards. What we thought of as prudence at the time, we now see as greed. We should have purchased a full position in the high-teens when we had the chance. We think the opportunities the market was offering up in Feb/March of 2009 in blue chip technology names are unlikely to return for years, if ever. Adobe is a cash-generating machine with a number of incredibly valuable software franchises, and terrific growth potential in its website development platform (Flash). At the time Adobe was trading at around 6.7x free cash flow, a silly multiple for such a strong business. Using conservative growth assumptions and a high cost of capital, we were modeling Adobe's intrinsic value at around 50% higher than its current price. As could be expected, Adobe quickly rebounded to levels we thought were much closer to fair value. In July we decided to sell two January 34 calls to collect additional premium. These calls were eventually exercised, and we sold 200 of our Adobe shares for an effective price of $36.50, less commissions. We then sold our remaining odd lot and have moved on. This of course isn't to suggest that we don't like the company or its prospects - we think they are great. We just think we can find better bargains elsewhere. All in, this investment generated a whole dollar profit of $4,348.18, on an initial investment of $4,010.05, which represents an investment IRR of 135.21%.

Other Put Sales

In 2009, we also sold cash-secured puts on Nike, Inc. (NKE) and Gamestop Corp. (GME) attempting to enter positions in these stocks at lower than market prices. Each set of puts was repurchased after a substantial decline in premium for a profit. We'd love the opportunity to purchase Nike at a price we thinks makes sense at some point in the future, but feel differently towards Gamestop after further analysis.

Microsoft Corporation Puts

noreply@blogger.com (North Fork Strategy) — Tue, 09 Feb 2010 23:32:00 +0000

On 1/29, we sold four April 28 puts on Microsoft Corporation (ticker symbol: MSFT) for a net credit of $437.04, and have reserved the cash necessary for exercise ($11,200). If the puts are exercised, we'll do a full write up for an investment in MSFT. We think MSFT is reasonably priced at 15x trailing earnings (before subtracting excess cash on its balance sheet) and believe its stock price will be lifted by considerable tailwinds through 2010 due to the successful release of Windows 7.

Yum Brands, Inc.

noreply@blogger.com (North Fork Strategy) — Tue, 09 Feb 2010 23:27:00 +0000

On 1/29, we purchased 150 shares of Yum Brands, Inc. (ticker symbol: YUM) for $34.47 per share. We also sold two March 34 puts for a net credit of $185.04, and have reserved the cash necessary for exercise ($6,800). If the puts are not exercised prior to March expiration, we will likely sell additional puts on Yum in an attempt to leg into a larger position at a lower price. Please check back for a full write up of this investment.

Berkshire Hathaway, Inc. (BRK/B)

noreply@blogger.com (North Fork Strategy) — Mon, 25 Jan 2010 18:10:00 +0000

Buy Price: $69.36

This morning we decided to purchase 144 shares or Berkshire Hathaway Class B shares. After the recent spilt we decided, like many others, it was time to enter the position as a core holding for our portfolio. Our short term outlook is that the stock split will cause short term price appreciation and volatility. Berkshire is currently at the lower end of historical price to book valuation and provides strong long term return possibilities. The diversification of the business holdings creates a margin of safety in the current market and economic conditions, more so than a lot of more concentrated businesses. We firmly believe in Berkshire management, and are excited about holding Berkshire for years to come.

Petmed Express, Inc.

noreply@blogger.com (North Fork Strategy) — Tue, 19 Jan 2010 05:46:00 +0000

Overview: On 12/21 we purchased 415 shares of Petmed Express, Inc. (ticker symbol: PETS) and are looking to purchase more in the event of any price weakness.

Investment Thesis: PETS operates an online and telephone pharmacy for prescription and non-prescription pet medicine, mostly for dogs, cats and horses, and is the market leader in the roughly $3.6B pet medicine market. PETS is a simple business and we have a simple investment thesis: We believe we've found an extremely capital light and scalable business with secular tailwinds and sustainable competitive advantages (a developing brand, a positive consumer experience and low prices) trading at a very reasonable valuation.

Business; Business Advantages: Despite PETS recent successes, most pet medicine today (roughly 80%) is sold through a veterinarian for marked up prices which reflect an expensive middleman. PETS is taking square aim at this large market. We, along with PETS management, believe that the long-term internet retail trend could very well affect the pet medicine market as much as the book or music markets. Setting aside emergency treatments, pet medicine is a product that translates easily to online sales - there isn't a consumer need for a unique or local experience and the product is small, light and easily shipped across long distances. Pet medicine is manufactured and sold by national pharmaceutical companies that have an interest in the greater consumption and consumer goodwill which results from lower retail prices. While the major pharmaceutical manufacturers have declined to sell directly to marketing companies such as PETS and instead sell indirectly to PETS through third party suppliers, PETS is working to develop direct supply channels with pharmaceutical companies for some widely purchased medicines. If successful, PETS could offer these medicines at even greater discounts which would further improve their competitive position. In addition to the broad-based internet consumption trend, we are attracted to the pet medicine business because it's anything but faddish, is recession resistant and is lightly regulated (unlike human medicine). We think it a foregone conclusion that spending on pet medicine will increase over time. We believe PETS is well positioned to participate in any increase in the broader pet medicine market while also gaining market share. In the grips of recession, the company attracted 802,000 new customers in 2009 vs. 710,000 in 2008.

Financials: The competitive advantages discussed above are demonstrated in PETS ten-year financials. In 2000, PETS generated $14.7M in revenue and lost $1.8M. In 2002, the company's first profitable year, PETS generated $32M in revenue, and $.8M in net income. In 2009, the company generated $219.4M in revenue and $23M in net income. PETS is one of those rare, scalable businesses where the bottom line grows quicker than the top line. The company's five-year average revenue growth rate is 18.5%, and five-year average net income growth rate is 31.4%. This difference can be explained by the operating leverage and cash flows an online retail operation can generate. As a very capital-light business, cash which doesn't need to be reinvested in the business can be used to repurchase the company's shares. PETS spent $11.6M in 2008 and $18.5M in 2009 in share repurchases. In 2009, the company began a quarterly dividend, rare for a young, high-growth company. Often a company's long-term competitive advantages can be seen in its annual return on assets and return on equity. PETS has maintained return on assets in the high 20s, and returns on equity in the low 30s over the last five years while offering consumers low prices for their pet medicine, an impressive feat that demonstrates the strength of this business.

Valuation: We think that PETS current price doesn't accurately reflect PETS growth prospects and business strengths. PETS trades at roughly 14.5x our estimate of fiscal year 2009 earnings, less on an enterprise value basis due to the more than $50M in excess cash on the company's balance sheet and its lack of debt. We think that it likely that both per share earnings and the stock's earnings multiple expand over the medium to long term, resulting in market-beating returns for this investment. Compare this multiple to other market-leading internet retailers: Amazon (AMZN) trades at roughly 74x trailing earnings, and Blue Nile Inc., the diamond retailer (NILE), trades at roughly 80x trailing earnings. Based on earnings growth and return on assets alone - admittedly a simplistic criteria - PETS is arguably a stronger company than either. (Note that we are not suggesting that PETS rivals Amazon in business strength or competitive advantages – we simply think we’re getting a much better bargain with PETS.)

The Amazon/Walmart Risk: We think that the market’s subdued enthusiasm for PETS can be largely attributed to the sense that the company's market position and continued growth is susceptible to a bigger, stronger competitor’s foray into the online pet medicine market, such as Amazon or Walmart. We think that it far more likely that a larger retailer would choose to purchase PETS at a hefty price given its growing customer base and customer goodwill. We also believe that the current thinking about Amazon – that it will become the Walmart of the internet, squeezing out niche online retailers – is an analogy to brick and mortar retail that doesn’t quite translate. Switching web pages is a much different experience than physically visiting many retail stores to purchase the goods one could buy at the lowest prices in a big box retailer. Finally, we think that purchasing pet medicine through PETS is a sticky user experience. As the market leader with the lowest prices and a quick and easy platform for repeat purchases, we find it unlikely that pet owners will actively shop around for pet medicine once plugged into the PETS system. Nevertheless, given PETS recent financial successes, we have little doubt that the online pet medicine business will attract competition and view the success of this competition as the single largest risk to this investment. We see the success of the company's advertising and the steps the company takes to create an increasingly efficient and enjoyable user experience as the two most critical components to staving off competition. Given the low capital requirements of the business, we wouldn't mind seeing an increase in advertising spending and website development at the expense of short term earnings.

PetMed Express Inc.

noreply@blogger.com (North Fork Strategy) — Tue, 22 Dec 2009 19:50:00 +0000

Yesterday we purchased 415 shares of PetMed Express Inc. (ticker symbol: PETS) at $18.09 per share for $7,507.35, less commissions. We will look to purchase more shares in the event the stock declines over the next few months. Please check back for a full write up of this investment.

WSP Holdings, Ltd.

noreply@blogger.com (North Fork Strategy) — Tue, 01 Dec 2009 01:23:00 +0000

Sell Price: $3.60

On Wednesday (11/26) we sold our 1,450 shares of WSP Holdings Ltd. (WH) for $3.60 per share. Our initial purchase was at $3.48 per share in May, and we received a $.45 per share special dividend in late June. Including the dividend, our IRR on this investment was 32.94%. We feel fortunate to have made a profit. During our holding period,WSP's business has deteriorated substantially, resulting in a recent quarterly loss. The company is facing large tariffs in the North American market, downward pricing pressure resulting from a glut of supply in the asian markets, and general declining demand. Due to rapid expansion and facility construction, the company's short term debt has increased substantially and is sitting at $500M as of September 30th. While we don't question the potential upside of an investment in WSP at current prices, we feel that there is far too much uncertainty facing this business to justify our continued investment, especially where we can exit with a modest profit.

Ark Restauraunts Corp.

noreply@blogger.com (North Fork Strategy) — Thu, 19 Nov 2009 06:06:00 +0000

Buy Price: $13.72

Overview:

On 10/29 and 10/30, after following the stock and its price movement for a number of months, we were happy to purchase 730 shares of Ark Restaurants Corp. (ticker symbol: ARKR) at an average cost of $13.72 per share.

Company Description:

Ark is a the owner or operator of roughly 50 restaurants, night clubs, bakeries and fast food facilities in the United States, primarily New York City, Las Vegas, Washington D.C., Boston, Florida and other locations in the northeast. Ark's restaurants are built around individual concepts and designed to cater to local markets, with exceptions being the America, Sequoia, Gonzalez y Gonzalez and Gallagher's Steakhouse concepts, which Ark owns two of each. Most restaurants are owned directly by Ark, although the company periodically enters into management arrangements with outside investors where the investors fund the building of the restaurant and Ark serves as manager, earning a percentage of revenues. Ark both purchases existing restaurants as well as designs and builds new restaurants depending on market opportunities. In development, management (i.e., CEO Michael Weinstein) targets tourist destinations with high foot traffic or other notable destination-type locations with robust economics (e.g., Bryant park in New York City behind the New York Public Library, the center of Union Station in Washington D.C. or Las Vegas casinos). Management spends considerable energy developing the "look and feel" of its restaurants, and to a certain extent atmosphere is more of a priority than food quality (like most successful restaurants). The company builds strong relationships with landlords and enters into long-term leases at rates which facilitate strong cash flow.

Management/Operations:

Ark has been in existence since 1983, when former investment banker, Michael Weinstein, decided to switch careers to restaurant ownership and management. Weinstein has a reputation for prudent capital allocation and business integrity as both a fiduciary to shareholders and an employer. Conference calls are quite enjoyable to listen to because of Weinstein's uncommon and refreshing candidness. Weinstein and his staff seek out locations for restaurants which will maintain sustainable economics and accretive cash flow as opposed to mindless revenue growth. Note that the company had a poor experience a number of years ago with several failed restaurants in suburban New Jersey, an experience which Weinstein and the company have learned from in selecting ongoing restaurant concepts and locations.

The company generally funds restaurant acquisitions and development from operating cash flow instead of additional stock sales or borrowing, and either distributes excess cash to shareholders or repurchases stock when there doesn't appear to be acceptable opportunities for growth. Shareholders received a $3.00 per share special dividend in 2007, a $1.00 per share special dividend in October of this year, and regular dividends when business operations support them. In March 2008, the board approved a stock repurchase program under which up to 500,000 shares of common stock may be acquired over a two-year period (no small amount given that the company only has about 3.5M shares outstanding).

While Ark isn't a traditional "wide-moat" business or in an industry we are particularly fond of (restaurants largely come and go), we think management's approach has given Ark a sustainable competitive advantage. The company's return on assets dwarfs other publicly traded restaurant companies (15.04% in 2004, 14.29% in 2005, 10.52% in 2006, 24.95% in 2007, 13.14% in 2008). For example, Brinker International, Inc. (EAT), Cheesecake Factory, Inc. (CAKE) and Darden Restaurants, In. (DRI) regularly achieve return on assets in the mid to high single digits.

In the last five years, management has achieved return on shareholder's equity in the high teens to mid 20s without the use of significant debt. While we believe Ark's casino-based concepts are struggling in the current economic environment, we worry very little about the stability and future cash flows of the company's urban locations - these restaurants are in premium locations with robust economics which simply can't be replicated in suburban strip-malls. For example, the company is in the process of opening a restaurant on the 9th floor of the Museum of Arts and Design at Columbus Circle in NYC, which will overlook Central Park. The term of the lease is 16 years, with two 5 year renewal options. While the lease commitment is substantial, we're confident that management can create a winning concept at this premium location and the long-term lease will end up being a substantial asset. We also don't question the long term viability of Las Vegas as a magnet for consumption.

Valuation:

At our purchase price of $13.72 per share, Ark's market cap is roughly $47.8 million. After distributing $3.5 million to shareholders as a special dividend, Ark will have excess working capital of around $5.7 million, and no long term debt. Assuming $1 million is needed for general working capital purposes, enterprise value is roughly $43.2 million.

Fiscal year 2007 and 2008 EBITDA was roughly 12.3 and 11 million respectively, for an EV/EBITDA multiple of 3.5x or 3.9x. Fiscal year 2007 and 2008 net income from continuing operations was $7.9 and $6.9 million respectively, for a EV/NI multiple of 5.4x and 6.2x. (We believe NI will be approximately $3.0 million for the fiscal year ended September 30, 2009, when released, for an EV/NI multiple of 14.4x) For comparison purposes, DRI and CAKE currently trade at EV/NI multiples of 2008 earnings in the high-teens, and most likely will be in the mid to high 20's using TTM figures. Both EBITDA and net income will be lower this year than 2008 given the tough economic environment (especially in Vegas), although Ark will report positive net income and, according to management, every one of its restaurants is cash flow positive.

We cannot predict the length of the current economic downturn, and aren't sure what to expect in the next couple of years, but believe operations and earnings will continue to improve, and begin to normalize if not grow. As this occurs, Ark's stock price will likely expand and reflect a multiple of earnings similar to its historical average (around 15x). Until this happens, we'll gladly collect the stock's $.25 quarterly dividend which is more than supported by current cash flows (a roughly 7.25% yield). While we can't be sure what Ark's theoretical intrinsic value is (we prefer the "know it when you see it" approach to value investing), we believe the stock's current price, given the company's debt-free balance sheet and shareholder-friendly management, provides a sufficient margin of safety and attractive upside potential to justify our investment.

Note about Liquidity and Ownership:

Ark is a micro-cap stock with very little liquidity and a wide bid-ask spread on any given day. One shouldn't invest in Ark without a medium to long term investment horizon, an approach we're happy to take. The company is entirely off wall-street's radar, which can result in inefficient pricing, but which can also make value realization a patience-trying experience. The company's float is very small, only about 1.8m shares. CEO Weinstein owns roughly 30% of the company, so he exercises substantial control over the company's activities, but also eats his own cooking...

China Nepstar Chain Drugstores, Ltd. Calls

noreply@blogger.com (North Fork Strategy) — Wed, 11 Nov 2009 18:06:00 +0000

On November 6th, we sold thirteen China Nepstar 7.50 calls which expire in March for $75 each. If exercised, our effective sales price of the 1,300 shares will be $8.25 per share, for a gain of roughly 214% on our purchase price before commissions. This return is calculated before taking into account this year's $.35 dividend, and the special dividend of $1.50 which will be paid around December 31st (which raises our return to roughly 262% in the aggregate, before commissions, not taking into account time differences in payment of the dividend, sale of the calls and sale of the stock). Note that the stock is now ex-dividend, and the price currently reflects the December special dividend.

Selling these options and our accrual of dividends has given us the ability to recoup approximately 67% of our initial investment in a short amount of time. The drastic multiple expansion and stock appreciation has occurred with relatively lackluster earnings reports and only modest expansion in Nepstar's business. $7.50 a share represents a roughly 20x EV/trailing EBITDA multiple - far above the 8x target we had discussed in our initial write-up. We have decided to sell the options to give ourselves time to see if the business fundamentals will catch up to the current valuation, and support continued investment. If this is not the case we will be very happy with our exit price with a holding period of just over one year.

Ark Restauraunts Corp. (Update)

noreply@blogger.com (North Fork Strategy) — Sun, 01 Nov 2009 22:28:00 +0000

On Friday, following a large drop in price in ARKR we decided to purchase an additional 380 shares at $13.18 per share. We will post a full write-up for this investment shortly.

Ark Restauraunts Corp.

noreply@blogger.com (North Fork Strategy) — Fri, 30 Oct 2009 01:51:00 +0000

Today we purchased 350 shares of Ark Restauraunts Corp. (ARKR) at $14.30 per share, and will look to purchase additional shares upon a decline in price. Ark is a small company which owns and operates a number of unique conventional and fast food restauraunts which generate solid returns on assets, and which operates with a very conservative balance sheet. Look for a full write-up on this investment shortly.

GameStop Corp and Nike Inc. Puts (Update)

noreply@blogger.com (North Fork Strategy) — Thu, 08 Oct 2009 20:52:00 +0000

On the 1st and 6th of this month we repurchased our two outstanding Nike puts, and four outstanding GameStop puts, respectively, each at $5.00 per put. By closing these transactions prior to their scheduled expiration, we eliminate all risks of the stocks declining below the strike prices (albeit a slight risk at current prices) as well as free up the reserved cash for other investment.

GameStop Corp

noreply@blogger.com (North Fork Strategy) — Fri, 21 Aug 2009 18:43:00 +0000

October 22.50 Put Option Price: $1.30

Today we sold four GameStop October 22.50 puts for $130 each. We will reserve the $9,000 cash required to make the purchase of 400 GameStop shares if exercised. We believe that an effective purchase price of GameStop at $21.20 per share would result in market beating returns over the next several years as both the video game industry grows and the american consumer returns. Like our sale of Nike puts, in the event the puts are exercised we will post a thorough analysis of this investment. If the puts are not exercised, we will receive a roughly 5.8% real return, or 35%+ IRR on our $9,000 in reserved cash.

Adobe Systems, Inc. (Update)

noreply@blogger.com (North Fork Strategy) — Fri, 31 Jul 2009 19:12:00 +0000

January 34 Call Option Price: $2.50

Yesterday we sold two Adobe 34 calls for $250 each. If exercised, our effective sale price of the 200 shares will be $36.50 per share (we would also sell our remaining 30 shares at this time and completely close our position), for a gain of roughly 110% on our purchase price, and a PE ratio of about 22x next year's estimated earnings. If Adobe shares remain below $34 by the third Friday of January, we will keep the $500 of premium and consider selling additional calls depending on the stock's price. We think that Adobe is an excellent company with a bright future, and initially planned (and hoped) to hold our position for a much longer time period as earnings grew and multiples slowly expanded. But the market had different ideas, and Adobe's tremendous run up has pushed Adobe's earnings multiple to lofty levels which we are uncomfortable with.

Nike Inc.

noreply@blogger.com (North Fork Strategy) — Wed, 29 Jul 2009 17:03:00 +0000

October 50 Put Option Price: $2.3

Yesterday we sold two Nike October 50 puts for $230 each. We feel that an effective purchase price of $47.7 per share of Nike would present a compelling opportunity to allocate about 8% of our capital to investing in one of the more iconic companies and powerful brands of our generation at a favorable valuation. We'd be thrilled to include Nike as one of our "core" holdings. In the event the puts are exercised, we will post a thorough analysis of this investment and the reasons for our expected return. Nevertheless, if Nike stock is above $50 at expiration and the puts are not exercised, we will receive a roughly 4.85% real return or roughly 19% IRR on our $10,000 in reserved cash.

WSP Holdings Ltd. (Cont.)

noreply@blogger.com (North Fork Strategy) — Tue, 02 Jun 2009 06:06:00 +0000

Buy Price: $3.48

Overview:

WSP (or "the company") is a Cayman corporation that conducts its operations through Chinese subsidiaries. The company manufactures seamless (as opposed to welded) oil country tubular goods (OCTG), which includes casing, tubing and drill pipes used in the drilling and extraction of oil and natural gas. WSP’s primary customers include the large Chinese oil and gas companies such as CNPC and Sinopec, but in recent years the company has expanded international sales particularly in North America (more on this later in the risks section). WSP manufactures products according to standards formulated by the American Petroleum Institute (API), as well as proprietary non-API products designed according to customer specifications and built to withstand harsher environments than the commodity-like API products. The non-API products are more expensive and generate higher margins than the API products and the company is focusing on developing this side of the business, as demonstrated by the following percentage increase in revenues vs. API products:

2006 API Revs: $299.1M (88%) 2006 Non-API Revs: $41.3M (12%)

2007 API Revs: $288.6M (65%) 2007 Non-API Revs: $152.4M (35%)

2008 API Revs: $505.3M (63%) 2008 Non-API Revs: $294.8M (37%)

Selling OCTG products (and global oil/gas exploration generally) has been an extremely profitable and growing business over the last decade, a trend which we believe has the potential to continue once the current slowdown is played out. We welcome the opportunity to invest in this line of business (especially one with a profitable run-rate) in a time of public disfavor.

Geographic Distribution of Sales: WSP’s international sales have expanded in recent years which has been a positive development for the bottom line, as export sales carry higher prices and higher margins. The following shows the domestic/export distribution of sales over the prior three years:

2006 Domestic Sales: $187.7M (54%) 2006 Export Sales: $156.2M (46%)

2007 Domestic Sales: $191.2M (47%) 2007 Export Sales: $218.8M (53%)

2008 Domestic Sales: $238M (39%) 2008 Export Sales: $370.5M (51%)

Facilities: The company operates ten threading lines, and two drill pipe production lines in various locations in China for the purpose of manufacturing finished OCTG goods. The company also operates three production lines for the purpose of manufacturing green pipes (unfinished steel pipes later transformed into finished OCTG goods). The company is also working on establishing a US manufacturing facility in Texas. Recently, the Company acquired a majority stake in a steel billet manufacturer (the principal material used in the manufacture of OCTG goods) hoping to exercise greater control over its cost structure. Expansion has been funded largely through operating cash flow and the company's IPO.

Cost Structure: Like many Chinese companies, WSP spends far less on corporate overhead, including compensation, insurance, regulatory compliance, etc. than their American counterparts. The company’s major cost is steel – expenditures on raw material accounted for 77.9% of revenues in 2008, and 80.9% in 2007. A low cost structure has allowed WSP to compete favorably on price in North America (but see litigation section below). Fortunately, when steel prices increase (like in 2008), oil and gas prices generally increase, allowing form some elasticity in the price of OCTG goods. This is not to say that WSP’s margins are immune from input cost pressure (2008 saw a decline in gross margins even with record revenue and net income).

Competition: WSP faces stiff competition in both China and internationally. It should be noted that several Chinese competitors are state-owned-enterprises and therefore have access to the greater resources that come with government support. Internationally, the company faces competition from big names like Tenaris (NYSE: TA), and US Steel (NYSE: X). Tenaris provides an interesting comparison for valuation purposes because they, like WSP, specialize in steel tubes designed for the oil and gas industry (see the valuation discussion below).

Initial Public Offering: WSP completed a sale of 50M shares at $8.50 per ADS on December 6, 2007, the proceeds of which have been used to acquire/construct facilities, for debt repayment and for working capital purposes. WSP’s underwriters exercised their over-allotment option and purchased an additional 2.9M ADSs. Like our investment in China Nepstar, we appreciate the opportunity to purchase a relatively stable and growing company far below its recent IPO price.

Dividend Policy: One thing that gives us comfort when investing in a small cap emerging market stock is dividend policy. WSP's board recently announced a one time special dividend of $.45 per ADR and an ongoing dividend policy of 30-50% of operating profit per year. Management believes that cash from operating activity less the dividend will be sufficient to fund future growth.

Ownership: Like many public Chinese companies, WSP stock is held 50%+ by its founder, Longhau Piao. We have mixed feelings about investing in a controlled corporation, given the potential for insider dealing. However,WSP’s dividend policy and record of insider transactions that actually favor the corporation (loans at below-market rates) demonstrate thus far that Mr. Piao appreciates his role as a fiduciary. We also note that WSP used the proceeds of its IPO for expansion purposes, not to “cash out” Mr. Piao. Nevertheless, we think that any transactions between Mr. Piao (or any of the other business ventures he’s involved in - and there are a few) and WSP should be closely scrutinized for fairness. Anecdotally, we’ve observed that transactions between Chinese companies and their founders is the norm, not an exception, and is something that should and likely will become more rare as the Chinese market develops.

Fundamentals:

Margins: WSP has healthy but not extraordinary margins for a capital-intensive manufacturing business. Gross margin has floated upwards from roughly 18% in 2005 to 23% in 2008 (albeit down from 2007), which compares unfavorably to Tenaris's mid 40s (WSP’s has lower prices) and slightly better than an American concern like US Steel which operates in the mid to high teens in good years. The company makes up for the cost of raw materials with low operating expenses, which have allowed it to maintain operating margins around 20% (generally low teens for US Steel, and high 20s for Tenaris).

Balance Sheet: WSP operates with a large amount of short term debt used to fund its raw material purchases, resulting in roughly $1B in short term liabilities. However, the company has successfully operated with a proportionally similar capital structure throughout the last five years. A large amount of the company's cash is used to secure the short-term financing, and held as "restricted cash" on the company's balance sheet. As of March 31, working capital was $84M, which appears to be adequate to fund ongoing operations. WSP has no long-term debt. We think that the company's large level of short-term borrowings is a point to monitor going forward but at this point not a reason to withhold our investment. We would like to see an increase in working capital as the company exits its post-IPO expansion stage.

Revenue/Earnings: WSP's revenue and earnings have grown substantially over the last five years due to the global energy exploration boom and the Chinese growth story. From 2004 to 2008, revenue CAGR equaled 64.2% and net income CAGR equaled 97.5%. We don't anticipate growth of this magnitude over the next five years nor does our investment thesis require this type of growth.

Valuation:

WSP is extremely cheap based on historical earnings and compared to shareholders equity. At the time of writing, shares traded at roughly 3.5x 2008 earnings (less if the business is valued without working capital), or EV/EBITDA of less than 2. We purchased shares at roughly .8x book value. While 2008 may have been the height of the company's growth and earnings, management has forecast solid revenue and earnings for 2009, at around $.70 per ADR, and backed it up with earnings of $.21 for ADR for the first quarter of 2009 during the global financial crisis when oil and gas cap-ex came to a screeching halt. At our purchase price we'd be satisfied with $.50 per ADR for 2009 and moderate growth in the following years.

Tenaris Comparison: Tenaris provides an interesting comparison for valuation purposes. At the time of our purchase of WSP, TS traded at about 2x book, 9x 2008 earnings and about 5x EV/EBITDA. But note that this is a far from perfect comparison - Tenaris is a more established, larger international competitor that isn't facing the litigation described below. We simply feel that WSP provides a better risk/reward profile.

Risks:

Litigation: In addition to the lull in oil and gas prices and cap ex, the company's shares are in deep-value territory because of two litigation matters in the US. While these matters are certainly not trivial and could result in a very negative effect on earnings, we believe that the most negative of potential outcomes is priced in to our purchase price. First, a number of US steel companies and the United Steelworkers Union has filed a petition with the International Trade Commission and the U.S. Department of Commerce alleging that China-based OCTG manufactures have dumped products into the US market with Chinese government subsidies. We expect that the governmental investigations could take a very long time, and may result in tariffs or other trade barriers (see the results of a similar Canadian investigation not discussed in this post). The second matter involves the company's relationship with a large US supplier to oil and gas companies, SB International, Inc., which is responsible for a large amount of the company's North American revenue. SB International has alleged that WSP has tortiously interfered with its relationships with oil and gas companies. Our uninformed suspicion is that this matter involves attempts by WSP to engage directly with US oil and gas companies and essentially remove the costly middleman. It should be noted that we believe the Company's greatest growth opportunities come in international markets, especially in China with Chinese oil and gas companies (see the Chinese stimulus package and the East-West Gas Pipeline project). Based on current valuation, we believe that over a long time horizon an investment in WSP at our purchase price will result in market-beating results even in the event US operations were dropped (but we doubt that the result of the litigation will be so extreme).

Other Risks: Global oil/gas prices will continue to affect the level of cap-ex, and in turn, the price and quantity of WSP's goods and sales. Steel is by far the company's largest cost, and rising steel prices in 2008 began to eat into WSP's margins, partially offset by increased selling prices. The ability of the company to procure cheap and consistent supplies will be a key factor in delivering market-beating gains for investors (see the Company's recent acquisition of a steel billet manufacturer). While we prefer to have managers with "skin in the game" we are weary of investing in controlled companies, like WSP. The potential for abuse is considerable and should be monitored.

Despite these risks, particularly the litigation matters discussed above, we believe that WSP's current valuation presents a favorable risk/reward scenario.

Bottom Line:

Long 5%

Greenlight Capital Q1 2009 Update

noreply@blogger.com (North Fork Strategy) — Fri, 08 May 2009 19:30:00 +0000

In February we purchased a 10% position in Greenlight Capital Re, Ltd., a reinsurance company which invests its "float" in the David Einhorn run hedge fund Greenlight Capital. We wrote that when purchased at or below book value, an investment in Greenlight has the potential for substantial market beating performance due to several factors, including: (i) favorable tax treatment on corporate earnings, (ii) profitable or at least break-even underwriting and the investment of insurance premiums, and (iii) the investment acumen of Einhorn and his team. The following updates the performance of both the business of Greenlight in Q1 2009 and the stock since mid-February.

When discussing Greenlight, its important to separate out underwriting results from investment results. While most of Greenlight's earnings will come from investment returns, Greenlight's underwriting has the potential to really accelerate or damage investment returns.

Underwriting Performance: We feel that if Greenlight can maintain a combined loss ratio of equal to or less than 100% (where net premiums earned (which represents the percentage of net premiums written (gross premiums written less retroceded premiums) allocated to the relevant period, less total expenses (which includes loss and loss adjustment expenses, acquisition costs and general and administrative expenses)) results in underwriting earnings), Greenlight will generate substantial long-term market beating results. A 100% or less combined loss ratio will essentially allow Greenlight to invest "borrowed" money interest free, expense free and tax free (subject to changing legislation of course). So both quantity and quality matter - the amount of premiums written, collected and invested as well as the performance of the underlying insurance contracts.

In Q1 2009, Greenlight wrote $71.8M in premiums, retroceded $1.2M, resulting in net premiums written of $70.6M, which compares favorably to the $61.5M in net premiums written in Q1 2008. Net premiums earned were $46.2M vs. $27.7M in Q1 2008. However, loss and loss adjustment expenses were $30.2M vs. $12.12M in Q1 2008. When loss and loss adjustment expenses are combined with acquisition costs and general and administrative costs, total expenses equaled $47.8M v. $26.5M, resulting in a combined loss ratio of 103.6% vs. around 96% in Q1 2008. Management has explained this increase due to one catastrophe contract which experienced greater than expected losses due to the combination of hurricanes Ike and Gustav as well as the large UK snow storm. On the positive side, expenses as a percentage of net premiums written decreased to 9.5% as compared to 16.2% for Q1 2008 due to relatively flat expenses and more written premiums. While we certainly would like a less than 100% combined loss ratio, we feel it is far too early to judge the underwriting performance of the underlying contracts, especially on a quarter-to-quarter basis. We will continue to monitor performance, but at this point feel quite confident in what appears to be conservative and analytical underwriting by management.

We also note that insurance pricing has been in a multi-year downward trend, which many insurance professionals (including those at Greenlight) believe is beginning to reverse or "harden" because of the lack of capacity in the industry due to massive 2008 investment losses. Any uptick in risk pricing will benefit Greenlight's underwriting results. We are also pleased with the increase in net premiums written. Greenlight's relationships with brokers and Cayman Islands captive insurance companies appears to be developing as planned.

Two underwriting side notes to report: First, management has created a subsidiary, "Verdant", in order to deploy capital in "strategic partnerships" which appear to be investments in certain insurance companies or agencies, with the goal of investment returns, fee income and continuous reinsurance business. One such investment resulted in a one-time $2M transaction fee this quarter which partially offset the insurance losses. Second, in September 2008 the Cayman Islands Monetary Authority granted approval to Greenlight to engage in long term business (life insurance, long term disability, long term care, etc.) in addition to the property and casualty business Greenlight currently writes. These two developments will be interesting to monitor going forward.

Greenlight's Investment Performance: Greenlight's investments returned 4.6% in Q1 (investment income of $27.7M) resulting in an increase in book value per share of 5.2%, to 14.25. This compares quite favorably to a -11.7% loss in the S&P 500. In Q1 Einhorn began to focus on distressed debt as a long investment hoping to "move up the corporate capital structure," and opened a large position in Ford secured bank debt, which was purchased at roughly $.35 on the dollar. At the end of the quarter, the investment portfolio was roughly 17% debt securities. Greenlight continues to maintain a substantial investment in gold and gold related companies. At March 31, Greenlight held $557M in investment securities, compared to stockholders equity of $520M. While we see some cause for concern in the underwriting portfolio, we are pleased with Greenlight's investment returns to date.

Other Items: On March 13, several insiders made very large purchases in Greenlight stock at around $15 per share, which we consider to be a positive development.

Stock Performance: We purchased shares of Greenlight at $12.9 in mid-February, which was slightly below book value at the time. In April, Greenlight's investments returned 6.3%, which we estimate to have increased book value roughly 7% to about $15.25 per share. At the time of writing this, Greenlight shares trade for $15.9. We are more than happy to hold at a modest premium to book value, but won't be adding to our position in the immediate future.

WSP Holdings Ltd.

noreply@blogger.com (North Fork Strategy) — Thu, 07 May 2009 17:51:00 +0000

Buy Price: $3.48

We have decided to purchase a roughly 5% stake (1450 shares for $5,046) in WSP Holdings Ltd., a Chinese manufacturer of oil country tubular goods (OCTG) which are used in oil and natural gas drilling and extraction. Please check back for a full write up about this investment.

Linn Energy, LLC (Update)

noreply@blogger.com (North Fork Strategy) — Mon, 30 Mar 2009 17:34:00 +0000

Buy Price: $14.63

Based on our continuing analysis we have decided to add to our initial LINE position. In reviewing Q4 2008 results, it is no wonder that LINE has decreased since our initial investment. We projected Q4 revenues at $150-$170m unhedged, $175-$201m hedged, actual results were far lower unhedged ($85m). Fourth quarter energy prices were far lower than we had anticipated and fires in the Southern California oil field contributed to the below normal production levels. With that said, hedged revenues came in just slightly lower than our projected range at $171m. This quarter has shown first hand the power of the LINE hedging portfolio. We expect Q1 2009 to be no different with $85 - $95m in unhedged revenues; $185 - $195m hedged realized revenues. We anticipate full year distribution coverage to be above 1.1 and look forward to the full year distribution of $2.52 to be paid without any problems (approx. 17% yield).

The Bottom Line:

Long 5%

We are adding 5% of our portfolio to purchasing additional LINN Energy to bring the total to approximately 10% of our total portfolio.

Adobe Systems, Inc. (Update)

noreply@blogger.com (North Fork Strategy) — Fri, 27 Mar 2009 18:52:00 +0000

We have decided to sell 4 July 17.5 puts for $95 each. As noted in our full Adobe post, we believe a purchase at 17.5 is a compelling investment, but are less enthusiastic about a purchase of Adobe at its current $22. We will reserve the $7000 required to purchase 400 shares of Adobe at 17.5 per share. Like our initial put sale, we will also place a good-until-canceled order to close out this position at $10 per put.

Adobe Systems, Inc. (Update)

noreply@blogger.com (North Fork Strategy) — Wed, 18 Mar 2009 16:19:00 +0000

Per a good-until-canceled order, we purchased to close our Adobe April 15 puts today at $10 each (originally sold for $75) and are exploring further options with regards to our Adobe position. Stay tuned for more information.

Adobe Systems, Inc. (cont.)

noreply@blogger.com (North Fork Strategy) — Thu, 05 Mar 2009 20:22:00 +0000

Overview:

Adobe Systems, Inc. ("Adobe") designs a number of ubiquitous software products most people who use a computer interact with on a daily basis, including Flash animation technology and the Flash Media Player (web video and other web applications), Adobe Acrobat (digital document creation/viewing), as well as a book of market-leading design products used by both professionals and amateurs including Photoshop (photo editing), Dreamweaver (website design), Encore (DVD creation), Illustrator (graphic design), InDesign (page layout), Premier (video editing), among others. Many of these products have become industry standards with defensible market positions due to both their high quality and the switching costs that accompany their wide acceptance.

Adobe's business is currently divided into five segments: (i) Creative Solutions, which focuses on the Adobe Creative Suite family of products and accounts for roughly 58% of revenues, (ii) Knowledge Worker, which produces the Acrobat family of products and accounts for roughly 23% of revenues, (iii) Enterprise, which focuses on interaction with data stored in enterprise applications and currently accounts for roughly 7% of revenues, (iv) Platform, which focuses on improving the way Web and mobile device developers engage their customers and accounts for roughly 6% of revenues, and (v) Print and Publishing, which accounts for approximately 6% of revenues. Adobe's business is truly international. In 2008, 42% of sales were in the United States 4% in other Americas, 34% in Europe, Africa and the Middle East, 13% in Japan and 7% in Asia (excluding Japan).

In Dec. 2005, Adobe purchased Macromedia for $3.4b in Adobe stock (at Adobe's 2005 price of about $35 a share). In doing so it acquired the creator of Flash technology and its biggest competitor in the media-rich web application space. This acquisition has also allowed Adobe to enter into the growing market for mobile device applications software and has substantially enhanced earnings and cash flow since 2005. Macromedia also created Dreamweaver, a leading product for website design. The acquisition has resulted in a large amount of intangible goodwill on Adobe's balance sheet as an asset (more on this later).

Industry Insight: Over the last 20-30 years the stocks of pure-play software companies (ORCL, MSFT, ADSK, ADBE among others) have largely been thought of as "growth" stocks with their best earnings ahead of them. Historically, the market has priced them accordingly. But these same software companies are creating an enormous amount of value in the present. As an industry they produce astronomical returns on invested capital and equity and generate free cash flow much higher than their net income. In this bear market, valuations have swung to the other extreme and these stocks are priced as if they are no-growth or slow-growth businesses (which they certainly will be in 2009 and maybe 2010). We think that generally an investor should purchase companies at a reasonable multiple of present earnings and view future growth as a bonus for which a small premium, if any, is paid. We feel that the current market prices of the mature pure-play software companies now present that opportunity. Adobe is our favorite.

Our Favorite: While we certainly don't pretend to understand the technology involved in creating software or the variables that make certain software products financial successes, we find in Adobe: (i) a company (and a management team) with an excellent track record of growing revenue, EPS and free cash flow, (ii) the ability to create products with a loyal (and sometimes passionate - see Photoshop) following and (iii) a company that is on the right side of a number of worldwide growth industries including web video and other web applications, web site development, internet advertising, mobile device applications, the paperless office concept, secure digital documentation, and digital creative content (video, photography, sound, etc.).

The Business:

ROA: Adobe's return on assets has historically been very high - around 30% in the late 90s decreasing to around 15% now. This decline is largely due to: (i) the large cash balance Adobe carries on its balance sheet, and (ii) the large amount of goodwill and intangibles on its balance sheet due to the Macromedia purchase (the latter totaling about 37% of total assets in November 2008), and not due to a decline in the quality of the "business" or its earnings power. If one strips out the intangibles and excess cash on Adobe's balance sheet, ROA rockets to around 60%. This is a capital-light business that generates an enormous amount of profits on its investments, at least its organic investments. Note that while the Macromedia purchase price was probably unreasonable on a stand alone basis (over 40 x Macromedia's trailing earnings), the consideration paid was the inflated stock of Adobe.

ROE: Adobe's return on equity could be stronger - dropping as low as 14.42% in 2007, and at 19.8% in 2008. This again is due to Adobe's large cash position and large amount of goodwill left over from the Macromedia purchase. We feel that Adobe holds too much cash and equivalents given the enormous amount of cash the business generates on an ongoing basis. The productive use of this current cash balance by management, as well as future cash flows, will be a key variable to the success of an investment in Adobe.

Margins: Adobe's gross margin has stayed consistently around the 90% range (as high as 94% in 2005). This high number is due to the nature of the business - customers purchase a license to easily-replicated digital information. Note that pure-play software companies MSFT and ORCL operate with lower gross margins - each in the low 80s. Adobe's operating margin is around 29%, down from as high as 37% in 2005. MSFT and ORCL both have operating margins in the mid 30’s. Operating margins have declined largely due to non-cash amortization/depreciation expenses, but we consider it one point to monitor going forward. We would hope that Adobe can maintain a non-GAAP operating margin above 30% indefinitely. Note that R&D as percentage of sales has stayed constant around 18-20%, a manageable number but slightly higher than MSFT and ORCL. We will assume that this difference reflects the comparative complexity of Adobe's design software, but we will examine this further.

Cash Flow: In each of last ten years free cash flow (operating cash flow - cap ex) has been substantially greater than net income. This is because large intangible amortization and depreciation expenses taken against earnings don't accurately reflect the reality of the "business" - the corresponding decline in the earnings power of these assets. We believe that this strong free cash flow generation demonstrates management's ability to invest in projects and acquisitions which add great value to Adobe's franchise over time. A separate point about FCF - software companies have relatively limited cap ex expenses (about 2-4% of sales for ADBE - similar to MSFT, ORCL). Investments instead take the form of R&D expenses, or acquisitions. The abundance of free cash flow puts management in an enviable position - determining how to spend it. Historically, management has chosen to repurchase an enormous amount of Adobe's shares and then given a number of these shares back to their employees. Adobe's large stock option grants are one item of concern and a point to monitor going forward.

Growth: Adobe's revenue, operating income and diluted EPS growth rates are as follows:

Revenue Growth: 10yr - 14.9%, 5yr - 22.6%, 3yr - 22.1%
Operating Income Growth: 10yr - 23.4%, 5yr - 22.1%, 3yr - 12.2%
EPS Growth: 10yr - 23.4%, 5yr - 23.7%, 3yr - 10.1%

The 3yr EPS of 10.1% appears to be an anomaly - in 2006 Adobe took non-cash charges against earnings in connection with the Macromedia acquisition. 2007 and 2008 saw EPS growth rates of 46% and 31%.

10yr EPS Growth Comparisons:

MSFT - 16.2%
ORCL - 23%

A 10yr EPS growth rate of 23.4% compares favorably to a 10yr revenue growth rate of 14.9%. However, we believe this difference could be drastically higher if fewer dilutive stock options were granted (we do however appreciate management's desire to hire and retain top talent). Nevertheless, the above growth rates exemplify management's ability to consistently grow sales over a substantial period of time with an eye towards the bottom line.

Balance Sheet: We generally prefer to invest in companies that operate with a small amount of debt relative to their assets. Adobe certainly falls into this category. In fact, as noted above Adobe probably carries too much cash and short term investments - about $2b (35% of assets) vs. long term debt of $350M.

Valuation:

As a capital-light business we view Adobe's balance sheet assets as largely irrelevant to the intrinsic value of the "business". Adobe's value is determined by the number of software licenses it can sell which in turn is determined by the quality of its employees and its intellectual property - not the equipment used to produce this software (computers, furniture, etc.) Thus, price/book ratios tell us very little. Instead, Adobe's intrinsic value is closer to the present value of its future cash flows (see below for an analysis of the present value of future cash flows).

EV/EBITDA: At the time we entered into our position Adobe's EV/2008 EBITDA was around 5.8, and EV/3yr Avg. EBITDA of roughly 6.26 - numbers appropriate for a business with very little growth if any. Stripping out Adobe's excess cash and short term investments, the market is assigning “the business” a PE ratio of around 8.

EV/FCF: At the time we entered our position, Adobe was trading at EV/2008 FCF of 6.7, and EV/3yr FCF of 7, very small numbers given Adobe's consistent cash generation. CAPM suggests an equity cost of capital around 12%-15%, EV/FCF ratio of around 6.6x for a zero growth company of Adobe’s size (10x for a company in Adobe's space with around 5% perpetual earnings growth, and 20x for a company in Adobe's space with around 10% perpetual earnings growth). As we have noted before, we believe attempting to assign an intrinsic value to be an educated guess at best - our guess would put intrinsic value at least 40-50% higher than current market price. We believe Adobe's current valuation combined with the stability of its business, and the "bonus" growth prospects provides a substantial margin of safety.

Valuation Comparisons (at the time we entered our position):

MSFT: ORCL:

EV/2008 EBITDA - 5.1 EV/2008 EBITDA - 8.3
EV/3yr EBITDA - 7.42 EV/3yr EBITDA - 11.2
EV/2008 FCF - 8.47 EV/2008 FCF - 11.75
EV/3yr FCF - 8.38 EV/3yr FCF - 15.13

Risks:

The current economic downturn will be tough on software companies, and Adobe in particular. A number of analysts have recently revised their estimates of Adobe's quarterly earnings and 2009 earnings downward. Design professionals and businesses will likely delay upgrading their software until the recession appears to be nearing its end (and then will likely all upgrade in mass). Amateurs will likely do the same. While these are disturbing trends for Adobe's short term prospects (1-2 years), we think that they are certainly priced into Adobe's current price and will soon enough (perhaps 5 years) be a distant memory. We believe Adobe's competitors present a more serious risk to its future than the economy. Microsoft has developed an alternative to Flash technology called Silverlight, and to the .pdf format called XML Paper Specification (XPS), and will undoubtedly be pushing these on Windows users. Tech powerhouses Apple and Google are also players in a number of Adobe's specialties (notably photo and video editing), especially with respect to the amateur market. We will closely watch the developments of Adobe's competitors.

Beyond competition, we think the second greatest risk to an investment in Adobe is the potential of management to misuse Adobe's strong cash flows (engaging in poor acquisitions, performing stock buybacks when the stock is inflated).

Finally, note that copyright infringement and piracy eats at Adobe's sales and is an ongoing risk to its business, especially in the less policed emerging markets.

The Models:

We've devised the following models which demonstrate the impact we believe Adobe's abundant free cash flow will have on the investor's rate of return.

In all scenarios we have assumed a required rate of return of 12.5%, this rate inherently captures the riskiness of the cash flow stream. If it were truly a risk free cash flow stream, we would discount the future cash flows at the current risk free rate (approx. 3.8%), providing a much higher present value of the future cash flows. The 12.5% also far outpaces the historical equity rate of about 9%.

In the conservative scenario we assumed absolutely zero perpetual growth of FCF from the base of $800 million. $800 million is very conservatively 66% of 2008 FCF of $1.2B as we are trying to capture the effect of the recessionary economy in the short term. This scenario produces a value per share of approximately $15. We see this as an extremely attractive valuation, (purchasing a proven cash flow stream, with an inherent 12.5% annual ROR) which ties into our put selling at $15 in the event of a near term dip to this level.

In the moderate scenario we assumed perpetual FCF growth of 5% from a base of $900 million. We see 5% growth as attainable by Adobe as historic growth has been closer to 20% (see above).

In the aggressive scenario we assumed a perpetual FCF growth of 7.5% from a base of $1 billion.

In the current scenario, we have reverse engineered the model from the current stock price, keeping the investors required return (12.5%) and beginning FCF the same, producing an implied perpetual growth of 2.1%, which we believe severely discounts Adobe's prospects (note that as discussed above this model begins with depressed 2009 FCF).

In addition to the above we have provided another table outlining what we view as the appropriate valuations of FCF into perpetuity, using different perpetual growth assumptions and require rates of return. In the below table we hold the base years FCF constant at $800 million.

Bottom Line:

Please see our February 25th post for information regarding our initial purchase of Adobe stock, and sale of Adobe put options.

Adobe Systems, Inc.

noreply@blogger.com (North Fork Strategy) — Wed, 25 Feb 2009 19:11:00 +0000

Buy Price: $17.37

April Put Option Price: $.75

We have finished our preliminary research and found Adobe Systems, Inc. (“Adobe”) to be a compelling investment at its current valuation. Adobe is a consistent, diversified market leader in the software solutions space with excellent cash flows from operations, growth potential, and a healthy balance sheet. Based on the recent volatility and decrease in the markets over the past two weeks, we are committing 4% of our portfolio to Adobe. In addition we are selling four put options expiring in April to purchase an additional 6% stake at $15 a share (if ADBE shares decline to this level), which we feel would be a very compelling price based on our initial analysis. As shown on our Master Spreadsheet, we are reserving the required cash to make this additional 6% purchase. We will complete our analysis and update with a full entry in the near future.

Bottom Line:

Long 4%

April put options at $15 per share for an additional 6%

China Nepstar Chain Drugstore, Ltd.

noreply@blogger.com (North Fork Strategy) — Thu, 19 Feb 2009 18:39:00 +0000

Buy Price: $3.86

Overview: China Nepstar Chain Drugstore, Ltd. ("Nepstar") is the largest drug store chain in China with over 2,600 stores located mainly in eastern China's urban centers. Nepstar's story is one of consolidation. China's drug store industry is highly fragmented, with Nepstar accounting for only .5% of the country's drug store revenues. Instead, China's drug store industry is dominated by "mom and pop" stores, and local chains, similar to the United States before the wave of consolidation resulting in the Walgreens, Rite-Aid and CVS behemoths. Through consolidation, Nepstar will continue to develop its brand value, with the goal of becoming the "go-to" drug store (or one of them) for China's enormous urban population. It is also in the process of developing a higher-margin private label line of OTC medicine and other health products, which thus far is largely absent from the Chinese market.

Nepstar is a market leader with the financial capacity to take advantage of a highly fragmented but stable industry, without the use of any leverage. While we generally place little emphasis on macro trends because of our firm belief that we can't predict the future, we also cannot ignore China's increasing urbanization, enormous population, increasing use of western medicine, and high personal savings rate. Each of these macro factors certainly bode well for the nation's largest drug store chain.

While investing in emerging market companies certainly comes with higher risk than domestic companies, we find some comfort in the fact that Nepstar has a big-four auditor (KPMG), trades on the New York Stock Exchange and is owned 25% by Goldman Sachs (its IPO underwriter).

Management Effectiveness: Nepstar's return on invested capital (assets-unused cash/securities) of 19% in 2007, and roughly 13% annualized thus far in 2008 (probably more realistic given the costs of being a public company) are very good for a chain retailer. While not a perfect comparison, note that US retailers and drug stores operate with far less ROIC. In 2007, WMT had return on invested capital of roughly 8%, TGT less than 7%, CVS 6%. This solid ROIC can translate to a high ROE once Nepstar's cash is either returned to shareholders (see below) or used to develop/acquire stores.

Cash Flow: In 2007 and 2008, cash flow provided by operating activities was/is greater than net income.

Balance Sheet (so good its almost bad):As of September 30, 2008, Nepstar was holding $200M cash and $169M investment securities and had $0 long term liabilities. This cash is either slowly being returned to shareholders or used to acquire/develop shares. Nepstar pays a 3% dividend (modest given its cash position), and is in the middle of executing a $40M share buyback. In 2007 Nepstar articulated a target of 1,050 new stores in 2008.

Risks: Investing in Nepstar comes with several risks. The Chinese medicine industry is substantially regulated and a significant number of Nepstar's products are subject to price controls. Future regulation could collapse Nepstar's margins, or in the worst case, prohibit Nepstar from selling certain products. China's economy could fall into a long and protracted recession, pinching consumers and hurting Nepstar's revenues. In addition, the founder and CEO of Nepstar owns approximately 50% of the Company. While this position ensures that he has a vested interest in increasing shareholder value, his ownership could prevent the future acquisition of Nepstar or other transactions that return value to shareholders. We will be closely monitoring any related party transactions between the CEO and Nepstar. Note also that Goldman Sachs could decide to liquidate its position in Nepstar. If this were to occur it would put substantial pressure on Nepstar's stock price.

Valuation: Nepstar has a market cap of 438 with a P/B ratio of roughly 1. Its cash and investment securities give it an EV of roughly $59M. Based on 2007 earnings, EV/EBITDA* is roughly 2.5 (after discounting for minority interest), a very low multiple. Given recent market turmoil and the unpredictable nature of an emerging market stock, we believe that any estimates of an intrinsic value are academic at best so we won't venture a guess. Our opinion is that if rational pricing prevailed Nepstar would be valued substantially higher than an EV/EBITDA of 2.5.

*For those who are unfamiliar with the concept of Enterprise Value: EV is the value the market places on the "enterprise", independent of how that enterprise is capitalized (capitalization is subject to change - see the dividend and share buyback).

The Model:

The following model projects a conservative snapshot of the business in 3 years. We will assume that costs stay relatively stable, and that Nepstar will be able to acquire or create essentially as many stores as it is financially able to (which appears to be a realistic assumption given how fragmented the industry is). For purposes of this model we will ignore dividends and share buybacks. We will present a model using conservative assumptions and then for reference provide moderate and aggressive alternatives.

In 2007, Nepstar added roughly 556 stores. In 2008, Nepstar anticipated adding approximately 1,050 new stores (as of Nov. 2008 there were 665 new stores added in 2008).

New Stores: Nepstar estimated that it would spend approximately 42M in 2008 building and acquiring 1,050 stores, which equals roughly $40K per store. Three acquisitions thus far roughly confirm this number - Nepstar has purchased stores in 2007/2008 for roughly 55K per store. It would be expected that organic store openings require less than money than store acquisitions. When acquiring stores, Nepstar must pay a goodwill premium instead of merely purchasing the assets required to open a new store.

Nepstar has available capital of $369M to open/acquire stores. If we assume that Nepstar can spend $150M of this in the next three years acquiring stores - at a conservative projection of $50K per store - this would equal roughly 3,000 more stores over a three year period (Nepstar's 2008 goal was 1,050 stores). Nepstar also anticipates spending approximately $20M on two new distribution centers. Assuming these capital expenditures, and a conservative estimate of cash flows, less the capital required to open new stores, of roughly 20M per year (2007 operating cash flow equaled approximately 23M) for each of the three years, the cost of the additional store openings and the distribution centers would result in the use of approximately $110M. Nepstar would retain roughly 259M in cash/securities on its balance sheet (again we are not accounting for share buybacks and dividends).

Revenue/Earnings: In 2005 and 2006 Nepstar stores averaged annual revenue of approximately $165K per store. In 2007 this number was roughly $133K. According to management, the difference is explained by the rise in revenue after a store ages beyond three years - following Nepstar's IPO many of its stores are less than three years old. This model assumes a conservative $125K per store.

With an increase of 3,000 stores following 2008 Q3, Nepstar would have roughly 5,600 stores in three years. Our conservative estimate of revenue would be $700M.

Nepstar's operating margin was roughly 10% in 2007 and roughly 7% in the first three quarters of 2008 (a more realistic margin given the costs of being a public company). American drug stores generally have operating margins in the 6% range. A gross margin of 7% on 700M results in EBITDA of approximately 49M.

ROIC: As of September 30th Nepstar had $212M of invested capital. Following the $150M in store openings and acquisitions, and $20M for distribution centers, invested capital would equal $382M. At a tax rate of a 27% ROIC would be approximately 9.5%, a reasonable figure.

EV/EBITDA calculation: American drug stores (CVS, RAD, WAG), which have lower ROIC, lower margins and arguably less growth potential trade in today's market turmoil at roughly 7-9 EV/trailing EBITDA, and historically at a higher rate. We think a conservative EV/EBITDA ratio (without today's market dislocation) of Nepstar in three years is 8 (which would roughly equal a PE ratio, after subtracting the cash which is being slowly returned to shareholders or used in the business, of around 11). This ratio would result in the market pricing the value of Nepstar's business at approximately $400M. Combining the additional cash of $259M results in a market cap of approximately $660M, for a annual ROR of approximately 15.5% which beats the S&P 500s historical return by over 6%. We believe this conservative model leaves substantial room for better margins, greater cash flow, and perhaps most importantly, multiple expansion.

Alternative #2 (moderate):

Cost of additional stores: $45K (3,333 additional stores)
Revenue per store: $140K ($830M total)
Free cash flow per year: $25M ($275M cash at end of period)
Operating Margin: 8% ($66M EBITDA)
EV/EBITDA: 10
Mkt Cap: ($935M)
Annual ROR: roughly 30%

Alternative #3 (aggressive):

Cost of additional stores: $40K (3750 additional stores)
Revenue per store: $155K ($984M total)
Free cash flow per year: $30M ($290M cash at end of period)
Operating margin: 9% ($88M EBITDA)
EV/EBITDA: 12 (PE, after subtracting cash, of approximately 16.5)
Mkt Cap: ($1,346M)
Annual ROR: roughly 46%

Bottom Line:

Long 5%. We will continue to monitor Nepstar's expansion and margins.

Linn Energy, LLC

noreply@blogger.com (North Fork Strategy) — Sat, 14 Feb 2009 00:55:00 +0000

Buy Price: $15.77

History / Profile:

Linn Energy is an independent oil and gas company focused on the development and acquisition of long life properties in the United States. They operate in the following regions:

• Mid-Continent — core operating areas in the Texas Panhandle and Oklahoma; and
• Western — the Brea Olinda Field of the Los Angeles Basin in California.

The Financials:

Income Statement:

Linn Energy hedges nearly 100% of their production for up to five years, and all hedging income (losses) are reported on the quarterly and annual income statements, creating a jumbled mess when it comes to trying to figure out recognized income for a period. We try to analyze current earnings as going rate commodity prices plus/minus recognized gains/losses on hedges to arrive at the quarterly revenues, stripping out gains/losses on future hedges, under the assumption that we will pick those up in future periods. Linn operates under the tenet that constant cash flows are better the volatile ones. We tend to agree with this philosophy. Under our revenues model, we have calculated LINN recognized revenues for the past four quarters as:

Q1 - $195m unhedged, $185m hedged

Q2 - $255m unhedged, $230m hedged

Q3 - $240m unhedged, $218m hedged

Q4 est. - $150-$170m unhedged, $175-$201m hedged.

In the first three quarters, operating income was approximately 36%, 48%, and 39% of hedged revenues, respectively. We expect Q4 to be in the 30%-36% range, producing between $55-$75m of EBIT. Overall, with the hedging mechanisms in place, we believe that this income stream will definitely continue into the future, and grow substantially based on Linn’s management acumen, commodity price rebounds, capacity increases, or any combination thereof.

Cash Flow Statement:

Linn consistently produces positive operating cash flows based on realized income levels, and investments into future hedging devices. As an oil and natural gas company it requires substantial investment in fixed assets.

Linn’s current dividend policy is set at 62.5 cents per quarter or $2.52 per unit. Earnings at the partnership level are not taxed (Energy MLP), but this payout is taxed at the investor level (ordinary income) and totals approx. $290m a year. On income of $200m this is a bit worrisome, and we don’t foresee this level into the distant future, unless of course commodity prices rebound dramatically, and income rises sharply, which would be great news for LINN owners. However, I feel the dividend will eventually decrease to a more sustainable level closer to 100% payout ratio.

Balance Sheet:

See Valuation section below.

Overall Picture:

On the institutional side, Baupost Group, an investment vehicle run by the extraordinary value investor Seth Klarman has a substantial stake in LINN Energy (might actually be his largest holding) which based on his historic results bodes well for our decision to purchase. We don’t necessarily decide to invest just because a respected institution is “all-in” but it definitely makes us take a detailed look.

In the current market conditions, we see substantial value in energy stocks in general. Does anyone believe that commodities will remain at their current levels indefinitely? Where will they be in five years? Linn has taken most of the market uncertainty out of the equation. We can calculate a relatively stable revenue stream and earnings for five years. Where else can you find this in the current market?

Valuation:

P/E Valuation: $3.3B or $28.60 per share

We estimate total year realized income of approx. $200m in FY 2008 and a conservative 5% growth rate, a CAPM discount rate of approximately 11% produces an earnings multiplier of 16.6 (keep in mind, we are calculating based on realized income only, which is very different than GAAP earnings) and a total enterprise valuation of $3.3B, which is a 74% premium to what it is trading at today.

Book Value Valuation: N/A

As of Sep. 30, Linn had assets of $4.0B and liabilities of $1.9B, therefore a book value of approximately $2.1B a slight premium to its market cap ($1.9B). Most ($3.6B) is tied up on PP&E which makes sense given the industry. Due to the subjectivity in valuation of the PP&E , we do not have an interest in speculating on the book value multiple it should be trading at (as it would take expertise on the side of valuing natural resources). We are intrigued by the company trading at below book value, but do not weigh this metric as heavily as cash flows or earnings.

Risks:

With a new democratic president in office, there is a risk that the tax-free status of energy partnerships will disappear. This could have a major effect on the income of LINN Energy (decreasing it by 40%). In addition, commodity prices have been highly volatile, and could continue to be highly volatile in the future.

The Bottom Line:

Long 5%

We are allocating 5% of our portfolio to purchasing LINN Energy. We will continue to monitor going forward.