Four pitches were selected as finalists, with the winner having the chance to give a 10 minute presentation in front of 2000+ people at the Ira Sohn Conference – in front of legendary investors like David Einhorn, Bill Ackman, Joel Greenblatt, Michael Price, and many more.

Obviously, this was a tremendous opportunity for any aspiring investor. Unfortunately, I did not make the finals, but still received a free ticket to attend the event. It was a great experience, as it was the first time I’ve had the chance to hear actual presentations from many of these investors.

Even more importantly, the event is for a great cause, as the conference has raised millions of dollars for pediatric cancer research.

Without further ado, my investment thesis for ABH, a deep value contrarian idea.

Note: The stock is down another ~10% since I put together the analysis, which makes the valuation even more compelling. I think the second quarter might be rough, but believe the company will start showing improvement in the second half of the year. I have a small starter position for now, as the stock price could certainly get worse before it gets better.

Company Intro

AbitibiBowater Inc. (changing its name to Resolute Forest Products, Ticker: ABH) was formed by the 2007 merger of U.S-based Bowater with the Quebec-based paper and pulp company Abitibi Consolidated. After the merger, the combined entity was the third largest paper and pulp company in North America and the eighth largest in the world.

A debt burden of $6b combined with the economic crisis forced the company to declare Chapter 11 bankruptcy in April 2009.

ABH received financing from Fairfax Financial during the bankruptcy, and emerged in December 2010 with restructured operations, a new management team, and the stock price around $21/share. The stock peaked near $30/share in February 2011, before starting to slide, and is now down 40% over the past year.

Fairfax purchased more shares after the emergence, and continues to hold 18% of the company. Of the top 10 institutional holders, position sizes were increased by +9.5m net new shares over the past two quarters.

Segment Breakdown

Newsprint now makes up 39% of sales and 36% of EBITDA, down substantially from 2008 when newsprint was almost 50% of sales and 45% of EBITDA.

The Fibrek acquisition gives the company more exposure to market pulp, which was the only segment to show industry-wide shipment growth in 2011 (up 3.5%, with a 30% increase in China).

(Note: Fairfax is also a significant shareholder in Fibrek. Fibrek decided to take the ABH bid despite a higher offer from Mercer…potential synergies to boost overall value of their combined stake?)

Investment Thesis

#1) With the recent sell-off, the market is pricing ABH as a distressed equity despite improving operations and continued evidence of execution of management’s turnaround plan –

ABH now trades at an EV/EBITDA of 3.3x (or 5.4x EV/EBITDA after adjusting for the underfunded pension) and P/TangBV of 0.4x.

This compares to an industry average EV/EBITDA and P/TangBV of 7.2x and 1.2x respectively.

With dramatically improved operations, ABH doesn’t deserve such a large discount, as management has executed on its restructuring plan while substantially reducing the annual carrying cost of running the business.

SG&A expenses were cut during the restructuring and continue to fall, as the line item has decreased from $330mm in 2008 to $158mm in 2011 – the company is approaching its target SG&A expenses of $20/ton (~$140mm).

These results have shown progress on the turnaround plan, as the company reported an operating profit of $261mm in 2011, the first annual profit since 2006.

#2) Dramatic restructuring efforts have substantially reduced ABH’s debt burden while allowing the closing of excess capacity and removal of outdated assets –

The bankruptcy proceedings reduced total debt from $6.8B in 2007 to only $900m. By selling non-core assets, management has taken steps to reduce debt even further, which has fallen to $620mm as of March 31, 2012 (corresponding to an annual interest expense of just $60-$65mm, down from almost $600mm prior to the reorg).

The company has also aggressively shut down excess capacity and old mills:

The revised product breakdown reduces the company’s dependence on newsprint (which continues to decline) while maintaining exposure to market pulp (a long-term growth story).

PP&E has been reduced from $5.7b in 2007 to $2.5b in 2011, with the majority of remaining mills operating in strategic locations close to port access, allowing ABH to take advantage of the export market.

The business does throw off a ton of cash flow, and with the new operating structure, this cash is finally available for something other than interest payments.

#3) ABH’s maintenance capex is far below depreciation –

This capex/depreciation spread helps boost FCF, with a current FCF yield to EV of 12% even after including substantial pension liabilities.

While the newsprint business remains the largest segment by total capacity and profits, management has recognized that newsprint is in a state of decline (especially in North America). Management has responded by slashing reinvestment – essentially, the business is being milked for cash flow, a situation enabled by ABH’s leading position in the global newsprint market.

Maintenance capex is forecasted at only 55-65% of D&A, or roughly $120-$150mm per year. This favorable depreciation/capex spread of $80-$100mm per year juices FCF, and should be sustainable as further capacity reductions continue.

This equates to a 12% FCF yield, and normalized FCF yield is much higher (see Valuation and Catalyst sections).

Bear View

Bears will say that, despite the restructuring, ABH remains in a commodity business with the wrong set of assets (namely major capacity in newsprint), old mills, and a tough labor environment. All of these are true but seem overblown as major factors, especially given the stock’s current valuation:

Risk #1) Newsprint, ABH’s largest business segment, is in a state of long-term decline –

Agreed! Here’s the data on newsprint volumes over the past five years:

After the large drop in 2009, the downward trend has at least stabilized, but newsprint is a business that isn’t going to return.

Counter:

The market (including ABH) has responded to these declines by cutting capacity at an even faster rate, leading to stable pricing (post-’09) – ABH’s newsprint segment remains solidly profitable despite declining demand.

Newsprint prices stabilized around $640/ton in 2011, and analysts are estimating prices increasing to $655/ton and $665/ton in 2012 and 2013 respectively, driven by the ONP/newsprint relationship in Asia (see Catalyst section for more detail).

According to ABH’s CEO in the Q4 conference call (emphasis mine):

“So with the continuous decline in newsprint demand in North America, there is less ONP, less recovered paper that is going to be available, so I think that it’s going to push that cost up, and because of the virgin fiber advantage, I think that this market is only going to continue to be open to us… I would not underestimate the potential to also sell in this market because of the advantage of the location of our mills”

A $25/ton increase in newsprint would raise ABH’s EBITDA by $67m annually.

Risk #2) The mills and other fixed assets are old –

True, but much of the oldest and most unproductive assets were sold off or closed down during the restructuring. The total number of paper machines was reduced 50% from 62 to 31.

Counter:

On the NA newsprint cost curve (how cost competitive each mill is with current equipment), 10 out of 12 ABH mills are in the 50th percentile or above, with 7 in the top 9 spots.

The reality is that the paper machines haven’t changed much in 150 years and are at low risk for obsolescence or major technological change – even old mills can get the job done.

Risk #3) ABH faces a tough labor environment in Canada with large pension liabilities –

True…but manageable. ABH’s balance sheet shows an underfunded pension of $1.5B, and the company warned that this funding level could increase after the next actuarial report in June.

Counter:

The company negotiated a deal with the Canadian provinces for pension relief that essentially capped the cash pension contribution over the next ten years, in exchange for certain covenants such as dividend restrictions, capex funding requirements in Quebec/Ontario, and further lump sum payments if capacity is shutdown in Quebec.

This agreement takes a big chunk out of the actual cash outlays and balance sheet liability.

Despite the restrictions, management has been able to downsize the employee base, with a reduction of 7,600 workers (-42%) so far. The negotiated pension plan reduces annual commitments from $300mm/yr to ~$100mm/yr – the estimated net pension liability with these caps is closer to $800m.

Valuation

Outside of its P/E multiple (ABH is still affected by non-operating/one-off charges post-bankruptcy), ABH is cheaper than the industry by 50% or more despite having comparable margins and a lower debt load.

On $456mm of current run-rate EBITDA, an EV/EBITDA multiple of 6x (a slight discount to peers considering post-bankruptcy uncertainties) would yield a per share value of $17.42, or 44% upside from current prices.

Normalized EBITDA is likely closer to $590mm:

A 6x multiple on $586mm run-rate would yield a per share value of $22.50 (86% upside). This translates into normalized FCF of around $385mm, for a FCF yield to EV of 16%.

This EBITDA run-rate does not take into account any upside in the wood product segment (due to improvements in NA housing starts), or further synergies and margin improvement on the pulp segment after the Fibrek acquisition (see Catalyst section).

These factors could increase normalized EBITDA to $650mm+, raising the FCF yield to almost 20%.

Catalysts

#1) Improving EPS after one-item items fall away –

In FY 2011, ABH reported $46mm ($32mm after-tax) in asset impairment and closure costs as the company shut down old mills, in addition to $47mm ($34mm after-tax) in costs related to post-emergence legal expenses.

In Q2, both of these costs have fallen dramatically, and the new run-rate points to a $0.37 EPS improvement, boosting EPS to $0.89 – this translates into a P/E of 13.6x – much closer to the industry.

Add another estimated $0.10 per share from Fibrek (and more with additional synergies), and normalized EPS tops $1.00.

#2) Fibrek acquisition boosts exposure to market pulp, a growing market with potential pricing improvements –

After a hard fought battle, ABH won the bidding for Fibrek (TSX:FBK), another Canadian paper & pulp company, which increases ABH’s capacity in market pulp by roughly 76%. (bid was $70mm in cash, payoff of $115m in debt, plus  ~3m shares).

On the pricing side, NBSK pulp prices have risen from $870/ton to near $900 in May, and analysts are forecasting future increases to $965/ton by FY2013.

Each $25/ton price increase generates an additional $26mm in EBITDA for ABH – with the addition of Fibrek, prices in the $950/ton range would mean an additional $120-$140mm in annual EBITDA for ABH.

#3) Upside in Wood Products due to (slow) recovery in housing starts –

With the severe downturn in housing, ABH’s wood products division has operated at a loss for several years. In 2006, the wood products segment generated EBITDA of over $80mm compared to TTM EBITDA of only $7mm.

Recent numbers show modest improvements in U.S. housing starts, up 18% YoY. With the number of new homes still far below replacement value, the market will eventually recover, driving lumber prices up and the Wood Products segment back to profitability.

Even a normalized EBITDA of $40-50mm would add another $200-300m to ABH’s value (~$2.50/share).

#4) Newsprint industry dynamics are misunderstood, and will lead to sustainable pricing and demand –

ABH relies on virgin fiber for its newsprint (via access to timber from the Canadian government) while China & India – where the growth is – have little virgin fiber of their own and therefore rely on recycled newsprint (ONP).

Historically, newsprint was in such large supply that ONP-based mills were much cheaper. But with such a steep drop-off in newsprint volumes, ONP prices have steadily increased, shifting the cost curve towards NA mills – 45% of ABH’s newsprint shipments were outside of the U.S., with 14% to Asia alone.

This creates a cycle:

growth in Asia – > greater demand for ONP – > but less newsprint supply – > higher newsprint prices

In addition, the industry is seeing further capacity reductions and bankruptcies. Since October, over 8% NA newsprint supply has been shut down, and both the #4 and #5 producers have filed for bankruptcy.

These dynamics will continue to stabilize (if not increase) pricing for newsprint going forward, counter to market expectations.

Disclosure

Long ABH 

©2012 Value Uncovered. All Rights Reserved.

Unfortunately, most of my current ideas in this space were disallowed due to market cap restrictions and other covenants in our school’s IPS, so I pitched a trade based on the ‘stub’ portion of Loews Corporation (L), a holding company run by the Tisch family.

The prices in the presentation are from a week or two ago but the story hasn’t changed much, as the current stub is valued at only ~$1.87/share for assets worth up to $19 or $20 per share.

However, the stub trade is volatile and expensive from a carrying cost perspective – in the end, I suggested a straight buy on the equity. The fact that management has compounded book value at 16% annually for fifty years is pretty impressive stuff.

Google Docs Link: Loews – Investment Pitch

A few other write-ups on Loews:

http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/33572

http://www.rationalwalk.com/?p=12522

Disclosure

No position

©2012 Value Uncovered. All Rights Reserved.

IEH Corp (IEHC)

Market Cap: 8.41mm	Last Trade Price: $3.65
FY11 (year end 3/11) EPS: $0.73	TTM EPS: $0.68
NCAV: $2.66	Book Value per Share: $3.25
Current P/E: 5.4x	EV/EBIT: 3.2x
Average ROE 2008-TTM: 24.1%

Price Chart

To estimate where the stock normally trades, I eliminated some of the larger price spikes, and using the previous year’s earnings from FY04-FY11, I estimated the median annual low P/E was 6.08, and the median high P/E was 13.15.

Company Overview

IEH Corp designs and manufactures connectors for military and commercial applications. It sells mostly through independent reps in North America, Europe and Asia. While it has a standard line of products, the company engineers will also work with the customer to create job-specific connectors. In 2011, 69% of sales were to the military, compared to a 73% average over the last ten years.

IEH’s connectors use hyperboloid technology, which uses curved wires to ensure the male and female parts of the connector maintain contact through any amounts of shock or vibration. It’s the same technology the competition uses, and has represented almost all of the product sales for over 15 years. These connectors are sold to end manufacturers of finished goods as a component of the final assembly (think of Raytheon using the connector as a part of a missile system). Since the products are similar, IEH has to focus more on service, customizing the products for the buyer.

The company was created in 1937 as the Industrial Heat Treating Company by Louis Offerman. Louis was succeeded by his son Bernard, and today Michael Offerman is the third generation CEO/Chairman of the firm, having served as CEO since 1987 and on the board since 1973. David Offerman, the VP-Sales, joined the firm in 2004 and is the fourth generation Offerman to work at IEH. Michael Offerman owns 40% of the company.

Paul Sonkin of Hummingbird Capital Management owns 13.2% of the company, with signification ownership first being stated in a 13D filing in April 2007.

Qualitative Overview

IEH’s competitors operate as subsidiaries of a multinational corporation – Smiths Group plc – and are banded together under Smiths Interconnect as Hypertac Ltd. Hypertac used the strategy of acquiring all competing makers of hyperboloid connectors, leaving IEH as the only independent manufacturer in the US. IEH tries to separate itself from the competition by offering custom engineered connectors for specific applications, while many competitors just sell from a catalog.

Both IEH and Smiths Group note that government spending reductions could hurt their revenues and margins (as happened to Smiths’ other defense areas in 2011), but both continue to see solid revenue growth with their connectors.

Why hasn’t the much larger Smiths Group hurt IEH’s sales? One possible explanation is paragraph two of the latest 10-K report:

“We have been approved by the federal government as a “Hub-Zone small business Company”. This classification is monitored, and while the Company must remain competitive, it is taken into consideration by large business concerns when awarding military contracts in support of government programs. The federal government has mandated that major corporations being awarded government contracts must give a specific percentage of such business to “Hub-Zone small business enterprises”.

To qualify as a Historically Underutilized Business zone company, the business must be in a SBA-designated area, majority owned by a US citizen, fit the NAICS small business designation (less than 500 employees, where IEH has 121), and have 35% of employees living in the Hub-Zone. Interestingly, using the company’s HQ address, the SBA site says it doesn’t fall into a Hub-Zone location, though it’s two blocks from the closest one.

IEH has been Hub-Zone company since 2007, which gives it a 10% price evaluation preference, and the government goal is to award 3% of federal prime contracts and subcontracts to Hub-Zone firms.

Between its standard products approved as military qualified product listings, the custom designed connectors for unique applications and the Hub-Zone small business company designation, the company has carved out a profitable niche in its industry.

Financial Overview

After the Gulf War, the military downsized its spending, causing IEH sales to remain in the range of 4-5mm between 1995 and 2004. But in the last 10 years, IEH has more than tripled sales. IEH’s top four customers account for 38% of sales.

The real impact on the stock price has come from the increase in margins. In the last decade, the company struggled with gross margins in the 26-29% range. But in the last five years it increased these margins to the 31-37% range, while also keeping the SG&A expense growth smaller in proportion to the top-line growth. This caused net margins to jump from 1-3% to 7-12%, leading to massive net income growth.

The company free cash flow is a much less compelling story: $0.08/share in the trailing twelve months, and $-.07/share in FY11. This is caused by a large buildup in inventory, specifically raw materials. The company has doubled sales since 2008 while raw materials have almost tripled. Most of IEH’s net income has gone towards purchasing raw materials, leading to the low free cash flow levels. The company’s most recent 10-Q states that it may purchase excess raw materials to take advantage of low prices or in anticipation of increased sales. From speaking with IEH, I gathered that the company was focusing on the latter, which makes sense as 2011 was a year with record backlog.

The company is debt free with $418k in cash, and owes an annual 150k and 111k for a building lease and pension expense. The pension is operated through the United Auto Worker’s union, and neither the plan net assets or unfunded pension obligation is available to IEH. Using the remaining lease payments, I estimated the present value of the building lease at $1.2mm.

Why the Fallen Stock Price, and Reason for Investment

From a high of $5.40 in August 2011, the stock price has fallen to $3.65. This coincides with two events. First, revenue in the September quarter was flat YoY, while December saw a fall from 2010 levels – a concerning fact since September and December had both seen YoY gains in each of the past four years. Second, the US declared an end to the Iraq War in December 2011 with a final large troop drawdown, as well as beginning large troop withdrawals in Afghanistan.

In short, it is doubtful that IEH will continue the previous trend by tripling sales growth over the next ten years. However, IEH doesn’t have a history of overinvesting in inventory, and combined with the record backlog levels it should indicate that the recent fall in sales should be the exception, rather than the rule.

The risk is that the connector market languishes under defense spending cuts, and the Smiths Group starts a price war for the remaining market share, cutting margins to the bone and creating a stagnant market like 1995-2004. A tighter margin environment like 2004-2005 would lead to a lower ROIC around 7-10%, as opposed to the 20-25% ROIC of the last couple of years.

The catalyst for the stock is the realization of anticipated increased sales, along with the eventual slowdown in raw materials buildup leading to higher free cash flow. At 1.12x book value and a 5.4 P/E, the current discount makes IEHC cheap enough to buy and wait for mean reversion towards the high end of the normal P/E range, with book value growth providing the margin of safety.

Resources

IEHC Filings

Smiths Group presentations/transcripts

Disclosure

Author of post is long IEHC

©2012 Value Uncovered. All Rights Reserved.

After lagging the indexes for most of the way, a strong finish helped the portfolio outperform the index during the first quarter of 2012.

In fact, the 15% return was my third-best quarter ever, trailing only two mammoth quarters during the stock market recovery in mid-2009.

As I mentioned in my 2011 year end-review, many of my holdings are extremely illiquid and volatile, and price swings on or near the period closing date can have a big impact on the portfolio’s final performance number.

Portfolio Breakdown

I continue to examine each holding in the portfolio, and have closed out or substantially reduced a number of legacy positions which have hit price targets or no longer fit into my investment philosophy.

The cash position will almost certainly increase due to buy-outs of several existing positions, so I’m on the hunt for new names and always open to hearing ideas from readers.

Position Updates

International Baler (IBAL) enjoyed a nice run-up after reporting a huge Q1. Sales were up more than 130% QoQ, and total backlog has increased to $7.8m compared to only $3.295m in the prior year. The stock is now up almost 400% since my initial post.

I’ve trimmed back my position significantly over the past quarter, but plan on holding onto the remaining stake – 2012 should be a record year.

Access Plans (APNC) announced a merger agreement with AON Corporation for $3.30/share, subject to certain revisions at closing. The preliminary proxy was filed on March 27, and it shed light on an interesting part of the agreement (emphasis mine):

“Prior to the closing of the Merger, Access Plans may declare a one-time cash dividend of up to $0.10 per share of Access Plans common stock then outstanding payable to Access Plans’ shareholders immediately prior to the closing (the “Special Dividend”). However, the Special Dividend is only permitted if (i) prior to the closing the full amount of the Special Dividend is paid to Access Plans’ transfer agent (for subsequent payment to the Access Plans shareholders) on terms and conditions acceptable to Affinity and (ii) the payment of the Special Dividend does not cause the net cash amount immediately prior to the effective time of the Merger to be less than $15.025 million.”

Merger and closing related expenses are estimated at $2.2m, so the ‘trigger point’ for a special dividend would be $17.225m.

As of 12/31/2011, APNC held $15.64m in net cash. In the previous year, the company generated roughly $8m in cash, or $2m per quarter.

If APNC continues to throw off the same amount of cash, and the merger closes at the end of Q2, those 2 quarters would give the company a cash balance in the $19m range.

If so, it’s likely that at least some (if not all) of the $0.10 dividend will be paid before closing, providing a nice boost even if another suitor does not emerge.

Access Plans is not the only holding that is ‘in play:’ New Frontier (NOOF) is the subject of an apparent bidding war.

The bidding started with an offer of $1.35/share by Longkloof Limited, which owns 15% of NOOF’s shares. Several weeks later, another potential acquirer emerged, with Manwin Holdings offering $1.50/share.

The interest caused NOOF’s management team to hire Avondale Partners to evaluate all alternatives:

“Our Board of Directors remains very enthusiastic about New Frontier Media’s future prospects and has made no decision to sell the Company. However, in keeping with our commitment to act in the best interests of all shareholders, we have decided to undergo a thorough review of strategic alternatives to determine the best opportunities for maximizing shareholder value at this time”

The stock is trading at a premium to the latest offer, so the market is certainly pricing in further action.

Finally, an activist investor emerged at Gaming Partners (GPIC), as Enclave Asset Management wrote a strongly-worded letter to the management team and proposed new board members at the upcoming annual meeting.

The company posted disappointing results for the fiscal year, with EPS falling from $0.54 last year to $0.45.

If nothing else, the quarter was certainly entertaining.

Disclosure

Long IBAL, NOOF, GPIC

©2012 Value Uncovered. All Rights Reserved.

Company Overview

TNRK designs, assembles, and sells batteries to a variety of industrial markets. The company purchases batteries from major and well-known manufactures such as Energizer or Sanyo, assembles the individual items into battery packs, and then maintains the inventory for sale and distribution.

The batteries are sold to OEM manufacturers, hotels/resorts, military, aerospace, and electrical wholesalers – TNRK even designs and assembles custom battery packs to customers’ specifications.

The company maintains two major distributions centers in Florida and California, and runs the websites www.batterystore.com and www.tnrbatteries.com.

Management & Ownership Structure

TNRK is family-held, with management and insiders holding 38% of the company. Wayne Thaw, the company’s Chairman of the Board and CEO, has been involved with the company since inception and held a management position since 1987.

His brother, Mitchell Thaw, serves on the board of directors and has an impressive Wall Street background, where he specialized in equity options and structured products, including running a $900M capital structure arbitrage fund.

The father, Norman Thaw, is a former director and still 17% of the company, giving the Thaw family effective control over the business.

Paul Sonkin of Hummingbird Capital Management, a micro-cap and nano-cap focused value investing fund, owns just over 65k shares, or 21% of the company, purchased in the 2007-2009 time period.

Financial Overview

TNRK is profitable but growing its top-line at 1.47% over the past ten years, not exactly an exciting growth rate and lagging inflation.

While the overall prospects for the battery industry remain bright (as society becomes more and more electronic), TNRK will continue to face significant challenges in growing its core business. In the company’s own words:

Battery wholesale distributors face increased competition as offshore (specifically China) and U.S. manufacturers continue to sell directly into the marketplace alongside an increasing number of web-based operations and expanding local battery franchises. Competitors continue to price their products aggressively which has a direct impact on the Company’s overall sales and gross margins.

Revenues peaked in 2006 at $9.72m, only to fall to a low of $8.73m in 2009. The company did show signs of improvement in 2010 and 2011, but sales seem to have stagnated around $9m.

Gross margins have remained steady in a range of 30-32% over the past five years . However, despite the lower sales, SG&A expenses increased from 18-19% of revenues to 24% in 2010 before falling to 22.7% in the TTM period.

Much of the recent decrease in SG&A can be attributed to a revision of the rental agreement for the company’s HQ, payable to a holding company owned by the CEO Wayne Thaw (the conflict of interest was disclosed in the annual report).

The lease agreement was renewed in 2007 at the height of the bubble, which made the rent expense seem high – the revised agreement provides a 27% lower rent payment to reflect depressed market conditions.

Operating margins have declined for the past five years to 6.3%, but seem to be leveling off around the 6% mark.

Despite the struggles in the industry outlook, the company has remained profitable in each of the past ten years.

Investment Thesis

1. TNRK is a net-net stock and therefore extremely cheap on an asset basis – P/B is 0.68x, and at current prices, TNRK trades for less the value of the current assets on the balance sheet after subtracting all liabilities: 

Even after taking downward adjustments for the A/R and inventory line items, adjusted NCAV (or liquidation value) is $9.18/share.

2. TNRK’s business fundamentals are actually decent – Many net-net stocks are in very ugly businesses with terrible capital allocation, high capex requirements, and inconsistent profits. While TNRK’s industry has its challenges, the core business requires little in the way of investment.

The company is overcapitalized (so ROE is low) but looking at the operating business itself reveals a decent fundamental picture: 

ROIC has fallen from the 30-40% range but seems to have stabilized around 17-18%, which is very good for a net-net stock (remember, the market is basically assigning zero value to the operating business).

While TNRK isn’t a great business, it isn’t a terrible one either – management does not appear to be destroying value by keeping the lights on.

3. Management is paying out surplus cash to shareholders – Over the past several years, excess cash has been returned to shareholders.

Since 2006, TNRK has paid out $5.5m in three large special dividends, or roughly $18/share. 

Too many companies with surplus cash balances try to diversify into other business lines, or (even worse), blow the cash on a bad acquisition.

These payments should continue to be a catalyst for unlocking value for existing shareholders, even if business conditions do not dramatically improve.

Return Scenarios

Despite the negative trends, TNRK continues to throw off a ton of cash.

TTM FCF is $640k, which equates to a 23% FCF yield – if you choose to calculate FCF yield as FCF/EV, the result is an absurd 97% yield.

At these prices, the market is not only assigning zero value to the company’s inventory, it is assigning zero value to a profitable operating business that should generate $250k-$500k in annual cash flow over the next several years.

Consider the picture of TNRK’s cash balance over the past few years: 

A nice pattern emerges: A run-up of excess cash over several quarters, then a special dividend to shareholders.

Keeping this pattern in mind, let’s assume that TNRK will pay out a $1m dividend at the end of each year that the cash balance reaches $2.5m.

I also simplified the calculations so that the annual change in cash = net income, as FCF has closely tracked income over the past five years.

Here’s how the scenario might unfold:

Bull Case

In this case, two separate $1m dividends are paid over the next five years, returning ~70% of the purchase price – and leaving a cost basis of $700k for a profitable business with $1.5m in cash in the bank.

Bear Case

Even under a more extreme scenario where EPS falls rapidly over the next five years, the company still pays a $1m dividend, returning 36% of the purchase price – and leaving a breakeven business with $1.76m in cash, few liabilities, and a several million dollars in additional current assets that could be liquidated.

Risks / Negatives

Tiny illiquid stock – TNRK often seems to trade by appointment. Many days or weeks can go by without a single trade, and even small blocks can cause double-digit price swings.

Management compensation is high – The top three officers took down $550k in salary and bonus in 2011, which is a significant chunk for a company with $9m in revenue (it is even higher if you include the rent expense to the CEO’s holding company, although TNRK would have to rent the space from someone).

Material business decline and/or obsolescence – Theoretically, TNRK’s suppliers could choose a different distribution channel and cutoff TNRK. The latest report also mentions a potential supply disruption in China due to more stringent environmental standards for lead acid batteries. If sales fall and management is unable to cut costs, the business could decline at an even more rapid rate, potentially limiting dividend payments.

Conclusion

This is a relatively simple investment case, as TNRK trades below its liquidation value despite a history of profitably and no signs of radical disruptions in the business outlook.

Through the first six months of fiscal 2012, the business is showing small glimmers of a turnaround (or at least a stabilization), with ROE, ROA, Gross Margin, and Net Margin all up over the prior twelve months.

TNRK is part of my basket of net-net stocks. Going forward, either:

1. The business model is not obsolete and conditions improve. Management is able to rein in the cost structure. Earnings return near historic levels.

Result: TNRK’s share price goes higher on a more rational multiple of earnings. Shareholders benefit from share appreciation and dividends.

Or…

2. The business continues on a steady decline, and management is unable to reduce costs to compensate for lower sales.

Result: The business stockpiles cash flow for several years, pays out special dividends, and eventually liquidates or goes private.

Both options seem to offer attractive returns over the next several years with limited downside – therefore, I continue to hold TNRK as part of my basket of net-net stocks.

Disclosure

Long TNRK

©2012 Value Uncovered. All Rights Reserved.

So far, it has been a lot of academic-focused lessons on efficient markets, betas, CAPM, and factor models…not exactly topics that mesh with trying to outperform the markets by picking undervalued stocks!

Even so, it has been helpful to understand the viewpoint of academic finance. Even if I do disagree with most of it, I can appreciate the process behind many of the studies.

In fact, the best part so far has been having access to massive amounts of quality financial data and academic research.

I thought I would include a few of the more interesting charts and graphs from the year so far.

Returns on Small vs. Big

Source: Professor Ken French’s Data, 1926-2008

Confirmation that small stocks outperform larger ones (and validation for the small-cap focused nature of this blog).

Returns on Value vs. Growth

Source: Professor Ken French’s Data, 1926-2008

And that value stocks outperform growth (high market-to-book = low P/B stocks):

Returns by Liquidity

Source: J. Liew and M. Vassalou, “Can Book-to-Market, Size and Momentum Be Risk Factors That Predict Economic Growth?”

Illiquidity can also be a factor in producing above-average returns. This chart shows the alpha generated by stocks across the liquidity range, above and beyond what is predicted by CAPM and the Fama-French 3-factor model.

Whether or not CAPM or the FF-model does a good job of predicting returns is another debate (they really don’t).

However, if an investor is patient, a willingness to tie up capital for an extended period (hopefully in an undervalued security) could yield above-average results.

Risk Premiums 

Source: John R. Graham & Campbell R. Harvey, “The Equity Risk Premium in 2010”

This chart is pulled from a forecast of CFOs on the equity risk premium used in cost of capital calculations.

An initial look at the graph shows that premiums are extremely volatile, which further weakens the validity of a CAPM model.

Interestingly, the reported risk premium hit a low in 2006/2007, just before the bubble popped (and when most stocks were overpriced).

On the other hand, CFOs demanded a much higher premium (and therefore thought future projects were riskier) in the early part of 2009, right when investors should have been buying.

Could a low risk premium be an indicator for poor stock market performance?

Earnings Surprises

Source: R.J. Rendleman Jr., C. P. Jones, and H. A. Latane, “Empirical Anomalies Based on Unexpected Earnings and the Importance of Risk Adjustments”

Many short-term focused hedge funds play an earnings game, and it turns out that there is some interesting effects, especially after large earnings surprises.

Efficient market proponents would argue that the market immediately adjusts to reflect the new earnings picture after an unexpected quarter, but studies have shown that earnings continue to drift for several months.

A possible takeaway: If a stock reports a surprisingly bad quarter which changes the fundamental thesis about the company, it’s better to sell right away vs. trying to time a better exit point in the future.

Activists

Despite some very high-profile activist campaigns, only 29% actually succeed. It’s no surprise that lowering compensation and removing a management team have a below-average success rate.

As a microcap investor, going private transactions have been a key source of unlocking value, and the success rate probably reflects the fact that management is often on board in these transactions.

Asset Class Returns

Access to high quality financial data allows a study of asset class returns over long time periods.

In this chart, the dip in 2008/2009 is clearly shown across almost every single asset class.

In fact, correlations between asset classes tend to increase significantly during high volatility periods, just at the time when diversification is supposed to provide the greatest benefits.

1982 – 2011

Look at the risk-reward of midcaps over the past 20 years…a possible underinvested asset class?

2002 – 2011

Over the past 10 years, stocks have performed poorly, as bonds returned nearly the same amount with much lower risk.

Final Thoughts

This post was a bit outside of my normal zone, so please let me know if you found this post interesting and/or worthwhile, and I’ll plan on collecting similar information going forward.

I’m also the getting involved in Kenan-Flagler’s student-run investment fund, which provides the opportunity to manage roughly $2m across a wide range of asset classes.

As the new Equities Manager, I’m responsible for the stock investments, so I’m looking forward to getting some practical experience over the next year – more stock pitches to follow!

©2012 Value Uncovered. All Rights Reserved.

Historically, BLMC rented out the land to exploration companies and collected a lease fee –in 2006, the company formed a subsidiary for active exploration, an aggressive shift in strategy that offers the potential for long-term investors.

Investment Thesis

1. Contrarian play on the bearish sentiment for natural gas – Natural gas prices have hit the lowest point in the past ten years, and the bears have been out in full force. Supply/demand economics argues that prices should eventually rise back to more normal levels (although it might not be until 2013 or later), and any boost will provide significant upside to BLMC.

2. New exploration subsidiary changes company’s strategy – Prior to 2006, BLMC was a passive land owner, leasing out land to other exploration companies in exchange for royalty income. The new B&L Exploration Company (B&L) is actively exploring on behalf of BLMC (with early signs of success).

3. Land provides downside protection – BLMC owns 90,000 acres in St. Bernard Parish in Louisiana, which is held on the books at significantly below market value. While the land is really only suitable for oil & gas drilling, the land should provide a backstop to the share price, limiting potential downside

4. Attractive dividend yield – The company has paid out $50m in dividends over the past ten years, with an average yield of 8.2%. Yields over the next 1-3 years will likely be lower given the recent price trend in natural gas, but any uptick in natural gas prices could result in a material increase.

Overview of the Natural Gas Industry

While I normally stay away from ‘macro’ plays, the success of this investment is so wrapped up in natural gas prices that additional detail is warranted.

A quick check through some of the latest news headlines shows the dynamic in natural gas right now:

• U.S. Natural Gas Extends Slump to Lowest Price Since March 2002 – Business Week, Jan 19
• Glut Hits Natural-Gas Prices – WSJ, Jan 12
• The Really Negative Story on Natural Gas – WSJ, Feb 2

And looking at the recent price levels at the Henry Hub in Louisiana:

So why such a drop?

• A very mild winter in the United States has put a damper on gas demand for heating
• Inventories are near record highs, creating a supply glut
• Incredible growth in natural gas from shale formations via innovative drilling techniques like hydraulic fracturing

The natural gas story is best told by pictures. Here is the growth in shale production: 

Source: EIA, “The Long-term Outlook for Natural Gas”, Feb 2011

And a map of the major shale plays in the U.S.: 

Source: EIA, “The Long-term Outlook for Natural Gas”, Feb 2011

However, this huge increase in production comes at a cost – literally – as these new shale plays are very expensive:

“Gas shale wells are expensive to drill and complete as well as the cost of the leases on which they are drilled. Even though initial gas production from shale wells is huge, the low price has depressed the amount of cash companies are receiving. As a result, producers are spending well in excess of their cash flows.”

In the rush to gobble up territory in these areas, exploration companies only have a few sources of cash:

1. Tapping Wall Street for debt & equity – While Wall Street can provide funding for far longer than is usually wise or prudent, there are signs that the other two sources are running out…

2. Investing in joint ventures – JV Investment are on the decline, with significant fall-offs in 2012 and 2013: 

3. Hedging future production – Another alternative, where companies use the promise of cash flow from future production in exchange for funds now. However, the timeframe for receiving a decent rate for future production is lengthening dramatically: 

These low prices are bad news for shale gas, as many cannot earn satisfactory rates of return if gas stays below $3 or even $4 per MMBTU:

Despite some of these warning signs of a correction in natural gas, there is definitely a chance (likely a certainty), that natural gas prices will go lower in 2012 on the back of a mild winter and higher-than-normal gas inventory – maybe even breaking the $2.00 barrier.

However, supply/demand economics dictate that producers will cut production if prices stay low, as many high-cost producers will eventually go out of business if the trend continues.

Even some of the more well-known names are already cutting production – Chesapeake Cuts Natural-Gas Output as Prices Hit 10-Year Low.

But enough of the macro picture, let’s take a look at BLMC.

BLMC Financial Overview

BLMC’s revenues ebb and flow with the rise and fall of natural gas prices, and have ranged from a high of $21m in 2004 down to a low of $0.598m in 2008.

In the last few years, the bottom line has been boosted by several legal settlements with the state of Louisiana ($24.2m in 2009 and $5.2m in 2010, with most of the windfalls paid out via dividends).

While operating income from the traditional royalty base has been positive, the company has been funneling dollars into the B&L exploration subsidiary, which flows back to BLMC’s accounts through the “Income (loss) from Investment in partnership” line.

Therefore, investments in exploration within the subsidiary show up as a loss on BLMC’s income statement, which can cause an ugly bottom-line earnings number.

Through the nine months ended Sept 30, 2011, the company reported a net loss of $1.2m, compared to a gain of $0.788m in the same period last year.

The big difference was the subsidiary: partnership losses came in at $2.4m through the first nine months, although $1m of that loss was from depreciation & depletion expense, a non-cash charge.

Much of this cash outlay went towards drilling new oil & gas wells, so the future odds of recouping this investment is still uncertain – however, initial results show much promise.

So while the income statement isn’t exciting right now, BLMC’s balance sheet is extremely strong, with cash and cash equivalents of $3.3m as of September 2011.

In addition, the company has a diversified portfolio of marketable securities, mostly in large-cap stocks and bonds, with a market value of $11m.

Unlike many companies, Biloxi does include a detailed breakdown of the marketable securities portfolio in each annual filing.

The Land 

Biloxi owns approx. 90,000 acres in Southeast Louisiana (see picture above). The company provides a detailed description of each plot, along with a property map highlighting the specific area.

Sadly, this is not land for development, as most of it is marshland and basically underwater – check out the scenic gallery here.

However, all of this land is being held on the books for $235k, or only $2.61/acre. This seems absurdly low, and reflects the fact that most of the land has been on the company’s books since the 1930s.

While the exact value of the land is open for disagreement, it HAS produced millions of cubic feet of natural gas, and would seem more valuable than $2.61/acre…

Could it be worth more than the current enterprise value of the entire company?

After talking with a Louisiana real estate expert, basic non-developed land goes for roughly $700-$1000 per acre. The inclusion of mineral rights (the ability to mine or drill for oil & gas and other minerals), adds roughly $100-$150/acre to a property’s value.

So even if we value the actual land at $0, and assign a value of $150 per acre for the rights only (on the high-end of the range, since it is a known gas-producing region), the total land value is $13.5m, compared to BLMC’s current EV of $12.5m.

Regardless of the true value, the land does provide a measure of downside protection, as management can always sell of parcels to meet funding requirements if the company was ever in dire straits.

Oil & Gas Properties

As of the latest quarterly press release, BLMC had ownership interest in 4 wells leased out to other exploration companies. In addition, the new B&L subsidiary has ownership interest in 6 wells, with an additional well being placed into production in the first quarter of 2012.

During the 2nd and 3rd quarter of 2011, B&L drilled four wells, with three out of four turning into successful commercial wells, a solid success rate (which also speaks to the quality of the management team).

After digging through the Louisiana SONRIS database and the company’s historical press releases & filings, I was able to piece together a rough picture of BLMC’s wells:

Note: Ownership interests of BLX are approximate %, as it depends on split between A & B shares (not public info)

And a graph showing the daily production from the producing wells:

While there could be additional wells not captured in the chart above (a well that was included in a 2008 report but not in 2011 for example), it does show a nice trend in the daily production. Most of this additional capacity is from the B&L exploration subsidiary.

I want to highlight one well in particular, the company’s new Harry Bourg No. 1, which was discussed in the Q3 2011 press release.

Daily production in the Harry Bourg well has increased from 26,303 in September to 71,779 in November, a nice steady increase – it’s already the 2nd highest producing well for BLMC.

The company expects at least 2 more wells to be in production by the next report.

Reserve Picture

Each year, BLMC conducts a reserve study via an independent third party, with the results for 2010 included below: 

In addition to the above amount, the B&L subsidiary owns an additional 2.3 BCF of natural gas and 25 MBBL of oil of reserves – combined, total reserves owned by BLMC come out to 4.01 BCF of gas.

Over the past 7 years, proven reserves have varied, with a high of 5.793 BCF in 2004 and a low of 2.502BCF in 2006.

The latest quarterly reports shows that total reserves have increased slightly to 4.10BCF.

Interestingly, a quote from the latest study was included in the 2010 President’s report:

“The recently drilled LL&E No. 1 well located in Lapeyrouse field in Terrabone Parish, Louisiana has not yet been completed and no tests have been performed. The well encountered several pay zones, some of which are considered PDNP based on log and core data. Other zones encountered by the well are potentially productive and may have significant value.”

The company provides an explanation for including the quote (emphasis mine):

“is to make investors aware that there is a probability that the LL&E No. 1 well may have significant reserves that are not included…”

A revised study will be included in the upcoming annual report, but the management team seems rather conservative, and I think there is a good chance for a fairly significant reserve increase in 2012.

Valuation

Biloxi’s market cap is roughly $26m, with $3m in net cash.

In addition, the company also holds a large but liquid portfolio of marketable securities – mostly large cap stocks & bonds – worth another $11m at the time of the most recent quarterly report.

After subtracting out the cash and marketable securities, total enterprise value is only $12.5m.

BLMC has two different sources of earnings: the traditional fee-based revenue, plus income from the new exploration subsidiary.

In the 2011 shareholder letter, the company had 2.29 BCF of gas in a combination of developed producing & developed non-producing reserves (the “2P” metric) – on its fee-producing lands (i.e. the land it leases out to 3rd parties), with a PV10 of $7.559m.

Note: PV10 is a standard oil & gas metric which measures the present value of a company’s reserves, by taking future revenues, subtracting out direct costs, and discounted back at 10%.

Through its interests in B&L, BMLC owns an additional 1.72 BCF of gas (an additional 75% on top of the company’s outright reserves) which brings the total up to 4.01BCF.

So a back of the envelope calculation the combined PV-10 = $7.559m * (75% additional from B&L) = $13.22m, which is more than BLMC’s current enterprise value.

Remember, the PV10 number is estimating how much revenues will be thrown off by the company’s existing wells, and does not account for any further upside from new exploration.

The latest reserve study was from March of last year. While gas prices have cratered over the last 6 months, the new PV10 figure will be based on the 12-month average natural gas price through the end of 2011.

Although the recent headlines and price action has been brutal, the average month-end gas price was only down 10% YoY.

So being conservative and taking a 15% haircut on the PV10 number yields an adjusted PV10 of $11.2m going into 2012– once again compared to the total company EV of only $12.5m.

At these prices, the market is basically assigning zero value to:

1. Any future appreciation in gas prices
2. Any new lessors of the company’s land for drilling purposes
3. Any future gas finds
4. And over 90,000 acres of land

My take on management’s comments is that they intend to pay out dividends on all income from fee-producing lands (i.e. the $7.6m PV10 figure from above), but re-invest the subsidiary’s earnings back into more exploration.

While dividends over the next few years will likely be lower than previous years (no legal settlements and lower natural gas prices), the resulting yield should still be decent in a zero interest rate environment (4-5%?).

Finally, looking at the valuation on a historical perspective, BLMC is selling at an EV/Proved Reserves of 3x versus. 20x in 2007 – natural gas prices are obviously much lower now, but not 6.5x lower.

Conclusion

In summary, while investors sit around and collect a nice dividend yield, there are several upside scenarios:

1. Gas prices improve, significantly boosting industry profits (2013?)
2. B&L hits it big with a large new find (management has been savvy so far)
3. Additional parties lease land on the property (in active discussions)
4. BLMC markets its 3D seismic data (the Tuscaloosa project is rumored to have up to 5 TCF of gas, worth billions of dollars…wild speculation for now, but interesting nonetheless for a $25-30m company)

With all of these upside scenarios, I think BLMC is a safe bet for those who want exposure to an eventual upswing in natural gas prices.

I’ll finish with a quote from Jeremy Grantham, the Chief Investment Strategist of GMO on natural gas (emphasis mine):

“There are obviously powerful technical reasons depressing the price for natural gas. But it’s the premium fuel. It burns cleaner and better than any other hydrocarbon, and it sells at the lowest ratio of heat equivalent to oil in 50 years. It is about 15% of the energy-equivalent of oil price. It has sold at parity from time to time over the last 30 years. This is a dazzling opportunity.”

Couldn’t have said it better myself…

Disclosure

Long BLMC

©2012 Value Uncovered. All Rights Reserved.

Here is the press release and merger document.

The purchase price is subject to a downward adjustment based on the net cash position of APNC at the closing of the merger, but is currently estimated at $3.30 per share.

This $3.30 consideration was an 18% premium to the latest closing price, and a 24% premium to APNC’s average price over the past 30 days.

In my view, AON is getting a steal with this transaction.

A $3.30 purchase price on $0.30 in diluted EPS (ttm), translates into a P/E of 11x or a rough EV/EBIT of 4-5x.

These are very low multiples for a business whose remaining two segments are generating 30%+ operating margins and steady revenue growth (and throwing in a $15m pile of cash as well).

According to Danny Wright, Access Plan’s Chairman and CEO:

“This sale represents a natural step for us. Becoming a part of the leading risk advisory firm translates into a positive outcome for our shareholders, greater options and value for our clients and increased opportunities for our employees.”

The negotiations are private, so it’s useless to speculative on how the final price was determined, but the management team and insiders hold 66% of shares outstanding, giving them effective control over such merger decisions.

APNC is in a unique business, so maybe the pool of suitors was limited for such a niche offering? Or maybe the management team just wanted to cash out and therefore took the first deal available?

It’s hard to say, though I’d be interested in hearing what RENN Capital (the largest institutional investor, with 11.5% of shares) thinks of the sale price…

Investment Review

It is hard to complain however, as my investment in APNC has turned out well:

I decided to sell some after the initial spike back in February 2011, but held on to a significant amount of my initial holding – APNC is the second largest position in my portfolio.

Although I have substantially changed my investment process and valuation methodology over the past two years, I thought it was interesting to look back at my initial forecasts from two years ago (February 2010): 

Averaging the aggressive valuations yields a price target of $3.27 – pretty darn close to the $3.30 merger price.

Final Thoughts

I do think there is a some possibility (15-20%?) that another offer emerges or the merger price is raised before the deal closes in the second quarter.

AON is a $15B company, and swallowing a $70m acquisition has relatively little risk, so I think that it’s unlikely the deal falls through outside of drastic circumstances.

However, APNC is a microcap and liquidity can be a concern, so I’ll look for an opportunity to reduce my position if nothing appears soon.

In a similar circumstance, I made the mistake of selling AMLJ after its buyout offer of $2.15, and missed out when another offer came through at $2.50.

Disclosure

Long APNC, for now

©2012 Value Uncovered. All Rights Reserved.

Hopefully it was deserving enough to earn a spot in the class!

If you have trouble with the format below, here is a Google Doc link.

The presentation is based on my original report, just in a slightly different format, although I made some modifications to the multiples & valuation method to reflect the FDA approval of the Pronto-7 device (which relieves some of the uncertainty around future growth).

The company reports FY results tomorrow, and I’m eager to hear management’s comments on the outlook for 2012.

Disclosure

Long MASI

©2012 Value Uncovered. All Rights Reserved.

Note: I completed this research report on January 9th to prepare for my investment management interviews, and of course MASI has managed to climb 17% since that time – the FDA approval of the Pronto-7 should now add materially to 2012 results.

While I normally don’t like publishing write-ups “after-the-fact,” I thought this was still worthwhile to share.

I think there remains substantial upside, with a target of $30 or higher not out of the question (especially for a possible acquirer).

Disclosure

Long MASI

©2012 Value Uncovered. All Rights Reserved.