NOT AN ANALYST

Background One of the most discussed topics in HY is Harrah Operating Company, one of the largest casino entertainment providers in the world. The enterprise has been taken private in January 2008 by a group of investors (Apollo, TPG and Paulson & Co. Inc) through an LBO and since then it has been cutting expenditures, reducing costs and initiating several debt-to-equity exchanges to avoid Chapter 11 filing. Despite those actions, Harrah continues to be a highly leveraged Company with a 10.3x Net Debt/Projected 2010 EBITDA and a 1.1 Projected 2010 EBITDA/Interest Expense.

Valuation and Leverage Harrah’s EBITDA has decreased in recent years, dropping to a projected 2 billion in 2010 from a peak of 2.8 billion in 2007. Despite debt exchanges, which have eliminated about 5 billion of debt, and substantial cost reductions, which have helped offset some of the decline in EBITDA, Harrah’s leverage in 2010 will be at 10.3x EBITDA and EBITDA coverage will be barely above 1. However, in 2011 the story is going to be a different. In June the equity sponsors announced a debt-to-equity swap that will cut about 1.118 billion in debt. Hence, in 2011 Harrah will have approximately 19.5 billion in net debt outstanding, assuming cash on hand remains constant. EBITDA will have to rise up to 2.4 billion or 20% (assuming 2010 EBITDA will be 2 billion) to reduce the multiple to 8.1x. At that level, Harrah’s debt is certainly something worth looking at, especially the second lien notes. Don’t get me wrong, this is still a leveraged capital structure, but certainly manageable giving the ample liquidity and an EBITDA at 2.4 billion/year. Although I expect the gaming industry to rebound next year, I don’t expect Harrah to reach its 2007 peak levels anytime soon. 

Public Offering and Implied Valuation A few weeks ago, Harrah Entertainment announced a plan to raise 575 million through an IPO for 9.75% of the Company to finance projects in Las Vegas and Ohio. The decision to invest capital rather than use it to reduce the already high debt level underlined the confidence of management in the turnaround of the business. Management probably expected to earn an IRR on the incremental capital that far exceeded the 13-15% pre-tax yield on the bonds if they were bought in the open market. However, the deal fell apart shortly after its announcement as market conditions were deemed hostile for private-equity backed IPOs but this scenario opened up a whole new valuation for Harrah. Let’s take a look. The IPO would have raised 575 million for a 9.75% stake in the Company, giving an implied equity value of 6.183 billion and an implied enterprise value of 25.63 billion after the 1.118 billion debt-to-equity exchange planned for next year. Considering that EBITDA for 2011 will probably be around 2.2 billion the implied EV/EBITDA multiple is 11.7x. Management is obviously extremely optimistic abut the outlook of the gaming industry but I think their projections and valuation are too generous and that the IPO is a bit pricy. However, I expect Harrah to launch another equity offering attempt next year, which will give us more information about the value of the enterprise.

What looks good? The first lien debt seems to be well covered in case of bankruptcy (see below) even if EBITDA will be 1.6 billion, which is very conservative. The second lien debt will experience above par recovery only if EV will be between 17.6 to 20.8 billion, the high end of the valuation. If you believe in the rebound of the gaming industry, the 10% Senior Secured Noted due 2018 are a good investment. They are currently trading at 89, with a CY of 12% and an YTM of 12.8%. All the Unsecured Notes trade at a significant discount to par, ranging from 60 cents to 90 cents on the dollar, but I don’t expect any meaningful recovery since Harrah has been exchanging them for equity at rates significantly below par.

Risks Harrah is a highly levered company; hence it would take a less significant decline in EBITDA to generate a payment default compared to a less levered company. S&P uses multiples of 5x to 8x EBITDA to value gaming companies, with an average multiple of 6.7x. This compares with the 5x to 7x used for most industrial sectors.

Bondholders will be pushed down the capital structure if the Revolver gets fully drawn (1,500 in available borrowing at the moment)

The presence of junior debt in the capital structures has resulted in higher recoveries for the loans senior to these obligations because senior lenders would have a priority claim to the total enterprise value of a firm. Harrah’s capital structure doesn’t contain many junior or subordinate notes.

Conclusion Although I don’t expect the economic recovery to allow the company to grow back to its 2007 peak, Harrah’ credit profile will get stronger in the next years. Looking at the capital structure, the best investment is to own the 10% Senior Secured Notes due 2018. Based on my calculations, above par recovery is possible if we apply a multiple of 8 to 2.4 billion in EBITDA, a plausible scenario in 2011 or 2012.

For all the loyal readers out there, this is why it pays off reading this Blog. One of my earliest posts was about a value opportunity that was hiding behind a technicality on certain Citigroup non-cum equity preferred shares (CprP, CprM and CprI). Here is a link to my post in case you don’t remember:

http://www.notananalyst.com/2009/10/17/citigroup-preferred-shares/

Background In February 2009, Citigroup announced the suspension of dividends on certain non-cum equity preferred (CprP, CprM and CprI) as the securities were converted into equity in an effort to raise tangible common equity and capital requirements. In theory, preferred shares that don’t pay a dividend are worthless based on the Gordon Growth Model but those preferred continued to trade despite the suspension of the dividend due to a technicality. That’s when the value opportunity became evident.

Technicality As I described in my original post, holders of the non-cum equity preferred shares were required to vote on a series of amendments and the most important among them was the dividend blocker. That amendment was designed to eliminate the legal obligation of the issuer or Citigroup to pay dividends on the non-cum equity preferred even if some investors elected not to exchange their shares. However, the dividend blocker didn’t pass and Citigroup became legally obligated to pay a dividend on the outstanding non-cum equity preferred shares before it could pay a dividend on common shares. As a result, the equity preferreds that were trading ex-dividend continued to rise, on speculation of a possible dividend payment in the future.

IRR In my original post, I proposed a scenario in which Citigroup would defer the dividend for six quarters and resume it afterwards. Now, after only four quarters, Citigroup has announced the reinstatement of the non-cum equity preferred dividend. The trade idea yielded an IRR of about 49.5% for each security, significantly higher that the 20% IRR I expected.  Here is the press release:

NEW YORK – The Board of Directors of Citigroup (NYSE:C) today declared dividends on preferred stock as follows:

6.5% Non-Cumulative Convertible Preferred Stock, Series T, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full convertible preferred share, will be paid $.8125 for each receipt held.

8.125% Non-Cumulative Preferred Stock, Series AA, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.5078125 for each receipt held.

8.40% Fixed Rate / Floating Rate Non-Cumulative Preferred Stock, Series E, payable November 1, 2010, to holders of record on October 20, 2010. Holders of depositary receipts, each representing one-twenty-fifth of a full preferred share, will be paid $42.00 for each receipt held.

8.50% Non-Cumulative Preferred Stock, Series F, payable December 15, 2010, to holders of record on December 3, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.53125 for each receipt held.

On February 27, 2009, at the time of the announcement of its public and private exchange offers, Citi announced the suspension of dividends on its Preferred Stock. Pursuant to the exchange offers, Citi offered to exchange up to $14,923,650,000 of its outstanding publicly-held Preferred Securities for Common Stock at a price per share of $3.25; 98% of the Preferred Stock elected to participate in the exchange offers. Dividends declared today will be paid on the Series AA, T, E and F Preferred Stock that remains outstanding.

Common Dividend The dividend reinstatement on those outstanding non-cum equity preferred is a hint to investors. Citigroup should be in no rush to reinstate the dividend on the non-cum equity preferred unless the Company is getting ready to repay a common dividend.  In my opinion, Citigroup will announce the payment of a $0.05 quarterly common dividend in the 1Q of 2011. Stay tuned.

Morgan Stanly Research Here is a research paper from MS highlighting the firestorm of news related to the “ mortgage mess” that hit the market in the past few days. The issues include “robo-signing”, the right of MER to foreclose, the assignment of mortgages to securitization trusts, and putback risk. Although some of these issue such as putbacks represent a real threat to the banking industry, the media has somewhat overestimated the extent of some of these issues and the respective costs to the industry.

Putback losses MS estimates that putback losses to the entire banking industry can account to 105 billion on a base case scenario over the course of the next two to four years, while, in another research report, JPM speculates that losses could add up 55 billion in a base case scenario over the course of the next five years. As you can see, the putback risk is real but it’s certainly “manageable” for banks.

Conflict of interest The recent lawsuit filed by PIMPCO, the New York Fed and Blackrock against Bank of America  is embedded with HUGE conflicts of interest that deserve some attention. First, BlackRock is the largest holder of Bank of America shares, owning about 5.35% of the outstanding BAC shares, for a total value of $6.6 billion. Second, PIMCO has the most to lose if the MBS crisis escalates and if all the MBS are unwound as they hold large positions. Third, the FRBNY’s effort to force the buyback of several billion of mortgages runs against the Fed’s goal of strengthening the banking system and will certainly defeat the purpose of the Fed.  I will let you be the judge of this.

MS-Putbacks

Investment Thesis I recommend readers to buy Solo Cup’s 8.5% Senior Subordinated notes due February 2014 for a price of 92.5 with YTM of 10.1% and CY of 7.8%. The bonds are well positioned in the capital structure and offer an attractive high yield opportunity with minimal risk in a market that is crowded with anemic yields. Additionally the fairly low price implies a lower risk in comparison to similar bonds from other competitors.

Company Description Solo Cup is a leading producer and manufacturer of products used to serve food companies and beverages in homes, restaurants and other food service settings. The Company manufactures and supplies a broad portfolio of single-use products including cups, lids, food containers, plates, bowls, portion cups, cutlery and straws. Products are available mostly in plastic and paper. Solo Cup has two main segments: the food service distributors and operators, and the retailers of consumer products.

Capital Structure Although the 8.5% Senior Subs are second lien notes and are junior to the 10.5% Senior Secured notes, they are well covered in case of bankruptcy because they are guaranteed by certain subsidiaries such as SF Holdings, SCOC and have an equity cushion of almost 300 million.

Net Operating Losses As of June 27 2010, Solo Cup accumulated 308 million of net operating losses carry forwards that will expire between 2018 and 2030. I can reasonably expect that tax liabilities will low in the future, therefore improving the bottom line of the income statement and FCF.

Valuation Although EBITDA and operating margins will not improve in the near future, I expect the Company to generate approximately 45 to 55 million of FCFE in each of the next three years as the lack of maturities will allow the company to accumulate a significant amount of cash. However, the FCFE generated will not be sufficient to repay the 8.5% Senior Subs, but it will reduce leverage ratios and improve the value and price of the bonds. Additionally, based on the last earnings report in August 2010, the borrowing capacity under the credit facility is 110 million.

Catalysts Improving fundamentals: because there are no maturities until July 2013, I expect Solo Cup to accumulate around 150 million in free cash flow by 2013 in a base case scenario.  

Refinancing: In July 2009, the worst time to raise capital, Solo Cup issued 325 million of 8.5% Senior Subordinate Notes due in 2014. I can reasonably expect that the Company will have access to credit markets in 2014 and be able to refinance 325 million coming due.

Potential IPO: Solo Cup is a privately held organization but sponsors would like to take the Company public. A public offering will be a deleveraging event.

Risks The power of buyers: approximately 81% of the 2009 annual sales comes from the food service operators and distributors. Customers of such segments are  well-known and include Starbucks, Dunkin’ Donuts and McDonald’s Corp; hence they can exercise significant price power.

Concentration risk: five customers and one customer account respectively for 30% and 9% of 2009 total sales. Not only the power of buyers is strong, but it is also concentrated in a small group

Rising raw material costs: raw material costs make up 40% of COGS and the Company has historically not hedged its exposure to fluctuations in raw material prices.

Summary Despite several headwinds along the value chain, I expect the bonds to experience a price appreciation above par in the next three to four years.

The initiation of coverage is probably more meaningful than the information contained in the research itself. It’s a beginning of a process that will open GGP to a completely new clientele and that will make GGP a “must” not only among mutual funds REITs but also among major REIT indexes.

The target price assigned by Credit Suisse is $16.50, a cautious estimate; however the timeframe for price appreciation is not disclosed. I hate sell-side research; it’s so vague and so long at the same time. That’s why my blog is called the way it is called.

However, there is some important information on the report, some regarding “Spinco” assets and its valuation, which I think it is worth a look:

• Several catalysts are mentioned for the price to reach $16.50; however I believe that it’s just a matter of when, rather than how, the company will reach its fair value value, which should be around $25, excluding Spinco, by the of 2011.
• After the recapitalization, GGP will remain a fairly leveraged company, with a LTD/EBITDA of 8.2x by the end of 2012, a multiple that should be below 7x. Post bankruptcy, additional deleveraging will have to occur, which can be a catalyst for equity appreciation over the long-term but it will depress the dividend yield.
• An interesting breakdown of “Spinco” assets and a highly subjective $4 price for “Spinco”.

Enjoy the reading!

Credit Suisse Report

Here you can find the Pershing Square Q1 and Q2 letter to investors. The Q3 letter highlights the possible consolidation of the retail book industry, which increases the probability that BGP is included in that potential merger activity. The Q1 letter, talks about the $20 bid from Simon Properties and why the GGP board wisely turned it down. Enjoy the reading.

Pershing-Q1-2010-Investor-Letter

Pershing-Square-Q2-10-Investor-Letter

A high return on capital should outweigh a low return of capital in the case of Domtar Corp (UFS) at current prices. In 2006, Domtar completed the acquisition of the Weyerhaeuser Fine Paper Business, which gave the company the #1 market share in North America for uncoated free sheet paper; this was a very important transaction for the company (and industry) as it turned the industry into an oligopoly.  Domtar is currently operating 10 paper mills with uncoated free sheet capacity of about 3.9mm tons and has the #1 market share in North America with about a 35% share; International Paper is #2 with about 25% share and Boise is #3 with about 10% share.

Business:

Domtar has three segments: (i.) Paper, which includes the uncoated free sheet manufacturing and pulp businesses, (ii.) Paper Merchant, which runs warehouses and distributes both Domtar paper and that of competitors, and (iii.) Wood, which the company has an agreement to sell and should close in the coming months.  The Wood business has been a money loser (even from an EBITDA perspective) over the past few years and the company will realize about $95mm in net cash proceeds from the sale.  The Paper Merchant business is not a meaningful cash flow perspective, but is noteworthy because sales of Domtar paper are much higher through this channel than with other distributors.

Positives/Negatives:

The biggest negative for the business overall is the structural industry decline of units of uncoated free sheet paper, which is due to increased use of computers, email, ipad, etc.  The management team pegs the decline in units at about 4% per annum, which we think is a reasonable estimate.  On the other hand, the consolidation of the industry has provided pricing power to the remaining players in the industry.  In fact, in one of the most difficult business environments in recent history (2008-2009) prices actually went up, which is shocking to anyone following the industry over time.

Pulp:

While the pure uncoated free sheet business has remained steady at about $200mm of EBITDA per quarter, the pulp business has been wildly volatile.  The pulp business lost about $75mm per quarter in the first half of 2009 and was positive by about $30mm in the 3/10Q.  The decline was primarily due to one of the sharpest declines in pricing ever in that industry.  The company has about 1.7mm ADMT per year of pulp in excess of the company’s internal requirements, which causes the swings in profitability.

Balance Sheet:

Net debt peaked in 2007 at about $2.4 billion following the Weyerhaeuser transaction and has steadily declined to about $1.3 billion at the end of the 3/10Q.  This can partially be attributed to strong cash flow from operations over that time frame, but also partially due to black liquor tax credits that the company received as a nice gift from the government.  I won’t get into the mechanics of the credit (Google it), but it basically provided the company with about $500mm in cash, of which the company will receive $350mm in the 6/10Q.  (Also noteworthy, the company is getting about $75mm from the Canadian government in tax credits to use to upgrade facilities.)  The company is using this cash initially to pay down debt; following a recently completed debt tender, the company should have ~$950mm of debt that is all senior notes (no bank debt) with most of the maturities after 2013.

Cash Flow:

Current sell-side estimates for EBITDA for 2010 and 2011 are about $1.0 billion and $900mm respectively.  We think the normalized over the next few years is about $775mm less $175mm main capex gets you to our normalized pretax unleveraged cash flow of about $600mm.  If you assume interest expense is $100mm and taxes of $125, the real free cash flow is about $375mm or about $8.75/share.  What are they going to do with all this cash if their debt is fixed for several years (and at their target leverage)?  Return it to shareholders.  The company reinstated its’ dividend at $1.00/share annually and has a $150mm authorization to buy back stock, which we think will be utilized in the near future (and probably increased).

Valuation:

Less than 6x after-tax normalized free cash flow in a relatively unleveraged company even for a paper company with declining units is cheap.

It’s in the best interest of every investor to know the exact value of their investments. However, more often than not, business value cannot be precisely determined. Any attempt to precisely value an enterprise, will yield values that are precisely inaccurate because business value changes over time, fluctuating along numerous variables such as macroeconomic and microeconomic factors. This is the beauty of valuation. It’s more an art than a science. How can you precisely value a business that, unlike debt instruments, may not have a constant stream of cash flows? Thus, the value of a business is never a single number, but a range of values where the highest estimate is sometimes twice as much as the lowest one. For example, we all experienced the difficulties or impossibility to value an enterprise such as General Growth Properties. I remember that at the beginning of the bankruptcy process, valuation ranged from $5 per shares to more than $20. That’s where opportunities arise. If securities could be valued precisely, there would be few differences in opinion, market prices would fluctuate less frequently, and trading would diminish significantly, making our job useless. Discrepancies over the value of a business result from differences among the assumptions used, especially discount rates, projected cash flows, differences among the valuation methods used. I consider three different valuation methods that can be used to value en enterprise.

Absolute value

When futures cash flows are reasonably predictable and an appropriate discount rate can be chosen, the absolute value represents the most reliable source of information. However, cash flows are usually uncertain and the choice of the appropriate discount rate is usually an area of debate, hence we have to be careful when we use this valuation method. In the context of absolute valuation, cash flow, which comprises of dividends, free cash flow or residual income, is discounted at the required rate of return to find the PV of such cash flows.

Dividends

Generally, using dividends as cash flows is most suitable when the company is dividend paying, the board of directors has established a dividend policy that bears an understandable and consistent relationship with profitability and the investor takes a non-controlling ownership, because shareholders do not have control over the dividend policy.

Free cash flow

Valuation using free cash flow to the firm (FCFF) or to equity (FCFE) is most suitable when a company is dividend-paying but dividends significantly fall short or exceed FCFE, the company doesn’t pay dividends at all and the investor takes the ownership prospective. However, applying the free cash flow approach posts problems in some cases.  Some companies have intense capital demands and, as a result, have negative expected free cash flows far into the future. A profitable enterprise that is expanding may have a negative free cash flow indefinitely because of the level of capital expenditures. The present value of a series of negative cash flows is a negative number, therefore the use of a free cash flow model entails a long forecast horizon to capture the point at which expected free cash flow turns positive. The uncertainty associated with such forecasts may be considerable.

Residual value

Conceptually, residual income is the book value per share plus the present value of expected future earnings reduced by the equity charge.  Because the record of residual income can always be calculated, a residual income model can be used for both dividend-paying and non-dividend-paying companies, and for companies with negative expected free cash flow with reasonable forecast horizon. However, the application of the residual income model requires a detailed knowledge of accrual accounting. In some cases, the degree of distortion and the quality of accounting disclosure can be such that the application of the residual income model is error-prone.

Relative value

A valuation method relies on price multiples that sophisticated and prudent investors have recently paid to purchase similar businesses. For example, multiplying a benchmark value of the price-to-earnings (P/E) by an estimate of a company’s EPS provides a quick estimate of the value of a company’s stock. The concept behind price multiples is that a stock’s price cannot be valued in isolation (absolute value). Rather, it needs to be evaluated in relation to what it buys in terms of earnings, net assets, or some other measure of value. The economic rationale behind the method of comparables is the “Law of one price”, which is the economic principle that two identical assets should sell at the same price. But what can constitute the benchmark? Generally, it’s the mean/median multiple of the company’s peer group within a certain industry, or the mean/median multiple of the company’s whole industry sector or the company’s own past multiples. However, this valuation method is not without shortcomings. The method of comparables argues that a firm with multiples below the benchmark is undervalued, and with multiples above the benchmark is overvalued. In this case, the fundamental of the stock have to be similar to the fundamental of the benchmark before we make any direct comparison and draw conclusions whether the stock is overvalued or undervalued. Let’s suppose that, after hours of research, you determine that the P/E of the stock you are trying to value is less than the benchmark. There are at least three possible explanations for this:

• The stock is undervalued
• The stock is properly valued, but it has a lower expected growth rate than the benchmark, which leads to a lower P/E
• The stock is properly valued, but it has a higher expected return (higher risk or required rate of return) than then benchmark, which leads to a lower P/E.

In order to conclude that the stock is truly undervalued, we have to make sure that the stock is comparable to the benchmark, it should have similar expected growth and similar risk/return.

Liquidation value

The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment opportunity. The assets of a company are generally worth more as a part of a going concern than in liquidation, hence liquidation value is generally a worst-case scenario assessment. When no crisis is at hand, liquidation proceeds are maximized through an orderly winding up of a business. Cash is worth one hundred cents on the dollar. Investment securities are valued at market prices, less any transaction cost. Accounts receivable are appraised at close to their face amount. The value of inventories is not easily determined and it depends on whether or not the inventories consist of finished goods, work in progress, or raw materials, and whether or not there is the risk of technological obsolescence. The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flow and their next best use. Emulating Benjamin Graham, the approximation of the liquidation value of a company can be calculated as “net-net working capital”, which is net working capital minus all long term liabilities. As long as working capital is not overstated and operations are not rapidly consuming cash, if a company could liquidate its assets, extinguish all liabilities and still distribute proceeds in excess of the market price to investors, it represents an attractive opportunity.

Investment Thesis Lodge Net (NASDAQ:LNET) might be a candidate for bankruptcy filing probably for mid-2012. The current balance sheet deleveraging efforts are putting a cap on expenditures, which are vital element for a tech Company. These efforts cannot last long because technology rapidly changes and the Company will eventually be forced to spend again or profitability will be eroded and margins will start to decline. Lodge Net also records on its balance sheet a large amount of goodwill and intangibles, which will eventually have to be written down as a rapid shift in technology will cause these intangible assets to be worthless.

Company description Lodge Net is a dominant provider of interactive television and media solutions solution to the hospitality industry in the US. The Company is divided in four main segments: Guest Entertainment, which provides a wide range of guest-paid entertainment options including movies, games, music and other interactive services delivered through the televisions, the Hotel Services segment, which provides services to hotels at a monthly fee, the System Sales segment, which delivers advertisement and TV commercials, and the Healthcare segment, which sells entertainment solutions to hospitals.

The levering up period For the last couple of years, Lodge Net has been trying to deleverage its balance sheet. In 2007, Lode Net acquired two competitors through a debt offering, creating a highly leveraged Company. The deleveraging efforts have been successful so far, mainly due to reduced capital expenditures. However, this trend is not sustainable because rapid technological changes, which are inevitable, will force Lodge Net to upgrade its systems, increasing capital expenditures and decreasing free cash flow significantly. At that point, Lodge Net will be force to stop pay down debt, affecting the compliance with debt covenants under its Credit Facility.

Misconception For the past 12 months, the company has shifted focus from increasing operating performance to optimizing its free cash flow, which has grown from 15mm in early 2009 to 23mm in Q110. The FCF is being used to reduce its long term debt which is currently at 417mm. Management is forced to undertake this strategy otherwise high leverage will cause non compliance with debt covenants in the near future. However, there is a flaw in the Management’s decision. Positive FCF is generated from reduction in capital expenditures and not from earning growth. Once Lodge Net will need to spend to keep up with new technology, capital expenditures will rise again, putting a dent on FCF and on the deleveraging efforts. The technology shift process is already in place. Lodge Net provides HD television system solutions, but its customers will eventually shift their taste, prefering 3D over HD TV for example, forcing Lodge Net to upgrade it system and write down intangibles.

Scenarios A shift in technology and consumer taste, which I assume will occur in the next 2 years, will put the company at a crossroad. If the Company does nothing and continues to keep cap ex low and use FCF to reduce leverage, profitability will be eroded.  If the Company starts spending, it will be able to keep up with demand, but at the expense of leverage, which will remain high. Either scenario doesn’t look too good. I am working on crunching some numbers to show how the two scenarios will affect the Company.

Goodwill and Intangibles Lodge Net has a significant amount of Goodwill and Intangibles on its balance sheet, approximately 206mm or 42% of all the assets. Considering tangible book value alone, the Company is highly overvalued at these levels.  Impairment of goodwill or intangibles will be warranted if technology or customer taste shift rapidly.

Company vs. Peers It’s not easy to find a true comparable in the industry as the Company provides a unique product not offered by competitors. Relative valuation is not meaningful in this case.

Conclusion Deleveraging is coming at the expense of profitability as the Company will not be able to increase its capital expenditures for some time. However, for a tech Company, R&D is vital as the industry shifts quickly. Not being able to adapt to new technologies, it will put a dent on profitability. In the next post I will get into more details and work the valuation.

Adjustment Error On the previous post, I introduced a capital structure trade on Town Sports International, recommending to sell short the equity and to buy the 11% Senior Note. However, it was brought to my attention by an alert follower that the adjustment for off-balance sheet liabilities was a little off. The correct adjustment for operating leases is to capitalize them, adding the PV of minimum lease payments to assets and liabilities and adding rent expense or calculating EBITDAR. For Town Sports Intl, the adjustment creates an EV/EBIDTAR multiple of 7.1 and EBITDAR/Interest Expense of 1.93, a slight improvement from my previous calculations but the fundamental idea remains intact. Now I want to take some time to go over few key aspects of investing: warning signs of earning s manipulation and balance sheet adjustments.  

Skeptical When you are valuing a company, as an investor, it is important to look at financial statements and management projections with skepticism. Sometimes management has an incentive to increase earnings or increase sales rather than maximize shareholders value. Sometimes financial statements need to be adjusted for valuation purposes, changing the picture of the overall company.

Manipulation When financial information is reported to capital markets, security prices move. This creates a clear incentive for management to report financial performance that meets or exceeds current expectations. The target that a Company is trying to achieve is a moving benchmark: the consensus sell –side analyst forecast. Investors need to be particularly skeptical about reporting earnings when: top management has a significant portion of vested options in the money, the company is trying to maintain a track record of successively meeting analyst forecasts and is looking to raise additional financing. The presence of these risk factors can provide an incentive to accelerate recognition of earnings or report aggressive earnings, which are transitory and non-persistent. A good example is Microstrategy. Between the end of 1999 and early 2000, the stock price of Microstrategy rose from $25 to above $300. But in March 2000, they announced a restatement of earnings because they accelerated the recognition of revenue by booking legitimate future sales orders in the current fiscal period. At a first glance, this doesn’t seem particularly egregious: after all, these would have been legitimate sales. But placed in the context of significant capital market pressures, where analysts and investors were looking for exponential sales growth to support very lofty stock prices, the front loading of revenues allowed Microstrategy to report very large revenue increases over the 1998-1999 period. When investors learned that this run up in sales was the result of front loading future sales, there was a quick correction in price. Did management knowingly accelerated earnings recognition? We will probably never know that but it’s beyond our point. A skeptical view on earnings report will help you identify potential manipulations.

Adjustments I will now introduce a brief discussion on two balance sheet issues, off-balance sheet debt and goodwill. Off-balance sheet debt includes items not reported in the body of the balance sheet but that might be associated with an obligation for future payments. The classic example is leases. US GAAP recognizes two types of leases (operating and capital) and provides different accounting rules for each. The treatment of operating leases relative to capital leases is dramatically different. An operating lease treats the cash outflow associated with the lease as a rental expense, which will be recorded on the income statement. With a capital lease, the PV of minimum lease payments is recognized on both assets and liabilities at the inception of the lease, and amortized over the life of the lease. Companies have a strong preference for operating leases, as this keeps the lease obligation off the balance sheet. The use of operating leases is pervasive in the retail sector with companies such as Walgreen, Wal-Mart, CVS and others having very large off-balance sheet operating leases obligations. The consequence of bringing these leases onto the balance sheet will be to increase leverage ratios; and depending on how these companies amortize the value of their assets, there could also be significant impact on reported earnings.

When a company acquires another company and records part of the acquisition price as goodwill, the goodwill is capitalized as an asset and no periodic amortization charges are taken against it. Instead, companies evaluate goodwill and other acquired intangible assets for impairment annually or whenever circumstances indicate that the value of such an asset is impaired. Disclosures for goodwill can be found in the supplemental information to the financial statements. Investors should look carefully at changes (or the absence of an impairment given overall economic conditions) in reported goodwill. Companies that continue to report goodwill on their balance sheet, but they have a market capitalization less than book value of equity, are certainly worth an examination to understand why an impairment charge was not taken.