NOT AN ANALYST

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.

AOL Spin-off On December 10 2009, AOL started to operate as a standalone entity and began trading on NYSE under the ticker “AOL”.  The Company has been spun off from Time Warner, which AOL acquired for 164 billion a decade ago. I am not going to go over the reason of the separation, but it became evident how AOL has been losing market share since the consolidation with Time Warner in 2000.

Investment thesis It’s hard to see any potential price appreciation, given the continuing deteriorating fundamentals. The stock can trade lower on a series of catalysts: additional goodwill impairments, higher than expected deterioration in subscription and/or advertising revenue and a rise in price without any fundamental change. I will keep it under the “stocks to short” list for 2010.

Shift in Business Given the declining revenue base and negative EBITDA growth experienced in the last 5 years, mainly attributable to a steep decline in subscription based revenue, the Company decided in 2006 to shift its core operation from subscription to advertising. However, results have not been great as competition from other popular sites like Google and Yahoo and/or social networking sites like Facebook and Twitter has been very intense. AOL’s new business focuses on five core business segments:  

• Web content; create and publish new original web content through its various site categories.
• Local and Mapping; provide local content, platforms and services covering geographic levels ranging from neighborhoods to major metropolitan areas like MapQuest,  Local Entertainment Guides, Local Directories and Local Events.
• Communications; email and instant messaging products and services like AOL Mail, ICQ and AIM.
• Online Search; offered through AOL Search and AOL Media, currently outsourced to Google.
• AOL Ventures; the investment/acquisition arm of AOL

Valuation I expect advertising revenue to decline 5% in 2009 and continue to decrease at a 5% rate every year after. Subscription based revenue will be 1,350 mm in 2009 and continue to decline at a 30% rate each year after. EBITDA margin will be 30% in 2009 and shrink 1% each year after, as a result of the continuation of the historical trend that saw operating revenue decline more than COGS and operating expenses. The Company is expecting to receive 250 mm Credit Facility with a maximum consolidated leverage ratio (total debt to EBITDA) not greater than 1.5 to 1.0 and a minimum consolidated interest coverage ratio (EBITDA to consolidated cash interest expense) of at least 4.0 to 1.0. Under the financial covenants, the Company can use up to 100 mm a year for acquisitions. Other than that, AOL has almost no debt; total fixed obligations due before the end of 2014 total 622 mm and are comprised of property and other operating leases. Liquidity doesn’t seem to be an issue; FCF will be the positive but decline in the coming years due to deteriorating fundaments. Given 823 mm of EBITDA in 2010, the Company currently trades at 3x 2010 EV/EBITDA, a discount compared to the average 2010 EV/EBITDA multiple for the top Internet Advertising Companies (7.9x) and Media Companies (7.3x). Cash generated from working capital in 2009 was mainly driven by changes in accrued compensation as the Company decided not to pay annual bonuses to employees related to 2008 performance.

Catalysts for a short sale An advance in price to 30 dollars per share or higher due to overall market appreciation without any change in fundamentals is the signal for a potential short opportunity.

If the Company deems that 50% of the fair value of goodwill is lower than then its carrying value, therefore impaired, the share price should drop by 10 dollars. In accordance with FAS 142, goodwill is tested for impairment at least annually. The fair value of the reporting unit is calculated using a DCF approach and a market approach. For the 2008 goodwill impairment analysis, the Company increased the discount rates utilized in the DCF analysis to a range of 13% to 15% from 12% in 2007, while the terminal growth rates for the advertising revenues were decreased to a range of 2.5% to 3% from 4.5% in 2007. What does this mean? Higher discount rates and lower growth rates produce a lower current value. There is a good chance of further adjustment in growth rates and/or discount rates, therefore potential impairments charges, if subscription based and/or advertising revenue deteriorates further from current levels. As of September 30 2009, 50% of the total asset or 2,175 mm is comprised of goodwill.

Conclusion I am keeping AOL under my list of stocks to short as it faces many challenges: The market place where it operates is highly competitive especially from Companies like Google, Yahoo, Microsoft, Facebook and Twitter and fundamentals are deteriorating quickly, increasing the chance of further impairments. The shift is strategy implemented in 2006 is towards the right direction but the company doesn’t seem to do enough to win market shares, mostly due to negative user experience built during the past years poor search results and lack of innovation.

Introduction The third quarter earnings season just kicked off few days ago and investors are looking for signs of an improving economy. Several companies are expected report good earnings but be aware that better then expected results doesn’t necessary mean good results. Here are some things to look for in the up comings earnings reports.

Guidance.It indicates the outlook for the future. If earnings figures are reported to be better then anticipated but the guidance is lowered, then you will see some heavy selling.

Good sales. Better then expected sales figures means that demand is stronger then originally thought. It’s probably going to be hard to see higher sales number versus a year ago so growing sales since Q1 is good news. Once it’s established that sales are increasing, look for drivers of sales growth.

For credit card companies and banks: revenue attributed to large reduction in doubtful accounts seems unjustified given this economic environment and it represents a warning sign for potential revenue overstatement.

For banks: Due to joint ventures, mergers and acquisitions, some financial companies may indicate higher asset values or one time gains in the income statement. Look for how much asset growth is attributable to goodwill and carefully monitor changes in reported goodwill. Absence of impairments in this tough economic environment or increase in goodwill is a sign of low quality earnings.

Retailers: large portion of revenue accounted to LIFO liquidation is not sustainable and should be removed. The company is no longer purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. Once it runs out of cheap inventory, it will have to purchase new inventory at a much higher cost base.

Computer software companies: with providers of goods and services sometimes there is discretion on deciding when a service has been provided. Revenue attributable to large decreases in unearned revenue is another warning signs as the unearned revenue account could be built up during periods of strong growth (customers prepay for service) and tapped into when times are tough like now.

EPS. It’s not necessary a good indication of growth in this economic environment because better net income can be the result of heavy cost cutting or one time tax credits.

Conclusion. Earnings have a tendency to revert back to normal levels (mean reversion) and very low or very high earnings are not expected to continue in the future. This has an economic meaning as capital migrates to more profitable businesses, increasing competition and reducing returns. The net effect of these competitive forces is a return to “normal” earnings levels