School Specialty 3.75% Convertible Subordinated Debentures

This is my take on an idea suggested by Tbone Sam in the comments section of a previous post.

School Specialty sells classroom, janitorial and office supplies to schools. It’s a cyclical business that took on far too much debt to fund acquisitions of businesses that were worth far less than the price it paid for them. As a result, with large debt maturities due in 2014, it’s in a bit of a pickle, perhaps presenting us with an opportunity.

The capital structure:

I.                Secured debt:

SCHS has drawn on $54.8 million of a total $200 million LIBOR + 250bps, Wells Fargo-led asset based loan facility (“ABLF”) that is secured by a first priority interest in substantially all of SCHS’ current  assets and a second priority interest in all other assets.

It owes a further $67 million under a Term Loan facility (“TLCF”) that has first claim on all non-current assets of the company and has a second priority claim on the current assets. This loan is held by Bayside Capital Partners, costs 12.75%.

It owes $12 million under capital leases and a further $65 million under its operating leases (or only $10 million under a liquidation scenario).

II.             Unsecured debt:

The company has issued convertible subordinated debentures (“the convertibles”) with a book value of $157.5 million and a 3.75% coupon payable semiannually in May & November.

The Opportunity:

Scenario #1: Refinancing of the convertibles

What’s important for our purposes is that the holders of the convertibles have the right to require the company to repurchase them on November 30, 2014 for $115.9  (including accreted principal) – a hard put that values them at 2.4x their current market value.

The company says that it plans “to refinance the debentures prior to September 30, 2014 and to obtain the money to refinance the debentures from the issuance of new debt and/or additional equity.” And it may be able to do just that, in which case for the convertibles is a simple and clean one.

Scenario #2 Involuntary Chapter 11 Reorganization

If the company is unable to refinance the convertibles before that date – the credit markets stink; the company’s cash flow profile deteriorates – then the company will be in default on the terms of the secured loans, the ABL and TLCF creditors will call in their loans, and SCHS will enter the Chapter 11 process.

One can see from the above that the business is worth something like $455 million. After accounting for the $134 million in secured liabilities, the residual value is ~$320 million, meaning that the convertibles will receive at least what they are owed, i.e. $183 million, either in cash or stock.

Of course, the restructuring process being what it is, and creditors being what they are, it seems quite probable that a  valuation professional engaged by the court could slap a 5x multiple on current (or on average trailing 2 year) EBITDA which, if approved , would value the enterprise at $400 million and the leave the convertibles owning 85% of the business (183/(400-134).  In that eventuality, the convertibles will be worth $270 million (85% of the real value of $320 million).

Scenario #3 Prepackaged Chapter 11 Reorganization

This seems to me the most likely scenario: covenants have been breached, forbearances granted, and reorganization lawyers and bankers engaged by both the secured and unsecured creditors.

One imagines that Bayside Capital Partners’ TLCF credit line to SCHS was strategic, and that they will pay off the ABL creditors and come to an arrangement with both the holders of the convertibles and with the equity owners whereby the equity survives (but only just), and Bayside and the holders of the convertibles take ownership of the lions’ share of the remainder.

It is hard to pin down the exact value of the convertibles under this scenario, but we can, I think, be confident that is somewhere between the minimum value envisaged under Scenario #1 and the maximum value envisaged under Scenario #2 – i.e., somewhere north of $115.9, though much closer, I would have thought, to the lower end of that range: Bayside Capital Partners’ hand seems to me much stronger in a prepack than it would be under an involuntary Chapter 11 process.

I haven’t discussed Chapter 7 scenarios because I don’t think there’s even a small chance of a liquidation process: all parties would lose under that scenario.

The bonds haven’t traded for a month. I think they are attractively priced: a likely 130% recovery in 21 months. If and when they trade at under $55, I’ll try to establish a position.

Portfolio Update

I am out of GEA at 71.80, and have used the proceeds to establish a fresh position in Lamprell. 

Portfolio Review

Time for a half-year review of my holdings and, while I’m at it, a discussion of what I have and haven’t (yet) learned from 2012.

I.  Current Holdings

Hawaiian is still good value. I estimate its worth at about $25 and, in so valuing Hawaiian, I have on my side arithmetic and, I think, some modest insight: Most market participants, even those who like HA, no doubt perceive it to be “an airline” with all that implies; I see it as a toll road to a favored destination. Hawaiian has a lot more in common with Mattel than it does with United Continental: an effective low-cost firewall behind which is a premium offering for a branded product for which demand will rise in the future. 

Dunkerley and the board seem to see it my way and every strategic move that they’ve made since 2008 – a second hub in Maui, adding Asian destinations, etc. – can be understood in the light of this perspective, as can the structure of the executive compensation plan.

Hawaiian is yielding 40% on trailing earnings. It more than earns its cost of capital, and growth, therefore, will add value – whether fuel prices rise or fall. And grow it will, meaning that one doesn’t have to fret about how long it will take for the gap between price and value to close.

Relative price appreciation has promoted it from a 20% share of my portfolio when I bought in, in August 2011, to a 33% position as of January 10th. In the three months since my last portfolio review, the stock price has moved from $5.30 to $7.30 to now $6.60 –sizeable moves but nevertheless just noise. 

It reports 4^th Quarter, and therefore full year, results at the end of the month. I expect headline EPS of $2.55 and true earnings, excluding the after-tax cost of intangible amortization, of $2.82.

Northgate is a new addition premised on arithmetic rather than any particular insight. “Return on Invested Capital” is, at bottom, nothing more than the cash that is generated in return for the cash invested in the business. The fastest way to calculate that relationship also happens to be the literal and best way of doing so:

[EBITDA *(1-Operating Tax Rate)]/[Operating Working Capital + Gross PP&E + Capitalized Leases + Gross Value of Operating Intangibles]

Northgate returns 16.4%, on average. Apply that figure to the net value of its operating assets, subtract the net non-operating liabilities, and one arrives at a value of 732p per share for the equity, almost 3x its price at the time that I took a position in it. I wish I’d seen it when it was selling at 160p in June. Woulda coulda. I bought it with the proceeds from the sale of my stake in Cegid – a fair exchange. What I particularly like about it is that the valuation is indifferent to the macroeconomic environment: its vehicle fleet is, for all intents and purposes, working capital and an economic downturn sees it converted into cash. And there’s nowhere for that cash to go but to debt repayment and buybacks. 

Cybergun is this quarter’s winner of the William Ewart Gladstone Award. A "stern and unbending" follower of High Church traditions takes in a lowly, reviled stock, gives it a cuppa and sees it on its way, after which he self-flagellates for being tempted by such a wretched creature, draws little whips in his journal, and vows not to do it again – until the next time. Except that the wretched stock still here, skulking, stinking up the joint.

I added to my position in Cybergun and lowered the cost basis from €2.29 to €1.97.  Minimum upside is, I think, €4.00.

More notable – and shameful – is what I didn’t do: Cybergun’s 2016 8% bonds fell to €32 implying a yield to maturity of 51% … and I didn’t buy them. A truly inexplicable mistake; I remember seeing it, I remember thinking “that’s good value”, but I don’t remember deciding not to buy it. (Similarly, at the start of 2012, I watched, slack-jawed, as Trident Microsystems fell to 6 cents, and only bought in when it had rallied to just above 15 cents. An unrepeatable mistake, I thought then.)

Precia. Nothing to report. Good stock, good price, profitable growth.

XPO Logistics. Nothing interesting to say about this one. I think it’s likely worth $75, although most of that perceived value is in the form of unmapped future growth. My aim is to lighten up on this stock as its price appreciates in 20% increments. It's the opportunity cost that I'm thinking about. The UK market, for example, is still stocked with some obvious bargains – notably Dewhurst, MS International, Lamprell, Instem, Northbridge, Finsbury Food Group, DRS Data & Research, Cambria Auto, Chemring, and Air Partner, to name only the ones that are selling at well below half their demonstrable value – and it would be a shame to completely miss out on these bird-in-the-hand opportunities for the somewhat more speculative opportunity that XPO’s unmapped growth represents.

GEA. I’ll be out of this one soon.

II. Full Year 2012 performance.

The first half of the year predates the blog and therefore predates the tracking portfolio that mimics my holdings. Nevertheless, for what it’s worth, here’s my 2012 performance:

Not quite as bad as throwing darts at the stocks page of the newspaper but, given the wealth of deep value opportunities available in 2012, it is a disappointing showing. I try to balance patience, action, and cash and I got that balance all wrong this year. I turned over 35% of the portfolio in 2012, which is about normal.

III. The blog

This blog is intended to be a real-time demonstration of a particular approach to value investing as well as a journal recording my mistakes.

I have fallen way short of describing my overall approach to value investing; that is something I’ll be focusing more on in the future.  I have written about French stocks in English only; I'll correct that going forward. I don't like 98.3% of the stocks that I look at. You'd never know it from reading the blog. So, I'll occasionally weigh in on why I don't like particular stocks that other value investors do like.

In order to minimize the chance that I’ll write utter nonsense just for the sake of something to say, I’ve set up an “inventory” page to track the performance of stocks that I have said I think are good value. In general, try to highlight those stocks (and, occasionally, bonds) that seem to me to priced at below half their value; the average performance of the stocks in the inventory page should therefore outperform the S&P by 2x or by 10% per year in any subsequent two year period. I can tell you now that the one post that I repudiate, am embarrassed by, and regret having written, is the one on Lojack, no matter how well it does in the future.

Ironically, aside from the mundane performance of my portfolio, 2012 was a productive year for me. I have managed to conclude a process that I started in 2010 of mapping out a large patch of the small cap equity space in the UK, France, Greece, Australia and NZ, sorting out good companies from bad, getting a sense of how their stock prices behave, and so on. It has been very interesting and helped greatly by bloggers in those countries – thank you! No doubt this preparatory work will come in handy at some point in the future. This year and next I hope to do the same for Germany, the Nordics, Switzerland, Austria and Spain.

IV “the 2013 Picks”

I have lately been experimenting with various approaches to automating a value investing approach that makes sense. I’d be happy enough to design an approach that I can rely on to earn good returns without regular attention to the markets.  In that context, the 2013 picks for the UK, the Eurozone, and the USA are attempts to accelerate this experimental process by running concurrent paper “portfolios” that use the same approach but in different markets. A paper portfolio that uses a slightly different approach that I started in April is doing okay, but probably not well enough for me to have full confidence in it. 

In any case, thanks for reading and Happy 2013 and, if you're new to the blog, please bear in mind that I'm an idiot.

Disclosure: I am long HA, XPO, NTG, PREC, and GEA

Decoupling

Universe Group - Payment & Loyalty Solutions

Next up is the Universe Group.

Wexboy has written about this company in his own inimitable style and I have nothing to add to his analysis, which I think is spot on.

Now that the extraneous businesses have been shed, and the core petrol forecourt/retail payments business is all that remains, we can have a look at its historical, pro-forma profile:

A valuation of ~6.4p is not unreasonable:

Half-price is fine, but there are currently (still) many decent UK stocks selling at half price. 

I have included it in my UK picks for 2013 because I think that there’s a more than reasonable chance that it will be acquired by Vianet after all: Vianet still owns a substantial share of UNG, and UNG’s business would represent a common sense tuck-in acquisition for Vianet.

Disclosure: No position

Lamprell Plc - Jack-up Rigs

The Arabian Gulf is a low cost source of oil and gas production and the UAE is the hub for support services for the gulf region’s oil industry. 

And, in the UAE (and the region generally), Lamprell is the leading refurbisher and manufacturer of jack-up rigs and Floating Production Storage Offloading (FPSO) structures. 

Which is significant because the UAE is characterized by limited industrial refurbishment and fabrication facilities, and especially limited in facilities with quayside access. Why? Because the physical space for them is limited: a natural barrier to entry. (In this sense, the case for Lamprell echoes the case for Hawaiian Holdings).

In 2010, there were four competitors in this naturally protected market: Lamprell was the largest and the others were Dubai Drydocks, Gulf Piping Co., and Maritime Industrial Services. Lamprell acquired MIS in 2011, and now there are three.

Natural barriers to entry and consolidation should mean above-normal returns on capital. And it turns out that Lamprell returns 33% on its operating capital. It’s a good business.

Note: USD

Lamprell has a newish sideline in manufacturing vessels used in installing offshore wind turbines. It won a 320m contract to supply two such vessels to Fred Olsen, the Norwegian 

shipping firm. One of these ships has been delivered and the other will be, soon. 

Lamprell’s present share price problem is that this project wasn’t executed well: it was a fixed-price contract, there were cost overruns and supplier problems, and there will be late delivery penalties. The total cost of this snafu is in the neighborhood of $175 million (GBP 108 million).

One would expect, therefore, that this amount (41p per share) would have been knocked off Lamprell’s enterprise value.  The market has, spurred on by analyst downgrades and a suspension of the interim dividend, instead wiped 6x this amount from Lamprell’s implied value. 

The result has been to price Lamprell in such a way as to say that either (a) it no longer has a competitive advantage in its traditional oil and gas rig markets or (b) the banks will refuse to renegotiate its loan covenants and will pull it into bankruptcy. 

Both these arguments are absurd; the former implication is plainly wrong and the latter scenario is highly unlikely to come about: Lamprell’s order book stands at 1.5 billion; it is the rare company that finds itself in a leading, competitive position in an industry that will experience steady real growth for decades to come.

Lamprell traditionally converts 10% of revenue into earnings and easily earns 30p per share. The shares are worth more than 300p. My sense is that they will re-price in fits over the next twelve months -- which is why I included them in my UK picks for 2013.

Disclosure: No position

Portfolio Update

I have added to my position in Cybergun's equity at an average price of 1.45

A US Portfolio

The dearth of value stocks in the United States is startling. The above represents my attempt at simulating a portfolio that will handily outperform the index in 2013. I have excluded those stocks that I own.

A Eurozone Portfolio

This is a second in a series of four. Same guidelines & caveats apply here as for the UK portfolio I posted last week. It is notable that all but one of the above stocks feature in mmi’s “BOSS score” harvests at Value and Opportunity. Google Docs doesn't have ticker codes for some of the above, so I'll update manually and occasionally. Disclosure: I have positions in Precia, GEA and Cybergun

Kraftwerk

Insight, arithmetic, prudence, and patience. Of these, insight is the hardest to come by and its cultivation is the highest form of craft that a value investor can aspire to – a form of sustainable advantage in an activity with otherwise nonexistent barriers to entry.

This is what one money manager wrote to his limited partners in 1967:

“the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a ‘high probability insight’. This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side – the figures should hit you over the head with a baseball bat.”

Insight is more likely to be a precise, sophisticated, and straightforward discourse on the interaction between a business model and the strategy that supports it than it is to be a throwaway line like “market share”, or “scale”, or “brand”. 

This is what an insight looks like:

“The question for the group is simple: Why has Wal-Mart been so successful? To start, I call on Bill, who had some experience in sales during the earlier part of his career. He begins with the ritual invocation of founder Sam Walton’s leadership. Neither agreeing nor disagreeing, I write “Sam Walton” on the board and press him further. “What did Walton do that made a difference?”

Bill looks at my labeled box on the board and says, “Walton broke the conventional wisdom. He put big stores in small towns. Wal-Mart had everyday low prices. Wal-Mart ran a computerized warehousing and trucking system to manage the movement of stock into stores. It was nonunion. It had low administrative expenses.”

It takes about thirty minutes for six other participants to flesh out this list. They are willing to throw anything into the bin, and I don’t stop them. I prod for detail and context, asking, “How big were the stores?” “How small were the towns?” “How did the computerized logistics system work?” And “What did Wal-Mart do to keep its administrative expenses so low?”

As the responses flood in, three diagrams take shape on the whiteboard. A circle appears, representing a small town of ten thousand persons. A large box drawn in the circle represents a forty-five-thousand-square-foot Wal-Mart store. A second diagram of the logistical system emerges. A square box represents a regional distribution center. From the box, a line marks the path of a truck, swooping out to pass by some of the 150 stores served by the distribution center. On the return path, the line passes vendors, picking up pallets of goods. The line plunges back to the square, where an “X” denotes cross-docking to an outgoing truck. Lines of a different color depict the data flows, from the store to a central computer, and then out to vendors and the distribution center. Finally, as we discuss the management system, I draw the paths of the regional managers as they follow a weekly circuit: Fly out from Bentonville, Arkansas, on Monday, visit stores, pick up and distribute information, and return to Bentonville on Thursday for group meetings on Friday and Saturday. The last two diagrams are eerily similar—both revealing the hub structure of efficient distribution.

The discussion slows. We have gotten most of the facts out. I look around the room, trying to include them all, and say, “If the policies you have listed are the reasons for Wal-Mart’s success, and if this case was published—let’s see—in 1986, then why was the company able to run rampant over Kmart for the next decade? Wasn’t the formula obvious? Where was the competition?”

Wal-Mart’s advantage must stem from something that competitors cannot easily copy, or do not copy because of inertia and incompetence. In the case of Wal-Mart, the principal competitive failure was Kmart.… After some moments I ask a more pointed question: “Both Wal-Mart and Kmart began to install bar-code scanners at cash registers in the early 1980s. Why did Wal-Mart seem to benefit from this more than Kmart?”

I turn back the whiteboard and stand right next to the boxed principle: “A full-line discount store needs a population base of at least 100,000.” I repeat his phrase, “The Wal-Mart store needs to be part of the network,” while drawing a circle around the word “store.” Then I wait.

With luck, someone will get it. As one student tries to articulate the discovery, others get it, and I sense a small avalanche of “ahas,” like a pot of corn kernels suddenly popping. It isn’t the store; it is the network of 150 stores. And the data flows and the management flows and a distribution hub. The network replaced the store. A regional network of 150 stores serves a population of millions! Walton didn’t break the conventional wisdom; he broke the old definition of a store. 

When you understand that Walton redefined the notion of “store,” your view of how Wal-Mart’s policies fit together undergoes a subtle shift. You begin to see the interdependencies among location decisions. Store locations express the economics of the network, not just the pull of demand. You also see the balance of power at Wal-Mart. The individual store has little negotiating power—its options are limited. Most crucially, the network, not the store, became Wal-Mart’s basic unit of management.

In making an integrated network into the operating unit of the company, instead of the individual store, Walton broke with an even deeper conventional wisdom of his era: the doctrine of decentralization, that each kettle should sit on its own bottom. Kmart had long adhered to this doctrine, giving each store manager authority to choose product lines, pick vendors, and set prices. After all, we are told that decentralization is a good thing. But the oft-forgotten cost of decentralization is lost coordination across units. Stores that do not choose the same vendors or negotiate the same terms cannot benefit from an integrated network of data and transport. Stores that do not share detailed information about what works and what does not cannot benefit from one another’s learning.

If your competitors also operate this kind of decentralized system, little may be lost. But once Walton’s insights made the decentralized structure a disadvantage, Kmart had a severe problem. A large organization may balk at adopting a new technique, but such change is manageable. But breaking with doctrine—with one’s basic philosophy—is rare absent a near-death experience.

The hidden power of Wal-Mart’s strategy came from a shift in perspective. Lacking that perspective, Kmart saw Wal-Mart like Goliath saw David—smaller and less experienced in the big leagues. But Wal-Mart’s advantages were not inherent in its history or size. They grew out of a subtle shift in how to think about discount retailing. Tradition saw discounting as tied to urban densities, whereas Sam Walton saw a way to build efficiency by embedding each store in a network of computing and logistics. Today we call this supply-chain management, but in 1984 it was as an unexpected shift in viewpoint. And it had the impact of David’s slung stone.”

Richard Rumelt, Good Strategy, Bad Strategy

In 1984, this particular insight was worth a compounded average annual return of 28% for fifteen years.

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For figures that hit you over the head with a baseball bat, no hunting ground is likely to be more fruitful than UnlistedStocks.net, curated by Nate Tobik. It's an excellent idea by a gifted analyst of small cap -- and oddball -- stocks.