- market leadership and long-term histories of profitability;
- financially strong balance sheets;
- first-rate management teams that have an understandable and successful business strategy;
- a deep value price based on normal free cash flows, earnings and balance sheet values.
In the fourth quarter, the managers bought no new stocks and added to just two of their holdings: Amerigroup Corp. (AGP) and Oshkosh (OSK).
Amerigroup Corp. (AGP)
Amerigroup is a Fortune 500 companies that manages publicly funded health programs for the underprivileged. The company does not deny coverage due to pre-existing medical conditions and does not use individual underwriting. Their goal is to provide quality health care access to their 2 million members while reducing costs for taxpayers.
The third quarter of 2011 was dramatic for Amerigroup’s stock price. It plunged 68% from July 28 to August 8 after it reported lower-than-expected earnings results. Net income was $44.3 million, or $0.83 per diluted share, versus net income of $67.2 million, or $1.31 per diluted share, for the second quarter of 2010, and $70.5 million, or $1.37 per diluted share, for the first quarter of 2011.
The primary cause for the decrease, however, was an approximately $13.8 million retroactive premium adjustment in the State of Georgia, or $0.16 per diluted share. Revenue actually increased 6.3% year over year and was about flat sequentially.
The State of Georgia problem occurred when Amerigroup recognized that the state was not merging duplicate member records. States commonly assign members more than one Medicaid number, which can result in duplicate premium payments and multiple member records, which states typically correct. After Amerigroup initiated a probe into the issue, they discovered that systemic record-keeping problems dated back as far as the start of the program in 2006.
By the end of the third quarter, the issue was largely resolved, perking up share prices. The company reported that it received $14.0 million of retroactive premium revenue, or $0.17 earnings per diluted share from increased premium rates which the State of Georgia recognized after conducting a special review of membership records and recouping premiums for duplicately enrolled members above and beyond normal monthly processing. They also received approximately $3.5 million retroactive to Sept. 1, 2010, from the State of Georgia due to an increase in newborn supplemental rates to match an eligibility change the state implemented at that time.
All told, net income for the third quarter of 2011 increased to $48.1 million, or $0.96 per diluted share, compared to $44.3 million, or $0.82 per diluted share, in the second quarter of 2011. Stocks responded positively to the news, increasing 43% in the month of October (results were released Oct. 29), and increasing 81% from the beginning of the fourth quarter to date.
FPA Funds bought Amerigroup shares in the third quarter of 2011 when the stock price had precipitously dropped after the disappointing earnings release. Their purchase was 443,100 shares at an average price of $53 per share. In the fourth quarter 2011, they added 496,800 shares at about $52.50 per share.
Amerigroup is an otherwise strong and growing company, with up-trending free cash flow a 10-year annual free cash flow per share growth rate of 10.4%, and a 10-year annual revenue per share growth rate of 20.5%.
The company is also focused on growth through acquisitions. An add-on offering of $50 million of its 7.5% Senior notes due 2019 announced Jan. 12, 2019 will be used for acquisitions and/or business development opportunities, as well as general corporate purposes. In October, it agreement to purchase substantially all of the operating assets and contract rights of Health Plus, one of New York’s largest Medicaid managed care companies, for $85 million, funded through available cash, and set to close in the first half of 2012. Health Plus is expected to generate about $1 billion in revenue in 2011.
FPA discussed in their third quarter letter their Amerigroup purchase, saying, “At our purchase price, we bought the shares of AGP at roughly 8x trailing-twelve month (TTM) earnings and at a 17% free cash flow yield. The investment thesis is that states are experiencing and will continue to experience difficulty in raising revenues and a greater demand to provide healthcare to needy people, particularly children. One solution for states to deal with these two issues is to outsource their Medicaid programs to managed-care companies like AGP. States save money because AGP has the operational scale, efficiencies, and the processes to drive costs out of the system yet provide equal or better care than government-managed healthcare programs. We expect state budgets to remain tight over the foreseeable future, in turn, providing good growth prospects for AGP.”
Oshkosh designs and builds large specialty trucks and truck bodies used in fields such as defense, concrete placement, refuse hauling, access equipment and fire and emergency, in 130 countries. They market their equipment in geographic regions where there is demand for vehicles they already sell, or where they can sell value-added features at a price premium. Its customers can get equipment, parts, service and financing from Oshkosh.
Like Amerigroup, Oshkosh shares suffered a significant drop in price recently, with a 52-week range of $14.07-$40.11. FPA Funds took advantage of this immediately. Their first purchase was of 576,000 shares in the second quarter of 2011; then in the third quarter they purchased 669,026 shares at an average price of $22; and in the fourth quarter, they added 21,874 shares to their holding at an average price of $20 per share. The company’s drop in performance was also met with an encounter with noted activist investor Carl Icahn.
In July, around the time Oshkosh’s share price began its decline, it released its third-quarter results. Net sales decreased to $2.02 billion, from net sales of $2.44 in the third quarter of 2010; earnings were reduced to $68 million, or $0.75 per share, from earnings of $211.2 million, or $2.31 per share in the third quarter of 2010.
Simultaneously, the company has been attempting to deal with the pending U.S. defense spending decline by positioning itself to benefit from the larger economic recovery in non-defense markets (defense segment sales decreased 34.9% already in the third quarter compared to the prior-year quarter). It is aiming to increase its market share, expand more into emerging markets, increase its investment in innovation, and optimize its cost structure, which will include restructuring.
Icahn, who owns 9.5% of Oshkosh, sent a letter to the company on Nov. 4, 2011, recommending six director candidates. Oshkosh then issued a letter urging shareholders to vote for its existing members, i.e., not Icahn’s candidates and on Jan. 9, 2012, gave a presentation indicating Icahn has a “mixed” track record delivering value to shareholders. In retaliation, Icahn sent a letter listing a litany of his successful investments and bringing up the fact that his funds achieved a gross return of nearly 50% in the last five years, compared to a negative 1.2% return for the S&P 500. In 2011 alone, his funds were up 35%, or $1.9 billion, which, he added, is about the entire market cap of Oshkosh.
Over the last 15 years, the company has achieved a greater than 18.5% annualized return for shareholders, compared to 5.9% for the S&P 500. It has also grown its revenue from $413 million to $7.6 billion in revenue, for a CAGR of approximately 21%. Icahn argued that the Oshkosh board presided over a 55% share price decline, representing a loss of over $4.3 billion in total enterprise value, over the last five years, in spite of a big M-ATV contract nearing expiration.
Shareholders will vote on Icahn’s candidates on January 27. From Nov. 4, 2011, the date of Icahn’s first letter to Oshkosh, to the present, the stock price has increased 14%.
Though Oshkosh’s revenue per share declined 24.9% in the last 12 months, over 10 years, it has increased at an annual rate of 17%, and though its cash flow per share declined 40% in the last 12 months, it has grown at an annual rate of 25.7% in the last 10 years, and has never been negative in the last decade.
A note about Oshkosh was included in FPA’s letter concerning the second quarter, when it opened its position: “What attracted us to Oshkosh was its long history and strong leadership positions in the markets it serves. The Company has great reach and invests heavily to provide superior products and services. An investment in OSK is about anticipation of future industrial recovery and a continued belief that our military is a logistics business, and therefore, the Department of Defense will at least maintain its vehicle fleet. The current strength in Oshkosh’s defense business should protect shareholders until there is a recovery in industrial and commercial markets. The company’s valuation during the second quarter met our parameters which resulted in initiating the position.”
The valuation they speak of includes a second quarter P/E in the range of4.67-7.44, P/S in the range of 0.29-0.41, and P/B of 1.84-2.14.
In the past several quarters, FPA Funds has taken advantage of stocks of relatively strong businesses that have experienced sudden share-price declines, but that now seem to already be rising again. Learn more about Robert Rodriguez and FPA funds, and see their portfolio picks here.