T2 Partners released their annual letter and provided the following notes on their largest positions.
Appendix A: 12 Largest Long Positions
Notes: The stocks are listed in descending order of size as of 12/31/10.
1) Grupo Prisa (formerly Liberty Acquisition Holdings)
It would be hard to find something more off the beaten path than Liberty Acquisition Holdings Corp., a Special Purpose Acquisition Company (SPAC) that recently merged with Grupo Prisa (PRIS and PRIS.B), a Spanish media conglomerate with a good business but a bad balance sheet. This transaction was ideal for both parties: Liberty deployed its cash at an attractive valuation while Prisa reduced and restructured its debt burden.
Our positions in Liberty stock and warrants β one of our biggest winners in 2010 β converted to cash and stock in Prisa, which we continue to hold because we think the underlying business, with a new, stronger balance sheet, will do well. In the near term, however, the stock could be volatile because the distribution of shares will initially be to unnatural shareholders (the original SPAC shareholders). Over time, however, we expect that the stock will migrate to intrinsic value.
We presented our analysis of Prisa and its value at the Value Investing Congress on October 13, 2010: www.tilsonfunds.com/Octpres.pdf (pages 32-46).
Here's a Wall St. Journal article from November about the deal, with the key part highlighted:
Liberty Turns Leader of the SPAC
The Wall Street Journal
Heard on the Street
November 1, 2010
By JOHN JANNARONE
Some blank checks are tough to cash.
Special-purpose-acquisition companies became popular in the boom, raising cash through initial public offerings that could be invested in virtually any business. The catch is that SPAC investments require approval from shareholders, who became skittish in the crunch. Of the $17.1 billion raised by the 50 largest SPACs since 2000, some $5.8 billion was returned to shareholders minus expenses, according to Dealogic. And among SPACs that managed to make investments, shares in the companies they bought generally have fared poorly.
But not all SPACs have cracked. Liberty Acquisition Holdings, the largest of the group with a $1 billion IPO in 2007, has proposed a deal giving investors a stake in struggling Spanish media firm Prisa. The deal looks likely to get approval because Liberty shares trade at $10.50, 6% higher than the $9.87 cash liquidation value of the trust. In contrast, most other SPACs traded at a discount even after announcing a deal because many shareholders planned to vote deals down and take cash.
Setting aside the complex deal structure, the investment makes sense for simpler reasons. First, the deal helps solve Prisa's key problem: financial distress. Having binged on acquisitions, net debt reached 7.6 times earnings before interest, taxes, depreciation and amortization at the end of 2009, says Citigroup's Thomas Singlehurst. Assuming the deal goes through and Prisa continues to reduce leverage, net debt will be just 3.5 times Ebitda at the end of next year, he says.
And because the family controlling Prisa faces heavy dilution, Liberty investors get a reasonable price with some downside protection. Each Liberty share will convert to a mix of cash, Prisa shares, and convertible Prisa bonds. Discounting the value of the convertible's dividend at 10%, Liberty investors essentially pay five times Mr. Singlehurst's expected 2011 earnings for their Prisa shares. That is far lower than multiples above 10 times for many media companies.
Admittedly, Spain's economy remains troubled. But, for local advertising, the worst may be past. Ad spending for both television and newspapers fell 23% in 2009, says media-buying firm ZenithOptimedia. The fall is much less this year, and spending is forecast at roughly flat in 2011. Prisa owns the leading Spanish newspaper and broadcast-TV channel, which may win share at the expense of smaller competitors if the market stays soft.
But Liberty's potential success isn't a ray of hope for SPACs in general. Even those run by well-known investors like Nelson Peltz, have failed to get deals done. Prisa may prove an exception because its controlling shareholders know they need Liberty's cash to set the company free.
2) Microsoft
Microsoft reported spectacular earnings in late October, handily beating analysts' estimates, yet the stock has barely moved so we'd added to our position.
Adjusting for the deferral of Windows 7 revenues last year, Microsoft reported revenue, EPS, bookings, and operating cash flow growth of 13%, 19%, 24%, and 34%, respectively. The company's results were strong across the board, riding a wave driven by its three main profit drivers, Windows, Office, and Server & Tools.
Capital allocation was excellent, as Microsoft has (so far anyway) avoided doing what so many other large, cash-rich companies are doing, making a big, overpriced acquisition, and has instead wisely ramped up returning cash to shareholders: $5.5 billion last quarter via $1.1 billion of dividends (the stock currently yields 2.3%) plus $4.4 billion of share repurchases (up 3x year-over-year, leading to the diluted share count falling 3.2%). At this rate, the company will retire nearly 8% of its outstanding shares in the next year.
The stock closed the year at $27.91 and the company has $3.85 of net cash ($4.91 if one includes "Equity and other investments"), so the stock, net of cash, is at $24.06. Trailing earnings are $2.32/share, so that's a P/E multiple of 10.4x. That's insanely low for a company with Microsoft's characteristics: dominant and stable market shares across various products, 81% gross margins, 33% net margins, an infinite return on capital, prodigious cash flows, and one of the strongest balance sheets in the world.
The consensus view is that Microsoft is an incompetent, lumbering dinosaur, declining rapidly toward the dustbin of history. Newspapers, check printers and paging companies, look out! The problem with this view is that there is no evidence for it. Despite endless predictions over the past decade of how Apple or Linux or Google Apps are going to erode Microsoft's dominance in its key product categories, the company's market shares are stable or rising. Revenues and profits, rather than falling, are rising sharply.
Yet analysts persist in ignoring the overwhelming evidence of Microsoft's powerful new product cycle and are projecting flat revenues and EPS down 8.1% for the current quarter (ending December 2010), and flat earnings for the remaining three quarters of the 2011 fiscal year. In light of such low -expectations, we believe Microsoft will continue to handily beat estimates over the next year, with earnings growth in the mid-teens. This, combined with likely multiple expansion, should result in the stock appreciating to at least the mid-$30s range with a year.
3) Berkshire Hathaway
Under Warren Buffett's direction, Berkshire's performance has been nothing short of remarkable over the past two years. His disciplined capital retention looked overly conservative for many years, but when the crisis hit there were few buyers and waves of panicked sellers, so he was able to deploy tens of billions of dollars in some terrific businesses, on highly favorable terms. Thus, ironically, while Berkshire's stock is down 15.0% since the beginning of 2008 (-31.8% in 2008, up 2.7% in 2009, and up 21.4% in 2010), the company's intrinsic value has risen markedly, which we believe makes it an exceptional bargain today.
While the stock was up 21.4% in 2010, we made a much higher return by correctly anticipating that Berkshire, once it completed the acquisition of Burlington Northern, would replace BNI in the S&P 100 and 500 indices. We estimated that index funds would have to buy approximately $38 billion worth of Berkshire stock, which would cause the price to jump, so we significantly increased our position β and were quickly rewarded when the stock popped 15.5% in January.
We have posted a detailed slide presentation of our analysis of Berkshire at: http:// www.tilsonfunds.com/BRK.pdf highlights the impact of the Burlington Northern acquisition: Berkshire's investments per share only declined slightly from the end of 2009 to the end of 2010, despite paying nearly $11 billion in cash as part of the acquisition, yet Berkshire's operating earnings have increased hugely, driving our estimate of intrinsic value to $160,000/A share, a 33% premium to the year-end price of $120,450.
4) BP
The overall story of BP's Gulf of Mexico disaster is well known, so we won't repeat it here. As an investment, there are two stories, reflecting two quite different investment opportunities.
The first was in June at the depths of the crisis, when the stock hit a 14-year low amidst hysteria that the company might have to file for bankruptcy. We started buying BP's stock in early June around $37 and bought all the way down to its late-June low of $26.75 (including some call options near the low). Our average cost at that time was around $29.
Our investment thesis, which we released publicly (see our June 19th article in Barron's at: http://online.barrons.com/article/SB50001424052970203296004575308800681560686.html and our full analysis at: www.tilsonfunds.com/BP.pdf), rested on the following beliefs: the well would be capped sooner than most investors expected; the environmental damage would be less than feared; the clean-up costs, fines and legal liabilities would be at the low end of estimates; and the company had the assets and cash flows to meet all eventualities. In less than two months, our investment thesis was almost entirely validated β most importantly, the well was capped β and the stock soared nearly 50%.
At that point, many investors seemed to think that the "easy money" had been made (there was nothing easy about it!) and sold, leading to the stock dropping from $43 to under $35 in less than three weeks in August. This presented a very different risk-reward equation than only two months earlier. Of course the stock wasn't as cheap, but the tail risk of bankruptcy was gone (given that the well was capped), BP had reported strong Q2 operating results, and had raised $7 billion by selling some non-core assets to Apache for a fantastic price of 2x book value and 42x cash flow. Thus, we concluded that the stock, on a risk-adjusted basis, was even more attractive than it was in June so we bought a lot more. This, too, has worked well as the stock has risen to $44.17 at year-end thanks to the company reporting solid Q3 earnings, strengthening its balance sheet, selling additional assets, and announcing that it will reinstate the dividend next quarter. At its current price, the stock trades at 8.1x estimated 2010 earnings (excluding the Gulf spill costs) and 7.3x 2011 estimates, which we believe is far too cheap, both on a relative and absolute basis.
5) General Growth Properties
General Growth Properties was our biggest winner for the second year in a row. After successfully shorting the stock from the $40s to near zero, we flipped around and purchased it in early 2009, initially at under $1, when we realized that there might be some recovery for the equity even though the company had filed for bankruptcy. We thought the upside potential was $20, but we kept it a small position at the time, reflecting the high risk that the equity could be worthless.
As the best-case scenario played out month after month, we let the position continue to grow because, like BP, the risk-reward equation kept getting more favorable, yet the stock price wasn't keeping up, so it remained cheap β and was becoming safer and safer as the credit crisis eased, allowing GGP to refinance its debt and progress quickly through bankruptcy.
It wasn't always a smooth ride, however. In December 2009, a hedge fund named Hovde Capital, which was short the stock, published three bearish analyses that knocked the stock down. We concluded that Hovde's analyses were flawed and rebutted them in three published articles (see: www.tilsonfunds.com/GGP.pdf). We ended up profiting from this volatility by adding to our position at temporarily distressed prices.
GGP exited bankruptcy on November 9th in the form of two companies: GGP, which will operate strictly as a mall operator, and Howard Hughes Corp., a real-estate development company. We have trimmed the positions, but continue to own both.
6) CIT Group
Founded in 1908 to provide financing for horse-drawn carriages, CIT Group is a major player in lending to small and mid-sized businesses, in particular in specialized areas such as asset-based lending to retail suppliers, transportation leasing and equipment finance. In November 2009, CIT filed for bankruptcy, crushed under the weight of increasing loan defaults, ill-timed forays into non-core areas such as student lending and subprime residential mortgages, and an inability to tap credit markets to finance its day-to-day operations. Shareholders were wiped out, including $2.3 billion in U.S. taxpayer money that the federal government had invested in the company a year before.
By the time it emerged from its prepackaged reorganization in December, CIT had shed $10.5 billion in debt, shrunk its asset base, and was touting a new and improved back-to-basics business plan.
Under new Chairman and CEO John Thain, CIT is refocusing on its core strengths in lending to smaller businesses across a wide variety of commercial and industrial sectors. The lack of competition for such business today from banks should allow CIT to not only take share, but to do so at attractive rates and without compromising on credit quality. The company certainly has the liquidity to lend should it choose to, with a post-bankruptcy balance sheet that sports $11.2 billion in cash.
One key challenge to investing in any distressed lending institution like CIT is gaining comfort that the asset values on the books reflect reality. As of September 30, CIT reported tangible book value of $42.20 per share, which we believe will prove reliable given that management had every incentive coming out of the bankruptcy process to write down or write off problem loans as much as possible and start off with a clean slate.
The company's primary challenge today is its cost of financing. Its net revenue spread is low due to CIT's very high cost of financing, but we believe the company will be able to lower its borrowing costs by refinancing existing high-cost obligations, using cash to buy back debt, and generating increased low-cost deposits from its bank subsidiary.
If CIT can capture the financing-cost savings we believe are possible, we think the company could earn around $5 per share. At a 12-14x multiple we think is reasonable, that translates into $60 to $70 per share, a 27%-49% premium to the year-end price of $47.10. Even more intriguing is the possibility that a healthy bank might acquire CIT, attracted by the enormous earnings leverage available in applying the acquiring bank's much lower borrowing costs to CIT's business model.
7) Kraft
Like many of our other top holdings, Kraft is a high-quality business trading at a historically low valuation. In addition, we believe the 2010 Cadbury acquisition will provide substantial upside.
Kraft is the world's 2nd largest food company, and owns some of the best-known brands of snack foods, beverages, cheeses, meat products and grocery items. With the acquisition of Cadbury, the company adds not only branded confectionery items, including gums and chocolates, but also a world-class distribution capability that is complementary to Kraft's existing distribution.
The stock currently trades at a market multiple, but we believe Kraft should trade at a premium given the stable, high-margin characteristics of its branded portfolio. In addition, Kraft has the opportunity over the next few years to materially improve its margins to industry norms and significantly reduce costs due to synergies with Cadbury.
We believe Kraft can earn around $3.00 per share within two years, which should result in a stock price approximately 50% above current levels.
8) Seagate Technologies
Seagate is a leading manufacturer of hard disk drive storage devices (HDDs.) The industry has experienced significant consolidation over the last decade, resulting in three major players. Seagate's market share is approximately 30%.
Consensus thinking for many years is that this is a cyclical, rapidly dying industry, and that Solid State Drives (SDDs) will soon replace HDDs in the majority of applications. Our variant perception is that the medium-term viability of hard disk storage is quite strong, given that HDDs have a roughly 10:1 cost advantage over SSDs. We expect that a substantial cost advantage will be sustained for some time.
In the meantime, Seagate is a powerful free cash generator. In FY 2010 (ending 7/2/10), the company had $1.6 billion of net income and generated $1.9 billion of operating cash flow vs. cap ex of only $639 million. The resulting in $1.3 billion of free cash flow allowed Seagate to buy back $584 million of stock and increase its cash hoard by $836 million.
The historical cyclicality of the business has been reduced thanks to the flexible nature of the manufacturing process and industry consolidation. Gross and operating margins in FY 2010 were 28% and 15%, respectively, vs. 23% and 9%, respectively in 2006.
The company has allocated its capital sensibly over time, and has retired 17% of its stock in the past three years. Continued buybacks should contribute to a materially higher valuation of the company over time.
If we are correct that Seagate's business isn't in rapid decline, then its stock is one of the cheapest in our portfolio, trading at a mere 4.8x trailing earnings and 2.8x enterprise value/EBITDA.
9) Iridium
Iridium operates a constellation of low-earth orbiting satellites that provide worldwide real-time data and voice capabilities over 100% of the earth. The company delivers secure mission-critical communications services to and from areas where landlines and terrestrial-based wireless services are either unavailable or unreliable. It is one of two major players in the Global Satellite Communications industry.
The company has a tumultuous history. Originally a division of Motorola, Iridium spent $5 billion launching satellites in the late 1990s, but filed for bankruptcy in 1999 with only 50,000 customers due to too much debt and clunky phones that didn't work inside buildings. Since then, however, Iridium has thrived. It is growing very rapidly and is taking market share from its competitors.
The company went public in late September, 2009 by merging with a Special Purpose Acquisition Company (SPAC) and has been weak since then, despite recently reporting strong results.
We continue to believe that this is an excellent company and that the stock is extremely undervalued. Comparable businesses are trading at 10x EV/EBITDA, while Iridium, which is growing significantly faster than and taking share from its competitors, trades at under 4x EBITDA. Finally, we are encouraged by the recent large insider purchases by both the CEO and Chairman of the company.
10) ADP
We recently added another high-quality blue-chip stock to our portfolio, Automatic Data Processing. ADP's core business is payroll processing and we believe that it is one of the world's great companies. It is more than four times the size of its nearest competitor and there are very high switching costs for its customers, so ADP has fabulous 20% operating margins and unlevered returns on equity in the mid-20% range. It is such a pillar of financial strength that it is one of only four companies left that still have the highest AAA credit rating (we also happen to own the other three, Microsoft, Exxon Mobil and Johnson & Johnson, though only the former in any size). Finally, ADP has excellent management and is very shareholder friendly, returning cash to shareholders via a healthy 3.1% dividend and share repurchases (17% of shares have been retired in the past five years).
So what's not to like? Two things: 1) Growth has disappeared (EPS in FY 2010, which ended on June 30th, declined 9% from the previous year, and the company only expects 1-3% revenue and EPS growth in FY 2011); and 2) The stock doesn't appear particularly cheap, trading at 19.3x trailing EPS, based on 2010's closing price of $46.28.
ADP historically has been a solid growth story β in the 13 years through FY 2009, for example, earnings per share grew 245% (10.0% annually) β so what happened? In short, ADP has been hit recently by two macroeconomic factors: high unemployment (meaning fewer paychecks being processed) and low interest rates, which reduce ADP's earnings from its float.
Float? ADP isn't an insurance company, so why does it have float? Allow us to explain: as a payroll processor, ADP collects cash from its customers and then issues paychecks, makes deposits in retirement accounts, and transfers funds for taxes. All of this happens quickly, but at any given time, ADP is sitting on more than $18 billion of cash, on which it can earn interest (it appears as a liability on the balance sheet under "Client funds obligations", offset by an asset called "Funds held for clients"). Each dollar that comes in goes out very quickly, but is replaced with another dollar, so this is, in effect, perpetual (and growing) float.
Of course ADP invests these funds very conservatively β this isn't long-term float like much of Berkshire Hathaway's that can be invested in stocks β so ADP's earnings from this float are highly dependent on short-term interest rates. As of December 31st, one-month Treasuries were paying a microscopic 0.05% vs. 5.05% only 40 months ago on August 1, 2007 (how the world has changed!).
Of course ADP isn't investing all of its float in one-month Treasuries β it's laddered such that the company generated $543 million of revenues in FY 2010 from "Interest on funds held for clients." ADP's float averaged $17.1 billion in FY 2010, so it earned a 3.2% return. Imagine that interest rates rise 300 basis points over time to more normal (although still low) levels β this would translate into an extra $540 million in pre-tax profits for ADP, boosting earnings by nearly 30%. In addition, someday employers in this country will begin to hire again, which will also fuel ADP's growth. For both of these reasons, we think ADP's earnings are depressed right now, making the stock cheaper than it appears.
While we think robust economic growth and a rise in interest rates is unlikely in the near term, when the economy eventually recovers, ADP should have turbocharged earnings growth. We are prepared to be patient, collecting a healthy dividend, because we believe the stock is worth at least $60, 30% above current levels, in even a remotely normal economic environment.
11) Resource America
Resource America rose 69.8% in 2010 thanks to strong results and a recovery in financial stocks. Interestingly, our analysis of REXI is little changed in the nearly two years since we wrote a chapter about it in our book, More Mortgage Meltdown: 6 Ways to Profit in These Bad Times, so we've posted this chapter at: www.tilsonfunds.com/REXIMMM.pdf. Here's an excerpt:
Resource America went public in 1986 as a specialty finance company that bought commercial mortgages at a discount. It also held some energy assets such as gas wells and pipelines. It built up Fidelity Leasing and in 2000 sold it to ABN AMRO for $583 million, approximately twice the net assets of the lease portfolio. a significant premium. Later, REXI IPO'd its energy assets by selling shares of Atlas America in 2004 and then spun off their remaining shares the next year. In 2005, REXI also created Resource Capital Corp., a REIT that trades separately under the ticker RSO. Overall, REXI has a very good track record of accumulating assets on the cheap and selling at good prices, with solid gains for shareholders.
Today, REXI manages assets across a broad range of categories and earns attractive spreads on structured finance pools. We believe that while some of these pools may experience problems, REXI has modest liability, which is more than discounted in the stock price. In addition to substantial excess assets outlined below, we estimate that REXI has earnings power of over $1 per share, though it will not reach this level in 2009; the company's guidance is $0.50-$0.70/share. REXI operates in three segments: Financial Fund Management, which manages various types of asset-backed securities; Real Estate, which invests in and manages multi-family and commercial real estate; and Commercial Finance, which is comprised of LEAF, a small equipment leasing business. We believe that the combined value of these businesses, when added to the value of other investments and what's on the balance sheet, is multiples of the current market price. REXI's upside is very high when the markets eventually recover.
12) Anheuser-Busch Inbev
AB InBev is the world's largest brewer, managing a portfolio of approximately 200 brands that includes Budweiser, Bud Light, Michelob, Stella Artois and Beck's. 13 brands have over $1 billion in sales and in its top 31 markets, AB InBev is #1 or #2 in 25 of them. We think the beer business is very stable, with slow growth in most of the world's largest markets, but with high growth potential in certain developing markets like China. Comparable businesses in our minds would be Coca Cola and McDonald's. This type of stable, dominant business gives us the confidence to project earnings and cash flows many years into the future, and we expect that we might hold this stock for a long time.
We think AB InBev's management team is among the finest we've ever invested alongside. They are renowned for being both great operators and also ruthless cost cutters β and there's a lot of fat to cut in the recently acquired Anheuser Busch business, which should lead to substantial cost savings (and a resulting jump in earnings).
We estimate pro forma free cash flow at $5.66/share in 2012. At a 14-16 multiple, that's $79-$91/share, 38%-59% above 2010's closing price of $57.09.
We presented AB InBev at the Value Investing Seminar on July 13, 2010: www.tilsonfunds.com/Julypres.pdf (pages 9-26).
Appendix A: 12 Largest Long Positions
Notes: The stocks are listed in descending order of size as of 12/31/10.
1) Grupo Prisa (formerly Liberty Acquisition Holdings)
It would be hard to find something more off the beaten path than Liberty Acquisition Holdings Corp., a Special Purpose Acquisition Company (SPAC) that recently merged with Grupo Prisa (PRIS and PRIS.B), a Spanish media conglomerate with a good business but a bad balance sheet. This transaction was ideal for both parties: Liberty deployed its cash at an attractive valuation while Prisa reduced and restructured its debt burden.
Our positions in Liberty stock and warrants β one of our biggest winners in 2010 β converted to cash and stock in Prisa, which we continue to hold because we think the underlying business, with a new, stronger balance sheet, will do well. In the near term, however, the stock could be volatile because the distribution of shares will initially be to unnatural shareholders (the original SPAC shareholders). Over time, however, we expect that the stock will migrate to intrinsic value.
We presented our analysis of Prisa and its value at the Value Investing Congress on October 13, 2010: www.tilsonfunds.com/Octpres.pdf (pages 32-46).
Here's a Wall St. Journal article from November about the deal, with the key part highlighted:
Liberty Turns Leader of the SPAC
The Wall Street Journal
Heard on the Street
November 1, 2010
By JOHN JANNARONE
Some blank checks are tough to cash.
Special-purpose-acquisition companies became popular in the boom, raising cash through initial public offerings that could be invested in virtually any business. The catch is that SPAC investments require approval from shareholders, who became skittish in the crunch. Of the $17.1 billion raised by the 50 largest SPACs since 2000, some $5.8 billion was returned to shareholders minus expenses, according to Dealogic. And among SPACs that managed to make investments, shares in the companies they bought generally have fared poorly.
But not all SPACs have cracked. Liberty Acquisition Holdings, the largest of the group with a $1 billion IPO in 2007, has proposed a deal giving investors a stake in struggling Spanish media firm Prisa. The deal looks likely to get approval because Liberty shares trade at $10.50, 6% higher than the $9.87 cash liquidation value of the trust. In contrast, most other SPACs traded at a discount even after announcing a deal because many shareholders planned to vote deals down and take cash.
Setting aside the complex deal structure, the investment makes sense for simpler reasons. First, the deal helps solve Prisa's key problem: financial distress. Having binged on acquisitions, net debt reached 7.6 times earnings before interest, taxes, depreciation and amortization at the end of 2009, says Citigroup's Thomas Singlehurst. Assuming the deal goes through and Prisa continues to reduce leverage, net debt will be just 3.5 times Ebitda at the end of next year, he says.
And because the family controlling Prisa faces heavy dilution, Liberty investors get a reasonable price with some downside protection. Each Liberty share will convert to a mix of cash, Prisa shares, and convertible Prisa bonds. Discounting the value of the convertible's dividend at 10%, Liberty investors essentially pay five times Mr. Singlehurst's expected 2011 earnings for their Prisa shares. That is far lower than multiples above 10 times for many media companies.
Admittedly, Spain's economy remains troubled. But, for local advertising, the worst may be past. Ad spending for both television and newspapers fell 23% in 2009, says media-buying firm ZenithOptimedia. The fall is much less this year, and spending is forecast at roughly flat in 2011. Prisa owns the leading Spanish newspaper and broadcast-TV channel, which may win share at the expense of smaller competitors if the market stays soft.
But Liberty's potential success isn't a ray of hope for SPACs in general. Even those run by well-known investors like Nelson Peltz, have failed to get deals done. Prisa may prove an exception because its controlling shareholders know they need Liberty's cash to set the company free.
2) Microsoft
Microsoft reported spectacular earnings in late October, handily beating analysts' estimates, yet the stock has barely moved so we'd added to our position.
Adjusting for the deferral of Windows 7 revenues last year, Microsoft reported revenue, EPS, bookings, and operating cash flow growth of 13%, 19%, 24%, and 34%, respectively. The company's results were strong across the board, riding a wave driven by its three main profit drivers, Windows, Office, and Server & Tools.
Capital allocation was excellent, as Microsoft has (so far anyway) avoided doing what so many other large, cash-rich companies are doing, making a big, overpriced acquisition, and has instead wisely ramped up returning cash to shareholders: $5.5 billion last quarter via $1.1 billion of dividends (the stock currently yields 2.3%) plus $4.4 billion of share repurchases (up 3x year-over-year, leading to the diluted share count falling 3.2%). At this rate, the company will retire nearly 8% of its outstanding shares in the next year.
The stock closed the year at $27.91 and the company has $3.85 of net cash ($4.91 if one includes "Equity and other investments"), so the stock, net of cash, is at $24.06. Trailing earnings are $2.32/share, so that's a P/E multiple of 10.4x. That's insanely low for a company with Microsoft's characteristics: dominant and stable market shares across various products, 81% gross margins, 33% net margins, an infinite return on capital, prodigious cash flows, and one of the strongest balance sheets in the world.
The consensus view is that Microsoft is an incompetent, lumbering dinosaur, declining rapidly toward the dustbin of history. Newspapers, check printers and paging companies, look out! The problem with this view is that there is no evidence for it. Despite endless predictions over the past decade of how Apple or Linux or Google Apps are going to erode Microsoft's dominance in its key product categories, the company's market shares are stable or rising. Revenues and profits, rather than falling, are rising sharply.
Yet analysts persist in ignoring the overwhelming evidence of Microsoft's powerful new product cycle and are projecting flat revenues and EPS down 8.1% for the current quarter (ending December 2010), and flat earnings for the remaining three quarters of the 2011 fiscal year. In light of such low -expectations, we believe Microsoft will continue to handily beat estimates over the next year, with earnings growth in the mid-teens. This, combined with likely multiple expansion, should result in the stock appreciating to at least the mid-$30s range with a year.
3) Berkshire Hathaway
Under Warren Buffett's direction, Berkshire's performance has been nothing short of remarkable over the past two years. His disciplined capital retention looked overly conservative for many years, but when the crisis hit there were few buyers and waves of panicked sellers, so he was able to deploy tens of billions of dollars in some terrific businesses, on highly favorable terms. Thus, ironically, while Berkshire's stock is down 15.0% since the beginning of 2008 (-31.8% in 2008, up 2.7% in 2009, and up 21.4% in 2010), the company's intrinsic value has risen markedly, which we believe makes it an exceptional bargain today.
While the stock was up 21.4% in 2010, we made a much higher return by correctly anticipating that Berkshire, once it completed the acquisition of Burlington Northern, would replace BNI in the S&P 100 and 500 indices. We estimated that index funds would have to buy approximately $38 billion worth of Berkshire stock, which would cause the price to jump, so we significantly increased our position β and were quickly rewarded when the stock popped 15.5% in January.
We have posted a detailed slide presentation of our analysis of Berkshire at: http:// www.tilsonfunds.com/BRK.pdf highlights the impact of the Burlington Northern acquisition: Berkshire's investments per share only declined slightly from the end of 2009 to the end of 2010, despite paying nearly $11 billion in cash as part of the acquisition, yet Berkshire's operating earnings have increased hugely, driving our estimate of intrinsic value to $160,000/A share, a 33% premium to the year-end price of $120,450.
4) BP
The overall story of BP's Gulf of Mexico disaster is well known, so we won't repeat it here. As an investment, there are two stories, reflecting two quite different investment opportunities.
The first was in June at the depths of the crisis, when the stock hit a 14-year low amidst hysteria that the company might have to file for bankruptcy. We started buying BP's stock in early June around $37 and bought all the way down to its late-June low of $26.75 (including some call options near the low). Our average cost at that time was around $29.
Our investment thesis, which we released publicly (see our June 19th article in Barron's at: http://online.barrons.com/article/SB50001424052970203296004575308800681560686.html and our full analysis at: www.tilsonfunds.com/BP.pdf), rested on the following beliefs: the well would be capped sooner than most investors expected; the environmental damage would be less than feared; the clean-up costs, fines and legal liabilities would be at the low end of estimates; and the company had the assets and cash flows to meet all eventualities. In less than two months, our investment thesis was almost entirely validated β most importantly, the well was capped β and the stock soared nearly 50%.
At that point, many investors seemed to think that the "easy money" had been made (there was nothing easy about it!) and sold, leading to the stock dropping from $43 to under $35 in less than three weeks in August. This presented a very different risk-reward equation than only two months earlier. Of course the stock wasn't as cheap, but the tail risk of bankruptcy was gone (given that the well was capped), BP had reported strong Q2 operating results, and had raised $7 billion by selling some non-core assets to Apache for a fantastic price of 2x book value and 42x cash flow. Thus, we concluded that the stock, on a risk-adjusted basis, was even more attractive than it was in June so we bought a lot more. This, too, has worked well as the stock has risen to $44.17 at year-end thanks to the company reporting solid Q3 earnings, strengthening its balance sheet, selling additional assets, and announcing that it will reinstate the dividend next quarter. At its current price, the stock trades at 8.1x estimated 2010 earnings (excluding the Gulf spill costs) and 7.3x 2011 estimates, which we believe is far too cheap, both on a relative and absolute basis.
5) General Growth Properties
General Growth Properties was our biggest winner for the second year in a row. After successfully shorting the stock from the $40s to near zero, we flipped around and purchased it in early 2009, initially at under $1, when we realized that there might be some recovery for the equity even though the company had filed for bankruptcy. We thought the upside potential was $20, but we kept it a small position at the time, reflecting the high risk that the equity could be worthless.
As the best-case scenario played out month after month, we let the position continue to grow because, like BP, the risk-reward equation kept getting more favorable, yet the stock price wasn't keeping up, so it remained cheap β and was becoming safer and safer as the credit crisis eased, allowing GGP to refinance its debt and progress quickly through bankruptcy.
It wasn't always a smooth ride, however. In December 2009, a hedge fund named Hovde Capital, which was short the stock, published three bearish analyses that knocked the stock down. We concluded that Hovde's analyses were flawed and rebutted them in three published articles (see: www.tilsonfunds.com/GGP.pdf). We ended up profiting from this volatility by adding to our position at temporarily distressed prices.
GGP exited bankruptcy on November 9th in the form of two companies: GGP, which will operate strictly as a mall operator, and Howard Hughes Corp., a real-estate development company. We have trimmed the positions, but continue to own both.
6) CIT Group
Founded in 1908 to provide financing for horse-drawn carriages, CIT Group is a major player in lending to small and mid-sized businesses, in particular in specialized areas such as asset-based lending to retail suppliers, transportation leasing and equipment finance. In November 2009, CIT filed for bankruptcy, crushed under the weight of increasing loan defaults, ill-timed forays into non-core areas such as student lending and subprime residential mortgages, and an inability to tap credit markets to finance its day-to-day operations. Shareholders were wiped out, including $2.3 billion in U.S. taxpayer money that the federal government had invested in the company a year before.
By the time it emerged from its prepackaged reorganization in December, CIT had shed $10.5 billion in debt, shrunk its asset base, and was touting a new and improved back-to-basics business plan.
Under new Chairman and CEO John Thain, CIT is refocusing on its core strengths in lending to smaller businesses across a wide variety of commercial and industrial sectors. The lack of competition for such business today from banks should allow CIT to not only take share, but to do so at attractive rates and without compromising on credit quality. The company certainly has the liquidity to lend should it choose to, with a post-bankruptcy balance sheet that sports $11.2 billion in cash.
One key challenge to investing in any distressed lending institution like CIT is gaining comfort that the asset values on the books reflect reality. As of September 30, CIT reported tangible book value of $42.20 per share, which we believe will prove reliable given that management had every incentive coming out of the bankruptcy process to write down or write off problem loans as much as possible and start off with a clean slate.
The company's primary challenge today is its cost of financing. Its net revenue spread is low due to CIT's very high cost of financing, but we believe the company will be able to lower its borrowing costs by refinancing existing high-cost obligations, using cash to buy back debt, and generating increased low-cost deposits from its bank subsidiary.
If CIT can capture the financing-cost savings we believe are possible, we think the company could earn around $5 per share. At a 12-14x multiple we think is reasonable, that translates into $60 to $70 per share, a 27%-49% premium to the year-end price of $47.10. Even more intriguing is the possibility that a healthy bank might acquire CIT, attracted by the enormous earnings leverage available in applying the acquiring bank's much lower borrowing costs to CIT's business model.
7) Kraft
Like many of our other top holdings, Kraft is a high-quality business trading at a historically low valuation. In addition, we believe the 2010 Cadbury acquisition will provide substantial upside.
Kraft is the world's 2nd largest food company, and owns some of the best-known brands of snack foods, beverages, cheeses, meat products and grocery items. With the acquisition of Cadbury, the company adds not only branded confectionery items, including gums and chocolates, but also a world-class distribution capability that is complementary to Kraft's existing distribution.
The stock currently trades at a market multiple, but we believe Kraft should trade at a premium given the stable, high-margin characteristics of its branded portfolio. In addition, Kraft has the opportunity over the next few years to materially improve its margins to industry norms and significantly reduce costs due to synergies with Cadbury.
We believe Kraft can earn around $3.00 per share within two years, which should result in a stock price approximately 50% above current levels.
8) Seagate Technologies
Seagate is a leading manufacturer of hard disk drive storage devices (HDDs.) The industry has experienced significant consolidation over the last decade, resulting in three major players. Seagate's market share is approximately 30%.
Consensus thinking for many years is that this is a cyclical, rapidly dying industry, and that Solid State Drives (SDDs) will soon replace HDDs in the majority of applications. Our variant perception is that the medium-term viability of hard disk storage is quite strong, given that HDDs have a roughly 10:1 cost advantage over SSDs. We expect that a substantial cost advantage will be sustained for some time.
In the meantime, Seagate is a powerful free cash generator. In FY 2010 (ending 7/2/10), the company had $1.6 billion of net income and generated $1.9 billion of operating cash flow vs. cap ex of only $639 million. The resulting in $1.3 billion of free cash flow allowed Seagate to buy back $584 million of stock and increase its cash hoard by $836 million.
The historical cyclicality of the business has been reduced thanks to the flexible nature of the manufacturing process and industry consolidation. Gross and operating margins in FY 2010 were 28% and 15%, respectively, vs. 23% and 9%, respectively in 2006.
The company has allocated its capital sensibly over time, and has retired 17% of its stock in the past three years. Continued buybacks should contribute to a materially higher valuation of the company over time.
If we are correct that Seagate's business isn't in rapid decline, then its stock is one of the cheapest in our portfolio, trading at a mere 4.8x trailing earnings and 2.8x enterprise value/EBITDA.
9) Iridium
Iridium operates a constellation of low-earth orbiting satellites that provide worldwide real-time data and voice capabilities over 100% of the earth. The company delivers secure mission-critical communications services to and from areas where landlines and terrestrial-based wireless services are either unavailable or unreliable. It is one of two major players in the Global Satellite Communications industry.
The company has a tumultuous history. Originally a division of Motorola, Iridium spent $5 billion launching satellites in the late 1990s, but filed for bankruptcy in 1999 with only 50,000 customers due to too much debt and clunky phones that didn't work inside buildings. Since then, however, Iridium has thrived. It is growing very rapidly and is taking market share from its competitors.
The company went public in late September, 2009 by merging with a Special Purpose Acquisition Company (SPAC) and has been weak since then, despite recently reporting strong results.
We continue to believe that this is an excellent company and that the stock is extremely undervalued. Comparable businesses are trading at 10x EV/EBITDA, while Iridium, which is growing significantly faster than and taking share from its competitors, trades at under 4x EBITDA. Finally, we are encouraged by the recent large insider purchases by both the CEO and Chairman of the company.
10) ADP
We recently added another high-quality blue-chip stock to our portfolio, Automatic Data Processing. ADP's core business is payroll processing and we believe that it is one of the world's great companies. It is more than four times the size of its nearest competitor and there are very high switching costs for its customers, so ADP has fabulous 20% operating margins and unlevered returns on equity in the mid-20% range. It is such a pillar of financial strength that it is one of only four companies left that still have the highest AAA credit rating (we also happen to own the other three, Microsoft, Exxon Mobil and Johnson & Johnson, though only the former in any size). Finally, ADP has excellent management and is very shareholder friendly, returning cash to shareholders via a healthy 3.1% dividend and share repurchases (17% of shares have been retired in the past five years).
So what's not to like? Two things: 1) Growth has disappeared (EPS in FY 2010, which ended on June 30th, declined 9% from the previous year, and the company only expects 1-3% revenue and EPS growth in FY 2011); and 2) The stock doesn't appear particularly cheap, trading at 19.3x trailing EPS, based on 2010's closing price of $46.28.
ADP historically has been a solid growth story β in the 13 years through FY 2009, for example, earnings per share grew 245% (10.0% annually) β so what happened? In short, ADP has been hit recently by two macroeconomic factors: high unemployment (meaning fewer paychecks being processed) and low interest rates, which reduce ADP's earnings from its float.
Float? ADP isn't an insurance company, so why does it have float? Allow us to explain: as a payroll processor, ADP collects cash from its customers and then issues paychecks, makes deposits in retirement accounts, and transfers funds for taxes. All of this happens quickly, but at any given time, ADP is sitting on more than $18 billion of cash, on which it can earn interest (it appears as a liability on the balance sheet under "Client funds obligations", offset by an asset called "Funds held for clients"). Each dollar that comes in goes out very quickly, but is replaced with another dollar, so this is, in effect, perpetual (and growing) float.
Of course ADP invests these funds very conservatively β this isn't long-term float like much of Berkshire Hathaway's that can be invested in stocks β so ADP's earnings from this float are highly dependent on short-term interest rates. As of December 31st, one-month Treasuries were paying a microscopic 0.05% vs. 5.05% only 40 months ago on August 1, 2007 (how the world has changed!).
Of course ADP isn't investing all of its float in one-month Treasuries β it's laddered such that the company generated $543 million of revenues in FY 2010 from "Interest on funds held for clients." ADP's float averaged $17.1 billion in FY 2010, so it earned a 3.2% return. Imagine that interest rates rise 300 basis points over time to more normal (although still low) levels β this would translate into an extra $540 million in pre-tax profits for ADP, boosting earnings by nearly 30%. In addition, someday employers in this country will begin to hire again, which will also fuel ADP's growth. For both of these reasons, we think ADP's earnings are depressed right now, making the stock cheaper than it appears.
While we think robust economic growth and a rise in interest rates is unlikely in the near term, when the economy eventually recovers, ADP should have turbocharged earnings growth. We are prepared to be patient, collecting a healthy dividend, because we believe the stock is worth at least $60, 30% above current levels, in even a remotely normal economic environment.
11) Resource America
Resource America rose 69.8% in 2010 thanks to strong results and a recovery in financial stocks. Interestingly, our analysis of REXI is little changed in the nearly two years since we wrote a chapter about it in our book, More Mortgage Meltdown: 6 Ways to Profit in These Bad Times, so we've posted this chapter at: www.tilsonfunds.com/REXIMMM.pdf. Here's an excerpt:
Resource America went public in 1986 as a specialty finance company that bought commercial mortgages at a discount. It also held some energy assets such as gas wells and pipelines. It built up Fidelity Leasing and in 2000 sold it to ABN AMRO for $583 million, approximately twice the net assets of the lease portfolio. a significant premium. Later, REXI IPO'd its energy assets by selling shares of Atlas America in 2004 and then spun off their remaining shares the next year. In 2005, REXI also created Resource Capital Corp., a REIT that trades separately under the ticker RSO. Overall, REXI has a very good track record of accumulating assets on the cheap and selling at good prices, with solid gains for shareholders.
Today, REXI manages assets across a broad range of categories and earns attractive spreads on structured finance pools. We believe that while some of these pools may experience problems, REXI has modest liability, which is more than discounted in the stock price. In addition to substantial excess assets outlined below, we estimate that REXI has earnings power of over $1 per share, though it will not reach this level in 2009; the company's guidance is $0.50-$0.70/share. REXI operates in three segments: Financial Fund Management, which manages various types of asset-backed securities; Real Estate, which invests in and manages multi-family and commercial real estate; and Commercial Finance, which is comprised of LEAF, a small equipment leasing business. We believe that the combined value of these businesses, when added to the value of other investments and what's on the balance sheet, is multiples of the current market price. REXI's upside is very high when the markets eventually recover.
12) Anheuser-Busch Inbev
AB InBev is the world's largest brewer, managing a portfolio of approximately 200 brands that includes Budweiser, Bud Light, Michelob, Stella Artois and Beck's. 13 brands have over $1 billion in sales and in its top 31 markets, AB InBev is #1 or #2 in 25 of them. We think the beer business is very stable, with slow growth in most of the world's largest markets, but with high growth potential in certain developing markets like China. Comparable businesses in our minds would be Coca Cola and McDonald's. This type of stable, dominant business gives us the confidence to project earnings and cash flows many years into the future, and we expect that we might hold this stock for a long time.
We think AB InBev's management team is among the finest we've ever invested alongside. They are renowned for being both great operators and also ruthless cost cutters β and there's a lot of fat to cut in the recently acquired Anheuser Busch business, which should lead to substantial cost savings (and a resulting jump in earnings).
We estimate pro forma free cash flow at $5.66/share in 2012. At a 14-16 multiple, that's $79-$91/share, 38%-59% above 2010's closing price of $57.09.
We presented AB InBev at the Value Investing Seminar on July 13, 2010: www.tilsonfunds.com/Julypres.pdf (pages 9-26).
