Newsletter Value Investor Insight carried an interview with Fairholme Capital's Bruce Berkowitz (pictured left), Larry Pitkowsky and Keith Trauner in its April 28th edition. The Fairholme Fund has returned 18.7% per year since its launch in 1999, versus a 0.4% annual loss for the S&P 500. Here's the segment of the interview in which they explain why they are long IDT Corp. (IDT), which was trading at $11.14 at the time of the interview:
Tell us about IDT Corp. (IDT).
KT: IDT is an example of the type of special situation we look look for, in which something has had the crap kicked out of it, there’s some good protection of our value, and maybe some very good things can happen.
IDT’s basic business is selling 400 million calling cards per year, largely to the Hispanic community in the U.S. That’s a great business, which we think is more resistant to disintermediation than some people think. The buyers of these cards are not going to be making calls using the Internet. It’s a very local distribution business and IDT has strong control over that. They have a strong private-label business, doing calling cards for companies like 7-Eleven and Walgreens. They own or lease their own network assets, which are relatively low cost, with gateways into some 60 different countries.
Beyond that, the company has what is basically a venture-capital business that throws a lot of things at the wall and tries to see what sticks. They have a tremendous amount of cash – about $850 million – which came from the partial sale of Net2Phone to AT&T. The cash comes to more than $8 per share, for a company trading at around $11.15.
Why has the stock been such a bust?
KT: Historically, the operating cash flow of the basic calling-card business was sufficient to fund all the extraneous investments. In the last year, though, they entered a major investment cycle and they’re now spending more than the cash flow. The market is understandably concerned with that, given that IDT is eroding its safety net.
BB: There are some other negatives. They bought network assets of Winstar Communications out of bankruptcy, which looked like a tremendous bargan at the time but turned out to be a disaster. The corporate governance is suspect and in the past they’ve given out stock options like drunken sailors. They’re now offering to buy all the options back at $2 per option, no matter what the strike price is, which is ridiculous.
But you know what, with all that we actually like Howard Jonas, the founder and chairman. He’s a quirky, Howard Hughes-type of character who doesn’t even show up at his own annual meeting. But he loves business and is a real entrepreneur, and unless I’m being totally snowed – which could happen – I think he surrounds himself with very high-energy, intelligent people.
What is the company investing in?
KT: They have a major push right now on pre-paid cell phones, also to the Hispanic community. They rolled out last quarter in Washington, D.C. and New York City and will launch in other major markets in the next few quarters. The international rates on these phones are very cheap and they’ve found that people with phones double or triple their minutes of use over calling cards. This effort will cost about $25 million this year.
In Europe, they’re spending another $25 million on a telephone/Internet business called Toucan in the U.K. and the Netherlands. They also recently bought Net2Phone back, for next to nothing. Net2Phone essentially invented the Voice over Internet Protocol [VoIP] business and they have some 40 patents for the technology. We’re not patent experts, but we think they have some valuable technology in a business that’s growing very rapidly.
One of the biggest bets IDT is making is on entertainment. Two or three years ago they put money into a software company that allowed computer animators to work in physically disparate locations and collaborate on the same project. Out of that and through acquisitions, they’ve built a full entertainment distribution and production company doing about $200 million in revenues per year. They have a used-DVD distribution business, are the back room for some well-known animated shows like The Simpsons and have produced an original series for Showtime.
Now they’re building out the entertainment company centered on computer- generated animated films and liveaction productions. They’ve attracted very good people to run the business. Neil Braun, who is president of feature films and television, was the president of the NBC television network. Janet Healy, the president of animation, built the first computer-generated animation studio in Los Angeles for DreamWorks. Chris McGurk, who just came on as a senior advisor for new ventures, was the vice chairman of MGM.
The company’s first animated feature, Everyone’s Hero, is coming out in September. They’re doing the animation work for a Simpsons’ movie coming out in 2007 and keep adding to the production slate.
BB: You can’t make this stuff up. The first feature film they’re doing is based on a story Howard Jonas told to his kids when they were young. What upside do you see for the stock?
KT: We basically look at this as having a decent core business, which generates about 80 cents per share in free cash flow, with options on several promising venture businesses. At the current share price, net of the $8 per share in cash, you’re paying less than 4.5x free cash flow. The trick will be how quickly the new businesses stop eating into cash and start paying off. We’re also encouraged by the fact they seem to be watching overhead more carefully, have been buying back stock and have slowed options issuance.
This is one that’s hard to value, but we think if they have any real success in entertainment alone, the stock is worth at least double the current price. If some of the other investments hit also, there’s a lot of upside.
BB: The fact that they’re eating into cash for the investments obviously worries us, but if you’ve got the right guy doing it, we’re OK with the model of using a cashcow business to fund venture-capital investments. At the current stock price, we like the odds of something good happening here.