Geoff Abbott is founder of GCA Partners, a long/short equity fund he launched after several years of experience in hedge fund work. GCA Partners does deep fundamental analysis to find shares trading at sizable discounts to intrinsic values.
If you could only hold one stock position in your portfolio (long or short), what would it be?
We would hold M&F Worldwide (MFW). MFW is a collection of various unconnected businesses assembled through acquisitions over the years. The company’s biggest business consists of printing checks. Additionally, it makes financial software, produces forms used in standardized testing, and processes licorice root for use in flavored cigarettes and candy.
The check-printing businesses composes about two-thirds of the company’s revenue. The financial software business accounts for roughly another 16%.
How does your choice reflect your fund's investment approach?
We view MFW as a deep value play. Though we prefer to buy good businesses at cheap prices, we also believe that we can be successful buying questionable businesses at extremely depressed prices. No doubt, MFW’s businesses aren’t the most exciting, and the company has a sizable debt load. However, the stock price is so egregiously depressed that there are far more things that can go right for MFW investors than can go wrong.
We are happy and comfortable to own businesses with weak fundamentals if the risk/reward profile is favorable. Though MFW’s businesses face serious headwinds going forward, one can assume an aggressive and accelerating rate of decline for each business and the company will still be able to service its debt load with plenty of value left over for equity holders. In all of our investments, we believe entry price will be the ultimate arbiter of our success, and we think our MFW entry price more than compensates us for any and all risks.
How much is your selection based on MFW's industry, as opposed to a pure bottom-up pick?
We’re strict bottom-up investors, but we seek to gain an intimate understanding of a company’s operating environment at part of our bottom-up analysis. MFW isn’t in an exciting industry, and its core check business has been declining at a modest, steady rate. In addition, the Licorice Products segment faces serious questions going forward. Governments around the world have become increasingly concerned about the health effects of menthol cigarettes, and the U.S. government is currently considering an outright ban.
Obviously, this isn’t an ideal operating environment for the company, and, as such, we’d never pay “full price” for the stock. That said, we’re thrilled to own the shares at less than 2x our adjusted earnings figure.
Generally speaking, how are you arriving at a multiple of 2? Is that a 12-month earnings horizon, or further out?
The company takes large intangible amortization charges as a result of its historic acquisitions. However, these charges represent neither cash out the door nor a real economic expense. Since we try to look past reported numbers to understand a company’s true operating performance, we add back these intangible amortization charges.
Take the numbers the company reported today. MFW reported $12.9 million in net income, but it charged $30 million in intangible amortization against earnings, and it took a one-time $20 million charge to discharge a legacy liability. Now, we’re wary of companies that always try to make weak earnings look strong with myriad add-backs. We don’t add charges back unless we truly believe that doing so gives us a better understanding of a company’s true earnings power.
We think this is the case with MFW. If you add the $30 million amortization charge and the $20 million one-time settlement charge to the net income figure, you get $62.9 million in earnings for the quarter. If you multiply this by four to annualize it (MFW’s business isn’t seasonal), you get about $250 million in earnings for the year. The market cap is about $460 million, so, by this measure, the stock is trading at about 1.85x earnings.
How is MFW positioned with regard to competitors?
MFW’s businesses are in competitive environments, but the company compares favorably to its competition. Also, competition is unlikely to increase given the fact that the various industries in which MFW competes are declining.
How about its valuation compared to its competitors?
We’ll use Deluxe Corp. (DLX) for comparison. Deluxe has a large check printing business. Like MFW, Deluxe’s business faces headwinds going forward. Use of printed checks is declining as electronic forms of payment become more popular. Deluxe’s stock trades at about 9x reported earnings (slightly less after you add back intangible amortization).
As we said before, MFW trades at less than 2x earnings when adjusted for amortization of intangibles. Now, MFW certainly has more debt than Deluxe, so it might well deserve a lower multiple. However, its more substantial leverage cannot justify a 2x earnings stock price. In our model, we assume a much greater rate of revenue and earnings decline for MFW than the current consensus.
Even with our pessimistic assumptions, the company will be able to earn enough to pay off a huge chunk of its debt load when its credit agreement matures in 2014. We’re confident it will be able to refinance into a much smaller term loan at that time. Also, though MFW has much more debt than Deluxe, it also has much more cash ($312.8 million as of year-end, vs. $17.4 million for Deluxe). We believe that the difference in leverage cannot account for the difference in valuation. MFW is very, very cheap both on an absolute basis and relative to its peers.
Right now, MFW’s market cap is about $460 million. Last year, the company earned about $264 million in adjusted earnings (our calculation, not theirs), up from $237 million in 2009. Since the company has been prudent with costs and has undertaken aggressive restructuring, its earnings are increasing while revenues are flat to declining. Clearly, we don’t need to be very optimistic with our multiple assumptions to arrive at a much, much higher stock price. Five times 2010 adjusted earnings gives us a $68 share price. This isn’t a prediction or a target price, but it is an illustration of how cheap MFW shares are right now.
Does your view differ widely from the consensus sentiment on MFW?
Needless to say, the stock price wouldn’t be so depressed if there wasn’t a great deal of pessimism surrounding the company. At the beginning of 2010, the stock was over $42. Since then, it has declined inexorably to below $24. We’re contrarian investors, so we followed the company as its shares got cheaper and cheaper. We acquired our shares below $25 earlier this year. The consensus outlook for the business is continued decline, and we share this view. However, the current stock price assumes a totally unrealistic rate of decline for the underlying businesses.
We share the consensus business outlook, but we’re contrarians on the stock. MFW’s revenue decline should be steady, but the stock price assumes the business will fall off a cliff. This is highly unlikely.
Does the company's management play a role in your selection?
Ronald Perelman is MFW’s chairman, and he indirectly owns about 43% of the stock. The Wall Street historians among us will be well aware of Perelman’s exploits and of the mixed record investors have when betting alongside him. Though investors aren’t always successful aligning themselves with Perelman, betting with him at $24 per MFW share is very different from doing so at $68 (the stock’s 2007 high).
Perelman is nothing if not an opportunist. He has the financial wherewithal and incentive to acquire the part of the company that he doesn’t currently own, and to pay a substantial premium. Even if he were to pay $40 per share for the rest of the stock, he could finance that with less than two years' worth of free cash flow. We think this is the best way for Perelman to maximize the value of his stake because it would give him control over the company’s current and future cash.
What catalysts, near-term or long-term, could move the stock significantly?
Certainly, a buyout by Perelman would substantially increase the stock price. However, this isn’t the only potential catalyst. After the long and grinding decline in the share price, we believe that there’s very little remaining downside. It’s likely that the current investors are mostly deep value players like us who are willing to wait patiently for the market to realize the value of the company. This could serve as an upside catalyst as well. The weak hands have likely been cleaned out.
As you noted, the company was aggressive about acquisitions before the recession, and those costs are still cutting into operating income (down 25.5% as reported today). The businesses are already disparate; do you see a change in the company's stance toward M&A in the future?
It’s hard to say what MFW’s acquisition strategy will look like going forward, and the company has made some questionable moves in the past. However, we believe that the shares currently offer such a massive margin of safety that we’re not concerned about future acquisitions. If management makes good moves that enhance value, that’s great for us. If it makes misguided moves that destroy value, we’re still in good shape because we purchased the shares at such a low price.
What could go wrong with your pick?
As we said before, MFW’s various businesses operate in unexciting, declining industries. Though we assume that the declines will continue, they could be more harsh than we currently expect (though our expectations are considerably more pessimistic than the consensus). If MFW’s businesses fall off a cliff, it could struggle to service its debts and wouldn’t be able to make future acquisitions to replenish its cash generation abilities. In this case, the stock would move lower.
Now, we regard this scenario as extremely unlikely, but we must always be vigilant to potential occurrences that would materially harm our positions.
Thanks, Geoff, for sharing your choice with us today.
Disclosure: GCA Partners is long MFW.
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