Three Cash-Heavy Long Ideas

In this article, I want to consider (for patient investors) three bottomed out stocks, Circuit City (CC), Heely’s (HLYS) and Moody’s (MCO), that have fallen out of investors’ favor. All three stocks trade a few dollars above their 52-week lows, hoard tons of cash, and therefore provide significant upside potential with a large margin of safety.

My top pick is CC, the iconic electronic goods retailer. CC has fallen from $22 in December 2006 to $5-$7 recently. Its problems include severe price competition from Best Buy (BBY) and Wal-Mart (WMT), operating losses in the past two quarters, management turnover and poor inventory management. Given its financial and operational woes, CC should be sold. The most likely buyer I believe would be a turn-around private equity firm. Other interested acquirers may include foreign retailers looking to gain a foothold in the USA or foreign billionaires with retail interests such as Carlos Slim (who owns the competing CompUSA chain) or Li-Ka Shing. CC’s sale may be aided by an activist shareholder and a depreciated dollar.

CC is best valued as a sum of its parts. I value CC’s U.S. and international divisions using revenue multiple and book value respectively. The valuation of the U.S. division applying a 0.15 revenue multiple (compared to Best Buy’s 0.57 revenue multiple) U.S. sales of $11.9 billion for the year ended February 28, 2007, is $1.78 billion. In addition, the book value of CC’s international business (comprised of 806 stores in Canada, including 506 company-owned stores, which may be worth substantially more) is $0.36 billion. Notably, CC will benefit from the Canadian dollar’s strength in case the international division is sold. Accordingly, I estimate CC’s break-up value (including cash) at $2.56 billion, or $14 per share, an upside potential of 89%.

My second recommendation is HLYS, a firm that designs, produces, markets and distributes shoes with in-line skates. HLYS stock price fell from low 20s to high single digits in August 2007 when it reduced guidance and cited increased inventory at the retailer level. However, I consider these problems temporary, mainly arising out of HLYS’s rapid growth. With a unique niche product protected by U.S. and European patents, HLYS enjoys vast opportunities to distribute its products in the U.S. and international markets. Furthermore, HLYS added Famous Footwear and Shoe Carnival as customers in the third quarter of 2007.

HLYS management predicted short-term sales momentum attributable to these new customer relationships, which would add 700 doors, bringing the U.S. total to approximately 6,000 doors. With a comfortably high operating margin of 19.2% (using Q3 2007 income statement), HLYS can support discounting and sales promotion activity to clear retail inventory, should it choose to do so.

I see limited downside to HLYS, because currently it trades at 53% of cash and 72% of net current working capital (using 09/30/07 balance sheet). Cautious investors are advised to await management’s update on resolving inventory issues and sales trends in the holiday season. Based on my assumption that HLYS will come out clean after two or three quarters, I estimate the stock is worth $11-$12, an upside of 77% from the current price.

My last and most easily understood recommendation is MCO. It provides credit ratings for fixed-income type securities and allied services. MCO offers a very compelling valuation entry point right now, as it has fallen from the $70-$73 range in June 2007 to $36-$40 range in early December 2007. As expected, investors are concerned about tightening credit markets, lawmakers’ criticism, a pending SEC probe regarding managing conflicts in rating mortgage-backed securities and reduced earnings guidance in September 2007. The investor concerns that are based on a short-term “find a scapegoat for the current mess” mentality are unfounded. I believe that credit rating agencies serve a useful purpose in guiding investors and they will come out unscathed out of the current credit debacle.

I like MCO’s solid business model, which enjoys sustainable competitive advantages. MCO and similar firms earn steady fees, because all bonds are required to be rated. Therefore, MCO has steady predictable cash flows linked to secular growth of debt and debt related instruments globally. Furthermore, aspiring credit agencies face the formidable task of gaining investor acceptance and developing proprietary rating systems. Also, debt issuers and investors want to deal with the minimum number of credit agencies.

As a result, the credit rating industry is a natural oligopolistic market and possesses high barriers to entry. As such, MCO faces minimal competition (mainly from Standard & Poor’s and to a limited extent, from Fitch Ratings). In addition, MCO enjoys low business risk because of high operating margins (70%+) and revenue streams coming from diverse regions and credit market segments.

MCO’s valuation is largely driven by its share repurchasing activity. MCO aggressively repurchased $1 billion and $1.4 billion worth of its own stock in 2006 and the first 3 quarters of 2007 respectively. Extrapolating these share repurchase trends, I expect MCO to repurchase stock annually equivalent to 10%-12% of its current market capitalization of $10.2 billion. Admittedly, MCO has used borrowed money to repurchase its stock. Even so, MCO’s financial risk is low, because MCO’s trailing 12 months EBITDA of $1.26 billion adequately covers its total debt of $1 billion. Applying an 11 EBITDA multiple to MCO’s trailing 12 months EBITDA and adjusting for balance sheet cash, I estimate MCO’s fair value at $55, an upside of about 40%.

Disclosure: Author doesn't hold positions in any of the stocks mentioned.

Comments

[Aquater]

Very well reasoned and well researched piece. Let us see how the three stocks do in the next year or longer term.

[ceguy]

Many facts you have about CC are wrong. First, they lost money the last FOUR quarters. Second, the Canadian sub has been for sale for some time now with no takers. It's losing money and has a real value of zero. Third, book value is highly overstated due to off balance sheet lease commitments, overvalued inventory, and the bulk of property being store equipment, not real estate. Furthermore, Carlos Slim no longer owns CompUSA having just sold it after losing several billions of dollars. The best bet is to let it go bankrupt and then reorganize like Lampert did with Kmart. Shareholders lost everything on that one.

[Long-Short Guy]

The problem with businesses like Circuit City is that they have heavy fixed costs and can therefore lose a lot of money, resulting in cash burn. Also, turning round a business like that is hard -- it's been underperforming for ages.