Joel M. Greenblatt has been a Managing Partner of Gotham Capital, a hedge fund that he founded, since 1985, and of Gotham Asset Management since 2002. Greenblatt is also the Managing Principal of Gotham Asset Management, LLC, a registered investment adviser (formerly known as Formula Investing, LLC). Greenblatt has, for the past 14 years, been an adjunct professor at Columbia University Business School, where he teaches value and special situation investing. He is also the former chairman of the board of Alliant Techsystems, a NYSE-listed aerospace and defense Company. Moreover, Greenblatt is the chairman of Success Charter Network, a network of charter schools in New York City.
Greenblatt is a graduate of The Wharton School at the University of Pennsylvania, and got his B.S. in 1979 and M.B.A. in 1980. He started Gotham Capital with $7 million, most of which junk-bond king Michael Milken provided. He has achieved double-digit returns since its inception, which gave Greenblatt one of the greatest investing records ever.
I consider it essential to acquire companies that sell products or services that are needed or desired, have no close substitutes, and are not regulated. I examined Greenblatt's portfolio via Whalewisdom.com and found that he also shares those business tenets. I will detail his holdings and the positives I found in each stock.
Saic is a scientific, engineering, and technology applications company aimed at solving problems of vital importance to the nation and the world, in national security, energy and the environment, critical infrastructure, and health, through its deep domain knowledge. The company's approximately 40,000 employees serve customers in the Department of Defense, the intelligence community, the U.S. Department of Homeland Security, other U.S. Government civil agencies and selected commercial markets.
While the softness in the U.S. Defense business is well-publicized, the fact that Saic operates in many pockets of other government businesses that may result in solid long-term growth convinced me that it could be a good pick to research. The firm has a developing energy and environmental business serving the Department of Energy, among others, for example. Moreover, within defense, Saic is positioned in many of the faster-growing segments such as intelligence, surveillance, and reconnaissance (ISR). As such, I believe Saic should be able to navigate through the treacherous waters the latest U.S. deficit reduction plan created.
Since 2006, when the company came into being, it has concentrated deeply on revenue growth, margins, and generating free cash flow. The result has been sales growth averaging more than 8% annually and margin improvement each year prior to fiscal 2012. Apart from this, with the industry currently in a state of flux, management has identified areas of growth in which it is planning to allocate a large proportion of its resources. For defense customers, these strategic growth areas, or SGAs, include ISR as well as cyber security and logistics. These areas tend to be critical to maintaining and improving the readiness and capabilities of the armed forces in the war on terrorism and unusual threats to U.S. security. These are also the less likely areas for cuts in spending, although under the currently contemplated cuts in defense spending I understand that most areas could result affected. Saic's long history in serving these markets, along with its staff of qualified personnel, should allow it to capture its fair share of this growth. Other SGAs include energy-related applications, consisting of engineering and process design on renewable energy and environmental projects. Saic has been a leader in this business for many years. Healthcare information systems are yet another sector with strong growth potential in which Saic has a long history of serving the government.
Saic's current net profit margin is 5.56%, currently higher than its 2010 margin of 4.58%. I like companies that increase profit margins in comparison to other years. It is essential to know the reason why that happened. Current return on equity for Saic is 25.85%. That's higher than the +20% standard I look for in companies I invest in, and also higher than its 2010 average ROE of 22.72%.
In terms of income and revenue growth, Saic has a three-year average revenue growth of 7.59% and a three-year net income average growth of 14.10 %. Its current revenue year-over-year growth is 2.50%, lower than its 2010 revenue growth of 7.71%. The current net income year-over-year growth is 24.35%, higher than its 2010 net income year-over-year growth of 9.96%. I like when net income growth is higher than in the past.
In terms of valuation ratios, Saic is trading at a price/book of 2.0 times, a price/sales of 0.4 times and a price/cash flow of 6.3 times. That compares to the industry averages of 3.2 times book, 0.8 times sales and 9.9 times cash flow. It is essential to analyze the current valuation of Saic and check how is trading in relation to its peer group. Saic appears undervalued.
Saic maintains solid financial health. Total debt to adjusted EBITDA remains below 2 times, where it has stayed since fiscal 2006. I predict leverage in the mid- to high 1 times area during the forecast period. The firm's total debt/capital has remained near 40%, and I don't expect much change going forward. EBITDA/interest coverage has typically exceeded 10 times, and this ratio is expected to be maintained in this range, depending on the firm's financing plans. I project continued strong free cash flow generation, which, together with the firm's typically high cash balances, revolver availability, and access to the debt markets, should provide ample financial flexibility.
Dolby Laboratories (DLB)
Dolby Laboratories aims at developing and delivering products and technologies that make the entertainment experience more realistic and immersive. For nearly four decades, Dolby has led defining high-quality audio and surrounds sound in cinema, broadcast, home audio systems, cars, DVDs, headphones, games, televisions, and personal computers. Headquartered in San Francisco with offices in England, the company has entertainment industry liaison offices in New York and Los Angeles, and licensing liaison offices in London, Shanghai, Beijing, Hong Kong, and Tokyo.
When studying this company for investing, I learned that Dolby's economic moat is derived from the patents that protect technologies it has established as industry standards. Then, once a standard is established, Dolby receives patent royalties on the equipment used to package and view content. For instance, Dolby Digital became the audio standard for traditional DVDs and Dolby leveraged the position into royalty income on the sale of televisions, DVD players, and even computers. Dolby's impressive ability to capture income from multiple sources on a single standard has helped drive licensing revenue growth averaging more than 20% during the last five years. In addition to this, Dolby has become hard to replace at the consumer level because of switching costs. Moreover, competing standards are available, but at least until its patents expire, Dolby's empire remains protected from consumers that demand backward compatibility to support their existing investments in content.
Furthermore, the next key driver for Dolby should be broadcast television. Although Dolby faces a more defying environment, this company is believed to be positioned to capitalize on new opportunities, given its history of innovation and solid brand recognition. The fact that Dolby is established in the United States for digital broadcast, cable, and satellite, and that it also is gaining acceptance internationally, securing a place in the digital standards for many countries including France, South Korea, and Brazil, is yet another positive when it comes to investing. Additionally, I am optimistic about efforts such as Dolby Mobile and Dolby Pulse, where the firm is after securing a position in rapidly evolving markets such as mobile phones and online content delivery. Dolby also is trying to move out of its traditional audio-only role into areas such as video, but I am concerned that the challenges outside of its core audio expertise may prove difficult to navigate. Finally, I believe the strength of Dolby's grip on the home theater experience will set up a strong base from which the firm will be able to successfully broaden into new markets.
Dolby's current net profit margin is 32.37%, currently higher than its 2010 margin of 30.72%. Current return on equity is 19.72%. In terms of income and revenue growth, it has a three-year average revenue growth of 14.28% and a three-year net income average growth of 15.74%.
In terms of valuation ratios, Dolby is trading at a price/book of 2.4 times, a price/sales of 4.5 times and a price/cash flow of 9.9 times in comparison to its industry averages of 1.9 times book, 1.6 times sales and 10.8 times cash flow. It is essential to analyze the current valuation of Dolby and check how it is trading in relation to its peer group.
Dolby features a healthy balance sheet with more than $1 billion in cash and investments with minimal debt. In addition to this, the firm produces free cash flow equal to more than 30% of sales.
Emcor Group (EME)
Emcor Group directs its business through subsidiaries, concentrates in the design, integration, installation, start-up, testing, operation and maintenance of complex mechanical and electrical systems. Additionally, certain of its subsidiaries operate and maintain mechanical and/or electrical systems for customers under contracts and provide other services to customers, at the customer's facilities, which services are commonly referred to as facilities management.
Recently Emcor reported Q1 earnings of $0.40 per share, $0.05 better than the Capital IQ consensus estimate of $0.35; revenues rose 21.6% year over year to $1.54 billion vs. the $1.4 billion consensus. Backlog as of March 31, 2012, was $3.39 billion, an increase of 2.9% over backlog of $3.29 billion a year ago, excluding Comstock Canada. Management noted that, based on the current size and mix of its contract backlog and assuming the continuation of current market conditions, it now expects to generate revenues in 2012 of ~$6.3 billion, vs. its previous expectation of ~$6.0 billion (vs. $6.03 billion Capital IQ consensus estimate). It expects diluted earnings per share of $1.70 to $1.95, vs. its prior expectation of $1.65 to $1.95 (vs. $1.94 Capital IQ consensus estimate). This shows that management has solid expectations for the business.
Emcor's current net profit margin is 2.33%, currently higher than its 2010 margin of -1.69%. Current return on equity is 10.96%. That's lower than the +20% standard I look for in companies I invest in, but higher than its 2010 average ROE of -7.31%.
In terms of income and revenue growth, Emcor has a three-year average revenue growth of -6.12% and a three-year net income average growth of -10.45 %. Its current revenue year-over-year growth is 15.69%, higher than its 2010 revenue growth of -12.55%. The fact that revenue increased from last year shows me that the business is performing well.
In terms of valuation ratios, Emcor is trading at a price/book of 1.5 times, a price/sales of 0.3 times and a price/cash flow of 12.7 times in comparison to industry averages of 1.7 times book, 0.5 times sales and 14.4 times cash flow. It is essential to analyze the current valuation of Emcor and check how it is trading in relation to its peer group.
ITT Corp. (ITT)
ITT Corp. is a global multi-industry leader in high technology engineering and manufacturing. It is aimed at the design, manufacture, and sale of a wide-range of engineered products and the provision of services. The company is based in New York City and employs approximately 40,000 people worldwide.
The company organizes its business into three main segments for financial reporting purposes: Defense and Information Solutions (approximately 53.6% of revenues in full-year 2010 came from this segment), Fluid Technology (33.4%), and Motion and Flow Control (13.1%).
The fact that the company continues to make investments in attractive growth areas such as air traffic management, emerging market expansion, product innovation, defense adjacency, diversity strategy and analytical instrumentation makes investing in ITT Corp. attractive. Moreover, I am especially bullish about two segments: water equipment (primarily pumps), which should benefit from the replacement and upgrading of aging networks in developed markets and the build out of infrastructure in the emerging markets; and ITT Corp.'s defense business, with the bulk of sales coming from electronic and network-centric warfare.
ITT Corp.'s product portfolio and geographical presence keeps enlarging while making a number of strategic acquisitions. For instance, the recently-acquired Godwin Pumps expands the company's global position in water, wastewater and industrial processes, and compliments ITT Corp.'s existing Fluid Technology portfolio. The company is deeply involved in its presence in the emerging markets. The acquisition of Canberra Pumps expands its footprint in Latin America, enabling it to provide more products to the growing oil and gas and mining markets there.
In terms of valuation ratios, ITT Corp. is trading at a price/book of 3.1 times, a price/sales of 1.0 times and a price/cash flow of 11.8 times. That compares to industry averages of 2.5 times book, 1.4 times sales and 10.1 times cash flow. It is essential to analyze the current valuation of ITT Corp. and check how it is trading in relation to its peer group.
ITT Corp.'s current trailing annual earnings multiple is 9.6 times, compared with the 14.7 times average for its peer group and 16.2 times for the S&P 500. Over the last five years, shares have traded in a range of 9.2 times to 22.1 times trailing annual earnings. The stock is trading at a discount to its peer group, based on forward earnings estimates.
The company's financial health is solid and should easily support management's plans to increase revenue an additional 2%-3% annually from acquisitions of companies with $15 million-$50 million of annual revenue. Those kinds of acquisitions are less competitive to bid, can be obtained at lower multiples, and are easier to digest and extract value.
Nonetheless, the after-tax cash costs from asbestos are expected to steadily grow from around $15 million annually for the next five years to $30 million over the following five years, with a highly undefined cash impact thereafter. Keys to the higher cash outflows are gaps in the insurance coverage showing the insolvency of certain insurers and previous insurance settlements, and certain policies from some of its insurers that will exhaust within the next 10 years. In fact, insurance recovery in the tenth year is expected to reach only 25% from well north of 50% currently.
Medicis Pharmaceuticals (MRX)
As an independent pharmaceutical company centering exclusively on the treatment of dermatological conditions, Medicis provides prescription, over-the-counter and physician-dispensed dermatology products, emphasizing its products clinical effectiveness, quality, affordability and cosmetic elegance. This company has achieved a leading position in branded products for the treatment of acne, acne-related conditions, psoriatic conditions and pruritic conditions, while also offering the leading over-the-counter topical analgesic and fade cream product in the U.S.
Medicis' success has stemmed from a handful of key innovations. The company owes an important portion of its success to Solodyn, its extended-release minocycline drug for treating acne. Solodyn accounts for more than 50% of Medicis' revenue and perhaps an even larger portion of earnings, and is known as the largest dermatology drug in the world by sales. In addition, Restylane (the first hyaluronic acid dermal filler for wrinkles approved in the United States) and Dysport (the second U.S.-approved botulinum toxin for wrinkles) make Medicis a major player in the cosmetic surgery market.
Medicis' current net profit margin is 17.55%, currently lower than its 2010 margin of 17.62%. Current return on equity is 15.25%, lower than the +20% standard I look for but higher than its 2010 average ROE of 16.20%.
In terms of income and revenue growth, Medicis has a three-year average revenue growth of 11.68% and a three-year net income average growth of 130.92%. Its current revenue year-over-year growth is 3.62%, lower than its 2010 revenue growth of 21.68%. The current net income year-over-year growth is 2.60%, lower than its 2010 net income year-over-year growth of 62.39%.
In terms of valuation ratios, Medicis is trading at a price/book of 2.7 times, a price/sales of 3.5 times and a price/cash flow of 14.6 times in comparison to its industry averages of 2.6 times book, 2.5 times sales and 12.9 times cash flow. It is essential to analyze the current valuation for Medicis and check how it is trading in relation to its peer group.
Regarding financial health, management maintains a solid balance sheet, which I think helps mitigate Medicis' higher-risk operations. The company does not have net debt. Historically, Medicis' EBITDA/interest expense ratio typically exceeds double digits, and after repurchasing debt in 2008, the debt/capital ratio fell to around 0.2. Although cash flows are likely to become more variable in the future due to increased generic competition and higher research expenses, I think management will still create plenty of cash to meet current financial obligations.