Undervalued Picks From A Pro Investor

by: FAF Research

Prem Watsa, the founder, chairman, and chief executive of Fairfax Financial Holdings, based in Toronto, Ontario, was born in 1950 in Hyderabad, India. He has been called the "Canadian Warren Buffett" by some during successful periods of investing in the past.

After reading Benjamin Graham's book, Prem Watsa acquired an appreciation of value investing. He also admires Buffett, modeling Fairfax after Warren's Berkshire Hathaway. Another great influence on Watsa was Sir John Templeton, who passed away recently and was a large shareholder of Fairfax Financial and close friend of Watsa. He used to visit Templeton at least once a year, and today keeps a large sculpture of Sir John Templeton, in Fairfax's boardroom.

When investing I consider myself as a business analyst, not market or macroeconomic analyst. This means that I invest with the outlook of a businessperson. I look at the business holistically, analyzing all quantitative and qualitative aspects of its management, financial position and its purchase price. I believe that Prem Watsa also shares this basic view. That is why I find interesting to research his holdings and see which of his picks I could research further. You can see more of his portfolio details at whalewisdom.com.

Research in Motion Limited (RIMM)

Research In Motion Ltd., designs, manufactures, and sells wireless solutions to the mobile communications market. Through the development and integration of hardware, software, and services, this company offers not only solutions for seamless access to time-sensitive information, including e-mail, phone messaging, but also Internet and Intranet based applications. The company's offerings also enable third-party developers and manufacturers to improve their products and services with proprietary wireless connections. Research In Motion´s portfolio of products includes the BlackBerry line of wireless e-mail devices, embedded radio modems, and software development tools.

RIMM reports in four business segments as follows: Handheld Devices (81%), Services (16%), Software (1.5%) and other (1.5%).

Despite RIMM's problems, International markets (outside the U.S. and Canada) may provide a new growth opportunity for Research In Motion. In the previous quarters, international return was 80% of total revenue. As smartphones have become the next-generation choice, taking over the market share from basic mobile handsets, I think that Watsa investing in this company was a wise decision. Several emerging markets are witnessing a surge of demand for smartphones. This opportunity provides a scope for Research In Motion to boost revenues going forward. The company has fixed effective sales distribution networks with 565 wireless carriers in over 175 countries. At the end of the third quarter of fiscal 2012, BlackBerry subscriber base was over 75 million, up 35% year over year. Recently Research In Motion confirmed the launch of BlackBerry 10 Platform. The Company released in beta the developer toolkit for the BlackBerry 10 platform, which will allow developers to build and test their apps in preparation for the BlackBerry 10 launch expected in the latter part of 2012.I think a good BlackBerry 10 launch could be bullish for the stock. I think that next Blackberry could be a great competitor to Android (NASDAQ:GOOG) phones.

In spite of facing significant erosion of market share in the last 3 years, Research In Motion is still a profit generating company. Thus, the company is accumulating cash compared to other smartphone manufacturers such as Nokia that are losing money. The company initiated a headcount reduction to optimize its cost structure and has started benefiting from this restructuring process. Moreover, the Board of Directors has authorized a share buyback program of up to 5% of the company´s outstanding common shares. All these initiatives may improve the company´s bottom line going forward.

RIMM´s Current Net Profit Margin is 17.13%, currently higher than its 2010 margin of 16.43%. In terms of Valuation Ratios, RIMM is trading at a Price/Book of 0.7x, a Price/Sales of 0.4x and a Price/Cash Flow of 2.6x in comparison to its Industry Averages of 2.3x Book, 1.7x Sales and 12.0x Cash Flow. It is essential to analyze the current valuation of RIMM and check how is trading in relation to its peer group.

In terms of Valuation, Research In Motion is now trading at 2.9x the fiscal 2012 earnings estimate. This is at a massive discount to both the S&P 500 average and industry average. Regarding the fiscal 2013 earnings estimate, the stock is trading at 3.8x, again a huge discount to both the S&P 500 average and the industry average. I believe this valuation discount derives from the company´s poor performance quarter over quarter and its inability to introduce a really innovative product. The smart-phone addressable market opportunity and the strong brand position of BlackBerry remain primary factors in terms of generating future return to shareholders. Nevertheless, in the recent times, the company lacked credibility regarding the newly launched smartphones due to an extremely challenging market. Going forward, these problems are expected to intensify further as the company is delaying the launch of new offerings. Nonetheless, the company´s low-level of current valuation may restrict further downside in the stock price.

It is important to understand that RIM's balance sheet is still solid, with $1.5 billion in cash and investments against no debt.

Johnson and Johnson (NYSE:JNJ)

Johnson & Johnson aims at the development, manufacturing and marketing of pharmaceutical, medical, and consumer related healthcare products. Its worldwide business is segregated into three sectors: Consumer (includes a broad range of products covering areas of baby care, skin care, oral care, wound care and women's health care, as well as nutritional and over the-counter pharmaceutical products), Pharmaceutical (it has one of the most diverse revenue streams in the industry within the pharmaceutical division), and Medical Devices & Diagnostics (offers wound care and minimally invasive surgical products, as well as orthopedics, and diagnostics). These segments contributed 23%, 37% and 40% respectively to the Company's return, for the full year 2011.

It is important to remark that Remicade, the best selling drug of Johnson & Johnson, continues to maintain momentum. Contributing about 20.6% to pharmaceutical product revenues, the drug produced $5.5 billion sales in 2011, an increase of 19.1% compared to 2010. Remicade overall has received approval for several indications including Crohn's disease, ankylosing spondylitis, psoriasis, psoriatic arthritis, ulcerative colitis and rheumatoid arthritis. Remicade growth derives from strong demand in the rheumatoid arthritis market, as well as a significant unmet need in the Crohn's disease and ulcerative colitis markets. Approval for pediatric Crohn's, psoriatic arthritis and chronic severe plaque psoriasis should help drive growth. Remicade gained FDA approval for the treatment of moderately to severely active ulcerative colitis in pediatric patients who have not responded adequately to conventional therapy in September 2011. Remicade is expected to continue to be a strong contributor to revenues. I am positive on Johnson & Johnson´s settlement of its arbitration with Merck regarding the ex-US rights of Remicade and Simponi. While the impact of this settlement was minimal in 2011, it should boost the bottom-line by 10-11 cents in the long term.

Apart from settled products, several new products recorded strong growth during 2011 and I think that momentum will continue in 2012. These include Prezista, Intelence, Velcade and Invega with growth of 41.3%, 29.2%, 18% and 17.7%, respectively. Additionally, drugs like Simponi and Stelara also hold promise. It was observed that plaque psoriasis patients treated with Stelara showed better clinical response in a head-to-head trial comparing its effectiveness with Amgen(NASDAQ:AMGN)/Pfizer's (NYSE:PFE) Enbrel. Moreover, Simponi received approval in the EU for the treatment of rheumatoid arthritis and other immune system disorders. Meanwhile, the approval of prostate cancer therapy, Zytiga, is a boost for Johnson & Johnson, a positive that is worth paying attention. Other significant product approvals include Incivo (Hepatitis C virus), Xarelto and Edurant. I believe in the forthcoming period, these drugs will contribute significantly to the company's top-line.

JNJ's Current Net Profit Margin is 14.87%, currently lower than its 2010 margin of 21.65%. I do not like when Companies have lower profit margins than the past. That could be a reason to analyze why that happened. Current Return on Equity for JNJ is 17.02%. Lower than the +20% standard I look for in Companies I invest and also lower than its 2010 average ROE of 24.88%.

In terms of income and revenue growth, JNJ has a 3 year average revenue growth of 0.67% and a 3 year Net Income average growth of -9.27 %. Its Current Revenue Year over Year growth is 5.59%, higher than its 2010 Revenue growth of 0.50%. The current Net income year over year growth is -27.46%, lower than its 2010 Net Income y/y growth of 8.71%. I do not like when current net income growth is less than the past year. I look for Companies that increases both profits and revenues.

In terms of Valuation Ratios, JNJ is trading at a Price/Book of 3.1x, a Price/Sales of 2.8x and a Price/Cash Flow of 12.6x in comparison to its Industry Averages of 2.7x Book, 2.6x Sales and 10.2x Cash Flow. It is essential to analyze the current valuation of JNJ and check how is trading in relation to its peer group.

Even though I expect the company to continue facing headwinds in the form of EU and Japan pricing pressure, unfavorable currency movements, manufacturing issues and U.S. healthcare reform, I believe Johnson & Johnson´s diversified business model, lack of cyclicality, strong financial position will continue helping the company pave its way through tough situations.

Johnson & Johnson´s current trailing annual earnings multiple is 13.1, compared to the industry average of 12.7 and 13.9 for the S&P 500. Over the last five years, Johnson & Johnson´s shares have traded in a range of 11.0x to 16.7x trailing annual earnings.

The company has been trying to offset the declining sales of some of its important products by bringing in new products through in-licensing deals and acquisitions. I believe the diversity and strength of the company's underlying businesses will continue to provide strong growth in future.

Johnson & Johnson owns of the best balance sheets in the pharmaceutical industry and holds the coveted AAA credit rating that eludes its peers. Even with the likely small- and mid-cap acquisitions during the next several years, I don't expect any deterioration to the company's solid financial position. Also, as equity is being utilized for 65% of the $21 billion acquisition of Synthes, I don't expect a meaningful deterioration of the company's financial health.

Level 3 Communications (NASDAQ:LVLT)

Level 3 Communications is an international communications and information services company. It runs one of the largest Internet backbones in the world, is one of the largest providers of wholesale dial-up service to ISPs in North America and is the primary provider of Internet connectivity for millions of broadband subscribers, through its cable and DSL partners. The company provides a wide range of communications services over its mile broadband fiber optic network including Internet Protocol services, broadband transport and infrastructure services, collocation services, and patented soft switch managed modem and voice services.

Recently LVLT reported Q1 (MAR) loss of $0.37 per share, ex-debt extinguishment losses, that may not be comparable to the Capital IQ Consensus Estimate of ($0.42); revenues rose 2.5% year/year (pro forma) to $1.59 bln vs. the $1.59 bln consensus. The deferred revenue balance was $1.143 bln at the end of the first quarter 2012, compared to $1.149 billion at the end of 4Q11. Management highlighted in the conference call:

"We are reiterating the guidance we provided on our fourth quarter 2011 call. We expect Core Network Services revenue to continue to grow sequentially for the rest of the year. We remain confident in our expectations for 20 to 25 percent Adjusted EBITDA growth for the full year 2012 from the starting point of $1.216 billion of pro forma Adjusted EBITDA for 2011. Given the capital markets transactions we completed in the first quarter, we are updating our interest expense guidance for the full year 2012, and now expect GAAP interest expense of ~$730 million and net cash interest expense of ~$675 million. We continue to expect capital expenditures for the full year 2012 to be ~12 percent of total revenue. In the aggregate for the remaining three quarters of 2012, we expect Free Cash Flow to be positive. We continue to have confidence in our outlook for this year, and expect to grow the business for the remainder of 2012."

LVLT´s Current Net Profit Margin is -17.45%, currently lower than its 2010 margin of -17.04%.

In terms of income and revenue growth, LVLT has a 3 year average revenue growth of 0.25%. Its Current Revenue Year over Year growth is 20.66%, higher than its 2010 Revenue growth of -4.55%. Both earnings and revenue growth has been very volatile in the recent years.

In terms of Valuation Ratios, LVLT is trading at a Price/Book of 4.8x, a Price/Sales of 0.9x and a Price/Cash Flow of 9.8x in comparison to its Industry Averages of 1.6x Book, 1.1x Sales and 4.2x Cash Flow. It is essential to analyze the current valuation of LVLT and check how is trading in relation to its peer group.

The New York Times Company (NYSE:NYT)

Founded in 1896 and based in New York City, New York, The New York Times Company runs as a diversified media company that includes newspapers, Internet businesses, investments in paper mills and other investments. The company reports through two sectors News Media Group (95% of fiscal 2011 total revenue) and About Group (5%).

The company's other investments comprises a 49% interest in Metro Boston, a 49% interest in a Canadian newsprint company, Donohue Malbaie; a 40% interest in a Madison Paper Industries; a 25% interest in quadrantONE, an online advertising network; and a 16.6% interest in New England Sports Ventures.

The fact that The New York Times Company has been adding diverse revenue streams, which include a circulation pricing model and a pay-and-read model for NYTimes.com and BostonGlobe.com, to make it less susceptible to the economic conditions, got my attention. The company is also adjusting to the changing facets of the multiplatform media universe, which currently comprises mobile, social media networks and reader application products in its portfolio.

The company remains aiming at lowering its debt load through cash produced from operations and divestiture activities. NYT prepaid $250 million 14.053% notes on August 15, 2011. The notes were due to mature on January 15, 2015. New York Times Company´s net debt load was $493 million at the end of 2011 compared with $597 million at end of the prior year. I believe it is prudent on the part of the company to repay the high cost obligations amidst dwindling global credit market.

Recently NYT announced strong circulation gains. The company reported weekday circulation up 73% over March 2011, Sunday up 50% in the Audit Bureau of Circulations (ABC) report. Total average circulation, which includes total print and total digital, was 1,586,757 for Monday-Friday and 2,003,247 for Sunday. The gains in total average circulation over the same period one year ago were 73% for Monday-Friday and 50% for Sunday. These gains can largely be attributed to the popularity of The Times's digital subscription packages, which launched in the United States on March 28, 2011 and also to new ABC rules on reporting digital circulation. For the ABC reporting period, total average digital circulation for Monday-Friday was 807,026 and for Sunday it was 737,408. Sunday home delivery grew by nearly 2% in this latest reporting period, the largest gain in more than five years. And, the group of core print subscribers (subscribers for 2 years or more) to The Times remains a "robust" 845,000.

In fact, management explained in the last earnings call:

"Paid subscriptions to all of the Company's digital packages, e-readers and replica editions totaled approximately 472,000 as of March 18, 2012. This confirms once again the validity of our digital strategy, which has provided a successful model for the industry. Our readers have embraced digital subscriptions and we expect to build on this strong start as we embark on our second year of digital paid subscriptions."

NYT´s Current Net Profit Margin is -1.71%, currently lower than its 2010 margin of 4.50%. Current Return on Equity for NYT is lower than the +20% standard I look for in Companies I invest.

In terms of income and revenue growth, NYT has a 3 year average revenue growth of -7.54%. Its Current Revenue Year over Year growth is -2.93%, lower than its 2010 Revenue growth of -1.92%. I do not like when current revenue growth is less than the past year.

In terms of Valuation Ratios, NYT is trading at a Price/Book of 2.0x, a Price/Sales of 0.4x and a Price/Cash Flow of 13.6x in comparison to its Industry Averages of 3.6x Book, 1.0x Sales and 7.1x Cash Flow. It is essential to analyze the current valuation of NYT and check how is trading in relation to its peer group.

Regarding valuation, the ongoing slump in the advertising market continues to weigh upon the company´s results. Print as well as total digital advertising returns fell 7.8% and 4.9%, respectively, during the fourth quarter of 2011. Nevertheless, the company is witnessing strength across digital advertising in News Media Group. I remain apprehensive about risks that the company faces due to its high dependence on advertising revenues. To mitigate this, the company is adding new return streams by diversifying its business, thereby reducing its susceptibility to economic conditions. The New York Times Company's current trailing annual earnings multiple is 11.3X, compared with 23.2X, the industry average and 14.3X for the S&P 500. Over the last five years, The New York Times Company's shares have traded in a wide range of 6.8X to 87.4X trailing annual earnings. The stock is trading at a discount based on forward earnings estimates.

New York Times is in decent financial health due to the paying of over $500 million in debt over the past four years. That said, the company is still highly leveraged, with lease-adjusted debt/EBITDA around 3 times. Pension obligations are another area of concern, as they add another two turns of leverage. Still, with minimal near-term debt obligations and copious free cash flow thanks to anemic capital expenditures, the company can comfortably cover its debt obligations with a Cash Flow Cushion of over 2 times the five-year base case expense and obligation forecast, along with an undrawn $400 million credit facility.

Disclosure: I am long GOOG.