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Geoffrey Rocca
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I am a California licensed attorney and have over six years' experience as an analyst and investor. My focus is on value investing opportunities in the equity and high yield fixed income areas.
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Fructivore Investments
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  • Analyzing Windstream's value based on its acquisitions and consolidated financials
    I have been following Windstream, a phone company focusing on rural areas, for some time. Over the last couple of years, it has made a number of acquisitions in order to facilitate its strategy of expanding high speed internet and business services in order to offset losses of retail customers. Many of these acquisitions are of private companies, which gives me pause because there are no audited public reports of these companies available, and without these I have no way to determine whether Windstream is paying a fair price or not. Sure, they release their expected synergies and a figure called "adjusted EBITDA," but experience counsels me that synergy is something that can't be counted on, and EBITDA is often meaningless to equity investors even if we knew what the adjustments were.

    Fortunately, last week Windstream released here an estimate of what their operating figures would look like for 2009 and the first three quarters of 2010, if the acquisitions had occurred at the beginning of 2009, including depreciation and capital expenditures. This finally allows us to calculate the overall free cash flows for the combined company to determine whether Windstream's current price represents a good value or not.

    Free cash flow can be estimated as reported earnings plus depreciation and
    amortization, minus capital expenditure. This figure represents the amount that a business can pay to its owners in a given period without diminishing its own earnings power. It is probably the most useful single measure an equity holder's earnings.

    Windstream calculates that operating earnings including depreciation and amortization, were $1940.8 million in 2009 and $1479.4 million for the first three quarters in 2010. (The release goes on to remove expenditures that they consider noncash or nonrecurring, like pensions, restructuring charges, and stock-based compensation. I would prefer to leave these in, particularly stock-based compensation, as it is the shareholders whose share this comes out of). Capital expenditures in 2009 for the combined businesses were $487.4 million, and 2010 year to date were $330.9 million, producing operating cash flow of 1453.4 in 2009 and $1148.5 in 2010 so far, which would be $1531.3 on a full year basis.

    Of course this is only operating cash flow, which must further be adjusted for Windstream's capital structure, interest requirements, and of course, taxes. Windstream did not consolidate this information, of course, because the results would have simply been an amalgamation of the balance sheets of the separate companies, which would be meaningless for projecting future results.

    So, we have to examine Windstream's own capital structure and interest. Windstream, although it has generally assumed the debts of its acquisition targets, cannot simply step into their shoes as a debtor and as such its borrowings are subject to its own interest rate. The company has recently issued an additional $500 million in 7.75% notes to cover the Q-comm acquisition, their latest, but other than that their interest payments can be approximated by the interest they have paid in the first three quarters of the current year. Their interest charges are $378.9 million year to date, which would be $505.2 million on a full year basis. Adding in the interest on the new bonds we get $543.95 million for their future interest requirements. Subtract that from of operating earnings we have pretax earnings of $909.45 million for 2009 and $987.35 million on a current basis. This also gives us an interest coverage ratio of 2.67x, which I think is reasonable for a utility company.

    Finally, we have to apply a tax rate of, say, 38% to deal with state and federal income taxes. A significant portion of free cash flow for Windstream comes from the excess of depreciation over capital expenditures, which means that it comes to them tax-free. However, all things being equal we may expect depreciation and capital expenditures to align with each other in the eventual future, so this free cash flow will eventually become taxable in the fullness of time. Taking away 38% in taxation we have $563.9 million in estimated consolidated free cash flow for 2009, and $612.1 million projected in 2010. This also means that their dividend requirements of roughly $120 million a quarter are covered, thus dispelling the concerns of people who argue, based on reported earnings and not free cash flow, that Windstream is paying out more money than its is making.

    At present, Windstream's market cap is $6.33 billion, which represents a multiple of 10.34x, a figure that is reasonable or even low in today's market. As a further advantage, the gap between depreciation and capital expenditures, projected to be $381 million for full year 2010, is still tax-free at present, which lets them squeeze out millions in extra cash flow for the near future. There is also the possibility that Windstream will be able to produce the synergy that they are counting on, but as I've said I believe in synergy when I see it, as studies show that it fails to materialize in a large proportion of mergers. I would therefore say that Windstream is very attractive at this level.

    What pleases me most, though, is simply that Windstream is willing to give investors the information we need in order to rationally analyze their acquisitions. I wish more acquisitive companies would be this helpful.

    Disclosure: I am long WIN.
    Tags: WIN, telecom, M A
    Jan 18 2:32 AM | Link | Comment!
  • Amkor Technology - Cheapest semiconductor packaging around

    I find that the stocks I like seem to come in pairs. I liked oil and gas producers Linn Energy and Breitburn;  I liked phone companies Windstream and Qwest, and now in the contract manufacturing sectors, I liked Keytronic now I like Amkor Technology (NASDAQ:AMKR).

    Amkor produces semiconductor packaging for other manufacturers, and also perform testing services. Most of their operations are in Asia. Based on today's prices, I would estimate their P/E ratio at a little over 7. I shall go into more detail on that later.

    On the downside, Amkor has significant debt; $2.7 billion in total assets and $2.2 billion in liabilities, producing a price/book ratio of around 2. Although they have significant R & D expenditures, and I have advocated capitalizing these, their interest coverage is still hovering around a little over 2x, firmly in junk status, although their credit rating was recently raised a notch to BB-.

    Furthermore, some of that debt is convertible at various prices, ranging from $14.59 per share to $250 million in notes at $3.02 per share (the price as of Monday's close is $5.61). As a result, there is a significant gap between normal and fully diluted earnings. The $3.02 convertible notes actually do deserve further attention; they were actually sold to the company's chairman in April 2009, and the conversion price is actually lower than the price of the stock was at any time during the month. Most convertible notes are issued with a conversion price that is at a significant premium to the current stock price. Now, I know that April 2009 was still a time of economic crisis and was only a month after the market hit bottom, and as a result financing was hard to come by, but even so this level of blatant self-dealing should be a black mark against the firm.

    Amkor is a cyclical company, and as a result sales for 2009 were no higher than they were in 2005. However, apart from a goodwill writeoff in 2008, the firm has been profitable every year since 2006. The recent improvement in the semiconductor device market has given the firm some improvement in their results as compared to last year. Turning now to earnings, in 2009 they reported earnings of $156 million, but because of operating losses, instead of paying taxes it worked out that the government actually owed them. If their tax liability had been normal, they would have earned only $80 million that year. They took $300 million in depreciation and amortization, and made $235 million in investments, producing free cash flow of $155 million. In 2008 the figure was $275 million, and in 2007, about $220 million.

    Year to date 2010, they have reported earnings of $104 million, which is again propped up by tax effects so the correct figure would be about $67 million. Depreciation year to date has been $154 million, and capital expenditures $143 million, producing free cash flow of about $78 million, or $156 million on a full year basis. The firm also disclosed in their SEC filings that they typically see better results in the last two quarters of the year, and also that they intended to front-load a significant amount of capital expenditures for the year, so it is possible that the full year's results will be even better. Furthermore, they have $300 million in net operating loss carryforwards to burn through as well.

    I think the main drag on Amkor's valuation is their significant debt levels, and although they have not made significant movement towards paying their debts down lately, which I would have preferred them to do, but they have at least been refinancing at lower rates. During the last quarter, they borrowed what amounts to $133 million at a variable rate, currently 4.5%, to be paid down by 2013, to replace $125 million of 9 1/4% notes due 2016 (I assume some of the difference went to loan costs and the rest they kept). They also issued $345 million of 7 3/8% notes due 2018 (which they intend to replace with publicly traded notes by the end of the year, otherwise they will be liable for more interest), to replace their existing notes due 2011 and 2013. These transactions cost them $17.8 million, which is theoretically nonrecurring, but since the company has a large variety of debt outstanding and therefore has to engage in these operations frequently, and also since 2009's results include a $16.8 million gain from similar transactions, I would not say that these costs are nonrecurring enough to eliminate from consideration. Pity they won't give the notes convertible at $3.02 this kind of refinncing treatment.

    As a final aside, I will note that their 10-K is a thing of beauty. Very clear writing and a lot of easily digestible subheadings.

    In the final analysis, I do think that the company is offering a very good return on investment and is capable of managing its debt load.

    Disclosure: None
    Tags: AMKR
    Aug 24 1:10 AM | Link | Comment!
  • Seagate Technology - Too cheap to be this big

    Seagate Technology (NASDAQ:STX) is the world's largest hard drive maker, producing a wide range of standard hard drives and since December of 2009 has also been producing a line of solid state drives, although they were a late entrant to the market. Of course, for enterprise or most consumer electronics, the spinny magnetic disk isn't going anywhere anytime soon.

    But what makes Seagate pop up on everyone's radar these days is, of course, their P/E ratio of 4 and a quarter, which is almost inconceivable in a company this large (market cap of $6 billion and annual sales of about $12 billion) and this well followed. My  initial instinct is that their earnings were distorted by nonrecurring gains, but I found that not to be the case. But I did find that the company had substantial tax benefits accrued and therefore has paid a negligible amount for income taxes year to date, but that only pushes the P/E up to about 7. I can't explain why such a large company should be the subject of this degree of market neglect (and large competitor Western Digital is also trading a low P/E), but I couldn't explain the mania for subprime mortgage derivatives either, and the wise value investor just takes cheapness as he or she finds it.

    I didn't find any major nonrecurring events in fiscal year 2010 (Seagate's fiscal year ends in June), but of course in fiscal year 2009 , like nearly every company with significant goodwill on the books, they wrote theirs off in its entirety. I've stated previously that goodwill writeoffs are a noncash expense, and of course goodwill on the balance sheet is a phantom asset, so it can safely be ignored in the majority of situations. Even ignoring the goodwill writeoff, they reported a loss in fiscal year 2009 as sales declined by 23%, but sales for this year seem to have rebounded at least to 2007 levels.

    In terms of earnings and cash flows, the company's free cash flow has been roughly equivalent to earnings, as depreciation and capital expenditures have tracked each other pretty well over the last few years. It was even nearly positive in fiscal year 2009 owing to a decline in capital expenditures ($600 million as opposed to $900 million), and the low level of capital expenditures seems to be continuing for the first three quarters of 2010 (less than $400 million year to date). Earnings year to date have been $1.2 billion, and depreciation $600 million, so the year's free cash flow to date is $1.4 billion, which is nearly $1.9 billion on an annual basis, creating a current price/free cash flow from operations ratio of less than 3.5. Even if capital expenditures return to historical levels, free cash flow would come to $1.4 or $1.5 billion. This produces, again a price/free cash flow from operations of around 4.5, a definitely attractive situation.

    Of course, price/free cash flow from operations is calculated before interest and taxes, and taking those into account we have a projected long term price/free cash flow ratio of approximately 7, which is still notably low for a company of this size, market presence, and stability.

    Turning to the balance sheet, most notable is the very top entry: over $2 billion in cash, and $200 million more in short term investments. This is almost 1/3 of the market cap. Midway through fiscal year 2009, Seagate suspended its modest dividend, and despite its impressive cash flow, it has also ceased to engage in shareholder buybacks, which totaled $1.3 billion in fiscal years 2008 and 2007. It may be unseemly to want a cash return on investment from a high technology firm, but I think nowadays hard drives are commoditized enough to be able to support dividend payments, and the rate of cash accumulation on the balance sheet is fairly good evidence for my view.

    Seagate claims that they suspended the dividend for liquidity reasons, and on paper their liabilities do come to 65% of their assets, but their interest coverage ratio for 2010 to date is approximately 10x based on earnings alone, suggesting to me that they have more than adequate liquidity. Curiously, their credit rating is a mere BB+, the best of the sub-investment grade ratings, and since a coverage ratio of 10x is more consistent with an AA rating, I think it is the apparent low level of asset coverage that gives the ratings agencies concern.

    However, the apparent low level of asset coverage and high debt should be analyzed in view of Damodaran's suggestion of a "research asset." Research and development produce benefits that are considered by accountants to be too nebulous to capitalize (or lend money against), so they must be expensed. However, R & D produces a definite benefit to the company, and in the hard drive business it is a practical necessity. Seagate has spent approximately $900 million on R & D every year for the last three full fiscal years, and is on track to do so in fiscal year 2010 as well. As R & D has been a large and growing category of "expense" for Seagate I can't say that amortization of this theoretical research asset is faster than its accrual, so it would definitely not be a source of free cash flow. But it should occupy a significant space on the balance sheet; it would certainly explain why a company with $1.5 billion in shareholder's equity can produce projected earnings of roughly $1 billion a year.

    I will add that I don't like their "anti-dilution" policy of buying back shares to offset the effect of stock grants and options exercises; it assures that they buy back stock after it goes up, not before.

    On the whole, though, I expect that Seagate's strong operations backed up by a demonstrated willingness to invest in capital and product development, should allow it to retain its market positions and generate the projected cash flows that indicate it to be a very attractively priced opportunity.

    Disclosure: None
    Tags: STX
    Jul 26 9:17 PM | Link | Comment!
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