H.J. Huneycutt - Seeking Alpha

Green Bankshares: Value in the Tennessee Valley

H.J. Huneycutt — Thu, 12 Nov 2009 08:53:10 -0500

H.J. Huney submits:

In my last article, I laid out a brief case on why I’ve been searching around in the world of small commercial banks. My basic hypothesis is that there are some huge opportunities in that sphere right now, as investor fear is at all-time highs. Contrast that to the rest of the market, which has been on an undeniable bull run over most of the past half year.

It’s easy to understand why people are scared of small commercial banks. They are not easy to analyze, the risks are high, earnings look terrible, and since these banks don’t qualify as “too big to fail,” the government isn’t going to come in and rescue them. In fact, the FDIC seems to close down a few banks every single Friday.

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Hampton Roads Bankshares: Strong Value in the Horrific World of Commercial Banks

H.J. Huneycutt — Tue, 10 Nov 2009 05:53:19 -0500

H.J. Huney submits:

Over the past few months, the market has climbed upwards relatively quickly, which has eliminated a lot of the deep bargains available. There are still some great deals out there and I’ve been fortunate enough to discover a few, but it’s become much more difficult to find stocks with the highly favorable risk-reward balances we saw earlier this year.

One sector where I believe huge opportunities have opened up is small commercial banks. These are not the Banks of America (BAC), the Citigroups (C), or even large regional players like SunTrust (STI) and Regions Financial (RF). Rather, these are often community banks or small regional banks that may operate in a few metropolitan areas.

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Buying Apple Today: Like Buying Microsoft in 1998?

H.J. Huneycutt — Fri, 11 Sep 2009 05:13:02 -0400

H.J. Huney submits:

It's rare that I venture into the world of megacap companies. I'd rather find underpriced small cap companies, particularly ones in volatile industries. Yet, it occurred to me that in the past year, I have never once looked at Apple's (AAPL) financials. There were reasons for that:

It's a megacap company and large companies typically have less room to grow.
It's too heavily followed to create much in the way of huge pricing inefficiencies on the downside; plus, it's been a trendy stock for years, which drives up its price further.
I've never felt comfortable analyzing companies with their hands in too many jars.
The consumer electronics industry is constantly in flux and most investors tend to value these companies based on overly optimistic long-term assumptions that rarely hold true.

All the same, given AAPL's market dominance over the past few years, you'd think I might have looked into it once before just so I'd know what was up with it.

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The Hun's Top 12 Value Buys

H.J. Huneycutt — Fri, 28 Aug 2009 05:55:50 -0400

H.J. Huney submits:

Over the past few months, I have made several successful calls and have earned an 80%+ return on my simulated portfolio; not to mention, my real life portfolio. Back in March, I began buying into quality REITs that could be had for bargain-basement prices. I have continued to research more companies in the REIT sector, most recently writing about DCT Industrial Trust (DCT) in late July. I recommended buying into Discover Financial Service (DFS) under $7 in late April; it now trades near the $14 mark. I even argued that microcap boat and yacht dealer MarineMax (HZO) could be a great buy under $3.50. HZO now trades over $7.50.

Given the market’s run-up, however, my views have shifted a bit. Once we tipped over Dow 9000, I felt as if we were entering a “change of seasons” and that it was time to start shifting my portfolios a bit. Marine Max might’ve been attractive at $3.50 and Discover might’ve looked good at $7, but at the current prices, I believe risk exceeds reward potential, so they are not great buys any more. The market changes quickly and you have to stay ahead.

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Harris Teeter Owner Ruddick Corp. Worth a Long Look

H.J. Huneycutt — Mon, 10 Aug 2009 10:00:04 -0400

H.J. Huney submits:

For those who follow my writings here at Seeking Alpha and my investment analysis at Motley Fool, you might know that I tend to veer towards stocks that offer the highest reward potential, which means I end up buying a lot of “medium risk” and “high risk” securities. However, there’s nothing I love more when the market offers stocks in what might-be-traditionally considered “lower risk” sectors at prices with “high reward” potential.

When I first started buying into REITs that was part of my rationale; there were many REITs with reasonable leverage and excellent hard assets on their balance sheets that were selling at ridiculous discounts to Net Asset Values [NAV] and historical cash flows. Even if I assumed worst-case scenarios, I’d still end up with values higher than the market in many cases. We’ve seen companies like Colonial Properties Trust (CLP), Brandywine Realty Trust (BDN), and DCT Industrial Trust (DCT) make significant gains since I originally wrote about them. At Motley Fool’s CAPS, I also mentioned another company with a lower beta that offered sizable reward potential recently that has started moving upwards: Callaway Golf (ELY).

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DCT Industrial Trust: A Best Buy Among REITs

H.J. Huneycutt — Tue, 21 Jul 2009 03:57:35 -0400

H.J. Huney submits:

Back in March, I postulated the idea that several REITs on the market were potentially screaming buys. Here in July, most of the REITs have seen significant appreciations in price as the market seems to slowly being realizing it overreacted just a tad.

Despite the run-up, I still believe many REITs are strong buys and offer opportunities for “multi-bag" returns.

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CBL & Associates: Less Margin for Error than Alternatives for This Undervalued REIT

H.J. Huneycutt — Thu, 16 Jul 2009 12:02:15 -0400

H.J. Huney submits:

Since early March, I have promulgated the idea that REITs have been overly punished by the market. While there are certainly some garbage REITs out there, there are also high-quality REITs selling at bargain-basement prices. Prices have risen since early March, but I still believe REITs in the aggregate tend to be undervalued. All the same, I want to focus my investing efforts on particular companies with attributes I like.

In my recent article on Pennsylvania REIT, a dissenting commenter wrote:

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Laying the Foundations for a Post-Oil Age Economy

H.J. Huneycutt — Wed, 15 Jul 2009 09:13:52 -0400

H.J. Huney submits:

For years, Americans allowed themselves to be convinced by mis-truths parroted by politicians and the National Association of Realtors that an economy based on home building and sprawl could thrive permanently. Just like the deluded investors in the Roaring Twenties who convinced themselves that stocks could go up forever, people became convinced that home values could see dramatic appreciations in value for the rest of time, with no negative side effects.

However, the myth of American economic infallibility has been destroyed over the past two years. Now, Americans suddenly find themselves reexamining the situation. In truth, this might only be the beginning of America’s economic decline as this nation is not built to thrive in a resource constrained world.

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Lexmark: Solid Value Play Under $18

H.J. Huneycutt — Fri, 12 Jun 2009 10:32:42 -0400

H.J. Huney submits:

I’ll admit that I’m a sucker for deep value stocks. When I spot a stock that appears to be selling well below its intrinsic value and seems to offer extremely favorable risk-reward prospects, I get giddy. Is that wrong? I hope not, because it feels so right.

So how do I spot deep value plays? I use screeners, glance at favorite plays recent picks in Motley Fool’s CAPS community, and read articles from similar minded folks. A couple of weeks ago, I spotted one of my favorite players at TMF green thumb Lexmark (LXK) and I became interested. Value Expectations also mentioned it in their “30 Attractive Companies Under $30” piece, so I decided to take a closer look.

Overview

Lexmark develops printing and imaging products for both home and office purposes. They manufacture laser and inkjet products and also sell dot matrix printers. Their products are sold in more than 150 countries and roughly 59% of their revenues are derived from international sales, with about 2/3 of that coming from Europe. Rather than spending an enormous amount of time describing what they do, I’ll simply suggest that you check out their web page if you want to learn more.

What makes Lexmark attractive to me is their historical sales record when compared to the stock’s current selling price. While their profitability has declined over the past six years, they have still been able to rake in a significant amount of free cash flows over the past few years. Under $17, that could make this quite a bargain. But before jumping into earnings and cash flows, let's take a glance at the foundation that all of it is based upon --- the balance sheet.

The Balance Sheet and Liquidity

Lexmark’s executives seemed to go to great lengths to talk about their strong balance sheet in their 1st Quarter earnings call. After examining LXK’s balance sheet, I felt as if the executives slightly exaggerated how great things were. My biggest qualm with their interpretation is that they suggested that having a ‘credit facility’ made their balance sheet strong. I imagine their credit facility is somewhat dependent on their cash flows. While having access to credit undoubtedly makes them more liquid, I don’t think it automatically gives them a “solid balance sheet.” Nevertheless, they are not in poor shape by any means.

Lexmark has a 72% Liability/Value ratio if we take their accounts at face value (and I rarely do). However, that might be propped up a bit. I worry that their inventories might be slightly overstated (due to the economic environment) and I’m extremely frustrated by their lack of disclosures in regards to their “other assets.” It's unclear to me what items were thrown into this basket.

Is goodwill in there? Based upon a scan of their most recent 10-K, it would appear that they do have “goodwill”, but I have no clue how sizable this account might be. It’s completely possible that there are other intangible assets in this account, as well. Given the fact that “other assets” constitute nearly 10% of LXK’s total assets, I think more visibility into this account is needed. As such, I have decided to indiscriminately discount it by 60%. If I can’t see it, it isn’t there, but I’ll give them the benefit of the doubt on 40% of it.

After discounting inventories by 20% and discounting “other assets” by 60%, I came up with adjusted stockholders equity of $598.8 million:

After these adjustments, I come up with an adjusted Liability/Value ratio of 78.7%. A bit higher than my original number, but still not terrible. That leaves Lexmark with adjusted assets of $7.64 per share.

As for liquidity, it’s not too bad. Current ratio is at 1.71 and quick ratio is at 1.11. I also use another metric for liquidity that I call the “Huney ratio.” I figure that since I made this metric up, I should at least get to name it after myself. Essentially, this metric is similar to the quick ratio except I add in cash flows from operations for the prior four quarters. Thus the formula is “(Liquid Assets + CFOs for Prior 4 Qtrs)/Current Liabilities)”. It came up with a Huney ratio of 1.31.

One final thing to consider is Lexmark’s pension obligations. Seeking Alpha writer Saj Karsan mentions this issue in a recent article. While I don’t believe it would be prudent to ignore that issue, I personally do not worry about it too much because the shortfall will decline as the market rises over time.

Overall, the liquidity picture looks alright and the balance sheet is not a huge cause for concern. I would like to see LXK lower their long-term debt of $648.8 million a slight bit, but it appears to be quite sustainable.

Earnings, Cash Flows, and Margins

Now it’s time to shift gears and look at the earnings and cash flows pictures. The first chart gives a glimpse at Lexmark’s earnings, cash flows, and a few other figures over the past six years. These are all raw numbers and denominated in millions:

The second chart is similar to the one above, except it shows some of the relevant figures from above in per share terms on a constant basis. I used 78.4 million shares to run this analysis, which was the stated number of diluted shares for LXK as of March 31, 2009:

From the above chart, one can see that Lexmark has had strong earnings and free cash flows. However, there is one disturbing trend --- both seem to be gradually moving downwards. In order to get to the bottom of this, I started looking at LXK’s revenues, expenses, and margins --- all of those are displayed in the below chart:

click to enlarge

Surprisingly, we find out that revenues have not declined significantly. Nor have LXK’s gross margins shifted in any dramatic style. These figures fluctuate a bit, but they mostly stay in a steady range. Rather, it’s LXK’s operating expenses that seem to be the real killer. If we examine that more closely, we find that their research and development (“R&D”) and selling, general, and administrative expenses (“SG&A”) are the culprits.

Both R&D and SG&A have been trending upwards despite the fact that revenues have not really been increasing. If you look at the last three lines of the chart, you can see that the decline in operating margin correlates strongly with the rise in R&D as a percentage of revenues (“R&D/rev) and SG&A as a percentage of revenues (SG&A/rev)

Valuation

The trickiest part about doing a valuation for Lexmark is trying to predict whether their negative growth will continue into the future. Will Lexmark eventually hit a steady state or will they continue to slowly drift downwards? One of my bigger concerns is the fact that I rarely see Lexmark printers. Hewlett Packard (HPQ) seems to dominate the market. I’ve seen a number of other brands in stores and at the office, but I can’t recall seeing too many Lexmark printers. All the same, Lexmark sells enough to be profitable --- even if not completely visible.

I decided to use an 11% cost of capital (“COC”) for Lexmark. I normally do not spend too much time coming up with a COC for companies --- I glance at the interest paid on their debt, look at their leverage, and try to play things conservatively. 11% might be a bit high, but it seems like a safe figure to me.

For all of my scenarios, I decide to come up with an initial year free cash flow ("FCF") forecast and simply use a long-term growth rate (“LTGR”) to project FCFs into the future. My difficulty was deciding what LTGR to use. I decide to run three sets of scenarios: the first uses a 3% LTG rate, the second uses 0% growth, and the last uses a -3% LTGR. Here are the results:

Think of the results as more of a set of possibilities. It allows us to see how Lexmark might be valued depending on what direction it goes in the future.

Analysis

I give Lexmark a probable valuation of $28 based on my research and valuation scenarios. This is sort of a hybrid between Scenario #6 with -3% growth and Scenario #6 with 0% growth. This might be a bit conservative, but I feel it’s a safer valuation than one that assumes LXK will continue to grow in the future.

My downside probable valuation is $22. This comes from Scenario #4 in the -3% Growth chart.
My upside probable valuation is $45. This comes from Scenario #8 in the 3% Growth chart. This gives me a rather large probable valuation range of $22 - $45, which shows how LXK’s stock could jump significantly if the company where able to shift their profitably upwards in minor ways. Still, I see a slight decline before eventually reaching a steady state as more likely.

For the next five years, I’d give a downside risk at $5. This is based on moderately high leverage, an LXK’s adjusted net tangible assets with a further discount to their “other assets” account, and short-term negative profitability scenario.

Upside potential is $60. I see this as unlikely, but for this to happen, the market would have to become very bullish again and Lexmark’s profitability would have to start moving back upwards towards the $3.50 free cash flow range.

Conclusion

I can find a lot of reasons to be negative on Lexmark, but I can also find a lot more reasons to be positive on the stock at the current levels. Under $17, it would appear the market is assuming that LXK’s profitability will decline at a massive rate. Risk-reward favors the long side greatly.

I would consider this a moderate risk stock that offers a decent possibility of a 100% gain over the next few years. However, I believe gains in the 60% - 80% range are more likely. That’s not bad considering the company’s historical free cash flows and net assets. Overall, this is a good value play with strong upside potential.

For my KaChing $10 million simulated portfolio, I have initiated a 1% position in LXK. As I am currently building up my cash cushion, I have not added this to my actual portfolio. However, if the price were to stay suppressed for the next few months, I might consider adding a position at some point.

Disclosure: Authors holds no position in LXK.

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Pennsylvania REIT: A Bargain in the Retail Sphere

H.J. Huneycutt — Wed, 10 Jun 2009 05:30:20 -0400

H.J. Huney submits:

The market continues to slowly inch forward, but there are still a lot of bargains out there. While the prospects for real estate continue to appear dim, many REITs are still worthwhile investments as the market has already priced the equivalent of a commercial real estate apocalypse into many securities. Even if there are a lot of companies that I would keep away from, my basic hypothesis is that there are many quality REITs getting overly punished right now and prudent investors can gobble them up for sizable discounts.

Thus far, I have examined seven REITs in detail:

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MarineMax: Boating Liquidation Sale of a Lifetime?

H.J. Huneycutt — Thu, 04 Jun 2009 03:41:21 -0400

H.J. Huney submits:

The odd thing about investing is that it is often a counter-intuitive pursuit. You may realize that a certain company has favorable prospects moving forward, but if the market has already priced these expectations into the price of a security, are you really getting a good value? Oftentimes, the answer is “no.” Buying into a company with horrifying bleak near-term prospects might seem suicidal but if the price is right, then why not?

Over the past few months, I have written extensively about seeking out bargains amongst Real Estate Investment Trusts (REITs). I have found quality companies that I believe can be had at huge discounts such as Brandywine (BDN), Lexington (LXP), and Winthrop (FUR). I have also found REITs that appeared to be priced well under liquidation value such as Colonial (CLP) under $4. These bargains have become available because of widespread fears about commercial real estate. Yet, these stocks are often priced with massive cushions built in so that even with massive declines in property values and high vacancy rates, you’d still be getting a deal.

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Jet Blue: Value Buy and Oil Hedge

H.J. Huneycutt — Tue, 02 Jun 2009 14:48:53 -0400

H.J. Huney submits:

"If capitalists had been present at Kitty Hawk when the Wright brothers' plane first took off, they should have shot it down." - Warren Buffett

Airlines --- the favorite punching bag of the market!

What other industry in America can claim 100 bankruptcies since 1978? What other industry that has managed to survive for over a century can claim to have never turned a net profit? What other industry has been so thoroughly propped up by the government, but still manages to fail every decade or so?

I would definitely not call myself a fan of the airline industry when it comes to investing. Most of the time, I’d rather be on the short side of airlines, but this isn’t one of those times. Airlines have been beaten down very thoroughly as oil prices have been rising over the past few months. This does not mean that I am in love with the industry by any stretch of the imagination. Nor does it mean that I would suggest buying airlines indiscriminately on a technical basis. However, I do believe a few air carriers could offer attractive value propositions at the current price levels. This might be especially attractive to those with bullish positions on oil, as this could give you a decent hedge on those positions.

On that note, let’s examine the case for mid-cap air carrier Jet Blue (JBLU) as a long candidate.

Overview

Jet Blue is the youngest of the major airlines, commencing service in 2000. It prides itself as a “value airline” with great customer services. The company also frequently harps on some of the minor luxuries available on their flights (e.g. free television, unlimited snacks). The basic business strategy seems to be cheap flights and good (but not costly) entertainment.

In its latest 10-K filing, Jet Blue claims to be the “most fuel efficient” of the airlines and serves 52 different markets in 19 states, Puerto Rico, Mexico, and a handful of Latin American and Caribbean nations. The majority of their operations have originated in New York City and they are the largest airline by number of passengers flying out of JFK International Airport. Jet Blue is also the largest carrier in Boston in terms of destinations served.

Jet Blue believes it has the lowest operating costs of all major airlines, calculating their “cost per available seat mile” at 5.94 cents. It only uses two types of aircraft: the Airbus A320 and the EMBRAER 190 and has an average aircraft age of 3-4 years. The frequent pitch is that Jet Blue is one of the best airlines from an investor perspective because its young fleet gives it greater fuel efficiency. Of course, this begs the question, what happens as JBLU’s fleet ages? I’ll leave you to determine the answer to that one. All the same, there still could be some value here.

With that, let’s move on to the financial aspects of JBLU that potentially make it attractive.

The Balance Sheet and Earnings

Comparatively speaking, Jet Blue has one of the strongest balance sheets amongst the major airlines. Only Southwest (LUV) seems to be in similar shape. The following chart lays out the Net Tangible Assets (NTA) of the major airlines and shows the ratio of Liabilities-over-NTA:

As you can see, most of the major airlines have a lot of leverage. Jet Blue and Southwest don’t appear to have anywhere near as much debt as the other carriers, which is a significant long-term advantage. Jet Blue also has a current ratio of 0.97, which compares favorably with many of their competitors.

As with most air carriers, earnings seem to shift back and forth for Jet Blue. Due to high depreciation and amortization charges, I would not peg “Net Income” as the most appropriate measure for a DCF valuation. The following chart lays out five different earnings-related measures over the past five years:

Please note that I translated all items to a per share basis based on 273 million shares outstanding (which assumes some slight dilution). For this reason, EPS figures are not necessarily going to match the figures on JBLU’s financial statements, but I do this more to create a steady state, while still speaking in per share terms.

The next chart lays out the 3-, 6-, and 9-year averages based on the above chart.

I also decided to chart out JBLU’s first Quarter ’09 figures:

If you need a quick guide to my abbreviations, here ya go:

CFOs = Cash Flows from Operations

FCFs = Free Cash Flows

NI (DEPS) = Net Income (Diluted Earnings Per Share)

NI + DA = Net Income plus Depreciation and Amortization

INCR in SE = Increase in Shareholders’ Equity

Overall, it would appear that JetBlue has been ever-so-slightly profitable over the long run --- which stands as a pretty big feat in the airline industry. Net Income Plus Depreciation & Amortization (NI + DA) would seem to be the most useful metric to use for my valuation since I calculate asset values separately. However, I could see the merits behind using Net Income, as well.

Other Considerations

My biggest concern from the above charts is Jet Blue’s highly negative free cash flows. That can be explained to some extent by the fact that they are a newer and growing airline. All the same, CapEx has dramatically exceeded Cash Flows from Operations in many years. In their most recent earnings call, CEO David Bargar stated that Jet Blue has taken steps to reduce capital expenditures in 2010 and wants to generate positive free cash flow.

The most recent quarter reflects this to a degree as operating cash flows were $124 million compared to CapEx of $149 million (which includes $58 million in flight equipment sales). That suggests that JBLU could be headed on the track towards positive FCFs.

Also from that earnings call (see call transcript), CEO David Bargar suggests that Jet Blue remains dedicated to not “nickel-and-dime... customers. While this might harm the bottom line in the short run, I believe this is more prudent for a long-term approach." One of the main reasons I like Jet Blue from an investment perspective is that they seem to have a more long-term view than their competitors.

One other area of interest is business travel. Jet Blue has not historically been the airline of corporate travelers, but as companies across the board look to lower their costs in the current environment, it stands to reason that JBLU may be a beneficiary due to their low-cost model.

Taking into account the financials and potential growth factors, let’s take a look at potential valuations for Jet Blue.

Valuation

I decided to run four quick DCF valuation scenarios. Jet Blue’s net tangible assets are worth roughly $4.80 per share. I decided to discount that to $4.50 in my first three scenarios for no particular reason, other than to be a little more on the safe side. Since JBLU is still growing and has significant CapEx that distorts its free cash flows, I’ve decided that Net Income Plus Depreciation/Amortization (NI + DA) is the best measure of “added value” for my valuation. However, this number is a bit more aggressive than Net Income/Earnings Per Share (EPS), so some of these scenarios veer closer to EPS.

For all of these scenarios, I used an 11% cost of capital. That might be a bit high given the stated interest rates I found for JBLU, but since I consider all airlines high-risk, I don’t think it’s a bad idea to play things on the conservative side.

For each scenario, I state an initial year “added value” figure (which represents a long-term average) and assume a 3% growth rate. Here’s a chart laying out the scenarios:

Analysis

Based on my valuation scenarios and all the data I have, I would value Jet Blue at $8. That would put my valuation closest between Scenarios #1 and #2 above. 35 cents per share in yearly “added value” seems to be a bit on the conservative side when compared to historical NI+DA figures that average closer to 50 – 60 cents per share on a yearly basis. However, given the risks involved with airlines, I believe it’s best to stay on the conservative side (without going overboard) and as I stated earlier, I can see legitimate reasons to believe that Net Income is a more accurate measure of real earnings.

My downside probable valuation is $6, which is a slight discount to Scenario #1. It would assume that Net Income is a better measure of added value and that GAAP earnings will drop a slight bit. My upside probable valuation is $11.

For downside risk --- I always warn people to assume it’s $0; but given JBLU’s assets and position, $2 might be more realistic. That figure implies that JBLU becomes slightly unprofitable over the long-term and that their net tangible assets are slightly overstated.

For upside potential, I’d suggest $13. I base this on their steady growth pattern (particularly in the NI + DA) figures.

Conclusion

While I like Jet Blue better than all the other major airlines (save perhaps Southwest), I wouldn’t go so far as to recommend it as a long-term investment (which I define as 2-10 years). I join Warren Buffett and other airline skeptics in that regard. Under $5, I think of it more as a medium-term value buy (6 months to 2 years). If I bought in at $4.60 and the stock hit $7 within the next 5 months, I would probably go ahead and sell it; especially considering the volatility of the airline stocks.

One reason I believe this might be a good buy right now is that the fundamentals don’t support oil at $60+/barrel at the current time. Inventory levels are too high, so if oil retreats a bit, the airlines will probably move upwards. But even if they don’t, I believe you have some margin of safety with JBLU based on their net tangible assets, fuel hedges, and past history of minor profitability. If you’re not completely convinced (don’t worry, I’m not either), it might be useful to think of it more as a potential hedge for bullish oil-related securities.

For my simulated $10 million portfolio, I have initiated a 0.9% position in JBLU at an average cost of $4.47 per share. I’ve also initiated a 0.7% position in Southwest (LUV) at $6.80 per share. As I suggested, this is more of a hedge play on my oil stocks (e.g. USO, USL, HERO, ATW), while giving me some potential to nab up some bargains. I will probably not consider adding this to my actual portfolio unless I see JBLU drop below $4 --- but it’s definitely worth keeping an eye on.

Disclosure: No position in JBLU or any airlines

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Brandywine Realty: A REIT Bargain Even with Impending Carnage

H.J. Huneycutt — Thu, 21 May 2009 09:47:13 -0400

H.J. Huney submits:

In the real estate apocalypse, I admit that I am an avid buyer. The naysayers have proclaimed that commercial real estate is the next shoe to fall. It may surprise you to learn that I don’t disagree with that hypothesis. In fact, I believe that commercial real estate will suffer over the next few years and residential real estate still has further to drop.

However, I would suggest that many stocks in the sector already are priced for a disaster of epic proportions and many high quality REITs have been overly punished due to the excesses of their peers.

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Hercules Offshore: Follow the Cash Flows

H.J. Huneycutt — Wed, 20 May 2009 08:34:21 -0400

H.J. Huney submits:

There are a lot of good buys among oil service companies right now as the market has hammered most of them due to the recessionary environment and the plunging oil prices we saw earlier in the year. Offshore oil related companies have been particularly hard hit, which makes it a particularly interesting sector to me.

From a macroeconomic perspective, I believe oil is going to hover around $60 - $80/gallon in the long-term, which will bring off-shore back into the fold. It might take a while for us to get in that range and stay there for a significant period of time, but the trend is that increasing difficulty of oil extraction is driving up costs.

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Lexington Realty Trust: A Solid REIT with Huge Potential

H.J. Huneycutt — Fri, 15 May 2009 08:58:05 -0400

H.J. Huney submits:

Since early March, I have postulated that the market has been overly punishing many quality REITs that could be had for sizable discounts. Thus far, I examined the following REITs in detail:

Part I: Winthrop Realty Trust (FUR)

Part II: Colonial Properties Trust (CLP)

Part III: Agree Realty Corporation (ADC)

Part IV: Douglas Emmett Incorporated (DEI)

Part V: Alexander’s (ALX)

This is Part VI in my “Quest for REIT Value” series. For this article, I will focus on commercial REIT, Lexington Realty Trust (LXP). If you want to read another take on this REIT, I’d also suggest Dan Wieman’s article on Lexington from January.

Qualifications

In my prior articles, I have mentioned several factors I look for when examining REITs:

· ... Relatively low leverage

· ... Insider buying and a substantial amount of inside ownership

· ... High levels of liquidity

· ... Properties in markets near a bottom

· ... Strong asset quality on Balance Sheet

· ... Focus on residential RE over commercial RE

There’s a solid case that Lexington qualifies for the first five of these prongs. With a 63% Liability/Value ratio, Lexington is one of the least levered REITs on the market. While Lexington does not have much in the way of liquid assets on their balance sheet, they produce a substantial amount of operating cash flows, to the extent that I do not foresee any major liquidity issues with them.

Yahoo Finance reports that Lexington has 22% inside ownership; however, it is not clear to me if that includes 5%+ owners since there are other REITs that own a stake in Lexington. Even if not major, there have been a few notable insider buys over the past few months.

As far as asset quality goes, my scan of Lexington’s properties leaves me happy with them. It’s also definitely worth noting that while they do have some holdings in Arizona, Las Vegas, and Florida, they are not overly exposed to any problem areas. Many, if not most, of their holdings are in medium-sized cities and not in the major bubble areas. For all these reasons, Lexington caught my eye as a potential buy in the REIT sector.

Overview

Lexington owns 225 consolidated real estate assets in 41 different states, plus the Netherlands. They own a well diversified portfolio of commercial, office, and industrial properties. p... also holds investments in loan assets and debt securities through a 50% ownership interest in Lex-Win Concord LLC.

I have actually encountered Lex-Win Concord before when examining Winthrop Realty Trust. Winthrop has taken substantial impairment charges relating to this venture. However, it’s important to keep things in context: Lexington and Winthrop both have already taken balance sheet hits as a result of this venture and Lexington’s total equity “Investment in Non-Consolidated Entities” only comprises 3.1% of its total balance sheet assets. Given this, even if the investment eventually had to be written down to $0, this would not necessarily mean that Lexington is a bad purchase.

Properties

My most major concern when examining the holdings of REITs is trying to find ways that balance sheet numbers might be inflated due to the bursting of the real estate bubble. In order to adjust book numbers, I like to examine the portfolio of properties. As it would be ridiculously time consuming to investigate every single property and try to ascertain a value, I scan through their holdings and look for two primary factors: (a) location of properties and (b) date acquired.

The former is important because properties in areas such as New York City, NY and Los Angeles, CA are much more likely to have inflated book values than properties in areas like Johnson City, TN or Salt Lake City, UT. The latter is important because properties with later acquisition dates are much more likely to be overstated on a balance sheet, while properties with earlier acquisition dates are more likely to be understated.

Most of Lexington’s holdings appear relatively safe to me and they own a lot of properties in medium-sized Southern and Midwestern cities where property values never became out-of-control. H... I did find some properties in some potential problem areas, including:

(1) Phoenix, AZ and Tempe, AZ

(2) Florida (Boca Raton, Fort Meyers, Lake Mary, Orlando, Palm Beach Gardens)

(3) Baltimore, MD

(4) Herndon, VA

(5) North Myrtle Beach, SC

(6) San Diego, CA

(7) Michigan (industrial properties)

(8) Suwannee, GA

(9) Los Angeles, CA

(10) Bay Area/Silicon Valley Holdings (Palo Alto, San Francisco)

That might seem like a sizable number of potentially problematic properties, but these holdings actually comprise a minority of their portfolio (probably in the range of 10% - 20%). It is worth noting that while these areas have and/or could experience major hits, some of these areas probably have a good outlook moving forward. I particularly like Baltimore property right now as I believe Baltimore is the type of city that will benefit from rising commodity prices due to its dense urban core.

From my quick scan, property locations are not a major concern to me. The more troubling issue to me is that 80%+ of their properties appear to have been acquired after 2004 and a majority of their properties were acquired in 2006 and 2007; the two years I dread seeing the most!

In his article, Dan Wieman concludes that Lexington’s properties are probably slightly undervalued on the balance sheet. He points out the gains they have made on some of their recent sales as evidence for this. While I can see how he might be right on this issue, I’m very skeptical on this and prefer to play things a bit on the conservative side, so I believe a small write-down (10% - 15%) might be in order.

It’s also worth noting that Lexington does have a few “risky tenants” including Dana Corporation, Tower Automotive, K-Mart, Bally’s Total Fitness (currently in Chapter 11), Tenneco Automotive, Chrysler, and potentially Nextel. Mind you, this is not based on a thorough investigation of the individual situations at each of these properties; these are simple casual observations about potential vacancies based on business prospects of individual tenants. Addition... about 6% of Lexington’s properties are vacant right now and management suggested in the most recent earnings call that this figure could rise to 8% by year end. Once again, however, I will state that these potentially problematic situations appear to make up a small minority in their overall portfolio.

Sample of Properties

One thing I always like to do is see some sample properties for the REITs I analyze. For those familiar with Google Maps, here are links to ten sample properties that you can examine via Google Street View. Note that you might have to look across the street to find the proper building for some of these links, as it is difficult to tell which side of the street is odd and which is even. Also note that my selection is biased in favor of urban properties because they are much easier to find and view via Google Street View. Without further adieu, here’s your selection of sample properties:

(1) 100 Light Street, Baltimore, MD

(2) 101 E. Erie St, Chicago, IL

(3) 10300 Kincaid Dr, Fisher, IN

(4) 110 South Front St, Memphis, TN

(5) 16676 Northchase Dr, Houston, TX

(6) 1460 Tobias Gadson Blvd, Charleston, SC

(7) 4001 International Pkwy, Carrollton, TX

(8) 6226 W. Sahara Ave, Las Vegas, NV

(9) 5200 Metcalf Ave, Overland Park, KS

(10) 1901 Ragu Dr, Owensboro, KY

Now, onto the financials!

Balance Sheet

When analyzing the balance sheet, my instinct is to find every single way I can discount the equity account for a company. For Lexington, the most obvious item I find is intangible assets. In their most recent 10-K, LXP’s intangible assets account consisted of lease origination costs, customer relationships, and above-market rent totaling $323 million. To play things on the conservative side, I write down that entire amount.

I also want to write down Lexington’s investment in non-consolidated entities, as well. While it is possible that these investments have bottomed out, I have enough concerns and do not feel knowledgeable enough about their Lex-Win Concord investment to take this at face value. For my purposes, I will discount the entire $125 million.

Finally, Lexington’s $3.3 billion net real estate account should be discounted as well given my fears that some of their properties might be overvalued. While I think a 10% discount is in order, I like to conduct my own “stress test” (so to speak) in order to see how further declines in property values might weaken their balance sheet. LXP’s book value is $13.21 per share with no discounts.

The chart below shows how Lexington’s book value would be impacted by certain write-downs. ... #2 shows LXP with a discount for intangible assets only. Row #3 discounts intangibles plus investments in non-consolidated entities (e.g. Lex-Win Concord). All the rows are cumulative after that. For instance, Row #4 shows the discounts from Row #3, plus a 5% write-down in Lexington’s real estate properties. Row #5 shows my most probable results based on my own assessment:

IMPAIRMENT CHART
*Impairment*	*Impairment Charge*	*Adjusted Equity*	*Adjusted BV*
None	0.00	1334.00	13.21
IAs	323.00	1011.00	10.01
IA + Concord	448.00	886.00	8.77
5%	600.78	733.22	7.26
10%	753.56	580.44	5.75
15%	906.34	427.66	4.23
20%	1059.12	274.88	2.72
25%	1211.90	122.11	1.21
30%	1364.67	-30.67	-0.30

My preferred discount method gives us a value of $5.75, which is about a 38% premium over the stock price at the close of the day on Wednesday ($4.16). I consider the 15% discount a good option, as well, for valuation purposes since it is a bit more on the conservative side.

Earnings, Cash Flows, and FFOs

I typically like to compile a chart that shows earnings, cash flows, and FFOs for several years based on the current number of shares outstanding. You can see my attempt to do so below:

	Q1 - 2009	Annualized	2008	2007	2006	Avr
*EPS*	0.72	2.88	-0.13	0.50	-0.09	0.09
*CFOs*	0.43	1.73	2.28	2.85	1.07	2.07
*FCFs*	0.43	1.72	4.46	5.70	0.01	3.39
*FFOs*	-0.17	-0.68	1.90	1.62	1.28	1.60
*INCR in SE*	-0.73	-2.92	4.55	-1.81	2.29	1.68

Here's a quick guide to my abbreviations:

EPS = Earnings Per Share
CFOs = Cash Flows from Operations
FCFs = Free Cash Flows
FFOs = Funds from Operations
INCR in SE = Increase in Stockholders' Equity

Unfortunately, the data in the chart does not seem to be all that incredibly meaningful. Part of the problem is that data for FFOs seem inconsistent and difficult to obtain for Lexington. I could not find a chart in their financial statements laying FFOs out plainly. Instead, I have to rely on scattered press releases and info from the corporate website. LXP's cash flows are also all over the place,so that makes it a difficult measure to ascertain, as well.

The fact that Lexington reported negative FFOs of $0.17 per share for the most recent quarter looks bad, but once you discount one-time impairment losses, things radically improve to 38 cents per share. On an annualized basis, that would equal $1.52 per share. That’s one starting point to determining FFOs for our own valuation.

Another way to analyze this would be to take Lexington’s current income statement and chop off a chunk of revenues; then take that discount to find adjusted FFOs. For this exercise, I decided to chop 10% off of Lexington’s FY 2008 revenues. FY ’08 revenues were $396.5 million, so let’s say a $40 million discount is in order. Let’s throw another $10 million on there just for fun. Using this discount, I come up with FFOs of $1.36 per share. If we go further and discount by 25% of revenues ($100 million total), I still come up with FFOs of 91 cents per share.

One final method to try to determine FFOs going forward is to simply take it straight from the horse’s mouth! Lexington's guidance for FFOs in FY ’09 is in the range of $1.30 - $1.37 per diluted share. ... to be on the safe side, we could discount that down further in some of our valuation scenarios.

Other Considerations

One of the most interesting trends of the current economic environment popped up during Lexington’s 4^th Quarter earnings call. CEO Will Elgin states:

“Given the returns available under current market conditions, we can earn substantially more by repurchasing our own debt than we can by holding on to [our] real estate assets.”

That should be the quote of the year in my view. Lexington has been selling off properties and buying back its own debt to increase its earnings. This is a bullish signal to me. If a company is wiping out its own debt at huge discounts, that would suggest to me that securities related to the company are mispriced.

It’s also intriguing that Lexington has been able to recognize gains on most of their property sales. This is likewise a good sign and might indicate their portfolio is in relatively good shape. All the same, I don’t want to get carried away and *assume* appreciations of value. I’d still rather assume that their properties get marked down a little bit just to be on the safe side. With that said, let’s move onto some valuation scenarios.

Valuation Scenarios

In order to gage a valuation range for Lexington, I’ve decided to run a few scenarios. The goal of this exercise is not to dogmatically nail down a value and assert that it absolutely must be correct. Rather, the goal is to get a range of outcomes and see how they should affect the underlying price for the stock.

For all scenarios, I have assigned a Year 1 FFOs/”added value” figure and I assume a growth rate of 3%. While Lexington’s cost of capital have traditionally been low when it comes to debt, I’ve decided to use a 10% cost of capital unless otherwise noted. “Adj... BV” is the term I use to note the underlying value of Lexington’s equity interest in their assets.

The scenarios are as follows:

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Why Hot Topic Is a Dangerous Short

H.J. Huneycutt — Mon, 11 May 2009 03:49:39 -0400

H.J. Huney submits:

Over the past few weeks, I have encountered an innumerable number of articles, pitches, and recommendations in favor of shorting Hot Topic (HOTT). Some have been argued poorly and some, such as Shaun Loh’s recent write-up on Seeking Alpha, have been argued fairly well.

Regardless, I’m not sold. I’m leaning in the completely opposite direction and would warn that Hot Topic is a very dangerous short.

Complete Story »

Hexcel: Value in the Honeycomb

H.J. Huneycutt — Thu, 30 Apr 2009 04:50:05 -0400

H.J. Huney submits:

The market has turned around over the past month and bargains are harder to come by than they were in March. In the aggregate, equities are still cheap, but not as cheap as before. Despite some of my bullish writings, I actually have a pessimistic long-term view on the economy. Nevertheless, I do like to pounce when the market overreacts and even if the long-term economic perspective isn’t rosy, it doesn’t mean there aren’t great buys out there. The key is valuation; even if the outlook is bad, if the market believes the outlook is significantly worse than reality might dictate, it can be very wise to buy in.

Over the past couple of months, I have examined several REITs, but as prices in that sector have rebounded significantly, I’ve decided to turn my attentions to the world of structural materials and small-cap manufacturer Hexcel (HXL). Hexcel soared in the commodities bull market of the past summer, peaking above $25 per share. It briefly dipped below $5 in March, before climbing back towards the $9 range. Unfortunately, I was not eying the stock back in March and it would've been an easy buy at that point. All the same, even in $9 or $10 range, it still looks quite attractive, so let's take a closer look.

Complete Story »

Discover Financial: An Average Company at a Great Price?

H.J. Huneycutt — Thu, 09 Apr 2009 15:25:42 -0400

H.J. Huney submits:

One mistake many investors make is assuming that buying stock is solely about picking out the best companies. The quality of a company is certainly an important consideration when investing, but price is just as important. As an investor, you like quality, but you also want to seek out stocks that give you the most favorable risk-reward prospects.

In my article several months ago about taking advantage of bankruptcy risks, I compared investing to buying fruit. Let’s say you want to buy bananas at the grocery store. You examine the external aspects of the bananas trying to make projections about what’s on the inside. You see a banana that appears to be “prime quality” and you believe there is a 90% chance it meets your standards for consumption. You then see another banana that looks alright, but you have more doubts about it. You assess the odds of this “average quality banana” meeting your standards for consumption to be about 70%.

Now imagine you walk into the grocery and you see a big table with all these bananas setting on it with a sign that says “bananas --- 80 cents.” Undoubtedly, you seek out the “prime quality” bananas. Most investors instinctively grasp this. Prices being equal, you always go for higher quality.

On the other hand, what if the grocer realizes it can sell the “prime quality” bananas at a premium and is having difficulty selling the “average quality” bananas at the 80 cent price. Maybe the grocer begins to segregate the bananas by quality and offers the “prime quality” bananas for $1.20 and the “average quality” bananas for 50 cents.

Which pile do you buy from if you’re only buying one? How about if you have enough money to buy $5 worth? Would you be better off buying four “prime quality” bananas at $4.80 or nine “average quality” bananas at $4.50? If you buy the four “prime quality” bananas, the odds suggest that at least three will be eatable and there’s a good chance that all four meet your standards. On the other hand, if you buy the nine average quality bananas, the odds suggest that you would obtain either 6 or 7 eatable bananas. Hence, from a risk-reward perspective, you got a better deal by taking advantage of the price discrepancies and nabbing up the “average quality” bananas.

The quality and pricing of bananas may not seem to have all that much to do with the stocks of credit card companies, but I’d argue it does. My concern right now is that Visa (V) is that high quality banana selling at a significant premium while Discover (DFS) is the average quality banana selling at a discount. But let’s quit talking about bananas and take a look at Discover Financial Services.

Discover’s Business Model

One interesting thing about the various competitors in the credit card sphere is the distinctness of the business models. Visa, for instance, does not take on the credit risks of those utilizing their cards. Instead, they make their revenues from service fees, data processing fees, and transaction fees. American Express (AXP) makes the largest chunk of their revenues from “discount fees”, which are similar to Visa’s “service fees”, but AXP also collects interest income, as well.

Discover is unique in the sense that it is involved with all stages of the food cycle, so to speak, since they are a credit card issuing company, an electronic payment services provider that owns its own U.S. payment network, has both credit and debit functionality, and acts as an originator of loans and other banking products. In other words – they do everything. Of course, that’s one of the major reasons why the market has soured on Discover, but has been less harsh on Master Card (MA) and seems mildly optimistic about Visa. Discover is lumped in with the banks that have taken on too much credit risk and have been hit hard as their stock price has fallen from peaks in the upper $20 range all the way down to $4 – 5 range, before jumping back up to the $6 – 7 range, where it sits now.

Contrary to popular market sentiment right now, this might not be such a horrible thing. Many people compare credit card debt to subprime loans, but there is one important distinction: the credit card companies charge rates that are more in line with the risks involved than subprime lenders did. Moreover, they have the flexibility to change those rates as conditions change. This is not to suggest that all is good and well in Credit Card Lending Land, but it is to suggest that the fears about them might be overblown.

It Will Be Brutal

All the same, 2009 is likely to be a brutal year for Discover. Discover reported earnings of 25 cents per share for the 1^st Quarter, but that’s a bit deceiving since they claimed $475 million from the Visa antitrust litigation settlement. Ignoring that special item, Discover’s income for the quarter plummets to 73 cent per share loss. That’s pretty ugly. If that trend were to hold up, they could lose $3 per share in normalized income for this fiscal year.

But wait there’s more! CEO David Nelms states that the charge-off rate for the 1^st Quarter came in at 6.5% and they expect the loss rate for the second quarter to exceed 7.5%. If unemployment continues to rise, that rate could get even higher.

However, the question isn’t so much whether this year will be bad for them. We already know this year will be dreadfully awful. The question is how bad will it be and how much has the market already discounted the stock price for this terrible news?

If there is any consolation, it’s that their cash flows are still positive. For the 1^st Quarter, Discover brought in $528 million in operating cash flows. It’s not completely clear to me whether they received the entire antitrust litigation settlement claimed in their Income Statement, but assuming they did, they still brought in $53 million (11 cents per share) discounting that item. Hardly a reason for great optimism, but it emphasizes the fact that most of their earnings loss comes from a higher charge-off rate for their “Provision for Loan Losses.” That brings me the one big positive here --- Discover’s balance sheet.

A Strong Balance Sheet

It’s not that Discover is poised for a tremendous year and it’s completely possible they suffer for a few years. The good news is that they have a balance sheet that would appear to be strong enough to absorb these impending losses.

BALANCE SHEET	*As of 2/28/2009*	*Per Share*
*Assets*
Cash + Equivalents	$8,724.00	$18.06
Investment Securities	$1,303.00	$2.70
Total Loan Receivables	$28,034.00	$58.04
Allowance for Loan Losses	-$1,879.00	-$3.89
Net Loans Receivables	$26,155.00	$54.15
Amounts Due for Asset Sec	$1,847.00	$3.82
Goodwill + Intangibles	$457.00	$0.95
Other	$2,121.00	$4.39
Total Assets	$40,607.00	$84.07
Total Liabilities	$34,607.00	$71.65
Stockholders' Equity	$5,999.00	$12.42
All amounts in millions

There are a few important items to note. First off, Discover has nearly $8.7 billion in cash and interest-earning deposits (“cash equivalents”) on their balance sheet. That balance is equal to roughly a quarter of their total liabilities. Add an additional $1.3 billion in investment securities and that gives Discover about $10 billion in liquid assets compared to $34.6 billion in total liabilities.

Stockholders’ Equity is about $6 billion or $12.42 in per share terms. Goodwill and intangible assets are also fairly low, which means that figure isn’t distorted much. Once you discount goodwill and intangibles, net tangible assets (NTA) are equal to $11.47 per share. If the stock were selling at $7, that would be 64% discount to NTA.

Naturally, we need to assume that Discover will take some significant losses on their portfolio. The good news is that Discover would appear to be playing things fairly conservatively as it is. They claim a $1.9 billion “Allowance for Loan Losses”, which is about 6.7% of their total loan portfolio. I want to see how their equity (discounted to net tangible assets) will be affected by that.

IMPAIRMENT TABLE
*Impairment %*	*Impairment Charge*	*Adjusted Equity*	*Per Share*
6.7%	$0	$5,542.00	$11.47
7.5%	$224	$5,318.45	$11.01
8.5%	$504	$5,038.11	$10.43
10.0%	$924	$4,617.60	$9.56
12.0%	$1,485	$4,056.92	$8.40
14.0%	$2,046	$3,496.24	$7.24
16.0%	$2,606	$2,935.56	$6.08
18.0%	$3,167	$2,374.88	$4.92
20.0%	$3,728	$1,814.20	$3.76
25.0%	$5,130	$412.50	$0.85
All amounts in millions

The amazing thing about this chart is that it suggests that Discover could absorb a 25% impairment charge and still have slightly positive net tangible assets. Of course, that is a somewhat meaningless measure because they’ll be out of business regardless if they have that high of a write-off rate, but it at least shows you the strength of their balance sheet. While they most certainly have a lot of risky debt on their books, they charge interest rates that are reasonable given the risks, and they have the liquidity and equity to absorb potentially huge losses. This differentiates Discover from many of the banks that are struggling right now.

Looking at this chart, I would wager to guess that if Discover is selling at $7, they could absorb a 10% - 12% delinquency rate and still be alright. That brings me to my primary rationale for believing that Discover might be a decent buy right now – the price already factors in astronomical losses. While the stock price has been particularly volatile, in the $6 to $7 range, it would appear that the market is expecting an extremely high amount of write-offs.

Valuation

Now that we’ve seen why this stock might be a worthwhile buy, let’s take a look at potential valuation. Undoubtedly, valuing Discover’s stock can be tricky. This is due to the high amount of uncertainty and risk inherent in their business and the current economic environment. Therefore, I am going to try to deduce a “probable valuation”, which is by no stretch of the imagination, an encouragement to buy at anything below that price. Rather, it’s the price I believe will most closely reflect Discover’s true value.

At the same time, you need to factor in the high levels of risk and uncertainty. For a company like Red Hat, which I analyzed back in mid-January, we can assume a much greater level of certainty about their near-term earnings and cash flows and hence, “probable valuation” might be fairly close to a price-point where I might consider it a “buy.” The same cannot be said for Discover. The high level of risk and uncertainty means I need to further discount the stock. Therefore, I will also look at potential downside valuations and upside valuations.

Normally for valuation purposes, I focus on free cash flows (FCFs). Occasionally, I look to operating cash flows and earnings for guidance, but the primary focus is on FCFs. For Discover, I’m going to focus on earnings instead. My primary reason for this is that earnings will probably be more conservative and they appear to be more predictable. Here are the scenarios:

Scenario #1: Probable Valuation

This might veer a bit on the conservative side, but these are the earnings projections for my Scenario #1 valuation:

Scenario #1
*Year*	*Earnings*
1	-2.5
2	-2
3	-1
4	0
5	1
6+	3% growth rate

My valuation for this scenario is $20.31.

Scenario #2: A Bit Uglier

Scenario #2
*Year*	*Earnings*
1	-3
2	-3
3	-2
4	-1
5	0
6	1
7+	3% growth rate

My valuation for this scenario is $12.71.

Scenario #3: Even Uglier

Scenario #3
*Year*	*Earnings*
1	-3.5
2	-3
3	-2.5
4	-1.5
5	-1
6	0
7	0.5
8	3% growth rate

My valuation for this scenario is $6.20.

Scenario #4: Somewhat Optimistic

Scenario #4
*Year*	*Earnings*
1	-2
2	-1
3	0
4	0.5
5	1
6+	3% growth rate

My valuation for this scenario is $22.80.

I never take the numbers a spreadsheet pumps out at face value. The important thing to understand is why one gets different results and how varying dynamics will change valuation. Based on these four scenarios, I come up with a probable valuation at $17. However, due to risk and uncertainty, I do not believe risk-reward favors the long-side unless the stock price is below $9 - $10. Under $8 it looks fairly attractive. In the $5 - $7 range, I would personally consider buying into it.

Upside potential for Discover in the next eight years might be in the $30 range. Downside risk is $0, but that won’t happen unless they go bust and given their strong balance sheet, it would take quite a lot to drag it that low. Assuming they survive, I’ll go with a downside risk of $3.

Versus Visa

Earlier this week, I wrote about why I am bearish on Visa. I also stated that I believe Discover is a better alternative. In regards to Visa, it appears to me the market has priced in very high expectations for the stock and I am unsure that Visa can meet them. Moreover, I believe the market is ignoring some of the risks associated with Visa. While Visa does not take on the debt risks of Visa cardholders, the banks that do will undoubtedly be lessening the amount of credit available in a prolonged recessionary environment. This means that Visa will collect fewer fees on transactions than expected.

Moreover, given that Visa appears to be priced for near-perfection, I am not sure how much upside Visa can have. One commentator on my article suggested $120 might be the upside. Even that seems very aggressive and it’s worthwhile to note that this stock never climbed above $90 even when the bulls were out in full force. From my perspective, Visa has a sizable downside and a limited upside.

On the other hand, while Discover has a noteworthy downside, it also has a huge upside. In the $6 - $7 range, I believe the odds favor at least a 100% return. At the $8 - $9 range, there’s still a good chance for double on the initial investment. I do not think $20+ is as far-fetched as some might believe, either. For this reason, Visa might be the proverbial overpriced “prime quality” banana, while Discover might be the underpriced “average quality” banana. I’d prefer to buy the latter.

Of course, there are reasons to believe that Discover might be a little bit better than average. My esteemed colleague Ryan Pollack pointed out in his bullish case for Visa that Visa has a tremendous advantage in market share. That might seem good to some investors, but to me, it’s also a bit dangerous. If one company has a majority of the market share, how much more can they expand in relation to their competitors? Discover has more room to grow than Visa.

Seeking Alpha contributor Frank Rong made an excellent case last July as to why Discover (and American Express) are better investments than Visa and Master Card. In that article, he mentions Discover’s increasing acceptance parity with Visa and Master Card. This is an excellent point because that has been one of the hardships Discover has faced in the past. As a Discover cardholder, I know this firsthand. Back in 1999, maybe 20-25% of the places I shopped would not accept Discover. Now, that number has declined significantly; it’s probably more like 5-10% now.

Discover also has a great amount of brand loyalty. You might even say that’s the only thing that has allowed them to survive through some of their formative years. Discover is, after all, “the card that pays you back.” I’m a bit disappointed they abandoned those commercials, but the fact remains that it was a clever idea and it’s still a good benefit, even if the other cards have been trying to mimic it with their own rewards programs. It’s also worth mentioning that the Diner’s Club acquisition was one of the shrewder moves made over the past few years. Discover should bring in substantial revenue from this acquisition.

I’m not suggesting that I believe Discover is going to experience 20% growth and overtake Visa or Master Card any time soon. But I am suggesting that if you peel away the skin, there’s a decent chance that you’re in fact getting a “prime quality” banana with Discover. But even if it simply stays an “average quality” banana, it still looks attractive to me at the current price levels.

Conclusion

Overall, the main takeaway is that the market is underestimating Discover’s growth potential and is overreacting to the effects of the financial crisis on Discover’s loan portfolio. Whereas, the market is pricing in too high expectations into Visa, which does have competition overseas in the markets it would like to grow in. As a risk-reward proposition, Discover makes a lot more sense to me at the current prices.

Disclosure: Author holds no position in any of the companies mentioned in this article, but may choose to initiate a position in DFS in the future.

Complete Story »

Visa: Not Everywhere I Want to Be

H.J. Huneycutt — Mon, 06 Apr 2009 12:07:50 -0400

H.J. Huney submits:

There has been no shortage of market commentators talking about an impending credit crunch that will hit the credit card companies severely at some point. Noted investor Peter Schiff even issued a wholesale condemnation of credit cards in the past month. While I agree that America has overdependence on credit and that the credit card companies will all suffer during the next year, the prognosticators that believe this is the end of credit cards are going overboard. The question is not whether the credit card companies will suffer; it’s how much they will suffer and how much of that is already reflected in the current prices.

There’s no question that the market does not like Capital One (COF) or American Express (AXP) right now. The market has also soured on Discover Financial Services (DFS) and to a much lesser extent, Master Card (MA). Strangely, however, Visa (V) has been spared much of the carnage. While Visa has dropped from its highs in the upper $80 range from late spring ‘08, it is only down marginally for the past year during a timeframe when the rest of the market has been completely obliterated.

Seeking Alpha contributor Ryan Pollack made a very well argued case in favor of Visa last week and before I go any further, I’d like to thank him for that analysis. I always enjoy reading well thought out cases for or against a particular stock whether I agree or disagree with the author’s conclusions. In this case, I find myself in disagreement with Mr. Pollack on Visa.

The Consumer Spending Crunch

Color me baffled as to why the market despises Discover right now, but has not turned on Visa. Perhaps this is because, as Mr. Pollack astutely points out, Visa does not take on the credit risks of its customers. While true, this seems to ignore the fact that someone does take on the credit risk of Visa’s customers and those companies that do are undoubtedly in the mood to tighten standards at the moment. With credit being contracted, that means less credit card usage. Since Visa makes its money off of service fees, data processing fees, and transaction fees; that means that Visa should not totally be spared, either.

Visa has benefited from the increasing use of debit cards by consumers as credit has been tightened. Certainly this can bode well for Visa, but I’m simply not convinced that consumer spending is going to reach the levels that it did earlier this decade any time soon. People will certainly continue to utilize their credit cards and debit cards as a preferred method of payment, but they will be paying for things less often.

In its latest earnings call, Visa’s executives have admitted that the economic slump has impacted them unfavorably as they lowered guidance on revenue growth. CEO Joseph Saunders stated that fiscal 2009 revenue growth now appears to be in the high single digits, which is below their long-term guidance in the 11% - 15% range. He also remarked on a pronounced decline in US payment volume growth and global cross border volumes.

The Shift To Plastic

On the other hand, there are some signs for optimism with Visa and I’m not oblivious to the bullish case. Despite prophecies of doom for plastic, consumers and business owners alike seem to prefer the relative ease and security of credit cards and debit cards. Quite frankly, it’s a lot easier to pull out a card and swipe it than it is to write a check or carry around wads of cash at all times. Credit card usage is still growing in the US if Visa’s financial results are any indication. During the current crisis, an increase in debit cards seems even more profound as Visa has 14% growth in its last quarter. While, it is probable that growth in the US market will probably slow up some in the coming years, there is strong growth in international markets where credit cards are becoming increasingly popular.

Mr. Pollack also makes another spectacular point in his article about Visa Europe. If you’re ignoring the international picture, you’re ignoring what makes Visa so attractive right now. Growth in Europe and Asia should be the driving force behind this machine in the future.

The other important thing to consider with Visa is the proverbial moat. In fact, calling it “a moat” seems to be an understatement. Visa has a well fortified castle, thousands of archers standing atop of the castle walls, and a thick swamp filled with alligators surrounding their business.

All this is to say, I don’t really disagree with Mr. Pollack’s bullish case on Visa’s growth prospects. Visa will continue to grow and plastic will continue to be the trend. However, in the end, everything comes down to valuation and I am not enamored with Visa’s balance sheet or cash flows relative to its price.

Goodwill and Intangibles

In his article, Mr. Pollack remarks on Visa’s “cleaner balance sheet” and favorable ratios. I find myself in disagreement on this issue. Certainly, Visa’s leverage ratios look very healthy if you take everything at face value. Their liability/value ratio is only 32%. Cash-to-liabilities is strong at 0.46 and if you include “restricted cash”, current ratio is 1.75, and their quick ratio is 1.30. However, looks can be deceiving sometimes.

My major qualm with Visa’s balance sheet is how much of it appears inflated due to the presence of, what I would term, “non-real assets.” In particular, I cannot help but to notice the colossal-sized amount of goodwill – a whopping $10.2 billion! For those not familiar with “goodwill”, it’s strictly an accounting concept meant to measure the premium a company paid over market value for acquisitions.

Having a large chunk of goodwill on the balance sheet is not necessarily a bad thing for a company; there might be legitimate reasons that it paid more than market value for an acquisition. However, it can be a deceiving since it is classified as an “asset.” If the price of an acquisition was justified, that should be reflected in future cash flows. There’s no real guarantee that the acquisition was truly worth the amount paid for it and “goodwill” is a very distortive measure in this regard.

Visa also has an extremely sizable amount attributed to intangible assets (IAs). Intangibles are a trickier issue than goodwill since some “intangibles” could be sold off to other companies. In this sense, you could say they are “real” in one sense. But given the fact that Visa has a $10.9 billion balance in that account and this constitutes over one-third of their total stated assets, it is important to analyze these items in detail.

From their latest 10-K statement, the breakdown for Visa’s intangibles is as follows:

Intangible Assets		FY 2008
Customer Relationships		$6,799.00
Tradename		$2,564.00
Visa Europe franchise right		$1,520.00
TOTAL INTANGIBLE ASSETS		$10,883.00
All amounts in millions

Certainly, I have to believe that the Visa Europe franchise right is a commodity that could be sold on the market for a significant return. While customer relationships and Visa’s tradename most certainly have value, I would be skeptical of treating them as full assets since their values are largely dependent on the success of Visa’s operations. Also, as I stated with goodwill, if these assets have such high stated values, that should be reflected in cash flows so counting them for valuation purposes is arguably duplicative.

A Modified Balance Sheet

Once you discount goodwill and intangible assets from Visa’s balance sheet, it does not look nearly as favorable. While Visa’s book value including the two accounts is $21.70 per share, their net tangible assets only add up to 55 cents per share:

	Amount	Book Value Per Share
Stockholders Equity (SE)	$21,645	$21.70
SE Minus Goodwill	$11,432	$11.46
Net Tangible Assets	$549	$0.55
All amounts in millions except per share figures

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Alexander's: Clearance Sale or Value Illusion?

H.J. Huneycutt — Thu, 02 Apr 2009 05:38:57 -0400

H.J. Huney submits:

REITs have become the spanking boy for the market over the past year and it’s difficult to find a REIT that has not lost at least half of its value from 2007 peaks. While much of this punishment is justified, my basic hypothesis is that the market has overly punished some quality REITs that might be had for sizable discounts at this point in time. Thus far, I’ve analyzed four REITs: Winthrop Realty Trust (FUR), Colonial Properties Trust (CLP), Agree Realty Corporation (ADC), and Douglas Emmett Incorporated (DEI). This is Part V in my (unofficially-titled) “Quest for REIT Value” series and I will take a look at New York-based commercial REIT, Alexander’s (ALX).

Overview

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