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Chuck Pink
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  • Health Reform and Perverse Incentives
    Health Reform and Perverse Incentives
     
    Health reform has been a highly contentious issue and after spending some time digging, I have reached the opinion that if left in its current form, it will corrupt the incentive system largely responsible for entrepreneurial and small-business growth. The major changes, which don’t roll out until 2014, will affect the cost structure of employers to such a degree that it will create perverse incentives and discourage growth among small to medium sized business owners and franchisees.  Left intact, the new rules will likely have a major impact on QSRs, restaurants, retailers, grocery chains, etc.  Investors should be aware of the potential consequences and adjust their portfolios accordingly.

    Background
    Most of the regulations that will affect small businesses won’t go into effect until 2014, but the consequences of the changes may appear much earlier than that. In regards to franchisees, the new rules and additional costs of paying for health insurance may make smaller franchisees reluctant to grow and potentially put some out of business.
     
    Starting in 2014, employers with 50 or more full-time equivalent employees will be required to pay for coverage or pay a penalty. Employers will NOT have to provide coverage for seasonal and temporary workers (working fewer than 90 days), for full-time workers during a 90 day waiting period, or if they have less than 50 full-time equivalent employees. 
    • Full-time equivalent employees: A full-time employee is defined as someone who works over 120 hours per month (an average of 30 hours per week). The number of full-time equivalent employees is the sum of all part-time employee hours worked in a month divided by 120. For example, a firm with 100 employees, each working an average of 15 hours per week (60 hours a month), has 50 full time equivalent employees.
     
    When these rules go into effect in 2014, it is my understanding small business owners will have three options:

    Provide “affordable” coverage.
    • Coverage is affordable as long as the employee’s premium contribution is less than 9.5% of their adjusted gross income. 
    • If an employee believes the coverage provided by their employer is NOT affordable, they must opt out of the plan, go to the exchange and demonstrate their employer was charging them over 9.5% of their AGI, demonstrate their AGI is less than 300% of the federal poverty level, and then qualify for a government subsidy.
    •  If an employer offers affordable coverage and the employee opts out, the employer doesn’t have to pay a penalty.
    Fund a 125 Cafeteria Plan (only available to firms with less than 100 full-time equivalent employees). Employees will then be required to purchase their own plans in state-based exchanges using pre-tax money.

    Pay a fine, either by not providing coverage or providing coverage deemed unaffordable (over 9.5% of the employees AGI).
    • The fine is the lesser of:
    1. $3,000 x # of full time employees receiving subsidies.
    2. $2,000 x # of all full-time employees.
    • Note: You won’t be subject to a penalty if your employees are eligible for Medicare or Medicaid.
     
    Below is a time line of when the various regulations will go into effect. 
     
    Changes in 2010
    • Reinsurance for retiree medical coverage. 
    • $250 rebate for seniors for coverage through the Medicare Part D gap of “donut hole”
    • Tax Credits for small employers.
    • Starting this year and going through 2013, small businesses will receive a tax credit to offset up to 35% of their health insurance costs, provided the firm contributes at least half of the employee's premium. 
    • Eligibility: Small businesses with 10 or fewer employees earning average annual incomes less than $50,000 a year will receive a pro-rata credit. Small businesses with 25 or fewer employees earning less than $25,000 a year will receive a full tax credit.

    Changes in 2011 (Calendar year plans)
    • Insurance and Employer-Sponsored Plans Must:
    • Cover dependent up to age 26 (if they have dependent coverage;
    • No lifetime limits, restrictive annual limits on essential benefits; rescissions (unless fraud), and cost sharing on certain prevention and wellness services (unless plan is grandfathered plan).

    No changes in 2012


    Changes in 2013
    • Tax Credits for small employers increases to 50% of the employer contribution (as long as the employer contributes at least half of the employee’s premium) and will be available to firms with the equivalent of 10 or fewer full-time workers paid, on average, less than $25,000; it phases out as the payroll, excluding seasonal workers, grows to 25 and wages rise to $50,000.

    Changes in 2014
    • Employer obligations go into effect. If you have more than 200 employees you must auto-enroll those employees in an insurance plan if you offer coverage. If you have over 50 full-time equivalent employees, you must offer affordable plans or pay a penalty.
    • Coverage is only required for full-time employees (work more than 30-hours per week or 120 hours a month) unless they are seasonal/temporary workers (working fewer than 90 days).
     
    Summary
    Depending on the circumstances, the fine employers will have to pay for not purchasing insurance from the state-based exchanges will be $2,000 - $3,000, an amount that will likely be less than the cost of insuring an employee.  With that said, any half-intelligent employer will just pay the fine.  But even if insurance policies offered on the exchanges cost less than the fines, they won't cost less by much.  So either way, anyone with over 50 FTEs will have a significant cost added to their business.  The effect of the cost will be passed on to consumers somehow, probably via price increases. This creates a perverse incentive for small business owners (businesses with fewer than 50 FTEs) and will encourage them to avoid growth.  Basically, it will create a profitability "dead zone" (see graph below). 
     
    The graph below demonstrates what I believe this will look like. The graph contains profitability on the y-axis and size (in this case FTEs) on the x-axis. From the 50 FTE point on there is a curve that resembles a pothole at the beginning of an uphill road.  The front lip of the pothole is the 50 FTE point on the x-axis.  This is because profitability will shrink somewhere between 50 FTEs and enough FTEs where economies of scale trump the costs associated with insurance obligations.  You could call this the profitability inflection point.  So the sweet spots for operators will either be owning a business that is large enough that the fines are relatively immaterial (right side of the pothole), or owning a business that is small enough that you aren't exposed to the fines (left side of the pothole, i.e. fewer than 50 FTEs).  I would argue this creates an advantage for businesses with fewer than 50 FTEs because they won't have the costs employers operating in the “dead zone” will have.  Essentially, the firms with fewer than 50 FTEs will become the low-cost providers and therefore have pricing power. 
     


     
    So, let’s say you own three Jack in the Box franchises, each with 15 employees, and you are hoping to expand. Your next location will put you over the 50 FTE limit and your profits will significantly decline. Faced with this scenario, you will have a few options; 1) Expand as quickly as possible to reach the profitability/FTE inflection point by 2014, 2) Accept lower profitability and grow into the “dead zone”, or 3) Maintain your current size. I can’t predict how operators will respond, but I imagine many will resist growth. This creates a problem for Jack in the Box and Jack in the Box shareholders (or any comparable business).
     
    This is how I am interpreting Health Care Reform. If anyone can tell me why this isn’t the case, I am all ears as I sincerely hope I am wrong. Until then, I encourage investors to consider the effects these new rules may have on their portfolio holdings. 
     
    Regards,
     
    Chuck Pink



    Disclosure: No positions
    May 14 10:59 AM | Link | Comment!
  • Nothing but Net...Net - Why I'm Long Linktone (LTON)

    Linktone (ADR: LTON)

     


     

    Stock Price

     $    1.59

    Shares outstanding

          42.1

    Cash & Short term investments per share

     $    2.42

    Total liabilities per share

     $    0.28

    Net cash and Short term investments

     $    2.14

     

     

    Upside to net cash and st. inv.

    34.59%

     

    Market Cap

     $       67

    Cash & ST Inv.

     $       102

    EV

    ($35.50)

     

     

    Current Assets

     $     127

    Total Assets

     $     140

    Total Liabilities

     $       12


    Background

    Wireless value added service provider (games, ringtones, screen savers, applications, etc.) in the midst of a turnaround.  They develop, market, and distribute content and applications for mobile and fixed line network operators in China and have goals of expanding into Indonesia and the Philippines.  They had a decent run from 2003 to 2006, growing revenues from $16m to $76m but in 2007 revenues declined 31% to $55 million after Chinese telecom regulators changed some of the mobile operator policies to protect consumers.  Specifically, service providers had to issue double confirmations for new subscriptions and were required to send reminders to existing monthly subscribers on fee information and automatically cancel inactive subs.  Despite the policy change, revenues rebounded in 2008 to $64.5 million but net income was negative due to costs associated with the termination of a cross-media business they entered in Q4 of 2006.


    Cross-Media Business

    In Q4 of 2006 they began to develop traditional media channels and combine them with their existing wireless platform.  The idea was to offer TV services over wireless devices and collect ad revenue.  They became the exclusive advertising agent and primary content provider of Qinhai Satellite Television, or QTV, and the exclusive ad agent for specific time slots of Tianjin Satellite Television, or TJSTV, both of which operate satellite TV channels in China.  They terminated the arrangements in September of 2008 to focus on their core telecom value-added services business or VAS business.  In hindsight, management would probably agree the foray into the media business was a mistake. 


    Additional Background

    The collapse in revenues due to policy changes, the unsuccessful venture into the media business, and the decline in the market (which ultimately led to Piper, Collins Stewart, Deutsche, and others all dropping coverage, likely because the market cap became so small) took the stock from over $5.00 to $0.80 cents per share at the end of 2008.  By Q1 of 2009 the company was in turnaround mode.  The chairman of the board took over as CEO and re-installed the CFO who was with LTON through the primary growth years (June 2005 – January 2008). 

    Since new management took over, three of the last four quarters have been profitable.  This is a respectable accomplishment considering the company had six consecutive quarters of negative earnings under the old management team.  On recent earnings calls management mentioned they are considering small acquisitions to help them expand into Indonesia and the Philippines.  Management also discussed the possibility of a buyback.

    Since last quarter, LTON has made two small acquisitions.  In January of 2010 LTON entered into a definitive agreement to acquire a controlling interest in Letang, Game Limited, a private Chinese company specializing in the development of mobile games and PC online games.  Letang offers a portfolio of games that can be played on major global mobile phone systems and platforms including Flash, Android, BlackBerry, iPhone and KJava.  Linktone agreed to pay up to $9.15 million to acquire 50.01% of the equity.  Letang will receive $2.56 million in cash at the closing of the acquisition with the remainder of the consideration payable upon the achievement by Letang of certain financial milestones during 2010 and 2011.

    On March 23, 2010, LTON announced that together with its majority shareholder, PT Media (MNC), they completed the acquisition of 75% of the share capital of InnoForm Group, a Singapore based company specializing in the development, distribution, and licensing of edutainment and entertainment products.  LTON and MNC will pay $7 million and will receive 50% and 25% of the share capital of InnoForm, respectively.

    Despite improving fundamentals and growth opportunities, the stock continues to trade at a depressed level.  The table below shows FCF with and without the effects of the discontinued media business.




    Reasons to own


    Valuation:

    • $2.36 in cash and short term investments per share and stock trades at $1.59.
    •  Best comp out there trades at over 2x sales and over 1.5x book.  That would make LTON a double.
    • EV/EBITDA not very useful at the moment for LTON because they are still in the process of changing the cost structure after terminating the media business.  More valuation notes are below.
    Growth opportunities:
    • Major player in Chinese mobile phone market which has over 700 million subs and penetration is estimated to be only 50%. 
    • Indonesia represents attractive opportunity and they have cash to spend on small acquisitions to gain a presence.

    Turnaround story:

    • New CEO and CFO and two board departures leaves a fresh team at the helm.
    • One board member who resigned was replaced by Oerianto Guyandi, a director of the largest and only integrated media company in Indonesia.  Formerly he was a director at Bhakti Investment, the largest investment company in Indonesia.
    • Note Bhakti was founded by the former LTON chairman, now the CEO.
    • Exiting advertising business and focusing on wireless value added services.
    • Management considering obtaining approval for a buyback.

     

    Risks

    • Acquisition risk
    • Regulatory risk (wireless industry policy changes in China)
    • Related party transactions by prior management.  An $11.5m loan to affiliated parties made under prior management is still outstanding and raises questions regarding the shareholder friendliness of certain board members.
    • LTON depends on contracts with a few large Chinese telecom providers, specifically China Mobile, China Unicom and China Telecom.
    • DilutionThe share count nearly doubled under the old management team, increasing from 24m to 42m since 2007.
    • Concentrated shareholder basePT Bhakti Investments, the largest Indonesian investment company (which happens to have been founded by the current LTON CEO), owns 57% of total shares outstanding.  This could be considered a positive as insiders are aligned with shareholders, but if this stake was sold it would put significant pressure on the stock.
    • Limited float so illiquidAn average of 45,000 shares trade a day.  At the current price of $1.59 that is only $71,550 dollars a day.

     

    Valuation

    LTON is priced for bankruptcy even though the underlying business is profitable.  In my opinion, a profitable business with immaterial future contractual obligations should not trade at over a 30% discount to the net cash on its balance sheet.  Considering the risks, a fair upside target may be the elimination of this discount, but It doesn’t seem unreasonable to assign the company a multiple considering their growth prospects.  If management is successful returning the business to profitability, it seems reasonable to believe LTON should receive a multiple in line with its closest peer, KONG, which currently trades at 7.4x Ebitda but has averaged 14x since 2005.

    Before prior LTON management entered the media business, EBITDA margins and net income margins were over 20%.  2010 revenues should be roughly $65m and 2011 revenues should be over $70m.  If management can get to 10% margins again, they should generate roughly $7m in EBITDA in 2011.  Adjusting for the $100m in net cash on the balance sheet and acquisition commitments of roughly $6m, yields a target market cap of $142m, or roughly $3.40 per share (114% upside).  This assumes very limited revenue growth.  If management is successful entering Indonesia, revenues should be much higher.    

     

    Regards,

     

    Chuck Pink

     

    Disclosure: long LTON

     



    Disclosure: Long LTON
    May 13 1:12 PM | Link | Comment!
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