"Fore"midable and Low-Risk Returns

Just nine months ago, we discussed Adams Golf (ADGF) as a potential value investment due to the severe discount at which the company was trading relative to its net current assets. Since that time, the stock has rallied over 40%. But more impressive than the return (after all, the general market has rallied over this period) is the low risk at which this return was achieved, due to the use of the all-important margin of safety.

What is important to realize is that this 40% jump in the stock price did not arise because the company had some positive surprise. To the contrary, the company has continued to rack up quarterly losses, and even settled a litigation dispute pretty close to the worst-case payment it would have had to make had it lost in court (though it likely did save on attorneys fees by settling).

The reason for the large rise in the stock's price is due to the fact that the market was totally mis-pricing the stock to begin with. Nine months ago, you could buy this company for $19 million even though it had cash of $3 million, $23 million owed to it by its customers and another $23 million of non-perishable inventory (golf clubs etc.) against just $14 million of liabilities.

In the last few months, the company has had to sell some of that inventory at a loss, and has agreed to pay $5 million to settle a lawsuit. As such, its net current assets reduced from about $35 million to $29 million. Despite this, the stock price has risen dramatically, as the company's market cap has recently spent some time trading just under $30 million. The massive margin of safety on this stock 9 months ago has allowed the investor to profit despite the absence of any company specific positive news!

Now that the stock trades for its net current asset value, ADGF becomes the latest stock to move from the Stock Ideas page to the Value In Action page. But the lack of discount to its net current assets doesn't mean all value investors who own it should sell it, however. An opportunity may remain for those who know the company well, including its products and its position relative to competitors. In other words, it may still be cheap relative to its intrinsic value. But at this price point, the value investor should ensure that the company is firmly within his circle of competence to avoid undue risk to his principal.

Disclosure: None

Management Trolls

Investors who conduct stock research online (e.g. readers of this site, or those who use www.sec.gov to access annual reports, as opposed to waiting for their snail mail copies) have likely spent at least some time in a stock message board. Unfortunately, there is a lot of misplaced advertising, spamming, falsities, and trolling that takes place on these boards that renders them virtually useless for the serious long-term investor. As such, it would seem highly unlikely that senior management would see it fit to spend any time perusing such non-valuable, non-credible arenas.

But that assumption would be wrong. The following exchange illustrates Blonder Tongue (BDR) COO Robert Palle's response to questions about management on the Yahoo! Message Board for BDR:

ajofny says: Where is this company going? The Chairman and CEO is 79, the COO is 63. What is its strategy?

newkram says: There is no strategy. management (such as it is) is just treading water till they retire or pass on ( whichever comes first). This is a company that should never have been allowed to go public. It is essentially a privately-held/family-owned company masquerading as a public company.

gands2 says: The family owned/family run image was reinforced when Palle, the co's president and largest shareholder, wasn't on the last CC, with Ms Nikoo the chairman's daughter as substitute. Nepotism an investor's red flag imo.

bobpalle22 says: At BT we are in the process of grooming the next generation of management. The last CC was reasonably benign as the numbers were in line with expectations. I chose to allow Ms Nikoo to represent me on this particular call. I think she performed wonderfully. Did you have any questions she could not answer? re my ownership....Come on girls, I am a buyer, and still a buyer, but the SEC window must be open to buy. Bob Palle

The other conversers are listed as male, leaving a question as to why Palle is referring to them as "girls".

How do we know this is actually Palle, and not some faker? The company issued a release to basically cancel his statement: "...[P]lease disregard Mr. Palle's message posted this morning and review the Company's press releases and SEC filings."

So here we have a company whose CEO recently underwent personal bankruptcy, and whose COO is going around responding to message board trolls. Meanwhile, just one day earlier, the company announced a new $4.1 million contract (last quarter's revenue: $7 million) for one of its brand new products. What to make of this company?

Disclosure: Author has a long position in shares of BDR

Transocean Oversold?

Value investors often look for opportunities where temporary circumstances have caused the market to unjustifiably depress prices. One such value-minded investor, Frank Voisin, may have uncovered such an opportunity. The following is a guest post where Frank makes his case for Transocean Ltd, a company whose stock has been punished as the massive oil leak on the Gulf of Mexico continues.

Transocean Ltd (RIG) is an international provider of offshore contract drilling services for oil and gas. Transocean is the largest such operator, with 138 mobile offshore drilling units, including 44 high-specification floaters which command the highest day-rates for use in the deepest, harshest drilling environments, 26 mid-water, 65 jack-ups, and 3 others.

On April 20, 2010, a Transocean rig leased to BP plc (BP), the Deepwater Horizon, suffered an explosion and sank two days later. The Deepwater Horizon was in the final stages of casing a well (adding a cement reinforcement liner to the well) when the explosion took place. The well was approximately 1 mile beneath the ocean surface, and extended approximately 5 miles underground. The explosion appears to have been the result of the cement casing not being fully cured, resulting in the release of a massive amount of pressure from the oil reservoir up through the well. Explosions of this sort are supposed to be prevented by a Blow-Out Preventer, a massive device (16m wide) with up to 12 different fail-safe mechanisms that can be manually activated to close over the well to prevent leaks and withstand the pressure. In this case, the Blow-Out Preventer was designed and built by Cameron International Corp (CAM).

The market appears to be expecting losses from this disaster to exceed a present value of $30 billion. This is based on the fact that BP, Transocean and Cameron have suffered market cap reductions of $25 billion, $5 billion and $1 billion respectively.

To put this in perspective, the Exxon Valdez disaster in Prince William Sound, Alaska, which, in 1989 resulted in 250,000 barrels being spilled, led to a jury award (in Baker v. Exxon) of $287 million actual damages + $5 billion punitive damages. The Deepwater Horizon disaster would have to continue, at a rate of 5,000 barrels per day (the current official estimate), for nearly two months to yield the same oil spillage as the Exxon Valdez, and the market would still be pricing a loss equal to 6x the Exxon Valdez.

It is important to note that the original $5,287m loss expected for the Exxon Valdez disaster was subsequently reduced to approximately $500m, and this was paid out 19 years later after substantial litigation, when the Supreme Court of the United States ultimately limited punitive damages to a 1:1 ratio with compensatory damages. At a 10% discount rate, this translates to a 1989 Present Value of less approximately $81m.

Based on the quantum of damages ultimately awarded in Exxon Valdez, and the relative size of the Exxon Valdez disaster to the Deepwater Horizon, we would expect the present value of future losses to be substantially smaller. However, the fact that the Deepwater Horizon disaster took place in a more heavily populated area of greater economic significance could support an argument that future losses will be substantially higher. For the sake of conservatism, we can assume the losses are substantially higher – closer to the amount the market is currently pricing ($30b) and now turn to loss apportionment to determine who would be responsible for these losses.

There are at least three categories of expenses associated with the disaster:

1) Personal Injury/Deaths
2) Loss of the Deepwater Horizon
3) Environmental remediation
4) Loss of revenue

My investigation has led me to conclude that Transocean will be responsible for the first two categories, and that BP will be responsible for the third category.

Transocean is fully insured for the loss of the Deepwater Horizon. The rig has an estimated replacement cost of $700m. Transocean’s 2009 Annual Report shows that it has a deductible of up to $1.5m on the loss of any rigs, and that is has a $10m-per-occurrence deductible on crew personal injury liability and $5m-per-occurrence on other third-party non-crew claims. These deductibles are for a $950m third-party liability coverage exclusive of the personal injury liability. Transocean is reputed to also have $700m in environmental remediation insurance. Thus, Transocean is fully insured for the first two categories, and partially insured for the third.

Given that Transocean is fully insured for the first two categories, the market appears to be pricing in a loss of approximately $5b above the $700m environmental remediation insurance cap. Will Transocean be responsible for environmental remediation? The answer appears quite clearly to be no, and that BP will be responsible for environmental remediation both due to common law, statutory law, and contract law.

Common Law

Under Maritime Common Law, there is an Anchored Tanker precedent, which states that the owner of an anchored tanker is liable for any damage resulting from it, even if that tanker is hit by another ship that was behaving in a reckless or negligent manner. BP, as the lessee of the Deepwater Horizon, is the owner of the anchored tanker, in this case.

Statutory Law

After Exxon Valdez, the US government passed the Oil Pollution Act, which clearly shows liability for the environmental damage to be BP’s responsibility.

Section 1002(a) of the Oil Pollution Act states that the “responsible party” for a facility from which oil is discharged is liable for removal costs and other specified damages.

Section 2701(32)(c) of the Oil Pollution Act states that the “responsible party” means, in the context of offshore facilities, the lessee of the area in which the facility is located, or the holder of a right to use and easement granted under the Outer Continental Shelf Lands Act.

Thus, BP, as the lessee of the facility, is the responsible party, and as such is liable for removal costs under statutory law.

Contract Law

With respect to contract law, various reports online state that a typical drilling contract used in the offshore drilling industry specifies that the lessor (Transocean) is not liable for blowouts. All liability in such situations is the responsibility of the lessee (BP), and that the lessee (BP) will indemnify the lessor (Transocean) even if they are shown to be reckless, negligent, or had behaved with gross misconduct. There has been no evidence presented to suggest that BP and Transocean did not use a standard contract. Given BP’s initial attempts at deflecting blame, it would seem that such an obvious opportunity to point blame at Transocean would have been utilized if available. Given that it was not utilized, I conclude that it is unlikely the contractual relationship between the parties contains anything out of the ordinary.

What The Involved Parties Are Saying

On April 29th, during a previously scheduled analyst call to discuss 2010 Q1 earnings, BP’s CFO, Byron Grote said the following:

"As far as the Gulf of Mexico goes, you asked about contracts, I believe are a kind of code word for here for where does liability lie. … [I]n general, Transocean was responsible for the operation of the rig vessel and its equipment including the blow-out preventer and for drilling the well. In general, the lease owner that’s BP and our partners in the field, are responsible for the cause of regaining control over the well and handling the related environmental cost."

On May 3rd, BP’s CEO, Tony Hayward told Good Morning America his company is “absolutely responsible” for the cleanup.

Transocean does not have insurance for loss of revenue associated with a lost rig. In September 2009, BP extended its lease of the Deepwater Horizon for an additional three years, for $544 million, which equates to approximately $181m per year. This is approximately 1.66% of Transocean’s 2009 revenue. Assuming for simplicity that this represents a similar portion of earnings, this translates to a decrease in earnings of approximately $53m. Using a 9x P/E multiple (the approximate multiple being used prior to the explosion), this should have wiped $477m off of Transocean’s market cap.

Instead, the market priced in 10x this amount. This appears to be an overreaction. This would be the maximum rational drop in market cap, however this figure is mitigated by two items:

1) One of the potential solutions to the continuing leak is to drill new wells into the old well, deep below the ocean floor, and inject cement into the original well. This process could take several months, and BP has begun drilling already. Media reports state that BP has hired Transocean rigs to drill these new wells, which would indicate that Transocean’s loss of revenue will be mitigated to some extent.

2) Since the Deepwater Horizon disaster, the price of oil increased from $84/barrel to $88/barrel. If this is due to the disaster itself, then this would be a persistent increase. Persistent increases in the price of oil have translated to higher dayrates, especially amongst higher specification rigs. Transocean has some of the most sophisticated rigs in the world, and may ultimately be able to charge higher dayrates on its other rigs, which would mitigate the loss of revenue from this one rig.

Conclusion

It appears that all of the parties involved, as well as numerous analysts and commentators, are confirming what the law states: BP will be responsible for environmental remediation, which will constitute the vast majority of expenses relating to this disaster. For those expenses which Transocean is responsible for, Transocean is adequately insured. With regard to the loss of revenues, the ultimate loss, regardless of how liberal they are expected to be, seems to be dwarfed by the amount the market is pricing into Transocean’s current market cap. There appears to be little by way of justification for such a decrease.

The market is being overly pessimistic with Transocean. I expect shares to return to their previous 9x multiple in the near future.

Disclosure: Guest author has a long position in shares of RIG

Sources:
http://www.businessinsurance.com/article/20100423/NEWS/100429963
http://online.barrons.com/article/SB127267764941385119.html
http://blog.iongeo.com/?p=1961 reporting on an expert panel organized by Morgan Stanley’s Oil Field Services analyst, Ole Sorer.
http://www.businessweek.com/news/2010-04-21/transocean-says-blowout-may-have-caused-rig-fire-update1-.html

Jet Setting

Of the 4500 or so airports in the United States, the major airlines only service about 10% of them. Security concerns have also made passenger airplane travel a time-consuming endeavor. As such, for some companies it's quite likely that a business case can be made for the purchase of a corporate jet (though not always).

But increasingly, executives have begun to make personal use of the corporate jet, for which no business case can be made. This is a veiled attempt at increasing compensation, without the appearance of doing so. In some cases, an executive's personal (i.e. non-business related activities) use of the company jet costs the company more than his entire salary! In most of these cases, the company will also issue a bonus to the executive to cover his related tax bill!

A strong corporate governance process is of vital importance to shareholders looking to maximize their returns. Shareholders can get clues as to the quality of a company's corporate governance by examining the company's behaviour when it comes to items like corporate jets.

For example, consider Abercrombie and Fitch, a company we discussed last year as one that re-affirmed its strategy, only to seemingly change it a few weeks later. The company and its CEO recently entered an agreement whereby the CEO was limited to keeping his personal use of the company jet to $200,000 per year. This still seems fairly generous, as $200K for vacation travel in a year does seem rather excessive, but at least it's capped at something, right?

Unfortunately, in return for signing this agreement, the CEO was provided $4 million in cash! This makes you wonder...how much personal use of the jet was he getting before this agreement? A significant amount, if this payment for the $200K cap is any indication. His base salary is just $1.5 million, meaning his use of the corporate jet was a significant perk!

Managers will always try to glean what they can from the company kitty. It's human nature, and so they can hardly be blamed in the aggregate. But as a result, the importance of a governance structure that protects shareholders is instrumental, so that the managers are working for, rather than against, the shareholders. Frivolous use of company property should be a clear sign to shareholders that all isn't right with a company's governance structure, and so they may wish to avoid such companies.

Disclosure: Author has no corporate jet, and reserves the right to change his mind should his company acquire one.

Revenue Timing

Canam (CAM) has dropped some 15% in the last few days, as the company reported a loss in its first quarter earnings results last week. However, Canam has been discussed on this site as a stock idea with long-term potential for gains due to its stable operating model and growing backlog. As a result, temporary pullbacks in the form of revenue timing issues appear to offer long-term investors an excellent buying opportunity.

While the market appears focused on the fact that revenue dropped from $180M to $105M in the first quarter (a large drop by any standard), it's important for long-term investors to look behind the numbers to understand the long-term implications. As a company that designs and builds large-ticket construction products that require long lead times, recessions will hit this company later than it will most. As a result, the slowdown in the economy that occurred in 2009 has only hit the company now. The important indicators for forward-looking shareholders, however, are the company's booking rates.

For Canam, booking rates have been out-pacing revenue, as the company's backlog is now at a record level, though the company has been in existence for 50 years! The company's backlog over the last several quarters is shown below:

There are two main reasons for the large backlog. First, the company has been building roofing installations for two large stadiums (BC Place in Vancouver and Marlins' Stadium in Miami), but isn't scheduled to start delivery of those structures until the second quarter. (In this case, revenue cannot be booked until delivery has taken place.) These contracts alone are worth $180M; compare that to the company's first quarter revenue of $105M. In essence, revenue from the first quarter was simply pushed to revenues in future quarters, making first quarter revenue look poorer than it was, but making future quarters look better than they should.

Second, with prices depressed among competitors and complementary businesses, Canam has been at work acquiring companies, including Tennessee-based FabSouth, which added another $100M+ to the company's backlog. Since FabSouth was not fully consolidated in Canam's results until most of the first quarter was complete, these revenue numbers don't show the full impact of Canam's full business. But as the company works through its record backlog (and it expects to deliver all of its current backlog within a year), those revenue numbers will see strong sequential growth.

Investors focused only on quarterly earnings are sure to make poor decisions when it comes to making purchase decisions for the long-term. For companies dealing in large-ticket items, revenue timing issues can play a significant role in any one quarter's results. As such, it's important that investors think about the company's business from a long-term perspective to put themselves in a position to properly value a company's stock.

Disclosure: Author has a long position in shares of CAM

New Era Value Investing: Chapter 3

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In this chapter, Tengler outlines a value strategy that she employs successfully, calling it Relative Dividend Yield (RDY).

With the increasing ability to use technology to compare various factors across a whole slew of stock issues in the 1970s, many investment ideas were spawned. Tengler believes RDY to be one that has much in the way of value appeal conceptually, along with a successful track record.

In RDY, a stock's dividend yield is compared to the market on a historical basis. If the stock's dividend yield beats that of the market by 25% or more, and the stock's yield is high on a historical basis (for this particular stock), it becomes an attractive buy. Should the stock rise to a point where the yield drops below the market's yield, it becomes a sell.

Tengler discusses several reasons that this strategy works. Dividends are more consistent than earnings, so while earnings can fluctuate, Tengler argues that dividends offer the best glimpse of management's view of a stable pay-out that the company can maintain for the long-term.

Furthermore, when a company's yield rises as compared to that of the market, it is a sign that it is not favoured by the market. Tengler argues that this is a good time to buy. She cites Coca-Cola and Johnson & Johnson as ideal examples of this in 2001-02.

Finally, Tengler notes that there are times when this strategy doesn't work. For example, if a stock's relative price to the market is uncorrelated with its RDY, Tengler notes that the strategy no longer outperforms.

New Era Value Investing: Chapter 2

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Tengler takes the reader through the history of fundamental analysis in the stock market. While many value investors know the history as far back as Benjamin Graham and David Dodd's Security Analysis, Tengler goes further back to give credit to two New Yorkers who laid the groundwork that allowed Graham and Dodd to do their thing.

In the late 1800's, the stock market was akin to a casino, as fraudulent activities reigned throughout. Louis Guenther started a magazine in 1902 that reported on and exposed securities fraud, while Alfred Best published a service focused on reporting accurate information on insurance company financials, originally to allow customers to buy fire insurance from reputable companies that weren't going to go under. It was Best that first noted the concept of intrinsic value, whereby investors were encouraged to purchase stocks if they traded below the estimate of their intrinsic values.

In the 1930s came the groundbreaking work from Graham and Dodd, but even in subsequent editions of Graham's books did his methods evolve, though based on the same principles. This is because the market continued to evolve, as the methods that worked the best during the Great Depression were not the same as those that worked the best during WWII.

Over time, the dividend has also become less relevant. At one time, it was a mark of a great company that could continually reward its shareholders, but more recently it has become a sign that a corporation does not have profitable uses for its earnings. Dividend-focused value investors would be forced to change.