Monday, February 7, 2011

M&F Worldwide Looks Cheap

M&F Worldwide (MFW) trades for just $466 million despite earnings over the last twelve months of $96 million, for a P/E of just 5. Furthermore, M&F's earnings understate its cash flow, as the company amortizes a ton of intangible assets on its income statement; the firm amortizes about $100 million a year from previous acquisitions, mostly under the "customer relationships" account. As such, the company's operating cash flow has been at least $200 million in each of the last three years, making it appear dirt cheap at its current market cap.

But this example illustrates one of the pitfalls of the P/E ratio: it ignores a company's financial risk. In the case of M&F, the company is loaded with debt. The firm owes $2.3 billion to its creditors, the bulk of which is borrowed against M&F's line of credit. Interest payments are based on a floating rate, so the company's net income looks good right now because rates are low. However, should rates tick up, the cost of debt has the potential to increase significantly.

The good news is that the revolver doesn't come due until 2014. So if the business can be counted on to continue to provide stable cash flow, and management applies that cash towards debt repayment, perhaps the company could be looked at as a sort of "public" leveraged buy-out situation, as seen with Supervalu. Unfortunately, neither of those two factors appear to be on the side of M&F.

First, the company derives a large portion of its operating income from check printing. But this industry is in decline, as electronic forms of cash transactions grow in popularity. Second, management is not showing any interest in debt repayment; the firm continues to make acquisitions. Following the release of its latest financials, M&F agreed to purchase a private company for $140 to $160 million. Obviously, acquisitions could bolster the company's earnings. But they also increase the company's risk, as leverage is already rather high.

Finally, there are some ethical considerations of which investors should be aware. A large portion of M&F is owned by Ronald Perelman, who a few years ago tried to sell a company he owned personally to M&F for four times its market value! A string of lawsuits eventually prevented this transaction from closing, but such self-dealing in the future could be harmful to shareholders.

M&F is cheap enough such that it may reward current shareholders handsomely. However, there is enough risk present such that the threat of permanent capital loss is still present. Should the company face operational difficulties at the same time as its debt comes due, an ugly situation could present itself.

Disclosure: No position


Anonymous said...

Hi Saj!

Glad you checked MFW! I pretty much agree with your thesis. The leverage and the Perlmann equation are no doubt substantial risks.

However the company is trading at very low valuations related to its peers: (I admit though, I haven't throughly analyzed it's competitors).

It seems to me that Mr. Market is exaggerating the decline of the check printing business. Having said that, MFW is also the worldwide leader of sales in licorice products.

But the debt, oh the debt, it still makes me jitter and unsure!

Cheers Saj!

Mario R.

Ankit Gupta said...

Even if it appears to trade at a "discount" to the peers, it could still be worth 0. Purchasing equity is a statement on your part that you believe the company, as a whole, is worth more than $2.3B, and that the value can be realized before this debt all comes due.

The market cap is $475M. Buying at today's prices is a belief that the company is worth $2.75B, or probably more, because you only buy if it's worth more than what you paid. With any decent margin of safety, you'd have to believe that the company is worth $3-3.5B to really want to look at this as a potential investment.

Anonymous said...

Saj, would you be so kind as to delete my previous comment (it has several grammatical and spelling errors), and post the following instead, thank you so much:

Ankit, you took me out of context here!

But of course, if I were to invest in this highly leveraged company, I would be betting on the fact that the company’s shareholders will, before the debt matures, owe most or all of the assets (and it's free cash flows) it borrowed against. I thought I made it clear I was terribly afraid of the debt load! And therefore, in this case the risk outweighs the reward...

Comparing a company to its peers, as you say, does not warrant it a sound investment, many other qualitative and quantitative variables must be revised thoroughly. However, I thought it was interesting to mention, given Mr. Market assigns DLX (a direct competitor to MFW) a price several times its book value, although its debt to equity ratio is much larger than MFW’s (again, I haven't checked its competitors well enough to understand why this is the case).

It’s a pity, after all, MFW is in several very boring businesses and I would have loved investing in it. Anyhow, it's a no called strike game, this that (as far as I can tell), Saj, you and I love: value investing. So let's keep looking for that home run!

Cheers to both of you!

Mario R.