2011 Pershing Square Challenge - parts 1 & 2

h/t to bonechip1 from the corner of berkshire & fairfax message board

A few updates...

I haven't had much time to write. But, I did want to let readers know that 2 of the positions previously mentioned on this blog have been closed out - Standard Financial & Lodgenet. The main reason, to raise cash for better opportunities. I've also been trimming my position in Carrefour, for the same reason (cash raise / better opportunities). But also because they've decided to hold off on the property ipo, which was a key part to my investment thesis.

In the meantime, I've made the following purchases, Iron Mountain (IRM), Penn Millers (PMIC), and Company X (I'll post on this one later, as I'm using this idea for the Ira Sohn Investment Contest). Iron Mountain and Penn Millers both fall in the event-driven / special situation theme that I like to invest in when markets are fairly valued.

Iron Mountain is a company I've been wanting to invest in for years. It has recurring revenue, which generates a tremendous amount of cash flow. The part that always bothered me though, was how that cash was being used. You could argue that it was being wasted on needless acquisitions and sub-optimal markets. Well, that's exactly the argument that Elliott Advisors made. Elliott put together a compelling presentation that made the case for reducing capital expenditures, increasing margins in their international markets, and reducing g&a expenses. Elliott also urged management to consider converting into a REIT. Interestingly enough, management seems to be listening. On April 14th, it was announced that Bob Brennan would resign as CEO and Richard Reese (previous CEO and current Chairman) would replace him immediately. Since then, IRM and Elliott have come to an agreement:

• IRM will return $1.2 billion to shareholders in the next 12 months via share repurchases and dividends
• IRM will distribute $2.2 billion to shareholders through 2013
• IRM will consider converting into a REIT
• One of Elliott's nominees will join the IRM Board
• IRM will also explore strategic alternatives for it's digital business

Today, IRM demonstrated just how serious they are about implementing this 3-year strategic plan:

Iron Mountain Announces $850 Increase to Share Repurchase Authorization...

For those of you that are interested in PMIC, I'd direct you to the following, which is a terrific blog and a terrific write up:

Above Average Odds Investing - PMIC write up

PMIC continues to trade below book value. And in the meanwhile, management continues to buy shares at a significant discount. But even better, I believe a buyout offer is in the making. On April 29th, the Lion Fund / Biglari Holdings filed a 13D, which indicates that the Lion Funds / Biglari Holdings now own 8.4% of the outstanding shares. Since the 13D is your typical, boiler-plate filing, it might not seem like much. But, Biglari has been eager to purchase an insurer - one can guess, so he can use the float to make more investments. Biglari aggressively pursued Fremont Michigan Insuracorp (FMMH.PK), but was eventually  topped by Auto Club Insurance Association. A closer look at the 13D will show that Biglari's initial purchase of PMIC was on March 9th. But you'll see that majority of the purchases take place on April 18th, the same day that FMMH announced it's agreement to be purchased by Auto Club.

Moats, Events, and Options

Generally speaking, there are three categories that comprise my portfolio:

Moats
First, I have what Warren Buffett has famously dubbed, the Generals. These are companies that have few competitors; strong, durable competitive advantages; high profit margins, ROE, and ROIC; minimal capital requirements; and steady cash flows. In other words, these companies have wide moats and should be around for a rather long time. To be clear, when companies like this trade at a discount, I like to pick up as many shares as I possibly can. An example of such a company is MasterCard. I first purchased shares of MasterCard shortly after they went public. Cost basis is just under fifty bucks a share. Mastercard met all of the above criteria. Due to some pending lawsuits, the shares were completely mispriced, which gave me the opportunity to load up on Mastercard's shares. Since then, I've sold some shares here and there to pursue other opportunities. But MasterCard still makes up a significant part of my portfolio.


Events
When I'm having trouble finding generals, which is quite often given their business superiority, I search for special situations. These include, but are not limited to, spinoffs, bankruptcy plays, mergers and acquisitions, and liquidations. For example, I currently hold a position in Carrefour. Partially because I believe they will spinoff their company owned stores into a publicly traded company. Such a move would certainly highlight the value of all the real estate that they own. General Growth Properties, an investment I made as soon as they entered bankruptcy, falls into this category as well as my next category. General Growth spunoff shares of the Howard Hughes Co. late last year. I continue to hold shares of HHC as I believe they have tremendous assets. I also believe Chairman Bill Ackman will create substantial value for shareholders.

Options
I'll often take very small positions in options. These could be traditional options with strike prices and expiry dates or these could be "options" in equity or preferred stock that have been left for dead. Back to General Growth, when I purchased General Growth it was trading at sixty one cents a share. I took a small position in the company knowing that shareholders could get wiped out. But I also knew that if the shares remained intact, shareholders would make multiple times their money. A similar situation can now be found in the Freddie and Fannie preferreds. The preference shares currently trade in an approximate range of three to five percent of par. Depending on what the government decides to do, these shares could become worthless.  However, if Freddie and Fannie can work things out with the government and begin paying the divided to the preference shares or if any other positive outcome of that nature occurs, investors will likely reap multiple times their money. So while such investments are not options in the traditional sense, they have option like tendencies. Small positions such as the ones mentioned above can have a significant impact on the portfolio when things workout. Small being the key word, should things not work out, it will be of minimal impact.

Lodgenet: The Stable, Possibly Declining, Cash Cow

This morning I initiated a small position in Lodgenet - LNET. There is much to question (durability of business model) and much to hate (tons of debt). But at the end of the day, it's tough to ignore the copious amounts of cash that this thing generates:

Cash Flow From Operations
2008 - $90 million
2009 - $86 million
TTM - $100 million

Free Cash Flow
2008 - $25 million
2009 - $65 million
TTM - $80 million

This all adds up to a P/CF multiple of 0.8 and a P/FCF multiple of 1.0! Now of course, this doesn't take debt into account, so lets take a look at that.

As of Q3 2010, LNET's net debt stood at $382.4 million. (in other words, more than 4x it's current market cap) That said, however, LNET has been able to bring down it's net debt from $611.3 million in Q1 2008 to the previously mentioned $382.4 million in it's most recent quarter. This means that on a quarterly basis LNET is eliminating nearly $23 million in net debt. So with that in mind lets take a look at a couple more multiples. As of today, LNET's Enterprise Value / EBITDA stands at 4.6 and Enterprise Value to Free Cash Flow is 6.0.

As the title suggests, the biggest risk is the stability of these cash flows. LNET dominates the market that it's in, but with the Internet and other emerging technologies, it is difficult to say how much longer it's business will be considered relevant. This investment, or should I say speculation, reminds me of Deluxe Corp in 2000. Many had written the company off, thinking checks would become extinct. However, management allocated the company's cash flows accordingly and was able to create substantial value for shareholders. (Deluxe's stock doubled within the next 2 years) In this case, management is intensely focused on free cash flow and paying down debt. Simply delevering the balance sheet should create extraordinary value for investors. In summary, an investment in LNET is simply a bet that the company will survive (that is be relevant) much longer than the market is currently expecting.

Bruce Flatt's comments on GGP

From his 2010 Q3 Letter to Shareholders:

 

General Growth Properties

 

Next week, General Growth Properties will emerge from bankruptcy and be split into two companies. Upon separation, we will own approximately 27% of General Growth (“GGP”) and approximately 14% of The Howard Hughes Corporation (“HHC”) on a fully diluted basis. Our overall investment will be approximately $2.5 billion, of which approximately $1 billion will be from our balance sheet and the remainder from our clients. GGP, the second largest U.S. mall owner, will complete an equity offering prior to year end to redeem some of the capital committed by other shareholders to the recapitalization and at that time, our three year involvement with GGP will result in the company being re-launched with a strong balance sheet, as it becomes a major investment for Brookfield.

 

From an economic standpoint, like most of our other businesses, we are seeing retail sales slowly recovering. With this recovery in front of us, and with some targeted strategic initiatives as well as capital investment, we believe we can remake GGP into the best retail shopping mall company in America. Recently, three of our officers were elected as board members of GGP, with me as chairman, and in addition we provided the company with a chief financial officer from our management team in order to assist in implementing its plans. GGP also last week announced the hiring of a CEO with extensive retail property experience, who we are very excited about working with. With these management additions, and in conjunction with the balance sheet strength coming out of recapitalization, we believe that GGP has substantial room to grow cash flows over the next five years.

 

In addition, as a result of the court reorganization, there are no make-whole costs to redeem the majority of the $18 billion of mortgages in place in the company and given current interest levels, the opportunity to refinance these mortgages is a benefit not envisaged two years ago. As a result, GGP is rapidly moving to lengthen the overall term of its financings, reduce interest costs, and eliminate much of the substantial amortization which was embedded into the mortgages currently in place.

 

We believe that with a concerted effort, GGP could be one of our more successful investments in the fullness of time, and we are excited to have an opportunity to be involved in this great company.

 

Full Disclosure: Long GGP / HHC

Standard Financial

Just picked up some shares of Standard Financial, which is a recent mutual-to-stock conversion selling well below book value.  Furthermore, activist investor Joseph Stilwell owns 8% of the company. Item 4 of his 13D filing states the following:

"We hope to work with existing management and the board of the Issuer to maximize shareholder value.  We will encourage management and the board to pay dividends to shareholders and repurchase shares of outstanding Common Stock with excess capital, and will support them if they do so.  We oppose using excess capital to "bulk up" on securities or to rapidly increase the loan portfolio.  We will support only a gradual increase in the branch network.  If the Issuer pursues any action that dilutes tangible book value per share, we will aggressively seek board representation."

Disclosure: Long Standard Financial (STND)

The Return of the Activist Investor...minus Chris Hohn

All week headlines have heralded the return of activist investors. However, one name is yet to be heard from - Chris Hohn. Chris Hohn is best known for his involvement in Deutsche Boerse. In the US, he was involved in a high-profile proxy battle against CSX. Unfortunately, since the credit crisis, things seemed to go downhill for Hohn and TCI Funds. Amid the commotion, Hohn's top lieutenants left the firm.

Enter the current environment. Ackman is back at it. He's teamed up with Vornado and built a massive position in JC Penney. Sardar Biglari, the controversial Chairman and CEO of Biglari Holdings, has just offered to buy Fremont Michigan InsuraCorp. Even 3G Capital, who teamed up with TCI in the CSX proxy battle, is back in the mix with an offer to buyout Burger King.

So where is Chris Hohn?

I ask because Hohn has always pursued some interesting companies. His ideal company seems to be one with monopolistic characteristics. Monopolies that are content with the status quo and just need a little push. It will be exciting to see if Hohn pops out of the woodwork in the coming months.