Thursday, November 29, 2007

Sally's first year

Sally Beauty reported it's first year results since being spun off from Alberto-Culver. I'd say the results are very encouraging. If you recall, the massive debt load from issuing a $25 a share dividend has been partially balanced by a significant tax savings. For the year:

Year                          2007    2006    2005    2004
Net interest expense       145,972      92   2,966   2,250
Provision for income taxes  38,121  69,916  73,154  62,059
That's a pretty significant tax savings, though not enough to offset the bigger interest expense. Sally's ability to finance the debt out of cash flow has improved:
Free cash flow             138,991 126,379  63,219 107,265
Free cash flow margin        5.53%   5.33%   2.80%   5.11%
In fact, all the margins (except net earnings) have improved:
Gross margin                45.90%  45.80%  45.56%  45.33%
Operating margin             9.09%   7.59%   8.54%   8.09%
Net margin                   1.77%   4.64%   5.17%   5.02%
One of the reasons for this is that Sally has improved its inventory picture:
Inventory DIO               152.82  163.15  156.17
Receivable DSO                7.46    6.99    6.53
Payable DPO                  47.41   50.12   44.94
Cash Conversion             112.87  120.03  117.76
A large part of these gains come because same store sales increased 4.5% despite losing L'Oreal products from BSG.

Overall, Sally Beauty is doing everything they need to do in order to make the special dividend gamble pay off. I'm quite happy to hang onto my shares while the company pays down debt and exploits its leverage.

Wednesday, November 21, 2007

Only swing at soft pitches

I've been working on a model for pricing options that does not rely on volatility as an input. (I know: I might as well try to design an airplane without wings.) Testing it out on real prices, I've found that it give vastly different answers for most options. But when the stock price is fairly close to the strike price and the expiration date is only a few months in the future, my estimate doesn't stray too far from the market quote. So as a general options pricing model, this one pretty much fails.

But today I realized that I really don't care. The vast majority of options are ones I don't really care to sell in the first place. For the most part, I want to sell options with strike prices near the price I would value a company. And options longer than a few months in duration are not interesting either since it would be hard to value the underlying shares. Further, I don't really plan on selling options that are less than 50 or 60¢ because commissions eat up too much of the premium. In essence, my model pins a value on the options I'd really like to sell and I don't care what it does to options I want nothing to do with.

Now I'm interested in selling a January $22.50 option on Oracle that currently trades for 50¢. It's pretty far out of the money, so my model does a rotten job of evaluating its price. It comes up with a negative price, which obviously won't work. On the other hand, my model values the $20 option at about $1.32 while the market says the option is worth $1.50. If I were interested in selling Oracle at $20, I'd take that price, which would amount to selling Oracle at $21.50 with a 67% probability.

As it turns out, if Oracle where trading at $22.50 today, I estimate that the $22.50 option would be worth about $1.24. Now there isn't much chance that Oracle will jump from $20.21 to $22.50 in one day, but it does exist. And if it did happen, I'd gladly sell an option on my Oracle shares for that price. It would be a pitch I'd know what to do with.

Monday, November 19, 2007

Value potential energy

Recently Vitaliy Katsenelson was interviewed by Philip Durell and Bill Mann. I picked up a few ideas that apply to my investments.


In the interview, Mr. Katsenelson pointed out that international investing may actually reduce risk in an otherwise US-based portfolio. When I first bought Canon, hedging against a dollar decline factored into the decision. Since then as the dollar has strengthened from about 105 ¥ to 109.61 ¥ with a lot of fluctuation in the interim. Canon has been increasing their dividend which yields about 2.7% compared to the Japanese 30 year bond that yields 2.27%. If (when) Japan raises rates, Canon's price measured in yen will likely go up to push its yield down. At the same time, the yen dividend will likely be more valuable in terms of dollars. Since Canon has a very strong product line, the stock is very close to a sure thing.

Another point the interview touched on is that the address of corporate headquarters doesn't tell the whole story of what countries a company is exposed to. While Canon is largely a Japanese company, it sells products all over the world and has manufacturing and R&D facilities spread around Europe, the United States, and Asia.

First Marblehead

I'll just quote Mr. Katsenelson:
Another one, and I know you guys both like is First Marblehead. This stock trades at what, eight, nine times earnings? It has a phenomenal growth rate ahead of it and I think the investors still put it into the subprime mortgage category, even thought the average FICO score of its portfolio is 714, which is very high; 83% of it loans co-signed.

The part that I love about it [is] this whole speculation about major customers JPMorgan and Bank of America going away [and] you can quantify that easily. You can figure out what impact it would have on the portfolio if both Bank of America and JPMorgan dropped First Marblehead and actually I figured it out and kind of my worst case, a year after JPMorgan dropped; if JPMorgan and Bank of America leave First Marblehead, its revenues would be up 20% or 30% over where they are today. So my downside is basically none.

You could argue that the margins may become compressed, but that the JPMorgan and Bank of America business is growing so fast that it should overcompensate that. I know you guys will agree.

Potential energy

Quite a bit of the interview was actually about the importance of price when it comes to investing. I starting thinking of it like the potential energy in a spring or a hot air balloon. In Active Value Investing, Vitaliy Katsenelson suggests the QVG framework for examining investments. Quality (Q) could loosely be tied to earnings, Value (V) is related to price, and Growth (G) is how earnings (or cash flow) are likely to change in the future. (This is far too simplistic I'm sure.) To go back to the balloon analogy, price is the altitude the balloon floats at, earnings are the buoyancy of the balloon and growth is how fast that buoyancy is changing.

Now investors looking at the balloon from outside try to guess where it will be floating over some period of time. As management dumps ballast (cuts costs) or adds heat (increasing revenues), the balloon ought to rise. If it can't for some reason (investors holding the price down), the potential energy increases. The altitude (price) is fairly easy to see, but the buoyancy and its rate of change (earnings and growth) are much harder to judge. As a result, lower altitude (price) might actually be the best signal to buy assuming buoyancy (earnings potential) is increasing.

The surrounding environment contributes to the potential energy as well. A balloon will be more buoyant on cold day, while stocks have the greatest potential in markets that have low P/E ratios. The inverse of P/E ratios, earnings yields is a direct measure of potential energy. Since P/E ratios for the market as a whole are trending down, prices won't be helped as much as they once were, so it's important to have good earning yields in the individual stocks you buy and own. Canon (6.78%) and First Marblehead (13.28%) are currently have the most potential energy in my portfolio.

Friday, November 16, 2007

Why I won't be rolling my Oracle call options

The November call option I wrote will be expiring this weekend and the December option is likely to expire too (35% chance). But instead of rolling them forward, I now plan on hanging on to my Oracle shares for a bit longer. I listened to the recent OpenWorld keynotes and also the analyst meeting and I think I've ignored some significant real options that Oracle might exploit.

According to my discount cash flow models, Oracle is well within the low range of its fair value. The market is assuming 10% growth for 10 years or 14% growth for 5 years. Safra Catz, Oracle's CFO, has set 20% as the goal and hinted at 26% as a possibility. Normally, there would be reasons to be skeptical of these claims, but Oracle has some unique attributes that make this sort of growth possible and even likely.

To begin with, much of Oracle's revenues are incompressible. In other words, once a client begins to depend on HR, accounting, CRM or other software as a critical element in their business, it isn't possible to reduce the licensing stream going to Oracle without shutting down altogether. As a result, there is a floor on how much revenues can fall. Also, the natural tendency is for margins to increase over time rather than decrease. Continuing licenses are nearly cost free to Oracle because of scale.

Now assuming there is a recession this year and next, Oracle will have a harder time growing organically. But the revenue stream shouldn't fall too much and it will have an opportunity to either lower costs or buy up other companies cheaply. If the recession doesn't occur or is mild, Oracle has the option to expand its offerings organically in addition. So because of the nature of its business, Oracle has more flexibility than most companies to deal with downturns. That flexibility represents a real option that I hadn't accounted for in the past. Being able to grow earnings in the face of economic headwinds could be a huge advantage.

I know I've flip-flopped on Oracle lately. Part of the reason is that its share price has been jumping around my lower edge of my value estimates. It hasn't gotten so expensive that I feel the need to sell right away, and it isn't so cheap I'm interested in buying more.

Thursday, November 15, 2007

Did BEA's financial results make it more valuable?

One of the tough things about evaluating BEA is that they have been delinquent in their SEC filings until today. For an Oracle investor trying to see if it makes sense to acquire BEAS, the only number that really matters is total revenue. Everything else is pretty much noise, since the purpose of such a deal would be allow much better operating margins. Over the last 12 months, revenues were $1,486,713,000 compared to $1,351,967,000 the twelve months before that. Given Oracle's operating margin (~33%), that would result in $491 million in operating income. That is a significant increase from the $206 million it made in FY 2006, which was the most recent filings investors have had access to. That would indicate Oracle would need to raise its price.

But I don't think that is going to happen. For one, only $541 million of the revenues are from licenses—the rest are from far less profitable services. Also, BEA's operating income was actually negative over the last 12 months. So independent of Oracle or some other buyer, BEAS may be worth less than it was before. Further, the profitable license reviews are decreasing while Oracle's middleware sales are increasing. In any case, Oracle is in an excellent negotiating position.

Wednesday, November 07, 2007

Can First Marblehead be worth $10?

Seeking Alpha asks: First Marblehead: Worth $10 or $60? Without going into the arguments presented, which weren't particularly quantitative anyway, I don't see how you could value the stock at $10. $60 or $30 or nothing seem better guesses.

Let's take the case for the business being worthless. Basically, if management is somehow fraudulent and has stolen or wasted all of the cash in the coffers while rendering the residuals on the balance sheet valueless. Throw in a lawsuit or ten for good measure. In that case, the company is headed for bankruptcy court. Otherwise, cash and residuals are worth about $10.80 a share all by themselves. Perhaps the residuals are carried on the books at a higher price than if they were sold on the market, but First Marblehead doesn't need to sell them at market prices as long as it's still in business. And as long as the company is still in business, its value is higher than the $10.80 per share book value.

A dividend discount model prices the current $1.10 a year dividend at $33 1/2 even if the dividend never increased. To state it another way, income of $1.10 a year forever discounted to the present at 11% is worth more than $30. Forever sounds like a long time, but it's important to remember the discount model explicitly weighs income from distant years less than income in the near future. Because the dividend in 2100 is much less likely than the dividend in 2010 it also provides a much smaller portion of the present value of the dividend stream.

Ok, so if First Marblehead isn't a complete disaster or a static income stream, what other possibilities exist? Well, it could continue to grow at a healthy, though maybe not rocket-like, pace. Presumably, the dividend cannot continue to grow at 77% like it did last year nor can earnings increase by 57%, 48%, or 112% as they did in the last three years. So let's assume the dividend grows by 10% or earnings grow by 15% over the next five years. In those scenarios, I calculate First Marblehead shares are worth about $60 each. Given some growth in First Marblehead's business, I don't think many would consider these growth rates aggressive.

At this point, you could put together an expected value based on the odds of the $0, $30, and $60 scenarios panning out, but I don't think I'll bother. The $0 and $30 values are based on completely unlikely possibilities in my opinion. They might be 5% possibilities combined. I'd say my $60 scenario has a better than 5% chance of being far too conservative, but we don't need to consider that to see that at $33 1/2 FMD is a bargain.

Tuesday, November 06, 2007

Why I sold two more call options on Oracle

This morning I sold November and December $22.50 call options that cover all of my remaining shares of Oracle for 60¢ and $1.05 respectively. I've already discussed a number of reasons for trying to sell, so I won't go into too much detail. I should note, that a) my call options have captured nearly a full year of Oracle's earnings and b) I find Wall Street's estimate of 20% earnings growth seems fairly unlikely. In fact, the next few quarters may very well be disappointing because of a global slowdown. Buying BEA, even at a discount, just isn't enough to justify Oracle's current market price and make up the difference.

I should point out that by writing calls for two separate expiry dates I'm raising my costs fairly dramatically. Assuming both options are assigned, I basically have doubled my costs. But I've also doubled my opportunities. Imagine a coin-flipping offer where you earn a prize each time you flip heads and lose the coin the first time you flip tails. If you can chose between one coin that earns $2 for heads or two coins that earn a dollar each, which is a better choice? Although the expected return on the first turn is the same ($1), taking two coins gives you a 3 of 4 chance to go to a second turn as opposed to a 50% with one coin. This won't change the expected return, but it does keep you in the game longer. With two coins, you have more expected options to leave the game if the odds were to shift.

Thanks to a 3.4% increase in Oracle today, the odds the November option will be used are 63% and for the December option 66%. There isn't much short interest to propel shares higher on unexpected news and the market is already expecting good news during next week's OpenWorld conference and Q2 earnings announced in December. Therefor, I feel these options are likely to be profitable for me even if my shares are called away.