Newsletter Q3 2000
July 15,
2000
Free
Cash Flow and Share Buybacks
Warren
Buffett stresses the importance of free cash flow in determining the value of
a business. Free cash flow
represents the cash that a business generates after capital expenditures and
increased working capital requirements that are necessary to grow the
business. As the sage of Omaha
has pointed out, the stock market is a voting machine or popularity contest in
the short run but a weighing machine (for cash) in the long run.
Investors will not ignore for long businesses that generate
progressively larger amounts of cash.
Businesses
that generate significant free cash flow have a greater ability to increase
dividends, buyback shares, reduce debt, or acquire other businesses.
Most of the companies in your portfolios have bought back a significant
number of shares outstanding during the last year.
PacifiCare Health Systems (PHSY), for example, has taken advantage of a
low stock price and repurchased 20% of its share outstanding during the last
twelve months. Although net income is expected to be slightly lower this
year, earnings per share should increase by approximately 20% due to fewer
shares outstanding.
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Updates
Meditrust
Companies (MT) has benefited from some investor interest as the price
increased at the end of June, after languishing in the cellar for a few
months. I am normally reluctant
to average down. However, at a
price of $2, MT was my highest rated stock by far and positions were increased
in all accounts. MT has not made
any announcements yet regarding the sale of their health care properties.
After the recent price rise, MT continues to sell for just over 2X
estimated funds from operations or 20% of book value, which is remarkably low,
even for the out-of-favor REIT industry.
General
Motors (GM) completed the repurchase of 86.4 million shares (14% of
outstanding shares) of GM in exchange for GM Class H (Hughes Electronics or
GMH) common stock. More shares
were tendered than expected and arbitrageurs unwound their positions after the
exchange by selling GM and buying GMH. The
result was a sharp but temporary price decline for GM.
GM still owns 35% of Hughes Electronics, which represents a value of
$24 per GM share. Some analysts
expect GM to spin-off its remaining interest in GMH to shareholders in 2001.
Assuming a spin-off of GMH, GM currently sells for 3.5X estimated
earnings or 3X free cash flow for 2001.
ICN
Pharmaceuticals, Inc. (ICN) announced a plan in June to enhance shareholder
value by splitting the company into three publicly traded companies.
The split would be accomplished with an IPO by selling 20% of two new
entities. Ribapharm Inc. will
receive the royalty stream from the company's highly successful ribavirin
(treatment for hepatitis) and will conduct research on ICN's library of more
than 3,500 nucleoside analog compounds. ICN
International will consist of ICN's operations in Russia, Europe and the
Pacific Basin. ICN Pharmaceuticals will continue to own 80% of the two
subsidiaries. The purpose of the
split is to provide greater transparency and visibility for the subsidiaries,
which will hopefully result in a higher combined valuation by investors.
Gehl
Company (GEHL) announced that reduced demand for its agricultural equipment,
due to lower milk prices, and higher interest rates would result in lower
earnings for the second quarter and full year.
GEHL is currently selling for 6.4X the reduced estimated earnings for
2000 or 5X the 2001 estimate. During
1999, GEHL reduced shares outstanding by 12% to 5.6 million and announced
another authorization in February to repurchase 325,000 shares.
The
Board of Directors of Dreyfus Strategic Governments Income, Inc. (DSI)
approved a proposal to merge into Dreyfus A Bonds Plus, Inc., an open-end
fund. If approved by
shareholders, the merger will result in the elimination of the discount to net
asset value. The share price has
risen in anticipation of shareholder approval.
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Additions
Abercrombie
& Fitch Company (ANF) has 275 retail stores that sell clothing for men,
women, and children and generate over $1 billion in revenue.
The price of the stock had dropped by 80% from its 1999 high due to
declining same store sales comparisons. In
1998, comparable store sales increased a spectacular 35%, followed by a 10%
increase in 1999. For the first 6 months of 2000, comparable store sales
declined by 8% while revenue increased by 11% due to new store openings.
ANF continues to have some of the highest operating margins in the
industry and revenue per square foot exceeds that of the GAP, which sells at a
much higher P/E ratio. The return
on investment for ANF's new stores is 80% so the company will continue to
prosper as they continue to expand through new store openings.
FINOVA
Corporation (FNV) is engaged in commercial lending to middle-market
businesses. The company has
assets in excess of $14 billion and maintains a fairly conservative
equity/asset ratio of 12%. In
April, FNV announced a $80 million special charge to pre-tax earnings for the
loan write-off of a major customer. Sam
Eichenfield, chairman and CEO, retired around the same time, which generated
much speculation. The company
stated that the write-off was not indicative of a systemic problem and Mr.
Eichenfield's retirement was not related to portfolio issues. Investors
feared the worst, however, and the subsequent decline in the price of FNV
reduced the market value of the company by $1.4 billion.
At that point in time, FNV was selling for 4X estimated earnings.
The overreaction by some investors created a good opportunity for us.
Meritor
Automotive, Inc. (MRA), a spin-off from Rockwell International, is a global
supplier of truck and automotive components with $4.5 billion in revenue.
Although North American truck sales have slowed down, MRA anticipates
double-digit earnings growth due to ongoing process improvement and cost
reduction efforts. Meritor and Arvin Industries (ARV) announced a merger that is
pending approval by the European Union. MRA
and ARV have different product lines with little overlap.
The companies anticipate cost savings after the merger of $100 million,
which represents approximately 20% of their combined 1999 pretax income.
MRA currently sells for 4X estimated earnings, which excludes any
post-merger savings.
Harmony
Gold Mining Co. Ltd. (HGMCY) is a South African company with over 24 million
ounces of total (proved and probable) gold reserves. Unlike many gold mining companies, HGMCY has only a small
amount of its production hedged. If
the price of gold rises, as I expect over the next few years, HGMCY will
receive the full benefit of its operating leverage.
HGMCY sells for 5X fiscal year 2001 estimated earnings.
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Deletions
Borders
Group (BGP) was sold at a profit and replaced by Abercrombie and Fitch in the
retail sector. Stewart
Enterprises (STEI) was sold at a loss, as competitive pressures have not
abated. Some small positions in
Sabre Holdings (TSG), Maxwell Shoes (MAXS), and Ducommun (DCO) were sold and
used as a source of cash for other purchases.
If
you have any questions regarding your accounts, please do not hesitate to call
me.
Sincerely,
Robert G. Kahl,
CFA,
CPA, MBA
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Sabino
Investment Management, L.L.C.