Amdocs: A Cash Machine On Sale



Amdocs (NASDAQ:DOX) has the type of strong, recurring cash flow stream that is normally highly valued by Wall Street. However, by looking at the valuation of Amdocs one would never know this. Excluding net cash (Amdocs has over $9 a share in cash), Amdocs trades at a roughly 10% trailing free cash flow yield and a little over 10 times forward earnings estimates.

Read the rest on Seeking Alpha

Higher One's High Potential Reward

*this was originally published on September 29 on SeekingAlpha and share price was ~$2.50. All figures are based on a ~$2.50 share price

Summary
  • Higher One generates roughly $40 million a year in free cash flow & trades at 3 times FCF.
  • Higher One has issues than can be worked through.
  • If Higher One can work through these issues it could be a $10 stock again.

Higher One's Business

Higher One (NYSE:ONE) operates in two related lines of business. Higher One's first line of business is providing software to universities. One of their software tools facilitates the transmission of financial aid to students. Financial aid is paid directly to the university from the government & private lenders. The universities take out tuition, room & board and then give the remaining amount to the student. Higher One's software facilitates these transfers and the processes associated with them. Roughly 35% of revenue comes from their software.

Higher One's second line of business is related to the software they provide for the transmission of financial aid. A student can choose to get their financial aid money in an ACH transfer to their bank account or receive a check. A third option is to open a Higher One account, mainly for students that do not have bank accounts. Higher One partners with banks to provide students with a debit/ATM card so that they could access their financial aid money. Roughly 65% of revenue comes from the Higher One account.

There are numerous ways Higher One earns money through their Higher One account. 45% of Higher One account revenue comes from interchange fees, which is the money merchants are charged when somebody uses their Higher One card to buy something. The other 55% of revenue is earned on fees charged to the student. These are typical fees banks charge such as a $2.50 fee for using the ATM of other banks rather than the ATMs provided by Higher One.

Higher One's Profitability

Higher One has an extremely profitable business. Over the past few years Higher One has generated roughly $40 million a year in free cash flow excluding the construction costs of their headquarters, which is completed, and similar onetime costs. Higher One is on track to produce a similar amount of cash this year excluding a onetime $15 million payment to settle a lawsuit.

So why does a company generating $40 million a year in cash trade at a market cap of less than $120 million. Higher One has two major overhangs:

The Federal Reserve

The Federal Reserve has told Higher One that they will seek up to $35 million from Higher One for misstatements & omissions related to the marketing of the Higher One account. Higher One believes they will be responsible to pay the FDIC an equal amount so the potential liability is $70 million. Currently the two parties are in negotiations. Higher One has taken a charge of $8.75 million relating to this matter but it will likely cost them more.

Higher One has ample free cash flow to cover a $70 million fine over time, even though the ultimate fine is unlikely to be that high. The issue is that Higher One has $16 million in cash and owes $94 million on their credit line. Paying a large fine would put Higher One in breach of one of their debt covenants. Additionally, they may need to borrow more money to cover the fine. Higher One's management says that their lenders want to work with them but want to know the amount of the fine first.

I believe the fine by the Federal Reserve is the biggest risk to Higher One as their destiny is not in their own hands. With that said, the most likely outcome is that Higher One's lenders work with them. It does not make any sense for Higher One's lenders to force a default. Higher One is not highly levered and is producing a lot of cash. I believe Higher One will have close to $40 million in cash by year end.

The Department of Education

The Department of Education (DOE) is attempting to make new rules concerning student bank accounts. The earliest these rules will come into effect is July 2016 if they are passed by November 2015. This year's rule making session ended without a vote as banks don't believe the Department of Education has the right to govern them. They believe any rules should come from their regulators. It is possible that this fight ends up in court and it takes years, if ever, for the new rules to come into effect. The good news for Higher One is that for the next 2 years their ability to continue to generate cash is unlikely to be impeded.

The original rule changes proposed by the DOE were draconian and would have been a tremendous hit for Higher One. The DOE proposed forcing banks to give students two free ATM withdrawals a month at other bank ATMs and curbing debit card fees. By the time the rule making session was over the DOE was open to allowing Higher One to charge ATM fees as long as they joined a larger ATM network. This would cost some money but ultimately is unlikely to hurt profitability much. Higher One may have to remove debit card fees but is seeking offsets to the debit card fees.

The bank lobby is fighting tooth & nail against the DOE regulating them and the bank lobby doesn't want to make any concessions. I would be surprised if anything passed but in the investing community I seem to be in the minority. The bank lobby also has the tools to punt this issue to the next administration by suing the DOE. The private colleges have delayed regulations by the DOE with lawsuits.

The Hyperbole

There is a lot of hyperbole directed at Higher One as an evil company that profits at the expense of students. In reality Higher One largely charges fees similar to their competitors. The two fees that critics are loudest about is the ATM fee & the debit card fee. Higher One charges $2.50 for using a competitor's ATM. Bank of America and Wells Fargo both charge $2.50, while Chase charges $2. Why this makes Higher One evil is beyond me.

Higher One charges 50 cents when using the debit card. However, the fee can be avoided by simply selecting credit when the cashier asks "debit or credit". I used to use a Chase debit card. But once the Fed limited debit card interchange fees Chase started charging me $15 a month to use my debit card. Their intention was to make me switch to credit so they can collect a higher interchange fee from the merchant, so I switched. All the student needs to do is to say credit to avoid the 50 cent fee and Higher One will earn their money from the merchant instead. And 50 cents is a lot better than $15 a month.

Cost Cutting

Higher One should be able to cut at least $10 million in costs. General & administrative costs as a percent of revenue have risen from 21% a few years ago to 28% today. This is partially due to merger integration costs and partly due to increased professional fees in related to the outstanding regulatory issues. The merger integration should be completed some time in 2015. Eventually the regulatory issues will be settled as well. Higher One management says that all costs are on the table. I suspect there are many costs to cut as Higher One was once a hot "payments" company that built themselves a fancy headquarters. I see no reason G&A can't go back down to its historical level which would save over $15 million a year. This would likely more than offset any revenue hit from new rules by the DOE.

Conclusion

Higher One is not without risk. It is possible their lenders or the government will put them out of business. This outcome is unlikely as it does not make sense for lenders to bankrupt a company that is able to pay. Debt covenant waivers are granted all the time and that is the most likely outcome here as well. The government doesn't generally put real companies providing a real service out of business. Despite the hyperbole Higher One provides a needed service for a similar price to its competitors. If Higher One can get through this mess at their current earnings level the company can one day trade at $10 again and be a multi-bagger.

Updated Market Thoughts

I have not written a post in over a year about the overall market. For nearly two years the market climbed higher despite extreme sentiment readings, with only minor blips along the way. Historically, Investors Intelligence bears readings below 20% were a warning sign.  Yet for the better part of two years Investors Intelligence bears were under 20% with no repercussions. There are numerous such examples. After a while I decided to stop pissing in the wind and stopped writing posts about the extremes in sentiment. With all the nervousness out there (myself included) I thought this would be a good time to update my market thoughts.

I believe the reason sentiment stopped working was that corporations have been providing a steady bid in the market through share repurchases and cash M&A. In the past couple of years corporations finally started to use the nearly free money in the bond market to lever up in earnest. I believe this steady bid from corporations combined with a positive feedback loop from investors has led to this steady grind higher. I would note that the S&P 500 has outperformed both small caps and international equities, as the bulk of share repurchase and cash M&A occurred in larger cap US stocks.

The good news is that the backdrop of corporations using cheap money to purchase stock is still in full force. Corporations are still able to borrow cheaply and are doing so.  In a recent three week period about $60 billion of cash M&A was announced, while the steady repurchases largely continue. The economic backdrop of steady yet uninspiring growth continues as well.

The bad news is that investors have grown complacent after two years of relatively little pain. Individual investors have historically high allocations to stocks, margin debt is at a record and I have heard endless stories of institutional allocators in search of more beta.  It appears that this positive sentiment is being unwound and given the aggressive positioning of the investment community there could be more to come.


If the unwind of excessive sentiment continues it is likely to trump corporate buying in the near term and the sharp, painful correction is likely to continue. However, over the medium term the steady bid from corporations is likely to assert itself again. Corporate buying combined with positive seasonality starting in November, make it likely that near term losses would be recuperated over the next few months. But in the interim it could get ugly and a few more sleepless nights may be ahead for investors. 

My Trip To the Crimson Wine Group Annual Meeting

I recently attended the annual meeting of Crimson Wine Group, the owner of 5 wine estates that was spun off from Leucadia in 2013. In the tradition of Leucadia, Crimson does not communicate with Wall Street. There are no earnings press releases, conference calls or presentations and management does not take phone calls. The only way to get information from Crimson is through their SEC filings. When I heard that Crimson would have a Q&A at their Annual Shareholders Meeting I decided to make the trip to Napa as I had a number of questions for management.

The annual meeting took place in a wine cave at the Pine Ridge estate. Ian Cummings (Leucadia co-founder) was supposed to host the event but due to a surgery Joseph Steinberg (Leucadia co-founder) did so in his place. Joseph Steinberg has a reputation for being the bad cop to Ian Cummings good cop and he lived up to his reputation. When asked why Crimson was spun off he answered, “because we wanted to”. Management declined to answer many of the questions but I learned a good deal about the company none the less.

The first question I asked the CEO was about a newspaper article that quoted him as saying that he wanted to reach $100 million in revenue by 2016. He seemed to back off that statement and said that he wished he did not say it. In addition, Joseph Steinberg emphasized numerous times not to have too high expectations for the short term as progress in the wine business takes time.

The most important piece of information I came away with from the meeting was finding out why Joseph Steinberg believes Crimson is a good investment. Joseph Steinberg alluded to the private market value of the wine estates being well above the GAAP book value. He called Napa the Hamptons of the Bay Area and noted how much prices have gone up since they purchased the estates. He also noted that as the Hamptons of the Bay Area, Napa/Sonoma real estate prices are likely to continue to rise over time. Steinberg views the rise in the estate values as part of his profits in addition to the profit of the actual wine business.

When an attendee asked Joseph Steinberg to value the five wine estates he replied “I’m not going to give you the NAV. You’re an analyst. I’m sure you can figure it out for yourself”. As an analyst I have taken many stabs at trying to figure the value of Crimson’s five estates and I believe that they are conservatively worth $15.50 a share (likely more). Assuming 3% a year asset appreciation on $15.50 of assets yields an additional 5% a year of return in asset appreciation on top of any earnings (at the current stock price). 


Joseph Steinberg spent most of the meeting playing down expectations and noting that progress takes time and patience in the wine business. However, he ended the meeting with a vote of confidence for the stock telling shareholders “we will get rich together slowly”.

Crimson Wine Group Asset Value

Valuing Crimson Based On Assets
Crimson has a stated book value of $8.12. However, this does not take into account the value of two of Crimson's most valuable estates. Crimson acquired Pine Ridge in 1991 and Archery Summit was started in 1993. These two estates are carried for next to nothing on Crimson's book due to GAAP accounting. In 2001 these two estates were put on the market for $150 million as seen in this Wine Spectator article. It makes little sense that they are assigned almost no value.
Napa Valley estates trade at record prices and at significantly higher prices today than they did in 2001. It is estimated that the Araujo Estate in Napa recently sold for over $100 million (or $2,630,000 per acre) . Araujo, has 38 acres and produces approximately 6,000 cases a year. Inglewood Estate, recently sold for an estimated $20 million (0r $666,000 per acre). Inglewood has 30 acres and produces 5,500 cases. The new owners are rebranding the estate suggesting weakness of the Inglewood brand.
Pine Ridge, which is located in Napa, currently produces 80,000 cases a year and has 168 acres. Pine Ridge has an additional 46,000 cases of capacity. Inglewood'd brand is clearly is clearly inferior to that of Pine Ridge. At Inglewood's valuation ($666.6 k per acre) Pine Ridge would be valued at $112 million. At Araujo's valuation ($2.63 million per acre)Pine Ridge would be worth $442 million. The answer to Pine Ridge's valuation likely lies somewhere in between. I believe that Pine Ridge alone could be sold for at least $200 million.
Archery Summit is the premiere estate in Willamette, Oregon. Archery Summit has 100 acres and produces 15,000 cases a year. Archery Summit is able to charge $150 for its Pinot Noir, far more than any other winemaker in the region. I estimate the value of Archery Summit to be $20 million.
Crimson's purchased its three other estates in recent years. Seghesio was bought for $86,000,000 in May 2011 and is located in Sonoma. Since then the value of Sonoma estates have risen significantly. Additionally, Crimson expanded capacity and has grown sales at Seghesio. Seghesio would likely sell today for over $100 million. Chamisal was bought for $19,200,000 in August of 2008. The purchase price of Double Canyon in 2005 and 2006 was undisclosed but I estimate it to be worth at least $10,000,000. Crimson recently sold land that it was not using at Double Canyon for 70% above book value. It is possible that even the land that Crimson bought in recent years is being carried drastically below market value.
The table below summarizes my estimate of the value of Crimson's wineries:
WineryValue
Pine Ridge / Archery Summit$ 220,000,000
Seghesio Family Vineyards$ 100,000,000
Chamisal Vineyards$ 19,200,000
Double Canyon$ 10,000,000
Total$ 349,200,000
Adding my estimated land value to the $30 million in cash & investments Crimson will likely have at the end of this quarter yields a tangible book value of roughly $15.50, or a price 75% higher than the current quote.

Dow Chemical's Risky Gambit

THE REPURCHASE

Dow Chemical announced that they will repurchase $4.5 billion worth of stock over the course of 2014 amounting to roughly 8% of the float of the stock at the current price. The vast majority of this repurchase will be done with borrowings as there will likely be very little cash left over after capital expenditures and dividends. Share repurchases of this size are generally very bullish for the near term performance of a stock but there is more than meets the eye to this repurchase.

THE CONVERTIBLE PREFERRED SHARES

In 2009 Dow issued a total of $4 billion in convertible preferred shares to Berkshire Hathaway and Saudi Aramco (SA) in order to complete their acquisition of Rohm & Haas. These shares pay a preferred dividend of 8.5% and have a strike price of $41.32. It is unlikely that Berkshire or SA will opt to convert these shares because of the hefty dividend and the value of the call options. However, this large dividend is burdensome to Dow and Dow can force conversion if the common stock price exceeds $53.72 per share for any 20 trading days in a consecutive 30-day window. I believe this share repurchase is essentially a risky gambit to force conversion of these preferred shares. If this plan is successful then there will actually be more shares outstanding following the plan than before the repurchase.

THE RISKS

On the surface this plan appears to be sound as it removes burdensome preferred shares paying an 8.5% dividend and replaces it with cheaper debt. The risk is that the plan fails (ie. Dow can’t force conversion) and that Dow enters the next down cycle with an additional $4.5 billion in debt, the burdensome 8.5% preferred and an enormous pension gap that would likely balloon further. It seems that Dow has the debt coverage ratio to take on the additional debt but that ignores the gaping pension hole and the likelihood that EBITDA would contract dramatically in a cyclical downturn. I am not predicting a cyclical downturn but noting the risks if it does occur.

THE OUTLOOK

My experience with share repurchase of this size is that they are positive for near term performance even if they are not in the best long term interest of the company. However, once the stock price approaches $53.72 Dow becomes a compelling short. In addition to the very rich valuation there would likely be enormous selling pressure at that price. At that price Berkshire and SA would need to start selling down shares unless they want to be owners of Dow Chemical stock. If Berkshire & SA sold down their stake it would amount to over $5 billion, greater than the amount of the Dow repurchase. It is also possible that funds aware of this situation would sell ahead of that price.

MY PLAN


Dow Chemical is one of five chemical stocks I am short against Eastman Chemical, a stock I believe is far more attractive. As a result of the share repurchase announcement I covered a portion of my Dow short despite the fact that I believe shares are overvalued. I don’t want to stand in front of an 8% repurchase as there is no money in being a martyr and I want to be in a position to short with reckless abandon if the shares approach $53.72.

Dow Chemical Is No Bargain

Dow Chemical is one of five chemical stocks that I am short against a long position in Eastman Chemical, a security that I believe is far more attractive (I explain my long case for Eastman in this article). In light of the Third Point letter on Dow Chemical I want to explain why I view shares of Dow as relatively unattractive.

Valuation

Dow Chemical trades at an expensive valuation compared to its chemical sector peers. As seen in the charts below, Dow has one of the lowest EBITDA margins in the chemical sector yet trades in the middle of the group in terms of valuation.




This comparison is generous to Dow as it ignores Dow’s $9 billion unfunded pension liability. If one includes the pension deficit in Dow’s enterprise value than EV/EBITDA is roughly 10 times. This adjustment puts Dow squarely in the high end of valuation versus its chemical peers despite a low quality mix of businesses.  An analysis based on P/E ratios would make Dow look even more expensive.

Turnaround

The Third Point letter points to “cost cutting and operating optimizations that could amount to several billion dollars a year in annual EBITDA”. Dow Chemical has announced multiple restructurings & layoffs over the years leading to the lowest SG&A/sales ratio in the chemical sector. Dow’s SG&A is only 5% of sales. This suggests limited room for margin improvement through cost cutting. Where else will the cost cutting come from if not from SG&A? Are they running their crackers inefficiently? Are they selling commodities at below market prices?

The Third Point letter gives no details of what operating optimizations could save billions so it is difficult for me to refute that point. However, later in the letter Third Point complains about “poor segment disclosure combined with Dow’s opaque and inconsistent transfer pricing”. This is seemingly contradictory. If Dow’s disclosures are poor, than how can Third Point be certain these optimizations are possible?

Spinoffs & Asset Sales

Justifying a high price target for Dow Chemical involves placing a premium multiple on every business line (while ignoring the pension deficit). If one takes any diversified chemical company and puts rich multiples on every segment than all of them will look cheap, with tremendous upside. There is no reason to believe that Dow will achieve these rich multiples. Proponents of Dow point to spin offs and asset sales.

It is unclear to me why spin offs will help Dow as their blended businesses already trade at relatively high multiples. Axiall, which is the comp for the business Dow is planning to spin off, trades at only six times EBITDA. Dow owns numerous low margin, commodity businesses that deserve to trade at low multiples. With Dow trading at roughly 10 times EBITDA (including pension) that means that the rest of Dow trades at well over 10 times EBITDA. Secondly, why would these spin-offs trade for best of breed multiples if they don’t perform like best of breed businesses?

Significant asset sales seem like a pipe dream as well. Dow and Dupont are the two largest US chemical companies. Both have activists and both are looking to sell assets. If the two largest companies are sellers, who will the buyers be? It is possible that Dow and Dupont will find buyers for some businesses but any sales are unlikely to be significant to either company.

Summary


Dow Chemical appears to be among the most overvalued chemical companies relative to its peers. Spinning off a business is not a magic elixir that turns around a business. There are higher quality companies with great managements available at cheaper multiples (see Eastman Chemical). A fixer upper is not always a great deal and can often be a money pit.