Leucadia and its principles have shown uncanny ability over the years to make opportunistic investments and profit from it. Capmark appears to be a case in point, and although all is not said and done yet, Cummings and Steinberg have terrific track record to finding value in the trash heap.

Commercial Real Estate company Capmark Financial filed for bankruptcy protection today. This is not a surprise to anyone watching the mortgage industry and was widely expected. Capmark entered into a pre-bankruptcy filing Asset Put Agreement with Berkadia III LLC, where Capmark can exercise its put rights to sell certain parts of the company to Berkadia III.

As you may know, Berkadia is a 50/50 partnership between Berkshire Hathaway and Leucadia National. This is indeed not the first joint transaction that these two companies have done. Here are the basic facts about the deal:

The Asset Put Agreement with Capmark

Under this deal, Capmark bought the right to sell certain assets to Berkadia III and paid Berkadia $40 million for the right. The right has to be exercised within 60 days of filing for bankruptcy, so the clock starts ticking today. If Capmark chooses not to exercise the right, they just handed Berkadia a $40 million gift. This can potential happen if Capmark finds a better price for these assets through the bankruptcy auction. On the other hand, if Berkadia decides to back out if certain closing conditions are not satisfied, than they have to pay back $20 million to Capmark (and keep $20 million for their troubles).

If the put is exercised, Berkadia will buy a) Capmark’s mortgage origination and servicing business for $490 million, and, b) Capmark’s owned mortgage loans outstanding, at par, for about $600 million.

Therefore, the total deal value is approximately $1,090 million.

Berkadia’s Capital Structure

It is instructive to look at Berkadia’s capital structure. Cash portion amounts to $188 m in cash contributions from both Leucadia and Berkshire each, and $40 million in the put consideration that Capmark paid for a total of $416 m. Berkshire will chip in another $650 m in debt financing. The remaining $24 million are likely to be in the form of Berkadia notes issued to Capmark.

So let’s recap what the Berkadia business will look like once the deal is completed

Cash inflows:

1. Any positive operating cash flows from the Capmark mortgage origination and servicing business and new mortgage loan originations

2. Interest and principal payments on the existing book of commercial mortgage loans (principal = $600m)

Cash outflows:

1. Interest/principal payments to Berkshire on $650 m in debt

2. Interest/principal payments to Capmark on $24 m in Berkadia notes

Therefore, as one can see, for Berkadia to make any money (and hence Leucadia and Berkshire Hathaway to profit) from the deal, profits from the new mortgage business + interest  income from the existing book (adjusted for defaults) should exceed the interest paid to Berkshire Hathaway and the smaller note to Capmark. Given Berkshire’s credit, its cost of capital is likely to be low (much lower than Capmark’s) so it is not difficult to imagine that this is a simple debt swap replacing expensive debt with a much cheaper one.

The big questions here is whether the $490 m paid for the origination and servicing business is a good price to pay. Given the parties involved one can be fairly sure that they are not over paying for the assets and with proper management of the mortgage origination and servicing business (Berkshire and Leucadia know a thing or two about this business), it can be turned into a profitable enterprise.

What is in it for Leucadia?

Leucadia  is essentially making a $200 m investment (188 in cash plus 50% of 24m in Berkadia notes) to gain 50% of a business worth $1 B at a conservative estimate. Will this be a good investment? The margin of safety appears to be there as even if the business eventually turns out to be worth only half of what they are currently valuing it at, Leucadia still comes out with a 25% ROI. If the business is indeed worth $1 B (or even more) and the cash flows work out in favor, than Leucadia’s potential gains are in excess of 150%.

Pretty sweet!

Yesterday I also commented that the convertible note offering is being done to finance an expansion project and as long as the interest payment on the note is lower than the return on capital the company is able to generate, one should view this as a positive value creating news and that the investors are wrong to sell off on this news.

Today the company released a little more information on the convertible note offering that supports my view.

The convertible note will pay an interest of 4% per annum and will be convertible at $23.33 per share of the ADS. Please note that the share price closed yesterday (Oct 15, 2009) at $16.62. There fore , there is 40% premium built into the conversion price over yesterday’s close. The notes are not dilutive, yet.

Also it is worth noting that while one cannot quite estimate the return on capital on the expansion project, it may be instructive to look back at what ROC Sterlite is able to achieve on its current business. Its trailing 1 year ROC is close to 15%, much much higher than the 4% interest it is going to pay out on the note, assuming that the company will be able to maintain the similar levels of returns in the future.

Yes, this may be a big if, but it certainly does not justify the stock sell off that ensued. If you are a holder, there is no reason to sell the stock now.

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American Trucking Association reports that the Truck Tonnage index inched up 2.1% in August. This is on top of the 2.1% increase in July. It is still down 7.5% year over year but this is the best performance of the index this year.

Truckers are the lifeblood of Travel Centers of America (TA), one of our key holdings. Increased tonnage may and should indicate increased number of trucks on the roads (assuming businesses were making rational decisions and not shipping trucks half empty during the depths of the recession). With the volumes increasing, this should have a positive effect on TA’s revenues, both Fuel and non-Fuel.

In fact, with increase in trucking volumes, one can reasonably expect that the truckers will feel more secure in their jobs and would be more willing to open up their wallets at the truck stop restaurants and convenience stores. This is where the company generates most of its margins.

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Overall the trends are encouraging and while there is no guarantee that they will continue, there appears to be enough momentum gathering in the economy that one can be hopeful. If nothing else, this holding still trades at a significant discount to its intrinsic value so there is enough margin of safety left.

The total investment in this capital project is estimated to be $500 million.

Concurrently, the company also launched a $500 million convertible debt offering which will be convertible to the ADS listed on New York Stock exchange.

Commodities are in a long term up-cycle and any new capital investment projects are likely to be value creators over the long term. Primary metals like copper are critical to the growth of emerging economies. While a convertible debt offering potentially dilutes the stockholders, it is important to note that a potentially more valuable asset is being created as long as the return on capital on this project exceeds the interest on the note. Of course, this remains to be seen. The stock is selling off on the news and can be an attractive entry point.

You may recall Sterlite from its bid to buy the Asarco mines in US. The following article in Forbes is also a great introduction to Sterlite/Vedanta and Anil Agarwal, the key man behind the company.

This is a small company in the sector and probably has one of the strongest balance sheet. It appears to be well positioned to prosper when the demand for its products improve. The catalyst here being a generally improving economy as well as  increased infrastructure spending in the next 2 years as part of the stimulus.

I am putting this company stock on my watch list, with an intention of committing money to it when my liquidity allows it. At that time, I will post a detailed analysis for the AIL Premium subscribers. But let us take a brief look at its financial condition.

Current Market Capitalization: 41.2 million

Balance Sheet (Q1 2010, most recent quarter):

Current Assets: 43.86 million, 21.87 million being cash

Total Assets: 61.39 million

Liabilities: 5.64 million, 0 long term debt

Equity: 55.75 million

Income Statement:

2009: 13.68m

Last 4 quarters: (0.16), (0.3), 4.56, 5.44 (in millions) = 9.54 million

Growth Rates (5 yr average)

Sales: 12.44%

Net Income: 40.07%

Other Ratios (5 yr average)

Return on Equity: 18.5

Return on Capital: 17.7 (company used to have debt earlier which has now been retired)

Finally, the stock is currently offered at:

Price/Book: 0.74

Price/Earnings: 4.3 (trailing 12 months)

Given that the company has $21.87 million in cash, assuming the company requires 5% of sales as working capital (in truth, the number is more like 2%), at 2009 sales level of 208 million, the company can realistically distribute 21.87 – 208 x 0.05 = 11.5 million back to the shareholders and still continue to operate its business without any problems.

Therefore in essence, a private buyer for the company can acquire the entire company for 41.2 (current market cap) – 11.5 (the cash that can be taken out) or 30.7 million. This means that in reality, the company is only selling for an equivalent of 30.7/9.54 = 3.22 P/E ratio.

The companies 10 year average P/E ratio is close to 10

At these prices, this company is a definite buy. The only risk going forward is whether the business environment will improve materially to make the company profitable again. But given that the company is well managed and its losses in the last 2 quarters have been minimal, I estimate that the company has sufficient liquidity at hand to survive for next 4 years at the current level of losses.

National Presto is currently valued at $600 million in market capitalization. It has no long term or short term debt, $146 million in cash and marketable securities and $310 million in Book Value. The question is, whether the shares are currently priced attractive enough to justify taking a position.

Valuing the Assets

This will be a quick exercise. It is evident that the company is selling at a premium to the book value (almost 2x). This is not a classic Grahamesque investment. Still, there are a few key takeaways that we need to consider.

a. The company has a large amount of cash on hand. Given that the company 2008 sales were $448 million, you would conservatively expect that the company does not need more than 2% of its sales in cash to support its ongoing business. Given that, about $10 million in cash is enough for the company to continue to operate and support its current level of sales. Therefore, the company can realistically distribute about $135 million in cash to the shareholders without much impact on its normal business. In reality, the company has been distributing the cash to the shareholders as dividends, which are often quite large ($4.25 per share for 2008, the current stock price is around $87 per share).

One reason the company is likely maintaining large cash position is for acquisitions. This is how the company has grown in the past.

b. The company has a pristine balance sheet. The current ratio is 5.8 which is phenomenal. There is no debt or off-balance sheet liabilities and that points to a conservative management.

c. Current Assets have shown a gradual decline over the years, largely due to high dividend payouts (this is also the reason why the annual cash flow is negative. ) Adding back the dividends to the cash flow puts it firmly in the positive territory. Apparently, the management believes that returning cash to the shareholders is important and it has sufficient liquidity to support its current business and next years growth. I agree.

Earnings Power and durable competitive advantage

The story of National Presto lies in its earnings power. A quick glance at the income statements show that in 2008, the company enjoyed a net profit margin of around 10%, a gross margin of almost 18%. The companies SG&A expense was only about 3.8%. The company appears to be running a very tight ship.

Does the company have a durable competitive advantage that allows it such great economics? It would appear so given the numbers. Also keep in mind that the housewares/small appliances segment is very competitive (Walmart being one of the key retail channels) but the company still managed to eke out a 22% gross margin in this segment. This is only possible with much more efficient cost structure than its competitor. This is not a surprise given that the company has been competing in this segment for over 100 years now.

The business in the Defense Products and the Absorbents segment have competitive advantages built in via medium to long term supply contracts with the government and private label customers.

Let us quickly put some numbers to the Earnings Power calculations. We will be using 2008 data from 2008 Annual Report and 5 year historical financial ratios.

Net Earnings: $44.18 million

Assumed Cost of Capital: 12% (suggesting that the company is a riskier investment than the average stock market. This is debatable as the company’s revenue sources are diversified and a large part of the revenue is easily estimated using the existing contracts. A more realistic number would be close to 10% but we will stick with 12% for now to be a little more conservative).

We will adjust Net Earnings to bring it closer to reality. The LIFO method of valuing inventory resulted in an increased cost of sales by about $2 million in 2008. This can be added back to the Net Earnings (also the current value of inventory should be 4.4 million higher after adjustment). One can also assume that the maintenance capex is lower than the depreciation expense on the P&L . Perhaps 25% of depreciation can be added back to Net Earnings (.25x 8.8 = $2.2 million). The company also has unrealized gains on marketable securities which are government bonds and therefore not risky in the amount of 0.36 million.

Adding these to the reported Net Earnings gives us an adjusted net earnings of 44.18+ 2+ 2.22+ 0.36 = $48.76 million

In a zero growth situation, the companies Earnings Power Value or EPV is 48.76/0.12 =$ 406.33 million

To get the intrinsic value of the company we will add to this number the excess distributable cash of $135 million and reduce this number by  the interest bearing debt (which is zero).

This gives us a no growth intrinsic value of 406.33+ 135 = $541.33 million.

But the company is not a zero growth company. Over the last 5 years, the companies Net Earnings have grown by 23.34%. Its 5 year Return on Capital is 10.3% (2008 ROC is almost 18%). If you conservatively assume that the company will continue to grow at 10% per year (keeping in mind that there are durable competitive advantages here that protect this growth and margins), than we can recalculate the EPV as initial cash flow/(cost of capital – growth rate).

New EPV in 10% growth scenario is (48.76 – 31)/(0.12 – 0.1) = 17.76/0.02 = $888 million.

Please note that we reduced the numerator by 10% of  Total Capital (Equity) assuming to generate 10% in growth, proportional amount of capital would need to be reinvested, reducing initial distributable cash earnings.

Intrinsic value in 10% growth scenario = 888 + 135 = $1,023 million, which is equivalent to $149/share.

The company currently sells for about $600 million, representing a 41% discount to the intrinsic value and should be bought.

Additional thoughts: If the company continues to make smart choices in how to deploy its cash (acquisitions), stays conservative and keeps the business lean, it will likely exceed our conservative estimates. This company may also become attractive acquisition candidate if the shares stay undervalued for long periods as this is a cash rich and very profitable company.

I bought my initial shares at 85.5 and will add more over time. I do not anticipate losing any sleep over this investment and plan to hold on to it for a long long time.

This is a free feature. You can access more ideas and analysis like this by becoming a AIL Premium member.

To make the decision easier, also consider the fact that the company has been more or less profitable through the downturn and has been generating positive cash flow and more recently the company reports that the business has been looking up. This is also a company that has been in the business for 40 years now. And just recently, the company fought off an unsolicited bid for acquisition from a rival.

Did I get your interest?

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The company in question is TII Network Technologies (TIII). As the subscribers to AIL Premium already know, I purchased shares in TIII recently.

According to its 10K, the company designs, manufactures and sells products to the service providers in the communications industry for use in their networks. Our products are typically found outdoors in the service provider’s distribution network, at the interface where the service provider’s network connects to the user’s network, and inside the user’s home or apartment, and are critical to the successful delivery of voice and broadband communication services.

Here is my rationale for the purchase.

The company is currently valued at $15.4 million by the market (as of Oct 2, 2009).

Lets look at its balance sheet for Q2, 2009 (numbers in 000s).

It is quite clear with a quick glance that the balance sheet is unusually rich in assets with very little debt. Additionally, most of the assets are current. The liquidation value of this company is going to be much much higher than $15.4 million that the market is currently pricing it. Not that the company is anywhere close to liquidation. Not at all. This makes the undervaluation even more striking.

To be conservative, you would discount some of the assets down (assuming a quick fire sale). Cash is cash and there is no reason to discount it. We will apply 15% discount to the AR assuming 15% in bad accounts. To be sure, the company’s bad account number is very nominal and 15% is being very conservative. The company also serves the market where the demand for its products will continue to exist with some obsolescence. You might therefore discount the inventory down by a greater amount, lets use 25%. Deferred tax assets have value but may take time to collect so you may choose to apply a 30% time value discount (which is also being conservative). PPE has lot of value, the company owns its own plant and property including land. Given that the company is a 40 year old company, the land values must be quite higher compared to what is being carried on the books. With that being said, taking a 30% discount to PPE number is very conservative. Finally, we will just ignore the other asset lines.

With these adjustments, the total adjusted assets for the company comes to:

10,780 + 3,017*.85 + 7,695*.75 + (611 + 8,617)*.7 + 8,308*.7 = 31,391

Subtracting the total Liabilities gives an Adjusted Book Value (or Intrinsic Value) of 31,391 – 2,465 = 28,926

Since the market is offering the company for sale at $15.4 million, we are able to buy the company at 47% discount to our conservative estimate of its book value.

This is quite a bargain.

Incidentally, this calculation also places the company intrinsic value at 28.9/14 = $2.07 per share

This valuation does not take the earnings power of the company into account. As the company continues to make money, its balance sheet will continue to improve and the intrinsic value will continue to rise.

If you demand atleast 30% return on investment in the company stock, you should be willing to buy the company shares upto 2.07*.7 = $1.45 per share today.

Now, I can also do an earnings power analysis and it will give me an intrinsic value that is higher than what we achieved here (Asset value + value of future earnings which are positive). Since the current analysis is sufficient to justify a purchase of the company stock, I will defer it until the time when the market price of the stock starts approaching the intrinsic value calculated here (to figure out if we should sell or hold).

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First, let’s talk about the sales:

Markel (MKL): I trimmed my stake in Markel. I still have a few shares left in my portfolio that I intend to keep holding for a long time (unless the company does something stupid, or Gayner leaves the company, which ever is earlier). Nothing wrong with the company today. It is currently selling at 1.36x book whereas traditionally it has sold for about 2x book so it is a good price to enter and hold the company if you look to history as a guide.

Fairholme Fund (FAIRX): This is more of a philosophical sale than anything else. Fairholme is one of the better mutual funds out there and they invest in the tradition of the best value investors. However, I am picky about the stocks that I buy and need to understand the business intimately. It may be that in the future some of the names in my portfolio and in FAIRX portfolio may overlap but atleast I will know why I bought the stock.

Now onto the Buys:

This is just a brief rationale, full analysis will be posted shortly.

National Presto Industries (NPK): National Presto manufactures small appliances (Presto Pressure Cookers anyone!), armaments for Dept of Defence and adult incontinence products (diapers). If you pay heed to CK Prahlad and Gary Hamel’s contention that a company should focus on their main core competency, than you will probably direct a bemused gaze on National Presto before quickly moving on. However, a quick study of the company’s past operational history shows that it is a tightly run ship with excellent return on equity, large amounts of cash on the balance sheet and shareholder friendly to the core. It is also a company with some durable advantage (in its cost structure) as it generates close to 20% or more gross margins in a highly competitive industry. Its SG&A costs are very reasonable and R&D costs almost non-existent. It does very little advertising.

The basic premise of investing in NPK is its earnings power. Its trailing PE ratio is close to 11 but if you take out close to $125 million in cash and short term investments on its books as the liquidity that can be returned to the shareholders (while leaving enough for working capital), than its adjusted PE ratio falls to below 9. Compare this with its return on equity of 18% or more and you have a company that is a pure cash generating machine. Not surprisingly the company has a history of paying large cash dividends to the shareholders every year (last year it paid out $5.55 per share in dividends).

TII Network Technologies (TIII): This is more of a asset play. The company sports a market capitalization of $16 million and has a book value of $37 million, out of which $22.5 million is in current assets and almost $11 million in cash. It has zero long term debt.

Best of all, the company generates positive cash flow and positive net income (if you take out the non-cash expense of stock option based compensation and depreciation). In the last 12 months, the company generated over $8 million in positive cash flow.

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The company is National Presto Industries (NYSE: NPK). Hat tip to @moderngraham for uncovering this. While with traditional strict Grahamian methods, one would give this company a pass, as Buffett and Greenwald contend, you need to also look at the companies franchise value (sometimes referred to as a moat, a term I happen to dislike, but that is my own personal preference). The company sports greater than 500 million in market capitalization with annual revenues touching $500 million. Its price to book ratio is close to 2 and this is where I have some concerns. But the return on equity of 18% is pretty attractive. Fortunately, not many analysts cover this stock.

And the company has a history of returning substantial money to the shareholders in form of dividends.

More on this later. In the meantime, if you have any thoughts on NPK, feel free to post it as a comment or in the forums.

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In this case, Travel Centers of America (TA) lost over 10% of it market value just in the first 2 hours of the market trading today. There are no reported company specific reasons for this. The driver appears to be the general market decline due to fed’s slowing of the stimulus and a decline in the reported existing home sales. I believe that despite this single data point (amongst the sea of other rising indicators), the economy is picking up sufficient momentum to jump start the industry and therefore increase the trucking volumes across the country. And if this belief turns out to be in accurate, than there is enough cash on hand at TA and enough margin of safety at the current stock price levels that we can afford to wait for a few quarters at least.

We shall see how this additional buy works out. At this point, my holding in TA is quite large proportion of my portfolio and I will likely not be buying anymore (of course this can all change if the market continues to act irrationally with regards to this issue).

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