How do you deal with the unexpected?

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The Reporting Persons have agreed to act in concert with the common purpose of assessing whether the Issuer’s management and board of directors are currently acting in the best interests of the shareholders and to potentially develop and recommend various courses of action for consideration by the Issuer’s management and board of directors that the Reporting Persons believe will maximize shareholder values.  A copy of the written Joint Filing Agreement among the Reporting Persons is attached as Exhibit 1.

As background, Jeffrey Gerstel, individually and on behalf of Enclave Asset Management LLC, has sent numerous written letters and electronic communications to various members of management and the board of directors of the Issuer.

See, for example, the letter to the board of directors of the Issuer dated July 8, 2011 attached here to as Exhibit 2. In these various communications, Mr. Gerstel has expressed his opinion that:  

1.           Management has failed to develop and/or implement effective strategies to exploit GPIC’s proprietary technology and to materially grow GPIC’s business and revenue;  

2.           Management has not prudently deployed, utilized or re-invested a cash surplus of approximately $25 million (as reflected in its quarterly report for the period ended September 30, 2011);  

3.           Management has engaged in employment and compensation practices that constitute conflicts of interest and/or self-dealing; and  

4.           Management has not timely disclosed certain material contracts and related party transactions or relationships.  

The legitimate concerns expressed in Mr. Gerstel’s communications to management and the board of directors have generally been ignored or side-stepped. For example, following Mr. Gerstel’s July 8. 2011 letter, the board of directors in a letter dated July 18, 2011 and attached hereto as Exhibit 3, responded in a superficial, generic and dismissive manner to the various and detailed concerns expressed by Mr. Gerstel. As subterfuge for an apparent desire to avoid accountability to a concerned shareholder, the board of directors mistakenly inferred that insider trading rules prevented them from being fully responsive. This was baffling to Mr. Gerstel since his letter was not an attempt to illicit material, non-public information from the board, but instead was a request for explanations or embellishments regarding previously disclosed corporate matters.  

On January 17, 2012, Enclave Asset Management, LLC, Jeffrey Gerstel, Jesse Gerstel, Eileen Gerstel and Warren Spivak, through counsel retained by them, sent a letter to the Board of Directors demanding that the Board immediately terminate the employment, for cause, of CEO Gregory Gronau and CFO Gerald Koslow and that GPIC commence a lawsuit against them.  A copy of the January 17th letter is attached as Exhibit 4.  The letter also outlined a series of acts that, in the belief of the Reporting Persons, constitute further acts of incompetence, gross mismanagement and even self-dealing.  More specifically, the Reporting Persons contend that:  

1.           Management has caused GPIC to engage in a share repurchase program that serves no legitimate corporate purpose.  

2.           Management has engaged in self-dealing and nepotism by hiring Mr. Gronau’s wife to provide real estate consulting services to the Company and Mr. Thieffry’s son in a significant accounting role;  

3.           With little or no justification, Management has terminated and compelled the resignation of highly performing personnel, such as Christophe Leroux (leading chip salesman) and Remi Nicolas (accountant for GPI SAS), and has replaced them with less experienced and incompetent employees; and  

4.           Management has failed to retain competent technology and engineering personnel and has been derelict in the management of its RFID technology license agreement, including by missing deadlines and opportunities for cooperation.  

The Reporting Persons received a response to their  January 17th letter from counsel to GPIC on January 27, 2012.  The letter did not indicate that independent counsel had been retained by the Board to evaluate the concerns expressed by the Reporting Persons, yet was critical and dismissive of those concerns. A copy of the January 27th letter is attached hereto as Exhibit 5.

On February 1, 2012, counsel to the Reporting Persons  sent a reply letter to GPIC’s counsel, highlighting the need for independent counsel to the Board,  reiterating its concerns concerning the management of the Company and its disclosures and demanding that the Company implement procedures to preserve electronic communications, data and information.  A copy of the February 1st letter is attached as Exhibit 6.

I definitely agree with complaints 1 and 2 but I disagree with Enclave’s issue with the corporate share repurchases. I wish Enclave well in forcing necessary change (though I doubt they will be successful, given that 61% of the company is held by insiders).

What do you think of this letter?

Author Disclosure: None

Talk to Frank about GPIC

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It seems logical to suppose that MWW’s fortunes would largely tied be to that of the real economy, in that MWW benefits from increased hiring activity, which is aligned with the business cycle. For value investors, the logic often goes something like this: the market often mistreats cyclical companies, putting greater weight on recent performance almost as if any single point in the business cycle will continue into perpetuity (there are a number of behavioural biases that lead us to make this mistake), resulting in expensive valuations at the peak of the cycle, and overly pessimistic valuations at the trough. Consequently, there are often opportunities in the trough.

It appears that value investors are not alone in seeing the opportunity. According to this Bloomberg article, MWW has been the subject of “at least 20 takeover rumors” and this number increases as the company’s share price continues to fall (it fell be roughly 2/3 in 2011). Furthermore, the company was trading in the 10th percentile of US Internet software and services companies on a price to sales basis, prompting further speculation that a buyout is likely. The potential valuations thrown out in the article suggest $15 – $20 a share could be reasonable. Compare this to the actual price of $8 per share as of the time of writing, and evidently some analysts think there is significant value at MWW. The reasons given focus largely on the company’s free cash flow:

‘Significant’ Cash Flow

A private equity buyer would get a company that has a free cash flow yield of 9.3 percent, compared with the median of 4.5 percent in the U.S. Internet software and services industry, data compiled by Bloomberg show. Monster’s cash of $322 million exceeded debt of $223 million at the end of September for a net cash position that’s also higher than the industry median, the data show.

Let’s consider this free cash flow for a moment.

Monster Worldwide, Inc - Free Cash Flows, 2005 - 3Q 2011

Here we see that, like many of MWW’s operating metrics, the company’s free cash flows were quite impressive leading up to the recession but then fell dramatically in 2009 and have been struggling to recover ever since. On a TTM basis, the company has generated approximately $90 million in free cash flow or an 8.7% yield. If we consider the average FCFs from peak to trough (for a rough approximation of normal FCFs) we see FCFs of around $120 million, or 1/3 higher than current levels. Furthermore, the company is lightly levered (it has $99 million of cash and securities net of total debt), and given that interest rates are low, it would appear that MWW could support much more debt, making an LBO possible (this is the gist of the Bloomberg article).

However, in calculating free cash flow above, I used one of the traditional equations, Cash Flows from Operations less Capital Expenditures. But it would appear that the company is acquisitive, spending approximately $110 million per year for the last six years on acquisitions (though, these purchases are lumpier than this suggests, as we’ll see in the next chart). When a company consistently spends a great deal on acquisitions, it is important to factor this into free cash flow calculations. If these acquisitions were not made, actual performance in subsequent years would be lower (by the contribution of the acquired companies) than it actually was. The best method of dealing with this is to calculate Free Cash Flows after Acquisitions, which shows the amount left over after the company has made its purchases. The following chart shows this figure over time.

Monster Worldwide, Inc - Free Cash Flows after Acquisitions, 2005 - 3Q 2011

Here we see how much the company has been spending, especially during the downturn. Consequently, the amount of cash flows that is truly “free” or distributable to stakeholders is far less. Rather than $120 million on average from peak to trough, the actual figure is closer to just $8.5 million!

Seen from this perspective, one has reason to question the suitability of an LBO. A potential suitor would be left with the option of diverting cash that would have been spent on acquisitions toward repaying the debt used to fund the acquisition. Unfortunately, this would mean only organic growth would remain (which may very well be negative for the near term). Alternatively, the suitor could continue funding inorganic growth by purchasing companies, but this would leave far less money left over to service the increased debt load. These are not exactly attractive options, and there are many more attractive LBO targets available.

The situation gets worse. There is reason to believe that MWW’s peak performance may be difficult to reach in the future. Over the past few years, strong competitors have emerged, most notably LinkedIn Corporation (NYSE: LNKD). LNKD has created a product that is far more “sticky” as a result of its integration of social networking, and has made significant inroads into capturing the professional-level l job market. It will be much more difficult to MWW to recapture this ground, though it is making the right steps to solidify its hold on the lower end of the market, launching the BeKnown app for Facebook in an effort to capitalize on social networking (though, I wonder how long it will be before Facebook launches its own proprietary job market for its users).

What I see here is a company that faces stiff competition that also appears incapable of responding via internally-driven innovation. The resulting over-reliance on acquisitions has led to a massive increase in intangibles to which I assign little to no value. On a tangible asset basis, MWW certainly is not cheap, and on a free cash flow (after acquisitions) it appears downright overvalued. I see no reason to suggest MWW is a good investment opportunity, for a value investor or otherwise.

What do you think of MWW?

Author Disclosure: No position.

Talk to Frank about Monster Worldwide, Inc.

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Think about the long-term implications of 50%+ unemployment among those just starting out in their careers. How will this impact these societies? Immigration? Innovation? Crime?

As I said, a scary chart indeed.

What do you think?

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Well, we have a problem in the BDI. It has closed down 27 days in a row. Brandon Smith notes:

Over the course of the past month, the BDI has fallen around 65% from above 1600 to 726.  Mainstream economists argue that the BDI’s fall in 2008 was a much higher percentage, and thus, a 65% drop is nothing to worry about.  They fail to mention that shipping rates never recovered from the 2008 collapse, and have hovered in a sickly manner near lows reached during the initial credit bubble burst.

While some analysts argue that this is the lingering consequence of the perfect storm that occurred from 2007-2008, when shipowners ordered new ships (which are still coming online now) aggressively just as the economy soured and demand for these services fell. This fails to explain the recent collapse:

There have been no mass increases or extreme changes in cargo fleets this past month, or at all since 2008, which means, the BDI’s decline has NOTHING to do with the number of ships in operation, and everything to do with decline in global demand.

 So where does this leave us?

What is the bottom line?  The stark decline in the BDI today should be taken very seriously.  Most similar declines have occurred right before or in tandem with economic instability and stock market upheaval.

Pretty scary stuff. What do you think? Is the BDI a useful leading indicator? Read the full article here.

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Talk to Frank about the Baltic Dry Index

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The next question that often comes up is how I get fundamental corporate data into my model. This is an easy one: I input it manually. There are services that you can subscribe to which allow you to do this automatically, but they are quite pricey and aimed toward investors with a significantly larger portfolio than mine. There is also a free solution using the Stock Market Functions Add-in (Excel only unfortunately, and no Macs either!) which grabs data from free online sources like Yahoo, Google and Morningstar (among several others). I toyed around with this last year as the opportunity to automate this process appeals greatly, but my experience was negative overall. Because the data are sourced from various websites, they suffer from the same limitations as those websites, namely that various line items that exist in the source material (the 10-Ks and 10-Qs) are categorized in order to simplify and standardize the presentation. This has the effect of removing an important level of information, in that many things get stuck under “Other.” This is fine if you only want a general understanding of how things are going for the company, but I am wary of eliminating important data, especially this early in the process.

The short story is that unless you can afford to pay for the top of the line services for full digital financial statement reproduction (Bloomberg terminals do this, and it appears that Fetch XL does this too), the gold standard is manual input. I do this for all of the companies I research, and usually I go back as far as the SEC’s data goes (c. 1994), inputting all of the annual data for the three main financial statements, and then I look at quarterly data usually up to two or three years unless there is a compelling reason to go further. Moreover, there is always information that is industry and company specific that I also grab, like Average Selling Price, Stores Open, Comparable Store Sales, etc. I cannot stress enough the importance of this information, especially for detecting possible financial shenanigans (Read Financial Shenanigans or my in-depth review to learn more), and now that I think of it, this is another reason why it is important to grab the information manually, since I don’t think any of the automated solutions grab this and you simply cannot afford to ignore this information.

I’ve been asked several times how I investigate companies, so I’ll give a brief overview here. Once I have manually input all of the fundamental data in my spreadsheet, I check the graphs. Since I’ve standardized the way I input the data, my spreadsheet is set up to  calculate relevant ratios and other second-order information automatically. The output of these calculations feed into a variety of charts that allow for the easy identification of trends and red flags. I should note that I do all of this before I read through a 10-K or conference call transcript. The rationale for this is that the red flags make me alert for things to watch for when digging through the company’s other filings.

After the graphs comes the documentation, which includes at least one 10-K and usually recent 8-Ks and the most recent conference call transcript. If, while checking the calculations and graphs, I notice something in the company’s history that I can’t explain, I’ll read the 10-K or other material from that time period to try to get an explanation (e.g. big drop off in revenues? check for information about divestiture or deconsolidation). After this, I take a stab at the valuation. Normalized historical performance is the starting point of my valuations, though I make considerable changes for persistent trends (which would render normalized performance inapplicable) and I use what I’ve learned from the conference calls and other material to help guide expectations for the future (e.g. the ongoing impact of increased competition on margins, or the price of a commodity on margins). 

If my valuation looks good, I will dig more deeply as necessary into other source material, such as the DEF-14A proxy statements (for source information on ownership structure and executive compensation) and any of the SC-13Ds over the last two years (which show whether there are activists involved and often have good commentaries from those agitating for change). Often specific questions can be answered by searching through older conference calls. It is often worth looking at competitors and their performance relative to their valuation as well (though I rarely let relative valuation guide an investment decision).

So there you have it, I’ve now provided a bit of insight into my process. What does your process look like? What tools do you find indispensable in analyzing investments?

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