Volume II, Issue 8 (posted to website on January 6, 2017)
Notes From Author: This Issue was originally sent to Newsletter subscribers on December 12, 2016 and included two attachments: a full investment research report and a stock pitch presentation on Time Inc. (TIME). The research report and stock pitch presentation on TIME attached as part of this Issue were updated versions of the research report and stock pitch on TIME that were both initially sent to subscribers on November 29, 2016. The full edited research report on TIME can be downloaded by clicking here and the edited stock pitch PowerPoint presentation can be downloaded by clicking here. See the Disclosures at the end of this report for additional information.
Thoughts On Four Companies:
A lot of interesting things happened recently with several of the companies I’ve discussed previously. I write to provide updates on four companies and to indicate areas of additional research I am pursuing.
I also published the stock pitches on SIG and WSM to my website on December 1, 2016, a few weeks after both pitches were made available to all of you - as always, I wanted to make sure that you all receive my analysis before it is published publicly.
The Greenbrier Companies, Inc. (GBX): No Longer Attractive Risk/Reward
In the last Issue of my Newsletter, I wrote that I thought GBX no longer offered an attractive risk/reward profile, and I changed my outlook from "buy" to "neutral." Since then, GBX has risen another 11.7% to close last week at $42.05, after reaching a new 52-week high of $42.65 on Friday. I now think that GBX has risen beyond the point that makes it worth owning. This conclusion was made based on my assessment of GBX's Risk/Reward and marks the end of a stock pick I made in Volume II, Issue 4 of my Newsletter (sent on April 3, 2016), which stated that an "ideal entry price range to maximize GBX's conservative potential return/risk ratio [was] $24.00 - $26.00" (GBX fell to the bottom of that range on April 5th).
Signet Jewelers Ltd. (SIG): Earnings Release
On November 9, 2016, I sent out my stock pitch on SIG as part of Volume II, Issue 6 of my Newsletter, and the stock closed at $86.75 that day. On November 22, 2016 SIG released its unaudited earnings results for FQ3 2017 (see here for the FQ3 2017 earnings presentation, and see here for the earnings call transcript). Revenue for the quarter was $1,186.2 million, which was down 2.5% YoY and roughly $10 million (1.1%) higher than consensus estimates, and adjusted diluted EPS was $0.30, which was down 9.1% YoY and $0.10 (46.6%) higher than consensus estimates. Revenue was $2.1 million (0.2%) below my estimate and EPS was $0.15 above my estimate, or $0.07 if you exclude the impact of the difference between my estimate of SIG's preferred dividend payment for the quarter and the actual recorded figure. SIG raised its adjusted EPS guidance for FY 2017 to $7.38 - $7.58 from $7.25 - $7.55, while SSS growth guidance for FY was kept at the same level (-2.5% through -1.0%). After releasing its FQ3 2017 results pre-market on November 22nd, SIG's price opened at $97.97 (+11.4% for the day), peaked at $101.46/share (+14.2% for the day), and then closed at $90.79 (+2.1% for the day).
The quarter's results had both positive and negative aspects. Credit portfolio metrics were slightly worse than figures reported in previous quarters (more on that in a future Issue of my Newsletter - see below for what that Issue will contain), and SSS figures for Jared and Kay were quite poor (-4.6% and -2.9%, respectively), but margins were better than I expected and the mid-point of Adjusted EPS guidance for FQ4 (the very important holiday quarter) of $4.10 was $0.15 (3.8%) higher than a consensus estimate of $3.95 prior to the release of SIG’s FQ3 2017 results, but only $0.02 higher than my estimate of $4.08. SIG's stock price proceeded to continue rising after its earnings release and closed at $98.72 on Friday.
What I am Working on for SIG: I am currently doing additional analysis on SIG's credit portfolio and accounting policies. More specifically, I am taking a closer look at SIG's accounting policies for its In-House Finance Receivables and Extended Service Plans (ESPs), the two main concerns of investors/analysts recently. I will also be analyzing the "worst case" scenario for SIG's credit portfolio and how much SIG's total profitability would be impacted if that worst case was to take place. I am doing this further analysis into SIG's credit portfolio as a follow-up to my prior analysis, as a way of reviewing risk and to test my investment thesis.
Time Inc. (TIME): More Buyout Speculation
On December 8, 2016, the Wall Street Journal reported that ("according to people familiar with the matter") TIME had hired Morgan Stanley and Bank of America to help it "field takeover or partnership interest," after receiving initial buyout interest from a group of investors in late November (as the New York Post originally reported on 11/28/2016, and as I mentioned in the last Issue of my Newsletter, sent on November 29th, which included my stock pitch and research report on TIME). After the news broke late in the trading day, TIME's stock price quickly surged higher and closed at $17.75 (+7.9% for the day - TIME closed at $17.80 on Friday, up 11.25% for the week).The WSJ article stated that the group of investors, which reportedly bid $18/share for TIME in late November, "remains interested" and that another potential bidder is Meredith Corp. (NYSE: MDP). Today, Bloomberg reported that Bronfman’s group of investors may have offered $18-$20/share initially, rather than the $18/share offer price that the New York Post reported, but the competing accounts of what the real situation is reveals just how uncertain this entire situation is. Regardless, TIME rose up to $18.00 today before closing at $17.60.
Possibility of MDP Merging with TIME: As discussed in my pitch and research report sent November 29th, MDP is the most comparable publicly-traded company to TIME. Back in 2013 (when TIME was still owned by Time Warner), TIME and MDP almost made a deal whereby many of TIME's main magazine brands, excluding Time, Fortune, and Sports Illustrated, would be combined with MDP's then 18 magazine brands to form a separate public company (see here for a 2013 WSJ report describing those negotiations). Some are speculating that something along those lines could happen again, especially now that it has been more than two years since TIME's tax free spin-off from Time Warner (having a merger take place within 2 years of the spin-off would imposed a tax burden on Time Warner, as discussed here).
In FY 2016, MDP had more than 20 subscription magazine brands and generated 67% of its total revenue from its National Media segment, with roughly 52% coming from magazine circulation and advertising and the remaining 15% coming from other activities related to magazines such as marketing, custom publishing, and brand licensing. If MDP were to merge with TIME the combined entity could likely produce significant cost savings synergies, which would theoretically justify MDP paying more for TIME than a private equity buyer, but I question whether MDP could pay more than the $18/share "bid" (assuming it was indeed offered by the PE buyers back in late November) for TIME. Based on my preliminary analysis, MDP could only add around $300 - $350 million in debt to its capital structure before it would be at risk of breaching a debt covenant, so any deal would have to be mostly a stock-for-stock transaction and MDP's management may have a tough time convincing shareholders of the wisdom of paying up to $350 million in cash and another $1.45+ billion in stock (vs. MDP's current market cap of $2.54 billion) for a company with roughly $940 million in net debt and declining revenue. Another negative for a merger is that most of TIME's current management team is very new (only in place since September 2016), and they might not be quick to accept a deal where they might be out of work after only a few months. As a result, I see TIME merging with MDP as possible but not necessarily likely - the key will be whether both companies' managements think they could sell a deal to shareholders, and whether MDP's stock price remains high (because that would account for the majority of the "currency" used in the transaction).
Possibility of a Private Equity Firm (or a group of investors) Buying TIME: As I mentioned in the last Issue of my Newsletter, the recent buyout speculation surrounding TIME started when the New York Post reported that the company's management had received, and turned down, an $18/share buyout offer from a group of investors that included billionaires Edgar Bronfman Jr. and Len Blavatnik. It is still possible that the group of investors could bid a higher amount for TIME, but given the investors' profiles they appear to be looking for media companies/assets they can buy at attractive prices and then reinvent or revitalize. As a result, they may not be willing to pay more than they previously offered. Private Equity buyers could get interested, especially now that TIME has hired Morgan Stanley and Bank of America, but TIME already has a fair amount of debt which could make a LBO more challenging. TIME does have some characteristics that make it attractive to a PE buyer, such as its strong FCF and the potential for a multi-year turnaround focused on digital advertising, and management would also likely be more willing to accept a PE buyout because they would likely be kept in place. A PE buyer, or group of investors, may want to sell some of TIME’s magazine brands after buying the entire company, and my research indicates that most of TIME’s more popular brands could be sold for P/S ratios of up to around 1.4x (see the slide in my stock pitch that analyzes the value of People magazine). In addition, the buyers may also have ideas for how some of the magazine brands could be reinvented, such as Bronfman’s ideas for reinventing Sports Illustrated.
Other Possible Outcomes for TIME: These include TIME and MDP forming a joint venture partnership, TIME selling some of its magazine brands (rather than a buyout), and, of course, absolutely nothing. If nothing happens that would be a shame because it will have distracted management for at least a month or two, required TIME to pay the bankers it hired,
Final Thoughts on TIME: Given that it closed at $17.60/share today, and everything I said above, I believe that TIME’s current price is factoring in a high probability that a deal takes place. As a result, I think TIME's current price is not attractive from a risk/reward standpoint and that the current price is not a good entry point. For example, with a share price of $17.60, TIME has 13.6% upside to my $20 Base Case price target, which could also be considered towards the higher-end of a potential buyout price range in this current environment (i.e. from the current suitors), and 37.5% downside to my $11 Bear Case price target (Bear Case assumes a successful digital transformation does not take place), which is not an attractive risk/reward opportunity. = However, I do think that even if a deal were not to take place the recent news would end up being a catalyst that could cause investors to take a look at the value of TIME’s brands and assess the company’s worth, which could lead to it trading above its pre-buyout-rumor price in the mid-to-high $13s and possibly help it move towards my Base Case price target over time (and after the initial drop in share price that would likely take place if the current situation does not result in a deal).
I have attached edited versions of both my stock pitch and research report on TIME. The content is the same, and none of the prices or figures have been updated, and the only changes made were for informational/grammatical purposes.
Flotek Industries Inc. (FTK): Another Short Seller Report
As long-time readers of my Newsletter will know, I first wrote about FTK in Volume II, Issue 1 of my Newsletter, sent on May 31, 2015, and after that I wrote a few follow-up pieces that primarily focused on the company's earnings reports. After opening at $11.54 on June 1, 2015, FTK's price rose to above $20 by early September 2015 (hitting a high of $21.72 on September 3rd) and then stayed between $16 and $21 until November 2015 when it plunged roughly 50% in two days (on November 9th and 10th) and closed at $9.04 on November 10th. By mid/late January 2016, FTK was trading at around $5-$6 a share, after hitting a low of $4.89 on January 20th, and then its price proceeded to rally up to nearly $17 by early September. FTK closed this last Friday at $11.21, down nearly 15% for the week, so it now back to more or less the same place that I first wrote about it (note: today FTK closed at $10.60).
Those who follow FTK are now experiencing déjà vu. The cause of the 15% decline last week was a report, written by a firm called FourWorld Capital Management – which is shorting FTK's stock. The report alleges that FTK’s signature product (CnF) does not work as well as claimed. Thus this allegation is similar to that made in a separate report written by a different short seller in November 2015, which caused the two-day 50% decline in FTK's price and likely contributed to the stock trending lower over the following few months. The most recent allegations shouldn't be taken lightly, because they (like one of the main allegations made in the first report) relate to how well the CnF products work relative to competitors' products and therefore whether FTK will be able to continue to sell it for a premium. FTK's management has long claimed that the company's suite of CnF products are significantly better than competitors' products at maximizing a well's oil/gas production, and they rely on that claim (along with the fact that the CnF products are "green") to justify the fact that the CnF products are sold at higher prices than competitors' products. The recent short seller report also alleged that the company has a very poor attrition rate with CnF customers. Given that FTK's CnF products accounted for approximately 44% of its total revenue in the last twelve months, based on approximate figures in the company's most recent investor presentation, the allegations are serious and should not be overlooked, but it is also important to know that the two consulting firms that FourWorld hired to conduct an analysis of FTK's products may have a conflict of interest because one of the disclosures in the report said the following:
"The consulting firms hired by FourWorld, and referenced in this paper, are receiving a fee that is based on the performance of FourWorld’s positions in Flotek stock, and, independent of FourWorld, may have a direct or indirect short position in Flotek stock."
Note: According to the same disclosure, "FourWorld, and FourWorld managed accounts, have a direct or indirect short position in Flotek Industries Inc. ('Flotek') stock, and therefore stand to realize significant gains in the event that the price of Flotek stock declines."
The apparent potential of a conflict of interest does not necessarily mean that the consulting firms’ analysis and conclusions are incorrect. It should be noted that their conclusions directly contrasts with the conclusions made by the independent studies conducted by the consultants FTK hired to analyze the performance of its CnF products after the first short seller report (of the three studies conducted by the consultants that FTK hired, one was released in January 2016 and the other two were released in July 2016).
In addition, despite the title of its report (i.e. "Flotek: Drilling Down To Zero"), FourWorld did not provide either a detailed analysis of FTK's balance sheet or a scenario analysis in which the company was projected to trigger either a technical default (caused by breaching a debt covenant) or a "money default" (caused by missing an interest payment or a principal payment). Rather, it was left to the reader to decide if FTK would truly go "down to zero" if the conclusions reached in the report proved accurate.
On the same day that FourWorld's report was published on Seeking Alpha (December 7th), FTK filed an 8-K that stated on December 6th the company "settled a short-swing profits claim under Section 16(b) of the Securities Exchange Act of 1934" against a shareholder that entitled FTK to receive "gross proceeds of approximately $15.5 million from the shareholder" (if the court approves the settlement). This settlement is important because receiving proceeds of $15.5 million would reduce FTK's net debt by 39.7%; if it is assumed there were $2 million of legal fees, then the net proceeds still reduce FTK's net debt by 34.5% (using balance sheet figures from FTK's most recent 10-Q filing as of 9/30/2016). Reducing FTK's net debt by over 30% would make it significantly easier for it to comply with its debt covenants, which reduces the probability of a technical default.
The entire scenario with FTK is still unfolding and, besides from an initial statement made at an investor presentation on December 7th (the day FourWorld's report was published) where an executive said that they "take these kind of claims very seriously" and are "in the process of reviewing the report," the company has yet to respond to the allegations and has not yet issued a press release regarding the claims. How management responds (or fails to respond) will have a big impact on the stock price's direction over the next few months.
Final Issue of My Newsletter
As I will be starting a permanent job this summer, I plan to have the final Issue of my Newsletter contain a summary of what I have learned over the three and a half years (expected release: April/May 2017). This will include FTK’s roller coaster ride over the last two years, and what I learned from my successful and unsuccessful stock picks made in my research reports and stock pitch presentations. Thanks, as always, for your interest and support.
Disclosure: This Issue of my Newsletter is not intended to be investment advice, and I am not a Registered Investment Advisor. I share this information for educational purposes, to document my own research, and to receive feedback (and learn) from my subscribers. I have no positions in any of the stocks mentioned in this report. I wrote this report myself, and it expresses my own opinions. I did not receive compensation for it. I have no business relationship with any company whose stock is mentioned in this report.