3/07/2007

Delta Financial: A Solid Subprime Lender Weather The Storm

This morning Delta Financial Corporation (DFC), a subprime mortgage lender we analyzed in September 2006, released its 4th quarter and fiscal year 2006 earnings.

Amid present subprime mortgage carnage Delta Financial performance is impressive.

Sticking to their strategy to focus on the fixed-rate loans niche (87% of their loans in 2006), the seasoned and conservative management reached amazing results:

1) Profits per share increased 22% compared to same quarter of last year while virtually all other subprime mortgage lenders reported losses in 4th quarter 2006.

2) They originated a record $4 billion loans, 5% more than 2005 volume.

3) They reached a truly outstanding low cost to originate (1.6%). According to the information we have in our hands we believe that in the 4th quarter they were the low origination cost leader in the subprime mortgage universe despite they spread their fixed cost on much smaller volume compared to their bigger competitors. The secret here is that are using their in-house origination platform which sports very low 1.1% origination costs against the 2.2% supported by the broker channel.

4) Their underwriting profit that is still near record highs.


period
Q3 2005
Q4 2005
Q1 2006
Q2 2006
Q3 2006
Q4 2006
gain on sale of whole loan sales
1.4%
1.4%
1.1%
1.3%
1.8%
1.6%


Regarding the outlook, the company CEO Hugh Miller is positive. He has not seen so far the usual seasonal decline in loan volume during the first quarter of the year and he plans to hire new loan officers to grow retail origination platform.
Loan losses are within expectations and 90+ days delinquent loans reached 5%, about half of what we believe to be the industry average.

At the current quote of $9.58 the company trades at 1.51 x book value, 7.5 x 2007 expected earnings and pays a 2.2% dividend.

Though company evaluation is richer than the other distressed subprime distressed competitors like New Century, Accredited Home Lenders or Novastar Financial which are currently fetching a fraction of their tangible book value, we believe that the company superior business model and management deserve the premium.


Disclosure: the author is long Delta Financial and Accredited Home Lenders Holding Co. at the time of posting

1/29/2007

Abitibi Shareholders Swimming In Good News

At the end of our post of two weeks ago regarding Abitibi Consolidated Inc. (ABY) we were stating that mergers and acquisitions and other resource conversion activities (like spin-off of under evaluated assets) were the main catalyst for a material share price increase of Abitibi depressed stock price but we were not expecting good news to materialize so quickly.

Today Abitibi announced that it agreed to merge with Greenville (S. Carolina) based Bowater Inc. (BOW).
Bowater is the largest newsprint and mechanical paper producer in United States. It also produces pulp, speciality paper, timber products and other timber related products in mills located in United States, Canada and South Korea. The company also own 835,0000 acres of timberland in United States and Canada.
The deal is subject to regulatory and shareholders approval and expected to close in the third quarter 2007. We will wait for some highlights on antitrust approval since both companies hold a meaningful share of the North American newspaper market.

The merger can be considered as a merger of equals. Executive Chairman and CEO office will be shared by respectively the present Abitibi and Bowater CEOs. The 14 members Board of Directors of the new company to be named AbitibiBowater will consist in 7 directors from each company.

Each common share of Abitibi will be exchanged for 0.06261 common share of AbitibiBowater and each share of Bowater will be exchanged with
0.52 share of the combined firm.
At Friday closing quote the new company would be 48% owned by former Abitibi shareholders and 52% owned by former Bowater shareholders.

Sales of AbitibiBowater should fetch $7.9 billion and enterprise value should exceed $8 billion.

Management expect to achieve annualized $250 million of cost cutting above the cost savings in place in both companies.

The deal should be highly rewarding for the shareholders of both companies.
We expect cost saving initiatives, better pricing power and assets use should materially improve cash flows and allow companies to reduce debt and invest profitably in value added paper mills.

We do not exclude further spin-off, refinancing or other assets conversion of certain Abitibi or Bowater assets to bring out to light the market value of their hydro power or timberland assets. Abitibi management already showed the way on Friday last with their announced sale of their Ontario based hydro power facilities to a majority owned joint-venture financed with non-recourse debt.

Before the announcement of merger agreement this morning Abitibi shareholders were already comforted by a Barron's column published this week-end.
The Seeking Alpha excerpt of the article is quoting John Schneider, the advisor of the Touchstone Large Cap Value Fund (fund started in March 2006, you can read a short bio of John Schneider here). He has some good points:

1) Canadian Dollar is weakening against the U.S. Dollar. (USD gained 5 cents from the highs), each cent gain is worth C$ 0.08 / share in earnings and something more in free cash flow, the stock was quoting on Friday C$3.11 in Toronto.

2) Worldwide newsprint demand is increasing despite the secular decline in North America but magazine paper volumes are catching up and should exceed newsprint volumes in 2010.

3) Sentiment is gloomy around the stock. The stock is the 20 years worst performer of the Toronto Stock index and we guess that a number of investors have been disappointed so far.

Before getting the merger news the fund manager said he was expecting a $0.50/share profit in "a few years" . Applying a 10 times multiple to these earnings the stock was expected to double in the meantime.

Barron's was focusing on the earnings side of the story that may mature in a few years. But the other side, the "assets conversion" story, already started to reward Abitibi shareholders. Abitibi was up 25% this morning at $3.34.



At the time of posting the author was long Abitibi Consolidated.

1/16/2007

The Ugly Paper Ducking Can Become a Swan.

Abitibi Consolidated is the worldwide leader newsprint producer.

Newspapers, no matter how prestigious is their brand, whatever is their business model or their specific audience are almost all facing a secular decline in circulation and readership. From 1994 to 2004 more than 90 daily U.S. newspapers closed, circulation declined 8% and almost 5 million readers have been lost these last 10 years.

The only way to maintain readership and attract a share of the growing online advertising budgets is, well, to publish online on the paperless world wide web. Publishers also try to save as much money as possible on their newsprint paper costs. They are reducing number and size of pages and using lighter paper. The last 5 years daily newspaper consumption has fallen 1.5 million metric tons (1 metric ton = 2205 pounds) or about 15%. North American newsprint consumption for all uses declined 5% in 2005 only.

Paper industry have been very disciplined in reducing capacity closing unprofitable mills or converting newsprint machines to produce other paper grades. Since 2001 output capacity per year has been slashed by 3.5 million tons. At the end of 2005 total North American newsprint capacity reached 13.2 million metric tons.

The result is that newsprint paper prices increased from $475 per ton in 2002 to slightly above $670 in these last weeks.

However prices increases did not compensate the reduced volume sold and costs increases notably transport, energy prices and strengthening of Canadian Dollar. These last issue is not a small one since about 60% or Abitibi capacity is located in Canada.

Bottom line is that profit margins vanished and the newsprint industry which has been traditionally a low return/capital intensive industry is trading at depressed valuation.

Despite all negatives listed above, Abitibi Consolidated, a Canadian company listed both on Toronto and New York stock exchange (ticker ABY), is a good long term investment due to its low cost advantage and to inevitable industry restructuring that is starting to accelerate.

The stock is unloved for good reasons. It's the last 20 years worst performer on the main Toronto stock market index and has a leveraged balance sheet though some assets are registered below their fair value.
Such investment can be classified in the "deep value" category therefore we urge readers to make further researchand allocate a small portion portion of their investments in this stock.


Profile

(figures: in Canadian Dollars "C$" or U.S. Dollars "$")

Montreal based Abitibi Consolidated is the global leader in newsprint and commercial printing paper. They have also a wood products business integrated with their paper mills operations.

Main figures (source Yahoo!):
quote: $2.72 = C$ 3.17
Shares outstanding: 440 million
Market cap: $1.2 billion = C$ 1.4 billion
Revenue (TTM): $3.5 billion = C$ $4.08 billion
Enterprise value: $4.39 billion = C$ 5.13 billion
P/B: 0.57
Enterprise value/EBITDA: 6.9
GAAP earnings per share: -$ 0.55 = -C$ 0.64
EBITDA (TTM): $643 million = C$ 751

The company is divided in three main operations: newsprint (sold in North America and international markets), commercial printing paper and wood products.

sales distribution  - http://sheet.zoho.com
(source: company presentation)

1) Newsprint
Paper used for newspapers, inserts, directories, guides, general commercial printing.
TTM volume: 3,581 tons
TTM sales: C$ 2,660 mil.

Despite secular decline for demand of this this product in North America and a low single digit demand growth in the rest of the world we think this is the most attractive part of the business.
The company has a strong low cost advantage and should already have, or close to have, all their newsprint mills in the best half of the cost curve as per their 2005 shareholder's letter.
Capital expenditures are limited and this sector is enjoying a strong cash flow. We expect that consolidation of the industry and closing of the competitors mills with highest costs will further improve already healthy cash flows.
Part of these cash profits will also be used to convert some of the newsprint machines to produce the commercial printing paper grades enjoying better growth prospects.
Abitibi is also the largest newspapers and magazine recyclers in North America collecting about 1.9 mil. tons of waste paper per year .

2) Commercial printing papers
Paper used for telephone directories, catalogues, inserts, flying, tabloids, digests stand-alones, books, magazines, catalogs, financial printing...
TTM sales volume: 1,775 mil. tons
TTM sales: C$ 1,529

Commercial paper demand is enjoying a slightly better demand growth than newsprint. Overall the segment should see a yearly North American demand increase in the low single digit. It may seem poor compared to other industries but it is a wonderful environment in the battered paper industry. Don't forget that it has been in the doldrums for many years and that capacity has not been increased but barely switched from a paper grade to another.
Some grades like uncoated groundwood specialities are even enjoying growth rate in excess of 20% per year.
This is also the most capex hungry business. We expect that the a great part of the yearly normalized C$ 180-200 million capex will be used to convert newsprint machines to commercial printing products.
Unfortunately all the Abitibi mills producing this kind of paper (and about 65% of newsprint capacity) are located in Canada. The 40% increase of Canadian Dollar in the last 5 years has badly hurt profit margins.





To give an idea of damage made by Canadian Dollar increase the last one year impact calculation is reported in the 2005 annual report. Management estimated that unfavorable currency moves (in fact the Canadian Dollar increase) weighted for C$ 265 million on EBITDA (about 20% of market cap or 6% of enterprise value).

The unfavorable forex impact is caused by the fact that the company record in U.S. dollar about 78% of its revenues but only 14% of its manufacturing costs. As a partial hedge all of its long term debt is issued in U.S. dollar.

If Canadian Dollar would reach just reach the average 5 years quote the positive impact would be huge.
According to variance analysis posted by the company in their last 2005 10K filing we would expect an improvement on earnings per share of about C$ 0.80 (about $0.68 per share).


3) Wood products
Used for roofs, housing, remodelling, mobile homes, flooring
TTM sales volume: 1,925 million board feet
TTM sales: C$ 792 mil.

Though being the main wood products producer in Eastern North America the business represent a tiny share portion of the whole company. It is integrated with paper mills and has been suffering first from anti-dumping duties (most of them refunded in December), from strong Canadian Dollar and from U.S. housing slump.
In October company shut down 20% of their timber capacity and closed four sawn mills laying off 380 workers.
Current EBITDA contribution will be improved when housing industry will recover but we don't think that, contrary to their newsprint business, they have any special cost advantage.

sales and EBITDA breakdown (TTM) - http://sheet.zoho.com
(source: company SEC filings)


Balance sheet

ABY is trading at a rock bottom 0.57 times GAAP book value.
A few remarks on our back of the envelope adjusted Net Assets Value calculation:

- In November company received $235 million as anti-dumping duties charged by U.S. government in last years, such amount is not reflected in last available quarterly report dated September 30th.

- Hydro electric power generating assets: we believe same are under rated since it's a cheap alternative to oil which, despite latest slump, is still trading at historically high prices. We have not in hands comparative evaluations elements to understand what is the market market value of these assets but there are good news in this respect. Within this quarter company will spin off a minority interest of 47.5% of these hydro assets in an income fund to keep control on one of the main low cost factors.
We will assume that hydro assets are of higher quality and offer a more stable and profitable stream of income than the average assets. Since full company is trading at 6.9 x EBITDA we will assign a very conservative 9 x EBITDA multiple assuming a similar equity/debt proportion. Is it scientific and accurate ? Definitively not, but it's simple and conservative enough. The IPO pricing in the next couple of months will provide a quick double check on our evaluations.

- Timberland: market value of timberland is not easy to assess. Basically it depends if same is located near a profitable sawn mill or paper mill and to which extent overall costs to sawn logs and transport logs for industrial purposes is cheap or not. We would say however that the general rule here, like other real estate assets, is that they tend to increase in value over time but are recorded according to official GAAP accounting rules at cost less amortization. We will use here a conservative assumption: we add back the amortization deduction mentioned in balance sheet (C$ 184 million) plus a totally arbitrary but conservative enough 10% on top of historic cost to recognize the long term appreciation of these assets (C$ 33 million). In total we will add C$ 217 million on top of GAAP timberland value.

- Pension underfunding: according to last annual report covering fiscal year ending in December 2005 pension defined plan were underfunded by C$ 700 million. Pension accounting is rather tricky and such under funding does not require an immediate cash funding by the company. But since we believe their estimated future assets yields and salaries increase are conservative enough we will detract these C$ 874 million from book value (special thanks to Ben McClure of the Investopedia.com website for his opinion on this item).

- Goodwill: to be very conservative we will erase all goodwill value assuming that all their previous assets or company acquisitions were concluded at prices that will not grant a positive return on investment. Note that the company is performing impairment tests on those assets each year and last time at the end of 2005 it evaluated that the value of those assets was intact.

- Property plan and equipment: according to successful value investors at Third Avenue management which own 6% of outstanding shares the low cost newsprinting plants are trading far below their replacement costs and their value to a properly funded private buyer would exceed their balance sheet value. To be conservative, due to gloomy prospect of the industry and lack of proper benchmarks we will consider PP&E as a correct estimated value of all company mills.

Here is a sum up of our fair Net Asset Value estimate (all figures in million except per share figures):

GAAP book value
C$ 2,415




plus adjustment hydro assets value
+ C$ 561

adjustment timberland value
+ C$ 217

U.S. softwood duties refund
+ C$ 270

goodwill
- C$ 1,296

pension plan deficit
- C$ 874




fair book value
C$ 1,293

divided by 440 million shares
C$ 2.94
$ 2.51
current quote
C$ 3.17
$ 2.72
price / fair BV
1.07



- Debt: after hydro assets IPO, receipt of U.S. softwood duties, purchase of the remaining minority interest in a paper mill located in August and simultaneous sale of 55.000 acres of timberland related to the mill, management expect to be free of long term debt to be repaid in 2007 and 2008. These two years are precious time to face a presumably still gloomy period and to have the time to be part of the coming industry consolidation.
Here are is a rough idea of how the long term debt repayment schedule should look like at the end of first quarter 2007 (in million):
2008: 0
2009: $151 (about C$ 177)
2010: $399 (about C$ 399)
2011-2015: $1,211 (about C$ 1,424)
2018-2030: $ 991 (about C$ 1,165)

Company long term debt is rated B+ by Standard and Poors, deep in the junk area.


Cash flows

We will not mention net income in this write up for two reasons. First because in case of very leveraged company we prefer to focus on cold hard cash. Second because net profits, taking into account the heavy non cash assets amortization will prevent to have a true idea of business cash generation potential.

Here is a free cash flow graph calculated by the company as EBITDA less interest expenses less capex (all figures about and excluding "specical items"):

free cash flow - http://sheet.zoho.com
(source company documents)

We calculated our own "free cash flow" on a more conservative basis replacing "interest" by "financial expenses" which include, among others, premium and other elements related to early debt retirement. Since company is very leveraged and operating in a difficult market, early retirement of debt is not a discretionary use of funds but a quasi-obligation.

According to these figures we estimate that if there are no major changes in industry and foreign exchanges normalized yearly free cash flow should be:

C$ 544: EBITDA
-C$ 240: financial expenses
-C$ 180: capex
---------
=C$ 104: normalized free cash flow (should be used mainly for debt repayment and cash contribution to pension fund)

In case of either industry consolidation, materially weaker Canadian Dollar or a smoother decline in the newsprint demand the effect on EBITDA would be material.

Management

The CEO John Weaver is at the helm since 1999. He is a 30 years veteran of the paper industry and first started as paper machine superintendent and then climbed all the stairs of the corporate scale up to the corner office.
We like his strategy of cost cutting and improving free cash flow generation to repay long term debt.
Selling General and Administrative expenses are already the lowest in the industry at 3% of sales.
In an heavy unionized industry management is not shy of closing or idling unprofitable mills to strengthen the company low cost advantage.

Excessive stock options grants are not an issue here. There are only a few thousands of stock options outstanding at a strike price which is the double of present quote. All the remaining options have strike prices which are several times higher than the present stock quote.


The elephant in the room

George Staphos, Bank of America analyst in charge of the paper and forest industry issued at the end of November a report mentioning "the elephant in the room" in paper industry: the mounting merger and acquisitions, private equity deals, spin off and other various resources conversion activities to rationalize the industry, reduce output, close unprofitable mills and bring out the valuable assets.

This is according to our opinion the strongest catalyst for a material share price increase.

"Canada's battered forestry sector is ripe for consolidation. With the competitive cost nature of our business, as it become more commodity pricing... we must find ways to consolidate the industry and even to consolidate on a local basis, say for instance our sawnmills.
In the newsprint business, specifically, I think there continues to be room for consolidation, whether it's among small players or even perhaps with us and a small player.". This Abitibi CEO opinion expressed last October is shared by many industry participants and by some smart investors.

Third Avenue Management, the famed value shop runned by Marty Whitman which owns a 6% share in Abitibi, is also very optimistic on the prospects of the paper industry mainly via mergers and acquisitions. They own also 38% of an Abitibi competitor, Catalyst Paper, a C$ 1.8 billion sales Canadian paper producer. Contrary to their common quiet passive investor behaviour Third Avenue Management launched last fall an hostile tender to increase their Catalyst stock holdings and obtained to nominate four new directors. Three of them have extensive experience in mergers and acquisitions. Yesterday the CEO and CFO of the company resigned. A forthcoming merger or assets conversion seems in the card. We are not sure that Abitibi will be involved but it will be good news for the stock in any case.

Canadian billionaire Jimmy Patison (net worth estimated at C$ 4 billion), a major shareholder of Canfor, a C$ 3.8 billion sales Canadian forestry firm, is a strong believer in the need to consolidate Canadian timber companies. According a Globe Investor column dated November 2006
he started to aggresively increase his holding in Canfor this spring. The Canadian anti-trust authority has not been very cooperative on the consolidation issue so far but things are changing.

Last week Canada's Competition Bureau decided not to challenge the Domtar's merger with Weyerhaeuser Co.'s (WY) fine-paper businesses.
Weyerhaeuser, the biggest North American forest products company, plans to spin off its fine-paper products businesses into a new, publicly traded company, which will then merge with Domtar, a $4 billion yearly sales Montreal-based paper, timber and packaging company, in a deal valued at $3.3 billion.


What to expect from an investment in Abitibi ?

Weakening Canadian dollar, falling energy prices and coming hydro power IPO recently propelled the stock higher. It already gained 20% from its end November lows.

When industry consolidation will accelerate we expect a further boost.

Like for every leveraged company risks and rewards are huge. If no dilutive equity deal is required to refinance debt, we see Abitibi market value to at least double or triple in the next 3-5 years. Even in case of moderately dilutive equity deal we expect a low double digit return on the investment.


Disclosure: at the time of posting the author was long Abitibi.

12/11/2006

Value Investor Weekly Reading List

Topic of the week was the plunge of Pfizer.
Since the stock is the darling of many value investors we will focus on it on this issue of the Value Investor Weekly Reading List.
The company stopped clinical trials of torcetrapib. This anti cholesterol drug was supposed to replace Lipitor which represents 25% of drug maker sales. Suddenly Pfizer drug pipeline seems rather dry.

At the end of the column we will submit you also an interesting value play, an intriguing story on analogy between investing and gambling and an entertaining and instructive Warren Buffett video.

First let's talk about Pfizer.

How the failure materialized ? Only two statistically abnormal deaths, in a clinical trial involving 15.000 patients (i.e. 0.02% of the sample), triggered the threesold which, almost on automatic pilot, forced Pfizer to stop the trial.

The Economist explains why the drugs industry may shares many of Pfzer's problems.

Fortune wonder if after the torcetrapib failure it is a good idea to outsource early stage drugs research and development .

Robert Stever at TheStreet.com sum up the long term revenue and earnings consequences of torcetrapib failure.

The Wall Street Journal reminds here that despite heavy losses suffered by investors and flat revenues expected by management for the next couple of years Pfizer still has hefty resources available. The recent cut of 20% of U.S. sale force will save $400 million a year. After receiving money from the sale of its consumer-products unit to Johnson & Johnson next month, Pfizer will have $34 billion (yes, billion with a "b") in cash. It may be enough to finance a successful turnaround.
The BreakingNews column , at the end of a gloomy article, point out that the company is expected to have a free cash flow after dividends of $10 billion next year.

Is the new Pfizer CEO nominated last July fitted to lead the turnaround ? Wall Street Journal has a positive column on him and list challenges which are facing the drug giant.
Jeffrey Kindler is an "inside outsider". He joined Pfizer in 2002 as general counsel and didn't have a previous experience in the pharma industry. He knows enough about the company to understand what need to be changed but he isn't "steeped in the company's and the industry's creaky traditions". Last but not least "until the stock goes up 50% from where it was when he took office (around $26) Mr. Kindler's stock options are worthless".

What should do investors with Pfizer stock ?

The Peridot Capitalist makes a strong case to hold on Pfizer . According to him it should be, at worst, a cash proxy yielding 4-5%. Any extra cost cutting efforts, positive surprise on remaining pipeline, smart acquisition or dividend boost can provide an attractive upside.
On the other side Marek Fuchs on TheStreet.com presents the bear case.

Investopedia explains how to evaluate drug makers .

Money Magazine provides three strategies for health care investing after the Pfizer flop.


And now an interesting value play.
Jim Clarke in an interview with Value Investor Insight suggest to have a look at Cavalier Homes (CAV). This manufactured house maker fetching $73 million market cap has a strong balance sheet. It still makes money in an industry at a 40-year low with only half of its plants operating. Downside is limited. If you apply to Cavalier Homes the multiple Warren Buffett paid for a competitor the stock has at least a 20% upside.


Vitaly Katsenelson relate a real life story which shows the similarities between successful gambling and successful investing.


Warren Buffett is in a great shape in this video of a speech to University of Florida students. Funny and insightful.

12/07/2006

A Few Thanks

We started publishing this blog on Sept. 15th 2006, three months ago only.

Beyond our most rosy expectations one of our posts regarding Pfizer has been mentioned yesterday by the Bible of investing blogs, the daily Blog Watch written by James Altucher on TheStreet.com website.
He has been certainly excessively generous in quoting us among first league investing blogs that we discovered reading his column. We are taking this mention as an encouragement to do more and better.

Mick Weinstein, the Editor-in-Chief of SeekingAlpha, deserves also a special mention in this "thank you" post. His website has been our first occasion to reach a broad audience and he has demonstrated a boatload of patience in correcting our posts.

A final "thank you" goes of course to our readers. The only fact that they pick our posts among hundreds of investing news sources and pay their attention to our research for a few minutes is our biggest reward. Their comments and suggestions are always welcome.

12/04/2006

Pfizer: Value Investors Saved By Margin Of Safety

Rule no.1: if a company is doing fine, look at the balance sheet.
Rule no.2: if a company is in trouble, see Rule no.1.
(Value Investor Blog)


Pfizer, the world leading drug maker has find a place in many of the major value managers portfolios. According to GuruFocus website here is a table of the most famous investors involved :


Ticker

Guru Name

Portfolio Date*

Current Shares

% of Total Assets

Change from Last Holdings

PFE

Arnold Van Den Berg (CM Advisors Fund)

2006-09-30

5,871,000

6.56%

-0.03%

PFE

Tweedy Browne

2006-09-30

7,454,663

6.49%

3.43%

PFE

Dodge & Cox

2006-09-30

27,392,094

3.18%

-78.54%

PFE

Ronald Muhlenkamp

2006-09-30

3,187,325

2.72%

0.69%

PFE

David Dreman

2006-09-30

16,426,784

2.66%

12.09%

PFE

Charles Brandes

2006-09-30

45,528,520

2.27%

-17%

PFE

Edward Owens

2006-09-30

17,611,570

2%

-37.13%

PFE

Michael Price

2006-09-30

335,000

1.67%

0%

PFE

Brian Rogers

2006-09-30

9,964,000

1.29%

-0.36%

PFE

George Soros

2006-09-30

296,500

0.48%

42%

PFE

Charles de Vaulx

2006-09-30

69,568

0.02%

-41.4%

PFE

Ruane Cunniff

2006-09-30

88,413

0.02%

-12%

PFE

Martin Whitman

2006-07-31

2,000,000

0.87%

0%

PFE

Bill Miller

2006-06-30

12,200,000

1.53%

6.03%

PFE

George Soros

2006-06-30

208,800

0.73%

91%


Two main reasons convinced them (and us) to invest in Pfizer stock: historical low P/E multiples and a AAA graded balance sheet. The latter is most important for us. Pfizer has about $14 billion cash and short term investments and only 8 billion of short and long term debt. One of the strongest balance sheet in big pharma industry with a debt to equity ratio of 0.116.

Balance-sheet is almost always overlooked by stock analysts but same is paramount to protect your investments value even in case of disaster.

And the company faced a true disaster yesterday. Few days after an analyst meeting with a very positive tone on their drug pipeline, following an abnormal death statistics of some patients under clinical trial, Pfizer decided yesterday to stop trials of the anti-cholesterol drug torcetrapib.

This sudden and unexpected stop is a major drawback for the company future since torcetrapib was supposed to replace Pfizer best selling drug, Lipitor which patent expires in 2010. In the last twelve months Lipitor were amounting to about a quarter of all Pfizer sale which suddenly have barely no replacement within four years.

What would have happened to a more levered company ? An immediate crash of 20/30% would have been in the cards.

In the case of Pfizer the balance sheet strength freeze somehow the slide. Ample cash at disposal allow management to put a floor on stock quote by:
- increasing dividend (already at 3.40%);
- buying back shares;
- investing in drug pipeline developed by other companies.

In fact, despite abysmal news, stock is presently trading at $24.71, at "only" 11.30% less than yesterday close of $27.86.

So what to do with stock now ?

We sold our 50% position bought at $24.79 in December 2004 at 2.6% loss. Including dividend the investment has been barely positive.

According to Value Investor Blog the main danger is now that cash on hands will be used to buy missing pipeline at an hefty price either by purchasing drugs from other pharmaceuticals companies or by merger and acquisitions operations at unfavourable terms for current Pfizer shareholders.

We must admit however that sofar the new CEO, Jeffrey Kindler, impressed us in his first months of tenure. He is aggressively cutting costs to adapt Pfizer structure to stagnant revenues and he has expressed a strong commitment on dividend increase shares buyback.

If he will start to do right moves to solve the poor Pfizer research and development productivity using wisely cash in hands Pfizer can become an attractive investment again. If balance sheet remains strong, of course.

Investors already long the stock may keep in hands at least part of their position and wait for a turnaround in the company pipeline while cashing a juicy dividend. The risk is that Pfizer will become dead money for a few years.

According to us rock bottom of stock quote is limited $20-21 / share if no major negative event impact the company. At this level we would consider again buying the stock.


Disclosure: at the time of posting the author did not have a position in stock mentioned in the post.

12/03/2006

Value Investor Blog Weekly Reading List

Every week we will list columns, blog posts, mutual funds shareholder letters and research papers which can be of interest to value investors.
Feel free to send your own readings ideas using the blog comments.

Here is today the first issue today for the VIB Weekly Reading List for the week ending Dec. 3rd.

Investopedia column on Overcoming Compounding's Dark Side is a clear illustration backed by few simple examples of Warren Buffet famous quote: "The first rule is not to lose. The second rule is not to forget the first rule".

Jim Cramer explains how to be a contrarian . I'm not a big fan of his kind of "contrarianism" which is based almost exclusively on short term analyst earnings expectations. Though we are not brothers in our investing process we may somehow cousins after all.

Associated Press have a look at the stagnant paper industry . Sentiment is poor and Wall Street, as usual, discounts present poor prospects in the future. After stock market euphoria starting last summer this is one of the few industries where you may still find some interesting value or deep value candidates.

Bill Cara has an interesting comment on whole stock market valuation . We share his prudence though huge flow of private equity and leveraged buyout money together with a benign economic environment still provide some kind of support to stock market.

Nicholas Yulico, a reporter at TheStreet.com, writes a textbook of analysis of BJ's Wholesale Club (BJ) . It's a pitty that same has been published only about ten days after a 9% spike on the stock.
His insightful column demonstrates that it's a good idea to concentrate your research a bit more on balance sheet items and a little bit less on the cents and pennies per share on the quarterly earnings figures.
At VIB we believe that discovering under rated balance sheet items provides at the same time a margin of safety on your investments and above average returns.