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.


(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.


(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"):


(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.

A Positive Quarter For Delta Financial

This morning Delta Financial (DFC), a subprime mortgage lender we analyzed in September, released its 3rd quarter earnings.

Despite housing slump, weak GDP growth and competitors woes company did a rather good job this quarter.

In a worsening environment, Delta obtained satisfying results sticking to its disciplined business model of originating mainly (87% this quarter) fixed rate mortgage loans sporting low pre-payment and default rates in large part through their in-house cheap retail channel (for about 50% of their loans).


3rd quarter 2006 highlights:

• 3rd quarter net income: $0.33 per diluted share (+6.5% year over year),
  
• originated $2.9 bil. year-to-date (+6% year over year but 3% less sequantially),
  
• mortgage loans held for investment at the end of September 2006: $6 bil. ( $4 bil. at the end of September 2005) granting in the next 12 months about $87 mil. of pre-tax interest income,
• gain on sale margin on the $197 mil. loans sold on "whole-loan" basis: 1.8% ((1.4% Q3 05, 1.4% Q4 05, 1.1% Q1 06, 1.3% Q2 06),
• increased their weighted average coupon to 9.06% (20 basis points more quarter-over-quarter).

The final result is a nice 22% after-tax return on equity.

Though we are expecting a softening origination volume for next year we are sticking to our long term price target price of $14 since originating margins are above our assumptions and default rates is still under check thanks to Delta underwriting discipline.
The stock, which trades at 6.14 times estimated 2007 earnings, can be considered as cheap.

Updated stock quote: $9.51 (+5.5% compared to 9/14/06 close, -0.83% compared to yesterday close).


Disclosure: author does not have a position in the securities discussed in this article at the time of posting.

Leucadia: A Smart Hedge To Protect Your Stock Portfolio

During the 3rd quarter 2006 the S&P 500 companies will enjoy their 18th consecutive quarter of double digit profit increase and analysts expect another double digit profit increase during the whole year 2007. Since the S&P 500 profits already reached an eye popping 49 years record level of 8.6% of GDP (total of product and services created by U.S. residents) there is some room for disappointment.

Since it's better worry about the storm when the sun is still shining, it's now the right time to wonder on how to hedge your stock portfolio against possible mediocre stock market returns.

The two major alternatives are:
- purchase of put options (or other options strategies): I tend to exclude this solution since protection is limited and cost (including commission and bid/ask spread) is expensive.
- diversifying in bonds or cash: short term investment grades bonds, U.S. Treasuries or cash do offer a limited reward (though about 2% over current inflation rate is historically a good level for cash equivalent investments), long term bonds at 4.8/5.5% do not offer an attractive reward and inflation protection. Spread of junk bonds over corporates are close to an historical low.

And what about an attractive third alternative: buying shares of a company which is thriving when the economy go bad but offers at the same time a long term track record of superior returns ?
This company exists: it's called Leucadia.


PROFILE

Key numbers (source: Yahoo)
Leucadia (LUK)
last quote (closing 10/24/06): $26.15
outstanding shares: $216 mil.
market cap: $5.66 bil.
P/E: 12.20
P/B: 1.49
dividend yield: 0.50%

Leucadia is often referred as a mini-Berkshire, the holding company of famed value investor Warren Buffett.
Though the company is described by S&P as a "Multi-Sector Holding" company, Leucadia looks more like a private equity firm.
Contrary to Warren Buffett favourite investment strategy, they are not chasing great companies available at acceptable valuations and hold them for a very long period.
They concentrate on deep value investments in distressed or out of favor assets often, but not always, involving bankrupt companies.
They usually prefer to move within their circle of competence which includes, among others, telecommunications, lending/banking, real-estate and mining industry.
Once they control the company they turn it around and sell it for what have been historically excess returns.

period 1979-2005	S&P 500	Leucadia
CAGR (1) index/share prices change (2)	+ 9.9%	+ 25.1%
CAGR Shareholders equity	N/A	+ 21.5%

(1) CAGR: compound annual growth rate
(2) includes dividends for S&P 500, excludes dividends for Leucadia
source: Leucadia Shareholders Letter 2005



comparison chart Leucadia - Berkshire Hathaway - S&P 500

The shop is run by Ian Cumming (Chairman of the Board) and Joseph Steinberg (President) which are deemed to be responsible of this notable long term performance.


BALANCE SHEET

Balance sheet is extremely liquid at the moment.
Long term debt stands at about 1 billion against 1.4 billion of net currents assets (which includes about 1.6 billion cash in cash or short term investment) and 3.8 billion of shareholders equity.
Hopefully in the next months at least part of this cash balance will be used in various investments opportunities.

One of the major assets items is a net Deferred Tax Assets worth about 1 billion which requires additional comment.
In 2005, following the sale of their telecom company WilTel to Level 3, Leucadia kept some assets in hands including this Deferred Tax Assets.
Since WilTel has accumulated about $5.1 bil. losses it accrued a credit on future federal income taxes of about $1.0 bil. which can be used to offset Leucadia profits on future investments at certain conditions for a period of about 20 years.

Each year, every time that Leucadia will accrue eligible profits:
- balance sheet Deferred Tax Assets will be reduced in proportion on federal taxes that the company should have paid on its profits,
- in Income Statement, a tax expense will RECORDED but not PAID.

Note that to ascertain the true company profitability in the future you should add back the non-cash federal taxes to the net profit reported until the whole Deferred Tax Asset will be used.

After checking company investment track record and company statements we based our analysis of net worth on the assumption that in the next 15-20 years Leucadia will generate enough taxable income to fully take advantage of the tax credit assets reported in balance sheet.


MANAGEMENT

Top management, Ian Cumming and Joseph Steinberg, are the main point of strength of the company. They are responsible for the stellar long term investment returns but they are 62 and 66 year old. However their new employment contract signed in 2005 expires in June 2015. They are in good health and according to what can be understood from their comments in last shareholders letter and last shareholders meeting they seem as enthusiasts as ever.
They own about 24% of the company which is a good guarantee that they will move in line with long term shareholders interest.

This summer there have a been some notable insider buying. Two directors bought shares worth about $534.000 at an average price of $25.74, a level close to present quote.


AN UNDERGROUND WEALTH BUILDER

Leucadia is not an ordinary conglomerate and its profitability is not easy to ascertain by following their quarterly earnings releases. Wealth is not built by a regular stream of operating income out of of long term assets. Management goal is to increase over time the company net worth which usually does not appear in balance sheet or income statement till the assets sale.
In the past most of their investments were concentrated in private companies or hard/financial assets which fair value is elusive for analyst not specifically involved in the relevant industry.

How to evaluate the business ? The main criteria should be, like an ordinary stock mutual fund, the Net Asset Value. But unlike a mutual fund, usually you cannot rely on daily market prices of listed stocks or bonds since their assets are not always publicly listed .

A deep and relevant analysis would be so time consuming that brokerage houses and investment banks decided not to cover the company despite its $5.7 mil. market cap. It tells a lot on how poor is Wall Street job on providing added value information on balance sheet statements and how much time and money are spent on trying to get right up to the penny the quarterly earning figures.

However you are now in a somehow lucky period regarding this issue since more than half of total assets are made of cash and short terms investments.
Out of total $5.5 bil. total assets appearing in last balance sheet for quarter ending June 2006 you have about 2 bil. of cash and short term investments and about 1 bil. of deferred tax assets (see above) which require no adjustment to reflect their fair value.

On top of that financial statements report a collection of minor assets which adjustment to get fair value would have only a very minor impact on reported balance sheet for two reasons:
- assets were acquired a short time ago (less than 1 year/1 year and half ago)
- they represent a minor share of total company assets

Here are the main assets excluding cash:

• $400 mil. invested in Fortescue, an Australian iron ore mining company ($300 equity and a $100 mil. note);
• timber and plastics manufacturing: paid $133 mil. in Apr.05 for Idaho Timber plus Conwed (plastics) which employed about $82 mil. assets;
• wineries located in California (225 acres in Napa Valley) and Oregon (115 acres in Willamette Valley), combined net investments amount to $71 mil.;
• real estate assets which book value at the end December 2005 was $166. I suppose that these assets should be materially undervalued. Accounting rules require to depreciate such assets though they tend to increase their value over time especially these last 3-4 years of white-hot real estate market;
• restricted 5.6 mil. shares of Canadian mining company INMET (worth today $ 265 mil. against $78 mil. reported in the books);
• a 30% interest in Goober Drilling paid $60 mil., plus a secured loan to the same company of $126 mil. (loan balance was $53 mil. in June 2006);
• $91 mil. investment to rebuild the Hard Rock Biloxi casino and hotel completely destroyed during Hurricane Katrina;
• about $250 mil. in a various hedge-funds and investment partnerships;
• Berkadia (it sounds like a joint-venture between Berkshire and Leucadia ? you're right, it is) which is close to complete the liquidation of assets of bankrupt Finova Capital Corporation.

After adjusting for market value of Inmet and real estate assets and after deducting unfunded defined benefit pension plans (calculated by Leucadia using a very conservative discount rate around 5.1%) and adjusted marked to market value of Fortescue equity I estimate that stock is trading at about 1.40 times adjusted B/V, more or less in line with the 1.50 times book value calculated as per official financial statements.

If you decide to buy the stock and want to follow the company investments or if you are willing to do some further research I highly recommend to read Leucadia candid, detailed and well written shareholders letters. You will have a good feel on how assets are performing and how management intend to move to allocate capital without the burden of time consuming assets valuations.

Since last summer, despite a buoyant stock market, shares have been performing poorly. The reason is that since Cumming and Steinberg have a strong investment discipline and they are not finding enough attractively priced distressed assets . The reason is that "competition for investment opportunities, roared back in the form of 35-year old hedge fund managers-private equity firms who have never known a bear market-and other investors willing to invest at high prices in risky assets with seemingly cheap money (they cite in their 2004 shareholders letter as example an ebullient junk bond market" and "hot potato loan market").
In the same 2004 shareholders letter, Cumming and Steinberg have been clear on their investing discipline: "either we invest in high returning opportunities or have the money in the bank or under our mattresses". At that time lack of opportunities induced a pessimistic tone: "if we run out of ideas or steam we will let you know and develop a plan to return money to shareholders" they said.

However their comments in their 2005 shareholders letter and during their shareholders meeting in spring 2006 were somehow more optimistic: "We have many things in the hopper that look interesting and hopefully by next year at this time we will have a measurable reduction in cash and an increase in higher yielding investments."

Since U.S. market of distressed assets seems ultra competitive due to hedge funds and private equity funds abundance of cash, Leucadia is looking more at foreign investments. Fortescue deal is a first step in this direction.


RISKS

If management is unable to finalize an attractive deals pipeline worth at least $2-3 bil., company will be unable to compound shareholders equity at the present 20% long term average rate and Deferred Tax Asset may loose value.

Foreign investments may prove less profitable than the U.S. distressed assets deals which historically have been the company bread and butter and the main source of profits.


CONCLUSION

If management is able to match even 3/4 of their historical investment returns paying present 1.4/1.5 book value seems a fair price. Don't forget that in this price you also have included a free built-in hedge since the worse the economy, the more opportunities for Leucadia to profitably invest their large cash hoard.

I plan to plan to buy a 1/3rd or 1/2 position at around $25.50/26.00 per share.



Disclosure: the author has no position in Leucadia at the time of posting.
Under no circumstances does the information in this post represents a recommendation to buy or sell stocks. Such information must be considered only as first step for further research.

Is DELL Too Cheap Not To Own ?

Negativity abounds around DELL.

Earnings warnings, 4.1 mil. laptops recall due to battery defect, SEC investigation on accounting issues, fierce competition against a reshaped Hewlett Packard and aggressive Far East boxmakers, poor customer service and depressed margins disappointed investors.

DELL shares crashed accordingly from the low forties to reach briefly a 5 years at around USD 19 in July. Since then the stock trades in a range between about $20 and $23.

Discounting weakness in business model in the foreseeable future, company is reaching today extreme low valuations.
Since 1997 DELL traded at the end of its fiscal years (ending Juanuary) at an average of 2.8 P/S ratio (min 1.28 end of FY 2006, source: MSN Money). At today current quote (around $23) DELL fetch a 0.9 P/S ratio.
Though a single rough ratio does not give a complete picture I think that at a normalized sales growth rate and profit margins, both lower than their long term average, DELL may be a safe and cheap investment at slightly below the present quote.


1) PROFILE

DELL is the world leader of PC makers. The company founded by its present president Michael Dell in his college dorm room in 1984 fetched 10.5% worldwide PC market share in FY 2000, today it reached at around 19%.
Note that Michael Dell till owns a bit more than 10% of total shares outstanding.

Excluding the networking business, DELL is the market leader in all geographical areas except Japan (no.2) and Asia-Pacific (which includes India and Cina and where DELL is no3. but gaining market share).

In U.S. DELL is the leader in all the clients segments (education, government, home, large and small business) with 34% market share.

Revenues in trailing 4 quarters are 57.4 Bil.

Business segments revenue breakdown (MRQ):
- desktops and mobility (mainly laptops): 61%
- software and peripherals: 16%
- servers and networking: 10%
- services (product warranties, training ...): 9%
- storage: about 3%
DELL does not disclose operating margins for each business line.

Geographical revenue breakdown (and year over year sales growth, MRQ):
- Americas: 65% (+3%)
- Europe: 21% (+3%)
- Asia-Pacific-Japan 14% (+17%)

Success of DELL has been driven by :
- 1) Their unique direct sale / build-to-order model which allows them to eliminate wholesalers and retailers margins and having a real-time feel on market needs and avoid inventory glut at the retailers level.
Cash from their sales is also directly reaching their coffers without being delayed in intermediate distribution channels.
- 2) An obsessive focus on continuously improving their best in class manufacturing and supply chain management practices. This manufacturing global giant is able to have an average of 5 days of inventory in stock only. They are therefore the first to introduce new components and the first to pass to their customers the savings of PC components which are in a secular downtrend prices.
They are also avoiding the high obsolescence risk in the ever changing PC business.
- 3) Concentration on standards-based technologies. Their R&D represents less than 1% sales. The reduced number of suppliers of mainstream components makes easier for them to efficiently manage their supply chain.
-4) Market share growth to preserve a strong bargaining power with their suppliers and spread their fixed costs over a large sale base.

Though their business mix is slowly making progress towards higher margin products and recurring products and services their main strength is basically being the low cost PC provider, delivering a competitive commodity product with an good service level. More on service issues and recent improvements below.


2) ROCK SOLID BALANCE SHEET, STRONG CASH FLOW AND AMAZING PROFITABILITY TRACK RECORD

Despite an historically low 4-6% operating margin investors tended recently to forget that DELL remains an amazingly solid profitable company.

DELL is sitting on a comfortable $ 10.8 Bil. cash and investments cushion. Long term debt is only $ 504 mil. However according to last quarterly conference call management advised that it will have to borrow on short term basis for his corporate/US operations. Cash hoard is increasing abroad where sales are growing a lot more than in USA. To take into account potential tax repatriation costs we will use a conservative
USD 9.0 Bil. excess cash at the end of FY 2008.

Management has always been able to squeeze prodigious amounts of cash flows despite modest operating margins.
They have a negative 44 days cash conversion cycle which means that their sales are converted in hard cash 44 days BEFORE the sale. How it is possible ? Low inventory and strong bargaining power over their suppliers on payment terms. On the other side their clients are paying cash in advance or shortly after delivery of the products.

In a trough margin environment DELL produced in trailing 12 months about $ 4.3 Bil. net free cash flows out of $ 57.4 Bil. sales. Free Cash Flows/Enteprise Value yield is around 9% for the same period.

Profitability for a product/service mix still heavily weighted on a commodity product are truly amazing.

The below figures provided by Reuters are self-explanatory.

Magement Effectiveness (%)	Company	Industry	Sector	S&P 500
Return On Assets (TTM)	12.57	10.35	11.21	8.13
Return On Assets - 5 Yr. Avg.	13.75	5.29	6.27	6.43
Return On Investment (TTM)	40.16	22.77	15.31	12.08
Return on Investment - 5 Yr. Avg.	33.44	12.57	8.91	10.01
Return On Equity (TTM)	68.75	33.13	19.46	20.05
Return On Equity - 5 Yr. Avg.	46.19	16.61	12.03	17.96

3) INDUSTRY TRENDS

PC worldwide industry is highly competitive. Through an aggressive price war this industry is slowly becoming an oligopoly where highly efficient global players put out of business or purchase the weakest PC makers (see sale of IBM PC business to LENOVO) .
Main competitors:
Hewlett-Packard with its more attractive product mix of high margin and recurrent revenues (their printer business) and their streamlined operations are a dangerous competitor. Turnaround leaded by the new CEO Mark Hurd has done a good job so far but he harvested mainly the "cutting costs" low hanging fruits and still heavily depends on H-P crown jewel printing business. Increasing revenues and profits in the next years will be more difficult. I assume recent boardroom scandal: will not have a relevant impact on company operations.

More dangerous, because traditionally less financially disciplined, is the competition of Far East competitors notably ACER and LENOVO. The last is more or less backed by the Chinese Government. It bought formed IBM PC business, and, like ACER, is aggressively pursuing market share gains pointing on price cuts notwithstanding what is believed to be a tiny (if any) real profit margin.
LENOVO is not forced to fill accounting documents according to GAAP rules. But a look at their most recent FY figures ending march 2006 is interesting. They reported the equivalent of $13.3 bil. sales and profit margin atribuable to Shareholders of the Company was the equivalent of about $13.309 mil., net profits (generously adding back restructuring charges and amortization of intangible assets) were the equivalent of about $100 mil. A meager 1.44% net margin profit compared to about 6.8% net margin of DELL during a similar period.

Price competition is expected to last at least few more quarters but, though DELL cost advantage is lower than a few years ago, they are still more efficient then their competitors.


4) CHALLENGES

Main competitors improved their supply chain management and DELL has lost part of its previous cost leadership though due to its direct sale/build-to-order it still avoids retail inventory burden. In order not to loose this critical advantage DELL cannot afford to deviate from its proven "no inventory" business model.

Poor customer service: DELL has finally recognized its weakness. They invested so far more USD 150 mil. Internal and independent customer satisfaction metrics are already improving.
The implementation of DellConnect, their new remote diagnostic tool designed to improve resolution of technical issues for free, has been used by more than 1 mil. customers and seems getting positive reviews by customers.

DELL has troubles to maintain market share in the consumer market.
Foray in flat panel TV, mp3 players has been performing poorly.
Mainstream consumer PC are priced below the USD 500 mark and are still expected to decrease further. The cost advantage at this level gets erased by the extra shipping costs of shipping unit by unit instead of bulk shipping to retail stores.
DELL is performing some tests with retail kiosks used to order PC with the assistance of a sales representative in malls, airports... I don't think that those sales will reach a meaningful amount.
Due to its "no inventory" business model, DELL is unable to match the rewarding experience of bringing back home the computer or printer you've just bought at the store. Management has repeated that they do not intend to develop a classic retail channel.
Only way to compete: investing in design and proposing more cool products, which to be fair are far to be DELL point of strength.
In September DELL added 500 new electrical, software and mechanical engineers and program managers in its central Texas product development operations to improve product quality.
Recent purchase the high-end gamers PC outfit ALIENWARE fits also the bill to improve overall product quality level: However the ALIENWARE $220 mil. yearly sales figures involved are merely a blip in DELL total turnover.

The dark side of DELL, stock options: company made an extremely liberal use of the stock options in the past. The use of capital to re-purchase stocks to avoid share dilution and shrink overall share base has been abysmal. Billions of dollars have been literally thrown out of the window to repurchase company stock which was trading at obscene valuation. On this matter there are however some improvements. Stocks options are now expensed in financial statements and taking into account by the analyst community. Issuance slowed down and in last 10K we calculated that about 80% of the outstanding options are out of money. DELL may re-price these options but they never did it in the past.

For several quarters in a row management advised that they were pricing too aggressively for a modest market share gain. My impression is that margin have been reduced due to lack of cheaper and better AMD processors in their products offering. See below.


5) OPPORTUNITIES

These last quarters AMD processors have sported better price and performance than their INTEL rivals. Since DELL was an INTEL-only shop to gain market share they have been forced to compete on price and lower their already thin margins.
Ironically, just when INTEL is proposing a competitive line of new products, DELL started to ship its first AMD powered PCs.
They will loose some support and contribution on marketing expenses from DELL but having the possibility to opportunistically play on both suppliers is in any case a long term positive for DELL.

DFS finance arm: leasing and financing on DELL products is now handled by DFS, a joint venture with CIT. So far this financing was proposed only to match financing offerings from competitors. It represents now a small portion of earnings but it may grow in the future. After learning how to profit from lending business DELL has already in place the agreement which will allow to purchase CIT stake.
Financing may be cash draining if they decide to keep loans on their books and earnings may be hit in cases of default during the trough of business cycle or if DELL has a poor underwriting discipline (which has not been the case sofar). Overall, the finance profits over a full business cycle will be a positive contributor to their structurally low margins. Commodity producers like auto makers GENERAL MOTORS and FORD granted their survival of their main operations and a more than adequate profit margin thanks to their finance arms.

Printers and ink: printer sales are in ramp up phase when they are sold slightly below cost to earn then after a high margin on ink refills. In financial statements you see so far the investments to spread the printers. Then after ink refill margins will start to materialize.

Monetizing desktop real estate: why about 85% of internet users still use Internet Eplorer to surf the web though they are much better free alternatives like Firefox ? Because it's the default preloaded version on their Microsoft PCs and they don't bother to change it. Desktop real estate is therefore worth a lot. In a 3 years deal Google agreed to pay what is rumored to be worth up to $1 Bil. according to Forbes magazine to pre-load Google Desktop Search and Google Toolbar in about 100 mil. PCs. I expect further similar deals with other software houses or websites though most probably worth smaller amounts.

Acquisitions: Michael Dell recently said the company may pursue further "small targeted acquisitions" after its recent purchase of high-end PC company Alienware to provide new services, products and geographic areas. Cash on balance sheet is more than enough to finance acquisitions. Acquisition discipline has not been tested in the past since company focused on organic growth or joint-ventures on storage products, finance arm and printers. Terms of recent Alienware acquisition have not been disclosed. I expect however that due to its cost conscious culture (stock repurchases issue excepted) DELL will not overpay. The ideal acquisition would be one which allows either permanent margin increases in the service area for exemple, and/or introduce some kind of recurrent revenues.

Launching of Vista, the new Microsoft operating system: the long overdue, but much improved compared to last Windows XP, is widely expected among consumers and business users. The first beta versions got positive reviews and first signs points to a strong start (see


6) RECENT ISSUES: LAPTOP RECALL, ACCOUNTING RESTATEMENT, EARNINGS MISS

Laptop recall: same was due to SONY batteries defect. SONY will pay almost all recall expenses. DELL was the most proactive to acknowledge the problem and quickly provided a solution to their customers. In a Barrons' interview Michael pointed out that they bought only 18% of defective batteries. "Where are the others ?" he wondered. In fact one after the other shoes are dropping. Weeks after DELL announcement Apple, Lenovo, Toshiba, Hewlett Packard, Hitachi finally recognized the issue and took proper steps.

Accounting restatement: after an informal SEC investigation which was deemed to be not material DELL has been forced to delay their quarterly 10Q filing and interrupt their share repurchase program. Accounting expert Jack Ciesielki gave his opinion of which misrepresentation may be involved. According to the few elements leaked on the issue, the eventual restatements should not affect company normalized profitability and strong balance sheet figures.

Potential future earnings miss: Think Equity, a research and investing boutique, is on the record warning on a possible earnings miss for current quarter. As a long term value investor, as far as I'm confident on assessment of company business value, earning pre-anouncements and their consequent investor over-reaction are not an issue but an opportunity to buy on the cheap.


7) MACRO ECONOMIC RISKS

This last decade both emerging and developed countries has been growing at a fast clip with the major notable exception of the Eurozone countries. Japan which arrived late at the growth party is joining the ranks. Corporations have records of cash and ready to invest it also in technology products. Interests are low and inflation is moderate. This almost ideal environment may become less accommodating in the next years especially if the U.S. or the white-hot China economies will slow down.


8) VALUATION

I evaluate DELL business value at 15 x FY 2008 earnings (less estimated $9 Bil. excess cash) based on average 7% sales growth and a normalized 7.5% operating margin. Reasonable valuation would be therefore in the area of $21/21.5 per share.
Stock is sitting about 8% less than present quote at $23.25 on Friday Oct. 6 close.

The most aggressive value investors may want to start a position alongside the founder Michael Dell which made one of the biggest insider purchase in open market ever in U.S. stock market. He bought $70 mil. worth shares on May 24th 2006 at $23.99.

A Little Gem Among Subprime Lenders

Business newspapers these last few months are filled with negative news on housing and on damages which have been created by loose lending standards of mortgage bankers. The low interest rates and hot housing market have created the ideal environment for a "credit bubble". The weakest home buyers have been lured by subprime mortgage banks with exotic proposals with strange names such as "interest only" loans, option or hybrid ARMs which a have a common point: very low first installments then, when the installment is reset and reach its normalized level, monthly payments surge suddenly and start to cause the default of many borrowers and an ugly hole in the lenders balance sheet (see L.A. Times column dated 8/15/06 "Sub-Prime Lenders' Shares Fall" or WSJ column dated 8/30/06, subscription is required for this one, "Mortgage Market Begins to See Cracks As Subprime-Loan Problems Emerge" ). Despite, and the contrarian investor would say thanks to, this gloomy environment some gems can be discovered in the trash. If you dig a bit, you may find a niche player in the subprime lending market with a very conservative business model, a solid balance sheet and a safe income stream. The company is called DELTA FINANCIAL CORPORATION (DFC). Profile: DFC is mortgage subprime lender based in Woodbury, New York. It's a small cap (about $210 million). The company has been founded in 1982 and it sells mortgage loans to so called "subprime lenders" which means consumers that either have high debt/equity ratio, poor credit history, weak or volatile income. In exchange of this extra-risk DFC charge higher interest rates and fees than a "prime lender". Loans are backed by a first mortgage on one to four-family residential properties. In Q2 2006 average interest rate on the loans was 8.85% and loan to value ratio was around 78%. Their customers are using these loans mainly (86% in Q2 06) as "cash out" and debt consolidation. It means that they are using the loan to consolidate their credit card debt, pay for college or health costs, finance their lifestyle etc... The company originates loans through about 11 retails offices and a network of about 3,000 independent brokers. In 2005 they originated $3.8 billion loans. In the first 6 months of 2006 they originated $1,915 billion loans. Geographical breakdown originated in Q2 2006 (very similar breakdown for the full year 2005 origination): 36% New York, New Jersey, Pennsylvania 14% Mid-Atlantic 14% Midwest 6% New England 19% Southwest 11% West (less than 2% in California) Once the loans have been originated they are kept on the company book till when they are either securitized (once a quarter) or sold on whole-loan sale basis. - Whole-loan sale basis (about 15% of the loan volume): it's a simple straight sale against cash of the loans on a "non-recourse" basis which means that if a borrower default, the loan buyer cannot ask DFC to pay on behalf of initial borrower (unless misleading or fraudulent documents are attached to loan ). - Securitization (about 85% of the loan volume): loans are sold to a Trust which finance this purchase issuing bonds called ABS (asset backed securities) to institutional investors (banks, hedge funds...). DFC retains a very small equity interest in the Trust. It also issues a bond backed by this small interest in the Trust called NIM (net interest margin). Note that both ABS and NIM bonds have no recourse on DFC assets. Which means that, unless documents attached to the loans are not correct or are lacking, DFC is free of any liability and bonds holders can try to recover their money only from the borrowers assets or from the very residual interest DFC has in the Trust in certain circumstances. What makes DFC different ? 1) Business model They originate almost half their loans (47% in 2q 2006) through their own low cost retail channel, balance is originated through their wholesale channel. The subprime industry usually originates a vast majority of their loans on wholesale basis which is a more expensive than the retail channel. 2) They are mainly a "fixed-rate" shop Contrary to the vast majority of the subprime mortgage lenders, DFC originates mainly fixed-rate loans (about 86% of their portfolio). In the most recent quarter (2q 2006) the exotic (and often toxic) Interest Only Adjustable Rate represented less than 1% of the loans originated and conventional Adjustable Rate loans 14%. Which are the benefits ? - Fixed-rate lending in subprime mortgage market is a niche. They are out of reach from the huge stocks of capital backing the subprime subsidiaries of HSBC, GMAC, Countrywide and Washington Mutual or their bigger subprime mortgage listed monolines competitors such as New Century Financial ($2.1 billion market cap, about $56 bil. origination) or Accredited Home Lenders ($700 million market cap, $16.6 bil. origination) or privately owned Ameriquest (75 bil. origination). - Fixed-rate is more difficult to sell to borrowers especially in an historically low-interest environment. A mortgage broker will find much easier to lure potential borrower with a lower-initial installment obtainable with an adjustable rate mortgage loan. - DFC have historically built a strong relationship with brokers which have access to customers interested in this type of loans. They also have built a retail channel able to approach this small portion of subprime mortgage borrowers. - Prepayments and default rates are lower on fixed-rate mortgages than on ARMs. Therefore prices fetched by fixed-rate mortgages in securitizations and whole-loan sales deals are higher then ARM. - Fixed rate borrowers are less interest rate sensitive. 3) Profitability Higher securitization income (due to premium fixed-rate mortgages pricing plus lower-than-industry "loan to value" ratio) less lower cost origination (almost 50% of loan originated via low-cost retail channel) = high profit margins. GAAP accounting undervalue real book value and profitability of the business: 1) Real value of equity is undervalued At first look, their last balance sheet (on 6/30/2006) is frightening. $5.525 billion subprime mortgage loans are balanced by $5.429 billion liabilities and only $144 million shareholders equity. Right, but remember that ABS bonds have no claim on company assets in case of loans default. Even in case the whole loans default book equity would remain exactly the same. So why insert both bonds and loans in balance sheet? Because the company is using from 2004 a very conservative accounting method called "portfolio accounting" (more below). In the meantime, note that in every 10K SEC report the company is required to state the fair market value of their assets and liabilities. In the last 10K which refers to fiscal year ending Dec. 2005 guess what ? The official GAAP accounting rules underestimated assets by $92 mil. and overstated liabilities by $49 mil. So marked-to-market book value on Dec. 31st 2005 was underestimated by $141 mil. (on Dec. 2004 it was underestimated by $123 mil). The gap between GAAP BV and marked-to-market BV should be wider now but let's stick with $141 mil. and let's calculate the true P/BV ratio: $210 mil. market cap / ($144 mil. GAAP BV + $141 marked-to-market adjustment) = 0.74. In other words the company sells at 75% of its liquidation value. For this reason private equity investors or competitors may consider DFC as a acquisition candidate if management which owns 30% of the comany agrees. 2) Conservative cash profits expected for next 12 months First let's come back to "portfolio accounting" mentioned before. The true moment of value creation in mortgage lending industry is when loan is originated. The usual accounting method to calculate this value is called "gains on sale" (or GOS) accounting. In GOS accounting the loans and ABS securities are not carried out on balance sheet and a profit is registered upon the sale of loans to a Special Purpose Vehicle using "best guess" estimates. If during the life of loans valuation assumptions regarding default and prepayment rates differ from real loans behavior profits or losses charges will be registered in the income statement when they occur. This accounting method has been a source of many investor disappointments expected profits did not materialize due to rosy prepayment and default expectations. In portfolio accounting you book the profits not upfront but during the whole life of the loans deducting cash paid to ABS holders from loan installments by borrowers. So the profit booked are real, cash ones. Once loans are on the books they deliver over a 3-4 years time span cash profits on automatic pilot. To give you an idea, DFC expects that the sole loan portfolio already in the books on June 2006 ($5.6 bil.), should bring till June 2007 a stream of future net interest income of $80 mil. This portfolio income due to loans securitized since 2004 will reach its full speed in 2007-2008 (loans remain usually 3-4 years on the books). Quick back of the envelope calculation of a yearly earning power of the origination platform (which excludes income from loans on portfolio): Origination volume $4 bil. (+5% over 2005 volume but origination on 1q06/1q05 +13% and 2q06/2q05 +10%) GOS Margin (assuming all loans sold for cash on whole loan sale basis): 1% (1.4% Q3 05, 1.4% Q4 05, 1.1% Q1 06, 1.3% Q2 06) Origination GOS margin: $40 mil. Warehouse margin (loans are not sold the day they are originated but they are packed together and resold say once a quarter, spread is higher than GOS since we are talking about very short term financing backed by freshly underwritten secured loans): 1 bil. quarterly loans x 2.5% spread x 2months average warehouse period: $12.5 mil. Origination profits: $52.5 mil. less 39% tax bill divided by 23.7 mil sh. = $1.35 In other words DFC is trading at only 6.6 times its origination business excluding the $5.6 bil. loan portfolio. Macroeconomic risks 1) interests rates: DFC customers need cash either to pay for important expenses (health care, college...) or to repay credit card debt which will always carry much higher debt interest rates than mortgage loans. They are not willing to lower the interest rate of their previous mortgage loan. The refinance boom which affected lenders to prime customers last couple of years did not affect the DFC market. DFC expected default rate would be only marginally affected since only less than 15% of their loans are ARM. Higher interests rates means higher installments so the size of the overall market demand could be reduced. 2) labor market: this factor can affect both existing loans (default rates) and future business prospects (less customers meeting income standards). Trend of unemployment rate should me carefully monitored by investors in DFC. 3) housing: the real housing bubble is concentrated in few markets. The average housing prices nationwide should weather a period of very moderate or very light decreasing in the next 1-2 years. The 78-80% of loan to value ration provides enough protection to DFC in case they have to proceed to foreclosure. We are coming out of an ideal situation of low rates, booming housing market and strong employment market. Credit markets already incorporate a future weakening in these 3 keys variables. Main concern regarding DFC should regard the employment market since on the other variables their business model concentrating on fixed rate loans, geographical distribution (less than 2% of their loans are in California but have a 17% exposure to Florida) and underwriting standards should be able to allow them to weather a temporary deterioration of macro economic environment. Competition Overall the industry is in full retreat mode after the last 3 bubble years. Abundance of capital, strong competition in the hottest markets (mainly California but also Florida, Nevada...) , loose underwriting standards (see huge originations of exotic "interest only, option ARMs etc...) and concentration on volume growth instead that profitability are starting to create some serious damages. Ameriquest is restructuring (closing 229 branches and eliminating 3800 jobs), New Century Financial has now an activist on the board (which suppose will have an hard look at underwriting criteria)... The small size of the fixed-rate market protect somehow DFC from players supported by financial powerhouses at their back. Management Hugh Miller is CEO since 21 years, the CFO, Richard Brass, has been working with DFC since 14 years. Insiders are owning 30% of outstanding shares therefore their interests are aligned with those of shareholders. It's a good guarantee that underwriting standards will remain high. Financial health No long term debt or convertible stocks on balance sheet. Loans on the books have no recourse on company assets (except very marginal cases of misrepresentation of loan documents). Future income stream on loans on portfolio will help DFC to weather some possible downturn in its origination business. Key figures name: DELTA FINANCIAL CORP. ticker: DFC market cap.: $210 mil. stock price (on 09/14/06): $9.01 Price/Book: 1.46 adjusted Price/Book (see above): 0.74 trailing P/E: 7.55 forward P/E (Dec. 07): 5.81 ROE: 22.33% dividend yield: 2.2% target price: $14 (8 x 2008 GAAP estimated earnings) Disclosure: It is not intended as a recommendation (or advice) to buy or sell securities. Author doesn't have a position in the securities discussed in this article at the time of posting. Security positions may change at any time.