Lecture 1; Lesson 2: A DEEP Value Investor/Activist in Action

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Lecture 1 The main points from Lesson 1

Jot down his numbers. Do you agree?  Read through the transcript Other Peoples Money_2 then see the video again.  What you saw was value investing in action.  Many of my videos are meant to entertain but this one has much to teach. Note his SEARCH and VALUATION PROCESS.

Now view the activist. Note the divergent incentives.

A Prayer   (Video link) What do YOU think?

A Prayer for the Dead. Amen, Amen, and Amen.

For Masters of the Universe (Investment Bankers)

Try this case study. Case Study – Munsingwear.  If you struggle, here is a hint: What would you tell someone who kept banging their head on the wall and complained of a headache?  In five days I will post the answer. This is an actual case so don’t cheat by Googling it.  This case is about thinking like Larry the Liquidator :).

Next week, I will post more on Lecture 1 and you should plan to read Chapter two in DEEP VALUE and the Chapters 1 & 2 in Quantitative Value. We will study those chapters AFTER next week. I am just giving you notice.

HAVE A GREAT WEEKEND!

22 responses to “Lecture 1; Lesson 2: A DEEP Value Investor/Activist in Action

  1. Aha. Didn’t you post this one before, John?

    Put it this way: I spent about 2 minutes on this, and figured out what I think is the answer. I’ll give other people a crack at the problem before I post my response.

    It at least shows that I have learnt something from you, John. I’ve also noticed some “astonishing facts” in all this … but I’ll wait a little while before revealing them.

  2. Interesting case, can’t quite see the answer yet as there is more information I would like to see, like how their expenses break down and how much they are paying for the licences? Royalties are bringing in $4.7m but how much are they spending on licenses to get that revenue. Really trying to find out where are they getting most bang for their buck.

    Both sales and costs went up $14m the past two years but as a % expenses are increasing faster. Some parts of the business are increasing sales faster than others i.e. premium/special markets but how much to they spend on this segment.

  3. Don’t get fancy or complicated. Work with what you see. Hint 2: Is this one business? No more hints or your fees will be slashed.

  4. This is a rubbish business. It filed for bankruptcy in 1991. It has managed to stagger on, making losses in the last 3 years. Astonishingly, the cash-flow statement shows they arranged new borrowings in the last two years. They have been throwing good money after bad, instead of facing up to the inevitable. Shareholder value is eroding by the day. Their best bet is to liquidate. Sell off assets, let leases expire, and try to salvage as much as possible. Maybe their brands are worth something to an outside buyer. Maybe they can milk the royalties dry, and dispurse the proceeds to the shareholders as they arise.

    Everything seems to be going wrong for the company. Backlog orders are declining, and the company has emphasised sales growth over profitability. “The apparel industry in the United States is highly competitive and characterized by a relatively small number of broad line companies and a large number of specialty manufacturers.” In that one sentence, the company has just explained why it is a lost cause.

    I’d add this: what this teaches us is that management put exciting spins on terrible results, and when management emphasise sales growth, you know you’re hosed. There’s a kind of irony here. Managment often tell you what you need to know, but not necessarily in the way that you or they think they mean it.

  5. I was thinking a little too hard until I saw John’s hint and it all made sense and the videos form Larry the Liquidator just confirm it.

  6. John puts a lot of great points in his post:
    * “amen” – or, in other words, hope is not an investment strategy
    * other people’s money – undoubtedly the film refers to Danny DeVito, but in this case it really is the about the directors, who keep the game going longer after it is a lost cause. As Joel Greenblatt said, companies often run out of cash sooner than managers run out of turnaround plans
    * the antidote for a headache due to banging your head on the wall is, of course, to stop banging. The managers of Munsingwear hadn’t figured that out, though.

    Having said all that, this case study seems to prove the opposite of the basic message of Deep Value investing, namely that there is reversion to the mean. Some things just never come back.

    So investors have to face a mass of contradictions, making it very hard to beat the market.

    Whilst we’re on the subject … IIRC Damodaran said that larger companies tended to have more stability of operating returns than do smaller companies. So, the Walmart of the 70’s showed great returns on capital, but could an investor have been sure at the time that those returns on capital are sustainable? Contrast with the situation WMT is in today, where everybody knows what a great investment it has been, but its shares are amply priced given we expect only anaemic growth.

    It’s very difficult to put together a simple formula, isn’t it?

  7. Royalties. Rest is junk. Return on capital is negative. Net assets is decreasing. Operating cash flow is negative. Funded by increasing line of credit. They are continuing to dig deeper.

    Suggest they sell all unneeded assets, pay down debt, and focus on growing the royalty business. Not sure how much capital is needed for this business, but would think it is significantly less than is currently there.

  8. I have a very rookie take on this. But, I will dare venture a opinion.

    There is not enough color on the nature of inventories. Information on how much of the borrowings was used directly for the premium brands and how profitable the premium/golf brands are unavailable. Or for that matter, the split between manufacturing vs corporate staff (for staff reductions)

    BTW, the cost benefits of both sourcing raw materials in the USA vs far east AND 100% manufacturing in far east is not readily available.

    There is really no future for the company other than the royalties (and given enough information, the premium/golf brands)

    This is what comes to my mind:
    —————————————–

    SCENARIO-1

    Spin off the royalties into a separate Master Limited Partnership MunsingWear Partners and have it pay annual dividends to the shareholders. Further, since Grand Slam Tour, Munsingwear and Penguin Brands are showing promise in terms of revenues(profits), license these as well and live off the royalties.

    1. There is probably some salvage value in property/plant and Equipment.
    2. Fire the staff of 343, significant drop in SG&A.
    3. Shut down the retail lines, production, sell the land (@full value) and equipment (50% on books).
    4. Ask Mr Lowell Fisher to retire.
    5. Maybe, use the liquidation proceeds to adjust against the valuation allowance and pay the shareholders a liquidation dividend of the operating business.

    SCENARION-2

    Spinoff royalites as in scenario 1.

    1. Shut down US manufacturing. Send the staff home.
    2. Move all manufacturing to the far-east.
    3. Shut down all loss making retail lines (license them though) and concentrate on sourcing Munsingwear, Grand Slam Tour and Penguin Brands from the far east and monitor…if this is still producing losses, license and shut down manufacturing.

    Without the information available of what the impact is to move the business far-east, it is tough to put a number on valuation (or I dont know how to do it)

  9. Apart from piecemeal liquidation, I would consider option of selling the company or at least its brand portfolio to a bigger competitor who can enjoy economies of scale in marketing, manufacturing and sourcing of raw materials.

  10. It could be the case that underlying assets are OK, but Munsingwear is just not their best owner. If some larger clothing company can use these assets more efficiently by increasing plant utilization, getting volume discounts on raw materials, or, more likely, realizing synergies in design, distribution and marketing, than it makes perfect sense to investigate the possibility of selling the company. In fact, we have seen a wave of consolidation in apparel industry which has been driven by cost savings and the need to increase bargaining power vis-a-vis retailers.

  11. This is what I see in the case
    POSITIVE : They have increasing cash flow coming from Royalty.
    NEGATIVE: They are losing money hand over fist on traditional retail discounting model.

    Except the brand names they have no edge, in scale, in sourcing raw material or in labor cost.

    As mentioned above, spin off the Royalty and licensing business, keep the brands and outsource or close everything else.

  12. The liquidation value of the company should be around 1,32.

    I started with Current Assets of 24,244 and subtract 50% of the inventory value. Which ends up in a value of 16,923.5, normally i would add up the value of the land and try to estimate the fair value of the building, but here it is not possible. Therefore I assume 0 (I think there is no value of old manufacturing equipment). Then I add up the Value of the Trade Marks (+4,173) and the Deferred Taxes (+2,309). I and up with an Asset Value of 23,405.5 from which I subtract the liabilities (-20.318 short-term/ – 351 long-Term).

    Then I have a left Value of 2.736,5 which I then divide by the number of shares (2.065,594).

    • 1. What about restructuing charges? Laying off 343 people and closing the plant may cost several million dollars
      2. Book value of trade marks of USD 4.2 million is less than annual roylaty revenue. Do you think that book value is a good proxy for market value of trademarks?

      • Perhaps the plant can be sold. You could deduct the closing costs, but if you keep it open with the current managment, then the company will bleed to death. If you lose money in an uneconomic plant, you won’t make it up on volume.

        No book is not a good proxy since it is historical cost. Go with revs/cash flows.

  13. I calculated the Nav of the company and my estimated nav is about $ 1,4 a share. What it is important is the actual market price is $ 7,4 way above nav . About a restructuring plan reading the statements we note:
    1) a grat inceraste in receivables, very bad sign
    2) a big increAse on interest charges, a direct effect of the inefficient working capital management
    3) operating income is negative so the manufacturing business is dead, it might be moved abroad but at what costs?

    A restructuring plan would be shutting down the manufacturing business and concentrate on licensing. To build a plan the contribution margin of licensing and Fixed costs are missing, we should estimate the layoff costs too.
    The immediate effects would be :
    No inventory and cash from its sale
    Sharp reduction of the bank line of credit
    Sharp interest expenses reduction
    No cost of good solds
    Selling and administrative cost reduction

    These efforts might not be sufficient.
    Thank you for lettino me comment!

  14. The manufacturing side is generating no return on it’s capital invested. The NCAV as per Ben Graham’s thesis is a reasonable measure of intrinsic value:
    Total Current Assets less all Liabilities: $24,244,000 less $20,669,000 = $3,575,000 or $1.76 per share.
    We also need to include the earnings power from the Royalty business to see if this makes up the difference between $1.76 per share of liquidation value for the manufacturing business and the current voting share market price of $7.25 on Apr 1 1996.

    I am going to assume that the royalty business can be run out of a smaller leased office space with a maximum staff of 10 people. Conservative estimate even though total staff is being cut by close to 97% is that SG&A expenses can be reduced by 85% to $2,100,000.
    Based on the 10 year US Govt. bond yielding 6.41% in 1996 and estimating a 15 year life of the trademarks. (amortization of 264,000 from 1995-1996 to a net trademark valuation of $4,173,000 using a straight line schedule)
    The royalty stream grew 20% 1994-1995 and 1 3/4% 1995-1996. I don’t think a 5% growth rate is unreasonable.
    Discounting the Royalty streams net of $2,100,000 SG&A expenses for 15 years gives a present value of $39,417,000 which is $19.35 on a per share basis.

    My proposal is to take the company private at the current market price of $7.25

  15. “investing is a numbers game”, how true and how off I was.

    I took a stab at it and am getting three different answers…I hate valuation 🙁 Can somebody please help?

    ====

    The Royalty in 1996 was 4.609M and showed a 1.7% increase yoy. 1994-1995 was a 1-off (showing 25% increase).

    Royalty per share = 4.609/2.066 = $2.23 (includes cost of running the show as well). Likely to trend higher if operational cost is cut to the bone.

    I am getting 2 different answers using these 2 techniques:

    Scenario 1:
    ===========

    Calcuate price of share considering dividends into perpetuity,

    P=DIV/g, where DIV=2.23 and g = 1.7%

    Price = 2.23/.017 = $131 per share.

    No Brainer, take the company private(Barry suggestion!) or spin off into a MLP.

    Scenario 2:
    ========
    Calculate the Present value of all dividends using 30 years(perpetuity) and a coupon = $2.23 growing at rate=.017

    =PV(.017,30,2.23)
    =$52.17

    Again, a no brainer. Spinoff or take company private (Barrys idea)

    NOTE: scenario 1 and scenario 2 should not be OFF by SUCH BIG MARGIN…years 31 to infinity should be barely noticeable. Something is wrong in my calcuation, appreciate any help here.

    Scenario 3:
    =========

    Calculate Future cash flows of all Royalties from 1997 to the next 30 years. Discount them back to the present using the 30 year treasury note of 6% and compute NPV

    NPV = $77.54M in royalties
    Price per share = $77.54M/2.066M = $37.53 per share (does not include SG&A)

    This is a no brainer.

    To each of the above scenarios, add a 10% overhead(ie, $.23 per share) to manage operations (SG&A hit) and we will still laugh our way to the bank.

    I am confident about my calculations wrt scenario3, I am going to lock my answer in 🙂

  16. So, John, now that we’ve all had a go at a solution, what’s the actual answer?

  17. Hi guys,

    I’m catching up from being on vacation for a while, so I’m trying to do myself a service by following along and participating as I catch up. Here’s my stab at the case study.

    To preface, I was a computer science major, and investing is a hobby of mine, so I’m not a CFA or an MBA grad. I watched the videos, the transcript, and read the 10K, and this is what I could conclude in about 5 minutes:

    * They claim that the retail business is tough because of the need for heavy discounts and increased competition, and yet they clearly pour most of their money INTO retail despite the fact that they clearly state that Golf pro shops was their one true hope. Which lead to my logical question: why not jump out of retail and focus on pro shops, if you HAVE to keep this business?
    * At first I saw all the licenses and thought “crap they are paying so much for licenses for excessive things!” But then I realized they were MAKING money from licensing, and quite brilliantly I might add. A license to Fruit of the Loom for underwear, when they mostly make knit men’s shirts? It seemed almost too good to be true that they could make money off of a license for things they weren’t even making!

    But the problem I see is that based on all of this, nonetheless, they incurred basically DOUBLE the debt in 1996, without actually doubling revenue. And while their revenue increased every year, it could not outpace their debts, so they were a sinking ship. To me it would make sense to, if they wanted to stay alive, to simply spin the company off into two things:

    * Profit off of (and continue to produce more of) their licenses
    * Sell clothing only to Pro shops, become a golf apparel company, where they are actually making money

    It’s still a small percentage of what they are currently making (so they’d have to sell most of their business), but it’s the only part that seems to be working.

    Was that a good overview? Am I on the right track here?

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