About Me

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This is written with serious investors in mind, though sometimes they're just drafts in progress. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

Sunday, November 17, 2013

My Neighbor's House is for Sale

My neighbor's house is for sale. They are asking $1.425M for it ...

... I'm told they bought it in 1998 for $98,000. That's an implied 19.4% CAGR over the last 15 years. My neighbor, two Polish sisters, have handily outperformed the stock market and have roughly matched Warren Buffett over that time period. Pretty impressive though I don't expect anyone will write any books about them.

If that current rate of growth continues, in 2028, the house will be "worth" $20M.

It's almost inconceivable to imagine this: What would have to happen over the next 15-years for the value of the house to rise that much? Concurrently, if asked that question in 1998, what would the answer have been?

The rapid growth in real estate prices around NYC and - generally speaking - in many major global cities over the last 20 years has several ramifications. The obvious wealth effect benefits the few who were lucky enough to buy and retain real estate before the bubble.

As far as negative consequences, I view it as part of the larger recurring transfer of wealth in this country from the young to the old. Concurrent with other costs that absorb incremental income for young people (healthcare, older people's pension liability and student loan debt), I'm struck by the imbalance. It's a pet peeve of mine, this generational wealth transfer from young to old. It's the inverse of historical norms and incongruent with a country's long term growth and sustainability.

I don't have a crystal ball on future real estate prices and everyone knows trees don't grow to the sky, but history is rife with sustained disbelief, so the current situation can persist until it doesn't anymore. I suspect that eventually as recent progress in education and crime slips, so will demographics and pricing.

Regardless, from a non-financial perspective, I hope we get a good neighbor, so we can cut the fence between our yards and make a big space for the kids to run around. That would make a rare and unusual property. I like rare and unusual things most of all, as they tend to grow in value over time.

Friday, November 15, 2013

Amaro Leading the Phillies as Fast Food Franchise

Welcome back Marlon!

An article by David Murphy in today's Philadelphia Daily News about the Phillies GM Reuben Amaro considers a range of errors in decision making related to the $16M 2-yr contract to 37 year old Marlon Byrd.

He observes that the signing reflects a misuse of data by the GM for
taking opinions from his scouts and acting on them without weighing, considering, waiting, questioning, analyzing or assessing. An error that pertains to investors and other in the world of information analysis.

Taking input without assessing it is ideal in the fast food world (do you want fries with that?), but in a decision making industry its a recipe for another losing season.    

The writer says context and opportunity cost analysis are lacking in the decision making process. "[The GM is] responsible for placing that evidence [from the scouts] into the context of all of the other evidence available to a major league front office in the year 2013".

Regarding the Byrd signing he says, the problem "lies not in the justifiability of the signing, but in the method of justification that Amaro says he employed.

Quoting Amaro: "We talked to our scouts about how his swing path and approach changed. He's worked on it. I have to trust my scouts on it." 

The writer's point is that in today's world, managers take in information and then weigh, assess and decide, not simply do what the scouts recommend. It's like a portfolio manager's actual job. 

Most everyone agrees $16M seems like a lot of money for an aging and deteriorating ball player, that the Phillies recent history is rife with examples of large contracts to old free agents and they are not sufficiently developing their farm system. In short, that their leadership is making lousy choices. 

Why - and how it's become this way - reflects a Phillies management team in disarray since Pat Gillick left, but who himself inherited the legacy of Ed Wade, in whose tenure from '98-'05 Pat Burrell (1998), Chase Utley (2000) and Ryan Howard (2001) were drafted and a new stadium built. The World Series was won around that core. Under Amaro, a loyal serf to the multi-partnered ownership family, the choices have been abysmal.  

This will continue, the writer says - and I paraphrase here - until the GM makes better decisions, interprets and utilizes probabilities at least as much as he interprets a player's ability. 

"Everyone sees the same numbers, the same games, the same video," the author writes. 

In that regard, Amaro is a lot like every other investor. He just happens to be a really bad one. 

Full article here: http://www.philly.com/philly/sports/phillies/20131115_Phillies_following_wrong_swing_path.html

Thursday, June 13, 2013

... it's the liberty bell!

The growth of US economy is virtually guaranteed for the initial years of our oil renaissance. But let's not confuse good timing and the fortune of real estate (above and below ground) with our best and most enduring asset. GDP growth is cyclical but the Liberty Bell endures.

Putting aside for a moment its unfortunate location in Philadelphia (where fans would boo a strong currency simply b/c it could beat the Eagles), the Liberty Bell - and the freedom it represents - is this country's truly unique assets.

The mall, Hollywood, and Wall Street have all been replicated elsewhere in the world but FREEDOM is the only idea of America that hasn't been commoditized and copied. That is special. It's our competitive advantage. It's why people want to come here.

So why is Congress trampling our liberty and making what is most attractive - the freedom to come and work here - into a liability? Someone should remind them we must lead with your strengths and promote, not suppress, our great experiment and our greatest assets.

Wednesday, May 15, 2013

From Omaha, With Love

Arrived in Omaha on a cold and rainy Friday evening overdressed and not knowing what to expect (you can get by in jeans, a flannel and workboots). I shared a room downtown with a value fund friend and agreed to go to the arena early to help him save seats. So at 5:45AM went to the Hilton to the skybridge entrance and at 6:30 did the high net worth wal*mart dash to get seats. The rest of the day was kind of surreal but here's a few things I saw and heard ...

Every meeting starts out with a few short movies and clips. This year's included a brilliant Breaking Bad spoof where Bryan Cranston and Aaron Paul (i.e Mr. White and Jesse Pinkman) cook-up out in the desert, but instead of making the blue meth, they make peanut brittle. ("Mr. White, I can't sling peanut brittle on the corner!"). But of course it's the best peanut brittle ever and WB shows up to buy them out. After some hard core negotiating they agree.

There was also a silly spoof where WB wanted to appear opposite Arnold Schwarzenegger in Terminator 5. Arnold chooses Charlie instead. Oh, and they premiered a GEICO ad ("as happy as a camel on hump day") and a version of YMCA that Buffett really grooved to: "We love the managers of BRKA". Silly.

I spent much of this time chatting with an analyst for a university endowment who shared with me his thoughts on starting a fund; "Whatever you start, you need to consider it as something to be built for decades." That's good advice about any career choice.

Charlie really had the most pithy and funniest quotes of the day so I'll start with him.

CM -
"my old age might come on at any time"
"game of life is a game of everlasting learning"
"it's important to know the edge of competency"
"i want to tell the Mungers in the audience don't be so stupid to sell the shares"
"it's true there's a history of big companies making bad acquisitions but we think we have a better system"
"you can't succeed at something you don't like doing. we were lucky to find things we liked doing early in life"
[on inflation] printing money has the potential to be inflationary - the professionals wish it were - but Japan has tried every trick in the economists book for the last 20 years and so far no inflation ... "this is a huge experiment"

[on making decisions] "shouldn't make decisions while tired. concurrently, making decisions is tiring. we have found that sugar and caffeine are great for making decisions."
[on newspapers, after WB gave a long explanation for why he invests in them] "it's an exception and you like doing it"
[on short selling] "we don't like trading agony for money"

WB -
"our competitive advantage is staying sane when other people are crazy"
"we treat subsidiaries the way we would want to be treated and be a good partner"
[on being thanked for letting investors in early] "if we'd owned a coat business we would have kept you outside"
"the distinction is a person who spends time learning new businesses vs. the person investing at the wrong time"
[on AIG poaching] "they reached out to us ... waited until AIG repaid the loans ... possibly more to follow"
[on question from doug kass about paying premia for acquisitions] "it's not bad to pay a premium for good management ... we paid up for GEICO ... we will pay up for extraordinary businesses"
[on HOG debt] "any company that gets its customers to tattoo ads on their chests must be a good company"
[asked if CM and WB should move closer to each other] "we know what each other thinks now. we used to talk a lot when it was expensive to call. now it's cheap and we don't have to talk."

mgr of BNSF -
[on the impact to rail assets if power plants convert from coal to natural gas] "oil by rail will remain important for a long time. one of the myths is that oil moves faster by pipeline but it actually moves faster by rail and it's more flexible. currently handling 650kbpd by rail and expect it to go to 1.2mbpd"

Thursday, May 2, 2013

A Short Call on CLH (written for hedge fund 3/22/13)

Price                                      $58 (at time this was written) 
Estimated fair value                $50
Shares Outstanding                60M
Market Cap                            $3.5B
Total debt                              $1.4B
Ent Value                               $4.9B

In our view, CLH is out over its skis, having made a (classic) mistake of acquiring (sexy) business at high multiples near the peak of the cycle, attracted most likely to its own success in its core business. I think the word is “hubris”, something the Greeks wrote about many many years ago. Recommendation: SHORT. 

Since its founding in 1980 by CEO Alan McKim, Clean Harbors (CLH) has been a major consolidator within hazardous waste industry. However, since 2009, it has "di-worse-ified" via acquisitions into non-core / non-waste / oil and gas field services that damage the attributes that had previously made it a great investment. These acquisitions face cyclical headwinds. 

The good news is that hazardous waste is a “moat” business (though still procyclical). The waste business is characterized by tight regulations, high fixed costs, substantial land / asset development costs, and significant investments in transportation and logistics that protects it from outside competitors, provides pricing power and reasonably strong free cash flow. However, it is not as defensive as one might think given its exposure to cyclical industrial businesses that generate waste, such as mining, chemicals and energy. 

Historically, the waste business – part of the "Technical Services" segment that includes landfill and incinerators – contributed around 45% of revenues and EBITDA. But with recent acquisitions, the contribution is likely to drop closer to 25% (and if it doesn't, it's b/c the acquisitions are not pulling their weight). 

In addition to its waste management business, CLH also has a Field Services business that helps institutions and companies manage the remediation and cleanup of their environmental waste, be they school labs, PCB’s, refineries, pipeline spills, etc. The Field Services business has a base business of stable recurring revenue and single digit / low double digit margin maintenance contracts and a higher margin / highly unpredictable disaster management piece. These services help the bottom line and feed capacity into the landfill and incinerators.

But recent acquisitions yield di-worse-ification. Not enough to leave the waste services business alone, CLH has still another business - in fact it has four other businesses - and these additional services are the catalysts to our negative call on the stock. 

These four business are Industrial Services (refinery turnaround, lodging and oil sands region maintenance), Oil/Gas Field Services (oil sands and Baaken shale exploration), and with the recent acquisition of Safety Kleen, the largest re-refining capacity in N. America and a national parts cleaning business. 

We outline in more detail our negative views on the oil/gas services business and the Safety Kleen acquisitions but on the latter issue simply note; 

the core CLH business is paid to take waste from customers in a market where it is a price maker while SK pays for waste to convert into a commodity product as a price taker and unfortunately in a market where supply capacity is expected to double. This is not an attractive model. 

Despite this diversification, the stock continues to trade as if it’s still a highly protected non-price sensitive business. But it is no longer that kind of business. Historically, the waste business – including the landfill, incinerators - and the field services pieces together contributed between 70% and 80% of revenues and EBITDA. However, with these additional business, contribution from the highly protected, high free cash flow generating business, now contributes by our estimate just 35% of revenues and 45% of segment EBITDA (before unallocated corporate). Investors have not digested these changes.

The capital structure furthermore puts the company at risk. The expansion since 2009 into non-core business was primarily debt enabled and has lead to a capital structure that is ~100% debt / equity, 50% debt / total cap and 3x debt to annualized EBITDA. On one hand, it is aligned with the median for the rest of the waste services industry. On the other hand, no one else in the waste services peer group has the same exposure to procyclical industrial services as CLH.

Slowing core growth. The company is not transparent enough to provide organic vs acquired growth and this lack of disclosure masks the precise decline in core revenues and earnings. But we have seen negative core growth since 2010 when EPS from continuous operations peaked at $2.44 before declining to $2.23 in 2011 and $1.87 in 2012 (after backing out a one-time tax benefit). Over that time EBITDA grew from $315 / $350 / $383M in 2010 / 2011 / 2012, with the bulk from 2010 to 2011 from the one-time benefit of the gulf coast clean-up in 2010 and in 2011 the acquisition of Peak Energy (~$25M in acquired EBITDA).

Volume concerns in the core landfill business. EPA data indicate a consistent decline in volume at CLH’s handling / incineration facilities during the recession. We expect a continued arrest in mine-related production concurrent with the easing of mineral prices (with these high fixed cost business, it’s either on or off). What’s strange about the data analysis – and something we need to better understand – is why revenues in the Technical Services segment has no apparent relationship with volume. (We have reached out to EPA and they indicated that the data should be accurate).

Waste Volumes Processed by CLH Facilities vs Technical Services revenues

Source: EPA & Company Reports

Value destructive acquisitions that increases risk in the business model and cash flows. The company has historically grown via acquisitions in its core waste markets. However, beginning in 2009 and more substantially in 2011 and 2012, acquisitions moved outside of “bolt on” acquisitions in core cash flow generating waste markets into non-related, cyclical and highly competitive oil/gas services markets via Peak (energy and gas drilling) and lower margin re-refining markets via Safety Kleen.

Headwinds – and there are several - in the oil/gas services business. These include rig count reduction from low natural gas prices in the Baaken shale regions, current and expected future production declines in the Canadian oil sands due to the combination of demand reductions from the US (higher CAFÉ standards, as we’ve seen in past cycles), more domestic production in the US, and the eventual resumption of lower priced imports from Venezuela (heavy oil similar to what we import from Canada). The derivative impact of lower production in Canadian oil sands adds a negative impact on the Industrial services / lodging business in that region.

Overall string of low quality earnings. Adjusted net EBITDA over the last three years was $1B while FCF over the same time frame was $268M. We view the delta as a symptom of low quality earnings and in fact DSO’s expanded from 74 days in 2010 to 95 days in 2012 (28%, roughly in line with the 26% growth in revenues over the same time frame). Another area of concern on earnings quality is the roughly $170M (pre Safety Kleen acquisition) accrued closure and environmental remediation liabilities. This represents roughly 12% of total liabilities. The company is required to account for future expenses of closing and remediating landfills based on expected costs from a third party provider. Since CLH performs the closure costs on its own, this account is persistently overstated.

CLH multiples and leverage ratios remain in line with its environmental services peer group. However, the due to acquisitions the dynamics of the business have changed. The core “Technical Services” segment (i.e. landfill and incinerators) represented just 25% of revenues in 2012 on a pro-forma basis (assuming SK acquisition occurred in beginning of 2012). The company shares a valuation and debt/equity ratio with its landfill / incinerator peers but has cash flow dynamics that have strayed from its peers concurrent with increased risk in its business model.

Source: Factset

Operationally, the company’s margins have lagged peers on a trailing 12-mos basis. This situation is likely to persist given the acquisition of the lower margin SK business.

Source: Factset

And finally, we see little opportunities for organic revenue growth. The company is not particularly well positioned in the wet gas regions to benefit from the “shale gas” explosion, positioned around and to dry gas clients. It’s industrial and oil/gas services business are clustered around the oil sands regions where price declines have already halted certain construction projects and will likely lead to decreased production growth. We fear further compression of organic volumes driven by lower commodity prices negatively impacting the metals mining industry, which is the largest producer of hazardous waste processed by third party facilities in the country.

Given my forecast, I estimate a fair value using peer group comps against my forecasts of ~$50 


Based in Norwell, MA and incorporated 1980, the company reports four organic segments with two additional segments that result from the Safety Kleen acquisition:

·        Technical services. hazardous materials mgmt. includes incinerators, landfills and wastewater and other treatment facilities
·        Field services. scheduled or (mostly) emergency field and offsite cleanup services, includes tanks, decontamination, remediation and spills
·        Industrial services. Scheduled asset maintenance services at refineries, chemical plants, oil sands facilities and other industrial facilities cleaning as well as catalyst handling and decoking + lodging / drill camp accommodations in the oil sands
·        Oil & Gas field services. fluid handling, equipment rentals, exploration, mapping, directional boring to oil/gas and power … entered business through acquisitions of Eveready and Peak Energy
·        Re-refining. (SK) owns and operates two oil re-refineries in East Chicago, IN (largest in N. America) and Breslau, ONT (largest in Canada). These two facilities represent approximately 60% of the total oil re-refining capacity in North America. Total US capacity is expected to double in next five years
·        Environmental services. (SK) Parts cleaning, containerized waste, oil collection and RFO.

Broadly speaking, Technical + Field are part of “CLH Environmental Services” and Industrial + Oil/Gas are part of CLH “Energy and Industrial Services” I anticipate SK enviro svcs will be folded into the industrial services segment and re-refining will remain on its own and perhaps be sold eventually. [NOTE, I WAS WRONG! IN 1Q13 THE COMPANY FOLDED THE REPORTING STRUCCTURE OF INDUSTRIAL AND FIELD SERVICES INTO ONE UNIT “INDUSTRIAL AND FIELD SERVICES” AND REPORTED SK REFINING AND SK ENVIRONMENTAL AS STANDALONE SEGMENTS].

Stock valuation is driven by performance in two segments: The core / cash cow landfill and incineration business with additional upside from the higher beta oil/gas field services segment. Market seems to discount one-off Field Service work and overall Industrial Services business.

Historical (Pre-Safety Kleen) Segment EBITDA Mix vs EV / Annualized EBITDA 2010-2012.

·        Landfill / incineration is a volume business. It is cyclical, particularly on the hazardous waste side which is driven by industrial activity
·        It is not very price sensitive. I saw evidence of recent 8% price increases to a large public client in 2012
·        It is difficult to permit and expand a landfill / incinerator, this protects competitive behavior
·        In general, this is a great business with low growth and stable margins
·        However, in the famous words of Peter Lynch, I think the company risks “diworsification” given recent acquisitions to non-core businesses

Top-10 industries (2011) transferring hazardous waste to offsite RCRA C and other landfills

Largest disposers are metals / mining +1B lbs but potential  to decline on lower resource prices, electrical utilities ~600M lbs (but declining on conversion to NG and reduction and coal and still prob not a driver of CLH revenues, and chemicals ~450M lbs and very strong potential growth area on NG expansion / availability

Total Transfers of Hazardous Waste to Offsite Facilities (1991-2011 All US / All Industries) - note cyclical decline.
Offsite disposal is small but growing percentage of total released environmental waste.

Hazardous Waste / Solvent Recovery Industry trends –diversion from waste stream to recycling a likely driver of SK acquisition
Shift towards more recycling is a benefit – and perhaps a justification – for the environmental services portion of the SK acquisition. It draws to my mind the possibility that CLH sells off the re-refining assets to HCCI or another pure player.

Excluding emergency response work, this is a $200M -$240M annual revenue business with a core high S/D or low teen EBITDA margin. The benefit from ER work is twofold; first, it has high incremental margins in the 20% - 30% range. Second, it scales the fixed costs of the business, improving margins on the base business as well.

However, for obvious reasons (weather and unexpected disasters), the segment is impossible to model. Regardless, the market seems to look completely past the impact of the ER business anyway. It is not a material reason to own the stock.

This segment compares to Pike Electric Corp (PIKE), which does post-hurricane / post-storm related electrical and transmission line repair and cleanup work. PIKE is a perennial market laggard with a mid-single digit ~7x EBITDA multiple.

This is a fixed asset services / maintenance business in contrast to Field Services, which is a mobile business. Maintenance / industrial services at refineries, chemical plants, oil sands facilities, pulp and paper mills, and other industrial facilities cleaning such as high pressure chemical cleaning, catalyst handling and decoking + lodging / drill camp accommodations in the oil sands

Good proxy for the business – lodging and oil sands industrial services – is CE Franklin, which National Oilwell Varco acquired in 2012 for ~8x EBITDA. I also look to TISI and URS / Flint Energy Services as comp.

Headwind as per negative news out of TISI >> “The revised guidance reflects disappointing results in Team's historically weak third fiscal quarter due primarily to lower than expected revenues from its Canadian and European business units as well as a now anticipated slowing of business growth in the fourth quarter due to the expected timing of large turnaround projects.”

Also, the headwinds to the oil/gas services business outlined above will negatively impact this segment going forward.

Fluid handling, rentals, exploration, mapping, directional boring
Many many headwinds …
New entrant >> Why would anyone use them for this???
Rig counts negatively impacted by low natural gas prices
Political issues around XL pipeline
Heavy competition and pricing pressures

HEK results >> “As expected, the industry related to our shale business slowed in the second half of 2012, particularly during the fourth quarter. Activity declines exceeed normal seasonal factors, which we believe was a function of drilling efficiencies pulling our customers’ capital expenditures forward in the year. Working closely with our customers, we planned for this pullback and reduced our capital expenditures, which totaled $11.8 million for the second half of the year, and in turn were able to grow our cash position in both the third and fourth quarters.”
12/28/12 CLH acquired SK for ~$1.3B cash utilizing $300M cash on hand + $370M from equity offering financed the purchase through a combination of approximately $300.0 million of existing cash, $370M from 6.9M share equity offering ($56/share) and $589M from a private debt offering of 5.125% sr unsecured notes (due 2021).

SK acq valuation reflected 7x annualized 2012 EBITDA of $190M.

Inputs to re-refined oil now a cost vs a revenues
Regulations lead to shift to lower margin aqueous cleaning market as solvents legislated out
Re-refining shifts model to higher volatile earnings
Have been here before? Laidlaw acquired the original Safety-Kleen business in May 1998, combining the collection and processing infrastructure of the original Safety-Kleen business with Laidlaw's waste disposal assets (landfills, incinerators, etc.). The proposed financial and operational benefits of the merger were never realized. As a result, in June 2000 our predecessor company filed for Chapter 11 bankruptcy protection.

Business Overview
SK is hq’d in Richardson, TX and is the largest re-refiner and recycler of used oil in North America and a leading provider of parts cleaning and environmental services to commercial, industrial and automotive customers. Prior to the acquisition, SK reported two segments

Segment 1 = Re-Refining.
SK owns and operates two oil re-refineries. One, in East Chicago, IN, is the largest in N. America and the other, in Breslau, ONT is the largest in Canada. These two facilities represent approximately 60% of the total oil re-refining capacity in North America.

In 2012 the company collected roughly 200M gallons of used oil and refined roughly 160M gallons. It recently completed a 10M gallon expansion at the Breslau facility, which cost $30M in CAPEX ($3 / gallon) and a third 50M gallon / $100M ($2 / gallon CAPEX) facility is in the development stages, proposed for the Gulf Coast and expected to complete in 1H15. >> CFO SAYS THIS WON’T HAPPEN; THEY ARE NOT BUILDING THIS

Over the last two years, SK generated roughly $0.70 EBITDA / gallon of re-refined oil. This is below the industry target (as per recent article see below).

Re-refining is largely a regional and commodity business driven by proximity to inputs (used fuel oil). Competitors include Evergreen Oil, Inc., HCCI (Heritage-Crystal Clean, run by former SK executives and pure play publicly traded re-refiner) and NAL.T (Newalta Corp.)

Volume capped by capacity. Price driven by commodity prices. “Re-refined prices and margins correlate with movements in the Independent Commodity Information Services—London Oil Reports (ICIS-LOR) rate, which is quoted weekly for base oil in Europe, Asia and North America. Higher ICIS-LOR yields higher price and margin. RFO price is affected by changes in the US Gulf Coast No. 6-3% oil index (“6-oil index”), which measures the price of heavy fuel oil. Higher 6-oil index yields higher RFO price and margin.”

Segment 2 = Environmental Svcs.
These are mobile operations / services around the fixed based of re-refining. These mobile operations include: parts cleaning, containerized waste services, RFO. This segment includes the costs of collecting reused oil.

Parts cleaning. Both solvent and aqueous cleaning. Business is transitioning towards aqueous cleaning, which reduces amount of waste to landfills. Company has exposure to aqueous work through a 50% JV with Dwight and Church. We recycle all of the used mineral spirits solvent that we collect from our parts washers and return it to our customers as clean solvent, which accounts for more than 60% of our solvent servicing requirements and we believe provides a cost advantage relative to the use of only virgin solvent for parts washer servicing. We dispose of all of the used aqueous fluid that we collect through various disposal channels.

Containerized waste services / Oil collection. “While in the past we have charged customers to collect and remove their used oil, with increases in oil commodity prices, most customers now require us to pay them for their used oil.”

Recycled Fuel Oil (RFO). Revenues from RFO represent direct sales of RFO to external customers. Movements in the price of RFO are generally correlated with movements in the 6-oil index. == U.S. Gulf Coast No. 6—3% oil index, measuring changes in the price of heavy fuel oil.

Total Project Management. Revenues from total project management represent fees charged for various services provided to our customers, such as chemical packing, on-site waste management, remediation, compliance training and emergency spill response or for the service of selecting and managing pre-qualified third party contractors or internal staff to provide such services. Fees charged are generally based on the duration of the project and the materials provided for the project.

Other Products and Services. Revenues from other products and services, such as degreasers, glass cleaners, thinners and hand cleansers and vacuum services represent sales of the relevant products and fees charged for the relevant services.

Monday, April 22, 2013

Bearish on NSR; Buying the Oct $40 Puts

NeuStar is a technology services company focused on telecommunications and internet infrastructure. 

With 68M shares outstanding and a share price of roughly $43, it has a market cap of $2.9B. After adding in $577M in long term debt, $8M in capital leases, and netting out $347M in cash, it has an enterprise value of $3.2B. In 2012 it reported total revenues of $831M, EBITDA of $370M and EPS of $2.30. 

On a forward looking basis, using published analyst expectations, it is trading at a roughly 25% discount to its peer group: 13x NTM EPS vs the peer group of roughly 18x, and 8.5x EBITDA vs the peer group of about 11x. 

The peer group discount reflects concerns about a large contract NSR holds with the FCC that is being competitively bid for the first time since 1997. The contract is for the management of the databases that enable telephone number portability (or "porting")  in the US and Canada. Local number portability allows us to change phones and phone companies but keep our phone numbers, either landline or wireless. 

Porting is mandated by the Telecommunications Act of 1996. In 1997, NSR was awarded its initial contract to manage porting databases in three of the seven US regions (corresponding to the seven  RBOCs). Perot Systems was awarded the other four regions plus Canada, but issues with its system implementation led the FCC to give the entire management contract to NSR. It has held a monopoly on the contract ever since, despite objections from competitors. 

The current contract expires in June 2015. 

An RFP has been issued inviting bids to manage the contract. The North American Portability Management LLC (NAPM) - the industry group overseeing the RFP - is expected to make a recommendation to the FCC in August 5, 2013 with the FCC approval expected in September 20, 2013. 

Given the timing and uncertainty with the outcome, we anticipate some volatility around the stock. It is likely that NSR either maintains its existing monopoly, that the contract will be broken up into pieces some of which NSR will maintain, that the incumbent will be removed from the contract, or that the contract is delayed. Given recent moves by the FCC to increase innovation and competition, we do not expect that monopoly will be maintained. 

The size of the contract is material to NSR, which becomes apparent once we look at the segment reporting structure. There are three segments: 

1) Carrier Services. This includes "Numbering Services" (the LNP contract), telecommunications "Order Management Services" and "IP Services", which manages the interconnects between public switched networks and IP address.

2) Enterprise services. This is its "Internet infrastructure" and "Registry" services business through which it provides Domain Name System (DNS), geolocation and website performance monitoring solutions as well as registries for the .biz, .us, .co, .tel and .travel top-level domains, and the gateways for China’s .cn and Taiwan’s .tw country-code top-level domains. 

3) Information services. This segment was created by the 2011 acquisition of TARGUSinfo. It provides Caller ID, local search and targeted advertising / lead generation. TARGUS was acquired for $650M in cash. At the time of the acquisition, it had TTM revenues of $149M and 45% EBITDA margins. 

While the infrastructure aspects of the company are attractive, all this is overwhelmed by the size of the LNP contract; it contributed $418M in revenues in 2012. This reflects 50% of total revenues (after including the a full year of the TARGUSinfo acquisition) and 83% of carrier services segment revenues. 

Carrier Services segment EBIT margins have been 87% for the last two years. With more than 80% of that segment's revenues from the LNP project, it is safe to assume that LNP contract margins are at least 87%. Arithmetically, this implies that the contract contributes $365M in segment EBIT in 2012, or 62% of total segment EBIT before unallocated expenses. In short, it is a significant contributor to profitability. 

Segment EBIT excludes unallocated corporate costs. If we conservatively reduced these unallocated costs by 50% - assuming (most conservatively) that they are all variable costs that go away if the contract were removed (which of course they are not) - we would be left with $115M in EBITDA excluding the LNP contract. 

The balance sheet of course would not change without the contract though forward cash flows will diminsh. Leaving Enterprise Value as is and applying the peer group multiple of 11x to the remaining EBITDA, then deducting the net debt implies a back of the envelope value of $15 / share for the non-LNP related business and therefore $30 for the contract alone. 

The market however has likely already adjusted for its expectations. At the same 11x multiple, the contract should be worth $37. In other words, the market through its valuing mechanism has already adjusted expectations down by ~20%. 

Our bet is that the market isn't making enough of an adjustment to account for the loss of revenues if the monopoly is broken because not only will revenues go away but we expect a decrease in margins that are competed away as well. And remember this analysis accounts for the most conservative expectations of unallocated costs.   

Another approach using a DCF analysis gets us to $35 / share value. Though I understand the value of DCF as a supposed objective artbiter of value, I tend to hate using it - too many assumptions on top of forecast assumptions - but it is an industry practice. This analysis assumes a 50% reduction in revenues from the contract beginning in 2016 with a 25% erosion in contract EBIT margins competed away but 10% growth and stable margins in the other business segments. It also uses an 8% WACC. 

Ostensibly, the acquisition of TARGUSinfo was an attempt to diversify revenues sources away from this one major contract. A wise decision. While there is always room for additional wisdom, there is little room for additional diversification. The company has borrowed 90% of equity, 48% of total capitalization and 1.6x annualized EBITDA (and even more if most of that EBITDA goes away). 

All of this leads us to make a negative call on NSR by buying the out of the money Oct $40 puts for $2.70. While shorting the stock obviates the time factor risk (ie if there's a delay in the decision) the option strategy limits my capital outlay and significantly levers up the potential % return. 

LNP = Local number portability. The system that enables end users to keep their telephone numbers when switching from one communications service provider to another 

NANP = North American Numbering Plan. The system for managing Local Number Portability

North American Portability Management LLC ("NAPM") -  industry group that represents all telecommunications service providers in the United States and administers the contract. 

NPAC = Number Portability Administration Center. The name of Neustar's database.  

History: Neustar was spun off from LMT in 1999 in a forced sale to Warburg, which brought it public in 2005. 

tidbits from the 10K: 
"We were awarded the contracts to administer these services in open and competitive procurement processes in which we competed against companies including Accenture plc, Computer Sciences Corporation, Hewlett-Packard Company, International Business Machines Corporation, or IBM, Noblis, Inc., Nortel Networks Corporation, Pearson Education, Inc., Perot Systems Corporation, Telcordia Technologies, Inc., which is now a wholly-owned subsidiary of LM Ericsson Telephone Company, and VeriSign, Inc. We have renewed or extended the term of several of these contracts since they were first awarded to us. Prior to the expiration of our contracts in June 2015 to provide NPAC Services in the United States, our competitors may submit proposals to replace us as the provider of the services covered by these contracts. In addition, NAPM has initiated a selection process for the administration of NPAC services upon the expiration of our existing NPAC contracts in June 2015."

"In January 2009, we amended our seven regional contracts with NAPM to provide for an annual fixed-fee pricing model under which the annual fixed fee, or Base Fee, was set at $340.0 million, $362.1 million, $385.6 million and $410.7 million in 2009, 2010, 2011 and 2012, respectively, and is subject to an annual price escalator of 6.5% in subsequent years." 

"On February 5, 2013, the NAPM released a Request for Proposal for the selection of the next local number portability administrator under new contracts that will take effect upon expiration of the current contracts. We will compete for these contracts and to remain as the local number portability administrator."