Strayer Education - Quality Educator For Sale

The for-profit education industry has been beaten down considerably in the recent past. I am almost sure that many value investors have done some research in this section of the market in search for bargains. There are numerous articles on companies such as Apollo, ITT Education, Career Education, Corinthian Colleges, Capella University and etc. Most articles conclude that for-profit education stocks are cheap based on valuation metrics but the regulatory risks are also very high. I will not repeat what has been widely known by the market participants. My thesis is built more on the qualitative analysis. 

I started my research on the for-profit education a few months ago. My goal was to find a company that combines quality and value in the for-profit education industry. My initial list includes Strayer Education, ITT Education, Apollo, Career Education, Corinthian Colleges and Capella University. After reading some 10ks, earnings call transcripts and articles, I've narrowed it down to Strayer Education and Capella University. I eliminated the others mainly based on qualitative issues. For example, while reading Apollo's annual report, I noticed that management claims that Apollo has "aligned our admissions practices to better support our students's success by eliminating enrollment measures as a factor in the evaluation and compensation of our admission advisory teams."  This sounds like a good intention. However, new regulation specifically states that "a school participating in Title IV programs may not pay any commission, bonus, or other incentive payments to any person involved in student recruitment or admissions or awarding of Title IV program funds, if such payments are based in any part directly or indirectly on success in enrolling students or obtaining student financial aid." If a management team blatantly writes misrepresenting statement in the annual letter to shareholders, I don't think there is much integrity in the business. Other examples include ITT Education's abysmal reviews from its students, Corinthian Colleges' officials' engagement in a no-holds-barred campaign to drive down their schools' rates by pushing former students to obtain temporary forbearance and deferments on their loans. The for-profit education industry is one in which greedy management can take advantage of the underprivileged students even though education in general is supposed to have noble intention.  No wonder the regulators have been more stringent. Unsurprisingly, on a quantitative level, such as manifested by the cohort default rate, schools with questionable management also score very low. The 3 year cohort default rate for the 2009 class is 26.4%, 28.8% and 34% for for Apollo, Corinthian College and ITT education whereas for Strayer and the Capella, the rates are only 13.9% and 9.70%. 

The more research I've done, the more Strayer Education stands out from its peers, both from a qualitative perspective and quantitative perspective. So after months of research, I've decided to select Strayer Education within the for-profit education industry as my recommendation. 

Business Description:

Strayer Education, Inc. was founded in 1892. Strayer University is an institution of higher learning that offers undergraduate and graduate degree programs in business administration, accounting, information technology, health care, education, and public administration at over 60 physical campuses. The Company is a for-profit post-secondary education services corporation. Its mission is to make post-secondary education achievable and convenient for working adults in today's economy. It works to fulfill this mission by offering a variety of academic programs through its wholly-owned subsidiary Strayer University, Inc., both in traditional classroom courses and through Strayer University Online. Strayer University makes post-secondary education accessible to working adults who were previously unable to take advantage of higher education opportunities. Strayer University provides access to higher education to working adult students. Marketing activities include direct mail, Internet marketing, marketing to its existing students, print and broadcast advertising, student referrals, and corporate and government outreach activities. Strayer University maintains booths and information tables at appropriate conferences and expos, as well as at transfer days at community colleges. It has a total of 92 campuses in various stages of growth. As an institution of higher education accredited by Middle States and operating in multiple jurisdictions, Strayer University is subject to accreditation rules and varying state licensing and regulatory requirements.

Quality of Business:

Strayer Education's moat fundamentally comes from a top-notch management team. The current Chairman and CEO Robert Silberman (will step down as the CEO but will remain Chairman of the Board), worked as the COO of Cal Energy, which was owned by Berkshire Hathaway, before he was recruited as the CEO of Strayer Education. He has done a remarkable job building up Strayer Education's moat in the for-profit education business. In his book The Investment Checklist, Michael Shearn enumerated various instances where Robert Silberman showed integrity and great leadership. Here is an excerpt from the book,  "When Robert Silberman took over as CEO of Strayer Education in 2001, he said he was not going to focus on any of the metrics that generally drive public company valuations, such as revenue growth, operating income growth and margin expansion. The only thing that was going to drive real sustainable long-term value of owners was the intangible value of Strayer University and the to increase the intangible value, you increase the level of learning outcomes."  

Strayer's annual reports also stand out from those of its peers. Each year's annual report contains a reprint of the Strayer's Business Model from the 2001 letter to shareholders, which clearly outlines

• What Strayer does
• How Strayer's business model generates both reported net income and owner’s distributable cash flow, and 
• Strayer's strategy to increase the intrinsic value of your investment in Strayer Education. 

Robert Silberman also writes letters to shareholders every year and his writings are vastly different from the CEOs of Strayer's peers. The letter starts with the past year's result, detailing both challenges and accomplishments. Unlike his peers, Silberman goes in depth to analyze the reasons behind the challenges and accomplishments so that shareholders can get a clear understanding of the overall picture. Here is an example from the 2011 letter in which he offers his insights on the decline in student enrollment, which is very different from the public perception.

After  reviewing  all  the  data,  I  believe  that  the  most significant factor behind Strayer University’s extended decline in new student enrollments during 2011 must have  been  the  sustained  level  of  distress  across  the economy, and specifically the markedly higher level of unemployment in our target student population. Real unemployment in this country among 25–50 year olds without  a  college  degree  was  a  devastating  22%  in 2011, up from 6% in 2008. It is even higher in some of  our  newer  geographic  markets  in  the  industrial Midwest. We  know  from  surveying  our  students  that the large commitments of time and finances necessary to  succeed  in  our  undergraduate  academic  programs are  often  too  daunting  for  those  adults  who  have  no steady  means  of  income  (particularly  those  with dependents). We also know from our surveys that most of  our  undergraduate  students  have  contemplated returning  to  college  for  upwards  of  two  years  before making the final commitment. They have had to truly “screw  their  courage  to  the  sticking  point”  before actually enrolling. Therefore, in many ways, there is a lag factor to the effect of serious economic disruptions on our new student enrollments. As I have written in this letter  in  the  past,  while  some  level  of  economic insecurity  does  indeed  drive  working  adults  back  to college, sustained unemployment does not, at least not to Strayer University. 

Silberman also summarizes the capital allocation results from the prior year and lays out the plan for next year .Capital allocation is extremely important for any business yet rarely does a CEO of a public company present the result of prior year's capital allocation in a shareholder-friendly way. This transparency by Silberman is another indicator of management quality.

At the end each year's annual report, Strayer's Heritage reprinted from the 1912 student catalog is always attached. This section speaks the character of the business. Below is the full catalog:



This catalog was written with a view of setting before the men and women of this community some of the advantages of a business education, and of acquainting them with the superior facilities of this school for giving high-grade business training. 

The courses have been designed and presented to meet the needs of the business office of today. The teachers are men and women who are specialists in their respective subjects. The school rooms have been chosen and equipped with special reference to light, comfort and sanitation, so as to make it an ideal place for study.

We ask that the public, in determining which school it shall attend, to consider the facts in connection with this school, as are outlined in this catalog and supplementary literature. It is twenty years old. It has grown steadily  since  the  beginning.  It  attributes  its  growth  to  correct  ideals,  careful  management  and  successful, enthusiastic, and rapidly increasing alumni.

While it is essential to its success that a school should give thorough instruction in the subjects that comprise its courses, yet the school that does  only this, falls short of its full mission. The development of those traits of character which make for reliability in business and good citizenship are the peculiar province of the school as well as the home. This school, then, has nothing in common, can have nothing in common, with those so-called business schools offering cheap and superficial courses. Such courses, while inexpensive, and possibly of short duration, cannot result in anything but disappointment in the end.

This  school,  then,  stands  for  high  ideals,  it  courts  investigation,  welcomes  comparison,  and  stands by  its  promises.  It  is  a  school  to  which  you  may  attend  with  the  knowledge  that  you  will  be  in  pleasant surroundings, will be accorded fair treatment, and will be given thorough and painstaking instruction.

Finally, in presenting this catalog, we want to thank a discerning public for its support, and assure it that we shall endeavor to continue to merit the bountiful confidence it has heretofore placed in us. 


Regulatory Compliance:

Regulatory compliance is the biggest perceived risk in this industry. Although this risk is high for companies like Corinthian, Career Education and ITT Education, Strayer is probably one of the best positioned companies in the for-profit industry and I think it is a good thing that regulators are spending more time and effort addressing the questionable practice by a lot for-profit educational companies. Strayer's risk of non-compliance is very low in my opinion. The most recent 3 year Cohort Default rate is 13.9%, well below the 25% threshhold and the revenue% from Title IV loans is only 76%.

Also, as noted in the 2012 annual report,

Senator Tom Harkin (D-Iowa), Chairman of the U.S. Senate Committee  on  Health,  Education,  Labor  and  Pensions (HELP). Senator Harkin’s committee staff conducted a two year investigation into tax-paying, investor-funded post-secondary  educational  institutions  and  concluded that, “Strayer’s  performance  is  one  of  the  best  of  any institution  examined,  and  it  appears  that  students  are faring well at this degree-based college.” 


For the last three years the Department of Education has reviewed the regulations that govern how for-profit universities qualify to receive the proceeds of Federal student loans as tuition revenue.
The Department ultimately adopted a number of new regulations, the most important of which (the “Gainful 

Employment  Regulation”)  measures  the  earnings  of 

graduates of for-profit universities and compares those 

earnings to the debt levels the graduates incurred to 

finance  their  education. There  is  a  rather  complicated

process for measurement, and the first full measurement

year  was  not  slated  to  be  until  2012,  but  the 

Department released in 2012 “illustrative” data for all 

for-profit  universities  for  the  year  2011,  so  as  to  give 

these universities an early look at their compliance. I am 

pleased to report that using the illustrative 2011 data, all 

of Strayer University’s programs passed the Gainful 

Employment  Regulation  with  flying  colors.  Although 

the regulation has since been declared invalid by a U.S.  

District  Court,  and  the  Department  has  not  yet 

announced its plans going forward, we remain confident 

in our ability to run our university in compliance with 

what we believe to be the Department’s intent.  

Valuation:

Based on my observation and understanding of the business, Free Cash Flow is probably best metric to be used to value Strayer Education. FCF per share was $3.93 10 years ago, peaked at about $10.45 during 2011 and dropped precipitously to just above $5 per share during 2012. On a statistical basis, if we take the lowest price of Strayer stock in the past 10 years,  divided by FCF per share, the average P/FCF using the lowest price is about 14.  If we take the highest price of Strayer's stock in the past 10 years, divided by FCF per share, the average P/FCF using the highest price is about 25.  Where does the P/FCF stand now? It's about 10 times, or more than 20% lower than the historical average using the lowest price during each of the past 10 years. Looking out 5 years, if the industry stabilizes and unemployment drops, Strayer can earn $8 FCF per share and apply a 14 times multiple, we get $112 per share. 133% higher than current price and ~18.5% compounded annually.

We can also use the P/S multiple as revenue fluctuate less than FCF and earnings. Again, on a statistical basis, if we take the lowest price of Strayer stock in the past 10 years,  divided by revenue per share, the average P/S using the lowest price is about 3.6.  If we take the highest price of Strayer's stock in the past 10 years, divided by revenue per share, the average P/S using the highest price is about 6.64.  Where does the P/S stand now? It's about 0.9, or more than 75% lower than the historical average using the lowest price during each of the past 10 years. Even if revenue per share stays the same at $50 per share and assume things revert back to the mean in 5 years, Strayer should be trading at $180 per share, 275% higher than the current price and ~30% compounded annually.


Strayer does look cheap from a statistical perspective. However, as Robert Silberman has candidly mentioned in the most recent annual report, things may very well not get better in the next several years. In this case, the return can be expected from shares repurchase (which is increased to $150 million). Assuming the shares are repurchased at $50 per share, resulting in a 3 million share (27% of total shares outstanding) shrinkage to 8 million shares outstanding, with  $57 million FCF, the per share FCF will be ~$7. Apply a 14 times multiple, we get $98 per share, or 15.5% compounded annually for 5 years.


Conclusion: At $48 per share, Strayer is a good combination of quality and value in the for-profit education industry.

Disclosure: Long STRA.

The Pareto Principle and Investing

The Pareto Principle states that 80% of the results, outputs, or rewards, are generated from only 20% of the causing inputs or efforts.

The implications for investing:

1. 20% of our best stocks will probably generate 80% of our overall profit.
2. 20% of the time we spent doing research usually generates the 80% most useful information.
3. 80% of the time we spent doing research is likely not very productive.

The above implications can be very  discouraging for investors who have never thought about applying the Pareto Principle to their investment research. In fact, I wrote this article because I was truly disappointed and bothered by the feeling that most of my time spent doing fundamental analysis is not targeting the most important things. Why? Because I often forget to write out the most important thing first before I even start my research. This article is trying to address implication 2 and 3 above.

 My investment research routine is

1. Research company background, read the most recent 3-5 10Ks and 10Qs of the company and those of its competitors to answer every question on my checklist.
2. Gather 10 years of financial statements and build the valuation model.
3. Calculate intrinsic value and  margin of safety.

I usually spent about 90% of the time performing step 1 and step 2 above. The intrinsic value and margin of safety calculation are the most important things but it usually takes about 10% of my time. Well, you can argue that step 1 and step 2 above are necessary as they build the foundation for step 3 but step 1 and step 2 frequently incorporate a lot of assumptions and each one of them may impact the ultimate result in step 3. Garbage in and garbage out. The majority of the information I gather in step 1 and step 2 end up being inconsequential. Therefore,  it's not the quantity of time you spend that will ultimately determine the quality of your research, it's the quantity of time you spend addressing the most important things that really matter.

Here is a most recent example. I have been digging into the for-profit education sector and have spent a massive amount of time just to gather all the financial data and incorporate them into the valuation model. I've also read the 10Ks for Strayer Education, Apollo, Capella and Career Education. However, just like someone driving around in a strange city without navigation, I wondered around for a while, lost and still not getting to the point. I read all the business description, all the risk factors and the regulatory environment but still have not put all the piecemeal information together in a meaningful way because I have already spent so much time and I feel justified to delay the ultimate intrinsic value calculation. To quote Michael Bauboussin "Most people do not find it natural to match ideas from their mental database to tricky situations in the real world. Our brains are not wired for the process of moving from preparation to recognition. Indeed, typical decision makers allocate only 25% of their time to thinking about the problem properly and learning from experience. Most spend their time gathering information, which feels like progress and appears diligent to superiors. But information without context is falsely empowering. if you do not properly understand the challenges involved in your decision, this data will offer nothing to improve the accuracy of the decision and actually may create misplaced confidence. "

He is exactly right. In doing fundamental research, we often gather information for the sake of gathering information, which feels like progress and create misplaced confidence because we tell ourselves that we spent a lot of time doing research and therefore, we should have confidence in our thesis. This fallacy is very dangerous, especially in the world of investing yet so many of us have been ignorant to it. In my opinion, the best way to cope with this is to begin our investment process by asking ourselves what are the most important things.

With regards to the for-profit education sector, the most important things are:

I.  How likely is an institution not in compliance with the regulation and can the institution go out of business if not in compliance?  Specifically, what is the institution's compliance status with regards to:

• Cohort Default Rate
• The 90/10 Rule
• Incentive Compensation
• Gainful Employment

1.  At least 35% of students are in satisfactory repayment status with respect to their federal student loans three to four years after entering repayments. 
2. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 30% of the average or median discretionary income in the third or fourth year after graduation; or
3. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 12% of the average or median annual earnings in the third or fourth year after graduation; 

II. Is the headwind that the for-profit education sector facing structural issue or cyclical issue?

III. If the headwind is a cyclical issue, what will enrollment level be once things return to normal?

IV.What strategies are being executed to address both the current headwind and future development?

V. Given I-IV, what is the intrinsic value of the business?

I am absolutely not indicating we should abandon hardcore fundamental analysis. Diligent fundamental analysis is what defines value investors. What I am suggesting in this article is that before we start our research, we should take the time to define our focus points in our research. Once we lay out the most important things, we can direct our research to address them first. Once we've answered all these vital questions, we can dive into other things.Warren Buffett once said: The chain of habit is too light to be felt until it's too heavy to be broken. The habits we cultivated as teenagers inevitably affect how to behave as adults. In investing, in order to not lose money and generate superior return, we have to be cognizant of the habits we cultivated when we were young that could inherently lower the quality of our research and hence, the potential return of our investment. It takes time and can be against human nature to step back and question ourselves but that's how we become better over time.

By the way, here are two  much better articles on similar topic from Geoff Gannon.

http://www.gurufocus.com/news/212478/5-things-i-look-for-in-a-stock

http://www.gurufocus.com/news/197914/whats-your-research-process



As always, I welcome all constructive criticism.

How Should We Look at The Relationship Between Operating Cash Flows and Operating Earnings

Operating Cash Flows and Operating Income are two metrics that every serious investor should spend some time on when conducting investment analysis because they provide very useful information on recurring earnings and cash flows from the normal business operations.

Furthermore, the relationship between Operating Cash Flow (adjusted for non-recurring and non-operating items) and Operating Income is important because it can be indicative of a company's earnings quality and financial health. Usually those two metrics should move in same direction and any inconsistencies may suggest accounting problems. However, there may be valid reasons for the divergence of Operating Cash Flow and Operating Income. As I search for authoritative guidance on this topic, I found Chapter Eight of the book Creative Cash Flow Reporting by Charles Mulford and Eugene Comiskey extremely helpful.

Here are my summaries and notes:

"Reported operating cash flow can be much larger than operating income for capital intensive businesses. A capital intensive company need to invest heavily in Property, Plant and Equipment and these expenditures are included in the investing cash flows whereas the related depreciation is added back to operating cash flows. In addition, through the use of accelerated depreciation for tax purposes, deferred taxes liabilities are often recorded, which reduce net income, but not operating cash flow."

Notes: For capital intensive industries such as airlines and utilities, subtract capital expenditures from the reported operating cash flows to get "normalized operating cash flows." Even though GAAP classifies capital expenditures as investing cash flows, for capital intensive businesses, capital expenditures are in reality cash flows to maintain normal business operations and hence, operating in nature.

"Seasonal factors can also validate the temporary divergence between Operating Cash Flow and Operating Income. In anticipating stronger sales (such as holiday season), companies often build up inventory, which lead to lower Operating Cash Flow. As sales build later, earnings increase and inventory acquired earlier is liquidated. The net result is that operating cash flows can grow at a faster pace than operating income."

Notes: This is certainly true for retailers. Using Macy's as an example, here is the quarterly information for inventory, change in inventory and operating cash flows:

We can tell that there is a surge in inventory and a dramatic decline in operating cash flows in every third quarter and a decline in inventory and improvement in operating cash flow in every fourth quarter. The implication is that when we analyze quarterly financial information for retailers such as Macy's and JC Penney, we have to consider seasonal factors that are inherent to the business.

"An important but often ignored valid factor that drives the divergence between Operating Cash Flow and Operating Income is business cycle development, especially for those cyclical companies. As companies and industries go through cyclical changes, the relationship between earnings and operating cash flow also change. During a recession, a cyclical company will experience a decline in revenue and operating income. Net losses may ensue. However, the company may also reduce inventory accordingly, resulting in improvement in operating cash flow. As the recovery goes, cash flow may decline as inventory levels are brought up back to the pre-recession levels whereas earnings are improving. Gradually, as the business moves beyond the effects of business-cycle changes on its operations, more stable relationship between earnings and operating cash flows should return."

Notes: Again, let's use Macy's to illustrate this point. Below is selected Macy's financial information from 2006 to 2012:

Even though Macy's operating income and net income deteriorated materially from 2006 to 2009, the drop in operating cash flow was not as dramatic. However, this divergence between operating cash flow and operating income is expected and therefore, not to be interpreted as red flags.

"Investors also often misunderstand the effect of business life cycle has on the relationship between Operating Cash Flow and Operating Income. A company's earnings and operating cash flows have certain characteristic relationships that depend on the stage of the life cycle in which it operates."

Notes: Business cycle development is certainly a factor that is often obliterated by investors. Here is the summary of the earnings and cash flow characteristics of each phase in the cycle.

• Start up phase (2003-2004): A start up firm usually experiences net losses as it spends on SG&A and not generating enough revenues. It may consume even more operating cash flow as early sales result in increase in A/R and as inventories are accumulated. 

• Early Growth Phase (2005-2006): Revenue continues to grow and earnings may turn positive. However, continued increase in A/R and inventory may cause the company to report negative Operating Cash Flow. In the transition between start-up and growth, earnings often turn positive before Operating Cash Flow. 

• Established Growth Phase (2007-2012): As the company continues to grow, the growth rate of A/R and inventory should gradually lag the growth rate of earnings and Operating Cash Flow should turn positive. Moreover, as depreciation continues to grow, lowering operating income without lowering Operating Cash, Operating Cash Flow should eventually exceed Operating Income. A company may operate in the growth stage of its life cycle for an extended period. During that period, the stable relationship between Operating Cash Flow and Operating Income should persist. 

• Late Growth Phase and Maturity Phase: As revenue growth slows or even declines, the company may still report operating income. Restructuring events are likely to happen. However, when the company begins taking significant NON-CASH restructuring charges, the spread between Operating Cash Flow and Operating Income will increase. It would not be surprising to see the company continue generating positive Operating Cash Flow. Only if the company were to remain unprofitable and enter an extended period of decline would it run the risk of beginning to consume cash from operations. 

• Decline Phase: A company in decline may report losses but provide ample amounts of operating cash flow as investments in working capital accumulated during earlier periods of growth are liquidated. However, as the decline continues, positive cash flows will likely turn negative. 

After considering the above factors, if a company's Operating Cash Flow is not consistent with the Operating Income, its earnings quality may very well be questionable. At this point, the prudent investor should adjust the reported cash flows from operations for non-recurring and non-operating items and adjust operating earnings for non-recurring and non-operating items as well. If there is still a significant divergence between the adjusted Operating Cash Flow and Operating Income after considering all the above factors, the investor should further analyze the reason for the divergence, extrapolate the implications and proceed with caution.

National Oilwell Varco -Stock Analysis Qualitative

1. Business Description (from google finance):

National Oilwell Varco, Inc. is a provider of equipment and components used in oil and gas drilling and production operations, oilfield services, and supply chain integration services to the upstream oil and gas industry. The Company operates through three segments. Its Rig Technology segment designs, manufactures, sells and services complete systems for the drilling, completion, and servicing of oil and gas wells. Its Petroleum Services & Supplies segment provides a variety of consumable goods and services used to drill, complete, remediate and workover oil and gas wells and service drill pipe, tubing, casing, flowlines and other oilfield tubular goods. Its Distribution & Transmission segment provides maintenance, repair and operating supplies and spare parts to drill site and production locations worldwide. 

2. How Does NOV Make Money? 

Revenues:

Rig Technology Segment: This segment designs, manufactures, sells and services complete system for the drilling, completion, and servicing of oil and gas wells. This segment offers a comprehensive line of highly-engineered equipment that automates complex well construction and management operations. Products include  topdrive, mud pump, pressure pumping equipment, drilling rig monitor, drawworks, pipe histering systems, workover rigs, land rig packages, blowout preventers, cranes, coiled tubing, wireline tubing. etc. 

Petroleum Services and Supplies: This segment provides a range of support equipment, spare parts, consumables and services. It sells and provides a variety of tubular services, composite tubing, and coiled tubing, inspection and reclamation services for drill pipe, casing, production tubing, suck rods and line pipe at drilling and workover rig locations. This segment also provides product and services that are used in the course of drilling oil and gas wells. The NOV Downhole business sells and rents bits, drilling motors and specialized downhole tools that are incorporated into the drill stem during drilling corporations. Furthermore, this segment offers solids control and waste management, and Coring Solutions (which enables the extraction of actual rock samples from a drilled well bore and allow geologists to examine the formations at the surface. 

Distribution and Transmission: The Distribution Services business unit provides supply chain management services to drilling contractors and exploration and production companies. It also stocks and sells a large line of oilfield products including consumable maintenance, repair and operating supplies, valves, fittings and other parts that are needed throughout the drilling, completion and production process.  NOV RigStore provides the installation, staffing and management of supply stores on offshore drilling rigs. 
The Transmission business unit supplies products and services used in the construction of water pipelines, lining and wind towers, progressing cavity pumps, grinders, filters, screens and a variety of artificial lift equipment. 

 Costs:

Raw Materials:Steel, other commodities and energy costs. 

Marketing costs.

Research and Development costs.

Engineering and Manufacturing costs. 

SG&A costs. 

3. How does the Company grow?

NOV grows both by organic growth and acquisition. Capital expenditure has been between 1.9% to 3.5% of revenues. Acquisition costs of $1 billion, 556 million and 573 million during 2011, 2010 and 2009. 

4. Moat: 

i. One-stop-shop. The firm supplies nearly all of the equipment needed for a land rig and much of the downhole equipment and consumables (which are being consumed at a greater rate than in the past) as well. 

ii. Scale and rig equipment dominance, particularly in deep-water rigs. NOV's equipment is on 90% of the world's rigs. 

iii. Premium products. 

Offshore drillers, it has the best and only source of rig equipment and the deep-water technology needed for new rigs to economically drill far more complex and deeper wells. 

iv.Diversified revenue stream

5.  3Cs:

(i) Customers: 

• Rig Technology: Drilling contractors, who provide the equipment, people and expertise to drill the wells, which can be either offshore or onshore. Such as Transocean and Diamond Offshore. Other customers include rig fabricators, well servicing companies, pressure pumping companies, national oil companies, major and independent oil and gas companies, supply stores, and pipe-running service providers. 

• Petroleum Services: Major and independent oil and gas companies, national oil companies, drilling and workover contractors, oilfield equipment and product distributors and manufacturers, oilfield service companies, steel mills, and other industrial companies. 

• Distribution Services: Major and independent oil and gas companies, national oil companies, drilling contractors, well services companies. 

• Transmission Services: Local, state and federal agencies, developers and general contractors. 
• Samsung Heavy Industries account for 12% of NOV's revenue. 

(ii) Cost structure: Fixed costs vs varying costs: Low operating leverage implies low fixed costs compared to various costs. (iii) Competitors: 

• Rig Technologies: Access Oil Tools;Aker Solutions AS; American Block; Cavins Oil Tools; Tesco Corporation; Vanoil; Huntings Ltd;

• Petroleum Services :Schlumberger; Baker Hughes; Halliburton; Weatherfold International; Shaw Cor Ltd; EDO Corporation; Patterson Tubular Services; Vallourec & Mannesmann; and Precision Tube (a division of Tenaris). 

• Distribution: WESCO International Inc;KS Energy Limited; Apex Distributions; CE Franklin; Wilson Supply ( a division of Schlumberger). 

• Transmission: Northwestern Pipe Company and a number of regional competitors. 

6. The selling process: 

• Rig Technology: Direct sales force and distribution service centers. 

• Petroleum Services: Direct sales force and through commissioned representatives. 

• Transmission and Distribution: NOV's own network of distribution service centers. 

7. Pricing Power:

Strong pricing power as disclosed by the Company: The Company has generally been successful in its effort to mitigate the financial impact of higher raw materials costs on its operations by applying surcharges to and adjusting prices on the products it sells. 

8. What’s the impact of govt regulations in the business and what’s the risk involved here?

The Business is subject to numerous federal, state and local laws, regulations and policies governing environmental protection, zoning and other mattes. The adoption of climate change legislation or regulations restricting emissions of greenhouse gases could increase its operating costs or reduce demands for NOV's products. 

9.What’s the spread of business between international and USA operations and the impact of foreign currency on earnings?

For 2011, 56% of the revenue NOV generated are international. NOV's foreign operations include Canada, Europe, Middle East, Africa, and Southeast Asia, Latin America. 

10. Important data to watch:

• West Texas Intermediate Crude
• Natural Gas Price
• Rig Counts. 

11. Does the balance sheet have a large amount of goodwill and intangibles?

As of 12/31/2011, goodwill totals $6.151 billion and intangibles totals $4.073 billion and total asset is $25.515 billion. Goodwill and intangibles represent 40% of total assets, which is not a small number. NOV is subject to future goodwill and intangibles impairment. 

12. Are there any quality issues with its products?

2010 Warranty Accrual: $52 million. Actual warranty amounts: $45 million

2011 Warranty Accrual: $40 million. Actual warranty amounts: $47 million

Warranty expense is very minor compared to sales (less than 1%). 

JC Penney - Maximum Pessimism?

If you go to Yahoo Finance and search for headlines of J.C. Penney (JCP), chances are you will not see many positive headlines. In fact, you probably don't even need to go to Yahoo Finance — the popular media and Wall Street analysts have been nothing but negative about the outlook for J.C. Penney. Below are a few quotes:

"An analyst at BMO Capital Markets downgraded JCP from marketperform to underperform, and said at this rate the company may go bankrupt next year. The company's stock is now at less than 40% of its 52-week high, which was a year ago tomorrow."

"J.C. Penney has been a train wreck whose comeback always seems just around the next earnings corner, but investors are beginning to doubt that CEO Ron Johnson can weave the same magic that he did at Apple." — CNBC

"J.C. Penney is doing everything short of walking into your living room and executing short trades for you. They're screaming from rooftops in their last annual filing that things aren't going as planned. The stock chart looks like a slalom route for the '98 Nagano men's Olympic downhill team." — Motley Fool

"The company is stuck on a mezozoic era branding problem, and has failed to make massive, paradigm shifting changes to their business. They are not focusing enough on online sales and younger generations, all the while seriously burning through cash." — Seeking Alpha

Further evidences of pessimism include a 42% short interest in J.C. Penney's stock and only one "buy" rating from analysts covering J.C. Penney. So the pessimism is obvious, but the question is, does this represent "rational herding" (i.e. JCP is a value trap) or does this represent a buying-at-maximum-pessimism opportunity? There are a few apparent and seemingly compelling arguments for being bearish on JCP:

1. The turnaround has not been working. Sales are down 25% year over year and 31% for the most recent quarter. The loss is even more horrendous and profit margin is deteriorating. 

2. J.C. Penny has been losing old customers and not been able to attract enough new customers. The pricing strategy in 2012 isolated itself from its loyal old customers and they may never come back. 

3. A major insider (Varnado) has lost faith in J.C. Penney by dumping 40% of its shares. 

4. J.C. Penney will be burning cash at an accelerated rate and may not exist in a few years. 

5. Sales will most likely continue to go down unless Johnson is fired.

6. The Martha Stewart Store may not work out. 

7. The shops are not enough to save J.C. Penney. 

8. J.C. Penney's new executives are not even living in Texas. They are not involved enough in the day-to-day operation. 

I think these are all valid points, but I do have a few questions to the investors who share the above bearish view:

1. Are the bad news reflected in JC Penney's stock price?

2. Does the other side of the trade-namely the buyers of JC Penneys' stock, know about those negative views? 

3. Are you subject to the availability bias, the confirmation bias, the endowment bias and the social proof bias?

4. Have you done a thorough research (not just visiting stores) and come up with risk/reward analysis?

5. Did Ron Johnson and the Penney Board ever say the turnaround will be done in 2013 and did he mention that sales and profits will be down for a while? 


If you read "Celebration of Fools" by Bill Hare, you will find out that the problem with J.C. Penney did not start with Ron Johnson. Early problems with J.C. Penney emerged at the late years when Bill Howell was still Penney's CEO. Bill Howell was not known for any particular stellar accomplishment, unlike the previous Penney's CEOs. He was charismatic politically with an executive image. He always chose his publicized appearance with great care, favoring prestige events like serving on a While House Blue ribbon panel. He started paying a lot of attention to Wall Street and under his reign, J.C. Penny became overly bureaucratic. Jim Osterreicher, the CEO after Bill Howell, was unable to make important decisions until last minutes and not communicating what he wanted exactly. Osterreicher also made bad acquisitions such as Eckerd. Neither Allen Questrom nor Mike Ullman made things better for J.C. Penney. Mike Ullman initiated massive off-mall stores investments which proved to be unsuccessful. 

Continued struggle since the 1990s made it clear that J.C. Penney needed a change, to quote Mil Batten, J.C. Penney's legendary CEO, "Change, of course, is the only constant, the future never assured. So to not plan for change and not invest in the future would be crazy, no matter what Wall Street says." This is why I believe Bill Ackman brought in Ron Johnson. J.C. Penney needed a change, and not a small one. 

The changes Johnson made have been discouraging so far, to say the best. However, there is some hope. First, Johnson made a few big mistakes, but he had realized that he screwed up and he had taken steps to correct those mistakes. Admitting mistakes and learning from them is not the easiest thing in the world. Second, J.C. Penney only installed a very small portion of shops so far. The result of Joe Fresh and the like is still to be seen, but it is hard to imagine those shops will do worse than their current lineups. Third, one reason sales and margins were down dramatically last year is that Johnson's team got rid of a lot of old obsolete inventories. Inventories went down by $600 million during 2012 and most likely the majority of them were sold below cost. This is unlikely to happen in 2013. Therefore, I expect at least better margins for 2013. 

One of my favorite and most respected writers and investors on GuruFocus, The Science of Hitting, has done a masterful job of analyzing J.C. Penney from a consumer's perspective. His article is a good read (at least for the sake of disconfirming evidence) for JCP bears. 

[url=http://www.gurufocus.com/news/192562/jcp--a-consumer-perspective ] 

As far as valuation is concerned, I calculated for the liquidation value and came up with a range of $13 to $16, assuming a 33% discount on inventory at lower cost or market as shown on the balance sheet, and if you mark up 40% of J.C. Penney's property value by 50% (Penney owns a little more than 40% of the approximately 1,100 stores). There are other assumptions regarding other assets such as deferred taxes assets but they are not material. I think Whitney Tilson and Bill Ackman have also calculated the down side risk for J.C. Penney as well. The point is, at less than $15 per share, the market has pretty much priced in the worst for J.C. Penney, and it looks that at this point the risk/reward ratio favors the long side of the stock. Of course I could be very wrong about JC Penney but if that's the case, I will be grateful for the learning oppportunity. 

I also want to share with you the stories of a few most recent notorious value traps:
           
NOK: 
52-Week Low:1.63
Current Price as of 3/26/2013: 3.30 

HPQ:
52-Week Low:11.35 
Current Price as of 3/26/2013:23.64

RIMM:
52-Week Low:6.22  
Current Price as of 3/26/2013:14.46

FSLR:
52-Week Low:11.43
Current Price as of 3/26/2013:27.60

RSH:
52-Week Low:1.90
Current Price as of 3/26/2013: 3.36

Let me end with one of my favorite quotes: 

"The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." — Sir John Templeton 

With that, I welcome any criticism and further discussion. 

Disclosure: Long JCP and long JCP Call Options

Mohnish Pabrai: What I've Learned From Warren and Charlie (BRK-A, BRK-B)

Mohnish Pabrai: What I've Learned From Warren and Charlie (BRK-A, BRK-B)

Liberty Media's Spin-off Brief Analysis

According to Liberty Media's press release: 
 http://ir.libertymedia.com/releasedetail.cfm?ReleaseID=733175

Liberty Media Corporation and Starz announced the completion of the spin-off of Liberty from Starz at 5:00 p.m on Jan 11, 2012. As a result, Liberty and Starz are now separate publicly traded companies. As announced earlier, in connection with the Spin-Off, Liberty changed its name from "Liberty Spinco, Inc." to "Liberty Media Corporation," and Starz changed its name from "Liberty Media Corporation" to "Starz." Both companies will begin trading regular way on The Nasdaq Stock Market, under the symbols listed above, on Monday, January 14, 2013.

Following the Spin-Off, Liberty's principal businesses and assets include its consolidated subsidiaries Atlanta National League Baseball Club, Inc. andTruePosition, Inc., equity affiliates Sirius XM Radio Inc. and Live Nation Entertainment, Inc. and minority investments in public companies such as Barnes & Noble, Inc., Time Warner Inc., Time Warner Cable Inc. and Viacom Inc.. Starz' businesses and assets consist of those of Starz, LLC, its wholly owned subsidiary.

As spin-offs usually create unusual profit opportunities for special situation investors and John Malone is a master in creating wealth using the spin-off technique, I decided to take a closer look at the spin-off. 

I. Reasons for spin-off: 

According to the Company's filing: 

The board of directors of Liberty Media periodically reviews with management the strategic goals and prospects of its various businesses, equity affiliates and other investments. As a result of a review undertaken during the summer of 2012 the Liberty Media board determined that the Spin-Off would allow each of Starz and Spinco to pursue strategic opportunities that are not otherwise available to them in Liberty Media's current configuration and, over time, enhance the operating performance of the two companies. Among the factors considered by the Liberty Media board in arriving at its determination were the following:

• By separating the more complex collection of businesses and investments that currently comprise Liberty Media from Starz, LLC, Liberty Media believes that the conglomerate or "holding company" discount inherent in Liberty Media's common stock will be eliminated, as Starz will become a "pure play" media company valued in a manner consistent with other companies in the premium television industry. The elimination of the holding company discount at Starz will create a more efficiently priced equity security for Starz to use to effect a complementary business combination using its equity and enable Starz's stock to be more accurately valued by potential acquirors.

• The Spin-Off is expected to cause the holding company discount with respect to the Spinco common stock to be reduced, as separating Starz, LLC and its subsidiaries will better highlight the discount at which the Liberty Media common stock historically has traded relative to its underlying asset composition. This reduction of the holding company discount associated with the Spinco common stock would enhance the ability of Spinco to issue its equity for purposes of making strategic acquisitions with less dilution to its stockholders.

• By effecting the Spin-Off, both companies will be better positioned to take advantage of business opportunities that are not available to them under Liberty Media's existing configuration. Each of Starz and Spinco will have greater flexibility in structuring strategic alliances, acquisitions and other business combinations and a stronger acquisition currency.

• The contribution of cash to Spinco in connection with the Spin-Off will provide Spinco with greater liquidity to acquire additional shares of its equity affiliates, invest in complementary businesses and pursue other strategic objectives and acquisitions.

• In connection with the internal restructuring and the cash contribution to Spinco, Starz will optimize its capital structure, through the draw down of the Starz credit facility, which is expected to provide for more attractive leveraged equity returns for Starz's stockholders.

Conclusion: The reasons for the spin off seem compelling. If things go as expected, not only will Starz benefit from the removal of discount associated with being part of a complex conglomerate but also it will benefit from a leveraged equity position, which may provide better returns. 

II. Insider Ownership and Equity Compensation:

1. John Malone will mostly likely continue to own a significant amount of ownership in both Spinco and Starz, given that he owned 1.8% of Class A shares and and 83.8% of Class B shares prior to the spin-off. 

2. The new option awards and the new SAR awards are set up in a way that the lower the stock price during the first 3 trading days of Starz and Spinco's stocks after the spin off, the more attractive the option awards and the SAR awards. Therefore, there's a reason to believe that insiders want Starz and Spinco's stock to trade low during the first 3 trading days starting Jan 14th. 

III. Back of Envelope Valuation:

Upon completion of spin-off, Starz will have approximately 124 million shares outstanding common stock. Starz made $240 million net income, or $1.94 per share duirng 2011. Applying a P/E multiple of 12, which is mildly conservative for a premium subscription video programming distributor, I come up with a value of $23.3 per share. Comparable companies such as Scripts Networks Interactive and Discovery Communications are valued at 17 plus P/E multiples. At an implied price of $14.20 per share (1/11/2012 closing price of LMCA 124.03 - 109.03 LMCAV), Starz looks fairly attractive. 

IV.Possible Indiscriminate Dump by Institutions:
Before the spin-off, Liberty Media is a large cap stock with a $13.5 billion market cap. After the spin-off, Starz, with a implied $14.2 share price and 124 million shares outstanding, will have a implied market cap of $1.7 billion. Institutions with cap size limits may be forced to sell Starz's stocks after the spin-off because it won't meet the large cap requirement, which in turn may also create good buying opportunities.