Visteon Simplifies Business, Plans Huge Buyback, Goes Unnoticed – VC

When it comes to investment theses, my view is the simpler the better. Better because the fewer assumptions I depend on, the lesser the chance I’ve made some fundamental error in calculation or my understanding of the company and its industry. I’ve no need for spreadsheets with twenty tabs modelling gross margins  for the next decade, or for novel-length PDFs with detailed biographical data of every middle manager. I look askance at projections longer than three years or so into the future, because the future so stubbornly refuses to conform to my wishes and predictions.

Visteon Corporation is an example of a simple investment thesis. Visteon is a supplier to auto manufacturers worldwide. Its biggest customers are Hyundai/Kia and Ford, and its chief products are climate control and electronics parts and systems. While Visteon has rapidly transformed its business, the market has failed to adequately recognize the progress. The case for investing in the company relies on only a few facts and assumptions.

  1. Visteon is overcapitalized and plans to return that capital to shareholders through a massive share repurchase. The company is authorized to repurchase $1 billion in shares by December, 2015, good for 26.2% of shares outstanding.
  2. Visteon has streamlined and focused its lines of business down to its highest-margin, fastest-growing operations: climate and electronics. Exiting slower-growing, lower-margin operations should merit a higher market multiple on the restructured business, yet Visteon trades at a very low multiple of projected results.

And that’s the whole of the thesis. Now allow me a little time to unpack each point.

Overcapitalized

Due to the recently announced sale of a significant division, Visteon is soon to be swimming in cash. In August, Visteon announced the sale of its portion of the Yanfeng Visteon Automotive Trim Systems joint venture to its Chinese partner. As part of the transaction, Visteon will assume majority control of the joint venture’s automotive electronics unit. The transactions will take some time to be finalized, but Visteon expects to receive $1.1 billion in cash before the end of the calendar year, then another $110 million in June 2014 and $14 million in June 2015. The transaction was born of Visteon’s desire to exit its automotive interiors businesses and focus on the more lucrative climate and electronics lines. Visteon intends to return nearly the entire proceeds of the sale to shareholders via share repurchases over the next two years.

Undervalued

Visteon has helpfully provided EBITDA estimates for 2014, adjusted for the sale of its joint venture stake. In 2014, Visteon expects to earn between $600 million and $640 million in EBITDA, adjusted for equity in affiliates and minority interests.

current valuationAt only 4.07 to 4.34 times 2014 EBITDA, Visteon looks extremely cheap. The market is clearly not giving Visteon credit for its massive cash balance that will be returned to shareholders.

But what should Visteon be worth? Others may use different metrics, but I generally value capital intensive, cyclical industries at around 6x mid-cycle EBITDA. A 6x multiple on 2014 EBITDA would equal $96.92-$101.69 per share for Visteon.

However, there is a good case for valuing Visteon at a premium. Both of Visteon’s core divisions are projected to enjoy strong growth: 7%+ for climate and 12%+ for electronics, according to Visteon’s internal projections. And Visteon has realigned its business to emphasize attractive geographic regions. The Halla Visteon climate segment does 59% of its business in Asia Pacific markets and the electronics segment will do 37% there post the joint venture transaction, more than it does in either North America or Europe.

Asia is Visteon’s focus, so much so that the company is reportedly exploring transferring its stock listing to Hong Kong. From a bloomberg.com article:

“’In Asia, where the bulk of our business is and the bulk of the automotive industry is, this is a growth industry, but we’re not getting growth multiples,’ Chief Executive Officer Tim Leuliette said in an interview after a Bloomberg auto forum in Southfield, Michigan, yesterday. ‘We need to start being valued on where we do business, not where we’re domiciled.’”

And that’s the whole pitch. I could go on and talk about Hyundai’s increasing success or the margin expansion that Visteon projects, but none of that is necessary to see Visteon’s value. Despite good growth potential, Visteon trades at a depressed multiple. Shares should benefit as the market recognizes this growth potential, and as the company hoovers up shares by the millions. I strongly recommend checking out Visteon’s investor relations page, where it archives presentations it has made at various investment conferences.

One more wrinkle – Visteon has a series of warrants outstanding, trading under the symbol VSTOW. These warrants have a strike price of $58.80 and expire in October, 2015. These warrants could be attractive to investors looking to leverage Visteon’s stock cheaply.

Accounts that I manage hold Visteon warrants.

 

How to Buy Empire State Realty Trust at a Discount

Earlier this month, one of the world’s most iconic buildings went public as a REIT. The Empire State Building and several smaller properties totaling 7.68 million rentable square feet were combined to form Empire State Realty Trust, Inc. The ticker is ESRT.

My purpose here today is not to examine the company’s valuation, or discuss its investment potential. (I’ll leave that to REIT specialists. The Empire State Building’s high vacancy rate and the ongoing and expensive renovations complicate the analysis.) The REIT may be cheap, dear, or fairly valued. What I am here to discuss is how a quirk of the formation process allows investors to buy identical claims on the REIT’s assets at discounts to the market price of 10% or more.

Prior to the IPO, the ownership structure of the Empire State Building and the trust’s other properties was positively byzantine. Individuals, partnerships, estates, individuals and corporations all owned bits and pieces of the various properties. In order to go public, dozens and dozens of separate owners had to be convinced to vote in favor of the transaction, which would result in them contributing their stakes in return for ownership in the new structure. The process was both lengthy and litigious, but ultimately successful.

Post-IPO, the newly-formed company’s ownership structure is still somewhat convoluted. All of the properties are owned by Empire State Realty OP, LP. This partnership is owned, in turn, by management, Empire State Realty Trust, Inc., and continuing investors who have received LP units in exchange for their stakes in the original ownership structures.

Here’s an ownership chart, adapted from the prospectus and adjusted for the over-allotment option which was fully subscribed.

Ownership Structure

Again, Empire State Realty Trust, Inc. is the public REIT while Empire State Realty OP, L.P. is the partnership that owns all of the properties.

In simple terms, this chart shows how little of the operating partnership that the public REIT actually owns, just 39.1%. Continuing investors hold a sizable ownership stake, nearly half of the operating partnership’s units.

These operating partnership units not owned by the public REIT or management present the opportunity. The partnership units consist of three different series, all of which are publicly traded.

series

 

These partnership units are economically identical to shares of Empire State Realty Trust, Inc., and will receive the same distributions. From the press release announcing the listing of the units:

“The operating partnership units are entitled to the same distributions on a per unit basis as ESRT Class A shares. However, they are non-voting securities with significantly less trading volume than ESRT Class A shares. An operating partnership unit is exchangeable for cash or shares of Class A common stock, on a one-to-one basis, at the Company’s election generally commencing on October 1, 2014.”

The only substantive difference between these operating units and shares of the REIT is voting rights, and the fact that they can be exchanged at the REIT’s option. Because their economic value is identical, the prices of these operating units ought to track the prices of the REIT very closely, with perhaps a small discount for the lack of voting rights. Instead, the units are currently trading at a substantial discount to Empire State Realty Trust, Inc.’s share price.

units

Discounts on the operating units range from nearly 7% to nearly 15%, based on last trades. Trading in the units has been erratic, with the Series ES units changing hands at $82.00 on October 9 and 10, roughly six times the value of the the REIT’s shares.

While the current discounts offered may be attractive, a larger opportunity could arise when the lockup period on these units expires. Holders of the Series ES, 60, and 250 units are currently prohibited from collectively selling more than the greater of 1.1 million units or $40 million worth of Series ES units, and their same proportional holdings of the series 60 and 250 units. $40 million worth of Series ES units equates to 3.08 million units at the REIT IPO price of $13. There are 46.22 million Series ES units outstanding, so owners may sell 6.67% of their Series ES, 60, and 250 units are any time.

The next substantial lockup expiration comes 180 days after the IPO, when owners may sell up to 50% of their holdings. Lockup restrictions expire completely after one year. I’ve made a simple chart to summarize the lockup calendar.

lockup

 

Presently, only a little more than $60 million worth of operating units can be sold, but this amount will balloon to over $450 million at the beginning of April, 2014. If the market is suddenly flooded with units, the discounts to the REIT price may blow out.

Investors should monitor the trading prices of these operating partnership units in order to take advantage of potential market dislocations caused by motivated sellers or an influx of newly tradable units. Investors who are bullish on Empire State Realty, Inc. could simply buy whichever operating unit offers the biggest discount to the REIT, while investors who are agnostic or bearish on the REIT could easily hedge the trade by purchasing the operating partnership units and shorting the REIT shares.

I must emphasize that the operating partnership units trade at extremely low volumes, and investors should exercise caution in buying or selling.

No position, but monitoring the situation.

Kinbasha Gaming International’s Extreme Leverage is Both Risk and Opportunity – KNBA

I’ve run across a company with an unusual amount of potential. Before anyone gets too excited, I mean as much potential for disaster as potential for extraordinary returns.

Kinbasha Gaming International is incorporated in Florida, but operates exclusively in Japan. The US company was formed via reverse merger when a public shell company merged with Kinbasha Co. Ltd., a Japanese company in operation since 1954. Following the reverse merger with the public shell, Kinbasha CEO Masatoshi Takahama owns 62.6% of shares outstanding.

Kinbasha operates 21 pachinko parlors in Japan, 18 in Ibaraki Prefecture northeast of Tokyo, two in metro Tokyo and one in Chiba Prefecture. I must admit I was not familiar with pachinko prior to researching this company, but pachinko is apparently a very popular pastime in Japan. Think of a pachinko machine as a mix between a slot machine and a pinball machine, housed in an arcade with hundreds of others. According to the company, Japan has over 12,000 pachinko parlors, which attracted 12.6 million players and $227 billion in total wagers in 2011.

Pachinko01

 

Players launch small steel pachinko balls and attempt to trap them, earning additional balls and points as they go. Much like pinball machines, pachinko machines are often themed, incorporating popular entertainment series and characters. Players trade the points they earn for items like candy and cigarettes on the premises, or can trade special vouchers awarded for high scores for cash off-site. Wikipedia has a much more thorough explanation.

Kinbasha’s pachinko parlors are successful and produce healthy operating profit, but the company has a serious problem: its balance sheet. As of June 30, Kinbasha had $122.48 million in total capital leases, notes payable, bonds payable and accrued interest against shareholders’ equity of negative $28.08 million. Worse, $92 million of this figure is in default. This massive debt relates to an expansionary effort the company undertook in the early 2000s, during which it attempted to build and operate restaurants and hotels. The expansion was a failure, and Kinbasha began to default on its debt in 2006. The company notes that its lenders could choose to foreclose at any time, which would result in the loss of its pachinko license and a wholesale liquidation, a scenario in which shareholders would likely receive absolutely nothing.

So here we have a company swimming in debt, with the specter of foreclosure and liquidation looming. Who in his right mind would invest in this? While the situation seems dire, things are actually not as bad as they look, for a few reasons.

1. This is Japan, where debt works differently. The Japanese government’s number one fear is deflation, because of the disastrous effect it can have on a highly-indebted, demographically stagnant society. In order to reduce the chances of deflation, the Japanese government leans heavily on banks and lenders, encouraging them to restructure and extend defaulted loans, rather than foreclose. This “extend and pretend” strategy has drawbacks of its own, but it benefits Kinbasha. Though some of its debt has been in default since 2006, lenders have made no effort to begin foreclosure proceedings, and have actually forgiven some debt in restructuring deals. The company notes that its defaulted debt is subject to penalty interest rates of 14% and up, but few lenders have opted to charge the penalty rates, allowing the average rate on the defaulted notes to remain a very manageable 3.60%.

2. The company’s operating profits are sufficient to cover interest expense and to make regular principal payments on its debt. Kinbasha produced $37.1 million in operating cash flow in fiscal 2013. The company used its cash flow to reduce debt and capital leases by $9.61 million in fiscal 2013, and by another $3.91 in the first quarter of fiscal 2014. Because Kinbasha generates this kind of cash flow, the company is worth more alive than it is dead. Lenders are not stupid, and they know that receiving full principal value over several years (with regular interest along the way) is better than shutting down the show and getting a fraction of principal in a liquidation.

As I mentioned in point 2, Kinbasha’s pachinko operations generate substantial operating profit. Adjusted for a one-time gain in fiscal 2013, the company’s EBIT was $11.69 million in fiscal 2013 and $13.75 million for the twelve trailing months. Fiscal 2013’s results were affected by the the Fukushima earthquake, so I view the twelve trailing months figure as more indicative of sustainable EBIT. Interest costs for the most recent quarter were $1.71 million, which annualizes to $6.82 million. Kinbasha has net operating loss carryforwards of around $13 million, which will buy it a few more tax free years. Subtracting annualized interest expense from trailing EBIT gives pro forma net income of $6.91 million.

Going with that $6.91 pro forma net income figure, let’s take a look at Kinbasha’s valuation. The company has 12.26 million shares outstanding, and a bid/ask midpoint of $0.825.

Kinbasha Valuation

 

With a market cap of only $10.11 million, Kinbasha trades at a pro forma P/E ratio of 1.46. At this point, you can probably see why I say Kinbasha has potential. Then again, I never look exclusively at a company’s equity. I always examine the valuation of the entire capital structure. Note: I have annualized the most recent quarter’s depreciation figure so as not to overstate it.

Kinbasha Valuation EV

 

From an enterprise perspective, Kinbasha looks cheap on an EV/EBITDA basis and reasonably valued based on EV/EBIT.

In essence, what we have here is a typical leveraged equity situation, just taken to an extreme. Kinbasha’s equity value is less than one tenth of its entire enterprise value, which results in a heavily compressed P/E ratio despite a relatively normal EV/EBIT ratio. Any change in the valuation ratio or the capital structure will have a disproportional effect on the value of Kinbasha’s equity because the company is so cartoonishly leveraged.

Here’s what I mean. Here is a range of values for Kinbasha’s equity, determined by holding the capital structure and EBIT equal and changing the EV/EBIT multiple.

EVEBIT Mults

 

Kinbasha’s operations must command an EV/EBIT multiple a little higher than 8.0 for the equity to be worth anything at all. (Below that, the equity is worthless and the debt is impaired as well.) But at higher multiples, more and more value accrues to the equity.

That’s one lever by which Kinbasha’s share price could increase. The market could decide to assign a higher valuation multiple, and the stock could be off to the races.

However, it’s not the only lever. The other is debt reduction. Highly leveraged firms can often create value for shareholders simply by reducing their excess debt to a manageable level. As long as the total enterprise of the firm remains the same, free cash flow from operations that is applied to debt reduction increases equity value dollar for dollar. When the equity proportion of the company’s enterprise value is so small to start, the effects can be dramatic. Compounding the effect is that debt reduction often reduces the company’s bankruptcy risk, leading to multiple expansion.

Let’s imagine that Kinbasha’s operations continue to do well. EBIT grows at 3% each year for the next three years, to $15.02 million. In each of the next three years, Kinbasha uses its free cash flow to pay down debt: $10 million this year, $11 million the next year, and $12 million the year after that. At the end of the three years, net debt will have been reduced by $33 million to $84.01 million.

Using the same valuation multiples as before except with higher EBIT and lower net debt shows massive potential increases in Kinbasha’s equity value three years from now.

EVEBIT Mults 3 year

 

That’s the power of leveraged equities. In Kinbasha is successful in reducing debt and maintaining/growing EBIT, its shares could double, triple or more.

Of course, that’s if things go as planned. Kinbasha’s lenders could decide to foreclose at any time, shuttering the entire operation. Or they could observe Kinbasha’s progress and choose to apply penalty rates, figuring the company could pay. That would crimp cash flow and slow debt reduction efforts.

Finally, Kinbasha itself could lose focus on debt reduction and choose to undertake another expansion. The company notes in its annual report that it would like to open another 15 pachinko parlors, three each year for five years. The company also notes this would require substantial capital, and the company will not proceed with its plans unless it can secure this capital. If the company is tempted to pursue equity financing at these levels, the resulting dilution would greatly reduce the potential returns from de-leveraging.

So there you have it. On one hand, Kinbasha is a deeply-indebted company in incurable default, relying on the mercy of lenders not to foreclose and cause a total loss for shareholders. Any decline in EBIT due to a poor economy, regulatory changes or changing consumer tastes would also destroy the equity’s value. On the other hand, you have a company with strong cash flow and ongoing debt reduction, as well as lenders with strong incentives not to upset the status quo.

A total loss on one hand, and a multi-bagger on the other. Kinbasha’s value proposition all depends on the respective likelihoods of these scenarios.

I think the chances are better than not that Kinbasha will succeed in deleveraging and will negotiate a debt restructuring with its creditors. Yet, the chances of total loss are material and this is not your ordinary equity investment. Proceed at your own risk.

No position.

 

Key Tronic Corp. – KTCC

Key Tronic Corp. is an electronics manufacturing services (EMS) provider that churns out custom parts and components by the millions. Key Tronic’s capabilities include design, manufacturing, supply chain and logistics functions through its locations in the US, Mexico and China. Key Tronic got its start as a manufacturer of keyboards, but abandoned that business in favor of serving as a supplier to the computer, automotive, medical industrial and military industries, among many others.

Key Tronic is capable of producing a staggering array of custom products through its advanced equipment and processes. A few examples from the company’s site:

projectorA projector.
 
sugarA blood sugar testing kit.
 
militarypowermgmt2Haven’t a clue.
 

As of June 30, the company was manufacturing products under 186 programs for 56 customers. Unfortunately, the majority of Key Tronic’s revenues are attributable to a small number of clients. In fiscal 2013, five customers accounted for 71% of sales. What’s more, the EMS industry is intensely competitive and margins are low. Gross margins for the trailing ten fiscal years averaged just 8.63%. Operating margins averaged just 3.03%.

If I haven’t scared you off yet, there is also a lot to like about Key Tronic. Despite operating in a challenging industry, the company has an impressive history of revenue and earnings growth. From fiscal 2003 to fiscal 2013, revenues rose at an annual rate of 10.7% and operating earnings grew at 21.4%. ROE averaged 14.3% and book value per share compounded at 13.7%. Recent results show rising margins. In fiscal 2013, Key Tronic achieved an operating margin north of 5% for the first time in at least a decade.

income statement

Historical free cash flow looks bad, but this is often the case with consistently growing companies. Increased revenues require additional investment in working capital, which depresses operating cash flow. The absence of free cash flow is not a concern, so long as investment in working capital continues to be profitable and the company’s ROE remains strong.

Key Tronic’s balance sheet is the healthiest it has been in a decade. The company used its strong 2013 free cash flow to pay off all debt and build a healthy cash cushion. The company’s current ratio and equity-to-assets ratio are the healthiest they have been at any point in the last decade.

Balance sheet

Subsequent to quarter’s end, Key Tronic purchased Sabre Manufacturing for $5.1 million in cash. Sabre is a metal fabricator located near to Key Tronic’s Juarez, Mexico plant. The company notes the acquisition will enable it to expand its service offerings to clients and will be immediately accretive to earnings.Key Tronic’s facilities in Mexico are valuable strategic assets as cost inflation makes Chinese manufacturing less competitive than it once was. Mexico’s proximity to US consumers and low energy costs combine to make Mexico a more attractive manufacturing location day by day.

For all Key Tronic’s historical success, the market is taking a dim view of the company’s prospects. Shares are off 18% from the yearly high set just two months ago. Perhaps the market is right, and advances in technology and changing consumer tastes will halt Key Tronic’s growth and hurt profitability. The PC industry is in the doldrums and 3D printing threatens to usher in a small-scale manufacturing boom. However, PC components are only one of Key Tronic’s many business lines, and the company has years to replace any lost revenue. PC sales have been in decline for some time now, yet last year’s revenues were a new record for Key Tronic. And while 3D printing will continue to advance, the technology is still a very long way from large-scale commercial viability and an even longer way from competing with high volume producers like Key Tronic. The market is discounting very long-term nebulous trends as if they were imminent threats to Key Tronic. Also, the market is completely ignoring the company’s recent balance sheet transition and the company’s excess cash position. Here are figures based on today’s closing price and ignoring the Sabre transaction.

Valuation

Key Tronic looks cheap, particularly on an EV/EBIT basis. Healthy, growing firms with zero debt do not routinely trade at a 5.5x multiple. I don’t know what will change the market’s mind, but I suspect it will change. Key Tronic does not deserve such a meager multiple and I expect the current depressed valuation will not last.

No position.

Bank of Utica is Very Safe and Very Cheap – BKUT/BKUTK

Bank of Utica is an 86-year old institution doing business in upstate New York. The bank operates only a single branch in downtown Utica, yet its balance sheet holds $912 million in assets and $727 million in deposits against $155 million in equity capital. Bank of Utica is controlled by the Sinnott family through a controlling stake in the bank’s voting shares.

Bank of Utica follows an unusual strategy. Most banks take deposits and originate loans, making their income on the interest rate spread, less loan losses. This process requires a host of loan officers and staff and all the associated salaries, office space, software and compliance costs. It also requires ongoing monitoring and management, plus additional expenses when a portion of the loan book inevitably sours.

Bank of Utica doesn’t bother. The bank takes deposits, then turns around and buys liquid debt securities like treasuries, municipal bonds, mortgage-backed securities, foreign bonds and others. Nearly 70% of these securities have maturities of three years or less, which greatly reduces interest rate risk. The yields on these assets may not be as robust as the yields on loans the bank could originate, but their credit risk is extremely low.

Bank of Utica does originate and run a small book of commercial, personal and real estate loans, but the loan origination business is clearly not the bank’s focus. For example, the bank’s only first position mortgage product is a 15 year fully-conforming loan at 4.95%, fully 1.50% above the national average. Bank of Utica will originate loans, but only opportunistically and on its own terms.

At quarter’s end, Bank of Utica’s net loan book was $47 million. Its securities holdings were $848 million. Interest on these securities accounted for 92% of Bank of Utica’s interest income for the first half of 2013.

Bank of Utica’s credit risk is extremely low due to its conservative investment policies. On top of this, the bank is highly over-capitalized. Bank of Utica’s common equity ratio is 17.04%. This figure includes nearly $20 million in unrealized gains, some of which are likely to disappear if interest rates rise. Excluding unrealized gains entirely, the bank’s common equity ratio is still a strong 15.20%.

Despite its conservative investing and over-capitalized balance sheet, Bank of Utica still manages good returns on assets and equity. For the last four quarters, the bank averaged a 10.00% annualized return on equity, and an average annualized return on assets of 1.60%. A big reason for these solid returns despite minimal leverage is Bank of Utica’s efficiency. With minimal staff and need for infrastructure, the bank’s operating expenses are very, very low. Operating expenses ate up only 25% of the bank’s net interest income over the past year, an almost absurdly low figure. Many banks struggle to keep this figure below 70%.

Bank of Utica’s geographic home is not the nation’s fastest-growing region, but the bank has still managed to grow its deposit base at a modest rate. Over the last five years, deposits grew at an annual rate of 3.9%. Deposits are the “fuel” that allow a bank to invest in additional earning assets and increase the bottom line.

Bank of Utica’s credit quality, capital position and efficiency are all high, but its valuation is not. The bank has two share classes outstanding. BKUT is the voting share class and is majority-owned by the Sinnott family. BKUTK is non-voting. There are 50,000 voting shares and 200,000 non-voting for a total of 250,000. The voting shares trade at a slight premium to the non-voting. I can’t imagine why an investor would pay up for the voting shares with no possibility of exerting influence, so I’ll concentrate on the non-voting shares, which last had a bid price of $420.00.

Bank of Utica has common equity of $621.76 per share, giving the non-voting shares a price to book ratio of just 67.6%. Trailing earnings per share are $63.24 for a trailing P/E of 6.64. These ratios are far too low for a bank of this quality and profitability.

Bank of Utica does not release financial statements on its website. If anyone is wondering where I found them, try here. When it comes to investing in banks, FDIC call reports are your best friend!

No position.