Value Portfolio

GrafTech International. On January 8, 2014, the Milikowsky brothers (Daniel and Nathan), who collectively own an 11.2 percent stake in this steel-centric materials company, filed an amended 13-D that says the following:

“The Reporting Persons and their representatives intend to engage in discussions from time to time with the directors and management of the Issuer, other stockholders of the Issuer and other relevant parties with respect to the Issuer. These discussions may include, without limitation, matters relating to the composition of the board of directors of the Issuer, its financial condition, business, assets, operations, capital structure, strategic plans.

Depending on various factors, including, without limitation, the Issuer’s strategic direction and financial position, actions taken or failures to act by the board of directors of the Issuer, price levels of shares of Common Stock, market conditions and general economic and industry conditions, the Reporting Persons may take such actions with respect to their investments in the Issuer as they deem appropriate, including, without limitation, purchasing additional shares of Common Stock or other financial instruments related to the Issuer or selling some or all of their beneficial or economic holdings, engaging in hedging or similar transactions with respect to securities relating to the Issuer, engaging in a proxy contest .”

The Milikowskys received their shares back on November 30, 2010 as part of GTI’s acquisition of Seadrift Coke and G/C Electrodes. In a December 10, 2010 13-D filing, the Milikowskys announced that they had signed a standstill agreement with GrafTech, locking up their shares and prohibiting them from discussions with management in the context of their shareholder status for a period of six months after a Milikowsky-nominated director was no longer present on GrafTech’s board of directors.

As part of the Seadrift acquisition, Nathan Milikowsky was appointed to GrafTech’s board of directors on December 9, 2010 and remained on the board until May 14, 2013 when the company did not re-nominate him for another one-year term. According to a New York Times article, the board decided to oust Milikowsky because it suspected him of leaking confidential information to a hedge fund. Nathan Milikowsky denies the charge, but admittedly was a vocal critic of how the company was being run and campaigned for Shular’s ouster.

On January 21^st, GrafTech announced that Craig Shular was retiring as CEO effective immediately, but would remain executive chairman for the remainder of 2014. Since Shular is only 61, this retirement appears abrupt and somehow related to the Milikowskys’ newfound shareholder activism. The new CEO is Joel Hawthorne, who was the head of the company’s relatively-small buy fast-growing Engineering Solutions division.

On January 24^th, the Milikowskys announced in another 13-D filing that they would be nominating “certain individuals” to GrafTech’s board for election at the annual shareholders meeting on May 14^th.  A proxy contest is likely and litigation is possible, since the filing says GrafTech believes the Milikowskys are still bound by the original standstill agreement, whereas the Milikowskys believe the standstill agreement lapsed six months after Nathan resigned from the board in May 2013.

How this boardroom conflict resolves itself is anybody’s guess, but I believe the conflict will push GrafTech’s stock price higher because both sides will be working hard to prove that they are doing everything possible to enhance shareholder value. On the same day as Shular’s retirement, the company issued a press release re-iterating its commitment to improve cash flow by $100 million over the next two years and cut costs by $75 million annually by axing 20% of its work force and closing two inefficient graphite electrode plants and a machine shop. We are sure to hear what further corporate improvements Nathan Milikowsky (a seasoned steel executive) plans for the company in the days ahead and I think GrafTech stock will react positively.

The entrance of Nathan Milikowsky into the mix with the potential for a proxy fight makes GrafTech even more interesting to me and consequently I am raising the buy-below price for GrafTech to $12.

Hill-Rom Holdings.  Expectations have been very low for this hospital bed and surgical instrument company, but the company’s first-quarter financial report somehow managed to miss already-pessimistic analyst estimates. In fact, it was the first time ever that quarterly results missed the company’s earnings guidance since the company began offering guidance two years ago. According to straight-shooting CEO John Greisch:

We are clearly disappointed. Following a weak fourth quarter, we were surprised by the sequential weakness in orders and revenue here in the first quarter. Economic uncertainty for our customers continues to impact the timing and the level of capital spending for our key product categories. Most of the weakness we are seeing in our capital business is in our high margin med-surg [hospital bed] category. So not only were orders and revenues weaker than expected, but our margin mix suffered as well.

As a result of all these factors, we have lowered our full-year revenue and earnings expectations from our original guidance.

It’s difficult to spin that statement positively, but Greisch assured investors that the weakness was not company-specific and Hill-Rom’s market share did not decline. The problem lies with hospital customers that continue to reduce or delay capital purchases in the wake of uncertainty surrounding reimbursement rates, patient levels, and the implementation of Obamacare. This seemingly endless healthcare uncertainty has to end at some point, right?

The good news is that the company announced a new restructuring program that will axe 350 jobs, generate $30 million in annual cost savings, boost free cash flow, and eventually increase earnings per share by $0.35. The poor profit margins of the first quarter are an anomaly that Greisch does not expect to be repeated in any of the remaining three quarters of 2014. So, the worst is definitely behind the company. Second-quarter results should show “significant improvement” compared to the first quarter. Full-year earnings are now expected to come in around $2.23 per share, which translates into a PE ratio at the current stock price of $36.87 of 16.5 times earnings, which is actually cheap given that Hill-Rom’s 2014 earnings are likely to mark the trough of the business cycle.

Furthermore, the company accelerated its repurchase of stock to one million shares at an average price of $42 per share ($42 million total) — one of the highest quarterly rates of repurchase at any point over the past several years. And the company’s strong balance sheet means that the poor Q1 operating results will have no effect on the ability or willingness of Hill-Rom management to finance a value-creating acquisition if one becomes available.

Lastly, new CFO James Saccaro comes to Hill-Rom from highly-regarded Baxter International and should be a valuable addition to the effort aimed at turning things around. I’m optimistic that the future will be better than the recent past and am frankly amazed that even after the horrible first-quarter results, the stock is still trading at $36.87 – 8.3% above Roadrunner’s initial purchase price of $34.06!

It just goes to show that investor expectations have been rock-bottom for so long that the stock is in very strong value-investor hands and will likely not fall much lower.  And, when the healthcare industry finally turns the corner and hospitals open up their purse strings, Hill-Rom’s cost structure will be so lean and mean that profit margins will skyrocket and the stock price will perform very well. All that is required is more patience, which I am more than willing to have because patience is what makes value investing so successful.

Momentum Portfolio

Ocwen Financial. The mortgage-servicer’s stock has sold off 22.5% since hitting an October all-time high of $60.18 on regulatory concerns. On December 19^th the Consumer Financial Protection Bureau (CFPB) ordered Ocwen to provide $2 billion in mortgage-loan principal reductions to homeowners with underwater mortgages (debt owed is more than value of house). Sounds like a crushing penalty, but in fact Ocwen is not on the hook for any of this principal write-down because it merely services the mortgages – it doesn’t own them. Bondholders of the mortgages will be the real losers. The settlement did not require Ocwen to admit any wrongdoing. According to Fitch Ratings, the principal reductions are something that Ocwen might have done on its own anyway based on its Shared Appreciation Modification (SAM) program, which reduces the principal owed by the homeowner in exchange for Ocwen receiving a share of any price appreciation the house experiences. The SAM program was big winner for Ocwen in 2013, which was the best year for home-price appreciation since 2005.

In addition, the CFPB ordered Ocwen to refund $125 million to 185,000 borrowers who suffered foreclosures of their homes during 2009-2012 based on phony robo-signed foreclosure documents. Ocwen will only pay $66.9 million of the refund, with the remaining $58.1 million the responsibility of the companies that sold the mortgages to Ocwen (i.e., Litton Loan Servicing and Homeward Residential). Virtually all of the $66.9 million Ocwen must pay had already been reserved in its second-quarter income statement from last August, so there will be no future hit to the company’s earnings. Even better, Ocwen is not required to withdraw any of the phony foreclosure documents it filed with recorders of deeds. All in all, the settlement does very little damage to Ocwen and removes a great deal of regulatory uncertainty.

On January 10, new mortgage-origination rules issued by the CFPB became effective that require mortgage lenders to verify a borrower’s ability to pay (ATR) before making a loan and provide lenders a safe harbor from being challenged on ATR if the loan meets the definition of a “qualified mortgage” (QM), which prohibits no-doc liar loans, negative amortization, interest-only payments, balloon payments, terms exceeding 30 years, or more than 3% of loan amount in processing fees.

Both the ATR and QM rules are expected to make new home mortgages harder to obtain, which could actually benefit Ocwen much because it is a servicer of pre-existing loans, which are less likely to be refinanced with a new loan thanks to the stricter requirements (higher interest rates expected in 2014 also make refinancing less likely). The more people who rent homes rather than buy them also benefits Ocwen indirectly through its Altisource Residential (NYSE: RESI) affiliate, which converts foreclosed homes into rental units.

Lastly, the new mortgage rules – combined with more stringent capital ratio requirements — are hitting the large banks hard, making them eager to shrink their home-mortgage exposure by selling off mortgage servicing rights (MSRs) to third-parties like Ocwen. On January 22^nd, Wells Fargo (the largest U.S. home lender) announced that it was selling 2% of its residential servicing portfolio to Ocwen. The portfolio consists of 184,000 mortgages with a collective principal balance of $39 billion. More mortgage loans to service means more fees to collect. Ka-ching!

An Ocwen insider purchased 1000 shares at $52.44 back in November. On December 3^rd, the company hosted its annual investor day meeting and CEO William Erbey’s presentation (page 4) was very bullish in emphasizing Ocwen’s four key strengths:

1. Capture adjacent revenue through its “strategic allies” (AMCC, ASPS, HLSS, RESI)
2. Low operating costs through the use of Indian call centers and artificial intelligence
3. Low cost of capital through accretive share issuances at increasing price-to-book ratios
4. Low effective global tax rate of 5%-10%
5. Minimizing interest-rate and pre-payment risk

The recent selloff in Ocwen’s stock price presents an excellent buying opportunity given that the company’s earnings are expected to double in 2014.

PriceSmart. Since hitting an all-time high of $126.64 on November 29^th, the Costco of Latin America has suffered a 26% price decline on fears of slowing emerging-market growth. As Zacks noted in early December:

PriceSmart seems to be witnessing a declining comps trend recently due to slowing consumer traffic. November’s comps were well short of 8.8%, 9.1% and 8.9% in October, September and August, respectively. In fact, since October, comps have gone below the 9%+ growth witnessed every month since April this year and were also much below PriceSmart’s past trend of double-digit growth.

In the first-quarter conference call, the company argued that it is focused on total sales growth and not same-store sales (SSS) growth, because as it adds more stores in a country some cannibalization of sales from the pre-existing stores is inevitable. So, lower SSS growth could actually a healthy sign of expansion.  

First-quarter financials were positive, with revenues up 13.1% and earnings up 7.6% year-over-year. However, analysts were expecting more and both figures missed estimates. The main cause of the sales miss was weaker-than-expected electronics sales – primarily televisions. With the 2014 World Cup in Brazil starting on June 12^th, television sales are expected to perk back up because World Cup soccer for Latin Americans is even bigger than the Super Bowl is for the U.S.

To some extent, consumer spending in PriceSmart’s Central American and Caribbean marketplace is held hostage by weak retail sales in the U.S., which have remained sluggish until very recently. Historically, Latin American SSS comps lag changes in U.S. comps by six months, so PriceSmart’s sales results should start to perk up by mid-year 2014 as U.S. consumer confidence in January hit a five-month high and consumer spending is forecast to have risen 4% in the fourth-quarter of 2013 – the fastest sales pace in three years.

Outside of U.S. effects, PriceSmart CEO Jose Luis Laparte remains very optimistic about the prospects for the domestic economies served by the company, saying “they keep growing.” Trinidad and Aruba are both strong in the Caribbean, which is marred by Jamaica’s currency devaluation, and “most” of the Central American economies are “solid” except Honduras which slowed thanks to political uncertainty associated with 2013 elections.

Columbia remains PriceSmart’s most-promising new market with three stores open and a fourth on the way, but the country’s attractiveness has brought competition from France’s Exito and Chile’s Carrefour. PriceSmart says that Chile and Peru have similar demographics and spending patterns to Columbia, so expansion into these shopping-friendly markets may be in the cards.

Bottom line: PriceSmart is hurting indirectly from the retail slowdown in the U.S. and its business slowdown is not due to company-specific problems. PriceSmart is actually doing relatively well compared to some other Latin American retailers – just look at the death spiral in McDonald’s franchisee Arcos Dorados (ARCO) to see how much worse things could be. The fact remains that PriceSmart’s emerging markets continue to grow at a higher rate than developed markets and are set to rebound strongly within a few months’ time thanks to the World Cup and as U.S. consumer spending stabilizes and strengthens. The added growth kicker is new store openings, with plans to open at least one or two new stores per year (slide no. 5) for the foreseeable future.

Similar to Ocwen, the recent price correction in PriceSmart’s shares may soon offer a nice buying opportunity for those looking to take a position. Given the company’s continued ability to grow sales at a double-digit rate and the likelihood that growth will accelerate by midyear 2014, I am raising my buy-below price on PriceSmart to $89 per share.