Quarterly Letters

Quarterly Update

Third Quarter Summary

As we have done in the first and second quarters of this year, we modestly grew our accounts in the third quarter.  Such modest growth does begin to add up: our Equity accounts are up, on average, 8.25% through the third quarter; our Balanced accounts are up, on average, 5.79% during the same period.  We continue to search for real value wherever we can find it; while not hesitating to remain in cash as we seek investment opportunities that offer exceptional risk/reward profiles.

Relying on the Balance Sheet

In Shakespeare’s Hamlet, perhaps Polonius was too extreme when telling his son, “Neither a borrower, nor lender be”.  We all borrow money, and when leverage is employed judiciously, it’s a wonderful thing.  Our homes are most often purchased with borrowed money and it all works out just fine for the vast majority of homeowners.  But borrowing is also what typically proceeds bankruptcy filings (be they corporate or individual events).  Further, excessive debt is almost always at the center of major financial strain: speculation with borrowed funds contributes greatly to the creation of bubbles of all sorts (1929 crash and the more recent dot com debacle), corporate blow-ups (Enron, WorldCom and the currently challenging outlook for the likes of General Motors and Eastman Kodak) and major investment failures (Long Term Capital Management, where a group of professionals, including two Nobel laureates in economics, levered up and lost big).  People simply do not invest “hard earned dollars” in the same fashion they do borrowed ones (which may be forgiven in some type of “work-out”). 

Our aversion to an over reliance on debt financing directly affects how we invest your money.   In fact, if a novice were to ask us for one simple rule to adhere to as he/she embarked on a strategy to invest in individual companies, we would say stay away from companies who rely heavily on debt financing and pursue those with strong balance sheets.  In other words, focus first and foremost on a business’s staying power and ability to survive regardless of the general economic or industry specific climate by referencing its balance sheet (including off-balance sheet items, such as unrealized real estate appreciation).  In fact, these companies often are able to thrive (in pursuit of long-term value creation), by being able to opportunistically purchase assets at distressed prices during industry slowdowns/depressions.  We’ve looked at a lot of companies recently that do in fact generate solid free cash flow.  However, what is interesting to us is how often the debt of a company is not factored into the analysis in some manner to effectively account for this real corporate liability.   

For instance, Anheuser-Busch Cos. Inc. (AB) generates about $1.9 billion in free cash which translates into a free cash flow yield of about 4.5% ($1.9 billion divided by its enterprise value of approximately $43 billion).  However, AB carries net debt of about $8 billion.  How do we account for this debt?  Is AB really a 4.5% free cash generator?  Consider Microsoft’s (one of our holdings) cash generating abilities: roughly $14 billion in annual free cash flow divided by its current enterprise value results in a free cash flow yield of about 5.8%.  However, Microsoft possesses about $40 billion in cash and has no debt!  Even if AB’s free cash flow yield was 6%, is it comparable to Microsoft’s (assuming equally stable business models)?  We think not.  The debt must be accounted for in the analysis if one is to properly weigh the risks of investing in each company.  If we amortize AB’s debt over ten years thereby reducing its free cash by $800 million per year, it effectively takes its yield to 2.6%.  This isn’t necessarily the best way to account for the debt, but it seems reasonable to apply some method to essentially reward Microsoft’s pristine balance sheet while penalizing AB’s lesser one (even withstanding the fact that it does indeed generate lots of cash).   Another consideration: what if AB has to refinance at an inopportune time, i.e., interest rates are high?  Truth be told, AB is a solid company with huge cash generating abilities, which surely contributed to Buffet’s Berkshire buying its depressed shares earlier this year.  In our opinion, however, when compared to Microsoft (another mature cash generating machine), AB’s the far lesser investment candidate.

In the company brochure we put together earlier this year, we outlined three principal ways we determine value: net asset value, private market value and going-concern value.  Whichever technique is used, the companies we invest in are typically extremely well-financed with significant cash and marketable securities and/or assets that can be readily monetized, e.g., real estate, a saleable division, etc.  Among our current non-financial portfolio holdings, 85% possess cash in excess of both long and short-term debt.  In fact, our typical non-financial holding was purchased at a price wherein the company’s net cash (defined as cash and marketable securities less long and short-term debt) equaled about 30% of its total market capitalization.  Moreover, these companies have an average equity to net assets ratio of approximately 70%, indicating an absence of excessive liabilities all together (debt and other liabilities).

Of course, companies with cash hordes can destroy value over time through inferior business models and/or poor execution strategies.  Similarly, companies relying on debt that can consistently achieve a return on investment in excess of their cost of capital can create value all day long.  That said, we will continue to focus on reducing investment risk by seeking out well-capitalized companies with exceptionally strong balance sheets that possess a multitude of value-enhancing strategies and do not have the added burden of undue debt service requirements.               

Our Three Top Purchases in the 3rd Quarter

Pier 1 Imports Inc., PIR.  Pier 1 is a nationwide specialty retailer of a wide variety of furniture, decorative accessories, dining and kitchen products, bed and bath products, and seasonal accessories.  Pier operates approximately 1,200 stores under the Pier 1 Imports and Pier 1 Kids brands.  Pier has spent over 40 years building an organization that specializes in direct importing.  Products are produced in their native countries and often brought directly from villages.  Pier has an experienced senior management team.  Marvin Girouard, who has served as Chairman and CEO since March 1999, has been with Pier for 29 years.  The company’s six executive vice presidents have been with Pier for 22 years, on average.  Pier is a turnaround for sure, but it is led by an experienced management team with an enviable retail track record by any measure.

Although Pier has been able to maintain annual revenue at approximately $1.8 billion over the past several years, profitability has recently declined due to missteps in its merchandising mix and advertising campaign (basic blocking and tackling for a retailer).  Same store sales (comparing current store sales with prior period store sales) have been largely negative during the past eighteen months.  Pier has taken steps to resolve these mistakes (e.g., eliminating certain product offerings, changing its advertising direction and rolling out its first catalog) and is awaiting results of the upcoming holiday season. 

At the time of our purchase of this turnaround situation, the company’s shares were selling at an Enterprise Value to Sales (Enterprise Value is defined as market capitalization plus debt less cash) of approximately 0.6x, near its absolute historical trough.  During the past ten years Pier has traded between an average high EV/Sales of about 1.0x and an average low EV/Sales of about 0.7x (thus at 0.6x we paid 85% of its average low valuation during the past ten years).  Pier had a solid balance sheet with net cash of about 14% of market capitalization at the time of purchase and has a history of producing strong free cash flow (actual cash left over after capital expenditures).  Management owns 5% of the company, perhaps contributing to their shareholder friendly actions: since FY ’00 the company has raised its dividend from $0.12/share to $0.40/share and bought back 24 million shares. There are trade-offs for attaining the pricing we did, and candidly, Pier has a tough road ahead of itself in righting its retailing.  If the company can simply get back to 70% of its historical margins, the investment should work out just fine.   

O’Charley’s Inc., CHUX.  O’Charley’s is a casual dining restaurant company that operates 340 O’Charley’s and Ninety Nine restaurants in the Southeast, Midwest and Northeast.  It offers a compelling price-to-value proposition to its customers.  In 2000, it acquired the upscale Stoney River Legendary Steaks concept, which now operates six units.

O’Charley’s has been struggling with weak sales and decreasing margins since 2003.  Higher food and labor costs and higher gasoline prices have been cited as key reasons for the underperformance.  Management has been working towards turning the operations around.  Today, we see an investment in CHUX as we did last year…as a net asset value play.  CHUX owns much of the land, building and equipment where its restaurants are situated.  We applied replacement cost values to the various combinations of O’Charley’s and Stoney River restaurant units (the various combinations of assets owned include:  1. land, building and equipment; 2. building and equipment; and, 3. equipment only).  We then added the value of the Ninety Nine chain, conservatively assuming that it is still only worth the price paid by O’Charley’s through a competitive bidding process in January 2003, even though Ninety Nine has increased its cash flow considerably since the acquisition.  We also added the value of its headquarters, which includes its commissary operations.  After deducting its net debt, we arrived at a value of about $16 per share.  Our average purchase price is below this net asset value.  With an asset value of $16, we are essentially receiving a free option on the turnaround of the restaurant business.  If management is unsuccessful with the turnaround, we are confident that a strategic or financial buyer will see the value of the O’Charley’s assets resulting in a very favorable outcome given that a purchase price would likely include a franchise value in addition to its hard asset value.

SeaChange International, Inc., SEAC.  SeaChange develops and manufactures digital video systems used by cable television providers and television networks.  SeaChange operates through three business units: Broadband Systems, Broadcast Systems, and Services.  The Broadband segment markets digital video storage and playback hardware and software to cable television providers, such as Comcast and Time Warner.  This bundled hardware/software package is the infrastructure that enables cable television providers to offer Video-On-Demand services wherein a virtual library of content is a few push buttons away.  SeaChange’s Broadcast unit sells digital video recording, archival, and playback systems to television networks.  The company’s Services division provides software development, installation, training, and maintenance services.

We purchased SeaChange because it is extremely well-capitalized and allows us an opportunity to invest in what we believe to be a compelling long-term growth story – VOD, video-on-demand.   We took advantage of a major sell-off in the shares over the past several months (the company missed Wall Street’s quarterly earnings estimates) allowing us to buy the company when its cash and investments represented approximately 46% of its market capitalization at the time of purchase.  The company is free cash flow positive as well.  SeaChange’s net cash position provides us reasonable assurance that it can operate and seek attractive investments even during periods of lumpy sales. 

At the time of purchase, SeaChange was trading at a significant discount to a recent private market transaction that underscores the value proposition.  C-COR Inc. paid 1.5x Enterprise Value/Sales to purchase nCUBE, a privately-held direct competitor of SeaChange (and that’s after discounting the stock side of the purchase price by 30% given that a combination of stock and cash was used in the transaction).  We purchased SeaChange shares at an average of 0.8x Enterprise Value/Sales, a 47% discount to the nCUBE deal.  We hired a highly knowledgeable industry insider who indicated that SeaChange is well-managed and highly regarded in the industry.  It is one of the top two companies standing in the “technological middle” of a larger VOD rollout among the cable operators.  Finally, SeaChange’s CEO and Chairman, William Styslinger, owns 10% of the company and recently acquired 91,000 additional shares in an open market purchase. 

Once again, we want to thank you for the trust and confidence you have placed in us.  We will continue to watch what the market appears to make cheap, diligently research those ideas and, in the end, select our investments cautiously.  If you are aware of individuals who would benefit from our approach, we would welcome the opportunity to talk with them.  You can always direct such individuals to our website, www.roumellasset.com.  Additionally, as we have mentioned in the past, we have lots of terrific restaurants in our neighborhood and would be happy to take you and a friend(s) to lunch to discuss our investment approach.  As always, please feel free to contact us directly about your account.

Performance Disclosures:

Investment Strategy:  Roumell Asset Management, LLC (“Roumell”) employs a value investment strategy in managing client portfolios.  Roumell Equity accounts can have up to 100% of assets invested in stocks; Roumell Balanced accounts typically have 65% of their assets allocated to stocks (though the figure can range from 50% to 80% depending upon the needs of the client).  

Calculation of Rates of Return:  First and foremost, readers of this letter should recognize past performance is no guarantee of future results.  Returns are reported net of all management fees and applicable trading costs; annualized returns are the result of linking quarterly returns (only accounts present for the entire quarter are included in a given quarter’s performance composite); returns are time-weighted; returns reflect reinvestment of dividends and other earnings.  These returns are based on a composite of Roumell’s accounts and therefore were not necessarily duplicated in any specific account.  These consolidated performance numbers include all of Roumell’s fully discretionary accounts within each category.  Discretion is defined as the ability of the firm to implement its intended investment strategy without restriction.

Inclusion of Accounts:  Currently, in the performance calculations for Roumell Equity, there are 257 equity portfolios totaling $85.1 million.  This represents 54.9% of total portfolios and 47.9% of total dollars under management.  Currently, in the performance calculations for Roumell Balanced, there are 137 balanced portfolios totaling $70.1 million.  This represents 29.3% of total portfolios and 39.4% of total dollars under management.  A complete list and description of the firm’s composites is available upon request.

Comparative Indices:  Because Roumell utilizes an all-cap (large, medium and small companies) investment strategy, there is no perfect index for comparison purposes.  We have included two equity indices and two balanced benchmarks to allow readers to judge our performance against benchmarks that collectively offer good comparative illustrations.

Additional Disclosures:

The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable.

Back to Quarterly Letters