Munger on PlanMaestro

Charlie does not believe in master plans! I should not think that everything is about me (how I hate that song) but it is funny and insightful

And there has never been a master plan. Anyone who wanted to do it, we fired because it takes on a life of its own and doesn’t cover new reality. We want people taking into account new information.

It wasn’t just Berkshire Hathaway that had this attitude about master plans. The modern Johns Hopkins [hospital and medical school] was created by Sir William Osler. He built it following what Carlyle said: “Our main business is not to see what lies dimly in the distance but to do what lies clearly at hand.”

Look at the guy who took over the company that became IBM. At the time, it had three equal sized business: [a division that made] scales, like those a butcher uses; one that made time clocks (they bought this for a block of shares, making an obscure family very rich); and the Hollerith Machine Company, which became IBM. He didn’t know this would be the winner, but when it took off, he had the good sense to focus on it. It was enlightened opportunism, not some master plan.

I happen to think great cities develop the way IBM or Berkshire did. I think master plans do more harm than good. Anyway, we don’t allow them at Berkshire, so you don’t have to worry about them.

via Mungerism: Wesco 2004 Annual Meeting.

Turnaround Cases: Premier Exhibitions Part 1 ($PRXI)

A great investment opportunity occurs when a marvellous business encounters a one-time, but solvable problem. You just need to know the business to recognize this – Warren Buffet

So after reviewing some situations where a turnaround was threatened by tough issues that were not completely on management’s control, we now move to situations where the core business is healthy but the performance has been compromised by solvable issues. This is usually the result of bad luck (it sometimes happens), internal issues brought upon themselves by incompetent leadership or by management’s inability to rise to a solvable new challenge.

What is the point of having a blog and end discussing examples with a strong consensus. Instead I am going to propose a controversial case: Premier Exhibitions (PRXI). You probably never heard that name before but you probably heard the names of its two exhibitions: Titanic and Bodies. Both are hit shows not only in the US but around the world and both continue to attract crowds. Bodies shows cadavers treated with a technical process that makes them viable for exhibition and Titanic shows pieces recovered from the wreckage. Someone appropriately used the adjective macabre to describe the situation however that is not necessarily bad. As Peter Lynch once wrote

Something that makes people shrug, or turn away in disgust is ideal – One Up on Wall Street

If you agree with that statement then Premier may be your kind of stock. This is a company well known for value investors since Mark Sellers, a respected hedge fund manager, is its majority shareholder. There are several articles on Premier’s good economics and the potential value of its Titanic assets so I am just going to make the introductions. Dear reader, here is Premier Exhibitions:

• Mark Sellers pitch in the Financial Times
• Value Investors Club (free subscription)
• Value Investing Congress Blog
• Fat Pitch Financials

Most of these articles were written before Premier hit an earnings bump. That bump’s cause, consequence, solution and opportunity are going to be the topic of several posts, but as an appetizer let me show you the historic stock price:

Wow, that is what I call a rise and fall. You just have to go through Yahoo’s board to retrace the story and is really something. You can read how early adopters bought the story of the unrecognized Titanic assets, were joined later by growth investors that valued the successful new Bodies exhibition, how pricing got out of hand with momentum investors pumping pie-in-the-sky projections and the sudden collapse. Now it had gone full circle becoming a value stock again: I recommend you to check the Complete Growth Investor podcast on Premier and get their free report. This is indeed the story of an Icarus growth stock.

The collapse has wrongly been attributed to the 20/20’s attempt on character assassination of Bodies –that I still recommend to watch, also here is Premier’s response - and the settled investigation of the bodies’ origin. To the contrary, both were short term attendance boosts because as we know there is no such thing as bad publicity.

The reason for the collapse was simpler: an outsized and undisciplined organization built by an entrepreneurial one man rule seeking growth on too many fronts without the needed processes to manage that growth. This is a story repeated time and again that has been the subject of some best sellers like “Inside the Tornado” and “Build to Last”. I do not offer these books necessarily as testaments of good research but as witnesses of the topicality of the challenge.

All investing is risky and growth stocks have their particular set of challenges. Their stocks multiples can collapse fast when earnings or growth disappoints. And the probability of disappointing is higher than people think: these are some Bain and Co. estimates of success for growth initiatives

If this is not material for a good series, I do not know what is. It certainly has drama. In the next part we are going to address the story of Premier’s collapse and discuss if it is solvable.

Long PRXI

Turnaround Lessons: When the tough gets going

I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over – Warren Buffett

The Eastman Kodak case should be an eye opener. Some turnarounds are just too tough.

So I decided to go over my watch list and highlight the ones that look difficult and not ready for the prime list. They are guilty until proven innocent: they have to show that things are improving according to plan, not from a stroke of luck, before considering them again. Then went through the list and tried to classify the reasons why I disliked them:

• End of a Demographic Trend (Gap)
• Technological Disruption (Kodak)
• Power Shift in the Value Chain (Newell Rubbermaid)
• Deteriorating Industry (Mesa Airlines)
• Threat of New Business Models (Dell)
• Second in a Winner Takes All (Yahoo)
• Quantity, Quality and/or Structure of Debt (Anthracite Capital)
• Marginal Player (too many to mention)

Will leave the point of quantity, quality, and/or structure of debt for maybe a future post since it merits its own discussion. The commonality among the rest is an external threat to the core long term profitability. That makes them tough:

• Success of the turnaround plan it is not entirely dependent on the company
• Even good management performing at its best could fail

To enter new industries, launch new products, develop new capabilities, change business models is high risk revolutionary change. Here are some Bain & Co estimates on the probability of success of different radical solutions to a deteriorating core business

The prospects do not look so bright when you consider that for most of these companies, failure means their core business declines into oblivion. Also some of them could not have those hidden capabilities, clients or platforms to leverage. Maybe a good financial position like Dell’s or Yahoo’s can give them some time to experiment and look for alternatives. But from the point of view of an investor even if the plan is successful the company will probably be a follower in the new industry, product, segment, business model: a shadow of its former self.

So the downside is not that well protected, the probabilities of success are not that good, and the upside will probably be limited: does not look like the recipe for successful investing. This is an area where I think value investors have to be careful. The first time I heard the term value trap I could not understand what it meant.

I think I can now define one specific situation for a value trap: a good company with a deteriorating profitability driven by external forces with a good management destroying value because they are fighting with a plan against the odds with the hope that it will succeed. Maybe this framework could be the start for a checklist on recognizing potential value traps and require extra margin of safety from them.

Did I depress you enough? Over the next posts I hope to brighten the spirits.

Turnaround Cases: Eastman Kodak ($EK)

After a while Buffett asked everyone to pick their favourite stock. What about Kodak? Asked Bill Ruane. He looked back at Gates to see what he would say.

“Kodak is toast” said Gates. Nobody else in the Buffett Group knew that the Internet and digital technology would make film cameras toast. In 1991, even Kodak didn’t know that it was toast.

“Bill probably thinks all the television networks are going to be killed” said Larry Tisch, whose company, Loews Corp., owned a stake in the CBS network.

“No, it’s not that simple” said Gates. “The way networks create and expose shows is different than camera film, and nothing is going to come in and fundamentally change that. You’ll see some falloff as people move toward variety, but the networks own the content and they can repurpose it. The networks face an interesting challenge as we move the transport of TV onto the internet. But it’s not like photograph, where you get rid of film so knowing how to make film becomes irrelevant” – The Snowball

Maybe I gave some of you the wrong impression in my previous post. Turnarounds are not the Holy Grail so let’s start by reviewing a dog. Well OK, maybe not a dog dog but a company that I decided not to invest in given the few signs that the turnaround was turning. And that company is Eastman Kodak.

Is Kodak worth analyzing? Well it is a company that symbolizes the best of American innovation and mass marketing in the twentieth century. Kodak is even today one of the most recognized brands in the world with a book of patents that used to be the envy of every business. A great blog Distressed Debt Investing has his sight on this situation as a debt opportunity and irony of ironies, Bill Gates has invested aggressively in it.

Is Kodak toast? The short answer is I don’t know. But it is also the wrong question, we should ask on the probability of Kodak going toast. And the best way to estimate that probability is to hear the story: what management is trying to achieve:

Is your case based on Kodak’s entry into the inkjet-printer business? The new printer business is part of the thesis, which is that Kodak has introduced a technology that has the potential to disrupt the entire industry because it will be able to charge a lot less for ink cartridges — about half the current price.

What’s the rest of the thesis? It’s simple. Throughout this entire transition, during which sales from film have dropped by almost two-thirds, Kodak has continued to generate about $1 billion in free cash flow before restructuring charges. That’s because as film sales have dropped, its graphic-communications and digital businesses have improved. Investors today are valuing $1 billion of free cash flow at $14 billion to $15 billion in the marketplace. But Kodak’s market value is just $6 billion. Why is it so low? Because for each of the past four or five years, Kodak had cash restructuring costs — for environmental-cleanup liabilities, for the costs of closing plants, for severance when there were layoffs — that have totalled roughly $600 million to $700 million per year at the peak. There will be $500 million to $600 million in additional restructuring charges this year related to closing film plants and the sale of Kodak’s health-care business. Next year, there will be no restructuring charges. Unless the business gets a lot worse in the next year or so, Kodak will do $1 billion to $1.2 billion of free cash flow in 2008. And if that happens, the stock should be up 50% to 100% in that period of time. – Bill Miller 2007

So this is a story of new divisions (graphic communications and digital) taking the torch from the traditional film division that is being milked down. These are the divisions

• Film Product Group is the remaining traditional film business, that will continue to decline. The decline rate will depend on the speed of the transition to digital in both the consumer and film markets.
• Consumer Digital Imaging Group includes digital still and video cameras, digital devices such as picture frames, snapshot printers and related media, kiosks and related media, consumer inkjet printing, Kodak Gallery, and imaging sensors. CDG also includes the licensing activities related to intellectual property in digital imaging. Expenditure will likely be down until the recession ends and if past performance indicates future performance it is unlikely to carry the whole group
• Graphic Communications Group serves a variety of business customers in the creative, in-plant, data center, commercial printing, packaging, newspaper and digital service bureau segments. Products and related services include workflow software and digital controllers; digital printing including equipment, consumables and service; prepress consumables; prepress equipment; and document scanners.

Here is a hint, the type of turnaround is critical. A turnaround based on closing or selling cash consuming divisions and cost cutting is usually much simpler than one that is based on new products, debt restructuring or business model innovation. Therefore, this is a difficult turnaround that merits a guilty veredict until proven innocent. What surprises me is that Bill Miller said so himself

There aren’t many companies that have been terribly successful making big technological transitions. How many typewriter businesses moved into computers? - Bill Miller about Kodak 2005

Besides having a credible story, the execution needs to measure up to the story because turnarounds usually do not have lucky breaks. You want to see the wheel turn. So what can we say about the Kodak execution

It seems that all divisions are struggling in the recession. A good point though is that the Film Products Group is not carrying the whole weight. Can the non-film divisions carry Kodak out of this difficult situation?

Well, maybe management was a little overoptimistic on these new businesses. Or maybe the new printers need more time to penetrate against strong competitors like HP and Lexmark. Also digital cameras are commodities with low margins and profitability. So it looks like this is a company carried by three motors, only one is working (traditional film) but it is stuttering and about to shutdown.

Also it seems that those restructuring costs are never ending.

So if we review a checklist summarizing the thesis of investing in Kodak the situation is bleak and deteriorating

• New inkjet-printer business? Not ready for rock and roll
• $1 billion in FCF before restructuring charges? Disappeared
• Graphic-communications improving? Doing just OK
• Digital businesses improving? Bleeding
• No more cash restructuring charges? Continuing and no sign of abating

This is a difficult turnaround, innovation does not work very well under stress, but I would not dismiss it with a hand wave. IBM’s turnaround, one of the most remarkable success stories in the 90s, was the result of the surge of the business service division.

Instead I am waiting, and this is a key difference with the traditional value investor mentality. A traditional value investor when faced with an asset play with a sufficient margin of safety he would make a decision right there: Is it cheap enough? I argue instead for the value of

• Waiting for confirmation instead of just buying
• Adjusting the commitment as the probability and value is discovered instead of just holding

Is it possible to find a margin of safety in turnarounds like Eastman Kodak? Just look at the deterioration of Kodak’s assets the last quarters, and take into account that it had more $4 billion in cash less than two years ago.

ASSETS	Q4 2008	Q1 2009	Q2 2009
Consumer Digital Imaging Group	1647	1498	1194
Film Products Group	2563	2408	2301
Graphic Communications Group	2190	2115	1826
All Other	8	1	5
Consolidated Total	6408	6022	5326
Cash and Marketeable Securities	2155	1319	1141
Deferred Income Tax Assets	620	587	639
Other Corporate Assets / Reserves	-4	1
Consolidated Total Assets	9179	7929	7106

It is critically important to avoid investing in turnarounds as if they were asset plays. The key success factors, the dynamics and the character traits needed for both situations are very different. With few chances of liquidation, hope trumping reality and red numbers for years, buying based on asset value is asking for pain. I will argue in future cases that it is possible to have some margin of safety but not in the traditional Graham way.