When Market Noise Breeds Opportunity by Joe Weidenburner, Aeternitas Investing
Much of the day to day market action is noise. Graham’s Mr. Market is an anxious fellow who frequently offers market quotations in strong businesses that are disconnected from the true per share business value of the enterprises. Long-term investors are best served by avoiding each day’s tick by tick action and instead focusing on the economics and structural advantages of the companies they own or follow.
Sometimes, however, the daily noise in the market provides opportunity to purchase initial or increased stakes in best of breed businesses. I find that volatile market action, particularly after long runs in market price, provides the patient investor with opportunity. We are seeing such opportunity in two of our favorite holdings.
Outerwall is a company I’ve covered in some depth in our second quarter management commentary, as well as its own dedicated post. The stock is down around 8% over the past week and almost 21% over the past month. The company reported earnings on July 30. The company beat on the bottom line ex items, but missed expectations for revenue in the quarter, and showed a modest decline in revenue year over year. The ex-items portion pertains to a goodwill impairment charge on the company’s ecoATM division which is failing to meet revenue and profitability standards. Wall Street was not impressed by the company’s full year guidance.
Those are the headline numbers and were not very well received. The stock fell over 13% the day following the report and has continued to show weakness. We think this is an opportunity to add to our position, and while we have not done so yet, we are considering it strongly. The headline numbers fail to mention the significant free cash flow generation of $55.6 million in the quarter. This is a cash generating company that returns 75-100% of the free cash flow it generates to shareholders. The full year guide on free cash flow was $231-271 million. The following table summarizes the FCF yields offered based on recent market quotation.
|Market Value: 1.13 b||Enterprise Value: 1.76 b|
|Low FCF bound: $231 m||FCF Yield: 20.4%||FCF Yield: 13.1%|
|High FCF bound: $271 m||FCF Yield: 24.0%||FCF Yield: 15.4%|
The company pays a modest dividend and repurchases shares aggressively, all for the benefit of owners. Other metrics such as net revenue per rental and operating margins showed increases in the quarter, reflective of the company’s recent price raise. While long-term operational challenges are likely, we believe the company remains well positioned with its existing retail footprint and value proposition for consumers to continue to earn significant cash returns on invested capital while maintaining capital allocation policies that are extremely owner friendly. When the market volatility offers us FCF yields from 13-24% based on your preferred denominator, we think it prudent to thank Mr. Market for the opportunity.
Time Warner is another holding in the portfolio that has been battered by volatile stock prices recently in the wake of investor concern over the media space. The stock is off around 10% over the last week based on the market reaction to earnings reports from media companies. The issue seems to be the decline in domestic ad revenue which is seen as a potential sign of the long awaited cord cutting in the cable space. First, Walt Disney caused a stir when it reported a decline in ad revenue coupled with subscriber declines in ESPN, arguably the most valuable cable property. Then, TWX reported on Wednesday and the market did not take kindly to management’s failure to reaffirm its stated financial target.
We believe Time Warner is the best positioned media company in the space and the earnings report did nothing to dissuade us from this thesis. The report was actually quite good, and the selloff had more to do with a market flush of the space rather than any subpar business performance on Time Warner’s part. Revenue increased 8% to $7.3 billion and EBIT increased 15% to $1.9 billion. EBIT margins increased 100 basis points to 25%. The company reported $1.8 billion in free cash flow. Results were very good in Turner and in the Warner Bros. segments, which offset modest declines in HBO, which we attribute to the build-out spend on the new HBO NOW over the top streaming service.
Time Warner owns HBO and the Turner networks, which we believe are tremendously valuable media properties. TBS and TNT are the top 2 networks among the highly coveted 18-49 demographic in primetime. Cash returns on average equity over the past 12 months approximate 12.2% with EBIT returns on equity around 24.5%, both very attractive. Given those returns, the recent decline in the share price offers us a roughly 4.5% FCF yield on market cap and 7% EBIT yield on total enterprise value, reasonable valuations given the quality of the properties Time Warner owns and the returns the business is able to generate.
Prices can be volatile over the short-term without much explanation or correlation to underlying business performance. As long-term owners of great businesses, we are mindful always of the business performance and any impact it has on long-term compounding potential for per share business value. While we often find it prudent to block out the majority of the market noise on a daily basis, we are quick to take advantage of Mr. Market’s irrational mispricings when they occur.