Revisiting Sears Spin-offs

I have written a couple of articles on the two Sears (SHLD) spin-offs, Orchard Supply Hardware (OSH) and Sears Hometown and Outlet (SHOS). I have received a lot of inquiry on what I thought of both of these companies after third quarter results came out. So, here is my analysis.

Orchard Supply Hardware

I am still short OSH. It has been one of my profitable investments this year. I shorted a little below $14 and covered around $8.50 before the third quarter results came out. Then I shorted again after the results at $7.30.

My original thesis still remains intact:

  • Small fish in a very competitive marketplace.
  • Still struggling to maintain financial covenants.
  • Unprofitable.

Third quarter results were horrible. Same store sales were essentially flat. However, margins were horrible even if you excluded the $72 million impairment charge. The company is not in compliance with its financial convenants and will not be in February, the next measurement date. 

The company is trying to turn it around by remodeling existing stores. However, this process is slow and a majority of the stores are still old.

The only thing that can save this company is the life in the housing economy. But as the third quarter results showed, this help has not been enough.

I plan to keep this short because I don’t believe this company has a future.

Sears Hometown and Outlet

I have a small short position in SHOS, but I am not as confident about this short as OSH. There are some good things about this company.

  • It is profitable.
  • It trades at a decent valuation. Around 10 times this years earnings.

The main reason for my short is that I still have not seen top line growth. As I mentioned in my previous article, the profitability improvement is due to margin improvements by cutting costs and converting to franchise stores. That can only last for so long.  

I don’t have much hope for Sears Hometown, but Sears Outlet is the wild card. It has seen strong same store sales growth over the last couple of years and has a unique business model. However, in the third quarter it was Sears Hometown with strong same store sales numbers and Sears Outlet with negative same store sales numbers.

I am curious to see how the numbers compare in the first quarter of 2013 before I decided to close my short or increase it.

I will keep you guys updated.

Disclosure: I am short OSH and SHOS

Upcoming Interesting Spin-offs

There are some big and interesting spin-offs coming up within the next couple of months.

Liberty Media

Liberty Media (LMCA) is spinning-off Starz, the premium cable channel in mid-January. After the spin-off, Starz is looking to sell itself. In fact, Liberty is already sending feelers out to potential interested parties such as CBS, Fox, Viacom and Univision.

Barron’s had an interesting sum-of-parts valuation of Liberty couple weeks back. It valued Starz at $125, about $15 above the Friday closing price of $110. I personally have not valued each of the businesses, but there are two potential big risks here:

  • The majority of Liberty’s valuation is based on Sirius. 
  • Netflix outbid Starz to carry Disney content after 2016. This could have an effect on Starz valuation going forward. Starz is trying to develop more original content to offset this loss.

There are a lot of believers in Liberty such as Warren Buffett and David Einhorn. However, both those investors were holding Liberty before the recent run up of the stock price.

Pfizer

Pfizer (PFE) is spinning-off its Animal Health Unit, Zoetis. It plans to launch a $4 billion IPO in January or February, valuing the Zoetis at around $20 billion. After the IPO, it plans to distribute the remaining 80% to shareholders.

 Check out the latest S1 here

I am avoiding holding Pfizer because

  • I am not a big fan of big pharmaceutical companies. They have to keep coming up with new drugs to maintain and grow revenue.
  • Zoetis valuation, even at $20 billion, will be around 10% of Pfizer’s market capitalization.

Although, Zoetis has been growing, it looks expensive from a brief reading of the S1.

News Corporation

News Corp (NWSA) is spinning-off its publishing unit early next year. There has not been much new information on this spin-off except it named Robert Thomson the CEO of the company.

Disclosure: I do not own NWSA, PFE, or LMCA

Einsteins Special Dividend

I wrote last month that Einstein’s (BAGL) stock price could possibly appreciate as much as $5 if its proposed recapitalization transaction goes through. Einstein was proposing a $9 special dividend financed through debt.

Last week, it announced a $4 special dividend payable on December 27, 2012. The ex-dividend date will be December 28, 2012.

The stock currently trades at $16. If the shares dip to the low $15 range before the dividend, I might initiate a small position. After the special dividend, I expect the stock to trade between $12-$13. At this price, the dividend (.50/share) yield will be around $4%.

Disclosure: I do not own BAGL

AbbVie Trading at $35

AbbVie (ABBV) began when-issued trading (ABBV-WI) today at $35+. This is well below my estimate of $45. The market must really not like the fact it is dependent on one drug, Humira. At this price, AbbVie will be trading at 10 times 2012 FCF with a nearly 5% dividend. 

This means that new Abbott will trade around $30. This will be over 20 times FCF and 12 times operating cash flow. It seems a bit expensive.

Disclosure: I do not own Abbott

Abbott Spinoff Analyzed

I spent some time this weekend taking a deeper look at the spin-off of Abbott’s (ABT) pharmaceutical unit, AbbVie Inc. (ABBV). For every share of Abbott at the close of business on December 12, 2012, investors will receive one share of AbbVie common stock. Abbott expects that AbbVie stock will be distributed on Jan. 1, 2013. AbbVie will trade on a “when issued” basis this Monday, December 10, 2012 under the symbol ABBV.WI.

AbbVie

AbbVie generates most of Abbott’s profit. For 2012, it will have between $5 – $6 billion in FCF or around $3.50/share. Earnings and revenue are growing. However, they are highly dependent on one drug, Humira. The patent for Humira expires in late 2016. As a result, AbbVie is a bit risky. Future growth, after Humiras patent expires, will depend on it finding new drugs.

The company expects to pay an annual dividend of $1.60/share. I expect the stock to trade around 12 to 13 times earnings or around $45. At this price, it should give a nice dividend of 3.5%. I personally would not want to own this stock because of the dependent on Humira.

Abbott

Abbott looks interesting post spin-off. The company expects operating cash flow of $4 billion after spin-off. If you factor in depreciation, interest expense, taxes and other expenses, Abbott’s FCF should be around $2 billion.

Abbott has market leading products across their different segments. It expects to grow revenue in mid-to-high-single-digits in 2013. Earnings could grow faster due to margin improvements. I expect it to trade around 15 times earnings or $20/share+.

Conclusion

Once AbbVie trades on a “when issued” basis this Monday, we should find out what the market thinks of the value of AbbVie. I think new Abbott will be a steal at any significant discount to my $20 fair value.

Disclosure: I do not own Abbott.

Pandora By The Numbers

Internet Radio Fairness Act

In my last article, I gave a general idea of why I initiated a small short position in Pandora (P). I argued the only way the stock has a chance of going up is if there is new legislation that significantly lowers music royalty rates.

This legislation is the “Internet Radio Fairness Act”, or IRFA. In fact, Pandora CEO is currently arguing on Capitol Hill that the royalty fees that it pays as a percentage of revenue (50+%) are unfair compared to what satellite radio (8%) and radio stations (0%) pay. Pandora wants Washington to cut royalty rates by more than 80%. On the other side, musicians are arguing that they do not make much as is.

I don’t understand why Washington has to get involved and if a company (Pandora) cannot make money based on the current royalty structure why is it still in business. Comparing royalty rates as a percentage of revenue is meaningless. For example, if Pandora gets higher advertising revenue, then the royalty rates a percentage of revenue go down. Maybe it needs to play more advertisements. Maybe it needs a new business model.

I don’t expect that the bill will get passed in its current state. However, if it does, the following table lists trailing 4 quarter earnings if there is a drastic 85% cut in royalty rates (35% tax rate).

  Jan 2012 April 2012 July 2012 October 2012
Earnings $21 Million $18 Million $29 Million $37 Million
Earnings Per Share .13/share .11/share .18/share .22/share

By my rough calculations, Pandora would have trailing 12 months earnings of .64/share or over $100 million and its stock price would more than double. On the other hand, it would also bring new competition into the now more profitable industry.  

Growth

There is no doubt that Pandora has experienced tremendous growth to the number of users and more importantly to listener hours. The growth is mostly due to the growth in smart phones. Users tend to listen more on phones, then on computers. 

However, this growth will slow considerably. Pandora had 62.4 million active users in the month of November. That is about 20% of the total US population. Also, the smart phone market is pretty mature in the US. See figure below. 

US Smart Phone MarketSource: Business Insider 

Monthly listener hours (in billions) numbers prove growth is slowing significantly. 

  Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Listener Hours .975 1 1..06 1.1 1.08 1.12 1.16 1.15 1.25 1.27
Growth(Y/Y) 101% 88% 87% 87% 77% 76% 70% 67% 65% 58%

One thing to note is that listening on the phone per hour is less profitable than on computers for Pandora due to lower advertisement revenues.

Conclusion

I only have a small short position in Pandora because of the current legislation risk. But I feel there are many things working against Pandora and expect that eventually the price of the stock will go down. Another way that I am thinking of playing Pandora is selling December naked calls as they are priced pretty high due to the stock’s volatility. 

Disclosure: I am short Pandora. 

Shorting Pandora

Pandora LogoPandora (P) is an internet radio service. “The company allows listeners to create up to 100 personalized stations to access unlimited hours of free music and comedy, as well as offers a paid subscription service to listeners.” Most of their revenue comes from advertisements that are run between songs. 

Yesterday, the company announced quarterly results that beat market expectations, but provided lowered fourth quarter guidance. The company blamed soft guidance on advertisers being cautious with spending due to macroeconomic concerns such as the fiscal cliff.

Due to weak guidance, the stock is down around 18% to $7.80 today. 

I have wanted to short Pandora for a long time, but never got around to doing it. But, finally I initiated a small short position today at $7.79. Here are the reasons for the short: 

Profitability

Even with huge subscriber growth, Pandora is having a hard time just breaking even. The reason is that Pandora has to pay royalties for every song a user listens to. So, as advertising revenue increases as more users join Pandora, so does the “content acquisition” cost.

In fact, it gets worse. The royalty rates are going to increase every year under the “Pureplay Settlement” with SoundExchange, which has set predetermined prices every year until 2015. 

Pandora has been lobbying in Washington to lower these rates to boost profitability. However, I don’t think anything will materialize and even if something does, it will be a long time away.

Competition

There is plenty of competition in this space. The biggest ones are Spotify, Apple, and Amazon. Spotify has a very similar service to Pandora except

  • Spotify has integration with Facebook which allows users to share songs with friends.
  • Spotify is free on personal computers. You can listen to any song in their library for free.

There has been a rumbling that Apple may enter the interent radio space. It seems a natural fit for Apple and Amazon as they already provide music content.

Also, there is nothing holding users from using other services beside maybe personalized stations that have been created on Pandora.

Conclusion

I am confident that Pandora will continue to go lower. The only thing that could save it is if it negotiates better rates for content acquisition.

Disclosure: I am short Pandora.

Dean Foods Sells Morningstar for $1.45 Billion

Dean Foods (DF) sold Morningstar for $1.45 Billion. “Dean Foods expects to realize $887 million in proceeds, net of taxes and expenses.” It will use all the proceeds to pay down debt. “Dean Foods’ management expects its net debt to EBITDA ratio to be below 3.0x at year end 2012.”

I actually sold my position on DF below $17 at a loss because I got scared of the volatility of WhiteWave. Today, it is up trading at $17.55. I expected them to pay some of the proceeds to pay a special dividend, but it looks like that is not happening. This changes a bit of my valuation on the lower side because Dean gets a low multiple of FCF. 

I expect the stock to trade around this price for a while. I will revisit this stock when they actually distribute the WhiteWave shares to shareholders. 

Disclosure: I do not own Dean.