September 2006 Issue:

Discover Hidden Value - 84 Years in the Making
by Chris Mayer

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Imagine owning an 84-year-old brand name, one of the best-known brands in its market. Imagine a franchise business model - where you, as the corporate owner, franchise out this valuable name to entrepreneurial owners. These owners buy their inventory from you, at a markup, and pay you a franchise fee. They run the store and keep any extra profits.

Also, you own the real estate on almost all these locations, and some excess real estate to boot. And since you've been in this market for 84 years, you've got plum locations in all the best spots. Inadvertently, you've created one of the most valuable real estate portfolios in retailing. It's like you are an accidental real estate tycoon.

The company is in good shape. There is not much debt. Cash flow is healthy. You've got capable managers running the show, so you can play golf, travel and do all the other things you love to do in your spare time.

Finally, the stock price of this business has nearly doubled over the past five years, giving you a terrific market-beating return.

Now I'm going to show you how you can own this business. And even though the stock price has gone up a lot over the past five years, I'll show you how this business could be worth at least C$135 per share - and how you can buy it for less than C$70 per share. That's a potential 93% return.

What makes this one a special situation? First, it trades on a foreign exchange, so it doesn't get a lot of press in the U.S. But it is easy to buy and you should have no problems getting it. Second, there are a lot of value-unlocking activities to pursue here - and the market misses this added level of complexity. This business is a sort of conglomerate with a few different businesses. However, the presence of a well-known and successful activist means that these shares won't likely remain this cheap for long. More on that later in this issue.

Breaking that up and more efficiently shuffling around the company's assets will harvest the value inherent in its different businesses. This is a process I call "resource conversion," borrowing from the great Martin Whitman at Third Avenue. Many of my best investments over the years were in companies with resource conversion potential. The company I'm writing to you about today is a classic case.

Let's take a look…

One of Canada's Largest Retailers… Or Is It?

Canadian Tire (CTC-A:tsx) is one of the largest retailers in Canada. It sells everything from clothing to utensils, from credit cards to gasoline. And yes, even tires.

But it is a retailer only on the surface. Really, it's a franchise business with a credit card operation and valuable real estate portfolio welded to it.

It's got four businesses. Let's take a quick look at each of these.

This is the general merchandiser with 462 stores across Canada. Individual operators run the stores via a franchise agreement. It also has 58 auto parts stores, also operated by franchisers. All told, this operation contributes about two-thirds of Canadian Tire's pretax profits.

The company owns the land and buildings on most of these locations. The operator leases them from the company. The operators of these stores also buy their inventory from the company at a markup. And these operators take all the inventory risk. But they also keep any profits they make. Canadian Tire takes 4% off the top from every store.

And the stores themselves are doing well, lest you think the operators are getting screwed somehow and Canadian Tire is some sham operation like Boston Chicken years ago (when corporate reported wonderful numbers, but investors forgot to ask the franchisers how they were doing. Turns out they were losing money. Boston Chicken soon tanked.)

Growth in these stores is in the mid-single digits. The operators who run them are entrepreneurial and usually local millionaires. The stores are profitable and the company is looking to expand their retail square footage.

This expansion plan caused Wall Street analysts to knock down earnings estimates, because these expansions cost some money and take time. That, in part, has created the opportunity to get into Canadian Tire today. But the stores where the company completed its expansion plans are doing well. Margins expanded and sales grew.

So you've got room for improvement in future performance, which Wall Street is discounting on short-term concerns. Plus, only around 35% of the company's inventory comes from outside of North America. Obviously, with the rising manufacturing efficiencies in Asia, there is potential to lower costs by getting these goods from somewhere else. The company targets a 50% ratio by 2009. As we get closer to that date, you can expect to see wider profit margins.

I mentioned the real estate, but didn't tell you much about it. The company accumulated this real estate over its 84-year history. And as I mentioned in my opener, it's got a lot of plum locations. Some of these locations would be better for other purposes. They are simply worth too much to put a Canadian Tire retail operation on.

I'll tackle more on how much the real estate is worth later in this letter. Let's first continue with the overview of the company's various parts. Now that we've got a basic summary of the retail operation - which you can see is not quite typical at all - let's look at the financial services part.

This is basically a credit card operation that pumps in about 20% of the company's pretax profits. There is always a natural tie-in with credit cards and retailers, though most retailers tend to lay off the business to a bank or credit card company. Canadian Tire runs its own card operations. This business sprouted up like a teenager in a summer growth spurt. Over the past five years, its credit card portfolio - now over C$3 billion - grew into the second largest in Canada. And it's done a good job running it, looking at delinquencies and whatnot.

I'll get into what this piece is worth later, too. But the basic idea is that this substantial credit portfolio is worth a lot more when you compare it to comparable credit card portfolios. Some bank or credit card company would pay a handsome price to own this portfolio.

This is a smaller piece of the pie, pitching in only about 10% of pretax profits, but it's interesting because it's doing so well - and because Canadian Tire bought it only a few years ago at a super-cheap price. It bought it for about C$112 million in 2002, and the stores cranked out C$84 million in pretax profit last year. That was a great acquisition. Imagine paying C$1,120 for an investment and then having it deliver pretax profits of C$840 in the third year.

Anyway, Mark's is made up of about 334 apparel stores, selling mostly private label stuff. In fact, about 75% of what it sells is its own label. That means that it is profitable as all hell.

That's basically it. This high-performing retailer, buried in this conglomerate structure, is super cheap. You could sell this thing off at a much higher multiple than what it's trading for now. More on that later, but first let's look at the final piece of the business.

This is basically a chain of gas stations, about 259 of them. They are hardly profitable and don't throw off much cash. They contribute about 3% of pretax profits, so we're not talking about much here. Management maintains there are good synergies in cross-selling the credit card and other stuff that ties back to the retailers. That may be.

The real value here, in my view, is the substantial asset base. The company owns about 60% of these locations. We'll get to the real estate value later.

Canadian Tire - The Parts Are Worth Much More Than the Whole

So that's an overall look at the business. You can see it's got a lot of parts. Now let's take a look at what this business is worth. We'll start with the big company in aggregate and then we'll work our way through these other businesses and see what they add incrementally to the share price.

As I write, Canadian Tire trades for less than C$70 per share. That works out to a market cap of about C$5.5 billion, for an enterprise value (EV) of about C$6.4 billion. Think of EV as the theoretical price to buy the whole company in the market today.

That's a price-to-earnings ratio of only about 14 times next year's estimates. Because of some of the accounting quirks in the business, earnings actually understate the cash flow the firm generates. Free cash flow should come in around C$6.50 per share for 2007. Based on a C$70 stock price, Canadian Tire is trading for only 11 times prospective cash flow - that's a terrific value in today's market.

On an EV basis, that's less than 7 times earnings before interest, taxes, depreciation and amortization (EBITDA). On the surface, it looks like a reasonable value for a retailer - but that doesn't take into account all the unique properties of Canadian Tire. On the whole, I doubt you'll find a real estate and franchise business model as cheap as this one.

All right, so enough of that. Let's talk about the parts and what they add…

What retailers with excess real estate have done in the past is sell the property and lease it back. The thinking is, "We are not in the real estate business, so why keep all this capital tied up in real estate? Let's sell it, take the cash and use it for our business." Then real estate investors come along and hold the property, happily enjoying the lease income stream. It's just a way to get that underlying value recognized, which otherwise would have remained buried.

So how would this work for Canadian Tire? Well, this can get complicated, so I will try to summarize as best as I can without bogging you down in the details.

The company has already leased back two big distribution centers in deals that netted the company about C$230 million. You can back in what kind of cap rate (or multiple) was used to value that property and it comes to something around 6%. That's a really low cap rate, meaning that the value of the property is quite high and reflects a strong market.

Still, it is hard to get a handle on what Canadian Tire's real estate portfolio is worth. It owns a lot of different kinds of properties all over Canada. The net book value of these properties is about C$1.8 billion - essentially, cost. Slap a 50% premium on that and you get another C$900 million in value. That's pretty conservative considering some of its recent transactions - recall two big distribution centers alone netted C$230 million.

It also has some big properties it is going to sell outright that are not part of the business. There two largest properties represent more than 5 million square feet of space. These noncore real estate assets kick in another C$4 per share or so.

I'd estimate the real estate portfolio is worth at least C$15 per share in incremental value, and probably much more.

Canadian Tire's credit card portfolio is very valuable. Most retailers have sold their credit card portfolios to banks and big credit card companies, who can fund the business much cheaper. Sears, Circuit City and Kohl's are all recent examples of companies that sold their credit card portfolios. And they get big multiples for doing this.

Sears Canada, for example, sold its portfolio for a 30% premium over book value. Canadian Tire's portfolio is similar to Sears' - another general merchandiser that sells just about everything. If you value Canadian Tire's credit card operations at a 30% premium of book value, then, after-tax, that comes to about C$1.3 billion in cash.

Stripping out the credit portfolio and valuing it this way adds about C$20 per share in value to Canadian Tire's stock price.

Bill Ackman is the principal of Pershing Square, an activist money management firm. What Pershing does is buy into companies and make suggested changes to management to unlock value. As it usually owns a lot of shares, its opinions carry some weight. Ackman is most famous among investors today for his involvement with McDonald's, in trying to get it to split into two operating companies. While McDonald's didn't do everything Ackman suggested, it did enough. Since his involvement, McDonald's shares have done very well.

Pershing is also buying shares of Canadian Tire. And it's put forth its idea of eventually converting Canadian Tire to a Canadian income trust. What this structure does, essentially, is eliminate corporate income tax. It's like a real estate investment trust in the States. It allows a business with stable cash flows and not a lot of reinvestment needs to pay out most of its earnings to shareholders tax-free.

Pershing feels such a conversion would add close to C$30 per share in value because of the tax savings involved. Ackman said he's met with Canadian Tire's management team and its newly appointed CEO. And he reports that they have been receptive to his recommendations - which also include a sale-leaseback of Canadian Tire's real estate and the sale of its credit card portfolio. They are shareholder friendly. Well, they ought to be: Management owns 15% of the stock.

Many of these moves result in substantial cash flowing into Tire's coffers. These proceeds could buy back stock or pay dividends. And I haven't really talked about the basic aspects of the business improving - like its store expansion - which also could drive earnings and push the market to award Canadian Tire with a higher multiple. There is lots of potential for good things to happen here.

Adding up the incremental value from real estate (C$15), credit cards (C$20) and trust conversion (C$30) gives you C$65 dollars in hidden value. This is a 93% gain from a stock price of C$70. That's pretty conservative, I feel, and gives you a lot of value for your money. This is safe and cheap investing at its finest.

Recommendation: Buy Canadian Tire (CTC-A:tsx) up to C$80 per share. These shares trade on the Toronto Stock Exchange. Be sure to buy the "A" shares.

The Leveraged Recap -
"This Is Where You Can Make the Big Money."

"Recap" is short for recapitalization. There is another kind of special situation we haven't tackled yet. Basically, when a company takes on a lot of debt and uses the cash proceeds for something (a dividend, stock buyback, whatever), the end result is that you have a highly leveraged company still owned by the original shareholders (so this excludes buyouts).

Investors often call this remaining equity a stub stock. Joel Greenblatt, the maestro at Gotham Capital (which generated ridiculous 40%-plus returns for its investors over the last two decades) and who is sort of the grand poobah of special situations, writes:

This is where you can make the big money. Essentially, investing in a stub stock is just like investing in a publicly traded leveraged buyout. Many leveraged buyouts have returned five or 10 times the original investment, and several stub stocks have produced similarly spectacular returns.

Leveraged buyouts can work because of the tax savings, but also because of the effect of leverage. It's just like buying your house with a big mortgage - and then you watch your house appreciate 20%, but your equity piece grows 80%. There is no smoke and mirrors involved. It's just simple math. That's the kind of effect investing in a successful recap can have.

In fact, Greenblatt says, "There is almost no other area in the stock market where research can be rewarded as quickly and as generously as in the careful analysis of stub stocks." Let's take a look at an intriguing stub stock available in the marketplace today.

The Dominant Maker of Tableware… Who Knew?

Libby Inc. (LBY:nyse) offers the world's largest selection of tableware - glassware, dinnerware, flatware and other sorts of "wares." It is the second largest maker of glassware in the world. It is also of a relatively rare and dying breed - an American manufacturer.

About one-third of its sales are overseas, in over 90 countries. Though it manufactures in America, it also makes stuff in Mexico, Portugal and the Netherlands. China is on tap for 2007. Its customers are what you might expect of such a company: restaurants, hotels, penal institutions, health care facilities, schools, airlines, cruise lines, country clubs, nightclubs, bars and more.

The company has old roots. Founded in 1818 as the New England Glass Co., in 1888, the company moved to Toledo, close to abundant sources of cheap sand and natural gas. This also put the company in a hub of steamship and railroad lines. In 1892, it became the Libbey Glass Co.

Back then, the company made its glass by hand, a process soon abandoned after World War II, when mechanization created a faster, cheaper way to produce the tableware consumers wanted.

In 1935, it became part of the conglomerate Owens-Illinois. Fast-forward nearly 60 years to when Libbey gains its independence once again. In 1993, the company spun off from Owens and went public. It has since acquired a number of other glassware companies and has come to dominate its markets.

The Hard Luck Part of the Story…

Of course, there would be no opportunity if this were just a feel-good story. No, this little company took a beating in 2004, and especially in 2005. Once a $40 stock, today Libbey is a more humble $8 and change. Not that it could get back to $40 - some think it could - but conservatively speaking, an $18 target over the next year is not unreasonable. That's a double from here. With a bit more luck and a more generous valuation, the shares could fetch considerably more.

The year 2005 was not kind to Libbey. High natural gas prices ate into profit margins. Post-retirement benefits also took their pound of flesh. Costs, in short, rose. Prices for its goods did not. Losses ensued. Last year, it lost about $20 million.

So management did what capable management teams do in such spots. They fire people and move someplace cheaper. They slashed the head count 10% or so. They cut the dividend. They closed plants in high-cost U.S. locales. They made new investments in Mexico and China.

Crisa, Libbey's most recent acquisition, is in Monterrey, Mexico. Located about 150 miles from the U.S border, it has the ability to produce more stuff than all of Libbey's U.S. plants combined. Yet last year, it represented less than 15% of total sales. Want to take a guess where new manufacturing capacity will come from? Hint: In Mexico, wages are less than $4 per hour - including benefits.

Then, too, there is the Chinese plant, north of Beijing. Apparently, there are a gazillion hotels opening up in Beijing over the next several years. The Chinese, too, it seems, use tableware. The plant will serve the Chinese market. Hence, we arrive at a bullish constellation of sorts:

Roll Your Own - A Homemade LBO

Of course, doing all of this wasn't free. The company had to borrow a boatload of money. The June numbers show total long-term debt at $464 million against the market cap (14 million shares at $8.35 as I write) of only $117 million. That is leverage.

Grant's Interest Rate Observer profiled Libbey back in April, and recently reiterated its bullishness on the company. It observed, "In effect, what is happening is that management is doing the LBO, and there are no private-equity guys in front of you collecting management fees, termination fees, carry, etc." It is a roll-your-own LBO (leveraged buyout). What's left is the classic stub stock Greenblatt described.

Libbey's financials are messy - lots of one-time charges and write-downs. Management maintains a goal of $800 million in sales and $100 million in EBITDA. A reasonable target, it seems to me. As late as 2003, the company generated EBITDA of $93 million. And based on the six-month results so far, the company is at least an even bet to top that forecast.

Today, this company trades for only about one-seventh of its revenue projection and about 1.2 times EBITDA. That is astoundingly cheap and seems to reflect the market's belief that Libbey will go broke. While the company is not without substantial risks, it appears to offer a compelling risk-reward scenario. Which is to say you stand to make a lot of money if it works out.

So how to value this company? We can start with the fact that Libbey paid 7 times EBITDA for Crisa, which establishes some market price for a comparable company. If Libbey meets its target of $100 million, that implies a value of $700 million. Take out the debt of $463 million and that leaves $237 million - which spread out over 14 million shares gives us a potential share price of $17, or 103% better than today's quotation.

Recommendation: Buy Libbey Inc. (LBY:nyse) for up to $11. Keep in mind this is a more risky investment. Plan accordingly, as I like to say.

The Cocaine of Private Equity

Leveraged recaps can go bust. Some recent headlines make the point: "Leveraged Recaps Could Increase Defaults," "Companies on Borrowing Binge - Can They Handle All the Debt?" "Is Debt Binge on Borrowed Time?" and "Debt on Debt: A Downside of Buyouts."

Some commentators call leveraged recaps "the cocaine of private equity." While there are various shades of recaps - some involving private-equity players taking a company private, some not and some, like Libbey, led entirely by management - I think we can safely say they all share the same risk: mainly, that the debt load proves too much.

Think of owning Libbey as owning a stock option without an expiration date. Your payoff can be quite large in these circumstances, but there is also a risk that it doesn't work.

I think Libbey will work. Lots of new productive capacity comes online in low-cost locations. Management slew many of the worst dragons already. The company is on target for $100 million in pretax earnings this year. And it has a large market share in all of its markets. So I like Libbey.

In looking over our portfolio, I like how it is shaping up. We have a good mix of solid long-term investments and more speculative plays. I would say PICO Holdings (PICO:nasdaq), Saskatchewan Wheat Pool (SWP:tsx) and Canadian Tire Corp are all well-financed, solid companies that you can hold for a long time.

Walter Industries (WLT:nyse), Abitibi Consolidated (ABY:nyse) and Libbey come with added risk, but shareholders also stand to make bigger gains. Each of these is more keyed to specific events unlocking value - and so our time horizon on these investments could be shorter than for the other three.

For example, with Walter, we await the final spinoff of Mueller Water shares. With Abitibi, we await the IPO of hydroelectric assets and the other steps management will take to improve results. With Libbey, a decent 2006 creates a greater opportunity for a lucrative 2007 - and as the market gets wind that the crisis passed, Libbey shares should take off.

The field for special situations is rich right now - we've added a lot of names in a short span of time. I don't expect that to always be the case. But you never know for sure what you might turn up. Just keep digging, is my motto.

Thanks for reading, and I look forward to writing you again soon.

Sincerely,

Chris Mayer