Beating the Street (44 page)

Wilson is considerably cheered by the news that Shawmut Bank, his biggest competitor in the area, also has recovered enough to escape the financial intensive care unit. First Essex still has a book value of $7, and the stock is selling for $3⅝. If the real-estate market continues to improve, First Essex could eventually earn $1 a share. Then the stock will be worth $7-$10.

Lawrence Savings, the other S&L with warts, I contacted in April and again in June. In April, the CEO, Paul Miller, reported that seven pages of nonperforming loans had been reduced to one and that new mortgage business was strong. He sounded optimistic. In June, he sounded discouraged.

At this point, Lawrence still had $55 million in commercial real estate loans outstanding, and its net worth was down to $21 million. If half of these commercial loans go sour, Lawrence will be wiped out.

This is the biggest difference between Lawrence and First Essex. First Essex had $46 million in net worth and $56 million in commercial loans outstanding, so if half of its commercial loans default, First Essex may manage to survive. Lawrence is in a more precarious position. If the recession gets worse and there is another wave of defaults, Lawrence will disappear.

Six months later, I counted six of the seven S&Ls I'd picked in
Barron's
as holds, mostly because they'd already gone up in price.
Also, a better buying opportunity had entered the picture: First Federal of Michigan (FFOM).

FFOM was brought to my attention by Dave Ellison, Fidelity's S&L analyst, during a plane ride to New York we shared back in January. It was too late to do the homework then, so I put the idea aside. I'm glad I did, because while all these other S&Ls had increased in value, FFOM hadn't budged.

If all stocks went up at the same rate, there would be nothing left to buy and stockpickers everywhere would be out of business. Fortunately, this is not the case. There is always a laggard to fall back on once you've sold a stock that has gotten ahead of itself. As of July 1992, FFOM was just such a stock.

This is a $9 billion Jimmy Stewart thrift that has avoided commercial lending and has minimal operating costs. It is being held back by two negative factors: the money it borrowed from the Federal Home Loan Bank (FHLB), and some unfavorable interest rate futures contracts.

Most S&Ls have benefited from the falling interest rates in recent years, but not FFOM. That's because FFOM financed its operations in part with loans from FHLB, and these loans carry a fixed rate. FFOM must continue to pay FHLB 8–10 percent through 1994, when all this high-priced paper comes due. Meanwhile, its own borrowers are refinancing their mortgages at lower and lower rates. This has put the squeeze on FFOM.

When you own mortgages that pay you 8–10 per cent, and you've borrowed money at the same level of interest, you won't make much of a profit. This is a painful lesson that FFOM has had to learn. Its operations in general are profitable, but the FHLB “block of granite” has been holding down the earnings.

This unfortunate situation will reverse itself once the FHLB debt is retired and the interest rate futures contracts expire. Then FFOM's earnings will explode. The resolution of these two problems has the potential of adding more than $2 a share to earnings in 1994-96. On current earnings of $2 a share, this is a $12 stock, so imagine what will happen if the company earns $4.

Moreover, FFOM has a book value of more than $26 a share. Back in 1989, it was a touch-and-go operation with an equity-to-assets ratio of only 3.81. Since then, it has crossed the magic threshold of 5. It reinstated the dividend in early 1992 and then proceeded to raise it. Its nonperforming loans are less than 1 percent of assets.

If short-term rates continue to decline, the stock might well fall below $10, but investors who know the story will be prepared to buy it on the way down. There's no coverage from the major brokerage houses.

An article published in
The Wall Street Journal
on June 30 reminded me that billions of dollars were pouring into the bond funds. The Colonial Group specializes in bond funds, particularly the tax-exempt and limited maturity U.S. government funds, which enjoy widespread popularity these days. Only 9 percent of the money it manages is invested in stock funds. If we have a bear market, as many people now predict, investors who are scared out of stocks will retreat into bond funds, and Colonial Group will become even more profitable than it already is.

Davey Scoon, the treasurer, tells me that sales of Colonial Group funds are up 58 percent in the recent quarter. It now manages $9.5 billion worth of assets, as opposed to the $8.1 billion it managed a year earlier. There is $4 a share in cash, with the stock now selling for around $20. Subtracting the cash, this becomes a $16 stock in a company that is expected to earn at least $1.80 in 1992. To add to the good news, the company has announced a $10 million stock buyback.

Stock in this Michigan utility bobbed up into the $20s on rumors that the public service commission would accept a rate compromise that was somewhat favorable to the company. After the commission rejected the compromise, the stock sank back to $16 then rose slightly to $17.75. And with no agreement currently in sight, Moody's has lowered its rating on CMS bonds to speculative levels.

This is always the issue with distressed utilities on the rebound—how much latitude will the governing bodies allow? Absent an equitable ruling from the state commission, CMS will take a write-off against earnings to pay for some of the costs it can't pass along to customers. The stock might fall to $10. Unless you're prepared
in advance to respond to such a drop by buying more shares, it's best not to own CMS during this uncertain stage.

In the long run, I'm convinced CMS will do well. The company is making plenty of money, and its excess cash flow eventually will lead to higher earnings. Energy demand is growing in the Midwest, and few if any new plants are being built to meet it. With reduced supply and increased demand, you know what will happen to electricity prices.

As with several other stocks on our list, the price of Sun TV moved higher at first, and then settled back to below where I recommended it. I called Bob Oyster, the CEO, on June 5. He reminded me that Sun TV has only $4 million in total debt. This is a very strong company, and its weaker competitors continue to disappear. Since January, one competitor has closed all his stores in the Ohio area, and another has gone completely out of business.

Sun TV is making money in spite of the recession. It might have made more except that cold weather in the spring and early summer hurt air conditioner sales. People who are freezing do not buy air conditioners. But they are still buying refrigerators and television sets, and Sun TV is sticking to its plan to open four to six new stores in 1993.

Mr. Oyster noted that Sun TV has the wherewithal to pay for several years' worth of expansion without selling more stock or taking on more debt.

Lou Cissone, Sun's vice-president of finance, went down the list of the various divisions. His report sounded so pessimistic that I was surprised the company as a whole had a profitable first quarter. The big issue is still the debt, $22 million of which is due in February 1993. Sun has been preparing for this payment the same way you and I would—cutting costs and repressing the instinct to go shopping.
Sun continued to refrain from making any new acquisitions. This was too bad, according to Cissone, because many companies in Sun's line of business—glass, hydraulics, and auto parts—could be bought at bargain prices.

The story here, as you may recall, is that the Class A shareholders get back $10 a share in 1997, whereas the Class B shareholders get the remaining assets. If the economy improves, I figure that the Class B shares could be worth $5-$8 apiece; in the current market they continue to sell for $3.

Meanwhile, I remind myself that if the economy gets worse, Sun can easily sell off any number of its previously acquired divisions to raise the cash to cover its debt payments. These valuable franchises give the company some disaster protection.

Tenera, the nuclear consulting firm in distress, is another victim of good news. The company announced two new contracts, one with Martin Marietta and one with Commonwealth Edison, the largest operator of nuclear power plants in the U.S. This proved that Tenera's consulting business is still viable—otherwise, why would Martin Marietta and Commonwealth Edison be wasting time with these people? Then the company announced it was close to a settlement of a class action suit, which is going to cost less than some investors had feared, and on top of that it broke even in the first quarter. The stock responded by going nowhere.

I remember what attracted me to Tenera in the first place—the company had no debt and a valuable consulting business, even though the software division was in shambles, and the stock was $2. If Tenera can make just $40 million in annual revenues, which seems more likely now than it did in January, the company could earn 40 cents a share. This is a long shot for which the story is getting better and the price has stayed the same. That puts it on the buy list.

I can't review one or two master limited partnerships without checking in on a few of the others that I have owned and recommended in the past. The high yields and the tax advantages make this a very attractive group. This time, I found two more to elevate to the buy list: Cedar Fair and Unimar.

Cedar Fair runs the Cedar Point amusement park on the shores
of Lake Erie. My family and I go there to ride the roller coasters in early August. This is my favorite summer research.

Cedar Fair has just made an important announcement: it is acquiring Dorney Park, a big amusement palace outside of Allentown, and another place to do summer research. This company hasn't adopted the stock symbol FUN for nothing.

What stopped me from recommending Cedar Fair at the beginning of 1992 was that I couldn't see how the company was going to boost its earnings. The Dorney Park acquisition is the answer. Cedar Fair will take over Dorney Park, add new rides, use the proven Cedar Fair techniques to attract more customers, and cut costs.

Whereas 4–5 million people live within driving distance of Cedar Point on Lake Erie, 20 million can reach Dorney Park in less than three hours.

The Cedar Fair people aren't exactly acquisition happy—this is the second they've made in 20 years. The math looks very favorable. The purchase price for Dorney is $48 million. Since Dorney earned nearly $4 million in the prior year, the p/e of the acquisition is 12.

Cedar Fair is not paying all cash. It is paying $27 million in cash, financed by debt, and the balance in a million Cedar Fair shares, to be given to the owners of Dorney Park.

Here's how I analyze the deal. Cedar Fair was earning $1.80 a share prior to the purchase. With a million new shares on the books, it will have to come up with an extra $1.8 million in earnings to maintain the status quo. It will also have to pay $1.7 million in interest on the $27 million it borrowed to make the acquisition.

Where will Cedar Fair get this $3.5 million in extra earnings plus interest payments? From Dorney Park's estimated $4 million annual earnings. On the face of it, this deal adds to Cedar Fair's earnings.

So what happened when the Dorney Park sale was announced? Cedar Fair's stock didn't budge from $19 for weeks. You don't have to be an insider to get in on this deal. You can read about it in the newspapers, take your time analyzing the situation, and still buy Cedar Fair stock at a predeal price.

Unimar has no employees. The payroll is nonexistent. This is a holding company with a simple job: collecting the proceeds from the sale of liquid natural gas that comes from Indonesia. These
proceeds are distributed quarterly to shareholders as a big dividend, which recently has been running at a nice 20 percent a year.

In the third quarter of 1999, the contract that Unimar has with Indonesia oil and gas producers will dissolve, and the stock will be worthless. This is a race against time—how much gas can be extracted and sold, and how many dividends will be paid, for the remaining six and a half years before the contract runs out.

As I write this, Unimar stock is selling for $6. If by 1999 the shareholder receives $6 worth of dividends, then Unimar has not been much of an investment. If he or she receives $10 worth of dividends, it will be a decent investment, and at $12 in dividends Unimar begins to get exciting.

The size of the dividend depends on two factors: how much natural gas Unimar can extract from the Indonesian fields (recently, the company has expanded the output, which adds to the attractiveness of this stock) and at what price it can sell the gas. If oil and gas prices go up, Unimar's payout goes up: if prices decline, so does the payout.

Unimar offers investors a chance to profit from a future increase in oil prices, and receive a handsome dividend along the way. This beats buying oil and gas futures, which is an expensive and more dangerous game.

Another bobble in the stock price gives investors the umpteenth chance to pick up shares in this remarkable company at a discount. The stock has fallen to the mid-$50s because legislation favorable to Fannie Mae has stalled in Congress.

Meanwhile, the company has enjoyed a good first quarter and a good second quarter and the mortgage-backed securities portfolio has grown to $413 billion. In the midst of a housing recession, Fannie Mae's loan delinquencies are a minuscule six tenths of 1 percent, half the level of five years earlier. The company will earn $6 in 1992 and $6.75 in 1993; it is maintaining its double-digit growth rate, and still was selling at a p/e of 10.

I called Janet Point, a corporate spokesperson, on June 23, 1992, to get the scoop on this stalled legislation. She assures me it's a nonevent. A bill that defines the roles of Fannie Mae, Freddie Mac,
etc., is almost sure to get through Congress, but whether it does or it doesn't is of little consequence to Fannie Mae, which can get along perfectly well without it.