Goode Trades

In the search of Goode value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. We must never combine those three, however. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.

For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap. If they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.

Movie Gallery is a great example of stupid management harming a company. The company’s stock traded as high as $30 in 2005; it now trades at $0.55. Movie Gallery runs a chain of video rental stores. They have historically been profitable. However, early in 2005 the company took on much debt to buy Hollywood Video. The company now has a market cap of $17 million and debt of $1.1 billion. The company’s bankruptcy is imminent. I would argue that the movie rental business is one of the best businesses to be in. People like watching movies, new movies cost a lot to see at movie theaters, and the competition (satellite and cable movies on demand) are not that great.

While Netflix (NFLX) has made it harder for bricks and mortar stores, I feel its impact has been drastically over-rated. I subscribe to the Netflix service, but there are plenty of people who do not. A bricks and mortar store can do good business because those that rent more infrequently will never subscribe to a Netflix-type service. Therefore, I think that Movie Gallery’s two chains, Movie Gallery and Hollywood Video, will still be around in one form or another fifteen years from now. The problem is that the debt of the current company will prevent it from responding to challenges. Bankruptcy is therefore almost certain

General Motors faces much the same problem. Unfortunately for the careless investor, their full debt his hidden in details in their financial statements about their union contracts and the number of retirees for whom they provide pensions. Some have estimated that GM will have to pay out over $70 billion in pensions and health care benefits to its current and future retirees. For a company that has consistently lost a few billion dollars per year over the last few years, this is a problem. In addition to its debt, GM has too many brands, too much production capacity, an unfavorable union contract, and shrinking sales. Without such a sizable debt, GM would stand a chance of restructuring and saving its stockholders. As it stands, it has no room to maneuver. Unless it can become highly profitable within a year or at most two years, it will go bankrupt.

So does debt matter for stock returns? Yes, at least according to this study (scroll down on the page to which I link to download the PDF). While the data are from the UK, the results are logical and should apply in the USA as well. While the correlation of debt ratio with stock returns is lower than the correlation of P/E with stock returns, there is still a definite negative correlation: the stock of those companies with the least debt did the best. The 30% of companies with the lowest debt showed a consistent advantage over those with higher debt. Those companies had leverage ratios of under 20%, meaning that total debt represented less than 20% of enterprise value. For comparison, MOVI has a leverage ratio of 99%, while GM has a leverage ratio of 96%.

Disclosure: I have no interest in any company mentioned. Since I wrote this article last spring both GM and MOVI have seen their stocks decline. MOVI looks like it is about to enter bankruptcy. I have a disclosure policy.

TSR Inc. [[tsri]] just announced a stock buyback of about 6.7% of its shares outstanding. This may come as a surprise to some investors. It is not a surprise to me, however. I was the one who recommended it, in a letter (pdf) that I sent to TSR directors back in late June 2007. TSR is a tiny computer staffing firm with a highly under-leveraged balance sheet (they have a lot of cash).

Did my actions directly cause the stock buyback? Probably not. The directors were not afraid of an investor with less than 0.5% of the shares outstanding in his possession. But it certainly did not hurt that I wrote and suggested that the company buy back stock (for a good reason, I might add). Perhaps that was just the push the directors needed to get them thinking about ways to deal with TSR’s cash hoard.

Perhaps TSR will take my other advice and declassify its board of directors. If not, I may not just sit back and wait. I might even try to get that on the next proxy ballot myself.

If you are too lazy to read my letter, here is my strongest reason for a buyback (which would reduce the company’s cash): “We of course do not need an academic study to prove the obvious point that the key driver of shareholder value is the ability of the company to provide a return on investment. A 5% yield in treasury securities that comprise the majority of a company’s equity is ipso facto inadequate for any corporation.”

Disclosure: I am long TSRI. I have a disclosure policy that generally does nothing until an unhappy reader writes it a letter.

Sometimes a large investor makes their presence known and it becomes fairly obvious who is causing a stock to move. This is particularly true in microcaps. So when the price of Noble Roman’s (OTC BB: NROM) stock jumped up 46% a week ago, it was not too hard to figure out that it was largely because of one large individual investor buying a chunk (although my initial guess was completely wrong). How do I know? He just filed a form 13G with the SEC, indicating that he now owns 10% of Noble Roman’s.

That buyer was none other than Robert P. Stiller, chairman of the board of Green Mountain Coffee [[gmcr]] (and for those old hippies out there, founder of E-Z Wider). Bob has owned the stock of Noble Roman’s since early in the spring of 2007. See his 13G filing on March 6, 2007, where he stated that he owns 1,000,000 shares. He increased that earlier this month to just under 2,000,000 shares. Green Mountain has a $900 million market cap. What does Bob want with a $40 million pizza company? And should anybody follow his example? That is the $4 million dollar question (for Bob at least).

So far, Bob has not done well on his Noble Roman’s investment. His average price on the earlier purchases in February and March 2007 was probably around $4.15. At a recent stock price of $2.40, he has lost 43%.

Microcaps will often see random individuals that buy large stakes. Sometimes the large investors are right, sometimes not. In this case, like with others, only time will tell.

Disclosure: I am short NROM. I have a disclosure policy.

A good executive knows when to take the blame: when his or her management or lack thereof causes a serious problem. Bad executives like to find scapegoats. That is exactly what Paul Mobley of Noble Roman’s (OTC BB: NROM) did in an article with Daniel Lee of the Indianapolis Star (see also the reader comments on the article). In describing the company’s expansion troubles, he placed blame for failed franchises fully on the franchisees, claiming that “Some of the franchises we sold didn’t have very much business or being-your-own-boss experience.” His comments make it seem like he was surprised. He should not be surprised: what does he expect when Noble Roman’s has such low requirements for franchisees? People who probably shouldn’t be franchisees (or who would need lots of help and training to succeed) choose Noble Roman’s over other franchisers solely because its fees are lower. Noble Roman’s then fails to provide proper support and training and the franchisees fail.

With about 1,000 franchisees, one would think that Noble Roman’s has some idea how to select and train franchisees. It is incredibly easy to select only experienced and well-financed franchisees. But Noble Roman’s executives do not appear to care about the success of their franchisees or even about the ultimate success of the company. All they seem to care about is “growing” as quickly as possible, even if most of the company’s growth is not real (over the last year, 90 Noble Roman’s franchisees opened, but 38 franchisees closed). (Noble Roman’s franchise closure rate of about 3.7% is fully one percentage point higher than the industry average of 2.7%.) And if Noble Roman’s were to be more selective and were to take the time to train its franchisees, it would not be quite so exciting as a “growth” company. Of course, to anyone who has looked at the company’s financial statements and seen how 24% of the company’s royalties are from one-time initial franchise or area developer fees, it is obvious that Noble Roman’s is not a growth company (number from the most recent 10Q).

Potential franchisees would do well to keep this in mind and avoid companies like Noble Roman’s whose sole selling point is their low franchise fees and requirements.

Disclosure: I am short NROM. I have a disclosure policy that has been franchised successfully in 87 galaxies.