Free NPV

Zip Realty has rallied strongly in the past few weeks, rising from a low of around $2.15 a share, all the way to $3.12 a share on strong volume. The reason it has increased in value so much has nothing to do with fundamentals, and thus provides a good entry point to reshort since the actual fundamentals have actually deteriorated.

Zip Realty received so much extra attention this week because one of its competitors, Zillow.com, went public and had a very strong opening. Based on this, ZIPR received a lot of attention and perhaps some investors thought ZIPR was cheap on a relative basis. They are wrong. While both companies lose money, there are still some major differences. Zillow has been growing revenue and site visits at a very quick rate over the last few years, having tripled revenue from 2008 to 2010 while ZIPR has seen flat to declining revenues and has been losing market share. Here is a graph showing the percent of traffic the top 10 online real estate websites in the United States capture each month. When a company drops off the top 10, it shows up in the graph as zero, so keep that in mind.

As you can see, in the last year ZIPR has dropped from 2.4% to less than 1.6% of the market. This means that we should not expect to see a reversal in ZIPR’s business anytime soon and that all the recent cost cutting they have done in the past 6 months may only balance out the declines in revenue. As well, this mitigates one of the big risks to this short trade, namely that ZIPR gets acquired by a competitor. If a competitor wanted to acquire ZIPR, the only logical reason would be for a land grab. ZIPR loses money, thus the only way a deal makes sense is to increase monthly page views at the aquiring company. With ZIPR grabbing a lower and lower share of the U.S. market in each passing month, a deal makes less and less sense. Based on these developments, I reshorted ZIPR at around $3.04 a share in the past 2 days.

School Specialty (SCHS) reported Q4 and full year results a few weeks ago. While results and forecasts came in lower than I had been expecting, the shares nonetheless rallied on the news. I guess this is a good example of investing with a margin of safety – even though I was wrong on my analysis the price was so cheap that it is still a profitable investment. Anyways, on to the results.

The 4th quarter (ends April 30th ) is historically a weaker one for SCHS. They make the majority of their sales in the 6 month period from May to October as schools plan for the new year. Still, there are important early indications of interest from school boards in late April that can help the company get better visibility on the upcoming year. For this quarter, revenues came in slightly higher, up 2% when adjusting for the extra week yoy. Gross profit was lower as margins dropped due to continuing weak demand. There were also some more non-cash charges relating to asset writedowns. These are not important. SCHS lost $22.6 million in the quarter, $17.2 million excluding the special charges, compared to a loss of $13.7 million in the year ago period.

If you remember my earlier posts, I was confident SCHS could achieve at least $50 million in free cash flow going forward. This year they came in slightly below that, generating $60 million in cash from operations but spending approximately $25 million on PP&E and product development costs. This means free cash flow was only $35 million for the year. However inventories increased by $11 million yoy, meaning adjusting for this increase, free cash was around $46 million, only slightly lower than their forecast. While this increase in inventories decreases free cash flows for the year, it actually bodes well for the future as management has indicated that they saw some opportunities and increased demand from the marketplace.

Looking forward, management went over most segments and the strengths or weaknesses that they are observing in each. At the end of the 4th quarter and looking at the first few weeks of Q1 2012, the CEO stated that they are cautiously optimistic. They are seeing some strength in furniture, which has been the segment most impacted by the recession. Sales have come in slightly above expectations and margins are improving. Supplies have not shown as much improvement. The accelerated learning group grew revenue by 4% in the fourth quarter, and hopefully demand will continue to improve. The debt issue was resolved in the quarter, and the company has financing in place to cover all debt redemptions through 2014.

For the 2012 fiscal year, SCHS announced they are expecting free cash flow to be $5 to $15 million after a one time deferred tax payment of $30 million, or $35 to $45 million normalized. This is weaker than what I thought SCHS would report, but like I mentioned at the top of this post, if you invest with a large enough margin of safety you can be wrong yet still make money. The stock rallied hard on the news, up 20%, but has since come back down to the $13 level. At this price you are getting the company for 6.2x free cash flows in what should be a trough year. With the company able to generate somewhere in the range of $60 to $75 million in a healthy economy, at this current price it’s a steal. I might just take slightly longer than I previously thought to realize full value on this trade.

Petrobank released a new investor presentation last week so I figured now is a good time to go over their recent results and see where they are in the development of their own oil projects. As you may recall Petrobank owns a 59% stake in Petrobakken, as well as their own oil assets. These assets consist of over 670 million barrels of likely reserves plus the valuable THAI oil extraction technology. This division is extremely undervalued by the market and it is possible to isolate this undervalued division by being long Petrobank and short Petrobakken.

In the investor presentation, Petrobank announced that their first well at the Kerrobert facility is up and running, and all 10 wells will be producing oil by mid July. This is a very important first step, as the market will be forced to recognize the value of the Petrobank stand alone unit when it starts to produce its own cash flows. The long term goal is for Petrobank to eventually be self sustaining and not rely on the dividend payments from Petrobakken to support the development of its wells. When this happens Petrobank will be able to spin out Petrobakken and the story will be much cleaner to the market. While this may be a few to many quarters away, starting to produce its own oil is an important first step.

Another source of potential cash flow is to licence out the THAI technology to other oil producers. Petrobank was able to enter into a collaboration agreement with Pemex, the large Mexican state run oil giant. This will hopefully lead to a full on licensing arrangement and become another source of cashflows.

So overall while the progress is slow, the story is advancing and hopefully the market will soon wake up to the undervalued Petrobank unit. This unit should be worth around $5 a share but is currently only receiving a valuation of around $.40 a share.