As the sale of General Cigar shows, there are still plenty of bargains to be found in "old economy" stocks
In recent years, we have seen unprecedented merger and acquisition activity--what we have termed the Third Great Wave of Takeovers. In 1999, there was $3.4 trillion worth of corporate transactions worldwide. In the first quarter of 2000, M&A activity remained torrid, with $1.166 trillion in global deals ($600 billion in the United States), compared with $1.086 trillion in the fourth quarter of 1999. We can see merger and acquisition numbers this year exceeding last year's impressive totals. In addition, the old financial engineers--leveraged buyout specialists--are resurfacing to take advantage of exceptional bargains in depressed "old economy" stocks.
Through the years, we have had many portfolio companies struck by takeover and leveraged-buyout lightning. We used to regularly publish a tongue-in-cheek "Rest In Peace" list of all the dearly (and quite profitably) departed companies from our portfolios. The departures are no accident. We look for business bargains--stocks trading significantly below our appraisal of their "real world" economic value. We analyze stocks from the same perspective as corporate acquirers and LBO firms, focusing on cash flow after capital expenditures and asset values rather than earnings per share. We have also had great success identifying industries ripe for consolidation.
Below, I will walk you through the basics of what we call Private Market Value investing. I'll also demonstrate how you can benefit by investing in the "back end" of deals through risk arbitrage.
After serving as a securities analyst for a decade at Loeb Rhodes and then at William D. Witter, I formed my own company in 1977. At the time, there was limited interest in stocks. The 1973-'74 bear market had frightened many investors away, and those who remained didn't have much to show for it. Stocks were mired in the stagflation economy (no growth combined with high inflation) of the 1970s. About the only stocks that were doing well were those of companies that were being bought by other companies or those being purchased by management itself with the help of a financial partner.
I wanted to tap into this profit well. So, I reoriented the focus of my firm's research efforts from growth to value, focusing on the ways a corporate acquirer or leveraged buyout firm evaluated a potential investment. I realized that the key was free cash flow, which we defined as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), minus the necessary capital expenditures to grow the business.
Why free cash flow rather than net earnings? Because when valuing a business investment, your primary interest is how much cash it throws off. If you are financing the purchase with debt--characteristic of a leverage buyout--the amount of cash flow determines how much you can pay for the business and comfortably meet obligations on the debt incurred in the transaction. If you are financing the deal with cash, you want to know how quickly your investment will pay for itself. If you are using stock, you need to know whether the cash being generated by your targeted acquisition will add to earnings and help propel your stock higher.
We also reappraised asset values. Stated book value often doesn't paint an accurate picture of a company's true economic value. For example, raw land and plant and equipment are generally carried on the books at cost rather than at current value. Inventory and receivables may be worth much less or much more than stated. Valuable assets like a dominant franchise or a high-quality brand name aren't accounted for in book value. We began recasting book value, evaluating all the on-book and off-book assets to come up with realistic business values.
Using this methodology, I was able to identify a lot of business bargains. But bargains often gather dust on the portfolio shelf. So, I looked for a catalyst--some element of change that would mark up portfolio merchandise. Often that catalyst was a potential deal.
In analyzing companies with some takeover flavor, I sought answers for a number of questions: Is a target company in a fragmented industry that is likely to be consolidated by larger players? What has management done in the past to enhance shareholder value? Does management own enough stock that would give them the financial incentive to consider selling the business, or are they simply hired guns that would block a deal to save their jobs? Are there any anti-takeover defenses (staggered boards, poison pills, etc.) that would preclude a hostile bid for the company? Have there been any 13d filings (Security and Exchange Commission filings indicating someone has bought more than 5 percent of the company's shares)? If so, do the businesses of the two companies complement each other? Are there any potential regulatory or antitrust problems that could prevent a deal? If I came up with the right answers to these questions, we would generally buy the stock.
This was a fresh approach to investing in publicly traded equities. So much so that Columbia University Graduate School of Business Professor Bruce Greenwald (successor to the brilliant Roger Murray, who inherited Ben Graham's chair at Columbia) has credited our firm with introducing the terms "Private Market Value" and the "catalyst" to the modern investment lexicon. Translating theory into reality, let's review our experience with General Cigar Holdings Inc. (NYSE, MPP), a company with which most of you are familiar. This is a long and somewhat involved takeover story, but one that demonstrates nearly all of the components of our Private Market Value methodology. In 1981, our private account management firm, GAMCO
Investors, began following (and slowly accumulating shares in) Culbro Corp., then the parent company of General Cigar. The catalyst that sparked our interest was the sale of its Ex-Lax business to Sandoz and the use of the proceeds to buy back stock.
When we analyzed the company, we saw a portfolio of strong, free cash flowgenerating businesses and a lot of raw Connecticut land on the books at a cost well below its current value. By our calculations, the raw land alone was worth Culbro's total market capitalization. So, we figured we were getting the businesses for free.
Over the next 15 years, the Cullman family, who were majority owners of Culbro, did many things to enhance shareholder value, including selling its Metropolitan Distributors to management, its snack food business to Bordens, and its smokeless tobacco unit to Swisher International Group Inc., and spinning off its Doral Financial division (the largest mortgage originator and servicer in Puerto Rico) to Culbro shareholders. In 1994, Spain's Tabacalera made a premium bid for Culbro's cigar business at a price that confirmed our appraisal of the company's value. The marriage was never consummated, partly because the deal was not structured in a tax-efficient manner for shareholders.
This set the stage for the 1996 recapitalization and restructuring of Culbro. The Connecticut land was spun off to shareholders in the form of Griffin Land Resources. The premium cigar business (Macanudo, Partagas, Punch, Hoyo de Monterrey and the potentially valuable U.S. rights to the Cohiba brand) and the nonpremium cigar business were packaged in a newly public company called General Cigar. Culbro shareholders, including the Cullman family, received super voting B shares, while A shares were sold to the public. The Cullmans retained control of the company via their ownership of the B shares. In March 1999, General Cigar sold its nonpremium cigar business to Swedish Match, turning itself into a "pure play" on premium cigars.
Since its birth as an independent company, General Cigar has had its ups and downs. When the cigar faddists stopped lighting up in late 1998 and 1999--leaving the market to us true aficionados--the stock weakened, and by last December it was trading around $8 per share. Still liking the company's dominant position in the premium cigar market and its strong balance sheet, we bought a lot more stock. On January 20, 2000, General Cigar agreed to sell 64 percent of the company to Swedish Match for $15.25 in cash per share for the Class A shares--a solid profit for our clients.
After the deal was announced, General Cigar stock traded at $14.50 per share, leaving $0.75 per share on the table for arbitrage investors. This worked out to a gross return of 5.2 percent, or an annualized gain of 17.25 percent from the time of the announcement to the expected mid-May closing date. With no market risk in this all-cash transaction, no apparent regulatory or antitrust hurdles, a motivated seller and a financially strong buyer, we were happy to take advantage of the back end of the deal as well.
You may be thinking, "Great, Mario, but this is a done deal. Give us a few names that might help us make a big score." Fair enough. Mark IV Industries (NYSE, IV, trading at 22 at press time), Wynn's International (NYSE, WN, 13 3/8) and Sybron Chemical (AMEX, SYC, 20 1/4) are all trading at deep discounts to our Private Market Value appraisals, and there are catalysts in place that lead us to believe that these companies might receive some interest from a corporate acquirer or LBO group. I'm not suggesting a profitable "event" is just around the corner. But these stocks are fairly compelling based on their own merits as independent companies.
Mario J. Gabelli is the founder and chairman of Gabelli Funds. Inc., a Rye, New York-based financial services company. He appears regularly on CNN and CNBC.