EXTRAORDINARY VALUES
(August, 1999)
"Investments must be rational; if you don't understand it, don't do it!"
Warren Buffet
In our April 1999 newsletter, we mentioned three companies which we thought represented extraordinary value and promised future updates.
These companies were:
• Schlumberger
• Toys R Us
• CPI Corporation Schlumberger
Schlumberger
We purchased Schlumberger for your portfolio at an average cost of $46 in November
1998 and at the end of June it closed at $63.69. We believe it is now trading
at fair value with the current private market value still at $92. One of the
reasons Schlumberger sold down to the low $40's from a high of $90 per share,
just one year before, was that the price of oil had dropped to $10.82 per barrel,
which was a 25-year low when adjusted for inflation. Investors feared that the
price would stay there or spiral downward, which created an environment of maximum
pessimism. This gave us the opportunity to acquire the premier company in the
oil service business at literally a 50% discount to its private market value.
CPI Corporation
CPI Corporation
We purchased CPI Corporation several years ago at an average cost of $16 per
share. For clients who started with us during the past 18 months, the average
cost is closer to $20 per share. In our April newsletter, we discussed the valuation
of CPI's private market value, and suggested that it was $50 per share. Recently,
CPI's management announced a management led buyout at a price of $37 per share.
Our reaction to this offer is one of mixed emotions. While we are happy for you that the stock has increased within a year from $20 per share to its current price of $32, and will eventually rise to $37 if the offer is accepted; we believe the management is short-changing the investors by about $13 per share. Therefore, we are not pleased with the management's offer because we feel it is does not reflect the true value of CPI.
In December 1996, Century Management was featured in the publication Outstanding Investor Digest. In this article, we discussed CPI Corporation's private market value and how it was selling at such an extraordinary price of $16 per share. At that time, we placed the private market value at $38 per share. Since then, CPI has made tremendous progress in increasing its profitability and establishing itself as a leader in its industry. With all major capital expenditures now behind it, CPI is positioned to reap the benefits of higher profits and increasing cash flow over the next two years. Based on this, we believe the company is worth a minimum of $50 per share. We sent a personal letter to the president of CPI expressing our disappointment and a similar letter to the board of directors indicating that we feel the offer is unfair and that they are taking advantage of their shareholders. We have received replies to both of our letters and we were disappointed with their response. Currently, a shareholder has filed suit against the company to challenge the low price that CPI's management is offering.
We, too, do not intend to sit idle while the management picks our pockets. Therefore, we will be sending you a letter concerning this issue and recommend that you vote against the management's proposal to buy the company unless a higher offer is forthcoming.
We believe there is a good chance that the company may increase their offer for two reasons. First, CPI's management, and most of the major shareholders, know this company is worth a great deal more than they are offering. In order for this buyout to be confirmed, the management needs 50% of the shareholders' votes approving the sale. While it is always possible that the major shareholders will accept this offer, there is a good chance that they will demand a higher price.
Second, CPI stock is currently trading at a 16% discount from the buyout price, indicating that arbitrageurs are not confident the sale will go through. Typically, stocks sell at a 5% to 10% discount from the buyout price offered. The discrepancy in this case would indicate that there is a low confidence level that the sale will be approved or that it will occur at this price.
If this management buyout does not occur, there is a temporary risk that the stock price could return to $27 or $28. We would prefer this short-term reversal, rather than sell out at $37. In the next two or three years, CPI should earn $4 to $5 per share. If you apply the average earnings multiple (P/E) of 17.5, which is the average P/E of the 5,700 companies covered in the Value Line universe, the price of CPI could range from $68 to $85 per share. However, CPI is not your average metal bender. On the contrary, CPI is a premier company and is poised to dominate its industry like it never has before. We suggest that a more appropriate multiple for this company over the next two years would be 20 to 22 times earnings as a buyout multiple. Either way you do the math, it's not difficult to see that the present value of CPI is worth a great deal more than the management offer of $37.
Toys R Us
We purchased Toys R Us at an average cost of $17.50. The stock rose to $24 per
share, but has since settled back down to $17.
The reason for this swift round-trip was that Toys R Us announced the creation
of an Internet division to be lead by a successful Internet industry executive.
However, a problem developed with his recruitment which has caused a temporary
delay in the placement of the Internet division CEO. Toys R Us has been actively
moving ahead with their executive search and we expect that a new division CEO
will be announced shortly.
At today's price, Toys R Us is selling at a P/E ratio of 11.2, based on last year's earnings, and a P/E of 10.5, based on projected earnings. This is in a market environment where the average stock in the 5,700 stock universe that Value Line covers has a P/E of 17.5 and the S&P 500 index trades at a P/E of 29. Clearly, Toys R US is a very cheap stock selling at maximum pessimism.
