Until then, we’ll share a couple of new pieces of information we’ve come across since our Aussie Pride post just a few days ago.  To begin, we think it’s worth noting that the peak in existing house sales in the U.S., led the peak in price by about six months.  It is intuitive that, Activity Leads Price in the real estate market.  With that little nugget in mind, homeowners in Australia may wish to note the following press releases from HIA’s Economics Group:

Approvals Nose-Dive in January, 3 March 2011

“Building approvals fell substantially in January 11, as higher interest rates have negatively impacted the demand for housing.”

“Total residential building approvals fell by 15.9% in January 2011 to be down 24.8% on a year earlier.”

“The January 2011 fall in approvals is the worst monthly decline we have seen since September 2002.”

“Today’s poor approvals numbers emphasise the extent to which the non-mining sectors can be squeezed as the RBA hikes rates to control price pressures coming out of the mining sector.”

Pulse of New Housing Too Slow, 9 March 2011

“The number of loans for construction fell by 9.4% in January 2011 to reach the lowest level since December 2008.  Loans for the purchase of new dwellings dropped by 13.5% in January 2011, which was also the weakest level since December 2008.”

“An unequivocally weak update on housing finance for January 2011 reinforces the appropriateness of a steady interest rate environment.  It is important the Reserve Bank maintains a clear message of stable rates.  Housing, like the majority of non-resource sectors, is performing below par in 2011.”

Investors are certainly entitled to their own opinions but that does not sound like a ringing endorsement for a fundamentally strong housing market to this simple mind.  It would appear that 8% interest rates on new loans are starting to take a bite out of the “non-mining” Ozzie Economy.

The numbers don’t lie.  But the anecdotal information we are coming across on a regular basis paints an even more colorful story.  Once Australian writer notes:

Southport Central — where 165 units remain for sale — was the city’s best-selling project for the quarter with 28 sales. Apartments in the project’s second and third towers are selling from $340,000, down from the 2007 entry-level price tag of $437,000.

More than 720 new apartments remain for sale across the Coast, equating to just over two years of stock at the current rate of take-up.

The number of newly advertised properties for sale is 25.9% higher than it was at the same time last year. The total number of properties currently being advertised for sale is at the highest level of any week since the beginning of 2007. The elevated stock level is largely due to the difficulty vendors are having selling their properties as investors and first home buyers remain on the sidelines. The total number of properties advertised for sale increased by 1.7% last week and is 24.2% higher than at the same time last year.

Disclosure: At the time of publication, the author was short the Australian Dollar, Australian interest rates and various Australian financials via traditional and derivative investment vehicles, although positions may change at any time.

Also opposing the duties is Lumber Liquidators Inc., a U.S. chain of flooring stores. The company said at a trade-commission hearing in November that certain types of Chinese flooring are among its most popular products and that U.S. manufacturers had failed to “adapt to the changing market trends.”

Importers would be in a tough spot if duties were imposed, said William Perry, a lawyer representing some of them. That’s because such levies can be adjusted by the federal government annually, and new duty rates are applied retroactively. As a result, importers don’t know how much they would have to pay when they agree to bring in Chinese products.

We find it intriguing (to say the least) that certain firms that are strongly opposing duties claim that Chinese MLWF imports are a minor percentage of sales yet, they have hired an army of attorneys to defend this small business segment and stated above, “certain types of Chinese flooring are among their most popular products.”

More recently, Tom Barkley of the WSJ, notified readers that the U.S. Plans to Impose Duties on Chinese Flooring:

The Commerce Department set preliminary duty rates of as much as 27.01% on the “multi-layered” flooring imports. The department is still reviewing the dumping charges, with an announcement expected in mid-May.

It is worth noting that, research we’ve reviewed suggests that over the last four years, 80% of all cases filed against China have resulted in a duty of some kind.  Countervailing Duties have averaged 53% in these cases, so the 27% duty on multi-layered flooring is roughly half of that average.  Importantly, Antidumping Charges have averaged a much larger 120% in these cases.  Even assuming that multi-layered wood flooring is charged half of the average, the total cost increase for Chinese imports would be nearly 90% higher.  As we discussed in our initial report, Got Wood, duties this high would put low-cost distributors in trouble as other countries (i.e. Indonesia and Malaysia) have only a fraction of China’s capacity.

In the meantime, the housing market is not waiting for an ITC determination as recent data points to accelerating declines.  We are not alone in our expectation for further weakness.  Robert Shiller recently said as much in the NY Times, noting the unrest in the Middle East, a large backlog of foreclosed houses, the uncertain future of the mortgage holding companies Fannie Mae and Freddie Mac and proposals to reduce the mortgage tax deduction, saw “a substantial risk” of declines of “15 percent, 20 percent, 25 percent.”

The numbers don’t lie.  Take a look at the most recent data we’ve collected this week:

Existing home sales slipped more than expected in February, falling 9.6% to a seasonally adjusted annual rate of 4.88 million. The housing market is, inescapably, weak.

Despite near record affordability, existing home sales continue their decline while housing inventory rose 3.5%, an 8.6 month supply at the current price, up from 7.5 months in January.

New home sales fell more than expected to a record low. February sales were 16.9% below the revised January rate and 28.0% below last year’s estimate.  Months of supply increased to 8.9 in February from 7.4 months in January.  This is very high as “normal” levels are less than six months supply.

Dept of Commerce Preliminary Finding of CVD

Disclosure: At the time of publication, the author was short Lumber Liquidators  (LL), although positions may change at any time.

As gauged by an aggregate of housing indexes dating to 1890, real home prices rose 85 percent to their highest level in August 2006. They have since declined 33 percent, falling short of most predictions for a cumulative correction of at least 40 percent.[1] In fact, home prices still must fall 23 percent if they are to revert to their long-term mean.

With this picture in mind, we were particularly interested in another report recently issued by the Joint Center for Housing Studies of Harvard University, titled A New Decade of Growth for Remodeling.  While the authors of the report are mildly bullish on the outlook for home improvement, we find it exceptionally difficult to get remotely excited about the industry, when comparing the chart above, to the one below.  The bottom line is simple – further declines in home prices, a near certainty based on a multitude of factors, portends further weakness in home improvement and remodeling spending.

We’ve come across several other reports on the industry with a modest bullish bias based upon a handful of arguments (some better than others).  We consider many of these factors potential positives for the likes of HD and LOW, but find little to get excited about with respect to more niche players in the industry (LL).  For example, one analyst points to the fact that a greater portion of home improvement spending is non-discretionary maintenance and repair versus more discretionary remodeling expenditures.  “If a window breaks, it needs to be fixed; snow needs to be shoveled and leaves need to be raked.”  We wonder how many floors “break” as homes age?  This trend towards “needs” and away from “wants” bodes favorably for HD/LOW relative to LL.

“The Street” also correctly identifies that ticket trends have been supported by small project spending.  Importantly, home prices are a key link to ticket trends since excess home equity has been a key source of larger project related spending (i.e. flooring).  The year-over-year change in HD and LOW average ticket has exhibited a close correlation (the r-squared since 2002 has been 0.78) to home price changes.  However, with most analysts modeling only a “modest” further decline in home prices, we think the downside in the industry is significant, should prices fall further toward the long term average.  Again, we encourage you to read the full report from the Dallas Fed (link above) to understand the multitude of factors which make a greater decline in housing our base case.  In any event, we would argue that even the “bullish” outlook on small project spending is yet another potential positive for HD/LOW but does little for those companies in the space focused solely on flooring (LL), which is quite a large ticket, particularly when discretionary income is increasingly soaked up at the gas pump.

But at the end of the day, we see more downside risk from these levels, particularly for more speculative stocks in the space (LL) that are priced for perfection:

• Historically, there has been a close correlation between mortgage rates and housing turnover.  Compliments of QE2, potential home buyers are unlikely to come out of the woodworks given the spike in mortgage rates since last summer.  Less turnover means less home improvement spending as the lion’s share of dollars in the space are spent by homeowners within their first two years of ownership.

• Homeownership rates and the number of homeowners have declined and are likely to continue their descent given demographic constraints and the threat of much higher interest rates in the years ahead.  The upward trend in home improvement spending in the decade leading up to the bubble was largely driven by reckless domestic policy which encouraged homeownership at any cost. Since homeowners spend more on improvements that renters, the reversal of this trend should turn this tailwind into a formidable headwind until homeownership levels revert back to more normal levels.

• Spending on home improvement has been fairly concentrated among a relatively small number of metropolitan areas with the top 35 markets accounting for nearly 55% of all spending.  It turns out that bubbly house prices have been a key determinant of these expenditures. As the housing bust and subsequent recession have been more severe in these markets (you know who you are), unemployment is likely to linger at structurally higher levels, while a greater percentage of homeowners are underwater on their mortgages. Let’s just say the largest spenders on home improvement are not exactly running out to dump more money into homes worth less that what they owe and still falling in value.

We discussed the risks of potenital dumping duties on Chinese imported engineered flooring in our original report, titled Got Wood?.  We encourage those invested in the flooring industry to take a close look at this analysis, as the risk is real, despite being underappreciated on “the street” and downplayed by management.  Given the potential combination of Housing Headwinds and Potent Protectionism, we wonder who exactly is buying shares of LL near 30x earnings.  For what it’s worth, it would seem that at least one other shareholder agrees with our assessment – Chairman and Founder, Tom Sullivan, has sold approximately 75% of his ownership stake since going public in 2007.  As another pioneer in the industry would say, “Haauh?“

Disclosure: At the time of publication, the author was short Lumber Liquidators  (LL), although positions may change at any time.

And yet “the street” has not put two and two together, as a simple news search on various financial websites makes no mention of this decision as it relates to Lumber Liquidators (LL).  We continue to believe that this represents a material risk to shareholders, as we discussed in our initial post on the company and recommend ignoring any commentary suggesting otherwise, especially coming from a small, wooden boy as he is likely to be constructed from MLWF.

Disclosure: At the time of publication, the author was short Lumber Liquidators  (LL), although positions may change at any time.

Hardwood floors represent 57% of their sales with the company’s flagship Bellawood product making up 20% of net sales in 2009. LL also sells laminates (18%), moldings (13%), and bamboo/cork products (11%). Their top ten suppliers accounted for 69% of 2009 flooring purchases with 44% sourced from Asia, 37% from North America, 13% from South America and 6% from other locations. All foreign purchases are negotiated and paid for in USD. In 2009, 88% of orders went through their Virginia distribution center. They are expanding a new program where goods are shipped directly to stores from China. LL’s hardwood flooring market share was roughly 10% in 2009 (8-9% in 2008 and 7% in 2007).

Da Bulls

Bulls view LL as one of the few remaining retail growth stories as management aims to open a few dozen stores annually for the next several years in a roughly equal mix of new and existing markets.  About half of the company’s stores have opened in the past three years. It is easy to understand why when new stores are typically profitable within three months and have returned the initial cash investment within a year. But while a rapidly expanding store base has produced revenue expansion throughout the housing bust, same stores sales fell off a cliff during this period. We wonder how quickly bullish optimism over new store growth might turn into concerns for cannibalization as comps at mature stores continue to deteriorate. As we discuss in detail below, we believe demand for LL’s core products are set to decline next year as the foreclosure moratorium and expiration of homebuyer tax credits will have a meaningfully negative impact on existing home sales.  With “the street” forecasting a much stronger outlook for home prices (we struggle to find anyone calling for a decline more than 0% – 5%), investors in LL shares are set up for a major disappointment.

Wall Street claims that LL’s low cost advantage provides the company with a market niche that is difficult to lose. Bulls point to its focused product assortment, direct sourcing and “good customer service” as core competitive advantages over “big box” retailers. We think “the street” is missing several key issues that are likely to present major challenges in the year ahead. First, gross margins are likely to come down more than expected due to rising energy and transportation costs and increasing wage pressures in China. Because labor is a greater percentage of the total cost for engineered wood flooring, increasing Chinese labor inflation would quickly put a big dent in any “cost advantage” assumed by the bulls. In addition to downward pressure on gross margins, we also anticipate upward pressure on SG&A due to continued difficulties with the implementation of SAP into next year. Management guidance and “the street’s” acceptance that this is a one or two quarter blip runs contrary to past experience. Last but certainly not least, we are shocked by investors’ total and complete disregard for the pending US International Trade Commission investigation into Multilayered Wood Flooring (MLWF) imports from China.  At best, this investigation introduces substantial uncertainty into the business and serves as a distraction to management’s limited time and resources.  At worst, if the ITC were to set a tariff anywhere near the maximum level requested, we believe LL’s business model and “cost advantage” would be severely challenged.

Six Minutes of Pleasure

Shares of LL rose 375% from a low of $7.02 in March 2009 to a high of $33.41 earlier this year.  It’s worth noting that Tom Sullivan has sold roughly five million shares since the March lows with the great majority of sales at prices north of $20. At last week’s closing price of $23.42, the stock changed hands at 24x and 18x 2010 and 2011 consensus earnings expectations, respectively. Analysts are looking for 30% earnings growth next year driven by new store openings, operating leverage, and stabilization in the domestic housing market.  We have our doubts. Taking management at their word that MLWF only represents 10% – 11% of total sales, we estimate that a 50% tariff on Chinese imports would reduce next year’s earnings to $0.94, other things being equal.  An earnings miss of this magnitude would likely result in multiple compression, as valuations of “high growth” retailers are inherently unstable. For perspective, note that LL has traded as low as 8.6x and as high as 27.6x forward earnings since the company went public. Even giving the company the benefit of the doubt, and maintaining the stock’s current forward multiple, shares could easily trade down toward the $11 to $16 range based on the midpoint of our estimates highlighted in this report. If our estimation that LL’s exposure to MLWF represents a much larger share of the hardwood segment is correct (our research points to anywhere from one half to two thirds of segment sales), the impact would be much, much greater. And a higher tariff (potentially north of 200 percent), when combined with greater exposure to engineered flooring (as we believe), could present a disaster scenario for LL shares.

LL – Mama Said Knock You Out

Disclosure: At the time of publication, the author was short Lumber Liquidators  (LL), although positions may change at any time.

We recently watched a certain TV personality jumping up and down, like Jo-Jo The Idiot Circus Boy with a pretty new pet, and yelling at his viewers to “Sell, Sell, Sell” The St.  Joe Company (JOE) after the stock had lost nearly half of its market capitalization in under two months.  Viewers were told, “I know it’s got a strong balance sheet.  SO WHAT!  It may have acquired 477,000 acres of land in North West Florida at a very low cost.  SO WHAT! . . . The risk from the oil spill is no longer a question of if, it’s not even a question of when.  Now the only question is how much is this going to hurt?  Could it wipe out the company??”

We’ll spare the suspense here and answer that one right up front – not a chance.  The St. Joe Company has $39.5MM in debt, $27.1MM of which is offset by pledged treasury securities, and $30.6MM in maturities after 2014.  The company has total liquidity of $286MM comprised of $164MM and $122MM of cash and credit facilities, respectively.  A strong balance sheet may not be of much importance to speculators, but it provides long term investors with a comfortable security blanket.  Not to mention, the company has 577,000 acres of land, but what’s a 100,000 acres if you’re not interested in the assets a company holds anyhow?

Later in the segment, the audience is told that, “I am not saying this company is going to go bankrupt.  It’s probably not.  That’s what I’m saying about BP.”  We thought that last comment was particularly interesting, considering that on May 3^rd, with BP trading over $50, our favorite TV personality explained that “BP’s debt to capital is really incredible” and on May 10, he told viewers that he was purchasing shares of BP for his charitable trust at just under $50. “If you get any good news at all, you’re at the bottom.”

Which leads us to our next question – why doesn’t the same hold true for JOE, a stock that is already selling at half the price it was trading at less than two months ago, with ZERO responsibility for the spill?  Instead, viewers are told, “We cannot quantify the downside.”  While this is certainly the case for BP, who’s costs and liabilities are rising by the day, anyone remotely interested in buying discounted Florida property, and willing to take the time to actually analyze the company’s assets, can “quantify the downside” in JOE pretty easily. At a minimum, we can get a sense for what the stock is currently pricing in.  To help us determine the risk of a permanent loss of capital, we ask ourselves a few straightforward questions when considering any investment opportunity:

1. Is the investment within our Circle of Confidence?  Can we describe our thesis in one paragraph?
2. Can we confidently estimate value in relation to price?  What is an appropriate Margin of Safety?
3. Does the business have a moat?  What is the firm’s competitive advantage?
4. Is the business run by honest and able people?  Is management an efficient steward of capital?
5. What can go wrong?  How much do we stand to lose?
6. Are we willing to invest a large part of our capital in the business?

These questions form the foundation of our investment thesis in The St. Joe Company, which is outlined below:

Buy When There’s Oil in the Water (Jun-10)

Disclosure: At the time of publication, the author was long the St. Joe Company (JOE), although positions may change at any time

In all of the hullabaloo over Goldman Sachs, a CQ analysis of the rating services – Moody’s, Standard & Poor’s and Fitch – has escaped front-page headlines. Not that a number of observers haven’t been on to them for a few years now, including yours truly. Back in July of 2007 some of you will remember my description of their role in the subprime crisis. “Many of these good-looking girls are not high-class assets worth 100 cents on the dollar. You were wooed, Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels and a ‘tramp stamp.’” Now, it seems, I was a little long on humor and a little short on the reality. Tramp stamp and hooker heels do not begin to describe the sordid, nonsensical role that the rating services performed in perpetrating and perpetuating the subprime craze, as well as reflecting the general deterioration of investment common sense during the past several decades. Their warnings were more than tardy when it came to the Enrons and the Worldcoms of ten years past, and most recently their blind faith in sovereign solvency has led to egregious excess in Greece and their southern neighbors. The result has been the foisting of AAA ratings on an unsuspecting (and ignorant) investment public who bought the rating service Kool-Aid that housing prices could never really go down or that countries don’t go bankrupt. Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them.

Such services, however, while necessary in the ongoing scheme of financial regulation, are overpriced as well as subject to the influence of the issuer, which in turn muddles their minds and clouds their judgment to say the least. E-mails from S&P employees have been cited discussing massaging subprime statistics in order to preserve S&P’s market share relative to their two competitors. PIMCO’s Paul McCulley said it as only he can – “[The breakdown of our financial system] was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out the fake IDs!”

Still, as future bond issuers belly up to the bar with their rating agency seals of approval, it is incumbent on the buying public to treat those IDs with a healthy skepticism. Firms such as PIMCO with large credit staffs of their own can bypass, anticipate and front run all three, benefiting from their timidity and lack of common sense. Take these recent examples for instance: S&P just this past week downgraded Spain “one notch” to AA from AA+, cautioning that they could face another downgrade if they weren’t careful. Oooh – so tough! And believe it or not, Moody’s and Fitch still have them as AAAs. Here’s a country with 20% unemployment, a recent current account deficit of 10%, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels, and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out. Some AAA!

It seems that someone is finally paying attention as per the company’s recently filed 10-Q:

On March 18, 2010, MIS received a “Wells Notice” from the Staff of the SEC stating that the Staff is considering recommending that the Commission institute administrative and cease-and-desist proceedings against MIS in connection with MIS’s initial June 2007 application on SEC Form NRSRO to register as a nationally recognized statistical rating organization under the Credit Rating Agency Reform Act of 2006.

Further complicating matters for the company is the prospect that new regulation gives investors the right to sue the credit rating agencies for “knowingly or recklessly” failing to conduct a serious investigation of the facts or to obtain analysis from an independent source. Buffet has been an aggressive seller of shares around $25 or better despite defending the company at Berkshire’s Annual Meeting.

The nostalgic image of the U.S. postman has quickly become old-fashioned. Mailing volumes worldwide have been stagnant since the new millennium – substitution of electronic forms of communication via the internet is an inevitable process in the long run. Personal mail has steadily migrated to email, text and social-networking sites just as news has shifted from print to desktops (i.e. WSJ to Seeking Alpha). The Great Recession has simply expedited this transformation, as companies have slashed direct-mail budgets and embraced the internet to reduce costs and maintain margins. The disruption to PBI’s largest customers (i.e. financial services, retail, etc.) has fundamentally changed many of these business models. Corporations are encouraging customers to do more business online and are increasingly sensitive to demands for “going green” resulting in reductions in printed material.

The Economist recently provided investors with an updated look into America’s Struggling Postal Service.  The USPS says it will lose nearly $8 billion this year and as much as $238 billion by 2020 unless big changes are made.  Apparently, not much has changed since our initial industry comments.

Source: The Economist

Disclosure: At the time of publication, the author was short shares of Pitney Bowes, although positions may change at any time.

Downside appears limited from here. The company recently made an important interest payment to bond holders during the first quarter – BBI’s largest seasonal drain on cash. Quarters two and three are generally cash neutral while the fourth quarter, which includes the important holiday season, is the largest generator of cash. The company appears to have cleared their biggest near term hurdle, especially when one considers recent deals with major studios for new payment terms which reduce working capital, freeing up additional cash flow.

Upside is substantial when one stops to consider the potential for positive surprises:

We stress the word should only because it is not apparent that shareholders have the right team on the bus today. We appreciate the tremendous value in this franchise, but question management’s ability or incentive to unlock this value. Blockbuster CEO, James Keyes, is saying all the right things. But he’s been saying all the right things for years now. Jim, if you’re listening, we’d offer up the following words of advice first – “Well done is better than well said.”

It’s pretty clear that this old boy’s club may need a fresh set of eyes on the inside. Or better yet, a fresh pair of shoes, to “walk the walk” since they seem to have no problem “talking the talk.” We didn’t get a chance to ask him when we spoke yesterday, but I’m guessing our new friend Gregory Meyer is walking around in some pretty comfortable running shoes. We urge interested investors to take a look at Greg’s recent letter to stockholders and his original letter to the Blockbuster Board of Directors in 2005. And Jim, if you’re still listening, we’d urge you and your Board to carefully consider what Greg might have to offer. The guy did hand you Redbox on a silver platter five years ago . . . he just might know a thing or two.

G Meyer Shareholder Letter

Disclosure: At the time of publication, the author was long Blockbuster Senior Subordinated notes, although positions may change at any time.

This simple question, posed by legendary value investor Bruce Berkowitz, puts the consensus concerns surrounding the managed care industry into perspective.  The bottom line is that the health insurers are the only shot we have at managing this mess.  As much as he might like to, Obama does not have another entity to do it.  And our growing government does not have the expertise or efficiency to manage the process.

The bear case for these stocks is well known and well discounted even at today’s levels.  Let’s take Humana (HUM), for example – 60% of the analysts that cover the company rate it “hold” or worse.  To help put this number in perspective, a whopping 1% of the S&P 500 is rated “sell” today.  So suffice it to say that the “bad stuff” is in the price.  And when the bar is set low enough, it is not difficult to surprise on the upside.  Perhaps this is why earnings estimates for the company have been marching steadily higher in recent months.  So let’s consider some of the potential “good stuff” that might shift sentiment in the period ahead:

• Roughly three quarters of Humana’s premium revenue is driven by government programs.  It’s safe to say that as long as the printing press is still running, Uncle Sam will pay his bills.
• Humana has experienced spectacular growth from these programs driven by Medicare Part D and the trend towards private plans.
• Management effectively capitalized on this opportunity when it was presented.  As such, shareholders have been well served by the company’s strategic focus.
• Those receiving insurance through employers has declined this decade, but Medicare enrollments are rising steadily and expected to accelerate as baby boomers enter retirement.
• Humana’s decades of experience in Medicare programs gives the company a competitive advantage in dealing with new government programs for boomers and the uninsured.
• Humana spends much more on SG&A than peers resulting in significantly lower operating margins, and offering plenty of potential to ‘cut the fat’ out of the business.

But rather than throwing darts at potential positive surprises, James Montier recommends turning the process on its head:

Analysts are called analysts, not forecasters, for a reason.  All investors should devote themselves to understanding the nature of the business and its intrinsic worth, rather than wasting their time trying to guess the unknowable future . . . Rather than trying to forecast the future, why not take the current market price and back out what it implies for future growth.

This echoes Ben Graham’s words that you don’t need to know a person’s exact weight to know whether they are overweight or underweight . . . The idea of investing without pretending you know the future gives you a very different perspective, and once you reject forecasting for the waste of time that it is, you will free up your time to concentrate on the things that really matter. So, when trying to overcome this behavioral pitfall, remember what Keynes said, “I’d prefer to be approximately right rather than precisely wrong.”

This is an exercise we perform regularly at Broyhill.  If nothing else, we think we know what we don’t know.  Accordingly, we seldom make forecasts.  Lucky for us, accurate forecasting is not a prerequisite for portfolio construction or superior risk adjusted returns.  Working backwards from today’s price is more consistent and a much simpler exercise.  In analyzing Humana, and most of the managed care space, margin assumptions clearly drive intrinsic value.  So it is critical to understand what margin expectations are priced into the stock today.  Using consensus forecasts for long term top line growth (recall this is a group that is generally bearish on the industry) we estimate that current prices imply long term EBITDA margins of 2.4% using AFG’s Value Expectations. This implied margin should be viewed in the context of the company’s five and ten year median margins of 4.5% and 3.0%, respectively.

In other words, Mr. Market is already pricing in a near 50% haircut in Humana’s recent EBITDA margins by Uncle Sam.  That’s pretty aggressive, even for Obamacare, and leaves plenty of room for upside surprises.  We use the matrix below to estimate the stock’s sensitivity to changes in consensus sales and margin assumptions.  The bottom line is that investors would require an additional 100 basis point reduction in consensus margin assumptions to justify modestly lower valuations.  More importantly, upside surprises offer the opportunity for extremely handsome profits.  We can live with those odds.

Source: The Applied Finance Group

Bruce Berkowitz of Fairholme Capital Management tries to kill the company rather than looking for all the information that would support an investment:

We look at companies, count the cash, and try to kill the company . . . We spend a lot of time thinking about what could go wrong with a company — whether it’s a recession, stagflation, zooming interest rates or a dirty bomb going off. We try every which way to kill our best ideas. If we can’t kill it, maybe we’re onto something. If you go with companies that are prepared for difficult times, especially if they are linked to managers who are engineered for difficult times, then you almost want those times because they plant the seeds of greatness . . . Companies die . . . Here are the ways you implode: you don’t generate cash, you burn cash, you’re over – leveraged, you play Russian Roulette, you have idiots for management, you have a bad board, you ‘de-worsify,’ you buy your stock too high, you lie with GAAP accounting.

Apparently, he was not able to murder Humana.  Fairholme owns over 9% of the float.

Disclosure: At the time of publication, the author was long Humana Inc., although positions may change at any time.