Tuesday, February 14, 2012

Daily Journal Corp. - Investment Portfolio Equals Nearly 80% of Market Capitalization

A follow up to this post. Daily Journal Coporation (DJCO), a publisher that relies on Chairman Charlie Munger when selecting investments, has substantially expanded its investment portfolio over the past five years.

The investment portfolio value is now nearly 80% of market capitalization (the company currently has no debt). As I'll cover below, subtract the portfolio's value from market capitalization and the business itself sells for roughly 3x earnings.

Daily Journal Expands Investment Portfolio

As I mentioned in the prior post, the company took what was roughly $ 12 million in net cash and investments back in 2006, combined it with free cash flow from the core business, then wisely reallocated into marketable securities -- mostly common stocks -- when prices were low. The latest 10-Q filing reveals that the portfolio has increased to just over $ 79 million.
(Now, the marketable securities didn't go up in value nearly seven-fold, it was the combination of capital appreciation and five years of free cash flow invested wisely.)

As far as allocation goes, the portfolio has moved from being 100% in cash, U.S. Treasury notes and bills in December of 2006 to now being almost entirely in marketable securities. The company's most recent 10-Q shows that 96% of the portfolio is now in marketable securities (primarily common stocks).

As recently as December of 2008, the portfolio continued to have zero common stock exposure.

Basically, leading up to the financial crisis the portfolio was well-positioned to act when attractive opportunities to invest became available.

Then, in early 2009, at the height of the crisis, the portfolio allocation was completely transformed.

Common stocks were purchased aggressively and have been held or added to since that time.

The company's 10-Q filing this past Friday outlined some of their moves into marketable securities in recent years. The filing also revealed a recent purchase "of common stock of another Fortune 200 company."

From the latest 10-Q of Daily Journal:

In February 2009, the Company purchased shares of common stock of two Fortune 200 companies and certain bonds of a third, and during the second and the third quarters of fiscal 2011, the Company bought shares of common stock of two foreign manufacturing companies. During the first quarter of fiscal 2012, the Company bought shares of common stock of another Fortune 200 company. The investments in marketable securities, which cost approximately $45,166,000 and had a market value of about $76,213,000 at December 31, 2011...

The rest of the portfolio is made up of $ 3.1 million in U.S. Treasury bills, cash and cash equivalents. So, in total, the portfolio was valued at $ 79.3 million at the end of the quarter (and probably more than that now considering the recent rally).

The past five years is a great example of building up capital and waiting patiently for attractive investments (something Munger has emphasized on many occasions) to emerge.

Let's compare, in some more detail, the situation now to where the company was just five years ago.

At the end of December 2006, Daily Journal's cash and investments in total were worth $ 16.54 million.

Debt was $ 4.16 million.

So net cash and investments (cash and investments minus debt) = $ 12.4 million.

Market Capitalization = ~$ 61 million.

Enterprise Value (EV = market capitalization minus cash and investments) = ~$ 49 million.

Average earnings over the previous five years (2002-2006) =  $ 2.8 million.

EV/Avg Earnings = 17.5x

Back then, investor's were willing to pay slightly more than 17.5x for the prior five years average earnings. If for some reason earnings capacity became compromised, there was little value in the investment portfolio compared to the market capitalization at that time.

Let's look at the business the same way today. At the end of December 2011, the Daily Journal's cash and investments in total were worth $ 79.3 million.

There's no debt now so, of course, net cash and investments also equals $ 79.3 million.

Market Capitalization = ~$ 101 million (based on yesterday's close)

Enterprise Value (EV) = ~$ 22 million

Average earnings over the past five years (2007-2011) = $ 7.2 million

EV/Avg Earnings = ~3x

Investor's are now willing to pay roughly 3x for what the business itself earned on average over the prior five years. Of course, what matters is what the company will earn going forward.
(The forward multiple is likely to be higher. Earnings were $ 7.9 million in its most recent fiscal year but seems poised to decline from here. Earnings were actually boosted by increases in foreclosures in recent years. Public notice advertising for foreclosures is mandated by law in California and Arizona. This most recent quarter saw earnings drop to just $ 1.70 million down from 2.18 million in the same quarter a year ago.)

The stock is up more than 70% since December of 2006 (share count shrunk somewhat so the per share price is up more than the % gain in market cap). Even with that rise in price, the enterprise value to earnings has dropped from 20x to 3x.

So, even if earnings drops substantially going forward, there's now plenty of value in the portfolio to support much of the market capitalization (since the portfolio equals nearly 80% of market capitalization). We don't know the specific holdings but odds are pretty good that, at least with Charlie Munger involved, the holdings are not exactly speculative. The portfolio is also likely to made up of shares in businesses with the capacity to increase intrinsic value over time.

More from the latest 10-Q of the Daily Journal:

The Company's Chairman of the Board, Charles Munger, is also the vice chairman of Berkshire Hathaway Inc., which maintains a substantial investment portfolio. The Company's Board of Directors has utilized his judgment and suggestions, as well as those of J.P. Guerin, the Company's vice chairman, when selecting investments, and both of them will continue to play an important role in monitoring existing investments and selecting any future investments.

In just five years, the net portfolio value has increased from under $ 12.4 million to $ 79.3 million using only the cash generation capacity of the business itself and some wise allocation.

It's a business that may have hard to predict long-term prospects but, since the traditional business needs little incremental capital, with smart allocation of funds value has been created.*

Even if the traditional business is in steady decline, since it doesn't consume much capital, the somewhat reduced earnings levels can continue to be deployed into other attractive investments. This works, of course, only as long as the core business can produce a positive even if somewhat reduced stream of earnings (a sudden sharp decline in earnings would be much more troublesome).

Some questions come to mind:

Will Daily Journal's core business remain profitable, even if somewhat less so than recent levels, for a very long time?

If so, then valuation seems very low. When you combine the value of the new cash earnings that will be coming in each year, potential intrinsic value growth over time of the existing portfolio, and who'll be allocating capital the recent market price seems a nice discount to intrinsic value. In fact, the stock wouldn't be expensive at even half recent profitability levels as long as those lower levels were sustainable long-term.
(Oh, and though it now seems unlikely, if there ended up being any sustained growth whatsoever in earnings then the stock would be truly cheap.)

Are much larger declines in profitability more imminent?

If that's the case then the current market price makes more sense. Under this scenario returns may not be great but the downside still appears somewhat limited by the investment portfolio's value as a percent of market cap.
***
I think knowing how long the core business will maintain favorable economics is a tough call but, as a result of smart capital allocation, risks have been managed very well (it helps to have a business that requires little capital).

The question is what level of revenues and profits can be considered normalized. A good answer to that question would make the shares quite a bit more attractive.

In recent years, unusually high levels of foreclosures in California and Arizona have temporarily boosted earnings but clearly aren't sustainable. Foreclosure notices decreased by 26% in the most recent quarter compared to the prior year period. The recent trends for their other key sources of revenues are also not particularly great. The company is expecting revenues to decline in 2012 and that would appear likely to continue.

So it's best to assume earnings in recent years were much stronger than they will be going forward (nothing wrong with expecting lower levels and being pleasantly surprised). The investment portfolio performance, effective allocation of future free cash flow, and the sustainability of the traditional business (even if at a lower level of free cash flow) remains the key to value creation at Daily Journal.
(Obviously at some point they could acquire a business with their capital instead of buying marketable securities.  My view is, at least at their current size, why bother when shares of many publicly traded attractive businesses are selling below intrinsic value.)

I still think it is fair to say not much right has to happen at the current valuation.  A sudden sharp decline in earnings and possibly a costly wind down of the business down is a risk. Otherwise, considering the balance sheet strength and who's involved in allocating capital, the margin of safety isn't too bad.

Keep in mind that insiders own a bunch of the stock and shares trade in an extremely illiquid fashion. Anyone interested in the shares had better avoid market orders.

Adam

No position in DJCO

I wouldn't equate the Daily Journal with Blue Chip Stamps but the redeployment of capital from a source with less attractive prospects toward something with more attractive prospects is familiar territory for Charlie Munger. The float from Blue Chip Stamps, a doomed business long ago, was intelligently used to buy See's Candies (among other things), a business that has created lots of value for Berkshire Hathaway over the years. In the case of Daily Journal, instead of float it is free cash flow but still a matter of allocating capital effectively. It would seem that Daily Journal has more favorable business prospects than Blue Chip Stamps but that's a separate question altogether.
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