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[petec]

I sincerely hope they don’t sell anything just because it hasn’t performed so far, but I do think a hard headed “why are we in this?” analysis needs to be performed on every holding.

I’m more bullish on Stelco than you. It seems to me that a lot of their prior errors have been in buying junk that has debt. Stelco is junk, but it’s super cheap and debt free.

If T”R”U is generating 100m of ebitda I think that’s great. I doubt much of that comes from amortising software and they can use it to pay debt before paying returns to equity. (Can you recall the size and terms of the revolver you reference, btw?). I was more worried by the wording in the call which made me wonder if it’s still generating that much ebitda.

[StubbleJumper]

I sincerely hope they don’t sell anything just because it hasn’t performed so far, but I do think a hard headed “why are we in this?” analysis needs to be performed on every holding.

I’m more bullish on Stelco than you. It seems to me that a lot of their prior errors have been in buying junk that has debt. Stelco is junk, but it’s super cheap and debt free.

If T”R”U is generating 100m of ebitda I think that’s great. I doubt much of that comes from amortising software and they can use it to pay debt before paying returns to equity. (Can you recall the size and terms of the revolver you reference, btw?). I was more worried by the wording in the call which made me wonder if it’s still generating that much ebitda.

Pete, the point is that even for a retailer, EBITDA and Earnings are not the same thing.  You might think it's great that Toys R Us generates $100m ebitda, but personally I cannot say whether it's great or terrible (but at least it's a positive number!). 

I have never seen a retailer that didn't spend considerable amounts of money on point of sale hardware and software and inventory management software.  Same thing with shelving, and the million bits and pieces of equipment that retailers require on the floor and in the back room.  These expenditures tend to be lumpy, but they should never be disregarded.  Similarly, it's a rare retailer that does not have considerable working capital requirements for inventory, and that is normally either funded through supplier credit or a revolver.  I have no idea what the magnitude of this might be for Toys R Us, but it will almost certainly be there and interest costs should not be disregarded (if you want to BS a bit about the possible working capital requirements, you can do a bit of hypothetical math -- $100m ebidta might be generated from $1.5b in sales, which could be $300m of inventory at 5 turns per year?  I pulled all of that out of my ass, but you get the idea).

I look forward to seeing whether there will be more disclosure in the annual, but on the other hand, it's not particularly material to overall operations.  I'd be curious to see what happens when that EBITA number flows down to the bottom line.  Do you end up with a positive number?  If it's positive, does it get haircut from $100m to less than $50m?  Less than $25m? 

Retail is a tough industry to compete in.  And it's a great place to find value traps (ask me how I know  )


SJ

[petec]

I generally hate ebitda as a measure so I have a lot of sympathy for what you’re saying. Nonetheless it’s a guide to cash flows and it’s the only one we have. I’m not aware of a reason to assume the business is sucking up working capital (sure, it probably needs some, but it’s a mature business so it’s likely to be fairly steady - the biggest danger is actually if it’s working capital positive and revenues are shrinking). D&A, sure, there will be some cash cost in there, but POS units and software can be run for years - the bigger cost is maintaining stores and even that can be deferred if you need to prioritise paying down debt etc. My point is simply that unless it’s loaded with debt, which I sincerely hope it isn’t, if it’s generating a decent slug of ebitda there’s a decent chance it’s FCF positive. Would I care to put a number on that? No. But if the real estate covers the purchase price then the risks are probably fairly low. That’s all I’m driving at.

[StubbleJumper]

I generally hate ebitda as a measure so I have a lot of sympathy for what you’re saying. Nonetheless it’s a guide to cash flows and it’s the only one we have. I’m not aware of a reason to assume the business is sucking up working capital (sure, it probably needs some, but it’s a mature business so it’s likely to be fairly steady - the biggest danger is actually if it’s working capital positive and revenues are shrinking). D&A, sure, there will be some cash cost in there, but POS units and software can be run for years - the bigger cost is maintaining stores and even that can be deferred if you need to prioritise paying down debt etc. My point is simply that unless it’s loaded with debt, which I sincerely hope it isn’t, if it’s generating a decent slug of ebitda there’s a decent chance it’s FCF positive. Would I care to put a number on that? No. But if the real estate covers the purchase price then the risks are probably fairly low. That’s all I’m driving at.

I don't have much doubt that it's FCF positive in the short term, I just question whether it is fundamentally profitable on a longer term, bottom-line net earnings basis.  If you are of the view that Toys will be put into run-off over the next five or so years, then depreciation and amortization are irrelevant and your FCF represents a bit of gravy while the main course is the capital gains from divesting the real estate.  On the other hand, if you elect to view Toys as a longer term going-concern, then you *need* to see a positive net earnings number.  A negative earnings number even with positive FCF isn't great because eventually you are forced to make leasehold improvements (spruce up the stores), buy or build new systems or replace other equipment.

In this aspect, it is a bit like the Sears story.  Based on a back-of-the-envelope sum of the parts analysis, it seemed pretty obvious 10 or 15 years ago that Eddie could easily buy Sears, sell off the assets and walk away with a few billion in profit.  Unfortunately for him, it took forever to divest the assets and, in the interim, the retail operations lost a hell of a lot of money before he could make his exit. 

Turning back to Toys, the comments on the FFH conference call have led me to believe that FFH wants Toys to be a going-concern, but as I said, it doesn't give me much confidence that they have provided shareholders with just an EBITDA number.  If it truly is a fundamentally profitable business (ie, positive net earnings), eventually they'll be able to sell it to somebody as a going-concern.  But, the concept of running it for a few years to see whether it can be turned around, and then liquidating if it can't be turned profitable strikes me as a pretty poor idea.

It'll be interesting to see what will be disclosed in the AR.


SJ

[petec]

Agreed. My thinking is that +ve FCF is useful if you want to a) pay down whatever debt there is, boosting net income and b) shop it to private equity which sounds like it might be on the cards. I'm not proposing that ebitda alone is enough for it to be a good long term hold.

[WhoIsWarren]

Regarding Toys R Us Paul Rivett said: "we got a business that was making over 10 years $100m of EBITDA year after year....the company continues to generate EBITDA...."  Unless I missed a clarification somewhere else, I took that to mean $100m was a 10 year average.  Isn't it likely that more recent years have been tougher?  $100m might not be a good benchmark for the future at all.  I am also very wary of the idea that they got valuable real estate with a toy business thrown in for free - if the liabilities from one can transfer over to the other, then it's just wrong to talk about them as two parts.  They know this too and when they make such statements I feel violated.

I'm also interested in what you guys think about the last question on the earnings call, which was about the level of equity securities on the balance sheet and whether a mark-to-market of their securities in a -50% stock market environment could wipe out 50% of Fairfax's equity capital.  He was giving rough numbers here of course, but it's a point worthy of serious consideration.  Not just a question for Fairfax mind you, but compare and contrast with Berkshire (a lot of wholly-owned businesses).

Paul's answer was pathetic -- this is "a stock picker's market", "we've got value stocks", we are "conservatively positioned", "we think there is....a potential for a trade deal that will extend the runway in the US..." -- but I will give him the benefit of the doubt for being caught on the hop.  Even if they are right that their equity investments are cheap long-term, mark-to-market can have real business implications in the short term.  Perhaps a hedge or, more simply, perhaps less equities is the answer?

A separate but related point is why insurance companies are run with debt.  I think there's enough risk in the business without it.  Bundled up in there is a question about how much insurance underwriting risk is being taken on, how much risk has been laid off to reinsurers etc., so it's a complicated topic.  It's not a free lunch though and I would personally prefer less than more.  Perhaps this topic has been discussed somewhere else, if so apologies.

[StubbleJumper]

Regarding Toys R Us Paul Rivett said: "we got a business that was making over 10 years $100m of EBITDA year after year....the company continues to generate EBITDA...."  Unless I missed a clarification somewhere else, I took that to mean $100m was a 10 year average.  Isn't it likely that more recent years have been tougher?  $100m might not be a good benchmark for the future at all.  I am also very wary of the idea that they got valuable real estate with a toy business thrown in for free - if the liabilities from one can transfer over to the other, then it's just wrong to talk about them as two parts.  They know this too and when they make such statements I feel violated.

I'm also interested in what you guys think about the last question on the earnings call, which was about the level of equity securities on the balance sheet and whether a mark-to-market of their securities in a -50% stock market environment could wipe out 50% of Fairfax's equity capital.  He was giving rough numbers here of course, but it's a point worthy of serious consideration.  Not just a question for Fairfax mind you, but compare and contrast with Berkshire (a lot of wholly-owned businesses).

Paul's answer was pathetic -- this is "a stock picker's market", "we've got value stocks", we are "conservatively positioned", "we think there is....a potential for a trade deal that will extend the runway in the US..." -- but I will give him the benefit of the doubt for being caught on the hop.  Even if they are right that their equity investments are cheap long-term, mark-to-market can have real business implications in the short term.  Perhaps a hedge or, more simply, perhaps less equities is the answer?

A separate but related point is why insurance companies are run with debt.  I think there's enough risk in the business without it.  Bundled up in there is a question about how much insurance underwriting risk is being taken on, how much risk has been laid off to reinsurers etc., so it's a complicated topic.  It's not a free lunch though and I would personally prefer less than more.  Perhaps this topic has been discussed somewhere else, if so apologies.

Paul's answer was definitely poor, and it effectively argued that cheap stocks can't get cheaper.  Blackberry is currently cheap, but in a market drawdown, it's impossible that the investment community will hate Blackberry even more than they hate it today!  It was not a great response, but he might have been a bit of a deer in the headlights on the subject of potential equity hedging.   

The better answer would be, who cares?  If equity is cut in half temporarily, it's cut in half temporarily.  As long as the regulators don't get their panties in a twist and as long as it doesn't violate some obscure bond covenant, everything is fine.  And, when you look at their premiums to surplus ratio, there's lots of room to haircut capital without constraining underwriting.  I don't doubt that a 50% haircut would cause a fair bit of dancing at FFH to move capital around the subs, they might need to make a few decisions about not renewing some business, and they'd probably need to issue a couple million more shares -- but it's probably not an existential question.


SJ

[sdev]

While I won't argue that the business will not grow / contract in the future, because it likely will - what is concerning is the equity investment strategy over the past 10 years has been a disaster, select large portfolio holdings are homerun swings without a clear strategy, and the forward equity strategy is a mixed bag of investments without any clear investor advantage other than, it's cheap.

The age old strategy is to be the best at your part of the world. I personally am guilty (perhaps very guilty) of thinking that my investable universe is larger than it should be. In my opinion Fairfax could do with an overhaul (read: narrowing) of how they deploy equity capital - as it's possible to buy "cheap" assets in any market, in any vertical - with patience and best in class platform / skills for the niche.

As my underwriting box thankfully narrows over time - Fairfax falls outside my criteria, and I'll be peeling off my 10+ year holdings over time, with remorse.

[WhoIsWarren]

The better answer would be, who cares?  If equity is cut in half temporarily, it's cut in half temporarily.  As long as the regulators don't get their panties in a twist and as long as it doesn't violate some obscure bond covenant, everything is fine.  And, when you look at their premiums to surplus ratio, there's lots of room to haircut capital without constraining underwriting.  I don't doubt that a 50% haircut would cause a fair bit of dancing at FFH to move capital around the subs, they might need to make a few decisions about not renewing some business, and they'd probably need to issue a couple million more shares -- but it's probably not an existential question.


SJ

Maybe you're right that it's not a big deal, but it's not a theoretical risk.   If the capital situation got bad enough they might have to raise capital (or at least have the threat of it hanging over them).  They could cut back on underwriting / increasing inwards reinsurance, but it might be precisely when insurance pricing is really attractive.  Mark-to-market can have a detrimental effect.  If I'm not mistaken, a whole host of insurers (Europeans?) got into trouble in the early 2000s as a result of having too much equity exposure.

I just hope management has run the scenarios and carefully considered the possible consequences.

[StubbleJumper]

The better answer would be, who cares?  If equity is cut in half temporarily, it's cut in half temporarily.  As long as the regulators don't get their panties in a twist and as long as it doesn't violate some obscure bond covenant, everything is fine.  And, when you look at their premiums to surplus ratio, there's lots of room to haircut capital without constraining underwriting.  I don't doubt that a 50% haircut would cause a fair bit of dancing at FFH to move capital around the subs, they might need to make a few decisions about not renewing some business, and they'd probably need to issue a couple million more shares -- but it's probably not an existential question.


SJ

Maybe you're right that it's not a big deal, but it's not a theoretical risk.   If the capital situation got bad enough they might have to raise capital (or at least have the threat of it hanging over them).  They could cut back on underwriting / increasing inwards reinsurance, but it might be precisely when insurance pricing is really attractive.  Mark-to-market can have a detrimental effect.  If I'm not mistaken, a whole host of insurers (Europeans?) got into trouble in the early 2000s as a result of having too much equity exposure.

I just hope management has run the scenarios and carefully considered the possible consequences.

No, don't get me wrong.  Seeing half of FFH's equity disappear temporarily would cause most of us to have a shit-fit.  But, the question on the conference call seemed to be driving at the notion that it was an existential issue, and I do not believe that to be the case.  It would certainly be bad, it would almost certainly result in an equity issuance that disadvantages existing shareholders, and it would certainly come at the cost of future growth. But, the countervailing factor is that FFH would probably make a pile of money on the investment side in those circumstances.


SJ