Could my Next Big Play be Leveraged Companies? (Y, NXST, HOV)

Early last year  I warmed up to the idea that housing was in the early stages of recovery and this single idea generated a number of successful investments for me (NCT, NSM, IMH, MTG, RDN, HOV…).  With many of these housing investments having now played out I have been trying to think of what big idea might drive my strategy in the next 9-12 months.

What occurred to me rather suddenly this week was that perhaps I had already figured that out, had even been acting on the idea, though I had not articulated it consciously.

Companies with excessive leverage have been shunned for the past 5 years. Many have lagged as questions about their ability to continue as a going-concern have superseded any potential out-performance to the upside if things take off.

I think that this might be the year that changes.

Much like my idea with housing last year, this is an idea, a theory, and by no means something that I am convinced will happen. Its something that makes sense to me and could be quite profitable if it plays out the way I imagine it.  Much like housing last year, it feels a bit scary.

Nevertheless, I have waded in with purchases of stocks like YRC Worldwide, Arkansas Best, Nexstar, Yellow Pages, and Axle Manufacturing (which I unfortunately subsequently sold), all of whom would be considered quite levered on most scales. I am actively looking for others.

The reason it makes sense is that we have entered the rather unique situation where either the US economy is going to start to improve (which some of the latest economic numbers suggest might be happening) or the Federal Reserve (along with just about every other Central Bank on the planet) is going to continue to print money and keep interest rates absurdly low. In the former scenario business could finally begin to improve enough to support the level of debt on the balance sheet (or at least give the perception that this is the case for a time) and in the latter investors will continue to look for places to put all of this money sloshing around, a situation that I have found to be beneficial of speculative plays (a case could be made that it is this behavior that has benefited Radian and MGIC),

The difference between this round of quantitative easing and the previous ones is that this time around its open-ended. So while in past incarnations investors have shied away from the more highly levered players because of the concern that they be left standing when the music stopped, the Federal Reserve has made it quite clear that this time the printing will continue until it is no longer needed. This seems to me to be an invitation to take on positions in longer duration stories.

Adding to Nexstar, Hovnanian, and Yellow Pages

In the spirit of this new idea, in the last few weeks I added to some leveraged names that have been working for me. Hovnanian has a market capitalization of $800 million (common only), negative common equity and debt of over $1.5 billion. Yellow Pages has $900 million of debt and debentures versus $240 million market capitalization. Nexstar has a market capitalization of $500 million, negative common equity and debt of $613 million.

In the case of Nexstar and Yellow Pages, both companies are generating significant free cash flow.

Nexstar posted $29 million of free cash flow in the fourth quarter. Estimates of free cash flow for 2013 are in the neighborhood of $3 per share, followed by $4 in 2014 (with the increase being partly due to advertising revenues from the political cycle). I think that with an improving US economy, a refresh in the auto-replacement cycle (car ads make up an amazing 26% of all advertising on television, something I just learned and was surprised by), and continued growth in re-transmission revenue that Nexstar gets paid from cable providers who carry their stations (note that this is a source of significant growth for Nexstar and probably deserves a post in its own right to explain properly).

I originally bought a half position in Nexstar at $15, bought the other half position at $14.30 and then again this week at $17.

As for Yellow Pages, I did some work on the stock back in early February, stepped through the 2012 numbers.  When I backed-out the one time charges associated with the restructuring I estimated that the company netted about $285 million in free cash flow in 2012. With roughly 28 million shares outstanding that works out to a rather insane $10 per share (the stock is trading at $8.50 right now).

The catch of course is that the company’s primary source of cash (phone books) is declining at a significant rate. Yet when I model out cash flow generation in 2013 and 2014, mitigating a 20% decline in phone book revenues with a 5% increase from the on-line and mobile businesses, and assuming a gross margins decline from the current 50% level to 40% by 2015, I still see cash flow generation of $250 million in 2013 and $200 million in 2014.

While its difficult to predict at what level free cash flow will eventually stabilize at (it won’t occur for a few years and depends on how successful the company is in growing their on-line brand), I suspect it will still be in the high double digits. By that time the cash flow generated in the interim will have been used to pay off most or all of the company’s debt, and the result should be a significantly higher share price. I also note with interest that Kyle Bass has taken a large position in the US yellow pages companies, Dex One and SuperMedia (two more stocks I need to look at when I find the time).

I also added a small amount to my position in Hovnanian after listening to the company’s first quarter conference call on Friday. The home building business seems to be progressing well. The company provided the following table of price increases occurring in Northern California over the past 13 weeks. Northern California was one of the hardest hit markets during the crash and is also an area where Hovnanian holds a lot of undeveloped, mothballed land.

While Hovnanian has a negative book value of about $480 million, its worth pointing out that they have written down to 20% undeveloped land that previously had a carrying value of $600 million. In addition the company has another $900 million in net operating losses that they have written off completely against a valuation allowance, but that would quickly come back on-balance sheet once the company can demonstrate profitability on a sustainable basis.

Also interesting with Hovnanian are the preferred shares, which were pointed out to me by a fellow on twitter that goes by the moniker @adoxen. He recommended I take a look, which I did, and I can see the opportunity. I might write up something more substantial on them once I’ve had time to finish working through the numbers on them.