Company Acme

• Revenue of $1,000,000
• Cost of running business $500,000/yr
• Original shares outstanding 100000
• Debt of 10 year $300,000 at 5%
• Shares trading at $50

Revenue $1,000,000
COGS $ 500,000
Interest Payment $ 15,000

Net Income = $485,000
Earnings per share = $485,000/100000 = $4.85/share

The company issues 6,000 shares at $50 bringing the share count to 106,000 and lowering the earnings per share from $4.85 to $4.57. The share count was increased by 6% and the earnings per share decreased by 6%. Now lets take a look at year two:

Revenue $1,000,000
COGS $ 500,000
Interest Payment $ 0

Net Income = $500,000
Earnings per share = $500,000/106,000 = $4.71/share

The earnings per share increased 3% from the reduction of the debt. This leaves more money in the company for operation, or dividends for shareholders. The company can initiate a share buyback to reduce the dilution from the swap. The company also has discretion about buying back stock, this freedom does not exist with a debt issue. Because of the freedom the company could buy back some of the stock if the price of the issue falls.

Ideally a company should never have to dilute shareholders in some situations it’s much better than being saddled with a big debt load. The debt for equity swap gives a company freedom in their financing activities and can allow a company to gain footing much quicker than issuing debt.

The news item that relates to E*Trade and this post can be found here: link

Disclaimer: I own a very small option position in E*Trade.

• product differentiation
• perceived product differentiation
• driving costs down
• locking in customers
• locking out competitors.

An investor could argue that some software company somewhere qualifies as having a moat under one of those qualities. What I want to consider is do software companies have a moat in general, and if they do what are common aspects of that moat.

I believe that tech companies in general all inherit common characteristics of the industry, and three of those characteristics are, driving costs down, locking in customers, and locking out competitors. Many software companies have perceived product differentiation (Apple and Oracle come to mind), but I don’t believe that’s a widespread trait. I also don’t believe that real product differentiation exists much in the software realm.

So what are the aspects of software companies that give them a moat? I want to discuss each below.

Low Costs: A software firm has fixed assets of possibly an office, and computer equipment, but outside of that, most of the companies assets is stored in the minds of it’s designers, engineers and programmers. People react much better to cost cutting than machines do. An employee is willing to take a pay cut if they believe that at some point in the future their hard work might pay off with stock options. Whereas a company that has fixed machinery can’t decide to only use half the electricity without damaging it’s production pace.

Locking in Customers: For most non-technical users learning a new software package is a big ordeal. Consider that Apple OS X is easier to use, but Microsoft Windows has a much bigger market share. Most users who learned Windows at the office purchased a PC to use Windows at home, even though there were superior choices available.

A second example of this is word processors. Microsoft Office is the word processing package of choice worldwide. There are not many people using WordPerfect, or OpenOffice, even though they provide the same user experience, often at a much lower cost (OpenOffice is free). Office has locked in users with training, and with file formats. To open a Word document a user must be running Office.

Software companies lock in customers much like a bank. They create a switching cost which is the hassle of installing and learning new package so high that users are content to use a product that might not be the best choice available.

Locking out Competitors: This is an area that I feel is opening up, but is still very real. Most software companies create products that conflict with competing products. Try running Oracle on Windows, it doesn’t work well because Microsoft has it’s own database engine SQL Server. The same can be applied almost across the board, Apple locks out competitors unless they use the Apple guidelines for software, Microsoft does the same thing with Windows.

With all the great things going for software companies what could stop them? I have a few value destroyers listed below.

• Open Source Software - This is a movement where programmers build software components for free for the good of humanity. The software is often equal to the commercial version, and the price most of the time is free. You can’t compete with free.
• Revenue Recognition - This is a dicey subject not talked about often, but it’s a grey area in the GAAP on how to recognize software revenue if software is a service. This issue is what led NEC from being delisted recently. Improper recognition could make a company seem much more profitable than it is.
• Unfair expectations - Most investors have not forgotten the DotCom bubble in the 90s, and there are still some of the same expectations floating around. This leads to unfairly high P/E ratios, and share prices that are often high flyers for companies that don’t have much of a profit.

Does the implied economic moat around most software companies create a good investment opportunity? I think this needs to be evaluated on a case by case, as there are definitely great opportunities amongst the industry. What is known is that software companies have a great competitive advantage that is not available in many other industries, and investors should take advantage of good bargins on solid software firms.

I kept my eye on GWR for the following few months but never made a purchase.  After looking at the chart today there were some great buying opportunities in the late summer and right at the beginning of the year sell-off.  Purchasing around $26 anywhere from August to early January would have yielded a 20% gain, not too bad for holding a few months.

The catalyst in the move was a better than expected earnings for the end of 2007.  Revenue increased 14%, they also benefited from currency conversio (dollar devaluation).

The reason I took a second look at GWR is I’m looking for a stock to write covered calls against, and GWR might be a great opportunity.  I hope to post a scenario in an upcoming post.

This is a welcome surprise, and one more sign the Bowl America management is shareholder focused.  Stated in the 8-k  the Board of Directors also increased the quarterly dividend from $.14/share to $.15/share to keep up with inflation.  At the $.60 dividend rate and the current trading price the yield is 3.87%, which is higher than ING Direct after the rate cut.

I have pasted the release below:

Memo from Leslie H. Goldberg, President, dated January 22, 2008,
 mailed to security holders of record January 10, 2008.

January 22, 2008

Dear Fellow Owners:

The enclosed third quarter dividend is being paid earlier than usual this year.
Today is the 50th anniversary of the opening of the Shirley Tenpin Bowl - Bowl
America's first center.  We have, therefore, included a $.10 extra dividend as
sort of a birthday present from us (it really is our money) to us.

Of equal importance, we have increased our regular quarterly dividend to $.15
per share.  If business conditions warrant, this increase will make this year
our 37th consecutive year of increased per share dividends.  Our corporate
objective remains to provide dividends that keep pace with inflation.

We are subject to the same pressures as every retail company.  We are hopeful
that the techniques we have learned in prior cutbacks in consumer discretionary
spending will enable us to continue to deal with the problems that we see today.

HAPPY BIRTHDAY SHIRLEY!

Bowl America (AMEX: BWL.A) is a closely held company that owns and runs 19 bowling centers in D.C., Baltimore, Richmond, Jacksonville, and Orlando. Bowl American runs 756 lanes across 19 facilities. Bowl America opened their first bowling center in 1958 in the Metro DC area. That facility is still open today. The company was founded by the current CEO and Chairman’s father C. Edward Goldberg.

I first ran into Bowl American through a stock screener on my Fidelity account. As I researched the company and read the presidents letters I fell in love with the company and the opportunity it provides. Bowl American is a pretty standard bowling operation, they generate revenue from three main sources, open bowling, league bowling, and concessions/merchandise. The first thing I liked about this company was the management’s philosophy, the management runs a very shareholder friendly company, and I dare say a shareholder focused company. In reading the president’s letters it’s very clear he is a strong believer in giving back company profits to shareholders in the form of a dividend. The dividend has been increasing for the last 50 years. In the current shareholder letter it’s stated that “…cumulative dividends on that single $2.00 share will exceed $100.” Besides paying a steady increasing dividend the company is run very conservatively, they own each center outright, have no debt on the books, and have a large cash position. Each new bowling center is financed out of their cash position.

Bowl American presents a unique challenge in deriving an intrinsic value. The reason for this is three-fold, the first is the real estate portion of the company is quite large, and most of it is valued on the books at it’s purchase price in the late 50s on up. Most of their properties are held in the Metro DC area, and for anyone who’s been asleep at the wheel a plot of land in DC is worth a little bit more now than it was in 1958. The second is the large securities portfolio the company holds. As of Sept 30th Bowl American had a securities portfolio value of $6,218,625. The third reason is that I don’t believe a classic P/E valuing correctly values the cash this business throws off, because of this I’m going to do a FCF analysis to determine the intrinsic value.

I searched through the latest 10-Q, annual report and last year’s first quarter 10-Q. In the first quarter last year they had an unusually high capital expenditure, they purchased a new bowling alley and recorded it in Q1. Due to this I’m adjusting the 2007 Q1 CapEx from 1,762,974 down to what has historically been the CapEx for that time period 220,000. By adding in the quarter that just ended and subtracting out Q1 last year from the figures in the 10-K I get

$5,957,998 Net Cash Provided by Operating Activities

$795,713 CapEx for fiscal year 2007

I’m using a discount rate of 10% and an annual growth rate of 5% with a FCF of $5,162,285, and 5,135,690 shares outstanding. With this I get a value of $20.10/share. (5162285)/(.1-.05))/5135690 = 20.1035. That’s without dividends subtracted. Adjusting for dividends I get $8.50/share. ((5162285-2978932)/(.1-.05))/5135690 But this is only part of the story, remember they have a large amount of stock on their balance sheet. The Chairman and CEO has mentioned that he is a ’stock nut’, which could explain the telcom stocks Bowl American holds. In the latest 10-Q there is a listing of share amounts and companies, from this and yahoo finance I can figure out the current value of the holdings. I have a list of the stocks and share amounts below.

• 3,946 shares of Alltel = 281981.16
• 45,580 shares of AT&T = 1845990
• 669 shares of Avaya = 11694.12
• 2,000 shares of Embarq = 95320
• 939 shares of Idearc = 15822.15
• 475 Shares of LSI = 2574.50
• 9,969 shares of Qwest Communications = 66991.68
• 40,000 shares of Sprint = 556400
• 18,784 shares of Verizon = 809590.4
• 11,865 shares of Vodafone = 427495.95
• 4,079 shares of Windstream = 53353.32

The total value of the securities portfolio as of the close at 4pm on 12/17/2007 is $4,167,213.

Taking the assumption that the cash and equities totaling $6,497,917.3 will be employed to grow the business at a rate of 5% I get a value of $25.30/share for the securities portion. Adding the securities/cash and the operating FCF together I get a value of $33.80 as the intrinsic value of Bowl America. Currently Bowl America is trading at $15.91 at 4pm on 12/17/2007. Given these figures Bowl American is trading at a discount of 52.9% to it’s intrinsic value.

I’m interested in anyone’s thoughts on this analysis. I’m open to suggestions or corrections in my math and/or assumptions.

Disclaimer: I have held shares of Bowl American since March 07. Also note Bowl American trades on the American Stock Exchange with very low volume, so liquidity can be an issue.