EATING SARDINE: Time Warner Inc. (TWX)

Last close: $35.07

Time Warner is a media and entertainment company involved in networks (e.g. HBO and Cinemax), film entertainment (e.g. Warner Bros.) and publishing (e.g. Time magazine). The company generates revenue from subscriptions (e.g. for pay television), advertising and content production (e.g. Harry Potter films). On a fully diluted basis, Time Warner’s market capitalization is $40.2 Bn and its enterprise value is $53.1 Bn.

Time Warner is a strong and stable business.

• Content ownership provides a natural “moat” to the company
• It has a consistent track record of generating cash flow, despite cyclical advertising exposure
• $8.6 Bn in unlevered free cash flow on average since 2003 ($4.7-$13.0 Bn range);
• $8.8 Bn in annualized unlevered free cash flow on average since Q4 2005; and
• $9.3 Bn in average rolling LTM unlevered free cash flow since Q3 2006
• The bond market is pricing all of Time Warner’s outstanding publicly traded debt above par
• The company could pay off all outstanding debt as of 31 December 2010 within 1.5 years, using available cash and based on historical through cycle cash generation. Incidentally, the company could also pay off all liabilities - including all outstanding debt - as of 31 December 2010 within 4 years, on the same basis

Time Warner’s equity is attractively priced, despite a 21% rally since July 2010 (which was in line with the market).

• The company is trading on a cash flow yield of more than 17%, based on cash generation both through the cycle and in the latest twelve months. For reference, the cash flow yield is more than 9% based on cash generation in the worst twelve month period since 2005 (LTM ending December 2008, which is understandable since this was the quarter after Lehman Brothers went bust)
• Current valuation implies that Time Warner’s cash generation will decline c. 9% in perpetuity, which is undoubtedly a bold statement to accept
• Other valuation metrics also support the Time Warner’s relative undervaluation compared to the company’s own trading history and comparable companies
• Risk-reward is attractive as downside is acceptably protected and upside is consumer spend and advertising driven, which are GDP linked. So, one is betting on (primarily US) GDP recovering for outperformance
• Outperformance vs. estimates over the last 9 quarters perhaps provides some comfort that a recovery is indeed underway
• The 2.7% dividend yield is an added sweetener

That’s all folks!

EATING SARDINE: Daiwa Industries Limited (6459.T)

Last close: JPY 412 (or USD 5.00)

For the sake of simplicity, all metrics are quoted in USD. To convert to JPY, multiply the USD metric by 82.4.

Daiwa Industries Limited manufactures and services industrial machinery for heating and cooling, such as freezers, showcases and ice machines. Daiwa’s current market value is $257 m and in 2010 it generated $342 m in revenue and $71 m in EBITDA (21% margin).

Daiwa is listed on the Tokyo Stock Exchange and all official communication from the company (i.e. website, reports, etc.) is in Japanese. I do not read Japanese, so I have relied on public databases to evaluate Daiwa’s published information. Daiwa is not covered by any Wall Street analyst.

At $5, an investment in Daiwa has very limited downside, if any.

• At 31 December 2010, Daiwa had total cash and short-term investments of $365 m and the company has no debt. Total liabilities were $91 m, primarily comprising current liabilities and pension obligations. So, if Daiwa paid down all its liabilities it would still have $274 m left in cash.
• This means that the market is valuing Daiwa’s cash (net of all liabilities) at a 6% discount, and its operations and assets at 0.

I am relatively less familiar with Japanese companies, so it is difficult to place a value on Daiwa’s operations and assets. But, the probability that Daiwa’s operations and assets are worth more than 0 is very high.

• Over the last 6 years, the company’s operations and assets have generated $70 m in free cash flow on average, and its margins and returns on capital/ equity were not bad either.
• At 31 December 2010, Daiwa had $57 m in receivables and inventory.
• Daiwa should be a “going concern” since it is unlikely to be liquidated (Ozaki family owns c. 45% of it and the probability that they would want to keep this company operational vs. liquidate it is high).

Finally, the probability that Daiwa’s accounts are fraudulent is very small because (a) Deloitte (the company’s auditors) have repeatedly qualified its accounts, and (b) Japanese culture - particularly for prominent family companies - limits the likelihood of this scenario.

Bottom line: at a minimum Daiwa’s shares are undervalued by ~6%, and potentially significantly more.

The catch is that -

• Daiwa’s publicly traded shares have a small float and trade volumes are small. As such, one’s ability to bet very large amounts of money is perhaps limited; and
• The market can be irrational for longer than one can remain solvent.

Maybe truly patient investors will even welcome a sandwich for lunch if it is free?