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May 26, 2005

The Unexploited Values': Delphi Management's Scott Black Digs Deep for Margin of Safety

By Kathryn M. Welling

Maybe you shouldn't complain after five years of relative outperformances by value stocks over the growth variety. But growth stocks don't look like screaming bargains, either. I agree. You can maybe point to things like the Bermuda re-insurers as being cheap, but people worry about the volatility of earnings in the group, not to mention all the investigations of AIG and its dealings with some of the reinsurers, has cast a pall over the whole industry. Beyond that, I still think some of the steel and commodities stocks are pretty cheap, but they're volatile, so you have to buy carefully - when they're down, not up! The energy stocks, of course, go up and down with the first derivative of a barrel of oil. It doesn't matter on an absolute basis if oil is 53 or 54. But if the price drops by a dollar a barrel, all the bulls run for the hills, irrespective of the valuation. Likewise, every time there's a report out of China on steel production and consumption, the metals go nuts. It reminds me of the mid-to-late 1970s in commodities. The difference is that back then there were values to be found in the stock market, because all the speculators were in the pits. There are stocks you could find out there, but you have to be willing to be patient. I mean, a company like Olympic Steel closed at 18 and change yesterday. The book is 16. Clean balance sheet. They are going to earn close to $4-4.50 for the year. So it is a 4 P/E. Ridiculous. What has it done to turn investors off? The price reflects some earnings disappointment, I guess. They came in with over $5 in earnings last year. But what Ben Graham called the margin of safety in this is getting ridiculous. It is selling at 1.2 times tangible book, has got a decent balance sheet, a good return on equity and the thing is selling at 4 times forward earnings. Granted, it isn't easy, as you say, to find stocks like that, but the contrast with what those private equity firms just agreed to pay for SunGard is enormous. The SunGard deal is nuts. Look at the price the private equity firms paid. The truth is, they are getting swamped with so much money that they feel justified in making bigger deals - and in overpaying for these bigger deals. When you go out like The Carlyle Group did and raise $10 billion instead of $1 billion, you are forced to move up in size and overpay. These mega firms are in the fee business. They are not in the performance business. They are doing what KKR did in the late 80's. They raise big money. So what sort of stock attracts you here? Aspen Insurance. It is a $25 stock. They earned about $3.75 this year, so it is trading at 6.7 times earnings. We hate overpaying. You make mistakes when you overpay. There are 69.3 million shares outstanding, so its market cap is about $1.7 billion. The book - and it is all hard book, no goodwill - is $21.37, which means it's selling at 1.17 times tangible book value. This is a company that came public about a year ago. Although now based in Bermuda, the business is 80 percent reinsurance. What else do you find irresistible here? I like Helen of Troy. Does your bride know? You know it's nothing like that. Nor does it have anything to do with the Iliad or the Odyssey. Or anything more exotic than Bobby pins and hair dryers? Exactly. They also have Dr. Scholl's foot products and recently bought Oxo, which is basically kitchen tools. They have had a straight-up record, from 2000. From 57 cents to 60 cents, then $1.06, $1.28, $2.20. It should report over $2.30 in the year that just ended. Trailing earnings are about $2.49. The stock is at 26. It has come down from over 37. What smacked it? The stock got hit when Mr. Rubin, who owns most of the company, decided he was going to cash in at $35. He did. It got down into the high 20's, rallied back up some and lately has been hit again. But this stock, under 27, is nuts. They have the license to sell Vidal Sassoon hair dryers and such and Revlon hair curlers. They compete against Conair; both companies have pretty equal market shares. Helen is a smart operation. Virtually everything is made in China. Its biggest customers are Wal-Mart and Walgreens. There's a distribution facility in Mississippi. Helen almost never physically touches its products. They come in from China, go to distribution and get sent out. It really is a marketing company. The price point for its curling irons and lots of its other products is $19.95 And management has been doing a good job of growing the company. For the year just ended, it did $574 million in revenue. We forecast revenue up about 12 percent to $645 million in the current year. That sounds like a growth company. You are buying some growth. They have got about 20 percent to 21 percent pre-tax margins, fully taxed. The stock is 27. It is a 9.5 P/E. The stated book is 13.66 but because of acquisitions and licenses, essentially, there is no tangible book. This is a marketing firm with a franchise essentially. There are 29.8 million shares so 27 times 29.8 is 805 million market cap. It doesn't bother you that the main man has been dumping shares? That is not an issue, he sold it when it was trading up around 12-13 times forward earnings. What I see is that you can have Helen for only 9.5 times earnings, even though it is earning about 22 percent on equity. It's not a great company, but it sure is a good one, at that price, when the market P/E is 17 and the market is not growing at 10 percent. Corporate earnings are only going to grow at about 6 percent to 8 percent this year. Helen's balance sheet has had very little debt in the past, but they did add debt to buy Oxo. They ended fiscal 2005 with $270 million in debt and $470 million in book, so it has about a .65 debt-equity ratio. They generate free cash on an ongoing basis. What is your third idea, Scott? It is the old Pohang Iron & Steel, now called Posco (PKX). We bought the stock as low as 42-43. The stock now is at 49. I have the earnings modeled out at about $10.25 for the year. So 49 divided by 10.25, means it is selling at a whopping 4.8 times this year's earnings. They earned 23.8 percent on equity last year. They have almost as much cash as they have debt, so they are making over 20 percent on total capital. They produced 28.9 million tons of steel last year. They are one of the lowest-cost providers of steel in the world. Of the steel they make, 68.9 percent stays within Korea. About 31 percent gets exported. Of that, China takes about 37 percent so that is 11 percent of the whole corporation's output. The book value is $37.52, and there's very little goodwill in that. Only 4 percent of the book is goodwill so the stock is selling at, roughly 1.3 times tangible book. They are going to do about $22.5 billion in revenue this year against $19.3 billion in the year that just ended, up another 16 percent. When you work it all through, let's say you get a little over $10 in earnings. Thanks, Scott. Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co., L.P., Greenwich, Conn.