Tuesday, May 24, 2005

Paring Back, Shifting Focus

Interview With Warren Isabelle, President, Ironwood Capital Management


THE IRONWOOD TREE, FROM WHICH Isabelle's $400 million Boston-based Ironwood Capital Management, takes its name, is a slow-growing, long-lived desert tree, with hard and dense wood, that eventually becomes the tallest tree on the landscape. When Isabelle picks stocks for his ICM Small Cap Value fund or the private accounts he manages, he is often looking for companies that exhibit the same potential as the ironwood tree. It is his special talent to be able to see through a company's plight and recognize the possibilities. That's how he has been able to deliver solid returns since launching the fund nearly seven years ago. Over that span, the fund is up 5.6% a year, on average, compared with 5.31% for the Russell 2000. The small-cap value style has struggled this year and the ICM Small Cap has taken its lumps, too. Not one to hide, Isabelle blames the underperformance on -- what else? -- bad stock picks.

So what's a portfolio manager to do? If you're Isabelle, regroup, rebalance and add some new names.

Barron's: What's your outlook for the economy?Isabelle: My concern is the yield curve. It is flattening, which suggests a recession. But I'm not sure I see us headed toward recession. The dollar is again on the verge of being really weak. I don't see how the dollar can stay weak and how rates can stay low. What if short rates continue to creep up by virtue of the Fed and long rates let go because the dollar weakens and inflation comes back?Every company I poll is seeing price increases in raw materials and is getting price increases in what they sell.

Unless I'm totally missing something, inflation has got to come out somewhere, even though so far none of the indicators have shown we've got much of it. If inflation pops up and the dollar weakens, then long rates, it would seem, would have to go up.My fear is that long rates jump rather sharply, and that won't be good for anybody. On the other hand, if long rates go up and the yield curve shifts in an orderly fashion, rates will still not be so high as to crimp capital spending.And that's the other question mark: Will capital spending pick up?

Either there will be no pickup in capital spending here because it's been soaked up by China and India, or we are just not there yet in terms of the cycle. In other words, the return on investment for some companies, given what they see in the future, still is not high enough for them to begin to reinvest.We could still see a pickup in capital spending mid-market that could sustain the economy and strengthen it. People keep saying the economic recovery is long in the tooth at three and a half years. But it hasn't felt like an across-the-board solid recovery to me. We kicked along the bottom for a while, companies got real conservative and built up cash and reduced their debt, but it's not as if there's been a big cycle change yet.

People are still skeptical about price increases sticking.Look at Aleris [ticker: ARS]. They did over $1 a share in earnings for the quarter. Their margins popped up and everything is working right, but they said they don't think results will be quite as strong next quarter. Now everybody is saying that's it, it's all over, and the stock price has retreated.Olin [OLN] is another company that produced very nice earnings and is at $18 a share now. They reported a fabulous quarter and everybody said, well, that's as high as chlor-alkali margins can go, they are at peak levels and that's all there is in the company. Well, there is also a metal segment, a big brass segment they bought that hasn't really been doing much and I'm not so sure the chlor-alkali business is over and done with in Olin's case because they have contracts that roll off over a period of time. So maybe there's another year to this, maybe a little longer. I'm not so sure we've seen a peak in margins despite what people are saying.

Even though the indicators aren't showing inflation, companies have been able to raise prices.

You've pared back your portfolio to 45 stocks. What kinds of sectors or companies did you exit?We probably had too many companies in the biotechnology area, partly because we invest a little bit like venture capitalists and take relatively slim positions. In terms of weighting it didn't do much, but it amounted to a lot of names. We also reduced the number of service and consumer-related stocks.We're trying to focus our attention on companies with operating leverage. We exited some companies that did perfectly well, but they didn't have quite the operating leverage I wanted. InfoUSA [IUSA], Lightbridge [LTBG], TeleTech [TTEC] and U.S. Physical Therapy [USPH] were some we got out of. We also got out of some stocks that we got wrong, such as Hanger Orthopedic [HGR] and Advanced MarketingAnything I'm looking at is something that has an investment story to it, is really undervalued and preferably one we can hold for a while and make a significant return.

Small-cap value has come under pressure. What's your outlook for the sector?

The Russell 2000 Value index is 34% financial-based -- more than a third. I'm not even close to that. We're much more attuned to the Russell 2000. We just try to pick stocks that have economic value, that's all. The biggest negative for us has been the pressure that some people have felt to move away from small- caps because the mantra has been that large-caps have the more modest valuations.There's been a rotation out of good performers and that has been a little bit vexing for us. But, by and large, we just keep searching for undervalued companies.

What has made the difference in the market this year? Why has it been so difficult to get positive results?It has been a litany of factors. That kind of uncertainty does not make markets happy. Smaller caps have taken it on the chin because they are more volatile in general and they've had a good run.

Financials have been much weaker this year because rates are going the other way. But overall there's been concern about budget deficits, consumer debt, oil prices and the weak dollar. Every other week we have some shudder of nervousness.

What have you been adding to your portfolio?

We used our cash to bulk up on the names we felt had lots of valuation room and selectively added some new positions.We added one company that is unusual for us: Western Silver, a mining company. Tom Patton runs it and he has excellent credentials. The bulk of their property is in the Chile Colorado and Penasquito region of Mexico. In the Penasquito region alone, they have about 150 million ounces of silver potential, 300 million ounces of gold and then about a billion ounces of zinc and lead, though their values pale in comparison to the values for the silver and gold. But still, at that level you can make some serious money. And Chile Colorado deposits are even bigger in size.Add all that up, and it comes to several billions of dollars in aggregate value. The stock has a market value of $400 million today. So you just have to say to yourself, how real are these deposits, and how difficult is it for them to get them out, and do you have confidence that they can do it? But the potential asset value is so far greater than the market price, even if we are off by some reasonable factor we are still going to have a lot of upside potential. That's the key here.

How close are they to developing this potential?

Originally we thought they would document all the finds, pick up a big partner and then develop it. Now they say they want to do it themselves. I believe that they are capable of doing it, but they will have to raise about $250 million in cash to build the mining facilitiesBy 2008 they could do it and earn between a $1.50 and $2 a share. The stock is at $7.50 a share. Based on their assets, we think it could be valued at $20 a share.

Wow. Think about it. The market value is $400 million. The silver and gold potential is about $2.3 billion. Add a few hundred million for the lead and the zinc and that brings you close to $3 billion. That's seven times the value of today's stock. To go from $7.50 to $20 is a little more than two times, so I'll take that. It may not hit the bull's eye but I know it is going to be in the general neighborhood.

Seems like an unusual stock for you.We usually like stocks that already have cash flow. This is unusual. It's a little earlier stage than we would like, but the economics, or apparent economics, are compelling. It is also an area that has had some renewed interest, and that was a catalyst.

What else have you been buying?A controversial one, Broadwing. We like to buy something for nothing. They are losing money, although they have a pretty good cash pile of about $300 million. They have convertible debt they can pay either in cash or stock. If they pay it all in cash and take their operating losses, a case can be made they can pay it off and go through their cash by year's end.What's killed the stock is the convertible arbitrageurs have been shorting the stock and buying the convertible. If they decide to pay in stock, the convert people can get the stock at a much cheaper price basically and cover their shorts. However, the company elected last quarter to pay the convertible holders in cash.

It's still not clear why you like this.Broadwing bought fiberoptic equipment from Cincinnati Bell. They bought $3 billion worth of equipment for $200 million. Now naysayers say there is a glut of fiber. But I say that's still a pretty good deal, and fiber is not obsolete by any means. They have cash.And they have $1 billion in net operating losses that could be attractive to another company and could be folded in and save people real money. The final thing, and most important of all, is its foundation of 5,000 customers and 18,000 miles of nationwide fiber- optic lines.

Any sense of what company would be interested in this?

It has been suggested if Qwest can't get MCI, they might turn around and buy something like Broadwing.

What else have you been buying? Maytag.

You? Maytag?Maytag is now a small-cap. Everything is going against it and I'm not claiming victory. Everybody hates it and they had a big fat dividend they just cut in half. But it has $4.6 billion in sales and it's market cap, drum roll please, is $899 million.

Contrast that with its peak market cap in 1998 of $5.5 billion. I believe the brand name carries some weight. I also believe that the level of debt is not insurmountable for a company with that level of sales. They have about $970 million of debt, which is a lot. Then they have $1.2 billion of pension liabilities.

Hefty, but not insurmountable.The guy now running it is Ralph Hake, a finance guy, not a marketing guy. And Maytag's long-term survival depends on getting some innovative products. That is critical. Hake has been able to do his cost-cutting judicially and allow the company to get on track again. But they need some innovative products. There is a lot of private equity money out there, so who knows? But Maytag is a company that by no means is dead.[Early Friday,
Maytag announced it was being acquired by an investment group led by a private-equity firm, Ripplewood Holdings, for $14 a share in cash.] We're voting against it [the buyout]. They are stealing the company. Essentially they are getting it free. Before the recent earnings announcement, Maytag was trading at 16 a share, and this values it at 14. We're hoping a higher bidder comes along. This is thievery.

What else do you own?

We took the plunge and own a couple of utilities. They are definitely the ugly ones: the Aquilas and Dynegys of the world.The basic reason we own them is they started out as pretty good utilities with some pretty fair numbers. Then they got caught up in the merchant-power fad and found themselves with upside-down contracts and so on. If they can revert to the mean, we'll make a lot of money. Dynegy has already bought out a number of their contracts and reduced their plant and equipment. They plan to sell their natural-gas subsidiary, and that should bring in a good chunk of money. And consolidation is occurring. Duke Energy is buying Cinergy for $9 billion.

You usually have an interesting biotech company, or are you shying away from biotech now?We like Durect. We've owned this for a while. It makes drug-delivery technologies and is run by former Alza Bioscience executives. Its market value is $160 million, and so it is relatively tiny. It has about $60 million or so in cash. The enterprise value is about $100 million.Durect is coming into its own at the moment. One of their products is Chronogesic, which is a thin tube that is implanted in somebody and releases pain medication at a set rate over a 90-day period. The stock had been very strong a few years ago but suffered a setback when 2% or 3% of their pumps failed within the last few days of the 90-day period. They pulled the product to fix it rather than try and seek approval of it. It might be reintroduced soon, which is a positive. But there are other technologies to be excited about also.Another technology, called Saber, is to treat post-operative pain for up to three days.

They are also working with Endo Pharmaceuticals on a seven-day drug adhesive patch called Transdur. They are working on something to treat tinnitus in ears.

They have so many different products, that's what we like. It's all based on related technology, and it allows them to build a nice platform with multiple avenues for commercialization. The chief executive, Jim Brown, likes to say they have multiple shots on goal.

How do you value this?

With any of these companies you look at the intellectual property and the management. You look at the cost to duplicate this technology. You look at whether the potential market is large enough and underserved enough. Then you can determine to a fuzzy extent what it is you are shooting at. So if you think each product could take 10% of a $5 billion market, and I'm just picking numbers now, and go through that with each of the different products, it gets you to $5 million. If you figure a good operating margin is 25%, that's $125 million in operating income.It's got a nice balance sheet on top of that. That's the kind of stuff we want. The whole key is whether you can place some reasonable economic probability to the story and whether you're buying it for something less than it would otherwise cost to have it today.In this case, Durect got down to a $1.50 a share for an implied market value of about $80 million when they probably had about that much in cash. We were basically paying nothing for their technology. Durect looks like it is going to be a very interesting company going forward.

Warren Isabelle's Picks
Company / Recent Price / Comment
Western Silver / $7.45 / Silver and gold assets in Mexico.
Broadwing /4.20 / Takeover candidate, operating losses.
Maytag / 11.56 / Buyout offer of $14 is "thievery."
Dynegy / 4.12 / Restructuring. Consolidation candidate?
Aquila / 3.27 / Back-to-basics electric utility.
Durect / 3.25 / Platform of drug-delivery technologies.

Source: Thomson Financial/Baseline


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