The Department of Education Commences Program Review at Kaplan University

In its 10-K, WPO disclosed that the Department of Education commenced a program review at Kaplan University in September 2009.   To our knowledge this is the first time that WPO has disclosed the matter.  We are not sure why this was not disclosed in the company’s 3Q09 10-Q filing given that in WPO’s own words: “No assurance can be given that the Department of Education’s final report will not have a significant adverse effect on Kaplan’s ability to continue to operate this school.“.  No details were given as to the scope or potential target of the Department of Education’s program review, except that it is being conducted at the Kaplan University offices in Fort Lauderdale, FL.

According to the company, Kaplan University had 65,500 students enrolled at the end of 2009 (60,400 online, 5,100 onsite), which means the school represented 62.4% of Kaplan Higher Education’s total student population.  Kaplan University has been a huge area of investment for WPO over the past decade. The company launched a massive, multi-million dollar national advertising campaign in 2009. We think the company’s increased investment in marketing was a primary driver behind the 38.5% YOY enrollment growth achieved by Kaplan University Online in 4Q09.  Any regulatory issue that could potentially impair consumer perception of the quality of Kaplan University would have a large impact on WPO’s profitability prospects.

A Quick Overview of the Department of Education Program Review Process

It has come to our attention that the relative knowledge gap between the typical WPO investor about the intricacies of the regulatory landscape in the for-profit postsecondary education sector compared to let’s say, the average COCO shareholder is fairly wide.  We thought it might be helpful to quickly cover what the Program Review process entails.   For those that are interested in learning more, we would encourage you to read this document published by the Department of Education.  Program reviews are not conducted with the same frequency as an audit, but are also not completely uncommon.  Typically a program review is prompted by concerns about a school’s regulatory compliance.  The Department of Education and Congress (through the Higher Education Act) have identified the following criteria to serve as impetus for conducting a program review:

1. High cohort default rates (over 25 percent)
2. Significant fluctuation in FFEL volume or Pell awards between years;
3. Serious deficiencies as reported by state licensing agencies or accrediting agencies;
4. High withdrawal rates; and
5. A significant risk of noncompliance with administrative capability or financial responsibility provisions of student financial aid programs, as determined by the Secretary

A program review can also be prompted from feedback received from other channels beyond the traditional operating metrics the Department of Education would receive from a postsecondary institution in normal course. These factors include:

1. Reports from agency partners, such as state licensing agencies, guaranty agencies and accrediting agencies;
2. Referrals from OIG; and/or
3. Student and/or institutional employee complaints.

When a program review is launched, a case-management team is sent to the school to collect information and inquire about some of the Department’s concerns on a face-to-face basis.  Typically, the Department of Education will issue a findings report to the institution, after which the school will have the opportunity to respond. A program review can be limited in scope to a few specific issues (think University of Phoenix incentive compensation) or include a complete analysis of a school’s regulatory compliance practices.  The Department of Education describes the purpose of the program review process as to:

1. Strengthen administrative capability and financial responsibility under Title IV statutes and regulations through on-site assessments of and technical assistance on institutional administration of the student financial aid programs.
2. Address financial harm to the taxpayer through liability assessments.
3. Tend to those institutions that are seriously mismanaging or abusing the student financial aid programs through referral for administrative action, including emergency action, and referrals to the Inspector General – Investigative Services when appropriate.

In the case of Kaplan University, we cannot point to any specific catalyst for the Department of Education to launch a program review based on publicly available information.  At the very least, we know that it was not prompted by Kaplan University Online’s cohort default rate for F07, which was 13.3%.  The program review could result in changes to Kaplan University’s enrollment, administrative, and regulatory compliance practices, a significant fine, or nothing at all.  We anticipate this could become an overhang on WPO shares given Kaplan University’s overall contribution to the company’s revenues and earnings.  The longer the program review lasts, the more likely it will result in material changes to Kaplan University’s practices, or potentially material fines, in our opinion.  Overall, we have argued for sometime that lax regulatory compliance at Kaplan Higher Education could become a material issue for the company and shareholders.  The combination of four outstanding false claim actions (qui tams) against Kaplan Higher Education and program review at Kaplan University adds further credence to our thesis.

A Few Kaplan Higher Education Schools Appear to Have Avoided a CDR Bullet

In our review of WPO’s 4Q09 results we wondered if the company would provide disclosure on preliminary cohort default rate data for FY08, which was released to postsecondary education institutions in early February. To the company’s credit they did provide some color on preliminary FY08 cohort default rates for Kaplan Higher Education.  Overall, the company expects the cohort default rate for Kaplan Higher Education to be in a range of 16-18%, which would be consistent with FY07 levels.  However, trends at Kaplan University continue to be worrisome. The company indicated that it expects the FY08 cohort default rate for Kaplan University to range between 15-17%, up from 13.3% in FY07 and 5.9% in FY05. The rapid rise in cohort default rates at Kaplan University cannot be attributed to the economy alone, in our opinion.  The data suggests that the company has been aggressive in its enrollment and admissions practices, which could lead to additional regulatory scrutiny down the line.  Perhaps most importantly, the overall Kaplan Higher Education 2-year cohort default rate data suggests the company will have difficulty maintaining regulatory compliance standards under a 3-year cohort default rate standard.

On a school by school basis, Kaplan Higher Education only had one institution whose cohort default rate exceeded 25% in FY08, which was down from four in FY07.  It appears that the company’s investments in default management have yielded positive results, particularly at TESST College – Baltimore, Texas Careers, TESST College – Townson, and the Texas School of Business, all of which had 2-year cohort default rates in excess of 25%.  WPO stated that no school had a cohort default rate in excess of 25% for two consecutive years.  This is particularly noteworthy for the company’s TESST College – Townson, which was at risk of losing access to Title IV if its cohort default rate exceed 25% in FY08.

Other Highlights from WPO’s 10-K:

• Kaplan University generated 87.5% of its revenue in 2009  from Title IV Funds, up from 85% in 2008.  The “90/10 Rule” could pose a significant challenge for Kaplan University when the grace period for the 2008 increase in student loan limits expires.
• 60.6% of Kaplan Higher Education students were enrolled in diploma or associate’s degree programs at the end of 2009.  For the first-time WPO disclosed the company’s enrollment mix by degree level.  The total percentage of students enrolled in bachelor’s or master’s degree programs increased from 33% in 2007 to 39% in 2009.
• Bad-debt expense as a percentage of total COMPANY-WIDE revenues increased from 3.5% in 2008 to 3.7% in 2009.  WPO does not disclose bad-debt expense as a percentage of revenue for Kaplan Higher Education on a stand-alone basis.  Given the nature of its other divisions, we think the bad-debt expense for those businesses is negligible. If all of the company’s allowances for doubtful accounts were attributed to Kaplan, bad-debt expense as a percentage of revenue would have been 6.4% in 2009.

Kaplan Higher Education continues to “fly under the radar” for most for-profit education investors, even though the company has more than 100,000 students enrolled and would be one of the largest players in the sector on a stand-alone basis.  We maintain the view that the company will need to dramatically alter its enrollment policies at many of its schools in order to maintain compliance with regulatory standards under a 3-year cohort default rate calculation. We anticipate this could be a significant headwind for the company over the next several years. Should the company choose to continue on its current path, it is our opinion that a number of the company’s schools could run the risk of losing access to Title IV funds in the next 3-4 years. In a scenario in which some of the regulatory issues are not addressed we anticipate the intrinsic of value of Kaplan could be impaired by as much as 30-40%, which would imply WPO shares would be worth as little as $275-$300. Conversely, we anticipate the neccesary remedies we proposed in the past could reduce the growth profile of Kaplan for 3-5 years, but perhaps only impair the intrinsic value of the company by 10-20%. Stated another way, should these regulatory issues go unchecked we estimate peak cycle earnings for WPO of $18-20 per share, assuming earnings recover for the company’s newspaper, magazine and broadcasting divisions. As WPO’s 10-K filing demonstrates, the regulatory and litigation issues continue to mount against Kaplan Higher Education.  The stakes are incredibly high for WPO shareholders.

As always, please act accordingly…

Performance Update

Thus far in 2010, the PAA Research SMid Cap Portfolio has delivered solid absolute and relative performance.  Performance was hampered in the past two weeks from sharp appreciation in some of our short positions, which was not offset commensurately by gains in our largest long holdings.  Here are the performance highlights:

• On a year-to-date basis, the PAA Research SMid Cap Portfolio has returned 3.8%, compared to 3.4% and 2.8% gains for the S&P 400 and Russell 2000, respectively.  The table below outlines the performance of the PAA Research SMid Cap Portfolio on a year-to-date basis compared to its most relevant benchmarks: the S&P 400 and the Russell  2000.

• 

  Source: Yahoo Finance, PAA Research

The portfolio has generated a 10.7% return since inception (9/3/09), compared to an 18.0% gain for the S&P 400 and a 15.6% increase in the Russell 2000.

Although the portfolio significantly underperformed over the past two weeks, there were a few positions on the long side that appreciated meaningfully, including: WWE (up 8%), RICK (up 23.0%), and LAD (up 18.9%). Each position was relatively small. Our top holdings underperformed significantly over the past two weeks.

Our short positions were a significant drag on performance over the past two weeks, most notably our positions in the for-profit education sector.  Most names in the group gained 10-15% over the past two weeks.  Additionally some of our other shorts in the consumer sector and one name in the materials sector detracted from performance.  There were no meaningful contributors to performance on the short side over the past two weeks.

We are making quite a few changes to the PAA Research SMid Cap Portfolio.  The net effect of these changes is to slightly decrease our net exposure from 45.8% as of 2/15/10 to 43.5%. Our gross exposure of $179.2 million, or 162.0% is a slight increase from 155.5% two-weeks ago. As a reminder, we do not manage the portfolio to a specific net position, rather the portfolio weightings and net exposure are determined by our stock specific analysis. Here are the changes we are making to the portfolio for this week:

Long Positions

Our top five holdings on the long side after giving effect to these changes are: THQI (9.5%), BCO (8.6%), IPSU (7.6%), GCA (6.4%), and ARP (6.1%).

Increased Positions: GCA, BGG and LAD

We are increasing our long position in GCA by approximately 70 bps. We introduced GCA as a long investment idea several months ago. You can read our original piece here and our most recent thoughts here.  The company’s 4Q09 results were somewhat disappointing, particularly the topline weakness stemming from the company’s clients located in non-destination gaming markets.  We still think the setup for 2010 remains favorable for the company.  Consensus estimates remain conservative and topline expectations are modest. GCA generated $80 million in free cash flow in 2009 and should generate a similar amount in 2010.  This will enable the company to repurchase approximately 3-5% of its shares outstanding, purchase Western Money Systems, develop new products, and potentially pursue other acquisition opportunities. GCA’s robust free cash flow should provide significant support for the stock until topline trends improve.

In the case of BGG, record snowfall will deplete any inventory of snowblowers available at retail. Although this will not have a meaningful impact on BGG’s 3Q10 results, it will set the stage for strong orders in early FY11 for the company.  Additionally, the inclement weather likely boosted sell-through for power-generators, another strong product line for the company.  Rain fall in warmer weather states thus far has been favorable, which could lead to a strong lawn mower season. As much as BGG’s longer term sales trends are correlated to housing, in the shorter term weather patterns are a stronger determinant of sell-through.

Decreased Positions: MLHR and WWE

We are reducing our MLHR long position again in order to lower our net exposure to the office furniture market.  As a reminder, we introduced a pair trade long MLHR/short HNI approximately nine months ago, based on our expectation that MLHR shares would start to outperform those of HNI after an extended period of underperformance.  Since inception the trade has not worked (-5% total return), but in the past three months MLHR shares have outperformed those of HNI by 30%.  Our thesis remains largely intact. MLHR is a superior company from a product-line and financial perspective.  HNI has done a commendable job of resolving its leverage issues, which we think led to significant appreciation in shares in the second half of 2009.  We still think MLHR shares will outperform but would like to reduce our overall net exposure to the office furniture market to 2.2% given continued weakness in demand trends.

WWE is one of our favorite companies. For all of its idiosyncracies, the company is remarkably well run, has one of the strongest franchises in all of entertainment, and generates more than enough cash to support its $0.36 quarterly dividend. That’s correct, WWE has a dividend yield in excess of 8% even after the recent run-up in shares.  There are some who would question the sustainability of the dividend but WWE now has more than $200 million in cash on hand (3+ years of dividend payments) and no debt. Management has targeted 15-20% annual EPS growth over the next 3-years, which we think is achievable if consumer spending trends slowly recover and the company’s international expansion efforts gain further traction.  We maintain a 3% long position in WWE.

Closed Out Positions: ZIPR, RICK, and RECN

We are closing out our long investment idea in ZIPR and removing it from the PAA Research SMid Cap portfolio. The stock has achieved our general price expectation and now reflects the company’s improving profitability prospects.  We introduced ZIPR in May 2009 as a way to play the stabilization in new and existing home sales. ZIPR is one of the top ten largest residential real estate firms in the country and has been gaining significant market share during the downturn. At the time we introduced ZIPR as an investment idea the stock traded at $2.79, even though the company had more than $2.00+ in cash and no debt. Clearly the market was banking on the company burning through its cash. For 2010, the company should generate positive cash flow and management has guided to break even profitability.  We think ZIPR remains a compelling long term story, but we have concerns about how the market will respond to potentially higher mortgage rates and the expiration of the home buyers tax credit.

New Positions: ASF and FITB

We have followed Administaff, Inc. for many years now. The company has a great reputation among small and mid-sized businesses and is recognized as the pre-eminent Professional Employer Organization (PEO).  The stock has come under significant pressure recently due to concerns about the company’s ability to manage higher healthcare costs, caused in large part by the government’s decision to extend healthcare benefits to COBRA recipients.  We view this as a relatively short term phenomenon and ASF should witness mean-reversion in its profitability profile in a few quarters. The company has 50% of its market cap in cash and no debt.  We expect the company to repurchase shares at current level. On a normalized basis ASF generates $50-$75 million of annual free cash flow. Additionally, the company is highly levered to hiring among small businesses.  We are not exactly bullish on hiring trends, but investors continue to bid-up names with traditional cyclical exposure.  This is one of the cheapest.

Short Positions:

Our top five short positions after giving effect to these changes are: ESI (3.8%), LINC (3.5%), WPO (3.4%), VPRT (3.3%), and COCO (3.1%). Recognize a theme here?

Increased Positions: COCO, VPRT, CLF, SFN

COCO is either an incredibly cheap stock trading at depressed levels due to regulatory concerns or a classic “value trap”. We think it is the latter. We’ve discussed our concerns about the group ad nauseum over the past 6-9 months.  We realized some profits in our short position in COCO a month ago based on our expectation that the group could be due for a rebound. Most of the names we follow in the for-profit postsecondary education sector have gained 10-20% over the past month.  Investors appear less concerned about the regulatory overhang created by “NegReg”and the Department of Education’s “gainful employment” proposal. Changes to the gainful employment proposal have been increasingly “priced in”. We think COCO is a compelling short irrespective of what happens with the 2009 NegReg proposals.  We have yet to receive a coherent answer to these two critical questions about COCO: 1) How will the company maintain compliance with regulatory standards in a 3-year cohort default rate calculation environment? and 2) How will COCO meet the 90/10 standard in July 2011 (coming sooner than you think)?

SFN, VPRT, and CLF are all stocks that have had disproportionate appreciation in the past two-weeks. SFN in particular is perplexing. At these levels, the stock discounts temporary staffing trends normally associated with a 5-7% unemployment rate environment. We’re a long way from that.

Reduced Positions: NILE

We reduced our short position in NILE again to lower our overall net exposure in our pair trade long SIG/short NILE to (-50 bps). NILE shares continue to defy gravity despite lackluster guidance and the threat of increased competitive headwinds.

Closed Out Positions: CAKE, BWLD, and THO

New Positions: TTC, BC, CAM, and RSH

Please click on this link to view the position detail of the PAA Research SMid Cap Portfolio.

As always, please act accordingly…

Source: Company Reports, PAA Research

Better than expected results in the company’s newspaper, broadcasting, and cable divisions enabled WPO to top our EBITDA estimate despite a large sequential margin decline from Kaplan Higher Education.  Here’s a quick overview on the performance of each of WPO’s major operating divisions:

• Kaplan/Education: Kaplan Higher Education continues to generate strong enrollment growth.  According to the company, enrollments increased 31.4% YOY to 104,800 students, while online enrollments increased 47% YOY.  We have discussed our concerns about WPO’s definition of an enrollment and some of the discrepancies in the company’s historical disclosures here and here.  The company’s fourth quarter earnings release has not offered any additional detail.  Operating margin for Kaplan Higher Education declined 3.9% sequentially to 17.8%.  We attribute the weakness in part to WPO’s investment in its national advertising campaign which continued into 1Q10.  Kaplan test prep continued to witness revenue and operating margin weakness due to both cyclical factors (low demand for real estate licensure prep, reduced discretionary spending) and secular factors (increased competition from online providers of test prep in the company’s core offerings).
• Newspaper: WPO’s efforts to right-size its newspaper division in 2008 and 2009 yielded results in the fourth quarter as the division generated positive EBITDA for the first time since 1Q08.  The overall demand environment for advertising remains weak and subscriber attrition remains high. We estimate WPO can generate mid-single digit EBITDA margins from its newspaper division and 5-8% YOY revenue growth in 2H10 as ad spending recovers.
• Broadcasting: EBITDA margins for WPO’s Broadcasting division increased more than 10% sequentially to 39.7%.  This is the highest EBITDA margin the division has generated since 4Q08.  Although we expect the secular shift away from television advertising spend to accelerate over time, next year WPO will benefit from an increase in political ad-spending, which should boost revenues by as much as $10-$15 million in 2009.
• Cable: CableOne generate a 4% YOY revenue increase in 4Q09.  A price increase of 4% implemented in July 2009 accounted for all of the topline growth.  Total RGU’s declined slightly sequentially to 1.390 million.  The company has witnessed three consecutive quarters of sequential declines in RGU’s.  The company continues to make steady progress in upselling basic subscriber to high speed data and telephony plans.  Total high speed data and telephony RGU’s increased 5% and 17% YOY, respectively.  The attrition in RGU’s can be attributed to cyclical factors, but we wonder if CableOne will ever achieve the same level of penetration of homes passed as other cable networks given mounting competition.  The company’s market opportunity window could be closing.
• Magazine: Total revenues declined 29.7% YOY to $52.4 million, the company’s circulation rate base adjustment earlier in 2009 continued to remain a large drag on topline in the fourth quarter.  To management’s credit, they have been able to eek out break-even EBITDA out of the magazine division despite the rapid decline in revenues.  We think the longer term prospects for this division are particularly bleak.  We have yet to receive a good answer to the question: Why does Newsweek exist?

Waiting on Improvements to WPO’s Disclosure on Kaplan Higher Education

By management’s own account, WPO is a company whose revenue, earnings, and free cash flow prospects are increasingly tied to the performance of Kaplan.  WPO is a for-profit education company.  In 2009, WPO’s Education division generated more than 50% of the company’s EBITDA.  As a leading for-profit education company, we think it is appropriate for WPO investors to expect a similar level of disclosure to that offered to shareholders of other publicly traded for-profit education companies.  We find it strange that management continues to offer, at times excruciating detail in its earnings releases on the newspaper, broadcasting, cable, and magazine divisions, yet investors don’t receive basic enrollment information (starts, online, international enrollments) about the Education division.  Does anyone else find it bizarre that RGU level detail has been provided for the Cable division, but WPO refuses to provide investors with new student start data?

WPO’s Education division has been the company’s “shining star” over the past decade and realistically is largely responsible for saving shareholders from a similar fate that investors in other traditional media companies experienced over the past few years.  Given the strong operating results, we’re not sure why the company has yet to provide investors with basic metrics that would enhance shareholder understanding of the divisions growth prospects. Here are the metrics, which we think the company should provide:

• Student starts
• Organic enrollment growth
• International enrollments (we can back into the data historically through 2Q09)
• A reconciliation of historical enrollments.  You can read more about the issues here.
• Online enrollments and starts.  Kaplan University Online is one of the company’s largest divisions, yet shareholders receive very little information about it
• Bad-debt expense.

We think the addition of these disclosures on a quarterly basis would help investors paint a more realistic picture of WPO and the company’s future earnings prospects. For example, we know that Kaplan Higher Education experienced a large sequential margin decline in 4Q09. We think higher marketing expense contributed to that, but it’s also highly possible (if not likely) that increased bad-debt expense played a role.

Finally, we are surprised that WPO did not make any comments on preliminary FY08 cohort default rate data, which will most certainly be material for a few of the company’s schools.  For FY07, Kaplan Higher Education had four schools whose cohort default rate exceeded 25%. One of these schools had a cohort default rate in excess of 25% for both FY06 and FY07.  As a reminder, if a school has a cohort default rate in excess of 25% for three consecutive years, it will lose access to Title IV funding. As we have discussed in the past, from a cohort default rate perspective Kaplan Higher Education has the worst compliance among publicly traded for-profit postsecondary education companies.  Preliminary cohort default data is certainly material to WPO shareholders given the mounting regulatory risks the company’s schools could face.

From a longer term perspective, we think the company will need to dramatically alter its enrollment policies at many of its schools in order to maintain compliance with regulatory standards under a 3-year cohort default rate calculation.  We anticipate this could be a significant headwind for the company over the next several years.  Should the company choose to continue on its current path, it is our opinion that a number of the company’s schools could run the risk of losing access to Title IV funds in the next 3-4 years.  In a scenario in which some of the regulatory issues are not addressed we anticipate the intrinsic of value of Kaplan could be impaired by as much as 30-40%, which would imply WPO shares would be worth as little as $275-$300. Conversely, we anticipate the neccesary remedies we proposed in the past could reduce the growth profile of Kaplan for 3-5 years, but perhaps only impair the intrinsic value of the company by 10-20%. Stated another way, should these regulatory issues go unchecked we estimate peak cycle earnings for WPO of $18-20 per share, assuming earnings recover for the company’s newspaper, magazine and broadcasting divisions. The stakes are incredibly high for WPO shareholders.

As always, please act accordingly…

What We Know About the Gaming Environment for 4Q09

The fourth quarter financial performance of most gaming operators can be best described as: “getting worse at a slower rate, but not yet improving”.  Although trends could hardly be characterized as robust, there are some reasons for optimism, particularly in Las Vegas.  We estimate GCA generates approximately 50% of its revenues from Las Vegas, Atlantic City, and Connecticut.  We focus on trends in those markets to gauge the accuracy of our same store sales estimate in any given quarter.  We currently forecast a 7% YOY decline in same store sales for GCA in 4Q09, which appears reasonable, if not conservative given the trends witnessed in key markets during the quarter.  Here are some of the highlights:

• Total visitation to Las Vegas increased 2.8% YOY in the fourth quarter.  This represents the first positive comp for visitation in Las Vegas since 1Q08.  Visitation has increased on a YOY basis for four consecutive months.
• Clark County gaming revenues decreased 2.4% YOY in 4Q09.  This represents the slowest rate of decline since 4Q07.  Clark County gaming revenues have now declined on a YOY basis for nine consecutive quarters. Within the quarter, gaming revenues actually increased in the month of November, but December proved to be weak.
• Win for Atlantic City casinos declined 9.9% YOY in 4Q09.  It’s hard to put a positive spin on this data. Atlantic City faces both cyclical pressures and secular headwinds from increased competition.  Atlantic City casinos have not posted a positive quarterly comp since 4Q06.  Given the expansion of gaming capacity in Pennsylvania, it could be difficult for Atlantic City casinos to generate positive comps for some time.
• In Connecticut, slot handle declined 5.7% YOY for 4Q09.  This represents an improvement from the 10.4% decrease witnessed in 3Q09.  In January, slot handle at the Mohegan Sun and Foxwoods increased 2.2%, which represents the first positive comp in more than a year.  It is too soon to characterize the January comp as a new trend, but it is encouraging.

In the chart below we compare GCA’s SSS comps to the YOY change in Las Vegas visitation, Clark Clark County revenues, and Atlantic City casino win.  We think our (-7%) SSS estimate for GCA for 4Q09 appears achievable.

Source: PAA Research

What the Big Boys Are Saying About 2010

Over the past two weeks four leading gaming operators have reported 4Q09 results.  Wall Street has been less than enthusiastic about the 4Q09 earnings results and 2010 outlook from PNK, PENN, MGM, and LVS.  The four stocks witnessed an 8% decline on average on the trading day following their earnings release.  While this might raise some concerns for GCA shareholders, we would argue the set-up heading into the company’s earnings is far different than was the case for the leading gaming operators (more on this later).  More importantly, we thought it might be helpful to look at some of the commentary offered by senior management of these companies to gain a better sense of what might be in store for 2010.

“We have seen the worst of the downturn…. Passenger declines have slowed…. Airlines are adding seats [more flights to Las Vegas] for the Spring… Auto traffic continues to grow… Our convention bookings in the fourth quarter of 440,000 rooms was four times the level of the fourth quarter of 2008”

Jim Murren, Chairman and CEO MGM

“Finally, let me spend a moment on Las Vegas. The good news is that group business is returning. In fact, our group business was up 20% in the first 40 days of 2010 compared to last year. Forward bookings were also increasing for both 2010 and 2011.”

Sheldon Adelson, Chairman and CEO LVS, Source: Seeking Alpha

“Our January performance in Las Vegas is quite healthy compared to last year, principally due to revenue growth and continued impact of our right-sizing initiatives….our gaming business is relatively healthy with volumes turning above 2008 levels and our costs are down”

Rob Goldstein, EVP and COO of The Venetian & The Palazzo Las Vegas.  Source: Seeking Alpha

“Well, here we are again at the end of another year and I can’t say I’m sorry to see it go. Looking forward as you can see from our guidance, we don’t see a whole lot of reason for enthusiasm in 2010… We don’t have a clue. We really don’t have a clue where this year is going to go. We had some optimism looking back more than a year ago that ‘09 by the latter part of the year was going to be more positive, but now, having been chase by the results of 2009, we don’t see a lot of reason for enthusiasm in 2010.“

Peter Carlino, Chairman and CEO PENN.  Source: Seeking Alpha

Based on these comments from industry leaders it seems reasonable to assume that Las Vegas could generate positive comps over the course of the year, while trends in local markets could continue to remain weak.  GCA has significant earnings leverage to an upswing in gaming traffic and dollar drop.  It appears a significant upturn could occur in the second half of 2010, at the earliest. Fortunately, these assumptions have already been factored into consensus estimates.

PAA Reserach 4Q09 and 2010 Estimates vs. Consensus – The “Bar” Appears Achievable

We think GCA could deliver modest upside to current 4Q09 consensus for revenues and cash EPS of $159.6 million and $0.17, respectively.  We currently forecast revenues of $164.0 million and cash EPS of $0.17.  Here are our key assumptions for the quarter:

• A YOY decline in same store sales of 7%
• A 20% YOY decline in cash advance revenues to $65.7 million.  GCA continues to suffer from a reduction in both transaction size for credit card cash advances and a reluctance on the part of the consumer to take on additional credit card debt.
• 6.7% YOY growth in ATM transactions. We have assumed GCA’s ATM transactions will benefit from the mix shift away from credit cards.
• Gross profit margin of 25.0% for 4Q09, up from 24.5% for 3Q09

We think the “set-up” for GCA shareholders in 2010 remains very favorable even though many key executives within gaming companies have offered a cautiously optimistic outlook on 2010, at best and an outright cautious outlook, at worst.  Current consensus revenue estimates for 2010 contemplate a 1% decline for GCA in 2010, which we would characterize as overly conservative given the momentum building in some of GCA’s key markets such as Las Vegas and Connecticut.  We currently forecast revenues and cash EPS of $693.7 million and $0.80 compared to consensus of $670.4 million and $0.78.  Our key assumptions for FY10 are as follows:

• A decline in same store sales of 5% in 1Q10, after which we expect comps to gradually improve over the course of the year.  We estimate GCA will exit 2010 generating 5% comps.
• An 11.7% YOY decline in credit card cash advance revenues in 1Q10.  We expect GCA to witness 5-7% revenue growth from credit card cash advance in the second half of 2010.
• 2.6% YOY growth in ATM transaction revenue for all of 2010.
• Gross profit margin for the full year of 25.9%, which would represent a 110 bps increase YOY.  GCA’s gross margins are highly levered to credit card cash advance volumes. In the past, when credit card cash advance revenues have exceeded 50% of the company’s total, GCA has generated gross margins in excess of 30%.
• Interest expense of $17.6 million for the full year.  Even though we expect GCA to continue to pursue debt repayment options, the company remains highly exposed to movements in 1-month LIBOR through its $410 cash facility (for its ATM’s and other cash advance terminals) through Bank of America.  We expect one-month LIBOR to increase to 75 bps from 40 bps currently.
• We forecast $85 million of FCF generation for GCA in 2010

Key Questions Heading into Earnings

Here is a list of questions and issues we would like GCA to address in its earnings release and subsequent conference call:

• How did the company’s same store sales trends progress over the course of the quarter? Was there a meaningful shift in credit card cash advance volume?
• How did revenue performance differ between the company’s larger markets and destination casinos (Las Vegas, Atlantic City, and Connecticut) and for that in local markets?
• What is the timing of closing for the Western Money Systems acquisition? How will this impact 2010 financial results?
• Will GCA pursue other acquisitions of equipment OEM’s? Is vertical integration a primary strategy for the company going forward?
• What new cashless gaming products does the company plan to introduce and deploy in 2010? Has the company obtained any new regulatory approvals for cashless gaming products?
• How is the rollout of QCP express progressing (credit card cash advance cashless product)? How many customers does the company currently have for the product?
• How will gaming expansion in Kansas, Maryland, Pennsylvania, and Ohio impact the company’s growth over the next 2-3 years?
• The tender premium (102%) for the company’s 8.75% senior subordinated notes expires March 2010.  Does the company plan to tender, repurchase, or otherwise refinance the senior subordinated notes?
• What is management’s orientation towards capital allocation between acquisitions, debt pay down, and share repurchase?

Valuation Remains Compelling

Historically, GCA has traded off a non-GAAP measure called “cash EPS” which is effectively GAAP EPS plus the benefit of the company’s $150 million deferred tax asset.  Remember, the company’s deferred tax asset will reduce cash taxes paid by $18 million annually through 2019.  On cash EPS, GCA shares now trade at 11.4x 2009 cash earnings.  We recognize that the secular growth story in the US gaming market and the notion that gaming revenues were “recession proof” has been more or less demolished by this downturn.  We now view the gaming industry as cyclical with the potential for cycle-to-cycle growth.  GCA’s revenues are far less cyclical and the company has the opportunity to expand into cashless gaming products, ancillary service lines, and introduce new products.  We find GCA’s current valuation of 11.4x and 9.9x our cash EPS estimates for FY09 and FY10 as excessively cheap.  We think a 14-16x multiple on cash EPS for GCA shares is more than reasonable given the stability of the company’s free cash flow, its strong market position, high ROE and improving returns on capital. At 14-16x our FY10 cash EPS estimate GCA shares would trade at $11.20-12.48/share or 40-60% above current levels.

Source: PAA Research

As always, please act accordingly…

To the company’s credit, the initiative has worked – financially.  APOL now has over 200,000 associate’s degree students and revenues have more than doubled over the past five years.  The move has not worked for shareholders. APOL shares are down 24.6% over the past 5-years.  The transition away from older, higher-quality working adult students has resulted in a host of regulatory issues and concerns for APOL, leading to dramatic multiple compression in the stock.  We can’t help but wonder if APOL shareholders would have been better off if  the company “stuck to its knitting” and expanded internationally in the working adult market, instead of moving “downstream” in the U.S.

Now here comes the “holy #$@^!” moment for longtime followers of the for-profit education sector: APOL’s bad-debt expense is now higher than COCO’s.  Truly astonishing.

Source: Company reports

A few observations we would like to make:

• The chart above should not be misconstrued as an indicator of improved student quality at COCO.  The chart above compares APOL’s bad-debt expense to that of COCO’s on a reported basis.  As we have been arguing for sometime,  COCO dramatically understates its true bad-debt expense by excluding reserves on notes receivable for its internal lending program.  We estimate “real bad-debt expense” for COCO in FY09 was closer to 12.0%, not the 8.5% the company reported.
• APOL continues to make it clear that they plan to “cull the herd” and reduce the number of higher risk associate’s degree students the company enrolls.  This should reduce APOL’s regulatory risk-profile over time and result in lower bad-debt expense.

We think Friday’s announcement from APOL should serve as a warning to all investor in the for-profit education sector.  Enrollment growth can be seductive, but it is incumbent upon senior executives in the space to consistently monitor the manner in which it is achieved.  We call this the “enrollment growth paradox” – it looks great in the short term, but often leads to significant negative regulatory repercussions in the long term.  APOL is the first company to dial-back on growth and implement extensive “self-regulation”, we are almost certain it won’t be the last.

As always, please act accordingly….

ESI Revenues from Federal Financial Aid Sky-Rocketed in 2009, Even Though the Company’s 90/10 Compliance Actually Improved

As part of its 10-K, ESI provides investors with more detail on the percentage of revenue the company generates from funding sources such as the Federal Family Education Loan program (FFEL), Federal Pell Grants, and private lending.  Here are the highlights:

• On a cash revenue basis, an astounding 84% of the company’s receipts came from Title IV programs in 2009.  To our knowledge this is the highest contribution that Title IV funds have represented as a percentage of ESI’s total revenues in the history of the company.  Clearly, ESI has benefited from higher student loan limits and expansion of the Pell Grant program.
• For 90/10 purposes, ESI generated 70% of its revenues from Title IV funds on a cash accounting basis in 2009. No school generated more than 74% of its revenues from Title IV funds from 90/10 compliance purposes.  As a reminder, revenues generated from the increase in student loan limits enacted in July 2008 will not be included in the calculation until July 2011. We expect most companies in the for-profit education sector to witness a sizeable gap between the percentage of cash revenues generated from Title IV and their 90/10 compliance over the next several years due to this regulatory concession.
• Pell Grants Are Now a Critical Source of Revenues for ESI.  Pell Grants represented 18% of ESI’s revenues in 2009, the highest level in the company’s history.  ESI has clearly benefited from the expansion in the Pell Grant program and increased funding limits per student. Stated another way, in 2006 ESI generated 11% of its revenues from Pell Grants, which implies they contributed $83 million to the company’s top-line. In 2009, Pell Grants accounted for $237 million of ESI’s total revenue – a three-fold increase!

In the chart below we outline ESI’s revenues by funding source over the past decade. It should become obvious that ESI is more reliant on federal financial aid than it ever has been.

Source: Company Reports

How Does ESI Generate Such a High Percentage of Its Revenues from Title IV Funds?

It sounds like a fairly obvious and simple question, but there is a component of the answer that is often over-looked by investors in the for-profit education sector.  At the simplest level here’s what we know about the math surrounding tuition at the ITT Technical Institute and how students finance it.

• The total cost of an associate’s degree at the ITT Technical Institute is now approximately $45,000 (please take a moment to absorb that).
• Assuming that every student that applies to ITT Tech is an independent, they are eligible for $9,500 and $10,500 in Stafford loans in their first and second year of study, respectively.
• Using these basic assumptions, an associate’s degree student would borrow $20,000 in Stafford loans to help finance their total associate’s degree tuition of $45,000.  This would imply that ESI should generate 44-45% of its revenues from FFEL ($20,000/$45,000), not the 66% the company reported in 2009.

How can we reconcile the discrepancy? It is a little known or discussed fact that students in their last two quarters of an associate’s degree program are considered third-year students for federal financial aid purposes.  ESI has structured its academic programs using a quarterly credit hour system. Under federal financial aid regulations, a student is considered a second year student once they have completed 36 credits in a quarter based program.  That student is then considered a third year student when 72 credit hours have been completed.  In order to earn an associate’s degree at the ITT Technical Institute a student must complete 96 credit hours, which means that for the last 24 credit hours that student is considered a third year student and has an additional Stafford loan borrowing limit of $12,500.  Under the same methodology, students completing their last 36 credit hours of the 180 required to obtain a bachelor’s degree at ITT Tech are considered fifth year students for federal financial aid purposes.  In the table below we compare the classification of academic year for federal financial aid purposes between traditional semester based programs and quarterly programs.

Source: Department of Education

It seems somewhat illogical that a student completing their associate’s degree program (a 2-year program) can be considered a third-year student for federal financial aid purposes. This is not an ESI specific issue, but an industry-wide phenomenon.  There’s a reason beyond pedagogy and enhanced facility utilization that most schools in the for-profit education sector have employed a quarterly academic model.  It helps to maximize federal financial aid funding for students.  The notion of double-dipping in the federal financial aid pool has received close attention of late as it relates to Pell Grants.  Recent expansion of the program has enabled students to secure Pell Grants twice within one calendar year.  There’s a reason outside of target student demographic that for-profit institutions received 25% of Pell Grant funding a year ago, even though they only accounted for 10-12% of total enrollments in the U.S.

Revisiting Our Original Short Thesis On ESI

Approximately 10-months ago, we published a report entitled “Whatever Happened to the More You Learn, the More You Earn? The Structural Problems With ESI’s Business Model“.  It has been one of the most popular reports we have published. At the time we recommended that investors sell or short ESI shares based on the following:

1. Over the next few quarters, ESI will continue to benefit from strong demand for its programs caused by the economic downturn. This is already reflected in consensus – strength should be sold or shorted.
2. ESI has broken “the more you learn, the more you earn” student covenant.
3. Student debt burden to attend ITT Tech now rivals mortgage debt burden at the peak of the housing bubble – cohort default rates should continue to surge higher.
4. Our proprietary survey suggests that students are finding it increasingly difficult to make student loan payments.
5. ESI has not disclosed that it is subject to a qui tam lawsuit based on alleged violations of the incentive compensation provisions of the Higher Education Act.
6. ESI is over-earning at the expense of its students – tuition price cuts will become a necessary remedy for the company to fix its business model, in our view. We estimate that restoring the affordability of ESI’s programs could negatively impact EPS by $2.50-$3.00 in 2010, if not more.

Our investment thesis appears as compelling today as it did 10-months ago.  At the time we published our original report we speculated that the company could witness a sharp uptick in its cohort default rates as a result of low returns (if not negative) on educational investment and high student debt burdens for graduates.  We thought high cohort default rates could become a catalyst for ESI to witness greater regulatory scrutiny.  It appears that this particular element of our investment thesis was incorrect based on the preliminary FY08 cohort default rate data ESI disclosed in its 2009 10-K.

ESI’s Cohort Default Rates Remain Surprisingly Low

For FY08 (captures students delinquent on student loan payments as of January 2009), ESI’s preliminary cohort default rate according to the Department of Education ranged between 3.6% and 15.5% for its schools.  This compares to a range of 2.7% to 15.2% for FY07.  We are stunned by both the absolute level of cohort default rates and the small increase from FY07 to FY08.  COCO witnessed a 4% average increase across its school network from FY07 to FY08.  We thought ESI would witness a similar, if not larger increase than COCO given the high price points for its programs, declining placement rates, and low starting salaries for graduates.  Thus far this has not come to fruition.

ESI is also bucking another trend with its cohort default rate data.  Historically for-profit education institutions that have witnessed a sharp increase in revenues from Pell Grants have seen a commensurate uptick in cohort default rates.  Think about it this way, COCO generated approximately 23% of its revenues from Pell Grants in FY09 and at this stage most investors are familiar with the company’s target student demographic and high cohort default rates.  Perhaps a sharp rise in ESI’s cohort default rates is still on the come or the company does a superior job of managing risk on the “back-end”.  Almost every single form of credit witnessed a rapid increase in delinquencies from 2008 to 2009 (the end of the measurement period for FY07 and FY08 cohort default rates), and yet ESI’s data reflects almost no change.  It is puzzling.

Whatever Happened to “the More You Learn, the More You Earn”?

The for-profit education space was effectively founded on the principle that “the more you learn, the more you earn” student covenant.  In the early days of the sector, for-profit education companies, including ESI, offered programs that were reasonably priced and offered students a compelling return on educational investment.  After more than a decade in which yearly tuition price increases have more than doubled the annual gain in starting salaries for its graduates, ESI has eroded return on educational investment to the point where it is highly questionable, if not outright negative, in our opinion.  Annual tuition has increased at a 7% CAGR since 1996, while starting salaries for ESI’s graduates (those who obtain job placement) have grown at a 3% rate.  This is an unsustainable trend to say the least.

We wanted to revisit a few data series in which we laid out the likely student loan servicing costs for ESI’s graduates at this point and how that compares to borrower mortgage burdens at prior peaks in the housing cycle.  First, students graduating from ESI’s associate’s and bachelor’s degree likely paid a total of $45,000 and $80,000 over their period of study.  We estimate those same degrees could cost as much as $47,000 and $90,000 for students starting those programs in 2010.  According to ESI management, the job placement rate for 2009 graduates was 74.6% at an average starting salary of $31,500 through January 2010.  As we have stated in the past, those numbers suggest that students are likely better off not attending ITT Tech at all.  In the table below, we compare the total cost of degree to average starting salary over the past 14-years. As you can see, the cost of ESI’s associate’s degree program is 140%+ of average starting salary and that for a bachelor’s degree 250%+.  These are troubling statistics.

Source: Company Reports, PAA Research

From a student debt burn perspective, the statistics are equally concerning. In the table below we compare the percentage of gross income an associate’s degree graduate of ITT Tech in 2009 would allocate to student loan payments to that for mortgage borrowers at prior housing cycle peaks. According to our analysis, ESI’s 2009 associate’s degree graduates might allocate as much as 20% of their gross income to student loan payments.  This is before shelter, food, and transportation costs. The student debt burden appears to be unsustainable and is close to matching the levels witnessed in prior housing cycle peaks.

Source: National Association of Realtors, Company Reports, PAA Research

In our analysis, we have assumed that students fund their tuition entirely with loans. Given the percentage of ESI’s students that now get Pell Grants, one could argue that we have overstated graduate debt burdens. Overall, the contribution of Pell Grants does not change the conclusions of this analysis meaningfully.  We are not the only ones concerned about student debt burdens.  As part of the Negotiated Rulemaking process for 2009, the Department of Education proposed a “gainful employment” provision, which would effectively limit the amount of tuition a school could charge based on starting salaries for its graduates.  The initial proposal contemplated an 8% debt/income ratio for graduates.  Based on our analysis, ESI’s graduates have a debt burden of more than twice the proposed level as a result of the company’s tuition policies and low starting salaries.

The battle over the “gainful employment” provision in Negotiated Rulemaking will be brutal. For-profit providers of postsecondary education have a lot at stake.  However, at the end of the day it’s the Department of Education’s call. Who in the government will oppose a provision that lowers tuition costs for students? That would be political suicide.  Tuition trends across the entire higher education sector are unsustainable. Every man, woman, and child in this country wants to pay less to go to college.  With this type of support, it’s not hard to see why Secretary Duncan and Mr. Shireman have pursued this policy initiative.

The “gainful employment” provision was never part of our original investment thesis on ESI.  It appears that people within the Department of Education have started to look at tuition pricing for certain for-profit education companies in a similar manner as we do.  In our original report, we argued that reducing tuition to the point where the return on educational investment would be restored for the student could cost ESI as much as $2.50-$3.00 in EPS.  If the government’s 8% debt/income ratio policy is implemented, the negative impact on ESI’s EPS could be far larger.

Our short call on ESI has delivered a modest return, but the stock has underperformed almost every major index over the past 10-months.  Fundamentally the thesis has yet to play out, but the stock has already witnessed substantial multiple compression.  We continue to think that ESI needs to take drastic steps to restore the return on educational investment for its students.  Large tuition reductions are the most likely and the most effective remedy in our opinion.

As always, please act accordingly…

Upcoming changes to pleaseactaccordingly.com

In approximately two weeks, we will be making significant changes to pleaseactaccordingly.com, which we think will substantially enhance the user experience.  Some of the new features of our redesigned website will include:

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As always, please act accordingly…

1. Why did senior management “talk down” IPSU’s ability to raise prices when the company is currently marketing refined sugar at $52-$55/cwt (compared to $39-$40/cwt spot raw sugar prices)?
2. What are the implications of IPSU’s sizeable inventory build on the company’s profitability going forward?
3. How will management approach the potential acquisition of the 50% ownership stake in Wholesome Sweeteners that IPSU does not own?
4. Are there any updates on the civil litigation related to the Port Wentworth refinery accident?
5. What is management’s approach to shareholder value creation given the seemingly large disconnect between the asset value of IPSU and the current stock price?

Below we discuss management’s responses to our series of questions and the implications for IPSU’s earnings going forward.

Why did senior management “talk down” IPSU’s ability to raise prices when the company is currently marketing refined sugar at $52-$55/cwt (compared to $39-$40/cwt spot raw sugar prices)?

Following IPSU’s 1Q10 earnings conference call we expressed puzzlement surrounding management’s commentary that it was having some difficulty implementing refined sugar prices increases.  Based on our recent checks with sugar brokers, we know that the company is currently marketing refined sugar in a range of $52-$55/cwt on a spot basis. We would characterize that as a fairly healthy spread compared to the spot price of raw sugar (the #16 sugar contract) of approximately $40.  Historically, a $12-$15 refined/raw sugar spread would imply high gross margins for IPSU.   Management acknowledged that it was currently marketing refined sugar at $52-$55/cwt, but stood by its previous comments about the difficulties the company was having in raising prices due to some competitive pressure from sugar beet producers.  Although management did not state this explicitly, we think part of the reason they have stated these concerns was to manage street expectations about pricing for their production that will be contracted on a spot basis for the remainder of FY10.

IPSU Remains On-Track to Generate a Refined/Raw Sugar Price Spread of $10-$12 for FY10

As a sugar refiner, there are three variables which determine gross profit margins for IPSU: 1) the refined/raw sugar price spread, 2) natural gas prices, and 3) operating efficiency/capacity utilization.  In the five years prior to the company’s Port Wentworth refinery accident, the correlation between the refined/raw price and gross margins for IPSU was 0.87.  As the chart below demonstrates, the Port Wentworth refinery accident has skewed the normal correlation between refined/raw sugar price spread and gross margins.

Source: Company reports

As the company achieves normal operating capacity, the refined/raw sugar price spread and natural gas prices will be the only two major variables that will dictate gross margins and we expect the normal correlation to resume.  In IPSU’s 1Q10 10-Q filing, the company indicated that it expected its raw sugar costs for all of FY10 to be $30.35/cwt based on spot prices as of 2/5/10.  Spot raw sugar prices have not moved materially since that time, so we have incorporated the company’s outlook for input costs into our model.  Despite the rapid increase in raw sugar costs, we still think IPSU can achieve a refined/raw sugar price spread of $10-$12 for the remainder of FY10.  In the table below we have outlined our key assumptions.  IPSU should benefit from the roll-off of legacy industrial contracts (18% of volume in 1Q10), which were priced at levels $8-$10/cwt below industry standard contract levels.  Overall, we expect pricing on the company’s industrial contracts to increase from the $32.04/cwt realized in 1Q10 to $36.76/cwt by fiscal year end.  For IPSU’s spot oriented business, we estimate the company will realize pricing close to $48-$49/cwt by fiscal year end.  We would characterize this assumption as reasonably conservative given current spot pricing of $52-$55/cwt.

As the chart above demonstrates, IPSU historically has generated gross margins well in excess of 8.0% during periods when the company can realize a refined/raw sugar price spread of $10.00+.  This year the company will have the added benefit of lower natural gas prices, which will provide a 40-50 bps tailwind to gross margins.

Source: PAA Research

What are the implications of IPSU’s sizeable inventory build on the company’s profitability going forward?

IPSU ended 1Q10 with $138 million of total inventory, the highest level since 4Q06.  According to management, the increase in inventories is the result of two factors: 1) IPSU produced more sugar in the quarter than it actually sold (a timing difference), and 2) IPSU built a significant amount of raw sugar inventory over the past 6-9 months in advance of the ramp-up of production at the Port Wentworth refinery.  As the chart below demonstrates, both raw-in-process and total inventories are at multi-year highs.

Source: Company Reports

According to management, current raw-in-process inventories are approximately $25-$30 million too high.  Normally the company can operate with $40-$50 million in raw-in-process inventory.  IPSU accounts for inventory on a LIFO basis.  As a result, the company would not normally benefit from the older inventory it had on hand that was priced at levels from 6-9 months ago. However, given the pace of capacity expansion at Port Wentworth, it is highly likely that IPSU will work down its raw-in-process sugar inventory to normalized levels over the next 2-3 quarters.  Although the company has not disclosed it, we estimate that the next LIFO layer was acquired somewhere between $22-27/cwt.  This should provide a favorable tailwind for the company’s gross margins over the course of the year. At those prices, margins on approximately 1.0-1.5 cwt could be impacted.

How will management approach the potential acquisition of the 50% ownership stake in Wholesome Sweeteners that IPSU does not own?

Wholesome Sweeteners has quickly become the crown jewel of IPSU’s asset portfolio given the company’s rapid growth rate and high margins.  IPSU currently owns 50% of the Wholesome Sweeteners and has the option to purchase the remaining ownership stake at a pre-determined multiple of EBITDA anytime between September 2010 and May 2011.  Although management did not explicitly state that it planned to pursue this option, they gave us every reason to believe that the company will purchase the outstanding ownership stake sometime within the next year.  We recently published a report in which we analyzed the financial impact of a potential acquisition of the remaining ownership stake of Wholesome Sweeteners.  In our original base case we used a $35 million purchase price, which based on our recent conversation with IPSU management now appears to low.  Assuming the company acquires the remaining stake in Wholesome Sweeteners for $50 million, we estimate the transaction would be $0.27 accretive to IPSU’s annual earnings (vs. $0.29 previously).  Our accretion/(dilution) analysis assumes IPSU finances the deal entirely with cash from operations.  It is possible that will not be the case, which would lower the level of accretion.

Source: PAA Research

More importantly, the acquisition of Wholesome Sweeteners would positively alter IPSU’s normalized earnings profile and should result in a higher valuation multiple for the stock going forward.  We expect the purchase of Wholesome Sweeteners to be IPSU’s next major use of discretionary capital to enhance shareholder returns, not a special dividend.

Are there any updates on the civil litigation related to the Port Wentworth refinery accident?

The short answer from management was no.  The company continues to state in its SEC filings that it views the likelihood that IPSU will incur damages that are not covered by its workers compensation and general liability insurance policies as remote.  As a reminder, the first case is expected to go to trial in May of this year.  We expect the eventual resolution of the company’s civil litigation matters to be a settlement structured by IPSU’s insurance providers.  Any resolution of the civil litigation would be an enormous positive catalyst for the stock and would likely result in IPSU shares trading towards their intrinsic value of $25-$30/share.

What is management’s approach to shareholder value creation given the seemingly large disconnect between the asset value of IPSU and the current stock price?

We might not have been the first and we certainly won’t be the last to pose this question to IPSU management given the huge gap between the current stock price and what a reasonable assessment of the company’s asset value implies.  Management has gone out of its way to make it clear that it does not expect the civil litigation associated with the Port Wentworth refinery accident to have an impact on the company’s financial position.  If this is the case, why hasn’t management done more to create shareholder value (share repurchases, insider buying, special dividends etc.)?

While management did not have a direct answer to our question, here are a few things that we discussed that are worth consideration:

• Historically, IPSU’s board has favored special dividends in lieu of share repurchase.  Management suggested that might be the case going forward
• As a result of the outstanding civil litigation, senior management is precluded from buying stock, even though they recognize the large disconnect between the current share price and the value of the company
• As mentioned above, the potential acquisition of Wholesome Sweeteners will probably all but eliminate the likelihood of special dividends in the near future

Global interest in sugar assets continues to surge.  IPSU’s management’s hands might be tied given outstanding litigation, but that doesn’t preclude a third-party from trying to extract value out of the company.  Disappointment over the pace of capacity expansion at Port Wentworth does not effect the long term value inherent in IPSU shares.  In our view, IPSU represents an excellent acquisition candidate given its asset value and its exposure to growth in refined sugar usage.  We find it highly unlikely that the stock will trade at 0.6x tangible book value and 55% of real asset value when the company’s earnings prospects are rapidly improving and global interest in sugar assets is surging.

As always, please act accordingly…

Performance Update

Thus far in 2010, the PAA Research SMid Cap Portfolio has delivered strong absolute and relative performance.  Both our longs and shorts have contributed positively to performance thus far this year.  Here are some of the performance highlights:

• On a year-to-date basis, the PAA Research SMid Cap Portfolio has returned 4.8%, compared to (-1.5%) and (-2.3%) declines for the S&P 400 and Russell 2000, respectively.  The table below outlines the performance of the PAA Research SMid Cap Portfolio on a year-to-date basis compared to its most relevant benchmarks: the S&P 400 and the Russell  2000.

Source: PAA Research

• The portfolio has generated an 11.7% return since inception (9/3/09), compared to a 12.4% gain for the S&P 400 and a 9.9% increase in the Russell 2000.
• Our top contributors to performance among our long positions over the past two weeks were: THQI (up 20.6%),  IPI (up 10.7%),  and POOL (up 12.2%).  The biggest detractors from performance on the long side were: IPSU (down 10.1%) and GLG (down 10.0%).
• On the short side, BWLD (down 8.3%), WPO (down 6.1%), and our short position in REIT’s contributed favorably to performance.

We are making some changes to the PAA Research SMid Cap Portfolio. We have taken profits on a few names, closed out a few short positions and added selectively to a few long positions.  The net effect of these changes is to decrease our net exposure from 45.8% as of 1/29/10 to 43.1%.  Our gross exposure of $173.7 million, or 155.5% is a slight increase from $168 million two-weeks ago. As a reminder, we do not manage the portfolio to a specific net position, rather the portfolio weightings and net exposure are determined by our stock specific analysis. Here are the changes we are making to the portfolio for this week:

Long Positions:

Our top five holdings on the long side after giving effect to these changes are: THQI (8.4%), IPSU (8.3%), BCO (8.3%), GCA (5.9%), and GLG (5.8%).

Increased Positions: IPSU and AKS

We continue to trade around our large position in IPSU.  Followers of the PAA Research SMid Cap Portfolio know that we have pared back our holdings and selectively added to the name more than four times over the past six months.  Although we only update the PAA Research SMid Cap Portfolio on a bi-weekly basis, it still does allow for us to exploit some selective trading opportunities.  IPSU shares traded off sharply following the company’s 1Q10 results due to disappointment about the pace of capacity expansion at the company’s Fort Wentworth refinery and concerns about IPSU’s ability to pass along higher raw sugar cane input costs.  As we have discussed in the past, we estimate the asset value of IPSU at $25-$30/share even if the company has some level of non-insured contingent liability from the civil litigation related to the Port Wentworth refinery accident.  We still expect the eventual outcome of those cases to be a settlement covered by IPSU’s insurance policies.  We still think IPSU can exit its 2Q10 with close to 100% capacity utilization at its Port Wentworth refinery.  This should enable IPSU to start to benefit in full from higher refined sugar prices (spot $52-$55/cwt) and a reasonably favorable refined/raw sugar spread, which we expect to remain between $10-$12 over the course of the year.

AKS is ahead of its peers in its cost rationalization efforts and has demonstrated the ability to generate profits despite a fairly tepid recovery in demand.  The company’s balance sheet is solid and we think AKS should start to pass along price increases over the coming months if demand in the US continues to stabilize.

Decreased Positions: THQI, MLHR, ZIPR, TXRH

We are taking some profits in some or our larger long positions. In the case of THQI, appreciation in the stock resulted in the position increasing to 9.7% of portfolio value over the past two weeks. As a risk management practice, we generally cut back on any holding that approaches 10% of portfolio value.  We remain very bullish on the appreciation prospects for THQI shares. The company has proven it can be profitable and generate ample free cash flow in a year win which it does not have a breakout hit among its owned IP portfolio. We think the stock has a ton of “optionality” over the next few years based on the company’s baseline profitability and the potential that one of its owned IP could become a breakout hit.

We have reduced our short position in HNI following a strong sell-off in the stock in the past week.  We continue to view a pair trade of long MLHR/short HNI as a compelling investment idea.  However, we want to appropriately manage our net exposure to the office furniture sector given weak demand trends and have cutback our holdings in MLHR to offset the reduction in our HNI short position.

Short Positions:

Our top five short positions after giving effect to these changes are: NILE (3.5%, paired against a long position in SIG), ESI (3.4%), WRLD (3.0%), LINC (3.0%), and LOOP (3.0%, paired against a long position in CSGP).

Increased Positions: RRC, SFLY, CAKE, SFN, and RGR

For the most part, we are slightly increasing our short positions in names that have run-up in the past two-weeks and in which we have previously taken profits.  In the case of RRC, SFLY, CAKE and RGR, we are adding 30-50 bps of short exposure to these names.  For SFN, we are effectively doubling the size of our short position to almost 1.8%.  We recognize the stock broke out of trading range in the past two weeks. However, we have our doubts about the timing and magnitude of a labor market recovery. At this stage, we think the stock discounts a similar recovery in employment trends that the U.S. witnessed in 2002/2003.  Thus far, there is little evidence to support that possible outcome.

Closed Out Positions: MLM, JCG

We generated 10%+ returns in our short positions in both MLM and JCG and the stocks have achieved our price expectations. MLM now trades at a four-year low following disappointing initial 2010 guidance. In the high $80’s the stock reflected a more meaningful contribution from the federal government’s stimulus package than was likely to occur. Our surveys of reprographers, office furniture dealers, and lighting agents all suggested that the stimulus package was having little overall impact on the level of project activity.  JCG shares look the most challenged from a “technical” perspective, but we think the stock is reasonably valued here given the operating momentum the company has.  Should the stock trade lower heading into the company’s earnings release, we would consider establishing a long position.

New Positions: TOL, CLF

The housing market has established a clear, but tenuous bottom over the past several quarters. The growth rate of defaults and foreclosures has subsided, but remains highly elevated. Option-ARM resets are likely to remain an overhang on the existing home market.  The homebuilders have rallied in recent weeks following strong results from a few key players and LEN’s announcement that it had purchased a portion of a $3.0 billion mortgage portfolio from the FDIC.  We think there are more compelling ways to play a recovery in housing that have less exposure to the new home market, which we expect to remain relatively weak for several years. TOL, in particular could have a difficult time generating growth given the company’s focus on the higher end consumer and move-up home buyer.  The expiration of the government’s home buyer tax credit could start to become an overhang on this group.

Within the S&P 500, materials has been the third worst performing sector on a year-to-date basis. While many in the media point to concerns about sovereign debt and Greece, we think more and more investors are growing uneasy about growing signs of a property bubble in China.  Recent efforts to curb lax lending practices in China are unlikely to yield a rapid reduction in bank lending , in our opinion.  Prices and vacancy rates are climbing, while transaction activity is slowing in China’s commercial real estate market.  We have established CLF as a short, in part to hedge our position in AKS and also as a result of CLF’s growing direct exposure to end-market demand in Asia.

Please click on this link to view the details of the PAA Research SMid Cap Portfolio.

As always, please act accordingly…

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company, and above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.“

Mr. Buffet summarized his investment approach using the castle/moat paradigm as follows:

“In business, I look for economic castles protected by unbreachable ‘moats’.”

We can think of no industry or ”castle” that will be under siege more over the next several years than that of commercial real estate.  The industry is highly reliant on employment trends and faces a steady sequence of mortgage maturies over the  next several years at a time when the market for CMBS could not be more uncertain. Consider the following:

• In the U.S. vacancy rates have risen for nine consecutive quarters and now eclipse 16%
• According to Real Capital Analytics there is now $176 billion in distressed commercial real estate property in the U.S. and that number is expected to grow over the coming years
• Transaction activity in the commercial real estate sector declined more than 60% YOY in 2009 and an astonishing 80%+ from peak levels in 2007.

Bid/ask spreads have narrowed, but remain too wide to facilitate meaningful price discovery and transaction activity. Cap rates have increased, but remain too low to entice buyers sitting on the sidelines.  It appears we are at an impasse of sorts where the lack of credit availability and real price discovery leave buyers waiting for forced sellers or  financing options.  However over the next several quarters, we think the grid-lock in commercial real estate could finally start to dissipate.  Despite all of the “doom and gloom” currently there are some signs that transaction activity in the U.S. commercial real estate sector could start to improve, albeit off incredibly depressed levels over the next 6-9 months.  Here is what Brett White the President and CEO of CB Richard Ellis (the world’s largest commercial real estate brokerage firm) had to say about the outlook for transaction activity in 2010 on their most recent earnings conference call:

“…the real estate investment property sales markets are showing increased activity and some value stabilization at the high end of the market….While U.S. investment sales remain historically depressed, activity has also recovered from the near-dormant state earlier in the year and cap rates have lowered for the best properties in the strongest markets. Global capital, foreign and domestic, is slowly coming off the sidelines.”

Source: Seeking Alpha

At this stage, it appears that the “sparks could start to fly” within the next 6-9 months in the commercial real estate market.  The space could finally receive a legitimate mark-to-market.  We anticipate investors could start to refocus their attention on companies that service the participants in the commercial real estate space that benefit directly from transaction activity, not simply price action and cap rates.  It will be a bumpy road.  Commercial real estate participants are likely to gravitate towards service offerings that provide transparency on value during a period of dynamic price discovery.   When an industry reaches an inflection point, we try to identify investment opportunities that offer the greatest risk-reward.  In the case of commercial real estate, the timing and magnitude of a real recovery (i.e. positive net absorption, increased transaction activity, lower cap rates etc.) remains highly uncertain.  It seems imprudent to establish a basic unhedged long position in the sector given the level of uncertainty.  As a result we ask the simple question: who can survive and even flourish when the commercial real estate sector is under siege?  Conversely, which company has the least defensible business model?  In short whose “castle” has a wide and deep moat and which company might have barbarians at the gate? 

We have identified two companies that meet our criteria: CoStar Group, Inc. and LoopNet, Inc.  CSGP has one of the most defensible business models in the commercial real estate sector and should benefit as transaction activity increases, while LOOP’s market position appears increasingly tenuous in light of competitive threats and the low barriers to entry for its offerings.  As a result we are introducing a pair trade: Long CoStar Group, Inc. (CSGP)/Short LoopNet, Inc. (LOOP) that we think should generate returns of 35-40% over the next 12-months based on the following:

1. CSGP has a highly diversified and defensible suite of product offerings, LOOP is a “one-trick pony”.  CoStar is the leading provider of information and marketing services to the commercial real estate sector in the U.S. and the U.K..  The company has more than 80,000 subscribers, 15,000+ clients, and a database of more than 3.5 million properties.  The company’s suite of product offerings and breadth of market coverage is unrivaled in the industry.  Additionally, CSGP’s recent acquisitions should dramatically enhance its value proposition to existing clients and expand the company’s addressable market. No longer should investors be concerned about potential market saturation for CSGP.  CSGP’s product portfolio and market coverage would be extraordinarily costly and difficult to replicate at this stage. LOOP on the other hand appears to be a “one-trick pony”.  The company owns and operates the largest online commercial real estate marketplace in the world.  However, the company has yet to demonstrate that it can diversify its revenue streams beyond subscriptons to loopnet.com.  We think this could pose significant challenges for the company in the future. 
2. LOOP’s core business faces direct competition from CSGP, which has tremendous competitive advantages.  Over the last several years, CSGP and LOOP have been involved in a nasty legal battle over their respective online commercial real estate transaction platforms: loopnet.com and showcase.com.  The companies settled all outstanding legal issues in 4Q09.  However, the operational battle wages on.  CSGP introduced Showcase, it’s own online commercial real estate transaction marketplace a few years ago to compete directly with LOOP.  Thus far, loopnet.com remains the clear market leader, but there are reasons to doubt whether LOOP can sustain that position.  First, CSGP has extensive relationships with brokers, REITs, and investment management firms that make up the vast majority of paying subscribers for LOOP.  Second, CSGP’s Showcase offering is priced at a significantly lower monthly subscriber cost. At this point, LOOP’s primary advantage is awareness and traffic, we think this could prove to be unsustainable.
3. CSGP should deliver higher incremental margins and faster revenue and EPS growth over the next 3-5 years.  Both CSGP and LOOP have compelling business models from an EBITDA margin, cash flow generation, and revenue visibility perspective.  For 2009, LOOP generated EBITDA margins of 40%+, while we estimate CSGP will deliver of 25% for the full year.  Going forward, we expect LOOP to generate slower subscriber growth and lower revenue-per-subscriber growth than it did in the prior commercial real estate cycle as a result of increased competitive pressures.  In the case of CSGP, the company has a long stated goal of achieving 30%+ EBITDA margins. We think CSGP’s recent acquisitions dramatically expand the company’s service offerings and addressable market.  Resumption of subscriber growth and an increase in revenue-per-subscriber should enable CSGP to achieve 30%+ EBITDA within 12-18 months.  Overall, we expect CSGP to deliver more revenue growth and earnings leverage than LOOP over the next 3-5 years.
4. CSGP shares are considerably cheaper than those of LOOP.  CSGP shares trade at 8.6x and 6.8x our 2010 and 2011 EBITDA estimates, while those of LOOP trade at 10.8x and 9.9x our 2010 and 2011 estimates. We expect the valuation discount for CSGP relative to LOOP to erode over the next 12-18 months as investors increasingly realize that CSGP market position and growth rates will be far more favorable than that of LOOP.

Risks to Our Thesis:

 There are a few risks to our investment thesis that we would like to highlight and discuss.

LOOP Could Be Acquired By CSGP or Another Commercial Real Estate Services Company

Before the legal battles between CSGP and LOOP escalated to vitriolic levels, we know that CSGP was genuinely interested in potentially acquiring LOOP.  CSGP is well capitalized ($250 million in cash on hand as of 9/30/09) and continues to look for ways to expand its suite of product offerings in areas that are tangential to the company’s core mission and that can accelerate growth.  LOOP certainly fits that criteria, or at least did in the past. Now, CSGP has fully invested in its Showcase platform and appears to have chosen the “build” approach versus “buy”.  At this stage given the heated legal battles between the two companies over the past several years we view a CSGP acquisition of LOOP as highly unlikely.  Otherwise, there are other commercial real estate services companies that could consider buying LOOP but the strategic value is not nearly as compelling for other players. Additionally, LOOP’s lofty valuation is likely to deter potential acquirers.

CSGP Could Face Difficulties Integrating the PPR and Resolve Technologies Acquisitions

In the past 6-months, CSGP has completed two strategically important acquisitions.  In July 2009, CSGP acquired Property and Portfolio Research, Inc. (PPR) for approximately $22 million and three months later purchased Resolve Technologies for roughly $4 million.  Both acquisitions expand CSGP’s addressable market and product offering portfolio.  However, both PPR and Resolve Technologies service offerings are delivered in a slightly different manner than CSGP’s core database product.   Additionally, the success of these acquisitions is contingent, in part on CSGP’s ability to cross-sell and upgrade it’s existing clients to higher priced service offerings.  We do not expect this to be an easy task in this environment.

A Brief Description of CoStar Group

Source: Company reports, Yahoo Finance, PAA Research

CoStar is the leading provider of information and marketing services for the commercial real estate sector in the U.S. and the U.K.  The company has more than 80,000 subscribers and 15,000 clients.  CoStar provides subscribers with access to a comprehensive database of commercial real estate information which has been researched and verified by the company’s employees.  The company provides property-by-property information on space available for lease, comparable sales information, tenant information, information about properties for sale, analytic information, and industry news.  The company’s breadth of market coverage is unrivaled in the industry.  The company’s database of properties increased 15% YOY for 3Q09 to 3.5 million.  Any meaningful player on a local, regional, or national level in the commercial real estate sector is likely a CoStar subscriber.  Historically, the company has had the strongest traction with brokers who rely on the company’s database to get real-time property level data about comparable sales, available for lease, and tenant information.  The company’s traditional service offerings include the following:

• CoStar Property Professional- Provides subscribers a comprehensive inventory of office, industrial, retail and multifamily properties and land in markets throughout the U.S., including for-lease and for-sale listings, historical data, building photographs, maps and floor plans. Clients also use CoStar Property to analyze market conditions by calculating current vacancy rates, absorption rates or average rental rates, and forecasting future trends based on user selected variables.
• CoStar COMPS Professional – Provides comprehensive coverage of comparable sales information in the U.S. commercial real estate industry.
• CoStar Tenant – Provides clients with comprehensive tenant and lease expiration data
• Showcase- Online commercial real estate marketplace (competitor to loopnet.com)
• CoStar Connect – White label technology enabling commercial real estate firms to market properties on their own websites
• CoStar Professional Directory – provides detailed contact information for approximately 1.1 million commercial real estate professionals, including specific information about an individual’s current and prior activities such as completed transactions, current landlord representation assignments, sublet listings, major tenants and owners represented and local and national affiliations.

The company recently completed two acquisitions, which expand the company’s product offerings and addresable market.  In the past, we have been concerned about CSGP achieving saturation of its potential client-base in its core markets.  We think the two acquisitions significantly expand CSGP’s addressable market and the company’s growth trajectory.  Here’s a brief review of the PPR deal:

Property and Portfolio Research, Inc.(PPR)- Purchased for $22 million, PPR had annual revenues of $18 million at the time of acquisition.  PPR is a leading provider of global commercial real estate analysis, forecasts, and credit risk analytics.  PPR can provide clients with strategic market level analysis in support of portfolio management, asset dispositions, acquisitions, and understanding mortgage default risks.  Prior to this acquisition, CSGP’s forecasting and credit risk analytics offerings were limited.  We anticipate CSGP will be able to upsell a high percentage of its existing clients to the PPR platform.  More importantly, the addition of PPR will enable CSGP to expand its relationships with REIT’s, pension funds, asset management firms, and hedge funds that have commercial real estate portfolios.  PPR had 5% EBITDA margins at the time of acquisition and should quickly approach company wide levels within 2-3 years.

A  Brief Description of LoopNet, Inc.

Source: Company Reports, Yahoo Finance, PAA Research

LoopNet burst on the season in the last commercial real estate cycle as the leading online commercial real estate  marketplace. LoopNet seized opportunity as commercial real estate brokers migrated their property listings online and a centralized database was needed.  The company’s website enables commercial real estate agents, working on behalf of property owners and landlords, to list properties for sale or for lease and submit detailed information on property listings including qualitative descriptions, financial and tenant information, photographs and key property characteristics, in order to find a buyer or tenant. Commercial real estate agents, buyers and tenants use the LoopNet online marketplace to search for available property listings that meet their commercial real estate criteria. For the quarter ended 9/30/09, loopnet.com average just over 1.0 million monthly unique visitors, had 729,000 listings, 3.7 members (free and paid), and approximately 70,000 paying subscribers.  The company’s subscriber base, traffic, and listings are multiple times the size of competitors that have commercial real estate transaction platforms.  In the chart below we outline LOOP’s listings and traffic growth for loopnet.com. 

Source: Company reports

In addition to its primary commercial real estate marketplace on loopnet.com, LOOP also offers the following services:

• LoopLink- integration of listings on loopnet.com with a commercial real estate firm’s own website.
• RecentSales- database of recent transactions nationwide in commercial real estate both on the LoopNet platform and off of it
• BizBuySell – an online marketplace for operating businesses for sale with approximately 50,000 listings. Members pay $59.95-$99.95/month to list their businesses.
• ReApplications – provides CRM, market research, commission management, and transaction management software on a SAAS basis.

Why Did LOOP Issue Preferred Stock in Early 2009?

On March 30, 2009, LOOP announced it had closed a private equity transaction with Calera Capital, Trinity Ventures, and Rustic Canyon Partners for $50 million.  The company issued non-dividend paying preferred stock to the investor group.  At the time LOOP’s CEO Richard Boyle stated: “This financing will provide LoopNet with additional resources to pursue and accelerate our growth strategy in this unprecedented market environment”.  The transaction was conspicuous to say the least,  at the time LOOP had more than $60 million in cash on hand and NO debt.  Additionally, the conversion price of the preferred stock was $6.72/share.  LOOP had repurchased $54 million in stock in 2008 between $10-$15/share. LOOP bought high and sold low.  Since that time, LOOP has not closed a meaningful acquisition.  We can’t help but wonder if LOOP issued the stock to protect itself from the threat of an acquisition.  Either way, for now it looks like a “bad trade” on behalf of senior management.

Investment Thesis In Detail

 As we discussed earlier, we expect the commercial real estate sector to remain under siege for the foreseeable future.  In this type of environment, we have identified an investment idea to go long the shares of CSGP, which has the widest “moat” among commercial real estate service providers and to go short the shares of LOOP, which has the least defensible position in the market place. We wanted to elaborate on the tenets of our investment thesis in more detail.

CSGP has a highly diversified and defensible suite of product offerings, LOOP is a “one-trick pony”

CoStar is the leading provider of information and marketing services to the commercial real estate sector in the U.S. and the U.K..  The company has more than 80,000 subscribers, 15,000+ clients, and a database of more than 3.5 million properties.  The company’s suite of product offerings and breadth of market coverage is unrivaled in the industry.  We think the value proposition of CSGP’s services is best expressed in the high subscriber retention rates the company has enjoyed over the past decade.  The company’s 12-month rolling subscriber retention rate has never dropped below 83%, impressive when you consider the average annual subscription value runs between $2,000-$2,500.  The diversity and breadth of CSGP’s core product offerings make the company’s service a must have.  At this stage we think it would be incredibly difficult for another to match the size of CSGP’s property database, the number of markets the company covers, and it’s team of researchers (900+).  This company has as wide a moat as you will find in the commercial real estate services sector.  In the chart below we outline CSGP’s 12-month rolling subscriber retention rate over the past decade.

Source: CoStar Group, PAA Research

Additionally, CSGP’s recent acquisitions should dramatically enhance its value proposition to existing clients and expand the company’s addressable market. No longer should investors be concerned about potential market saturation for CSGP.  CSGP’s product portfolio and market coverage would be extraordinarily costly and difficult to replicate at this stage. LOOP on the other hand appears to be a “one-trick pony”.  The company owns and operates the largest online commercial real estate marketplace in the world.  However, the company has yet to demonstrate that it can diversify its revenue streams beyond subscriptions to loopnet.com.  We think this could pose significant challenges for the company in the future.

LOOP’s Core Business Faces Direct Competition From CSGP, Which Has Tremendous Competitive Advantages

Loopnet.com is far and away the largest commercial real estate marketplace currently.  The site generates more than 1.0 million monthly unique visitors and has more than 4.0 million free and paid users.  From a traffic perspective, loopnet.com is 8-10x the size of its next largest competitor, showcase.com.  However, we expect the marketplace for listings in the commercial real estate space to evolve in a similar fashion to that in the residential real estate space.  Initially one or two websites emerged as the primary destination for those seeking to search for properties online.  Over time, more third party websites emerged and brokers became more sophisticated in their online offerings.  Today in the residential real estate market there are a host of websites providing MLS (multiple listing service) data.  While the equivalent of the MLS does not exist in the commercial real estate sector, we expect more competitive threats to emerge to LOOP’s core business.

We think CSGP could become a viable competitor to LOOP over the next 2-3 years based on the following: 1) CSGP has extensive relationships with broker’s who are likely to list with any website that can generate leads for them, 2) CSGP can leverage the information in its property database to provide a superior experience to the user, and 3) CSGP has more than enough capital to make showcase.com the number one online commercial real estate marketplace if it so desires.  In the table below we have compared showcase.com and loopnet.com along a few key criteria.  It should become immediately clear that CSGP is competing with LOOP, in part on price.  Subscribers to showcase.com can post an unlimited number of listings whereas loopnet.com premium members pay additional amounts for incremental listings.  From an end-user perspective, we have spent some time navigating both sites and the differentiation is not enormous.

Source: Company reports, ComScore, PAA Research

 The pricing dynamic is particularly problematic for LOOP in our view.  A significant portion of LOOP’s growth over the past 2-3 years has been driven by an increase in revenue-per-premium member.  Over the past three years revenue-per-subscriber for LOOP has increased approximately 45% to $66.26/month.  This compares to CSGP’s monthly pricing of $49.95. In the table below we outline LOOP’s historical and our projections for total subscribers and monthly revenue-per-subscriber.  As you can see, revenue-per-sub has been the primary growth story for LOOP over the past few years.

Source: Company reports, PAA Research

Showcase.com has generated strong growth over the past year, albeit off a small base.  We anticipate showcase.com will continue to gain traction with brokers and commercial real estate investors.  This will likely manifest itself in the form of pricing pressure and higher marketing costs for LOOP. 

CSGP Should Deliver Higher Incremental Margins and Faster Revenue and EPS growth Over the Next 3-5 Years

Both CSGP and LOOP have compelling business models from a EBITDA margin, cash flow generation, and revenue visibility perspective.  For 2009, LOOP generated EBITDA margins of 40%+, while we estimate CSGP will deliver of 25% for the full year.  Going forward, we expect LOOP to generate slower subscriber growth and lower revenue-per-subscriber growth than it did in the prior commercial real estate cycle as a result of increased competitive pressures.  In the case of CSGP, the company has a long stated goal of achieving 30%+ EBITDA margins. In the company’s core market in the U.S., CSGP was able to generate 30% plus EBITDA margins for three consecutive quarters in the latter half of 2008 and early 2009 despite a rapidly weakening commercial real estate market. We think this underscores the leverage inherent in CSGP’s business model as the company achieves scale in individual markets and product lines.  CSGP management has indicated that product line EBITDA margins can exceed 60% in some cases.  The company’s U.K. operations have been a drag on margins over the past several years, although we expect that to change over the next 12-18 months as the company improves client traction and completes most of its market research.

Source: Company Reports

We think CSGP’s recent acquisitions dramatically expand the company’s service offerings and addressable market.  The acquired companies are lower margin, but should enable CSGP to achieve 10-15% compound annual revenue growth over the next 3-5 years.  Resumption of subscriber growth and an increase in revenue-per-subscriber should help CSGP achieve 30%+ EBITDA within 12-18 months.  We estimate CSGP will generate 60%+ incremental EBITDA margins for the next 2-3 years.

Overall, we expect CSGP to deliver more revenue growth and earnings leverage than LOOP over the next 3-5 years.  LOOP’s margins have little room to grow given the competitive threats we expect the company to face from CSGP and potentially others.  Retrenchment in pricing alone could reduce LOOP’s EBITDA margins from the 40%+ level to the mid-30’s.  We have not included a meaningful retrenchment in LOOP’s EBITDA margins in our base case forecast.  However, we think its is highly possible LOOP could face significant pricing pressure in the next 2-3 years as Showcase achieves greater awareness and scale.  In the table below we compare EBITDA margins for CSGP and LOOP. As you can see, we expect rapid margin expansion for CSGP in the back half of 2010 and 2011 and almost none for LOOP. LOOP will not be able to achieve prior cycle peak margins in our opinion.

Source: Company Reports, PAA Research

Valuation Favors CSGP

Given the predictability and sustainability of CSGP’s revenues, the prospects for growth over the next several years, and likelihood that CSGP will deliver stronger margin expansion over the next 3-5 years we are surprised that LOOP shares command a valuation premium to those of CSGP.  Both stocks appear relatively expensive when evaluated on a P/E basis alone. However, in the case of CSGP we think there is still room for multiple expansion on an EV/EBITDA basis as incremantal margins expand and ROIC increases.  We expect CSGP to eventually trade at a valuation premium to LOOP as investors come to realize how wide CSGP’s “moat” is and how precarious LOOP’s market position could become.

Source: Yahoo Finance, PAA Research

Pair Long CSGP/Short LOOP Target Return of 35-40%

 We anticipate CSGP shares could trade as high as $55-$60/share over the next 12-months, which would represent an 11.5-12.5x multiple on our FY11 EBITDA estimate.  A long position in CSGP can generate returns of 40-50% over the next 12-months.  In the case of LOOP, we see little upside in the stock given the competitive challenges the company is likely to face over the next several years.  However, we recognize that some investors could bid up the name as transaction volumes in the commercial real estate sector increase.  In that scenario, we anticipate LOOP could trade as high as 11-12x our FY11 EBITDA estimate which would represent a stock price of $10-$11, or approximately 10-15% above current levels.

As always, please act accordingly….