Major Conflict of Interest at Dover Motorsports

In November, I wrote about Dover Motorsports and described it as an interesting investment opportunity despite the poor performance of the Company's management. If you did not have a chance to read it, you can access it by going to the following link:

http://classicvalueinvestors.blogspot.com/2009/11/dover-motorsports-dvd_4409.html

When I posted this report on the Internet, I had no idea it would create so much interest from the shareholders of Dover Motorsports. The next day, I received numerous e-mails and phone calls from angry investors who were fed up with the management. The amount of money that these shareholders lost is significant. At first, I wasn't going to do anything because I bought the stock of Dover Motorsports at less than $2 per share, which means I will probably make money no matter what the management does. I just don't think they can destroy this company any further.

Then I saw a press release announcing that the University of Iowa is going to award Henry Tippie, chairman of Dover Motorsports, an honorary doctorate during the commencement ceremonies on Saturday, December 19, 2009. Tippie lost hundreds of millions of dollars for Dover Motorsports' shareholders, and now, he is getting an honorary doctorate. This is an insult to the shareholders of Dover Motorsports, and the University of Iowa should be embarrassed to be giving him an honorary doctorate. Does this mean that our universities only care about donations? What is the price that one has to pay to receive an honorary doctorate? Are we teaching our students that donations can buy us anything? The press release stated:

"Henry Tippie is a man of humble demeanor but extraordinary achievement, and he is a role model for University of Iowa students. He has built his businesses the right way, with hard work and ethical considerations always foremost."

Source: http://tippie.uiowa.edu/news/story.cfm?id=2248

Maybe Tippie built his businesses the right way, with hard work and ethical considerations, but he is not currently running Dover Motorsports the right way and with ethical considerations. He ignores shareholders and destroys the shareholders' value. Refer to my analysis on Dover Motorsport for these details. I don't believe that he is an appropriate role model for University of Iowa students.

Tippie is also involved with other public companies such as Rollins, Inc. (ROL), RPC, Inc. (RES), Marine Products (MPX), and Dover Downs Entertainment (DDE). Based on the earnings per share growth and the return on equity, these companies are not run as poorly as Dover Motorsports. But if I were a shareholder of any of these companies, I don't think I would want to own a piece of these businesses knowing that Tippie has any involvement. The only reason why I own Dover Motorsports is because I don't think the management can perform any worse than they already have. This is the only company I am aware of that even if it went bankrupt, shareholders would still double or triple their money from today's prices because the assets could be auctioned off for a high enough price to pay off the lenders and reward shareholders handsomely with whatever remains.

So how can Tippie get away with this? It took me some time to investigate the answer to this question. There is a serious conflict of interest at Dover Motorsports. Tippie is one of the trustees of RMT Trust, the largest shareholder of Dover Motorsports. The other two trustees are R. Randall Rollins and Michele M. Rollins. Because Randall and Michele granted all of the voting power to Tippie, he has full control over shares held by the RMT Trust. As a trustee, he has a fiduciary responsibility to the beneficiaries of the trust; in this case, Michele is not only one of the trustees but is also the beneficiary. As a responsible trustee, Tippie should care about the performance of Dover Motorsports because RMT Trust is its largest shareholder. If the company does not act in the best interest of the shareholders, he should either sell the stock or apply pressure to the management and the board of directors to improve their performance and start realizing that they work for the shareholders. However, because Tippie also serves as the chairman of Dover Motorsports' board of directors, this does not happen. He controls over 50 percent of the voting power in the company. Of course he is not going to pressure himself to change his own performance. Instead, he keeps running Dover Motorsports into the ground by making bad acquisitions, keeping unprofitable racetracks that drain the company's financial resources, and refusing to sell the company to one of its competitors who would pay premium prices for its assets.

Under normal circumstances, it would be logical to assume that Randall and Michele would stand up to Tippie and confront his poor performance. According to the will that made Michele the beneficiary of the RMT Trust, she has the power to require the trustee to convert any non-income producing property into income producing property. Because Dover Motorsports does not pay dividends anymore, it is considered a non-income producing property. It could be converted into an income producing property if it was sold. However, standing up to Tippie is not that simple. By reading the book, Hanging the Moon: The Rollins Rise to Riches, by Drury L. Pifer, it is evident that the Rollins would probably not be where they are today had it not been for Tippie. The Rollins brothers, John and Wayne, created a fortune for the family. Michele is John's third wife and Randall is Wayne's son. The brothers were involved in many different businesses, and they were very successful, but their problem was that they kept poor accounting records. This is not unusual among entrepreneurs. They had no idea how much money was coming in and how much was going out, which was a recipe for disaster. To solve their accounting deficiencies, they hired Tippie. Pifer said,

"Now the three men began to function as three forces, each one driving as well as balancing the other two. … Wayne might be viewed as the genius of business, Henry as the civilizing force of government, and John as the creative power that brings the dead to life. In any case, they operated as a system of checks and balances. The success of their collective creation depended on that."

In 1971, Tippie moved his family to Austin, Texas. By 1974, the Rollins brothers, without the third leg of the stool, nearly went bankrupt. Once again, they reached out to Tippie to rescue them. Before Tippie agreed to help them, he spelled out his terms. He asked for full control and power to make whatever decisions he felt were necessary. Pifer quoted him saying, "I was not going to get involved if I'd be second guessed." He eliminated the directors that he felt were not useful and cut costs left and right by firing executives and other employees he considered to be "fat." In the end, he turned those businesses around.

After the death of the two brothers, the Rollins family inherited their wealth while Tippie remained in control. Randall and Michele are so indebted to him that they must risk allowing him to destroy Dover Motorsports. The question is how far does Tippie need to go before they say anything? Does he have to destroy Rollins, Inc. (ROL), RPC, Inc. (RES), Marine Products (MPX), and Dover Downs Entertainment (DDE) before they stand up to him? I am not sure. This is something that only they can answer. With the exception of Rollins Inc., the stock prices of these companies, which are the ultimate measure of long-term success, do not look favorable.

I just cannot believe that Tippie was able to fix all of these problems and is now destroying Dover Motorsports. However, I think there is more to this picture. One time, Warren Buffett said that newspapers, such as the New York Times, are valued more than just on cash flow. Aside from financial rewards, these owners benefit from an enhanced status in society. The same concept applies to professional sports teams and this is no different with NASCAR. Because Dover Motorsports hosts two Sprint Cup races, this allows Tippie to go to two races a year where he can feel important shaking hands of the movers and shakers of major corporations who are involved in various sponsorship programs.

Angry shareholders of Dover Motorsports are asking for the company to sell itself to one of its competitors. I am not sure if Tippie will do what is right for shareholders or what is right for his ego. Time will tell.

Disclosure: Long DVD. No position in ROL, RES, MPX, and DDE.

International Speedway Corporation – NASCAR’s best

Company's Business

Have you ever heard of the Daytona 500? You probably have because it is the "Super Bowl" of NASCAR sporting events. While every driver dreams of winning this event, I dream of owning it. Can you imagine collecting the income stream from hundreds of thousands of people paying for admissions, hot dogs, and the most overpriced American beverage – beer? But that's not all. If you owned the Daytona 500, you would also receive income from television media rights fees, corporate sponsorship, advertising, royalties from licenses of trademarks, track rentals, and merchandise sales. As you can probably imagine, this is "big money." Even if you could afford to buy the Daytona 500, the current owners would not likely sell it to you because they know its value. But you might say, "Everything is for sale for the right price." I agree. But the right price would most likely be right for the current owners and too high for you. But in the stock market, it is a different story. Since shareholders often do not really act like real owners, but more like day traders, they get shortsighted, which allows you to scoop up fabulous businesses at pretty good prices.

International Speedway Corporation is an example of a fabulous company, and it owns and operates 13 of the nation's major motorsports entertainment facilities, including the home of the Daytona 500 – Daytona International Speedway. Other famous facilities include Talladega Superspeedway, Richmond International Raceway, and Darlington Raceway. At all of these facilities, the company promotes over 100 stock car, open wheel, sports car, truck, motorcycle and other racing events. The most prestigious is the Sprint Cup series which includes a total of 38 races; 21 of these belong to International Speedway Corporation.

NASCAR's Origins

To understand International Speedway Corporation, it is necessary to understand the history of NASCAR. Stock car racing was born in the South on the roads of the Appalachian Mountains. For years, farmers in the mountains made their own whiskey, and during Prohibition in 1919, they sold their product to residents of local towns. By 1933, the government repealed Prohibition, but this did not reduce the demand for whiskey because people turned to alcohol during the Great Depression.

During the Great Depression, the government needed revenue to fund the New Deal programs so it pursued farmers involved in illegal alcohol production by sending federal revenue agents to the Appalachian Mountains to stop their illegal activities. As a result, farmers conducted their entire business, including the transportation of alcohol, at night. This is where the term "moonshiner" comes from.

Drivers constantly worked on their cars to make them faster and more reliable to be able to escape the federal revenue agents who chased them. After a while, some of these drivers and their cars started to attract a following. They bragged about their cars' performance and their driving abilities. Eventually, someone constructed a quarter-mile dirt track in the middle of a farm, and stock car racing was born. As more people started showing up to watch moonshiners race each other, the farmer fenced the track and charged admission. Over time, more and more drivers came because part of that admission was paid out as prize money.

NASCAR racing would probably not be what it is today had it not been for William Henry Getty France whose nickname was "Big Bill." As a young man, he was a race car driver from Washington, D.C. Because he disliked cold weather, he decided to move his family to Miami, Florida. During the move, they stopped in Daytona Beach and realized they did not need to continue all the way to Miami. He opened a gas station and soon his business became a hangout place for race car drivers and mechanics.

To attract visitors, Daytona Beach held two races in 1936 and 1937. However, both of them were poorly run and, as a result, they were financial losers. Because France was very well liked in the community, the Daytona Beach Chamber of Commerce told him that there would be no more races unless he was the organizer. France agreed and started his promotional activities. The race took place on July 4, 1938, and it was a great success with 4,500 spectators attending.

Buoyed by his success in Daytona, France wanted to organize another race in Charlotte, North Carolina, after he learned that an oval dirt track was for rent. The media was reluctant to cover the race because it did not have any official sanctioning body. France contacted the Automobile Association of American (AAA), but he was turned down. So he decided to organize his own sanctioning body – The National Championship Stock Car Circuit (NCSCC).

He was not pleased that the business of racing did not have a good reputation. Track owners promised certain purses to the drivers and on numerous occasions did not deliver on these promises. The entire business of racing was disorganized and unethical. On February 15, 1948, France incorporated The National Association for Stock Car Auto Racing (NASCAR). The purpose of this organization was "to unite all stock car racing under one set of rules; to set up a benevolent fund and a national point standing whereby only one stock car driver would be crowned National Champion."

NASCAR guaranteed the purses for the races it sanctioned. In order to hold a NASCAR race, track owners were required to deposit purse money with NASCAR before the race. This was instrumental because it earned drivers' respect. NASCAR also created a national point system where drivers earned points depending on their placements and the driver with the most number of points was crowned the champion. This was very important because it motivated drivers to show up to all the races so that they would not lose points. Even today, this rule is instrumental because fans go to see their favorite drivers. The point system ensures that drivers show up and do not leave their fans disappointed.

Today, NASCAR is owned by the France family. When the organization was incorporated, four people invested in it including Bill France. Over the years, the France family bought out the other three partners.

The NASCAR Business and its Industry

Because the NASCAR organization is not a publicly traded company, investors can only indirectly benefit from it by owning related companies such as International Speedway Corporation. Track owners have three primary revenue providers: race fans, sponsors, and television networks.

NASCAR race fans are probably more loyal and fanatic about their sport than fans of any other sport. It is not uncommon to see them tattooing the faces of their favorite drivers on their bodies. Most of them attend one to two races per year and travel on average six hours to attend them. What is so different about these fans is that they are extremely aware of the different sponsors supporting the sport. If you ask most fans about the main sponsors of their favorite drivers, they will be able tell you their names without hesitation. In fact, they actually look down on drivers without sponsors. Not only are they aware of these sponsors, they also actively buy their products or services. They know that in order for NASCAR to survive, it needs sponsors, so they support the sponsors who support their favorite sport by voting with their wallets.

Sponsors are very happy to reach the captive audience at the stands and on TV screens. But it wasn't always like this. Unlike basketball or baseball, stock car racing is an expensive sport. In the past, drivers and teams struggled financially. They barely had enough money for replacement parts just to keep going from one race to another. The prize money was not enough to cover these expenses. In 1972, R. J. Reynolds Tobacco Company became the sport's primary sponsor because it was prohibited from advertising cigarettes on television. It was looking for other ways to advertise its cigarettes and found NASCAR. This gave birth to corporate sponsorship in NASCAR, which was a new form of marketing. The difference between sponsorship and advertising may not seem obvious, but advertising creates quick results without long-lasting effects while sponsorship creates a bond between the customer and the company and lasts longer than advertising. This is a win-win situation for everybody. Sponsors want their brands to gain greater exposure, so they make it possible for race teams to afford expensive equipment. Drivers return the favor by constantly talking about their sponsors to their fans. Fans go to the stores and buy their products because they know that without sponsors, ticket prices would be much higher.

You might think that television networks jumped on the idea of broadcasting the race to millions of fans around this time, but it wasn't until 1979. This was the first year that the Daytona 500 was broadcasted live. There were doubts whether such a move would be successful. NASCAR was a sport from the South and it was not certain that it would be well-received by other parts of the country. To everyone's surprise, the 1979 Daytona 500 live broadcast was an incredible success with 15 million viewers. This created headlines all over the country. Now NASCAR was being exposed not only to thousands of people, but to millions.

The media found a goldmine in NASCAR as racing became the second most-watched sport in America after football. Why did NASCAR become so successful in comparison to other sports? When you watch football, basketball, or baseball, you have to wait the entire season to watch the best teams play each other. In NASCAR, you get to watch the best drivers race each other every time there is a race. This is exciting. Another reason for the success is the limited schedule. There are only so many weeks in the year and NASCAR's Sprint Cup races 38 weekends in a year. The open weekends are used to reschedule events that are canceled due to weather. If you miss a race, you might have to wait a week or two for another one. In other sports, you are overwhelmed with the number of games that you can watch.

Moat

A moat is what gives a company an advantage over its competitors. It keeps competitors at bay so that a company can keep generating profits and grow over time. The two companies that dominate the NASCAR racing scene are the International Speedway Corporation (ISCA) and Speedway Motorsports (TRK). International Speedway Corporation owns 13 racetracks which constitutes half of all the tracks in the nation. Speedway Motorsports owns seven racetracks.

A competitor could technically build a state-of-the-art racetrack, but it wouldn't be worth much until the track could get a Sprint Cup race. Non-Sprint Cup races would not bring enough fans and broadcasting rights to make such a project financially feasible. It costs over $100 million to build a racetrack.

NASCAR determines every year which track gets what race. Because fans and drivers are used to having certain races at certain tracks, NASCAR tends to keep races at the same locations for years. But from the point of view of a track owner, NASCAR's power to revoke a race possesses a certain risk. If for some reason NASCAR decided to move the Daytona 500 from the facility owned by International Speedway Corporation to another facility owned by a competitor, this would result in a tremendous loss for the company and it would most definitely be reflected in a falling stock price. This, however, is unlikely to ever happen because International Speedway Corporation is controlled by the France family which also owns and controls NASCAR. The France family is unlikely to take races away from their own tracks.

It is evident that International Speedway Corporation enjoys a wide moat that serves a tremendous barrier to entry to another competitor.

Management

International Speedway Corporation is controlled by the France family who owns 40 percent of the shares and controls 68 percent of voting power. In 1992, Bill France passed away and his son William Clifton France (also known as Bill, Jr.) took over. There was some concern whether he would do a good enough job running NASCAR and International Speedway Corporation. Under his leadership, NASCAR exploded. He really put International Speedway Corporation on the map as a big business. Bill Sr. saw NASCAR as a sport, and Bill Jr. saw it as a product. Bill Jr.'s children, Brian and Lesa had an even greater vision for NASCAR because they saw it not just as a product, but as entertainment that could attract not only men, but also families with children. Today, women constitute 40 percent of NASCAR's fan base.

By owning such a significant portion of the company, the France family's interests are aligned with the interests of shareholders.

Analysis

Bill France founded International Speedway Corporation in 1953, but back then it was under a different name – Bill France Racing, Inc. In 1957, he renamed it Daytona International Speedway Corporation and, as the name implies, the company only had one track. When it acquired Talladega Superspeedway in 1968, the name of the company changed to what it is today. Over the years, the company strategically acquired different racetracks. Today, the company owns the majority of racing's prime real estate.

On November 4, 1996, the company went public at $20 per share. Today, it can be purchased for about $26 per share. It has been 13 years and the stock only appreciated $6 per share. The company must not have grown very much since then, right? Well, let's take a look at a chart comparing 1996 and 2008.

	1996	2008	Change
Number of Racetracks	4	13	225.0%
Total Revenues	$97,996,000	$787,254,000	703.4%
Net Income	$18,834,000	$134,595,000	614.6%
Earnings per Share	$0.54	$2.80	418.5%
Book Value per Share	$3.10	$23.43	655.8%

It can be seen that the number of tracks increased by 225 percent, which pales in comparison to the performance of the other metrics. Revenues increased 703.4 percent, net income by 614.6 percent, earnings per share by 418.5 percent, and book value per share by 655.8 percent. Despite these increases, the stock is trading only 30 percent higher than what it was in 1996. Isn't this just ridiculous? I think it is. You might say that in 1996, the stock was overpriced because it had a P/E ratio of 37. If we use a P/E ratio of 20 instead, the stock would have had a price of $11 per share. Comparing it to $26 per share, this would be an increase of 136 percent. Either way, I still cannot believe that investors have the opportunity to buy this company for $26 per share.

How could the company only increase the number of tracks by 225 percent and increase other metrics by 418 to 703 percent? As mentioned before, the company has three sources of revenues: race fans, sponsors, and television networks. The company not only increased revenues from race fans by increasing the prices of tickets, concessions, and parking, etc., but also by adding seating capacity at its racing facilities. Since the demand from race fans was so strong over the last decade, the company was barely able to keep up with all of the ongoing expansion projects.

The company also increased revenues from sponsorships. This type of revenue growth is cheap in comparison to capacity expansion. This is because the company does not have to build anything from concrete to add more sponsors. NASCAR sponsorship was created in 1972 and kept growing because as more people became saturated with advertising, sponsorships allowed companies to sneak in their marketing message to race fans without being totally explicit about their marketing.

Revenues from television broadcasting rights also grew much faster than the number of tracks that International Speedway Corporation owns. Similarly to sponsorship dollars, broadcasting rights revenues can grow without much capital. Since there is only one NASCAR, television networks are fighting over the rights to broadcast the event in order to attract viewers. From the point of view of NASCAR and International Speedway Corporation, it is a good place to be. These revenues are likely to keep going up.

What is even more ridiculous about the current stock price is that the comparison chart between 1996 and 2008 does not include the full impact of television rights that NASCAR negotiated for the eight-year period from 2007 and 2014. In 2007, NASCAR entered into an eight-year contract with FOX, ABC/ESPN, TNT and SPEED for the broadcasting rights for three national touring series – Sprint Cup, Nationwide, and Craftsman Truck. The agreement is for $4.5 billion over the eight-year period. This equates to $560 million average per year for the entire industry, which is 40 percent higher than the last contract for $400 million per year. The contract also contains annual increases of about 3 percent per year. This income stream provides stability and predictability. It is particularly important to all the companies in the industry when race attendance is down. This income is also easy because it doesn't require any work. It is like saying to the television networks, "I am running a number of race events. Bring your cameras and do what you need to do to expose my sport. After you are done, take your stuff, come back next year, and don't forget to write me a check for half a billion dollars. Once the contract is up in 2014, we will probably jack up the price because we are pretty sure that NASCAR will be even more popular and advertisers on your television networks will be fighting each other to get a chance to have a 30-second commercial exposed to NASCAR fans."

However, International Speedway Corporation is not getting the entire $560 million because this is for all the companies in the industry. In 2008, the company received $257 million and only $189 million went straight into operating income. The reason why the entire $257 million wasn't retained was because about 25 percent goes to the drivers. Still, the operating margins on the television rights are about 73.5 percent. Based on the current stock price, the company is trading for a market capitalization of $1.3 billion. If you just take the television rights at $189 million and place a conservative multiple between 6 and 8, the value of these television rights is between $1.1 and $1.5 billion. In other words, the television rights on its own are worth as much as the entire company. By purchasing it at $26 per share or $1.3 billion of market capitalization, you are paying for the television rights and getting all the racetracks and sponsorship dollars for free.

Why is International Speedway Corporation's stock so cheap?

As mentioned before, track owners have three primary revenue providers: race fans, sponsors, and television networks. It costs about $50 to $100 for an admission ticket, but if the hotel, travel, food and everything else is included, it is not unreasonable to say that it costs approximately $1,000 per person to attend a race. Since most fans attend one to two races per year, this equals to an annual expenditure of $1,000 to $2,000 which comes from discretionary income. Half of NASCAR's fans earn $50,000 or less annually. The current recession definitely has negative effects on their attendance, but this happens because fans are less able to afford it and not because they dislike the sport. I believe that this is only temporary for as long as the economy stays weak.

Sponsors that are seeing the attendance down and their own businesses struggling from the effects of the recession are cutting down on their marketing budgets. Some of them might not be able to afford sponsorship and others might be cutting expenses to protect their stock prices. For whatever reason they are pulling back, I believe this also is temporary. In the end, there is only one NASCAR. If they want to advertise in a newspaper, they have plenty of choices, but if they want to reach NASCAR fans, they can only do so through NASCAR or racetrack owners. Sponsors will be back because if they don't, there will always be someone who will want to reach NASCAR's fans even if it means that it will be foreign companies. NASCAR has a toll bridge and whoever wants to drive through has to pay up. It is that simple.

When the top line revenue declines, expenses stay relatively stable because the majority of them are fixed. The expenses include sanctioning fees to NASCAR, prize money to drivers, and other operational costs. The track owners have to pay a NASCAR sanctioning fee and drivers' prize money no matter how many people show up to the race. The costs that are variable are the operating costs such as the number of employees during the race. Track owners usually hire one employee for every 75 race fans and this expense can obviously be reduced as fewer fans show up. The good news is that when the recession ends, the top line will recover, the bottom line will grow much faster.

Valuation

I believe that the normalized earnings power of International Speedway Corporation is about $3 per share. For a company of this caliber, I have estimated an earnings multiple between 15 and 20. Based on this, the stock is worth between $45 and $60 per share. The average is $52.50 per share.

On Yahoo finance, you might notice that earnings per share are $0.65 which means that the P/E ratio is about 40. This is misleading because the earnings per share listed includes a non-cash equity impairment charge in the second quarter of 2009 for $57 million or $1.18 per share. This impairment charge is a one-time hit against earnings. Without this charge, earnings per share would have been much higher and the P/E ratio much lower.

Conclusion

Wall Street, with its short-term mentality, is giving this company away for about 50 cents on the dollar because it is unable to see past the current weaknesses in the company's earnings. This is why recessions produce investment opportunities because they make investors do unwise things such as selling wonderful businesses at cheap prices. But the key here is patience, which is always in short supply on Wall Street. NASCAR is not going anywhere and owning International Speedway Corporation is the best way to benefit from this sport. The time will come when this company will shine again, and when it does, Wall Street will pay us a price much higher than what is it is today because it will see all the positive things about this company that now it refuses to acknowledge.

 

Disclosure:

I, or persons whose accounts I manage, own shares of International Speedway Corporation at the time of this report. This report is not a solicitation to buy or sell securities. Neither Mariusz Skonieczny nor Classic Value Investors, LLC, is responsible for any losses resulting from purchasing shares of International Speedway Corporation. You are advised to consult your financial advisor or conduct the due diligence yourself.

Dover Motorsports - DVD

Dover Motorsports is an interesting investment opportunity. I stumbled upon it while writing a report about International Speedway Corporation for my clients. Please refer to my report on International Speedway Corporation for background on NASCAR and the racing industry.

Dover Motorsports promotes NASCAR races. It owns four motorsports tracks which include Dover International Speedway in Dover, Delaware; Gateway International Raceway near St. Louis, Missouri; Memphis Motorsports Park in Memphis (recently shut down), Tennessee; and Nashville Superspeedway near Nashville, Tennessee. It generates revenues from admissions, concessions, television media rights fees, corporate sponsorship, advertising, royalties from licenses of trademarks, track rentals, and merchandise sales.

Unlike its competitor, International Speedway Corporation, Dover Motorsports does not possess any moat that would protect it from its competitors. It is actually at a disadvantage to its competitors. Not only that, the company is run by incompetent managers who did nothing but destroyed shareholders' value over the last decade. In my book, Why Are We So Clueless about the Stock Market?, I stress the importance of investing in companies that possess moats and are run by good managers. Why would I want to invest in a company that lacks these two characteristics? Let me give you some background on this company before I answer this question. The company owns four tracks that are like four separate businesses. Even though the company as a whole has no moat, Dover International Speedway is extremely valuable and does possess a moat which I will describe in more detail later in this report. First, I want to discuss the performance of the current management.

Let's look at some metrics illustrated below.

	2001	2002	2003	2004	2005	2006	2007	2008
Revenues	86,551	93,731	93,626	93,617	90,999	91,274	86,052	84,279
Net Earnings	6,871	-27,195	-22,138	2,440	3,975	35,345	3,744	-5,679
Share holders' equity	244519	160533	137372	138466	113277	74,260	76,116	67,447

Revenues remained mostly flat from 2001 to 2008. Net earnings fluctuated widely, but on average they were negative $9,166. The shareholders' equity was destroyed from $244,519 in 2001 to $67,477 in 2008. The stock price was as high as $8.95 per share on April 10, 2002. Today, it is trading at around $1.80 per share.

How did the management achieve this "fabulous" performance?

On October 3, 1996, the company was taken public by Merrill Lynch under the name Dover Downs. It only had one racetrack, Dover Downs International Speedway. However, racing contributed only 30 percent of the revenues. The other 70 percent came from gambling. In March 2002, the company spun off its gambling division as a separate company – Dower Downs Casino.

Beginning in 1998, the company acquired three Midwest racetracks: Nashville Superspeedway, Gateway International Raceway, and Memphis Motorsports Park. These tracks turned out to be financial losers. Since the company was unable to obtain another Sprint Cup race from NASCAR (which shows just how difficult it is to be awarded additional Sprint Cup races from NASCAR) for one of these facilities, it was never able to operate these facilities with profitability. You might think that the management would finally either sell these assets or shut them down to stop the bleeding, but this was not the case here. The management used the cash flow from profitable operations and kept wasting shareholders' money by keeping unprofitable operations open. As a result, the company had to make impairment charges to assets and goodwill. The list is long. Take a look.

2002 Goodwill Write down	$28,606,000
2003 Goodwill Write down	$13,362,000
2003 Asset Impairment	$2,867,000
2003 Asset Impairment	$4,309,000
2006 Asset Impairment (Gateway)	$37,357,000
2006 Asset Impairment (Memphis)	$7,882,000
2006 Asset Impairment (Nashville)	$16,170,000
2006 Goodwill Impairment (Midwest)	$2,487,000
2008 Asset Impairment (Nashville)	$3,140,000
2008 Asset Impairment (Memphis)	$2,150,000
2008 Asset Impairment (Gateway)	$7,505,000
2009 Asset Impairment (Memphis)	$7,478,000
Total	$133,313,000

The management wrote down over $133 million against income for its mistakes. I understand when a company has to write down one or two mistakes. Even International Speedway Corporation, a competitor, had an impairment charge in 2009. No one is perfect, and even the best managers get it wrong on some acquisitions. But to be wrong on every single one is just mind-boggling. To put this in perspective, the entire market capitalization of this company is $65 million as of the date of this report. The amount of money the management wasted was double the current sale price of the entire company.

You might think that after their failures, the management would acknowledge their mistakes. Again, this was not the case. The managers are in complete denial as demonstrated by a comment made by Denis McGlynn, the company's CEO:

"We're still a successful company here, doing very well. Only because somebody is now comparing us against Speedway Motorsports, which is a megamonolith, and ISC [International Speedway Corporation], do we get criticized. But we are still the same successful company that we were before. So life is not bad here. And we're doing fine."

Source: http://www.scenedaily.com/news/articles/sprintcupseries/Do_Dover_and_Pocono_have_a_future_in_NASCAR.html

Shareholders' Criticism

As you can probably imagine, the shareholders are not too thrilled with the management. Mario D. Cibelli, the managing member of Marathon Partners L.P., has been a major shareholder of Dover Motorsports for approximately seven years. Cibelli has run out of patience and expressed his frustration in the letters to the Dover Motorsports' board of directors. You can access these letters at www.sellthecompany.com. He is pressuring the management to sell the company or liquidate its unprofitable assets.

Cibelli owns 16.3 percent of Dover Motorsports, but controls only 1.3 percent of voting stock. Henry B. Tippie is the Chairman of the Board of Directors and controls in excess of fifty percent of the voting power. This means that he can determine the outcome of anything he wants including the election of directors or other corporate actions. His actions don't seem to illustrate that he cares much about what shareholders want. After repeated complaints from Cibelli and other shareholders, he further aggravated shareholders by eliminating the question and answer session during the company's quarterly conference calls. I guess he grew tired of listening to shareholders' complaints. What is so ironic about Tippie is that he is a CPA, so he should have no problem understanding finance and shareholders' value. The University of Iowa named its business program after him – The Henry B. Tippie College of Business.

In one of the letters, Cibelli included Tippie's comments to students at the Tippie College of Business:

"We're in much faster-moving society today. If you go back to the '30s, '40s or even the 1950s, change was fairly slow in coming. Today, change is much more rapid and you must change with the times. If you don't change, you're going to get 'left at the gate,' so to speak."

It would be nice if Tippie followed his advice with Dover Motorsports and sold the company or closed down its money-draining operations. As Cibelli said, the days of independent racetrack operators are gone. Bigger players, such as International Speedway Corporation or Speedway Motorsports, have more resources and can run individual racetracks much more efficiently than independent owners.

Why Do I Think Dover Motorsports is a Good Investment?

It is obvious that the management is terrible and we cannot count on them to create shareholders' value. Why do I think that Dover Motorsports is a good investment? Because it possesses something extremely valuable in relation to the sale price of the company.

As mentioned before, the company owns four motorsports tracks which are as follows:

• Dover International Speedway in Dover, Delaware
  
• Gateway International Raceway near St. Louis, Missouri
  
• Memphis Motorsports Park in Memphis, Tennessee (recently shut down)
  
• Nashville Superspeedway near Nashville, Tennessee
  

As of December 31, 2008, the company has the following simplified balance sheet. I am using the 2008 figures because more disclosure is provided in comparison to the latest quarter. In any event, the balance sheet is not that much different now from what it was on December 31, 2008.

ASSETS		$155,179,000	LIABILITIES	$87,732,000
Dover International Speedway	$69,651,000
Gateway International Raceway	$10,000,000
Memphis Motorsports	$10,000,000		SHAREHOLDERS' EQUITY	$67,447,000
Nashville Superspeedway	$51,500,000		Equity per Share	$1.88

When acquiring any company, you are taking possession of all the assets and liabilities and their ability to generate future income. By purchasing all of Dover Motorsports, you would be getting over $155 million worth of assets. But just as a single-family home can have an existing mortgage, Dover Motorsports comes with $87.7 million of liabilities. This means your equity would be $67.4 million. How much would you be paying for this equity? Based on the current stock price, the market capitalization is $65 million. If you bought Dover Motorsports, you would be paying $65 million and getting $67.4 million of equity. You would be paying almost exactly what the company is worth. But it gets better. In the above chart, assets are equal to over $155 million and most of that value comes from the four racetracks which are valued at $141,151,000 ($69,651,000 + $10,000,000 + $10,000,000 + $51,500,000).

The problem is that these values are not correct because they follow accounting rules under GAAP (Generally Accepted Accounting Principles) that require properties such as racetracks to be recorded at cost and not market value. You know very well that just because you paid $100,000 for your house, it doesn't mean that this is how much your house is worth today. A house purchased for $100,000 years ago could be worth $300,000 or even more today.

As I mentioned before, Gateway International Raceway, Memphis Motorsports, and Nashville Superspeedway are financial losers. They do not operate profitably and they drag down the profitability of the entire company. Maybe these three facilities are worth what the company's balance sheet indicates, but since they are losing money, I will treat them as if they were worthless.

Dover International Speedway is a diamond. As shown above, it is valued at $69,651,000. This is way too low. Based on my research, this track is worth between $200 and $300 million. I will explain my valuation analysis in the next section. If I create a scenario using these values, we arrive at the following estimate.

ASSETS		$300,000,000	LIABILITIES	$87,732,000
Dover International Speedway	$300,000,000
Gateway International Raceway	$0
Memphis Motorsports	$0		SHAREHOLDERS' EQUITY	$212,268,000
Nashville Superspeedway	$0		Equity per Share	$5.91

In this scenario, I assigned Dover International Speedway a value of $300 million and all the other tracks and assets a value of $0. After subtracting all the liabilities, we are left with shareholders' equity of over $212 million. Remember that we can purchase this company for $65 million. In other words, the shareholders' equity of $212 million is the same as equity per share of $5.91. Today, the stock can be purchased for $1.80 per share. Is this a good deal? I think it is, but let's rerun the numbers more conservatively, assuming that Dover International Speedway is only worth $200 million.

ASSETS		$200,000,000	LIABILITIES	$87,732,000
Dover International Speedway	$200,000,000
Gateway International Raceway	$0
Memphis Motorsports	$0		SHAREHOLDERS' EQUITY	$112,268,000
Nashville Superspeedway	$0		Equity per Share	$3.12

In this case, all the other assets were assigned a value of $0 and Dover International Speedway a value of $200 million. This translates into shareholders' equity of over $112 million or $3.12 per share.

The stock of Dover Motorsports is worth between $3.12 and $5.91 per share. If you buy it at $1.80 per share and the more conservative scenario plays out, you almost double your money, and if the less conservative scenario plays out, you may be able to more than triple your money. The downside is limited because the company's value is backed by hard assets.

Why Do I Think Dover International Speedway is So Valuable?

NASCAR sanctions different types of races but the Sprint Cup series is the major league. This is where you get to see Jeff Gordon and Dale Earnhardt, Jr., race each other. This is where all the money is made by the track owners. Racetracks without Sprint Cup races are not very profitable, if they are profitable at all. Dover Motorsports' three financial losers (Gateway International Raceway, Memphis Motorsports, and Nashville Superspeedway) are examples of tracks without Sprint Cup races.

There are a total of 38 Sprint Cup races and they are allocated in the following way:

International Speedway Corporation	21
Speedway Motorsports	12
Pocono Raceway	2
Indianapolis Motor Speedway	1
Dover Motorsports	2
Total Sprint Cup Races	38

Note: Dover Motorsports holds two Sprint Cup races at one facility – Dover International Speedway.

International Speedway Corporation and Speedway Motorsports control more than 86 percent of Sprint Cup races. They have been acquiring racetracks with Sprint Cup dates for years. These two companies simply dominate the industry. Because of economies of scale, they are able to operate individual racetracks much more efficiently than independent owners. For example, they can offer multi-track sponsoring agreements to major corporations. Individual track owners are at a disadvantage.

NASCAR could add more Sprint Cup races, but the organization wants to limit the supply of these races to make them more valuable. Refer to my previous report on International Speedway Corporation to fully understand the rationale behind this. The bottom line is this: there are only five Sprint Cup races left and Dover Motorsports has two. This is significant particularly because Ponoco Raceway expressed on numerous occasions that their racetrack with two Sprint Cup dates is not for sale. It is family-owned, fully paid off, and intended to be passed onto the owners' grandchildren through trusts that have already been established. Indianapolis Motor Speedway has a long tradition of racing aside from NASCAR's influence. It is highly unlikely the owners will ever sell its facility or the Sprint Cup date. So there are only two Sprint Cups that remain and they belong to Dover Motorsports. This is the last prime racing real estate available that International Speedway Corporation and Speedway Motorsports can get their hands on. There is a really good chance that the management will finally give in and sell because it does not have the luxury of being a private company such as Ponoco Raceway and because it is constantly being pressured to do the right thing for its shareholders.

According to Burton Smith, Chairman and CEO of Speedway Motorsports, Dover International Speedway is for sale. He said that he spoke with Henry B. Tippie of Dover Motorsports and it is all about the price. Tippie does not want to give it away because he knows that Dover International Speedway is the last piece of the industry's consolidation puzzle and Smith does not want to pay too much. But Smith will have to pay up if he wants it. He is a motivated buyer, and here is why.

In December 2008, Smith acquired Kentucky Speedway for an incredibly cheap price of $78 million. He said that it was the best deal he ever made. He bought it from the owners who failed to get a Sprint Cup race and therefore sold him the facility at a cheap price. His goal is to put a Sprint Cup there. Smith knows that without another Sprint Cup date, his purchase is not worth much. He also wants another race for his Las Vegas facility. The only way he can get it is through another racetrack acquisition. Since he needs two additional Sprint Cups, acquiring Dover Motorsports or Ponoco Raceway would solve his predicament. As mentioned before, Ponoco Raceway is not for sale. The current owners said that even if it was for sale, it would be sold to the France family at International Speedway Corporation and not to Smith. Just to illustrate how much he might pay for a racetrack with Sprint Cup dates, it is helpful to go back to 2007 because that's when he paid $340 million in cash for New Hampshire International Speedway which had two Sprint Cup races. This facility had 40,000 fewer seats than Dover International Speedway. This transaction is the best comparable to show what price might be appropriate for Dover International Speedway. But since we are in 2009 and the economy is not as great as it was in 2007, we might have to adjust the price downward. It is not unreasonable to think that Dover International Speedway can be sold on the low end for $200 million and on the high end for $300 million. Who knows, maybe it can even be sold for $400 million. It all depends on how badly Smith wants its two Sprint Cup dates.

But using just one comparable sale to value Dover International Speedway might not be a good idea. Let me use another comparable sale. In 2007, International Speedway Corporation paid $215 million for Chicagoland Speedway in Joliet, IL. This facility had 75,000 seats and only one Sprint Cup race. Dover International Speedway has 135,000 seats and two Sprint Cup races. This sale comparable indicates that my low end estimate, $200 million, of Dover International Speedway is probably too conservative.

Dover International Speedway is a unique one-mile track. Unlike some superspeedways, it offers fans a superior, unobstructed view of the entire track. The speedway surface is not asphalt like the surface of other Sprint Cup tracks; instead, is all concrete. The facility is known for its race called "the Monster Mile." Its mid-Atlantic geographic location is excellent because it serves Philadelphia, New York City, Baltimore and Washington, D.C. The company has had its Sprint Cup date for 40 consecutive years.

It is really hard to predict whether the management will sell the company or not. If it does sell, then the shareholders would benefit greatly from this decision. How much they would benefit depends on the sale price. Smith claims that the company is for sale depending on the price. The management stated that they don't want to sell at the bottom. Even though the company's earnings per share are negative, it is not losing money. The company is cash flow positive, but because of various impairment charges against income, it seems as if it is not profitable. However, those impairment charges are for past mistakes and they do not affect cash flow.

At the current price of $1.80 per share or market capitalization of $65 million, it would not take much for the management to cause the stock price to double from these levels even if they chose not to sell. Based on Cibelli's letters the three unprofitable tracks are losing approximately $6 million per year which means that by simply closing them down, the company could save $6 million per year. By using a multiple of 10, this amount of savings is worth $60 million which would make the company be worth twice as much as what it is selling for today. I believe that there is hope and I am saying this because the company put its Memphis facility up for sale at a price of $10 million. The deal did not close and therefore, the management recently decided to shut it down. This is the first smart move that they have made in a long time.

I think that there is a chance that the management is trying to clean up its act and increase its share price so that when they do decide to sell the company, they are in a position to ask for more money. Since the company is cash flow positive, they are not in a hurry to sell which is good and bad. The good part is that they will not be forced to sell at a cheap price. The bad part is that they might not want to sell at all. What is encouraging is that there are willing buyers for Dover International Speedway and Dover Motorsport's stock. Cibelli already owns almost 3 million shares and recently, he made an offer to buy 8 million shares for $2.35 per share. Tippie purchased $239,928 worth of Dover Motorsports' shares just in November 2009. While he didn't impress shareholders with his capital allocating skills, I think that he's got it right this time by purchasing shares of Dover Motorsports for his personal account at these levels.

Conclusion

Even thought Dover Motorsports does not possess a companywide moat, Dover International Speedway does. This facility on its own is worth more than what the entire company is selling for on the stock market. Although management is incompetent, I believe that the positives far outweigh negatives. The way I feel about this company can be best described by Warren Buffett's words of wisdom:

"I try to buy stock in businesses that are so wonderful that an idiot can run them because sooner or later, one will."

Disclosure:

I, or persons whose accounts I manage, own shares of Dover Motorsports at the time of this report. This report is not a solicitation to buy or sell securities. Neither Mariusz Skonieczny nor Classic Value Investors, LLC, is responsible for any losses resulting from purchasing shares of Dover Motorsports. You are advised to consult your financial advisor or conduct the due diligence yourself.

Due Diligence Is YOUR Job

Due diligence can mean different things to different people. But, as an investor, it is your job and responsibility to do it. Otherwise, it can be very costly. Don't count on anyone to do it for you. Some think that reading annual reports, proxy statements, and other documents filed with the SEC is due diligence. I don't think this is good enough, especially for small-cap companies. Remember that these documents are drafted in a way to make the company look as good as possible. If reading available information is not good enough, what should investors do? I believe that investors should call the management, industry experts, reporters, former employees, or anyone else who can answer their questions.

This year, I invested in FortuNet (FNET), a manufacturer of multi-game and multi-player server-based gaming platforms. The company has had very stable revenues and earnings. Earnings per share were $0.27, $0.28, $0.27, $0.18, $0.35, and $0.25 in Years 2003, 2004, 2005, 2006, 2007, and 2008, respectively. I paid $1.20 per share for FortuNet's stock, which is equivalent to a P/E ratio of 4.44 using the average earnings per share of $0.27. However, there was an issue - Aces Wired, parent company of K&B Sales Incorporated, was involved in illegal activities and was raided by Texas authorities who shut down its operations. K&B Sales Incorporated provides 36% of FortuNet's revenues. If K&B Sales Incorporated lost its distribution license because of Aces Wired's illegal activities, this would be detrimental to FortuNet's revenues. The stock price could take a huge beating. However, at a price of $1.20, I felt that this risk was already priced into FortuNet's stock price.

On one day in September, the price of the stock soared over 200% to almost $4.00 per share within minutes on no news. It finally settled around $2.00. After several days, a market participant enlightened everyone on the Yahoo message board that the reason for the stock's rally was that the Texas authorities had settled the case with Aces Wired and kept K&B Sales Incorporated's license intact. With this new information, the stock seemed a good deal even at $2.00 per share.

Before committing more money into FortuNet's position, I decided to confirm the new information about K&B Sales Incorporated. I called Bruce Miner, Licensing Services Manager from Texas Lottery Commission, a governmental body in charge of approving and revoking gaming licenses. He told me that the case is not settled. K&B Sales Incorporated's license is still under review. If the commission finds anything out of line, the license will be revoked. Now, it seems like the market is pricing FortuNet's stock as if K&B Sales Incorporated's license is safe. Even though I believe that FortuNet has a bright future, I am not willing to see my investment get cut in half because the market is misinformed. I think there is a good chance that K&B Sales Incorporated will lose its license. If this happens, the stock is likely to get punished severely, and I will be waiting to pick up some shares at incredible prices. As of now, I exited my position after making over 50%.

I think that investors can lose a lot of money by relying only on information that is contained in reports filed with the SEC. I passed on several companies this year that looked great on paper because after making several phone calls, I learned that the risks were too high. You never know what you might learn about a company after you speak with industry experts. You will not know until you call.

Disclosure: I, or persons whose accounts I manage, do not own shares of FortuNet at the time of this posting.

A Pittsburgh Diamond

Some of you may have listened to my radio interviews on The American Entrepreneur on September 12 and October 10. If you wish to and were not able to, you can listen to them by clicking on the links below.

http://recordings.talkshoe.com/TC-139/TS-268470.mp3

http://recordings.talkshoe.com/TC-139/TS-278506.mp3

I became acquainted with the host, Ron Morris, while researching a small company called Mastech (MHH). I called him to ask a question, and after speaking with him, he invited me to do an interview on his show.

Background of Mastech

Mastech is a provider of IT and brokerage operations staffing, and consulting services to Fortune 500 companies. In the most basic terms, the company pays an IT specialist $50,000 a year and contracts him or her for $250,000 to major companies who need IT services. With today's technological complexities, who doesn't need IT help?

Mastech has been in business for more than 20 years but was formerly part of a parent company called iGate. Credit Suisse advised iGate's management to split the two companies so that each one would have a higher value in the marketplace. In September 2008, they spun off Mastech from iGate at around $10 per share. Within several days, the stock went down to about $1 per share. Why did this happen? The shares of Mastech were given to shareholders of iGate upon the spin-off. iGate shareholders were not interested in Mastech because they had purchased iGate's shares for the purpose of owning iGate, not Mastech, so when they received shares of Mastech, it was easier for them to sell the stock because they lacked an understanding of its underlying business.

While researching the company, I learned that when Mastech was part of iGate, it had earnings per share of $0.98, $1.51, $1.92, $1.60, and $1.76 in Years 2008, 2007, 2006, 2005, and 2004, respectively. I did a double take when I saw this because it meant that the average earnings per share were $1.55 - higher than the stock price of $1 per share. Conservatively, using a P/E ratio of 10, the stock of Mastech should be trading at approximately $15 per share. In contrast, Mastech had a P/E ratio of less than 1. Unfortunately, the $1 per share price didn't last long because the management began buying the stock for their personal portfolios, bidding the price substantially higher.

When I discovered this company, the price was already at $3.50 per share, which is over 200% higher than what I would have paid had I purchased it at $1 per share. But, it was still an incredible deal. However, one event really bothered me - the CEO, Steve Shangold, resigned during the first quarter of 2009. He was with the company for over 15 years. I needed to find out why he left. In doing my research, I ran across a radio interview between Steve Shangold and Ron Morris of The American Entrepreneur, and it seemed like Ron and Steve knew each other. So I called Ron to ask if he knew why Steve left and was pleased to learn that his reasons for leaving had nothing to do with the company or its performance. In addition, I also learned that Ron was one of the founders of Mastech and had actually hired Steve Shangold himself.

Currently, the price of Mastech's stock is slightly below $5.00 per share. I was fortunate enough to purchase shares for myself and my clients for prices between $3.60 and $4.80 per share. I still think that the stock is a steal, but it will take some time for the market to realize the true potential of Mastech. Because Mastech is a staffing company, its business doesn't perform very well when the unemployment rate is high. Mastech provides temporary employment services, and when companies are laying employees off, they start with temporary employees. But, when the economy starts recovering, companies are likely to hire temporary employees before permanent ones. So, Mastech will be one of the first to benefit from the recovery.

Disclosure: I, or persons whose accounts I manage, own shares of Mastech at the time of this posting.

Readers' Questions

1. How do I determine the Discount Rate?

The best explanation on how to determine a discount rate can be found in Aswath Damodaran's book, The Dark Side of Valuation. But I don't get into too many details about the discount rate. I just use 10%. I simply want to get an idea of whether a stock is undervalued. I am not interested in being exact. I don't believe anyone can be exact.

2. What are some helpful websites for determining 5-year and 10-year projected earnings for a stock?

You can look at morningstar.com

3. How ofter is a discount to value greater than 40 percent? What is the track record of your valuation model?

The amount of discount varies based on the economy and particular securities. For example, during the current recession it is relatively easy to find companies trading at a 40% discount to value. But there are particular securities that enjoy even higher discounts.

As far as the track record, I don't think about it this way. The valuation model is no the answer to riches. It is just one of the tools to assist investors in valuing a stock. There are also other ways to value a company. For example, investors can look at the hard assets and estimate what they could be sold for if the company was liquidated. The valuation model works all the time. The question is whether investors are right about the assumptions. You can make any company be worth anything you want depending on the assumptions.

4. Will value investing become more popular as the economy moves into a prolong recession or mile depression?

I am not sure whether the popularity of value investing will increase, but what I know for sure is that when the economy deteriorates, investors are likely to oversell, sending stocks way below their values. This will provide opportunities to pick up good companies at great prices. Not every company will go out of business. I just watched a documentary about Coca-Cola and it showed that even during the Great Depression, the company was doing fine.

Why Are We So Clueless about the Stock Market?

I was inspired to write this book by the 2008-09 economic recession that started with the bust in the housing market. The Dow Jones Industrial Average fell from its high of approximately 14,000 in July 2007 to about 6,500 in March 2009. The majority of people who were invested in the stock market saw their 401(k)s, IRAs, or other investment accounts decline 50% or more.

During the same period, my investment portfolio lost nothing. As a matter of fact, it showed a gain of 5.81% in 2008 and 258% year-to-date. Why did I achieve this performance when everyone else experienced investment losses? Is the answer that I am some kind of a stock market genius or hold a PhD in economics? No, neither of these descriptions is the reason. The answer lies in the fact that I was almost 100% in cash before the market started collapsing. When analyzing stock in 2007 and early 2008, I was not able to find anything trading at reasonable prices. Staying in cash was the best alternative.

As I later realized, I was not the only one having this problem. Warren Buffett was not buying much during the same period but was just accumulating cash. He was criticized for doing so because some wanted him to invest it and others wanted him to return it to Berkshire Hathaway's shareholders in the form of dividends. Like Mr. Buffett, I patiently waited for opportunities.

When the stock market crashed, the opportunities to buy excellent companies were plentiful. The companies, such as American Express and Wells Fargo, which I had dreamed of owning for years, became available at prices well below their values.

So how come most mutual funds, financial advisors, and other money managers failed to see the lack of investment opportunities during the peak in 2007 and early 2008? Maybe some of them did, but even so, they would have failed to act because of the compensation system that was in place. The majority of money managers are paid a percentage of assets under management. For example, if the assets under management are $100 million and the management fee is 1.5%, the money manager will receive $1.5 million (1.5% x $100 million). Under this compensation system, generating above-average returns and protecting investors' money is secondary. The primary concern for these managers is to have as much assets under management as possible and to be fully invested at all times. How likely is it for a money manager making $1.5 million if fees to go 100% when he or she is supposed to be investing the money, not sitting on cash? If a money manager did go 100% cash, he or she would have been criticized as Warren Buffett was criticized for having too much cash. Going cash or returning the money to the investors would be equivalent to quitting a $1.5 million job.

So what could the individual investors have done to prevent themselves from seeing their portfolios lose half of their values within a matter of months? Since investment professionals and other so called experts may not always act in their clients' best interests, there is only one option left: do it yourself. But the problem is that the majority of the general public does not have enough knowledge to take it upon themselves. To illustrate my point, let me pose this question:

What did the general public do when the 2008-09 recession provided 1-in-a-100-years investment opportunities?

Many panicked and sold their holdings by cashing in their retirement plans or other investment accounts. The investors who did not sell kept sitting on the same stocks that had lost money. If an investor's portfolio went from $100,000 to $50,000, in order to break even the $50,000 portfolio would have to double. However, it might not be realistic to break even with the same set of stocks. An investor in this situation should ask himself or herself,

If I had $50,000 in cash would I still invest in the stocks that I currently hold?

If the answer is no, the funds should be placed somewhere else where there is a greater potential for growth. If on December 31, 2008, the above investor had invested this $50,000 in stocks that were in my portfolio, it would have growth to about $179,000 as of the date of this article.

The panicky and fearful behavior of many individual investors is indicative of how unprepared and uninformed we as a society are about investing. It has been my experience that most people lack basic investment knowledge, but because some of use are successful in our careers, we assume that we will be good at investing. Nothing can be further from the truth.

Why Are We So Clueless about the Stock Market?

Because we

* panic and run away when the stock market is serving us unbelievable deals,
* jump on the wagon or stay in the wagon when the market is overpriced,
* do not understand the difference between stocks and businesses,
* cannot differentiate between excellent and mediocre businesses,
* do not know how to value stocks,
* do not realized how over-diversification can destroy returns, and
* do not understand why investing in IPOs is not a good idea.

In this book readers will learn to identify the missing pieces of the puzzle in investment strategies and the way to arrange them in order to realize investment success. The fundamentals presented will decrease the chances of making investment mistakes, and most importantly, will make us think twice about whether we are investing or simply gambling and calling it investing.

If it’s not the time to buy American Express, then when is it?

Every day I listen to experts argue about when is the best time to get back into the market, and I have to say that I am sick of it. They tend to find something to worry or disagree about. One day, it might be about future inflation, and another day, it might be the weakness of a dollar. When the stock market appreciates for several days or weeks, they start questioning whether the rally is for real and how long it will last. My take on this is: “Please, stop scaring people because they have had enough.” This article is not about the general direction of the stock market or the economy, but about American Express and how it just might be an excellent buy for long-term investors.

At the beginning of this month, American Express’s stock was trading at $23, which is as low as the lowest price in 1998. Is the stock cheap? To answer this, let’s learn a bit about the company and its industry.

Description of the Company and its Industry

American Express is a leading global payments, network, and travel firm that was founded in 1850. The company’s business consists of two segments: Global Consumer and Global Business-to-Business. Global consumer includes products such as charge and credit card products for consumers and small businesses worldwide. Global business-to-business includes business travel, corporate cards, network services, and merchant services.

American Express, just as other credit card companies, makes money from two primary sources: fees and interest income. Fees include merchant discount fees, annual membership fees, late fees, service fees, and foreign exchange fees. A merchant discount fee is a payment that a merchant makes when a consumer purchases its products or services. The amount of the fee ranges depending on what card is used. Interest income is earned simply when a customer carries a credit card balance and is charged a hefty 20 percent or more interest rate.

How is American Express different?

When people think of paying with plastic, three companies come into mind: Visa, MasterCard, and American Express. Visa and MasterCard operate in a similar way, but they are different from American Express. Visa and MasterCard are not credit card companies. They are networks, meaning that they do not extend credit and only process transactions.

There are two types of credit card networks: open and closed. Visa and MasterCard participate in an open credit card network. In this type of network, the merchant discount fee is split among different members because each of them performs a different function. There is the card issuer, the merchant acquirer, and the network. The card issuer could be a bank, such as Bank of America or an insurance company, such as State Farm. The merchant acquirer is a company that pays the merchant and connects it to the network, which in this case could be Visa or MasterCard.

American Express operates a closed network, where the company acts as the issuer, the merchant acquirer, and the network. As mentioned before, because the company performs all these functions, it keeps the entire merchant discount fee.

The company is also different from other credit card companies because it follows a “spend-centric” business model instead of “lend-centric.” Most credit card companies have the latter business model, meaning that the majority of revenues are earned by charging high interest rates on credit card balances. American Express makes only 11 to 13 percent of total revenues from interest income. Because its business model is “spend-centric,” the majority of revenues come from the merchant discount fees. This is an important distinction because as more people default, American Express is less affected by it than other credit card companies, such as Capital One.

American Express Advantage

Not only does American Express keep the whole merchant discount fee, but also charges a higher fee compared to the competitors. The merchant discount fee is slightly over 2.5 percent for American Express and 2.0 percent or less for the competitors. Why is the company able to do that? It is because its card holders spend significantly more than card holders of competing cards. But why? To answer this, one has to understand the history of American Express.

In the early days, the company was mainly a travel firm and people using its services were wealthy individuals. When it transitioned into being a credit card company, it already had relationships with big spenders who are more valuable to merchants. These merchants are willing to pay a higher fee to get these spenders in the door.

The company also encourages its card holders to use the card as much as possible. It does so is by charging annual membership fees and offering rewards. Card holders who pay annual fees are more likely to use the card frequently to earn rewards to justify the annual cost. As a result, the company is able to offer the best rewards in the industry.

American Express has another advantage, and it stems from operating a closed network. Because the company performs all the functions, it has access to information from direct relationships with merchants and card members. Because of this advantage, it is able to market and promote its services in more targeted way than competitors using the open network.

Since a closed network offers advantages over an open network, why don’t other credit card companies operate in the same way? Because, it is not easy to build a closed network. Over the years, American Express had to recruit merchants that were willing to accept its card and also card holders that were willing to use it. In order for merchants to accept the cards, they want to make sure that there are card holders willing to pay with it. Card holders, on the other hand, are not willing to sign up for the card unless they know there are merchants accepting it. It is a Catch 22 for any company trying to duplicate what American Express has done. This gives the company a tremendous advantage.

Profitability of American Express

This advantage allowed the company to earn incredible returns on equity. According to Value Line, the company earned the following returns on equity:

1999	2000	2001	2002	2003	2004	2005	2006	2007	2008
24.5%	24.1%	14.3%	19.3%	19.6%	21.9%	27.4%	33.1%	35.8%	22.8%

The rest was used to grow earnings. The earnings per share are shown below:

1999	2000	2001	2002	2003	2004	2005	2006	2007	2008
1.81	2.07	1.28	2.01	2.31	2.74	2.30	2.82	3.29	2.33

Current Situation

During the current recession, most companies are experiencing problems, and American Express is no different. During past recessions, the company was immune to problems shared by others because affluent consumers held up relatively well compared to the broader population. This recession, however, is different because it is hitting the affluent hard. Many of these consumers saw their home value, personal wealth, and job security erode. As a result, they cut back significantly on their discretionary purchases.

American Express saw a decrease in overall spending, which affected the merchant discount fee. It also saw an increase in late payments and defaults in the charge cards and lending portfolios. The company had to add more money to its credit reserves to protect it from future losses.

When consumers purchase items from merchants, they do not pay for the purchases immediately. Usually, they have 30 days to pay off the card. Meanwhile, the merchants get the money advanced by American Express, which finances these amounts through various types of financing. During the fourth quarter 2008, some of the financing options, such as commercial paper froze up, making it difficult for American Express. This is when the company searched for other financing alternatives. As a result, the company became a bank holding company, because this classification allowed it to benefit from government assistance and permitted it to accept retail deposits. The company received $3.39 billion from the government, which in return received preferred shares of American Express. On June 17, 2009 the company announced that it has repurchased the $3.39 billion of preferred shares.

Things got so bad that the company only earned $0.32 the first quarter of 2009. On an annualized basis, this is $1.28, and it represents a considerable drop from $3.29 and $2.33 in 2007 and 2008, respectively. Because the company’s management forecasts that fundamentals will deteriorate further, Value Line estimates that earnings per share will be $0.90 in 2009. The last time earnings per share were this low was in 1994. The good news is that the company is still profitable due to its flexibility in its cost structure, which can be adjusted with the level of revenues.

American Express Valuation

Some experts argue that American Express’s stock is undervalued and others disagree. Perhaps the bears see nothing but negative news and continued deteriorations in the economy. But, I tend to agree with the CEO of American Express who said,

“… just as good economic times don’t last forever, neither do bad times.”

So what exactly is American Express’s stock worth? I will not get into too much detail here. I teach investors how to value companies in my book, Why Are We So Clueless about the Stock Market. In this blog, I will do a comparative analysis of 2008 vs. 1998 and let readers draw their own conclusions on whether American Express is overvalued or undervalued and whether it is a good buy.

I chose 1998 because this is the level that the stock is trading at as of this posting.

	1998	2008
Revenues	$19.1 billion	$28.4 billion
Net Income	$2.1 billion	$2.7 billion
Cards in Force	42.7 million	92.4 million
Card member Spending	$6,885	$11,594

These findings tell us that if we bought the stock in 1998, we would acquire a company with $19.1 billion in revenues, $2.1 billion in net income, 42.7 million cards in force, and $6,885 average card member spending. Fast forward to 2008 and 2009 - we could purchase this same company but with a much better earning power of $28.4 billion compared with $19.1 billion, with 94.4 million cards in force compared with 42.7 million, and with $11,594 average card member spending compared with $6,885. The only metric that is almost the same is the net income. What did it take to increase net income from $2.1 billion in 1998 to $3.9 billion in 2007? It required more card members, which resulted in more cards in force, and higher average card member spending.

Today, the company already has it all. It has more card members than it did in 1998, and these members also spend significantly more dollars than they did in 1998. But, the market is pricing it identically to what it did in 1998. What needs to happen now for net income to return to more normalized levels? Card members have to stop seeing their home values, personal wealth, and job security erode. This will only happen when the economy improves. The improvement will not happen overnight, but eventually it will take place. When net income recovers to a more normalized level, what likely to happen with the stock price? Well, readers can make this determination themselves.

Disclosure: I, or persons whose accounts I manage, own shares of American Express at the time of this posting.

Is U.S. Bancorp going to earn itself out of trouble?

It is not surprising to see U.S. Bancorp, or in fact, any other bank facing losses due to defaults, foreclosures, late payments, and so on. During the first quarter of 2009, investors feared that the U.S. Government was going to nationalize the banks. Since this did not happen, many banks, including U.S. Bancorp, saw their stock prices appreciate significantly.

The problems that banks face are far from being over, but can U.S. Bancorp survive and earn itself out of trouble? Before answering this question, let’s talk about banking in general.

The Banking Industry

Banks are in the business of selling a commodity product called money. Like other businesses, banks buy their raw materials for one price and resell them for a higher price. Banks mainly get their money from depositors who open a checking or savings account. People might not think of it this way, but by depositing money in the bank, the general public is simply lending money to the banks. Banks might pay 1 percent to depositors and lend it to consumers or businesses for 6 percent.

Banks are highly leveraged institutions: for every $100 in assets, $90 is borrowed from depositors or other lenders and only $10 is in the form of equity. Being leveraged so much makes banks vulnerable to economic downturns. Because of very thin margins, one bad loan may wipe out the profits of several good loans. A poorly managed bank can destroy shareholders’ wealth quickly. This was perfectly demonstrated by Citigroup, Inc.

U.S. Bancorp

Investors might throw all the banks in the same category, and say that they are all the same. Would they say that all restaurants are the same? Probably not. Each bank is a different company following a distinctive business model.

U.S. Bancorp has a reputation of being one of the most conservative banks in the industry. The bank was not involved in loaning money to the risky borrowers that other banks loaned. Instead, it followed strict underwriting criteria that kept it from getting into problems that other banks now face. But even though it was more conservative, it saw an increase in delinquencies, foreclosures, and write-offs. As unemployment kept getting worse, even the best borrowers defaulted.

Another important point that makes U.S. Bancorp different from other banks is the diversified nature of its business. The company operates in four separate business segments: consumer banking, wholesale banking, payment services, and wealth management & securities services. Consumer and wholesale banking contributed 60 percent of revenue. Payment services, and wealth management & securities services, contributed 27 percent and 13 percent, respectively. This diversification is important to point out that the non-banking segments can be used to offset losses from banking operations.

Conclusion

U.S. Bancorp has a high probability of earning itself out of their problems, and therefore, forcing its stock price to trade much higher in three to five years (notice the time frame is not three to five months). As people lost a significant amount of money in the stock market in 2008, many sold their holdings and converted them into cash. Because of this flight to quality, most banks, especially strong ones like U.S Bancorp or Wells Fargo, saw significant increases in deposits. As mentioned before, money is a raw material to banks and deposits are the way to get it. As more people are hoarding cash, banks are able to get this raw material more cheaply. Later, they can lend it out at much higher rates. In addition, as other banks facing more severe problems are not able to lend, U.S. Bancorp can cherry-pick borrowers and still charge enough to make good returns.

Some investors might argue losses are still going up and U.S. Bancorp is not even close to being on its way up. While this is true, the losses are mainly from loans made in the past. Nonperforming loans will finally get written off, meaning they will be taken off the balance sheet, and the collateral will be taken and sold off by the bank. It is just a matter of time before losses start trending down because the new loans are underwritten with even more care than ever before. Despite all the losses, the bank is still profitable. It just generates less profit than before.
The reason why the stock is trading at around $19 is because the majority of investors are not able to sleep at night knowing that the price could decline. Most mutual funds or hedge funds are afraid to acquire the stock because it is unlikely to show short-term gains which could lead to losing clients.
The stock is cheap because there is short-term uncertainty. Once the uncertainty is gone, the $19 price tag will be history.

Disclosure: I, or persons whose accounts I manage, own shares of U.S. Bancorp at the time of this posting.

Arctic Cat: Is this a SCREAMING DEAL or not?

Arctic Cat manufactures snowmobiles and all-terrain vehicles (ATVs) and sells related parts, garments and accessories. The company was formed in 1983 as a snowmobile manufacturer.

In 1995, the company entered the fast-growing market of ATVs. Because it had already established its brand among snowmobile customers, it was logical to cross-sell them and offer ATVs. In 1996, only 3 percent of revenue came from ATV sales. By 2007, 55 percent of revenues came from ATVs and only 32 percent came from snowmobiles. From the time that Arctic Cat entered the ATV market, its sales grew faster than the industry's. Based on several conversations with dealers of Arctic Cat, some of the reasons for Arctic Cat's success in the ATV business are:

• brand loyalty from the snowmobile clients
• superior suspension system
• high durability
• faster response time for customer demand as a result of the company's smaller size
• innovation where competitors, such as Honda, are too complacent

Arctic Cat has a better brand name in the snowmobile market and faces fewer competitors (Polaris, Yamaha, and Bombardier) than in the ATV market (Polaris, Honda, Yamaha, Kawasaki, Suzuki, and Bombardier).

Its stock is extremely attractive because of the trading price. As of the date of this posting, the market capitalization (total # shares x price per share) for the entire company was approximately $70 million. Its inventory cost the company more than the price tag of the entire company. But some might argue that the inventory value is declining because fewer customers are buying snowmobiles and ATVs in this economy. While this is true, it does not mean that the stock is not a good deal.

Let's say we want to get into the business of manufacturing snowmobiles and ATVs because we believe that eventually the economy will be better than it is today. What things do we need to start? Besides technical knowledge, we would need a factory, equipment, tools, raw materials (inventory), etc. These are all the things that are listed on Arctic Cat's balance sheet. Let's say we spend a total of $100 million, of which $50 million is spent on inventory and the other $50 million on equipment, tools, and a factory. Would it make any sense for us to say, "Well, we are losing money this year so we will sell it all for $25 million, which is half of what we spent on inventory?" Clearly, it would not make any sense, but this is what Arctic Cat is selling for.

But even if we could produce these snowmobiles and ATVs, how are we going to sell them? Most of these products are sold by dealers and trying to convince them to carry our product would not be easy. Without an established brand name, building a network of dealers is extremely hard and it would take a significant amount of time and money. The Arctic Cat brand has been around for 45 years, and the company established itself as a leader in snowmobiles and a significant player in the ATV business.

The company already has a strong dealer network. It is not hard to see that its brand name and dealer network are assets to a company such as Arctic Cat. Since they are assets, they must be included on the balance sheet, right? Actually, they are not, even though they probably are worth more than any single item listed on the balance sheet. A balance sheet mainly includes historical costs such as inventory, equipment, and properties. Arctic Cat did not purchase its brand or its dealer network but built both by promoting and advertising over many years. Promotion and advertising are expensed as incurred, and they flow through the income statement and do not create an asset. The only way for Arctic Cat's brand and dealer network to appear on the balance sheet would be when an outside company such as Polaris or Kawasaki purchases the company outright. Then, all the tangible assets such as inventory, equipment, and property would be recorded on the acquirer's balance sheet and the difference between the purcahse price and tangible assets would be recorded as goodwill.

Even if the brand and dealer network were worthless, buying the stock of Arctic Cat is still below net working capital (current assets - current liabilities). Anybody buying Arctic Cat outright could liquidate the company by selling inventory, equipment, and properties and still end up with more money than the $75.5 million dollar price tag.

So, why is the stock so cheap? As a start, Arctic Cat is bleeding cash. Because the economy is weak, people tend to postpone purchases of discretionary items such as snowmobiles and ATVs. Also according to the article "Thin Ice at Arctic Cat" by Dee DePass (http://www.startribune.com/business/11903626.html), some institutional holders bailed out, selling 12 million shares on the market. Keep in mind that there are only about 18 million shares outstanding and Arctic Cat's stock does not trade on huge volume. Imagine what can happen to the price of a stock when 66 percent of shares are being sold. Driving the price to the current levels is beyond logic. Professional money managers are people and just like individual investors, when the fear of losing money is present, logic goes out the window. The good news is that when the stock is purchased before some of the institutional investors return as the economy improves, the stock price has a chance to take off like a rocket.

But since the company is losing money, it can go bankrupt, right? What is the requirement for a company to go bankrupt? It first must have debt, and Arctic Cat has no debt. Arctic Cat learned its lesson in 1981 when it went bankrupt after lenders called all the loans due. The original founder and some key managers went to the auction and bought up the company in pieces and started Arctco, which later became Arctic Cat.

Even though Arctic Cat has no debt, it is still losing money because of large fixed expenses associated with the manufacturing business. To preserve cash, the company already suspended share buybacks and divideds. From my estimation, the company will lose anywhere from $30 to $50 million in 2010, and it does not have enough cash on hand to weather this situation. But just because the company is losing money does not mean that the stock price will drop more or is not a good buy. As of this posting, the market knows the company will continue to lose money, so this information is already priced into the stock.

The bottom line is this - Arctic Cat will have to get the cash to cover the shortfall. Some market participants are worried that Arctic Cat will not be able to raise any cash because no one will want to lend them money. I have a different view. If the company cannot secure any conventional financing, it still has many options. First, it can get an asset-based loan against accounts receivable and inventory. Second, the company owns some real estate: manufacturing/corporate office (558,000 square feet), distribution center (220,000 square feet), test & development facility (3,000 square feet), and manufacturing facility (60,800 square feet). Many investors overlook real estate. Having experience in commercial real estate, I know that Arctic Cat could easily sell these facilities to raise cash and lease them back from the buyer. This is called a sale-leaseback transaction. Third, even if all of the above fail, the company may sell itself to the bigger players such as Polaris, Kawasaki, Suzuki, etc. All of these players would love to acquire the brand name of Arctic Cat.

Last time I invested in a similar situation where financing was in question, I more than quadrupled my money. The company was called Teck Resources (TCK), and I bought it for $3.32 and sold it for $14.35.

Arctic Cat is a great company with a recognizable brand name. Currently it is going through tough times due to the economic recession. Patient investors might find the stock to be attractively priced. But before investing in the company do you own research and consult your financial advisor.

Disclosure: I, or persons whose accounts I manage, own shares of Arctic Cat at the time of this posting.