Scale this problem up by a factor of a thousand and you have companies with warehouses full of garbage they don’t need. So insert in a company like Liquidity Services (NYSE: LQDT) and take a look at what they’ve done since the economic crisis:

Suffice to say, the horse is completely out of the barn now and the company will be facing the law of large numbers soon (i.e. growth percentages are going to slow down), but I just found this interesting. Companies finding profitable ways of getting rid of junk assets (either through re-selling them or otherwise trashing or recycling them) should continue to do well.

Can anybody with a straight face look at their 10-K and make heads or tails of it?

In essence, when you invest in these types of companies you are really taking a leap of faith that the assets they claim to have are real and collectible, and that the liabilities aren’t misstated in such a way that causes them to pay out more than what you see on the books. You are also taking a leap of faith that their loan portfolio takes in more income than they pay out to depositors.

On paper, you are paying $37/share for a company that analysts (before this 50 cent per share trading loss) believe will make $4.97/share this year and $5.60/share next year. Let’s pretend this is true. Sound cheap? Sounds like it, but ultimately do you really know what you are purchasing?

You are buying an implicit guarantee that JPM will crank up its dividend yield over a period of time and hopefully rack up some capital appreciation since its earnings are significantly higher than its dividend payout. The question is – will the company blow up? JP Morgan blowing up doesn’t seem all that likely right now, but just ask people that invested in Bear Stearns, Merrill Lynch, Wachovia, or Washington Mutual five years ago, where an implosion equally seemed unlikely. Who knows? I don’t, and that’s why I’m staying away from these true leap of faiths like JP Morgan equity.

This type of thinking applies to most large cap financial companies, including the large Canadian Banks (specifically, TD, RY, CM, BMO, BNS and to a lesser degree NA and CWB).

That said, you can also invest in these large capital financial firms as a variety of a Pascal Wager where if companies like JPM collapse (or one of the big five Canadian banks) that there is going to be so much collateral damage that subsequently earning a return on investment is not going to make much difference since you’ll be hiding in your underground bunker while civilization collapses around you.

The company was compelling for a few reasons:

1. They had a well known, existing franchise in a sector (language learning) that clearly would benefit from globalization and not be whittled away by other companies’ offerings (which exist and are relevant competition);
2. Their balance sheet was very clean, having (assuming the $7.50 price point) about $100 million in the bank and a market cap of about $160 million; this means an investor was paying for very little to own the underlying franchise;
3. And speaking of the franchise, it is a $250M/year business selling software. Similar to selling pharmaceuticals, software tends to be a very capital-intense up-front business, and the main operating expenses tend to be sales and marketing. So for the princely sum of about $60 million, you could buy into a business at a P/R of about a quarter, fairly cheap if you assume that the software asset is actually worth anything (and indeed, it is, you just can’t see it on the balance sheet since R&D expenses are mostly expensed away and not capitalized).
4. Google Translator and other such “free” services (such as speaking into your iPhone) doesn’t really intersect too much with the language learning software market. If anything, these free services are a compliment.

There were some negatives, including:

1. The previous history of the company being an LBO target and then going public again; there were significant shareholders in the corporation that are actively divesting their interest. Correspondingly, management doesn’t have too much of an ownership stake in the firm – the new CEO has about a 1.5% stake in the company, while the former CEO has about 5%;
2. The profitability of the company has been low, but this is primarily due to marketing expenses;
3. Penetration into international markets has been less successful than originally desired by management;
4. Pressures dealing with US markets (specifically those somewhat exposed to government funding such as education);
5. Management changes – the CEO at the top recently stepped down and they have internally promoted their CFO to CEO and recently hired a new CFO.

I’ll leave out the hard-core quantitative metrics. I’ll condense it by saying the company appeared cheap at their single-digit valuation. Since I’m no longer interested in accumulating shares, I’m holding it in my portfolio since my price target has not been reached yet even with the past week’s action where a relatively rosy quarterly report took them up 30% and I am revealing this holding to the world.

All I have to do now is find 6 or 7 of them and start using the cash balances and who knows, 2012 might turn out to be profitable compared to the (relative) disaster I had in 2011.

While the headline EBITDA result of $146 million may seem positive, all other metrics suggest a “steeper than expected” softening of key metrics. I will take some direct quotations from their MD&A:

The decrease [in revenues] for the three-month period ended March 31, 2012 is due to lower print revenues, especially in urban markets where revenues declined at a much higher rate than rural markets. We have identified new trends, which indicate that the print decline will be more rapid and enduring than previously anticipated.

I like the statement “we have identified new trends” since it implies that management did some deep research to discover this when it seems pretty obvious the company had to identify this by experiencing it directly.

Online advertisers, who in the past, purchased our legacy online products, are not migrating to our new products as quickly as we had anticipated. This now suggests that the online revenue growth will be slower than we had projected [...] Online revenue growth is not expected to compensate for the declining revenue in our traditional print offerings in the near future.

Uh-oh! Could it be the case that the online advertising market is a hell of a lot more competitive?

In terms of the numbers themselves, the focus should be on the balance sheet: The company on March 31 had $310 million in cash, and on May 7 had $292 million in cash. When you account for the fact the company made a $25 million payment on their non-revolving credit facility, it actually implies they generated $8 million during those 5 weeks. I wouldn’t extrapolate this for the whole year!

The “adjusted earnings”, which is roughly a modified free cash flow calculation, was $67.3 million, down from $133.6 million from the quarter in the previous year. While the company is still generating a good deal of cash, the amount is declining at an alarming rate.

I ignore the $3 billion write-down of goodwill – for the uninitiated, they will now see the $785 million stockholders’ deficiency when normally they are accustomed to seeing it called stockholders’ equity. Any analyst worth his/her salt would have made that mental adjustment from day one, and this will hopefully silence the lunatics citing Yellow Media as a good value because of its exceedingly good price to book ratio.

In the raw calculus, the company has $292 million in cash, and they have to pay back $394 million by February, 2013, another $130 million by July 2013, and $125 million by December 2013. If you take the optimistic approach and assuming their decay in cash generation will flatten, they can barely pay off the maturities to the end of 2013, but who in their right mind would believe that things have flattened out?

The company is most likely going to go into some form of restructuring that will address its debt issues. This is likely to be very punitive toward equity holders and also the subordinated debenture holders. They will probably be given a few scrap bones to expedite the process.

Medium term notes are at around 67 cents for the near maturity, and about 60 cents for further maturities on the ask. Debentures are at 17 cents, and perpetual preferred shares (TSX: YLO.PR.C / YLO.PR.D) received a speculative spike over the past few days from 3 cents of par to 4. Suffice to say, the dividends on those preferred shares aren’t coming back anytime soon.

Thankfully, no positions in YLO – I’ve already taken my lumps previously and am just watching how this very unusual financial train wreck unfolds.

It has a few claims to fame. The most positive and negative aspects of the company seem to be directly related to its CEO, Aubrey McClendon. Concentrating on the negative side of the story, is that McClendon formerly owned about 5% of the company, got liquidated out on a huge margin call in the 2008 economic crisis. He was forced to liquidate his stake in the company at very adverse market prices. This would be a pretty good signal to anybody that the main person at the top is one tremendous risk-taker, but that risk is a double edged sword.

The corporation’s board of directors are directly in McClendon’s pocket as they subsequently awarded him a $75 million bonus in deferred compensation relating to well drillings and other such matters, but this presumably related to rubbing a salve on the huge financial wound that was incurred back in 2008.

His financial troubles have recently re-emerged when it was revealed that he had partial ownership stakes in natural gas wells that were also jointly owned by the corporation and this created a conflict of interest with respect to liquidation. Basically the conflict is that McClendon was in a position to front-run his own company or otherwise receive preferential treatment. Compounding the matter was the rumour that he apparently has a billion dollars that he loaned to take such an interest in these wells.

It is not helping the company that natural gas prices have reached record lows, which will be depressing the company’s profit margins.

So why the heck would anybody want to invest in this basket case? The only rationale is that investors would have to believe that the board of directors would be overturned and they would be able to no longer be in the back pocket of management.

Perhaps the way out for the company is an outright buyout, but this is assuming there are no other lingering financial matters within a corporation that has management that does not exactly seem to be aligned with shareholders’ interests.

I haven’t had time to do a more rigorous financial analysis on the firm, but it appears to be another oil-and-gas type company that is blowing more money out on the capital expenditure side than receiving in operating cash flow, and with the decrease of natural gas prices, those capital expenditures will have to slow down quite quickly.

Despite all of these internal struggles, the bond market appears to be somewhat calm with the credit-worthiness of the company – an example would be their bonds maturing in 2020, trading from a yield to maturity of about 6% to about 7.25% in recent times over the past three months. Preferred shares are also trading at around the 6% level, which is odd to say the least.

They have about 11 months to figure out a solution to their imminent debt situation before they will go into default. The medium term notes (which are equal in level to the bank debt in seniority) trade at around 50 cents on the ask at present. The convertible debentures (junior to the MTNs and bank debt) are at about 12 cents on the dollar, while preferred shares are at about 3 cents on the dollar.

The logical investment conclusion is to buy the MTNs if you believe the entity has value after restructuring, or buy the preferred shares if you believe there will be a hugely messy process but not something that wipes out the preferred shareholders. The “middle ground” debentures will probably profit less than the preferred shareholders if there is some sort of recovery.

My best guess is that they’ll give out a regular dividend. It will be around $3-4/quarter.

Whatever the company decides, it will have zero impact on its value, but the market will bid it up like crazy since a dividend means it can also be included on the eligibility list of six billion income mutual funds out there.

That said, everybody and their grandmothers are long on Apple. If you buy the Nasdaq 100 you have a ridiculously large fraction of Apple. The S&P 500 has over 4% of Apple. Apple has been going up parabolically since the beginning of the year, and while it has killed the equity of a lot of short sellers, a parabolic trajectory up cannot be sustained indefinitely.

This type of catalyst kind of reminds me of what happened back in the internet stock days when they announced stock splits. Now the valueless news du jour is announcing dividends.

No positions. I don’t intend on going long or short – the best thing to do about this freight train is get out of the way and look for value elsewhere since Apple is doing a wonderful job of sucking capital from other worthy candidates.

Although my portfolio is substantially all cash and this is pleasant for me to see, I think this brief downturn is just that – brief. Still being patient.

First Uranium had two assets: a profitable Mine Waste Solutions asset, which was sold to AngloGold Ashanti for $335 million in cash; and a woefully cash-sucking and unprofitable Ezulwini mine, which was sold for $70 million in cash.

Most notably is the impact to the debtholders. The subordinated convertible debentures get the following (if they approve of the various changes proposed):

Furthermore, Debenture holders will agree to accept on closing of the Transactions a cash payment of 95% of the principal amount of the Debentures, an additional 2% of the principal amount if they have executed and delivered a validly completed form of election proxy voted in favour of the Company’s proposals on or before the early consent deadline to be set (the 2% will be allocated pro rata to holders tendering by the deadline) and an additional payment of the lesser of (i) 3% of the principal amount or (ii) the total amount released to the Company from the Escrows, in priority to any distribution to FIU shareholders from the Escrows.

It is likely that these holders will receive 97% of principal value, which is significantly better than the 70% the market had them pegged at a week ago. The debenture holders will have no choice to accept the deal since otherwise they will be converted into common equity of the company.

Debentures (TSX: FIU.DB) are trading at bid/ask 90/91 cents on the dollar, so people wanting to pick up the cigar butt off the street for one last puff still have a shot here.

The noteholders will get paid 100% of par value, and also accrue interest up to March 31, 2012. They are likely to be made whole whether they vote for or against the agreement; in the event they vote against the agreement, it brings up an interesting risk scenario. I am wondering why the company did not include a small sweetener for the noteholders as they have the ability to really botch things up for the company by voting against a change in their sledgehammer clause which gives them security over both Mine Waste Solutions and Ezulwini.

Notes (TSX: FIU.NT) are trading at bid/ask 96.5/98.5, so again, there is opportunity to squeak out a few percentage points at the risk of having your capital wound up in some calamity in the unlikely event the vote fails.

Once this is done, the rest of the corporation is going to be winded up.

This ends the sad, sad tale of First Uranium. Onto bigger and better things.

The key quotation is the following:

Under what’s known as the “Always Fresh Conversion” several years ago, the company stopped making baked goods from scratch in each location every day, and instead started shipping partially baked items that had been flash frozen before final baking in ovens at all Tims locations every morning.

This “several years ago”, to my own experience was nearly a decade ago. While I was not a huge consumer of doughnuts to begin with, they were good for parties and the like. After they did this conversion I no longer purchased them and notably did not find any substitute products that were baked of sufficient quality that I could go to.

I’m somewhat surprised that Tim Hortons is able to retain such a high amount of customer share despite the perception of product quality being somewhat worse than McDonalds (NYSE: MCD). Financially, Tim Hortons is quite well managed, with them reporting a 2011 fiscal year earnings that was about 11% better in operating income than in 2010 (adjusting from a one-time gain from the sale of their bakery). Their balance sheet is relatively clean, with a year’s worth of income of long term debt.

They do appear a tad expensive, with a valuation of 22.5 times 2011 earnings.

The lesson for investors is that product branding is a very strong intangible asset of a business. It takes more than flash-frozen not-so-fresh doughnuts to turn off consumers and their fast food habits.

I guess my sour grapes is still remembering staring at my computer screen in 2003 and seeing McDonalds trading at $15 a share and thinking that despite its operational woes at the time, the company was worth purchasing. The original parent of Tim Horton’s, Wendy’s (NYSE: WEN) just doesn’t have the allure at current valuations either – their branding is much, much less valuable. Everybody around the planet knows about McDonalds and this is what makes their brand so powerful.