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EUGENE FOX, III, is a Managing Partner of Cardinal Capital Management, L.L.C., and is
responsible for investment research and portfolio management. Mr. Fox has been in the
investment industry since 1987. Prior to joining Cardinal in 1995, Mr. Fox was a Managing Director
at Deltec Asset Management, LLC, where he and Amy Minella built the value equity investment
management business. Mr. Fox joined Deltec in 1993 from D.S. Kennedy & Co., a small-cap value
equity firm, where he was an Investment Analyst. Prior to joining Kennedy, Mr. Fox held financial
positions at FMC Corporation from 1984 to 1991, including five years as the Director of Pension
Investments, where he selected and monitored value-oriented investment advisers for the
company’s top-performing $2 billion pension plan. While at FMC, Mr. Fox also completed the
nation’s second largest pension plan reversion. Mr. Fox earned a B.A. in economics from the
University of Virginia and an MBA in finance, statistics and accounting from The University of
Chicago Booth School of Business.
RACHEL D. MATTHEWS is a Portfolio Manager and Research Analyst at Cardinal Capital
Management, L.L.C. She is responsible for investment research and portfolio management. Ms.
Matthews has been in the investment industry since 1989. Prior to joining Cardinal in 2001 she
was a High-Yield Bond Trader at OppenheimerFunds, Inc., from 1996 to 1999. She traded U.S.
government securities at HSBC Securities Services from 1994 to 1996. Previously, Ms. Matthews
was a Private Placement Credit Analyst at the Mutual Life Insurance Company of New York. Ms.
Matthews earned a B.A. from Columbia University and an MBA from New York University.
ROBERT B. KIRKPATRICK, CFA, is a Managing Partner of Cardinal Capital Management, L.L.C. Mr.
Kirkpatrick is responsible for investment research and portfolio management. He has been in the
investment industry since 1985. Prior to joining Cardinal in 2000, Mr. Kirkpatrick was a Partner at
Breeco Management, LP, a $125 million research-driven equity hedge fund, for three years. Previously,
Mr. Kirkpatrick held senior equity portfolio management positions with Unifund S.A., a Swiss-based
global private investment company with more than $1 billion in capital. Mr. Kirkpatrick also served for
six years as a Managing Director at Bigler Investment Management, a $700 million venture capital and
small-cap investment management firm. Mr. Kirkpatrick began his investment career in 1985 at CIGNA
Corporation, where he was a Sector Portfolio Manager. Mr. Kirkpatrick earned a B.A. in economics
from Williams College, and he earned the CFA professional designation in 1988.
SECTOR — GENERAL INVESTING
TWST: Let’s start with a brief history of Cardinal Capital
Management and an overview of the firm today.
Mr. Kirkpatrick: Cardinal traces its roots back to Deltec Asset
Management based in New York City where my two partners, Gene Fox
and Amy Minella, started a value equity product in 1992. In 1995 they left
Deltec along with four colleagues and formed Cardinal Capital Management in Greenwich, Conn. The value equity strategy started at Deltec with
$1 million in capital and has grown to $1.3 billion in assets under management at Cardinal today. Managed and wholly owned by the three senior
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investment professionals, Cardinal’s objective is to generate high long-term
investment returns with little risk of loss by utilizing a free cash flow-based
framework combined with intensive fundamental research.
Cardinal operates as a team with four portfolio managers/research analysts and two dedicated research analysts working across Cardinal’s three value equity strategies. Small Cap Value, the firm’s flagship
strategy, accounts for roughly 75% of assets under management, with the
balance split between Mid Cap Value and SMID Cap Value. Our client
base is 80% institutional and tax-exempt money, with public pension
plans and corporate pension plans accounting for 50% of the assets under
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management. About 25% of the assets come from foundations and endowments, and the rest is largely subadvisory of public mutual funds. We
subadvise on a number of mutual funds, including the Brown Cardinal
Small Companies Fund, BIACX, the ASTON/Cardinal Mid Cap Value
Fund, ACDMX, the multimanager Vanguard Explorer Value Fund,
VEVFX, and the multimanager Northern Trust small-cap fund, NOSGX.
TWST: How would you describe your overall investment
philosophy?
Mr. Kirkpatrick: Our philosophy, which has remained the
same for the 18 years we’ve been in business, is that a company’s stock
price is ultimately determined by its ability to generate free cash flow
and to redeploy that cash to enhance shareholder value. Cash flow is
what management can use to build value and the redeployment of it
through share repurchases, acquisitions or reinvestment in the business,
either through fixed or working capital expenditures, requires judgment.
We capitalize on our philosophy by integrating our intensive fundamental research with an in-depth five-year discounted cash flow-based valuation analysis. We then use our portfolio management skills to create a
broadly diversified portfolio weighted towards our best ideas.
different times for that same company. It may be appropriate for the company to be repurchasing its stock at one time, but not at another time. So
it’s up to us through our research to become comfortable that management
is running the company as we would run it if we were in their shoes.
Mr. Fox: The decisions that we’re focused on are typically not
going to affect this quarter or this year, but more often the long-term strategic direction. We will express our views to management on these issues,
so that we have a clear understanding and an ongoing dialogue as to strategy and how and why free cash flow is being redeployed. As a result the
numbers that we are focused on are different than Wall Street analysts who
worry about this quarter, this year’s or next year’s results when they’re
trying to determine whether or not a company is attractive to investors.
Mr. Kirkpatrick: One of the keys for Cardinal’s approach is
to apply the discounted cash flow methodology to the right type of
company, meaning businesses with characteristics that enable us to
forecast their financial results out five years with reasonable accuracy.
Our term for these businesses is stable and predictable, and examples
include revenue visibility via recurring revenue, whether by subscription, backlog or long-term fixed price contracts. Inelastic demand,
Mr. Fox: Cardinal’s investment process is absolute, not relative-value based. Our long-term return objective
is 20% per annum, and it is built into our discounted cash flow analysis. As a result we are looking for a
higher rate of return than you would expect to earn under normal stock market conditions.
Mr. Fox: Our process is also different than most other investment advisers when it comes to idea generation, as we don’t do conventional screening. We find ideas opportunistically by looking in market
niches which we believe are inefficient, either because the standard financial information does not yet exist or because it’s not readily transparent, such as the difference between cash flow and earnings, or NOLs that
aren’t captured. Also there may be money-losing divisions of companies
which make the value of the whole company and its parts difficult to
calculate, or where there have been changes in the business either
through management or events, which have not yet been reflected in the
numbers. Our goal is to end up with a portfolio that could not be easily
assembled by someone with a database and computer. As Rob said, we
do our own research. We do not rely on the Street for the numbers that
go into our discounted cash flow analysis. Everything that goes into our
decision process is based on the research that we do, not what someone
else has done.
TWST: Mr. Kirkpatrick mentioned looking for free cash
flow that can be used to enhance shareholder value. Do you look for
companies that pay out dividends or that are buying stock back?
What do you look for?
Ms. Matthews: We look at all of the above. But as Gene
said, we don’t just screen for dividends because there is no single right
answer for all companies. As part of our due diligence process with
management, we form an opinion as to what’s the appropriate use of
capital at each company. Whether that is stock buybacks, acquisitions
or internal growth opportunities where they make capital expenditures
or working capital commitments. It differs by company, management,
business and situation.
Mr. Kirkpatrick: Let me add to what Rachel said. I think not
only is capital redeployment different for every company, but it differs at
pricing power, economies of scale, intellectual property and monopolies are other factors that we look at in making this assessment. Without
reasonably accurate forecasts, discounted cash flow can get investors
into trouble because the range of outcomes is too wide, and that makes
it very difficult to make attractive long-term returns.
Mr. Fox: To follow on to Rob’s last point, Cardinal’s investment process is absolute, not relative value based. Our long-term return
objective is 20% per annum, and it is built into our discounted cash flow
analysis. As a result we are looking for a higher rate of return than you
would expect to earn under normal stock market conditions. We assume
that the companies that we’re investing in are out of favor, and it is
critical for us to understand why and what it is about that investment that
is creating the high return that we’re looking for. We must understand
what needs to change about the perception of that business in order for
us to make those returns. That is all part of our investment process, and
what we look at when we are trying to assess whether we should make
the investment, or continue to hold an investment.
TWST: What kinds of opportunities do you find today in
the small- and midcap areas of the markets?
Mr. Fox: The obvious area of opportunity is companies that
have significant amounts of cash on their balance sheets, because that
cash is earning almost nothing today. These companies are receiving essentially no credit for the cash in their valuations despite the fact that, if
the company chose to redeploy that cash through any of the means that
Rachel highlighted earlier, significant value would be created. In fact
several of our portfolio companies have been very active redeploying
cash recently, which does raise the issue as to why now. What we think
changed is that post-credit crisis companies were holding dry powder for
once-in-a-lifetime opportunities and those never happened. As a result,
with the credit markets in better shape, buyers are more willing to pay up
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for acquisitions as business confidence improved. Deals are still generally very accretive and debt is available and at very low interest rates by
historical standards.
TWST: It seems a lot of the recovery in the equity markets has been more in the small- and midcap range and not as
much in the large-cap area. Do you have to dig deeper to find good
values today?
Mr. Kirkpatrick: One thing that we look at is the valuation of
our companies on an enterprise value-to-EBITDA basis. Historically
what we have found is that our portfolio tends to trade between five and
eight times EBITDA. Immediately after the financial crisis, as you
would expect, it was close to five times. Preceding that by a bit, it was
into the high sevens. Today it’s about 6.5, which places it squarely in the
middle of the range. To answer your question, when the portfolio was
around five times EBITDA, when the market was at its low in early
2009, we had more opportunities than today. So we do have to dig a little
deeper, but there are still plenty of opportunities out there.
TWST: What have been some of your successful investment picks in the past?
Mr. Fox: M&A, which has been an important contributor to our
performance historically, picked up relatively significantly last year and
was a major tailwind behind our performance. The relevance of M&A to
our strategy comes from the fact that our methodology is very similar to
what private equity firms look for in businesses. Consequently, as the
to repurchase a substantial part of the noninsider float in the company,
when the stock declined substantially.
After finishing our due diligence we began purchasing the
stock, and Cardinal became Argon’s largest outside shareholder by late
2008. The financial crisis hit but the company’s business remained
strong, and when the third founder retired it became apparent to us that
the retirees who still owned 30% of the shares would want to monetize
their investment. Argon stock, however, was selling at 7.5 times
EBITDA, and we felt that the real value of the business was closer to 12
to 14 times EBITDA based on its proprietary technology, the significant
programs that Argon had won and the excellent multiyear visibility that
the company had to deliver higher revenues and earnings. So Argon was
at an inflection point in late 2009, and publicly disclosed their decision
to explore strategic alternatives. Although there was a great deal of skepticism among analysts as to the value of the company, our work led us to
retain the vast majority of our Argon stock right up until it was announced that Boeing Company (BA) was buying Argon ST at a substantial premium to the market.
Mr. Fox: We also had several other companies acquired last
year in our small- and midcap portfolios: Interactive Data and SkillSoft
in our small-cap portfolios, and Hewitt Associates, NBTY and Interactive Data in our midcap portfolios. We believe that M&A is going to
continue to be an important contributor in the future because Cardinal’s
view is that the economic environment is going to be one of modest
Mr. Kirkpatrick: As a result of our process our portfolios never mirror the benchmark and are broadly
diversified. We believe this has, in fact, been a source of value added to our returns. Historically our
portfolios are typically underweight financial stocks, usually banks and insurance companies, and
overweight consumer stocks.
credit markets opened and private equity firms had cash to spend, and
corporations/strategic buyers looked to increase or maintain their earnings
growth rate through acquisitions — we were quite well positioned to benefit. Specifically last year, we had two of our defense electronic investments, Argon ST and Applied Signal, acquired at very nice premiums and
attractive valuations. Those were two very well-positioned companies
where we had strong conviction that they had substantially more value to
the prime defense contractors than they did as standalone companies. It
was simply a matter of time before these companies were acquired, and
that was a major contributor to our performance.
Mr. Kirkpatrick: I can walk you through the Argon ST investment. Argon was the merger of two small defense electronics contractors early in the last decade. The four entrepreneurs who founded and
ran the two companies ended up owning 40%-plus of the merged entity.
Cardinal has successfully invested in several smaller defense businesses,
and we had just sold our investment in EDO Corporation at a nice profit
when it was purchased by ITT (ITT) in 2007. Argon’s business had gone
through a downturn as a result of the cancellation of the Aerial Common
Sensor program. Although the issue was beyond its control, Argon’s
backlog and earnings did drop, but seemed to have bottomed and were
poised to resume growth. Argon’s founders were also starting to retire,
but had retained their equity stakes. In fact only two of the four were in
operating positions at Argon when we first purchased the stock in late
2007. What peaked our interest in Argon was management’s willingness
growth, and therefore all companies, but particularly large ones, are
going to be challenged for growth; however, since interest rates are very
low today, we believe that a number of large companies can and will
pursue acquisitions to bolster their growth rates because most acquisitions are very accretive. Small-cap companies are less challenged for
growth because they are starting from a smaller base and have opportunities to grow in a number of different ways, including geographic expansion. With respect to valuation, small-cap stocks also deserve an M&A
premium relative to large caps because they are the targets.
TWST: Do you look to overweight or underweight particular economic sectors?
Mr. Kirkpatrick: As a result of our process, our portfolios
never mirror the benchmark and are broadly diversified. We believe
this has, in fact, been a source of value added to our returns. Historically our portfolios are typically underweight financial stocks, usually
banks and insurance companies, and overweight consumer stocks. We
believe over long periods of time these differences are one reason that
our performance should do much better than our benchmarks. And our
returns support this.
TWST: Are there particular industry sectors you are looking to add to, or decrease, your exposure?
Mr. Kirkpatrick: I don’t think we target sectors per se. I can
tell you today we have greater-than-index weights in technology and
industrials, and much lower-than-index weights in financials, primarily
MONEY MANAGER INTERVIEW ——————— FCF-BASED FUNDAMENTAL, BOTTOM-UP INVESTING
banks and utilities. We also have less exposure to consumer stocks than
we have had historically.
TWST: What sort of broader economic or macro trends
are you keeping an eye on that may impact the small- and midcap
stock space? Is M&A the primary one or are there others?
Mr. Fox: Since Cardinal is a bottom-up, not top-down, firm
and we don’t make major portfolios changes based on our macroeconomic views. What we have done is maintain relatively consistent levels
of broad exposure through economic cycles. If you make major changes
in economic exposure, you have to be right on your macroeconomic
calls, and that’s not our competitive advantage. We pay attention to individual companies and monitor changes in their businesses.
We obviously have economic views. They just make their way
into our investment decisions through our company forecasts. In this
regard we have forecast a prolonged economic recovery for some time.
We also thought interest rates would remain very low because of the
challenges to employment and housing, and that too has played out. The
challenges to the banking system, although less publicized, are no less
real as regulators remain concerned about capital levels and commercial
real estate exposure. As a result we believe that regulators need to keep
interest rates low so that banks can earn their way out of their capital
problems. These are our views. They haven’t changed materially, but we
keep them in mind when we think about businesses and particular exposures in the portfolio.
fees, compared to the Russell 2500 Value, which returned 8.9% for the
same time period. So we’ve outperformed by 150 basis points. Cardinal’s newest product, Mid Cap Value, was launched in 2006 and has an
annualized return of 6% before fees, versus the Russell Midcap Value
Index, which returned 5.1% for the same period. So we outperformed in
all three products.
TWST: What advice would you give investors today?
Mr. Kirkpatrick: Our view, which we really became quite
vocal about after the third quarter of last year, is that we think people are
too bearish about the equity markets and too bullish about bonds as a
result of poor returns in the equity markets over the last decade, in particular the decline in 2008 and the strong returns in bonds over the same
period. The mutual fund flow data over the 2009 to 2010 period really
does show that that’s what’s gone on with most investors.
Mr. Fox: We think that investors with a long-term view
should be buying equities and selling bonds. Simply, equities are trading
near their historical norm from a valuation standpoint despite the fact
that interest rates are very low. So we argue that equity prices are relatively cheap. Bonds, however, are trading at historically low yields. Although real interest returns are still positive, with the 10-year government
bond yielding 3.5% and reported inflation at 1%-2%, we feel investors
are being paid very little to take the risk that inflation will eventually rise.
In addition, because equity market expectations are low, equities are inherently less risky, while as bonds are priced for perfection, they have
Ms. Matthews: The SMID-cap value product, which we started in 2002, has an annualized return since
inception of 10.4% before fees, compared to the Russell 2500 Value, which returned 8.9% for the same time
period. So we’ve outperformed by 150 basis points.
TWST: Talking about Cardinal Capital Management itself, would you tell us a bit about the firm’s performance?
Mr. Fox: Cardinal has been in business since 1995, but
our performance record goes back to June of 1992 at Deltec. We
have an annualized return before fees of 14.3% through February
versus 11.5% for the Russell 2000 Value. At least as important, with
the exception of 2008, our lowest annual return in any year over the
past 18 was -2.5%. We are proud of this performance because it
demonstrates that our investment process does in fact protect capital
in most bad equity markets as we would expect. This consistency is
evident in our peer group rankings, where since inception, we have
the lowest standard deviation of returns, or volatility, of any of the
30 small-cap value investment managers with an 18 year performance record. This is more impressive when you consider that only
about a third of the products that were in the small-cap value universe, when we started our product, remain in the universe today.
For the same period we also rank in the top 10 small-cap value
products on most every measure of performance.
Mr. Kirkpatrick: Gene was speaking specifically about Cardinal’s small-cap value product. We also have a small- to midcap value
product and a midcap value product, and both of those have performance
records going back a number of years, and Rachel will talk about the
returns on those.
Ms. Matthews: The SMID-cap value product, which we
started in 2002, has an annualized return since inception of 10.4% before
nowhere to go but down. Since we went out with this view, stock prices
have risen and bond prices have declined and fund flows are starting to
reverse. Our view though is this is just the beginning of a cyclical process, and equities remain quite reasonably valued, so equity investors
with patience will be rewarded.
Mr. Kirkpatrick: The other thing that investors have to
keep in mind is that future investment returns are a function of the
price which you pay to purchase the investment today, not your cost
or past returns.
TWST: Would each of you offer one or two investment
ideas that are in your portfolios today?
Ms. Matthews: I want to highlight DG FastChannel (DGIT).
It’s a company we first invested in late in 2010. DG is a leading provider
of digital technology that’s used to facilitate the electronic delivery of
advertisements, syndicated programs and video primarily to the broadcast networks, local television stations and cable television companies in
the U.S. We began to research the company because the stock price fell
drastically due to temporary factors that we believe are unrelated to and
did not significantly diminish the value of the business franchise, which
we feel remains very attractive. This goes back to our approach of finding stocks that are unduly depressed for reasons that we understand, and
at the same time uncovering catalysts or reasons why the perception
should improve.
As we did our research we concluded that DG’s stock price
fell due to perceived increased competition, concern that the pricing on
MONEY MANAGER INTERVIEW ——————— FCF-BASED FUNDAMENTAL, BOTTOM-UP INVESTING
HD advertising was going to fall dramatically and the company’s mismanagement of the process of implementing quarterly earnings guidance. With respect to competition, DG was perceived to be a monopoly,
but the startup of two competitors and the loss of a handful of accounts
to one of them raised concerns. On closer examination, however, neither
competitor had the same capabilities as DG nor could they operate profitably, and the client losses were relationship not business issues. In fact
nue grows; the shift in direct-response marketing from SD to HD; and
the opportunity for international expansion. DG’s free cash flow characteristics are compelling. Currently the stock trades at six times EV/
EBITDA with an 11% free cash flow yield on enterprise value. At its
current price of $31 the stock is up significantly from our first purchase
price late last year in the low $20s; however, we feel the stock is worth
well over $40, which is where it was traded before the events of late last
Ms. Matthews: We began to research [DG FastChannel] because the stock price fell drastically due to
temporary factors that we believe are unrelated to and did not significantly diminish the value of the
business franchise, which we feel remains very attractive.
1-Year Daily Chart of DG FastChannel
Chart provided by www.BigCharts.com
summer. The company has a share repurchase program and has been active. As investors realize that there is no imminent competitive threat to
DG’s dominant market position and the shift to HD electronic delivery
of advertising occurs at a faster pace than expected, we think the DG
FastChannel stock should move materially higher.
Mr. Kirkpatrick: I would like to discuss Kaman Corporation (KAMN). Kaman is a company started after World War II by an
entrepreneur named Charlie Kaman. He ran the company, controlled it,
fell ill in the late 1990s and then brought in professional executive management. That team came in, and in 2005 recapitalized the company by
eliminating the super-voting stock owned by Kaman and his family and
created one class of voting stock. That’s when we got interested because
it became a company where we felt that shareholders would be amply
represented. Kaman at that time was in three business lines: aerospace,
1-Year Daily Chart of Kaman Corporation
one of the two has already exited the business. With respect to pricing,
we believe declining prices are actually a positive as the industry moves
from electronic delivery of standard-definition advertising to high definition over the next several years. Although HD prices are likely to fall,
and we have made some conservative assumptions in our model, our
long-term penetration rates for HD, which has much higher margins,
than SD are also very conservative.
Standard definition pricing is $10 to $12 electronically, versus
HD, which is $150 per unit. So you can see, if that shift happens quickly
and extensively, the revenue opportunity is pretty dramatic. Also HD
penetration is only 11% today. It started last year in the mid-single-digits.
We’re only assuming that it gets to 30% over the next five years. It
clearly has the opportunity to get a lot higher than that, but we don’t need
to be so aggressive in order to make our targeted level of returns.
When we look at the business today, its cash flow margins are
almost 50%. That’s a fixed-cost structure. Every incremental dollar that
flows through is very, very profitable. We are also conservative in our
modeling, assuming that the HD price comes down so that they get no
margin expansion over time. In reality they are likely to get margin expansion because the price decline in HD isn’t likely to be as rapid, and if
it is rapid, it’s likely to be because the share growth, the penetration, is
that much higher. These are the dynamics that we focus on. It’s also
important to us that management owns over 10% of the company, so they
are not working against us. They are working with us.
There are a host of reasons we like DG, including its fixed-cost
business model, which provides significant operating leverage as reve-
Chart provided by www.BigCharts.com
which is a combination of commercial and defense, but primarily defense; an industrial distribution business, where they are the number
three player in the industrial distribution area, behind Genuine Parts
(GPC) and Applied Industrial Technologies (AIT); and a music distribution and instrument business, which they subsequently sold in 2007.
Current management joined in 2007 and is led by Neal Keating, who has a background in aerospace and industrial distribution —
strangely enough, the exact two business lines that Kaman was left with
after it sold its music business. Keating has brought in a new CFO and
appointed new heads of both the aerospace and industrial distribution
businesses. The charge the board gave him was to profitably grow the
two remaining businesses, which were substandard in size. As a result
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the management team reinvested the proceeds from the music sale into
acquisitions on both the aerospace and industrial distribution side. They
have also cleaned up legacy issues, including a large troubled Australian
helicopter contract and pension underfunding. They have also continued
to grow each business organically as well as via acquisition.
In 2008 the company’s EBITDA reached a new peak, and then
the financial crisis intervened. In 2009 EBITDA declined about 25%, but
Motorola (MMI), Sony (SNE) and LG Electronics (LPL), whose contract expired at the end of last year and with whom they are negotiating
a new 3G and a 4G license.
As context, after Qualcomm (QCOM), InterDigital has the
second position in terms of non-carrier-based IP that’s used in wireless
cellular devices, and we would ultimately expect that the company’s technology will be licensed by everybody in the industry. Today InterDigital
Mr. Fox: [InterDigital] is a $2.1 billion market-cap company which designs and develops advanced
digital wireless technologies used in virtually all digital cellular and wireless products and networks and
adopted by the international standards for 3G, 4G as well as earlier standards.
1-Year Daily Chart of InterDigital
Chart provided by www.BigCharts.com
2010 was a very solid rebound year and back toward previous peak
EBITDA levels. We believe that the company should be able to substantially grow sales, profits and free cash flow of each business over the
next few years and thus leverage corporate overhead. Kaman stock sells
in the low $30s or 7.5 times EV/EBITDA today, and if the company can
meet its publicly disclosed revenue and margin targets by 2014, that
would imply a stock price at the current valuation well north of twice the
current stock price today.
Mr. Fox: I am going to talk about InterDigital (IDCC). It is a
$2.1 billion market-cap company which designs and develops advanced
digital wireless technologies used in virtually all digital cellular and wireless
products and networks, and adopted by the international standards for 3G,
4G, as well as earlier standards. The business was founded in the late 1960s
by Sherwin Seligsohn, an entrepreneur who got tired of having to go to a
phone booth to put in his stock trades while he was on the beach.
He founded International Mobile Machines, the predecessor
company to InterDigital, in 1972. InterDigital today has almost 20,000
patents that are essential to virtually every wireless device. Its 2G technology has been licensed by all of the mobile handset carriers, and its 3G
technology is presently licensed by over half of the vendors. InterDigital is currently in litigation with Nokia (NOK) over their use of its 3G
technology, although Nokia has an existing license for their 2G technology and licensed their 3G technology through April 30, 2006, but has not
been willing to sign a license since. The litigation has lasted for several
years, but is hopefully nearing a conclusion as the Federal Circuit Court
of Appeals should rule shortly. At present the only other large mobile
carriers which they do not have a current license agreement with are
has $572 million in cash, or about $12 a share, so we are paying about $35
per share or 10 times last year’s earnings, very modest for the growth that
we see. For example, the demand for mobile phones is forecasted to grow
substantially over the next several years at 30%-plus per annum, and about
half of their licensees pay royalties based on units sold. Many of the other
licensees — including Apple (AAPL), HTC (2498.TW), Samsung
(005930.KS) and LG — have fixed-price contracts based on far fewer
units than they are selling today. These contracts expire over the next few
years and are likely to be reset to reflect those higher volumes.
For example, when InterDigital signed Apple to a license in
2006, Apple was selling less than 10% of the iPhones that they are selling today. So we would expect when these licenses get re-signed in a few
1-Year Daily Chart of IAC/InterActiveCorp.
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years, Apple and others will pay much more. Factoring in the sales and
profits from signing licenses with Nokia, Motorola and Sony, we believe that the earnings power of this company is likely to be much higher
than we have seen in recent years.
In addition, none of the existing license agreements reflect the
benefit of InterDigital’s 4G patent portfolio, which we believe is more
valuable and entitle it to higher royalties than their 3G technology. Finally, the company is currently spending considerable resources and efforts on solving the wireless data capacity problem. Simply, the capacity
of the existing infrastructure and technology to meet today’s demand for
high speed and quality data is insufficient, which is why your wireless
devices don’t work very quickly. So InterDigital is spending resources
to solve the problem of how to get data on a timelier and more efficient
basis to an increasing number of phones by improving the dimensions of
MONEY MANAGER INTERVIEW ——————— FCF-BASED FUNDAMENTAL, BOTTOM-UP INVESTING
the pipes that transmit the data. We believe that this is likely to be a large
business opportunity, and they are only starting to see revenue from it as
it will take time to play out.
For such a well-positioned company it surprised us that InterDigital has no major Street coverage. In the short run the catalyst for the
stock is likely to be the sale via bankruptcy court auction of Nortel’s
wireless patent portfolio, which is expected to fetch over a billion dollars, and be a valuation benchmark for this company. We expect the
buyer will likely be Apple or Google (GOOG), because it’s very important in the wireless handset business that you have critical IP so that you
can cross license your IP with competitors rather than pay a royalty to
everybody, which can run up to 15% of the cost of each device. What
they basically do is agree not to fight each other.
TWST: Would you like to add one more, Ms. Matthews?
Ms. Matthews: I’m going to discuss InterActive Corp. (IACI),
which operates more than 35 online brands and is what remains of Barry
are earning nothing on that cash and receiving little credit for it in their
valuation. Also that $12/share in net cash is after buying back about a third
of the market cap in the previous three years. We look at this company two
different ways. We’ve done our DCF analysis as the businesses are solid
and free cash flow generating. The company itself has over a 20% free
cash flow yield on enterprise value. We think management will continue to
put the cash to work given these returns, primarily through share repurchases, and that’s what they have said. They are not expecting to do any
major acquisitions, and now that Diller is no longer CEO the market seems
more comfortable that won’t be the case. So using our DCF model and
putting the cash they have now to work plus any future cash that they
generate, we get a mid- to high-$30s sell price.
On a sum of the parts analysis, if Match.com ranges from $1
billion to $1.5 billion, that implies a seven or eight times multiple, which
is very low in the Internet-based subscription model world. If you use an
even lower valuation on the search and ServiceMaster businesses of five,
Ms. Matthews: What intrigued us with this company was its valuation and business improvement. The
stock was trading in the high-$20s, and going back to Gene’s earlier comments, IACI has about $12/
share or $1.2 billion of net cash on the books, which is almost half of the value.
Diller’s conglomerate after the spin-off of Ticketmaster (LYV), HSN
(HSNI), LendingTree (TREE) and Interval (IILG) back in 2008. Barry
Diller was the Chairman and CEO of the company, but recently stepped
down and named Greg Blatt — the CEO of Match.com, one of his business
segments — as the new CEO of InterActive. Barry remains Chairman. The
company has four business segments, the first one being search.
Their primary search business is called Ask.com, but there is
also a toolbars and applications business. Last year the company restructured Ask.com, number four or five in search, as they couldn’t effectively
compete against Google or Yahoo! (YHOO). So they’ve essentially
outsourced most of their operating expenses, which is going to materially
improve the profitability of that segment. The toolbars and apps business
has above-average growth and profitability, which is where they’re seeing most of their growth in the search segment.
The second segment is Match.com, which is the personals business. It’s a very fragmented business where the company sees a lot of opportunity for growth. The target demographic for growth is slightly older
and wealthier, and they feel that they can more than double their subscription-based revenues without coming close to penetrating the market. Analysts have valued the Match.com business at $1 billion to $1.5 billion.
The third segment is ServiceMaster, which is a small online
service-request business that has been hurt by weakness in the housing
market over the last couple of years. They are seeing improvement, and
there is a lot of room to expand their margins back to historical levels.
The fourth segment is what they call “media and other,” and that’s where
they put their incubation businesses that they’re investing in and trying
to decide what these businesses will be once they get to critical mass and
whether they will keep them.
What intrigued us with this company was its valuation and business improvement. The stock was trading in the high-$20s, and going back
to Gene’s earlier comments, IACI has about $12/share or $1.2 billion of
net cash on the books, which is almost half of the value. Obviously they
six times EBITDA, given that neither is a market leader you get a comparable valuation but with a conglomerate discount, which is how the
market world has typically looked at IAC. So as the company monetizes
their portfolio and narrows their business focus, you could see that discount go away and the company trade at a higher valuation.
TWST: Would you like to add anything else?
Mr. Fox: As you may have gathered from this interview, the
vast majority of our time is spent gathering and analyzing information
about businesses and people. We are trained to do it. We are very experienced at it, and we do it extremely well. It is a key part of our sustainable competitive advantage. To summarize, Cardinal is about research
and about generating attractive risk-adjusted returns, risk being defined
as risk of loss. Our performance record demonstrates that our returns
mirror our process. We also continue to own the firm. One thing that Rob
didn’t mention earlier is we have significant amounts of our own capital
invested in our products, north of $5 million, meaning our interests are
aligned with those of our investors. We believe that we offer a very good
value proposition for investors.
TWST: Thank you. (MN)
EUGENE FOX, III
RACHEL D. MATTHEWS
ROBERT B. KIRKPATRICK, CFA
Cardinal Capital Management, L.L.C.
One Greenwich Office Park
Building 1 North
Greenwich, CT 06831
(203) 863-8990
(203) 861-4112 — FAX
www.cardcap.com
e-mail: rkapp@cardcap.com
MONEY MANAGER INTERVIEW ——————— FCF-BASED FUNDAMENTAL, BOTTOM-UP INVESTING
The information presented herein should not be considered a recommendation to purchase or sell any particular security. There can be no assurance
that any securities discussed herein remains in a client portfolio or if sold will not be repurchased. The securities discussed herein do not represent a
client’s entire portfolio and in the aggregate may represent only a small percentage of a client’s portfolio holdings. It should not be assumed that any
of the securities discussed herein have been or will be profitable, or that recommendations made in the future will be profitable or will equal the
investment performance of the securities discussed herein.
This document does not constitute an offer to sell, or a solicitation of an offer to buy, any interest or investment in Cardinal’s private fund clients,
which may only be made at the time a qualified offeree receives a confidential explanatory memorandum describing the offering and related
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