Chuck Royce's New Buys (Part I)

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Chuck Royce, the founder of Royce & Associates, has been quite successful in investing in small cap stocks for more than 40 years. For the last 10 years, the cumulative return of his fund was 159% while the return of S&P500 was only 34.8%. In the fourth quarter, he initiated long positions in four small cap stocks including Alere (NYSE: ALR), Saga Communications (NYSEMKT: SGA), Geospace Technologies and BankUnited. In this article, we will look closer into Alere and Saga Communications first.

A Business With Huge Goodwill and Intangible Assets

Alere is in the business of developing capabilities in near-patient diagnosis, monitoring and health management, with three main business segments: professional diagnostics, health management and consumer diagnostics. The majority of Alere’s revenue, $1.44 billion, or 67.5%, was generated from the professional diagnostics segment. The health management segment ranked second, with nearly $600 million in revenue.

What impressed me was Alere's 10-year consistent growth in both revenue and operating cash flow. Its revenue has grown more than ten times to $2.39 billion, whereas its operating cash flow has increased 20 times to $271 million. However, there were two issues concerning balance sheet strength. First, Alere seemed to be a bit over-leveraged. As of September 2012, it had $2.23 billion in total stockholders’ equity, $303 million in cash, and more than $3.5 billion in long-term debt. Second, the equity was just half of the company's goodwill and intangible assets, which were a whopping $4.95 billion. Thus, it seems that Alere's growth relied heavily on acquisitions. With the huge amount of goodwill and negative tangible book value, Alere is quite vulnerable to huge write-downs in the near future, which would affect its earnings negatively.  

Chuck Royce bought 409,000 of Alere’s shares at around $19 per share, with the total transaction value of more than $7.7 million. At the current trading price of $22.66 per share, the total market capitalization is $1.83 billion. The market is valuing Alere at 8.44x EV/EBITDA. 

Broadcasting Business with Consistent Cash Flow

Saga Communications is a broadcast company with two main business segments: television and radio. It is currently operating five TV stations, four low-power TV stations, five radio information networks, 61 FM and 30 AM radio stations. The majority of Saga’s net operating revenue, $108.9 million, or 85.5%, was generated from the radio segment in 2011. The radio segment generated nearly $30 million in operating income while the TV segment generated only $4.13 million in operating profit.

What I like about Saga are its stable operating cash flows for the past 10 years, in the range of $25 - $30 million. Saga could use its stable cash flow generated to either grow its business or buy back the shares or pay dividends to shareholders. Indeed, Saga paid the special dividend of $1.65 per share to shareholders on November 2012.

Royce purchased nearly 183,000 shares, accounting for around 4.3% stake in Saga. The average purchase price was around $33 per share, with the total transaction value of $6 million. Saga is trading at $47.54 per share, with the total market cap of nearly $260 million. The market is valuing Saga at 8.54x EV/EBITDA.

One of its listed peers, Entercom Communications (NYSE: ETM) has the same EV multiple with Saga’s valuation, at 8.54x. Entercom is trading at nearly $8.10 per share, with the total market cap of $311.65 million. In terms of profitability, Entercom had a slightly higher operating margin, at 25% while the operating margin of Saga was 23%. Compared to Saga, Entercom was much more leveraged. Its debt/equity ratio was 2.2x while Saga’s D/E was around 0.6x. At the same time, Saga’s interest coverage was much higher at 7.2x, whereas the interest coverage of Entercom was 3.1x.

Foolish Bottom Line

Both Alere and Saga have quite reasonable valuations. However, I prefer Saga to Alere. Alere had a huge amount of goodwill that is quite vulnerable to impairment charges. Saga, on the other hand, is a consistent cash generator that is poised for success.


hoangquocanh has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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