3 Undervalued Picks From A Top Value Investor

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In this article I analyze Joel Greenblatt’s Gotham Partners. Known for his Magic Formula Investing, and founder of the New York Securities Auction Corporation (NYSAC), Greenblatt is founder and managing partner of Gotham Capital. He is the author of two investment books, including The little Book that Beats the Market. Greenblatt tries to find both cheap and good companies. He looks for value with a catalyst. Greenblatt likes special situations, and thinks that they are simply different places to find cheap stocks. In his own hedge fund, Greenblatt uses the basic principals in the Magic Formula: Look for high ROIC and high earnings yield (the opposite calculation of the P/E ratio). He tries to figure out what "normalized earnings" will be 3-4 years into the future.

I mentioned many times in my blog the importance to study what top hedge funds hold in their portfolios. Let’s review Gotham's current holdings.

Gotham’s second biggest holding is Gamestop (NYSE: GME). I highlight that 3Q results came better than the market expected in advance of the acceleration into the next generation console cycle (Nintendo Wii U). In the last report, the company gave several strong points:

  • GameStop repurchased 3.7 million shares and also announced that the board of directors has approved a new $500 million share repurchase plan, replacing the remaining $242 million available on the existing authorization. I like companies that buy back its own shares.
  • Gamestop produced very strong margin expansion during the quarter, up 200 basis points year-over-year and 260 basis points in 2 years.
  • The transformation into a more digital oriented model is performing well. GME management is transforming the business model towards richer margins through the creation of the new categories of digital and mobile to supplement the company’s pre-owned and new software and hardware. In fact, digital sales increased 32% over the third quarter, with strong growth in PC digital at 55% and console digital growing at 20%
  • New consoles will drive growth in the coming quarters lead by the new Nintendo Wii U. Gamestop has nearly 500,000 customers on its Wii U reservation wait list worldwide, expecting strong demand for this console. Wii U software is also reserving very strong with over 1.2 million reserved titles worldwide.

I think that Gamestop has an attractive blend of new products, easy comparisons, favorable mix shifts, and a shrinking capital base. These factors should drive earnings growth and improved returns starting in 4Q and continuing through FY13. Shares are attractively valued at a Forward P/E of 7.5x, an EV/EBITDA of 3.46x. The balance sheet is solid with no long term debt and strong retained earnings which creates a high ROIC, a metric that Joel Greenblatt focuses when selecting stocks.

Gotham also holds Dolby (NYSE: DLB), a position the fund increased by 21% last quarter. Dolby laboratories is a leader in sound technology and a growth story that the market played until 2010. Dolby's playback technologies are embedded in most home theater systems, DVD and Blu-Ray players, PCs, and set-top boxes. Dolby is also licensing its sound technologies for mobile phones and tablets including new licensing deals for the Samsung Galaxy SIII and Amazon's Kindle Fire. In addition, Dolby's media servers, projectors, and audio products are installed in many theaters around the world.

I highlight that Dolby has a very solid balance sheet and compelling valuation. The company has no long-term debt or off-balance sheet liabilities. Dolby's ROE and ROIC for FY2012 were 15% and 26%, respectively. The stock trades at a P/BV of just 1.7x, a reasonable Forward P/E of 14x and an EV/EBITDA of 5.5x. In terms of multiples, the undervaluation opportunity seems quite obvious.

While I think the stock is cheap I stay away from this stock considering the declining revenues that Dolby is experiencing and the potential ¨patent cliff¨ the company could experience in 2017, when its most important sound patents expire. Dolby's revenue declined by 3% in FY 2012 compared with FY 2011 and net income fell more sharply, by 14.5% YoY.

The patents on Dolby Digital will expire between now and 2017. It is important to highlight that Dolby's licensing revenue is dependent on the company's large IP portfolio. If the company fails to replace these patents with new patents, the company's revenue can decline materially. Here is an article that explains very well the problems that Dolby could face in the future.

The third company I would like to describe is Tempur-Pedic (NYSE: TPX). It is interesting to note that TPX went from $87.50 to $30 in just 8 months. That downtrend is the result from several missed quarterly earnings reports that started in April 2012.

In the last Q3 results, Tempur-Pedic also fell short of expectations, reflecting continued competitive pressures in North America, slowing trends in Europe, as well as the cost of initiatives designed to jump-start growth. Tempur-Pedic revenues fell 9.2% year/year to $347.9 million vs the $362.48 million consensus. Mattress sales decreased 11% globally in the third quarter of 2012.  The company also lowered its 2012 adjusted EPS guidance, after having raised it in July. Despite some signs of stabilization in North America late in the quarter, I am skeptical on Tempur Pedic given weakening trends in Europe, a distinct lack of visibility, as well as uncertainties regarding the strategic rationale behind the pending Sealy acquisition.

Tempur Pedic bought Sealy (NYSE: ZZ) because the company was facing broad based competition and declining results. Sealy expands its market presence and distribution channels (while coupling with a competitor). Tempur made this deal in order to benefit from long term revenue synergies which will be visible over three years and cost synergies, which will be realized in the near term.

martinzaldua has no positions in the stocks mentioned above. The Motley Fool owns shares of GameStop and Tempur-Pedic International. Motley Fool newsletter services recommend Dolby Laboratories and GameStop. 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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