An Analysis of a Chinese Hotel company

Insight views Home Inns and Hotels Management Inc. (HMIN), a Chinese hotel company, as providing broad exposure to the Chinese economy, ex exports. The Chinese economy is growing quickly, and Insight views such growth as likely to continue for many years to come. In addition, an investment in HMIN will benefit from a weak dollar, which Insight views as likely to continue.

Insight conducted a market opportunity analysis for the company. The general idea was to use hotel penetration and revpar (revenue per available room) in 2009 in the US as a basis for determining the total Chinese hotel revenue opportunity. To do this it was necessary to ascertain when Chinese GDP would catch up to 2009 US GDP. Having done the above, HMIN's market share and margin could be estimated , capitalized, and then discounted back to get the present value of HMIN stock.

Implicit in the analysis is the assumption that hotel usage in China 19 years from now will constitute a greater share of GDP than it does in the US now. This assumption was made based on the hugely greater Chinese population vis the US and thus what Insight believes will be greater domestic demand for leisure services in China than in the US. Insight also believes foreigners will provide significant demand for tourism China in future years, although such demand has not been quantified in the current analysis.

Available data suggests that the total number of hotel rooms in the US today is about 4.7 million, and the current US GDP is about $14 trillion. It was then calculated how long it will take Chinese GSP, currently around $3.4 trillion, to get to current US GDP of $14 trillion. Chinese real GDP has averaged about 10% growth annually over the last 19 years. In the analysis this figure was haircutted and 8% average annual real GDP growth was assumed for the next 19 years, which leads to the conclusion that after 19 years Chinese GDP will be about at 2009 US GDP levels. It was then calculated what the total revenue opportunity for the Chinese hotel market will be in 19 years assuming the same proportion of hotel rooms in China as exists today in the US. The Chinese population today is about 1.3 bn, or some 4X greater than the US population. Based on this demographic analysis it was assumed that there will be about 4X more hotel rooms in China 19 years from now as there are in the US now, or some 20 mn. Since it was assumed that Chinese GDP will be in 19 years the same as US GDP today, it was assumed that in 19 years, the revpar in China will be the same as in the US today. Marriott International's recent revpar of $100 was used in Insight's calculation. The total hotel revenue opportunity in China 19 years from now was then calculated. Revpar of $100 times 360(days per year) times the projected number of hotel rooms (20 mn) =$728bn. It was assumed that HMIN will remain one of the top ten economy brands in China over the next 19 years and at that time have a 5% share of the total market, or some $36 bn. Marriott's net margin was in the 20% area in 2006, a good year, so it was assumed that HMIN would have a net margin of 15% for total net income of $5.5 bn. Let's assume the market puts a 15 PE multiple on this net income for a total market cap of $82bn. HMIN's beta is 2, and to be conservative this market cap was discounted at 15% over 19 years for a total present value of $ 5.8bn. Based on a current share price of about $35, the current market cap is about $1.4 bn.

Thus by this analysis HMIN provides an opportunity for a potential 300% return. Even if it is assumed HMIN only gets a 2.5% market share it provides potential for a 100% return from here. Please note the above analysis contains several assumptions, which may not hold or come to fruition. Still, Insight views HMIN as an investment with significant potential.

Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
insight-asset@earthlink.net

Insight Asset Management LLC is currently long Home Inns and Hotels Management Inc. (HMIN) in its model portfolio and in its client portfolios

March 2009: The Market is Treacherous Still

The market has been rallying I think on optimism about the TALF plan and the related plan to get toxic assets off of bank balance sheets. Also, and more importantly to me, the economic numbers such as home sales and durable goods numbers have been better (and in a way too good. Given the state of the world the durable goods number seems odd. I wouldn;t be surprised to see downward revisions). For the private equity firms, buying toxic assets and asset backed paper are in essence LBOs financed by the government, providing the private equity firms with call options on the economy. But how do the private equity firms get a low enough price to make a good profit? I think the answer lies in the government owning big pieces of the major banks. The government through "stress tests" will put pressure on the banks, forcing them to either sell assets at a cheap enough price and line up private capital to cover shortfalls or merge with another bank, or the government will seize the bank. The government I think hopes that via this approach, while the government will have to pony up some capital, a lot of the capital will come from the private sector. Will this work? You cannot get water from a stone, and alot of toxic assets are terminally so--CDOs, CLOs, and many CMBS securities worth maybe $.25 on the dollar. Also as Chanos pointed out in the Wall Street Journal only a small percentage of toxic assets have been truly marked to market. I think we will see further consolidation in the banks. And Geithner's hands may be progressively tied. Congress is going to be very reluctant after AIG to ok more bailouts. If this toxic asset plan does not work the government is going to have problems, and will probably try an end run around Congress via the Fed and FDIC (as they are doing even now). Zombie banks, ala Japan, are still not out of the question, as the government hopes time, spread lending, and moving away from mark to market accounting will help the banks.

What of the "stimulus program?" Much of it is fundamentally based on taxing and and spending, rather than truly on investing. It looks like US debt is going to double to about $20 trillion within 10 years, based on what's been provided. I think in the end the present government is counting on nationalizing health care and putting price controls on doctors and drug companies and cutting back drastically on social security to the "rich", under the present government’s basically redistributioning wealth to the "poor", non-capitalist agenda. You can see the US moving very deliberately now to a European style soft socialist model. Ironic that the government is trying to use the private sector and private equity and hedge funds to bring this about. While the "stimulus" may provide a near term boost, and the Fed is trying to use the same playbook it has used for a long time of inflating us out of problems, I can't see where the framework is now being set for robust economic growth. Becker, a Noble Prize winning economist pointed out in the Wall Street Journal that the multiplier effect of government spending is less than 1. I think government efforts to prop up the housing market may have some small effect in the short run,but in the end impede price discovery, and impede a bull market in real estate. We are entering an era of increased regulation, higher taxes, government debt crowding out private sector investment, coupled with cutbacks in defense. Europe has endured chronically high unemployment and subpar GDP growth under such a regimen. The government is too cute by half, in my view. They are trying to use the private sector toward their redistributionist ends, rather than letting private enterprise flourish via low taxes and as little government intervention as possible. It's interesting to see how much the US has gotten away with. We have the privilege of being able to denominate our debt in dollars and having the world's reserve currency along with 30% of world GDP. Absent this, given our huge run up in debt our currency would share the same fate as Iceland's or Hungary's. And even so we are beginning to see strains in the Treasury market. If Treasury yields rise appreciably, which could happen as China pulls back from buying our debt and in the midst of heavy issuance, reverberating problems in the markets could arise. The government has taken a radical Kenynesian approach in what amounts only to a grand experiment, based on the view that FDR's New Deal led the US out of the Great Depression. It can easily be argued that FDR’s New Deal did not work, and instead World War II, and the world wide demand for US manufacturing is what did work to put the economy on the right path. Currently, at about 20X potential trough earnings, the S&P 500 is not cheap. In my view, this remains a treacherous market due to the global structural problems we have not witnessed since the Great Depression. Bear market rallies can be seductive. In Insight’s model portfolio, therefore, much cash is being held along with short positions as hedges against limited long positions. There will be a time to allocate heavily to long equity positions. The markets now are in much flux, and that time could come soon, depending on a variety of factors including valuation. But that time has not yet arrived, in Insight’s view.

Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net

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Four Ideas

1) The government is exchanging preferred for common re: Citigroup, and mandating that no dividends be paid to preferreds. Through its actions, the governmentt has basically compelled the other preferreds of Citi to convert to common: If you're not going to get a dividend, you might as well at least get a vote by converting to common. Govt actions have made the preferreds of other companies worry that the same fate applies to them, and in so doing upended the whole preferred market, just as happened when the govt took over Fannie Mae. Another unintended consequence of govt meddling in private business.

2) Re: banks. Where are we? The government is backing away from doing something about toxic assets , instead moving again to capital injections. The govt won't nationalize or put the banks into receivership for fear of another Lehman-like effect on the market. But this course of action leads down the path of a Japanese style lost decade. There is no easy way out of the current predicament.

3) I cracked out by macro notes from my MBA studies, and my macro textbook, co-written by Bernanke no less. What determines investment? I f(-r, -t, Af). Investment is negatively affected by higher real interest rates, negatively affected by higher taxes on investment and positively affected by the future marginal product of capital , which itself is a function of productivity. In the long run the government's massive issuance of debt will likely raise interest rates. Unless the government can repeal the laws of economics, higher taxes and issuance of govt debt should hurt investment which will in turn hurt GDP, which will in turn hurt the stock market.

4) Re: taxes--The new administration wants to eliminate the tax shield that companies get from conducting business abroad. This is a big deal. Many of the companies I model have effective tax rates in the 25% range because of this tax shield. If you move from a 25% tax rate to a 35% tax rate, EBITDA (1-t) goes down by in excess of 10%. And incorporating this into my discounted cash flow (DCF) models, DCF price values are lessened by 20% in several cases I've looked at. There is a reason the market is falling. If 600 to 700 was a price target on the S&P before, 550 to 650 is a credible price target now, and that's assuming we have a depression with a small d and not a Depression with a big D.


Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net

Berkshire Hathaway Class A (BRKA) Would Be Conservatively Valued at $152,000 Per Share

Berkshire Hathaway stock (BRKB) is a core holding in Insight’s client portfolios. BRKB has the same claim on Berkshire Hathaway’s assets as does Berkshire Hathaway Class A stock (BRKA), but is worth 1/30th of BRKA, which makes BRKB more affordable. BRKA recently sold for $140,000 per share. The stock may be under some pressure after its recent earnings release, showing a quarterly earnings decline. Those who use PE ratios to value stocks may also focus on the stock selling for 16X trailing earnings, with the prospect of a tougher insurance climate in 2008. However, PE ratios are the least sophisticated way to value stocks, and I believe BRKA would be conservatively valued at $152,000 per share. If the economy should surprise on the upside, a case could easily be made for a BRKA price of $180,000 per share. Further, BRKA with its $38 billion in cash and strong balance sheet, is well positioned to make opportunistic deals. In the years to come I believe activist hedge funds may well push for spin-offs and the like which will further realize Berkshire Hathaway’s (Berkshire) value.

What follows is a very conservative analysis which supports the view that BRKA’s stock price is certainly not overvalued, and that BRKB and BRKA are excellent holdings in today’s turbulent market. I utilized four valuation methods in valuing Berkshire Hathaway: a discounted cash flow analysis, price/book, look through earnings, and a sum of the parts analysis.

First, I conducted a 30 year discounted cash flow analysis (DCF) by adding taxed earnings, look through earnings (tax effected), and depreciation, and subtracting capital expenditure, and acquisition expense (projected by using historical acquisition expense as a percentage of revenues). I assumed 5% in annual growth in revenues, 10% operating margins declining to 8% operating margins in later years, 3% growth in perpetuity, and an 8% discount factor. I also assumed growth in look through earnings will slow from 10% to 8% over the years. Working capital is not easy to forecast, and a case can be made for either positive or negative working capital needs, so working capital needs were not incorporated in the DCF. As a check I calculated on a revenue basis what Berkshire’s share of GDP would be under my model in year 30, as compared to share of GDP presently. The fact that GDP share would be roughly comparable in year 30 suggests I am not being overly-aggressive in my revenue growth assumptions. The discount factor of of 8% is based upon CAPM which includes a risk premium of 4.5% , a riskless rate of 4% ( a little higher than the current ten-year treasury interest rate, to be conservative) , and a beta of 1. I assumed Berkshire will have the same beta as the S&P over the long-term. This is actually a conservative discount rate as one could argue that Berkshire’s cost of capital is substantially lower. I have treated acquisitions as an expense even though this item does not flow through the income statement. Growth through acquisition has been a major component of Berkshire’s strategy over recent years as it has transformed itself into a conglomerate. And acquisitions, whether by way of cash or by the issuance of stock represent an expense (cash) or a cost (stock issuance) to the Company even though this expense or cost does not run through the income statement. The DCF suggests a conservative valuation of $141,000 to $150,000 per share for BRKA.

Since Berkshire is conservatively capitalized and relatively unleveraged, its ROE is lower than that of a more leveraged entity. I believe that some investors make the mistake of seeing this lower ROE as making Berkshire less valuable than an entity with a higher ROE. Rather, I see Berkshire’s lower ROE as indicative of a less leveraged balance sheet, and thus of a company which will hold up better in a market correction, as it has proven in 2007. In addition, stated accounting ROE actually underestimates economic ROE, as stated ROE excludes look through earnings.

In general, I believe Wall Street does not fully grasp Berkshire as an entity. It is vastly transformed from what it was several years ago when it was largely an insurance operation with a portfolio of common stocks. Over recent years Mr. Buffett has transformed Berkshire into what we it is now as part conglomerate (with additions ranging from the Israeli company Iscar Metalworking to MidAmerican Energy Holdings to Shaw Industries to Clayton Homes), part hedge fund (which has included a significant bet against the dollar, and in the past a large bet on bonds), and part a portfolio of common stocks. )

The stock was recently trading at 1.80X book value, a 1/3 discount to the S&P 500 average of 2.7X (at 12/31/2007). I see Berkshire’s non-insurance parts as being worth at least the 2.7X book of the typical S&P company. Given Berkshire’s diverse interests, I believe that the S&P 500 average book value is a better comparison for the stock than are other insurance companies whose sole business is insurance. Incidentally, if we add back to book value ½ the liability of deferred taxes and the full value of unearned premiums, Berkshire is trading at 1.6X book value. Since Berkshire’s non-insurance earnings before tax (EBT) and minority interest constitute about 45% of total EBT and minority interest, it could be argued that Berkshire’s proper price to book should be a blended rate of 45% of the S&P 500 average book value, and 55% of the average book value of 1.08 of various insurance companies (which has been depressed by the travails of AIG and the problem of writeoffs). This is about where BRKA recently traded, at $140,000 per share.


Let us now look at Berkshire on a look-through earnings basis. Look through earnings are earnings of companies in which Berkshire holds minority investments, in proportion to shares owned, treated as if they are Berkshire’s own earnings. Dividend income is subtracted to avoid double counting. In essence look through earnings account for minority investments as if they met the criteria for utilizing the equity method of accounting. I estimate BRKA is now trading for 13X trailing look through earnings. If we use a conservative 15X 2007 earnings multiple to value Berkshire, a fair price per share for BRKA is $156,000.

Let us now look at Berkshire on a sum of the parts basis. First, the current value of Berkshire’s cash and investments minus all liabilities (excluding unearned premiums and ½ of deferred taxes) is computed. This amounts to $4,900 per share. Next I value the current insurance business by placing a 10X multiple on EBT. This amounts to $52,500 per share. Next I value Berkshire’s float by utilizing a ten-year DCF, growth in float year per year of 5%, conservative margins of 10% on float, and growth in perpetuity of 3%. This DCF indicates that Berkshire’s float should be valued at $49,000 per share. I next value the non-insurance business, assuming a 10X multiple of 2007 trailing earnings before tax. This amounts to $43,500 per share. Next we determine the value of Berkshire’s after-tax investment gains exclusive of its equity holdings. This would include such things as its previous bets against the dollar and bets on bonds. These investment gains have averaged $2,750 per share over the last five years. If we put a 10X multiple on this number, we come to a value of $18,000 per share. This sum of the parts analysis suggests a fair price for BRKA of $168,000 per share.

Overall then, whether we use a price/book value approach, look through earnings, a discounted cash flow analysis or a sum of the parts analysis, Berkshire appears undervalued. The average of all the valuations conducted provides the best estimate of BRKA’s value. This average estimate is about $152,000 per A share, some $12,000 per share more than its recent value of $140,000.

Concern has often been expressed that no successor could duplicate Buffett’s prowess. Insight has shared similar concerns. However, the valuation work above assumes almost no Buffett premium. Even in the sum of the parts analysis, if the investment gain portion of $18,000 is subtracted, BRKA would still be worth $150,000 per share in the sum of the parts analysis. The Buffett model of acquisitions in which talented managers are left to run their businesses as they see fit, puts Berkshire on very solid footing even after Buffett is no longer at the helm.

Further, I view Buffett’s donation of Berkshire stock to the Gates Foundation as a long-term positive for the stock. As the Gates Foundation sells its Berkshire stock, activist hedge funds may well be buyers and push for a break up of Berkshire, which as the sum of the parts analysis shows is undervalued. Further, stand alone entities such as MidAmerican and Geico would quite possibly fetch even higher valuations than are implicit in my modeling. The future activity of activist hedge funds could eliminate Berkshire’s holding company discount, in my view.
In addition, Berkshire’s strong balance sheet, with some $38 billion in cash, provides outstanding opportunities in these turbulent stock market times. Berkshire’s deal with Swiss Re, its deal with the Pritzkers for Marmon, its creation of a new bond insurer, are but a few examples of Berkshire’s saavy. Whereas many companies are value destroyers with ill timed stock buybacks and poor acquisitions, Berkshire has shown itself to be a master allocator of capital in which building shareholder value is paramount.

Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net


Note: Insight Asset Management LLC is long BRKB in its model portfolio, and in its client portfolios.

EchoStar’s SpinOff and the New Teleommunications and Media Landscape

The telecommunications and media landscape is evolving as mobile networks and devices assume more and more prominence as firms strive for control of the underlying software, hardware, content, and networks . EchoStar has significant strategic value in this process. A spun off entity from EchoStar will become effective 1/1/2008. This entity will house EchoStar’s infrastructure assets (SATS), while the remaining entity will be comprised of EchoStar’s pay-TV business (the new Dish). Insight has an interest in both entities post-spin. This is a special situation where value is fairly independent of what the overall stock market does. There is some belief on Wall Street that AT&T is interested in the non-spun entity, the new Dish. There is a law that except in certain circumstances, in the event of a spin-off , a stock deal cannot be done for two years afterward. So it would appear that an AT*T purchase is less likely (they could always do a cash deal), post the spin off. Perhaps this means a DirectTV-Echostar deal is more likely. Based on reports, it looks like there are $3 billion in synergies to be gained from a DirectTV or AT&T merger. That works out to about $44 per a new Dish share (tax effected with a 10 PE slapped on synergies). So even if the synergies are split evenly with the acquirer, there should be $20 per share upside to the new Dish if it is acquired. I think this EchoStar’s spin-off is ultimately about an acquisition, either by AT&T or the new Liberty Entertainment and DirectTV. As far as SATS, as an infrastructure company, it may get a higher valuation. So
post-spin, Insight has an interest in both the new Dish and SATS. This deal also underlies Insight’s interest in the spin creating Liberty Entertainment by Liberty Capital which will contain a big chunk of DirectTV. Given the possibility of a Democrat controlled White House and Congress in 2009, there is some pressure I believe to get mergers done in 2008. This factor also provides impetus for an EchoStar deal.

Note: Insight Asset Management LLC's model portfolio currently has long positions in Liberty Capital and EchoStar



Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net

Thoughts on Google's Valuation

The price action in Google has been good lately, no question. In general, there has been a market rotation into technology. As interest rates rise, tech is viewed as being less interest rate sensitive, and more removed from a feared economic slowdown which will affect the consumer first. As to Google's valuation, it all comes down to what decision is made about the terminal multiple. In Insight's 30 year discounted cash flow analysis (DCF), a 25% return on invested capital in year 30 has been assumed, as has been a 3% required growth rate. The big question is how to estimate capital expenditures (cap ex) in the terminal year of the DCF. I believe the formula: EBIT * (Required Return/ROIC) is a good one for estimating cap ex. So, Multiplying EBIT by (1- required (growth of 3%/roic of 25%)),dividing by the perpetuity of the discount factor minus 3%, and discounting thirty years back gets you to a stock price of about $525, in Insight's analysis. Now it so happens that this is equivalent to a terminal EBITDA multiple of about 5.5 times. MSFT currently has an EV/EBITDA multiple of about 12X. So if you believe the argument that Google should have the same EBITDA multiple in year 30 as MSFT currently has, a stock price of $800 per share would be indicated. However, I believe that the market is using a higher discount factor to value tech companies than is suggested by the Capital Asset Pricing Model (CAPM). One possible reason for this is that as interest rates rise, tech companies may be disproportionally affected since so much of their valuation stems from the out years. (It is ironic that as interest rates rise presently we are seeing a rotation into techology stocks). Still, based on a PE ratio to growth (PEG) analysis and a DCF sensitivity analysis, the argument for a $600 stock price for Google does make some sense. Insight does hold some Google in its client portfolios. Yet, with a forward PE of about 27X, Google is not cheap and does have significant potential downside. Insight in general feels more comfortable investing its client's assets in stocks with cheaper enterprise values/EBITDA and cheaper PE ratios.



Philip Frank, PhD
President and Portfolio Manager
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net

Special Dividends as a Means of Doing Deals By Shrinking Shareholder Equity

Merger proxies are quite revealing. I have closely read the merger proxy in which ABC Radio Business is to be spun off from Disney to Disney shareholders and then merged into Citadel Broadcasting. This deal was structured as a reverse Morris trust which enabled both the shareholders of Disney and Disney to escape any taxation. But to structure a reverse Morris Trust it is necessary that a larger entity be merged into a smaller entity. Pre-merger Citadel's equity was valued more highly than ABC radio stations. So, how did the companies manage to structure this deal as tax free? A special dividend will be paid to only Citadel shareholders prior to the merger with the ABC Radio Business, thus increasing debt and shrinking Citadel's equity and enabling Disney to have a greater than 50% equity interest in the merged Citadel-ABC entity.

Earlier this week I did some work on the $325 million investment of a private equity firm into Palm in return for a 25% interest in Palm. Here also a special dividend was paid out to Palm shareholders, at the same time that their equity interest was reduced to 75%. This special dividend was promoted as being very shareholder friendly by both providing shareholders with a cash payout while allowing them to retain an interest in the new entity's equity. In reality though the special dividend functioned to shrink shareholder equity of Palm so that the private equity firm would have to pay less than it would have otherwise for a comparable percentage stake in the entity. Had the special dividend not been instituted, in order to gain a 25% stake in Palm, the private equity firm would have had to pony up some $550 mn, as opposed to the $325 mn it did pay.

So in both these cases the aim was to shrink existing shareholder equity: In the first case so that the parent spinning off a subsidiary would avoid tax, and in the second case so as to make it cheaper for a PE firm to gain a large voting interest in a public company. In both cases the special dividends were promoted as being shareholder friendly. In both cases I believe the special dividends were structured so as to enable transactions to proceed. After all shareholders could simply have sold their shares to raise cash had they so desired. Since the special dividends served to foist increased debt on both companies, other than in providing the discipline that all debt forces on managers, I can see no particular benefit to the shareholders involved other the lesser tax owed on dividends than capital gains. Still, I think these tax benefits to shareholders were not the primary motivation: Getting the deals done was the primary motivation. A company choosing an innovative deal structure in order to get a deal done does not in of itself make that company a long or a short. At Insight we believe though that understanding the structure of deals is important to understanding valuation which is key for investment decisions



Philip Frank, PhD
President and Portfolio Manager
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net