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Value Workshop: Indigo (TSX:IDG)

We're putting Indigo Books & Music (IDG on the TSX) under the microscope today.

Let's kick things off on a bullish note with a nice presentation given by Jeffrey D. Stacey, CFA, of Waterloo-based Stacey Muirhead Capital Management to George Athanassakos' class at the Richard Ivey School of Business which is linked below.

Jeffrey Stacey's Lecture [21-36 Min]
Jeffrey Stacey's Slides [Pg 10-17]

While the entire lecture is well worth you time, the Indigo section starts at about the 21 minute mark and slide 10 in the accompanying material. As a short cut, the slides make a very concise case for Indigo with slide 15 highlighting an important strength of Indigo's balance sheet. Namely, the firm has a big cash hoard.

But Stacey's talk was given in February 2010 and Indigo has since posted its Q1 results. At the end of Q1 the firm had $84,314k in cash (not including a small amount of restricted cash). Q1 also marks the typical yearly low point for the company's cash and, as a result, current cash levels represent a low estimate of how much money the company could pay out to shareholders should it choose to do so. (An aggressive CEO could lard up Indigo's balance sheet with debt and pay even more.)

In any event, Indigo had about 24,731k shares at the end of the quarter and 1,815k in options for a total of 26,546k shares (or equivalents). As a result, it has nearly $3.18 per share in excess cash.

(To be sure the company is finding uses for the cash. It's testing a new Pistachio store concept and pushing into the eBook market via kobo.)

Indigo's stock is currently (August 12, 2010) trading at about $15 per share. If you take out the cash, that falls to roughly $12 per share. Meanwhile, Indigo earned $1.31 per share over the last year with most of its profits being generated in the important Christmas season. Because cash doesn't generate much in the way of income these days, the firm's P/E ratio, after extracting the excess cash, is about $12 divided by $1.3 or 9.2 which puts it nicely in value territory.

In other words, Stacey's bullish case still stands. But the company isn't without risk due to the advent of eBooks. It also brings me to the main reason for posting this article.

I was approached, some time ago now, by Aly G. Mawji, CA, of Value Beacon who wanted a little feedback on his valuation methods. So, I had him investigate Indigo with a view to get a second opinion on the firm. (I've personally been following the company since late 2002 when it traded at only $4.25 per share.)

Check out his overview on the firm and his valuation spreadsheets via the links below. (Much like Stacey's presentation, Mawji's work was largely done a few months ago.)

Indigo Overview
Indigo Valuation Spreadsheets

Importantly, Mawji would very much like to receive constructive criticism. If you can suggest improvements to his approach, please send me an email and I'll pass it along. I'll also add good suggestions, or criticisms, to this page. (If you've a position in IDG, please say so.)

The idea here is to try to develop a nice moderated discussion of Mawji's analysis and of Indigo, as an investment, more generally.

But, before being accused of being too bullish, I also want to highlight Tim McElvaine's recent move to trim his position in Indigo. McElvaine, CA, CFA, runs McElvaine Investment Management and he reduced his fund's 15% position in Indigo at the end of March to 8.6% by the end of June. He also talked a little bit about the company at his recent conference and I direct you to page 26 of the transcript linked below.

Partners' Investment Conference [Page 26]

McElvaine's decision to sell a big fraction of his investment in Indigo isn't what I'd call bullish.

But, what do you think? Is Indigo a good buy or destined to decline?

Gino Caputo was kind enough to send along the following comments ...

Financially, the company is sound. Balance sheet is strong, liquid and no issues here.

I would recommend staying away from using DCFs. While it is theoretically correct there are way too many variables to consider and not to mention relying on relatively large terminal values that are so sensitive to future growth rates.

I prefer starting with asset value (reproduction value for a going concern). I calculate reproduction value between 400MM and 500MM (this assumes 3 yrs of capitalized SG&A expenses which assumes a new competitor who would have to build that level of market branding....not scientific but 3 yrs worth seems reasonable.

2nd, I calculate the value of their earnings power assuming no growth. if you assume the 30MM of earnings is sustainable and assume 15% discount for the inherent online & technology risk than you get 200MM of earning power value + 75MM of excess cash for 275MM or $11/share of equity value assuming no growth.

I would not pay for growth here as the future is too uncertain..15% seems high given overall low interest rates, but I don't see strong incumbent competitive advantages so I would need to earn min 15%....perhaps even 20% if the future is really one of negative growth because of competitive threat

None of the competitive advantages outlined by Mawji are actually competitive advantages. Competitive advantages are those that are not replicable by new entrant competition.....each of the ones he listed can be replicated. Having said that, there does seem to be some persistency in the company's ROC which has been in the mid to high teens and suggests possible franchise value. (would note that the current earning power appears to be in the 30MM range and not +40MM....he uses CFO which appears to have benefited from spontaneous working capital changes.....EBIT appears fairly simply and accurate for this business so the company's reported earnings appear reasonable. Also, growth came from new store openings....comp's were negative. The stock is trading with an earnings yield of 13% net of excess cash (I assumed 1.30 run rate eps and 75MM of excess cash). So from a valuation perspective the stock is not expensive. However, going back to the competitive advantages....I just don't get there are strong competitive advantages here....gut feel. online threat is real and even though they are pursuing the online initiative with Kobo, they are late in the game and I don't believe they'll have any competitive advantages in the online world as new and late entrants.

More on competitive advantage...I'm not an expert here but, here are some questions I would dig deeper in;

1. Do they have a demand advantage - do they have captive customers? I buy my books from Amazon off the web....I like to read real books not electronic so I do think there is a segment of the population that still enjoys the romance of reading a paper back vs wiping an electronic screen with their finger. 2. Do they have a meaningful scale advantage concentrated in a local the fixed costs of this business large in relation to the market size and their share of market whereby a would be competitor would have a tough time paying for the fixed costs without share of market required to build that scale?

So is this a 13% earnings yielder that will slowly reduce.....I think. Balance sheet is strong so there doesn't appear to be risk of permanent impairment.

Contrast this to say MSFT which is currently trading at 10% yield + valuable franchise growth....I'd rather take MSFT than IND at these prices.

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