Sunday, May 13, 2012

RSY: Buy CNAF, CMO, Optional Options, Update

The rejection of the offer by Covington to purchase all outstanding shares of Advocat (AVCA) represents a missed opportunity for capital gains in this position for the RSY portfolio. Covington luckily has kept the offer open and have written a letter to shareholders expressing their position in support of the buyout (Reprinted below.). If the offer was dead, then we might expect a drop to pre-offer levels at around the mid $4 range as even stated in the letter. That exposes the portfolio to volatility, but with that possible opportunities to unload either the first tranche or the complete position as stated in the last RSY post.

One stock to look at more closely is Commercial National Financial Corporation (CNAF). It has above average forensic accounting score with low downside risk that should outperform the market over the medium term. Sabrient gives CNAF excellent marks in growth and momentum that are rated over 88 both (ratings 1-100). And importantly to the RSY portfolio it has 71.6 in value, 94.4 in earnings, and a fundamental score of 80.5.

Another stock that shows great potential is Capstead Mortgage Corporation (CMO) which is a REIT in the Real Estate Operations Services. Just like CNAF, CMO has higher growth potential with lower risks and above average forensic accounting score. The Sabrient Fundamental Score is the broad measure of a company's financial health, including its balance sheet, cash flow, revenue, and earnings quality. With a Sabrient Fundamental Score of 95.8, Capstead Mortgage is substantially higher than the average of its industry group, which carries a Sabrient Fundamental Score of 59.8.

Even though CNAF is a regional bank like our position in PULB and BRKL, and CMO is a REIT in the Real Estate Operations industry like IVR, RSY recommends getting long positions in both but of limited size with a limit order of 200 shares of CNAF at a price of $25.01 (GTC). And place a limit order of 300 shares of CMO at a price of $13.21 (GTC).

Optional Options...
KRO expired this Friday worthless and the RSY pocketed the $1.45 per contract at 400 shares for around $569.00. This obviously gives us a chance to write another covered call which RSY recommends writing 4 contracts of KRO Nov-12 $17.50 call options at a limit price of $3.3 (GTC), 1 contract of ARLP Dec 22 '12 $60 call options at a limit price of $4.00, and 4 contracts of IVR Oct 20 '12 $18 call options at a limit price of $0.70 (GTC). Both KRO and IVR are rated Strong Buys by Sabrient Systems and RSY recommends holding on to these two. ARLP is rated a hold now but even though down from initial purchase, but have maintained close to break even with dividends and options sold.

Transactions Update
The table below shows the RSY model portfolio transactions since the beginning of this year, and below that our current positions in the model portfolio and lastly the open letter from Covington to shareholders of AVCA.

(Click to enlarge.)

Dear Fellow Shareholder:

We are extremely disappointed by the response of Advocat Inc.'s Board of Directors on May 14, 2012, rejecting our proposal to acquire all common stock of Advocat for $8.50 a share in cash. Just two business days after our letter and press release on May 11, 2012, the Advocat Board released a letter that says it has thoroughly evaluated Covington's proposal and rejects it in favor of pursuing its own strategic plan. Advocat's letter states that the Board takes its fiduciary responsibility seriously and has thoroughly reviewed our proposal, but it appears to us that the evaluation of Covington's high premium offer was done without obtaining outside advice from an independent financial advisor.

Our proposed price of $8.50 a share represents almost a 100% premium to the unaffected share price and values Advocat at premium multiples compared to other publicly traded skilled nursing facility companies. We believe it is a compelling proposal. Advocat's Board indicates our offer is inadequate, but does not articulate how its strategic plan (which, as indicated in the Attachment to this letter, has not significantly evolved in years) will achieve more value in the foreseeable future. As shareholders, you have a right to understand the clear basis for the Board's determination of the inadequacy of our offer.

Advocat also indicates its stock is undervalued. We believe that the unaffected stock price reflects the uncertainty of Advocat's strategic plan and that, in the absence of our offer, it will stay at or around the unaffected price based on the Company's performance. We are offering a near 100% premium to the unaffected price to finally allow shareholders to achieve a return at a full and fair price. One need only look at a stock chart to recognize the shares have not appreciated in value and have traded in a fairly tight range for the last several years in spite of the strategic plan referenced by the Company. Our offer also eliminates the substantial industry and strategic execution risks facing the Company.

Advocat in its letter states that its strategic initiatives and investments will generate value that "will be realized over the next several years." We disagree. These strategic initiatives have been discussed by the Company in its quarterly earnings calls and SEC filings for the past several years. However, recent quarterly earnings do not show any track record of significant improvement. Moreover, the Company's own proxy statement filed on April 30, 2012, points to declining financial goals in terms of setting the bar for executive compensation. Specifically, the proxy states that 40% of the bonus for executive officers is based on operating income performance. It then states that the budgeted operating income, as adjusted, for 2012 is $9,299,000. This compares to the budgeted operating income in the 2011 proxy for determining executive bonuses of $11,556,000, a 20% decrease. Actual operating income, as adjusted, for 2011 was $6,127,000. How long must shareholders wait for things to improve such that value in excess of $8.50 a share is created for shareholders? And why should shareholders accept operating income levels for determining bonuses that actually decrease? The Company appears to be aiming lower not higher.

Rather than seeking independent shareholder input on our proposal, Advocat put forward that the opinions of its Chairman and Vice Chairman of the Board "serve as useful proxies for the views of many of [Advocat's] shareholders." We think it is important that the Board consider what is in the interests of all shareholders, not just "two of [its] significant shareholders" who have financial interests as directors that are not the same as the other shareholders. Moreover, contrary to the Company's assertion, the objection of these shareholders is not determinative of the successful conclusion of a negotiated merger transaction, and should not be a legitimate reason to support a decision not to engage with us. We do not understand how the Board can put a "not for sale" sign on the Company, especially in the face of an offer with such a significant premium relative to the Company's strategic plan which simply has not materialized.

In its letter, Advocat implies that it has engaged with Covington by referring to a meeting with two directors solely "in their capacity as significant shareholders" of the Company. However, they did not say anything or ask questions at this meeting. In our view, a one-sided conversation does not amount to engaging with us, and we remain perplexed at the Company's continuing refusal to do so.

Please join us in expressing your dissatisfaction with the Advocat Board's decision. Specifically, we encourage you to call or write the directors and management urging them to engage in meaningful discussions with Covington regarding our proposal. As stated previously, we remain interested in a mutually agreeable and negotiated transaction. The contact details are:

Advocat Inc. 1621 Galleria Boulevard Brentwood, TN 37027-2926 Ph: (615) 771-7575 Fax: (615) 771-7409

It is clearly in the interests of all shareholders for the Board to take prompt action to allow shareholders to realize compelling value for their shares now.



John E. McMullan President Covington Investments, LLC

Optional Options
IVR {2+2} Oct 2012 @ $18 for 0.70
ARLP {1} Dec at $60 for $4.4
KRO expires this week, {4} Nov 2012 @ 22.5 for 1.75

CODI-Sucks Nov 2012, 0.50


OLN {5-6?, 2-8}:
AGR 61
StockScouter: 9
Sabrient: V 94.1, G 88,
Fun 89.7, Balance 33.2, Earnings 64.3

ARLP = $1080.75 15.4% profit
Bought 1-13-2011



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