LodgeNet: Out Of Control

Value investors prefer investing in companies that control their own destinies. That way, if things aren't going well, fixes can be implemented to avoid a loss in asset value or earnings power, either by existing management or a new one. When a company faces problems as a result of external factors beyond the company's control, however, there is nothing the investor can do but hope for the best.

Needless to say, this is not ideal for the value investor, who prefers to minimize his downside risk.

The most common situation where external factors play a dominant role in a company's success occurs when a firm has a large portion of its revenue or costs based on a commodity product with a volatile price (e.g. oil, gold etc.). Changes in the commodity's price can often be the determining factor between a highly profitable few years and several years of persistent losses. But reliance on a commodity price is far from the only situation where a company's success is strongly influenced by external factors.

Consider LodgeNet Interactive (LNET), provider of interactive connectivity solutions to the hospitality industry (e.g. internet and cable services to hotels for their guests). The company trades for just $60 million, despite generating annual operating cash flows closer to $70 million in each of the last four years.

Despite the company's apparent attractive price relative to its cash flows, its fortunes are tied to those of the economy. This is due to the $400 million of debt the company has outstanding. This debt load is basically a self-induced amplification of the effects that external factors already have on the business.

The company is heavily reliant on hotel occupancy rates, and how much those guests wish to spend on video-on-demand and other services. As previously discussed, travel expenditures are highly sensitive to the economy. Due to the leverage effect of debt, LodgeNet's fortunes are highly sensitive to travel expenditures, which are in turn already highly sensitive to the economy.

Another external factor that affects the company is that it operates in an industry constantly undergoing change. To remain competitive, the company may face capital requirements it did not expect (e.g. with the popularity of High-Definition (HD), the company has to make capital investments to upgrade existing infrastructure). Furthermore, there is a risk that disruptive technologies reduce the demand for the company's services (e.g. the proliferation of mobile devices may reduce the need for the company's broadband offering).

If the economy remains as it is or even gradually improves, LodgeNet could turn out to be a steal at the current price. It generates enough cash flow to pay down its debt obligations despite interest payments that reduce the company's net profits to negative. However, this is nonetheless a risky situation, as the company is reliant on factors out of its control in order to stay afloat. If the economy recedes further and/or disruptive technologies bite into the company's existing revenues, the investor does not appear protected on the downside.

Disclosure: NoneThis article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please consider subscribing to the RSS feed.