Description

VALU offers an extraordinary risk/reward at current levels. The market is not currently giving appropriate value to VALU’s potential to reap reward as a result of the independent research settlement on Wall St. VALU is a pure-play on the research settlement - the market is currently not recognizing the option value.

Value Line, Inc. produces investment-related periodical publications through Value Line Publishing, Inc. (VLP), and provides investment advisory services to mutual funds, institutions and individual clients. VLP publishes The Value Line Investment Survey, a periodical investment service, among other publications.

To most managers screening small cap names, VALU trades at 16x trailing earnings, a modest discount to other asset managers, and is thus not overly compelling when combined with the fact that it is not very liquid, is run very much like a private, family owned business and management is not very investor friendly. However, using conservative assumptions that have been discussed with several people familiar with the research settlement, and adjusting for VALU’s enormous cash and investment position, VALU trades at 7.2x projected 2004 cash flow and 7.8x 2004 earnings.

The independent research settlement will approximate $500 million paid out from various firms over the next 4-5 years (still being debated) to firms providing a research supplement to the brokerage house’s traditional retail research offering. It will be 9 months or so before recipients are finalized, but suffice it to say Wall St. does not want to give money to start-up firms that may use it to build research teams that will challenge their own institutional research, nor do they want to give it to their existing competitors (ie. CSFB setting up DLJ Research). The ideal would be recognized and trusted brands among retail investors - ValuLine, Standard & Poors, and Morningstar Equity Research, whose analysis metrics do not compete directly with the sell side. For VALU any agreement would, at worst, lead to a new distribution channel with high incremental margins.

Below is an paraphrased excerpt from the April 7 New Yorker on the settlement -"Spitzer, who had originally called for a complete seperation of analyst and investment bankers, also backed off the suggestion that the investment banks be forced to finance a new independent research consortium. Instead, he agreed to an alternative proposal, under which Wall Street would provide investors with independent research from existing sources, such as Value Line and Standard & Poor's" While I have read many articles on the settlement, this is the only one I have read that mentioned VALU. You can make your own judgement as to whether this made it into the share price; I believe it did not by any means.

I have confirmed with both VALU management and brokerage executives that negotiations are ongoing, but they are understandably tight-lipped.

This will be an extraordinarily profitable endavor, as VALU will simply have to send its already existing research through the brokers. I believe I am being conservative by estimating an 85% incremental margin. Further, the brokers have little incentive to play hardball on price as they already know how much they have to pay in total.

Below are the key assumptions I have used in my valuation

total settlement amount 500,000,000
years 4
VALU share 25%
Incremental margin to VALU 85%
Annual Revenue to VALU 31,250,000
Annual Income to VALU 26,562,500
After Tax 15,937,500

Note that if indeed VALU and S&P are the leading candidates as I believe they are, 25% could prove conservative.

Valuation Using Annualized Trailing 9 month EPS

per
share shares
Trailing 9 month earnings 13,195,000 1.32 9,996,212
Less Tax Effected Securities Gains (1,996,800) (0.20) 9,996,212
Operating Earnings 11,198,200 1.12 9,996,212
Annualized Earnings 14,930,933 1.49 9,996,212
Market Cap 465,000,000 46.52 9,996,212
Cash and Securities (225,767,000) (22.59) 9,996,212
239,233,000 23.93

Valuation on Annualized Earnings Ex-Cash - 16
Estimated 2004 Net Income 30,868,433 3.09 9,996,212
P/E ex cash on F2004 EPS - 7.8

Valuation Using Annualized Trailing 9 month cash flow

per
share
Trailing 9 month cash flow 12,991,000 1.32
Annualized Cash Flow 17,321,333 1.76

Ex-Cash Valuation on annualized cash flow - 14
Estimated 2004 Cash Flow 33,258,833 3.38
Current multiple ex cash on F2004 CF estimate - 7.2


Some Background on Ownership

Arnold Bernhard broke into the investment management business, first as an analyst with Moody's Investor Service and later as an account executive managing investments. The crash of 1929 led to his lay off from Moody's, but he retained some of his clients. Bernhard then began to develop his statistical method for picking stocks, and soon began publishing his investment survey. He continued to expand the business, adding the other publications and mutual funds along the way. In May 1983, Value Line sold stock for the public for the first time, though the Bernhard family retained 80% control. Bernhard died in December 1987, and his daughter, Jean Bernhard Buttner was named CEO of Value Line shortly thereafter.

The 80% family stake in Value Line is kept in a holding company called Arnold Bernhard & Co., and Arnold Bernhard willed his daughter 2 more shares than her twin brother, Arnold Van Hoven Bernhard. Arnold Jr. was upset by this arrangement, and sued to get control of the company. In 1996, the suit was settled with Jean buying out her brother's stake.

Other positives:
· While it is noted above that management is not overly investor friendly, there is incentive alignment (we own the same shares).
· Cash rich balance sheet that could offer huge share price support in form of potential buybacks (plus 80% owner can buy more shares). I would, in fact, expect VALU to buy back some shares from Arnold Bernhard & Co in the near future as Jean Buttner may start to think about estate planning and wealth diversification issues (she's 67). This would lower the share count considerably. Assuming VALU used 65% of its cash horde to buy shares, the 2004 EPS estimate above goes to $4.51. Using the average asset manager mutliple of 16x 2004 yields a price of 72 (55% upside). This is a realistic scenario as I feel there will be plenty of diversified small cap managers willing to put such a multiple on reported EPS.
· nearly all of VALU’s mutual funds are rated 4 or 5 by Morningstar and fund flow have been and should continue to be fairly stable.
· As mentioned above, the CEO is 67. I don’t know the succession story, but I would not rule out a transaction.

Other negatives
· You could argue that the research settlement has a finite life and thus is worth a considerably lower multiple, or perhaps we should just add the present value of the expected payments into the valuation, which is better than the zero currently being valued but doesn’t give you extraordinary upside. However, it is highly probably that this will just open up a new channel of relationships with the Wall St. firms, and at worst, is free publicity (ie. some who receive the research may like it and not like it when their broker stops sending it, so either the brokers will keep up the relationship or potentially lose business to VALU’s traditional publications)
· Retail stock investing is arguably in secular or at least cyclical decline which hurts both the publiching and mutual fund business (but VALU stands to benefit at the margin from share gain at the expense of the Wall St. firms given negative press)
· VALU is not a liquid name since only 20% floats, but there is probably time to build a position and it is entirely possible that some institutions would be interested in block trades, as I do not believe many investors have considered the implications of the settlement.

This can be paired with any asset manager (TROW) to mitigate the risk of falling equity values which could hurt average assets and thus earnings in 2004. This also takes away the risk of massive retail investor withdrawal from the market.

Catalyst

2004 earnings will be significantly higher due to Wall St. research settlement.
Company may buy back massive amount of shares from majority owner.
Company could possibly be an acquisition candidate.