Sangoma Technologies a cheap turnaround

Sangoma Technologies (STC.TSX, SAMOF.Pink Sheets)

Price: C$.52 (7/27/2011)


note: All $ amounts in this article are Canadian dollars.

This is a company that was suggested to me by a reader of the blog as a cheap company that's in the process of turning around.  I've kept the company on my radar and finally decided to write them up.

Sangoma is a technology company that develops and sells hardware and software solutions for the telephony market.  I'm actually somewhat familiar with this technology because I worked in a building where the landlord was obsessed with Asterisk (a Sangoma product) an Open Source PBX software product and he'd routinely come upstairs and tell anyone who was listening (or not) all about what he was playing around with.

Sangoma is fascinating because they are a company that was founded on an Open Source platform and successfully sell Open Source software and hardware solutions.  For any non-gearheads out there Open Source is software where the creator gives away the computer code used to generate the program for free and allows users to modify the code.  Other examples of Open Source programs are the operating system Linux, OpenOffice, Sun Solaris, amongst millions of other programs.  Many advocates of Open Source treat it as a bit of a religious campaign, but it's really just a way of licensing software in a way that enables work to be shared with a community.  The best analogy I could think of is that Open Source software is like if an automaker gave away all of the specs to build the car to anyone who asks for them.

While Open Source has a reputation for free software Sangoma has taken that platform and build customer hardware devices and customized software and turned a nice profit with it.  Sangoma states that they are the biggest distributor of Asterisk outside of the company which holds the copyright to it.

The best way to think about Sangoma's product suite is to think of your office phone system.  Sangoma builds all of the hardware to handle voicemail systems, routing calls to different offices, transitioning between digital and analog among other things.  The software to manage the entire system is custom built on the Open Source platform.

A customer might buy a Sangoma telephone card for a standard PC and then install the Asterisk software on the PC turning a cheap PC into an office PBX solution.

Investment Thesis

-The company is very asset rich, with $7.6m net cash/share against a market cap of $15m.
-The company is profitable and cash flow positive.
-Free cash flow has gone into buying back shares, the company has authorized a 5% reduction in shares.
-EV/EBIT of 3.33 on a TTM basis
-EV/EBIT of 6 for the 9 months of the 2010-2011 fiscal year.
-Margins: 72% gross, 13.5% operating,  11% net.
-A new CEO was appointed in September 2010 which could be a catalyst for improved growth.
-High insider ownership 20%+.

Catalyst?

The company experienced a very disappointing Q1 2011 (July - Sept) with a 20% drop in sales and a 90% drop in net income.  The company attributed the drop to a lack of new products in addition to softness in the North American market.  At the same time they brought in a new CEO who has been successful at past companies.

In addition to the drop in sales and net the company also experienced a contraction in margins.  While gross margin has remained somewhat steady the net margin has gone from the low 20% to 11% an almost 50% drop.

While Sangoma appears to be cheap on some basic metrics they also look like they have the perfect conditions in place for a decent turnaround.  If the CEO is able to jump start product development (which is happening in the most recent quarter an increase in R&D was recorded), and raise the net margin back to the historical norm the company should treat shareholders well.

Valuation

Due to the volatile nature of the business and the company being in the midst of a turnaround I decided to work out a few different valuation scenarios.

Worst Case

For the worst case I put the latest Sangoma numbers into my net-net template:

The raw NCAV is $.36, with cash per share of $.30 and net cash per share of $.25.   I should also point out the income tax item which I added to this spreadsheet.  You might be wondering why they are getting a tax refund if the company's profitable, I asked the same question as well.  Sangoma is the recipient of some tax credits, and development incentives from the Canadian government regardless of profitability.

The base case assumes that Sangoma will be liquidated or is only worth its asset value, for a company with consistent profitability and free cash flow I don't think that's accurate, so let's take a look at two other models.

Medium Case

This scenario has Sangoma earning $.04 a share for the fiscal year which I think is reasonable at the current run rate.  Applying a 10x P/E to $.04 plus the value of the net cash gives us the value:

$.40 + $.25 = $.65/share or 25% above the current price.

I think the medium case value is an accurate fair value for Sangoma if profits stay steady at the current level.  As mentioned above I think the medium case is probably a bit on the low side as well assuming performance will stay depressed, so onto the best case scenario.

Best case

I did the best case in two parts, the first is zero revenue growth with a return to the previous net margins, and the second is 5% revenue growth with the same 20% net margins.

It's pretty clear the value proposition with the shares is that management will be able to reverse the margin contraction and restore net margins to the historical 20%.  If they're able to do that Sangoma is the proverbial $1 for $.50.


Talk to Nate about Sangoma

Additional Resources
An excellent thread about Sangoma can be found here: Corner of Berkshire
Investor material: http://sangoma.com/about_us/investor_relations.html

Disclosure: No position in Sangoma

Solitron Q1 results out

Solitron Devices gets limited visibility and I noticed they filed a 10-Q for Q1 a few weeks ago so I figured I'd highlight the latest results.

I have posted about Solitron before in a three part series
Part 1
Part 2
Part 3

The company is a classic net-net and I'm happy to report with the latest quarter the company is still trading below NCAV, my thesis is still intact.  I have a copy of the updated net-net template below:

The biggest changes are an increase in cash, and a slight uptick in liabilities due to an increase in payables.  The NCAV is slightly lower at 3.71 vs 3.80, this is related to the uptick in payables.

Operating Performance

The good news is the company is performing well, revenue increased 2% while net margin increased from 21% to 24% due to lower material costs.  Net income increased 17.5% on the lower goods costs.

The company generated $459k in operating cash flow, and spent $10k on capex, the free cash flow went directly onto the balance sheet as an increase in cash and treasury bills.

The negative news is that the order backlog decreased 7% YoY and the company has changed their line from expecting to operate at a break even in the future to the possibility of a loss if current conditions continue.  Management also mentions that higher cost of materials could result in a loss, which seems to be in direct conflict with what they actually experienced this past quarter.  I take these statements with a grain of salt considering at the end of the year they expected to merely break even yet the company generated a 17% increase YoY on it's net income.

Final Thoughts

I'm happy with the quarter, the company is still profitable, cash flow positive and growing their cash balance.  My biggest concern is the change of the language in their filing regarding future orders.  No one can predict the future, and Solitron has generally been very negative regarding future prospects but it's still a point of concern for me.  I haven't changed my position at all, I'm still waiting for the market to recognize Solitron's value.

Disclosure: Long Solitron Devices

Cork company comparison

I hope not to bore readers with another post on Corticeira Amorim but I wanted to do a side by side comparison with a competitor, French company Oeneo.  Just as a side note I'm expecting to have a much longer post ready later this week for readers who are looking for a deeper company analysis.

As I posted here and here Corticeira Amorim produces cork products including wine cork stoppers, cork flooring, insulation, and other cork products.  While Corticeira is a hidden champion this doesn't mean that they have a monopoly on the cork market, one company they share the wine stopper market with is Oeneo.

A bit of background, Oeneo considers itself a wine products company with a division in the corking business, different than Corticeira who considers themselves a cork company.  Either way I think the comparison is fair.

I like doing comparisons like this and probably don't do them often enough but they highlight important differences.  The biggest item that stands out to me is that Oeneo has a 7.21% profit margin vs the 4.5% margin of Corticeira.  On the other hand Corticeira appears more undervalued with a lower P/E and lower P/B.

The question an investor needs to ask themselves before investing in corks or wine making is would they rather pay more for a company with higher margins or a less profitably company that is selling at a cheaper price?  Or to flip it around, does a 7.2% profit margin vs a 4.5% profit margin justify an almost double P/E?

Disclosure: Long Corticeira Amorim

Argo Group, UK net-net

Argo Group Ltd (ARGO.UK)

Price 13.75 pence £10.2m market cap (7/18/2011)

I'm on a small vacation in sunny south Florida and reading the book Free Capital: How 12 private investors made millions in the stock market which is mainly about 12 British investors who have made millions in UK small caps.  The book is good, it's a nice light read which is perfect for the pool and beach.  I've been squeezing in a chapter here and there between playing in the waves with my son.  In the spirit of the book I decided to do a post on a UK small cap.

Argo Group is an investment management company that runs five emerging market funds.  The company is headquarters in Isle of Man but claims its main place of business is Cyprus.  The funds the company runs are headquartered in a variety of countries ranging from Cyprus, Romania, and Singapore to the UK.  The company is listed in the AIM yet uses the US Dollar as its functional currency even though it has no operations or tie to the US.  The company has been managing funds since the year 2000 and has 26 employees.

The funds Argo manages:
Argo Fund - A fixed income fund that invests in corporate and sovereign debt in addition to currencies. This fund is quoted on the Irish exchange and was founded in Oct 2000.
Global Special Situations Fund - Deals in distressed credits and special situations across all levels of the capital structure.
Capital Partners Fund - A closed-end fund founded in 2006 which aims to invest with a two to three year time horizon.  The fund invests in stocks, bonds, PIK loans, warrants, convertibles and shareholder loans.
Real Estate Opportunities Fund - A fund quoted on the AIM (AREOF) committed to property investments in Romania, Moldova and Ukraine.
Distressed Credit Fund - A bottom up distressed credit fund founded in 2008.

The company is a spinoff from Absolute Capital Management (ACMH) and was party to a lawsuit from before the spinoff.  It seems that the legal dispute was a very big weight on the shares, the case was dismissed a few months back.

Napkin sized investment thesis
-Fundholder lawsuit was dismissed in June ending the legal liability overhang as well as ongoing litigation costs ($614k in 2010 and $866k in 2009).
-Trading at a 40% discount to discounted NCAV
-Trading at a 38% discount to net cash
-Turned an operating profit of $1.2, net income of $1.7m in 2010
-$932k in CFO and $924k in FCF
-The company pays a 1.2p dividend yielding 8.8%
-Management is buying back $2m worth of shares
-Insider ownership is around 35%

This is a pretty clear net-net investment, the company is trading at a discount to it's net cash position and in addition is showing a small profit and free cash flow.  Here is my net-net worksheet, note the USD/Pound conversion.

The company seems to be doing a lot of things right in the absence of dynamic growth, they are returning cash to shareholders by paying out a generous dividend in addition to buying back shares.

While profitability and revenue have been declining for the past few years the company still sports impressive margins.
-Operating margin: 11%
-Net margin: 16%
-FCF margin: 8.4%

Why is it cheap?
I think there are a few things working against Argo that are causing the shares to trade below NCAV.
-The company is small, £10m market cap
-The company is closely held with a public float of £6.5m outstanding
-Argo was a spinoff which usually face indiscriminate selling and a short operating history.
-There was a lawsuit which was proving to be a slow cash drain, and had the possibility to threaten the business.
-The company is generally misunderstood, it's traded in the UK yet is based in Cyprus and uses the USD as its functional and presentation currency.  A cursory look via FT.com will give incorrect values.

I don't own any shares of Argo yet, but I'm strongly considering adding them to my net-net portfolio.  Just a small warning, the company is small with an average trading volume of £8k and appears to be pretty volatile in trading.

Talk to Nate about Argo

Disclosure: No position in Argo, I am doing further research and might initiate one at any time.

Daxor a gamble on management

Daxor (DXR.AMEX)

Price: $10.17 (7/11/2011)

Daxor is a company trading below net current assets or a net-net stock, it's a curious stock, all of the current assets are liquid and the company pays about a 5.8% dividend.  What's not to like?  Daxor is a classic case of buying one thing and getting another.

Daxor claims to be a medical innovation company, their main product is a blood volume analyzer product.  The blood volume analyzer takes a patients blood and is able to measure it very quickly.  The product seems simple enough and in a growing heath care market the sky is the limit.

The company also has $.88 in earnings per share and a solid slug of marketable securities.  Here is the net-net worksheet.

The net-net worksheet looks great, a nice amount of receivables and $53m in marketable securities, 123% of the market cap.

So what's the problem?  The problem is when digging into the income and cash flow statements we realized the medical devices are a red herring for the real business.  Let's take a look at the latest period income statement.

The company lost $2.17m in continuing operations yet had $.88 a share in EPS, the difference?  All made up in the following two line items: "Dividend income-investment portfolio" and "Realized gain on of securities, net".  Daxor is really an investment company in disguise.  While the medical device division lost $2.17m investments contributed $4.3m in gains.  The effects are more pronounced when taking a look at the full year results broken down by division.

The operating business lost $5.7m while investment income kicked in $10m in income, enough to offset the medical losses and post a positive gain.

When examining this stock rationally an investor might consider why management hasn't shut down its device division and liquidated the portfolio locking in a gain for investors.  I think the reason for this is if the medical division is abandoned Daxor would be considered an investment company and would be subject to SEC regulation.

Investment Portfolio

The 10-k has a section describing the investment guidelines for the company which are:

-Preferred and utility stocks

-Maintain 80% of the portfolio in utility stocks

-Maximum of 15% in speculative issues including short sales

-Use of options to increase income.

The risk for an investor is they are effectively trusting Daxor to manage their investments.  While the past results are satisfactory I'm not sure I want the possible turn around of a net-net hinging on a options trading setup.

It would be much easier to setup their own utility investment portfolio and sell covered calls themselves.  

Summary

I wanted to show in this post that even a net-net has manager risk to a varying degree.  I think there exists a faulty assumption that when investing in a net-net the investor can ignore the quality of management, that's not the case at all.  A net-net investor is relying on management to not make a stupid decision impairing the margin of safety.  

Talk to Nate about Daxor

Disclosure: No position in Daxor

Hidden Champion Corticeira Amorim part 2

This is the part two post about Corticeira Amorim (COR.Portugal), you can view part one here.

In the first post I discussed the business units and some of the strengths Corticeira Amorim embodies as a hidden champion.  In this post I want to focus on the financial aspects that support the thesis first presented in part one.

I am going to take a look at the following items, return on invested capital, dividend history, a duPont analysis, free cash flow yield and the degree of operating leverage.  I will show the numbers for each figure, and then have a small amount of analysis around it.  My goal is taking this post with the first post will present a full figured analysis of Corticeira Amorim.  Each specific item is titled so it should be easy to skip to a certain piece of information.

Return on Invested Capital

I calculated ROIC for the past five years:

The good news is ROIC has been increasing and rapidly the last two years.  In 2009 the increase in FCF was due to working down receivables and inventory, whereas I believe 2010 is a more accurate picture of what an investor can expect in the future.

The second item that stands out is that ROIC has increased due to the repayment of debt over the past two years.  

Dividend History

The company has acted somewhat prudently with regards to dividends.  From 2005-2007 they had a conservative payout ratio which spiked during the recession.  In 2008 they paid out 140% of earnings, and halted the dividend in 2009 while they paid down debt and strengthened their balance sheet.

I actually appreciate the decisions management made with regards to a dividend, and the quickness in which it was restored as well.  The dividend was steadily climbing in the earlier part of this decade and if results continue to grow I would expect the dividend to continue to increase.

DuPont Analysis and ROE

A DuPont analysis breaks down the return on equity to a more granular level.  A ROE is composed of return on sales * asset turnover * leverage.  Examining the breakdown in each can show how the company is generating it's ROE and if the company is working with an efficient capital structure.

Here is the DuPont breakdown for Amorim:

The return on sales and asset turnover are about average for a business such as Amorim, and ROE gets a bit of juice from the leverage.  I appreciate that the company is paying down debt, and I like firms with little to no debt, but I think a bit of debt for Amorim is appropriate in the capital structure.

FCF Yield

There are a few ways to look at FCF Yield, FCF/MCap, FCF/EV, FCF/Equity.  I just went ahead and calculated all three values.  In addition there is the tangible yield which is what the company is paying out to shareholders as dividends mentioned above.

I'm not going to lie, these are great numbers, numbers I would expect for a hidden champion.

Degree of Operating Leverage

I was fascinated by how much earnings swung up from 2009 to 2010 on a small increase in sales, so I went ahead and put together a historical view of the operating leverage for Amorim.  Operating leverage is a way to look at how the company is able to scale on a fixed capital base.  Put another way a company that's a service company has to add more people, or have the people work longer hours to increase revenue and profits which are usually at a sort of fixed ratio.  A company with operating leverage is able to increase output on the same machines (fixed capital base) and increase profit without as big of a marginal capital commitment.

Operating leverage cuts both ways, on the way up it's magnificent because each dollar of revenue is a multiple of profit.  On the way down it hurts because the fixed capital requirement is constant, so in a downturn the company could start to turn a loss just trying to maintain the facilities.

In Amorim's case the operating leverage tells the story.  Sales increased 10% but EBIT increased 152%.  Higher incremental ticks in revenue are more valuable to the bottom line.

Valuation Scenarios


Corticeira Amorim has a lot of things going for it, a great free cash flow yield, a good dividend, great operating leverage.  The company is also trading on a cheap basis, with a EV/EBIT of 5.5 and P/E of 5.5.  Given all of this I wanted to plug the numbers into a few simple valuations based on multiples.

I was originally going to do a dividend discount model but I struggled with the discount rate.  The problem is the risk free rate isn't exactly risk free in Portugal, and with most sales international Amorim isn't really constrained to one market where a national bond could be used.  I gave up and decided a multiple analysis, and a comparison to Oeneo would be sufficient.

Oeneo (SBT:FR) is in the same line of business, they trade with a P/E of 11.28 and a EV/EBIT of 9.9.  The multiples on Oeneo are reasonable and considering they are in the same line of business, in the same market it's reasonable to conclude that Corticeira Amorim should trade at similar multiples.

Resources (in English)
2010 Annual Report
2009 Annual Report
2008 Annual Report
2007 Annual Report
Company Website

Talk to Nate about Corticeira Amorim

Disclosure: Long Corticeira Amorim

Looking at Hidden Champion Corticeira Amorim Part 1

Corticeira Amorim (http://www.bloomberg.com/apps/quote?ticker=COR:PL)

Price €.99 (7/5/2011)

I have been reading the book Hidden Champions of the Twenty-First Century: The Success Strategies of Unknown World Market Leaders and one of the companies mentioned in the book is Corticeira Amorim a cork company based on Portugal.  I had looked at this company back in February but took a pass because the 2010 financials hadn't been released yet.  When I saw the company mentioned in the book I decided to take a look again and I really like what I found.

I wanted to break this post into two, the first portion I'm going to describe the business and what makes it a hidden champion in addition to some highlights.  In the second post out later this week I will dig into the financials that support this post.

I wanted to start with something I had read recently which is the thought that an investment thesis is too complex if it can't be written on the back of a napkin.  I liked this because it really makes an investor focus on what's important to a thesis.  When looking at a potential investment there is a lot of information to be sifted through, and the napkin approach distills the information to a nice tight thesis.  Without further ado:

Corticeria Amorim is a compelling investment based on the following factors:
-Ability to deliver in all kinds of markets since 1870
-Global market leader in the cork niche
-Insiders purchasing shares above current prices
-Company buying back shares
-Company trading at a reasonable value EV/EBIT of 5.5
-ROIC of 11%
-Latest dividend of €.10 for a 10.99% yield
-Company is associated with Portugal giving the cheap price while over 80% of business is from outside Portugal, export oriented.
-Has paid down 50% of debt in the past two years.

The idea behind the hidden champions is companies that are global market leaders that most people outside of the niche market have never heard of.  The companies focus on one product or idea, heavily invest in research, are conservatively run and financed, have decentralized business units, export oriented and growing.

Business Overview

Amorim operates in four business segments, Cork Stoppers, Cork Insulation, Floor and Wall Coverings, and Composite Cork.  Amorim embodies one aspect of hidden champions in how they view their business units.  Each business unit is run independently and operates almost as a separate company.  This gives the management in control flexibility and reduces layers of beurocracy.

Cork Stoppers - This is the business unit most people think of when they think of cork, wine bottle corks.  The Cork Stoppers unit supplies the big wine markets, France, Italy and Spain among others.  In the major wine markets wine consumption has increased 1.3% in 2010.  The stopper group increased volume 13.3% in 2010.  Gross margin for the division increased 18% over 2009 and EBIT increased 23% due to operating leverage.

Cork Insulation - The insulation business unit deals with cork sheets used as building insulation.  The sheets of cork are very dense, stable at high temperatures and provide excellent acoustic and thermal insulation.  I attempted to find an R-value for cork insulation but in doing so realized the R-value is a American industry created metric that favors fiber insulation.  Sales for this unit increased 5% in 2010 mainly in Europe and the Middle East.  The gross margin increased 7% over 2009 and EBIT increased 13%.

Floor and Wall Coverings - This business unit was founded in 1978 and located in Portugal, the unit designs and builds flooring composed of cork.  The products are environmentally friends, cost effective, retain heat well and don't retain dirt.  The products are sold to wholesalers who sell to the DIY market and professional installers.  Sales in this unit grew 7.6% in 2010 and the company achieved some cost reductions with regards to compensation.

Composite Cork - The composite cork unit focuses on integrating cork into non-standard applications, such as automotive gaskets, thermal protection shields, footwear and electronics.  This unit really took off in 2010 with sales increasing 23% and EBIT increasing 200%.  The large increase in EBIT was due to operating leverage and increases in production efficiency.

In the 2010 annual report Amorim has a picture showing sales by business unit:

I want to make a note, the Raw Materials unit is mostly internal sales as seen by the small amount of sales, they mostly supply the material for the other business units.  The picture is great in showing that Amorim is nicely diversified across business units, while the stopper unit is the biggest at 58% composite cork and the floor and wall covering units have sizable pieces as well.

Export Oriented

A large feature of hidden champions is that while they might be located in a home market most of their business comes from outside of the home market.  Amorim is no exception to this rule, while they are located in Portugal over 95% of their sales come from outside of their home market.  The following picture from the annual report shows this well:

The company also has sales offices in over 100 countries and major operations in Portugal, Spain, France, Italy, Germany, Poland, the United States, Brazil, Argentina, China, Tunisia and Australia.

The advantage for a company that's export oriented is that they have the ability to weather local market recessions better than home market companies.  As proof to this Amorim didn't experience any losses in 2008 and 2009, some of their business units in emerging markets actually posted record growth proving diversification works.

Going into 2011 the company devotes a section of their report to the economic conditions of Portugal in which they state they expect Portugal to head into another recession in addition to the sovereign debt crisis.  While this is not good for the country the company believes they won't be affected largely due to the strength of their worldwide operations and export nature.

Niche Leader

One common theme through all hidden champions is that they are the leader in their own niche market, Amorim is no exception.  Amorim reports the following market shares:

• Cork stoppers: 25%
• Floor and Wall Coverings: 65%
• Composite Cork: 55%
• Insulation Cork: 80%

In addition to being a market leader they aren't satisfied and invest in additional research and development.  Some of the current projects underway are to discover new applications for cork, research TBA in cork, and study how to remove dust from corks in wine bottles among other items.

Ownership

One last thing I want to mention is the ownership structure of the company.  An interesting point about hidden champions is that many of them aren't publicly traded.  According to the author between 6 and 9% of hidden champions trade on public exchanges.  Most are private family run companies.  Amorim blends a bit of both styles when it comes to ownership structure.

While the company trades publicly and is available for purchase to anyone with a brokerage it is 75% owned by the Amorim family through a private fund.  Various members of the family serve on the board and in executive roles.  Two other funds own stakes reducing the float to about 15% of outstanding shares.  In addition to this the company has been buying back shares in 2010 reducing the float by about 3%.

Talk to Nate about Corticeira Amorim

Disclosure: Long Corticeira Amorim.  In addition for each purchase made through the Amazon link I will receive a small commission from Amazon.  The price for the item is the same through my site as it would be if you visited Amazon.com directly.