Is Guinness Peat Group still a buy? The Coats story..

The holy grail of a deep value investment is a company that's in the process of liquidating and selling on the market for less than the amount to be realized in the liquidation.  Situations like this don't come along too often, but one did recently, Guinness Peat Group (GPG.LSE/ASX/NSX).  The difference between the Guinness Peat Group liquidation, and a usual liquidation is what happens at the end of the process.  In a normal liquidation shareholders end up with cash, for GPG shareholders they will end up with a exposure to a company called Coats.

I wrote previously about GPG with the thesis being that it was selling at too low of a price considering their assets and what Coats could potentially be worth.  In the intervening months a lot has happened for GPG and shareholders have been provided with the official liquidation plan.  The company plans on selling all of their non-Coats investments and using the cash to buy back shares.  Eventually GPG shareholders will have a pure exposure to Coats through GPG.  When I wrote about GPG in the past shares were trading below the book value of the investments, but since then they've converged, with book value decreasing and the share price increasing.  The quick gain in a few months, and the fundamental business change for GPG has led me to re-examine the situation.

Coats background

Coats is the world's largest thread manufacturer for industrial and craft uses.  They are three times the size of their next nearest competitor.  The company's threads are used in everything from shoes, to clothes, to coats, to knitting yarn.  According to the company's website 20% of all thread originates from Coats.  The company is also an industry pioneer for thread innovations.  Operations are spread out across the world, and clients are large brand name apparel manufacturers.

The company was publicly traded up until 2003 when Guinness Peat Group took them over and took the company private.  GPG paid £414m for Coats, over the ensuing decade the value of Coats has fallen with GPG internally valuing them at £320m.

The investment case

The market is valuing GPG at book value, which means Coats is being valued at £80m by the market.  GPG has an internal value for Coats of £320m which is four times more than what the market is saying they're worth.  In addition the per share value of Coats should increase as GPG sells off their investments and buys back shares.  An investment in GPG at current prices means an investor has the ability to buy Coats for £80m, the question I had was, is this a good price for Coats, and would I want to own them?

Here is a spreadsheet I put together with some historical data for Coats:

Before diving into the details of Coats I want to mention one thing regarding currency.  GPG is a New Zealand company listed in New Zealand, Australia, and the United Kingdom, they use the Pound as their functional currency, but provide figures in NZD as convenient.  Coats uses the US Dollar as their functional currency, but is a UK company, headquartered and taxed in the UK in Pounds.  Guinness Peat Group is listed in the UK, New Zealand, and Australia.  The currencies are confusing to say the least.  I take everything in the company's functional currency and convert to something else where appropriate.

The bull case has already been well established, but the results bolster it further.  The company earned $61m in 2011, and have average earnings of $20m.  Coats is trading for an effective P/E of 6x on average earnings, or a P/E of 2.2x based on last year's earnings.  The company has £77m in cash on the books too.  Coats is also attractive on an EV/EBIT basis, trading with a ratio of 2.74x.

Here are averages for the last eight years:

My concerns about Coats doesn't have anything to do with their valuation, it has to do with their debt, and their ability to earn a satisfactory return.

Coats is highly levered, at the middle of the year they had $350m in short and long term debt.  It's concerning to me that they continue to carry, and rely on short term debt as much as they do.  Short term debt is riskier than longer term debt.  If the company fails to roll over the short term debt within a year they could be in default and bankers would be deciding the fate of my investment.  In general I'm adverse to debt, but if a company prudently borrows long term I don't have as much of a concern.  I get concerned when a company continually needs to go back to their bankers, rolling forward their debt to operate, that's the position Coats is in.

Another concern I have with Coats regarding their debt is that their interest coverage isn't that high.  In their best years Coats had their interest covered 5x, but the coverage ratio isn't consistent.  At worst interest was covered less than 2x in 2009.  This year is trending to be slightly less than 3x.

My second concern is about the financial return that Coats is making on their invested capital.  I purposely didn't include ROE on my spreadsheet because it would be artificially high.  In 2011 the company earned $61m on equity of $114m for a ROE of 54%, unrealistically high.  The company was able to achieve a high ROE because they have almost no equity.  A better measure of performance is return on invested capital.  I calculate it using free cash flow dividend by the total invested capital.  If you're confused as to why I do it this way I wrote a post a while ago explaining my reasoning.  The ROIC metric tells a much different story about Coats.  Rather than having incredible earning power Coats is barely generating a return on all of the capital they have invested.

The company achieved their highest ROIC in 2009, most likely because they were working off excess inventory, and didn't re-invest as needed, generating higher than normal free cash flow.  Outside of 2009 the company earned anywhere from nothing to 8% in 2004.  Last year came in above 6%, but the company doesn't think that historic performance will be repeated.

It's confusing to consider GPG and Coats within the context of the investment liquidations and share buybacks.  I decided to consider Coats and GPG different.  I looked at Coats in isolation and asked the question, "Would I buy Coats for £80m?"  On first glance the investment is appealing, the company is clearly cheap, and they hold a leading market position.  My problem is there doesn't appear to be much of a margin of safety at these levels.  There are plenty of highly levered companies selling at low multiples, the risk is that business stays steady or grows and we avoid a downturn.  Coats issued a press release stating they believe the 2012 levels of business will be below 2011 levels.

When I initially purchased GPG there was a strong margin of safety, the company was selling below the value of their investments.  But as the price has run up, and results have come in for Coats the investment has changed.  I still think Coats is cheap, but it's more of a speculative return from here, not a safe return.  I will most likely be selling out of my Guinness Peat Group shares to buy something much safer.

Before I wrap up I do want to mention that if Coats traded for £320m, the internal value that would be a 67% gain from these levels.

Talk to Nate about Coats/GPG

Disclosure: Long GPG shares for now.

Argo, an undervalued asset manager with a potential catalyst

Some of the best investment opportunities are the hardest to write about, the stocks are plain cheap and there isn't much to say.  I've heard it said in the past that there are stocks that make good stories and there are stocks that make good investments.  My goal on this blog has always been to find stocks that could potentially be good investments, and if they have a great story attached all the better.  Argo has a mixture of both.

I first came across Argo and wrote about them a year and a half ago.  They came up on a net-net screen I ran for profitable net-nets trading in the UK.  I spend a few hours reading their annual reports and ended up purchasing shares.  At some point between then and now I doubled my investment, the date or reason doesn't matter because the thesis (and price!) has stayed the same since then.

The Argo Group Limited (ARGO.London) is an alternative asset manager.  The company manages a number of emerging market fixed income hedge funds.  In their admission document to the AIM they make they claim that they seek to be fundamental value investors in the emerging fixed income space.  The funds invest in fixed income, special situations, local currencies, interest rate strategies, private equity, real estate, and quoted equities.  The only things I didn't seen mentioned in that list were gold and farmland.  As most investors know asset management is a great business model, fixed costs are low and the business is scalable.  

The company came into being publicly traded through a strange set of circumstances.  Initially Argo was founded by the Rialas brothers, Andreas and Kyriakos.  The company was privately held and was fairly successful.  Assets under management grew significantly, and their funds won a number of awards.  The success didn't go unnoticed as they were acquired by Absolute Capital Management Holdings in 2007.  Absolute Capital Management Holdings Limited was a Swiss hedge fund firm that traded in London.  Absolute Capital Management hit a rocky patch as the founder left in 2007 and it was revealed that he put more than half of their biggest funds' assets into highly illiquid pink sheets.  Not only did they invest in illiquid stocks they also worked with another party to manipulate the price of the pink sheet stocks to inflate the NAV of their flagship fund.

While Absolute Capital Management hemorrhaged assets the Rialas brothers wanted a clean break from the troubled parent.  They engineered a spin-off of the Argo assets before Absolute Capital Management folded.  

There are some other aspects of the company's history that are fascinating, but ultimately they aren't relevant to the main reason why Argo is worth considering.  The biggest attraction to Argo is that they're a net-net, and not only a net-net, but a net-net with a decent asset management business along for the ride.

The company has a NCAV of £15.98 against a marketcap of £8.34, the company's NCAV is almost double the last trade.  The company had an operating profit of £411 in the first semester this year.  They reported a loss due to a goodwill write down.  The company's balance sheet has almost no liabilities and assets consist of cash, receivables, and an investment in their flagship fund.  

The company has significant earning power even at their lower asset levels, last year they earned £1.36m on close to $400m in assets.  The first semester this year they paid out £870,000 in dividends. 

Before moving on I want to highlight that Argo is trading at half of their net current asset value.  In addition they have reasonable earning power for a fund their size, and pay out most of their profits as dividends.  While shareholders sit and wait for Argo to appreciate towards its true value they're paid close to a 10% yield, the dividend yield alone is satisfactory for most investors.

I'm not going to sugarcoat Argo, the only reason the company is attractive is because they're selling at such a low valuation.  If someone presented me this company selling for £35m I wouldn't be interested, but at £8m I am.  The company has considerable headwinds, the biggest are the slide in assets and problems with their real estate fund.  The asset outflows stem from below average performance in some newer funds right after the lockup expired.  The Argo Fund (TAF) has performed acceptably well.  The Special Situations Fund, and the real estate fund both have done poorly.  The Real Estate Opportunities Fund (AREOF) invests in entire real estate projects in Eastern Europe.  

The AREOF purchased two shopping centers in Romania in the past year stating that they believed the malls were bargains.  The only problem is the fund was short on cash and was having trouble obtaining credit.  At one point they were in default on some of their loans.  The fund was able to secure lending with Argo backstopping the fund.  Even working through the numbers with the backstop factored in Argo is still cheap.

Another issue is that Argo operates out of Cyprus while being listed in London.  Cyprus has been in the news recently as a potential trouble spot in Europe.  At one point the company had offices throughout the world.  Before any reader is impressed my initial impression when seeing eight or so world offices for a company of 30 was that regional offices such as Buenos Aires were nothing more than an analyst working out of their apartment.  The company's address is on the Isle of Man, and I have a suspicion one would be very hard pressed to find a physical office for Argo.  A distributed company doesn't concern me, but some might believe management is up to no good.

With all the problems the company is facing a valid question to ask is whether they are actually worth any more than NCAV?  The valuation gap between the current price and NCAV is enough for an acceptable return, but some investors aren't satisfied playing for doubles, they want triples and home runs.  

The standard way to value an asset management firm is a percentage of AUM.  A great asset manager might be worth 7% of AUM, a poor one 1-3% of AUM.  I would expect Argo to be worth at least the low end of the valuation scale, so $3-9m for just the asset management business alone.  Add in the cash and securities and they're worth a bit more than double.  A side note, the company's functional currency is the US Dollar, all trading stats are in Pounds.  

If the valuation gap between NCAV and the current price isn't enough there's a potential catalyst for Argo.  A fellow blogger Wexboy has been in communication with the Rialas brothers about ways to unlock value for shareholders.  He's written two letters to the Board.  Guy Thomas, the author of Free Capital has also become a significant shareholder and has signed onto Wexboy's campaign.  The first signs are encouraging, management has been receptive to communication. 

When considering Argo and their valuation gap, plus a potential catalyst I'm reminded of a Walter Schloss quote "something good will happen."

Talk to Nate about Argo

Disclosure: Long Argo

Margin of safety

So many things wrong, cyprus, aum, real estate fund

Not many need to go right, activist (wexboy link)

13 stocks for 2013

The popular thing to do this time of the year seems to be generating lists of stocks that will do the best over the next year.  I thought I'd get in the game with a twist, I won't claim any of these stocks will do well in the next year, but I think over the next three to five you'd be happy to own them.  Most of the stocks are companies I have written up in the past, some aren't, but I own shares in all of them.  I put my money where my mouth is, I have adding to, or been trying to add to some of these positions recently.  All of the following stocks are just as attractive as when I wrote about them, or first purchased them.

I thought about naming this post "13 stocks to make you rich", or "The HOTTEST 13 stocks", but I don't have glossy ads I need to sell, so I'll leave those to the magazines.  I would challenge any magazine to pit their stocks against mine over a five year period.  I'd much rather own this motley group over any set of blue chips English majors from an Ivy picked.

The stocks are ordered alphabetically.


Argo (ARGO.UK) - I first wrote about Argo about a year and a half ago, and they're even more attractive now then they were then.  The company is an emerging markets asset manager listed in London but based out of Cyprus.  They are trading far below NCAV, and even below net cash.  There are some value bloggers who've started to raise the undervaluation issue with management, and management has been very receptive.  I plan on posting about them again soon.

Bank of the James (BOTJ) - I don't write about banks, but that doesn't mean I don't invest in them, I actually own quite a few community banks.  Bank of the James is a classic community bank, they own a number of branches in Lynchburg Virginia, and are exposed to the local market.  Losses are rolling off and branches that were opened in 2008 are becoming profitable.  The bank could do more to improve their efficiency ratio, but I don't think cuts are in the future.  A community bank trading far below book with a low earnings multiple, and recovering earnings, I'm a buyer.

Carlo Gavazzi (GAV.Swiss) - Carlo Gavazzi is a Swiss manufacturing company, but they're more than Swiss, they're global.  The company manufacturers automation components, whole bus assemblies and sensors such as the ones that keep elevator doors open.  The company is cheap on an EV/EBIT basis and earns an outsized return on invested capital.  They're family owned and controlled through a dual share structure which is a turn off for a lot of investors.  The family is conservative and eschews debt, they're focusing on growth outside of Europe.

Conduril (CDU.Portugal) - A Portuguese construction company that could be one of the cheaper equities on the continent.  They have a P/E of 2x and are a net-net, they're also family owned and controlled.  The family tried to take the company private a few years ago but the regulator wouldn't let them.  The company is heavily exposed to African construction, the writeup on them is here.

Conrad Industries (CNRD) - A stock I researched then dilly-dalled on buying, much to my dismay.  An American boat builder based in Louisiana.  Another family controlled company with outsized metrics, high returns on equity, an extremely low P/E and some potential catalysts.  The family has engaged a banker to examine strategic alternatives, they've also declared a $2/sh special dividend.  In addition to all of this they're using their copious free cash flow to buy back shares.

FRMO (FRMO) - A strange unlisted public company that generated a lot of interest.  This is Murray Stahl and Steven Bregman's personal investment vehicle.  The company owns close to a 1% stake in Horizon Kinetics along with a slew of owner operated equities.  It's like owning a fund managed by Stahl and Bregman without the expenses.

Goodheart-Willcox (GWOX) - An text book publisher that hit hard times over the past few years.  The company's market appears to be bottoming with sales finally increasing over the last quarter.  The company was a cash box but put most of the cash to use buying back shares.  Because of the buyback earnings only need to recover to a mere shadow of what they once were before this is a P/E 4x stock.

Hanover (HNFSB) - This is a great story stock that's incredibly cheap, I wrote a two part series here, and here.  Even though shares are up since my initial post the company has continued to grow and the valuation gap remains.  If you can get past the self-interested CEO you'll find a food company growing at close to 8% a year selling for 30% of book value with a P/E of 5x.

Installux (STAL.France) - This is a classic French owner-operator company.  The company manufacturers aluminum panels and decorative pieces for the sides of buildings.  They're a cash box, and if you back out cash ROE is 14%.  They earned €17.97 in 2011, €21.78 in 2010, and €15.57 for the first six months of 2011 (they trade at €140).  Sales have increased year over year, and cash increased €5.1m this past quarter.  Of course they're mostly exposed to domestic French policies, but that's also why they're so cheap.

Japanese net-nets (Japan) - Not a specific company per-se, but a general investing theme.  I strongly believe an investor buying a number of Japanese net-nets at well below NCAV will be satisfied with their returns in three to five years.  I embarked on the great Japanese investment project, and it's still in progress.  Unfortunately Schwab is a bit more restrictive in what I can purchase, so I've pared back my expectations, but the process is still ongoing.  I actually purchased two new Japanese net-nets tonight.  I'll have a follow up on this in the next few weeks.

Nexeya (ALNEX.France) - A defense contractor in France that is a classic two pillar stock.  The stock has run up quite a bit since I posted, but improved results have also come out and the stock is still cheap.  Not much else to be said about them beyond what was already said in my initial post.

Precia (PREC.France) - A weighting (scale) manufacturer with global reach based in France.  The company is expanding quickly overseas especially in India.  Sales in the Eurozone are slow, but sales outside of Europe are growing fast.  For the fast growth and high ROE the company is rewarded with a P/E of 9x and shares trade at book value.  I liked the company when I first wrote them up, and I still like them increasing my position two weeks ago.

Solitron Devices (SODI) - I have written about Solitron a number of times on the blog.  I was so frustrated by the undervaluation I went as far as writing the CEO a letter urging action and rallying support through the blog.  Solitron responded to the shareholder outcry with a share buyback and the initiation of an annual meeting next summer.  The shares are still extremely cheap.

Talk to Nate

Disclosure: Long all companies mentioned!

What's your real business? The National Stockyards story

Ever wonder how companies get their names?  Older companies usually have descriptive names while newer ones have names generated by marketing departments.  A name like National Can describes what the company did well.  A name like Accenture means nothing, and says nothing about what its employees do.  Sometimes a company moves beyond their name, this is the case with the National Stock Yards (NSYC) company.

Based on the name National Stock Yards should be doing something with cattle, and they do.  The company owns two subsidiaries, the Oklahoma National Stockyards, and the St Louis National Stockyards.  The St Louis Stockyards closed in the late 1990s due to declining cattle volume, while the Oklahoma stockyards are still in operation.  If National Stockyards were simply a cattle operation it would be easy to pull national beef pricing data and expectations and estimate a value for the company. Fortunately there is more to the story.

What makes National Stockyards interesting is the small set of businesses they own and operate.  The company runs the namesake livestock auction, a livestock warehouse rental business, office rentals, a legacy holding in a railroad, an equity interest in a golf course, and a large real estate development interest.  From what I could tell the railroad is defunct and exists in name only, but they still claim an ownership interest.

The company's cattle operations provide the top live revenue, but the livestock operations don't totally cover their cost.  Over the past two years the company has lost money on their livestock and livestock real estate operations.  In 2009 the company made a slight profit.  The company's auction operations profitability is closely linked to cattle sales.  The auction house gets a cut of each animal sold, fewer animals auctioned means lower revenues.  It doesn't help National Stock Yards that American beef consumption has been falling since 1970.  Beef consumption is to levels that haven't been since in the last 40 years; as Americans cut the red meat National Stock Yards suffers.  The following chart illustrates very well why National Stock Yards was able to have multiple facilities for years, and then why they eventually closed one, and run the other two days a week.

The interesting twist with National Stock Yards is what appears to be a cattle story is more of a real estate story.  The company closed down their St Louis stock yards in the late 1990s which left them with close to 600 acres of developable real estate.  Since the 1990s the company has developed and sold off more than half of that real estate.  A portion of the real estate was swapped for an equity interest in a golf course located on their land.  The golf course is held on the books at $0.  Any savvy investor can recognize that even a money losing golf course has a value of more than $0.

The real story at National Stock Yards is the future real estate development in Illinois (East St. Louis, right across the river).  The two states of Illinois and Missouri are in the process of building a new bridge across the Mississippi, the location crosses National Stock Yards land.  The company has sold a number of plots to the state over the past few years as part of the bridge building effort.  As a condition of the sale the state has put money into a trust to develop water and sewer connections on the company's land.  The state also agreed to demolish unused buildings at the state's expense.  Understanding the impact the bridge will have to National Stock Yards is difficult without a picture:

The company's land is located in or right near the blue circle with "3" on both sides, to the left of the "Fairmont City" label.  For the bridge to be completed the highway has been re-aligned and new interchanges built, one exit will provide ready access to the company's real estate.  The new bridge and connections should be open to traffic in 2014.

All of this is to say that the portion of undeveloped real estate left is highly salable, and is in a desirable location.  Some readers (most from the MidWest) will dispute my last sentence citing the proximity to East St Louis.  Painting with a broad brush, East St Louis is a very depressed and crime-ridden city, and real estate in East St Louis is about as valuable as real estate in the inner city of Detroit.  I initially wrote off the value of the company's land when I read where it was located until I took a look on Google Maps.  The company's real estate is a few miles outside of the ghetto-ish area, and abuts farmland.  The Illinois side of St Louis turns rural very quickly as one travels away from the Mississippi.

It's probably possible to get a very accurate valuation of the land for sale by calling a commercial broker in the area.  In the absence of the actual listed value I looked for some rough comps in the area.  I also took the values from the land sales to the state and come up with a valuation range:

The first value is the current book value of the property, $12,242 per acre.  The last two prices are actual comps in the area, the middle two numbers are values at which the company has sold pieces of the land to the state.  One 10 acre plot went for $247,000, and a three acre plot went for $107,000, both sales were in the past two years.

Sometimes real estate companies can end up with pie in the sky valuations when the price of one valuable piece of property is extrapolated out to the rest of the holdings.  A situation like that is possible with National Stock Yards, but I found a line in the annual report to be reassuring in this regard: "Management estimates that the fair value of the Company's St. Louis real estate is in excess of its carrying value and demolition costs.."

The best way to value National Stock Yards is on a sum of the parts basis.  The stockyards themselves throw off a few hundred thousand in operating cash flow a year, and have a book value of about $4m. I have no idea what a stockyard could be worth to a buyer, if there are any, so I'll just take book value at face value.

The company's share of the golf course is worth something although an exact value is probably impossible to obtain considering the carrying cost is zero.  The golf course is an equity investment, and unfortunately the annual report doesn't have a statement of equity.  There are a few lines showing beginning equity, dividends accrued and ending equity.  If the golf course is the only equity investment then they're accounting for a $100-$300k change in equity per year.  Maybe the interest is worth $500k, or maybe a million, either way it's a bonus to the valuation.

The final piece is the real estate holdings in East St Louis.  If we assume all of the land is worth the lowest price IDOT paid it's worth $6.5m, double the carrying cost.

Add up $4m, $6.5m and $1m and the company is potentially worth $11.5m.  Given that their market cap is currently $7.2m I'd say they're trading at a sizable discount.  If the company can sell any of their holdings for more than $25k an acre the valuation quickly becomes more appealing.

Lastly it's worth noting that in the past when the company has sold real estate holdings they generally pay out almost all of the proceeds as a dividend.  They paid a $35 p/s dividend in 2009 and a $12 p/s dividend in 2010.  I won't speculate on what future dividends could be, but they could be large.

If you're looking for more information on National Stock Yards you'll need to buy a share for $166 and call the Treasurer with proof of ownership for a copy of their latest annual report.  Of course financial information is available on Unlistedstocks.net along with details on 68 other unlisted companies as well.

Disclosure: I own one share as a tracker position.

Investing like a lender

I recently wrote a post where I discussed using a bond investor approach to evaluating equities.  I've continued to think about that post since writing it, and wanted to write a follow up extending that line of thinking further.  This post could really be thought of as the second half to my bond investor post.

A bond investor is buying a security issued by a company on the market.  The bond investor is worried about losing money and ensuring the business has enough operating earnings to cover interest costs.

A lender is one step closer to the business than a bond investor.  The bond investor is buying what the company is offering, a lender is taking a look at a given company and evaluating what to offer them.  A company wants or needs capital and they're at the mercy of the lender.  The bond investor is at the mercy of the company.  Thinking through this subtle difference can be helpful in making investment decisions.

The best way to apply this thinking is to ask the question "would I loan this company money, how much, and where on the seniority ladder?" when looking at a potential investment.  Asking questions like this can root out all sorts of seemingly tiny problems that have the potential to grow into large problems.

I like to take the lender approach when looking at net-nets if possible.  Obviously net-nets have large unencumbered asset balances, so it would be relatively simple to make them a loan correct?  Not exactly.  A lender is worried about collateral quality and the borrower's ability to pay.  The ability to pay concerns the borrower's operations.  If operations are slowly melting away, the company's current assets could be at risk.  It's hard without having a frame of reference to know if current assets are at risk in a poorly performing net-net.  Using the lending framework makes it easier.  Think through how much you'd potentially lend to a given net-net, and think about how long the company would be able to pay your rate.  Next think about what might have to happen before your money is at risk.  It seems like a bit of a jump for an equity investment, but it really isn't.  Given a net-net that doesn't have debt, the equity is the most senior claim.  The "interest" you'd receive is the earnings yield.  Maybe the company isn't earning anything, would you be happy loaning a company money for no return?  The loan would be similar to a zero-coupon bond, would you issue something like that to the company?

Often using the lending framework I'm able to flush out small details that make me really uncomfortable with an investment.  There have been two investments recently where using this framework would have been very helpful.  In the first instance I didn't think like this and I ended up with a slight loss.  The loss could have been greater but I realized my mistake quickly and sold very quickly.  The second, which I'll detail below was an investment where I wasn't completely comfortable and I avoided a loss.

Some readers will be familiar with Eagle Hospitality Trust.  The company was a REIT that owned a series of hotels in the Midwest.  The trust fell on hard times and cancelled their common stock and began to run into problems with their lender.  A lot of things happened during the financial crisis, but their debt eventually ended up with the Fed who sold it to Blackstone.  Operations never righted themselves and Blackstone threatened to foreclose on the properties if the trust couldn't sell them first.

The trust had some preferred shares outstanding, and writeups I'd seen online talked about how the preferreds could be worth up to $15 per share depending on the outcome of the hotel sale.  This was really enticing because the shares were trading at $5 apiece.  To add to the intrigue the trust is a dark company, requiring a share purchase and proof of ownership to get financial statements.  When the company distributed the financials they included a disclaimer stating that the following information was confidential and shareholders weren't allowed to discuss or share it with anyone.  So all online writeups were of the cloak and dagger variety.  As I stated, I have the financials, my email is below, hint hint.

The thesis on Eagle was that the hotels would sell for some rich valuation and the remaining cash and receivables would end up going to the preferred shareholders.  The potential reward on this investment was significant, it was exciting.  I kept looking at it and thinking that I could double or triple my money in a short period of time.  Then I started to look at Eagle from the lender perspective.

My first thought was why would Blackstone agree to let Eagle sell the properties and pay back their loan at a discount?  Some people thought it was because Blackstone were a bunch of nice guys, and by doing so Blackstone would juice their fund's IRR.  My concern was that the hotels might not be worth as much, or be as salable as initially thought.  I thought about this from the perspective of would I lend Eagle any of my own money, and how much, and at what rate, and what asset would back it?

The problem is when I started to think like a lender I couldn't get comfortable that I'd be guaranteed to get my money back.  The company was losing money so they wouldn't be able to pay any interest.  The hotels were spoken for by Blackstone and I was left with some cash and miscellaneous items that might or might not have value.  What I couldn't escape was that while there was the potential for a huge upside there was also the potential for a complete loss.  Not just a 5% or 10% loss, but a 100% loss.  If the hotels went to Blackstone, Eagle would be left with nothing.  As a claim holder at the bottom of the chain I had a claim on nothing if the hotels didn't sell for a high value.  Eagle would have been a great investment if I was in Blackstone's shoes, buying cash producing hotels at a discounted valuation.

I never got comfortable with Eagle and never increased my tracker position.  I owned 10 shares at $5, so I was in for $50.  This week the news came out that Eagle was unable to sell their properties and just turned them over to Blackstone.  They stated they expected to deplete the rest of their cash winding down operations and expected to make no distributions.  I sold my 10 shares for $.12 apiece. No need to feel bad, I can handle a $50 loss, the lessons learned were worth much more than $50.

I'm happy that I avoided a bigger loss, but it was just as likely that a positive outcome could have happened with Eagle.  Alternatively I could have been sitting here with my $50 that turned into $150 wishing I mortgaged the house to invest.  The truth is we never know the future, but in the face of uncertainty I want to work on what I can control, avoiding losses, instead of shooting for large gains.

Talk to Nate

Review: ConferenceCallTranscripts.org

I have a confession to make, I'm terrible at routinely following up with companies I'm invested in.  I'll give my left brained readers a few seconds to wipe up the coffee they spewed on their keyboard.  I know, I know, I can't be a great investor if I'm not routinely following every last detail and following up on every fact.  The truth is that's not my personality, I'm a more fly by the seat of my pants type.  One one hand I'm more of a creative thinker, yet on the other hand I'm not overly methodical.  I have a funky system for keeping up with companies I own.  I will log into my portfolio at some interval, the interval is random and varies, and will look at some company and think "I wonder what Installux has done recently…"  Then I'll go dig up their filings and read a quarter or two worth of information at once.

Some companies I own are really easy to follow, they publish an annual report once a year, and I get it in the mail.  I always remember to read paper copies of things, but I have a hard time searching for a digital copy of a filing.  If all my holdings mailed their filings and important news to me I'd be set, I'd probably never log into my brokerage, content to read my monthly statements and mailed news.

What's even tougher (for me at least) to keep track of is quarterly conference calls.  Most of the holdings I have don't hold calls, but I do own a few companies that hold calls.  Beyond that there are a few companies that I don't own, but I like to know what they're up to, and it's much easier to read a transcript rather than listen to 45m of "great quarter guys".

The problem is there's no central repository for conference call transcripts.  Some transcripts appear on Yahoo! Finance, but others don't.  At times it's possible to dig through Seeking Alpha and find what I need, but other times I'll get lost reading a flamewar and forget why I visited Seeking Alpha in the first place.

Thankfully Saj Karsan of BarelKarsan.com has come up with a really cool solution.  He wrote a site called Conferencecalltranscripts.org.  The site goes out and visits a number of sites and indexes conference call transcript locations.  He then stores that information and lets users search for transcripts. The site also allows users to create an account and get notified when one of the companies they're interested in has a conference call.

The notification feature is great, I'm signed up and following five companies with notifications.  When things are mailed (physical) or emailed to me I take action.  It's much easier to be prompted to take action rather than remember to take action at some certain interval.

Signing up is FREE, and anyone can use the site without a username or password.  Even if you're just looking for a single transcript it's much easier to look at Conferencecalltranscripts.org rather than bounce between three or four sites.

http://www.conferencecalltranscripts.org

Thinking like a bond investor

"It would be a sounder procedure to start with minimum standards of safety, which all bonds must be required to meet in order to be eligible for further consideration.  Issues failing to meet these minimum requirements should be automatically disqualified as straight investments, regardless of high yield, attractive prospects, or other grounds for partiality.  Having thus delimited the field of eligible investments, the buyer may then apply such further selective processes as he deems appropriate.  He may desire elements of safety far beyond the accepted minima, in which case he must ordinarily make some sacrifice of yield.  He may also indulge his preferences as to the nature of the business and the character of the management.  But, essentially, bond selection should consist of working upward from definite minimum standards rather than working downward in haphazard fashion from some ideal but unacceptable level of maximum security." - Benjamin Graham, Security Analysis 1951.

I have been thinking a lot recently about stocks as bonds, and looking at a stock the same way a bond buyer would.  For whatever reason the investment world is divided into stock investors and bond investors.  The division seems strange to me because both parties are investing in securities issued by the same companies.  Bond investors are usually worried about principal protection, and yield secondarily.  Equity investors are worried about what yield they can obtain for a security, and sometimes concerned about potential for losses, if at all.

I number of investors have stated to me that they don't know where to look for stocks.  With 60,000 stocks worldwide it's no surprise.  It's much easier to start with a narrow focus and work outwards from there.  In the quote at the top of this post Graham talks about finding a minimum set of acceptable parameters for an investment and using those as a starting point.  A lot of readers believe I only own net-nets.  I write about a lot of net-nets, but my portfolio has a nice mix of stocks, not all net-nets, not even a majority.  My minimum standard of acceptability is a net-net, followed by a low P/B stock, low P/E, EV/EBIT stock, and finally a franchise company.

For me finding a franchise company selling cheap, without serious issues, is the holy grail of investing. All I need to do (theoretically) is buy, and in 15 years I'll have 4x or 5x my money as the business compounds my investment year after year.  A lot of investors start by looking for these franchise companies and then when they don't find any start to move down the chain of potential investments.  Eventually they might end up slumming it and buying a company trading for less than book value, or (gasp) less than NCAV.

The valuation of a franchise company might rest on dozens of variables.  If any one of the variables is misjudged it's possible that the investment thesis could be thrown off, or the result isn't one an investor initially expected.  The opposite is true for a net-net.  There is really only one variable for a net-net, is the company going out of business?  If a net-net isn't facing a situation where they'll cease to exist soon then their valuation is unreasonable.  No going concern should be worth less than their current assets minus all liabilities.

The math starts to get more complicated as one travels upwards from the minimum criteria for investment.  "Is this business worth book value?", "Are earning sustainable?", "What happens if the management team leaves?", "Am I projecting a reasonable growth rate?"

At the beginning of this post I mentioned that I'd been thinking about stocks as fixed income investments.  Part of that thinking relates to making sure my principle is safe when I invest in a given stock.  Buying a net-net is similar to buying a bond below par.  If I buy a bond at $.65 (par $1) and the company is only able to pay $.85 I still have a gain on my investment.  When looking at a deeply discounted bond I am concerned about the collateral, what's the quality of it, can the company use it to borrow against, or sell for a reasonable value?  I'm worried about the seniority of my investment as well.  If I'm behind a number of other claims it doesn't matter that I'm buying at $.65, I might only get $.45 back after everyone else is paid.  But most importantly I'm worried about interest coverage.

Bond investors are content as long as their interest is covered by operating earnings.  If the company is able to generate sufficient operating earnings in a period of distress they will receive interest due to them.  If the bond is backed by high quality collateral and has seniority then interest coverage rules the day.

As equity investors I don't think we spend enough time looking at coverage ratios.  If a company has debt I know most investors make sure the interest is adequately covered, but beyond that there isn't much research.  I've been toying with the idea recently of stress testing net-nets and companies I'm interested in.  What I mean is not only looking at how many times the company can cover their debt with operating earnings, but how many times a company can cover operating expenses, and how much of a revenue drop is necessary before the company falls into the red.

I recently profiled Mexican Restaurants, and one of the reasons I haven't invested yet is because I'm worried about this stress test.  Mexican Restaurants has their lease expense covered 3x by sales minus labor/sg&a/cogs.  The company has lease expenses of $5m in 2012, and only $800k in the bank.  If sales dropped off 25% they would have trouble paying for their locations, this is a major concern.  At the opposite end of the spectrum a cash-box I own, Goodheart-Willcox could last almost two years with zero revenue before they would have problems paying employees and printing textbooks.  The company has almost two years of cost of goods sold and SG&A expenses in the bank.

An extreme case of this is some Japanese net-nets which could operate for a number of years without ever selling an item.  The more applicable example would be looking at how far sales need to fall before the company starts to lose money and has trouble paying their bills.  After determining this value the next step is to look in the recent or even the distant past and see if sales have ever dropped by that amount.  If they have a moment of deep introspection will be required.  If sales dropped by 35% in the past, and 32% pushes the company into the red, what does that mean for an investor?  How long can the company survive losing money?

My goal is to not lose money when I invest.  I fail at achieving this goal, but I can work hard to minimize it.  I think looking at worst case scenarios, and viewing stocks as bonds can help mitigate a loss situation.  Any company is vulnerable to a random exogenous event, but losing money in a situation that was predictable ahead of time is unacceptable.

I recently walked through this method with a long time holding of mine.  I realized that the the upside was limited due to the fact the company already had a monopoly in many markets.  Yet the downside was potentially large because regulators had suddenly taken an interest in the company, and wanted the company to pay for the monopolistic "sins".  I ended up selling off a large portion of my position, the risk was asymmetric on the downside.

As investors we need to be mindful of our principle, always watching and ensuring we don't lose principle.  If we buy enough equities or bonds below par the returns will work themselves out.

Talk to Nate

Big announcement

I am happy to announce an outgrowth of Oddball Stocks, Unlistedstocks.net!  This has been a project I've been working on for greater than six months, and it's finally ready for the general investing public.

Many of the stocks that I profile on this blog are not exchanged traded.  That means they trade on the pink sheets, or the over the counter market.  Prices are set by quotes obtained from brokers.  Some unlisted stocks report financials to the SEC or OTC Markets.  Other unlisted companies are completely dark, essentially private companies with a portion of the float available for investable by the public.

Up to now obtaining information on the darkest companies was a tough task.  An investor had to place an order and wait sometimes months before getting a fill.  Then they had to call the CFO and ask for a copy of the latest financials.  The process is tiresome and tedious, especially if the company isn't worth a further investment.

Unlistedstocks.net solves this problem. The site is an online database of unlisted stocks.  The database allows users to view updated financial information about unlisted companies.  In addition users can screen the database for specific criteria they might be interested in.  Users are encouraged to comment on companies as well adding additional information such as blog posts, new articles, or general insights.

I wrote the entire site myself, it was born out of an idea I had for a community of unlisted stock investors back in April.  I am not a coding guru so I favored simplicity where possible.  The result is a very fast and clean site with just the information you need.

How to join?

There are two ways to join.  The first is to sign up as a user, pricing for users can be found here.  This option is appropriate for most investors.

The second way to join is as a contributor.  A contributor is someone who might already invest in this space, and in exchange for financial information on a company not yet in the database the user receives a discount on their subscription price.  Keeping the contributor rate is easy, just upload an updated annual report for the company you initially submitted and your discount will remain intact year to year.

One final note for contributors, no bank stocks will be accepted to the database.  I have a second project focusing specifically on bank stocks, Unlistedstocks.net is non-bank stocks only.

In celebration of the Unlistedstocks.net launch I'm offering a coupon for the next week (expires 12/10/12) to readers of Oddball Stocks.  When you signup for Unlistedstocks.net use the coupon "oddballstocks" for 10% off.

Why join?

Some of the companies in the database are expensive with share prices in the hundreds to thousands of dollars per share.  You could end up spending $1,000 for a share to learn the company isn't worth an investment.  Do this often enough and you'll have thousands of dollars invested just to get information.

Instead of spending thousands of dollars to get this information you could get it for just a few hundred dollars on Unlistedstocks.net.  To buy one share of every stock in the database would currently cost $8,649.26, that's a lot of money just to find out if these stocks are worth buying.  You would have to subscribe to Unlistedstocks.net for 29 years before it would be cheaper to do this on your own.

I would be surprised if you didn't make your subscription back from an investment in some of the companies in the database.  Incidentally there's a company I didn't put in the database because as I was researching them for entry I noticed they were being taken private.  The company is going private for $4.05 a share and shares trade between $2 and $3, this is an inefficient area of the market for sure!

If you want to purchase this through your company and need an invoice please email me.  The price is low enough you could probably just sneak it through your expense account.

Join here

Screenshots:

Here is a typical detail page for a given company:

If you like a company you're looking at you can always add them to a watchlist.  The watchlist page is a great place to keep notes and thoughts while researching a given company.

If going through the database one by one isn't your style you can run a pre-set screen, or generate your own custom screen with specified criteria.

All of the information for each company is exportable to Excel using the following icon:

Here is the Excel spreadsheet generated for Goodheart Wilcox:

Looking for more information beyond what's in this post?  Have a question you want answered directly, email me about Unlistedstocks.net.

Cheaper than a burrito, Mexican Restaurants

I enjoy meaningless metrics for some reason.  I remember in 2008 hearing a commentator on TV say that Citi's shares cost less than an overdraft fee.  In the case of Mexican Restaurants (CASA) you could either buy a combo platter at one of their restaurants, or 8-10 shares of their stock.  Mexican food is known for being inexpensive, and like the food Mexican Restaurants is inexpensive as well.

Mexican Restaurants falls into one of my favorite investing categories, a company that is mis-priced on so many different levels it's almost unbelievable that the opportunity exists.  Let me lay out exactly how cheap Mexican Restaurants is; the cost to franchise one of Mexican Restaurant brands is between $814,000 and $2,504,000 per store.  As an individual you could either invest $2.5m to start a franchised location, or buy all of 52 of Mexican Restaurant's stores for $3.7m.

The company is a restaurant operator in the American Southwest, they own 52 locations, have 13 franchisees and one licensed location.  The company has had a rocky few years with a trail of losses extending from 2008 until very recently.  As the company accumulated losses over the past few years they cut underperforming stores and rationalized their workforce.  They continued to lose money until this year when operations turned around and their cost cutting paid off.  As part of the cost cutting measures the company delisted.  If anyone is still wondering why they're cheap, they have a history of losses, they're tiny, and they're unlisted.

There's not much about Mexican Restaurant's stock to not like.  They are trading at 35% of book value, and at 5x their net income from the first 9 months of this year.  After a $2m debt payment this quarter book value will increase to around $4 per share.  The company will also be debt free at the end of the year.

Here are the company's results for the past three years:

Valuing the two pillars, asset and earnings

Assets - Valuing the company on an asset basis is the easiest and most stable.  Earnings can change from quarter to quarter and year to year, asset values are much stabler.

The company's most recent book value was $11.285m, this is against a market cap of $3.6m.  Most of the company's assets consist of restaurant locations and associated equipment.  The company leases their locations, it's unclear if they own the buildings or just the equipment inside the buildings.  Without this information it's really hard to know the exact value of their property plant and equipment.

It's hard to know the exact value, but we're not out of luck, on the Casa Ole (one of their brands) website there is a little tab with information about franchising a location.  The website states that it takes an investment of between $814,000 and $2,504,000 open a single location.  Based on that information I built the following table:

We don't know the breakdown of costs per location so I created three scenarios: pessimistic, moderate and optimistic.  I just did some basic extrapolation to get a total number.  The number you're looking at is what it would cost in theory for the company to re-create themselves at the current investment level they demand of a franchisee.  The first thing you'll notice is that these values greatly exceed the market cap, by a factor of 10x to 36x.  

It would be foolish to stop here and state that Mexican Restaurants is worth anywhere between $42m and $130m on a replacement cost basis.  No one is replacing the company, or trying to build them from scratch.  Their equipment is used, and has probably lost a lot of value.  Even with a lot of the value lost there is still value left.  If we take my grid above and estimate that a current location is worth 10% of the buildout cost the value of the assets drop to a range of $4m to $13m.  The book value of the locations is $12.3m, which after working through the gymnastics above seems to be reasonable.

I wanted to work through all of this to show that even though book value is an accounting construct it does roughly reflect a real world value.  Some readers might question my 90% discount as overly cautious, but I'll ask a rhetorical question to answer why I used that value.  A set of new chairs and a table for a restaurant cost $300 based on prices online.  If a local Mexican restaurant was going out of business and was selling their tables and chairs how much would you willingly pay for the used set?  For $30 I could probably convince my wife to put them in a man cave, anything more and they wouldn't be coming home with me.

Earnings - Initially it would seem tough to value the company based on earnings coming out of a recent turnaround.  The company has been losing money for the past four years, so maybe the recent earnings are a fluke.  If one looks further back into their history it's clear they know how to make a profit, here's a clip from their 2009 annual report:

Note that they earned $.63 a share in 2005, $.32 in 2006, and $.10 in 2007.  The number of shares in the above graphic are similar to the current number, so the EPS figures are relevant.  If the company can get anywhere near past earnings this is an incredibly cheap stock.

Over the past nine months the company has earned $722k against a market cap of $3.6m.  If the company just breaks even the next quarter they're trading at an effective P/E of 5x.  My suspicion is that now that costs have been contained they're going to do better than break-even next quarter.  It's not hard to see where if earnings do recover how this company could be a double or triple at a minimum.

Of course no company is perfect, and it's always possible to find something to not like about an investment.  In Mexican Restaurants' case there are a few things I could nit-pick on, the first is they have a convoluted capital structure.  The company has convertible preferred stock, common stock, and warrants.  A company with multiple securities in the capital structure isn't necessarily bad, but it's a sign that they had to resort to expensive equity raising measures in the past.  The company has some cash in the bank, but not nearly enough to weather another extended downturn.  If results were to head south of the border again they might have to raise money through equity or preferred offerings again.

A second nit-picky item is the company reports in their latest annual report that $167k of their cash was restricted.  It was ear-marked for community relation purposes at employee discretion.  In theory this could be anything from someone wearing a burrito suit standing on a corner with a sign advertising to a charitable donation, or a local restaurant sponsoring a baseball team.  Without further detail it's hard to know exactly, but the result is clear, $167k of the cash should be removed from the balance sheet.

Lastly even though the company is escaping the burdens of debt they do still lease a number of their properties.  They don't break out ownership vs lease, but my impression is a large number of the locations are leased.

The risk with Mexican Restaurants is that they'll hit with another prolonged downturn and their lease expenses become a burden.  If they don't hit another bump in the road it's hard to see how this stock doesn't appreciate significantly.

If you're looking for even more reading on the company my friend at OTC Adventures wrote them up here.

Talk to Nate about Mexican Restaurants

Disclosure: No position

The problem with linear thinking

Congratulations for actually reading this post, most people saw the title and clicked away thinking "I don't do that, it's not for me."  This post isn't breaking any new ground.  Maybe a few will learn something new, and while it's important to keep learning, it's also important to continue to refresh existing knowledge.  This is a refresher post.

Linear thinking is a shortcut for completely thinking through a problem.  It's easier to look at quarterly earnings of $.25 and multiply by 4 rather than estimate what they might actually be due to seasonal fluctuations.  Linear thinking and estimations are everywhere, a casual read of the news or research papers would leave one with the impression that we live in a linear world.  The problem is we don't, often trends reverse, or change due to some inflection point.  I think people like linear trends because it makes them feel like they can guess what the future might look like.  No one knows the future no matter how hard we try to predict it.

My favorite example of linear thinking is personnel assignment for projects.  If a project is estimated to take one person 80 hours there's this widespread myth that assigning two people will get it done in 40 hours, and four people in 20 hours.  The problem is that doesn't account for overlap, or communication overhead.  At a certain point adding an extra person on the team actually lengthens the time needed to finish a project.  There's a book on this topic dealing specifically with software engineering, but the principles are universal, The Mythical Man Month.

Mythical man months and linear thinking are everywhere in investing.  Just go back to any article from 2006 and you'll see the economy and stocks will follow a nice smooth path upwards forever.  I don't know why people accept this sort of reasoning.  Anyone who's lived for even a little bit knows it's not true.  Growth comes in spurts, a child grows very quickly the slows down with bits of fast growth.  Most businesses are similar, they grow fast for a while then mature.  Even nations grow in spurts, the baby boom in the US was a large spurt, the echo-boom a smaller one.  Between those population booms were years of lower than trend birth rates.  With regards to birth rates linear thinking abounds, every few months a story will appear saying Russians will disappear in 400 years, or the Japanese will cease to exist in 300 years at current rates.  When birth rates are high articles are written discussing when the world will run out of capacity, or strategies to slow down growth.

Very few companies have linear growth, for me this is the downfall of DCF calculations.  How do you model lumpy growth?  Some companies do have this predictability, I worked for one that signed all customers to long term contracts with 5% increases each year.  So for them it would be appropriate to model out 5% growth to eternity.  Or at least growth until technology blows up their market.

Warren Buffett, or his followers talk about only buying companies if you know what they will look like in 10 years.  This is great sound bite material for CNBC, but it's unrealistic.  Did Buffett really know what investment banking would look like in 2018 when he made his Goldman Sachs investment?  I doubt it.  We often look at things in a linear fashion when trying to estimate far into the future, and it can be a downfall.  The problem with a linear thought is it blinds us to uncertainty and potentially negative consequences.  The strong moat of Eastman Kodak in 2000 was worthless in 2010, but how many predicted digital cameras would be in cell phones in every pocket back in 2000?  I know I sure didn't.  I remember seeing my first digital camera in 1993, it could fit 100 pictures on a 3.5in floppy disk.  That means each picture was around 14k, the camera was huge and bulky, it was a hobby thing.  Serious photographers used film cameras.  Now about 20 years later I have a camera in my iPhone that's probably 100x or 1000x better than that bulky digital camera and at 1/10th of the cost or less, not to mention the size difference.

Some companies that look strong in the moment fall quickly to technological, or cultural shifts.  MySpace was the king of social networking a few years back.  Who would have thought they'd be complete irrelevant now?  I own a franchise company (Mastercard) and I think about this often.  They have a strong network, but very quickly a competitor could emerge and turn the industry on its side destroying Mastercard's moat.  My concern is that I'll spot this too late after my investment is impaired.

A parting thought before moving on is that the average lifespan of a company has shrunk from 67 years in 1920 to 15 years in 2012.  So when someone says to think 10 or 15 years out that means thinking about the successor or bankruptcy of the company you're examining, a sobering thought.

When I considered doing this post my first intention was to bring awareness to thinking that could be harmful to our investments.  The second goal was to show how this could be exploited.

I find that investors have a very strange fondness for linear thinking thar's often not found outside of investing.  When two sport teams play each other a non-committed bystander usually roots for the underdog.  A very common plot for American movies is an underdog achieving greatness against all odds.  Yet when it comes to an underdog company the standard expectation is it will just decline into oblivion in a straight line.  Conversely great companies like Apple or Starbucks will just grow to the sky forever with investors enjoying sunny days and endless dividends.

When presented with a tight situation people are able to dig down and find resolve to face a tough situation.  Ideas and strength not found in everyday life present themselves and can come to the rescue.  Not every desperate situation works out well, but enough do solely on human perseverance that others in dire straits can remain hopeful.  Investing in cigar butt companies can be similar to a down and out individual.  Not much needs to go right for things to change.  If the negative trend merely stops that can sometimes be enough.

Linear thinkers believe that all net-nets go to zero, why else would a company trade for less than NCAV?  Of course the evidence says otherwise.  Linear thinking says that big giant companies with steady growth will continue to grow forever, a quick look at the Dow over the past 100 years says otherwise.  Beware of linear thinking, and take advantage of it when the opportunity presents itself.

Talk to Nate

Bogen a spinoff with uncertain motivations

Unlisted companies are famously opaque, so it's no surprise when an unlisted company decides to spinoff a division that they're less than forthcoming with information.  The company in question is Bogen Communications International.  Thanks to a Twitter message, and a post from Inelegant Investor   at Stock Spinoffs I was alerted to the strange spinoff occurring at Bogen.

The company recently issued a press release stating they were spinning off a wholly owned subsidiary named Bogen Corporation.  The release is confusing to say the least, the company announced the spin of a subsidiary, except there is almost no mention of this sub in their annual reports.  The company announced the spin on November 20th, which is curious considering the record date for the spinoff was November 19th.  Shareholders will allegedly get to vote on this, but with management owning 70% the vote is nothing more than a token measure.

This transaction caught my attention for two reasons, the first is this is an unlisted stock, and I'm naturally attracted to these, and secondly after looking at the annual report is seemed like there might be some opportunity here.  The company barely makes mention of their two divisions except for a small section at the bottom of the notes in the annual report.

The company is an audio products company, they design, and manufacturer speakers, amplifiers, and sound systems.  The products all appear to have professional applications, from stadium speakers, to rack mountable mixing boards.  The company also sells products for intercoms and school broadcast systems.  Further evidence that the company targets a professional customer is the fact that the only way to purchase products is through a sales rep, or a very limited set of distributors.

In the US spinoffs are known to be an area of the market where outsized returns can be found.  I find it fascinating that spinoffs have generally only been profitable when American companies are doing the spinoff. I remember seeing some literature (don't remember where) a year or two ago that looked at global spinoffs and for the most part the stocks of the spun off companies resulted in a small loss.  My impression is that American companies spin off a division to unlock value; they provide incentives to management at the new spun off company to do well.  Non-American companies spinning off divisions do it to dump an underperforming division.

The motivation behind the Bogen spinoff is very unclear, but looking at the segment information from the past few annual reports we can get a glimpse of what management is thinking.

The above are the results for the Bogen Corporation division for the past six years.  The company's US operations have been profitable every year except for 2009.  The foreign operations haven't been profitably any of the past six years.

The company has a respectable gross margin and operating margin.  I didn't calculate the net margin because my net income figures are estimated.  The company carries a small amount of debt, and I'm not sure which division the debt belongs to, or how the interest costs might break down.

Maybe the company's international operations will turn around, it's possible, but I wouldn't want to speculate on it.  Instead I think the opportunity here lies in the domestic operations.  The company states that 58% of the total assets belong to the domestic operations.  The domestic subsidiary generates 100% of the profits.  Spinoffs are usually conducted on an asset basis not an earnings basis.  If we applied that formula to Bogen the domestic operations would have a market cap of $10.44m against a net income of $2.8m for a P/E of 3.73x.  Clearly the better investment is the Bogen Corp spinoff, and I think management realizes this.

Why would the company management suddenly decide to spin off the profitable operation?  Management owns 70% of the outstanding shares, and they can effectively do what they want with the company.  My guess is they are looking to sell one of the divisions and a potential acquirer said they would be interested but they only wanted to buy a portion of the company.  It was easier to spin off the undesired division rather than complete a purchase for a portion of the company.

After looking into Bogen the question I had was how do I buy the spun off shares?  I don't have an answer, I'm not sure if the Bogen Corp shares will even trade publicly after the spinoff.  If the Bogen Corporation shares do eventually trade I think they offer a very compelling opportunity, with an extremely low valuation, and a management that might be motivated to sell.  If anyone has more information regarding this spinoff I'd appreciate an email, or a comment.

Talk to Nate about Bogen

Disclosure: No position

A profitable cash box, or a cash box with profits?

A common feature of most net-nets is a pile of assets with a tiny obsolete business attached.  While his isn't always the case, is the exception not the rule to find a good profitable business selling so cheaply.  Metalink (MTLK) was suggested to me by a reader (thank you!), they're a foreign issuer, a cash box, and a net-net, the siren call was strong, how could I not look at them?

There's a certain market cap threshold where even I get a little queasy.  I don't have a problem investing in a company with a $6m market cap, yet once the market cap drops below $3m I start to get nervous.  I get nervous because my pool of potential buyers shrinks.  I know that by investing in the microcap space I'm already limiting myself to retail investors, and small funds, but below a certain market cap I'm limiting myself to other individuals as crazy as myself.  Metalink falls below my psychological threshold of $3m, although only slightly.

Metalink might be the first investment that literally checks off every potential box for a net-net.  Profitable: yes, mostly cash: yes, obsolete business: yes, no debt: yes, no liabilities: yes, no leases: yes, no future direction: yes, and on and on.

The company is a DSL chipset manufacturer.  For anyone born after 1988 DSL is a technology that ushered the US onto the information superhighway.  DSL technology was an enormous improvement in internet connection speed.  Allow me to take a quick walk back in time.  I remember my first modem, it was 2400 baud, I had a friend with a 4800 baud of whom I was jealous.  I'm guessing a few readers are thinking "wow, 2400 baud, he's young" and the rest are clicking to Facebook while the thought "what's a baud" is forgotten.  Technology quickly went from 300 baud, to 1200, to 2400, to 4800, then 9600.  From there we jumped to 14.4, and finally 28.8 and theoretically 56.6.  When the dot-com bubble was booming most people were connecting to the internet at 28.8k or 56k speeds.  In about 10 years connection speeds had increased 10x.  This is the reason the internet boomed, we always had those networks (BBS anyone?) but they were so slow that anything more than colored text was unusable.  Telecom companies were looking to maximize connection speeds using existing technology, which were copper wires and DSL fit the bill.  When a human talks on the phone voice only utilizes a portion of the frequencies that the wire can carry, DSL sought to fill this extra space with data.  Customers used to have to install DSL splitters to block out the data frequencies on their land lines.

DSL technology seems so quant today where we can connect at speeds of 10 Mbps or 25 Mbps on a standard internet package.  But keep in mind the jump, a standard DSL connection was 768kbps verses the fastest model a 56k which at most could do about 43kbps.  Going from a fast modem to a DSL connection was almost a 20x increase in speed.  A similar jump was possible with cable, but not all neighborhoods were wired for cable, whereas anyone with a phone in theory could have DSL as long as there was a DSLAM installed at the local switchboard.  The limit to DSL was the drop distance, that is the distance from the DSLAM to the end point.  The longer the distance the slower the speed of the connection.  Warren Buffett claims all knowledge is cumulative, I never thought the things I learned about DSL 15 years ago would be relevant today, yet here we are...

Metalink comes into the picture in the sense that they coordinate manufacturing and distribution of DSL chipsets.  For years they were involved in the research and development of new chips, but as DSL has moved from the front to the back of the broadband line they eliminated all R&D.  The company has whittled themselves down to simply a distributor of their old DSL chipsets.  They outsource fabrication to third party chip fabs and sell to a few remaining customers.  The company end of lifed their chips back in 2008.

The company doesn't have much going for them in terms of a future outlook, they aren't developing any new products, and plan to continue selling existing products until clients don't need them anymore.  The business has stabilized and the current run rate should be expected into the future until demand ceases.  With a more normalized cost structure they've moved from losses to making a profit.

Let me summarize the high level discussion before diving into the details of this investment.  Metalink sells an outdated obsolete chip technology that's currently profitable with an uncertain outlook.

The starting point for analyzing Metalink is the balance sheet, here is their balance sheet summarized in my net-net template:

The company has an excellent balance sheet with $1.89 in NCAV, a discounted NCAV of $1.82 and a net cash position of $1.67.  It's worth mentioning that shares are trading at $1.04.  In other words, this is a profitable net-net selling for less than net cash outside of Japan.  Their location (Israel) isn't without risk, which I'll discuss below.

I want to call out a few things from the balance sheet, the first is the company doesn't have much inventory.  This is because chips are manufactured as customers demand them, and are shipped straight from the fabrication location.  The chips that have been manufactured but haven't been received by the customer are what's been captured on the balance sheet.

The second item I want to call out is the lack of liabilities.  The company has some accounts payable, that's it, no other liabilities.  I don't think I've ever seen a company with so few liabilities.

Metalink's record of profits has been much worse than their working capital management.  They were consistently unprofitable until they sold off a loss making division a few years ago.  Since then they've only had the DSL chip business that doesn't generate much revenue, but it's enough to cover fixed expenses with a tiny bit left over.  While the company is profitable the statement I'd make is caution needs to be taken when considering their future.  The business is unsustainable and it's possible sales could dry up, I don't know if that's in six months, or three or nine years, regardless of the timing it will happen eventually.

A discussion of Metalink wouldn't be complete without a discussion of management and their plans for the pile of cash.  Management owns 40% of the outstanding shares, which isn't a majority, but enough to push the company in any direction they want.  In the 20-F statement the company mentions they would like to use their cash for something strategic, possibly an acquisition.  This is where things get a little crazy in my mind.

The company only has one employee at this point, the CEO.  He's essentially arranging the fabrication, then the shipment of the completed chips to the destination location.  He's also in charge of filing the SEC statements, and whatever else a middleman does.  The company has $5m in cash and is looking to do something with it.  The problem is that while $5m is a lot of money in normal people terms, it isn't all that much in business terms.  I'm not sure what sort of company besides a smaller local one could be purchased for $5m or less.  And I can't imagine purchasing a company and trying to get up to speed and taking control with only one employee either.

Due to the logistical problem, and the low absolute level of cash I don't see an acquisition in the company's future, more likely is a tender, or a buyback to completely go private.

I'd be remiss if I didn't point out the biggest risk to this investment, which is Metalink's location.  The company is located in Tel-Aviv, which as of late isn't the safest place in the world.  The job the CEO is doing appears to be done from home, and in theory could be done anywhere in the world.  He's a plane ride away from moving the business to London or New York.

The second biggest risk is the uncertain future outlook.  We don't know if Metalink will be churning out DSL chips for the next three months, or the next three years.  We also don't know what the CEO will decide to do as his next move, will he tender for the outstanding shares, or will he go out and buy whatever he can for $5m?  If you can reconcile those two risks and are comfortable with them I don't think there's any problem purchasing shares of Metalink.

Talk to Nate about Metalink

Disclosure: None