Tom Shohfi
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Free cash flow (FCF) yield can is an often overlooked financial metric in equity valuation. The cash generated from operations after capital expenditures is what effectively belongs to shareholders in the form of dividends or retained earnings. That’s why many fundamental value analysts use FCF yield as an important gauge of the ongoing financial health of a company. If cash is king, then free cash flow is the path to royalty. Here are ten stocks with high double digit last twelve months free cash flow yields (actually greater than 12.5% FCF yield when considering an anticipated drop of no less than 20% during a weaker 2009) with price to tangible book values and trailing P/E ratios less than or equal to the average values of the Russell 2000 small cap index. 
This article is also available at Seeking Alpha.
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As a technology specialist, Monday’s blockbuster deal between Oracle (ORCL) and Sun Microsystems (JAVA) left me fielding questions from a number of investors. Following the breakdown of Sun’s talks with IBM, Scott McNealy’s company seemed like the unwanted stepchild of the data center. Why would Oracle want them? There are plenty of reasons. First and foremost, there is MySQL, the database platform that Sun acquired for $1B in early 2008. MySQL has been the fastest growing database platform in the market and has long been a thorn in Oracle’s side. Oracle even purchased some of the internal technology within MySQLto disrupt the platform’s advancement. Now Larry Ellison and company control an even larger share of the database market, can maintain or improve margins and have the ability to offer best in class proprietary or open source database solutions. Meanwhile, IBM’s DB2 is losing share and big blue missed a serious opportunity to revitalize its RDBM segment.
Next, of course, there is Sun’s ticker and omnipresent development platform, Java. Twelve years ago, I recall the novelty of taking my first college level computer science classes in Java rather than Pascal. Java is under pressure from the likes of C# and PHP, but it is still the premier development platform and a crucial component of custom enterprise applications. Is there any wonder why Oracle representatives said that Java is “the most important software that Oracle has ever acquired.” Java is, quite simply, the crown jewel of Sun.
There’s a slew of other great assets in Sun’s business. Solaris, OpenOffice, UltraSPARC to name just a few. The big issue has been that they don’t necessarily work together and this is clear in the company’s recent profitability. Notice the upward trend in the top line despite erratic net income.
While Jonathan Schwartz assumed the role of Sun’s CEO in 2006, the bulk of this failure has to be on former CEO and current chairman Scott McNealy. If management can’t trim and/or control costs, then someone else will come in and do exactly just that. While IBM missed that opportunity, Oracle will once again show that the company is the corporate master of rapid acquisition and integration. Regardless of what Oracle does with some of Sun’s assets, it’s clear that there is value to be found in tech M&A.
Still, I don’t believe that this is an opportunity to buy large cap technology names. Like Barron’s points out this weekend, it’s an opportunity to capitalize on the M&A wave and establish positions in target companies. We saw this again last week with Broadcom’s (BRCM) bid for Emulex (ELX). There are plenty of small cap technology names with depressed valuations that could provide tremendous synergies with large cap tech companies in both hardware and software. Mid caps will likely not be snapped up since the few independent names that are still left are either viewed as “lame ducks” (CA, SY, etc) or have incredibly strong cultures that make integration more difficult (RHT, CRM, etc). I’m keeping my eye out for inexpensive small cap tuck-ins that can offer real value to cash rich companies looking to enhance growth.
Disclosure: The author does not have a position in any of the mentioned companies.
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Last November, my first Seeking Alpha contribution featured five profitable small capitalization stocks priced at significant discounts to tangible book value. Since that time, the Russell 2000 (^RUT) has fallen about 13%. However, all five of those stocks have outperformed the index and two, Chinese dietary supplement manufacturer Tiens Biotech Group (TBV) and zinc producer Horsehead Holdings (ZINC), have seen very high returns over the past five months. I once heard a director of equity research at a large buy side firm say that an analyst doesn’t necessarily have to be right on stock calls more than 50% of the time, but when he/she makes a right call, it better be very right. TBV no longer fits the criteria of trading at a fraction of tangible book value. However, since ZINC is still trading at a slight discount and is a reasonably good dollar weakness play, I’m still holding on to it for now but am examining other opportunities that may represent better present values. 
There are still a number of these values out there. This time, my screener is set for public companies with market capitalization less than $250 million, a price to tangible book ratio of less than half market value, normalized trailing twelve month P/E of less than 25 (this premium multiple is, in my opinion, acceptable given the low P/TBV ceiling used) and a LTM interest coverage ratio no lower than 15 (or zero debt). The resulting list of profitable, discounted, yet balance sheet healthy, companies is much shorter than it was late last year. Five names on this list, nearly all of which have posted solid returns through the first quarter of 2009, caught my attention. 
Avalon Holdings (AWX)This nanocap sports a market cap of less than six million but also has one of the most unique combinations of business lines that one can find. They provide waste management services in addition to owning and operating several golf courses including those at the Avalon Golf and Country Club in Ohio. In 2008, 80.4% of Avalon’s revenues came from waste management services. 48% of the company’s market cap is net cash and management sees their stable cash flow and access to credit as an opportunity to acquire new golf facilities in order to expand that side of the business. Liquidity, however, is definitely an issue with AWX shares – its heaviest trading day in 2009 was a whopping 10,200 shares. That liquidity risk may be worth some price impact considering if the stock traded at just half of tangible book value, it would represent a 246% return from its current price per share of $1.53.
Benihana (BNHNA)Since the opening of its first New York restaurant in 1964, Benihana has grown to become one of the best known teppanyaki restaurants in the United States. From Anchorage to Caracas, BNHNA’s core “entertainment cuisine” is complemented by its newer northeast-based Haru and southwest RA Sushi. Of the five stocks in this list, BNHNA has been the best performer year to date and is up nearly 150% since hitting its 52-week low in November. I wouldn’t let that nor the stock’s relatively high P/E deter me from giving it a look. Taking into account $4.2M of restructuring charges and a $9.6M non-cash asset impairment charge in fiscal Q3 (which is calendar Q4 for the company), normalized EPS implies a price-to-earnings ratio of 5.83. That charge resulted in the first loss for Benihana in any quarter over the past fifteen years - quite a track record. Shares got a nice boost last week when the company announced a 5.4% sales increase from calendar Q1 of 2008. To help provide capital for expansion and continued revenue growth, Benihana secured a relatively inexpensive (2.2%) $75M credit line in March of 2007, of which it has borrowed a little over a third, and has access to that credit for another three years.
GSI Group (GSIG)GSI Group, a maker of lasers, laser systems and precision motion equipment is likely the most speculative of these five stocks. First and foremost, the company has some unresolved accounting issues from as far back as 2006. The company has stated that it “does not expect its cash position will be materially impacted by the correction of these accounting errors.” Since GSIG shares trade at $0.10 on the dollar of tangible equity and roughly 19% of its last reported net cash position (June 2008 balance sheet), the market, however, isn’t as confident. There are others who believe that GSI Group will get through these accounting problems and see a major recovery in share price. One such believer is Stephen Bershad, the CEO of precision motion rival Axsys Technologies (AXYS). According to this SEC filing, Mr. Bershad personally purchased 3.3 million shares of GSIG in February and did so perhaps based on interest in purchasing Axsys that he’s received from large defense contractors. AXYS, by comparison, trades at 5.16 times tangible book value. Another Seeking Alpha contributor noted these same potential catalysts in mid-March. Unless an utterly catastrophic accounting correction takes place in the next few months and annihilates management credibility, it seems as though much of the bad news is currently priced into GSIG shares.
SORL Auto Parts (SORL)The one Chinese stock on this list is also from an industry that’s under tremendous pressure these days. SORL Auto Parts is China’s largest manufacturer of air brake systems for commercial vehicles. 2008 was a great year for the company as revenues rose 13% and net income improved 15% from 2007. There was, as expected, significant weakness in Q4 2008 as sales fell and net income dropped to $0.10/share. Even if quarterly net income dropped another 20%, SORL shares would be trading at an annualized P/E of 6.25. That’s hardly rich for a company that’s poised to benefit from growing transportation needs in China and access to markets across the globe.
TII Network Technologies (TIII)Founded in 1964 and currently based out of Edgewood, New York, Tii Network Technologies is the second nanocap on this list. The company develops a number of connectivity products for in triple play or strictly VoIP services. Considering that TIII had $8.28M of net cash on its balance sheet at the end of 2008 and now trades at a market cap just below that level, the market is clearly pricing in weakness for telco spending in 2009 having a serious impact on the company. There are some deteriorating product lines and that has shown up in near 25% top line decrease from 2007 to 2008 and a quarterly loss to close out an otherwise profitable year. Current CEO Ken Paladino helped see Tii through difficult times as CFO in 2003. After dropping by more than half since the beginning of the decade, company revenue troughed that year and began a steady recovery. TIII shares saw a low of $0.13/share in 2003, but bounced back sharply to see prices greater than $2 by the end of that year. On a positive note, insiders have been acquiring stock over the past six months. If the company can manage costs through an economic slowdown and kick start growth in certain product lines, profitability could be maintained and shares would then likely see a very sharp rise later this year.
While these five stocks have passed the initial screener and my brief, preliminary analysis, I have not fully analyzed these companies. If you find any of them interesting you should perform additional research before investing. This article is also available at Seeking Alpha including relevant comments. Disclosure: At the time of this writing, the author has long positions in QXM and ZINC.
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As Don Clark’s WSJ blog entry noted earlier this month, many Rambus shareholders form “an active community that buzzes in online forums over each twist and turn in the company’s complex legal battles.” These passionate shareholders, sometimes referred to as “Ramboids”, have strongly expressed their disagreement to my earlier contribution on Rambus. Lead Ramboid and fellow Seeking Alpha contributor “Prufrock” has loosely tossed around the word “fact” in his contributions. I’m sorry, but to say that an activist shareholder website like Rambus.org is full of “facts” or is “independent” is simply absurd. Ramboids use sites like this and message boards to try to tell their side of the story and the reasons why they believe that RMBS shares are a good investment. Their efforts and dedication are to be admired, but insults and unwillingness to hear an opposing viewpoint are not. Here’s a fact: that contradictory view so far has been the correct one. The performance of RMBS shares has been, particularly on a risk adjusted basis, simply awful.  In one, two, three and five year time periods, Rambus shares have significantly underperformed the NASDAQ 100 Trust Shares. In a ten year time frame, performance is better. Considering that the volatility of Rambus shares is much, much higher than the relevant indices and the historical Sharpe ratio is much lower, the risk adjusted returns of Rambus shares are poor even in the ten year time frame. However, as most mutual funds will tell prospective investors, past results are not necessarily indicative of future performance. Without a doubt, litigation and possible settlements will play a huge role in the direction of those results. I have expressed my bearish view on the direction of RMBS shares and I’ll add a couple of additional points before offering an alternative strategy.
First, there’s the legendary JEDEC saga that started it all. The Ramboids’ beloved Judge Whyte did confirm the March 2008 jury decision that found Rambus “not to have unfairly withheld information from other JEDEC members.” I don’t agree with this decision and JEDEC’s need to change industry specification development to prevent “gaming” supports this view. Harvard Business School professor Josh Lerner describes what happened this way: "Ultimately, however, the centralized appellate court for patent cases in the U.S., the Court of Appeals for the Federal Circuit, decided that Rambus' behavior was acceptable. In effect, the appeals court did not dispute that Rambus tried to commit fraud, but ruled that they didn't succeed: Despite Rambus' best efforts to craft their patent claims around the elements of the standard, it was, in the court's judgment, possible to comply with the standard without infringing any of the Rambus patents. And the court ruled that, as a legal matter, there could be no fraud in this case because the JEDEC policy only required disclosure of patent applications on inventions necessary for the standard. Rambus was thus free to sue—and demand huge settlements from—rivals who took part in the JEDEC's standard setting process in good faith." The FTC didn’t agree with the court that it was possible to comply with the standard without infringing on Rambus patents and so began the FTC’s anti-trust action, referred to by Ramboids as a “witch hunt.” The FTC’s mission is to protect consumers, not Rambus shareholders, and that is why they took this action as far as it could go and conceded to the recent Supreme Court decision. The European Union has similar action in progress, though that action may certainly lose momentum given the FTC’s concession.
As much as Ramboids love San Jose District Court Judge Ronald Whyte and his wishes to push settlements through to end this dispute, they loathe Delaware District Court Judge Sue Robinson and her decision that Rambus’ patents are unenforceable. An excerpt from this Bloomberg bulletin summarizes: U.S. District Judge Sue L. Robinson in Wilmington said today the patents are unenforceable because Rambus destroyed documents in the infringement lawsuit. She called Rambus’s litigation conduct “obstructive at best, misleading at worst.” “The very integrity of the litigation process has been impugned,” Robinson said in the decision. Rambus said it would appeal, saying in a statement “we respectfully, but strongly disagree with this opinion.” This ruling led to a 39% single day drop in RMBS shares and added to the long list of double digit percentage moves that I mentioned earlier.
As Bloomberg again notes, the opinions of Whyte and Robinson are inconsistent and will likely result in a long legal stalemate. In the meantime, the many “new innovations” that Rambus offers aren’t leading to increased sales. Revenue fell 7.8% in 2007 and 20.8% in 2008. The company has made efforts to adjust its cost structure and reduce its annual cash burn rate of $38M, which is roughly 36% of Rambus’ net cash position ($345M cash and equivalents - $240M face value zero coupon convertible issue). If that burn rate remains constant, the company can fund eleven quarters of operations with its working capital.. In terms of future revenue, even Rambus’ most senior engineer expressed concern about real industry support for its technology in this New York Times piece. If there are cash flows from settlements, they are likely to be delayed and will need to come in at some point before working capital dries up. In the bearish view, which is likely shared by the staff at MaximumPC who have also referred to Rambus as a patent troll (because Rambus doesn’t manufacture anything and new “innovative” patents are not gaining market acceptance), this legal stalemate will persist and cash will continue to dwindle until the company is insolvent. In the contrary Ramboid view, settlements could be as high as $13B. In the financial world, we discount cash flows according to their timing. Roughly speaking, at a cost of equity of roughly 20% (a WACC approach will be slightly different), the present value of these cash flows in two years is just over $9B, which, given a 100% certainty of these cash flows, would imply that Rambus is priced at a 89% discount to its “true” value. That’s the uber-bull case. For the moderately bullish, even at a 25% probability plus present tangible book value, this valuation method would infer a price of $25/share. Adjusting probability according to individual assessment of the likelihood of these settlement dollars will produce various valuations.
Whether you’re a Rambus bear, a bull or a Ramboid uber-bull, be aware that either a long or short only position on the stock involves significant risk. As “Prufrock” suggests, RMBS could indeed bubble to $100. I’m more inclined to believe that it could fizzle to $2. In the middle of these two possible outcomes, investors who are moderately bullish on the prospects of Rambus may prefer owning the company’s zero coupon convertible bonds rather than its equity. These converts provide significant downside protection and equity like performance in the uber-bull scenario. A convertible arbitrage style strategy, however, can make money in either scenario. 
Given the recent surge in volatility in RMBS shares, over 4x the implied volatility shown by the VIX, now might be the best time to implement such a strategy: This 4x multiple is actually far from the peak of its two year range, but the absolute spread in volatility between RMBS and the VIX has not been higher in that period.  Using the zero coupon conversion ratio of 37.26, the following returns could be generated by buying these convertible notes and selling January 2010 $25 strike calls to offset the long equity component of the bonds. The returns are calculated using the holding period yield to the date of maturity due February 1st, 2010 at the specified convertible price levels plus the collected option premium.
Provided that the notes are held to maturity, this strategy results in an extremely low risk, but not entirely risk free return. Despite these notes being unsecured, default risk is very low due to the cash on Rambus’ balance sheet. Those dollars will almost certainly be returned to bondholders provided that the company’s cash burn rate does not greatly accelerate in 2009. There’s also some risk to these returns if RMBS shares fall between $25 and $26 at expiration. For example, collecting an option premium $0.80 and having RMBS shares at $25.76 at expiration would essentially erase that collected premium from the return. Finally, since standard options contracts are being used, the options don’t provide a perfect delta (strike mismatch) or theta (Jan 2010 contracts expire on the 15th) hedge.
In terms of the viewpoints, I’ve stated the bear and “Prufrock” has taken care of the bull. This convertible arbitrage strategy sidesteps the volatility that is sure to move Rambus shares in one direction or the other as the company’s ongoing litigation saga continues and the Ramboids rejoice or despair over each new development.
Disclosure: The author does not hold positions in any of the mentioned securities at the time of this writing.
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The ratings agencies have taken their fair share of abuse from Congress, media outlets as well as SeekingAlpha’s contributors. Todd Sullivan, Money Morning, Tom Brown are just a few of the contributors who have taken their shots against the controversial trio of Standard & Poor’s (MHP), Moody’s (MCO) and Fitch Ratings. Add another one to that list. These companies have destroyed the meaning of their very own ratings. They have played a crucial role in redefining how investors view the risk of assets. MHP and MCO shares, however, have held up reasonably well to the financial sector (XLF).  Since the start of 2009, ratings agency shares have even begun to outperform the sector. Meanwhile, monoline insurers and many toxic asset holders like investment banks have seen 90%+ declines in market value over the past two years. Shares of the agencies have not yet taken the beating that they deserve. Shorting the shares outright is going against major institutional grain. As of 2008 year end, Berkshire Hathaway owns 20% of MCO and T. Rowe Price holds just over 10% of MHP. Yet, after simply examining the operating segments of these two major public companies in the credit rating business, one can see that they’re not quite equals. Moody’s operating segments are all financial related while Standard & Poor’s is only one, though by far the most profitable, of three divisions within parent company McGraw-Hill. McGraw-Hill is more than just a financial company. The company generated $3.6B of revenue in non-financial businesses in 2008. These education and media businesses, however, have far lower profit margins than its financial segment. Information and media, unlike education and financial services, saw revenue growth from 2007 to 2008. Certainly, the non-financial segments of McGraw-Hill have positive value in addition to providing a bit more business diversification than its counterpart Moody’s. When strictly comparing the operating income of S&P and Moody’s in relation to the market value of the latter (as of market close on March, 20th 2009), these two segments of McGraw-Hill appear to be worthless.
Rather than risk a pure short position on MHP/MCO, this back of the envelope, sum of the parts valuation supports a long MHP/short MCO pair trade. Plus, there’s a bit more cushion from the fact that MHP’s 4.8% dividend yield is substantially higher than MCO’s 2.1%. There are no perfect peers for valuation in this manner and peer companies certainly need to have positive operating income for this methodology to apply properly. If Moody’s is considered to be slightly stronger in credit and S&P is a bit more diversified in its financial service lines, then even these two may be valued differently. I don’t believe that difference, given the extremely high correlation between the two stocks, is strong enough to produce such a large gap in present market valuation.
This article is also available at Seeking Alpha. Disclosure: The author does not hold any positions in any of the mentioned securities at the time of this writing.
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Part of the reason behind today's rally was due to Representative Barney Frank's statement that the uptick rule will be back in effect within a month. I wrote about this briefly in this article about Steve Forbes' solution to the financial crisis and I still believe that naked shorting is by far the bigger issue. Outside of the professional investing/trading circles, short selling is highly criticized, and I was reminded of this fact by the many comments on my first bearish article at SeekingAlpha. Short selling is necessary to help markets operate efficiently, but it can be abused. Prime brokerages and other security dealers whose compensation is based on transactions aren't going to turn away clients, even when shares are hard to come by. Typically, broker-dealers have up to three days to deliver shares that have been sold short. Retail brokers won't even lend their accounts shares unless they have possession of them. Don't get me started on the opportunity that I lost when my brokerage couldn't lend me shares of Dendreon (DNDN) in April of 2007. My complaints are nothing compared to those that the SEC has received for its ineffective policing of naked short sales. The SEC can only do so much given its current order ticket requirements. There's an old school solution that can help them track and enforce short selling practices.
 I'm not suggesting that we bring back stock certificate. Though OneShare.com is making a pretty good business doing just that. I'm thinking about picking up a share of Citicorp with a memorable inscription to help remember the lessons of this financial crisis and to decorate my living room wall. My solution focuses on the red numbers on the stock certificate. The concept of a serial number and a share (or block of shares) of stock has been long lost and nearly erased in the digital age. I think it's time that we bring it back and make it a mandatory piece of order ticket sales. The SEC can allocate digital serial number blocks to various holders and specify minimum block sizes at their discretion. If an abusive short seller tries to push through a trade, even a short term trade, with a block that is sitting in a cash account, the SEC can finally track them with a system like this. Maintaining a system like this, however, requires a new school solution. Hard disk defragmentation is a perfect model. As you use your computer, blocks on a disk, groups of which make up single files, get overwritten. These blocks can become fragmented and blocks that make up a single file can become highly discontiguous, which results in higher access times. In the same way that an operating system performs routine disk defragmentation, the SEC can reassign digital stock serial number on whatever basis it sees fit as periodic short sale lending and overall trading disrupt block assignments (likely that this would be monthly or quarterly). With a system like this in place, the SEC would finally have the forensics infrastructure in place to fight abusive naked short selling. This could have a huge impact on highly shorted names. However, heavily shorted names are not all the same. The metrics that we use to determine the extent that a stock is short sold vary greatly. Some are relative to volume/liquidity and some are not.
The above top ten screen lists small cap companies (less than $2B in market cap) companies with greater than 20% of their shares outstanding sold short. Certainly, each of these companies has different operational situations that need to be examined on a case by case basis. Because these names have relatively strong daily trading volume, it is likely that they would benefit more from a new naked short selling forensic program rather than the restoration of the uptick rule. A thicker order book would provide more resistance to a short seller attempting to crush the bid and move the stock price downward.
In this screen, which considers companies with greater than 10% shares short, there is a strong inverse correlation between days to cover and daily volume. Here, both the uptick rule and naked short selling forensics would likely be useful. As investors, we must consider how regulation changes will effect our holdings and these heavily shorted names should be impacted more than most others.
Disclosure: The author does not hold any positions in any of the mentioned securities at the time of this writing.
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When it comes to Rambus (RMBS), a lawyer might be better qualified than a financial analyst to determine the direction of its shares. Wednesday was another fine example of this stock’s volatile responsiveness to legal and regulatory developments. Rambus shares rose 8.8% after a US District court in San Francisco ruled in their favor on Tuesday afternoon. RMBS is, after all, a high beta (~2.2) stock and large moves are to be expected. The stock has posted double digit percentage gains on 123 trading days since its IPO on May 14th, 1997. However, even when including the years before the tech bubble burst, most of these big moves have come from legal, not product or real earnings related developments.
Nine out of the ten biggest daily percentage price movements in this stock have been due to legal decisions or speculation of a forthcoming ruling. It’s not likely to end soon either. Ever since Samsung, Hynix and Infineon settled after a price fixing suit by the Department of Justice, Rambus has been fully committed to pursuing legal action to gain compensation for the utter failure of RDRAM in the PC market. RDRAM failed because the minimal performance benefits that it provided were not worth the cost to consumers. This was the core reason for the mass adoption of cheaper chipsets supporting SDRAM and the marginalization of Rambus’s technology. That didn’t stop them. The company used its memory intellectual property portfolio to levy royalties on DDR (double-data rate) SDRAM and is still fighting the FTC to keep royalty levels high. Rambus also has legal proceedings in process against graphics giant Nvidia (NVDA) and Micron Technology (MU). They would probably sue everyone who has ever put random access memory in a chassis if juicy settlements would come out of it. In the tech world (or geek speak), a company like this is called a patent troll. The claim is that a company that behaves this way stifles innovation by preventing or inhibiting the creation of open standards that result in cheaper, royalty free (or low royalty) technologies. I personally agree with this claim, but it’s certainly open for debate and viewed differently by those companies who possess valuable intellectual property and those who profit from the proliferation of open standards. With a business model that focuses on the design of memory systems and enforcement of a substantial IP portfolio, Rambus is the former of those two.
That business, however, has been struggling. Rambus has posted a net loss in 9 out its 10 last quarters. Revenues have declined steadily while costs have remained high. Litigation expense is on pace to overtake research and development for the first time in three years. That’s hardly a commitment to innovation. Market factors aren’t working in the company’s favor either. Gartner’s dire forecast for the PC sales is not going to help. Increasing video game console life cycles won’t present design opportunities for Rambus like it did for the Playstation 3. So, the business of Rambus is in decline. In this economic environment, particularly with memory components and specialty semiconductors, what technology company isn’t struggling? Shares of RMBS are not reflecting this fact. It trades at nearly 4x tangible book value while shares of SanDisk (SNDK) and Micron trade at fractions of theirs. Sure, big manufacturers like those have different cost structures and that should be reflected in valuation, but Rambus even trades at a significant premium to profitable fabless semiconductor companies like Sigma Designs (SIGM – 1.3x tangible book value) and Actions (ACTS – 0.4x). $345M of cash on Rambus’s balance sheet is a positive thing, but using it to fund an army of lawyers and buy back stock on the way down isn’t. This cash came via a zero coupon convertible bond offering (currently yielding 6.86%) that is due on February 1st, 2010. The tangible assets of Rambus are minimal. If the company’s cash burn rate continues (or accelerates) and the credit markets remain tight, then the bond holders may be in just as much trouble.
The potential litigation rewards for Rambus could present ephemeral trouble for anyone who is short this stock. A “not-so-normal” return distribution above demonstrates this. Price movements in RMBS shares are extreme – take a look at the jagged cliffs of any multi-year chart to see for yourself. Given valuation, there is probably a large, nine-figure litigation reward already priced into the company’s shares. I am not a lawyer, but I have followed this company for a long time and believe that I am providing a reasonable estimate. Even if that massive settlement actually happens, where is Rambus headed? It would be a monumental task to get Rambus back to profitability and build its client base after dragging so many technology companies through their legal meat grinder.
This article is also available at Seeking Alpha. Disclosure: The author holds a long position in SIGM at the time of this writing.
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Following my colleague John Femino’s recent article, I wanted to add my own contribution on some great high yielding equity opportunities in the lower end of the market capitalization spectrum. Long term investors can use a high, consistent dividend yield combined with a DRIP (Dividend Reinvestment Plan) to boost returns over time or provide a steady income stream. Plus, it's a widely held belief that small and micro capitalization value stocks are leading performers during market recoveries. Don’t just take my word, take Fidelity’s (though the analysis is via John Prestbo from MarketWatch). Yet with dividends now being slashed on non-financials, how can we find safe dividend stocks? There are no guarantees, but companies that payout less than 100% of earnings and have the net cash to cover a large dividend are capable of preserving high yields despite difficult economic times. If a company has little debt and can deliver cash to shareholders from both operations and its balance sheet, it is truly the widest margin of safety that an investor can hope to find. The five following stocks meet these criteria:
Despite having a really neat ticker symbol, Astro-Med currently trades well below its $7 tangible book value per share. The Rhode Island based company operates in three divisions, the largest of which is QuickLabel Systems (52.7% of revenue, 46.7% of operating income). Grass Technologies (24.9%, 26.1%), makers of neurophysiology monitoring devices, and its test and measurement group (22.4%, 27.2%), clients of which include Boeing and Airbus, make up the other half of sales. It is an interesting product mix, but the combination has led to flat sales from 2007 to 2008. Astro-Med expects to report a net income drop of 33% from the prior fiscal year which is driven by sales from the Q4 falling 14% from 2007. The company announced preliminary earnings on February 18th and tempered investor expectations for the coming year. Trading at a 12 month average volume of just over 5100 shares, liquidity has been an issue with this stock as it often is with many micro caps (including those in this list). In fact, ALOT stock had zero volume on 29 days over the past full year and traded more than $100,000 in dollar volume on only twenty of those trading days. However, with over three dollars in cash per share on its balance sheet and nearly six million dollars in free cash flow generated during the twelve months prior to November 2008, Astro-Med’s own liquidity is ample to sustain its dividend through deteriorating economic conditions.
Towering over this list at a yield of over 18%, consumer goods company CCA Industries will pay out its quarterly dividend of $0.11 on March 3rd, 2009. CCA sells a variety of brands in dietary supplements (Mega-T), skin (HairOff, Bikini Zone), hair (Wash ‘N Curl), nail (Nutra Nail) and oral care (Plus White). These brands are typically geared towards the budget conscious and should show some resistance during the consumer slowdown. While the company sells its products to the big three drug stores (Walgreens, Rite-Aid and CVS), 44% of CCA’s 2008 revenue came from Wal-Mart and they could reap some tailwinds from the mega-retailer’s recession-proof sales machine. So far, that thesis hasn’t held up. While the company reported a $0.20 profit for its fiscal 2008, the last quarter was challenging for the CCA. The company saw a 16% revenue decrease and posted a loss of $0.12/share. Like many larger branded companies, CCA management continued to invest in its brands during the fourth quarter recession which led to a larger loss from increased SG&A. But at only $2.36/share, CCA trades at 56% of its tangible book value. With zero long term debt on its balance sheet, valuation would indicate that there is a lot of downside presently priced into the stock.
At well under ten million, this “nano cap” is another stock with a great ticker symbol (not that a great ticker symbol has anything to do with being a great stock). Electro-Sensors is a very small company with less than fifty employees, but it has been in business for forty years and publicly traded since 1990. That’s not exactly a “fly by night” micro/nano capitalization company. Electro-Sensors has an impressive customer list. That may not be important for a large corporation, but for a company of this size, having many Fortune 500 customers provides significant reputational capital. The company has two operating segments, but production monitoring products, which are effectively sensors and other industrial parts, make up 92% of their revenue and an even higher percentage of pretax income (see note 9 of their latest Q3 10-Q filing). The other operating segment of the company is a subsidiary called AutoData Systems, which produces OCR (optical character recognition) software and hardware. Despite the subsidiary’s small footprint in the overall company, the unit did see 31% revenue year-over-year growth during Q3 2008. The cyclical exposure of their core business is a large reason why the stock trades at a discount to net cash and securities, but Electro-Sensor’s last quarterly dividend of four cents was still paid out like clockwork on February 20th, 2009. With their current cash position, management can pay a $0.16 annual dividend out fifteen times over.
MOCON is the largest of these companies by market capitalization and, since it trades at close to twice tangible book value, is also the most expensive relative to its balance sheet. MOCON’s name comes from the original corporation called Modern Controls, Inc. that was formed in 1966 and renamed just two years later. Founded and still based out of Minneapolis, MOCON now designs and manufactures instruments that detect and analyze gases and trace compounds in the air. The applications for these products vary from homeland security, air quality as well as oil/gas exploration and over 60% of MOCON’s revenue now comes from outside of the United States. Sales in Asia during Q3 2008 grew 32% year-over-year, offsetting domestic softness. The company has paid a dividend for 82 straight quarters and just increased its annual payout to $0.36/share, representing an increase of 12.5% from a year ago. MOCO has been public since 1989 and has not posted a loss in any full year since its IPO. With $15 million of cash on its balance sheet and trailing twelve month free cash flow of $3.7 million, their growing yearly dividend payout, which is roughly half of that FCF, looks relatively safe.
Wayside Technology Group (WSTG) This is probably one of the worst named public companies that I’ve come across. Wayside’s single digit gross margins also aren’t the best that an investor could hope for, but considering its triple digit inventory turns, the company’s distribution system may have enough flexibility to handle declining sales (and they did decline 3.2% in 2008). WSTG’s three sub brands, Lifeboat Distribution, TechXtend and Programmer’s Paradise are all resellers of third party software and hardware. It appears that the loss of VMware resales through Lifeboat Distribution, which made up 17% of total sales, was a real blow to Wayside. The company is trying to move that division’s sales force over to Virtual Iron to pick up the slack. Let’s face it, this is not really a technology company. It’s a sales force that sells IT products. As a tech guy, that’s not very interesting. However, as a value investor seeking high yields and solid balance sheets, WSTG’s $4 in cash per share doesn’t look quite so bad. Plus, management has a serious stake. CEO Simon Nynes, who has been with Wayside for over ten years and at the helm for just under three, owns 4.7% of the company. He’s also done a reasonable job managing SG&A expenses which is of crucial importance given those thin gross margins. Those expenses are now roughly half what they were before the last economic slowdown.
While these five stocks have passed the initial screener and my brief, preliminary analysis, I have not fully analyzed these companies. If you find any of them interesting you should perform additional research before investing. Please contact us to be notified if one of our analysts assumes full coverage of one of these companies. This article is also available at SeekingAlpha. Disclosure: The author does not have a position in any of the stocks mentioned in this article.
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A few days ago, I received an interesting presentation from a current student in UNC's MBA program about the spread between gold and platinum. I can't say that I follow platinum prices with any regularity, but, as my students can affirm, I've been a gold bull for several months. There has been a lot of talk about a gold bubble recently and his gold/platinum argument was intriguing, so I thought I'd take a deeper look at the relationship between these two precious metals. The last time gold was above a thousand dollars an ounce, platinum was well over two thousand. A year later, gold is back near that level and platinum is less than half of its earlier peak.  The student, who is using this analysis to demonstrate a long platinum/short gold trade, started out with a Bloomberg screen grab of the absolute spread between the two metals since the early 1990's. He's not the only one who is behind such a trade - apparently, the Financial Times Lex column is with him. There's certainly a huge surge in the absolute ratio during the recent commodity bull run, but what about a longer time frame? Thanks to the data at bullion dealer Kitco, we can look at data from the past 40 years only to find that platinum has indeed traded at a discount to gold for extended periods of time. 1981 through 1987 serves as the best lesson for those who believe that Pt must trade at premium to Au.  Gold may be the ultimate safety position for economically uncertain times. Kitco's senior analyst Jon Nadler even referred to gold as "life insurance for your portfolio." Platinum simply doesn't have the same stigma. Plus, with all of the ETF gold products out there (GLD, IAU, GTU, etc) platinum is also not nearly as liquid. However, Barron's notes that this ETF explosion may be amplifying gold's upward momentum. Even in the face of gold's upward trajectory, there are plenty of reasons why platinum is worth more than gold and history offers more proof.  Since 1973, platinum has seen an average monthly price at least 20% higher than gold for 292 months, which is just over two-thirds of the time frame. Compare that to the much rarer discount case which occurred in only five and half years. Platinum may be thirty times more scarce and more difficult to mine than gold, but demand has also been heavily correlated historically to the success of the auto industry. Before I get into a twenty page discussion of why that's keeping platinum lower than gold, let's just ask a simple question: what are investors looking for? The answer: safety. Historical analysis of gold and platinum returns over the past forty years shows that gold has offered much more safety and stability.  Now, I am far from an expert on commodities, but this analysis clearly shows that gold is a lower beta asset than platinum. In fact, it's a more efficient asset. It has a lower standard deviation of return in all but one of the above time periods and holds up very well in terms of returns. This is at the heart of what is driving up the price of gold. ETFs and other new gold ownership securities may be adding a few percentage points. This analysis really tells me that a gold versus platinum decision depends on your economic outlook and inflation expectations. If you're a bear and are more concerned about continued deflation rather than inflation, buy gold. If you're a bear and feel that inflation is right around the corner with all of the money that's being printed, both precious metals should do well if the dollar falters. If you're a bull, and I like to think I have a few horns left in me, platinum should outperform gold. However, if gold continues its run and platinum begins to trade at a 20%+ discount, the historical study indicates that it's probably better to send your gold out in those envelopes and be long platinum regardless of overall sentiment.
Some of the resources in this article were contributed by the aforementioned first year UNC MBA student. If you would like to get in touch with him regarding his analysis, please contact us and we will forward your request. Disclosure: The author does not have a position in any of the mentioned companies or ETFs.
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Mandates Drive BehaviorToby emphasized the role of government mandates in dictating how green technologies will be adopted. One of these mandates is a ban of the traditional incandescent light bulbs that so many of us have used all our lives. It is widely known that incandescent bulbs produce a lot of heat and don't last particularly long. Many countries currently have restrictions in place and bans in Europe will begin in 2012. The United States is expected to follow in 2014. This has led to increased sales of the coiled CFL (compact fluorescent light) bulbs, particularly at leaders like Wal-Mart. According to Mr. Smith, CFL (~75% light efficient) is the first step and that LED (light-emitting diode) technology (~95% efficient), despite its present cost, is next. To capitalize on this trend, one of the ideas that Toby likes (and owns a small position in) is Durham, North Carolina based CREE and is "thoroughly amazed that Philips hasn't bought them yet." Philips did decide to buy Color Kinetics in the summer of 2007, so perhaps they feel that their LED portfolio is complete. Adding to his thesis is that Cree's LED intellectual property is deep and offers a lucrative license revenue stream. If the company stays independent, its China-based manufacturing capabilities acquired from Cotco should help it compete in production with larger LED rivals Philips and GE. Government support for increasing the financing behind power purchase agreements (PPA) is something that Tobin says could be a major driver for green adoption. While the new democratic administration has its own solar plans, Toby thinks this alternative could have huge upside in terms of energy independence and making strides in updating the nation's infrastructure. He proposes the creation of a "Greenie Mae" - essentially an environmental version of Ginnie Mae that would issue twenty year paper at some spread over treasuries to back the purchase of solar and smart utility equipment that could then be used to sell power back to electric utilities (this is the basics of a PPA). It's an interesting idea, but there are quite a few problems, some of which Toby freely recognizes. First, with all of the capital losses in the markets right now, few actually need the tax credits that this would provide. Second, declines in energy prices make this less viable - for now. Finally, the name "Greenie Mae" is just awful. He's working on a new one. How about Sunnie Mae or Green Energy Investment Cooperation (aka GEICO)? The government can simply piggy back on the brand equity that Warren Buffett's auto insurer has built up by saturating television stations with images of cavemen in inappropriate situations. Smart InfrastructureAll kidding aside, Tobin believes that there are plenty of great investment opportunities in smart electric infrastructure. Google's recent announcement of PowerMeter validates this thesis from the software and services side. Itron (ITRI) is one of Toby's favorites. He points out that their acquisitions have made the company the leader in advanced meter technology. Echelon Corporation (ELON), which offers software and hardware for metering and electric control, is another of his favorites. Echelon's technology lets users look up and adjust energy usage remotely, and, for those who have power generation equipment like solar on site, measure how much electricity was sold back to utilities. Be wary about valuation with both of these stocks. Though it does have an $80M cash cushion (roughly a third of its market cap), Echelon has not had a profitable year since 2004. Likewise, Itron's 2007 acquisiton of Actaris for $1.6B dramatically increased the combined company's leverage. At 70x trailing twelve months earnings, it looks pretty expensive. 13x TTM free cash flow may seem a bit cheaper, but certainly not a bargain given the valuations in this market. Quite a few other speakers at the show recommended Quanta Services (PWR) as the best way to play government infrastructure spending towards a smarter, more efficient grid. Tobin says that, while Quanta is a primary beneficiary, it is more about the company's ability to navigate local regulatory authorities rather than a distinct technology advantage. To him, Quanta is more of a construction company than a pure play on the emerging smart grid and it's therefore likely that the stock will reflect valuation of its construction peer group. Realities vs Hype of Green AdoptionThis is one of the most significant topics in Billion Dollar Green. Tobin Smith hopes that his book will be a guide for those who are trying to distinguish between hype and reality in green investing. For example, take a look at fuel cell technology. There are dozens of microcaps out there with no revenue that promise the next great breakthrough, but his favorite is a private company called Bloom Energy. For full disclosure, Mr. Smith is an angel/VC investor in this company and claims that the company has a $150M backlog and boasts Google among its biggest customers. Toby says that Google is using 200 of the company's fuel cells to power its data centers. I can't verify that claim, but I can say that CNN Money named Bloom Energy one its 15 Companies that will Change the World. Bloom has been in business for eight years and if the company does go public, it's likely that investors like Tobin will require quite a multiple to divest. Tobin also thinks a company like FPL Group (FPL), with its leading position in wind energy generation, is far from hype. It seems like a high growth utility to me and there may be reason for concern about growth in Florida, by far its largest market. In terms of hype, Tobin's capitalized short opportunities in names like Energy Conversion Devices (ENER) and LDK Solar (LDK), but wouldn't stay short at these levels. "Energy Conversion Devices has a viable business with their thin film products, but the valuation was simply too high," he noted. Tobin and I both agreed that shorts are getting harder to find with the market correction. I suggested former high flier Hoku Scientific (HOKU) and he jumped right on it as a potential short idea. He pointed out that the company has little to no revenue, got into polysilicon production near the peak of the market, the few customers it does have are armed with buyout provisions in their contracts and that their hydrogen fuel cell technology is unproven. I enjoyed my conversation with Tobin Smith and I hope that his book proves to be a success. This article is also available at Seeking Alpha. Disclosure: The author does not have a position in any of the mentioned companies.
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Last Wednesday I had an opportunity to hear Steve Forbes speak at the World Money Show. After participating in a panel discussion with Standard & Poors' chief economist David Wyss, John Rutledge, Dennis Gartman and former FDIC chairman Bill Isaac, Forbes gave an interesting keynote address. I've never been a big fan of Forbes, but he was entertaining. It reminded me of his Saturday Night Live appearance during his presidential campaign and the emergence of Teve Torbes. He did throw in quite a few shots against the IRS without even outrightly mentioning his infamous flat tax proposals, but I was much more interested in his four step solution to the current economic and financial crisis. Promote a Strong and Stable DollarForbes' strong dollar stance is probably part of a longer term philosophy than the three other components. This will require higher interest rates, something that certainly can't be done in this environment. Eventually, he sees private, personal social security investment accounts taking advantage of low-risk, high yielding financial instruments. I'm not sure that we'll ever see the high interest rates like the country had under former Fed chairman and current Obama economic advisory panel leader Paul Volcker. As for dollar stability, that seems like a no brainer but it's dependent on market conditions that may be highly resistant to policy measures. Eliminate Mark-to-Market AccountingThere was a lot of talk at the event about mark-to-market accounting and its role in the financial crisis. Some suggest eliminating it all together, while others believe that just a brief suspension of the practice would help to restore confidence. Not just the banks are effected, but, as I wrote earlier, private equity investors as well. I find it ironic that avid free market proponents like Forbes would want to move away from market based pricing to mark-to-model. This is especially true considering that the models used to price these assets were flawed. That's a big reason why I believe that the ratings agencies that produced those models haven't yet felt their maximum pain. To capitalize on this possibility, a good pair trade to consider is long McGraw-Hill (MHP), the parent company of Standard & Poor's, and short Moody's (MCO). McGraw-Hill is currently yielding 3.6% (a full two hundred basis points over Moody's), trades at a lower trailing and forward earnings multiple and has a much more diversified business model that includes education and media services. Meanwhile, these two stocks have a 0.98 correlation over the past three years. Look for that to change. Restore the Uptick RuleThis is a topic that I wrote a paper about last spring and had shared through my old, now defunct, blog, Techuities.com. In a declining market, the uptick rule does add some stability, but it's not the cure all for which many are looking. If a stock is sufficiently liquid and shares sold short are not fabricated (see the next item), the market should be able to prevent a bear raid without the uptick rule. Enforce Rules Against Naked Short SellingWhile the uptick rule places an artificial restriction on market participants who wish to short, naked shorting is something very different. Simply put, it is shorting a stock without first finding shares of the stock to borrow for sale. Forbes is right, this is a serious problem. I've heard hedge fund managers say that they should be able to short a stock without restriction. Should anyone be able to conduct an exchange with something they don't first possess? No, otherwise someone would make a fortune selling invisible houses. It would allow stocks to have more than 100% of their shares sold short. It's rare to see this in monthly short interest snapshots, but it's likely to happen at multiple points in time between the data points that the exchanges report. While the SEC takes the bulk of the blame for this, they have been making efforts to step up enforcement on abusive short selling. The prime brokerages of the investment banks that rake in fees from hedge funds certainly have a role in this as well, but they've got bigger problems. Frankly, this is a byproduct of the digital trading age and the only way to solve the problem is to take a zero tolerance approach to naked shorting by improving the SEC's digital forensics capabilities.
Disclosure: The author does not have a position in any of the mentioned companies.
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Having been so intrigued by James Altucher's pick Cynosure (CYNO), I decided to listen to his longer individual presentation on the demographic investing opportunities explored in his new book. Altucher is a manager of a fund of hedge funds called Formula Capital and, like myself, has a background in computer science. One of the organizers of the World Money Show said that Altucher would be willing to be interviewed, but since my e-mails went unresponded, apparently, not interviewed by someone writing for SeekingAlpha. Oh well, I suppose RealMoney and TheStreet.com are fighting hard for web traffic these days. Regardless, I find Altucher's ideas interesting and thought it would be worthwhile to examine some of the themes that he sees driving profits and high equity returns through the next few years (aside from tattoo removal). ObesityIt's pretty clear that obesity is an enormous problem in the U.S., but apparently the old favorites NutriSystem (NTSI) and Weight Watchers (WTW) may not be the best way to play this unfortunate trend. While drug makers search for new obesity treatments to find a quicker fix, Altucher found an interesting corollary play related to sleep apnea in the form of ResMed (RMD). According to SleepEducation.com, there is a strong relationship between weight and obstructive sleep apnea (OSA), with OSA being most common in obese, middle-aged men. ResMed makes diagnostic and treatment equipment for sleep-disordered breathing. At 27x trailing/16x forward EPS, there is a lot of growth priced in to RMD shares. His other obesity related idea is small cap Synovis Life Technologies (SYNO) which makes biomaterial surgical staples and related products that are used in, among other procedures, gastric bypass surgery. I wonder how New York Governor Patterson's proposed soda tax fits into this thesis! Auto SafetyAs automakers focus on fuel efficiency and produce even lighter cars, safety is a more paramount concern than ever before. Altucher's way to play this is through AutoLiv (ALV). A large holder in ALV is Renaissance Technologies, an exceptional hedge fund that is known primarily for its quantitative strategies. Altucher is a pretty big fan of RenTec. It seems, however, that auto parts manufacturers are facing some serious headwinds. Despite AutoLiv's safety patent portfolio and 4.7% dividend yield, I've been told by an auto analyst, who knows that business far better than I ever will, that Borg Warner (BWA) is one of the few names to own in that space. Clean WaterAccording to Altucher, the world's population has doubled since 1950 but water consumption has increased three fold. His pick to capitalize on this trend is IDEXX Laboratories (IDXX) which offers water testing services. The company is not really known for that business. 82% of its 2007 revenue came from its veterinary division compared to 7% for water. I suppose that increased pet ownership is also a demographic trend and pets do need clean water! I don't have an alternative clean water investment on hand, but our industrial analyst is going to keep an eye out for some. Baby BoomersAnother well known trend, but he focuses on Alzheimer's and likes some of the large cap pharma that have promising treatments for the degenerative brain disease. This is such a well known trend that it's difficult to find an untapped investment idea in the area. Aside from healthcare, it's tough to throw all boomers into a category of consumption. Some will travel and others will play golf. I think a better way to play this trend is through Zimmer Holdings (ZMH), one of the leaders in joint reconstruction. The baby boomers have been an active generation and will require many knee and hip replacements in the coming years. ZMH has been halved since September and hasn't been available at a single digit earnings multiple for many years. Identity TheftHe really skipped over this trend, but I caught a glimpse of his small cap pick, Intersections (INTX). Intersections is a Virginia based company that also offers background check services for employers. This is a name that I have been examining for coverage over at SmicroCaps. INTX's 30%+ top line growth is impressive, but it's sub-$100M market cap and lack of liquidity suggests limited institutional interest.  The stock trades roughly $80,000 average daily dollar volume - that's thin for retail. Combine that with bid-ask spreads that can often exceed 6% of trading prices for sustained periods (see the above chart - how about a 12% round trip haircut!) and the illiquidity is pretty clear. Like pretty much everyone else, INTX's management acknowledges a tough environment, and Q4 results will be interesting. The company has a large fixed cost structure that could leave it vulnerable to a revenue shortfall. Pawn ShopsThe idea that cash strapped consumers will line up to sell goods like gold at bargain basement prices is not new. That's why this is probably his worst, late to the game theme for which he recommends with Cash America International (CSH). Many pawn shop related stocks have handily outperformed the S&P 500 over the past year and CSH, which, after a recent dive, has performed no better than the index's dismal return. Meanwhile, its peers EZPW (low single digit return) and FCFS (~80% 1-year return) have done very well.
Altucher jokes that the best part of his book is a crossword puzzle that he created and I'm not sure if that's his unique brand of humor or some weird marketing ploy. He is; however, one of the better analysts from that other financial site. I still have a hard time believing that their dividend and value analyst recommended MON. No matter what you think of the company's business, 8x tangible book could hardly be considered a value investment in this market (unless growth style has completely disappeared). Plus, how can a paltry 1.5% yield be the compelling factor to go long when the S&P 500 is yielding 2.9%? Simply put, MON is a growth stock. This article is also available at SeekingAlpha. Disclosure: The author does not have a position in any of the mentioned companies.
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This is my first trip to InterShow’s the World Money Show in Orlando, Florida. After speaking to a few frequenters of the event, the list of speakers is completely different this year. Last year’s group apparently lost a lot of credibility after the market plunge of 2008. While the attendees at the event are almost entirely retail investors and the majority have AARP cards, the morning’s economic speaker Ron Muhlenkamp summed it up well for the younger ones among the crowd. He said, “everyone’s first recession as an adult is traumatic.” It takes living through four or five to truly have perspective during troubled times.
That’s why most of the attendees are looking for ideas for putting money to work. There are some great panels, lecture topics and individual speakers, but the two most prominent topics are energy investing and technical analysis. Now, having received my financial education from a distinguished professor who is a product of the University of Chicago’s efficient market school of thought, I simply can’t buy into any of the schools of technical analysis or high frequency trading philosophies. Volatility and market distortions can destroy any methodology, but when fundamentals are not working, market technicians seem to have more pull than ever.
Unlike the chartists, the distributions paid by energy trusts are real. Pengrowth’s (PGH) presence here is clear to everyone wearing a name tag. Here’s a sample of high yielding energy plays that are here at the show:
Are dividends falling? Certainly they have to as energy prices have declined, but they’re holding up well and many of them pay monthly distributions that offer a lot more visibility into future payouts.
The panel assembled to promote TheStreet.com’s (TSCM) investment products offered a few interesting ideas. The most interesting of these to me is Cynosure (CYNO), which was recommended by James Altucher. Altucher’s new book, The Forever Portfolio, seeks investing opportunities in long term demographic trends. Along with skin tightening and other cosmetic procedures, Cynosure develops tattoo removal systems. While I think he may have found something here, the number of tattooed Americans doesn’t seem to be all that astronomical. Yet at 5x trailing EPS and two thirds of tangible book value, it looks very cheap and will find a place on my due diligence to-do list. This article is also available at SeekingAlpha. Disclosure: The author does not have a position in any of the mentioned companies.
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I was fortunate enough to attend the UNC Kenan-Flagler 2nd Annual Alternative Investments Conferrence last Thursday. The student organizers assembled an outstanding group of speakers and panel members and this year's conference was even better than last year's inaugural event. The day began with a bearish keynote from Daniel D'Aniello, a founding partner of the Carlyle Group. Mr. D'Aniello predicted 2009 global GDP contraction (in fact, he used a picture of a toilet to describe his outlook), a mid-2010 recovery with much more deflation and deleveraging to come. He boasted about Carlyle's ample dry powder, but noted that most endowments and institutions have significant overallocations in private equity investments due to lack of mark-to-market valuation. The impact of FAS 157 on private equity accounting was a pervasive topic at this year's conference. As someone whose available investment universe is limited to the public arena, I believe it's only fair that asset devaluation and the new reality of things be reflected in private equity portfolios. To begin the day's discussions, I moved on to a panel discussion entitled "The Ever Crowding Middle-Market." The common themes were present here: deals are still getting done but with far less leverage and at new valuation metrics that could persist for five to seven years. Sellers to private equity investors are being patient as the multiples that their businesses command have decreased. Will they be more inclined to sell if the current situation persists? If the business is still producing healthy cash flow, that's unlikely. One manager noted that there are still exits available for strategic corporate buyers. In cash rich technology and healthcare public sectors, strategic acquisitions are of paramount importance, but buyers can find plenty of cheap valuations in the public markets. Private equity sellers who paid premium multiples with leverage in prior years and are under pressure to return capital to investors will face severe headwinds even if their portfolio companies offer significant strategic value. Next, I was off to the "Mindset of the Limited Partner" panel to see how the asset allocation gurus are faring. These folks are the sources of capital for private equity firms and they spoke heavily of FAS 157. The speakers were asked for markdown estimates and responses were mixed. One speaker said he expected markdowns of their private investments to be 15-20% while another pondered whether or not, in highly leveraged deals, there is any equity left at this point. One interesting note from Mark Newcomb, a public investment manager at UTIMCO's $18B+ asset base, is that he is expecting less disparity among asset class returns in the future. In other words, the high risk adjusted returns of private equity and hedge fund vehicles in the past may no longer be superior given valuations in public stocks and bonds. As expected, the bulk of the discussion here focused around hedge funds. A compensation scheme disguised as an asset class (or investment vehicle) is a term that I've heard many times to describe hedge funds and it was certainly used by the panelists. I'm not sure anyone in the investment community should use the word scheme lightly these days. One of the panelists pointed out that hedge fund gating of client capital usually preludes the fund's demise and that the shakeout in the hedge fund industry will have long term benefits to institutional investors. Then off to lunch to try to enjoy a somewhat bland chicken dish. The entertaining, yet dismally gloomy, presentation of T2 Partners' Whitney Tilson quickly took attention away from the food. If the attendees had thought that Daniel D'Aniello's speech was considered bearish, they had not seen anything yet. Tilson has done very well with short positions in a number of large financial companies. The slides in his presentation were framed perfectly to his point of view that pending Alt-A residential mortgage defaults and commercial real estate lending will make subprime and the first half of option ARM resets look like a grand old time. I was almost happy to hear that he acknowledged that securitization "spun straw into gold through the magic of ratings agencies" and expected Mr. Tilson to announce a short position in Moody's, but heard no such thing. Perhaps it is easier to short financials that hold toxic assets rather than the company that sold out it's reputation and did a whole lot to put those assets there in the first place. My final panel of the day was entitled "Corporate Governance / Board Control Strategies to Enhance Returns." The conversation seemed to be largely legal based and that left a lot of speaking to Mr. Jeff Allred of law firm Nelson Mullins. It was particularly interesting to hear Mr. Allred speak about equitable subordination given that one of the panel members was from BlackStone. Blackstone, of course, has considered buying private debt in their own equity investments and equitable subordination would put their claims behind those of the other bond holders. The panel also spoke about the decreasing desirability of being a board member or even becoming CEO of a public company. One of the panelists said that regulation and compensation restrictions have made CEO aspirations less widespread/desirable for top talent than in the past. Likewise, liability exposure, as well as an inability to have a relatively good handle on a company's day-to-day operations, has left experienced executives less likely to take on board roles. There was a lot of criticism towards public company boards and governance across the panel. The consensus is that ownership and governance are better aligned with private directors, who, unlike their public counterparts, are major stakeholders via their private equity investing employers. There is certainly some truth to this, but there are disfunctional boards in both the public and private space. The nuances within this subject made it the most intriguing panel of the day. The day concluded with cocktails during a keynote from Dennis Gartman. The long time author of the Gartman Letter was much more comical than the earlier speakers. Dennis was full of one-liner nuggets of wisdom like "If it's not working, stop doing it. If it's working, keep doing it." He claimed that there is one absolute carcinogen in investing - averaging down and not admitting that you're wrong. "There is no such thing as value," he claimed. I had a chance to meet Dennis briefly in the lobby of the event's great venue, the Carolina Club. It's pretty clear that Dennis has a trader's mentality rather than a long term, Buffet/Graham style philosophy. He is an entertaining speaker with some insightful points of view. In particular, Dennis claims that he doesn't pay attention to government economic statistics but only looks at tax revenues. Of course, he says it in a much more libertarian, government incompetentcy kind of way that gets a few chuckles from the crowd. I found this observation very intriguing, but am still curious to know how examining only tax revenue provides short term insight or granularity into subsectors of economic activity. I'm looking forward to seeing Dennis speak again next week in Orlando. In summary, this year's event was a tremendous success. While the tone was remarkably somber given the change in economic conditions over the past year, the idea that there are once in a lifetime opportunities in the marketplace was also common among the speakers and attendees. For those who have dry powder and can do deals without much leverage, the returns for investment vintages in recessionary years can be exceptional. BlackStone's Schwarzman, front and center at Davos, wants to take full advantage of these opportunities, but with leverage that the banks can no longer provide. Felix Salmon's article sums it up nicely.
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Like its fellow universal bank Citigroup (C), Bank of America (BAC) has tapped the government for as much capital as it can and has helped rock financial stocks once again. First and foremost, in the interest of fair disclosure, I worked in Banc of America's capital markets division for a summer and know many people who have been through the organization and are still employed there. Even in my brief time there, I could definitely sense an inferiority complex about not being "bulge bracket" like the pure play investment banks or even the universal banks with deeper ties to Wall Street history (JP Morgan, Salomon Brothers). Among other things, buying Merrill Lynch was the way to end all discussion about being bulge bracket. The irony is that Wall Street, in its transformation, ignored a potential problem that has plagued M&A deals across many industries: culture conflict.
In July of 2007, I had a brief e-mail exchange with Matt Asay, an executive at open source software company Alfresco and writer of the Open Road, a well known blog on everything that is open source. At the time, Oracle had been on a buying spree and M&A deal talk speculation was everywhere and he had written a bit about some potential culture pitfalls. Here's an unedited excerpt that I wrote to Mr. Asay: Oracle's strategy of incorporating all of their M&A under one brand reinforces the importance of a focused company like Red Hat. With Novell, some of the "DNA" that they acquired in Ximian has, in my opinion, "corroded" somewhat due to business decisions made by Novell management. Perhaps you have better insight into this than I do. Fifteen months later, this actually happens. After the fall of Lehman, John Thain knows who would be next and saves Merrill by selling to a buyer with, what was considered to be at the time, ample liquidity. Ken Lewis bought BBC - bulge bracket culture and the premiere brokerage force in the world. The rest is history. Now with Merrill and Countrywide's marks weighing on BofA's books, the mega-bank is facing tons of near term pressure. This is not a discussion of capital injections, overpayment for Merrill, lack of real due diligence, asset correlations or bad hedging - it's about culture and the long term issues that can result from culture clash. Just like open source, bulge bracket culture is very strong. The tech equivalent would be Microsoft's recent fall behind in recruiting when compared to sexier, more open source friendly, large caps like Apple and Google. Business school graduates that went to Merrill in previous years and passed up on BofA and others did so for the culture as well as the opportunity. From what I hear, BofA folks are worried about, if they've haven't already lost, their jobs while many Merrill people believe that they've somehow got a raw deal (tell that to the Lehman employees who didn't get offers at Barclays). Real, decisive talent knows what culture it can thrive in and needs to choose that culture rather than having someone else decide. If the new BofA needs proof of that in the financial world, take a deeper look at Citi's many culture issues over the years.
In the not too recent past, I have been a BofA bear. While I have never taken a short position in any BAC securities, in November 2007, I wagered a steak dinner with the director of a major independent equity research department that the bank would cut its dividend at some point over the next three years. Well, the dividend has been cut twice and I'm still hungry, but, at this point, more massive deterioration in BofA's asset base would be far too detrimental to the financial system and our economy that is so widely serviced by the commercial and retail banking areas. I want BAC to succeed, but it will take a leader that can redefine and strengthen the culture across the entire organization. Capital is crucial in the short term, but building a new BBC for BAC will help the bank accomplish what Citi could not.
Culture is something that can't be modeled, but must always be considered for success. Tech companies do a wonderful job of examining culture compatibility in their acquisition and internal venture capital strategies. When I'm asked about the potential for a deal between two companies, integration isn't just about products, geography and cost savings - that's why I believe that Matt Asay and many others appreciate this author's insight on the subject. This article is also available at SeekingAlpha. Disclosure: The author does not have a position in any of the mentioned companies.
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Original Post Date: November 4th, 2008 In this kind of bear market, the phrase “throwing the baby out with the bath water” gets used quite frequently. However, there are some stocks that are truly worthy of this claim. Small caps in particular present some intriguing values with shares of profitable companies trading at a discount to tangible book value. Why consider buying opaque financial assets at pennies on the dollar when there are real companies, with little to no debt, that can be purchased at similar markdowns? Our screens found five companies, in different industries, that are currently priced at significant discounts to tangible book:
Disclosure: The author has long positions in QXM and ZINC.
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