Oddball Stocks

How about those Japanese net-net's?

2012-03-01T22:13:00.003-08:00

I'm in California on vacation, and since I'm physically as close as I've ever been to Japan it seems appropriate to do a post looking back on the Japanese net-net's I've profiled and mentioned on the blog.

I put together a spreadsheet showing the performance of all of the Japanese stocks mentioned on this blog over the past year. I also included all of the stocks I profiled in my Japanese net-net reports.

So first off the results are impressive. An investor would have only lost money on one stock which is pretty remarkable. If someone bought an even amount of each stock they would have had their portfolio return 32.6% against a index return of -4.2%.

Let me put this in perspective. Let's take a hypothetical investor who invests $5,000 into each of the stocks presented above. As of May 1st 2011 they would have had $80,000 which was gradually invested into the 16 stock portfolio. As of 2/28/2012 their portfolio would be worth $106,080, a very nice return. US Dollar based investors would have had an extra boost from the Yen appreciation although for my purposes I did everything in Yen so currency movement wasn't a factor in my analysis.

An investor could have an even higher return if they would have kept their eye on the stocks throughout the year and sold when certain stocks hit their NCAV. I held Dainichi for a while but sold when the price jumped into the high 900s and low 1000s. The stock has since fallen back to 790 for a 30% gain, but an alert investor could have walked away with much more.

I didn't do anything special to get the list above, some of the stocks were net-net's others were trading close to gross cash. Some were profitable, others weren't but overall these were a group of very cheap neglected stocks that the Japanese market left for dead.

I'm sure some of you are wondering how did I do personally? I didn't quite do as well as the group average although I did beat the median return; my own set of Japanese net-net's returned 24% since purchasing. I sold off Dainichi when it made it's climb into the low 1000s.

My take away from this is that net-net investing works, even in terrible markets when the market return is negative a portfolio of net-net's seems to do well. Every market pundit I've read or heard talks about how Japan is a dead market that investors should avoid. Prudent investors who went in seeking a margin of safety in the form of buying companies for less than liquidation value did very well for themselves.

Disclosure: Long SPK, Sugimoto, Asics Trading

Hickok - Intangibly cheap

2012-02-28T01:25:00.005-08:00

HICKA

Price: $1.85 (2/27/2012)

I ran across Hickok in the Walkers Manual and upon looking up their address realized I've driven past this place probably hundreds of times on the way to visit my grandparents while growing up. I also used to drive near this area for a summer job I had during college as a painter. To toss in another strange coincidence my brother works for a company that's located about a half mile east of Hickok. So after realizing all of this how could I not look at the company?

To give some background Hickok is a company that manufactures automotive diagnostic equipment. These are the sort of computers that your mechanic will have to read the diagnostic codes when the service engine light comes on. Codes are specific to manufacturers so a shop that services domestic cars needs to have a Ford, Chevy, and Chrysler kit.

The company is small with 71 employees spread across two locations, Cleveland (what I referenced above), and Greenwood Mississippi.

So if the coincidences couldn't be enough at this point imagine my surprise when I realized this company was darn close to being a net-net as well. Here is my worksheet:

There's more than a balance sheet

It's often heard in value circles that buying shares is buying a piece of a business. Another expression is that we should be thinking like businesspeople. These are two great expressions but rarely are they carried out. Most of the time a few quick glances at a balance sheet or income statement are enough to get the Excel wheels turning. And once Excel is roaring hours/days/weeks/months/lifetimes can be lost building financial models.

I think it's often useful to take a step back away from the financial statements after a very cursory overview and consider the question, "Would I buy this company outright if I had the ability?" This is a loaded question, a lot depends on the price offered among other things. But since the company is public we have a price and many investors never move beyond that point. So the next question is "Would I buy this company outright at today's market price if possible?" This seems like such a slam dunk question, especially in the case of a net-net. Who wouldn't buy a company for less than working capital if given the opportunity? Or even buying a company below book value, surely a nice margin of safety exists.

I wouldn't buy this company, and here's why

First off the company is losing money, but losses have been moderating and it's possible they will turn things around. The problem is I think the environment they're operating in will make it hard to turn things around and be successful on a continual basis going forward. This is of course what I'd be looking for as an owner, can this company turn around and operate profitably in the future? If not will I be able to at least get my money back from the book value of assets?

The company's land and buildings are on the balance sheet with an original cost of $1.6m. I'm not sure exactly when the building was purchased, the company was founded in 1915, and went public in 1959. As I mentioned above I know the area, and only a fool would pay $1.6m for their location, especially today. Hickok is located in a very undesirable area, a heavy industrial area that's seen better days. Maybe they purchased the land and building during the better times when there wasn't as much overcapacity, maybe..

The problem is the value their facilities might have held when they were originally purchased is now gone. Of course that's reflected in the balance sheet somewhat with the value of land/buildings/machinery depreciated down to $300k. This would seem like a more appropriate amount but I still think it's too high. If you look on Google Maps you can see that most of the area around Hickok is empty lots. This is where knowing the backstory helps.

In parts of Cleveland there were problems with abandoned houses, drug dealers, and squatters. The city started to take over abandoned homes and bulldozing the properties. The lots are owned by the city and are available for sale if anyone wants them. The problem is there are a lot of empty lots, and no one is really interested in buying.

The other problem is there are a lot of empty industrial buildings similar to Hickok's facilities up for sale as well. I did a quick search and found a place with 3x the square footage of Hickok located less than a half mile away in a much more desirable location. The property is listed for $499k or $3.78 per sq ft. From the ad it looks like they throw in all the cranes and loading equipment as well, surely some scrap value there.

So what's my point? The point is the location is in a bad neighborhood, an area with past problems so bad the city took over homes and demolished them. An area with such a high industrial overcapacity that much better facilities can be found down the street for almost nothing. These things don't mean that Hickok can't do well, but the odds are stacked against them. Workers reporting to work drive past all of these things everyday. I worked in a metal stamping shop in college, and the surroundings affect the workers. Seedier parts of town don't attract the best talent, simply put.

The problem is none of this stuff is visible from a balance sheet, but it would be clear to a potential owner. A potential owner would visit and see the location and start to think about having to move, or worrying about protecting the cars in the parking lot. These are intangible costs, or intangible hurdles to an acquisition. Sometimes as investors we wonder why a company isn't being bought out when everything appears in their favor, maybe there's a physical intangible known to everyone who visits but unknown to those of us who only read financial statements.

Summary

This has been a bit of an odd post, maybe different from most I do. My point is that demanding a margin of safety isn't some sort of theoretical thing, there's a real world purpose to it. If we demand a large margin of safety on our investments it compensates for some of these factors that are unknowable without local on the ground knowledge. Some investments look incredibly risky from a financial statement point of view, but from a local knowledge standpoint might be entirely safe. Other times something might look very safe on a 10-K but a bit of unknown local knowledge could make it terribly risky.

By definition a value investment is cheap, there is always a reason for cheapness. I think most of the time we don't dig deep enough to understand or know why. Understanding why a company might be cheap helps determine the margin of safety required. I think understanding both of these points well is really the foundation of avoiding losses. Many investors are surprised by events that shouldn't be all that surprising if we really understood what we were invested in.

Disclosure: No longer live in Cleveland, not a Browns fan, will cheer for the Indians if they make a playoff run.

Investment strategies for a devaluation

2012-02-24T09:36:00.000-08:00

The idea for this post came from a thread on the Corner of Berkshire and Fairfax message board asking about Portuguese investment opportunities, and then a follow on email conversation with a blog reader. One of the questions the reader asked was what were my thoughts on a devaluation in Portugal.

The question was interesting, and I've been thinking about this for while and wanted to put together some thoughts I have on it. Mainly this would apply to European periphery countries right now but could really be any country at some point in the future.

If anyone has access to the data I'd be interested in knowing how companies that matched my criteria in Argentina back in 2001 did after the devaluation.

What is a devaluation?

Simply put a devaluation is when some sort of event takes place that makes a countries currency suddenly worth less. On Monday 100 units of currency are required to buy an item and suddenly on Tuesday 150 units of the same currency are required to buy the same item. This isn't inflation, it's when the currency is deemed to have less value. The mechanism for this to happen isn't always the same, in the case of Portugal a devaluation would most likely occur if they left the Euro and began to use the escudo again. In the case of a Portugal the country would be using the Euro on Monday, and suddenly on Tuesday all Euro deposits would be replaced by some escudo deposits possibly at a reduced rate, or at a much higher conversion rate.

How to invest?

The general idea is to find a company that will be unfairly punished in a devaluation, or a company that might benefit from a devaluation. Here are a few bullet point thoughts on what might be good to look for.

Most important, the company needs to be export driven, most sales should come from out of the devalued country, greater than 75%.
The company should have a solid earnings stream, this closely relates to the above bullet.
Avoid companies that are cash heavy unless the cash is foreign denominated (and even still be wary).
Avoid companies with large receivables in the new devalued currency.
Look for companies with payables in the new currency.
High debt isn't always bad if it's in the new currency, is devalued and can be paid off with export sales in a foreign currency.
Look for some sort of competitive advantage, or brand. Will an exporter have a stigma attached because they operate out of a devalued country? Global recognition should mitigate this risk.
Put limited emphasis on assets, these will be worth much less after a devaluation.
The exception to the above bullet is if the assets are extremely rare and supply is limited. A priceless asset might apply as well.

A devaluation could be a catalyst for a generally marginal business. If the business has local denominated debt, local labor and exports their suddenly strong earnings stream will be able to quickly reduce debt and margins will increase with their new lower labor costs.

Here are two possible investments in Portugal

A decent business with a good earnings stream likely to be unharmed:

Corticeria Amorim, written about here , here and here.

A marginally profitable exporter that could be helped by a devaluation:

FISIPE website, financials

Disclosure: Long COR

SeaEnergy, lots of cash but no energy business....yet

2012-02-22T07:12:00.000-08:00

SeaEnergy (SEA.UK)

Price: 26.25p (2/22/2010)

This is a stock I kept getting mentioned on Twitter and I finally got around to looking into it recently. SeaEnergy is a Scottish company that used to own an energy company which they sold for £38.6m back in June of 2011.

When I first looked over the company's interim report I was a bit confused. I kept seeing pictures of boats yet the long term asset account was non-existant. I then looked for leases and didn't find that either. I looked at the pictures closer and realized they were computer drawn, not real boats. I surfed their website a bit more and discovered that the company is currently a shell of cash, and they hope to get into the business of servicing offshore wind farms with a fleet of service ships.

Balance sheet

SeaEnergy is a really simple company to understand, they're a pile of cash, plus a 24.68% stake in listed company Lansdowne Oil and Gas. This is simple enough I'm just going to show my net-net worksheet below:

Looking at the spreadsheet there's obvious value here. The shares are trading at 26.25p against a discounted net asset value of 45p and net cash of 42p. What's attractive about SeaEnergy is that almost all of their assets are completely liquid.

What's really interesting is that management mentions with their interim results that they've restructured the balance sheet so they can return some of the cash to shareholders in the form of dividends or buybacks. Management plans to make an announcement once the audit of 2011 results are complete, so I'd expect something in a few months.

Looking forward

The big selling point to SeaEnergy is the pile of cash that management has indicated they intend to return a portion of. What I haven't discussed yet is the business plan that should soak up the rest of the cash.

Sometimes a value thesis will rest on a pile of cash and the fact the company is selling for less than cash, a thesis similar to the one for SeaEnergy. The flaw with this is that unless the company plans on liquidating that cash has little purpose. I prefer to buy businesses that are cash heavy, or selling below NCAV/cash, but rarely cash shells. The problem with a cash shell is they either need to enter a business (using the cash), or liquidate which I mentioned is unlikely. A typical net-net is just a dumpy business that has hit hard times and is trading at an absurd valuation. A cash shell is similar to a venture firm, they have raised investment funds and are planning on launching a new business.

SeaEnergy has chosen to do a bit of both, give back some cash and use the rest to start a new business. They have identified that offshore wind farms have some hurdles in maintainability that they feel could be solved with a fleet of service ships.

SeaEnergy plans on building ships customized specifically to service wind farms on the North Sea. Conditions on the North Sea are rougher than other locations where wind farms currently exist making current servicing fleets ineffective. In the shareholder letter they state that they plan on being in operation by 2014 but they are testing their concept this winter with a trial ship.

There really isn't enough information for me to go in depth on the potential for the business. Management has put out a few slide decks discussing the problem and their potential solutions. I like that they're taking on the servicing aspect of the renewable market. Servicing isn't as capital intensive as constructing and maintaining the farm itself. SeaEnergy has also talked to potential customers and they've expressed interested in their business model. I want to press the pause button here to mention one thing. I've been involved in startups, and known a lot of startup guys, and let me state that ALL entrepreneurs talk to potential customers, and ALL potential customers express interest. The problem is when payment is required that sudden expression of interest is more of a nice to have rather than a necessity.

What I don't like

The one thing that I really didn't like is that SeaEnergy is highly promotional, not unlike many US biotech cash shells. The biotech's always have the next greatest drug that will cure the world of all disease with limitless profitability. Unfortunately for most investors biotech's almost universally have two outcomes, 1) a buyout (rare, but good outcome) 2) management burns the cash, pays themselves well and investors are diluted to nothing.

SeaEnergy's website is all geared toward potential investors with lots of charts and news releases about how the company is poised for growth. I'm not sure what the goal is outside of moving the share price. I would think the management team would be intensely focused on the design of their ships rather than the share price.

Another intangible is that if management knew how explosive this potential servicing business was why aren't they happy to have the company selling below cash while they scoop up shares like crazy. Instead they seem very concerned about the market discounting their share value.

This stock isn't without a conspiracy theory either. There was a regulatory filing saying some third party was trying to scam shareholders into giving up shares or entering into phony warrant transactions. I don't know how the UK works, but stuff like this in the US is always a red flag. Since I'm not as familiar with the UK markets I'm going to just go yellow flag on this one. This could be a result of the sometimes wacky investors who form a cult following around stocks like this.

I know these are intangible items, and for most investors these things might not matter much, but for me they're things I try to consider before an investment.

Summary

My last few paragraphs might have seemed a bit overly critical, but it's not common to find a company that's selling below cash without some sort of negative. If there wasn't a negative aspect I'd be worried!

In short SeaEnergy is like buying into an overcapitalized venture investment. There is too much cash for the future servicing business so some of it will be returned. Future gains will be made as a result of the success of the servicing business. The nice kicker here is that this is different from investing in a venture fund that's returning capital because this isn't your money that's being returned, it's someone else's initial investment being returned to you.

I'm going to watch SeaEnergy play out but hold off on an investment. I don't know enough about the offshore renewables servicing business to take a gamble on it, and I haven't done very well investing in cash shells. Some of the intangibles concern me as well. I think this would be a great investment for someone who is more knowledgable with UK energy investments.

Talk to Nate about SeaEnergy

Disclosure: No position

A few thoughts on ROIC

2012-02-17T02:21:00.000-08:00

"the cash return on cash spent for capital." - Ken Hackel

It never fails, if I include my return on invested capital calculation in a post I will invariably get a few comments or emails questioning it or asking for clarification. This last post was no exception.

The ROIC calculation I use is a bit unique, but I can't take credit for it. I use a calculation that Ken Hackel presents in his book Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making. The book focuses on evaluating companies on a cash flow basis. This means looking at free cash flow, cash return on invested cash, and sources and uses of cash.

Cash and cash flow are the focus of the book because cash flow based numbers show a true flow of what's moving in and out of a business not an accounting version. Often the accounting picture can be gamed by adjusting estimates. Some accounting metrics are just outlandish, my favorite is Adjusted-EBITDA. It seems every company now has an Adjusted-EBITDA number that only includes good things and excludes any potentially bad items. I've also noticed that executive bonuses are usually based on these fiction numbers as well. Quite a nice gig if you can get it!

Ken Hackel gives this reason to use a cash flow based ROIC formula verses a more standard EBITDA/EBIT version:

"In essence, entities having a low ROIC or dependent on large capital expenditures resulting in small amounts of distributable cash flows deserve low valuation metrics despite their higher rates of growth in GAAP-related yardsticks. This is why many investors are fooled, having invested in low-P/E companies." (Hackel, p252)

Hackel mentions that he searched EDGAR to find the most common ROIC formula that companies use to measure themselves, this was the result:

EBITDA + interest income * (1-tax rate) + goodwill amortization

-------------------------------------------------------------------------------

total assets - (current liabilities + short term debt + accumulated depreciation)

A more accurate cash based version presented in the book is as follows:

free cash flow - net interest income
------------------------------------------------------
invested capital(equity + total interest bearing debt + present value of leases - cash marketable securities)

Hackel provides some reasons why specific values are included in the calculation. Instead of trying to summarize his points I'm just going to quote him, he says it much better than I would.

"
1. Intangible assets because those funds were used to aquire cash producing assets.
2. All interest-bearing debt because this too was sold to purchase productive assets.
3. Present value of operating leases because this represents contractual debt in exchange for required assets needed to produce revenue, hence cash flows. To exclude operating leases would be to unfairly boost the ROIC and to distort the comparison between companies that buy assets or enter into capital leases and those which enter into operating leases.
4. Since free cash flow is uses, it includes the payment of cash taxes and the elimination of other accruals." (Hackel, p252)

Of course no formula is perfect and there are a few downsides to this formula. Activities that go straight to the equity statement such as foreign currency translation adjustments, actuarial gains/losses, changes in fair value of available-for-sale assets/cash flow hedges, and revaluations of property, plant and equipment end up affecting the formula. These changes would need to be backed out to get an accurate picture of the company's cash return on capital acquired for cash.

When I read this formula in the book it really resonated with me and I've been using it as I analyze companies. Some investors might consider it a bit too stringent, but I don't mind that. The formula has come in handy finding companies that end up directing most of their cash to working capital or capex. I don't want to invest in companies that have great net income numbers but don't have the cash flow to back it up.

Disclosure: If you purchase the book through Amazon I will receive a small commission. There is no difference in book price entering Amazon through my link, or on your own. I received this book as a gift from a family member, the author or publisher has never contacted me.

Branding this Canadian Leather Retailer as Cheap

2012-02-15T08:10:00.001-08:00

Danier Leather (DL.Canada)

Price: C$10.70 (2/15/2012)

Recently a reader sent me an email asking for my opinion on a stock they were looking at. The company is Danier Leather a Canadian retailer. The company has retail locations located in malls and power centers which are large outdoor malls. Danier is a vertically integrated leather company meaning they don't just sell leather apparel they also design and manufacture it. They source their leather from China and then manufacture their designs domestically.

Before I dive into the weeds I want to make a small investment case for Danier Leather:
-Trading slightly above NCAV
-55% of market cap in cash
-EV/EBIT of 2.16
-EV/FCF of 11.02
-ROE of 12%

Asset value examined

I recently overhauled my net-net template to something that I think will be easier to read and contain more information. Danier is a perfect company to trial the template on:

There are two columns, the first shows the balance sheet values for different assets. The second column shows a discounted value of that asset. Both columns have a per share breakdown as well.

So as you can see with Danier they have an NCAV of $9.06 a share, and a discounted NCAV of $6.08 per share. Most of the company's assets are in cash and inventory which isn't surprising given they are a retailer. It might seem strange that they don't have a large account receivable balance but this makes sense. When a customer comes into a store they pay on the spot, the company shouldn't be waiting for a payment from customers at all.

The item that stuck out to me when reviewing the balance sheet was that there was a relatively small balance of fixed assets. Knowing that most locations are in malls I figured Danier doesn't own any retails space. So I searched the annual report for operating leases and voila an off balance sheet contingency.

Adding back the operating leases discounted to the present squarely knocks Danier out of the net-net category. If they were to liquidate they could still contractually be on the hook for those leases, and the minimum lease amount is more than cash on hand eliminating that buffer.

Fortunately for the reader who asked about Danier all is not lost. Even though Danier isn't a solid net-net it's not really a problem, the company has no plans to liquidate and in fact they have something most net-net's don't have, a decent business.

The operating business

The company has had a nice run of profitability outside of a small loss in 2009 which is a bit surprising because Canada only had a mild recession as a result of missing the housing bubble. Some people argue that Canada is in a housing bubble now, but based on Danier's earnings it doesn't appear like too many people are borrowing on their homes to purchase leather goods.

The company has a nice summary in their annual report of the past few years results:

The key takeaway for me is that results aren't consistent but they've been profitable four out of the last five years. The second key point is that shares outstanding has been declining at a pretty rapid pace, almost 30% fewer shares in 2011 than in 2007.

The next thing I did was to steal an idea from Richard Beddard at Interactive Investor Blog (a must read if you don't already). He likes to show the growth in book value by breaking out tangible assets, intangible assets and cumulative dividends. Danier doesn't pay a dividend so I decided to do two charts, one showing assets on a gross basis, and the second showing assets on a per share basis. The second chart is what shareholders get as a result of buybacks, a steadily increasing book value per share.

Gross Assets

Assets per Share

The last thing I looked at was the return on invested capital. I get questions about this all the time so I want to explain my calculation. I take free cash flow divided by equity minus cash plus debt and operating leases. So let me explain a bit, I use free cash flow because this is a realized return above what the company needs to operate. This eliminates companies that eat up a dollar generating a dollar even if on a net income or EBIT basis returns look great there's nothing left over for shareholders. Secondly I add in operating leases because this is an intangible asset the company needs for their business. If Danier didn't have their leases they wouldn't have a place to sell their apparel.

In computing this for Danier I ended up with a 3.56% ROIC. Here is the calculation:

Putting it all together

So what we have is a retailer that has a solid balance sheet operating leases not withstanding. They have a stable sales history and a pretty good track record of profitability recently. The company's free cash flow has fluctuated over the years with inventory build ups and draw downs. When free cash is flush the company's used it to buy back shares which have increased the book value for shareholders.

I like to invest in businesses that have an absolute margin of safety which is something I'm not seeing with Danier. The balance sheet at first appears to provide it but once all liabilities are considered the margin disappears. The company is undeniably cheap trading below book, with a low P/E and EV/EBIT multiple.

Danier doesn't jump out to me as a fat pitch stock. The stock is cheap, but there are a lot of cheap stocks out there. The question to ask "Is Danier cheap due to it's business or something external?" I don't know the answer. I also recognized I'm biased because leather doesn't seem to be in style in the US, which means nothing for Canada and a Canadian retailer. This is probably the type of stock for someone who likes to build a portfolio of low EV/EBITDA, EV/EBIT or P/CF stocks would own and do well with.

Talk to Nate about Danier Leather

Disclosure: No position

One heck of a hidden asset

2012-02-08T09:36:00.000-08:00

Central Natural Resources (CTNR.OTC)

Price: $27 (2/7/2012)

Market Cap: $13,000,000

Often I will read an investment thesis that hinges on some sort of hidden asset. A hidden asset is something a company might own that is either under monetized or maybe held on the books at an exceptionally low cost. In theory most investors somehow skip over these hidden assets when doing their research leaving them as a pot of gold for enterprising or inquiring investors.

I have my doubts about how many hidden assets are truly actually hidden and missed by investors. I own one company that could possibly qualify, Bowl America. They own 17 bowling alleys in the DC area and Florida, the real estate is held on the books at cost. The key is these centers were purchased in the 1950s, so presumably DC real estate is worth much more now than in 1950. Even though the real estate would qualify as a hidden asset I'm not sure how hidden it is. Most of the investment writeups on Bowl America all discuss the hidden value of the real estate. If all investors are looking at the mis-priced real estate it's not all that hidden.

One example of a asset being truly hidden is the case of EDCI. EDCI was a company that entered liquidation a while back that I owned and followed. At one point in their liquidation process they announced they sold some patents they regarded as worthless for a few million dollars.

Readers might have noticed that recently I'm highlighting a lot of un-followed and mostly unknown companies. For some background I've been working my way through a book the Walkers Manual of Unlisted stocks. I started with the A's and have been steadily moving towards Z. Some of the companies have gone private, for others there is no information available at all. Some like Central Natural Resources don't file with the SEC but do put their financials out on their website. The exercise has been fun, most of these companies are simple to research and it's fun to hunt down hard to find information.

For a quick background Central Natural Resources is a resource company based out of Kansas City. They own some coal properties along with some gas wells. Most of their income comes from mineral leases on the land they own. The company is pretty simple and straight forward, price of gas/coal * amount extracted minus extraction costs and salary equals profit for investors. The company has been pretty good about paying out a good chunk of profits to investors as dividends.

The hidden asset at Central Natural Resources is a bit more hidden than usual, it only appears in the annual reports as a single sentence.

This is curious, the company has a large coal deposit which hasn't been mined yet being carried for $700,000. When I read about this I wondered what 92m tons of coal would go for on the spot market. Using a NYMEX quote of $57.87 per ton that coal has a gross value of $5 billion dollars! Sure there are mining costs, and transport costs and all sorts of other things but remember that Central Natural Resources's market cap is $13,000,000, there is a lot of wiggle room there. The value of the coal alone is 400x the trading price of this company.

The problem I have with hidden assets is that while they're supposedly unknown to investors they are well known to the people running the company. And it's not a far stretch to say insiders probably know the true value of the asset. Sometimes an insider will be buying back stock trying to capitalize on this discrepancy. But mostly insiders don't seem to care much, and are content to let a supposedly valuable asset lie idle or dormant.

As I was thinking about Central Natural I kept thinking that management knew they had a $13 million dollar company with a $5 billion dollar asset, so why didn't they get moving on mining it? I skimmed a few of their annual reports and found some vague references answering my question. It seems those 92m tons of coal aren't exactly easy to extract, the company has looked into mining it but there have been no mine operators who are interested in digging it out.

Maybe after all the $700k carrying value is overstated? If there's a pot of gold in the ground that's impossible to extract does it have a value? Maybe this coal will be like the shale gas, in a few years someone will discover a way to extract hard to reach coal cheaply and Central Natural Resources will make a lot of investors rich.

My conclusion is that relying on a hidden asset to make an investment thesis seems fraught with problems, most where were highlighted above. This doesn't mean an investor should ignore an asset like the 92m tons of coal, but rather they should view it as an option on their investment. If something lucky happens and the coal is dug out everyone wins. On the other hand if the investment thesis is based on the value of the coal there's the potential and likely outcome of disappointment when the coal remains in the ground forever.

At this point I should mention that Central Natural Resources actually looks attractive on a stand alone basis, they're overcapitalized with $4.6m in cash and a small amount of debt. They're trading at a EV/FCF multiple of 6x. If natural gas prices or coal prices rise again they should do very well.

Talk to Nate about Central Natural Resources

Disclosure: No position

Rules for net-net investing

2012-02-02T05:52:00.000-08:00

I often write about net-net's on this blog and from time to time I get questions asking for certain clarifications to my net-net investment process. I don't have a written guide so I thought this would be a good place to put down some rules I try to follow.

I guess in a way this could be considered a checklist for investing in a net-net. I prefer to think of these notes as my net-net guidelines. Even though these rules are numbered there is no importance to the numbering. The reason for this is that each investment is different, for some companies #6 might be the most important issue, whereas for others #2 might be more important.

1) All rules can be broken but only for a very good reason. Good reasons must have a much higher burden of proof.

2) Always prefer cash to inventory and receivables unless:

Management is acquisitive, in general stay away.
There are restrictions on a dividend.

3) If there are securities on the balance sheet consider if they are encumbered by a relationship. Are the securities a company in the supply chain, or a cross holding?

4) Prefer shrinking receivables and shrinking inventory accounts.

If inventory is shrinking too fast cash will need to be used to build it back up soon, beware.

5) Prefer cash flow and free cash flow over net income if a decision is forced. Prefer both if possible.

Check the accruals ratio for both balance sheet and cash flow accruals. High accruals are a concern.

6) Stay away from companies that continually change strategy and business line.

7) If operating results are poor is there a chance they will turn around?

8) Determine why the company is selling below NCAV.

Is it a good reason?
Is the general industry in decline?
How obvious is the reason?
What changed recently?

9) Would I loan this company my own money for a five year term? How likely is it I would get it back?

10) Am I relying on non-liquid assets that need to be liquidated? Is there a market for those assets? How quickly do those assets sell?

11) If possible try to ascertain how long the company has been trading below NCAV.

12) Always check message boards and blogs if possible. Current investors have much better insight into the ongoing operations and past struggles.

13) Are there a ton of value investors already invested in this stock? If this is such a popular idea why is it still cheap?

14) Is there a catalyst on the horizon? Have there been rumors of catalysts for years that have never materialized?

15) Do I need to rely on a catalyst to realize my investment?

If you have any more suggestions to add I'd love to hear them, leave them in the comments or feel free to send me an email.

Talk to Nate about net-net investing

3U Holdings a true Ben Graham net-net stock

2012-01-29T21:05:00.000-08:00

3U Holdings AG (UUUX.Germany)

Price: €.72 (1/29/2012)

A reader left a comment under my post on the performance of international net-net stocks and mentioned 3U Holdings AG. It's possible most readers missed the comment since it was in French but thanks to my French/English dictionary from high school and Google Translate I was able to muddle through. I'm glad I did because 3U Holdings is a really interesting company. So to the commenter:

Merci de mentionner 3U Holdings, la société est intéressante et bonne valeur mais ne pas parfait.

Background

3U Holdings started off in 1997 as a German long distance carrier. Through the years the company acquired other telecom companies and grew to service other countries in Europe. It seems the company stayed in the wireline business with a few brief jaunts into presentation lines and SMS technology. In 2007 the company decided they didn't want to be in the wireline operations business anymore so they outsourced operations and became an investment holding company.

Then in 2009 the company decided to change strategies again, they felt that renewable energy would be the future so they entered the solar production market. They have a subsidiary which produces solar vacuum systems and another subsidiary that manufactures solar components.

In summary the company owns a handful of network operator codes in Germany, some SMS companies, a management consulting arm, and finally the solar components pieces.

Investment Thesis

The reason I was interested in 3U Holdings is because the stock is trading below NCAV, it's actually trading below net cash value.

Here is my net-net worksheet for the company:

The first thing that stands out is that this company is trading below net cash value, not by a lot but by a few eurocents. The next thing I noticed is that 3U Holdings is trading below 66% of NCAV, they're trading at 63.7% of NCAV. Ben Graham mentioned that buying a handful of securities for 2/3 or less of NCAV and selling when NAV is reached is a very profitable strategy. The idea is to avoid concentration in just a few of these companies but instead purchase a basket of similar companies all selling below 2/3 of NCAV, 3U Holdings surely qualifies.

The company seems to be prudently selling off old wireline assets and growing their cash hoard. As with most legacy telecom businesses revenue has been declining from the wireline segment but the renewable energy segment's growth was enough to offset the decline for now. The company is expecting a boom in 2012 due to Germany lowering renewable rates 15%. I believe this means that consumers will pay 15% less for energy from a renewable source which should spur growth in the renewable energy market.

What's the risk?

3U Holdings reminds me of another company I looked at recently LICT. The issue with both of these companies is that their main business is capital intensive and sales are declining. The good news for 3U Holdings is that they don't have any debt. The bad news is that the wireline business is sucking up a lot of cash.

In the trailing nine months operations sopped up €11m in cash. The company received €27m from a sale of discontinued operations but due to working capital changes and capex costs the cash balance only increased by €5m during the year.

As readers of the blog know I'm married to the concept of a margin of safety. 3U Holdings has a very strong asset margin of safety, but I'm concerned about the margin one level deeper at the operating company. I want to see the company's operations turn cash flow positive or at least as close as possible. If the company continues to lose money there's the potential that the cash balance could be wiped out and the asset margin disappear.

To me the biggest risk and the reason this stock is selling so low is that there isn't clarity as to whether the cash balance will remain untouched or if operations will burn through it over the course of the next few years.

So what happens next?

I have referenced in previous posts that with a net-net stock the logical thing to do would be to either liquidate or reshuffle operations so the market recognizes the value of the organization. The reason for this is that if management continues to operate the company in a way that got them to trade below NCAV shareholders would be better off if the company just liquidated than continue down the same path as before.

The good news for 3U Holdings shareholders is that management recognizes there is a problem with the valuation and they are attempting to do something about it. The company authorized and plans to commence a buyback of 10% of the shares outstanding. In addition managers have purchased more shares adding to the 28% they already own.

The company also pays out a dividend and the shares currently yield 2.78%.

Summary

3U Holdings is a tough stock for me, the discount to tangible assets and cash is enticing. I'm practicing restraint for now because the company is eating through cash. I've been easily lured into asset discount situations in the past and then was surprised when a mildly struggling operation turned into a dire situation and ate through my margin of safety.

I think I'm going to sit on the sidelines with 3U Holdings and wait a quarter or two and watch their cash flow statements. If the cash starts to stabilize I will probably buy a small stake.

Talk to Nate about 3U Holdings

Disclosure: No position

CIBL: spinoff, yes; catalyst, yes; possible five bagger, yes

2012-01-26T22:00:00.000-08:00

CIBL (CIBY.OTC)
Company website: http://www.ciblinc.com/index.htm

Price: $625

I want to thank Adam Sues from Value Uncovered for mentioning this stock to me. If you don't know Adam he's an avid deep value investor who has an interest in the same types of stocks I like. I reached out to him a while back and mentioned a few obscure names and when he commented he'd already seen the companies and researched them I knew I found a kindred spirit. Adam doesn't post as often now that he's pursuing his MBA but I would highly recommend adding his site to RSS. Also I know he's looking for internships, so if you work at a value fund and have a position consider reaching out to him.

Edit: I made a slight change to this post after first posting due to a comment. I added in net income multiples to the TV Station spreadsheet. I also changed the final share total.

Background

CIBL is a small holding company that was spun out of LICT (posted about here) a bit over three years ago. LICT is a wireline company and when spinning out CIBL saddled it with a lot of seemingly random assets. CIBL has ownership interests in the following, two Iowa TV stations a wireless partnership interests in New Mexico, a loan to a LICT subsidiary and 10,000 shares of a privately held company Solix Inc.

The company has a familiar face on the board, Mario Gabelli of Gamco investors. Gabelli is a Graham and Dodd value investor, so there is some comfort there that value should be maximized for shareholders.

Structure

To understand CIBL you have to understand their holdings, and the structure of the holdings. CIBL doesn't own the TV stations or wireless partnerships completely, they own interests in these entities. CIBL owns 20% of WHBF and 50% of WOI-TV ABC.

The wireless partnerships are a bit more complicated, CIBL owns 51% of Wescel Wireless which in turn owns a 33% interest in New Mexico RSA #5 and a 25% interest in New Mexico RSA #3. CIBL also owns a portion of Wescel II which owns 8.33% in New Mexico RSA #3. The RSA's have a wireless service area of 160,000 people. The general partner on the wireless interests is Verizon Wireless and the wireless service is sold as Verizon.

Why is it cheap?

I have what I think are the reasons that CIBL is selling at such a low valuation.

Small illiquid stock - Perfectly valid reason, $15m market cap with shares that trade rarely.
Limited float - Most of the float is owned by Gamco partners, this ties into the first reason.
No SEC filings - A lot of investors pass companies that don't file, CIBL is unlisted but publishes audited financials on their website.
Complex structure - CIBL doesn't own any of their assets outright, they own interests in assets, this could complicate a valuation.

All of the reasons for cheapness can be summed up in the statement that CIBL is a very small unknown, under researched company that is hard to buy shares in. Not many people want to deal with something in the $15m range especially if the company doesn't file with the SEC. The good news is this leaves a lot of room for enterprising investors.

Catalyst

Usually I will present a company and a valuation before I talk about a potential catalyst. I'm switching things around for CIBL because the valuation depends on the catalyst.

In the latest annual report and then in subsequent quarterly reports there is a very interesting quote

"The Company has received, and is reviewing an expression of interest in certain of its remaining telecommunications properties at values in excess of the current trading price for CIBL stock. There can be no assurance that this expression of interest will result in a transaction of any sort, and the Company cannot predict the outcome, timing or any other element of this matter. However, it is possible that the result could be financially significant for the Company."

Let me summarize, someone wants to buy the wireless assets and the price for the wireless alone is greater than the current market cap which includes the TV assets among other things. Not only is the price greater than the current value of the company it's significantly greater.

Valuation

In light of the catalyst I want to break down CIBL's valuation into two parts the TV stations and the wireless assets. The way I want to look at both assets is on a buyout basis since management has stated that they intend to wind down the company if possible.

TV Stations

I did some searching and was able to find that in general TV stations usually sell for 6-10x broadcast cash flow. Broadcast cash flow is considered cash flow before depreciation, time brokerage fees, and corporate and general expenses. In addition to valuing the cash flow the value of the real estate is also considered. So a complete TV station transaction would be 6-10x BCF plus the value of the real estate. Notice that only the real estate is included not all the TV equipment, this is included in the BCF calculation, all that equipment is required to generate the cash flow.

The annual report and quarterly reports have a small footnote showing a summary balance sheet and three line income statement for both TV stations. Unfortunately the only values we have to work with are revenue, gross profit and net income. I put together a spreadsheet to estimate a potential range of TV station values based on what CIBL provides. I estimated depreciation at 8% and the real estate portion at 10% of PP&E. Both of these are estimates, 8% is what I've seen for capital intensive businesses, and 10% is based on the fact that TV stations need to buy a lot of expensive equipment to broadcast, it seems that 10% is probably a reasonable estimate for what the real estate is worth.

I put together a spreadsheet based on the 2010 annual report numbers. Trailing twelve month numbers are in the Q3 report, but I don't know enough about TV to extrapolate what a fourth quarter might look like. The Q3 numbers appear to be trending a bit better than last year at this time so if anything I'm a bit on the conservative side if the fourth quarter is similar to last year.

As you can see the range I came up with was $5.4m to $13.8m for the interest CIBL owns in the two TV stations. I find it interesting that the high end estimate is basically the market cap of CIBL.

If you're uncomfortable with my estimated BCF I have multiples of net income in the spreadsheet as well.

Wireless

As expressed in the company's MD&A there has been interest in buying out a part or all of the wireless assets for more than the current share price. So when thinking about a valuation it's safe to put a downside on the wireless assets at the current market price of $15m.

I did a lot of Googling and found some references stating that rural wireless companies have sold in the 9x EBITDA range over the past few years. Like the TV interests breakout we don't have much for the wireless outside of revenue, gross profit, net income either.

I put together a spreadsheet like I did for the broadcast assets and I valued the wireless on two different metrics. The first was I created an estimated EBITDA, I used 15% of revenue for depreciation, and figured the long term liabilities were debt at 5%. The second metric was I just did a straight valuation based on net income. This is a much more conservative approach, but even the lowest net income multiple valuation is higher than the market cap alone.

Here is the spreadsheet:

Other assets

When looking at a valuation there are a few other assets that CIBL owns that need to be valued as well, these include a note to a LICT subsidiary and 10,000 shares of Solix Inc a private company. For the purposes of a breakup valuation we can probably take the note at face value which is $961,000 as of Sept 30th. The note has a 5% interest rate and LICT's subsidiary has been paying it down over the past few quarters.

The value of the Solix stock is really tough, the company seems to be decent sized with over 400 employees and 65,000 sq ft of office space in NJ. I couldn't find much beyond the typical webpage marketing fluff. Solix could have 25,000 shares outstanding and this is an extremely valuable position or they could have 2b shares and the 10k that CIBL owns is a teeny tiny footnote. Due to the uncertainty I'm going to just assign a value of zero to this position.

Putting things together

When looking at the pieces of CIBL the absurd valuation is clear, for CIBL to be fairly valued at current prices the TV stations need to be worthless, and the wireless partnerships are valued at 3x net income.

Here is the sum of the parts for CIBL:

An argument could be made that the total company won't be liquidated so an investor won't actually see this sort of return. I would agree, but CIBL seems intent on paying out extra cash as dividends so in the worst case the return from the subsidiaries is paid out to shareholders while they wait for a liquidation. I would also say that as CIBL has sold off assets in the past they've returned the entire proceeds to investors as a special dividend, so I'm not sure why a wireless asset sale would be any different.

Other resources

Another way to approach a valuation of CIBL would be to look at the cash distributions from the subsidiaries and value the company on a multiple of cash distributions. If the company wasn't considering divesting a portion of itself I think this would be the best way to value CIBL. For anyone interested I put together the cash flows for the last few years into a spreadsheet and have a picture of it below.

Summary

CIBL is fascinating in that the obscure structure masks the true valuation. Management seems to know what the company is really worth and is attempting to sell off pieces, the problem for investors is that shares are hard to obtain.

I recognize that with this valuation I used a lot more assumptions than I normally would, but even in a worst case scenario where the wireless sells for 3x net income I still have a very large margin of safety. The point of a margin of safety is to protect an investor against errors in assumptions. If CIBL sells their broadcast for 2x BCF and wireless for 2x net income I would still make a profit at the current price.

Talk to Nate about CIBL

Disclosure: Long CIBL, attempting to accumulate more shares if possible.

International net-net's one year later (performance update)

2012-01-15T20:58:00.000-08:00

About a year ago I created a list on Screener.co of all the stocks in ten different countries trading below NCAV that were debt free. Over the past year I've profiled some of the companies and looked at numerous others. I felt it would be fitting to go back and look at how all of the stocks that came up on my screener have performed over the past year.

Methodology

My testing was pretty simple, I put all of the quotes and data into a giant spreadsheet and I typed in each ticker one by one into FT.com. I used the FT.com 1yr return as my return statistic, I have no idea how accurate this is, but in looking at the data I have a feeling it's generally more right than wrong.

For stocks that I could no longer get a quote I left them blank, and left them out of the average calculations. I recognize that this could skew the results some. Some of these companies have been acquired, but the potential also exists that others have gone out of business. I did some googling on a few of them and the ones I looked up fell roughly into the two buckets (bought out, failed) equally. I didn't want to spend more time on this but if anyone is interested in backfilling this data I'd be interested in the refined set.

I am not an Excel guru so I've uploaded my spreadsheet to Google Docs and attached a link at the bottom of this post. If anyone is so inclined I would love to know any fun facts from readers slicing and dicing the data. Also if anyone has the returns for the missing companies I'd love to see that as well.

Results

Observations

As I was entering the numbers I had a feeling that the net-net strategy had failed over the past year, as most of the returns I entered were negative. Consider out of the 214 that started 2011 only 30 had a positive return. Overall an equal weighted portfolio would have just about broken even although poor it trounced a global ex-US benchmark. The problem is that since so much outperformance came from such a small set of stocks it's likely an investor would have emotionally sold out after Comwest a $55,000 market cap company quadrupled, although at that point it still almost doubled again.

Here are a few general observations:

Canada has the best returns due to a few tiny speculative companies. Building a position would have required purchasing most of the shares outstanding meaning these returns are mostly unachievable.
Germany had a 11% gain which seemed attainable by an average investor.
Only 21 companies had a return greater than 10%.
Buying only FCF positive or dividend paying firms resulting in a loss but still beat the benchmark.
Firms with a greater than 1m (in own currency) market cap returned -13.44%.
Firms with a smaller than 1m (in own currency) market cap returned 58%.
All of these returns assume a hedged portfolio.
Forty companies lost 50% or greater with a number of total losses.
The UK had the most "missing" companies. I hope this is because the UK is more shareholder friendly and management worked to merge or take companies private.

Conclusion

Often I'll come across a blog post, or an article on the internet where the author posits that buying any company below NCAV is a good investment decision. The data supports that conclusion if the investor buys ALL stocks selling below NCAV since the outperformance came from a very small set. If someone were to just buy a random set of stocks below NCAV it's likely they would have performed close to the benchmark at best.

Looking through the list and then looking at my own portfolio led me to the conclusion that NCAV is a great starting point but further work needs to be done. I say this because my own net-net portfolio performed quite well this past year, out of the 13 net-net's I own/owned only one is negative (Titon Holdings) all the rest are positive. The reason for my good fortune isn't that I happened to buy a lucky handful of net-net's but rather that I looked through a lot and discarded them rather then buying anything, I ensured I had a valid margin of safety and that the business wasn't impaired.

This was a fun exercise, I still plan on hunting through net-net land, but as I mention above it's only a starting point.

Talk to Nate about net-net performance

Link to the spreadsheet (click File->Download Original)

Disclosure: Long 7466, 9814, 9932, ARGO, HYI, TON, VIN

Rella Holdings, profitable company trading below net cash

2012-01-12T04:55:00.000-08:00

Rella Holding (RELLA.Denmark)

The following is a guest post by a long time reader who wishes to stay anonymous due to various restrictions.

Market Capitalization: 580mln DKK

Price: 24 DKK per share

Price to net assets value: 0.36x

Target Price: 48 DKK per share Upside: 100%

EV/EBIT: Negative -> High cash position.

Investment Case:

Rella Holding S/A is an investment vehicle that owns 57.5% of the shares of Aller Holding S/A, a Scandinavian publisher with an approximate 60% market share of Scandinavian (Finland, Denmark, Norway, Sweden) weekly magazines. Although profitable (EBIT margins have averaged 6% over the past ten years), the prime attraction of this investment is the high discount to net asset value on the balance sheet. Taking into account the large securities & cash position, the real estate as well as small working capital position implies that Rella trades at only 35% of net asset value. In other words, a liquidation scenario would yield to substantial (>60%) returns. We believe the main risk of the investment case is continued poor capital allocation by the Aller family, who has the majority of voting rights. Given the exceptionally large discount to liquidation value, we believe that there is a low risk of permanent loss of capital. Although no immediate catalysts are in place (with the exception of continued share buy-backs by Rella Holding A/S), we find comfort in buying 1 DKK of assets for 36 cents. We maintain the mantra that if the assets are in place, goods things will happen.

From an asset perspective, the main attraction is the large cash & securities pile sitting on the balance sheet of the holding. From speaking to the CEO of Rella Holding S/A, we believe the assets are primarily invested in corporate and sovereign debt with sufficient liquidity enabling it to be liquidated within a number of days. Next to a small position in A/R and inventory, Aller Holding S/A also has substantial real estate assets. This includes the new Allerhuset office building (18.000m2) located in Copenhagen, where a number of the magazines are produced:

The shares are very cheap from a net net perspective, but if the business is burning cash, the value can and will disappear. Fortunately, partially due to its high market shares, the magazine business has remained profitable 9 out of the past 10 years.

The magazine business came under pressure in 2009, due to the financial crisis but cost restructuring has helped return the company to average profitability. The magazine business will likely continue to face pressure from increased internet usage and the advent of tablet pc’s, but we believe that given the high market shares in the Scandinavia it is well positioned to survive declines in circulation numbers.

While well positioned, the decline in its main business also poses the main risk to our investment thesis. This is because the family owns the majority of a-shares which gives it full control over future capital allocation decisions.

We believe that in an attempt to secure the future viability of the business the family could make poor use of the hard assets on the balance sheet and replace them with sub-par long shot investments. Indeed, history has shown that the family has already spent a considerable amount of CAPEX over the past years

Overall, while some of the investments can be explained, especially during 2007-2009, with the investment in the aforementioned Allerhuset, other ventures have yet to prove themselves. Capital allocation based on family driven investments remains the largest risk to the shareholder of Rella. While this is the main risk, we believe the discount to NAV already assumes substantial value destruction and does not take into account any other more positive alternatives.

Poor capital allocation is always a risk when one is an OPMI (outside passive minority investor), but given the sheer size of the discount to NAV we have tried to ascertain why the market is giving us such a seemingly attractive deal.

Reasons for Cheapness:

Obscure Holding Structure
Low market liquidity/Capitalization
Relatively poor disclosure
Family owned
No voting rights
No immediate catalysts
Balance sheet investment (vs. Institutional Earnings Myopia)Declining Business
Poor share price performance becoming self-reinforcing
Listed in Europe

Overall we believe these are all valid reasons for why Rella is so cheap, but given the large and liquid asset base, the risks to prospective shareholders is minimal. At the current share price, Rella is being offered at a price that offers only a miniscule risk of permanent loss of capital with very substantial upside if any asset conversion event occurs in the future (be it M&A, liquidation, higher payout ratios, going private or a more aggressive use of assets).

Disclosure: Author long, Nate no position

Can a cheap company in a bad industry be a good investment?

2012-01-09T20:20:00.000-08:00

LICT (LICT.Pinks)

Price: $2055 (1/9/2012)

Is it worth buying a dollar for fifty cents if next year that dollar will only be worth ninety cents? I keep thinking about this and a few other questions as I've been looking at LICT corporation. I'm sure most readers have never heard of LICT but I'm guessing most have heard of LICT's Chairman and CEO, Mario Gabelli the CEO of Gamco funds.

So what is LICT? LICT is a holding company filled with a set of regionally diverse RLECs (Rural Local Exchange Carrier), in other words small local telecom companies. The company owns fourteen different rural telecom subsidiaries that range in size from 800 lines to 7500 lines. These are small companies in places like the Upper Peninsula Michigan, or Central Scott Iowa, let's not forget Bretton Woods NH. In 2010 the company serviced 45,680 telephone lines and 17,599 DSL lines. It seems that the closest companies are a few hundred miles apart from each other and none share the same infrastructure. This means LICT essentially holds fourteen independent rural telecom companies.

So what's the good news? I was attracted to this stock for a reason. There are a few things that caught my eye, the first is that this company is serving an important niche market, when you live in the boonies there aren't exactly a lot of communication options to choose from. Often cell service is spotty and high speed internet is non-existant. Besides the somewhat sheltered business model there were a few financial highlights that caught my eye:

The company spent close to $300m building their network, they now trade for $56m quite a discount to a theoretical replacement cost. (theoretical because it has been replaced, see Verizon/ATT cell network buildout costs.)
LICT earned $450 per share in 2010, TTM they earned $409/sh for a P/E of 5
The company has $330 of FCF in the TTM for a P/FCF of 6.23
Book value of $70m meaning the shares trade at 20% discount to book.
The company is looking to restructure it's hodge-podge of debt.
A well known value investor as CEO who is determined to increase shareholder value.

If LICT wasn't in the rural telecom business these stats would make me think that LICT was a Chinese RTO fraud, P/E of 5, P/FCF of 6, trading below book, a catalyst. All of the raw metrics, and financial figures make LICT seem like an absolute slam dunk investment. The problem is that as I look at them I can't get the feeling out of my mind that I'm staring down a value trap.

This is a company that is clearly cheap, their main problem is they're resident in a declining industry. In the past two chairman letters Gabelli states the industry is going the way of the horse and carriage, something I don't disagree with. LICT has been experiencing modest residential line terminations which have been offset with a slight uptick in DSL, but if we're honest DSL isn't exactly the latest model technology either. This is like jumping from a horse to a Model T in the age of Ferraris.

The question I mentioned in my first line is the crux to an investment like this. Is there a big enough discount to a declining value so that LICT can be a good investment? In one scenario maybe the company will just pay the free cash flow back to shareholders realizing further network investment is pointless. If the declining free cash is greater than the price paid this could do well. In another scenario the company could continue to invest yet come to the same terminal point with shareholders wishing for a turnaround the entire way down.

I don't really see any options for this business besides managing the assets they currently have. It's unlikely that a buyer will emerge and want a bunch of rural telecom companies with a declining user base. Yet at the same time management realizes the predicament they are in and have been doing all the right things, asset sales, spin offs, special dividends.

At the end of the day I want a margin of safety in my investments, a real actual margin of safety not a facade of safety. It seems my lack of comfort with LICT is that I can't readily identify their margin of safety. This is a plain cheap company, but not a safe and cheap company. I just don't know if LICT will be able to outrun their industry's decline, I sure hope so for their investors sake, but I'm just not so sure myself.

I'd love to hear your thoughts, leave a comment below or email me by clicking the following link.

Talk to Nate about LICT

Disclosure: No position

Bioqual - a beginner net-net

2012-01-01T21:46:00.000-08:00

Bioqual (BIOQ.Pinks)

Price: $8.90 (1/1/2012)

Continuing the trend of identifying stocks that have limited or no market visibility but are attractive businesses at attractive prices I present Bioqual. Bioqual is a medical research company, their researchers are located in three facilities spanning over 130,000 sq ft. The company researches all sorts of infectious diseases, cancer they also take part in an activity they call animal modeling. To anyone not versed in medical speak 'animal modeling' means lab conducted medical tests, think lab mice. This probably isn't the prettiest business but someone has to do it if people want to continue taking pills for various ailments.

The company scientists on staff that do proprietary and published research, the company also does contract research for the government groups such as the EPA, or universities. The company is awarded contracts that have a guaranteed minimum revenue and a maximum revenue per year. The company doesn't give much detail in what drives the differences in revenues but my guess is that it's a milestone based system. The client sets out certain milestones and goals they wish to achieve. Bioqual will begin tests and as certain phases are completed the client examines the results and determines if it's worth continuing further. If everything hits according to plan maximum revenue targets can be hit. Of course this is all speculation on my part, but based on the limited details the company has released this seems to be the case. I want to note the ranges are wild, for a contract mentioned in the 2010 annual report the minimum revenue is $47k and maximum is $25m.

Investment Thesis

I wanted to highlight a few of the reasons the stock interested me first before diving into the weeds.

Stock is trading slightly above NCAV, recent price of $8.90 against a NCAV of $7.96
Market cap of $7.8m, EV of $4m
Q1 had $1.16 FCF per share, $.30 EPS
Q1 ROIC of 13%
$4.20 per share in cash

Why is it cheap?

This is the first question I ask myself when looking at a stock. For most of my pink sheet stocks the answer is found in the obscurity and illiquidity. I think those are two valid reasons for Bioqual's relative discount but there's a third reason. As for the first two the company doesn't file with the SEC so information can be hard to find although the company does publish audited financials on their website going back to 2009, and historic financials (pre-2002) can be found in EDGAR.

Within the realm of illiquid small stocks Bioqual does trade fairly frequently. Looking back at trade history about 500 shares trade at least once a week, sometimes more. I know this seems like a puny amount but for a lot of these tiny stocks that's considered liquid. If someone soaked up all of the liquidity for a year they'd own about 3% of the company.

I think the real reason the company is cheap is due to a contract change that has lead to revenue uncertainty. For years Bioqual was growing revenue at a steady pace, they only had a slight blip from 2008 going into 2009 and largely avoided the recession. That all changed in 2010, as I mentioned above the government in many capacities is one of their largest clients. The government changed the requirements of the contract process demanding an expert in all phases be available at all times. The problem with this is that experts always need to be available but can't always be billable. This means that overhead started to rise and at times it wasn't profitable to bid on contracts where in the past it would have been leading to a decline in revenue.

The conclusion I draw from this is that there has been a structural shift for the company, one that isn't going away. In this light I think it's important to look at some of the past financials, but more emphasis should be placed on the more recent information. I also think it's silly to look at past EPS and hope for some sort of mean reversion.

Financial information

I first wanted to show my net-net worksheet. When I first found this stock they were trading below NCAV, but as with many microcaps 900 shares traded hands and the price jumped 13%. As recently as 12/21/2011 the company was trading below NCAV. As a tip, if anyone is interested in Bioqual I'd put in a bid in the $7s and let it sit, it wouldn't surprise me if it's filled in a week or two, these shares tend to be very volatile.

The first thing that jumped out to me was the high cash balance, this has been a consistent factor for Bioqual through the years. I don't think a potential investor can count on a big special dividend paying it back, the company likes to run with a heavy cash balance.

The second thing that popped out at me was that most of the rest of current assets was composed of receivables, and the company had no inventory. Having no inventory makes sense considering that Bioqual is a service company. The high receivables make sense considering the government is the biggest client and often there are numerous hoops to jump through to satisfy government billing meaning slow payments at times.

I didn't put a PP&E number on my worksheet because the other assets on the balance sheet are leasehold improvements which I would peg in a liquidation to a very low value. Maybe Bioqual has some very fascinating equipment but I'm guessing in a fire sale the right buyer isn't likely to emerge, so this stuff would be going for scrap prices.

The good news is the company isn't liquidating, quite the opposite they have a nice track record of profitability so the above mentioned assets can be considered essential for generating a return for the business. I went ahead and put together a nice spreadsheet for Bioqual that I've posted below. I added a column between each year showing YoY changes. I realized that by not including this column in the past I might have missed nuances in the data. If anyone is interested in the Excel copy of this file email me and I'll send it to you.

The revenue decline is pretty clear in the spreadsheet, I think it's safe to say things will probably stabilize close to the 2011 level. I also want to note that the company mentioned that capex for the 2012 year will total ~$87,000, a large decline from the previous years. This will in turn be a one time boost for free cash flow and could lead to a larger than normal year end dividend.

I don't feel like I have much else to say about the company since the spreadsheet contains so much data. This is a company that has a track record of a very volatile ROE and ROIC yet they are both mostly positive. The company has been increasing book value consistently since 2008. The cash balances have been increasing for the past few years, and the number of shares outstanding have been dropping. All of these things are great signs. Additionally a relatively modest amount of cash is returned to shareholders each year as dividends. For an investor who is worried about being "stuck" in Bioqual I can think of much worst stocks to be stuck in. Consider someone who buys today and can't sell for five years; in five years they'd own a slight bit more of a more valuable company, and would have received about 10% of their purchase returned as dividends.

I think Bioqual is a great beginner net-net stock. There is a real margin of safety here in the liquidation value, yet at the same time value will be realized by the company's operations not some sort of asset liquidation. For someone who has never invested in a net-net there isn't as big of a leap of faith to put a few grand into Bioqual because the operations aren't that risky. The company's contracts are long term and they seem to have a high level of profit visibility at the management level.

With all of this said it probably seems like the perfect stock and at this point you the reader are wondering how much of my money I have invested. The answer is none, I really like Bioqual, but there are much cheaper stocks on my radar. If anything I might put in a lowball bid at $7 or so for a small position but nothing more. While this has the potential for a nice return I don't think it's a dollar for fifty cents.

Talk to Nate about Bioqual

Disclosure: No position

Two very different un-researched companies

2011-12-21T09:39:00.000-08:00

I'm combining two companies into this post because each company doesn't have enough to fill a post on their own yet they are interesting enough to discuss, these are true oddball stocks. If people seem to like this format I'll probably continue it as I journey through my 2003 Walkers Manual of Unlisted Stocks.

Before I start both of these companies are small (although on different spectrums one $9m, other $1b) unlisted stocks and illiquidity can be a problem. Both companies below are fairly illiquid although Ash Grove Cement is a bit more liquid than OPT Sciences. DO NOT USE A MARKET ORDER WHEN ATTEMPTING TO BUY!

I also want to mention that Ash Grove doesn't list their financials online or to the SEC. If you want to get an annual report you need to buy one share, fax the company proof of shareholding and they will mail you a copy of the 2010 report. I would expect the 2011 report to come out sometime in March. I went through this process and it's pretty easy and quick.

OPT Sciences (OPST.Pinks)

Price: $11.80 (Last trade 12/19/2011)
Market Cap: $9.15m
Shares: 775,585

OPT Sciences manufactures anti-glare coatings for glass and LCDs. Their main customer is the aviation industry who uses the coatings on airplane instrument panels. There isn't much to discuss regarding the actual business, it's pretty straightforward. If the aviation industry is doing well OPT Sciences is doing well and visa versa. All orders are customer made to specification meaning that sales vary quarter to quarter, delivery time is between four to twelve weeks.

What got me interested in OPT Sciences is that the company is selling for a discount to it's net current asset value, or in other words this is a net-net stocks. I have my net-net worksheet below:

The big risk with OPT Sciences is that their two largest customers make up 69% of sales. Additionally their delivery timeline is the customer's timeline and not based on their ability to manufacture. The second risk is that 66% of the shares are owned by the Arthur John Kania Trust further limiting the float and any chance for a shareholder to stir up the pot.

Investment highlights

-$12.34 in gross cash per share, $11.59 of net cash

-Manufacturing facilities owned free and clear, no debt

-$4.7m in sales 9 months ending July 30, $4.9m in sales 2010, $4.8m in sales 2009

-$.77 EPS 9m 2011, $.59 EPS 2010, $.35 EPS 2009

-23% ROE with excess cash removed

-35% ROIC in 2010

This is an impressive little company, most of their 2010 and 2011 results are from pent up demand following the 2008 and 2009 downturn. Even if earnings shrink there is still a considerable margin of safety considering the investor is able to purchase for less than liquidation value.

The only problem with OPT Sciences is that liquidity is very limited and it doesn't seem that there's any sort of value creation catalyst. The company states they are unlikely to pay a dividend in the future so for now that cash is locked away tight. My guess is that at some point the trust that owns a majority of the shares decides they want a bit of liquidity and the company starts to pay out earnings and possibly cash as a dividend. If I could ever get an order to fill I'd be happy to own a bit of them and sit back and wait.

Ash Grove Cement (ASHG.Pinks)

Price: $128.03 (12/21/11)
Market Cap: $1.048b
Shares: 8,190,061

Ash Grove Cement as its name implies is one of the largest portland cement producers in the US. The company has facilities spread across the western US and is headquartered in Kansas City. The cement business is pretty simple, buy aggregate, add sand, crush it and distribute as cement mix or add water and distribute as cement in a truck to a construction site.

What got me interested in the company was seeing that they had a ~$200m market cap and over $1b in sales back in 2008. The market cap figure listed was wrong on the site I was looking at but it was too late at that point, I didn't realize this until I got a copy of the annual report. The company had quite a run of sales going from $682m in 2001 to $1.2b in 2007. Sales dropped off from during the financial crisis falling to $872m in 2010 tracking the fall in housing.

Cement production is pretty resource intensive with high fixed costs which have really hurt the company the past few years. The gross margin in 2009 was 21% and 15.8% in 2010, net margin was 7.9% in 2009 and 4.28% in 2010. In the annual report management warned that they expect conditions to be even worse in 2011. In the winters of 2010 and 2011 the company idled their plants because inventory storage was full and it was unlikely that it would be worked down over the winter.

The balance sheet is interesting, the company is selling for far less than book value, the depreciated value of the PP&E is $167.85 a share alone.

Investment highlights:
-EV/FCF 8.5x
-EV/EBIT 15x
-11x interest coverage
-1.7% weighted average rate on the long term debt, it seems some of this is due to state sponsored bonds.
-$30.29 a share in cash and cash equivelants
-$206.13 book value
-Pays a $1.76 per share dividend
-Earned $4.56 in 2010 per share and $8.44 in 2009

Ash Grove Cement might be a good investment if the housing market starts to recover or demand for cement picks up. The company has the balance sheet to wait out a long recovery, they've been in business for 130 years and even in this dry stretch have been able to operate profitably.

If you're interested in any further information drop me an email.

Talk to Nate about either company

Disclosure: Attempting to buy shares in OPT Systems, no position in Ash Grove Cement

Hidden Champion Basler

2011-12-18T19:09:00.000-08:00

Basler (BSLX.Germany)

Price: €11.27

I want to look at another hidden champion in this post. I previously examined Corticeira Amorim in this post, and this post. Hidden champions are companies that are usually market leaders in a niche industry or technology. Hidden champions by their very nature are businesses with moats, often due to a few factors, technological advantages, cultural advantages, and worldwide distribution. It's no accident that hidden champions are the top of their field. Most hidden champions are private companies, only about 9% are publicly listed. Considering the small relative float, and the superior execution level these companies exhibit it's rare to find them selling cheaply. What got me interested is that with the European crisis many hidden champions have seen their prices fall along with the broader market, and I think we might be in a rare period when some of these companies can be picked up at reasonable prices. So now onto the current hidden champion Basler.

Basler is an optics company located in Northern Germany near Hamburg. The company makes a variety of different cameras for industrial applications. The cameras Basler sells are focused on three main markets, the industrial segment, traffic segment, and medical segment, the key is that these aren't consumer cameras.

The cameras are interesting, they come in all shapes and sizes but the company specializes in small fast ethernet cameras. The cameras only need to be connected to an ethernet cable, the cable can be up to 100m in length. The ethernet powers the camera (Power over Ethernet technology) and also sends the video back to a computer. The cameras are tiny and have some impressive stats. I picked one from the Area Scan category as an example, the camera is 42mm x 29mm x 29mm (1.65in x 1.14in x 1.14in), it can capture color video at a resolution of 1294 x 964 pixels at 30fps and send the video back over Gigabit ethernet. If you're having trouble picturing the size the lens is about the same size as a beer bottle cap. Basler makes both the camera hardware and software to accompany it.

I briefly mentioned possible applications above. To dive a bit deeper Basler breaks out camera application into three categories:

Industrial - Cameras in this category can be put on a production line and used as sensors. For example a camera might check a food assembly line for foreign objects in a package. If the camera is applied to the print industry it could be used for quality control, or sorting.

Medical - A camera in this category can be used in surgery or highly demanding medical devices. The company mentions microscopy as one use. I had a knee scoped a few years ago and now I'm wondering if a Basler camera was used. Complete random aside, if you're considering a scope I'd highly recommend it, I'm back to running, skiing and biking without any issues or pain.

Traffic - Basler cameras can be applied to traffic in three different applications, traffic control, traffic enforcement and tolling. Traffic control is a monitoring application, used by a local transportation department and often shared to local news websites as "traffic cams". Enforcement is the dreaded red light cameras, and tolling is something like EZ-Pass an automated toll system where a device resides in the car and there's no need to stop and pay a toll the driver just passes straight through.

At this point it might be appropriate to ask how Basler is a hidden champion. The company is considered a leader in the vision technology field. They were the first to incorporate Gigabit ethernet into their cameras and they're helping to define the USB 3.0 video camera standard. The company has over 50 models of cameras and are considered the highest quality in the field by clients. In addition the company has more than 20 years of experience in their current niche. I would say these things qualify Basler as a hidden champion, a leader in a niche category, a high quality producer, and a culture that has experiencing operating at this level for years.

Recent Performance

The company had a record year in 2010 where they surpassed the 2007 high water mark for sales. According to the annual report they expect single digit growth in the industrial market and double digit growth in the medical and traffic markets. The company expects to grow at a steady 5% rate for the foreseeable future. In the first nine months of 2011 revenues are running ahead of 2010 with expected revenue in the €54m range. If the recent margins remain stable the company should have EBIT come in at €8m with net income slightly higher due to tax benefits.

In the half year results Basler reports that their sales breakdown into the following geographic areas:
43% Asia
35% Europe
22% North America

It should be noted that Basler has sales offices in the top optics locations worldwide. They also have sales offices in areas where customers are concentrated.

Examining the financials

When I looked at Basler's current results I was favorably impressed, the company has a nice return on invested capital, and great margins. I wanted to get a historical perspective to see if the company had always operated at this level, or if it's recent. I put together this spreadsheet with some relevant information from the past five years.

The first thing that stood out to me was that ROIC and ROE are really only above average recently. Additionally there seems to be a break right around 2009 where something changed dramatically. So I went digging and the answer was found in the 2009 annual report. It seems that Basler was rocked by the financial crisis reporting a sizable loss in 2009. The crisis and dire conditions caused the board and management to re-evaluate the business. Consequently they sold off a lower earning core division and streamlined operations (presumably by firing employees). The result of this was that the company lowered their break even point from €51m to €36.5m.

The changes management took in 2009 seem to have been prudent and the right course of action looking back two years later. Sales picked up in the camera business and due to the increased operating leverage earnings received a nice boost and subsequently ROIC and ROE rose as well.

One thing an enterprising reader of my spreadsheet might notice is that I included Basler's leases in my calculations. The company leases all of their facilities, and a substantial portion of their assets are leasehold improvements. I don't like the structure of something like this because the company doesn't own what they've developed. I'm sure it could be argued that all they're leasing is a building space and in theory they could move their equipment and setup somewhere else if they needed to. The problem I have with this is that the company is at the mercy of their lessors. The lessor knows considerable improvements have been made and it gives them leverage to raise the lease price cutting into Basler's results. I'm not privy to the decision making behind this, but it seems that Basler has operated this way as far back as I can find results. The notes mention that Basler has the option of buying out the buildings at the end of the lease. The rate on the lease is 6.34%, I have no idea if this is a competitive rate in Germany, it's slightly higher than their outstanding notes but lower than their bank rate.

One last point I want to mention is on the tax front. If you notice the company actually gets a boost to net income in 2010 from a tax refund even though they were profitable. This seemed like a potential red flag but I found buried in the notes that Basler has €17m in a tax loss carry forward that they're working down. I don't know exactly how these work in Germany but I'd estimate they have a year or two of this left.

What can go wrong?

After reading so much about this company I started to feel like I was wearing rose colored glasses. I'm a sucker for their technology it's really cool stuff, and a lot of financial metrics looked great. I needed to step back and evaluate, so I took a look at a few things, the first was earnings quality. Earnings quality is excellent, with a very low amount of accruals, and net income confirmed with solid cash generation.

I also looked at cash flow, the company is a consistent cash flow generator. They do have to re-invest a substantial amount back into development but they have continually thrown off free cash flow. The free cash has been used to pay back bank debt and pay dividends among other things.

Other red flags or points of queasy-ness did emerge for me. The biggest is that a few people in management have made loans to the company at market rates. I'm not sure why this is necessary but it leaves me uneasy. On the flip side the same people also own significant shareholdings. I just can't imagine a situation where management offers to loan the company from their own personal fortune. I should note these loans do seem to be paid back, but it's a constant revolving door. As one loan is repaid another one is extended.

Of course the biggest thing that can go wrong is for Basler's sales to drop off. Basler doesn't have a margin of safety in the traditional sense that I like. Most companies I take a look at have a large slug of assets protecting my downside. Yet at the same time Basler is a great company with a nice moat that no net-net could ever dream of. In a sense the margin of safety is the moat, the competitive position Basler holds in their market. The risk here is that if sales do drop the shares can fall hard, back in 2009 when they reported a loss the market cap was €19m half of what it is today.

Catalysts

I'm not sure if the following items are catalysts but I think they're good things that can only help the company.

The first is Basler authorized a 10% buyback, so they'll buyback up to 350,000 shares on the open market. This could be a great way to support increased trading volume in the company. The justification for the buyback is fascinating. The board said the shares are at a very low level and they want to buy them when cheap and hold on so at some future point when they're more richly valued they can use them in an acquisition. The bad news in this is that the buyback won't be canceling any shares. I'd prefer a buyback to shrink the piece of the pie I own.

The second item is that the company has formally instituted a dividend policy as of last year. They declared that there is a fixed dividend component of €.20 a share and a variable component both together totaling 30% of net income. The dividend paid for last year which should be similar to the amount this year gives the shares a modest 2.5% dividend yield.

What's a good price?

Past readers of the blog might have noticed that I didn't include a section discussing why the company is cheap. Partially the reason is I'm not sure if they're exactly cheap. On a pure metrics basis of say EV/EBIT they seem cheap sporting a ratio of 4.32. But once you add back in those pesky leases the EV-adj/EBIT bounces up to 6.4x. Another measure of value the P/E ratio stands at 4.6x seems crazy cheap, but if you back out the tax advantage to earnings the stock is at 6.23x which is close to the DAX P/E and reasonable considering the illiquidity. So all things considered Basler is basically trading at a market multiple with the DAX.

With some of the metrics behind us I think it's fair to conclude that the stock is attractively priced, but probably not cheap. If I wanted to find a reason this is at €11.27 and not €18 I think it's found squarely in two things, the market cap and associated illiquidity and the fact that it's family owned. This is a €39m company we're talking about that only traded 5500 shares last year. Put another way only 16% of the company traded. This is way too small for many funds to invest in, and even if they wanted to invest the volume isn't there.

The second issue is that the company is 51% owned by the founding family. Often family controlled companies scare away institutional money. Strangely enough I find myself researching and investing in a lot of these family companies across Europe. My rational as an individual is that often a controlling family won't do anything that could put their fortune at risk. This often means a company might not run at the optimal level, yet it gives me comfort that my investment is safe. Of course all this presumes that management isn't looting the company from shareholders which doesn't seem to be the case. Salaries are modest and low compared to US standards. The one outstanding question are those loans the officers keep making, I'm not sure what to make of them.

Why I can't bring myself to buy

I wrote the bulk of this post over two days and as I started I kept thinking that this is a great company I'd love to own, my feelings slowly changed as I wrapped things up. Everything seemed great at first, a reasonable price, great returns and significant earnings momentum. Basler seemed to be a fat pitch a great company at a really good price. But for some reason after I finished researching and typing this post the thought of buying Basler shares just didn't sit well with me.

I thought this over a lot Sunday afternoon and I think I know why I'm unsettled. The first thing I started to think about was my downside risk, I discuss this above. The next thing I kept thinking about was what happens to me as an investor if the market never realizes that Basler is relatively cheap, where am I in five years? At first I thought no problem I could invest and let them compound my money for me at nice rates. In a few years I would own a piece of a company who's book value had increased at 15% or so for the holding period. The problem I realized is that while the company has a really nice ROE and ROIC the invested capital is mostly debt, leases and intangibles. The problem is even if I held for 5 years and ROE averaged 15% for those five years as an investor I wouldn't have anything tangible that increased.

The problem is the company needs to constantly re-invest in R&D to maintain their competitive advantage. This investment is recorded as intangibles on the balance sheet, the problem is this isn't something that can be easily realized or maybe realized at all. In a sense the earnings are a product of the intangibles, but the intangibles might not have much value themselves. The R&D is a necessary expense, they can't sell off their intangibles if times get tough, the intangibles are the business.

The other problem is the biggest asset is the company's leasehold improvements. I realize that there is value to these improvements yet at the same time it's not like the company could sell their facilities if they needed to. They could probably sell some equipment, but definitely not the land and buildings. And unfortunately for Basler land and buildings are re-usable and retain value whereas specialized technology for camera production does not. Looking forward in five or ten years the land and building will probably be the same value or more, the camera technology not as much. I'm willing to be ten year old camera manufacturing equipment is on eBay for pennies on the dollar.

So my final conclusion was that for me to realize a return with Basler I would be relying on two things outside of my control, multiple expansion and continued earnings momentum. If earnings stay strong and continue, and the margin expands an investor would do well in Basler. The problem is if neither of these things happen my fear is an investor will find themselves a few years down the road in the exact same spot as now, invested in a company with great metrics but nothing tangible to show for it.

I would love to be persuaded otherwise, leave a comment or send me an email!

Talk to Nate about Basler

Disclosure: No position in Basler, long Corticeira Amorim

A small cap pure timber play, Keweenaw Land Association

2011-12-13T08:31:00.000-08:00

Keweenaw Land Association (KEWL.Pink Sheets)

Price: $76 (12/13/2011) - note this is an extremely illiquid stock, small trades can really move the stock price.

A bit back I did a post on investing in Timber and got some great emails from readers regarding other companies that are more pure timber plays. One of the companies mentioned was Keweenaw Land Association a smaller company traded on the pink sheets. In my last post on Queen City Investments I mentioned pink sheet stocks often having a story that follows them, Kewneenaw doesn't disappoint in this regard.

Keweenaw doesn't report to the SEC but they do offer quarterly reports on their website along with their audited annual report. The company isn't "dark" by any means, they are transparent with shareholders and tout the cost savings from non reporting as an investment advantage. There are actually a few presentations on their site showing the potential cost of becoming a REIT and filing.

Company Background

Keweenaw has a long history, it began as a land grant after the Civil War. The company owns 159,831 acres of land of which 153,074 is timberland in the Upper Peninsula of Michigan and northern Wisconsin along with 405,985 acres of mineral rights.

For much of it's history Keweenaw made money on mineral royalties and timber harvests. For years the company harvested more timber than they grew. In the 1960s the company made a decision to manage the woodland in a more sustainable manner, and began this aggressively in the early 1990s. Now the company grows more timber than they harvest and focus on increasing the asset value of the timber holdings.

Activist Story

As I mentioned above almost no pink sheet stock escapes without having some sort of story to tell, Keweenaw is no different. The story here is a bit unique, there are two shareholders Ron Gutstein and Scott Frisoli who for the past few years have been offering shareholder proposals and director nominations at each election.

The shareholder proposals seem to change each year, in the beginning there was a laundry list of suggestions to unlock value including the following, a snowmobile theme park, wind power generation, a REIT conversion, elimination of the dividend, and a buyback.

The proposals haven't been for naught, the company has put together some great presentations explaining why it isn't in the best interest of shareholders to convert to a REIT. They also commenced buyback and eliminated the dividend. The dividend was eliminated with the purpose of channeling the money back into growing the business.

Here is a letter from Ron Gutstein with some of his proposals back in 2009: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aDbpkM.zuib8

For each letter and proposal Mr Gutstein submitted David Ayers wrote a rebuttal and posted it on the company website. Some rebuttals are quite elaborate with presentations and lots of good information, others are simply a few lines.

For all this back and forth the company claims to have spent over $300,000 defending themselves. Keweenaw tries to paint Mr Gutstein and Mr Frisoli as corporate raiders who will come along and gut the company with financial engineering. Some of the shareholder proposals are a little out in left field, but others have a lot of merit.

For all the defense management has put into the proxy fight they aren't exactly shining defenders of shareholder value either. Management likes to discuss how they've increased the asset value of their holdings with organic (literally and figuratively) growth. For all this growth management seems to have a plan to grow on a much later scale, this past proxy season they increased the authorized shares from 2.5m shares to 10m shares. Management has stated that they might need extra shares to raise capital and expand. The expansion would be good for themselves as they'd be able to draw a larger salary and run a bigger company but would utterly dilute current shareholders. Amazingly enough the current holders voted for this measure. Based on the current outstanding shares (1.29m) raising the full amount of capital would reduce shareholders ownership by almost 90%, a staggering number.

I think management would probably be quick to dismiss a massive dilution, but their actions say otherwise. The previous amount of outstanding shares was 2.5m meaning that 1.21 shares were available to be issued which at current market prices is around $94m. For some reason management believes they need to raise more than $94m for "General corporate purposes" to grow the company, which in turn will cut current holders' stakes in half or less.

Gutstein and Frisoli have been reducing their demands each year while at the same time trying to secure a board seat. I think in a situation like Keweenaw having a vocal investor is actually helpful in highlighting issues that might not be much visibility due to the non-reporting nature.

One last thought before moving onto the valuation, reading these letters and the corresponding shareholder reaction reminds me of what Ben Graham says about shareholders in Security Analysis "It is a notorious fact, however, that the typical American stockholder is the most docile and apathetic animal in captivity. He does what the board of directors tell him to do and rarely thinks of asserting his individual rights as owner of the business and employer of its paid officers." This could not be more true than with Keweenaw, in reading some message board posts most shareholders voted for the dilution and consider Ron Gutstein a thorn in the companies side. It blows me away that people would voluntarily vote to reduce their stake in a company up to 90%

Valuation

Keweenaw has worked very hard to help investors understand how to value a sometimes complex investment, on their website they have a file called "Understanding KLA Asset Value and Operations". The company commissioned appraisals in 1998, 2000, 2003 and 2006 of the land value, and the timber value.

The appraisal valued the company in two different ways. The first was on a single transaction basis, this means they looked at comparable timber sales and estimated what the company would fetch in the market if everything was sold at once. The second was a discount cash flow based on selling the timber down over a period of seven years. This method assumes that the company sells down their trees for both pulp and lumber at 06 market prices and then adds in a raw land value.

There is also some discussion in the report about the value of the land if it was sold for non-timber uses in parcels, but no work is taken to peg a value for that. Obviously liquidating a company in this manner would be difficult and costly.

The last item relevant to a valuation is the mineral rights. The appraisals didn't include mineral rights, but the company touches on the possible value briefly. From 1891 to 2006 Keweenaw recognized $78m dollars in mineral royalties, which translated to 2006 dollars is $552m. The company claims there are still significant copper, iron ore, and silver deposits on the land but at the time they're not economical to recover on a large scale.

With regards to mineral rights, there are two companies currently interested in mining operations. One company has permits and could begin exploration soon, the other has leased the land, but there isn't any further information on them.

So piecing this together, at the price the market is valuing Keweenaw at $640 per acre of standing timber. This is down from the 2006 appraised value of $836 an acre, and more in line with the 2003 assessed value of $668. I wasn't able to find any charts going back to 2003 but I did find some going back to 2006 regarding timber prices. Sawtimber prices have fallen from the $40s to the low $20s while pulp wood has remained slightly steady at just under $10 a ton.

Considering current wood prices, and the composition of timber offerings I think Keweenaw is probably fairly valued on a standing timber basis. If we look at a liquidation value, or add in mineral rights they are probably slightly undervalued. The problem is they don't have any intention of liquidating so a liquidation valuation isn't appropriate. With regards to mineral rights it's yet to be seen if anything can be extracted, all of the easy minerals are gone, I think the market is correct to peg the mineral rights at or near zero.

One thing worthy of a mention, the company does have earnings and cash flow that I've largely neglected in this post. The reason is that neither the market, the company, or competitors operating in this market value standing timber on the basis of cut earnings. The money earned from timbering is used for administrative expenses and reinvested in the properties.

Final Thoughts

I think Keweenaw is doing a lot of the right things to manage their resources appropriately, they've worked to increase the quality of the wood, they're selling off non-core rural lots for residential use, and they're working to maximize the mineral assets. At this point I think Keweenaw is probably fairly valued, the stock price seems to be accurately reflecting a $600-$700 per acre price for the standing wood. The company would argue they're worth more due to the mineral rights, but my view is that if the mineral deposits were as rich as they say then someone would be mining already. I think the fact that mining isn't taking place at any level reinforces the claim in the appraisal that the deposits might be large, but they're extremely hard to get to at this point.

I think Keweenaw could probably be best looked at as a pure play on raw timber lands with the minerals adding a bit of a potential upside in the form of a free option. If the minerals are extracted it will provide a really nice boost, but if nothing happens the company's valuation doesn't change.

I really like Keweenaw and their approach to managing the forest and their properties, but I just can't get past the potential dilution. I realize that a dilution possibility exists for almost every equity investment, but Keweenaw management has stated that they intend to dilute, it's just a matter of the magnitude of the dilution. Increasing the shares 10x is a major concern, and for the time being will keep me from being a shareholder. It's worth keeping the company on the radar, and if this is an interesting investment maybe holding off until after the dilution.

I'd love to hear thoughts and comments on Keweenaw. If anyone has experience in small cap pink sheet activism I'd love to hear about that as well.

Talk to Nate about Keweenaw

Where to find more data?

I'm trying something new with some of the pink sheet stocks. I'm offering for sale an excel file with the last three years balance sheet and income statement. The cost of the spreadsheet is $10, you can purchase it by clicking on the link below. If you still want the data but don't want to pay everything is available on the company's website in PDF form for free. I'm offering convenience and usability, I've already exported the data out of excel. After clicking buy now you'll be emailed a link with the spreadsheet.

Disclosure: No position

Investigating an unlisted stock

2011-12-04T20:02:00.000-08:00

Queen City Investments (QUCT.Pink Sheets)

Price: $992 (12/4/2011)

I've been engaged in an email conversation with a reader about some pink sheet stocks and one stock he mentioned was Queen City Investments. The stock is like most pink sheet stocks in that they aren't required to file anything with the SEC making the hunt for information frustrating but often rewarding.

Pink sheet stocks have long fascinated me because it seems like a cult following will emerge around these companies. A cult following is often a cruel irony, passionate shareholders in unlisted companies are usually minority holders without many rights whereas apathetic shareholders of listed companies have a lot more rights which they work hard to neglect. A second feature of pink sheet stocks is they usually have a interesting story to go with them. Rarely have I ever dug into a stock on the pinks and not encountered some sort of storyline that is essential to understanding the investment. Oddly enough this seems limited to OTC/Pinks for some reason. I've never had to understand why some land deal to a brother-in-law's great aunt in 1978 was essential to an investment thesis for a listed company but often stories like this will manifest themselves in pink sheet stocks.

I think there's a common misconception that unlisted stocks are all penny stocks. The unlisted market has everything, the typical junior miner penny stocks and on the other side community banks trading for $4,000 a share. The downside is that for most unlisted stocks (unless they're temporarly part of a pump and dump) liquidity is limited or even non-existant. Queen City Investments falls into the limited to impossible camp when it comes to liquidity. As far as I can tell the last time Queen City traded was on November 1st with 10 shares.

One unlisted stock with a cult following and quite a back story is JG Boswell. Boswell has been written up extensively from an investment point of view by Jon Heller over at Cheap Stocks. If you're interested in understanding the history of the company and some history of California there's the 400pg book "The King of California" that dives into the nitty gritty details of the companies back story. The book is great, the characters are colorful and entertaining, if you're interested in water rights, Central Cali, or Boswell I'd highly recommend it. Like most pinks Boswell's investment thesis rests on a complex story which in part has roots in water rights granted in the 1930s.

Queen City Investments is a parent company to three different companies, a trust company, a California cattle ranch, and some commercial real estate holdings in California. The appeal to the company is that it's asset rich, loaded with cash, securities, and land that's potentially undervalued. What's nice about Queen City is that they aren't only a pile of assets they also have earnings from the trust management company. Queen City was spun off from the Farmers and Merchants bank a number of years ago, the company is closely held by the Walker family.

There really isn't much to talk about in terms of the business operation because it's almost impossible to find information on the business. The annual report I was able to dig up contained a few terse statements about the three holdings and not much else. The best information I could find about the company was actually on the yahoo message boards. Some posters have details on the cattle ranch which is approximately 25,000 acres, and some of the specific commercial holdings in LA.

All this leads to the question, how does one find information on these unlisted stocks? For Queen City Investments I was able to dig up the 2010 annual report and proxy with some creative Googling. Some unlisted stocks freely publish their financial reports on their website. Personally I'd prefer investing in a company where I can easily find quarterly, or at least twice a year statements including an annual report. I have the links to the Queen City reports below under Resources.

Valuation

I think the best way to approach Queen City Investments is to first show what a buyer is getting per share:

Liquid Assets
51.76 share cash
399.93 securities
37.80 in repo T bills

Semi-liquid
16.64 notes receivables
18.54 Locust LLC property
8.65 a share in cattle
294.86 a share in land

Liabilities
59.60 in notes payable
16.64 line of credit

125.34 total liabilities

Having these values gets us much closer to determining the value of the operations:

48.36 per share in earnings
43.35 in CFO
15.36 CFI, no capex to speak of

10 in dividends paid

Take all of this and break it apart and we find for the operations:

Current price: 992 current price
Remove the cash: 502.51
Remove the cattle, commercial property and land: 163.82
Add back in 50% of the debt (some of the debt presumably is tied to the property): 201.94

This means that the trust company is trading at 4.17x earnings
or 4.65x cash flow.

So a buyer at current prices can get the land and cash at book, and a trust that manages $2b in assets for 4.17x earnings or 4.65x cash flow, quite attractive!

A second way to look at this is building off the land value and working backwards. From my searching I was able to find California ranch land selling in the $1500 an acre range.

An investor buys two shares ($1,984 paid), they receive

1 acre of ranch land valued at approx $1500
Cash and securities totaling $978.98
A bunch of commercial property and some cattle thrown in for free
And a trust business that throws off $48.36 a year in cash flow for free

Even if the commercial property and trust is hard to value exactly looking from the land perspective it's pretty clear this stock is undervalued.

So what's the catch?

This is the type of investment a value investor dreams of, tangible assets selling for nothing. Of course with something like this there has to be a catch right? Most investments that look this appealing on a listed exchange have some big hairy problem, usually not so for unlisted stocks. There are two big problems stocks like this, the first is it's nearly impossible to buy shares, any quantity. The company is closely held and current investors just aren't selling. If we wanted to presume that a 10% position would allow someone influence enough to realize value building the position ($4.7m) would literally take years of buying 100% of every share offered in the market.

The second problem is closely related to the first in that this is a closely held company. The Walker family has run Farmers and Merchants Trust and their associated companies for generations, they apparently like the comfort of being overcapitalized and it's unlikely they will suddenly have a change of heart.

Buying into Queen City Investments thinking that Mr Market will wake up and revalue suddenly is foolish, shares like this can and do stay cheap for years or even decades. Value is often unlocked by corporate actions, a merger, or a buyout and often the controlling family is in no hurry to take action, instead they're content to plod along and collect dividends.

In the end Queen City is fascinating to look at, and a great example of the price of transparency and liquidity. I don't own any shares or plan to buy any, but I'd love to hear from shareholders, or anyone who has more details on Queen City.

Resources:
Annual report: http://www.amstock.com/proxyservices/Files/AR16728.pdf
The 2010 proxy: http://www.amstock.com/proxyservices/Files/PS16728.pdf

Talk to Nate about Queen City Investments

Disclosure: No position. If you click buy the book mentioned above I will receive a small commission from Amazon.com. The price through the link is no different than if you visited on your own.

A sum of the parts..Renault

2011-11-29T20:05:00.000-08:00

Renault (RNO.France)

Price: €26.35 (11/29/2011)

This is an unusual finding for me, a large cap trading at such a discount. I'm not adverse to buying large caps, my portfolio has a few, but I tend to avoid writing about them because a lot of ink is already spilled following the largest companies. In the case of Renault I haven't been able to find much about this except for a brief mention in this past weekend's Barrons.

Background

In the late 90s the automotive industry was experiencing a consolidation wave, instead of merging Renault decided to form a new type of alliance with Nissan. Renualt bought 34% of Nissan's outstanding shares with the agreement that Nissan would purchase part of Renault when financially able. Nissan had hit a financial rough patch and had a near bankruptcy experience in 2000. Nissan recovered and purchased 15% of Renault in 2001. Eventually Renault increased their stake in Nissan to 44%.

The idea behind the alliance is that both companies can operate independently and retain their branding yet share key strategic technologies. The cross shareholding structure encourages both companies to act in the best interest of themselves and the partner company. A partnership structure like this seems very strange to US investors, but it was actually very common in Japan in the 60s and 70s but less so today. A company would purchase shares of suppliers and distributors creating an incentive to work together. At times the crossholdings could also lead to a certain nepotism where a company would use their preferred supplier even if the supplier had a higher price and worse execution.

Outside of the Nissan stake Renault also owns stakes in Volvo AB which is a truck manufacturer, and a stake in AvtoVAZ which is a Russian car company. Renault looks at both holdings as strategic alliances but not to the same level as the Nissan holding.

As a note when looking at Renault's statements they use the equity method under IFRS to consolidate their statements, if anyone is unfamiliar with this method here is a great link.

Sum of the parts breakdown

Renault has a holdings in three public companies, Nissan, Volvo AB, and AvtoVAZ, since all of the holdings are public it's easy to piece together the current value of what Renault owns. I have it broken down the values and translated to Euro in the following spreadsheet:

What's pretty clear right away is that the total of Renault's public equity holdings is twice the current market cap and amounts to €49.78 a share. If we assume that Renault's market cap is an accurate reflection of their current operations alone and add back their holdings the total is €74.38.

A discount to such a tangible asset value is rare especially for a large cap. Just a simple analysis like this is really enticing, this is the elusive $1 for $.50, but with a caveat. The problem is the liquid assets most likely aren't realizable (I discuss below), and in a down market the value of all the holdings will shrink because Volvo, Nissan and AvtoVAZ are all automakers.

I think the better way to look at this investment is an investment in Renault with a sizable margin of safety. At this point I'm not comfortable enough with my own understanding of Renault's operations to make an investment. I think this is more of an investment in Renault with downside protection than an asset play.

Why does this exist?

In a lot of my recent posts I've been asking the question "why is the stock cheap?" as a way to examine if the stock is deservedly cheap. The reasons for the Renault cheapness I think are a bit more straightforward and probably even more warranted.

The first thing is that Renault has no intention of liquidating the Nissan stake to unlock value. Renault looks at the Nissan holding as a strategic relationship, where selling off Nissan would almost be like spinning off a subsidiary company. I think the market reaction would actually be negative regarding a share sale instead of something positive that unlocks value. I think this is true especially considering the fact that both parties talk about how great the relationship is to their related businesses.

The second reason I think this disparity exists is that the market judges both Renault and Nissan on their own respective operations. The joint holdings have existed for more than a decade meaning this isn't some sort of hidden asset.

I'm not sure if either reason is a good reason for Renault to be selling at such a discount, I'd actually be interested if someone out there knows how long this condition has persisted.

Talk to Nate about Renault

Disclosure: No position

Adams Golf has a margin of safety and a catalyst

2011-11-25T21:02:00.000-08:00

Adams Golf (ADGF)

Price: $5.54 (11/25/22)

Note: This post appeared in some RSS feeds prematurely because I accidentally hit the wrong button while working on it. This is the completed version, sorry for the confusion.

Adams Golf is a small golf manufacturer located in Texas, they make the full range of clubs and associated accessories such as bags and hats. I haven't ever played on an Adams club, so I went online looking for reviews. Most agreed with the statement that the irons were about average and the hybrids were really nice clubs. I wouldn't mind adding a hybrid to my set, so if a very generous reader out there wants to buy me a Adams hybrid I will be sure to put it through a few rounds of "testing". I talked to some relatives who are more "in the know" with golf gear, and their opinion was that Adams Golf made some decent stuff.

The attraction to the stock is that it came up in a list of stocks selling below NCAV. Here is my back of the napkin investment thesis for Adams Golf:

-A NCAV of $4.94 with a tangible NCAV of $2.77 against a price of $5.54

-EV/EBIT of 4.8

-EV/FCF of 14.5

-No debt

-Room for margin expansion, current net margin 5.53%, net margin in 2006 was 11.84% and 2007 9.94%.

Balance Sheet

The balance sheet is what got me interested in Adams Golf, here is my net-net worksheet:

A few things stand out, the first is that for a manufacturing company Adams Golf has a very small amount of property plant and equipment. The reason for this is that the manufacturing facilities are leased and found under contractual obligations. The facility operating lease is up in 2013, so there is a potential that costs could slightly tick up for the facility.

The other aspect is that inventory and receivables make up the bulk (80%) of NCAV, this is expected for a manufacturing concern. Both inventory and receivables as a percentage are at reasonable levels compared to past history.

The balance sheet is good, I think all of the values on the worksheet are reasonable in a liquidation scenario. Golf clubs tend to sell relatively quickly, and even models a year old sell pretty easily. The difference between a 2010 and a 2011 club isn't all that great no matter what the marketing people would want you to believe.

Business Quality

For any business selling below NCAV we have to assume there's a problem, if there isn't a problem the stock probably isn't selling cheap. The case with Adams Golf is a little interesting, I think there are a few reasons the stock is selling cheaply.

The first and most benign is that the company has a history of lumpy profitability. In the last ten years they've been profitable 60% of the time. The company has a high degree of operating leverage so when they hit a high volume the profits and cash roll in. On the other hand a slight downtick in volumes can result in a loss. The lumpy profits means uncertainty on Wall Street, and Wall Street hates uncertainty giving Adams a lower multiple.

The second reason is that Adams was involved in a class action lawsuit related to their IPO in 1999; they ended up losing with a verdict of $16.5m issued against them. Insurance paid out $11.5 million, and Adams paid out $5m which was accrued in 2010. In addition there is still a patent infringement lawsuit outstanding which is currently in discovery. The outcome of the lawsuit is uncertain, and if it goes against them a negative verdict could require either a payment, a club sales halt , or a redesign of certain models, all costly solutions.

The third reason is that management isn't exactly viewed as shareholder friendly. For the past ten years shares outstanding has been steadily increasing due to executive compensation. Compensation that isn't always deserved considering the company has only been profitable 60% of the time, and had free cash flow 50% of the time.

The following picture gives a nice overview of the past ten years. I show the cash flow (operating, capex, and free cash flow), in addition to the book value. I also show the ROIC with the positive ROIC in bold.

What the spreadsheet reinforces is that when times are good and volume comes in ROIC can be high, very high (60% in 2004). ROIC for the past twelve months isn't all that high, but it is positive. Considering that Adams is coming out of a downturn there is a lot of room for improvement.

Catalyst

What makes Adams Golf a very interesting investment is that a few large shareholders are starting to agitate for action. Two shareholders who own around 35% of the outstanding shares submitted a 13D/A pledging to do the following:

(a) appear at each such meeting or otherwise cause the Covered Shares to be counted as present thereat for purposes of calculating a quorum; and
(b) vote (or cause to be voted), in person or by proxy, or deliver (or cause to be delivered) a written consent covering, all of the Covered Shares:
(i) in favor of an increase in the authorized number of directors of the Company and the election as directors of the Company of each of:
-Roland E. Casati; and
-such additional persons as the Gregorys may nominate or support for election as directors at such meeting (understanding that it is the current intent of the Gregorys to not vote in favor of the election as directors of Oliver G. (Chip) Brewer III or Russell L. Fleisher at such meeting);
(ii) in favor of an increase in the authorized number of directors by up to two (and possibly more if necessary in response to actions that the Company might take);
(iii) in favor of a stockholder proposal to declassify the Company’s Board of Directors;
(iv) in favor of the Company’s proposal to ratify the appointment of BKD, LLP as the Company’s independent auditors for the year ending December 31, 2012; and
(v) as instructed by the Gregorys on all other matters presented to a vote of the stockholders at such meeting.

Here are two more relevant links: brief post discussing the activism
A letter to the major shareholders which initiated the action

After the filing the price moved up a bit, but there is still a lot of room to move, especially if the company starts to move in a more shareholder friendly direction.

I think Adams Golf has a lot of potential, especially for margin expansion and some possibly shareholder friendly moves. I think the current assets also provide a nice bit of downside protection. I haven't invested in Adams Golf yet but I'm watching this situation closely.

Talk to Nate about Adams Golf

Disclosure: No position

Why Sycamore Networks?

2011-11-20T20:02:00.000-08:00

Sycamore Networks (SCMR)

Price: 19.39 (11/20/11)

I want to apologize for the slowdown in posts, I've been working on finishing (remodeling) our basement which has sucked up pretty much all of my free time. I'm just about done framing, so I only have a bit of electrical and drywall left, hopefully I'll hit my goal of completing by Christmas. Until then I'm hoping to get a post out once a week or so.

Onto Sycamore Networks..

This is a stock I first saw discussed in a Marty Whitman shareholder letter (my wife has the Third Avenue Value fund in an IRA) as a net-net the fund had purchased. I took a look but the stock wasn't selling below NCAV, and I didn't see any other attraction at that time. This weekend I saw an article in Barrons that mentioned Seth Klarman's hedge fund had started to purchase shares in Sycamore Networks and I decided to take a look again.

After digging into the 10-K I can't figure out why Marty Whitman or Seth Klarman have invested, the thesis is somehow beyond me. These are two very smart investors, so I'm presuming that I have somehow overlooked something hidden that's really big and important, if you know what that is please email me or leave a comment at the end of the post.

The business

Sycamore Networks builds specialized switching equipment that helps reduce network congestion. The company sells products for the fixed line market, mobile, and broadband networks. There are a few problems Sycamore is trying to solve, the first is general network congestion, this is where the traffic amount is larger than the bandwidth available. The second is peak demand, a network might be able to handle traffic for most of the day but if there is a spike due to some external event network traffic might grind to a halt, as an example I remember trying to get to CNN.com on 9/11, no matter how many times I hit refresh nothing would load in any reasonable speed.

The sweet spot for Sycamore is a customer who wants to stretch their existing network a little bit more without having to upgrade the infrastructure completely. In a computer network there are a few important pieces, the wires, the routers, repeaters and switches. The wire in the ground might be able to support 600Mbps or even 1Gbps the limiting factor with regards to maximum speed are the endpoint switches and repeaters. To upgrade a network segment all of the switches and repeaters need to be upgraded to the higher standard. This can be costly considering in some situations repeaters are buried underground, or in hard to access locations. Secondly if a provider upgrades the network there is no guarantee clients will be willing to pay for increased speeds in an amount that will cover the upgrade cost.

Sycamore helps this by working to streamline traffic on a congested segment. The company website has all sorts of great marketing spin videos explaining their secret sauce but it boils down to a simple technology, QoS or Quality of Service. Each packet sent from a computer over a network has a priority code, normally each packet is treated equally. A packet containing banking information is given no higher priority than a packet destined for YouTube. Video and gaming are very high demand applications, but often low priority. A video can drop a frame or two and it will be almost indiscernible to the user, whereas a dropped packet from a website might mean the site won't load at all.

QoS isn't anything extraordinary, the Linksys router I have in our basement has a very rudimentary version of it allowing me to statically state that web traffic is more important than Kazaa, or video game traffic. The shortfall is there isn't much configuration available, and the routing is based on the port, not the content of the packet.

What makes Sycamore devices valuable is the software installed can intelligently determine what is inside of a packet and prioritize dynamically. This means if a network segment starts to become highly congested packets destined for YouTube can be de-prioritized and web traffic prioritized. Or on a telephone network calls can be routed differently to avoid busy signals.

I'll be the first to admit the technology is cool and very innovative. I'm sure Sycamore has a building full of very bright people up in Massachusetts figuring out these problems, and it seems like there's demand for a product like this with broadband usage exploding and mobile data usage growing quickly.

The history

The company IPO'ed back in 1999 during the height of the dot-com boom, they did a follow on offering in 2000. It seems that they've been working down the IPO cash ever since. This is where the mystery of the attraction starts to begin for me.

Since the IPO the company has never recorded an operating profit, only once they recorded a profit which was due to other income. The company was cash flow positive 2006, 2007 and 2008, and had a meager amount of free cash flow in each of those years.

The one bright light I can see in this stock is that gross margins have been increasing which is good, the problem is R&D expenses track pretty well with gross profit. That means that by the time SG&A comes along the company is already in the red.

Valuation details

I don't really have much to add here, the numbers speak for themselves, so I'm just going to dump out some stats.

-P/S 11.3

-EV/Sales 3.3

-Gross Margin: 52.8 TTM

-Book Value 15.71

-Revenue Growth: 3yr -25%, 5yr -11%, 10yr -18%

-NCAV of $15.34, Net Cash of $14.63/sh

None of these numbers jump out at me as a screaming buy outside of the high cash value per share. The problem is the company is constantly eating into the cash balance each quarter as sales fail to cover expenses.

Summary

I can understand the appeal of Sycamore Networks as a story stock, broadband and mobile data are growing rapidly and the company has a solution that can save carriers a lot of money. The problem to me is that broadband has been growing since 1999 at a fairly rapid clip, and the company has never been able to turn an operating profit, and they've only been cash flow positive in three of the last ten years. And the last ten years have been prime years for data growth If Sycamore hasn't been able to capitalize in the past when conditions were ripe what will be different going forward?

The one thing I do get is the high cash balance, but there are other router and networking companies with high cash balances selling at cheap valuations.

I guess my confusion lies with the fact that two renowned value managers have positions in this stock. I recognize they're far more intelligent than I am, so I'm presuming I'm missing something. If you have any ideas on what I'm missing please send me an email or leave a comment.

Talk to Nate about Sycamore Networks

Disclosure: Long Third Avenue Value fund, and by proxy long Sycamore Networks.

What was cheap gets cheaper

2011-11-08T08:20:00.000-08:00

Vianini Industria (VIN.Italy)

Price: €1.27 (11/8/11)

I posted about Vianini Industria previously, it was one of my first posts about international net-net's. Since the post I'd kept my eye on it, but not very closely. A few days ago I received a comment on the post which made me revisit the stock. Here's the comment:

Mauro said...

Hi Nate,

it has been years since I'm following this stock and I've decided to buy it today...
now VIN is at 1.15,about €35mln in market cap. VIN holds now €30mln in cash, about €26mln in good stock shares(who are on their lows) and total liabilities about €7mln,so no debt... not to mention all the credits,physical assets that it owns.
In the June2011 semester report there's a little note saying that there's an additional €46mln in fixed assets which have been totally depreciated,thus not resulting on the book: about €11mln of these are buildings and land. With a very very conservative calculation,I think that this €46mln can have a value of around €10-15mln to add on the book...
with my analysis VIN's value is around €80-90mln,thus between 2.6-3.0 per share.

VIN is a deeply undervalued stock but should be considered because:
-the company is relatively stable and the losses it had are made by financial loss with it's stock portfolio
-the assets are tangible and very liquid
-in economic crisis people want to trade liquid stocks to get out quickly,so only the bigger ones...thus the small ones get dumped without much thought
-after years of inactivity the company is in work progress to install a huge solar power plant,thus a way to invest the huge cash it has and hopefully producing a decent income(and dividends)...and of course it will be more visible to investors.

My concerns when I looked at the company previously were the quality of earnings, and margin of safety. I want to take a look at both of those items seven months later.

Asset Value

This is really the main driver for the investment, Vianini Industria is selling at an incredible discount to it's asset value. Here is my net-net worksheet:

Right away the first thing that hits me is that the discounted NCAV is almost double the current price, this is rare. What's even rarer is the composition of assets that the company has. On the balance sheet €60m is in cash and publicly traded securities, liquid assets that could be sold today and fair value realized. The securities are holdings in two companies Assicurazioni Generali SpA and Cementir Holding SpA, both Italian securities.

Taking this right off the bat we have a stock with €60m in cash and securities with €7m in liabilities (none of it debt), or a net-cash position of €53m against a market cap of €38m. The company is selling at a discount of about 28% to the net cash value.

What I really like about Vianini Industria is something Mauro pointed in the comment was that the company has some hidden assets. The details are found on page 29 of the HY report in note 1. The note discusses the property plant and equipment account, following the discussing of the balance sheet values is the following translated text, "The following are the values of tangible assets fully depreciated but still in use.

Cost 30.06.2011

Buildings 11,771

Plant and machinery 33,282

Industrial and commercial 2,509

Other assets 340

Total 47,902"

This is an interesting note, basically the company has €47m in assets that are being used to create cement products that aren't reflected on the balance sheet at all. These assets consist of the the land the cement plants sit on throughout Italy and the cement facilities themselves. Even though these assets don't have an actual balance sheet value they have a very real world value, these are the assets the company is using to generate it's non-financial returns.

In my net-net worksheet I only give these assets a value of about 10%, but that's probably on the low side. In reality the assets are probably worth a bit more, my question would be who is interested in the properties and equipment. I'm not sure how many other cement companies are operating in Italy that would be interested in swallowing the Vianini Industria operations. Secondly the land appears to be in some very rural places, so I'm not sure if a ready buyer would emerge quickly. Discounting 90% takes all of this into account and gives a wide buffer for error.

Overall on an asset basis Vianini Industria is very attractive, and selling at a deep discount.

Earnings Value

When I previously looked at this company one of the things that concerned me was that most of the company's earnings was from financial income, or dividends of holding companies verses operating earnings. The operating earnings record is quite poor and very lumpy as seen below.

For the trailing nine months EBITDA is barely positive, and after taking a depreciation charge operating earnings are negative. This was a big concern I wasn't able to overcome previously, but my thinking has changed some in the past seven months.

First and foremost I always want a stable margin of safety, the last thing I want to do is invest in a company that is destroying the margin with a large cash burn or terrible acquisitions. I don't see either with Vianini Industria. The operations of the company are very poor, but the difference is made up with dividends from other cement holdings. In addition the company has a high amount of operating leverage, meaning if the cement market starts to have an upturn earnings could shoot up dramatically for the company.

The company currently has a backlog of about €8m in projects, with the possibility of €9 more in extensions. The company also has started supplying cement to a new energy plant which Mauro mentioned and is mentioned in the HY report. Taken together this is about another year or year and a half of earnings at the current pace before new works needs to be found.

I would prefer that the company earn a 15% ROE and have great operations but that's unrealistic considering I'm able to buy the assets for less than 50%. With Vianini Industria I'm buying the assets, and my hope is that the operations aren't acting against me, which they aren't.

Margin of Safety

The margin of safety for Vianini Industria is very obvious, the company has a large amount of liquid assets in excess of its market cap, additionally they have some hidden assets, and a business that isn't eating at the asset value.

I keep trying to think of the worst case scenarios for Vianini Industria in an attempt to kill the stock.

The cement business hits a downturn - This is already true, I guess it could be even worse and there is a complete stop to railroad construction in Europe. I believe this is already priced into the stock, and additionally even at low levels of production the company is squeaking by and just barely covering costs. Secondly most of the company's earnings don't come from the cement operations, they come from dividends of other cement companies.

Their equity cement holdings could eliminate their dividends - This is a risk, although considering the market environment and they fact they're still operating and able to pay a dividend currently I think it's probably fair to say they'll be able to continue in the future. Even if the holdings cut their dividends 50% Vianini Industria will be able to record a profit.

All cement production in Europe ceases - This is truly the worst case scenario, Vianini Industria would be operating at a loss, and so would the equity holdings. In this case if they didn't cut any staff or costs they have enough cash to survive a complete halt for five years.

The Caltagirone family takes it private or takes the cash and securities - This is probably the biggest risk, the family holding the company takes it private at some low multiple. The family already has control of the company, and the company supplies the other family companies. While this is a risk I see it as a unlikely risk.

If none of those scenarios play out the company has enough cash to weather a very long dry spell in the cement business. I feel that I'm adequately protected against a loss by buying the assets at such a big discount, additionally once earnings turn around I think the stock could begin to rise quickly.

Why is it cheap?

There are some obvious reasons why Vianini Industria is cheap, and the reasons are pretty good, I'm just going to list them out.

The company is 66% controlled by the Caltagirone family, only 33% of the float is public.
The actual business is pretty bad, low margin, loss making, terrible return on equity.
The stock has a small market cap, and is priced around €1, not much institutional interest.
There are a lot of related party transactions with other family controlled companies, it's possible Vianini Industria isn't getting the best prices for their goods, or they are overpaying for materials and supplies.

All of the above reasons are perfectly valid, and if I was looking at Vianini Industria as an investment into the cement making business I would probably avoid it. The key to this stock is that the value doesn't reside in the business, it resides in the assets, and the hidden assets.

The question I asked when looking at Vianini Industria is do I think that cement production will completely halt in Europe for five years? That's my worst case scenario, and the scenario where this is a losing investment. I don't think that will happen, I have an adequate margin of safety protecting my investment and the company has the resources to wait out the downturn.

Talk to Nate about Vianini Industria

Disclosure: Long a small stake in Vianini Industria looking to increase it over the next few days.

Einhell Gruppe AG

2011-10-31T09:09:00.000-07:00

Einhell Gruppe (EIN3.Germany)

Price: €35.64 (10/31/11)

I stumbled upon Einhell through a screen I recently ran at FT.com. I wanted to find stocks that had decent long term operating stats but had been dragged down in Europe as part of the debt debacle. I ended up with a good list of stocks that aren't superstars, but are consistent operators that have probably been unfairly dragged down.

The first I want to look at is Einhell a Germany tool manufacturer, I'd love to go to Lowes and personally examine the quality of the tools, but they sell their tools everywhere but North America. Einhell manufacturers all sorts of power tools for remodeling, such as circular saws, reciprocating saws, drills, sanders, lawnmowers, small greenhouses, and air conditioners. The company's sales are pretty evenly divided between power tools and lawn equipment.

The company's philosophy is to sell quality tools to the recreational user. I would think a recreational user is the type of person who has to cut at 2x4 maybe two or three times a year for simple projects. Although I can't examine any of the products myself I'd probably equate Einhell to something like Harbor Freight Tools. Harbor Freight is great, you can buy anything there cheap and it seems like a panacea until you use the tool more frequently than it was built for and realize it probably would have been wise to pay up in quality. This isn't to say that those sorts of tools don't have a place, they do, and the place is in most people's workshops. The reality is that most tools are used infrequently outside of hard core DIY'ers, and professionals.

Valuation

I was able to find 10yr stats for Einhell via MSN Money, so I want to take a look at the company in light of it's historical results, and I also want to consider the margin of safety for an investor.

I want to speak for just a minute as to why the company is selling at such a cheap valuation. Einhell has fallen in general with the German market, this is the first and main reason for the depressed valuation. The second reason is with a depressed market there are fears that consumer goods companies will fall as consumers stop purchasing non essential items.

Einhell sells 38% of their products to the domestic German market, they sell 79% of their products in the EU, and the rest in Asia and Australia. Even with the European debt crisis the company recorded an increase in revenue at the latest interim statement. Sales have been growing overseas enough to counter domestic declines. I believe this finally changed in the most recent quarter, but we'll have to wait until November to see how bad the decline is.

Investment Thesis

I think the thesis for Einhell can be summed up quite nicely in the following stats showing that on a number of different metrics Einhell is selling cheaply:

In addition the company has about €139m in working capital against a market cap of €54m which makes it a net-net. I didn't screen to find any net-net's, these companies are just somehow attracted to me which I thought was an interesting coincidence.

Since Einhell qualifies as a net-net I through the worksheet would provide a good overview of the current balance sheet.

The composition of the balance sheet is heavily weighted towards inventory and receivables which is understandable for a consumer products company. Liabilities are composed mostly of bank debt and accounts payable. There is also a provision account of €14m, this account is mostly held for warranty repair work.

Looking at the net-net worksheet I would say the Einhell balance sheet qualifies as a quasi margin of safety. In a liquidation scenario with discounted receivables and inventory the company would probably fetch around €7 which is a lot lower than the current market price. The company also doesn't have much cash on the balance sheet.

10yr Balance Sheet

I recently discovered that MSN Money provides ten year income and balance sheet statements for a lot of different international stocks, so I pulled in the ten year stats for Einhell.

A few things stood out to me when taking a look at the historic balance sheet. The first was that NCAV has been growing at about a 10% clip over the last decade. A growing NCAV isn't a bad thing if the growth is due to increasing cash balances or a growth in the equity account, this isn't the case with Einhell. The growth in NCAV is due to increases in receivables and inventory over the years, a growth in both accounts should be expected to stay roughly in line with a growth in sales. In the case of Einhell sales have been lumpy for the past decade and current assets have consistently grown, this is a caution flag for me.

The second thing that stands out is that Einhell isn't too heavily indebted. The company has made further progress on this front reporting that they paid down €20m right after the H1 statement. I would estimate that the current debt load is in the €25m range or so, which is very manageable.

The last thing to note is the increase in shares outstanding in 2003. Dilution is always a concern for equity investors and can destroy a margin of safety quickly. The cause for the 2003 dilution seems to stem from the major loss Einhell experience in 2002. My guess is their capital ratio went negative and they were required to raise capital to remain in compliance with their listing.

10yr Income Statement

The historic income statement paints a much better picture of the company than the historic balance sheet. Einhell is a pretty consistent company, they've had sales in the range of €234m to €417m over the last decade and margins have remained pretty consistent.

In terms of current operating performance Einhell is a bit on the high side of history which is good, the H1 EBIT margin came in at 6.7% and net margin at 4.9%. It's questionable if those margins can stay high considering the possible downturn in revenue for H2.

Cash Flows

When I took a look at the cash flows for Einhell that's when the thesis started to break down for me. A company can be wildly profitable but if the cash isn't coming in the door the profits are just a fiction.

Einhell has been very profitable in 2010 and H1 2011, yet when I look at the cash from operations it's been negative the entire time. Where did the cash go? The cash all went into increases in working capital, mainly inventory and some receivables. The shortfall from CFO is accounted for in the dwindling cash balance.

I wasn't able to get a ten year outlook on cash flows, so I had to settle with the five year lookback that FT.com provides. Einhell seems to be pretty volatile when it comes to cash from operations, and in turn free cash flow generation. They seem to run in streaks where they will build up working capital and then wind it down. In some years working off inventory provided a nice boost to cash. The problem is this isn't a sustainable pattern. I would rather see a company with consistent inventory balances and consistent cash flow verses a bonanza year and then a few lean years.

When I saw the spotty cash flow record I decided to put Einhell's numbers into my accruals worksheet which is basically a quality of earnings spreadsheet. The accrual numbers for Einhell aren't pretty:

I like to see accruals to be in the 8% and below range for most companies. At times there can be exceptions but in the case of Einhell this spreadsheet just confirmed my fears from the cash flow statement.

Where is the margin of safety?

I really like Einhell, I don't really like the lack of cash to back up the accounting profits. The company is selling for less than working capital yet I kept asking myself if a true margin of safety exists. I think it does, and I think the margin exists higher up the capital structure at the bank debt level. I would buy Einhell bonds all day, there is adequate interest coverage, and good asset protection. At the equity level I just don't have the same level of confidence.

Bottom line

Einhell is a company I'd consider owning if the quality of earnings improved, some of the asset balances declined and the cash started flowing. I am planning on keeping my eye on the company for Q3 results at the end of November. What I originally thought was going to turn out to be a great investment turned out to be more of a dud with some future potential. In the case of Einhell the investment decision didn't rest on any problem with the business, it rested with more of a problem with the financials.

Talk to Nate about Einhell

Disclosure: No position

Gencor, selling below net cash, but is there more than meets the eye?

2011-10-25T21:17:00.000-07:00

Gencor (GENC)

Price: $7.00 (10/25/2011)

I saw this idea posted over at the ST Report, plugged the numbers into my net-net worksheet and realized this is a company selling for less than net cash in the US. I have to admit, at first glance when I saw this I was excited, it seemed like the type of company I like to hold, selling for less than cash and profitable.

Basically every single net-net has a problem, it could be a small problem that looks big, or a big problem that looks small. The trick is identifying companies where the problem appears big but is really small or manageable. The first red flag for me was that Gencor didn't appear to have an obvious problem, when I see this I get worried.

I want to examine this stock by looking at both the bull and bear case.

Bull Case

The bull case is pretty simple, the company is selling for less than cash and marketable securities net all liabilities. Here is my net-net worksheet:

In addition to having a fortress balance sheet the company has a good record of profitability. Here is a look at their profits and a few select margins for the past ten years:

Source: MSN.com

One criticism against the history of profitability is that a lot of the profits come from the marketable securities and operating profits are a bit spottier. I can accept this argument, but since this is a net-cash stock we're discussing I think any profits are acceptable.

So in summary the stock is extremely cheap, and has a positive ten year history of earning money. For the past ten years the balance sheet has only grown stronger.

To put a conservative value on the stock I think it's fair to take the cash and securities at face value and add a 8x multiple to earnings. Taking this approach we have EPS of $.71 at 8x ($5.68) plus the $7.61 in net cash giving a value of $13.29, almost a double from this point. This is a true dollar selling for fifty cents!

Bear Case

One thing I've really been concentrating on when examining investments is looking at why a company is cheap, and what sort of margin of safety exists. In the case of Gencor the margin of safety is the discount to the liquid assets, and the fact that the market is valuing the operations at nothing.

The first thing I did was go Googling for why Gencor was cheap and most of the reasons I saw on the internet tied to the fact that the operating company had a spotty history of profitability and the business was a generally poor one. I can accept this argument but I think it's a bit too simplistic. There are many poor businesses selling with high multiples, there are even many more businesses that have never turned a profit that are selling well above asset value.

I believe there are multiple reasons behind the valuation discount at Gencor, I want to break each down individually. First off I want to state that the bear case has been made much simpler thanks to American tax payer dollars, the SEC has asked extensive questions of the company all recorded through EDGAR. Some of the questions are basic, others dig into nitty gritty accounting details.

1) What exactly is happening with the CFO? - This might not be the most important issue, but it raised the biggest red flag for me, in the past three years the company has had a total of five people in the CFO position, two actual CFO's, two interim CFOs, and one acting CFO.

Here is a table breaking down the personnel changes:

I should also note that the company failed to file an 8-k on multiple occasions when a CFO or acting/interim CFO left.

It's odd to me that none of the interim CFO's became full time, and the length of tenure is frightening. I don't know many people who are hired at a company and feel that in five or six months they've made such an impact that they're ready to move on. Usually people who move on quickly do so because they realize they are not a good fit at the company, or they feel they're unable to fulfill the role.

There could be a perfectly valid reason for each CFO leaving, but in total there appears to be a pattern here that's concerning to a potential investor.

2) What is the purpose of the cash? - For any company that is cash rich there is always the possibility that management could squander the cash on failed acquisitions or just plain bungle things destroying shareholder value(MSFT...).

In a response to the SEC the company states that "The “Acquisition Fund” is an amount of cash accumulated over years by the Company and intended to support its operations, as well as to be used in and when an appropriate acquisition becomes available."

A response like this is concerning because my margin of safety is the fact that the company can liquidate and return cash in excess of my purchase price. If the company is planning on using the cash to purchase another company my margin of safety could be destroyed by bad capital allocation. This is a big risk, and while an acquisition hasn't happened yet it doesn't mean that it's impossible either.

3) Is Gencore an investment company? - In a few of the letters the questioning from the SEC revolves around the idea that Gencor should be classified as an investment company. The company responds saying they have an engineering bent, and are focused on driving operations. The SEC response is that while it's nice Gencor is focused on operations a potential investor isn't getting an engineering company they're actually purchasing an opaque securities portfolio.

What's interesting on this point is the SEC says they disagree with the company's classification and basically say they aren't going to argue the point further. This is a potential risk, investment companies have much different and more stringent regulations than public companies. Any sort of action by the SEC to classify Gencor as an investment company might force management to unload the marketable securities portfolio; a possibility is a dividend, or a terrible acquisition. Based on the companies stated purpose for the cash I'd wager a shotgun acquisition is more likely.

4) Questionable receivables accounting - Each of the above items I was able to somewhat justify away but when I hit this item it killed the thesis and shed some light on a possible reason why the company has been through five CFO's recently.

The company claims in filings that "the majority of company sales require payments of cash before shipping" and then go on to claim that approximately 47% of accounts receivable are flagged as a doubtful accounts.

So right now something should be clicking saying that if customers are required to pay in cash upfront how can 47% of receivables be in question? I'm not exactly sure, and the company never fully explained it to the SEC's satisfaction either. Either the majority didn't actually pay upfront in cash, or 100% of the non-majority hasn't paid at all. Given that 47% is less than a majority I'm leaning towards the notion that most or all of the non-prepaid customer have paid a dime.

That brings us to the next issue which is the status on the doubtful accounts. Gencor claims to extend credit to clients in the form of receivables financing. What this means is that a customer can contract for a job and not pay until the job is done, or after the job is done and pay a small interest charge to Gencore. For Gencore this is considered an account receivable, and as noted above most of those receivables financed are outstanding and according to the filing notes are 90 days past due. The company states that they are slow to write down bad debts because they continue to hold out hope that the client will eventually pay. And if they think the client will pay eventually it shouldn't be considered a bad debt.

The logic of this defies me, the company seems to believe the if a client hasn't paid in 180 days but claims the check is in the mail that the receivable is money good.

Edit: I forgot to put this in the article originally but from the most recent annual report the auditors did not review internal controls whereas in the past they had. Management was asked by the SEC to include a note to this effect and to certify according to management that the internal controls were sound.

I know there are more items lurking in the accounting, and a few of them are detailed here, here and here in the SEC letters. But after hitting the four above items I decided to move on from Gencor. I recognize the company is cheap but I think there are very good reasons for the cheapness, and I think the margin of safety is an illusion with Gencor.

I'm interested in hearing holes in my thinking or answers to the bear questions.

Talk to Nate about Gencor

Disclosure: No position

Timber as an investment

2011-10-18T20:17:00.000-07:00

I love the woods, I love walking in the woods, camping in the woods, and just being in the woods. Often when I'm in the woods I consider timberland as an investment, I've been looking at timber on and off since probably 2006. This past weekend was no exception, as I backpacked in Dolly Sods Wilderness with a friend of mine I started thinking about buying timberland again.

Timberland is an interesting vehicle for investment, as an asset class it has returns of about 7% a year and is an excellent inflation hedge. In addition the land owner has optionality on when to sell, if prices are depressed they can avoid harvesting for a few years and wait for a rebound. When the timber is harvested the sale is considered a long term capital gain (in the US) even if the land owner has owned the land for less than a year. With all these factors timberland seems to be the perfect investment, put all your money in timberland, do a bit of hunting and camping on the land and retire rich.

The problem with that scenario is timberland is a very hard asset to own. The problem is often tracts of land that support timber production are large and aren't easily broken apart. Often pension plans and institutions will buy into a large timber tract and contract for harvesting. There are a few REITs that own land, but none are actual pure plays on land. This leave an investor with an option to either buy land directly which could cause some portfolio management (and time management) problems, or buy through some sort of exchange vehicle.

As I've mentioned earlier I've had my eye open on small plots of land in Pennsylvania, West Virginia, and southern NY for the past few years. I haven't purchased yet for a few reasons, the first is the hands on nature of the investment. I just don't have the time at this point to spend time prepping the land, planting, visiting to make sure everything is ok (i.e. no hunting, no atv trails, no dumping). The second reason is the difficulty with finding the "right" plot. If I buy too big of a plot my portfolio is out of balance, at this point I don't feel like I'm ready to bite off 40 acres of woods. Yet I would need at least 10 acres before I could make any money. The problem with small plots is they are usually viewed as a lot for building instead of raw land for timber. This means that small plots carry prices in the $10k/acre price vs the $1200-1400 going price for timber acreage. Paying anything more than $1400 makes it very difficult to turn a profit. Finding a small plot for a cheap price is difficult, trust me, I've been looking for the past five years. If anyone knows of a 10 acre plot in WV or PA for around $8500 or less, let me know!

So what does a piece of land actually look like? Here is 44.8 acres of land in southern NY for $36k, which comes out to $850/acre; while this is a good deal (includes mineral rights) the problem is the size and maintenance. For anyone with less than a $720k portfolio this piece of land would be a 5% or bigger position size. Maintenance costs would probably be low, but a small continual cost, in addition if the owner doesn't live close there would be travel costs as well.

If you give a small tree 10-15 years to grow they can fetch about $500 for pulp, and mature trees (age 25-30 years) 4-5k an acre at current prices. So at a purchase price of $36k, sitting for 25 years and selling the wood for $225k ends in a return of about 6.7%. Factor in the ability to sell the land for probably close to the purchase price and we have a 7.2% gain over the life of the investment. There is probably also a value to the mineral rights which I'm not including. This is a great number for something completely uncorrelated with the markets.

The downside is an investor now has $36k tied up in Ripley NY, what happens if that plot gets hit by a tree disease, or has the soil go bad, or a multitude of other things? This is a large concentrated risk, and an investor needs to hold for a long time 25-30 years to make a decent return, not something many people have the fortitude to do.

So what's the alternative to owning small plots directly? I found two closed end timber funds that are about as pure play as possible, they both operate in the US but trade on the London Stock Exchange. And as expected for something posted on this blog, both funds are trading at a discount to net asset value.

The table below breaks down each fund:

Buying at the current prices the investor is getting timberland cheaper by buying Phaunos. The caveat with Phaunos is that some of the plots they are a minority holder whereas with Cambium they own the acreage outright.

Phaunos is a bit of a strange fund, the fund trades on the LSE in dollars which is something not all brokers can trade easily.

Owning timber in a fund is a bit different from a direct holding. In a fund the managers are constantly working to manage the land holdings to ensure a return for shareholders. In the direct scenario nature takes it's course and the return materializes as the trees grow and are eventually cut down.

One risk I haven't mentioned yet is the risk that these funds could be a fraud. Recently there was a story of a Chinese timber company Sino-Forest which falsified the size of their land holdings. This could be true with both closed end funds as well, and is most likely the reason for the discount to NCAV.

I enjoyed reading the filings for both companies, but would prefer a direct holding of timber personally. If the land is close enough I can enjoy it while waiting on investment to grow, something I can't do with a fund.

Talk to Nate about timber

Disclosure: No positions