P/E: 10.3
P/B: 1.5
P/S: 0.2
P/CF: 8.4

hhgregg (HGG) is a small-cap retailer of consumer electronics and home appliances. The company caught my eye because the stock has been beaten down almost 50% from the 52-week high and sold at a surprisingly low P/E for its earnings and sales growth.

It has an interesting recent corporate history. The company was recapitalized in 2005 (hence the jump in total debt) and then IPO-ed in 2007 (hence the sudden reduction in debt). Growth in store count was relatively slow until the IPO, with only 4-10 new stores opening per year. After the IPO store openings increased ever year, totaling 42 net openings in 2011.

To get a sense of how this has affected the company, I built this sheet of its performance over the past decade to take a look at its performance over time:

A few things stand out. As others have pointed out, part of the recent decline in ROE comes from the steady decrease in leverage. It also comes from a slight decline in ROA which you can also see reflected in the downward trend in sales and earnings per store. Returns on invested capital remain strong, however, and actually inched upward in FY 2011 due to the reduction in debt.

Returns per store are also surprisingly high in spite of the decline in per store profitability. Capex for 2011 was about $60m and HGG opened 42 stores, so figure a rough cost per store of $1.43m. If their stores continue to earn around $0.28m per year, that’s a 19.6% return on their invested capital for newly opened stores – definitely better than you would expect given the its current valuation and 50% decline from the 52-week high.

A less impressive figure is its record of earnings growth. Over the past 10 years, earnings have increased 64%. That’s a compound growth rate of 5.1%. Store count, on the other hand, grew four-fold from 42 to 173. This comparison is somewhat skewed because HGG was an S-corp in 2002 and distributed its earnings directly to owners for whom it was taxed as income and therefore it incurred no corporate income taxes. Adjusting for taxes using the 2011 tax rate, 2002 income was $18.8m and ten-year earnings growth improves to 156%. That’s a little under 10% per year against annual store growth of 15%. Earnings growth still lags but the shortfall is much smaller.

With that in mind, growth is a mixed bag for HGG. The general decline in same-store sales means that a moderate amount of growth is required just to maintain earnings and that growth will continuously become less efficient as long as the trend continues. It also means that HGG’s substantial expansion has proved less profitable than management might have hoped. On the other hand, growth is now relatively safe for HGG. The company was able to fund its capital expenditures out of operating cash flow in FY2011 and should be able to do the same in 2012. There’s no need to issue debt – in fact, the company just paid down the last of its debt – or dilute existing shareholders (they’re actually planning to buy back shares). There’s also not much financial risk now that HGG finished clearing out all its long-term debt. This makes it a lot more comfortable risk-wise to wait patiently for conditions to improve.

2011 annual report

Hi-Tech Pharmacal is a manufacturer of generic, branded over-the-counter, and prescription medicines. The company concentrates its efforts on liquid and spray products. The company experienced two years of stagnating sales and losses in 2007 and 2008 before returning to profitability in 2009 and seeing sales surge in 2010/2011 on the strength of its generic Flonase/Flovent product.

The relative valuation seems extremely appealing, perhaps due muted analyst projections for the coming year. According to data available on Reuters, even the most optimistic of the three analysts covering HITK expects 2012 sales and earnings to be below 2011 levels. Analysts are probably concerned because the FDA has stopped the sale of Lodrane, a cold/flu medicine that is the primary product of HITK’s branded prescription medicine division. I think that those projections are too pessimistic, but even if they prove accurate the company still provides reasonable value for the price over the long term.

I like that the company has three times as much cash as total liabilities, with no major spending commitments or off-balance sheet liabilities. The only contracted purchase was $1M worth of supplies and equipment that was completed in FY2011. Free cash flow has generally been positive throughout the past 10 years, except during the rough patch in 2007-2008. I see this as a positive sign from a business and shareholder perspective. Since the company produces enough cash to fund its working capital increases and capital expenditures with significant money left over, it is not dependent outside capital to grow or survive. This contributes to its strong balance sheet, which enables it to survive in difficult times. Two benefits from a shareholder point of view are the lack of dilution (as it’s able to fund growth internally) and the availability of cash for stockholder-friendly actions like buybacks.

HITK is not an asset-based value investment. The current market cap is more than twice the total asset value of the company. Licensed and patented drugs are definitely valuable assets for the company, and perhaps more valuable than their carrying value might reflect, but its most significant products (like generic Flonase) are not reflected on the balance sheet and in any case would not vastly increase net asset value.

Both sales and earnings have grown very rapidly over the past few years. Obviously investors are somewhat skeptical that this will continue, else the stock would not have a P/E of under 10.

Much of the growth has been supplied by the skyrocketing sales of generic Flonase. The valuation is in part the result of this product concentration. It’s important to note that most other areas of the business also experienced growth in FY 2010 and FY2011. Runaway success with fluticasone was very helpful, but others products also seem to have appeal in their niches.

Concentration does present a risk, but only a modest one. Flonase is an established product rather than a speculative development or new drug. It has been on the market for 17 years and thus has a mature market. It also has a fairly sizable one – four years after the expiration of their patent on fluticasone propionate, GlaxoSmithKline still reported sales of 800M pounds. For this reason I would expect that fluticasone sales, while they might not grow at the prodigious rate of the past year, would at least remain steady. It’s an accepted product with a stable market. The age of the product also reduces (but does not entirely eliminate, I must admit) the risk that catastrophic side effects would be discovered and lead to bans or litigation.

It might appear self-serving or dangerously optimistic to dismiss the the negative views of analysts to present a bullish case, but I think there are concrete reasons to question their conclusions. The first is their consistent underestimation of the company’s prospects for the past four quarters. Future FY estimates that were founded open overly pessimistic quarterly estimates are also going to underestimate future performance.

Second, the rapid growth in fluticasone market share from quarter to quarter means that even maintaining the market share achieved in Q4 results in a modest amount of revenue growth. Observe this chart of past and potential FY2012 sales:

I figure that Q4 and Q1 (February through July) will probably be the periods of peak allergy season and therefore the peak sales period and assigned those $27M in sales, essentially what the company achieved in Q4. The off-peak quarters get a slight increase in this scenario to account for the large increase in market share achieved in Q4. The loss of Lodrane from the product lineup is expected to reduce revenues for the branded prescription segment ECR by $16M. As you can see, a flat market share for Flonase suffices to overcome much of the shortfall from losing Lodrane. If fluticasone sales continue to rise, then the shortfall definitely disappears.

For a business where the biggest products are quite literally generic, quality management is crucial. One measure is consistently strong returns on invested capital. Over the past ten years HITK has achieved an average ROIC of 15.7%. Recent years have been even better, with a three year average above 24%. I prefer to focus on the first value, however, since I want to measure the success of management policies in general rather than just the single (obviously quite successful) decision to market fluticasone.

HITK’s focus on liquids, creams, and sprays builds a market niche. Their goal is presumably to take advantage of scale effects and strong reputation within their markets. According to company claims (which are difficult to properly verify without access to IMS sales data), 70% of their products are first or second in their respective markets as of 2010.

The biggest risk is of course that something will curtail sales of fluticasone or drag down its margins. As I mentioned above, the drug is old enough that surprising new effects are unlikely. Margin compression is a more likely possibility and the effects can be seen the in decreased importance of HITK products like dorzolamide, which has seen unit sales increase but sales prices decline drastically. This resulted in declining revenues from that drug despite its increasing sales. A quick scan of the SEC filings of other generic drug manufacturers (Mylan, Watson, etc.) did not suggest that any other big players were planning to enter this market, but it’s something to keep a watchful eye on.

There’s also management risk. Recent product decisions have performed well for the company, but many others have not. The acquisition of Midlothian Labs proved unwise and that company was recently divested at a modest loss, as was a previous were previous unsuccessful product acquisitions like Brometane and Naprelan. If the company hit a rough streak where these bad decisions outweighed the positive ones, investors would be in for a rough ride. Since the nature of the industry requires a constant search for new and better medicine, investors need to watch management carefully for signs that they are losing focus or making careless/overpriced acquisitions. The high cash balances make that a major point of concern, since rising ability to make purchases often becomes a rising incentive to buy regardless of price.

Another risk is the family element. David Seltzer seems to have demonstrated solid leadership, but the expensive involvement of his brother Reuben is troubling. Reuben Seltzer (a director and major shareholder) provides “legal and new business development services.” I suspect but cannot prove that this is a simply a cushy family job. Total payments to Reuben Seltzer in 2010 were $435,000 – nearly as high as David Seltzer’s salary (only $16,000 less) and 67% greater than the next highest paid corporate officer. I would also point to his lack of direct knowledge or experience in the field and his presumably disastrous tenure at Neuro-HiTech, a company where he was CEO and where the current value of HITK’s entire investment would perhaps pay for a nice meal. HITK is currently a 17.7% partner in a joint venture alongside Reuben Seltzer and is also invested with EMET Pharmaceuticals (where Reuben is a principal) developing generic drugs in a pharmaceutical field that is admittedly “outside of its area of expertise.” Between the money paid to Reuben in FY2010 and the $713,000 in R&D funds allotted to the EMET project over $1M was spent on the man last year. HITK could benefit substantially from ending this relationship, but realistically that will never happen and he will continue to be a modest liability for the company in years to come. It looks like HITK did a bit of work between the 2011 and 2010 annual reports to obscure the resources he is consuming, so I’ll probably do another post to take a look at that.

Before the Q4 financials came out, I would have listed the buildup of inventory as a potential sign that the company was betting too heavily on continued sales increases. The increase was not extraordinary, but it did exceed demand and might have signaled declining growth. Demand clearly proved to be present, since sales were up 45% in Q4 and 20% for FY2011. Accounts receivable, on the other hand, became more of a concern on the FY2011 statements. Receivables were up 45% year-over-year whereas sales were up only 20% and earnings 33%. HITK claims that there was a surge of orders late in March/April that have yet to be collected on, but that is certainly a substantial jump. I’ll probably want to do a bit more digging there as well.

In spite of the concerns listed above, I feel cautiously optimistic about HITK. It’s not a high-concentration bet, but it appears to be a simple and undervalued way to tap into the generic drug market.

HITK Hi-Tech Pharmacal Co

MKS Instruments is a provider of instruments, subsystems, and process control solutions for markets like semiconductor capital equipment manufacturing that is selling at an appealing discount. Financial risk is almost non-existent and earnings- and profitability-wise the valuation is quite cheap.

Safety for an investment in MKSI is a relative term. The company, as its 2008-2009 results demonstrate, is going to ride the cycles of the semiconductor market up and down. The company has other product lines that account for a significant portion of revenues (about a third in 2010) and management intends to focus on developing a broader range of business, but investors hoping that increasing product diversity will ease the the big swings that come with the semiconductor market are being overly optimistic. Safety here means a rock-solid balance sheet that enables the company to ride out any kind of soft market with relative ease. Cash on hand is almost $480M, several times total liabilities, and capital expenditures are minimal and could easily be funded out of either free cash flow or the aforementioned store of cash.

As you can see above, the company is cheap on a relative basis, especially when the cash is taken into consideration. Profitability is also quite strong. ROA, ROE, ROIC, and CROIC (using free cash flow) are cyclical but definitely above-average. Business won’t be booming forever – you can actually see from the days sales and days inventory figures that it’s starting to slow down a bit – but the company produces solid returns on capital with a comforting level of financial security.

I think the biggest risk with MKSI is what Peter Lynch called the Bladder Theory of corporate finance – the more cash builds up on the balance sheet, the more urgently management feels the need to piss it all away. Large acquisitions that load up the balance sheet with goodwill are a potential value-destroyer and if management starts getting an itchy acquisition trigger finger it may be time to move along. In recent years management has made shareholder-friendly uses of cash by paying down debt, buying back stock, and declaring a dividend. This doesn’t guarantee future good behavior – $478M in cash is a lot of temptation – but it does buy them the benefit of the doubt.

Tata Sponge Iron (TSI) looks interesting. It’s got a P/E of 5.35, a yield of 2.28%, and P/B a bit over 1. It’s actually one of those companies that gives me the creeps: it’s cheap and I don’t see any reason for it to be such a bargain.

The company’s business is the manufacture of sponge iron, also called direct-reduced iron. It is partially owned (40% stake) by Tata Steel, one of the world’s larger steel companies. TSI has a relatively small share of the total Indian DRI market, about 1.5% as of 2009/2010. A total of 1.44B in sales went to Tata Steel in FY 2010, accounting for 27.6% of sales. Normally high customer concentration is off-putting to me, but the customer’s large ownership interest complicates the situation in this case. On one hand, the Tata Steel has a financial interest in continuing to do business with its affiliate (TSI), since moving its business elsewhere would knock down the value of their investments in TSI. On the other hand, Tata Steel would have a lot of power to push for deals that gave it preferential treatment at the expense of TSI and its shareholders. That doesn’t appear to have been a problem recently – margins and earnings look pretty strong – but that could change in the future.

TSI currently has a great financial position. The company currently has 1.8 billion INR in cash against zero debt and a market cap of 5.38 billion. The only threat to its financial stability would be the capital-intensive nature of its industry. Luckily it appears that the company is now producing enough free cash to fund its operations internally. Big capex years consume about 1B INR, but the company has produced operating cash flow in the billion-rupee range for several years now so that level of expenditure looks supportable. Shares outstanding have remained stable at 15M for many years and all long-term debt was paid down back in 2009.

Returns on invested capital have been fairly high for many years. Return on invested capital (using net income), cash return on invested capital (using free cash flow), and return on equity have typically been 20% or higher for the past five years. It looks like capital expenditures follow a three year cycle, where two years of modest capex are followed by a year with substantial expenditures of up to 1 billion INR. This causes CROIC to intermittently plunge, so a more accurate and less volatile figure might be a three year average. The average CROIC for 2008-2010 is 20.3%.

The company is small and not widely followed, so it’s difficult to know exactly which factors are spooking investors and keeping the valuation so low. My research leads me to think that potential areas of concern for TSI’s future would be the sponge iron market, the overall Indian economy, margin compression, competition, expenditure requirements, conflicts of interest between Tata Steel and other shareholders, and past valuation levels.

The health of the sponge/DRI market probably isn’t the cause. Figures here show that production had been increasing steadily for decades up until 2009, when it dipped from the global recession. It began rising again in 2010. India has provided more and more of the world’s production as the years went by. As of 2010 India accounted for 36.5% of world DRI production. As you can see, the growth curve leveled out in recent years (a comparison of annual growth rates is available in the spreadsheet at the bottom). Considering the size of its production share and the decelerating production, it feels fair to assume that production will rise long-term by a single-digit rate rather than the 25% CAGR of the past 30 years.

With that conservative assumption, TSI is undervalued based on its substantial ability to generate free cash flow. After all, if there is no need to expand capacity, there is no need for large expenditures and that cash could be put to profitable use for the shareholders. If, on the other hand, DRI production began increasing again in India, then its current valuation would be severely discounting its ability to serve the growing demand. Granted, it would need to at least maintain market share to participate in the DRI market’s overall growth but in that case the concentration of sales with a customer who (all else equal) has an incentive to buy with TSI would serve it well.

Tentative figures from the World Steel Association suggest that production is increasing once again. Total estimated Indian DRI production from the January – April period is 8.521 million metric tons. Annualizing that production level leads to a rough 2011 output of 34.084 million metric tons. Projecting that forward for the rest of the year seems reasonable given that monthly crude steel and iron output (2010 and 2009 for steel; 2008 for iron in Table 43) seems to vary little from month to month. Even if production falls off toward the end of the year, 2011 production is still on track to substantially exceed 2010’s 20.65 million ton output.

A bit of reverse-DCF might be useful to illustrate the kinds of assumptions that the market is pricing in. With a required rate of return (k) of .2,  net income of 1,013M, and market cap of 5.42B, this is the level of growth that the current valuation implies:

(in millions of INR)
5420 = 1013 / (.2 – g)
g = .0131 or 1.31%

That’s a pretty simplistic calculation, but it gives you an idea of the kind of implicit assumptions going on here.

The health of the overall Indian economy is a bit harder to judge. I don’t have any particular edge in judging where it’s going, so I’ll limit my analysis here to the possible impact of less-than-favorable economic outcomes. At its current price the company wouldn’t require runaway economic growth to provide a solid return to its shareholders. It produces a lot of cash and you’d be getting that cash flow dirt cheap. The main problem would be if the economy dipped into a recession. On that front, the massive growth of the Indian housing market is a red flag (gee, does that look familiar?). Steel consumption – and therefore iron consumption, since 98% of iron ore is used for steel-making purposes – in India is spread across a number of areas unrelated to the real estate market, but the economic effects of a major decline in real estate values would probably put a damper on overall steel consumption. Figure revenue dropping to something like FY2010 levels (fiscal year ends in March, so that’s primarily 2009 sales numbers) for a year or more in that case before steel consumption picks up again. TSI’s strong financial position makes this outcome a short-term nuisance rather than a solvency-threatening dilemma.

I think that margin compression might be less of an problem for investors, since they would be buying in when gross margin is approaching its 2007 low  rather than during a period of peak margins:

A bigger factor driving earnings – or rather, not driving them – would be that sales will probably be flat for the immediate future, since any expansion of existing capacity would take time.

Competition is definitely a concern since this is a commodity business with a small market share. Here again the self-interested customer/shareholder might be somewhat advantageous, since there is at least a modest incentive to make purchase from TSI. Management has also performed well by generating very strong returns on invested capital.

Expenditure requirements are probably the least of the company’s (and investors’) worries. Not only is DRI production a less capital-intensive process than blast furnace iron production – the process used to make pig iron – but the company currently produces enough cash (especially over a full multi-year cycle) to cover its expenditures.

To me, the company’s past valuation levels represent both the biggest puzzle and the biggest risk. Going by Reuters’ info, this outwardly healthy company has within the past five years traded for as little as 1.58x earnings. That period looks like it was in 2008/2009 when markets were bottoming out, but even still that’s unsettling to say the least.  It’s also worrisome to see that the peak valuation over the past five years has been 6.89x earnigns. As a result the single biggest risk to an investment in TSI appears to be valuation-based rather than business-based. Despite the fact that the company is cheap by virtually any metric, an investment here could be obliterated by these peculiar valuations or end up as dead money.

With that in mind I’d opt for a “safety first” approach. The fiscal years ends in March, so I figure the annual report ought to be up on their site within a month or so. A look at that might be a bit reassuring.

A few financial notes:
The “other expenses section” on the spreadsheets is the result of classifications by the Financial Times (the source of all the info). On the actual financial statements these expenses are all filed under the heading “Manufacturing and other expenses” and broken down in detail.

Since the financial statements use Indian-style numbering a quick explanation is in order. In Indian numbering, commas appear at the thousand, lac, and crore levels. A “lac” (commonly seen in the financial statements) is 100,000. http://en.wikipedia.org/wiki/Indian_numbering_system

Allan International Holdings is a holding company based in Hong Kong that specializes in constructing household electrical appliances. It drew my eye with its low P/E (6.35), relatively high yield (6.15%), and rock-solid financial position.

AIH has virtually no debt and a cash balance of 332M HKD as of the interim report (Sep 2010). The company also has a recent record of positive free cash flow, so it has been able to fund its growth internally without needing to go to the capital markets. Both are good signs about the company’s ability to withstand another severe downturn, as is its strong performance during the last crisis.

Management has a significant stake in the company (44%) and seems to avoid any equity dilution. The family’s been running it for decades and it feels unlikely that they would suddenly put that at risk to grab a quick profit. Given the size of their stake and the length of their involvement it’s fair to say that their interests are aligned with outside shareholders.

So, why’s it so cheap? I see a few issues that might be putting off investors. There’s a lot of exposure to Europe, currency and commodity movements are squeezing margins, and receivables are way up as of the interim report.

I think that exposure to Europe is the least of AIH’s problems. Sales in Europe accounted for about 50% of FY2010 sales volume, so it is definitely the primary geographic region, but sales there held reasonably steady even during the financial crisis. Sales are invoiced in dollars, so the weak dollar ought to help sales, and national debt crises probably won’t prevent European consumers from replacing their blenders. It’s probably a short-term concern at most.

Margins will probably be a bigger issue. Gross margin is currently at a five-year high (possibly longer since I only went back five years) but is already creeping down towards the historical average. I’m not going to try to predict the direction/magnitude of commodity price changes over the next year or two, but to be on the safe side it would make sense to assume that gross margin would be at or below the level of 2008 (lowest of the past five years). Applying that assumption to TTM earnings basically cuts them in half and results in an adjusted P/E of 13.4.

The real issue comes from the growth of receivables. Receivables were way up at the interim mark and let to the company burning a lot of cash. A look at previous interim reports shows that mid-year receivable growth is something of a pattern for AIH, but this year’s growth was larger than in previous years and significantly outpaced revenue growth.

AIH has very substantial customer concentration (another issue I’m not thrilled about), which makes the receivables issue more serious. Their largest customer accounts for 49% of sales and the top five collectively provide 92% of sales. Since the biggest three customers account for 80% of receivables on average, I’d wait to see the receivables balance decline a bit before jumping in. AIH doesn’t seem to have had any problems with bad receivables during the recession and despite the pile-up receivables also don’t seem to be aging – only a small fraction more are more than 90 days old – but a problem with any of their major customers would result in a a substantial write-down as well as a major decline in future revenue. With that in mind I’ll take a lesson from SKX and steer clear of even potential working capital issues.

Their fiscal year ended March 31, so the annual report ought to be due out soon. That ought to clarify where the receivables issue stands. There is also a growing percentage of finished goods in the inventory. Inventory growth didn’t exceed revenue growth, but I’d like to see that play out a little more as well. Overall it seems like an interesting opportunity and the annual report ought to give a good sense of how serious these issues actually are.

York Timber Holdings is an integrated timber company based in South Africa. After severe brush fires in 2007/8 and poor FY2009 performance, the company’s stock plunged from above R9.00 per share to below R3.00. Investors like Jeremy Grantham are very positive about the prospects for timber and it’s frequently touted as an excellent hedge against inflation, so this seemed like an interesting opportunity to explore.

FY 2010 saw a lot of earnings improvement, but the true extent was buried under revaluations and write-downs. Biological assets were revalued upwards 10.5% after a switch to DCF valuation, reversing most of an impairment recognized in FY2009 and adding R200M to earnings. Impairments to goodwill resulted in charges of R42.6M. Directly removing all non-recurring charges gives an adjusted net income of R-93.1M or a total comprehensive income of R-29.6M. Definitely an improvement from 2009, but less so than the raw numbers lead you to believe.

Improvement did continue in the six months ending December 2010. Two factors appear to be behind the improvement. The first is the drastically lower interest costs from the company’s 2010 debt reduction. Proceeds from a stock offering (about R450M out of the total raised) were used to pay down a large amount of debt and a comparison of year-over-year changes in financing costs illustrates the large savings. This more than anything else, I think, helped get normalized earnings positive again. York also managed to maintain the improvements to its gross margin that it achieved in FY2010. In fact, it boosted gross margin all the way to 46%. It’s probably unrealistic to expect gross margin to remain quite so high, but it suggests that the cost-saving restructuring York has undergone genuinely paid off for the company.

Evaluating timber investments is a bit outside my circle of competence at the moment, but a quick comparison between York and a few U.S. timber companies demonstrates that it is fairly cheap on a relative basis:

Obviously York’s P/E is inflated by the aforementioned non-recurring charges (the same appears to be true of WY from what I saw), so that’s not a terribly useful point of comparison. To me the interesting points are the substantial difference in P/B ratios and gross margins between York and the others. Investors would be buying into an improving business at a big discount to book value, which looks like a promising combination. Those with the knowledge/desire to invest in timber might find solid returns with a margin of safety by moving a little bit off the beaten path.

Investing abroad does introduce other risks like currency fluctuations. That said, the Rand/Dollar relationship has been relatively stable over the long term in the past five years. In fact, the Rand appreciated a moderate amount since 2009 and would have benefited an investment made at that time. That’s probably at an end due to pressure from manufacturing groups, but it’s reassuring to see that the country’s currency has a recent history of stability.

A related point of interest is the rights offering that York used to fund its debt reduction. The rights offering price was set at R2 per share, up to 30% below then-current prices. Of course there’s the cost of the rights themselves to consider but prior to the offering the stock price was hovering around R2.50 per share with roughly 78.4M shares outstanding. Book value at that point was about R1.35B, so the regular trading price at the time was a substantial discount to book value even after taking into account the diluting effect of the new shares. The rights offering provided potential investors with an even greater discount. It had never occurred to me to search out special-situations opportunities outside of major countries because I had assumed that information would simply be too scarce, but at least in this case that would have meant missing out on a promising opportunity. That’s a useful lesson.

The Catch, Part I (Earnings)

2010’s earnings growth is largely an illusion. The first sign comes from a comparison between net income and operating cash flow. It’s generally considered a negative indicator when income exceeds operating cash flow and in this case operating cash flow ($18M) is 30% lower than net income ($25.7M). That’s a big turnaround from the previous year, when operating cash flow ($20.4M) exceeded net income ($14.4M) by 40%.

Almost all of the change comes from a single payable/receivable account: Due From (To) Humana. This account jumped from a $1.4M liability in 2009 to a $9.1M asset in 2010. A value in the low millions is a historically normal value for this account; a value of $9M is quite high. As far as I can tell that’s the highest it’s been in a very long time, which makes me wonder if MDF is getting a little too aggressive in its revenue recognition.

The 2004 and 2003 figures are adjusted from the stated receivable values on the balance sheet (which themselves were net of $2.9M and $2.5M allowances) by Humana’s stated shares of 73% and 83%. The collection of this receivable is not guaranteed despite the company’s close relationship with Humana. An example of this occurred in 2006, when MDF wrote off $1.6M out of $4M originally due for the reimbursement of defibrillator implants. If the same occurs again – a distinct possibility since this account is unusually bloated – then future earnings could take a significant hit. The note regarding the amount owed by Humana (note 6) is two lines long and quite uninformative in this issue.

The “Major Customers” segment reveals that part of the receivable comes from an estimate of the retroactive Medicare Risk Adjustment capitation fee. The MRA is the result of changes in the health status – and therefore fee payments covering – Medicare users. In 2009, the company wrote off $800K after the retroactive fee came in below estimates ($3M versus an estimate of $3.8M). The current estimate for 2010’s fee is $2.2M.

The second sign that this extreme earnings growth might be illusory/unsustainable is the company’s extremely low – historically low, in fact – medical expense ratio (MER). The MER is total medical expenses divided by revenue. According to MDF, 2010’s decline in medical expenses is the result of the modification of plan benefits and co-payments along with the elimination of certain costly high risk plans. Compare to their results since 2003:

This is by far the lowest MER has been during the entire period. Operating expenses, on the other hand, increased from 5.4% to 6.7%. Adjusting 2010 to the average MER of the previous three years provides a net margin of 3.68% (after subtracting a MER of 87.4% and expenses of 6.7% with a 38.2% tax rate) and net income of $13.55M. That’s below 2009’s earnings even with the (tax-adjusted) profits from the HMO sale subtracted out for comparison. Due to the increase in other expenses more than 100% of this year’s gain can be attributed to the improved MER.

The changes in MER aren’t attributed to one-time non-recurring events, but if management was capable of sustainably achieving such a significant reduction in expenses – raising profits almost 80% on a 4% gain in sales – by simply altering benefits and removing expensive plans, then what took them so long? It’s not like there’s been a change of management lately.

Let’s examine what happens if the MER rolls back to the median between 2009’s and 2010’s values, 85.3%, if all else remains the same.

Suppose revenue increases by 4% again in the coming year. This results in revenue of $386.6M and net income of $19.1M using the above margins. That’s a disappointing step down from 2010’s results. Even if the company returned to 2009’s lower operating expenses in this scenario it would still slightly underperform the results of 2010, with net income of $24.1M.

The Catch, Part II (Concentration)

The receivables issue highlights MDF’s close and potentially dangerous relationship with Humana. Humana is Metropolitan Health Networks’ sole partner and is tied to it (for the most of their business) by a contract renewed yearly. Any disruptions in this relationship would be disastrous for MDF. As they note in the 10-K’s “Risks” segment, MDF has little ability to effectively bargain with Humana, presumably due in part to their dependent position. Compare their situation with that of Continucare, a publicly traded competitor mentioned in their annual report. Continucare has relationships with three HMOs, decreasing the dependence on any single partner.

25,000 of MDF’s patients are covered under an annual Humana contract, while 9,000 are covered under a separate agreement that lasts until 2013. According to the terms of both contracts the company is specifically restricted from forming relationships with other Medicare Advantage providers. This limits MDF’s ability to lower its immense concentration risk.

The long-term 9,000 patient contract also provides limited security. It does reduce the yearly renewal risk, but it doesn’t cover enough patients to ensure profitability in the absence of other revenue. As MDF points out, even if its other contract was not renewed it would still be required to treat the remaining patients and it would likely be doing so at a loss after fixed costs were spread across a smaller base.

The Catch, Part III (Regulations)

A number of upcoming changes to Medicare and other healthcare regulations due to recent healthcare reforms may have an unpleasant effect on MDF’s business. Risk scores, which determine the amount of money paid per Medicare patient, will be adjusted downward in the future to account for the fact that insurance companies and healthcare providers tend to emphasize negative information when reporting information to inflate risk scores and receive larger payments. Other changes will cap cost-sharing and decrease payment benchmarks.

What looks to be the most important change is the creation of a minimum MLR of 85% starting in 2014. MLR is the medical loss ratio, the percentage of insurance premiums spent on direct medical expenses.

Now, since MDF is a provider services network rather than an insurance company like Humana, I’m not entirely certain which company this cap will specifically apply to. Either way the result won’t be good for MDF. If it applies to Humana, then the two companies must split the 15% (maximum) for non-medical expenses. If it applies to directly MDF, then it means that 85% would be the minimum MER value in the future. In either case the current MER is probably not sustainable long-term in light of this regulation.

The Catch, Part IV (Boardroom Drama)

There have been strange goings-on at the higher levels of MDF over the past few years. In 2009 Earley agreed to step down as CEO and Chairman of the Board in the middle of 2010 or upon the appointment of his successor. Two months before the end of his tenure 5 independent board members resigned and their replacements re-hired Earley as CEO and Chairman. That’s a somewhat odd chain of events and the matter-of-fact description in the annual report (as if this weren’t an odd situation) is a bit unnerving.

Insiders – among them the CEO and CFO – have also been doing a lot of selling recently. I generally agree with Peter Lynch that a modest amount of insider selling aren’t necessarily a bad sign. Insiders can sell for a variety of reasons, some of which are benign (funding a fancy new home/Ferrari collection) and some of which are less so (fleeing an impending collapse). Modest is a key word here, and insiders at MDF haven’t been all that modest with their sales. Over the past 6 months, they’ve collectively made 23 substantial sales totaling almost $2.6M. Extend the timeline to a year and those numbers increase to 35 sales totaling almost $4.5M. The CEO and CFO unloaded $1.5M worth of stock between them during the past year. There were no insider purchases during that time period, despite the fact that MDF at times traded in the $3 range during that period.

Put it all together and there’s too much uncertainty in MDF’s future. There’s no financial integrity since the business is dependent on a single annually renewable relationship and earnings, the main driver of the company’s value since it sells at a large premium to book value, are unstable and possibly a bit inflated at the moment. Definitely not a buy, and as a value investor I’d close out the position if I owned it.

Financial Integrity and a Margin of Safety
Imation offers investors acceptable protection on the downside, especially given the company’s current distress. Downside can be examined from two perspective: financial integrity and a margin of safety. The first – crucial for examining a distressed business – determines whether the company possesses the financial resources to continue as a going concern and the second determines whether investors are buying in at a sufficient discount to fair value.

Imation’s ability to continue as going concern is beyond question. Imation currently has no long-term debt or significant off-balance sheet liabilities, only a relatively minor purchasing commitment with flexible terms. The company has a substantial store of cash: $300M against a market cap of $420M. That stockpile has been built up through consistent free cash flow production, even in years of substantially negative earnings ($143M/$56.5M/$71.1M in 2010/2009/2008 respectively). Consistently positive free cash flow means that IMN does not require infusions of cash from the capital markets to fund expenditures, acquisitions, or simple survival.

Stability is aided by the business’ low capital expenditure needs. Even in 2008, before cost-cutting and efficiency measures began in earnest, capital expenditures were only $20M. Current capital expenditures are lower still and even at/above 2008 levels they are much lower than combined depreciation and amortization expenses. Management has announced plans to increase expenditures in 2011 as part of their greater restructuring plans, but even a 100% increase from 2008’s capex would be covered by projected cash flows (see below).

The margin of safety here comes from the substantial discount to book value. Currently the P/B ratio is only .53. This discount is so significant that even if all of the company’s intangible assets (valued at $320.4M) were written off immediately it would still trade at a discount – albeit a smaller one – to that impaired book value.

The discount is also significant enough that IMN is trading near a rough estimate of its liquidation value (assuming a relatively orderly liquidation rather than a fire sale because the company is not in immediate distress):

This acts as a soft price floor for IMN, since it is unlikely to continuously trade below its liquidation value. The company could potentially impair its liquidation value through poor performance or unwise acquisitions, but as you can see below IMN would require extraordinarily poor performance to seriously impair its liquidation value. Most of its liquidation value is derived from current assets, so another round of restructuring charges would do little to impair its value and only truly severe losses could even moderately deplete its store of cash. Bad acquisitions are still a potential issue and something to be watched after, but since management’s largest hypothetical target would be in the $50M range that would only be a 12.5% loss even on a completely worthless acquisition.

Cash Flows
Imation currently sells for wildly low Price-to-Cash Flow multiples: P/FCF of 3x and an EV/FCF only slightly over 1x (and that assumes that $50M in cash is necessary for the business). Alas, these valuations are temporary and driven by the substantial increases in working capital efficiency over the past three years. Although management no doubt would like to extend their successes further, it is unrealistic to assume that efficiency gains will continue.

Here is a slightly more modest set of  rough projections:

These projections are not meant to be predictive, only illustrative. They provide a sense of what effect different outcomes might have. Maintaining the status quo as in scenario A means another 10% decline in revenue, keeping gross margin flat, raising R&D 30%, and seeing SG&A rise to 14.5%. Scenario B provides an idea of how income/cash flows might look if IMN’s fortunes began to improve in 2011. Here revenues again decline 10%, but the gross margin is 2010 gross margin adjusted for the $14.2M inventory write-off. This scenario also shows the impact of flat SG&A and modest improvement in working capital management. The third scenario shows the impact of a lower gross margin (15%), lower revenues (declined 15%), and additional restructuring charges due to the continued poor performance.

Scenario B illustrates that management’s goal of shifting resources towards their higher margin products could return IMN to profitability with only a small improvement in gross margin. Scenario C, while not a full-fledged disaster scenario, illustrates that a true disaster rather than a simple bad year or accelerated decline would be required to impair the company’s liquidation value.

Future Developments and Valuation
The ambiguity about the future is key to the option-like nature of IMN. In the face of large paper losses and future uncertainty investors have deserted the company in droves over the years and driven the price down to the point where it becomes appealing for conservative investors.

There has been insider selling but only from Linda Hart, the non-executive chairman of the board. Her sales could be construed as a lack of faith in IMN, but it seems more likely that the sales are tied to her impending retirement from the board of directors in May since none of the other directors – who are privy to the same information – are currently selling.

To me, the first red flag is that the company’s primary source of cobalt, a critical raw material, is located in the DRC and operated in a joint venture with Groupe George Forrest (25%) and Gécamines (20%), a state-owned entity of the DRC. The wikipedia entry is here, but suffice to say that the country’s overall history can safely be classified as “sad” and (key point) its stability is tenuous. Judging by

The other partner, GGF, was the beneficiary of a loan from OMG to refinance its capital contribution. Of the remaining $19.1M owed to OMG by Groupe George Forrest, $5.2M has already been written off, with the remainder guaranteed by the partner’s returns on the joint venture. First off, it’s a bad sign that there’s already a valuation allowance for 20% of the value of the loan. It also strikes me as somewhat paradoxical collateral: GGF primarily deals in metals, so if price changes of raw materials leave GGF strapped for cash then it’s possible that the joint venture might be experiencing similar price pressure, making it unable to cover the loan.

As an addendum to this risk, the company’s $68.1M “restricted cash” asset is actually money held in trust pending the outcome of a lawsuit against GTL, the joint venture company. The company (of course) assures shareholders that they expect everything to be fine and dandy. Since company’s rarely feel the need to draw attention to potentially crushing losses, I’d view their optimism with a bit of skepticism.

Regarding the balance sheet, there is also a disturbing jump of “Other Current Assets” from $32M in 2009 to $44M in 2010. Most of the increase – most of the account itself, actually – is not adequately accounted for anywhere in the 10-K. Derivatives, deferred income taxes, and the recent acquisition of EaglePicher Technologies account for perhaps 25% of that total and the rest remains a mystery. In “Financial Shenanigans” (great read, by the way) Howard Shcilit mentions that companies can inflate earnings by capitalizing costs and lumping them under the heading of “Other Current Assets” and a suspicious mind might question whether the same thing is occurring here.

OMG (I’m starting to feel silly typing that…) also has more customer concentration than I like to see. 50% of its battery sales go to three customers. That’s not quite ruinous concentration – they’ve got other business lines, after all – but it’s more than I like to see with all those other questions floating around.

Just to top it off, most of the cash (87%) is held overseas and will remain there for tax reasons. The company has explicitly stated that it will not pay dividends and it doesn’t seem particularly interested in buybacks either.

Other, more quantitative measures of value are more forgiving – low level of debt, decently low valuation relative to its free cash flow – but all of the concerns above suggest that the company’s financial integrity and asset quality are a lot more questionable than simple financial ratios and earnings multiples let on. I’ll pass.