FormFactor selling for close to cash

FormFactor (FORM.Nasdaq)

Price: $6.45 (9/27/2011)

I was going through a list of net-nets by market cap and stumbled upon FormFactor, what intrigued me about FormFactor was that I noticed looking at the balance sheet that they're selling slightly more than cash value, something rare for an American company. 

What does FormFactor do?

Like many companies currently trading below net current asset value (NCAV) FormFactor is involved in the semiconductor business.  FormFactor designs and manufactures silicon wafer test probes.  The probes are used to test integrated circuits.  The company states that their technology moves wafer burn-in and sort upstream to increase chip yield.  I'm not exactly sure what that means in technical terms but in laymen terms FormFactor builds equipment that improves the chip manufacturing process.

Balance Sheet

The balance sheet is the highlight of FormFactor, they have $324m in cash and marketable securities against $44m in liabilities.  They also have $50m in receivables and inventory, my net-net worksheet is below which gives a great overview of the balance sheet position.

I show the Property Plant and Equipment account on the worksheet but don't include the value as a part of NCAV.


As with many net-net stocks FormFactor isn't profitable and claims to be in the midst of a turnaround plan.   FormFactor violates one of my rules for net-net investing which is that the company needs to be profitable or at least cash flow positive.  FormFactor has been losing money since 2008 and eating into their cash pile, although the cash burn as slowed down recently.

A company's plans for profitability usually consist of two factors, reduced expenses and increased margins.  Usually a good situation is one where a company only needs to focus on one factor to turn operations around, in the case of FormFactor they have problems with both factors.

Reading through a smattering of press releases it seems that management would want investors to believe a turnaround in profitability hinges on revenues, in which part it does, but that's not the whole story.  The company has a gross margin of 21% (most recent quarter) which is up being negative for most of the past two years.  The real problem though is expenses. In the latest quarter SG&A and R&D expenses were double the gross profit.

While costs have come down some since 2009 they haven't come down enough, the company is spending $10m a quarter on R&D.  To operate at break even the company would need to increase revenues by around 20% a quarter or about $40m a year to about $240m.  The company only achieved this revenue number twice in the last ten years in 2006 and 2007 the last two years they were profitable.

To get back to profitability the company either needs to double their gross margin, increase revenues to record levels or make deep cuts in expenses.  I'm not sure of the feasibility of any of these but until one or more is accomplished the company will continue to burn through their cash holdings.

I have attached an imagine of FormFactor's comon-sized income statement from Morningstar.  The graphic really highlights the problems with their margins and how out of control expenses are.


The issue for an investor considering FormFactor is they need to consider the probability of either revenue increasing rapidly, expenses being cut, or management slowly burning the cash pile trying to accomplish either item.  I don't really know what the most likely option is, but I do know from watching a lot of net-net's that most of the time management will see the cash pile as a bit too tempting and use a portion of it on an acquisition with the idea that an acquisition will turn things around.  Even with the great balance sheet the turnaround risk is real and there isn't enough of a margin of safety for me to invest in FormFactor.

Talk to Nate about FormFactor

Disclosure: No position

Comparing Railroads

Whenever I think of a business with a moat I think of a railroad as having the ultimate moat.  I can't imagine a new railroad trying to build tracks through an urban area today without a ton of NIMBY opposition.  In addition to the opposition there is the expense, where I live the public transit authority in the process of completing a two mile subway/light rail extension at the cost of close to $500m.

I was curious to see how different railroads compared so I put together this spreadsheet.  I realize that lumping large freight with small railroads with foreign passenger railroads is comparing apples to oranges but I don't really care.  I just wanted an overview of investable railroads.

(click on the picture for a bigger view)

The biggest thing that jumped out to me when putting this together is that the market often gets things right.  The better operated railroads trade at a higher multiple, whereas companies that have trouble earning their keep trade low.

-Genesee & Wyoming isn't a single railroad, they run a number of short line railroads in the US and Australia.
-Guangshen has both freight and passenger service in China
-Both Florida East Coast and BNSF are privately held but continue to report.  Florida East Coast has publicly traded bonds.
-East Japan and West Japan Railroads should probably be compared as well.

I'm interested in knowing about publicly traded railroads worldwide to add to my comparison matrix, if you know of any I've missed please email me.  If there is any interest in the actual spreadsheet I'll make the Google Docs link public for download.

Talk to Nate about the railroad industry

Disclosure: No positions

Is Delta Galil a magic six stock cheap?

Delta Galil (DELT.Tel Aviv, DELTY.Pink Sheets)

Price: 18.20 NIS or $4.64 (9/22/11)

This is a post about another "magic six" stock, but based on some feedback from the post on Molins I want to take this post in a different direction.  In the previous post the issue was raised in the comments that it would be unusual to find a great company trading so cheap and there must be a reason for the cheapness.  This comment really honed in on the heart of the matter for these stocks.  We already know they are cheap, and a magic six isn't a net-net where I'm worried about the tangible book value.  The most important thing is knowing why the stock is cheap and if the reason for the low price are justified or not.  So instead of digging into the components of a magic six (P/E < 6, P/B < 60%, Div > 6%) I'm doing to look at the reasons why Delta Galil is trading at a low price.  A low prices doesn't always equal a cheap stock.

Delta Galil is a Israeli company that designs and manufactures intimate apparel for both men and women.  Based on their site I would say they tend to focus more on women's apparel.  The company sells most of their goods through major retailers worldwide such as, Marks and Spencer, Carrefour, Victoria's Secret, GAP, J Crew, Banana Republic, and JC Penny among others.  Clothes are sold both as private label and with their own brand.  The company is one of the largest undergarment manufacturers in the world, and the largest textile manufacturer in Israel.

As with all magic six stocks on a valuation basis the stock is very cheap, a P/E of 4.98, 53% of book value, and a dividend yield of 13% on a TTM basis.

Why is it cheap?

There are a lot of potential reasons for Delta Galil to be trading at a depressed valuation, I'm going to quickly go through each and discuss whether the issue is a driver for true undervaluation or an issue that doesn't really affect the business value.

Mideast violence - This is the first reason I think most western investors might take a flyer on Delta Galil, the company operates in a very volatile part of the world and the volatility has affected company operations in the past.  During the Arab Spring the company's factory in Egypt had to be shut down for a period of time due to unrest.  While this is a real risk I view it as a headline risk, the company is used to operating in the environment has has found a way to be successful.  I don't see why this would change going forward.  Side note, there is a great article in Businessweek about the Palestine Stock Exchange and how they are able to operate with constant disruptions.

Small cap, illiquid - This is a favorite reason for undervaluation, a neglected un-tradeable stock, and I have to admit I've used it as justification a few times myself.  Delta Galil has a $108m market cap and trades in an emerging market which means not a lot of visibility to foreign investors.  With that said the company operates globally and is part of the Tel Aviv market index.  As for illiquidity the US ADR shares are pretty illiquid, but the ordinary shares traded in Israel seem to have a decent amount of volume.

Family owned and controlled - The CEO owns 54% of the company which could scare off potential activist investors or investors who hope to push management for change.  I tend to prefer family held companies because I feel that my interests are aligned with the management.  My number one interest is safety of capital, which for most tightly held companies is a priority for them as well.  If a closely held company is a fantastic business the market will reflect that with a P/E higher than 5, I don't think this is a reason for the undervaluation.

I believe there are actually two very big reasons that the shares trade at such a low price.

The first is that the company doesn't have a very good track record of profitability.  The company has been profitable recently stating that they have had nine straight quarters of increasing profitability in a soft market.  It is good to see an upturn in business but investors might not believe the upturn is sustainable.  The company recorded a loss in both 2007 and 2008 on revenues similar to the current run rate.  In addition to this the US market segment has been operating at a loss for the year 2011, the company states they believe this will turn, but who knows.

The company is currently operating profitable the biggest component of their expenses was on a tear most of this year, the price of cotton.  The price has dropped recently but it is still above the long term "normal" price range.  Cotton accounts for 30-50% of the cost of goods sold.  In the past they have tried to adjust their product lines to accommodate higher cotton prices, but this introduces a fashion risk.  An apparel item that uses less cotton might not be as desirable to consumers.

The second major reason the shares are at a low price is that the company is very sensitive to currency fluctuations, both in USD and EUR.  I have included the two charts the company uses to show the potential impact of currency changes in USD and EUR:

The first thing to notice on this chart is that fair value is 1.425 EUR/USD, at today's mark the EUR/USD was 1.346 which puts the company in the 5% decrease category from the balance sheet presented.  This results in a loss of value on the cash and receivables mostly.

This second graphic shows the impact of the USD/NIS exchange rate on swap contracts the company holds to hedge their NIS debt in USD.  As of today the USD/NIS stood at 3.72 which is in the 5-10% increase range.  This will result in somewhere between a $3m and $5.8m loss if the exchange rate persists.  To put this in perspective in 2010 net income was $22m, which means the swap loss at this point is about a 20% hit to net income.

Are these real reasons?

Are any of the reasons I presented above legitimate reasons to avoid investing in Delta Galil?  I think any of them potentially could be but realistically the variability of the company's operating performance on the price of cotton and currency markets is enough for me to avoid an investment for now.

The reason I say this is that I have no idea if the price of cotton falling recently is due to macro-economic trends which could be temporary or if it's some sort of mean reverting change which would help the company going forward on a permanent basis.  What's clear is that Delta Galil doesn't have much if any pricing power which means they could get squeezed if cotton rises again and their buyers refuse to pay higher prices.  I should note that both of those things mentioned in the last sentence happened at the end of 2010, it's just at the moment they've reversed.

Contrary viewpoint

This post wouldn't be complete without the bullish viewpoint which I think I could probably sum up in a few bullets:
-The company is trading at a big discount to book value.
-The price of cotton has declined almost 50% in the past few months
-The company has restructured after the 2007/2008 losses and turned a profit in a tough economy
-Most of the profits are paid out as dividends giving a shareholder a cash return
-The company's bonds are trading very close to par or at par depending on the day meaning bondholders believe their investment is safe.

The bottom line

If Delta Galil was a net-net where all I was worried about was the quality of the balance sheet and a return to NCAV I would probably feel somewhat comfortable investing in the business.  But that isn't what this investment is about, this is about a low margin textile business that is trading at a low price due to very volatile and uncertain inputs to their business.  I think the price is probably too low, but I'm not sure what the exact level of discount should be given the risk factors.  So while Delta Galil is cheap I don't think it's safe, and there are many other safer cheap stocks available to pick from.

Talk to Nate about Delta Galil

Disclosure: No position

Heelys selling for less than net cash, can they ever turn things around?

Heelys (HLYS)

Price: $2.06 (9/18/2011)

I have been bouncing recently between a list of net-net's and a list of magic six stocks, while I was working on a magic six I decided to take a break and look at a net-net, Heelys was the next on the list.  Heelys as a stock has the ick factor without a doubt but some aspects of the financials were interesting enough that I decided to turn some of my thoughts into a post.  I should have the magic six writeup later this week.

Heelys is what I would consider a fad product company.  They develop shoes with a small wheel in the back.  The purpose of the shoes is to allow the user to take a few steps then skate along quickly.  The shoes were all the rage a few years ago, you couldn't go to a school, mall or park without seeing kids skating around on Heelys.  The stock was also a high flyer, it IPO'ed at $32, rose to $38 and then sunk lower and lower finally reaching the current $2 price.

So what killed Heelys?  I think two things, the first was most schools started to ban the shoes in the name of safety.  Once a ban was in place it was a lot harder for parents to justify a shoe purchase that could only be worn at home or outside.  The second was fashion, by this I mean that kids who owned Heelys and thought they were cool grew up a bit and realized they weren't as cool anymore.  Just like any fad at the time it seems like there is some sort of staying power but as quickly as it appeared the fad is gone.

Here is a picture of a Heely shoe, note the wheel in the heel:

The shoes come with either one or two wheels and retail anywhere from $40 to $85.  Heelys also sells another product called the Nano for $85 which is a weird sort of one foot skateboard thing that attaches to a Heely shoe using the wheel socket.  To use the Nano a buyer would need to spend a minimum of $125 and up to $170.  

The company is a net-net, here is my worksheet for them:

So the biggest thing that stands out is that currently Heelys is trading at a one cent discount to net cash per share.  It is very rare to find a company in the US trading below net cash, this is a very cheap company possibly for good reason.  If shareholders were able to force a liquidation there is a very strong chance they would see a nice return on their investment.

The problem is it doesn't seem that management is willing to liquidate the company.  This is something that Ben Graham points out in chapter 44 of Security Analysis.  Graham states that often the interests of management and investors are in conflict, and based on the fact that American shareholders are the most docile creatures in the world it is unlikely shareholders will work to force change.  Graham sets up criteria for investing in a net-net: either the company has a good chance of profitability in the future, or the company is currently profitable.

To invest in Heelys an investor needs to have hope that the company will have some sort of reversion to the mean turn-around at some point in the future.  So how does the company stack up on an operating basis?  In one word terribly..

The ten year results of Heelys aren't pretty, the company's revenue rose from $20m in 2001 to $188m in 2006 the year before their IPO.  In 2007 revenue was $183m before it fell off to $71m and most recently $29m.  The fall in revenue wouldn't be a problem if the company sized their operations accordingly.  Unfortunately that hasn't been the case, operating income was last positive in 2007, and operating expenses have been rising since 2004.

The cash flow is just as bad, the company briefly had positive operating cash flow in 2010, but otherwise it's all been negative.  The cash burn isn't terrible, but it's a steady drip emptying the balance sheet.

I would best describe the financial history of Heelys as follows; the company went public with record results, they saved their earnings and have worked off the excess hoping to create the next fad.

So the question I have to ask myself is do I trust Heely's management to do the best thing for shareholders and liquidate?  If they don't liquidate do I think their market will improve?  Based on the fact that the product was a sort of fad and not depressed as a result of some sort of slack in demand or over capacity I don't have any sort of assurance that the market will ever turn positive for them.  

After browsing their filings and reading through their website my takeaway is that management intends to keep charging forward until either they suddenly strike gold and turn profitable or run out of cash.  I've passed on Heelys but I'd always love to read the bull case.

Disclosure: No position in Heelys

Molins, a magic six stock: P/E 6, P/B 60%, Div 6%

Molins (MLIN.UK)

Price: 90p (9/11/2011)

First off I want to thank Andrew over at Frogs Kiss for sending me a list of Peter Cundill magic six stocks.  A stock that qualifies for the magic six designation is trading with a P/E of 6, a dividend yield of 6% or greater and a P/B of 60% or less.  Peter Cundill loved to invest in magic six stocks as discussed in the excellent book There's Always Something to Do: The Peter Cundill Investment Approach.

Of the 53 stocks that qualify world-wide as a magic six none of them are in the US which I find fascinating.  The first magic six stock I want to dig into is a British stock, Molins Ltd.  Molins is a machinery supply company that builds equipment for three different customer types; Scientific Services, Tobacco Machinery, and Packaging Machinery.

While at first glance it might seem like the product lines are diversified they are not; all deal with the tobacco industry.  The Scientific Services group deals with machines and instruments for tobacco labs.  The Packaging Machinery division creates machines that handle tubular product packaging.  And finally the Tobacco Machinery division builds machines which are used in the manufacture, distribution, and processing of tobacco products such as cigarettes.

The company has a long history in dealing with the tobacco industry, Molins was founded in the late 1800s and incorporated in 1912.  The company started with the founder hand rolling cigars and cigarettes in Cuba which led him to design a machine to roll smokes automatically, a breakthrough at the time.

I want to break down this post into three sections, I'm going to look at the earnings, the book value, and the dividend, all three main elements in the magic six formula.  But before I dive into each I want to present my quick back of the napkin thesis:

Quick Thesis

-63p per share is cash
-ROE 13.2%
-EV/EBIT 2.14
-EV/FCF 1.27
-£18m market cap
-Investor return of 36% (ROE * B/P), this is the return an investor gets by buying at such a discount to book, if the company continues to earn a 13% ROE compounded on the low price paid for the company.
-Sustainable 6% dividend yield

The stock is cheap, and I mean absolutely cheap, after backing out the cash it's barely trading above 1x FCF.


A dividend yield of 6% or above is unusual, it often means the company is in some sort of financial distress or the company is a REIT.

The company seems to target a 20% payout ratio which is conservative.  During the financial crisis the payout ratio hit the low 60s but still not high enough to cause any concern.  I have a detail of the dividends and payouts for the past five years.

As you can see above the company appears to adjust the dividend policy based on profitability although it appears they might have been a bit hesitant to cut the dividend in 2009.  Molins has been able to pay a consistent dividend throughout the financial crisis, I don't think a dividend cut is really much of a worry.

Book Value

In taking a look at a magic six stock I tend to put a lot of emphasis on the composition of book value.  In most stocks I analyst I look at the net current asset value which is much more liquid than book value and usually the values are a bit more accurate as well.  General book value could include intangibles such as goodwill or the values of a property and plant account that might not be realistic.

In the case of Molins book value is £50m against a market cap of £18m.  Here is the breakdown of the book value:

The first item that sticks out as a potential item of concern is £14.7m of intangibles, this is likely a value that won't be realized in a sort of liquidation scenario.  I looked at the annual report and there is a note (note 13) which discusses the intangibles, and found the item intangibles is goodwill amount carried on the books as a result of a few acquisitions in the Scientific Services group.

The second item of note is the surplus for the pension account.  It's a bit unusual to see a surplus for a company sponsored pension plan, especially in the last few years.  The gross pension assets are £327m with a benefit obligation of £314.  I like seeing the surplus but in reading the statements it appears to be a more recent development, as of June 30 2010 the company pension plan was operating with a £34m deficit.  The surplus is a result from rising asset values.  With the falling European markets I'm wondering if the surplus has disappeared since the interim statement came out.

As mentioned earlier in the post Molins has £12m of cash on the balance sheet in addition to a sizable amount of inventory and receivables.  As a whole the NCAV is 61p per share which is a liquidation value 32% lower than the current price.  I think liquidation value is the absolute worst case scenario for book value.  If we add in the £10m property plant and equipment amount in figuring out a base book value it rises from 61p to 114p or 26% higher than the current price.


Book value and net current asset value are nice but I've been burned on "cheap" stocks without earnings in the past so evaluating the earnings and cash flow record is important to me.

I grabbed the 10 year data from MSN money and put together a spreadsheet and a graph of sales, EBIT and net income for the past 10 full years.

Sales have been pretty steady for the past six years following a drop earlier in the decade.  Although sales have been steady EBIT and net income are all over the place.  Even though earnings are lumpy they are all positive except for a major loss in 2004.  The company website only has reports back to 2005 available so I wasn't able to determine what made 2004 so significant.  My gut feel is that they took some sort of write down in 2004 that resulted in the loss.

Earnings and EBIT seem pretty decent, to double check the quality of earnings I also put together a little worksheet showing cash from operations, capital expenditures and then free cash flow.

Looking at cash flow is always interesting.  In 2008 there was a profit if an investor only focused on earnings yet the company went cash flow negative due to working capital changes.  My guess is the company continued to build up inventory and then had a tough time working off the increase.  Evidence of this is in the increased receivables and increased inventory for 2008.

Overall for such a cheap company the earnings are decent and while not steady and predictable it does seem likely that they will continue to be profitable into the future.  And considering the long history of the company and the ability to mostly be continually be profitably I think a P/E higher than 6 is probably deserved.  Molins isn't going out of business anytime soon, a P/E of 10 is probably more appropriate.

Why is it cheap?

This is a question that has been nagging me since I first started looking at Molins, why would a decent company be selling so cheap?  The first answer is that the size of the company is tiny and there are a lot of inefficiencies with small companies.  While that's true it's not a very satisfying answer.  I went digging through the messages at to see if there was anything value related to Molons.  It seems that the elephant in the room is the enormous pension account.  Currently the pension is in the black, but with markets volatile it could easily swing negative and be a large liability on the balance sheet as well.  A lot of posters on ADVFN seem concerned about the size and gains/losses with the pension.  I'm not sure if this is some sort of conservative British concern or something legitimate.  In the US companies run a negative pension balance for years without a problem, there is a day of reckoning eventually but usually it's a LONG way off.


Molins occupies a middleman position in the cigarette supply chain, they make the tools that are necessary for cigarette production.  The company is cheap on both an earnings and book value basis and pays a generous dividend.  I'm not sure how much upside is realistic on an earnings basis but even if there is a little getting paid 6% to wait seems worth it.  I'm not entirely comfortable with the company yet so I'm passing on an investment at this time.  I'd love to hear anyone's opinion on Molins.

Talk to Nate about Molins

Disclosure: No position in Molins.  

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Almost a net-net Ingram Micro

Ingram Micro (IM:NYSE)

Price: $17.66  (9/1/2011)

note: I wrote this post before going on vacation, the price could be a bit stale.

Ingram Micro attracted my attention because they are an IT supply company and I had good success purchasing PC Connection a competitor when it was trading below NCAV.  I thought I'd take a look at Ingram Micro and see if I could replicate the same results.

Ingram Micro considers themselves a technology distribution company.  They are essentially a middle man in the IT chain.  They connect vendors with resellers and piece together customer solutions.  If you own a small business you might contact a local sales person for a solution on building out a new IT office space solution.  The local reseller might not have the expertise or connections to support the buildout on their own so they talk to Ingram Micro who sources from their 1400 vendors to provide a cost competitive solution.  The reseller can also offer financing options and support options all provided through Ingram Micro.

Basis for investment

In a previous post I discussed when to sell a net-net and I made the differentiation of buying a net-net on an asset basis, or on a cheap company basis.  When taking a look at Ingram Micro I would consider buying them on a cheap operating basis and using the net-net value as downside protection.

The reason I make this distinction is that IM needs to have a large inventory available and will usually carry a large amount of receivables as part of how they run their business.  It's very unlikely that suddenly management will wind down their inventory and receivables and distribute the cash to shareholders.  Instead those values could be looked at as supporting values in creating a margin of safety for a shareholder.  In the worst case scenario the company could be liquidated and the NCAV or discounted NCAV might be realized, this is the downside.

Evaluating the balance sheet

The company's current assets are mostly composed of inventory and receivables which is normal for this type of a business.  Ingram Micro also has a nice allocation of cash, 48% of the market cap is held in cash, quite a number!  There is also a small amount of PP&E that's not included in the net-net worksheet but it amounts to about $1.50 a share.

As for the liabilities 78% of the liabilities are accounts payable, the rest is in debt and accrued expenses.  I usually shy away from net-net companies with debt on the balance sheet but in the case of IM the debt is small and manageable.  Their debt to equity stands at 18%, in the most recent quarter they paid down $120m of debt with $522 remaining.  At the current rate the debt will be paid off in slightly more than four quarters.

Overall this is a nice balance sheet, and it provides a lot of downside protection for an investor.


One of the problems for companies in this space is that the margins are absolutely terrible, Ingram Micro has a 5.4% gross margin, 1.3% operating margin and .8% net margin.  These margins are similar across the industry, but it's a bit surprising, some of the Japanese net-net's I've profiled have better margins.

The company has a 3.56% Return on Assets and a 9.36% Return on Equity.  Based on the differential ROE is juiced by financial leverage.  Looking at the ROE through a duPont lens we have ROA * leverage = ROE.

3.56% * 2.62 = 9.36%

The 2.62 is the financial built into the business structure, most of the financial leverage is due to the fact that the company is carrying around a large amount of account payables.  A large account payable balance is like receiving financing from your customers at a 0% rate.

As for Return on Invested Capital Ingram Micro here's my worksheet:

The ROIC comes out to 8.47% which is acceptable for the industry.  The one thing I want to highlight from the worksheet is that Ingram Micro has $411m in operating leases that only appear in the 10-k.  The operating leases are similar to debt but don't appear on the balance sheet.


Here are a few quick valuation stats:
-P/E of 9.69
-EV/EBIT 3.08
-EV/FCF 5.52

So on a few simple metrics the company is coming up cheap.  What might be an appropriate valuation for Ingram Micro?  The industry average P/E is 10.5, which if IM traded at that level they would be at $19.11, not much upside.

A P/E of 10.5 plus cash results in a price of $27.75 per share.

If the company traded at an EV/EBIT of 8 the price would be $32.34 which is quite a bit higher than $17.66.


Ingram Micro is trading at a very cheap discount to net assets, and the business is trading cheaply as well.  Even with both of those factors I don't have a good feeling about Ingram Micro.  The company has a decent amount of debt and operating leases, and earnings are extremely lumpy.  I also don't know how much valuation expansion exists.  Clearly the company is cheap, but how much cheaper than peers.  And for an industry that has bad margins maybe a P/E of 10 is warranted.  If the market values based on P/E they are already close to full value.  This is going into my consider further, and re-consider if it drops bin.

Talk to Nate about Ingram Micro

Disclosure: No position in Ingram Micro, Long PC Connection