Monday, July 30, 2012

RadioShack as a net-net?…well sort of

Tandy Computers, CB radios, satellite dishes, transistors, capacitors, and stereo systems; what do they all have in common?  They were standard inventory at RadioShack just a few years ago, well maybe decades ago.  RadioShack has been hitting the news recently as they've become the most recognized "net-net" struggling with a turnaround.

RadioShack is an American retail chain that started as an electronics outlet and morphed into a cell phone store.  The company has a storied history with a whole website devoted to old RadioShack catalogs, and plenty of retro commercials on YouTube.  I spent some time browsing the old catalogs, it's amazing how much better and cheaper things are now.  To RadioShack's credit they were early on the cell phone trend.  Here's a little comparison:

Then (1987)


Now


Interesting to note that the monthly price only dropped $10 over the last 25 years.

Is it a net-net?

The purpose of this post isn't to walk down memory lane, but to evaluate how attractive RadioShack is now that they're purported to be a net-net.  I use purported and net-net in quotes above because as you'll see below they don't quite qualify as a net-net as Benjamin Graham would define it.  Graham defined a net-net as net current assets minus all liabilities.  If an investor just focuses on the balance sheet RadioShack qualifies with current assets of $1741m and total liabilities of $1383m for a NCAV of $358m against a current market cap of $257m.  Seems great right?  RadioShack is trading at 71% of NCAV and cash flow positive, so what's the problem?

There was a very good reason Graham took liabilities at face value and discounted assets.  Liabilities have a way of torpedoing investments whereas companies are rarely evaluated on their assets alone.  The goal of determining NCAV is to calculate a price at which buying below gives a margin of safety.  If assets are included that can't be sold, or select liabilities ignored the investor is just fooling themselves into thinking an investment is safer than it actually might be.  To me this is the most serious error an investor can make, an underestimating risk.

I have my own spreadsheet that I use to calculate NCAV, I only use cash, receivables, and inventory against all liabilities.  Here is what it looked like for RadioShack using just the balance sheet from the latest 10-Q:


My numbers are slightly lower than the back of the envelope calculation above.  With a current price of $2.59 against my calculated NCAV of $1.63 RadioShack doesn't qualify as a net-net. If an investor moved on at this point it would be understandable, but I want to drill a bit deeper to highlight an second issue.

Many investors don't take liabilities seriously enough.  A net-net investor could be forgiven because after discounting assets and subtracting liabilities the value they have is very conservative.  The problem is some companies like RadioShack have liabilities that are off balance sheet, mainly leases and purchase commitments.

RadioShack's operating leases are non-cancellable, which means the lessor is going to get their money before a shareholder gets a dime.  Purchase commitments in RadioShack's case are contracts to purchase a certain amount of inventory over the next year.  They also have some marketing expenses grouped in with purchase commitments.  Purchase commitments are sometimes necessary for a company to lock in discounts on bulk inventory purchases.  It could also be necessary if the retailer is buying a specialty item where a custom production run is necessary.  The marketing expenses could be things like TV or radio advertising where blocks of time need to be purchased in advance.

If I re-do the net-net worksheet to include both the operating leases (discounted at 6%) and purchase commitments RadioShack fails to be categorized as a net-net.  Unless the company increases their inventory (which would be bad), their receivables (bad as well), or their cash it doesn't look like an investment in them on a net-net basis would have any margin of safety.




Can it turnaround?

I'm not an expert in turnarounds, but I did notice something while browsing through the old catalogs, RadioShack is no stranger to reinventing themselves.  In the 1940s the company billed itself as the largest distributor of amateur radio equipment.  In the 1950s and 1960s the stores started to carry more stereos and TV equipment.  In the 1960s RadioShack started to ride the CB radio trend feeding right back into the stereo craze of the 1970s.  In the 1980s RadioShack the store introduced computers, and VCRs.  The 1990s brought cordless phones, answering machines and pagers.  The company seems to have lost their way a bit in the early 2000s before stumbling back into the cell phone business.

I don't know if the transformations are in the company's DNA or if they were a forced necessity.  I would have more confidence investing in a company that's reinvented themselves multiple times over a company that's attempting it for the first time.  The big question to ask though is what's next for RadioShack?  What's the next big trend they can grab onto and ride to profitability?


Disclosure: No position


Friday, July 27, 2012

Is this net-net a fraud? An example and guidelines

If a company is selling below liquidation value it must be a fraud or on the brink of bankruptcy right?  That's often how the market thinks about these companies, and in the case of Chinese reverse merger stocks the market has been correct.  In a recent post I looked at the performance of net-nets over different periods of time, one conclusion drawn from the data was not to focus on potential upside, but to just avoid potential losers.  A few of the companies that turned up in the historical screens and subsequently lost 99% turned out to be frauds.

I'm no expert in spotting fraud, but I feel that a few simple things can protect most investors.  The most important is a common sense check.  If something appears too good to be true it probably is.  If a company passes a common sense check I'll run some financial checks on it next.  There are plenty of investment opportunities worldwide, if a company has a red flag or two and I'm uncomfortable I will move on.  I don't need to waste my time trying to justify something questionable when there is another company just as cheap without the questionable items.

To show how an investor might evaluate a net-net for fraud I wanted to walk through an example with a stock I've talked about a lot recently Solitron Devices.  I did this because a few readers mentioned that the frequent switch of auditors for Solitron was a massive red flag for fraud.

The way I'm going to structure this post is simple.  For each check I did against the company there will be a header then a short description and then evidence for or against the specific check.  I'm not going to conclude anything, I'll let the evidence speak for itself.

Establish the company is real

I don't believe establishing a physical presence exists and that a company does what they say they do is necessary for most investments.  If fraud is going to occur (outside of China) it's usually a company fudging the numbers a bit, not a complete sham operation.  But sham operations do exist so it's always good to check.

I have never visited Solitron so I can't vouch for their physical presence, but there is enough evidence on the internet that convinces me this is a real company.  Starting from the most important to the least important.

Solitron is a government contractor and as such bids and contracts for work can be searched online.  The search results include when the contract was opened, when it was fulfilled and the amount.  The database contains a number of entries for shipped and completed orders to Raytheon a company Solitron names as a large client in their 10-K.

The company is subject to environmental violations related to past operations, the EPA is the monitoring agency.  The EPA has detailed on-site visits with text and pictures describing what they found.  The government is also getting paid a set amount from Solitron each year, if the government failed to receive what they were owed there would be litigation to reflect that, none exists.

A previous Solitron location is now a Superfund site, a lot of information regarding the site can be found here.

There is a company that will buy out out of production Solitron parts for resale.

The company has received an AS Accreditation.

Of course what's a company without employees.  Salary and work environment information can be found here, here and here.

Large increases in inventory or receivables

Sometimes a company will inflate revenue by selling products without actually distributing them.  A sign a company might be inflating revenue is if accounts receivable grows rapidly.  The company sells products but doesn't collect the cash for the items sold, a major warning sign.

Here is the accounts receivable and inventory growth for the past five years:



Off balance sheet liabilities

A company can often make their balance more attractive by hiding liabilities off the balance sheet.  One way of doing this is operating leases, other ways include special purpose vehicles, and joint ventures of dubious value.

Solitron has an operating lease that's clearly disclosed both in the 10-K and in an 8-K when they renegotiated the contract.  I don't like operating leases, but if a company doesn't want to buy a facility they don't have many other options.  I always include operating leases in my net-net worksheets.



Impairments or write-downs

A company that makes bad capital allocation decisions ends up writing down the balance sheet value of assets they had acquired in the past.  Solitron as far back as I looked hasn't recorded any impairments.

Cash flow tracks net income

Outside of timing differences net income should track operating cash flow very closely.


A second way of looking at this CFO/Net Income:



Excess cash margin

This is a formula from the book Creative Cash Flow Reporting that is: CFO - EBIT / Revenue.  The book discusses it in detail but the idea is the excess cash margin should be slightly positive.  A negative margin indicates that net income could fall in the future.



Accruals

Items accrued on the balance sheet are a result in timing differences between cash and accounting entries.  For example an expense might be incurred yet not paid out in cash during a specific period.  Management can use accrual entries to artificially inflate profit or lower expenses.  As a general rule lower accruals indicate higher quality earnings.



There are many other financial statement quality checks that can be completed but at this point I think there is enough evidence for a reader to make a determination on their own.

Talk to Nate about this post.

Disclosure: Long Solitron Devices





Wednesday, July 25, 2012

Is Bralirwa actually investable?

My last post on Bralirwa was met with enthusiasm then disappointment.  A few readers commented that the post was a tease and it is hard if not impossible to trade the stock.  I wanted to see how true their assertion was so I took it upon myself to do a little research.

The method I used to find a broker in Rwanda is no different than how I'd find a broker anywhere else in the world.  The technique is crude but works, I'm not original with the idea, I borrowed it from the book The World Is Your Oyster.  The book is about global investing with some reasons why to invest globally but mainly how to do it.  The book was written before American brokerage firms had the ability to trade internationally so trading in New Zealand meant calling New Zealand and opening an account.  The book is alright, I borrowed it from the library and read it in a few days, I'd recommend that.  If you want to read it I wouldn't recommend paying more than a few dollars for it used.

To find a Rwandan brokerage I went to the Rwanda Stock Exchange website and I surfed around until I found a page with the firms who have access listed.  I then emailed every single firm listed on the page asking if they would allow an American to open an account in local currency and if I could trade Bralirwa.  The next business day I had an email from Core Securities that it wouldn't be a problem at all.  All I had to do was fill out an account opening form, give them a copy of my passport, a signature, and a passport photo.  After that I could wire them the money and trade in Rwanda Franc any of the three stocks I wanted.  Of course there is some risk here, you're wiring money to someone in a country you've never met and who knows what safeguards or assurances exist.

I'm not actually going to open an account because while Bralirwa looks interesting it's also the first stock I've looked at in Africa.  But I did want to point out this isn't a fantasy trade.  I also know that institutional investors have access to the Africa market.  For most readers their primary broker might not have access but access can be gained through opening a new account.  An objection to this might be that investing globally in non-developed markets could result in a number of new brokerage accounts to hold one or two stocks.  Yes this is true, if you go this route the goal is to find a market with a lot of cross listings.  So in Africa, Kenya and Nigeria are markets containing a lot of cross listings. Opening an account in either Kenya or Nigeria might maximize the investable options in Africa.  Of course if your goal is to only trade Bralirwa then you'd need to have an account in Rwanda.

If anyone is actually interested in opening an account to trade this stock drop me an email at the link below and I'll pass along the firm contact and account opening instructions.

Talk to Nate

Disclosure: No positions

Monday, July 23, 2012

How far off the beaten path for a moat?

Warren Buffett made a lot of money for himself and shareholders by investing in Coca-Cola in the 1980s when beverages were a growth industry.  How many Buffett watchers wish they could go back in time and replicate that trade in their own accounts?  Well the opportunity exists by investing in Bralirwa the only listed company in Rwanda.  I should clarify, there are actually three listed stocks in Rwanda, but the other two are Kenyan cross listings.  Bralirwa (BLR.Rwanda) is the only domestic Rwandan stock.  I've been known to find some companies off the beaten path, but I think this is the furthest from the path I've ever strayed.  Bralirwa has all the characteristics that investors salivate over, a moat, enormous growth, and most important a reasonable price.

Bralirwa produces a variety of beer products and has held an exclusive license to distribute Coca-Cola products in Rwanda since the 1970s.  Consider this the ultimate moat, an exclusive license to sell a product for which demand is exploding.  For the upwardly mobile in Africa displays of wealth often start with small things such as upgrading from crummy water to Coke, or home-brew beer to bottled beer.  Bralirwa is capitalizing on this process and in turn minting money.

Rwanda's image is scared by the horrible genocide of the 1990s but things have improved since then.  The country is known for its coffee export and has been making headway in tourism.  Incredibly 42% of the population is under the age of 15.  The country's economy has grown like a weed rising from a GDP of $2b in the year 2000 to $6b in 2011.

Pulling Bralirwa up on a screener doesn't immediately reveal anything exciting.  The company has a P/E of 12, a P/B of 9x and EV/EBITDA of 7.2x.  One enticing aspect is that 85% of earnings are paid out as a dividend which gives the stock a current yield of 6.8%.  The stock seems fairly valued using developed world numbers, but that paradigm might not be applicable to Bralirwa.  How many developed companies with the growth shown below sport a P/E of 12?


It's not uncommon for a company to have a break out year reporting a 40% increase in profits, what's not common is for a company compound net profit at 40% annually over the past five years.  Astute readers will notice unit volume has only grown 8% indicating revenue and profits are coming from a more profitable product mix and expense management.

The company sports an impressive 22% net margin and an eye-popping 74% return on equity.  The balance sheet is simple consisting of the current assets, some plant and equipment with liabilities not much more than a few payables.  The return on equity can in part be explained by the fact that property plant and equipment are held on the balance sheet at cost minus depreciation.  In a country where inflation has risen as high as 25% in the last decade it doesn't take long before the plant cost is insignificant.  Current inflation is somewhere between 2% and 6% depending on the data source used.

Eventually growth will have to slow, the market will be saturated and Bralirwa will move from growth to being mature, but it doesn't seem like that day is coming anytime soon.  The company reported in their 2011 annual report that they expect future results to be consistent with the past.  In support of this view the company is expanding their manufacturing facilities to support increased demand.  Return on equity will drop with a recently priced facility on the balance sheet.  For a company being priced on growth a lower return on equity shouldn't have much of an impact.  

The question to ask when looking at Bralirwa is does this company with a 22% profit margin, 40% annual growth, and a solid moat deserve to trade with a P/E of 12, or a EV/EBITDA of 7x?  There are definitely risks involved with investing in Africa, but has that already been priced in?  If the company can keep up the frantic growth pace five years from now they'll be earning Rfw 79m which on today's purchase price would be a P/E of about 2x.

Maybe the Bralirwa growth story is enticing but you don't have a way to trade in Africa, there happens to be another way to own a piece of this company.  Bralirwa is 75% owned by Heineken which trades in the Netherlands and in the US with an ADR.  There's actually a bit of a valuation discrepancy between Heineken and Heineken Holdings which could enable an investor to buy Bralirwa even cheaper.  I'll leave it to the reader to find this little quirk.


Disclosure: No position

Sunday, July 22, 2012

Where are they now? Part 3

In part one and part two of this series I looked at investing in net-nets both at market bottoms (2002,2009) and then right before a market drop (2008) and finally a relatively flat market (2010).  For the first two posts I intentionally decided to leave out conclusions and commentary for brevity sake.  I've now had some time to sit and look at some of the stocks and wanted to try to wrap things up.

I don't really have a grand narrative to tie this together, instead I have five observations which I think will serve net-net investors well.


1. It's not finding the winners it's avoiding the losers.

This seems obvious and it is, but it's also true.  Just avoiding the three companies that lost 99% in 2008 improved returns from 28% to 46%.  That's almost a 20% increase by just avoiding three companies.  So how hard was it to avoid those?  One CommercePlanet was unable to file quarterly statements and was under investigation by the FTC for unfair trade practices.  The company also fired their auditors in 2008 only to bring in new ones who ordered a restatement of financials.  Too many red flags to invest, move on.  The other two didn't have any filings with the SEC or on OTCMarkets making it much harder to get information.  Dark companies aren't necessarily bad, but I require a much higher margin of safety, without seeing the financials it's impossible to know if that existed.

Another big loser was Independence Resources losing 65% over the time period.  The company appeared profitable but a closer look revealed the profit was a one time license sale.  The company is still struggling along, but the cash from the one time sale has been quickly disappearing as losses mount.  Independence Resources falls into the category of a melting ice cube.

I did some spot checks on the data and most of the big losers fell into the melting ice cube category.  Of course there's a reason most of these stocks are selling for less than NCAV so warts and problems are to be expected.  The discerning investor needs to be able to tell the difference in a temporary impairment of operations and a permanent problem.

I prefer to stick with companies that have either a temporary problem, or steady profits and cash flows.  I realize this eliminates most net-net candidates, but I also am working to avoid losing money.

Another way to avoid losers is to avoid companies that appear to be fraudulent or have the characteristics of fraud.  Currently a screen of net-nets brings back a lot of Chinese reverse merger stocks with characteristics of fraud.  Avoid those if possible, if a company's results appear too good to be true, or something can't be reconciled move on.  There is no reason to invest in something questionable when many perfectly good investment options exist.

2. Buy and hold for net-nets isn't ideal.

The dataset I had ran a simulation presuming an investor purchased the stock and then held without selling.  This can be acceptable strategy if a net-net is actually a good business hidden by a pile of cash, or by a temporary difficultly.  Sometimes if net-nets are very small companies that are completely neglected, I don't think there's any penalty to holding that sort of company long term.  These sorts of investments are very rare.  Of the 100 or so net-nets in the US right now I can probably count on one hand the ones with average businesses, and of those, maybe one or two is worth holding.

So what does this mean?  A net-net investor needs to be nimble, these companies are called cigar butts for a reason.  Take the last puff and move on.  Often investors want an investment to fit their timeframe, so a holding period of one year to avoid a short term gain, or a nice steady distribution of returns.  I have had two net-nets that I purchased and sold within three months because the stock had risen to NCAV, I had my puff and moved on.

I picked a few stocks at random and there were plenty of opportunities for an investor to sell with a 50% gain.  One of these was Wireless Xcessories Group (WIRX).  The company on 6/15/2008 was selling for less than 2/3 NCAV at $.85/sh.  I counted three peaks on a chart where an investor could have sold their shares for $1.20-$1.29 up to 18mo after the initial investment.

3. A margin of safety exists.

Someone left a comment on one of the previous posts mentioning the point of a NCAV strategy is to ensure a margin of safety.  I agree, but I think a distinction needs to me made; not every company selling for less than NCAV has a margin of safety.  Graham made an effort to point this out as well, he showed an example of two companies one where NCAV was growing over time and one where it was shrinking.  Both companies were net-nets, and Graham clearly pointed out that the company with a growing NCAV was a desirable investment while the company experiencing a shrinking NCAV was not, even though it was a net-net.

Buying for less than some multiple be it book value, NCAV or even 2/3 NCAV doesn't ensure a margin of safety it just increases the probability of one occurring.  The work of the analyst is to ensure an actual margin exists.  Some net-nets screen well but are terrible investments, other companies don't appear to be safe at first sight but with some digging are in reality very safe.

One of my goals on this blog is when I write about net-nets I like to highlight if there is a bonafide margin of safety, or just the illusion of safety.

4. Value works because sometimes it doesn't.

I stole that quote from Joel Greenblatt but it's true.  There are plenty of time periods where a NCAV strategy might not work.  Take for example the results I turned up from investing in 2010.  At best the investor would have done slightly worse than the index, but at worst trailed by 4% over two years.  Numbers like that are what get professionals fired.  Sure over the long term the results turn out great, but what if an employer doesn't have patience?

I'm not sure if anyone read the Henry Oppenheimer study I linked to but there was a very interesting footnote on one of the pages.  It said time periods in the 1950s and 1960s were studied but NCAV outperformance was spotty and not sustained.  The father of net-net investing himself mentioned this as well in the 1951 and 1962 editions of Security Analysis.  Graham mentions a NCAV strategy is superior but the stocks are hard if not impossible to find.  One thing that benefits investors today is no one is locked into a single market.  While there aren't many net-nets in Europe right now there are plenty in Japan.

The strategy might underperform for a time but one thing it hasn't done is lose money and that is essential.  To me successful investing is avoiding losses, sticking to cheap businesses ensures gains at some point.  Even if investing in net-nets underperforms an index for a period of time it hasn't resulted in permanent losses yet, and I doubt it ever will.

5. Diversification is essential.

I looked at a number of historical filings for the companies that appeared on these screens.  The scariest part was some of the biggest melting ice cubes looked bad, but investable bad.  There were a few stocks that lost 60-70% that while they were losing money had considerable cash cushions and no liabilities beyond a few accounts payable.  I have a rule myself to only invest in profitable net-nets, this was a suggestion Graham made as well.  Oppenheimer found that companies losing money tended to slightly outperform the profitable ones.  My number one rule of investing is margin of safety, and even with a very wide berth of assets the assets aren't safe if the company is burning cash.

The point is it's easy to look at the results and say "Oh I'd avoid xyz for sure", but at the time very few would make that call.  Owning a larger batch of net-nets prevents against the possibility of owning all losers.  From 2008 there were more losers than winners, it's just that the gains from the winners were enough to offset the losses from the losers.  This really reinforces my first point avoid companies that have a high potential of losses and the gains will worth themselves out.


Talk to Nate

Disclosure: None

Wednesday, July 18, 2012

Where are they now? Part 2

This is part two of a series, if you haven't read part one yet I'd encourage you to.  Link to part one.

Before I begin this post I want to address a few comments readers made on my last post.  The point of these posts looking back on net-nets isn't to create an academic record that investing in net-net stocks outperform the market.  I don't have the analytical tools, or the desire to undertake that.  As most readers probably know this blog and investing are a hobby for me.  I have a job, a wife, two sons (youngest just born Sunday!!) and when I find free time late at night I like to research stocks.  Given my limited time availability I'd prefer to research new ideas rather than conduct a full academic study on net-net investing.  If anyone is interested in academic studies there is the Tweedy Browne article, the Henry Oppenheimer research.  Those two pieces look at investing in net-nets from 1970 to 1984 with full statistical rigor.  They also show the strategy has outperformed.  Unfortunately those studies end in1984, but fortunately a paper came out recently that fills in the gap.  Floris Oliemans studied the performance of Graham's NCAV strategy from 1984 to 2008.  His paper is here, I'd highly recommend everyone read it if they get the chance.  There's also the study that Ben Graham conducted himself from the 1930s to the 1970s where he said investing at 2/3 NCAV and selling at 1x NCAV returned 20% annually.

So what is the purpose of these posts?  There are really a few purposes, I wanted to look and see how investors would do if they bought net-nets and subsequently forgot about them.  In my last post I wanted to see how investing in net-nets would do in a market bottom.  This post I am going to show how they did purchasing right before the market drop, and then after the rise from the bottom.  The next post in this series will be a summary wrapping things up and giving my overall thoughts on this process.

Four years later

The criteria for both of these runs were companies that had one straight year of profit, in June of 2008 there were 39 companies that matched this criteria.  If an investor went out and spend $39,000 buying $1,000 of each and then subsequently forgot about those stocks until 6/15/2012 they would have $50,069.  A few went bankrupt, a few went nowhere, some went up a bit and one went up 10x.

Here is the list of stocks with the beginning price, end price, end value in dollars as well as market cap, current assets and current liabilities:



Based on some recommendations from my last post I also highlighted the stocks trading at 2/3 NCAV and did a separate performance analysis on those.

Two years later

The criteria for the two years later is the same as four years later.  This screen turned up 33 names including 11 which were trading at 2/3 NCAV.  Here is the list:


Two years isn't all that long and many names on that list are current net-nets such as OPT Sciences, Coast Distribution, Solitron, TSR and others.

Performance

Some readers will probably look at the lists above and actually examine the data, most probably only care about the performance blurbs below.  I can understand that although close examination of the data provides some interesting insights into this strategy, I'll cover that in the third part of this series.

The index return is the Vanguard Small Cap Index ETF with the ticker VBR.

Here is how the net-nets from four years ago fared:


And here are the ones from two years ago:



Talk to Nate

Disclosure: I own some of the companies that appear in the screens.

Friday, July 13, 2012

Where are they now? Part 1

In a previous post on Boss Holdings I looked back at the history of two net-nets from 2007, Boss Holdings and Concord Camera.  The post started the gears in my mind asking questions like  "How did other net-nets fare over the past decade?" or "Does a longer time frame result in higher returns?", and "what about those net-nets not purchased at market lows?" I don't have any stock databases at my fingertips so I asked Geoff Gannon to run some point in time searches for me.  A big thank you to Geoff!

This post is the first part of a three part series.

First off I think it's helpful to consider what Ben Graham said about net-net investing and market conditions:

"It may be pointed out, however, that investment in such bargain issues needs to be carried on with some regard to general market conditions at the time.  Strangely enough, this is a type of operation that fares best, relatively speaking, when price levels are neither extremely high nor extremely low." (Graham, Security Analysis 6th edition, p571)

What Graham contends is that when the market bottoms it's much better to buy quality companies that have fallen disproportionately with the market rather than focus on net-nets.  I would agree with this with the caveat as you'll see below, market bottoms offer opportunities to buy "quality" net-nets, companies that have long records of profitability and are selling below NCAV.  There's no reason an investor couldn't combine investment styles, purchasing some quality companies cheap as well as quality net-nets in a low market.

Of course the data shows that net-nets purchased in 2002 and 2009 with long strings of profitability rewarded shareholders.  This is an obvious conclusion, buying almost anything at a market bottom had positive returns.  These are the results of the point in time screen Geoff ran for me.  The picture shows the results of the screen, there are the important pieces of information.  First is the ticker and company name.  The start column is the price at 6/15/2002, and end is the price at 6/15/2012, or the buyout price.  The other columns are self explanatory, but I want to highlight the last one, it's the number of years with positive earnings.  Here are the results:


As a comparison I imagine a hypothetical portfolio where someone invests $1000 equally into the ten stocks.  For comparison I use the Vanguard Small Cap Value Index with the same starting sum and same date range.

Starting sum: $10,000
Net-net investor: $16,558
Index investor: $14,511

Net-net investor outperformed by 14%.

I should also note none of these figures include dividends, they're prices only.  The index is price return as well, so it should be a good comparison.

Sure raw data is nice to look at, but I'm always fascinated with the stories of the actual companies.  So in VH1 style I went and dug around to find out what these old net-nets were up to now.

Blair - Bought out in 2007 by Appleseeds and Golden Gate Capital.  A value investor talking to management was the catalyst for this transaction.
Friedman Industries - Still trading and looks decently attractive, 5.2% dividend, P/E of 9x.
Electro-Sensors - Still trading, it hit $11 back in 2006 but has generally traded in the $2-4 range since the early 1990s.
Refac Optical Group - Bought out by a Private Equity firm in a LBO.
Books-A-Million - Going private.  I want to make a mention with them, if a shareholder purchased in 2002 and held on they'd be looking at a 25% gain over the last ten years.  This masks the fact that coming out of the 2002 recession Books-A-Million shares climbed almost 10x topping out close to $25.  It's a shame the shares didn't do the same thing the second time they found themselves in the net-net bin.
Allou Healthcare - It turns out this net-net was a massive fraud.  Execs booked phony sales, inflated inventory and eventually burned down their warehouse.  Fraud is always a concern with net-nets, I have a post coming up on this in the very near future.
Ambassadors International - The data appears incorrect on this one, the company is around and trading at $5.18 a share.  The company has made some acquisitions over the years and is slightly profitable.
BCT International - Management bought out shareholders in 2003.  The company appears to still be operating.  I find it ironic that in the news release mentioning the going private transaction it also notes earnings grew 59% and revenue grew 10% that year.
Control Chief Holdings - They executed a reverse merger and went dark, very dark.  To get financials one needs to be a shareholder, and becoming a shareholder isn't easy.  I've had bids out at times over the past year without getting a hit.  The last trade supposedly took place in 2011.  If anyone has information on this company please email me below.
TransNet Corporation - The company struggled through the decade and has been consistently losing money over the past few years.  They haven't been able to file with the SEC for the past year.  They're literally a penny stock, their price is 1¢.

The results from 2002 were pretty remarkable, as a group an investor who purchased the top ten did very well.  It's interesting that the results are polarized, companies either went to zero, or recovered nicely.  There are no companies on that list down 30% over the decade, if there were losses they were total losses.

Here are the companies from 2009:


My first observation is that five of the ten are still net-nets!  The good news is that the share prices haven't remained flat the entire time.  Here's how the hypothetical investor would have fared investing $10,000 equally into these stocks using the same criteria that I mentioned above.

Starting sum: $10,000
Net-net investor: $17,457
Index investor: $14,191

Net-net investor outperformed by 23%.

In both cases of buying at the market bottom the pure net-net investor came out ahead of someone buying the value index.  The difference between 2002 and 2009 is that since 2009 there haven't been any total losses yet.

Superior Uniform Group - The company has recovered strongly coming out of the recession by doubling profit.
Flexsteel Industries - I wrote them up last August, I don't believe they're a net-net anymore.
Abatix Corp - Still a net-net, there's a great writeup about them at OTC Adventures.
Nortech Systems - Still a net-net, I just looked at them recently, they're steadily plodding along.
Performance Technologies - The chart for them is a line steadily sloping down and to the right, not a good sign.  It appears their earnings have taken the same path.
Movado Group - This stock's outperformance came pretty recently, it had traded in the $10 range until the end of 2011 when the company stopped losing money and reported profits.
TSR - Still a net-net, Whopper has covered them here.
Lakeland Industries - A net-net that's taken a turn for the worst, they lost an important court case that requires them to pay $10m.  This company has also been covered by Whopper.
RF Industries - The company's results have been lumpy over the past few years but their price has recovered and now the company sells above book value with a P/E of 39.  Just as the market can overshoot to the downside, it can overshoot on the way back up as well.
Paradise - This is still a net-net and a bit of a niche hidden champion.  Despite still selling below NCAV the company's results have improved and the share price has reflected that.

A general observation is that none of the top net-nets in 2009 were bought out or went private.  The ones that performed well were due to company results improving.  In a few cases it looks like the market went from overly pessimistic to overly optimistic.

In the next part of this post I'm going to take a look at what happens when an investor buys net-nets in a market that's neither high nor low.

Talk to Nate

Disclosure: No positions

Monday, July 9, 2012

When dot-coms die: The LookSmart tender offer

Everyone seems to love special situations, invest some money now and get a reasonable return a short time later.  Leverage that simple return and get a spectacular return.  So what happens when we combine a special situation with a net-net?  We get LookSmart Ltd with the cool 90s-esque ticker LOOK.

LookSmart is relic from the dot-com boom from a time when people thought they would order groceries and pizza online.  Well eventually people did start to order groceries and pizza online, but about 12 years too late for LookSmart.  The company is a second run text ad network.  They provide ads for search engines that aren't part of the "Big Three", Google, Bing and Yahoo.  So who are these search engines?  They have names like Altavista, Lycos, AOL, it's like a whos-who of busted internet names.  It seemed like a reasonable strategy to advertise on these second tier search engines until the second tier engines realized they were better off using Google and Yahoo for their results.  Of the three I mentioned above Lycos is the only one who seems to be doing their own searching anymore, Altavista adopted Yahoo, and AOL adopted Google.

LookSmart's financials are told through it's stock price, with an IPO price of $12, a high of $70 and the last trade at $.89.  Nope not eighty nine dollars, eighty nine cents, a 20oz of Coke cost more than a share of LookSmart.  The company has been profitable four of the last ten years and has struggled recently.  In the last five years they've lost $23m and had a profit of $4m for a net loss of $19m.  Performance like this has propelled the shares straight to the net-net list.

Here's how the company looks in the eyes of a net-net investor:


Let your eyes fall to the net cash line on the bottom left, $1.08 a share, yup almost 20% higher than the last trade.  The company is basically a little cash box with a tiny amount of receivables, some real estate in San Francisco, and some executives trying to stay relevant.

If this was just a money losing cash box net-net I probably wouldn't be posting about it, but there's something that makes this really interesting.  A consortium of hedge funds that owns 14% of the company has offered a tender for any and all shares at $1 a share.  Here is the news headline:


In cases like this the shares of the target company usually trade up close to the offer price, in LookSmart's case they haven't.  There's still an 11% difference between the tender price and where the shares last traded.  

Some shareholders are crying foul, one wrote up a post on SeekingAlpha about this.  He thinks there's enough upside for the hedge fund group to boost their bid 30-405, maybe there is, and maybe it's worth the risk.  I don't exactly see the value for LookSmart, but some people do.  I wonder out loud if these funds plan to purchase the company and wind it down.  If levered this would be a really nice gain potentially quickly, they'd just have to shut down the servers and distribute the cash.

So what would I do if I was a shareholder?  I'd tender my shares, take the money and run.  While there might be some upside beyond the tender price there's also risk involved.  LookSmart isn't exactly a cash cow, they're a bit of a cash consumer, in the last quarter alone $2.7m of cash walked out the door.  It's worth noting that last year they just about broke even.  I don't know if the next quarter will look like last year or last quarter, but with an offer on the table why risk it?

As long time readers know I want a margin of safety in my investments.  With net-nets I want companies that are cash flow positive, and aren't in any danger of burning through my margin.  Unfortunately for me LookSmart doesn't qualify, but that doesn't mean this is a bad investment.  I'm sure plenty of readers play the arbitrage game, and for them there's 11% for the taking.  A total of 49% of the company is owned by hedge funds and insiders meaning 51% or so is still free floating.  To put that into dollar terms there is $7.8m still out there waiting to be purchased and tendered giving someone a $850,000 arbitrage profit.  While this isn't for me I hope a few readers get to take home a piece of that $850,000!


Disclosure: None

Friday, July 6, 2012

A Fortune to be made, a chance to participate in a LBO

A wealthy executive comes down with a terminal disease, his shareholdings are pledged as collateral and are in default.  Two cunning executives use a complicated financial transaction to recapitalize the company further solidifying control.  The only thing missing from this is a few terrorists and a bomb and this could be an episode of "24".  Instead it's the storyline for Fortune Industries a tiny Indianapolis company going through a seismic change in ownership that will create wealth and throw off cash.  So where to begin?

Once upon a time..

A long time ago in a galaxy far away companies had human resource departments brimming with staff.  The HR department was responsible for all sorts of miscellaneous functions such as managing defined benefit plans, screening and verifying employment candidates, and payroll services.  Eventually a company figured out they could provide these HR services for many companies at once and due to economies of scale reduce costs for clients.  The Professional Employer Organization (PEO) was born.  Companies started to outsource HR functionality and reduce HR headcount, PEO firms prospered and everyone was happy.  Well not everyone, employees pine for the old days when they could walk down the hall to ask a question instead of calling a 1-800 number.

Fortune Industries was formed in 1988 as a combination of three PEO organizations Century II, Employer Solutions Group, and Professional Staff Management.  The three subsidiaries are amongst the oldest PEO's in the country and are considered market leaders.

The company was founded and run by Carter Fortune who remains the Chairman of the Board.

Uncertain way forward

The company is closely held with over 60% of the common shares owned by Mr. Fortune, the CEO Ms. Mayberry, and the CFO Mr. Butler.  Outside shareholders currently own about 32% of the company.  The company also has a class of preferred stocks which is entirely owned by Mr. Fortune which pays him a generous dividend.

What could go wrong with this?  The company is humming along on all cylinders, reporting profits and recovering from the recession.  Well it seems the Director Mr. Fortune had a bit of financial difficulties on his own.  He pledged his shares in Fortune Industries to the Bank of Indiana as collateral for a loan.  Then Mr. Fortune was diagnosed with a terminal illness and went into default on his loan.  The bank that holds the loan was working to re-negotiate but was purchased by a larger bank.  The bank holds a lien on Mr. Fortune's shares.  What a mess!

The company didn't want their largest shareholder to be a disinterested bank so they decided something needed to happen.  They offered Mr. Fortune's stake in the company up for sale, a few buyers materialized but weren't able to secure financing.  The Board then hired consultants to devise a way forward.  The consultants recommended to the company that they do a reverse merger and cash out small shareholders, delist and save $150,000 a year.  Then they recommended that a new entity purchase the company and convert the onerous preferred shares into a amortizing bank loan paid down over six years.  The result of this transaction would be the CEO, CFO, and Mr. Fortune would own 91% of the company with $12m in debt of which $6m will be owed to a bank and $6m will be owed to Mr. Fortune.  The money from the bank loan will be used to pay Mr. Fortune $6m in cash, and the other $6.3m will be given to him in dribbles through the payment of his note.  The bank loan has an interest rate of 6% while the note to Mr. Fortune bears a rate of 10%.

When the company announced their plan shares were trading in the $.46 range with consideration given to small holders paid at $.61 a share.  The shareholder base doesn't seem to like the plan and presumably they've been selling their shares in droves with the price most recently at $.16 a share.

The future

The above two sections are a lot to digest, so take a break and go get some coffee.  If you've made it this far we now need to think about two things, what will this company look like going forward, and with the sharp fall off in share price is there any opportunity here?

To get a grasp of what the company could look like once the merger is complete I think it's appropriate to look at a pro forma balance sheet and income statement.

Balance Sheet

I took the latest quarterly balance sheet and lumped in the new debt to create an estimate of what Fortune's balance sheet might look like on the day the merger is consummated:


My first thought when working through this was it's incredible how quickly wealth is transferred with debt. This was a company with a book value of $17m that is reduced to $6m in this transaction.  The shares are currently trading slightly above book.  Something to remember is over the next six years book value is going to double which is growth of 12% a year.  This is simply due to the reduction of the bank loan.  If the company used their cash to pay off Mr. Fortune it would reduce interest expense but wouldn't change the balance sheet at all.  I think this might be part of their strategy, use some cash on hand to pay down a portion of the loan to the founder.  Keep this thought in the bank of your mind when looking at the income statement.

Income Statement

In the company's going dark filing they published a nice income statement showing the results over the past few years in addition to what they expect to earn in the next two and a half years.  Of course no one knows the future, but these seem like reasonable estimates so I built my model with them.


I used the number of shares that will exist after the merger is complete for past results for comparability sake.  I also removed the SEC reporting costs the company expects to save in the future.  As you can see the projection is very similar to a leveraged buyout.  As the company pays down the bank loan interest costs decrease and net income increases.  Earnings should increase even if the company just treads water.

Debt will be 3x EBITDA and interest coverage will be covered by EBITDA 4.73x.  This income statement could change a lot with a few simple tweaks by management.  For example if they decided to use half of their cash on hand to pay down the Fortune loan net income would increase by $.004 to $.032 a share, a noticeable difference.

Good, bad, indifferent?

I think this transaction is good for the company, there is a lot of uncertainty if they continue down their current path.  While the transaction is good for the health of the company shareholders weren't pleased.  There are a number of ambulance chaser lawsuits and shares have sold down to $.16 a share. But all is not lost for someone who buys today.  A buyer at this price gets a company with a P/E of 5.35 at slightly above book value.  If they hold for the next six years and the company is able to pay off their loan book value will grow to $.22 a share and earnings could be in the $.05 range.  If trades at the same multiples in six years as it does today it could easily be a double.

Under a best case scenario the company is able to pay off both loans in the next six years which would result in a book value of $.56 p/s.  Doing that would increase earnings by a cent or more per share.  Instead of owning a double this could be worth 4x the current price or more.

Of course a lot of things could go wrong as well.  What was a very conservatively financed company has now become much riskier with a leveraged capital structure.  If the economy hits the rocks again Fortune could have a hard time paying down the loans and the built in increase in EPS and book value could never materialize.  There are plenty of private equity shops that built out little models like mine in 2007 who are looking at much different results right now.

Of course I'm no expert in looking at these situations, so if you see an error or something I missed please let me know!

I want to thank a reader for sending this idea along to me.

Talk to Nate about Fortune Industries

Disclosure: Long a small amount of shares for the odd lot tender

Wednesday, July 4, 2012

Is it cheap or just cyclical?

Sometimes I find the stocks that I write up on this blog, other times as with Ampco-Pittsburgh the stock finds me.  A reader emailed asking if I could take a look at the company, I read a quarterly filing but nothing really caught my eye.  Then I saw Geoff Gannon did a post on solid stocks most investors ignore at their own peril.  The post is worth reading if you have time, towards the end Geoff names 15 stocks which exhibit the following characteristics, past profitability, low EV/EBITDA, and little to no analyst coverage.  Lo and behold Ampco-Pittsburgh made number 11 on the list, I decided it was time to look at this company again.

Many long time readers know I'm a sucker for a stock that I have some sort of connection with, and Ampco-Pittsburgh is no exception.  When I stand at the top of my driveway the only building downtown poking above the hills is the one they're located in.  One of their subsidiaries has a terribly ugly sign next to a major highway that I commuted on daily for years.  I can't tell you the number of times I've read "Union Electric Steel Corporation" and thought they should tear the sign down and stick it in a retro museum.

There's the quote "If you don't know where you're going any road will get you there."  I find the quote is true when looking at stocks.  If I just crack open an annual report and start reading without any frame of reference I have a hard time putting things into context.  Sure I learn more about a company or an industry, but I don't have a measuring stick.  My solution is to take a quick look at a company then create a very simple thesis.  As I research this thesis serves as my framework.  Often the thesis will change as I learn more, that's fine, at least I have a starting point.  The thesis tells me why I'm looking at this company, no sense in looking at something if it's pointless.

Here is the quick thesis for Ampco-Pittsburgh:
-$197m market cap of which $77m is cash (39%)
-Selling almost exactly at book value, when I first looked they were at a slight discount.
-EV/EBITDA of 3.28
-EV/EBIT of 4.28

Background

Ampco-Pittsburgh is a holding company for five different companies broken down into two divisions.  The two divisions are Forged and Cast Rolled and Air and Liquid Processing.  The Forged and Cast Rolled segment pertains to steel production.  The Air and Liquid Processing segment deals mainly with refrigeration such as industrial sized systems, heat exchangers and centrifugal pumps.  The company has operations mostly in the US, UK and a joint venture in China.

Is the stock cheap or cyclical?

My first thought when I went to Ampco-Pittsburgh's website was that this must be a cyclical steel company and they were either punished with the rest of the steel producers, or they were at the top of their cycle.  In the 10-K there's a nice graph showing the company's stock along with other benchmarks, follow the Ampco-Pittsburgh line and contrast it to the Morningstar Steel Index line.


If I was a CFA I could run a regression and show that Ampco-Pittsburgh has more in common with the S&P then the steel industry.  Unfortunately I'm not a CFA (failed level 2, decided I'd rather blog than study) and a good old pair of eyes gets the job done in this case.  The company's stock trades closer to the S&P than the steel index. 

While the stock doesn't trade along with the steel industry the results over the past ten years are less conclusive.  Here is a little Excel blurb showing the last decade's worth of results:


This looks a lot more cyclical to me, here's the same numbers in a graph:

 

I'm inclined to say that Ampco-Pittsburgh is a cyclical steel stock due to the fact that 72% of its revenue comes from the forged and rolled steel segment.  The mix of steel vs refrigeration has been increasing in favor of the steel segment in recent years and this is a good thing.  The steel segment has a 15% operating margin whereas the refrigeration has only a 8% operating margin.

The company is a bit cheaper than competitors but nothing significant.  I also noticed the company appears to be struggling with a Chinese joint venture.  The joint venture continues to contribute losses to the equity statement.  The fact that there is a steel glut in China and management continues to hold onto the joint venture isn't an encouraging sign.  While the stock doesn't trade with industry peers the results seem to mirror industry peer results.

Importance of reading

I didn't have a good name for this heading, so I picked something functional.  One of my biggest goals as an investor is to avoid losses, if I can avoid losses gains should take care of themselves.  Many times an investor will be blinded by possible gains and fail to read fine print that could scuttle the entire investment, unfortunately Ampco-Pittsburgh has a bit of that fine print.

I believe a margin of safety is derived from the balance sheet first, income statement second and competitive position third.  A company with a great competitive position that's laden with debt and an inefficient cost structure is an investment to avoid.  Conversely an average company with a strong balance sheet and reasonable earning power can have a strong margin of safety if the price is well below a private market valuation.  When I evaluate a company I look to the balance sheet first, Ampco-Pittsburgh was no exception.

When I read the balance sheet a few lines stood out "Insurance receivables - asbestos", "Asbestos liability".  Now the word asbestos is a loaded word especially amongst lawyers and investors.  Ampco-Pittsburgh had acquired some companies in the past that brought their liability along with them.  One of the subsidiaries was dissolved but the asbestos claims are still outstanding, these things just don't go away.  There are currently 8,145 asbestos lawsuits outstanding.  The company paid $22.7m in 2011 to settle 1,501 claims or about $15,000 per claim.  I won't get into details but this number lines up with the going rate of what companies are willing to pay to settle these claims.

A casual read through the balance sheet results in the conclusion that the gap between what the company is likely to receive from insurance companies and the amount they expect to pay out isn't all that large, especially when paid over twenty or thirty years.  This is where the importance of reading comes into play, the balance sheet isn't the final word on the asbestos, the notes are.

The notes describe a few items I find really concerning, the first is the company sued their insurance carriers in 2011.  This is the result of a dispute about how much should be paid out for claims that occurred from 1981-1984.  I find this concerning because these issues are so long lived, something that happened 30 years ago is having a potentially material ripple effect now.  This has current ramifications as well, the company's balance sheet is modeled using estimated numbers for insurance receivables and potential claims.  If these numbers aren't settled from cases 30 years ago it adds an additional measure of uncertainty for me when I look at the balance sheet.  An uncertain balance sheet requires a greater margin of safety.

The second concerning issue is another asbestos note, the company mentions if they used a slightly different formula for calculating insurance receivables the number would be a lot lower.  This is another item that adds uncertainty to the balance sheet.  At the current price there isn't enough of a discount to account for this uncertainty.

Conclusion

I can't get comfortable enough with Ampco-Pittsburgh to investigate further, the asbestos uncertainty along with the industry position is enough for me.  Industry uncertainty seems like a strange reason to avoid an investment.  Ampco-Pittsburgh is selling in line with industry peers, maybe at a slight discount but nothing extraordinary.  If I was forced to invest in steel I would prefer a tangible asset bargain, or I would prefer to buy the best company in the industry.  If the entire sector is depressed the industry leader will usually have the balance sheet to weather the storm, and they'll recover the quickest and strongest.   Ampco-Pittsburgh could be an attractive investment if steel recovers and the company's share price remains flat while results improve, although that seems unlikely.  Until then I'll keep hunting..

Talk to Nate

Disclosure: None




Sunday, July 1, 2012

Why one reader won't invest in Solitron, and my response

I received an excellent email recently from a reader who explained they took a look at Solitron Devices and decided to pass on because they saw too many red flags.  As long time readers know I've held Solitron for a few years and have written the company up in the past.  More recently I wrote the Board a letter urging an annual meeting and a share buyback.

I wanted to respond to the reader's questions publicly because I suspect other investors might have similar questions and my responses would be helpful.  I have taken the following format, the reader's email is in italics and my responses are below in non-italics text.  I have used arrows to break apart each question.

>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>


And the answer I arrive at says no, or at the very least there's simply too many warning signs for my comfort. After all, the wise man did say we never have to swing if the offering is not to our liking.

Where do I start? With some numbers.

Let's first take a look at total compensation of the CEO which, according to the latest 10-K, stood at $379,918 in 2012 compared to $471,182 in 2011. Not too bad in this age of multi-millions employment contracts. 

That is until put in perspective with the net income of the company, which stood at $746K and $1,261K for 2012 and 2011 respectively. In other words, the CEO took home a total amount equivalent to 50% of net income available to shareholders in 2011, and 37% in 2011. Nice work, if you can get it. I probably do not need to mention that any reduction in expenses such as compensation flows directly to the bottom line (after taxes, which are minimal in this case).

Not saying it is the case, but if all you intend to do is ensuring your salary is paid in the upcoming years, parking cash in treasuries would actually make some sense...  

This could be looked at two ways, the first is that the CEO is overpaying himself and it would be nice to get a run of the mill operator in there who'd take the job for $200k.  I would be surprised if you could get a CEO for less than $200k.  My idea situation would be a low salary with a high stock component, not options, but actual stock.

The second view is this CEO is actually running a one man show at Solitron.  Based on his titles I'm inclined to believe this.  For a small company and as an executive wearing many hats it's plausible that Mr. Saraf is holding the whole operation together and his departure could jeopardize client contracts.  

While I would love to see compensation much lower a reasonably compensated CEO is possibly the rarest of creatures in the world if US listed stocks.  I have seen MANY companies the size of Solitron where the CEO is walking away with a million a year.


CEO pay scales up, but it unfortunately doesn't scale down past a certain point, I think that's what we see at Solitron.  


>>>>>>>>>>>>>>>>>>>>>>>>>>>>

Then there's the environmental liability. I've read here and on the letter sent to the "Board" (I simply cannot bring myself to write it without quotation marks), that the liability ends in 2013, and elsewhere in 2016. I may be dead wrong, but I read the 10-K differently. Note 2 of the financial statements reads : 

"At February 29, 2012, the Company is scheduled to pay approximately $1,002,000 to holders of allowed unsecured claims in quarterly installments of approximately $7,000. As of February 29, 2012, the amount due to holders of allowed unsecured claims is accrued as a current pre-petition liability."

And lo and behold, this account ("Accounts payable-Pre-petition (Note 2)" in the balance sheet) did indeed decrease to $1,002K from $1,030 in 2012. Consistent with 4 quarterly instalments of $7,000. Which means that at the current rate of payment, it will take Solitron 145 more quarters to pay it off (unless they decide to accelerate payments, which so far they have not).

This is a tricky issue there are actually a number of liabilities and settlements, let me try to break it down.


There are two liabilities, the pre-petition liabilities that you mention, and the environmental liabilities.  Pre-petition liabilities are items the company owed before filing bankruptcy.  During the bankruptcy proceedings they were negotiated down to a level the court believed the company could pay, this is the $1m you see being paid in small dribbles.


I feel that being able to negotiate a $1m liability down to $28,000 installments shows savvy on the CEO's part.  If you do a time value of money on this settlement the creditors are walking away with a few pennies on the dollar.


Here is the line mentioning dividends:


"Pursuant to the Company’s ability to pay its settlement proposal with the USEPA, the Company agreed not to pay dividends on any shares of capital stock until the settlement amount for environmental liabilities is agreed upon and paid in full." (2012 10-K, p17)


The key in this line is the USEPA agreement that Solitron made, so let's look at that agreement.  Here's what it is:


"The Settlement Agreement required the Company to pay to USEPA the sum of $74,000 by February 24, 2008; the Company paid the entire sum of $74,000 to USEPA on February 27, 2006. In addition, the Company is required to pay to USEPA the sum of $10,000 or 5% of Solitron’s net after-tax income over the first $500,000, if any, whichever is greater, for each year from fiscal years 2009-2013." (2012 10-k, p9)


Solitron is required to pay $10,000 or 5% of their net income exceeding $500,000 from 2009 to 2013.  Based on the 2012 annual report Solitron paid out approximately $10,000.  If you look a bit further in the annual report they actually mention they reserved $23,000 for 2012 and 2013 payments.  Once the final payment is sent next year the company has no agreement with any other creditor to not pay dividends.


I also want to highlight that when I look at the liquidation value of the company I presume the entire pre-petition amount is due today, the full $1m and deduct that from assets.  This is not true, but it examines a worst case scenario.  Even under that worse case presuming creditors needed to be paid off today the company is still trading for 33% less than NCAV.

>>>>>>>>>>>>>>>>>>>>>>>>>>>


Then there's the frequent changes of auditors, which in itself is actually quite impressive:

2011-2012  Meeks International LLC
2009-2010  Friedman, Cohen, Tubman & Company LLC
2006-2008  DeLeon & Company PA
2005  Goldstein, Lewin & Co. CPA (could be the same Goldstein as below, who knows?)
2004  Berkovits, Lago & Company LLP
2000-2003  Goldstein Golub Kessler LLP
1997-1999  Milward & Co CPAs
1995-1996  BDO Seidman LLP
1994  Arthur Andersen & Co

This could very well be nothing. But one thing is certain: frequent changes in auditors is never a positive sign. A one-time occurrence can easily be explained to reduce professional servcies costs, but at least in one case the associated costs increased with the change.

This was something I was concerned about when I first came across the company so I called the CEO to ask about it.  It was explained that each switch they were able to squeeze the new auditing firm and get a lower price.  If the CEO doesn't care about shareholders I'm not sure he cares about the impression switching auditing firms would have either.  The checks I made of professional fees supported his claims.  

I think this is where the investor really needs to leverage their own knowledge and skills.  The Chinese reverse merger companies all had clean audits until after they were revealed as frauds.  Enron had a clean audit for years as well.  Auditors are not out to protect against fraud, that's the investor's job.  I've done some quality of earnings checks, and outside of actually calling the bank to verify the Treasuries exist I'm reasonably confident this is an up and up firm.

One other item to consider when the company appealed the environmental claims they had to submit their books to the court and regulators to support their assertion that they couldn't pay the initial claim amount.  I don't know if the court or regulators ever inspected their books, but they looked at something before revising the settlement downward.

>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

Members of the "Board" whose terms have all expired, lack of annual meetings, late filings with the SEC, 80% vote required to amend company bylaws...

This is a very legitimate claim against the company, something that concerns me as well and a factor that persuaded me to write the company a letter.

>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

And of course, there's the poison pill you already mentioned being adopted seemingly as a response to the arrival of a new (and currently largest, if not including rights) investor.


It's easy to see a poison pill as a shareholder and jump to the conclusion that management is only out to protect their own job.  There is a second possibility that someone alerted me to, that if an outside shareholder acquires more than 15% of a company's shares within a certain amount of time the target company's net operating losses (NOLs) could be viewed as invalid by the IRS.


Let me try to simplify this a little bit.  Solitron is allowed to carry forward losses they experienced in the 1990s to offset income earned now.  There is a time limit on the NOLs based on IRS rules.  If a shareholder comes along and suddenly buys up 20% of Solitron in the view of the IRS Solitron's NOLs are no longer able to be carried forward.  This would mean any income earned would be taxed.  To prevent this companies have put in place rights offerings at a 15% threshold which protect the NOLs.  The purpose of the rights offering isn't to blunt a takeover attempt, it's to protect the NOLs.


There are a lot of articles on the internet explaining this mechanism, here is a recent ruling where a company set their rights threshold at 4.99%: here


Here's another article with good background on NOLs and poison pills: here

Conclusion

I don't blame you for walking away from Solitron, there are hundreds of cheap companies to choose from so why put your money in something that makes you uncomfortable?  My view is any company selling for less than NCAV is going to have some issues, either management issues, industry issues or external issues, that's why the shares are cheap.  The goal of buying a net-net is that the discount to a private market value is so great even a few errors can be made and the investor will still realize a profit.

The rhetorical question I ask is at what price would these problems be ok?  Is trading below net cash cheap enough?  What about 50% of net cash?  I prefer to look at stocks on the basis of what I think they might be worth to a private businessman.  Buying Solitron for less than liquidation value I believes gives a sufficient margin of safety.

Talk to Nate about Solitron


Disclosure: Long Solitron Devices