Blogvesting

An enduring principle in value investing is to buy at the point of maximum fear. When a company becomes embroiled in complicated and uncertain legal troubles, it becomes shunned by Wall Street, and its stock can often be bought at unbelievable bargains. Such stocks often rapidly regain their true value as soon as the legal troubles are cleared up. A discerning investor who is able to correctly analyze all the legal issues involved and predict a probable outcome may be able net a spectacular return in a relatively short time. Cardiac Science (CSCX) is a company in such a situation.

Cardiac Science is a company that primarily makes automatic external defibrillators (AEDs). AEDs are required to treat people suffering from sudden cardiac arrest (SCA), which is a sudden electrical malfunction of the heart that causes cardiac arrest. A cardiac arrest is different from a heart attack, where blood flow to the heart is impaired. A cardiac arrest may be caused by a heart attack, or a heart may simply spontaneously develop an abnormal electrical rhythm and stop beating normally. If heart contraction does not resume within 4 minutes of arrest, the patient suffers irreversible brain damage, and death occurs rapidly thereafter. Due to the extremely short window during which medical treatment must be administered, the mortality rate for SCA is 95% for an out-of-hospital attack, whereas immediate treatment with an AED brings mortality rate down to 50%. An AED is able to automatically detect whether abnormal heart rhythm is present, and will give an escalating series of shocks to restart the heart, and will not shock the heart if abnormal rhythm is not present. Modern AEDs are safe enough to be used by even untrained personnel, and AED use is covered by Good Samaritan laws, which prevent liability for AED users if the device is used by volunteers in good faith. All emergency response personnel are equipped with AEDs, and laws mandate that AEDs be available at schools, cruise ships, airports and bus terminals.

CSCX sells the well-regarded PowerHeart AEDs, and holds a wide range of patents relating to AED technology, including patents on software that allows AEDs to self-test frequently, and patents on AED mounts that sound an alarm and automatically alert emergency services when opened. CSCX was experiencing rapid growth in sales as a result of laws mandating AEDs in various buildings. However, in 2009, it was revealed of its entire installed base of 300,000 AEDs manufactured before August 2009, approximately 1 in 75,000 contained 2 components that could fail, and this has resulted in a failure to deliver therapy in 2 cases over the past 6 years. The company suspended production for 5 weeks as it sourced alternative components, and resumed production in September 2009. Still, there remains the important problem of 300,000 potentially faulty AEDs in the field.

Under advice from outside experts and lawyers, the company decided that it was irresponsible to recall all 300,000 AEDs when it did not have the inventory to replace the AEDs, and given the low frequency of the failure, it was safer to leave the AEDs in the field than to recall the AED and have the AED unavailable for weeks. A main reason that the faulty components took so long to come to light was that the self-test software had been unable to detect the failure, and the company decided to work on a software update that would detect the failed components, and then specifically replace those AEDs. The software update was completed ahead of schedule in February 2010, just in time for CSCX to be hit with an FDA warning letter, which stated that FDA views the software update to be an unsatisfactory response to the problem, as it only detects the problem and does not fix it, and that leaving faulty AEDs in the field constitutes disregard of public safety on the part of CSCX. The letter threatens possible fines, seizures and injunction for CSCX if the matter is not resolved promptly. The gradually recovering stock promptly took another swoon.

Before the disclosure of the faulty AEDs, CSCX had free cash flow of approximately $12 million in 2008, up from $7 million in 2007. In 2009, CSCX set aside $18 million as liability for the recall, and posted an earnings loss. The company has $30 million in cash, $60 million in book value, and no debt. Currently, CSCX has a market capitalization of almost $50 million. A number of future scenarios are possible

Worst case scenario: FDA gets a court injunction forcing the company into an immediate recall of all 300,000 AEDs, and the company is barred from selling AEDs until the recall is complete. This leads to the collapse of the company, as the company is unable to replace all AEDs, and all $30 million of cash is expended in recalling whatever AEDs it can, leaving no value for shareholders. This scenario is unlikely to happen, as FDA will realize that it essentially means the death penalty for a company with a relatively minor infraction, and is an anti-consumer move since it leaves a huge installed base of AEDs without future service and support.

Medium case scenario: FDA fines the company $10 million for the delay in recall. The company spends $50 per AED to roll out its software update and replaces faulty AEDs, at a total cost of $20 million. This consumes all of its cash. Reputational damage results in severe decrease in sales, resulting in a 60% drop of free cash flow to $5 million annually. Applying a PE of 10 to that cash flow brings us to the current $50 million market capitalization.

Best case scenario: The company rolls out its software update to all AEDs, and expends $20 million in so doing. All faulty AEDs are replaced. The FDA is satisfied that this is a reasonable and responsible course of action, and fines the company a relatively modest $5 million. Reputational damage is minor, leading to a free cash flow of $10 million. Applying a PE of 10 to that cash flow brings us to $100 million market capitalization, a double from current levels.

Given that there has been multiple recalls of other brands of AEDs recently, and that Cardiac Science has a longstanding reputation as a purveyor of quality products, I believe that CSCX will survive this crisis in good shape.

Risks : CSCX is at risk of monetary fines and injunctions from the FDA.

Disclosure : I have a long position in CSCX.

Over the weekend, I was inspired by several blogs (The bull case for Conn’s; How to Analyze Receivables & Inventory; Conn’s Inc.) to dig further into the annual reports of the company CONN. What I found was very interesting, and highlights the dangers of investing blindly solely on the basis of financial numbers, without peering deeper into what those numbers mean.

Conns is a retailer of electronics and electrical appliances, with 75 stores in Texas. On casual inspection, the company appears to be moderately undervalued. On an asset basis, Conns has a book value of $337 million, compared to a current market cap of $102 million. On a cash flow basis, Conns has had declining earnings for years, earned $25 million in 2008, and will probably earn $2-12 million in 2009 (depending on whether one calculates on an earnings or cash flow basis). The problem, as has been pointed out before, is that Conns relies heavily on extending credit to its customers to buy its products in its business. Therefore, Conns is a combination of a retailer and a bank, and both parts of its businesses should be examined.

The electronics retail industry is a cut-throat one, as seen by the bankruptcy of Circuit City. While some have argued that Conns should gain additional market share with the demise of Circuit City, revenue has been declining in 2009 versus 2008, suggesting that Conns is losing market share instead. I detect no obvious reason why one would want to shop at Conns versus, say, at Best Buy or Walmart, except perhaps for its more generous credit policies. In the most optimistic scenario, disregarding finance charges, free cash flow is about $12 million. However, current trends of declining revenue suggest that this will further decline in 2010. The upshot is that the retail business is poised to generate rapidly declining cash flows, and the bulk of the intrinsic value of Conns is in its assets.

More than 50% of sales at Conns is financed by Conns itself. In the past, Conns has offloaded credit risk to other investors by securitizing the loans and selling them in the secondary market. Typically, such securitization deals are structured as a trust with various tranches, and the most toxic tranche which bears the risk of first loss is usually retained by the originator, as a guard against reckless underwriting. Conns has almost $150 million of these toxic securitized interests on its books. Since the collapse of the securitization markets, Conns has been unable to offload loans off its books, and hence customer receivables have been building up at a startling rate of more than 100% in a year, reaching $136 million in 2009. To finance these receivables, Conns has been drawing down its line of credit.

Clearly, Conns entire business model was based on easy credit and is now unsustainable. At some point, banks will stop extending credit to Conns, and Conns will no longer be able to extend credit to customers. The ensuing loss of 50% of revenue will be a great challenge to most businesses, and will be fatal in an industry with razor thin margins like retail. Banks and creditors will demand an immediate liquidation to protect their assets. The $150 million of securitized on its books are likely to be worth zero, given that even modest 5-10% losses in the underlying loans will likely wipe out the entire toxic tranche. The other $136 million of customer receivables will likely be sold under duress, generating an additional haircut on top of credit losses on the receivables, so I estimate a value of 50% recoverable ($70 million). I estimate that the value of inventory and cash will cover current liabilities, while the long term liabilities of $120 million will be partially covered by the sale of $60 million of hard physical assets (stores, equipment and land), held on the books at cost. In the best case scenario, the physical assets are sold at prices way above their book value (likely but not completely certain), meaning that after liquidation, the company has residual value of about $70 million derived from its customer’s receivables. This exact scenario, while speculative, is not particularly far-fetched, and is the primary reason why the company is now trading at a value of $100 million market cap, and has an incredible 44% short interest despite this. In summary, stay away from this company.

Stock Investment Risks: This is a retailer with a broken business model in its terminal spiral of death. Enormous uncertainties surround the recoverable value from the enterprise.

Stock Investment Disclosure: I have no position in CONN.

Share prices of companies that make industrial equipment tend to be very volatile. These companies are especially dependent on a healthy economy, and every time a new batch of economic statistics is released, the share prices of these companies gyrate wildly depending on the prevailing mood. However, to investors willing to take a longer-term perspective, the wild price swings in conservatively managed equipment manufacturers can be a source of great opportunities. One such company is Chart Industries (GTLS).

GTLS Stock Analysis:

Chart Industries is a company that makes equipment for the production, transport and storage of industrial gases. Its products include equipment such as cold boxes for liquefaction of gases and pressurized cryogenic cylinders for gas transport, and Chart Industries is the leading supplier in several of these product segments. The largest portion of their sales come from natural gas related businesses (62%), with the second largest segment being businesses that produce cryogenic gases (25%, mainly liquid nitrogen), and the smallest segment being businesses that produce medical respiratory gases (13%). About 65% of sales come from outside the US, but it is the US market that has the largest potential for growth, with the discovery of large natural gas deposits in the US and the tantalizing possibility of US energy independence.

Recently, enormous deposits of natural gas have been discovered in shale rock in Pennsylvania (the Report in New York Times). The natural gas deposits are large enough to theoretically power all cars in the US if the entire fleet is converted to use electrical power, thus ending US dependence on foreign oil. In addition, natural gas is a greener fuel than oil or coal, producing less carbon dioxide per unit energy released. The major obstacle to widespread use of natural gas is that utilization of natural gas requires expensive investment in equipment to liquefy, store and transport the gas. However, given that the alternative is funding expensive wars in foreign countries, there has been increasing talk of embarking on a large scale natural gas initiative in the US (a related report in New York Times), which, while expensive, would provide employment and energy security for the US.

Chart Industries has been consistently profitable through the financial crisis. Analysts predict that revenues will continue their decline in 2010 and 2011, though the company is still expected to be profitable. The company currently trades for $470 million, about 1x book value. I am predicting a free cash flow of $50-70 million conservatively, meaning that the company is now trading at below 10x earnings. The company has $190 million in cash, and $240 million in long term debt ($160 million due in 2015, $80 million due in 2012). I believe that the company has tangible assets (factories) and intangible reputation that is difficult to replicate, and that it will easily survive the downturn to capitalize on the growth industries of the future.

Stock Investment Risks : The company is in a cyclical industry, and is tied to commodity price swings. Share price also tends to be highly volatile due to low float.

Stock Investment Disclosure : I have a long position in GTLS.

Harvest Natural Resources (HNR) is an oil producer whose major oil producing assets are located in Venezuela, where it is subject to confiscatory taxes or outright nationalization by Hugo Chavez. Its major attraction is it cash-rich and debt-free status. HNR has approximately $2.85 per share in cash free and clear. The rest of HNR’s value derives from possible cash flow from its Venezuelian assets, as well as oil exploration projects now ongoing in other parts of the world.

HNR has been extensively written up previously (see this excellent article at Seeking Alpha, as well as writeups at Value Investing Club), and I agree with the central theses of these articles. In a nutshell, although contract law does not exist in Venezuela and cash flow is likely to fluctuate according to the whims of Chavez, it is unlikely to drop to zero. In other nationalizations that Chavez has ordered, the companies have been reasonably (but not lavishly) compensated for their losses, and have generally found it desirable to continue operations at low to moderate levels of profitability, if only to extract residual value from their now annexed assets. Chavez is a power-hungry thug, but he also understands that he needs foreign expertise to continue to extract money from Venezuela’s natural resources, and he is intelligent enough to realize that if he wants somebody to work for him, he has to pay them at some level.

My main purpose for investing in HNR is that it is a low-risk high reward way to hedge inflation risks and ride any upside in oil price. HNR should not fall past $3 due to its cash, but can possibly ride up to $10 or more depending on prevailing oil price and Chavez’s whims. I believe China will now vigorously diversify away from its huge US dollar exposure by aggressively bidding for commodities as well as commodity-producing assets. Rather than buying gold (a non-productive asset, and one in which China found impossible to accumulate holdings of any size without moving the gold price), China could stockpile crude oil (a productive asset, and one with a much deeper and broader market) and build a Strategic Petroleum Reserve much like the US has done. Stockpiling an essential input to its economy at historically cheap prices makes a lot of economic and military sense. Along the same lines, I also have positions in ZINC and MEOH, both of which are premier companies in their industries and should serve as excellent inflation hedges.

I now hold HNR at an average buy-in price of $5, and am unlikely to liquidate this position without hitting at least $8-10.

Biogen Idec (BIIB) is a biotechnology company with two major products, Avonex (an interferon), which treats multiple sclerosis, and Rituxan (a monoclonal antibody), which treats non-Hodgkin’s lymphoma. Near-term growth is likely to come from the drug Tysabri, another monoclonal antibody meant for treatment of multiple sclerosis. Tysabri was withdrawn from the market after several clinical trial patients developed progressive multifocal leukoencephalopathy (PML), but was later reintroduced into the market when FDA determined that the benefits outweighed the risks. Despite a few additional reports of PML, sales of Tysabri have grown rapidly, and the company has a robust pipeline of potential drugs. During the wave of pharmaceutical-biotech mergers that took place in 2008, BIIB’s stock was driven into the $80s as its acquisition by a major pharmaceutical company was widely anticipated. BIIB plummeted when it’s CEO revealed that there were no buyers willing to bid for Biogen. A major factor for the lack of bids is believed to be the complicated contracts covering its two main products. Both products were co-owned or co-marketed with other major pharmaceutical companies, which means that much of the value will be derived from the pipeline of drugs, which is highly uncertain. However, I believe that the decline has overshot, and based on the cash flow potential of Biogen’s 3 major drugs, even assuming a zero value for the pipeline, the stock is siginificantly underpriced. With analysts estimating an EPS of $3.70-$4.30 for the current year, and minimal 10% growth in profits year over year, BIIB is trading at a conservative PE of 11-12 at a share price $45-46. Furthermore, BIIB is in the drug industry, which tends to perform adequately even in recession. The biotechnology industry in particular is a coveted segment of the drug industry, as FDA has not provided a process for the testing and manufacture of biotechnology drugs, which are significantly more complicated to manufacture than simple chemical drugs. This makes it very likely that even off-patent biotechnology drugs will remain very lucrative, which is a major reason for the recent acquisition of biotech companies by traditional pharmaceuticals.

Fresh Del Monte Produce Inc (FDP) is a vertically integrated producer of fresh and canned fruits and vegetables. While most fruits and vegetables require minimal processing and are typically shipped directly from local farmers to supermarkets over several hundred miles, some produce (notably bananas) are shipped over thousands of miles and/or require canning and extensive processing, and therefore require an intermediary which can handle these diverse operations. FDP owns and operates ocean freighters, land trucks, distribution depots, canning/juicing factories, and of course, farms. The chief attraction of FDP is that it is in the recession-proof food business. Analysts are predicing EPS of $2.00 to $2.40 for 2009. I estimate that FDP will sustain a free cash flow of at least $1.50 per share in 2009. With a modest $150 million in LTD (1.5x annual free cash flow), FDP is trading $15-16, which is around PE 10 off my conservative estimate of FCF, and has insider trading at the $14.50 level. I have a largish position in FDP at a small loss, and intend to add more if the price drops further.

Regal Entertainment group owns the largest theatre network in USA, mainly under the Regal Cinemas and United Artists brand. I initiated this position due to the reputation of movies being a robust industry in a depression, and also because I had a price target of $15, which is a PE of 20 over its previous year’s EPS of $0.73. During the two months when I held it, the stock has underperformed the general stock market, and does not appear to be moving towards the price target. I liquidated my position for a small profit of 6% over 2 months. Perhaps the threat of Internet distribution of movies is threatening the core business of RGC, or perhaps a PE of 20 is simply too rich in this climate. I chalk this one up as a miss.

Ball Corporation is a major manufacturer of metal and plastic packaging for food manufacturers, with a minor business in aerospace and defense. Almost 80% of revenues are derived from making aluminum cans for beverages, with the remaining 20% from plastic packaging and the aerospace business. A significant amount of revenue is derived from sale of beer cans, with Ball having 30% of the US market. This is largely a mature industry, although there are small pockets of innovation and higher-than-normal profit niches, such as the introduction of vented wide-mouth cans for pouring, and cold-activated cans. Profitability is dependent on the price of aluminum and demand from major customers such as Coors and Miller.

Free cash flow in 2008 came in at around $300 million, or $3.20 per share. Analyst estimates for 2009 range from $3.70 to $4.00. Assuming an EPS of $3.50, BLL should trade at $35 at a PE of 10, $44 at a PE of 12.5, and $53 at a PE of 15. There appears to be major support at $37.50, and some resistance at $44. Given the recent improvement in economic conditions, it is likely that demand for its product will show a slight improvement. For an established company in a defensive industry, despite a moderate exposure to commodity price swings, I feel that a PE of 12.5-15 is reasonable. I have initiated a position at a price of $41.50.

To the 5 people who are still reading this blog, I apologize for not writing any posts for the past 2-3 months. I was experimenting with several new strategies incorporating a technical analysis component in my stock analysis. I felt that, as an amateur investor, I could not compete with professional stock analysts, all of whom can read the same annual reports that I can read, and have the time and resources to do back channel checks that I cannot do. My only advantage is my small size, which means I can enter and exit positions without moving the price.

Early in this experimental stage, I tried several charting techniques, but eventually found that because they were too “black magic” and did not satisfy my rational side, I did not have the confidence to take large positions with them. Eventually, I found two technical factors that were backed up by academic studies and grounded in human psychology. Firstly, the stock market overeacts to events, and corrections and pullbacks occur with a greater than normal probability. However, I found that this mean reversion effect takes place over time frames of only 1-2 days, and is really suited for automated trading rather than human trading. Secondly, runs in the stock market occur with greater length and frequency than a random walk, a phenomenon called the momentum which has been attributed to many causes, including the the herding tendency of investors and to institutional investors moving prices when they enter or exit a stock. The momentum effect is most pronounced on small cap stocks, suggesting that the role of institutional investors is dominant. I figured that if I could try and spot stocks which are starting a trend, and then use manual fundamental analysis to figure out a plausible investment thesis and thus predict where the price is headed, I could hop onto stocks just when they are making a move, and then switch to other stocks once the move is finished, maximizing my returns.

For the past 3 months, I have used a strategy where I screen stocks with the ADX technical indicator to identify stocks which are in a new uptrend or downtrend, and then manually go through them to pick out the stocks where a plausible investment thesis exists. Often, I find that due to my fundamental analysis, I am able to predict quite accurately what price level the stock is moving to (stock prices often move to round PE values). This strategy, executed in the context of a rising market, has resulted in my outperforming the stock market by a significant margin. I found that if I cut my losses within 1 month if the stock doesn’t move as I predicted and let my winners run to my anticipated targets, my profits vastly exceed my losses despite the fact that I have only a 60-70% chance of picking winners.

Because I am not a long term stock holder with this strategy, and to keep my workload reasonable, my analysis of each stock will necessarily be much shorter and shallower than my previous analyses. In the future, I will be presenting my analyses as short blurbs about specific stocks instead of the more in-depth articles that I have been writing. I also intend to devote susbtantial time to the study of human psychology and how it interacts with the stock market to present opportunities that can be taken advantage of.

The latest banking rescue has been widely panned by the punditry, with even Krugman voicing his dismay, yet was warmly received by the markets. The pundits are correct : this plan will not rescue the bad banks. Instead, the new plan will grease the flow of credit into the real economy, and lift all banks, both good and bad, along with the entire economy. In fact, I think that the new plan is a piece of genius. It finally rewards the good guys instead of the bad ones.

From the viewpoint of rescuing banks, the plan looks like a failure. It will accelerate price discovery of loans, which may cause the balance sheets of weak banks to actually deteriorate rather than improve. Banks will not tender their loans for sale if they know that the loans will fetch prices lower than their marked down value. The bad loans will stay on the books of the bad banks. What will come off the books of the banks are the good loans, those that are likely to perform well, but have been lumped together with the bad apples and now are stuck on the balance sheets of the good banks. By getting those loans off their balance sheets, the good banks will be able to do what they do well, assess credit risks and make more loans to good risks. The net effect will be an extension of credit to the economy, but in an intelligent manner, by making use of the expertise of the good bankers.

Under this plan, two groups will make out like bandits. The first group are the good banks which will be able to securitize and unload their good loans onto the markets, enabling them to make more loans. The second group are the investors in those securitized loans, who will be getting a huge government-sponsored loan on intrinsically profitable loans, leveraging their profit many times. To me, this is a refreshing change. Rather then rewarding the bad bankers who could not differentiate good credit risks from bad ones, and rewarding investors who relied on leverage to obtain eye-popping gains, the government is finally rewarding the good bankers who knew good from bad risks, and the conservative investors who did not rely on leverage and kept their powder dry.

Part of the reason why the plan has been so roundly criticized by bloggers is that the favored solution has been outright nationalization. The previous solution of extending government guarantees to loans on the books of the banks has a negative effect on the economy. It does not make the banks in question healthy enough to lend again. Instead, it is effectively a tax on the good banks to throw at the bad banks, since the bad banks are in business only because of the government guarantees. Nationalization is a possible way out of the impasse. Certainly, a nationalized bank can be made lend again, relying on the balance sheet of the government. However, this is also a tax on the good banks, because depositors and investors will prefer dealing with the government over private parties. The new Geithner plan suggests a third way out that avoids nationalization and is economically beneficial. Pump so much money into the good banks that they can now take over the bad banks. Although a bank such as Citigroup (and perhaps Bank of America) looks too large to be sold to any group, if the current plan manages to pump enough money into the good banks, there is hope that a conglomerate of the good banks can absorb a sufficient portion of Citigroup’s assets to finally solve the problem. It may seem unlikely now, but then again, mega-banks such as Wachovia, Merrill Lynch and Wachovia once looked too big to be taken over too.

The final criticism of the current Geithner plan is that it is too punitive on the taxpayer, who stand to lose too much. However, the bad loans have already been made and the losses have already been incurred. When the decision was made that bad banks cannot be allowed to collapse, it is just a matter of determining the combination of parties who should be made to shoulder the losses. Due to the magnitude of the losses, realistically speaking, the taxpayer has to shoulder the lion’s share. The only question is what mechanism to use to shift the losses onto the taxpayer. We can extend government guarantees to loans, nationalize banks, or pay private investors to absorb the losses. It seems to me that the last way is the only way which rewards the good guys, and are the least objectionable.