The Fire Drill

These days the only thing for certain is that there is a buoyant amount of uncertainty in the markets. Government reform, fiscal and monetary policy, unemployment, and earnings are a short representation of the factors contributing to the recently choppy markets. With blind (literally) forecasters predicting crashes through technical patterns with names such as the “Hindenburg Omen“  and Jet Blue flight attendants jumping out of 757’s, it’s  no wonder why many people are scratching their heads unable to make sense of it all. And who’s to blame when Ben Bernanke is describing the outlook of the economy as “unusually uncertain”? On August 26th I came across an article by James B. Stewart of the Wall Street Journal discussing the recent spike in M&A that only helped to make things even muggier. Let’s discuss.

Mr. Stewart makes the argument that a surge in deal volume can be useful as an indicator of an up and coming downturn in the financial markets. His hypothesis is backed with some data, such as the all-time record M&A volume of 2007 that was followed by the brutal “great recession”. Furthermore, he states that as the market began to turn positive in March of 2009, at which time M&A activity was scarce. Should we be satisfied? A week of roughly $90 billion in deal volume – sell, sell, sell?! …. No! It is never that easy.

The mid-point of August has seen an aggregate volume of $197.6 billion in M&A transactions, which includes the recent week of $90 billion, but this is still some way from records made in August 2006 when M&A activity totaled $260 billion. Moreover, although 2010 may top the depressed levels of 2008, it is highly unlikely this figure would top the record $4.3 trillion of 2007, especially with all the aforementioned uncertainty. To further drive my point home, let us look at Intel’s acquisition of McAfee. Intel’s offer came in at $48 a share, a 60% premium at the time of the announcement. A closer examination shows us that Intel only paid a premium of roughly 4% to McAfee’s 52-week high, not exactly what good ‘ol Alan Greenspan would describe as irrational exuberance.

With U.S. public companies holding $2.03 trillion in cash on their balance sheets at the end of the first quarter, maybe executives are getting antsy and are tired of the measly return they are receiving from the federal government, but there are alternatives such as share buybacks and dividend distributions. Can all of the year-to-date transactions be described as great values and bright decisions? Probably not, and to be honest, I do not know. I refuse to make any predictions on the direction of this schizophrenic market, but keep in mind as the Oracle Of Omaha once said “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”

As of today HQS is trading at levels last seen around 1997-98. Before I delve deeper into some of the potential reasons behind this, I’d like to take a step back and process this rationally. What kind of numbers (Revenue, EPS, Margins) were being reported by HQS in 1998?  

• Revenue FY 1998:  $2.56 mm
• EPS: $0.04
• Gross Margin: 32%

Let’s compare the numbers from 1998 to the most recent FY:

• Revenue FY 2009:  $72.9mm
• EPS: $0.60
• Gross Margin: 42%

By  looking exclusively at the above numbers and not having any further knowledge about the business, this seems to be  a steal. This brings me to the various reasons provided as to why the stock may be trading at such depressed prices. First, there is plenty of negativity towards  Norbert Sporns, the CEO at HQS and his arguably poor decisions of the past (Sporns has a tendency to raise money in a dilutive fashion, avoiding other less costly means of financing with the most recent being an $11mm equity raise in August 2010). Second, is the voting power of the common shareholders, none.  The preferred effectively hold all of the voting power and management happens to hold the preferred. Finally, the revenue composition consists of sales recognized before the cash has actually been received. HQS has a large amount of A/R that seems to be only modestly improving.

HQS is not for the faint of heart, as there are many fishy (pun intended) reasons to stay away, but perhaps these various reasons provide a great deep value investment. Paraphrasing Ben Graham, he denounces the risk of a security to be tied to volatility, as all securities move up and down in price depending on the situation Mr. Market provides. It is up to the investor to buy or sell the security at the various prices the market presents. A value investor is not tied down to price and not a slave to time, as all returns are approached as absolute and not relative. A value investor spends his time on looking at the current condition and value of a security relative to the price being provided by the often irratic market.

Final note: After the August $11mm equity raise at 3.61 a share, the stock still trades at a discount to its intrinsic value using the NCAV method mentioned in my earlier posts. I genuinely believe that all of the reasons given above are debatable and can be countered. At todays price of $2.70 a investments pose some sort of uncertainty and risk. By no means is this post sufficient enough to make a buy or sell decision. I hope this has sparked some interest to dig deeper on your own!

When searching for places to put capital to work, the first step usually involves filtering for concerns that meet your investment criteria. After running a screen based on the NCAV method (Current Assets – Total Liabilities) that resulted in a modest amount of companies, the second step involves a bottom-up approach to further refine  the potential investment opportunities. This post will discuss a stock that came up on the screen and after further research still met my requirements, let’s discuss.

HQ Sustainable Maritime Industries, Inc (AMEX:HQS) is involved in the business of aqua-culture. It is a vertically intergrated company that manages the entire process from production of feed to the marketing of their various talapia based products. To get a better sense of where the value lies, lets take a moment to discuss the most recent quarter’s balance sheet. Summing up the current assets (Cash & Equivalents, Recievables, and Inventory) we reach a total of  $98 million on the conservative side.  The total liabilities come out to, once again on the conservative side, $8 million. This provides us with an NCAV of $90 million, which divided by the outstanding shares of 14,681,002, I arrived at a liquidation value of around $6.15/share. This price would not be sufficient to Benjamin Graham’s approach, he would desire a larger “margin of safety”. The quintessential price for Graham would be 66% of $6.15, or $4.05 a share. Why demand a discount to the liquidation price? This deals with the uncertainty in the appraisal of assets during the liquidation process that one must take into consideration.

Great! Now that we know the stock is trading at a discount to its liquidation value do we pull the trigger? The answer is no, the next steps involve reading up on the industry and what it takes to succeed in this area. Ask yourself questions about the nature of the industry, its growth prospects, barriers to entry, typical margins, etc. Next, take a look at the company specific operating metrics, such as revenue growth, historical earnings trends, composition of revenues, margins, receivables turnover, and so on. What kind of story is being drawn up from your research? If the meterics give a poor reason for the declining stock price, you may have a winner.

In my next post, I want to dive into further detail pertaining to HQS and its prospects as a value investment. I fell upon some issues of uncertainty, which include its capital structure and revenue composition. For now, I invite you to go ahead and take a look at it for yourself. In addition, click here for a link to an article posted by J. Royden Ward, Editor of the Cabot Benjamin Graham Value Letter who does a great job in providing further information about the company and the stock’s consideration as a value investment.

Please excuse the lack of new material on the website in the past few months as I have been quite busy with work related pursuits. Having cleared that up, I wanted to switch gears and discuss a subject that diverges a bit from the topic of investment banking, if anything this post will relate more to the buy-side.

In the past few weeks, I have partnered up with a relative to form an LLC. The primary objective of the company is to follow a deep value investment strategy that emulates the likes of Benjamin Graham. One of the ideas that Graham stressed was to invest in companies that are trading below their intrinsic value (think of receiving a nickel in exchange for a penny). To further increase the margin of safety, one must also limit investments in companies that are trading roughly at or below  2/3 (66%) of their intrinsic value.

You may now be asking yourself, what is the intrinsic value of a company? There are many methods used in calculating the IV of a concern, which include the DCF and comparable analysis methods frequently seen in I-banking. The issue with these methods is that they are essentialy built on many assumptions. For example, the DCF focuses on potential future cash flows discounted back to the present day at the required rate of return. It would be quite difficult for an investor to accurately predict future financial data points that are necessary to construct a DCF model without the help of company management. Even then, the management may be overly optimistic when providing projections (this occurs more often than not).

One should note this is a very tiny portion of the work involved in successfully picking stocks and investing. The goal was to engage the reader’s curiosity, I will be posting more on this subject in the near future.

For now I recommend visiting an extremely resourceful website dedicated to the subject.

Check out the Comparable Company Analysis on PLCM available on the Valuation Resources page.

I want to spend a few words on the valuation and procedure that was used. First, as the case with the DCF method, the assumptions used for a comp analysis can be subjective and molded in many different ways. For example, the selection of peers can vary drastically. Some bankers use a large selection of peers, which they may tier into different categories such as size and relevance. Secondly, when spreading the financial statistics of your target and its peers, there is no limit to the types and number of ratios a banker may implement (liquidity ratios, leverage ratios, activity ratios, profitability ratios, and so on.) Finally, it is important to read up on your target’s sector and industry, the more depth/detail the better! That being said, below are a few bullet points on the Communications Equipment sector that is  relevant to the analysis:

• Enterprise spending is picking up
• IBM, a bell weather and proxy for technology spending, mentions it is seeing a broad improvement in tech spending, reported a 13% increase in profits
• Forrester Research projects U.S. spending on information technology will rise 8.4% to $550 billion this year, following a 9% decline in 2009, as reported by Investor’s Business Daily
• Consolidation is beginning to heat up: Recent deals of note include Cisco Systems acquiring video conferencing maker Tandberg
• Hewlett-Packard agreeing to acquire switch maker 3Coms for $3.1 billion in November.
• Technology shifting toward convergence, where product platform will likely need to offer computing, routing and switching connectivity, security, wireless access, and other applications all in one package. Industry becoming intertwined, Cisco now competing with HP, Dell, by setting foot into the server industry.
• March 15/16: rumors were spread that company is in talks to go private with Apax Partners. Around that time stock spiked to high of $34/Share

Furthermore, click here for an interesting article, which discusses how Cisco’s TelePresence Technology has witnessed a huge spike in volume due to the volcanic ash clouds from the recent volcanic eruption in Iceland.

Enjoy and don’t forget to check back for updates!

As requested by a visitor, a valuation of Polycom (Ticker: PLCM) will be posted within the next week or so. This time around a comparable company analysis will be used as opposed to the discounted cash flow analysis we used for EGLE. While we work on the model, please enjoy the Financial Ratios PowerPoint presented below. I found it to be a great supplement and refresher. It will assist  in explaining the different types of commonly used ratios/statistics and their calculations.  Enjoy and don’t forget to check back for updates!

Any sophisticated investor will utilize  publicly available financial information about a company in order to fully understand, analyze, and value a potential investment in the firm. The most telling information about a firm’s history can be sourced from the three financial statements: Income Statement, Balance Sheet, and Cash Flow Statement. As a rule of thumb, the investor will use SEC filings to find the 3 statements from which he/she will then be able to calculate important financial statistics and ratios. Below I will briefly go over the four most important SEC filings and what they present:

1. 10-K

This is the annual report filed with the SEC by a publicly traded company. It will provide a detailed review of the company and its prior fiscal year performance. Along with the 3 financial statements, it includes a list of disclosure items that are important when analyzing the company: Detailed business description, the MD&A (Management, Discussion & Analysis) – here you will find discussion about the prior year performance and some forward looking information and analysis, audited financial statements, outstanding debt information, and stock options & warrants data. You may also find discussion on competition, significant recent events, and risk factors that are affecting or may affect the firm in the future.

2. 10-Q

This is the quarterly report filed with the SEC. Here you will find a review of the most recent quarter and year-to-date period. This filing will be less detailed than the 10-K, and although the financial statements are reviewed by a CPA, they are not audited.

3. 8-K

This may also be referred to as the “Current Report”. It is filed by a publicly traded entity in the event of material corporate changes (“triggering events”) that are important to shareholders. These may include earnings announcements, acquisitions, capital market transactions, corporate governance changes, and so on. This filing may be useful to update financial information for the most recent 10-K or 10-Q.

4. Proxy Statement

Prior to a shareholder meeting, whether an annual or special meeting, this document will be sent to shareholders. It contains material information on matters which the shareholders will be voting on. For the investor, its importance comes from the fact that it includes information on the basic shares outstanding count. The annual proxy statement, filed right before the release of the 10-k  may also include information about a suggested peer group (comparable competiton) of the firm.

If your looking for a more comprehensive review,  check out Investment Banking by Rosenbaum & Pearl as it provides a great overview of the filings and their relevance to valuation models. If your budget is tight, you can try the SEC website as it explains each filing in greater detail.

Enjoy and don’t forget to check back for updates!

Through the use of a Discounted Cash Flow analysis we were able to reach a per share value for Eagle Corporation. The value we have reached ranged from around $1.00 per share to $4.00 per share. The stock currently trades at $5.99 per share, not too far from our target range. In conclusion, our assessment shows that the stock is either overvalued or that we were on the conservative side with our projections. A more detailed summary of our assumptions and calculations will be posted within a few days. For now you are welcome to take a look at the model, which you can download by clicking on the link below.

Enjoy and don’t forget to check back for updates!

EGLE Discounted Cash Flow Analysis

It is important to have a solid core in order to recognize your full potential in any subject or area. Do you want to pursue a career in Investment Banking? Maintaining a GPA in the top 10% of your class is a good place to start. Besides your outstanding grades, you must have a solid understanding of what an Investment Bank does. Below is a  presentation, which I believe hits all the main points and can serve as a basis for further investigation. There are also many other publications that go into further detail, such as the Vault and WSO guides, both of which I recommend. These will cost you around $20. The sooner you begin sculpting your core, the greater your advantage in the future. Best of luck in all of your pursuits!

Enjoy and don’t forget to check back for updates!

There are many ways to make projections. For example, future revenue growth can be based upon a historical average or a leading economic indicator. There is no exact science, the techniques and inputs used are subjective and rely on many assumptions. The more accurate projections are the ones that usually make more sense.

Within the next few days we will be posting a valuation of Eagle Bulk Shipping, Inc. (Ticker: EGLE) using the Discounted Cash Flow method. Appropriately, let us share a few thoughts about a recent article in the WSJ discussing the Baltic Dry Bulk Index as a measure of the global economy and its connection to future trends in the maritime transportation industry.

The article highlights the issue of shipping industry oversupply and as a result, the fading power of the Baltic index as a barometer of world economy. We have considered this index more precisely as an indicator of world trade. We see the current situation in the maritime transportation industry somewhat similar to the natural gas industry where recent explorations created a glut on the US natural gas market. Nevertheless, shippers have some advantages in handling the supply problem – scrapping old ships or canceling current orders. Additionally, economists agree that major exporters and importers will grow this year by around 3% in the US, 4.5% in Brazil, and close to 9.5% in China.

BDI is currently well below its long-term 5 year and 10 year average value (we expect upward correction within 12 to 18 months). Therefore, we see current valuations of shippers such as Eagle Shipping and Dryships as very attractive (looking both at P/E and EV/EBITDA). On the other hand, current rates pressure the bottom line of the shippers who are significantly exposed to spot rates (this is evident from the recent earnings released by EGLE).  We believe that smaller sized shipping companies with spot rate exposure are set to struggle and may be either targets for acquisition or liquidation. Some consolidation in the industry looks necessary to counter the issue of oversupply.

Click here for the article and don’t forget to check back for updates!