Written by

Jae Jun

Allegiant Travel Company (ALGT) is a very interesting company. It is an airline company so when I first heard the name in 2009 or so, I immediately dismissed it as I don’t bother with airlines.

ALGT came up again in the 2011 Forbes Best Small Company list so it was time to give it a chance. After all, I can’t always spoil myself by studying companies that always meet my criteria. That would only limit my investment view and learning curve. As I wrote previously, studying bad companies is good for you.

Upon reading ALGT’s company reports, I found it very educational and highly entertaining.

I definitely recommend you to read the annual report to get a bigger picture of the airline industry and especially ALGT.

Allegiant Travel Company (ALGT) Analysis

ALGT Business Description

From the 10-K:

Operates a low-cost passenger airline marketed to leisure travelers in small cities, allowing us to sell air travel both on a stand-alone basis and bundled with hotel rooms, rental cars and other travel related services.

Management

• Paid one time dividend in 2010 of $0.75 per share. Always a good sign when management is willing to distribute one time dividends.
• 2010 executive compensation was 0.6% of 2010 revenue
• Strong insider ownership of 22.3%
• Recent big sales on the open market by President
• CEO background is an investor and entrepreneur. He was one of the founders of ValueJet. Also founded MPower Communications. Got to have good business sense and vision to successfully create companies.

Strategic Advantage/Moat

The airline industry is highly competitive yet ALGT has many advantages over its bigger and smaller competitors. In most businesses, efficiency comes from scaling operations, but not in the airline industry.

ALGT proves this in the way it does business.

They have less planes, less flights and less routes, yet are better off than most of their competitors who continue to lose money year after year.

Here is how they do it.

• Low cost operator. In a capital intensive commodity business, having a low cost business model is utmost important.
• Focuses on the leisure traveler instead of business travelers. Leisure travelers want cheapest airfares first and schedule their trip around their flight itinerary. Business travelers place great importance on their own business schedule with price coming second. This strategy allows ALGT to provide low frequency services from small cities but makes full use of capacity.
• Every flight is a direct flight. No connecting flights.
• Uses larger jet aircraft to provide nonstop service from small cities direct to leisure destinations.
• Does not use frequent flyer programs or code-share arrangements. Only worthwhile for heavy travelers who use the same airline to accrue points. Doesn’t suit the leisure traveler who wants the cheapest flight.
• Sells directly to travelers without participation in global distribution systems. This means ALGT does not sell tickets through Expedia, Travelocity or any other travel website. Tickets can only be purchased via their website, over the phone or at a ticket counter. This equates to less expenses.
• Has a variable flight schedule. Depending on demand and profitability, ALGT will cut or add flight routes. One example is how they moved back to Orlando Sanford International airport from Orlando International Airport as there wasn’t enough profit from operating in Orlando International Airport.
• The variable flight model also allowed ALGT to cut flights by half when oil prices skyrocketed in 2008 and the recession hit later on. They can easily ramp up the flights when oil prices are low or when holiday season begins as well.
• The entire goal for a flight is to fly full, yet most airlines can’t achieve this. ALGT temporarily suspends flying to some holiday destinations during non peak periods when demand is down.
• Focuses on markets where competitors will find it difficult to enter. The bigger airlines will have to accept losing money in these markets if they want to compete for market share.
• Sells holiday packages in additional to tickets. Contracts with hotels and resorts to provide holiday package deals to customers.
• ALGT also makes good revenue from optional fees. The fees listed below was from a review of ALGT found online. Link is available at the bottom.

- Priority boarding: $9.99 – allows you to get on the plane first making sure you have overhead room.

- Premium seat selection: $9.99 – you get an assigned seat near the front or at the exit rows.

- Standard seat assignment: $6.99 – gives you an assigned seat towards the back of the aircraft.

- Online checked bag fee: $39.98 – might be more than the industry average, but you want to pay it online, since it will cost you $70.00 per bag at the airport.

• Makes use of strategically located bases to shift schedules and flights, perform line maintenance, overnight parking of aircraft, and other operations support.
• Does not hedge fuel costs

I’ve probably only gotten half deep into ALGT’s way of doing business but I’m sure you can agree that there are not many airlines that operate as strategically and savvy as ALGT.

Growth

The main growth driver comes from ALGT’s ability to expand into more smaller cities. There are hundreds of smaller cities located hours away from international airports, and people living in these areas also have to fly somehow.

Since ALGT purchases used MD-80 airplanes on the cheap, it will be able to penetrate these locations as their cost to open a new route is much cheaper than a bigger airline.

Growth also comes from ancillary revenue. By making better deals with resorts, hotels and casinos, ALGT is able to generate more commission from its package sales.

ALGT is working on a direct flight to Hawaii which should add growth.

Competitors

• Of the 161 routes it flies (according to last 10-K), only 10 routes have competition.
• Due to its profitability, ALGT trades at a premium to its peers.
• Gross margin is around 40%. Unheard of. Comps are around 15-18%.

Risks

• MD-80 airplane engines no longer being made could lead to parts shortage.
• Having to replace their current fleet of MD-80’s. Different planes mean new maintenance, training, schedules, parts etc
• MD-80 planes are also about 20 years old which is a risk. This has been discussed in the forum so I’ll leave out full details today.
• Increased industry regulation resulting in higher fees and licenses.
• Bigger competitor willing to lose money to take market share from ALGT.
• Another recession or terrorist activity causing a big decline in flights.

Valuation

• On Feb 1, ALGT announced their 36th consecutive profitable quarter
• Passenger revenue per available seat mile (PRASM), perhaps the most important bottom-line measure of an airline’s health, increased 11.7% over the year-ago period and 19.2% for all of 2011.
• $320M in cash and only $146M in debt
• I’ll leave valuation out this time around as I am not comfortable valuing airlines.

Catalysts

• Reconfiguring fleet of MD-80 aircrafts from 150 seats to 166 seats. The increase in seats per plane directly increases revenue potential.
• New flight routes to Hawaii will meet the popularity of Hawaii vacations.
• New and additional ancillary third party products. Create better holiday packages to drive additional revenue.

Conclusion

While learning about the company, I couldn’t help but be impressed by the business strategy and business savvy. Maybe it is because the CEO is an entrepreneur at heart.

Previously, I had never thought about airlines as a potential investment opportunity but ALGT completely shatters that assumption.

At the current price, it is clearly at a premium, but if it comes down to a reasonable range, ALGT is definitely one to watch out for. As the spider graph shows at the top, ALGT is a well rounded company.

Additional Links

• http://en.wikipedia.org/wiki/Allegiant_Air
• http://www.airlinequality.com/Forum/allegiant.htm
• http://www.airlinereporter.com/2010/12/my-review-flying-allegiant-air-for-the-first-time/
• http://beta.fool.com/enigmadude/2012/02/07/airline-stock-surely-you-cant-be-serious/1726/?source=eogyholnk0000001
• http://seekingalpha.com/article/312232-is-allegiant-king-of-the-airline-stocks
• http://seekingalpha.com/article/251672-allegiant-has-found-the-keys-to-airline-profitability
• http://seekingalpha.com/article/171389-allegiant-october-year-over-year-comps-are-strong
• Allegiant company presentation http://bit.ly/yBxA1N
• http://www.glassdoor.com/Job/allegiant-travel-jobs-SRCH_KE0,16.htm

Disclosure

None

No related posts.

Is it Worth the Time to Study Bad Companies?

It is always easier to read and write about companies that I would buy. Passing on a company is easy and is recommended by most people. I could skip a lot of the companies I come across and move on to a better opportunity, but I am learning that this should not always be the case.

It is hard work to study a company you have no interest in. I would say it takes twice the mental effort because your brain just screams at you to stop wasting time and move on.

You lose concentration quicker because you are reading something you are not interested in.

You feel like you are not achieving anything.

But don’t jump to conclusions. You have achieved something. There is a reason why the cliché “never give up” and “fight to the end” exists. It makes you stronger.

Bad Companies are Good for You

The more you fight your nature from taking the easy route, the more analytical and objective you become in your research.

This is a direct battle against a behavior you may never have thought about.

It literally takes me twice as long to get through and understand an annual report of a bad company compared to a company I am interested in.

Here are a few points that I guarantee will result from analyzing bad companies

• You start to focus on risk more than anything
• You are no longer bound to confirmation bias
• You become objective which helps you identify the important information from the noise
• You start to follow a process such as an investing checklist. Here’s another stock selection checklist.
• Practice makes perfect

Trust me when I say I don’t want to spend hours writing up an analysis of bad companies such as OCC, MPAC and IGOI. However, I have discovered new risks that I would not have regarded had I focused purely on companies that met my criteria.

I’m bad at remembering things, but I read in some book that the secret to success is fairly consistent. Study the behavior and characteristics of successful people and they share many commonalities. However, the recipe for disaster is unique and as diverse as it can possibly get.

You have no doubt spent years reading about good companies. You have to start reading about bad companies to appreciate the good ones.

This is why I will continue to post stock analyses of companies I would never buy.

Two roads diverged in a wood, and I,
I took the one less traveled by,
And that has made all the difference. – Robert Frost

No related posts.

Written by

Jae Jun

Piotroski Screener & Piotroski Spreadsheet

I currently have a Piotroski screener which I update weekly or so as well as a free Piotroski spreadsheet that makes use of the excellent SMF excel plugin.

I have gone through in detail the Piotroski criteria and backtested the results to see whether it really did achieve what the academic papers claim. My conclusion? It has resulted in outstanding performance.

While all my other value strategies did poorly in 2011, the Piotroski 2011 performance was very respectable at -1.3%.

Best Piotroski Screen Combination Test

The Piotroski score is a great mechanism for filtering stocks, but I want to see whether better results can be achieved. So I am going to share with you my test results of numerous combinations utilizing the 9 point scoring system derived by Piotroski. My goal is to try and nail down the best combination that will outperform the standard Piotroski screen.

I did something similar with Graham’s stock selection checklist. Graham originally had a 10 item checklist which I felt were not all necessary. By going through  the list and eliminating criteria such as a stock having to be priced at 2/3 of NCAV, the modified screen turned out to be much better.

The Initial Test Filter

With 9 criteria, there are hundreds of possible combinations, but there is no way of testing each one.

In order to cut the time and labor, I back tested one criteria at a time against the past 5 years – from 2007 to 2011.

Then I sorted the criteria based on the return it made. If you look at the image below, criteria #6, the latest current ratio being greater than the prior year current ratio, performed the best.

But using a single criteria as a screen itself is too broad and results in far too many stocks in the final output.

The Best Piotroski Criteria Combination

Using the findings from above, I tried combinations such as the top three, top five, positive only, bottom three etc, but results were not what I expected. Thus, the process of elimination began.

Rather than wasting your time explaining every thought process, I’ll just dumb it down.

I started with the best two criteria as the foundation and added one criteria at a time. If the new combination beat the previous combination, I continued with the new combination. If not, then the criteria was eliminated and so on.

The combinations were back tested over a one year, 3 year, 5 year and 10 year period and then ranked. The lower the total rank, the better.

As you can see, the best combinations (#6,9,1) and (#6,7,1,2) both tied for first place. However, I am awarding combination (#6,9,1) first place as it protected the downside better in 2011.

The original Piostroki screen placed 10th place and is the only one that posted positive numbers across all time periods. Impressive indeed.

In the end though, the best Piotroski combination is a very simple selection criteria which doesn’t resemble Piotroski at all.

• Current ratio should increase
• Decrease in shares outstanding compared to prior year
• Positive net income

The results adhere to the rule of keeping it simple.

20 Stocks for the Best Piotroski Screener Combination

(stock price is from Feb 12, 2011)

Disclosure

None

You may also be interested in:

1. Graham’s Stock Selection Screen Part 2
2. Piotroski Score Screen Performance
3. Full 2011 Value Stock Screen Performance

Written by

Jae Jun

Verdict

• Management: B+
• Growth: B-
• Moat: C
• Risk: C
• Valuation: B+
• Overall: B-

Business Description from the 10-K

IEC Electronics (IEC) is a provider of electronic manufacturing services (EMS) to technology companies. The Company specializes in the custom manufacture of circuit cards, system level assemblies, a range of custom cable and wire harness assemblies, and precision sheet metal.

Their business segments consists of Military and Aerospace, Industrial & Communications, Medical and other.

Why is it Cheap? / Is it Cheap?

The initial question I start with, but in this case, nothing jumped out screaming value.

On a side note, IEC is ranked number 3 in the 2011 Forbes Best Small Companies list and the companies that show up  on this list are usually growth orientated which is why I can’t conclude as easily whether it is cheap or not.

Management Check

The best place to get information about management is to read the Proxy. The code for the Proxy document is “DEF 14A”. You can then automatically track the SEC filings and use the method described in the tutorial for detecting changes in SEC documents.

Here are some points regarding management and their decisions.

• Insider ownership is high at 16.59%
• CEO is also chairman of the board
• Huge increase in salaries for insiders in 2011 vs 2010. CEO compensation increased 75%. Although performance targets were met, most of these numbers were possible only through acquisitions instead of actual organic business growth.
• Management does not buy back shares or buy their own stock even at low prices.

Another piece of interesting information is the debt acquired to finance acquisitions. The interest rate on these loans is between 2.5 to 4%. With such low interest rates, using debt instead of using their cash on hand is a no brainer. Nice move by management.

Growth Plans

The murky aspect of any analysis. Always filled with what if’s.

As a smaller company in a highly fragmented industry, acquiring companies to grow is a must and IEC has shown that it will acquire. As mentioned above, they have gone about it smartly the past couple of years.

IEC also has some additional potential because they do business in several segments. Revenue is diversified and if IEC locks down additional contracts for each segment, that should help drive further business.

Another aspect that is advantageous for IEC is that none of the their competitors are “giant” corporations, but on the flip side, it will be equally difficult for IEC to become a giant. At some point it will plateau.

Strategic Advantage/Moat

Companies like IEC could claim all sorts of strategic advantages, but in reality there is none.

By none, I mean none of the claims are durable. A competitor could easily do the same thing. Here are some strategic advantages the company claims. You judge for yourself.

• Company strategy is to focus on creating manufacturing partnerships with new and old OEM’s. This allows IEC to have a broader product line without a need to buy out every company.
• Another way of looking at it, IEC depends on having really good relations with customers. Help the customers save money, and then make it difficult for the customer to switch to another company because the service is so good. If a customer is saving money and happy with IEC, why would they want to change?
• By having multiple manufacturing partnerships, rather than just supplying a certain part of a product, IEC can provide parts for the entire supply chain and build the entire product for the customer.
• It would be better to be the low cost provider in this industry, but IEC is not.

Competitor Discussion

There are plenty of companies, both private and public, that provide the same type of service.

With a lack of durable strategic advantages as explained in the previous section, it’s expected that plenty of competitors exist.

The one thing I can see that sets IEC apart from their competitors is their military and aerospace business segment. Due to regulations, the government is not allowed to purchase from suppliers outside the USA.

Risks

Always protect the downside. Apply risk protection methods first and the upside will take care of itself.

Refer to the risks associated with the company.

Inventory Risk

• Does not hold too much inventory (could be an advantage actually).
• Has to purchase raw materials up front or receive them from customers. Uses turnkey services which could be a problem is the supplier does not have the required parts. Also it means IEC has to purchase small quantities regularly which is more expensive than buying in bulk.
• Obtained 53% of materials from two suppliers. If a relationship broke down with any one of the two, it would cause big delays and losses.

Concentrated Customers

• Concentrated customers. In 2011, Sigma represented 16% of revenue, GE represented 10% of revenue and the top 5 customers make up 45% of revenue.
• 56% of revenue come from military and aerospace. Any reductions in military and aerospace budget will affect IEC.
• Customers do not commit to long term production schedules. They could cancel, delay or change orders any time.
• Solvency will be an issue if they lose just one major account.

Valuation

IEC’s business has turned around since 2005. Margins have dramatically increased compared to early 2000’s and the company is  cheap on a P/S basis. P/B and P/Tangible Book is on the average side.

ROE has been excellent, but the use of debt has been helping. ROE since 2005 has been 23% average. Compare with CROIC which is 17% during same period. Still high but the number has dropped to 8.3% in 2011.

Long term debt has increased due to the acquisitions, but with such low interest rates, it shouldn’t be a problem.

Inventory turn has decreased from 2010 to 2011. This only confirms that the top line growth was from acquisitions.

Share dilution seems to be an issue. Increases by about 5% annually.

Has an extraordinarily high accrual buildup. Accounting isn’t very good. Red flag.

Using a couple of quick stock valuation tools to check out what the market is expecting from the current stock price;

• Reverse DCF shows the market is expecting about 5.5% growth with a 12% discount rate.
• A reverse Graham valuation with EPS of $0.68 so the expected growth to be 1%.

Possible Catalysts

Some potential business developments that could help IEC.

• Government defense budget is not cut
• USA gets involved in another war (hope not)
• Acquisitions proves to do well
• Partners with several additional suppliers to stabilize its distribution channel
• Diversifies customer base without losing sales

Other Pieces of Info of Interest

• Was created through a merger in 1990
• Founded in 1966
• Acquisitions in each of the past 3 years
• 33% higher backlog in 2011 vs 2010
• Acknowledges that employees are biggest assets
• Good relations with employees. No work stoppages, no unions. Only 1 review on glassdoor.com but it’s a good one.
• Certain “covenants in IEC’s credit agreement with Manufacturers and Traders Trust Company restrict the Company from paying cash dividends.”

Conclusion

Management looks capable but I have to question their shareholder friendliness. The company will never pay a dividend, salary spikes are enormous and there will be consistent share dilution without any buybacks or open market purchases.

It feels like the management team is more content with their corporate lives and benefits vs rewarding shareholders.

Growth is limited and will mainly come from acquisitions. Business has no moat with plenty of risks to consider.

Ultimately, the company is a little too much on the risky side, even though valuation based on earnings is low.

Other Links

http://seekingalpha.com/article/316036-iec-electronics-lining-shareholders-pockets-or-management-s

Disclosure

None

You may also be interested in:

1. MPAC: Typical Scenario of Ineffective Management
2. Portfolio Management and Asset Allocation
3. UFPT Savvy Acquisitions & Making it Work

Written by

Jae Jun

The Secret GRVY Recipe

• ADR – Small Korean online game development company
• Stock price below $5. “Was” trading below NCAV.
• Dirt cheap fundamemtals for a profitable company
• No chance for activism because of 51% owner
• 7+ years of delays for game release
• Catalyst of impending game release

Mix the ingredients together and you get a value investor’s dream dish in the name of Gravity Co (GRVY).

There is no need for me to go over everything again because I’ve written about GRVY numerous times. Several other value investors have also written detailed analysis of the company which I’ve linked to at the bottom of the page.

Right now, I just want to get straight into an updated valuation because YTD, GRVY has shot up 50% with increasing volume and it is a good time to review the probabilities of downside vs upside.

GRVY’s Impending Game Release is a Huge Catalyst

I am still very bullish on the company and the original thesis is still intact. GRVY is set to release the sequel to their blockbuster game after 7 long years of delays, redevelopment and more delays.

Waiting has been difficult because GRVY has a talent for announcing a release date and then delaying the date a month or so before the deadline.

But the company is finally entering their Open Beta test phase on Feb 22, which is a big step from Closed Beta testing and towards commercial launch set for March 2012.

It is one small step for GRVY, but one giant leap for shareholders.

7 years of disappointment and being ignored by Mr Market is about to end.

GRVY offers Downside Protection

First thing to consider is the downside. In the previous post where I detailed the market expectations of GRVY, I went through the NNWC, NCAV and tangible book value numbers to show the downside.

For a company that is

• profitable and FCF positive
• has very little debt
• has plenty of liquid assets and cash
• and has high margins

then the least it should be trading at is book value.

With the 50% jump since the beginning of the year, GRVY is now just above tangible book value.

Q4 results is not yet available to dig into, but based on Q3 results

• NNWC value is $1.50
• NCAV value is $1.78
• Tangible book value is $1.99
• Book value is $3.42
• Current price is $2.15

GRVY offers Upside Potential

The current price still reflects a business that is selling for close to tangible book value.

At the current price, you are getting the portfolio of games, future of RO2 as well as additional revenue streams from licensing to other countries and growing mobile gaming revenue for free.

So what is the upside? Here are a few possible scenarios to consider.

Book value scenario: Suppose the market accepts the fact that the game acquisition prices are fair. Then the stock price should be at least book value instead of tangible book value.

That makes 1x BV = $3.42 a very reasonable target price. There is still 59% upside from today’s price of $2.15 to reach $3.42.

• Zynga (ZNGA) is 11.5x BV
• Glu Mobile (GLUU) is 4.4x BV
• Majesco Entertainment (COOL) is 4.5x BV
• A company like KONG that is bleeding money is 0.7x BV

If you take time to go through more competitors, you will see that profitable gaming companies tend to trade at about 4x BV.

As the other gaming revenues continue bring in additional revenue and RO2 starts commercial business, there is no reason why GRVY can’t be valued at a paltry 1x or even 1.5x BV.

At 1.5x BV, GRVY would be worth $5.13 which is 140% from today’s price.

EBIT Multiple Scenario: If GRVY has another profitable fourth quarter, my estimate for full year EBIT is $9m.

Based on my rule of thumb, a company like GRVY should be trading at 10x EBIT. On a per share basis, it is worth$3.30, but this value is based on the current EBIT ignoring future revenue increases.

Earnings Multiple Scenario: I’m estimating that fiscal year EPS will be approx $0.30 to $0.32. Again, this is based on pre RO2 revenue. Slap a multiple of 10x EPS and the target price comes to $3.00 to $3.20.

Valuation Scenarios

• Conservative value: $3.00
• Normal value: $5.00
• Aggressive value: $7.00

Not saying that I am going to hold until $7 or even $5 because it all depends on how well the company markets and launches RO2 as well as expanding revenue from its other games.

But considering the bigger picture, the easy conclusion is that GRVY is still cheap at $2.15.

GRVY is still finger licking good.

Other Links

http://www.oldschoolvalue.com/blog/stock-analysis/the-expectations-built-into-grvy-is-dead-wrong/

http://www.oldschoolvalue.com/blog/forum/g-stocks/grvy-gravity-co-ltd/

http://www.gurufocus.com/news/152147/gravity-grvy–an-irresistible-force-

http://www.gurufocus.com/news/130916/is-a-5-stock-selling-for-under-2

http://longtermvalue.wordpress.com/2011/10/25/gravity-ltd-another-look/

Disclosure

Long GRVY at time of writing

You may also be interested in:

1. The Expectations Built into GRVY is Dead Wrong
2. Cheap Stock under $2: GRVY
3. (Exclusive) GRVY Video Conference Notes

MOD-PAC is a high value-added, on-demand print services firm that is focused on the design and manufacture of folding cartons.  It also has a personalized print product line.

The term folding cartons is the box packaging used for cereals and any other product with box based packaging with printed designs.

Personalized print is customized printing for such things as letterheads, business cards, posters, invitations and cards.

Why is it Cheap? / Is it Cheap?

• Very small company
• Operates in a very competitive industry
• Competition consists of both large corporations to small independent companies
• Exited commercial print business in 2009 as revenue deteriorated after losing VistraPrint contract in 2004. The impairment caused a drop in earnings.
• Was spun off from Astronics (ATRO) in 2003. A totally unrelated parent.

Management

• Daniel Keane is CEO. Kevin Keane is chairman of the board. Must be father and son combo. Not an independent board.
• Strong insider ownership but dual share structure. Inside executives and directors own 33.5% of class A stock.
• Daniel Keane and Kevin Keane own 48% of class B stock.
• Total executive compensation in 2010 made up 3% of revenue in 2010. 3% is borderline so the company is pushing it by my standards.
• Not much insider buying except in Oct 2011 where a few insiders bought in the open market. Majority of insider activities are stock option acquisitions.
• The company has never really outperformed its peers, but bonuses to executives are always given.
• CEO get his “club fees” of $13,858 paid by the company, personal finance planning fees paid, tax return preparation expenses paid. COO gets similar benefits. Useless perks that can be paid by themselves as it has nothing to do with the company.
• From what I can tell, management is looking out for their own interests first.

Growth

• Not much growth that MPAC can achieve. It is operating in a niche where it has basically filled the position that it is in. Only way to grow is to acquire other companies, but current financials do not support this.
• MPAC isn’t big enough to get national customers. Has to work within regions where they are located.
• The personalized print business is not a good business model. Competition is everywhere from a single person operation to big corporations.

Strategic Advantage/Moat

• No moat.
• MPAC does have a strategic advantage in that it is more nimble and efficient than bigger competitors, as well as being able to handle more capacity than the small companies to keep their prices low.
• The main advantage that comes up often in the annual report is that “MOD-PAC’s focus is on niche market opportunities requiring short print runs, which capitalize on our efficient processes and operations to meet customers’ highly variable needs.” – In other words, short run printing.
• Short cycle time means they don’t have to lock in futures contracts to purchase raw materials. They also don’t need to hold much inventory.

Competitors

• Highly fragmented and competitive industry.
• Unable to compete with bigger players.
• Bigger competition also have integrated paper business which makes them efficient and cost effective in long run printing.
• Competes with many other smaller mom and pop shops.

Risks

• Customer concentration. About 30% of sales come from two customers.
• Intense competition
• Needs to regularly upgrade equipment to maintain edge over smaller shops as well as keep up with bigger competitors.
• Company remains in stalemate mode and where shareholders will lose out.

Valuation

• Off balance sheet liabilities consists of leases.
• Revenue has remained flat for 5 years. TTM is better due to additional revenue from folding cartons business.
• Margins have declined for years and only now seeing some slight improvements.
• Shareholders equity has also been flat. No shareholder value growth.
• FCF hovers slightly above or below the zero line.
• Average ROE over 10 years is 3.8%
• Average ROA over 10 years is 1.9%
• Average CROIC over 10 years is 2%
• Inventory age increasing. In 2007, it was 31 days. In 2010 it is now 47 days.

Catalysts

• MPAC could be the one to get bought out.
• MPAC signs a new big contract that diversifies customers, but no such news of anything like this. Just a wild possibility.
• Management’s plan to increase growth in folding carton business succeeds.
• Company buys back shares

Conclusion

Became interested in the business after reading that it was spinoff, but from the looks of the company, the parent was the one with hidden value.

Operates as a niche player in a competitive industry with ineffective management. Company is not positioned to grow and does not have the firepower needed to generate growth.

Easy one to throw in the pass pile.

Verdict

• Management: C
• Growth: C
• Moat: C
• Risk: B
• Valuation: C
• Overall: C

Disclosure

None

You may also be interested in:

1. IEC: Capable Management but Shareholder Friendly?
2. Portfolio Management and Asset Allocation
3. UFPT Savvy Acquisitions & Making it Work

Written by

Jae Jun

UFP Technologies (UFPT) creates custom packaging, component and product solutions for the following markets: medical, automotive, aerospace & defense, industrial, electronics and consumer.

When you buy an electronic item, the foam or egg carton type cardboard protectors are the types of products UFPT makes. Visit their website to see exactly what I am talking about.

Why is it Cheap?

• Small cap in a highly fragmented and boring packaging industry
• Thinly traded and low float
• High insider ownership

Management

• Steady share dilution through options
• Approved 25k shares to CEO under the 2003 incentive plan.
• Strong insider ownership at 25%. CEO owns 14%. All directors own more than 1%. Very good. Acts in the interest of shareholders.
• CEO is also president and chairman of the board. Not much independence here as the CEO has influence on the company as a whole.
• Total exec compensation is 2.5%. Below my 3% maximum but still a little on the high side.
• CEO has held position since 1995. Been with the company since 1988 and worked his way up. Very familiar with business.
• No open market buys. Mostly selling between $14 – $17.

Growth

• Growth has come from organic + acquisition growth
• The only way to really grow is to get more contracts. To do this, they need customers. The easiest way to do this in a highly fragmented industry is to acquire other companies and consolidate it.

Strategic Advantage/Moat

• Requires in-depth knowledge of customer requirements as many orders are specially engineered and customized.
• It is not difficult for customers to leave UFPT and create new relationships with UFPT competitors.
• Designs own packaging equipment for increased efficiency instead of buying off the shelf machinery.
• Does not have a huge moat. Very competitive industry, but the fact that such a small company is highly specialized and able to move quickly and efficiently is going to help.
• Offers high quality at a fair price. Not the lowest cost provider.
• Relies on trade secrets and continues development of new products to maintain competitive advantage. Product life cycles are very short so R&D has to develop new and better products constantly to be ahead.

Competitors

• Highly fragmented and competitive industry.
• Competes with many other smaller package producers using different material.

Risks

• Regulatory risk to meet environmental standards and to become greener, which is always expensive.
• Top 10 customers make up 31% of sales.
• A single customer accounted for 14% of sales.
• Requires growth through acquisitions. If management is unsavvy, then acquisitions will be overpaid with a good chance it may not work out.
• Pricing of product is strongly dependent on raw materials.
• If customers move their manufacturing overseas or just outsource the packaging directly to China or other cheaper countries, then UFPT will lose business.

Valuation

• UFPT owns 26.32% of United Development Company Limited (UDT), a realty limited partnership but recognizes 100% of the revenue and balance sheet. In reality even if UFPT is it’s only customer, only 26.32% should be recognized.
• Inventory shows a big increase in work in process. Raw materials has increased a little with finished goods around the same. Seems like UFPT is getting ready for a big order.
• Off balance sheet liabilities are quite high starting in 2012. In 2012: $2.5m, 2013: $1.76m, 2014: $1.4m, 2015+: $5m
• Company really has seen a turnaround since 2005. Acquisitions have really added value. There has been a significant increase in margins and overall, just better numbers.
• Even with all those acquisitions, goodwill hasn’t increased. Intangible assets hasn’t increased. Management looks to be buying companies below book value.
• Balance sheet is fantastic. Just remember to include the off balance sheet liabilities.
• Reverse DCF with $9m and 12% discount rate implies 0% growth. $7m FCF with 12% discount rate implies growth rate of 4.5%.
• Using the new accrual method, stock could be worth around $23.
• Reverse Graham with TTM EPS of $1.50 implies EPS growth rate of 3.5%. Considerably undermining the company in my opinion.
• EPV shows it to be about $22 + cash = $26
• Range of valuation looks to be consistently around $23 ~ $26
• CROIC since 2005 is 15%
• FCF/sales in past 2 years is 7.7%
• ROE has now increased to 18%

Catalysts

• Continued acquisitions below book value driving an increase in cash flow and EPS.
• Analyst coverage will really move the stock price due to the low float.
• Overall nothing dramatic or exciting. Just a boring business continuing to execute.

Verdict

• Management: A
• Growth: C
• Moat: B
• Risk: B
• Valuation: A
• Overall: A-

Conclusion

Most companies growing through acquisitions fail after several years. However, the biggest surprise is that management seems to buy companies below their book value.

Recent acquisitions have not added to goodwill and they are adding tremendous tangible book value, earnings and cash flow. Pre 2006, the company was horrible but since then, a remarkable turnaround has occurred.

Compared to a company like Timken (TKR) which also grows through acquisitions, there is close to no growth expected from UFPT.

Seems like the market hasn’t caught on yet.

Other Links

http://seekingalpha.com/article/33835-eye-on-ufp-technologies-consider-biodegradable-packaging

http://seekingalpha.com/article/192929-ufp-technologies-inflection-point-has-been-hit

http://seekingalpha.com/article/204111-ufp-technologies-sound-financial-management-results-in-good-growth

http://seekingalpha.com/article/245985-ufp-technologies-building-a-strong-portfolio-of-acquisitions

http://seekingalpha.com/article/261705-ufpt-a-small-cap-that-generates-giant-yields-on-free-cash-flow

Disclosure

Long UFPT

You may also be interested in:

1. Mergers and Acquisitions Arbitrage Activity
2. Making Decisions Without All The Facts
3. MPAC: Typical Scenario of Ineffective Management

Written by

Jae Jun

Here is a good case study to go through.

Diamond Foods (DMND) is being investigated by the SEC and DoJ for potential accounting fraud.

I will go through a few methods to detect earnings quality, manipulation and aggressive accounting to see how well it comes up against DMND.

So as we go through this, the question is, could you have identified DMND’s accounting shenanigans in advance by using such methods?

Accounting Fraud Accusation against DMND

From the Forbes article,

“Allegedly, the company delivered so-called “momentum payments” to walnut farmers in order cook their earnings filings.”

Momentum payments mean that DMND paid their suppliers in advance. Future expenses is shifted to an earlier period which will inflate earnings.

If the audit proves to be true, then based on a Bloomberg magazine article (no link sorry), DMND’s 2011 earnings will be reinstated from $2.22 to $1.14. That’s close to 50%. Ouch!

Earnings Shenanigans

In Financial Shenanigans, shifting expenses to another period is clearly defined as one of the shenanigans used to manipulate earnings. Now in the Bloomberg article, Mendes, the CEO, is portrayed as a very ambitious and business aggressive man. If the article is true, that “could” explain the aggressiveness in the accounting.

If you have read The Art of Short Selling, you will know that there have been many companies throughout history where such CEO characteristics have led to accounting frauds.

Balance Sheet Check

Let’s get down to the numbers.

Take a quick glance at the balance sheet. Even though a company like Diamond Foods is all about the brand of its products, the balance sheet is very unattractive. Just looking at the total intangibles should immediately raise red flags.

66% of total assets is made up of intangibles.

Accrual Ratios

Previously I went through examples of how to analyze accruals. One of the examples featured Dolby (DLB) where accruals were consistently above 25% for 4 years, yet DLB increased cash and reduced debt. DLB’s Sloan ratio was higher than the recommended 8%, but nothing jumped out and the result was inconclusive.

However, take a look at DMND below. (These numbers are from my stock analyzer and the model will be included in the next update.)

Cash balance is close to zero, debt has sky rocketed with all the acquisitions, net income is increasing but cash flow from operations is erratic. Dangerous signs already.

The accruals for 2009 and 2010 is shocking. In 2010 and 2011, there is a very good chance that DMND’s growth in EPS came from accruals. In other words, low quality and cookie jar type earnings.

Beneish M (Manipulation) Score

The third method you can use is the Beneish M score to detect earnings manipulation. Full details of how this model works is in the Beneish M Score article.

A score greater than -2.22 indicates a strong likelihood of a firm being a manipulator.

Coincidentally, the 2009 and 2010 numbers are red flagged.

Conclusion?

By checking the balance sheet, accruals and M score, warnings are flashing everywhere. DMND is innocent until proven guilty, but by my definition, shifting expenses to inflate earnings is fraud.

Summing up, do you:

• check the financial shenanigans checklist?
• look at the construction of the balance sheet ?
• analyze the accruals?
• calculate the Beneish M score?

Disclosure

No position in DMND

You may also be interested in:

1. Satyam Accounting Fraud Exposed
2. Agressive and Conservative Accounting Policies
3. Aggressive Accounting: Reserves, Allowances, Contingent Liabilities

Written by

Jae Jun

Darling International (DAR)

Darling International is a rendering company. A rendering company is one where it goes around collecting oil, waste and other animal by-products from meat processors, bakeries, grocery stores, butcher shops and restaurants to recycle it into things such as pet food, soap and bio fuel.

Why is it Cheap?

• Non-glamorous/dirty industry the business is in
• Very old company. Over 100 years in the business.
• Not cheap in my opinion
• Only national publicly traded company in the rendering business. No comps and therefore lack of coverage despite being over $1b in market cap.

Management

• Total executive compensation makes up 1% of revenue. Very good.
• A lot of insiders selling recently at $14 – $15
• Share count continues to increase. Lots of options to insiders. Not great.
• Insider ownership is only 2.53%. Feel it is better not to buy when insiders are selling.

Growth

• Can continue to grow by acquiring more contracts. There is a definite need for such a service and if DAR can efficiently expand its region, growth should come slowly and consistently.
• Acquisition of Griffin added a new business segment
• Growth could “possibly” could come from the joint venture with Valero in producing renewable diesel fuel but they are still several years away.
• The industry itself isn’t hot or growing, therefore overall growth will be limited to territories.

Strategic Advantage

• With the Griffin acquisition, it is now the biggest rendering company in the USA.
• DAR may have economies of scale but can’t be too certain because operations involve capital intensive costs that can’t be lowered even with big scale operations. You still need to go out to each store, factory or restaurant to collect the waste. There will always be fuel, labor and truck maintenance cost involved.
• Not a lot of competition due to nature of the industry. Not many entrepreneurs willing to start up a rendering company. No VC will fund them.

Competitors

• No comparable comp on the public market
• Final products compete with other commodities primarily corn, soybean oil and soybean meal. DAR’s product pricing depends on how these commodities are priced. If corn prices go down, they have to lower their price to compete. Riskiest part of their business as it is completely out of their control.

Risks

• Pricing pressure as mentioned above.
• Is the acquisition worth the price paid?
• Can DAR consolidate the acquisition properly?
• Relies on macro factors more than I thought. Such as commodity prices, energy prices because DAR uses a lot of natural gas to run boilers.
• “operating performance was challenged by extreme summer temperatures in the Midwest”. Is temperature a risk?
• A lot of FDA issues could arise based on how the animal feed is produced
• Fair amount of off balance sheet liabilities
• Underfunded pension plan + accrued liabilities

“As of October 1, 2011, the Company has an accrued liability of approximately $1.0 million representing the present value of scheduled withdrawal liability payments under this multiemployer plan”

Off balance sheet liabilities

Here are some sections from the 10-Q, 10-K.

“Company has commitments to purchase $27.8 million of commodity products consisting of approximately $19.9 million of finished products and approximately $7.9 million of natural gas and diesel fuel during the next twelve months, which are not included in liabilities on the Company’s balance sheet at October 1, 2011.”

“Company has committed to contribute approximately $93.2 million of the estimated aggregate costs for completion of the Facility in joint venture. Also has to pay 50% of everything overbudget.”

Expects to pay approximately $14.4 million in operating lease obligations during the next twelve months.

Total: $163m+ off balance sheet liabilities

Valuation

• Acquisition in Dec 2010 so prior numbers do not have the new revenue included.
• Looking at historical figures, DAR is not cheap at the moment.
• P/B in the 2.5 ~ 3 range
• P/FCF is greater than 20
• ROIC is average 11% over 10 years
• ROE average 18% over 10 years
• Balance sheet shows company to be capital intensive
• Debt from acquisition has been aggressively paid off but still remains
• Even assuming that DAR makes $100m in FCF, a discount rate of 15% gives a market implied growth rate of 17%. Too high.
• Based on last years EPS of $0.53, market implied growth is 20% using graham formula. EPS of $0.70 gives implied growth of 13%. Still too high.
• If I adjust numbers to include the acquisition and what I “think” it will be, reverse DCF gives growth rate of 10% and reverse Graham gives 5%. Debt is at 8% interest so their growth should be higher than this to cover leverage costs.
• All in all, looks fairly valued at current price of $13-14

Catalysts

• Griffin acquisitions makes big impact to business
• Macro tailwinds. If prices of corn goes up, DAR can increase their prices too. Energy price goes down, they will save money.
• Joint venture works out quicker than planned. (Don’t expect it though. Likely take minimum 3-5 years before anything happens.)

Conclusion

A dirty business off the radar on wall street. Business model is the type that value investors will enjoy, but whether management acts for shareholders is a concern. High capital business makes for slow growth in a slow industry.

Decent company overall but too much risk in the current stock price considering the growth expectations. Could easily keep running up as the acquisition proves to work itself out. If it drops to $10, then buy.

Verdict

• Management: B-
• Growth: B-
• Moat: B+
• Risk:B-
• Valuation: B
• Overall: B

Other Links

http://seekingalpha.com/article/99139-quick-take-darling-international-still-dirty-sexy-money

http://seekingalpha.com/article/317291-darling-international-inc-rendering-profits

http://seekingalpha.com/article/276290-darling-international-rendering-good-results

http://seekingalpha.com/article/287221-darling-international-strong-earnings-recent-acquisition-great-value-play

The Timken Company (TKR)

You may also be interested in:

1. Straight Line and Accelerated Depreciation Methods
2. 20 Stocks Round 2
3. 10 Cheap Value Net Net Stocks Available

Written by

Jae Jun

As I mentioned in an earlier stock analysis post, one of my goals this year is to write more analyses. I won’t limit the companies I analyze to strictly small caps, however, there are definitely sectors and countries that I won’t be able to cover.

Therefore, I want to bring to your attention two stock picking newsletters and a short term project offer that may interest you.

Classic Value Investors

One is by Mariusz Skonieczny, fund manager of Classic Value Investors and also the author of Why are we so clueless about the stock market.

Mariusz just launched his newsletter and if you have read his blog or any of his investment theses, you will know that he goes to extraordinary lengths in researching his companies. Expect the same quality in his newsletter. You can sign up and get a free sample.

Go check out his newsletter now.

Eurosharelab

Next up is Tim Du Toit from Eurosharelab. Tim has had a couple of guest articles on Old School Value. You may recall his 40 point investment checklist article and an older, art of selling stocks.

What I can’t do Tim does because he is based in Europe and focuses on European companies. Especially with the Europe crisis ongoing, Europe should be filled with bargains. I’m sure there are many high quality companies selling for dirt cheap in Europe as everything is being thrown out the window. Unfortunately, I don’t have the knowledge or the tools to efficiently find such gems.

Tim does a much  better job.

If you are interested in diversifying into Europe, go read the contents of his site and free newsletter to decide whether his service will be of value.

You can be involved in this new Project

A friend, who also happens to run his own financial firm is looking for somebody with VBA programming skills to help him improve his models and processes. He needs to have it automated and more robust. The ultimate goal is to customize my spreadsheet to pull in data from Bloomberg for global companies, which is fine since he paid for it and is customizing it.

If I had the time, I would love to tackle it, but I had to turn it down.

Here’s some more information.

• Joint project between Feinberg Capital, a value oriented investment firm and Timbervest, a multi billion timber firm.
• Incentives are negotiable. There is a budget for this so you can be paid or you could be more creative and ask for a 1 or 2 month internship or something.
• Need to be able to work with Bloomberg API to get data directly into a spreadsheet.
• The solution could be much simpler as I’m sure Feinberg Capital is flexible in finding solutions.
• contact mfeinberg@feinbergcapital.com if you are interested.

Disclosure

Not affiliated in any way with the websites or people mentioned. Not an endorsement. No responsibility held for loss of investment.

You may also be interested in:

1. Forbes 200 Best Small Companies Project
2. Forbes Best Small Companies Project: Part 2
3. Forbes Best Small Companies Project: Part 3

Written by

Jae Jun

A project that I’ve always had, was to improve on my stock portfolio tracking spreadsheets.

During this time, I’ve probably used 10 or so different portfolio trackers, but nothing met my needs. I don’t do complicated transactions, but still, nothing could really satisfy me.

But those four long years have passed, and I believe I finally have a version that will serve my needs and fulfill its purpose for a long time.

Main Needs from a Portfolio Spreadsheet

• Enter transactions into a single column without splitting up different transactions
• Spreadsheet should be able to automatically update how many shares I’m holding for any company
• Account for dividends
• Account for splits

I don’t do options so I have no need for such transactions. Don’t see why it would be hard for you to edit though.

Previous Versions

The original portfolio spreadsheet could only factor in simple buy and sell transactions and had to separate it.

Then a Google spreadsheet version was released which made it easier to track but not being able to automatically update the cumulative number of shares held for each position, made keeping track difficult.

The improved portfolio spreadsheet even had an interactive time line to track the portfolio growth but it never really took off. Too much hassle of having to update the portfolio values regularly. Also bad to look at your total portfolio that often as well.

Now this new stock portfolio tracking spreadsheet blows it all out of the water. It doesn’t solve everything but it does most of what I need.

New Stock Portfolio Tracker Spreadsheet

Full credit goes to Investment Moats for his amazing spreadsheet. See it in action.

The creator is a Singaporean investor and it will work right away with what he has, but I made some edits to tailor it for the US exchanges (including pink sheets, OTC and ADR’s) and to clean it up a little.

So you have two options. Use the original or use my edited version.

How to Use and Save a Copy

Full details and instructions can be found on Investment Moats’ website. Read the “Read me section” in the spreadsheet as well.

Yellow highlight cells is where you manually enter data. Aqua colored cells are formulas so do not overwrite.

To save a copy into your own account, do the following

• Sign into your Google Docs account
• Open Stock Portfolio Tracking Spreadsheet
• Go to File > Make a Copy
• Rename and press OK to save to your account

How to Edit the Charts

I’ve added three charts to the summary tab. For every new position, you will have to edit the ranges for it to be reflected in the graphs. I will show you how here.

There is a tab called “ChartsData” which holds and sorts the data for the graphs by market value. No need to change anything in the “ChartsData” tab. This tab is only used to display and sort data. Do not enter anything in this section.

Below is one of the graphs/tables in the Summary section.

Click on the table once and a “Chart” menu will appear. Click that and in the menu you can edit the chart.

Select Edit Chart to bring up the chart editor.

The data range is: ChartData!B1:B11, ChartData!D1:D11, ChartData!M1:N11, ChartData!Q1:R11

Columns B, D, M, N, Q and R are used in the table with values from row 1 to 11. In the spreadsheet, I only have 10 holding positions where row 1 is the table headings and the data is contained within row 2 to row 11.

E.g. if you have 20 current holdings and need to update the graph, the data ranges would be

ChartData!B1:B21, ChartData!D1:D21, ChartData!M1:N21, ChartData!Q1:R21

To see the ranges in more detail, click the grid icon next to the range values to bring up this window.

You can add more detail to your table by adding another range.

Press ok and save.

The other two graphs you will need to update include a pie chart displaying sizing and gain/loss.

Another Portfolio Tracker made in Java

Maybe you don’t like the idea of storing your information on the cloud.

Then as an alternative, here is a free, lite, portable and java portfolio tracker that you can use. Again thanks to Investment Moats for bringing it to my attention.

You need to have Java installed on your computer for this to run though. It is still in beta stage so expect bugs and limited documentation but a very good freebie.

Import feature doesn’t work too well so if you have hundreds of transactions to enter, it will take you a long time. But still, better than most.

Truly the Best Stock Portfolio Tracker

After plugging in all my historical transactions, all I can say is that I’m hooked with this version. It has made tracking so much easier. I will continue to add good features when it becomes a need, but until then, enjoy.

Don’t forget to Like, share or tweet it if you like this.

You may also be interested in:

1. Improved Investment Tracking Spreadsheet
2. Online Investment Tracking Spreadsheet
3. Benjamin Graham Formula Free Stock Valuation Spreadsheet

Written by

Jae Jun

What a great turnout. More than 400 votes were tallied in selecting the best stocks for 2012.

Each position starts with an equal $10k allocation. Total starting portfolio is $100k.

You can see the details of each holding such as unrealized gain/loss figures in absolute dollar and percentage terms on the Top 10 2012 stocks page. I’ve put up a 20 minute delayed, auto updating graph and table you can follow.

2 brains are better than one and that is the main objective for tracking these stocks. Each submission is supposedly a best idea. I want to see whether voting for the best of the best ideas will “normalize” the bad decisions by an individual. Hopefully this will lead to an awe inspiring portfolio.

Don’t get the wrong idea that this is some sort of “herd” investing. Herd investing is where you mindlessly follow other picks. Here, it is a silent debate over the best idea. Just like a ballot.

Top 10 Stocks for 2012 as Voted by You

click image to go to the page

Below are the short elevator pitches for each submitted idea that made the top 10.

1. Oracle [ORCL] - Stock declined 18% in 2011. Sell-off on recent earnings miss is overdone. Has a wide moat. Larry Ellison is a good CEO. Stock currently appears in Greenblatt’s magic formula screener. Cash earnings yield over 9%.

2. Bank of America [BAC] – Most hated stock in the DOW. Big institutions are bound to realize that BAC is well funded and isn’t dying anytime soon.

3. Western Digital Corp [WDC] – Sells for a Fwd P/E=6 and BV=1.27. For a tech company it’s really cheap.

4. Gravity [GRVY] – Once they have their new game up and running it’ll start inching up to something at least more in line with book value.

5. Dell [DELL]- $15 stock with $7 in cash. Company moving away from PC’s and into higher margin enterprise solutions.

6. Corning [GLW] - A great innovative company. The stock price has taken a deep hit this year.

7. Microsoft [MSFT] – Appears in Greenblatt’s magic formula screener with FCF Yield 13.85% and EV/EBITDA for 2012 at 5.52

9. Goldman Sachs [GS] – With share price at $90, company is buying back as much of itself as it can. All of that is accretive eventually and if anyone will find a way to make a good return on capital it will be GS despite obvious headwinds.

10. ADDvantage Technologies Group [AEY] – Profitable for last 25 years, Surplus Cash = 58% share price., TBV = 163% share price, NCAV = 127% share price. Avg. 10yr op. margin = 17%. ROA= 16%, Classic Graham Net-Net.

Disclosure

Long AEY, GRVY at time of writing

You may also be interested in:

1. 10 Cheap Value Net Net Stocks Available
2. The Art of Selling Stocks
3. Fortune Best Stocks to Retire On: Part 4

Keeping it simple. Just two links for you this weekend.

Netflix’s History and Its Business Transformation

In particular, the business model of Netflix is changing and its financial performance will be quite different in the future. Anyone investing in Netflix right now is essentially investing in a restructuring. However, unlike classic restructuring carried out at the last minute when the company is failing, Netflix is profitable and is trying to create a new market.

The Loser’s Game (pdf)

Most institutional investment managers continue to believe, or at least say they believe, that they can and soon will again “outperform the market.” They won’t and they can’t. And the purpose of this article is to explain why not… The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.

You may also be interested in:

1. How to Find Ideas based on Industry & Competitors
2. Rarely do you See Such an Excellent Airline
3. Business Valuation of iGo Inc (IGOI):Part 1

Written by

Jae Jun

What I’m going to try to do this year is to write more stock analyses. Whether it be official ones published on the blog or point form published on the forum, I want to keep training myself to continually read, write and come up with new and better ideas. I like to write in point form because it’s quick and straight to the point. I don’t have to worry about prettying it up like I do when writing on this blog.

Each of the below analysis was written after reading one 10-k or 10-Q. You know the 80-20 rule right? Well 80% of the information will come from one annual report which only takes 20% of the time.

Articles by other authors help to speed things up in getting to know the company. Financial analysis and stock valuation is then performed with the stock valuation tools.

So far, here are three that I have written.

1. ADDvantage Technologies Group (AEY)

2. Hibbett Sports (HIBB)

3. iGo Inc (IGOI)

ADDvantage Technologies Group (AEY)

ADDvantage Technologies Group, Inc., through its subsidiaries, distributes and services a line of electronics and hardware for the cable television (CATV) industry. The products, the Company sells and services are used to acquire, distribute, receive and protect the communications signals carried on fiber-optic, coaxial cable and wireless distribution systems.

Why is it Cheap?

• Boring business
• Reseller of equipment to companies such as Comcast, Direct TV, CenturyLink etc
• Industry risk. Consolidation could mean loss in revenue. Customers have slowed down their network upgrades.
• Builds up inventory of new and used equipment to sell
• Not followed or held by any of the big boys

Management

• Not much insider buying even at these low levels
• Total exec compensation was 2.4% of revenue in 2010. Below my 3% threshold which is good.

Growth

• Not much room for growth. But with such a healthy balance sheet, their returns do not have to be high to produce growth.
• Market is assuming that the max it can do is 4% growth by reverse engineering prices
• Acquisitions will help with growth. Their acquisitions are small and targeted based on the target’s distribution channel and product offerings.

Moat

• Niche player. Can’t beat the OEM’s in providing equipment, but does take advantage of the many black holes left behind by them.
• Sustainability is absent. A new competitor with money could come overnight and take them out.

Competitors

• Competitive business
• Trading at net net value means there are better competitors otherwise it wouldn’t trade below asset value

Risks

• Inventory valuation. If it had to be liquidated, how much would it be worth?
• Strategy of building up inventory – very low inventory turnovers. All costs money and working capital.
• New agreement with CSCO isn’t the best. They now have to resell CSCO products which will lower margins.
• No dividends. Just builds cash.
• Don’t see much chance of buyout for such a company

Valuation

• no matter what I try, I keep coming up with a low range of $2.80 to $3 which gives 34% upside potential as a minimum.
• Operating at low end of business cycle as the industry has slowed down. Cash flow will reduce.
• I’m estimating EPS of $0.28 for 2011 without doing much more work.

Catalysts

• Industry starts spending for network upgrades
• (hmm can’t think of many catalysts other than being cheap)

Conclusion

Quality net net currently operating at the down cycle. Room for revenue and cash flow growth if the industry picks up. A bit too reliant on external factors but management has been able to handle the business very well. Great ROE, CROIC for a net net. Not many profitable ones out there. Business is easy to understand and the biggest risk really comes down to whether the inventory is really worth what it is.

I wouldn’t call it a value trap because their business model is consistent.

Verdict

• Management: B
• Growth: C
• Moat: C
• Risk: A
• Valuation: A
• Total: B

Buy a small position and wait for a long time to play out.

Other links on AEY

http://www.whopperinvestments.com/addvantage-technologies-aey

http://seekingalpha.com/article/270351-addvantage-technologies-group-bad-quarter-good-price

http://seekingalpha.com/article/252702-the-safer-and-cheaper-addvantage

http://seekingalpha.com/article/237046-addvantage-technologies-high-quality-micro-cap

Hibbett Sports (HIBB)

Hibbett Sports, Inc. operates sporting goods stores in small to mid-sized markets, in the Southeast, Southwest, Mid-Atlantic and lower Midwest regions of the United States. The Company’s stores offer a range of athletic equipment, footwear and apparel.

iGo Inc (IGOI)

iGo, Inc. (iGo) is a provider of accessories and power management solutions for the electronics industry. As of December 31, 2010, the Company marketed its electronics accessory products in three categories: power, protection and audio. It also markets other mobile electronic accessories, including laptop cooling stands, mounts, and mini-projectors (also known as pico projectors) that attach to mobile electronic devices for displaying video.

iGo primarily sells its products through retailers, such as RadioShack, Walmart, Office Depot, Hudson News and Inmotion Entertainment; resellers, such as Ingram Micro, Inc., Microcel, and Superior Communications, and directly to end users through its iGo and Aerial7 websites.

Business Overview

• Company makes after market power (laptop power adapter, phone chargers), batteries, audio (ear phones), protection (skins, cases, screen protectors)
• Highly competitive and commodity business. No moat or advantage in any of the products. Maybe the power adapter, but not really.
• Theoretically for this type of business, the only competitive advantage would be distribution channels and pricing.

Risks

• Wal-Mart is the biggest customer. Lose Wal-Mart and the company is finished. They already lost Belkin a few years back.
• Revenue from Radioshack continues to decline
• Commodity business. A better competitor could come along any time. Batteries, audio, protection products all suck.
• Volatile business. Retail business. Subject to macro.
• Recent acquisitions worth it? Will it work?

Management

• Management compensation levels are fair. Does not exceed 3% of revenues.
• Open market purchase by President/CEO Heil in Dec.

Financials

• Historically lost more money than made
• SG&A rising offset by cost of revenues
• R&D expense decreasing
• Bad returns. ROE in the low single digits, CROIC regularly in negative territory
• DSO has increased dramatically
• Inventory turnover decreased

Valuation

• Same thoughts as when I held it in 2009. Business and management sucks.
• Only thing going for it is the asset valuation.
• NCAV is $0.88 vs current $0.77. Net net (NNWC) value is $0.62.
• Wouldn’t buy IGOI at anything other than 10-15% below NNWC value.

Other

A lot of hope seems to be placed in the partnership with Texas instruments in energy saving chips, but that is too far down the road. Even if you try to put a value on that relationship and the growth that “could” come out of it, it isn’t worth it.

Verdict

• Management: C
• Growth: B
• Moat: C
• Risk: B
• Valuation: B
• Total: B-

Not a company to value based on earnings. Best play would be when it falls below NCAV or NNWC. Anything else is too risky.

Disclosure

Long AEY.

You may also be interested in:

1. DIVX Negative Enterprise Value Stock Analysis
2. Investing Forum Stock Analysis by Members
3. Stock Research and Analysis: Mastech Holdings (MHH) Part 1

Written by

Jae Jun

Full 2011 Year End Value Stock Screen Performances

Compare with 2010 Value Stock Screens

Stock Screen Results Discussion

A much different story compared to 2010. It has been a brutal year for many investing strategies. Of the 13 value stock screens that I track, only two were positive for the year and one was breakeven. The remaining 10 value stock screeners underperformed by big margins.

I wanted to see whether it was just my strategies that did poorly but it seems like AAII didn’t have a good year as well. The most surprising difference between my screen results and AAII was the performance of the Piotroski stock screener. The standard version I have performed well again this year compared to AAII’s -36.7% return.

Screen Settings

For these performance measurements, I use just 15 stocks. On the screener pages, I list 30 just to keep ideas flowing for everyone. Certain volume and price requirements must be met and I’ve tried to weed out Chinese stocks. As always, I don’t include financial companies, REIT’s and holding companies.

Observations and Takeaways of each Stock Screener

Negative Enterprise: Companies that have negative enterprise value are always flush with cash. This criteria became a problem in 2011 when Chinese reverse mergers began popping up everywhere.

These Chinese companies were just loaded with cash and filled the screen. Since reverse mergers are not listed as ADR’s, I couldn’t find a way to weed it out. If this continues to happen, I am thinking of just deleting the screen entirely.

Altman Z Screen: Anything categorized as low quality took a big hit last year. Seems like the majority stuck with high quality stocks which Altman Z score screens for. The screen like all the others tend to focus on small caps and so a -5.8% is acceptable in my opinion.

CROIC and FCF Cows: I was surprised that these two did so poorly. Fundamentals of the companies were strong, returns high, cash flow is positive and strong. The end result was poor. I will have to take a look at the criteria and see whether I have to tweak it.

Graham Checklist & Graham Formula: Decent results. The best as the Graham checklist screen under performed and the Graham formula matched the S&P. Still did very well when compared to the others.

Graham emphasized that investing shouldn’t be rocket science and it was best to keep it simple. His methods are proving to be correct again.

Insider Buys: AAII also had a horrible year for their insider buy screen. Is it because management is over optimistic and that insiders do not analyze their own company objectively? One issue I found is that screens have a hard time of picking the difference between open market purchases and stock options.

NCAV, NNWC & NNWC incr: NCAV screen was actually a surprise this year. It was the best performer this year, partly due to the end of year run ups from PARL and other micro caps which even I find to be risky more than doubling in the year.

Seeing how NCAV did so well, I would have thought the NNWC stock screen would have done just as good, but since the companies on this screen are more asset based opportunities without a valid business model, it got crushed.

NNWC increasing stocks didn’t fair better. If tangible book value is increasing, then it is expected that the company would be able to earn a return off the increasing book value, leading to higher earnings and stock prices. Not true this year. More monitoring required on this.

Piotroski Screen: Has been a soldier. Consistent and steady. So far the screen has been able to outperform in the good years and not lose too much in bad years. Quality companies based on accounting figures seems to be working.

Share Buyback: Any stock that got hit hard bought shares. Some went onto to further losses. Remember what they say. “Just because it is cheap, doesn’t mean it can’t get cheaper.” How very true. A difficult lesson for me in 2011.

Low Expectations: The market may be expecting little from these companies, but as a contrarian strategy, it certainly did meet my expectations. Healthcare stocks which I would have avoided due to regulatory risk were some of the best performers. These cheap companies in out of favor industries looks like a good strategy to further enhance.

I have not published the low expectations screen yet. It’s on my todo list. Let’s see how these stock screens handle 2012.

You may also be interested in:

1. Value Stock Screen Q1 2011 Performance
2. Value Stock Screen Performance YTD Part 2
3. Piotroski Score Screen Performance

Few links to start off your week.

Value Traps and Investor Psychology

Value traps take the form of companies that seem inexpensive in terms of attractive valuation metrics. Despite this allure, these companies typically possess underlying fundamentals that suggest they are in secular (long-term), not cyclical (shorter-term), decline.

Why Best Buy is Going out of Business…Gradually – Forbes

Electronics retailer Best Buy is headed for the exits.  I can’t say when exactly, but my guess is that it’s only a matter of time, maybe a few more years. Consider a few key metrics.  Despite the disappearance of competitors including Circuit City, the company is losing market share. Its last earnings announcement disappointed investors.

Are you an asset based or franchise value investor?

Today, I want to talk about the two types of value investing and the differences between the two. In my mind, there are two types of investments, asset based or franchise (Bruce Greenwald’s Value Investing book mentions three: asset, earnings power, and franchise. I think the line between earnings based and asset based is too thin to distinguish between the two).

You may also be interested in:

1. Value Traps
2. Bankruptcy Investing: MMPIQ

Guest Post by

Daniel Sparks

Value Folio

Warren Buffett’s Berkshire Hathaway holdings (both subsidiaries and stocks) are all very different types of businesses. Consider these different industries which Berkshire has holdings in:

• Insurance
• Manufactured Homes
• Jewelry
• Fast Food
• Aviation
• Chemical
• Underwear
• Journalism
• TV Networks
• Furniture
• Banking
• Kitchenware
• Railroad

This list, of course, is only touching the surface.

Point being, Berkshire owns businesses in many different industries.

How, then, does Buffett still claim to stay within his “circle of competence”?

There must be some common factor among his holdings. As successful as Buffett has been during his investing career, the common factor should be regarded with great reverence. So what is it?

Many of you, I’m sure, have already guessed it. There is nothing complicated here. The answer is so simple that it almost seems like a waste of time. But perhaps there is power in simplicity.

This time, take a look at a list of actual businesses in Berkshire’s portfolio (subsidiaries and stock). The list is made up of many of Berkshire’s largest holdings:

• GEICO Auto Insurance
• Coca-Cola
• IBM
• American Express Co
• Burlington Northern Santa Fe Railroad
• Wells Fargo & Co
• Wal-Mart
• Procter & Gamble
• ConocoPhillips
• Dairy Queen
• Nebraska Furniture Mart

While I am sure it is possible to argue that there is more than one common characteristic between these businesses, the one screaming similarity is that they all have some sort of durable competitive advantage. None of these businesses would easily lose its competitive advantage overnight. Warren Buffett has clearly explained that he only invests in companies with an economic moat (his term for durable competitive advantage).

Recently, as Warren Buffett was justifying his $10 billion purchase of IBM stock, he used another word in place of economic moat. He explained that IBM has “continuity”. A close look at the definition shows a great resemblance to “economic moat” or at least it portrays the reason an economic moat is so necessary.

continuity: the unbroken and consistent existence or operation of something over a period of time

So for those of us Value Investors that are trying to emulate Warren Buffett, perhaps the most important question we could ask ourselves when considering our next purchase of a stock is

• Do the economics and competitive landscape of this investment allow for continuity?
• Does this business possess a wide and deep economic moat?

Answering this question, of course, is not easy. Two of the most common approaches include:

1. Looking for businesses that have higher gross margins than their competitors

2. Taking a good look at the business’ revenue stream, looking for (1) continuing demand, and (2) a promise of continuity. The best way to do this is to break down a business revenue stream by major products or services. Then you can get a better idea of where the revenue is coming from, how much demand there really is, and how sustainable it is.

Sometimes, however, just sitting back and thinking after you have done your research on the company might be your best option on deciding whether you think the competitive advantage is sustainable or not.

Warren Buffett and Charlie Munger have often said they spend much of their time simply thinking and reading. If the economic moat isn’t obvious, perhaps there is a good chance it doesn’t have an economic moat at all. That is at least the feeling I get when I look over Warren Buffett’s holdings.

About the author: Daniel Sparks is an MBA student at Colorado State University. He has a passion for value investing and runs a value investing blog at ValueFolio. He can be reached at danielsparks11@gmail.com

You may also be interested in:

1. Stock Research and Analysis: Mastech Holdings (MHH) Part 1
2. The Evolution of Warren Buffett as an Investor
3. Stop fooling yourself. You are not Warren Buffett.

Written by

Jae Jun

Let’s try an interesting experiment in 2012. I don’t know whether this has been done before, but I’ve set up a voting system where you can submit a short analysis (max 350 characters) of any stock.

You can then vote up or down a submission. Depending on the numbers of submissions and votes, the top 10 stocks will be tracked in a portfolio for 2012 and beyond.

This is where we get to see whether a community portfolio will outperform an individual portfolio or the index.

You can copy and paste a URL of a good stock analysis if you wish. Just make sure to minimize the URL via bit.ly

Go submit your best idea and vote for others by clicking this link.

Click the image to go to the page.

I’ve gotten the ball rolling with DACHA which I voted down just to be fair.

Voting will remain open for a week, or until I get enough samples.

Be sure to tell your friends about it. Share it on Facebook or Twitter.

This will be a fun experiment.

You may also be interested in:

1. Top 10 Stocks for 2012
2. How to Find Value Stocks and Ideas
3. 8 Cheap Stocks below Net Net Working Capital

Written by

Jae Jun

In adherence to my blog posting policy of quality and timelessness over quantity, I didn’t write as frequently as previous years but I’m happy that  you’ve found a lot of the content in 2011 useful.

I’m going to break down the most popular posts by category. Bookmark this page or save the links, because they are full of practical information.

Now let’s take a look back.

10 Most Popular Articles of 2011

Finally! 7 Ways to Achieve Mind Blowing Returns : A list of 7 characteristics you need to beat the market.

Now is the time to PANIC : In a volatile year, full of uncertainty, this is a call to get up and keep your head on straight.

Tutorial to Easily Auto Track Insider Transactions : One of the many tutorials and how to’s I wrote this year. Learn how to track all insider transactions without having to pay for anything.

Tutorial to Quickly Detect Changes in the Footnotes : An excellent technique to quickly find any changes in the footnotes of 10-Q’s and 10-K’s. Will save you tons of time.

My Highest Conviction Pick and Other Links : A discussion of Dacha along with other links timeless articles to help your investing.

The Business and Risk of Bolt Technologies & Here’s One Stock to Boost Your Portfolio : Deeper stock analysis of BOLT which I find to be a high quality company.

On Sale. 40% off my Highest Conviction Pick : Full stock analysis and discussion of Dacha Strategic Metals.

You Just Made These 5 Investing Mistakes : Find out whether you are making these simple mistakes when investing.

How about Going Through 200 Stocks with Me? : Each year, I go through the Forbes Best Small Companies. This year, I revisited the Forbes 2009 list consisting of 200 companies.

Basics Series

A collection of my experiences of how I went about learning to invest.

How to Invest In the Stock Market-Background

How to Invest In the Stock Market-Getting Started

How to Invest In the Stock Market-Getting Harder

How to Invest in the Stock Market-Reflections

Book Reviews

Increase your knowledge through good books.

Investment Book Review: Financial Shenanigans

You Can Be A Stock Market Genius!

Guest Posts

Fine articles by guest posters.

Stop fooling yourself. You are not Warren Buffett.

The Evolution of Warren Buffett as an Investor

Investing without a framework is financial suicide

Investing Perspectives

A couple of old links but heavily read. Timeless material.

The Value of Not Being Sure: Seth Klarman

Value Stock Investment Criteria

Investment Strategies

A new screen I created and monitoring is doing very well in the market.

This Low Expectation Screen is Outperforming by 13% YTD

Valuation Methods

Practical tutorials on stock valuation.

Value Stocks Like a Pro. The Absolute PE Model

How to Value a Stock with Reverse DCF

Discounted Cash Flow & Stock Valuation

Financial Statement Series

You need to master the financial statements to be a better investor.

How to Master Analyzing the Cash Flow Statement

How to Master Analyzing the Income Statement

How to Master Analyzing the Balance Sheet

How Companies Misuse Capitalizing of Expenses

You may also be interested in:

1. Durable Competitive Advantages through the Cash Flow Statement
2. Identify Durable Competitive Advantages through the Income Statement
3. Investing Book Review: Quality of Earnings

Written by

Jae Jun

A week or so ago, I had a guest post about accruals and determining quality of earnings. I hadn’t heard much about it before then so I did some reading am finding it increasingly interesting.

Interesting and useful enough to create an accrual analysis section in the stock valuation models.

Rather than going over the whole accrual topic again, read the article on determining earnings quality through accruals.

Signal of Future Stock Performance?

Based on a 6 page report (pdf) produced by Bernstein Investment Management and Research, companies with low balance sheet accruals out performed companies with high balance sheet accruals by 8-10%.

Other than the equations for finding the accrual ratios from the previous post, I don’t have any information on how Bernstein modified their conditions to get the results, but the theory is the same and is important to understand.

Cash Flow vs Accrual Accounting

Majority of my focus has been on cash flow where there is less room for accounting manipulation because in the real world, we pay cash for something and receive cash for products or services rendered.

This is an ideal scenario and is basically means that earnings should equal the change in cash.

However, this would cause accounting issues as a business could spend a lot of money building inventory one year and not selling it until the next.

Accrual accounting attempts to fix such issues by matching costs with related revenues but he problem is that this method introduces subjective judgments and assumptions.

Here are some other quick observations regarding accrual accounting you need to understand.

Accrual Accounting Observations

(Read the PDF for detailed explanations.)

• Earnings growth due to accrual growth is not sustainable. This is like cookie jar accounting where a company “borrows” earnings from the future to make earnings look good today.

• Balance sheet accrual can indicate whether capital is being used properly. A company with high accruals can come from acquiring or merging with companies which expands the asset base. Low balance sheet accrual companies tend to shrink their balance sheet through spin offs, share repurchases or large write offs. In these situations, it is usually removing bad performing assets or returning money to shareholders which is always a good use of capital.

• High accruals indicate that the company has expanded its asset base rapidly.

• Companies with high balance sheet accruals tend to have higher sales growth than low balance sheet accrual companies.

• High balance sheet accruals also have a higher ROE.

• Remember that maintaining a high sales growth or high ROE is difficult unless you have an entrenched moat. Such companies revert to the mean and disappoints analysts.

• Companies with low balance sheet accruals tend to have below average returns on equity. Analysts expect the company to lag.

All of this sounds a like regular value investing and contrarian investing principles.

Examples to Analyze

Let’s analyze an example to nail the concepts into our heads. You and I have the benefit of hindsight bias with these examples.

I’ve chosen DLB as my first example because it is a current holding of mine and it’s always a good idea to challenge current holdings with new ideas.

Both the balance sheet and cash flow accrual for DLB has been growing quickly. The accrual ratios suggest that DLB relies on accruals to post positive earnings. But the assumption can’t just end there.

Cash has been increasing with decreasing debt, total liabilities well under control with consistently increasing net income.

If net income drops with accruals increasing, watch out.

The Sloan ratio is best when kept below 8%. You see in 2007 – 2009, it was much too high. It may have been that all those accruals finally got to the stock price in 2010 as it hit $70. Then with news that DLB won’t be included in Windows 8, the stock reverted to the mean level where all future revenue for Windows 8 is removed.

Do Accruals Indicate Stock Performance?

I must have gone through about 20 companies to try and find a obvious example, but it is much harder to find that I thought. Many companies with horrible accruals ended up shooting up with a stock price still strong after 5 years.

I’m not surprised though because the accrual ratio is still just one way of analyzing a company’s health.

A better way to go about doing it would be to compare direct competitors to see how the ratios stand within the industry.

Your Homework

Here is your  mission. Go through the numbers quickly for Western Digital (WDC) and tell me what you think about its accruals.

You shouldn’t take more than 5 minutes.

There is no right or wrong answer as this analysis still involves some subjective thought processing.

Final Thoughts

Red warnings signs won’t show up for every stock that you look at. If you do this exercise with AAPL, you will notice that it breaks all rules. As a cash flow investor, I’ve focused most of my energy on the cash flow until now, but understanding how that cash flow is related to earnings is a great check to include in your analysis.

The accrual ratios won’t help you find killer investments, but it will help with building a healthy portfolio. I’ve yet to see how I can fully maximize the lessons from here myself, but I will definitely be including a check in the accruals in my investment process and stock valuation models to speed things up.

You may also be interested in:

1. You Need to Determine Earnings Quality Through Accruals
2. Company Assessment, Checklist and Spider Graphs
3. Quality Systems Inc (QSII) is a Quality Company