Tuesday, October 25, 2005

Friday's Presentation

Man, I'm really psyched about presenting ETLT with my man Krish (even if it's a battle). I think it's going to be a super interesting presentation that will hopefully keep the club awake :D

Friday, October 21, 2005

Eternal Technologies

Yo. Ticker ETLT. This is a company that does livestock breeding operations in Inner Mongolia of China. They run a breeding center, transplant embryos, and breed meet sheep and other livestocks. This must sound pretty nasty for all you animal rights people... but just because it's nasty doesn't mean it wouldn't be a good investment!

This is the biggest mind-boggling investment that I have found in a while.
They have 21m in cash, and is trading for 13m!!!

But don't be fooled, that cash is restricted only for uses in China. Meaning, management has specifically allocated this resource for uses inside the people's republic, and if the company wants to expand abroad, it will have to do so through new stock/debt financing. But hey... what's wrong with keeping the money where it's at?

Even if you really don't feel comfortable with where the cash is being kept... this company makes a pretty good value company in America look like shit. You got a P/E of 3.18 on this company that is expected to have more growth in the future due to increased demand. Well, I guess you could argue that the cash earnings they make can only be kept in China (see above paragraph) so it's not really "cash" in USD. Yes, definitely arguable...

But! The RMB is supposed to appreciate against the dollar from now on isn't it? What's wrong with buying into a premenant RMB asset? Unless you just hate China.

On top of it all, the Chinese have a zero-tax policy to companies like these because they operate in agriculture, and this isn't expected to end until July 2008. Sweet deal.

They are expected to come out with a pretty awesome Q3 and Q4 (historically good quarters) because of new contracts and orders, which a bulk of is usually realized in these two periods. So there's a pretty good 'catalyst' if you can call it that.

Alright, I'm almost sold on this stock.

Wednesday, October 12, 2005

Silverleaf Resorts

Here's an interesting company that might deserve the attention of some financial theorists:

There's a company out there that owns lots and lots of vacation land and resorts mainly down south (in fact, 45% of their sales come from good ol' Texas, the Long Star State) and they sell "timeshare" resort ownerships to interested purchasers who are willing to pay a certain amount of money to own a vacation spot for certain time-slots in the year. They are pretty much exactly like a real-estate company in that 1.) they sell mortgage notes and ownership to purchasers of time-shares 2.) they lever up financially to support the notes and various maintenance operations.

Their main sources of revenue are:

10% downpayment on ownership of timeshare resort
15% annualized rates on the principal owned to them though mortgage notes

Their main sources of expense are:

Cost of debt of around 6.5% per annum
Certain principal payments due (but theoretically this company can just keep borrowing money to build resorts and pocket the interest income/expense spread year on year)


Not quite... but before I get to that, I'd like to mention the implications this would have on MC/FCFE and EV/FCFF. As you've probably already guessed, the EV/FCFF ratio is going to be much higher than the MC/FCFE. Why?

Frequent readers might remember me mentioning the effects of "Financial Leverage" on the value of an equity security. As debt load decreases, interest expense decreases as well. What happens in this company is a BUTTLOAD of debt exists in the enterprise value calculation that makes the EV/FCFF ratio very large. Interest expense is by no means enough to increase FCFF enough to offset the effects of a large EV. Anyway, that's my story and I'm sticking to it...

*Gosh, who the hell stays up until 5:39 AM and writes in an investment blog anyway!?*


Im so tired. Let me wrap this up some other time... but the main points i'd like to make about this stock is:

It could have a very attractive forecast going forward provided that they can collect the debt owed to them on a consistent basis. But accoring to thier annual report a whopping 20% of their debt is delinquent, as people just default on the mortgage payments--in which case the company sells the timeshare back to someone else and gets a 10% downpayment anew. Still, the effects of this bad-debt provision is not too clear, but suppose new people keep replacing the old who default on the loan... it shouldn't have too much of an effect on the company's sales--what will be most worrisome is if no sales are generated as ownership turns over. And... that MIGHT JUST happen because of a slumping economy and an overall cloudy forecast for consumer spending and confidence.

But who knows?

The company is also exposed to very real interest rate risk. Remember the debt that the company has to keep on borrowing in order to finance its receivables? Well, we all know what's happening to interest rates these days. The spread on which the company makes its money (appx. 17% of their revenue) is going to get knocked pretty hard in the foreseeable future. But still, 70-80% of their revenue comes from principal payments, so I'm not TOO worried.

One very good thing about the company:

Holds REAL land that could be sold for multiples of what they bought at.

Now... if we can figure out what management plans to do with all their free cash generated from property sales and interest spreads then this would be a really cool investment. Paying down debt would be the best scenario.

Im out.


For anyone who doesn't understand what the heck the title of this blog entry means... you're not alone! Heck, I myself don't quite understand it fully either, but I'm going to try to explain anyway :) My latest idea deeply involves the conceptual knowledge that goes behind these two ratios--it'll be the first time I actually try to explain MC/FCFE and EV/FCFF what they mean to me. So here goes!


I suppose the easiest way to start is with a question: What happens when a firm is loaded up the wazoo on debt, but still manage to make cash quarter-over-quarter and year-over-year? How do you measure the firm's profitability in terms of how much profit it can generate for equity holders and both debt AND equity holders? Well, my friends, you've guessed it... that's why MC/FCFE and EV/FCFF exists. They are seperate ratios measuring different returns different kind of investors look at when they value a firm. One is from an equity perspective, and one is from a debt perspective. Now, let me go over some quick definitions:

MC/FCFE is an abbreviation for the ratio between a company's Market Capitalization Rate (MC) and its Free Cash Flow to Equity (FCFE). Now, market capitalization rate I'm sure you all are familiar with, but what is Free Cash Flow to Equity you ask? Well grasshopper, the general equation to figure out FCFE is "Operating Income + Depreciation + Amortization - Capital Expenditures - Net Change in Working Capital - Interest Expense - Tax Expense" and sometimes it has R&D, Operating leases, debt issuance/payments that we don't need to worry about too much for the sake of simplicity.

EV/FCFE is an abbreviation for the ratio between a company's Enterprise Value (EV) and its Free Cash Flow to FIRM (FCFF). The enterprise value of a company can be calculated quite simply: "Market Capitalization + Net Debt" (Net Debt = Long/Short-term Debt Issuances - Cash). What does EV mean in abstract? Well, let's pretend that there's a company, and all that exists in this company is a I.O.U. note for $50mm and a bag of gold bricks worth $20mm. The market is currently trading this company at $30mm because the company is expected to magically make some income over the next couple of years. In a simple Market Capitalization scenario, we would put the company's value at what is stated: $30mm. In an Enterprise Value scenario, we also like to take into account the I.O.U. note and the brick of gold, which nets out to be $10mm in debt. So when you buy this company, what are you REALLY paying? $30mm? or $40mm? I'll let you smarties figure that out :D -- Free Cash Flow to Firm is exactly like Free Cash Flow to Equity, except you put back in what you've subtracted as interest expense.


So what are the implications of these two distinctions? Well for starters, MC/FCFE measures the profitability to SHAREHOLDERS the best, while EV/FCFF measures the profitability of the ENTIRE BUSINESS (shareholders and debt-holders). So how do we know which one to use when we're valuing a business?

The key point in the answer to that question lies in whichever fits the company's current state of operations the best. I've generally followed three guidelines when comparing the relative importance of the two ratios on a company.

1.) If the company is a cash monster and has no debt, then use EV/FCFF because its basically the same as MC/FCFE except your getting "cash back" with the EV adjustment

2.) If a company is highly levered, then use MC/FCFE because interest payments and debt is financial leverage that could be paid down over time, reducing expenses incurred by shareholders. If a company has $100mm in debt, and pays $10mm in interest expense every year. But that company is able generate $20mm a year, and use the remaining $10mm to pay the $100mm debt down gradually, then it will 1.) have less interest rate at the end of every quarter compounded to pay 2.) have more money left over to pay the principal. Lower debt + lower interest = higher value for shareholders.

3.) If a company's debt and cash balances are quite similar, then value both ratios equally. Chances are, they will come down to a pretty similar ratio figure anyways.

By following these guidelines, in a way, you are putting more emphasis on what you are buying the entire firm for when the company is cash rich and debt poor, and emphasis on what you are buying equity in a firm for when the company is debt rich and cash poor. This is what my mentor Steve taught me back in the day. And he called the latter phenomenon where shareholders get progressively better returns as debt is being paid down "Financial Leverage"

Sunday, October 09, 2005

Tangible Book Value as Downside Cushion

Bonso Electronics, Inc. is a really great classic value stock that we don't ever expect to find on the market anymore, but nevertheless, it is there. I've looked everywhere for a possible reason why the stock can be so cheap, and here are some reasons I've found:

- Company operates in China, where the political/business environment is uncertain
- Company is losing sales in one of its seasonal segments
- Company relies too much on 7-8 large customers for its sales

True, these are very good reasons why a company would be trading at a discount. Currently the ratio of MC/FCFE on this company is around 6x... pretty steep, even for a company with that kind of risk.

Now, the China risk is understandable. This company incurrs around a 15% effective tax rate because of a special business status it holds in the ShenZhen area, should that change at anytime, they would be forced to pay higher taxes that would lower their profits.

But the fact that the sales on a seasonal segment is flailing should be no cause for concern--this is their telecommunications product segment by the way. The Scales segment is growing and is projected to more than make up for the losses there (Scales segment have better margins, and better scale 'no pun intended' har har har)

The 7-8 large customers is not a problem either because the company is actively seeking out new partnerships and also is integrating distribution channels to offset potential loss.


I like this stock not only because of the attractive discount, but also because of its limited downside. Even if all the worse case scenarios happen, the company still boasts a tangible book value of around 30m, which would more than cushion the downside. We have very little risk in that area.

What happens if the company starts losing money, you say? Well, due to the nature of the company's operations (a manufacturing facility in China), it is highly doubtful that the costs of running this company would be fixed to the extent that a reduction in sales could reduce its margins enough to go into the negative. As cruel as it sounds... Chinese labor is very expendable.

Anyway, I'm beginning to put a small position in the company for the Initiative...

Friday, October 07, 2005

Arbitrage Without a Long/Short is Stupid

Remember when I said that you could make some money on SPCHA because it's trading at a 16.5% discount relative to SPCHB? Unless you have a way of shorting SPCHB and longing SPCHA... forget it! That's the lesson I learned on $1000 lost! :D

I bought some shares in SPCHA the other day, thinking that there is absolutely no reason for the stock to go down because SPCHB is trading at a price that can't possibly go lower--what's my reasoning? The stock is illiquid enough so that thoughout its history, it has hovered around it's 11.00 value without much trading going on. A "stock split" shouldn't change the value of the B class too much right? WRONG!

For the sake of clarity, let me reiterate what happend:

- Class B shareholders have 1 vote for every share held
- And for every share held, they got a new Class A share which have 1/20th of a vote, but garners 110% of cash dividends paid to Class B shareholders...

Well, what's probably happening on the market right now is the origial Class B shareholders are selling their Class A shares like crazy, in order to use the proceeds to buy more Class B stock, so that their voting rights are not being diluted with the new split, or gain even more voting rights (hey the two stocks trade at almost the same price, why not have more of the one with more votes?)

Me, like an idiot, bought into the Class A shares, thinking the value of the two should converge on technicality, because a 16.5% discount is a little steep... AND I DID THIS WITHOUT SHORTING THE CLASS B SHARES--Ameritrade doesn't offer that option :( So, as the Class B gets lower and lower--probably from a strong selling reaction on the Class A--Class A followed suit. And I'm left with a big REFLEXIVITY fart.

For everyone who doesn't know what "shorting" means... it is generally a strategy that daring and intelligent investors use to make money on FALLING stock prices. The investor generally goes to a broker and asks to "borrow" shares of stock--say at $100, and he sells the shares on the open market at the current price--while paying some interest to the broker that's negligible if he makes a killing. If the stock indeed did fall--say to $50. The investor can buy the shares back, and give the "borrowed" shares back to the broker, and then keep the $50 spread minus interest per share (if this is done with millions of dollars, you generally double your money. Get it?) So if I had shorted SPCHB, I would have made some pretty good money, even though I lost money on SPCHA, and the difference would have came up to be around 0.

Anyway, I mentioned reflexivity too...

(reflexivity means when two things happen at the same time, and they both CORRELATE and REINFORCE one another. Some really good examples are: Hedge Funds pulling out of Asia thinking the economy is bad, making the economy bad at the same time... Me pulling out of SPCHA thinking the stock is going to fall, making the stock price fall as I sell on a lower dollar value... and M.C. Escher's drawings... for more details on reflexivity, The Alchemy of Finance is a good read, and so is Godel, Escher Bach)

So, I'm left with another chunky loss on my PA (parent's account)... ever since that humongoloid gain I've had with Omni, I've been more and more daring to try new things--since my cusion is bigger for the next quarter...

If only I took more wise risks instead of stupid ones like these... URG!!!


P.S. Will the stock price bounce back up as a result of a stronger SPCHB in the future as buying continues on this stock, reinforcing the Class A shares again? Maybe... but there are better opportunities out there and I'm not one to wait around for this turnaround!

Wednesday, October 05, 2005

Desperate Times & Screwed Shareholders

This post updates where we last left off with JWL... back when I said 1.38 might have been a good investment because liquidating it would give us a value approximately 34% of that. Lo and behold, it didn't work out that way, much like I predicted--instead of liquidating the company, the board and managers have decided to screw the current shareholders, continue running the company, and came up with a re-financing plan that takes all the value out of the company. Boy, am I glad I didn't buy! :D

Infact, what they did to the current shareholders should even be considered illegal. It completely dilutes the value of existing shares, in favor of the company simply "surviving". Just as I thought! After looking at the situation with our beloved Krish (the AllStar PM), we can pretty much summarize the whole investment situation for you:

Whitehall ran into some liquidity problems and was short on cash. They couldn't pay the interest on the $85m dollars debt they had and one of their lenders called default on them. Now Whitehall is refinancing the company, and the terms are:

- 30m Bridge Loan due Dec. 31 2005, on 18% interest
- 1,970,000 warrants, exercisable at $.75
- 50m Convertible debt, on 12% interest, at conversion price of .75 a share

The last two financing options is what completely screws the shareholders over. This dilutes the market capitalization rate so brutally, that there is absolutely no hope of recovering shareholder value again on this company--at least not for the next decade or so. The 50m convertible notes are used to pay down the 30m Bridge loan by the end of the year to save interest... and the rest of the cash will be used to finance their last round of jewelry purchasing and interest payments to make them barely survive past this year. This leaves about 20m more debt on their balance sheets, increasing the figure to roughly 100m. But that's not the killer... noo... the killer is this:

1,970,000 warrants, exercisable at $0.75, and 50m of convertible debt, exercisable at $0.75

Usually, the convertible rate on convertible notes are at least market value to make it fair to the current shareholders that their ownership would not be diluted. But this company issued $50m worth of both ownership of the company and debt, practically at a 35% discount (more if the share prices go up, in the bizarre and twisted event that it actually does go up). It's like Whitehall issued 68 millions shares of stock practically for free--plus they pay a 12% interest on $50 million dollars worth of those stocks. And when the interest is sucked dry, debt holders are sure to convert and realize the rest of the gains on the market.

And I'm not even going to mention the warrants. The warrants were FREE. Period--a thank you gift, rather... to the hedge fund that completely preyed on this company's shareholders.

Now, I re-iterate. At a market capitalization rate of around $20 million Management and the Board could have decided to liquidate the company, and Shareholders would have at least been able to realize 40% more of the stock's value.

This is now a debt-holder's company. Shareholders of Whitehall should sue this action! I just can't seem to get it through my head how wrong it is to deprive shareholders' value this way. Liquidating the company would have made much more economic, as well as moral & ethical sense.

Tuesday, October 04, 2005

Shareholder Class

Looked at an interesting company today called Sport Chalet, Inc. They sell sporting goods and provides various lessons on skiing and scuba diving in Nevada and California. From a fundamental standpoint, the company itself is nothing interesting. It's trading for about 12x earnings (though its a bit less than it's industry peers). But it just got done with an interesting stock split, where the "Common Stock" was made into Class B, and Class B shares got 7 Class A shares as a stock dividend.

Class A common stock holds 1/20th of a vote for every share, and Class B stock holds 1 vote for every share. Class A common stock also gets 110% of dividends that Class B gets, in order to offset for any discounts that it might be trading on the market.

Currently, the Class A share is trading at a discount of about 16.7% relative to the class B. How did I figure that out?

Well, the ratio of A : B shares outstanding was 7, and the ratio of A : B market capitalization is 6. Technically, there should be no discount due to the 110% dividend provision, but alas, there is. This is a classic arbitrage opportunity! Why don't we buy a million shares of Class A and short 900,000 shares of class B!

Wait... oh snap... this company only trades about 5,000 shares a day... poop.
The entire company is worth about 140m--A and B combined.

Pick it up for the PA and make some pocket change if you'd like, but this can't possibly go in the IAG porfolio (at 2% daily volume)--since the commissions will more than offset any gains.

Monday, October 03, 2005

Earthlink: A Lesson on Working Capital

So the newest little security in my lonely little investing world is Earthlink, Inc. (Ticker: ELNK). Many of you may know it as the formerly popular dial-up connection service that boasts 4x the speed of AOL. They aren't doing so well these days. Their subscriber bases are falling as more and more Americans switch to broadband, and the competitive branches Earthlink does have in broadband has terrible margins compared to traditional dial-up. This company is what I'd like to call a "transition" company.

If we take a look at its financials, we'll see a very strong balance sheet with virtually no debt and over 450m in cash and marketable securities. With a Market Cap of around 1.4b, that makes up close to 1/3 of their company value! Their income statement isn't so shabby either; in fact, it will probably make about 120m annually going forward if we annualize the latest quarter (but that may be a bit too liberal, since the summer months are usually the best for ISPs). With an enterprise value of around $1b, and earnings of say, 100m, it doesn't seem like too deep of a discount...

But take a look at their cash-generation. Net out the investments they put into marketable securities and the money they spend buying back their own stock... this company is generating around $100m in cash every quarter!!! Now, let this be a Working Capital lesson to all those who are interested in learning:

You see, a company's earnings, while they are important, is not the "accurate" way to measure how a company can generate money. In fact, I would argue that Income Statements serve the purpose of "normalizing" earnings instead of reporting what is actually there. For a more detailed analysis of the earning power of a company, we would have to turn to its balance sheets and its cashflow statements. Why on earth would we look at a balance sheet, you ask? What possibly can balance sheets tell me about a company's earning power? Ahh, you ask good questions, grasshopper... you see, the balance sheet is a snapshot of the financial condition of a company in a single moment in time. When you analyze the changes in the financial conditions of a business at different moments in time, you can more clearly see how assets, liabilities, and equity move around than you can with any earnings statement.

Now, let me define working capital for you. Working capital, traditionally, means Current Assets minus Current Liabilities. It's supposed to measure a firm's ability to finance it's debt or growth. Current Assets is assumed to be readily convertible into cash, and Current Liabilities is assumed to be debts that are coming due. If a firm has negative working capital in this sense, it usually is a bad sign, prognosticating the probability that a firm might go bankrupt because it will not be able to finance its operations.

But in order to measure how cash flows in and out of the business, we must let go of a traditional assumption, and assume a definition of working capital that is slightly different. Let's define working capital as All non-cash assets, minus All non-debt liabilities. We do this for one simple reason: because the changes in working capital period on period will give us a hint as to how the firm's cash flows in and out of asset and liability accounts, and how the net change affects the cash balance in the period.


Now why is Earthlink interesting? Well for one, changes in working capital has provided this company with about $15 - $100m dollars in free cash flow per quarter over the past couple of years. Now, theoretically, this should be impossible to sustain--and it probably is. Upon closer inspection, We find that the biggest changes in working capital comes from moving in and out of large investments. You see, the working capital increases when there are either 1.) an increase in the Assets, or two, a decrease in the liabilities. Similarly, when working capital decreases, either the assets decreased or the liabilities increased. Now, we should know that when non-cash assets increase, it is probably either financed by an increase in liabilities, or a decrease in cash. And also when non-debt liabilities increase, it is either due to an increase in assets, or a decrease in cash. What we are able to do with working capital is analyzing periodic changes in a businesses balance sheet to see how the cash changed. When we subtract the working capital of one period from another, we are literally seeing the difference in cash between the two. Since any changes in assets or liabilities would already be netted into the difference, it would only be the changes in cash that we see. Did you understand that? If not, read it again.

In the case of Earthlink, they sold investments and bought into investments constantly, creating gains for their assets, the "cash and marketable securities" account would keep getting bigger, allowing Earthlink to invest in new projects and make more and more investments. But this, as you all smarty-pants will know, would not exactly provide "free cash flow" in the form of working capital to Earthlink. What DOES provide "free cash flow" is the payment of liabilities. Just go look at Earthlink's liabilities, and you will see some crazy payments going in and out all the time.


Anyway, working capital aside... now that you know how it affects working capital... I've decided to value Earthlink without the effect of its working capital. In fact, I've even assumed a 10% loss on their investments (by decreasing the marketable securities total by 10%, and netting it into enterprise value) to see if this is a good company going forward.

What I found is interesting:
Declining margins, but increasing subscribers--attributable to decline of more profitable narrowband service and increase of less profitable broadband service. Increase in subscribers offsets decrease in margins, making the company's earnings seem constant. The question for this company is... what can make its broadband grow even more? Especially in light of all the competition from local cable service providers? This company trades at about 10x earnings going forward, about 7x cash (net out gains from investments)... The market is betting this company will be history in the next 7 years. What do you think? Can Earthlink successfully compete and provide consumer value in the highly competitive market of Broadband internet access?


No buy for the third quarter... traditionally, 3rd quarter is much worse than 2nd quarter (summer season).

Saturday, October 01, 2005

IAG's Alumni Presentations

Everyone in IAG should take some time out and look at the presentations done prior to the start of this year. You can drench yourself in self-pity at the wisdom of Steve, Tom, Rahat, Eric, and other brilliant financiers that aren't around anymore. It's going to be mighty hard living up to their legacies. There's a huge talent void/gap left by the brilliant people of last year who graduated. We sure have some big shoes to fill.


On a lighter note, third quarter earnings start coming out in the form of 10-Qs in the next couple of weeks or so. Usually, earnings season is very important catalysts for companies that are value-oriented or under the radar, and a tremendous upside potential could be realized in the next month or so if we play our cards right. Hopefully, we will be pretty invested soon--right now the initiative is currently at around 35% invested, and the All-Star I believe is only 30%... we really hope to increase that percentage in the coming weeks... but of course, not without good ideas first.