SIN Picks

Subscriber Pick: Precision Castparts (PCP)

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December 5, 2008 | SIN Picks | Author Asif

We started the month of December with the National Bureau of Economic Research officially declaring that the recession we are currently in started in December 2007. The Dow reacted with a massive 679.95 points or 7.7% sell-off, only to recover most of that drop over the next two trading session. The crazy volatility we have been experiencing is very much alive and well. At this point, the current recession is already longer than the 8 month recessions we experienced in 2001 and 1990/1991. The interesting thing about this declaration is that if we consider the classic definition of a recession, which is two quarters of negative GDP growth, we are still not in a recession. Second quarter 2008 GDP increased 2.8% before falling 0.5% in the third quarter. Quite clearly the official version has gotten it right and many stocks like Emerson Electric (EMR) and Precision Castparts (PCP) in the cyclical Industrial sector started falling last December.

In this environment, I am sure that the last thing the majority of you want me to discuss is even more stocks. But instead of participating in the doom and gloom (I already went into that in great detail in the December newsletter), for those you who still have capital and are still bargain hunting, a company that a subscriber brought to my attention recently is worth sharing with all of you.

A couple of weeks ago, a subscriber who has periodically been in touch with me since the early days of SINLetter, wanted to know my thoughts about Portland, Oregon based Precision Castparts (PCP). My short response to him was,

“I just got a chance to review PCP and without digging in deep about future business potential, the company looks awesome. The balance sheet is strong, there is little debt (not sure about the $376.4 million in other liabilities though), operating margins are awesome considering gross margins are under 30%, operating cash flow is off the charts and there have been small insider purchases. “

I decided to dig in deeper and like what I see. Precision Castparts is a company that creates everything from fasteners to “the world’s largest diameter stainless steel, nickel-based superalloy, and titanium components” according to their website. The company primarily services the aerospace, power generation (gas turbine, coal and nuclear) and automotive industry. More than half their revenue (51% to be precise) comes from the aerospace sector, while power generation represents 23% of revenue. Given the current state of the automotive industry, thankfully the company only derives 5% of its revenue from the automotive sector as you can see from the chart below.  Over the last two years, the company has been shifting its revenue mix to reduce its dependence on the aerospace sector.

Source: PCC’s 11/19/2008 presentation (PDF) at Credit Suisse

The company makes parts that are used both in Boeing and Airbus aircraft as well as military planes and choppers. To mitigate its risk from rising metal prices, the company acquired Nickel alloy producer Special Metals Corporation in 2006. Beyond this direct exposure to the commodity market, the company should actually benefit from the recent drop in metal prices. Management appears to be confident about its business pipeline and based on this positive outlook, Moody’s upgraded Precision Castpart’s corporate debt from Baa2 to Baa1.

The stock has dropped from a high of over $150 last December to yesterday’s close of $50.77. Since the company is in the cyclical industrial sector, a drop makes sense but the magnitude of this drop is already bigger than the roughly 56% drop the company experienced during the last two recessions. The company is currently trading at a forward P/E of just 5.85 and a PEG ratio of 0.43. The company is also trading at a discount to peers like Emerson Electric (EMR) and Eaton Corporation (ETN).

I am going to add Precision Castparts to the SINLetter model portfolio and if I can free up the capital through year-end tax loss selling, will also buy it in my personal portfolio. To make room for PCP, I am going to sell our position in Johnson & Johnson (JNJ). While Johnson & Johnson did not do much for us in terms of gains since we added the stock to the portfolio in 2006, the stock has held its value while paying out an above average dividend. The portfolio will continue to have enough exposure to the consumer non-discretionary sector through Procter & Gamble (PG) and Unilever (UL) even after we sell Johnson & Johnson. Changes to the portfolio will be based on the closing prices on Friday.

A note of caution. Even though the stock looks attractive and has taken a harder hit than the overall market, in this kind of environment the cheap often get cheaper. To put that in context, according to Princeton University professor Burton G. Malkiel in his book A Random Walk Down Wall Street, during the bear market following the 1929 crash, General Electric (GE) fell from a high of $396.25 to a low of $8, which works out to the stock losing 98% of its value (prices not adjusted for subsequent splits). Given that some economists expect this recession to continue at least until the end of 2009, there may still be room for the industrials and PCP to fall further.

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Towerstream (TWER) Trading Below Cash

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November 26, 2008 | SIN Picks | Author Asif

The 12% surge in the Dow over the last three trading sessions was certainly welcome but has hardly alleviated the level of anxiety felt by most investors as it could easily turn out to be a bear market rally. It is interesting to see from the adjacent table by Paul Kedrosky that out of the 13 biggest two day advances in the Dow Jones Industrial Average that have occurred going back to the stock market crash of 1929, 11 of them took place during the great depression and 5 of these occurred before the Dow hit its bottom in July 1932.

In this uncertain environment it is easy to find companies not only selling at low single digit P/E ratios (with earnings in jeopardy, investors are looking at low P/E ratios with a wary eye), but often below tangible book value. A quick stock screen I ran brought up 2,181 companies that are trading below book value. However there are only a handful of companies that are trading below book value, have little or no debt and are actually trading below the cash they hold on their balance sheet. One such company is our portfolio holding Towerstream (TWER), a provider of commercial wireless internet service, which we featured in the July 2008 edition of our investment newsletter.

The stock has lost nearly half its value since then but interestingly enough the story has hardly changed and if anything has gotten better. The stock with a market cap of $23.5 million not only sells for below book value of $35 million, it is selling at a discount to the $25.4 million in cash it holds on its balance sheet after removing $2.6 million in debt.

Towerstream reported third quarter 2008 results earlier this month and almost every single metric improved year-over-year with the exception of average revenue per user (ARPU) for new customers, which decreased from $748 in Q3 2007 to $733 last quarter. Gross margins increased from 63% to 64%, ARPU per customer increased from $694 to $827 and churn rate dropped from 1.26% to 1.22%. Towerstream has consistently maintained low churn rates and from what I have heard, customers who have initially purchased an internet line from them as a backup or load balancing solution have often made it their primary internet connection. While operating expenses dropped from $6.26 million to $6.09 million on a sequential quarter basis, they increased significantly from $3.96 million in Q3 2007 due to the company entering new markets and expanding its sales force.

Shortly after results were announced, Canaccord Adams upgraded the stock from a hold to a buy with a $1.50 price target over a 12 month period. While I think that price target is conservative, it still represents the potential of over 100% gains from these levels. Obviously the key concern with Towerstream is its ability to scale the business while at the same time reducing or eliminating cash burn. Cash burn in the third quarter was $3.9 million after falling for two consecutive quarters. Anyone who has been involved with start-ups can tell you that attempting to scale a business while preserving capital is a tough act.

I got a chance to talk to Towerstream’s CEO Jeff Thompson last week and he reaffirmed the company’s outlook of becoming EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) positive by the end of Q1 2009. He also addressed my concern about an economic slowdown affecting small businesses and in turn impacting Towerstream’s business by letting me know that a majority of Towerstream’s customers are mid to large size businesses. The company’s 8 MBPS solution at a very competitive price point has also been received well by customers. Having priced a 1.5 MBPS T1 internet line and periodically looking through Towerstream’s offerings, I can personally attest to their competitive pricing.

In light of the roll out of WiMax in countries like South Korea where wireless access is available in subways and buses as well as Australia’s plan to spend nearly AUD $1 billion to provide wireless access to rural areas, the United States has been slow to adopt WiMax. Since Towerstream has been one of the early members of the WiMax forum, I asked Jeff his opinion about the ramp up of WiMax in the U.S and competing technologies. Jeff mentioned that with Clearwire shareholder approval in place of the ClearWire, Sprint, Google, Intel, Comcast and Time Warner deal (could there be any more companies collaborating on this deal?), WiMax adoption will hopefully increase. He also mentioned that LTE, a technology that is being touted as a WiMax alternative, is probably 3 to 4 years away.

According to Jeff, one of their equipment providers is another portfolio holding Alvarion (ALVR) and they have been happy with their experience with Alvarion as it does not take “10 engineers to get their stuff working”. However they have the option to use various other manufacturers and expect equipment prices to come down next year, helping reduce cash burn even more.

The stock has been under $1 since October 22nd and would normally get a delisting notice from Nasdaq as the stock has been under $1 for 30 consecutive days. Given the number of stocks that are currently trading below $1, the Nasdaq has temporarily suspended this rule and hence delisting is not an immediate problem.

Companies usually have a six month period after violating listing requirements to meet those requirements again. Some companies opt for a reverse merger to accomplish this but with a few exceptions like Priceline (PCLN), stocks of companies using reverse mergers generally tend to drop after the merger. As I was mentioning to a friend, Sun Microsystems (JAVA) was trading in a $3 to $5 range for quite some time before its 4 to 1 reverse split, that pushed its price all the way up to $20 post split only to see the stock meander back down to a little over $3 today. Had the reverse split not occurred, Sun’s stock would have been trading under $1 right now. Please note that beyond stock price, there are also other requirements related to market cap, shareholder equity and net income. You can find all the Nasdaq listing requirements here (pdf).

Overall management sounded very confident on the call and while Towerstream has all the risks associated with start-ups, it certainly feels like the company is at the point of proving out its business model while posting impressive year-over-year growth even in this difficult environment. I am going to add 3,000 shares of Towerstream to our existing position in the model portfolio and also plan on adding to the position in my personal portfolio after this blog entry is published. The closing price of the day will be used for the model portfolio.

Voluntary Disclosure: Long Towerstream.

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Adding Sterlite Industries (SLT) To Portfolio

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November 6, 2008 | SIN Picks | Author Asif

As discussed in our previous blog entry What Next?, taking advantage of the general market weakness over the last two days and a nearly 15% drop in Indian mining giant Sterlite Industries (SLT) today, I am starting a position in the company both in the model portfolio and my personal portfolio. I will use the closing price of the day to purchase 2,000 shares of Sterlite for the model portfolio. We added Sterlite to our watch list in January 2008 and I have been patiently waiting since then for an opportunity to get into this company.

As a subscriber pointed out this morning, the company has a market cap of $3.34 billion and is trading below the value of cash and short-term investments it holds even after taking out short-term and long-term debt. This is based on the March 2008 balance sheet available on Yahoo Finance. Looking at the balance sheet as of June 2008 on Google Finance, both current assets and total assets have gone up more than the increase in current liabilities and total liabilities. Please note that the financials on Google Finance are in Indian Rupees and you will need the exchange rate of $1=Rs48 to convert the numbers to dollars.

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What Next?

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October 28, 2008 | SIN Picks | Author Asif

Benjamin Graham, the teacher and mentor of Warren Buffett, wrote two seminal tomes on value investing called Security Analysis in 1934 and The Intelligent Investor in 1949. I was reading The Intelligent Investor at a time when the bear market following the dot com bubble was in full swing and I remember thinking to myself that some of what Mr. Graham mentions in his book may no longer hold true as even at that point  it was almost impossible to find stocks that met his criteria such as a Price/Book ratio of less than 1.5, a P/E < 15, uninterrupted dividends for last 20 years and an adequate margin of safety.

If you like bargain hunting for things, you are probably aware that there is an intrinsic value to things and unless the seller is in distress it is very difficult to get something below this intrinsic value. However the market, which is driven more by psychology than the underlying realities sometimes offers us opportunities at deep discounts to their intrinsic value. This is one of those times and if you have the courage to act, it could represent the opportunity of a lifetime. To quote Mr. Graham,

“Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it- even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”

If you did not see ahead of the curve (very few people do) and rebalanced your portfolio at the start of this year, there isn’t much point in liquidating now as you would be reacting to current events and headlines rather than looking ahead to the next curve in the road.

In the 2008 Outlook section of the January 2008 investment newsletter, I wrote,

“With rising unemployment, declining manufacturing activity, home prices declining 6.7% in the 10 largest metropolitan areas, the inventory of unsold homes representing a 10.3 month supply and record levels of national/personal debt, my enthusiasm for common U.S stocks is the lowest it has been in years and I am even more bearish than I was at the start of 2007. I believe that cash, certain high yielding investments like Canadian energy trusts as mentioned in the blog entry Quest For a 6% yield, generic drug manufacturers like Teva Pharmaceutical (TEVA) and consumer staples companies like Unilever (UL), Church & Dwight (CHD) (the company that makes Arm & Hammer products as well as Trojan condoms) and Procter & Gamble (PG) might be the best places to be in 2008. Unilever and Procter & Gamble have the added advantage of benefiting from middle class expansion in Countries like India and China not to mention a favorable exchange rate.”

After a nearly 40% year to date drop in the major indices, most individual investors are panicking and moving to cash or worse yet are ready to accept negative yields on treasury bonds. The oft repeated mantra is that it is best to wait until things stabilize and a clear uptrend is established. Unfortunately just as it was difficult for most investors to predict this bear market, it is going to be equally difficult to identify signs of stabilization when they occur or identify a “clear” uptrend as any move up could just as easily turn out to be another bear market rally.

Record redemptions from mutual funds and margin calls at hedge funds have created an environment where almost every sector, asset class and country is declining simultaneously. Former hedge fund favorites like commodities and emerging markets are especially hard hit.

My personal favorite indicator of just how scared investors have become is this story about how sales of safes increased 50% towards the end of September and early October. Anecdotal evidence aside, the P/E10 of the S&P 500 is currently about 13.86 based on Yale Economist Robert Shiller’s data (excel), which uses the average of 10 years of trailing inflation adjusted earnings. This is a level not seen since 1987. Please note that since Dr. Shiller last published his P/E10 value in August 2008 and I used a 33% drop in the S&P 500 since then to reach the number 13.86 assuming that average trailing 10 year earnings stayed constant in September and October.

Certain individual stocks are selling at even lower valuations and the key is to focus on companies with strong balance sheets and steady free cash flow. I have started buying aggressively for my personal portfolio in October and have added to my positions in the following stocks: Intel (INTC), Pfizer (PFE), Activision Blizzard (ATVI), Lionsgate Entertainment (LGF), Nokia (NOK), Mattel (MAT), Barclays Plc (BCS), Alvarion (ALVR), Tata Motors (TTM), Powershares Water ETF (PHO) and Jan 2009 calls on ICICI Bank (IBN). As you can see from the archives section of SINLetter, every one of these stocks has been featured in past newsletters and you could consider this list my current high conviction list.

I plan to make one additional round of purchases to buy Sterlite Industries (SLT) and Flextronics (FLEX), which has a forward P/E of 3.05 and P/S of 0.09. I am also considering buying Suburban Propane (SPH) with its 10.2% dividend yield (distributed from operational cash flow). I plan to cover Suburban Propane in more detail in the next investment newsletter and as usual will post my plans about purchasing these stocks on the blog before I buy them for my personal portfolios.

I am also going to try and leave some cash around to buy either S&P 500 or Nasdaq LEAPS if the market drops an additional 15% to 20% from these levels.

Given the uncertainty that many are facing at a time when even disruptive companies like Tesla Motors are laying off employees, it may be a good idea to increase emergency cash from the usual 3 to 6 months of living expenses to a year of living expenses based on job security and other factors. These are trying times and the economic news is likely to get worse for months to come before it gets better. As always do your own research and come to your own conclusions before taking any action.

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Getting Ready to Strangle ICICI Bank (IBN)

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October 9, 2008 | SIN Picks | Author Asif

The deep decline in markets worldwide that has left many an investor in despair and has prompted some to take extreme steps like committing suicide seems to show no signs of bottoming out. A coordinated move by central banks to lower interest rates had no impact yesterday and central bankers appear as helpless as a child on her first day at school. As I usually tend to do, I was early in my expectations of an economic decline tied to housing as discussed in the hedging the economy through LEAP puts section of the November 2006 newsletter and am probably going to be early in turning bullish once again.

However there is a way to take advantage of the extreme volatility we are currently experiencing by making neutral bets using a couple of options strategies called straddles and strangles. We have used strangles in the past to profit from earnings related volatility in Apple (AAPL) and I discussed using strangles in great detail in my blog post Getting Ready To Strangle Apple. Ironically I started that blog entry with the words,

“If the 2000-2003 bear market was one of the longest bear markets in history, this resilient bull market, which has now lasted over 52 months also happens to be one of the longest bull markets without a meaningful correction. It is getting harder and harder to find good opportunities whether you look at different asset classes (stocks, bonds, real estate, commodities, etc.) or in geographically diverse locations.”

The largest private bank in India, ICICI Bank (IBN) drank from the same well that many of the banks in the United States did and as a result the stock has taken a very hard hit since the start of this year, falling from over $72 in January to its current $17. ICICI has also fallen with the rest of the Indian market, which dropped 45% over the same time period and on account of recent rumors questioning the financial strength of the bank. While management has strongly denied these rumors, it remains to be seen if they are pure speculation or have some substance to them.

The Reserve Bank of India (RBI) has stepped up to provide enough cash to ICICI during the recent run on the bank just like it did a few years ago when ICICI experienced a run in 2003. Letting ICICI fail would be the equivalent of letting Bank of America fail in the United States. Following the 2003 run, ICICI went on to post spectacular gains. The difference between 2003 and now is that back then the bank had one of the greatest bull market winds on its back with the BSE Sensex quadrupling in value over the next five years.

Whether ICICI rebounds from these levels (current P/E is 12.91) or continues to fall further, the moves on either side are likely to be sharp and hence my plan to strangle ICICI with out of money options and a slight bullish bias. I am going to purchase the following set of options for ICICI both in the SINLetter model portfolio and my personal portfolio. The closing price of the day will be used as the purchase price for the model portfolio.

  • 5 Contracts of Jan 2009 $20 Calls on ICICI (IBNAZ.X)
  • 5 Contracts of Jan 2009 $12.50 Puts on ICICI (IBNMV.X)

As discussed in the October 2008 investment newsletter, I am also starting a position in Intel (INTC) by purchasing 500 shares for the model portfolio. I will also add to my existing Intel position in my personal portfolio.

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