Tuesday, December 27, 2011

An Update on American Superconductor (AMSC)

In June 2011, we wrote an article about American Superconductor (AMSC), and its key investor – Kevin Douglas. We noticed the company because its stock dropped sharply after a loss of a major customer (Sinovel), while Kevin Douglas – a large investor in AMSC – continued to acquire shares. Let's revisit AMSC and our past forecasts for the company.

We previously estimated that AMSC would record a net loss of $4M - $34M for the fiscal 2011, translating into a book value drop of up to $0.75 per share. Once the company restated its income statement for FY 2011, the actual loss turned out to be $186M, or $3.95 per share – much worse than expected.

The difference came from several factors:
Revenue drop$75M$144M
Gross margin40%(7.5%)
Goodwill write-off--$50M
Operating income drop$30M
(from $39M to $9M)
(from $39M to -$178M)

Our estimates had relied on the company’s guidance that annual revenue may drop from $430M to "below $355M" – a drop of $75M+. Eventually, the company reported revenue of $286M for the year – a drop of $144M.

Gross margin
To gauge the impact of the revenue drop on operating income, we had used a gross margin of 40%. This was foolish. Given that AMSC had already manufactured the products that were rejected by Sinovel, we should have assumed that all of the revenue drop would go straight into a decrease in operating income.

Goodwill write-off
We did not factor in any goodwill write-offs, but the company ended up writing off all of its goodwill – to the tune of $50M. This could have been anticipated, given that much of the goodwill came from the acquisition of Windtec, a business unit whose wind turbine sales were primarily to Sinovel. According to its 10-K filing for FY 2011 (page 71), the company now values Windtec at net assets.

AMSC is actively restructuring in an attempt to return to profitability. It has cut its work force by 50%, which should bring annual SG&A and R&D expenses from about $100M down to $50M. Assuming that the gross margin returns to 40%, AMSC would need revenue of $125M to break even. It has booked revenues of $21M and $30M for the quarter and six months ending Sept 30, 2011 – a run rate well short of the break-even point.

AMSC should not face liquidity problems in the immediate future. The company has a current ratio of 1.8, $94M in cash, and no debt. It has terminated the planned merger with The Switch, which would have required it to raise funds at a challenging time. AMSC shares are trading close to the book value of $4.09.

In September, Mr. Douglas purchased close to 1M additional AMSC shares at $4.32 - $4.36, increasing his stake to 25%. We maintain a speculative long position, on the hope that this insider has an accurate view of the value of AMSC, but want to clearly state that AMSC does not meet our criteria for a long-term value investment.

Wednesday, October 5, 2011

Comparing Retailers Using DuPont Analysis

Long-term investors often look for companies with a demonstrated earning power over a period of 10+ years, as measured by the Return on Equity (“ROE”). In the words of Warren Buffett, “We're looking for... businesses earning good returns on equity while employing little or no debt.” DuPont analysis is a particularly useful tool for examining trends and causes of ROE. In this article we apply DuPont analysis to compare four retailers: Kohl’s (KSS), Macy’s (M), Target (TGT), and TJX Companies (TJX).

The returns on equity earned by these companies span the range from mediocre to stellar. Here are the median ROEs for these companies since 1996 - 97, according to StockPup.com:
M: 10%
KSS: 16.8%
TGT: 18.4%
TJX: 40.8%

Macy’s is below average for the S&P 500, Kohl’s and Target are solid performers, while TJX results are phenomenal. Not surprisingly, TJX shareholders saw their shares appreciate from $4.70 in 1997 (adjusted for dividends) to $55.50 today – a compounded annual growth rate (“CAGR”) of 19%, while Macy’s shareholders watched their shares slog from $16.43 to $26.32 over the same period – a CAGR of only 3.4%.

One of the key questions for an investor is what kind of performance can be expected from these companies going forward. History, seen through the prism of DuPont Analysis, offers some clues. In its most common form, DuPont equation is a decomposition of ROE into 3 factors:
ROE = (Net Margin) * (Asset Turnover) * (Asset to Equity Ratio)
Net Margin indicates operating efficiency, Asset Turnover measures the total asset use efficiency, and the Asset to Equity Ratio is a measure of financial leverage.

Let’s start with TJX, and look at its return on equity, and its components:

We observe that its ROE has been consistently between 30 and 50%. Changes in ROE have been mostly driven by changes in the Net Margin and the Asset to Equity Ratio, while asset turnover has been extremely stable. The Net Margin reached the top of its 4-6% range this year. The Asset to Equity Ratio has been generally going down since 2006 – a positive sign of financial health. Indeed, while the Equity of the company has been growing, its long-term debt is roughly the same as in 2006:

Let’s compare this with the runner-up – Target (TGT). At Target we also find a relatively consistent ROE track record, generally hovering around 18%.

The Net Margin’s at TGT are historically around 5%, similar to TJX, although lower in the past few years. The big difference lies in asset utilization. While the Asset Turnover at TJX gets as high as 300%, meaning that for every $1 tied up in Assets, TJX produces $3 in Sales, TGT saw its Asset Turnover slide from 200% to 150% over the past 10 years or so. This is nearly two times worse than at TJX. If you were considering TGT and TJX for your investment portfolio, you would want to dig deeper into the causes of this difference.

Let’s add Kohl’s (KSS) to the picture. The ROE at KSS is roughly similar to TGT – a bit lower. The Asset Turnover is also similar to TGT. However, we see a consistently higher Net Margin and significantly lower leverage, as measured by the Asset to Equity Ratio. The lesson is that Kohl’s is operationally more efficient than TGT and even TJX, and chooses a much safer financial structure, with over a 60% of its Assets coming from Equity, compared to less than 40% at TGT or TJX. This choice of a safer balance sheet reduces Kohl’s earning power, but makes it more attractive to investors seeking safety.

Finally, let’s take a look at a very different picture at Macy’s (M). The earning potential here is very inconsistent. Even in good times, Macy’s rarely achieves returns on equity above 15%. Further, in 3 out the past 10 years the company has suffered losses, manifested by dips on the ROE chart.

The last of these big losses came in 2009, when the company had to write off some $5B of Goodwill it picked up as a result of a $12B acquisition of May Department Stores in 2005 (the “M” indicator on the chart below)

Macy’s problems are not limited to corporate action that destroyed shareholder equity. The company has the lowest Asset Turnover of the four retailers in this comparison, at the same or lower margin. Further, its leverage is much higher. While leverage props up ROE, it is a warning signal for investors that the company may not be able to weather bad economic times as well as its competitors.

For investors looking to build a stock portfolio of strong long-term performers, a high Return on Equity is one of the most desirable characteristics in a company. DuPont analysis provides a way to study the ROE, and understand the key factors that define this metric. In the case of the four retailers we examined, DuPont analysis sheds light on the trade-offs between business performance and balance sheet risk. It also points at further research questions, e.g. “why are Asset Turnovers different among these companies”, that an investor would want answered to choose among these companies.

Wednesday, June 1, 2011

American Superconductor and its key investor Kevin Douglas

On April 5, American Superconductor (AMSC) announced that its major customer, Sinovel Wind Group, refused a product shipment. With Sinovel accounting for 73% of AMSC revenues, the news sent AMSC shares diving from $24.88 to $14.47. Since then, the stock has fallen further, reaching $8.10 on June 1. While the price drop may be appropriate given the fundamentals of AMSC, which we examine later in this article, there is one curious circumstance that suggests there may be an opportunity here. AMSC has a large beneficial owner, Kevin Douglas, who has accumulated a 22.8% stake in the company, buying shares both before and after the bad news. Let's take a look at who Mr. Douglas is, and what we can learn about AMSC from his track record.

We examined ownership reports filed with the SEC for companies where Mr. Douglas was a 10% beneficial owner. We excluded Stamps.com (STMP), where Mr. Douglas was a director, and EnteroMedics (ETRM), which is a new investment. We found the following investments:
  • IMAX Corporation (IMAX). Between April 2007 and May 2008, Mr. Douglas acquired 8.6M shares at prices ranging from $4 to $7.22 per share. He sold 0.9M shares in November 2010 at $21.87 - $22.75. The current IMAX stock price is $34.24. We estimate the total return on this $50M investment at 6x within 3.5 years, or a CAGR of 67%.
  • Westport Innovations (WPRT). Between February and July 2010, Mr. Douglas acquired 7.5M shares at prices ranging from $12.95 to $19.36. The stock currently trades at $24.89. We estimate the total gain on this $112M investment at 60% in 1 year.
  • Rural Cellular Corp. Between July and September 2005, Mr. Douglas acquired 1.8M shares at prices ranging from $7.19 to $12.02 per share. Rural Cellular was acquired by Verizon for $45 per share some 2 years later (announced in 2007, the acquisition closed in August 2008). We estimate Mr. Douglas' gain at 5.8x on this $14M investment, and CAGR at 25%.
  • Friendly Ice Cream Corp. Between July and November 2004, Mr. Douglas acquired 0.8M shares, at prices between $7.74 and $12.28. The company was acquired in June 2007 for $15.50 a share, translating into a 25% gain on the total investment of $10.5M over 3 years, leading to a sub-par CAGR of 8%.
  • Hansen Natural Corporation (HANS). Between June 2003 and January 2004, Mr. Douglas acquired 0.3M shares at an average price of $0.58. With HANS currently trading at $69.62, his relatively small investment of $190K has grown more than 100 fold, or a CAGR of some 80%.
We published detailed records of the Mr. Douglas' transactions in the following spreadsheet: http://goo.gl/gKKkM Mr. Douglas had a number of wins. "Smart money" comes to mind. Mr. Douglas has now invested around $270M in AMSC at a weighted average price of $28.26, making the current price appear attractive. His latest purchase was of 3M shares at $14.47 on April 6, after the bad news came out.

AMSC is currently priced below the Book Value of its equity ($9.86). The company has been modestly profitable since 2009, most recently generating a return on equity (ROE) of 10%. We should note that the longer term history of AMSC is that of over a decade of consistent losses:

The company survived by repeatedly raising capital through stock offerings, indicated by (SO) markers on the chart below, leading to massive dilution of its common stock:

The brief period of profitability is now set to end. Why would a smart investor like Mr. Douglas be interested in AMSC? We can only speculate that the main value of this company may be in its IP portfolio and know-how in the booming markets for wind power generation and smart electrical grid infrastructure, making it essentially a venture investment.

How big of a loss can one expect? AMSC announced that the annual revenue may drop from $430M to below $355M. The company has a gross margin of about 40%, so the $75M+ drop in revenue can translate into a $30M+ drop in operating income. The company is reviewing at least $56M of already recognized revenue, which is not surprising as its accounts receivable jumped to $114M as of December 31, 2010, from $49M a year earlier. A reduction in the income tax expense could partially offset the loss, perhaps by $10M or so. Overall, we guess that the net income could drop by anywhere from $20M to $50M. In fiscal 2010, the net income was $16M. A $4M to $34M loss in fiscal 2011 could reduce the book value by $0.09 to $0.75 per share. The company has delayed the 10-K filing due at the end of May, as it is reviewing revenue recognition, so it may be some time before we find out the extent of its problems.

We should note that AMSC has a strong balance sheet with $500M in equity out of $640M in total assets, and almost no debt. Goodwill and intangibles are small at $53M, and there is $240M is cash and securities. At the same time, the company is in the process of a $265M acquisition of The Switch Engineering company, expected to close in August, which is certain to result in further dilution at this difficult time.

To quote Warren Buffett, "Time is the friend of the wonderful company, the enemy of the mediocre." So, we normally prefer to invest in companies with strong records of long-term profitability and compounding, to have time on our side. AMSC is certainly not one of them. However, given the attractive price close to book value, a strong balance sheet, and a vote of confidence from Kevin Douglas, we see AMSC as an attractive speculative opportunity.

Disclosure: long on AMSC.

Saturday, April 30, 2011

The big migration

We love investing. In our quest to collect and analyze more data on more companies, we had accumulating many engineering "debts." And so we spent the last month cleaning up the StockPup website, and solving various deferred engineering issues. This work culminated in our "big migration" to the cloud infrastructure powered by Amazon Web Services.

We were quite happy with our previous web hosting company, DreamHost. We still think they offer a great hosting solution that makes it very easy to prototype and run small web sites. Their customer service is terrific. Thanks DreamHost! However, as StockPup subscriber base grew, we felt it was time to move to a more scalable and highly reliable solution.

Today, StockPup.com is running on Amazon Elastic Compute Cloud or "EC2". In a great irony of life, Amazon had one of its worse outages of all time in the middle of our switch over, bringing many Amazon-hosted sites down, including Reddit and Quora, and slowing down our work. We remain confident, however, that over the long haul Amazon will help us run a responsive and reliable site that you will enjoy.

We'd also like to thank several blogs that helped us migrate our Django-powered site to Amazon EC2. It would have been hard and lonely up there without you:

Monday, January 17, 2011

Blind valuation test

Via Geoff Gannon comes this "blind valuation" test. It is a good exercise for calibrating your stock valuation skills. Takes only a minute to go through. And the answer is? :)

Tuesday, December 28, 2010

Share buybacks

Saj Karsan has published a blog post on the poor timing of corporate share buyback programs. He observes that companies often repurchase their shares when the market is most enthusiastic about their prospects, and the share prices are correspondingly high. While Saj makes an excellent and important point, I want to defend some of the companies Saj sites as examples in his post.

A share buyback is a way for a company to allocate capital that cannot be productively deployed in its operations. The company can pay the money out as a dividend, or use it to repurchase some of its stock. By reducing the number of outstanding shares, the company increases the share of future earnings that an ongoing investor will receive. Is this increased share of future earnings worth the money spent on the stock repurchase, or would shareholders be better off simply receiving a dividend?

The decision by a company to repurchase its own stock can be viewed as any other investment decision. Instead of buying its own shares, the company could have purchased shares of another business, which would have also contributed to future earnings of the company's shareholders. So, whether a buyback is a good investment comes down to price. Companies should only repurchase their shares if those shares are undervalued.

As Saj points out, the overall record is not good. Companies tend to repurchase their shares at the wrong time, when the share prices are high, and to slow down their repurchases when the share prices are in fact attractive. This is understandable: prices are generally high when companies have strong earnings and thus have money to spend on buybacks. But it is not excusable, as it wastes shareholder equity.

At the same time, long-term buyback records are quite rational for several companies Saj sites as examples of poor buyback timing in the near-term. Let's look at Lowe's (LOW). Here is how the number of outstanding shares of LOW has been changing over time:

We see that Lowe's has been buying back its shares between 2006 and 2008, and then again in 2010. Share buybacks were apparently on hold from 2008 till 2010. This timing is indeed imperfect, since LOW shares were cheaper between 2008 and 2010 than in the years immediately before or after. However, let's put this in the longer term perspective. Here is a look at LOW's price-to-book ratio for the past 16 years:

Since 2007, the price of Lowe's shares has been low by historic standards, compared to the value of underlying shareholder equity. While Lowe's may have started buybacks too early, and not have perfectly timed them to the short-term market swings, their long-term timing is quite reasonable.

A similar picture emerges when we look at Walmart (WMT).

WMT had significant buybacks between 2003 and 2005, in 2007, and after 2009. Looking at their P/B ratio, we conclude that the relative price may have been too high in 2003, but certainly looks reasonable in the more recent years.

Timing of corporate share buyback programs is an important consideration in making stock investment decisions. Companies that overpay for their own stock destroy shareholder value, and should be avoided. Companies that repurchase shares when the price is right, create additional value for their investors, above and beyond the value generated by the underlying business. At StockPup.com, you can find tools to evaluate share buyback programs over the long-term of 15 years or more.

Friday, December 17, 2010

Staples and OfficeMax – same business, different results

In this article we compare two office product distributors – Staples (SPLS) and OfficeMax (OMX). Both sell through retail stores, web and mail catalogs, as well as delivery contracts with larger customers. With annual sales of $24B, Staples is more than 3 times larger than its rival, which generated $7.2B in sales last year. But the differences go much deeper than size. From the perspective of long-term shareholders, Staples exemplifies a consistently profitable business that is good at allocating and growing its capital. OfficeMax, on the other hand, is a story of capital tied up in barely profitable operations, and diminished by corporate actions

Over the past 14 years, Staples has nurtured the equity of its shareholders from $1.27 per share to $9.37 – representing a compounding annual growth rate (CAGR) of 15.3%. Including dividends, the shareholder wealth grew from $1.27 to $11.18. That’s a solid CAGR of 16.8%.

(circled letters are corporate event indicators that you can explore on the StockPup.com web site; "M" indicates M&A activity)

The equity of OfficeMax shareholders, in comparison, has been mostly flat, with no compounding to speak of, and significant equity destruction in recent years.

OfficeMax as we know it was formed in 2003, when Boise Cascade Corporation, a paper and wood products manufacturer and office product distributor, acquired the original OfficeMax, Inc. (data prior to 2003 is for Boise Cascade). The paper and wood business was spun-off in 2004, and the company changed its name to OfficeMax Incorporated. Neither before nor after the 2004 merger, however, was the company able to grow shareholder equity.

The 2003 acquisition loaded the OfficeMax balance sheet with goodwill and intangibles, which were subsequently written off in 2008. The $1.3B write-off represented the entire purchase price of the original OfficeMax! OfficeMax has further demonstrated an ability to decimate shareholder equity via corporate action: in 2008, in addition to the aforementioned $1.3B write-off, the company recorded a $735 impairment charge on a note guaranteed by Lehman Brothers, in the wake of the Lehman Brothers bankruptcy.

The growth of Staples has not been entirely organic either – Staples acquired Quill Corporation in 1998, bought the European mail order businesses of Guilbert SA in 2002, and acquired Corporate Express in 2008.

While the Quill acquisition diluted Staples shareholders by some 20%, and the Guilbert SA and Corporate Express acquisitions added close to $1B and $3B of goodwill and intangibles, respectively, to the balance sheet, neither has resulted in write-offs or significantly affected the company’s ability to generate returns. The median ROE is around 16%, and the median ROA is 7.3%.

Staples is under significant pressure due to the recession. Its Retail segment (about 40% of overall sales, and half the profits) was hit by a 2% year-on-year decline in same store sales. A similarly sized Delivery segment has grown sales at a modest 8% last year. And the faster growing (13% y-o-y) International segment remains relatively small (21% of sales and 7% of profits). Despite this challenging environment, Staples remained profitable and achieved a respectable ROE of 12.6%, giving hope that ROE will recover to its historic 16% level when conditions improve.

By comparison, the median ROA for OfficeMax is a meager 1.1%, and the ROA is close to zero.

Throughout OfficeMax history, years of modest profits alternated with periods of losses. Keeping this long-term perspective will protect investors from extrapolating a good year or two into future earnings growth.

Compare this with the consistent earnings history of Staples:

We believe that Staples is attractively priced at a historically low price to book ratio of 2.4. Given its healthy balance sheet and limited growth opportunities, we would like the company to continue its share repurchases, suspended after the Corporate Express acquisition.

Examining long-term fundamentals of companies such as SPLS and OMX, and considering their long-term records in handling shareholder equity, is critically important for investors who want to select the winning investment in a particular industry, or make long-short pair investments. Staples and OfficeMax make for one such potential long-short pair, as do Walgreens (WAG) and CVS Caremark (CVS) – two companies we compared in a previous article. At StockPup.com, you can find a wealth of long-term analytical charts and data covering over 15 years of corporate fundamentals, including all charts and corporate events mentioned in this article. Registration is free.