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Archive for July, 2008

Improve Your Investment Game By Focusing On One Opening Move

July 31st, 2008 by Yehuda Fruchter   |   2 Comments

Even though investing tends to take on a serious tone in our lives, it is important to sometimes remember that investing, like any other business, is really only a game. Many people, of course, would recoil at the suggestion that investing is only a game, particularly those whose job it is to market and manage the investment game. However, even in the event that you consider investing to be an elevated activity, thinking of it as a game would certainly improve your performance by helping to eliminate the debilitating emotions, such as fear, that wreck most of our daily financial and non-financial decisions. Chess is one of the games that I’ve always loved to play, and in this post I’ll discuss one particular lesson that I think chess offers to those playing the investment game.

If you’ve ever played chess against a particularly skillful opponent or half-decent computer program, I’m sure it got you thinking about the thought processes, or algorithms, that make these opponents impossible to beat. There have been, of course, quite a few books and theories written about chess grandmasters, and how they think. One particularly interesting insight that I have read about is the ability of better players to quickly, and almost unconsciously, eliminate bad plays.

Basically, when most of us look at a chess board, we see a bewildering array of possibilities and it’s nearly impossible for us to figure out what to do. More skillful players, however, because of significant experience and innate abilities, are quickly able to eliminate most possibilities from the set of moves, and thereby concentrate on only a few promising moves. This focus on only a few moves greatly increases their chance of success in finding winning patterns, since with fewer moves there are simply fewer possible combinations and it becomes easier to spot winning patterns, even without looking too far ahead into the game. Ultimately, superior pattern-recognition abilities is what differentiates top chess players from average players, and one of the best ways to improve ones pattern-recognition skills is simply to work with a smaller set of variables.

Following upon this train of thought, one of the best pieces of advice I’ve been given about chess is to stick to the same opening repertoire in every game until you master that one opening. Essentially by focusing on only one particular type of opening, you significantly narrow down the number of possible directions the game can take, and thereby increase your chances of discovering the moves or combinations that work or don’t work in this particular subset of chess moves. Furthermore, even when you encounter new combinations, at least your grounding in one particular opening system, provides you with basic principles that help to eliminate obvious losing moves.

Applying the above insights to the investing game is quite straightforward. To become a more successful investor it is important to be able to quickly, and at some point unconsciously, eliminate many obviously losing investment choices. By eliminating bad choices, one is able to focus on fewer investment ideas and with this narrower set of choices, pattern-recognition kicks in, helping you to more easily spot winning investment combinations.

Taking this a step further, one of the easiest ways to eliminate many losing investment choices is by focusing on one particular “opening” investment move. As it pertains to the stock market, this means that you need to focus on only specific investment situations at the start. For some this may mean sticking to investments in companies with no debt, while for others it may mean investing in only one particular industry. Whatever the criteria, it is vital to stick to only one opening move.

The difficulty, of course in the stock market, as opposed to chess, is in deciding which openings you’ll focus on, since there are so many suggested openings and little evidence for which investment openings have a history of success. In fact, many classic opening moves, such as low P/E’s or low P/B stocks, have been mostly discredited and other opening moves, such as those based technical analysis criteria, make little rational sense. Nevertheless, it’s important to find opening investment moves that have some element of rationality, evidence, and match well with ones innate personality. Then by stubbornly sticking to the same investment moves, you’ll eventually spot some winning patterns that you can exploit to make money.

Pulse Data (PSD.TO): Another Low-Risk Oil and Natural Gas Service Stock

July 15th, 2008 by Yehuda Fruchter   |   1 Comment

Introduction:
We first wrote about Pulse Data (PSD.TO) nearly two years ago, on our previous blog, CasinoCapitalism.com. Since that time, the shares have basically moved nowhere. However, we think that due to certain company changes and industry events, PSD.TO may finally provide patient shareholders a significant return in the coming year. At the same time, downside risk seems low given the company’s continued buyback program, a price that is below a previous takeout over, and considering the company’s stable and high dividend yield (6.8%).

What Does PSD.TO Do?
Pulse Data is a licensor of 2D and 3D seismic data in Canada. In fact, Pulse owns the second largest seismic data library in Canada.

What Went Wrong at Pulse?

  • Non-Core Business Produced Losses

    • Up until recently, Pulse Data owned another non-seismic related business called Terrapoint, which supplied LiDAR services. This business routinely lost money, distracted management, and may have dissuaded investors looking for a pure play seismic company from investing in PSD.TO.

  • Slowdown in Canadian Drilling Cap-Ex

    • As Pulse explains:

    “In 2007 the new Alberta royalty program and the related uncertainty led many Pulse clients to re-evaluate their spending strategies, while in 2006 the federal government’s announcement of the future taxation of income trusts beginning in 2011 caused a similar environment of concern.”

  • Confusing Financials and Low Accounting Earnings Because of Less Participation Surveys

    • In general, most investors, particularly the momentum players, understand one thing when it comes to stocks: Accounting Earnings and EPS. However, for some companies accounting earnings show a very misleading picture. This situation is very acute for seismic licensors since their two means generating revenue (i.e. data licensing and seismic surveys) have two very different impacts on accounting earnings and cash-flow. In addition, the high level of amortization at seismic companies is overlooked by investors who are focused more on accounting earnings. Basically, while data licensing greatly increases cash-flows it has no real impact on accounting earnings. At the same time, seismic surveys positively impact earnings and yet are cash-flow negative.

    This is how Pulse describes it:

    “Participation surveys create a misleading picture of revenue and earnings. Participation surveys are new, generally 3D seismic surveys which Pulse leads and to which one or more customers contribute to the initial cost. These contributions generate high levels of recorded revenues.

    But because the entire capital cost of the participation survey is capitalized and amortized, only a portion of the cost is recorded against the revenue. This accounting results in “earnings” – taxable earnings. Yet 100 percent of the funds are tied up in the survey. Participation surveys essentially create a “false positive” reading for investors. In fact, they usually generate negative free cash flow in the year they’re conducted. ”

    So to the extent that Pulse has decreased participation surveys which it did, accounting earnings will suffer and many investors will ignore the stock.

    What Has Changed?

  • Non-Core Terrapoint Business Was Sold

    • Recently, Pulse announced the sale of its Terrapoint business. As Pulse explains:

    “Pulse now focuses on what it does best: growing its 2D and 3D library of seismic data that is located in active exploration areas in western Canada, and marketing that data to the oil and natural gas industry. We have divested of non-core subsidiaries. Result: a pure play in a business niche with growth potential.”

  • Higher Natural Gas Prices and Regulatory Changes: Improve Outlook for Data Licensing and Participation Surveys

    • Pulse states:

    “after a two-year period of weakness, the recovery in natural gas prices began in the first quarter of 2008 and accelerated in the second quarter, with the Nymex natural gas futures price approaching $11 per mmbtu in late April, 2008. In early April the Government of Alberta announced revisions to its new royalty program that should partially restore deep oil and natural gas drilling incentives. This announcement removed an important element of uncertainty and potentially improves the economics of deep wells drilled in 2009 and beyond. Finally, strong successes experienced in exploratory drilling of several large unconventional natural gas and crude oil plays (including areas in which Pulse provides seismic coverage) are generating industry excitement and motivating new activities by competing companies. All of these factors bode well for seismic library data demand as well as increased demand for new participation surveys.”

    Given the above, we expect very strong revenue generation and cash-flow from Pulse in the year ahead.

  • More Participation Surveys Increase Earnings and Could Generate Investor Excitement

    • As Pulse explains,

    “In 2007 and 2006 Pulse concentrated on acquiring data by purchasing pre-owned datasets rather than committing its capital to participation surveys, partially because field acquisition costs were significantly elevated during this time. In 2008, given a more favourable industry cost structure, the Corporation plans to resume a higher level of participation surveys. The effects of seasonality on the timing of participation surveys are changing slightly, and the Corporation expects to conduct participation surveys throughout the year as opportunities arise.”

    Even though accounting earnings are not relevant to the value of the company in reality, most investors (and many quantatively-based investment strategies) only focus on accounting earnings gains. As such, the growth of participation surveys, should greatly increase PSD.TO’s earnings in the year ahead and hence bring in more investors into the stock.

    Risks
    The basic risk for PSD.TO as for any oil/natural gas service related play is greatly reduced commodity prices.

    Valuation Downside/Upside
    In order to best understand the following discussion, please view our spreadsheet for PSD.TO at:

    http://spreadsheets.google.com/pub?key=pb-Z9URIzMG28Zo1kIdKkcw

    In attempting to prove that Pulse Data has low downside risk at this level, I think there are four main considerations:
    1. Stock is still trading about 10% beneath Seitel’s last offer of around $3.20 per share. We think that an offer price from a credible competitor is probably the best measure to use for the base value of PSD.TO’s shares.
    2. Additionally, on several valuations measures, the stock is trading at a very low valuation. Management claims that PSD.TO’s seismic data has a $1 billion replacement value. However, even ignoring that number, which seems somewhat exaggerated, the stock is trading at EV/TTM EBITDA of 5, notwithstanding 80% EBITDA margins. This is cheap. Even on a fully-taxed EV/FCF of less than 15X.
    3. PSD.TO management continues to buyback shares at prices near the current price. Recently, the company bought 1.2 million shares at $2.75.
    4. The company’s dividend of $0.20 per share per year implies a yield of 6.8%. This is extraordinarily high considering current money market rates. Notably the dividend is safe and could quite possibly grow in the next year.

    In attempting to forecast an upside price, we’ll go with $5 (a 70% gain). This would represent 8.5X TTM EBITDA.

    Conclusion

    Given the strong odds of improving results at PSD.TO over the coming year, and the low valuation of the shares, we think PSD.TO offers an excellent investment opportunity.

    Disclosure: I am currently long shares of PSD.TO and I may buy and sell shares at any time without telling you about these actions. I do not have any obligation to share with you any updated information about PSD.TO in the future.

    All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

    Canadian Solar (CSIQ) Announces Share Offering: Is This Just The Beginning?

    July 14th, 2008 by Yehuda Fruchter   |   No Comments

    After the close tonight, Canadian Solar (CSIQ) announced plans to sell 3.5 million common shares, raising the company’s expected fully diluted share count to nearly 36 million shares (32.3 million shares as of last report + 3.5 million shares from the announced secondary) and its enterprise value to nearly $1.4 billion.

    Given our past discussion concerning the financing needs of several polysilicon-based module manufacturers, we were not taken aback by CSIQ’s latest secondary announcement, however we were somewhat surprised by the company’s financing method. We were expecting a larger convertible offering, instead of a direct placement of common shares. Arguably a convertible is a better means of long-term financing, since there is no immediate dilution to common shareholders.


    Financing Still a Concern

    Notwithstanding issues surrounding the current financing method, though, we think it’s important for investors to realize that this latest financing nowhere meets the actual financing needs of CSIQ, and as such we expect continued financings for CSIQ over the next year.


    $1.7 Billion in Purchase Obligations
    CSIQ’s financing needs are a direct result of the company’s astounding $1.7 billion in purchase obligations (page 64 in CSIQ’s 20-F). Interestingly, this number may in fact be conservative considering the company’s recent initiatives. Since the company will have to pay the vast majority of these obligations up-front to suppliers in cash, and will not receive adequate cash receipts from customers prior to the necessary payments to suppliers, CSIQ will be in need of serious cash in order to meet its production goals. Ironically, the more CSIQ pursues contracts at any price, the more cash it will need to fund its supplier obligations, and the more dilution shareholders should expect.

    Future Cash Needs Uncertain As Cash Receipts from Customers Remain Unclear

    At this point, it’s extremely difficult to project CSIQ’s real cash needs, since, as opposed to purchase obligations to suppliers, the company provides little disclosure as to its current payment terms with customers. Therefore, notwithstanding rosy revenue projections, it is completely unclear what the company’s actual cash receipts from customers are, and what the cash payment cycles looks like for new contracts.

    Based upon our research, and a small dose of common sense when looking at businesses whose customers rely on government subsidies, our belief is that CSIQ currently receives little to no money up-front for customer orders and cash payments for these orders are being spread over ever longer periods of time. As such, we think that CSIQ’s reported accounting revenues and projections, greatly overstate the company’s actual cash receipts from customers, and hence significantly understate the company’s financing needs.

    Our low-ball estimate is that CSIQ will need at least an additional $200 million in financing to support operations in the coming year. This cash may come from the Chinese banks (short-term loans) and/or Wall Street. In either case, the company’s enterprise valuation will increase even without a corresponding increase in the share price, leaving investors with little in the way of capital gains. Of course, if the stock price for some reason soars to irrational levels, the company’s financing issues may quickly evaporate. But, since we cannot forecast stock prices, we wouldn’t want to bet on this scenario.

    Ignore Accounting Earnings and Wall Street Forecasts

    Looking forward, since access to continued financing is CSIQ’s only means of survival, we would expect Wall Street analysts to continue recommending purchase of the shares based upon accounting revenue projections and paper profit (i.e. accounting earnings) valuations (e.g. P/E). At the same time, we anticipate that concerns regarding CSIQ’s serious working capital and future financing needs will receive little attention by analysts, though these are the main factors which will ultimately determine the value of the shares for longer-term investors. Therefore, we advise investors to look past these simplistic valuation models, and pay closer attention to CSIQ’s raw material and other purchase obligations, the outlook for raw material supply, and finally to the company’s actual/expected cash receipts from customers. These factors will surely play a greater role in the company’s longer-term share performance, than the other issues which may effect the nearly unpredictable day-to-day price movements.

    Conclusion: Cash Flow Concerns Could Dominate for Quite Awhile and There are Possibly Better Alternatives

    Ultimately, the bullish case for CSIQ rests on the assumption that because of escalating demand for polysilicon-based solar modules, the company will at some point become self-funding and will be generating more than enough cash to pay down obligations (both purchase and credit) and justify its enterprise valuation, even after dilutive actions.

    However, since we remain reasonably certain that the suppliers of polysilicon-based solar modules (an extremely low barrier to entry business), will vastly exceed the suppliers of the raw material (e.g. polysilicion) for these modules (a very high barrier to entry business) for the foreseeable future, we believe that the suppliers of polysilicon-based solar modules will constantly be squeezed from both their customers and their suppliers of materials. As such, we do not believe that these companies will be self-funding any time soon and the future free cash-flow (if any) will not justify the current enterprise valuation. Investors looking to profit from the solar boom are probably best advised to research the investment potential of raw material and other suppliers to these polysilicon-based solar modules and/or stick to companies that have already proven their ability to generate operating cash-flow (i.e cash-flows prior to cap-ex).

    Earnings Preview: Lufkin Industries (LUFK)

    July 11th, 2008 by Yehuda Fruchter   |   No Comments

    Introduction
    Lufkin Industries (Nasdaq: LUFK, Market Cap.: $1.1 billion) is an oil services stock that could move 50% higher by year end. Importantly, the first catalyst for an improving share price may come next week when the company announces second quarter fiscal 2008 earnings. We believe that the upcoming report will finally be the start of renewed earnings momentum at the company after nearly two years of sluggish growth on the back of the disappointing results of the company’s non-energy related trailer business. Importantly, LUFK discontinued the non-energy related trailer business in January 2008, and this will be the real first quarter without the drag of this division, allowing the booming oilfield service and power transmission markets to really improve the bottom line.

    The favorable earnings comparisons could boost the shares at a time when many investors are scouring for reasonably valued oilfield service shares following the excellent performance of oilfield service shares over the last few years. LUFK is only one of a handful of oil service shares that appears reasonably valued on an absolute basis, and significantly undervalued on a relative basis. Notably, LUFK is sitting on $100 million in cash and has no debt.

    Company Background
    LUFK was founded in 1902 and is primarily known for designing, manufacturing and marketing the industry standard conventional, Mark II and other rod lift pumping units that are used to lift oil from wells. However, the company actually currently operates in two broad divisions: Oilfield Services and Power Transmission (actually the fastest growing division at LUFK increasing 27% in 2007 over 2006).

    The oilfield services business manufacturers pumping units, as mentioned, however, LUFK also provides additional oil services equipment and services.

    The Power Transmission Division, makes precision-made gears in weights from 300 pounds to 250 tons and in power levels from 20 to 85,000 horsepower. These highly engineered products are used in industrial applications in a variety of industries, such as oil and gas, petrochemical, steel, plastics, sugar, rubber, marine and power generation.

    What Went Wrong at LUFK?

    Basically LUFK has suffered from two major problems: A slowdown in its largest business, i.e. pumping units in the North American market, and the poor performance of the company’s former trailer division.

    As regards to the North American market, LUFK had this to say in its 10-K:

    During 2007, demand in the North American market has been negatively affected, compared to 2006 levels, by the impact of lower natural gas prices on coal-bed methane and other unconventional gas production that use rod pumps to de-water wells, drilling program delays from M&A activity, cost control efforts deferring or reducing capital spending programs and the competitive pressure from lower-priced pumping units in areas traditionally served by the used unit market.

    What Has Changed?
    Two significant changes have eliminated the problems mentioned above, and augur well for LUFK’s future operating results.

    1. LUFK Discontinues the Trailer Division

    As noted in LUFK’s 10-K:

    Due to these market conditions, in January 2008, the Company announced the decision to suspend its participation in the commercial trailer markets and to develop a plan to run-out existing inventories, fulfill
    contractual obligations and close all trailer facilities during 2008.

    As noted in the recent 10Q:

    During the first quarter, all remaining trailer orders were manufactured and the manufacturing workforce was redeployed throughout the Company or terminated. Also, several service centers were closed and the inventory was consolidated at the Lufkin, Texas facility for future aftermarket sales. During the second quarter of 2008, it is expected that the remaining backlog of trailers will be sold, the manufacturing facility will be closed, with any remaining equipment sold, and the remaining service center will be closed and consolidated into the Lufkin, Texas facility. The Company is exploring options for serving the future aftermarket parts business and fulfilling contractual warranty obligations.

    2. Due to Sustained High Oil and Natural Gas Prices The North American Market is Picking Up

    Based on information provided by LUFK and it’s main competitors (i.e. WFT), the North American market is picking up steam.

    As noted in LUFK’s recent 10Q:

    During the first quarter of 2008, demand levels in North America increased over the levels experienced in the latter half of 2007 as higher energy prices drove increased drilling and workover activity. Additionally, the demand for pumping units, oilfield services and automation equipment continues to increase in international markets. While a majority of the segment’s revenues are in North America, international opportunities continue to increase as new drilling increases and existing fields mature, requiring increased use of pumping units for artificial lift, especially in the South American, Russian and Middle Eastern markets.

    Oil Field’s backlog increased to $97.1 million as of March 31, 2008, from $58.1 million at March 31, 2007, and $76.9 million at December 31, 2007. This increase over the December 31, 2007, level was driven by increased bookings for new units for the U.S. market as higher energy prices drove increased drilling and workover activity. The increase over the March 31, 2007, level also reflects the growth of international orders for new units.

    Valuation (Upside Case)
    I’ll keep this valuation part very short, since the case for LUFK is quite simple. Basically, we believe that by next quarter, LUFK will be on a run rate of $1.50 per share in earnings on a quarterly basis. This works out to $6 per share earnings power on a yearly basis. The best comp for LUFK is WFT, which trades at approximately 20X earnings or so (higher if take other factors into consideration). Given LUFK’s solid growth potential in the coming years, particularly for the company’s lesser known power division, I see no reason why LUFK will not trade at 20X multiple (including $7 per share in cash) once earnings growth resumes. That leads to my target price of $120 on LUFK in the year ahead.

    Note: If you go thru LUFK’s past financial statements, you’ll notice that the earnings basically equal the free cash-flow for the company and that the company has been a solid cash generator for years.

    Risks
    The risk for LUFK is the same as that faced by any other energy-related issue, namely the risk of a significant decline in oil and/or natural gas prices. Obviously, we have no idea where energy prices will head in the coming year, but our strong belief is that even at lower prices the demand for oilfield and power transmission equipment, will still be very high and LUFK will have no trouble maintaining strong cash-flow. If oil prices completely collapsed (say to $50), in the next six months, then of course all bets are off. But we think the odds of that happening are extremely low.

    Incredimail’s Stock (MAIL) Could Get A Boost

    July 9th, 2008 by Yehuda Fruchter   |   No Comments

    Introduction
    Incredimail (Nasdaq: MAIL, Market Cap.: $32 million) is a decent speculation at current prices or lower. My optimism for the shares, at least over a short-period of time, is driven by the fact that the shares remain over 60% below their highs, and yet three positive pieces of news were recently delivered that seemingly could boost the stock price.

    Specifically, in the last few weeks: MAIL signed a direct agreement with Google, announced the re-pricing and forfeiture of various options, and perhaps, most importantly, SEC filings indicate the culmination of selling by the company’s largest outside shareholder. Notably, the downside risk in the stock seems minimal at current prices given that nearly 75% of the market cap is in cash (MAIL has no debt), and the valuation measures seem very low (i.e. Enterprise Value (EV) relative to TTM Sales of 0.5X, and EV/Free Cash-Flow Potential of a mere 5X).

    Company Background
    MAIL basically provides some gimmicky free email services that have attracted about 10 million users. The company makes money by selling some premium products (e.g. a spam filter product), and increasingly via advertising thru Google’s AdSense program (a mostly automated Pay-Per-Click (PPC) advertising program). My own personal opinion is that Google’s Adsense program is one of the greatest businesses going right now worldwide, and I’m always interested in investing in businesses that can generate significant revenue via the program. There is obviously a ton of competition for MAIL’s service, but the fact remains that the company has already attracted a huge amount of users allowing it to generate about $9 million in advertising revenue in 2007, nearly four times what it did the year before.

    Financial Facts concerning MAIL are available at this link:

    What Went Wrong at MAIL?
    In early 2008, Google abruptly decided to stop its Adsense partnership with MAIL, leading to a collapse in MAIL’s stock price as Adsense is the company’s primary, and most profitable, revenue stream. Though Google soon reinstated MAIL back into the Adsense program, there was still concern over the initial Google ban and a fear that the company could lose Google Adsense over the long-term.

    In addition, to the Google mishap, MAIL did have a fair amount of auction rate securities (nearly $5 million) on its balance sheet which it needed to write off in 2007. This write off effected reported earnings and, like many other tech companies with large cash positions, has cast some doubt as to the value of the company’s other cash holdings. For more on the cash situation, please see the “Risk” section below.

    What Has Changed?
    The Google mishap led to a management shakeup at MAIL, and the start of renewed negotiations with Google. In early July 2008, MAIL finally announced the signing of a Google Adsense direct agreement, which I think completely allays the fears over the future of the Google business and removes a large amount skepticism related to MAIL’s ongoing viability.

    In addition, to the Google announcement I also noticed that one of the largest sharholders of the company, LongView Fund, who was sitting on a major loss in MAIL’s stock finally dumped all of their remaining shares at about $2.60. The culmination of selling by a large shareholder removes the selling pressure in MAIL’s stock, and should help the upside when and if good news is announced.

    Finally, just the other day, MAIL announced another repricing of options for key employees that I thought was quite revealing. Namely, the company moved up the strike price from $3 to $3.75 and cancelled the options of the CEO.

    Valuation

    As for the valuation of MAIL, I think the repricing of options to $3.75 strongly reveals management’s view as to the downside value of the stock and the potential for a nice gain from those levels.

    From a financial perspective, please see this link:
    to the financial figures below for MAIL where I list certain key figures for the company.

    My feeling is that a company that is growing revenues at a double digit rate, has gross margins of 90%, and almost no cap-ex, is extremely undervalued selling at 0.5X revenue and less than 3X EBITDA. Of course this valuation reflects lingering skepticism towards MAIL, its management team, and its business model.

    On the upside, though, should MAIL demonstrate some renewed financial momentum and should investors regain trust in the business, it would appear that the stock could easily double, at which price the shares would be trading at about 2X revenue and a little over 10X TTM EBITDA, both reasonable values for this company. I would note that I use TTM EBITDA as the benchmark for the company’s EBITDA and FCF potential and hence upside valuation since the recent earnings report was somewhat disappointing due to some one-time write offs and a large uptick in R&D as the company is nearing the launch of some new products.

    Risks

    The major risks for MAIL are:

    Cash Value: In looking at the most recent 20-F, it would appear that the company has entirely written off the auction rate securities and the vast majority of the remaining cash ($17 million or so), is invested in corporate debt securities which have an active market. However, I can not be completely sure as to the ultimate liquidity of these holdings and/or whether the company can readily convert these to cash. My assumption is that the Auction Rate security debacle has probably refocused CFO’s and that the remaining cash is liquid.

    Ongoing Business: While the company can generate nice gross margins off the Adsense business, the issue is whether management will bring those dollars to the bottom line or whether they will waste the profits on new endeavors that will never pay off. The risk of this type of situation is not all that remote given the large uptick in R&D expenses in the most recent quarter, reflecting the upcoming release of new products as detailed in the company’s earnings release. Of course, if AdSense revenue continues to grow, these additional expenses will be negligible, but investors need to pay close attention to upcoming financial reports and sell on any indication that profits are being sucked out of the business, instead of flowing to the bottom line. It may take a few quarters to get a sense of the financial direction of the company.

    Disclosure: I am currently long shares of MAIL and I may buy and sell shares at any time without telling you about these actions. I do not have any obligation to share with you any updated information about MAIL in the future.
    All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

    Funding for Polysilicon-Based PV Manufacturers: A Look at Four Companies

    July 6th, 2008 by Yehuda Fruchter   |   No Comments

    In this post we will take a look at the future capital needs and funding requirements of four Chinese polysilicon-based PV Manufacturers.

    Briefly, our conclusion, based on current low cash levels, high outstanding short-term debt as a percentage of total capital, and future capital needs, in the form of outstanding purchase obligations listed in recent 20-F filings, is that nearly all of the companies mentioned here will have a significant weakening of balance sheets in the near term, as short-term debt levels soar to support growing operating cash losses and purchase obligations. The prospect of immediate dilution via direct equity share offerings is clearly remote, as past history shows that these companies prefer to use convertible debt issues, as opposed to straight equity, as a longer-term financing vehicle.

    Note: Subscribers can access spreadsheets on the company’s mentioned in this report by visiting this link:
    http://spreadsheets.google.com/pub?key=pb-Z9URIzMG0KVo0cCO7QZw
    We will update this link as earnings seasons progresses, as well as add additional companies, as time permits.

    The current method of financing for these companies, in the absence of converts, is short-term bank loans from local Chinese banks, with much of these loans secured by related parties. The growing balance of short-term loans is apparently not seen as risky, even when they approach high levels of total capital, since these companies have, in the past, been able to quickly flip these loans into longer-term convertible issues, when, and if, share prices recover for short periods.

    This ponzi-like cycle of financing can, in theory, continue indefinitely, until foreign investors become concerned about the continued cash losses, and deteriorating balance sheets. At that point business models may be questioned, share prices could plummet further, and investors could refuse to participate in the longer-term financings to replace the local bank loans. Chinese banks may conceivably continue to support these companies, but ironically their seeming refusal to currently finance these companies on a longer-term basis, does not bode well for their willingness to offer longer-term financing in the future if cash becomes scarce from foreign investors.

    Alternatively, it’s conceivable that some of these polysilicon-based PV Manufacturers will secure enough financing to survive until they become self-sufficient on an operating cash-flow basis. However, as noted in past reports, the nature of the business implies that operating self-sufficiency is far off into the future for all these companies and given their position in the solar supply chain may, in fact, be a “pipe dream”.

    Interestingly, though the “polysilicon supply/price situation will ease soon” meme appears to resurface every once in awhile, supporting improved cash-flow projections, it’s unclear where the source of optimism originates from. Every single 20-F from each of the mentioned manufacturers, and others, projects continued polysilicon shortages and high poly prices for the foreseeable future.

    In sum, we continue to advise investors to avoid the shares of all of these Chinese polysilicon-based PV Manufacturers , until specific financing is announced and the longer-term financing and negative cash-flow issues facing these companies is addressed.

    And now onto specific companies:

    Trina Solar (TSL):

    TSL is currently the company that is most heavily reliant on short-term financing, with $322 million in short-term loans as of May 2008 (see page 58 in 20-F), up an incredible 100% from $160 million at year end 2007. The current short-term debt figure represents nearly 50% of the company’s total capital. TSL had $38 million in cash as of 3/31/2008, but that cash level has been increased via the recent boost in short-term loans.

    With an Envoy estimated 2008 EBITDA of approximately $145 million, and purchase obligations of roughly $245 million this year (including cap-ex), and $217 million in the next 1 to 3 years (page 58 in 20-F), we estimate that TSL has a funding gap of at least $180 million in the coming year. (Note that due to accounts receivable, and other financing, issues as discussed in previous posts, not all estimated EBITDA can be used for capital purposes).

    As noted above, since TSL has already secured nearly $160 million in short-term financing already this year, it would appear that the company will probably only need to raise an additional $50 million or so in the next six months to support operations.
    However, given the company’s already high level of short-term debt, one wonders how much more debt the local Chinese banks will lend to TSL. More importantly, it’s unclear why these banks will care to hold onto this debt, particularly given the prospects of continued cash losses for TSL in 2009. As such, it seems highly unlikely that TSL can carry such a high balance of short-term loans for much longer and the company must surely be facing pressure to refinance these loans. As such, we expect a convertible offering from TSL in the coming months, which will be used to pay off these short-term loans.

    The higher proportion of short-term financing as a percentage of total capital, could be the reason for TSL’s lower valuation relative to the others in the group. At current prices, TSL trades for an Enterprise Value or EV (Market Cap – Cash + Debt) to estimated 2008 EBITDA of about 6.5 and EV/Sales of 1.2X. (Note: The level of debt at these companies necessitates an enterprise valuation, and market cap valuations, such as P/E’s, which do not take current and future debt levels into consideration, are highly misleading and unjustifiable).

    Canadian Solar (CSIQ)

    CSIQ has the highest relative valuation of the current group of companies, and at the same time highest purchase obligations in the next 1 to 3 years.

    As of 3/31/2008, CSIQ had total debt of about $90 million ($71 million in short-term debt, up from $40 million at year end 2007) and $32 million in cash, taking into consideration the conversion of the company’s previous $75 million of convertible notes, which added about 4 million shares to the company’s share count.

    Though, CSIQ’s total debt is still relatively low as a percentage of total capital, that situation will surely change dramatically in the coming weeks or months. That is because, CSIQ has $338 million in purchase obligations (including cap-ex) this year and an additional whopping $632 million is due within 1 to 3 years (see page 60 in CSIQ 20-F). As noted above, the company had a mere $32 million of cash as of 3/31/2008, to support these obligations. Moreover, CSIQ recently upped its cap-ex budget for 2008, so our estimates above could prove to be too low.

    With an Envoy estimated EBITDA in 2008 of about $115 million, and increasing accounts receivable growth, we believe that CSIQ is need of at least $320 million relatively quickly, in order to support operations. It will be interesting to see how the company plans to finance these cash needs when the next earnings report is announced. If we had to guess, the company is currently being held on life support by Chinese banks until a very large convertible can be completed on Wall Street.

    At over 10X EV/2008 Est. EBITDA and 1.5X EV/2008 Est. Sales (EV is calculated using the additional 4 million shares from the recent Note conversion), the shares appear quite expensive, especially considering the near-term financing issues.

    Solarfun (SOLF)

    As of 3/31/2008, SOLF had $85 million in cash, and $339 million in total debt ($143 million short-term and $172 million in converts due in 2018).

    With an Envoy estimated $95 million in 2008 EBITDA, and nearly $550 million in purchase obligations (includes $150 million in cap-ex) in the next year and $350 million in the next 1 to 3 years (see page 65 in SOLF 20-F), we think SOLF is on the hook for at least another $400 million in 2008.

    Given SOLF’s already high debt level as a percentage of capital and lower EBITDA prospects as compared to the CSIQ and TSL, we think the financing of $400 million for SOLF will be quite tricky in the months ahead. Luckily, the company completed a large convertible earlier this year, and the cash proceeds could conceivably support the company for one more quarter or two. After that, expect another large convertible.

    At over 9.5X EV/2008 Est. EBITDA and 1.3X EV/2008 Est. Sales, the shares appear expensive and we have strong doubts about SOLF’s long-term viability given the already high debt level.

    Yingli Enery (YGE)

    YGE is seemingly the most vertically-integrated of the companies mentioned in this post, and therefore reports the highest reporting operating margins of the group. Nevertheless, despite the relatively better operating profile, the company is not immune to the cash-flow issues facing the industry.

    As of 3/31/2008, YGE had $80 million in cash, and $290 million in total debt ($115 million short-term and $175 million in converts).
    With an Envoy estimated $200 million in 2008 EBITDA, and nearly $585 million in purchase obligations (includes cap-ex of about $275 million), in the next year and $150 million in the next 1 to 3 years (see page 98 in YGE 20-F), we think YGE requires about $450 million 2008.

    Given YGE’s lower overall debt level as a percentage of total capital, higher estimated EBITDA and lower capital needs looking out 1 to 3 years, it would appear that the company may have a somewhat easier time raising appropriate financing than the other companies mentioned in this report.

    However, at about 10X EV/2008 Est. EBITDA and 2X EV/2008 Est. Sales, the shares appear to already reflect the company’s better relative positioning and financing “breathing room”.

    Conclusion
    In conclusion, for TSL, CSIQ, SOLF, and YGE, the same story should play out over the next few months and year. Balance sheets will continue to deteriorate as debts pile up to support operating cash losses (due to previously mentioned raw material purchase obligations and higher accounts receivables) and cap-ex. At some point, foreign investors will tire of financing these companies, particularly since none have them have any particularly unique/defensible technology and/or pricing power. Investors should continue to be suspect of valuations of these companies that utilize accounting earnings and revenues, and instead should focus more on operating cash-flow, balance sheets, financing options, and future purchase obligations.

    Clarifying The Financial Issues Facing Polysilicon-Based PV Manufacturers

    July 3rd, 2008 by Yehuda Fruchter   |   No Comments

    In this post, I will address the two most common criticisms of our article last month on several polysilicon-based PV manufacturers and thereby hopefully clarify the financial issues that confront many of these polysilicon-based PV manufacturers.

    Before getting to the criticisms, though, it is important to note that nearly all of the comments to the post fail to distinguish between cash outflows due to capital expenditure requirements and cash-outflows due to working capital management. However, these are two entirely different issues.

    If the significant cash losses for some of the polysilicon-based PV manufacturers were just due to significant cap-ex needs, there would really be no major cause for concern as it would be a natural outcome of their growth and need to meet future capacity.

    The issue, though, is that many polysilicon-based PV manufacturers have significant cash outflows even before cap-ex needs and it is this problem which needs to be addressed, especially considering the mismatch between positive accounting earnings reports and this negative cash-flow before cap-ex. Basically, the existence of significant cap-ex needs merely aggravates an already tenuous cash-flow situation, but it is not the major problem in itself.

    As noted in the original post, when looking at several of these polysilicon-based PV manufacturers, it is clear that the main reason for these cash outflows before cap-ex, is due to the fact that these companies need to shell out huge amounts of money to suppliers of polysilicon, well in advance of receiving any actual cash revenue from customers. As these payables are dramatically increasing, the competitive dynamic of the industry is causing much greater use of longer-term credit-based sales resulting in very high accounts receivables growth. It is in fact questionable whether certain types of longer-term credit sales should even be recognized as revenue.

    This is the crux of the working capital cash issues and given the competitive nature of the industry and still very tight supply of polysilicon, it is a situation that would seem to be getting worse, rather than better.

    With that said, we can now move onto the two most common critiques:

    Criticism I: Every Young Business That is Growing Rapidly Drains Cash

    Answer    : Obviously, young and fast-growing companies in any manufacturing-based industry will need to expend cash in building out infrastructure to support the production of products and future demand. However, as noted above, the issue here is not about cash drains due to cap-ex, but due to working capital cash outflows, i.e. cash negative outflows before cap-ex.

    There is not one shred of evidence or any economic rationale to the assertion that fast-growing companies should lose cash before cap-ex after they reach a certain sales level. I’m not sure how anyone can assert that a company nearing a reported $1 billion in sales, needs to burn thru tons of cash before cap-ex needs and yet at the same time report extraordinary accounting earnings gains. In fact, just to put this criticism to rest, one counterexample, in the same exact industry, should suffice.

    The most valuable company in the solar space now is the thin-film manufacturer, First Solar (FSLR). First Solar is growing as rapidly as any polysilicon-based manufacturer, and yet it’s operating cash-flow, before cap-ex, is solidly in the black and has been for quite some time. Interestingly, as opposed to many polysilicon-based manufacturers, First Solar makes it quite easy to track cash flows into the company, as it reports its cash flow quite simply as Cash Received from Customers and Cash Paid to Suppliers and Employees.

    Criticism II:
    The Solar Industry Is Growing Rapidly and Therefore The Concerns Regarding polysilicon-based PV Manufacturers Is Misguided

    Answer:
    Apparently, many readers took the concerns raised against polysilicon-based PV manufacturers as an attack on the entire solar industry. However, this was not the intent of the article.

    Even if one believes strongly in the secular growth of the solar industry, as I personally do, it is obvious, based on past business history in every other major growth industry that ever existed, that many of the companies participating in the industry will simply go bankrupt or fail to provide any return to shareholders for various reasons. There are countless recent examples of this (i.e. fiber optic component suppliers) economic reality.

    The fact is that a growth of an industry does not benefit all players in the industry’s ecosystem, as certain business models simply don’t have economic viability and many companies fail to receive adequate financing.

    In regards to the solar industry, despite the secular growth, investing in many polysilicon-based manufacturers in the current environment may turn out to be a losing bet. The situation could, of course, change if a wave of merger activity goes thru sector, consolidating the power of the industry into a few large companies, and thereby the improving the negotiating strength over suppliers and customers and eliminating much of the working capital cash issues.

    In conclusion, the solar industry presents some very attractive investment opportunities, but investors still need to focus on those companies that can at some point be self-funding on an operating basis, and have a unique technology that reduces competitive pressures.

    In the case of many polysilicon-based PV manufacturers the cash outflows raise serious and real financing concerns and it is incorrect to value these companies off of accounting earnings and revenues. It will be paramount for investors to gain a clearer understanding of these companies polysilicon agreements and customer credit/sales terms, two facts that are not often disclosed in public filings, but should be addressed by management.

    ATS Automation Tooling Systems (ATA.TO) Restructuring Shows Evidence of Success: Does the Stock Still Have Upside?

    July 1st, 2008 by Yehuda Fruchter   |   No Comments

    In this post, I’ll take a look at ATS Automation (ATA.TO or ATSAF.PK ), a Canadian company that primarily specializes in providing automated manufacturing systems to various sectors, including the fast-growing alternative energy industry. In addition, the company also owns PhotoWatt France, a provider of photovoltaic solar modules and is a leader in the manufacture of refined metallurgical silicon (UMGSi) silicon cells and modules. UMGSi a lower grade of silicon that can be acquired more readily than polysilicon.

    ATS Automation has been in restructuring mode since September 2007, when a group of shareholders successfully ousted past management and installed a whole new leadership team. Recently, the company’s fourth quarter fiscal 2008 financial results demonstrated significant financial improvements and a strong outlook for fiscal 2009, prompting me to take a closer look at the company. Although the stock has appreciated dramatically from its low earlier this year, I still believe that ATS Automation (ATA.TO – PinkSheets), has significant upside (100%) in the next one to three years.

    Summary: Why Is ATS Automation (ATA.TO) a Potentially Attractive Speculation

    The following criteria combine to imply that ATA. TO shares have low risk and attractive upside over the next one to two years:

    • Depressed Price: Although the stock has appreciated dramatically from its low earlier this year, when there appears to have been some liquidity concerns, it is important to note that ATA.TO is still significantly lower than its high of nearly $18 back in April 2006 and is still well below prices that were reached over five years ago.
    • Corporate Restructuring and Divestitures: Over the last six months or so, the company has significantly restructured its workforce and started to divest significant asset holdings, including an entire business division. Details can be found in the last MD&A report, here: http://www.atsautomation.com/profile/investors/pdf/ATS%202008%20Annual%20MD&A.pdf
    • Attractive Industry Dynamics: As will be detailed further below, both of ATA.TO remaining operating subsidiaries have significant exposure to the high growth alternative energy sector.
    • Improving Financials and Year-Over-Year Comparisons: As can be seen below, ATA.TO’s fiscal 2008 fourth quarter demonstrated significant profitability improvements and top-line growth prospects, implying that in the coming year the company’s financial reports should show significant improvements and growth.
    • Low Valuation: As I’ll show below, despite the recent rebound in its shares, ATA.TO is still a cheap stock based on potential EBITDA assumptions. On an even more simplistic level, ATA.TO stock trades at an EV/Sales ratio of less than 1, despite improving profitability ratios and a strong sales outlook.
    • Healthy Balance Sheet: ATA.TO has a net cash position and little debt.
    • Seemingly Unknown to Most Alternative Energy Investors: Despite investor fascination with alternative energy plays, particularly the Chinese solar companies which I wrote negatively about in a previous post, I have seen little to no mention of ATA.TO as a solid alternative energy play in any popular media or top tier Wall Street analysts reports.
    • Continued Good News Over The Next Year Creates Positive Feedback Loop Over the next year, I believe that ATA.TO will continue to report solid financial results and could in addition release exciting strategic news, including additional partnerships for PhotoWatt, the sale of the company’s discontinued operation, as well as additional alternative energy contracts for the company’s main ASG subsidiary. Combined all of these news items should help to create a positive feedback loop for the company and the stock.

    Company Background

    ATS Automation Tooling Systems Inc. (“ATS” or the “Company”) operates in two segments:

    • Automation Systems Group (“ASG”) is an industry-leader in planning, designing, building, commissioning and servicing automated manufacturing and assembly systems – including repetitive equipment manufacturing and test solutions – in the worldwide market for healthcare, computer-electronics, automotive, energy and consumer products automation. Interestingly, the fastest growing segment of ASG is in the solar and nuclear manufacturing automation markets.
    • Photowatt Technologies includes Photowatt France, a vertically-integrated manufacturer of ingots, wafers, solar cells and solar modules. Photowatt France has developed processes and technologies to manufacture solar cells from UMGSi silicon, a lower grade of silicon that can be acquired more readily than polysilicon. This is an important advantage since there is not enough polysilicon available to meet current industry demand and polysilicon is a primary raw material used by most solar manufacturers. As of March 31, 2008, Photowatt France had annual ingot, wafer, cell and module production capacity of approximately 60 megawatts (“MW”).

    Quantative Background Statistics (as of 3/31/2008 – All numbers in Canadian):

    • Share Price:

    High Share: April 2006 about $18.00
    Low Share Price: December 2007 at about $4

    • Shares Outstanding: 70.5 million
    • Current Share Price as of this report: $7.40 (Canadian)
    • Market Cap: $525 million
    • Cash: $57 million
    • Debt: $29 million

    Envoy Research Note: The balance sheet could change dramatically over the coming year due to various divestitures as well as access to credit lines. Effective June 2008, a 17-month credit agreement was signed providing credit facilities of up to $85 million.

    • Enterprise Value: $500 million
    • 2008 Sales: $664 million (ASG: $465 million and PhotoWatt: $199 million)

    Envoy Note: ASG: Fiscal 2008 Order Bookings were $531 million, 20% higher than the previous year, driven primarily by strong Order Bookings in healthcare and energy sectors. Order Backlog of $232 million at March 31, 2008 was 25% higher than at March 31, 2007 primarily reflecting higher Order Bookings throughout fiscal 2008 compared to fiscal 2007.

    • 2008 EBITDA By Segment:
    • ASG Fiscal 2008: Excluding severance costs fiscal 2008 EBITDA was $20.0 million (actual operating earnings were $12 million or 3% of sales), compared to EBITDA of $21.3 million in fiscal 2007
    • ASG Fiscal Fourth Quarter 2008: Excluding severance costs, fiscal 2008 fourth quarter EBITDA was approximately $7 million compared to $1 million EBITDA the year before.

    Note: In 2005, which appeared to have been ASG’s best year in recent history, the company reported operating earnings of $38 million or about 7% of sales on revenue of $547 million. So in theory, assuming the company continued to reduce costs and improve profitability, ASG could achieve 7% operating margins, implying Operating Earnings of approximately $47 million and EBITDA potential of approximately $55 million.

    • PhotoWatt Fiscal 2008: Excluding certain one-time gains 2008 EBITDA was $6.0 million, compared to EBITDA of $29 million in fiscal 2007
    • PhotoWatt Fiscal Fourth Quarter 2008: fiscal 2008 fourth quarter EBITDA was approximately $7 million compared to $6 million EBITDA the year before.

    Envoy Note: Lower profitability in fiscal 2008 primarily reflected the launch of UMGSi products. UMGSi products were sold at up to a 10% discount compared to polysilicon products, and produced lower cell efficiency resulting in fewer watts to sell at a given level of production. In addition, Photowatt France initially experienced high scrap rates and reduced throughput as it ramped UMGSi production. However, in the fourth quarter of fiscal 2008 UMGSi cell efficiency improved, selling price differentials decreased and throughput and scrap rates for UMGSi products achieved more acceptable levels. Overall it would appear that with despite lower operating profits from UMGSi modules, it would seem that with increased sales PhotoWatt absolute EBITDA dollar value could easily equal $30 million per year.

    • Capital Expenditures:

      • Cap-Ex 2008: $21 million – $4 million for ASG and $17 million for PhotoWatt

      Envoy Note: What is clear from these cap-ex numbers is that despite the need for significant cap-ex at PhotoWatt to expand operations, ATA.TO’s ASG business can generate enough positive free cash-flow (EBITDA – Cap Ex) from operations to support that business, as well as the ASG business.

    Summary Quantative Analysis/Valuation:

    Overall the numbers, in a somewhat simplistic manner (which is all that is really needed for stock analysis) above seem indicate that the current valuation of ATS does not take into consideration the value of at least of its subsidiaries.

    From one perspective, it would seem reasonable to price ASG at 10X potential EBITDA or about $550 million, implying that the current share price assigns zero value to the PhotoWatt business. From another angle, one can argue that PhotoWatt could be worth about 2X revenue (as many other solar suppliers are worth) or about $400 million, implying that ASG is valued at a mere 2X EBITDA.

    In sum, my guess is that based on the operating potential here one could easily justify a price tag of $13 to $15 for ATS or about $800 to $1 billion in Enterprise Value (10X EBITDA for ASG and 2X Revenue for PhotoWatt, about 15X potential EBITDA of $30 million).

    What Went Wrong and What Has Changed?

    There was so much that was wrong at the old ATA and so many new changes are in the process of being implemented that it is difficult to addresses all of these issues in one post. More importantly, the company has already neatly outlined all of the past problems and current resolutions in its annual MD&A report. I, therefore, recommend that interested investors read at least the first five pages of this report for a quick summary of What Went Wrong at ATA.TO and What Has Changed. You can click here to download the MD&A report.

    What Are the Major Risks To ATA.TO?