Small Cap Stocks

This morning Lufkin (LUFK) reported outstanding third quarter results and a growing backlog. Additionally, the company’s balance sheet remains pristine, with $110 million in cash and no debt. Despite the positives, the stock tanked, amidst continued deterioration of the equity markets, and extreme bearishness in energy-related equities as the stocks appear to be pricing in sub-$50 oil.

Nevertheless, I remain bullish on LUFK, considering the depressed valuation (well under 10X cash-flow), and solid growth opportunities in both energy and alternative energy sectors. I plan to average down on this stock once the election is over and Paulson is fired. Even assuming that the company’s earnings are halved in the coming recession, the stock is still cheap.

What’s important to note is that on LUFK’s conference call the company made three important points:

Our poll of customers suggests that most 2009 budgets that they’re developing are assuming an economic hurdle rate on a per barrel basis in the range of $60 to $70 and somewhat lower in more mature basins. However we recognize that if events in the broader economy affect either energy demand or access to credit might well alter this picture. Based on information we are getting we believe that the majors and large independents will have a strong cash flow and will be well positioned to maintain their development programs into 2009. We will monitor the pulse of the small and medium independents carefully.

We also expect that a few of the resource plays may come under greater scrutiny at gas prices under $7.00 per mcf. Fortunately we’re strongly leveraged to oil. Last quarter for example about 4/5 of our new bookings in the oilfield division were oil projects and 1/5 natural gas projects. So on a company-wide basis we are less sensitive to changes in gas-related activity than oil.

Eric Mintz – Eagle Asset Management
You mentioned I think you said a significant pick up in power gen. Would that be related to wind energy?

John F. Glick
A lot of what we’re seeing right now is related to gas turbine power gen, but we are working on some things that we may want to talk about in future calls on wind energy both in our operations in Europe and our operations here. We’re making some capital investments to position ourselves a little bit more strongly for those sectors. There is going to be that in the future but my reference was more to the gas turbine sector.

Bel-Fuse, a competitor of Power-One (PWER), and a major shareholder, recently upped it’s stake in PWER at share prices of around $1.30 per share. Bel-Fuse first bought into PWER and attempted to acquire the company back in February 2008. The original shares were purchased at little over $2.

I consider Bel-Fuse’s purchases significant, since as an industry insider, Bel-Fuse has a deep understanding of PWER’s businesses and hence a better chance than most investors of determining a fair value for PWER.

The major risk with PWER, is as I’ve mentioned in the past, is the company’s high leverage, and inability, at least in the past to deliver consistent, if any, profits. The high debt level is especially risky in the current credit environment, and probably explains the nearly 40% drop from my original purchase price (though the 40% drop in the overall market is a contributing factor, as well).

However, my gamble on PWER is predicated on the company’s rapidly expanding alternative energy business. My feeling remains that PWER’s alternative energy business (inverters for solar and wind) will experience exponential growth in the coming years, and bring the company back to sustained profitability this quarter or next.

Basically, if the company can navigate thru this credit crisis, and survive, the equity will experience a tremendous rebound on the heels of a rapidly growing inverter business and vastly improved financial results.

But, will the company survive? That’s the question. We’ll find out more information at the company’s next quarterly conference call slated for next week.

Incidentally, since the company has not warned this quarter, I have a strong suspicion that they will meet or beat estimates, as they did last quarter. A report of even a tiny profit this coming quarter and/or some degree of positivity regarding future financial performance, could send the stock up 50%+ in a matter of days.

Summary:
Power-One Inc. (Nasdaq: PWER – Current Price: 2.10) could potentially rise 50% to 100% over the next twelve months, as financial results, driven by the company’s fast-growing solar and winder inverter business, begin to show significant improvement. In addition, a recent acquisition of a competitor to PWER by Schneider Electric , a huge European conglomerate, provides a solid metric for estimating the potential takeout value of PWER under various scenarios.

Background on Company:
From SEC Filing:

We are a worldwide organization and leading designer and manufacturer of hundreds of high-quality brand name AC/DC power supplies and DC/DC converters, inverters and power management products. We are engaged in the design and production of renewable energy inverters. Our renewable energy products, also called alternative energy products, are generally stand alone units that are sometimes called “inverters.” These products are DC-to-AC converters that convert DC voltage from solar arrays, wind generators, or fuel cells into useable AC power; and range in size from a briefcase to a large cabinet. The global demand for harvesting power from the sun (called solar or photovoltaic energy) and wind to be converted into useable power is one of the fastest growing markets due to increasing energy costs and concern for the overall environment. Additionally, the cost of renewable energy products is decreasing and with many countries offering incentives to individuals and companies, we expect this market to expand rapidly throughout the world.

Current Price: $2.10
Shares Outstanding: 88 million EV: $255 million
Cash: $38 million Debt: $112 million (see debt notes at end of this post).
Estimated 2008 Sales: $555 million ($50 million in renewable)
Gross Margins: 20% (projected to improve dramatically in the year ahead due to renewable sales)

What Went Wrong?:
Power-One has been a terribly mismanaged company for quite some time, as past financials indicate. The past problems would seem to lie in poorly integrated acquisitions and a significant drop in gross margins due to product mixes (and likely competition in mature markets). As a result of these problems PWER’s stock has been quite depressed falling to about $2 from over $10 a few years ago.

What Changed?
There are three major changes related to PWER that I think increase the probability of improving financial results going forward:

Notably, the new CEO of PWER, Richard Thompson (joined PWER in 2/2008), was CFO of two competitors of PWER which were ultimately sold for significant premiums. Interestingly, the last company PWER CEO was at was APC which was sold to Schneider (same company that recently purchased another competitor of PWER – see below) for $2 billion.

The inverter market for renewable energy (solar and wind) is booming and PWER’s sales in this market are growing quickly (i.e. the company expects renewable inverter sales to double in 2009 and double every year for a few years). Importantly, gross margins for renewable energy inverters are much higher than the traditional margins for PWER products, so as the sales of renewable energy inverters increase as a percentage of sales, the company’s bottom line will get a significant boost. In terms of information about Renewable Energy Inverters this information from the last conference call is extremely interesting:

“Now, let’s discuss the increasing opportunity we are seeing in the renewable energy inverter market. While this market is still in its infancy, it is estimated that total available market for solar inverters will be $1.3 billion in 2008 and currently growing over 30% a year. Additionally inventers in the wind market are expected to be $1.1 billion. At the current time the market for our products is largely in Europe where governments are driving adoption of alternative energy by offering subsidies and putting into effect a variety of regulations that are stimulating the adoption of greener power. We continue to broaden our reach in many European countries including Germany, Italy and Spain. During the quarter, we strengthened our renewable energy sales and service team in Germany in order to address a growing market demand for our products in that country. Our ability to be flexible and scale our operations in this market allows us to quickly implement product innovations. Our products range from 1.5kW to 300kW are both grid and off-grid and address both solar and wind while most companies in the market address either solar or wind but generally not both. As I discussed earlier, this quarter we introduced five new products in renewable energy. We plan to introduce more products including 100kW to 300kW products for the commercial market in the US. Our inverters deliver over 96% efficiency over an extremely wide operating range and we have a very broad product portfolio.

Power-One currently has a small market share in inverters for renewable energy. We estimate it as under 5% of the worldwide market for solar and wind which we regard as an enormous opportunity. By making investments in engineering and infrastructure and also through strategic partnerships, we believe we will double this business each year for the next several years. We expect that this market at the end of 2008 will have a revenue run rate of more than 10% of our sales and sales in 2009 will surpass the $100 million mark. “

In late July 2008, Xantrex Technology (XTX.TO) a Canadian competitor of PWER, a major player in the renewable energy inverter market agreed to be acquired by Schneider Electric for C$500 million. Details of the transaction are available below. In the valuation section for this post, I’ll discuss how this acquisition relates to the potential value of PWER.

Acquisition Information:

On July 27, 2008, Xantrex announced that it has entered into a definitive agreement to be acquired by Schneider Electric for a purchase price of $15.00 per share. The all-cash transaction has an equity value of approximately C$500 million ($US 468 million). As a condition to the sale of Xantrex to Schneider Electric, Xantrex also entered into a definitive agreement for the sale of its Programmable Power business to AMETEK, Inc. for US $150 million.

So total value of transaction for XTX.TO in US dollars using current exchange rates is:

U$150 million Valuation for Programmable Power: Estimated C$80 million (US$75 million) in programmable sales in 2008, so about 2X Revenue.

U$280 million Valuation for Remaining Business (subtracting about C$40 million in debt), which includes Renewable Power (C$155 million – US$145 million estimated revenue) and Mobile Power (C$60 million – US$56 estimated revenue) for total estimated sales of US$200 million. Valuation = 1.4X Revenue.

Total Valuation of XTX.TO: US $430 million or about 1.5X Sales. Notably, gross margins for XTX. TO were about 33% and climbing.

Financial Evidence for Improving Results:
Interestingly, aside from management’s forecasts, there is some financial evidence that PWER’s results are improving.

PWER has very High D&A charges of nearly $20 million a year and extremely low cap-ex relative to sales of about $9 million. As such, the company’s accounting earnings are misleading to an extent and greatly overestimate current losses. On a theoretically non-leveraged business in a breakeven scenario, the company’s free cash-flow, based on D&A and maintenance cap-ex would be about $10 million a year ( 15X that is $150 million or $1.75).

Though PWER still has some working capital issues to deal with, the company’s EBITDA swung into positive territory in the June 2008 quarter. This is vs. losses in the year ago period and previous quarter. Specifically, EBITDA was about $5 million+ in the June quarter vs. a $600K loss last year and about an adjusted $5 million EBITDA loss in the 1st quarter.

As of March 2008 180-day backlog w as $132.8 million and 90-Day was at $109 million, up significantly year-over-year. In the June 2008 quarter, 180-day backlog w as $134 million and 90-Day was at $107 million, up 60% and 40% year-over-year.

Risks:
There are two major company-specific risks for PWER:

High Leverage (at 50% of current market cap and $9 million a year in interest expenses, which eat up the high D&A) leave Little Liquidity Room If Results Do Not Improve and Cash Losses continue.

The company does not have a history of executing well on its business plans and it’s still not clear whether new management has revamped the company’s operations well enough to take full advantage of the renewable opportunity

The Numbers and Valuation: (Upside/Downside)
At the current price of about $2.10 per share, PWER’s Enterprise Value is about $260 million.
The following are several valuation scenarios:

Based on core cash-flow assuming no leverage and a breakeven, as discussed above, I think PWER can throw off $10 million a year in free cash-flow. At 15X that number the valuation would be about $150 million or about $1.70 per share. This implies about 25% downside.

Based on the takeout of XTX.TO, I’d go with the following valuations for PWER:
Total estimated revenue in 2008 of about $555 million with Inverter sales at 10% of that.
$50 million in Inverter sales would be valued at 1.5X Revenue or $75 million.

Rest of business will be at $500 million in revenue and worst case (because of much lower gross margins) would be valued at $250 million (0.5 X Sales, way beneath the XTX.TO valuation).

So total valuation on a takeout should be at least $325 million or about $3 per share (0.6X EV/Total Estimated 2008 Sales). This is vs. a current enterprise value of $260 million. A near 50% upside.

However, considering the fact that inverter sales may grow to $100 million next year, the valuation of that business could jump to $150 million. The remaining business, if profitability could be achieved could be worth about 1X revenue or $500 million. Total Value would then be $650 million or about $6.50 per share (enterprise value). An over 200% upside.

It’s always difficult to define a worst case in a PWER situation, but assuming continued cash losses and a major economic slowdown, the stock could easily drop 50% and head to $1. However, I do think that the probability of this low, especially considering the core unlevered cash-flow figure.

In any case, taking the four scenarios outlined above and assigning equal probabilities would yield a fair value target for PWER of about $3 per share or 50% above the current price. Importantly, if financial results improve the probability weights would change dramatically and the fair value of the stock would jump significantly.

Timing of Purchase
PWER stock is trading at multi-year lows and is off over 50% this year alone.

Conclusion:
If PWER continues to execute on its renewable energy inverter growth and the company’s core business operating results improve, the company’s stock could increase significantly, given the low valuation relative to recently completed acquisitions. A Probability-Weighted Scenario analysis of PWER, suggests a current fair value of about $3 or 50% above the current price.

Debt Notes from PWER SEC Filings:

$80 Million in Convertibles

On June 12, 2008, the Company entered into a purchase agreement (the “Purchase Agreement”) under which the Company agreed to sell $75 million aggregate principal amount of its 8% Senior Secured Convertible Notes due 2013 (the “Notes”) to Lehman Brothers Inc., as initial purchaser (the “Initial Purchaser”) for resale to certain qualified institutional buyers in compliance with Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”). On June 17, 2008, the Company issued $75 million of the Notes. The Company also granted the Initial Purchaser a 30-day option to purchase up to an additional $5 million aggregate principal amount of the Notes. On July 16, 2008, the Company issued the additional $5 million of the Notes.

The Notes are governed by an indenture, dated as of June 17, 2008 (the “Indenture”) between the Company and The Bank of New York Trust Company, N.A., as trustee. The Notes bear interest at a rate of 8% per annum, payable in cash in arrears on March 31, June 30, September 30 and December 31 of each year, beginning September 30, 2008. The Notes will mature on June 17, 2013. The Notes will rank equal in right of payment with all of the Company’s existing and any future senior unsecured indebtedness that is not subordinated by its terms.

The Notes are convertible, at any time prior to the close of business on the business day immediately preceding the maturity date, into shares of common stock of the Company, $0.001 par value per share (the “Common Stock”), at an initial conversion rate of 304.8780 shares of Common Stock per $1,000 in principal amount of the Notes (which is equivalent to an initial conversion price of approximately $3.28 per share), subject to certain adjustments set forth therein, including a potential reset to the conversion rate on June 18, 2009 if the average Common Stock price is lower than the initial conversion price during the five trading days preceding the reset date, subject to a conversion price floor and limitations on conversion under the rules of The Nasdaq Global Market.

Credit Facilities $32 million

At June 29, 2008, $30.7 million of the total $31.9 million credit facilities outstanding were held at a subsidiary that the Company acquired in connection with the acquisition of the Power Electronics Group of Magnetek, Inc. in October 2006 of which $23.7 million relates to revolving credit arrangements with various banks. These revolving credit arrangements bear interest at various rates based on the European Interbank Offering Rate (EURIBOR) and bore a weighted average interest rate of 6.6% at June 29, 2008.

In addition, this acquired subsidiary has an agreement with a European bank to provide borrowings secured by the subsidiary’s land and building over a ten-year period. The initial commitment to lend under this agreement was $9.2 million, with the commitment amount reduced ratably on a quarterly basis beginning March 31, 2004 and ending December 30, 2013. Borrowings outstanding under this agreement were $7.1 million at June 29, 2008 and bore interest at the EURIBOR plus one and one-half percent (6.4% at June 29, 2008). The agreement contains financial covenants that require a minimum EBITDA as a percentage of net revenue and a maximum percentage of debt to equity. At June 29, 2008, this subsidiary was not in compliance with these financial covenants. The $7.1 million outstanding balance under this credit agreement at a 6.4% interest has been classified as a current liability as the Company has not sought to obtain a waiver and considers this debt potentially callable by the bank.