Tuesday, February 10, 2009

Government Action Falls Short

The Geithner Plan was announced today and caused a major sell-off in the market. I was hoping his speech would cause this type of reaction because I was hoping it would mean the government is announcing a hard-line stance against troubled banks with bold action to eliminate ‘zombie banks’ but that wasn’t exactly the reason for the sell-off. Instead, the sell-off was probably more due to the many unanswered questions in the plan and the uncertainty in its meaning.

It seems that whatever side of the fence you are on about what is best for the financial system depends on your diagnosis of the problem. The Treasury appears to be fighting this problem like it is a liquidity issue that is causing temporarily depressed asset prices. The plan in both its original and current form is to pump enough capital to the banks to keep them afloat until the prices correct and everyone gets their money back (or at least most of it). The other camp is arguing that the banks are insolvent because they are holding permanently impaired assets and the government is artificially keeping them in business even though they are technically bankrupt. Their solution would be to assess the banks needing government intervention, wipe out the current shareholders and management of those banks deemed insolvent, and use some form of bankruptcy proceedings, nationalization, or negotiated private industry sale to start-over with a recapitalized bank.

In the end, maybe Nouriel Roubini is right in his assessment the Treasury seems to be following a course of action based on political reasons. The consensus opinion is that Bank of America and Citi are effectively insolvent while Wells Fargo and JP Morgan are not yet as of today. Instead of taking over BoA and Citi, which risks causing panic for Wells Fargo and JP Morgan, why not delay the decision and hope the economy turns around in the meantime? I actually hope this assessment is more accurate than the more cynical conclusion that the Treasury and Fed are protecting the interests of the big banks at any cost to the taxpayer. I find it ironic that Obama’s speech last night warned if we did not act boldly today that the U.S. could enter a “lost decade” similar to Japan in the 1990’s and the very next day his Treasury Secretary announces a plan that keeps our insolvent banks in business which was one of the major criticisms of Japan during their lost decade. To be more optimistic, at least the groundwork is being laid for the inevitable.

This doesn’t fundamentally change any of my views and I still will wait on the sidelines for better prices in the marketplace. Unfortunately for me, so far, this strategy has not materialized yet as the stocks I am following are almost all up even after today’s fall. Regardless, between the tepid stimulus package and the Treasury plan, I see no reason to expect a strong rebound in the global economy anytime soon and thus see no major catalysts for the U.S. equity markets.

Tuesday, February 3, 2009

Companies Under Consideration

The following are stocks that I believe fit into the criteria I discussed in the previous blog entry. With the exception of Gulf Resources, I currently do not own any of the following stocks, but will look to purchase the rest at periods of particular weakness throughout 2009.

Gulf Resources (GFRE.OB)
Summary:
This is one stock I currently own. Gulf Resources is China’s largest producer of bromine and also sells crude salt and chemical products. In China, a net importer of bromine, Gulf Resources is the market leader with over 20% market share and the Chinese government is not licensing for any further domestic competition. The stock currently trades at a P/E of close to one, attributed to a sell-off of a larger shareholder who received the shares as compensation for helping take the company public. This has offered a compelling buy at current prices as downside risk is limited.

The Market:
Global production bromine capacity is approximately 720,000 metric tons and dominated by three international players: ICL, Chemtura, and Albemarle. With about 33,000 metric tons capacity, Gulf Resources provides roughly 5% of the global capacity but currently sells only in China. It is estimated that China demand is 190,000 metric tons per year but the country can only supply 160,000 tons per year.

Competitive Advantages:
Government regulation provides high barriers to entry for Gulf Resources. Gulf Resources is one of only six license holders permitted to extract bromine in China. The government issued a decree that they would not grant any more licenses in the future. Gulf Resources has grown significantly by buying up unlicensed producers who are legally not permitted to produce bromine. The company is certainly not immune to a global slowdown but Gulf Resources should be one of the first to emerge from it since it supplies many industries that should recover including energy and waste water treatment.

Business Model:
Gulf Resources generates sales with cash in advance from customers they have long-standing relationships with, which generates solid cash flow.

Valuation:
Gulf Resources will earn $0.20-$0.23 per share in 2008. This provides a compelling valuation of 1x earnings for a company with high barriers to entry, strong cash flow generation, and products that should have strong demand once the world economy recovers. Debt load is minimal so the company should survive any sustained downturn and emerge from it in a position of strength. This company should trade again at least an 8x earnings multiple once the investment climate stabilizes suggesting significant appreciation potential.

ChinaCast Education Corporation (CAST)
Summary:
ChinaCast Education Corporation uses its brick-and-mortar schools and a satellite broadband network to serve the growing Chinese post-secondary and e-learning education market, similar to Devry, Strayer or Phoenix University in the United States. Flying under the radar, this company is quietly building up an impressive infrastructure and cash reserve to take advantage of a huge untapped market.

The Market:
The education market in China is expected to be one of the biggest growth markets in China for the foreseeable future with the post-seconday market particularly appealing due to its value proposition. Despite recent annual growth of 23% over the last five years, only 5% of the population possesses college degrees and there is a clear value proposition for pursuing a degree since the average wage increases are over 200% for post-secondary degree. Distance learning will also continue to fulfill a glaring need for the Chinese Education market. According to China’s Ministry of Education in 2007, there were over 100 million higher education students, while universities had sufficient physical space to accommodate only about 15% of the students qualified to attend.

Competitive Advantages:
The company is still establishing its moat but does enjoy some competitive advantages. The company possesses two important operating licenses including one from the Ministry of Education for its accredited degree programs and the other from the Ministry of Information Industry for its nationwide satellite broadband internet license which it hopes to build a nationwide network of campuses and an e-learning network throughout China. The company believes the satellite license gives them a first-mover advantage for their e-learning segment over competitors using terrestrial networks and they have the cash to make strategic acquisitions to expand its national coverage.

Business Model:
This business model generates lots of free cash with stable, recurring revenue streams and low CAPEX. This is a cash business right now compared to the United States, loans are not really existent so the company collects the cash up front or the student does not go to school.

Valuation:
ChinaCast has an Enterprise Value of approximately $19M and has generated free cash flow of $19.6M in the first nine months of 2008. With $2.00 in Net Cash and roughly $0.30EPS, the company is basically selling for nothing right now. It may take time for the company to prove itself to the investment community and justify a higher premium, but in the meantime the company will continue spitting out significant free cash flow and building its moat in this attractive market.

China Medical (CMED)
Summary:
With the recent sale of one of its main subsidiaries, China Medical is now focused on the attractive advanced (in-vitro) diagnostic market selling highly recurring reagent kits, probes, and chips in China used to detect various diseases. Investor sentiment in the stock is low right now partly due to the dubious nature of the sale of its subsidiary to a major shareholder, but the sale frees the company to focus on the in-vitro market that offers appealing long-term potential with a business model that ensures significant cash flow.

The Market:
The company serves the Chinese in-vitro market, estimated at around $1.5B today with strong continued growth expected, using ECLIA, FISH, and SPR technologies to detect diseases. In the interest of brevity, ECLIA is a test that detects diseases based on a reaction of the patient’s bodily fluid, such as blood, with a reagent to create a light emission and the analyzer measures this light to detect a specific disease. FISH probes are used commonly for prenatal and postnatal diagnosis and certain types of cancers while SPR is used primarily for cervical cancer. ECLIA products have been targeted to small-medium hospitals while FISH and SPR have been targeted at large hospitals.

Business Model:
The company is now focused on the highly recurring, high margin sales of reagent kits and probes. In order to build its established base to sell these kits and probes, the company has recently made it easier for hospitals to install their systems by either renting it out for free or reducing prices. The company hopes the familiarity of use and high costs to replace their system with an international competitor will be enough to generate substantial long-term revenue streams.

Competitive Advantages:
This company’s competitors include international giants such as Johnson & Johnson and Beckman Coulter. Despite this, the company can price significantly lower than these competitors and is establishing positions in the small-medium hospitals vice the large hospitals targeted by its larger competitors. As the company wisely builds up its installed base by selling their systems at reduced prices, high switching costs will keep sales of its reagent kits, probes, and chips recurring in the long-term.

Valuation:
The company has an estimated $167M in cash and $150M in convertible debt. Estimating what earnings are today excluding the sale of its recent subsidiary is about $1.20-$1.50 per share, placing the stock at multiple of 10-12.5x earnings. For a company with highly recurring sales and strong cash flows with a growing installed base, this makes a good entry point.

Heckmann Corporation (HEK)
Summary:
China is facing a potential water crisis. The statistics are sobering, with 90% of cities’ groundwater and 75% of rivers and lakes causing 700 million people to drink contaminated water per day. Northern China faces an even more severe water shortage, as more than 63% of the country possesses less than 20% of the water supply. Heckmann Corporation has established an entry point into the market with the purchase of China Water, the fifth-largest bottled water company in China, and has $380M remaining in cash with negligible debt to consolidate what is presently a highly fragmented industry. Chairman and CEO is Richard Heckman has a proven track-record, executing a comparable strategy in the US by buying US Filter for $1.6M in 1990 and selling it to Vivendi in 1999 for approximately $10B. The attractiveness of this investment is based primarily on the potential due to such high sustainable demand for water in China, but at today’s prices you don’t have to pay for the speculation.

The Market:
The bottled water market in China is estimated at $4.6B and is growing at about 17.5% per year for the last five years. It is still an industry in its infancy as China is only starting to embrace bottled water in comparison to the rest of the world. As a comparison, China has 4x the population of the United States but only consumes 40% the amount of bottled water. China will desperately need to establish industrial wastewater treatment which offers another compelling opportunity.

Competitive Advantages:
The company is the key supplier of bottled water to Coca Cola in China since 1996. It currently has six facilities located throughout China and is in process of expanding to nine in the near future. The company plans to use its superior cash reserve to purchase companies in this down market and expand its facilities.

Business Model:
The company is still in the initial stages of defining itself but the new acquisition is reported to generate cash from operations equal to 38.1% of revenues.

Valuation:
Heckmann has $330M in cash and potentially about 165.7 million shares outstanding which is roughly $2 per share in net cash. The China Water acquisition is expected to earn over $0.38 per share in 2008. This equates to under 10x earnings net of cash. This valuation does not even take into consideration the cash the company would raise if warrants were exercised. The company is actively buying back warrants given the depressed market value which should be a good use of cash for existing shareholders to prevent dilution.

Potash Corporation (POT)
Summary:
The economic downturn did not spare the agriculture industry as everyone conserved cash, including farmers. This may have affected potash demand, especially in North America, but it does not change the long-term strengths of the fertilizer industry. The three main fertilizer nutrients are nitrogen, phosphate, and potash. Nitrogen and phosphate are competitive industries with low margins, but the potash industry is an oligopoly which can better control supply and thus margins. Since populations and meat consumption are increasing (it takes approx. 7 pounds of grain to produce 1 pound of beef) while available farming land per person decreases, the need for higher yields becomes imperative which provides continued strong demand for fertilizers. Potash Corporation will see continued strong demand with high barriers to entry for many years while farmers work to address a severe global grain shortage.

The Market:
Potash Corp has capacity for 10M tones per year with planned expansion to 18M by 2012. The potash market is currently underserved in major developing countries such as India and China. In countries such as the U.S., the mixture of the three nutrients in fertilizer is typically 0.4 units each of Potassium (Potash is Potassium Chloride) and Phosphate for one unit of nitrogen. India and China use far less Potassium, in fact China would need to double their potash application to meet this ratio.

Competitive Advantages:
Potash sells nitrogen, phosphate, and potash but it is potash that is the obvious crown jewel for the company. Potash is known as the quality nutrient since it is credited with improving the crop’s disease resistance and nutrient value. Usually a commodity producer will find it impossible to possess a strong competitive advantage, but a lack of economically viable deposits, high production costs, and long lead times make this an industry with high barriers to entry. Potash will be supply challenged over the next five years and Potash Corp will supply over half of increased supply in that time. “Greenfield projects” (developing brand-new supply) costs roughly $3B and takes about a decade to show investment returns so the costs to enter this space, especially in current credit conditions, are steep.

Valuation:
Any near-term weakness in earnings is already factored into the stock so this represents a good opportunity to invest in a company with dominant position in an attractive long-term market. The company forecasts $10-12 per share in earnings for 2009, which equates to a 6-8 Forward P/E. The company also has long-term investments that are far in excess of debt. Potash was a hot stock in 2008 that came crashing down, but it is more than hype and will come back strong.

Intuitive Surgical (ISRG)
Summary:
Intuitive Surgical provides their proprietary “da Vinci Surgical System” to hospitals, which they believe is a next generation surgery technique that will replace minimally invasive surgery. The da Vinci Surgical System consists of a surgeon’s console, a patient-side cart, a high performance vision system and proprietary “wristed” instruments. By placing computer-enhanced technology between the surgeon and patient, the system translates the surgeon’s natural hand movements on instrument controls at a console into corresponding micro-movements of instruments positioned inside the patient through small puncture incisions, or ports. This robotic surgery results in faster patient recovery times and thus less lengthy hospital stays. The penetration rates for this system are still very low but the barriers to entry are high as adoption increases. While still in its infant stages, this technology is being used effectively today, with 136,000 operations last year representing a 60% increase from prior year. The sales cycle for selling a new system is long due to the high capital expenditure required by the hospital. This has caused growth investors to flee this stock given the current economic climate and is providing an attractive valuation for long-term investors.

The Market:
The da Vinci system is cleared by the FDA to perform urologic, gynecologic, cardiothoracic, and general surgery. The company has sold about 1,111 units to date and believes the total market is about 6,000 worldwide.

Competitive Advantages:
The company believes this system has significant advantages over the Minimally Invasive Surgery and Open Surgery techniques used predominantly today to provide a solid return on investment for hospitals. Due to the lengthy FDA approval process and IP protection, it will take time for direct competition in robotic surgery and currently the biggest competition is status quo with current surgical techniques.

Business Model:
The business model is essentially a "razor/razor blade" model. The company sells and installs the da Vinci Surgical System for about $1M at their customer sites (hospitals) and then generates recurring revenue as the system is used to perform surgery and, in the process, necessitates buying and consuming new EndoWrist instrument and accessory products. The recurring revenue comes in the form of about $100K service contracts and $2K replacement parts for each surgery. Recurring revenues currently accounts for close to 50% of the company’s sales.

Valuation:
With no debt, the company has about $22 per share of net cash. With earnings of about $5.30 per share, this represents a P/E below 14 for a company establishing an impressive recurring revenue stream.

PowerShares DB Crude Oil Dble Long ETN (DXO)
Summary:
Despite the reduced demand for oil due to the global recession, there are two main reasons to be long oil in the long-term. The most commonly cited reason is that oil supplies are declining with some suggesting we are past peak oil. The other reason to be long oil is as an inflation hedge against the U.S. Dollar.

Based on research developed by Paul Van Eeden which tracks the price of oil in nominal terms and inflation adjusted in relation to US dollars and ounces of gold, the average price of oil since 1931 in these inflation-adjusted terms is approximately $87 per barrel. While the collapse of global demand has crushed oil prices to lows many thought we would never see again, this low price is actually a disincentive for companies to spend capital for new exploration and will only exacerbate the fundamental supply problem once global demand returns.

The exact time to go long on oil is another question entirely. There are indications OPEC is not able to cut production as quickly is it wants to, as evidenced by a new forecast by tanker-tracker PetroLogistics which pins January OPEC output at 26.15 million barrels a day, which is 5.4% lower than the firm's December figures, but well below its target of 24.8 million barrels a day in production. U.S. crude inventories have risen by 14 million barrels in just the last three weeks (January, 2009), according to the Department of Energy's Energy Information Administration. With increasing supply and decreasing demand, oil is likely going to go down in the near future from its current price of $47 per barrel and test the low $30’s. This would be an attractive entry point.

An ETN is a simple way to invest in oil. The PowerShares DB Crude Oil Double Long ETN (DXO) is a senior unsecured obligation issued by Deutsche Bank AG, London Branch that is linked to a total return version of a Deutsche Bank crude oil index designed to offer two times leveraged exposure to the monthly performance of the DB optimum yield crude oil index plus the monthly TBill Index return, subject to an investor fee. One thing to keep in mind in this investment is volatility may not be good for performance. As an example assume a $100 investment in the ETN, if oil goes down 5% one day, then the ETN will go down 10%; if oil rises 5%, then the ETN will go up 10%. However, the fund is still down $1 since the value of the investment went from $100->$90->$99.

Oil prices have potential for further drop as the recession deepens, but long-term fundamentals are still there and expect oil to be one of the first assets to rebound from the global recession.

UltraShort Lehman 20+ Trsy ProShares (TBT)
Summary:
Investors trying to avoid the bloodshed of collapsing assets prices in 2008 flooded to the U.S. Treasury Market. The interest rate on a 30-year Treasury Bonds stands today at approximately 3% and offers investors liquidity and safety they are not finding anywhere else. Treasuries may continue to show strength in the near-term as the Fed works to keep interest rates low to stimulate the economy and investors stay on the sideline until there are more visible signs of a recovery. However, one of the easiest investments today for someone with a long-term horizon is to short U.S. Treasuries. Interest rates on long-term U.S. government debt will rise substantially in the future as inflation sets in on a depreciating currency for a government with a massive amount of debt and less tax revenues from a retiring workforce.

The US government has massive obligation coming due in the not-so-distant future with Social Security and Medicare programs while it fights today fears of a deflationary spiral due mainly to a deleveraging process and credit crisis in the banking system. The current government programs such as the first $350M installment of the TARP program is expected to be just the beginning and it could take well over a trillion dollars of investment before banks start to become adequately recapitalized. This does not include all the other stimulus and bail-outs that may be implemented. The government will run trillion dollar budget deficits and spend as much money as necessary until the nominal economy is growing and inflation is rising (which would be evidence that deflation is not occurring).

This is another investment where it is not a question of if, but when. The current yield on long-term Treasuries is much too low to compensate for the inflation risk and investors will eventually demand a higher return to hold these investments once panic subsides in the market. An opportunity to enter this investment should occur in the near future as economic data and failing institutions spook investors back to U.S. Treasuries in the near-term.