A good week
With the utmost humility I am quite pleased with how my picks have performed to date. On Monday Sun Gro Horticulture was the subject of a friendly takeover at 6.60, which I highlighted as a strong possibility when I recommended the story. Here is how my picks have panned out so far:
Sun Gro +50%
Westaim +21%
MB Bonds +1% (+accrued)
Imris +10%
I am fully aware that it is not normal to have all of ones securities go up, especially in a short amount of time. In my writings I mentioned how these were bound to work over a longer time period. I do not expect my next selections to perform this well off the hop, and some of these names (not the Sun Gro) could go down before I decide to sell. Actually, while purchasing these securities I kept some dry powder to buy them should they get cheaper. It worked in the case of Sun Gro, I was able to average down at $4, but the rest of them shot up. I suppose you cannot be too cute with these things. Anyways, I will certainly enjoy it while it lasts.
Going forward there will be several postings per week. There are alot of ideas that don't make the cut, either because I don't really understand what the company does (and do not have time to figure it out, since I work) or the margin of safety is not large enough. Correctly identifying that something does not work can often be just as helpful as identifying an idea that does from a personal development perspective. That being said, I will always sit on cash until another good idea comes along. You get paid for aggressively implementing a conservative approach, not through frequent activity.
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Friday, January 21, 2011
Thursday, January 20, 2011
Musings on Investment Philosophy
I have spent a considerable amount of time thinking about how one should approach investing. While merely a memo and not a comprehensive essay, I hope to summarize my views in a quick but concise manor. I believe that an investor needs to get comfortable with what they are truly capable of knowing about the economy, assets within the economy, managements that determine the use of those assets, and securities that entitle holders to legal claims upon assets and cash flows. How much can you know about each of these topics, and how much do you need to know? What is more important, a grandiose top down view of where the world is headed or bottom up understanding of a business? Finally, and most importatly, how does this factor into the price you pay for a security?
Many market participants pontificate about what GDP growth will be, what Ben Bernanke will say in the next FOMC, when China will raise rates, what the forward PE
of the market is, and volumes of other data that investing professionals think is crucial to asset allocation. The truth is, any student of economic history knows that in aggregate people are horrible at forecasting the future of the economy. It has been shown by SocGen's Dylan Grice, Reinhart and Rogoff, and Nassim Taleb that asset price performance is highly nonlinear. There is a very simple reason for this: it is impossible to know the future! Even if you feel reasonably assured of the future, at least a range of possible outcomes, you will not realize a high return on your investment unless you pay a price for a security that ensures a high return. The price that ensures a rate of return whileminimizing downside risk is arrived at only through a bottom up analysis of a number of scenarios. The scenarios can be a number of company specific outcomes (i.e. will the company win a large new contract?) or macro outcomes (will oil be at $80 or $50?).
Purchasing a equity or debt security gives you legal claim on specific assets and cash flows associated with those assets. Although financial accounting is not perfect, audited financial statements and publically disclosed documentation give you
an assessment of asset value under a given set of assumptions. Historical financial statements also give you an idea of what cash flows the assets can generate under a variety of economic scenarios, if the asset base has not changed considerably. The problem is that consistent strong historical performance is easily recognized so the securities on such companies are often well picked over and fully valued on a risk reward basis.
It is critical that valuation is performed on an "a prioi" basis. Some of the best opportunities arise out of corporate events where 1) the asset base is completely different that prior reporting periods, and therefore has limited historical operating data (see my prior piece on Westaim's purchase of Jevco assets), or 2) claims on a companies assets have changed, either through recapitalization or emergence from bankruptcy (see Mega Brand bonds). There are a large number of other corporate actions that provide such opportunity, like spin outs, mergers, etc... Change is what creates opportunity, especially change that other investors feel is out of their expertise. Publically disclosed documents on corporate actions combined with good old fashioned scuttlebutt can give you an idea of what performance can be expected out of a new operating entity. This type of data is not uploaded into database that can be screened for valuation ratios or growth rates, so it is often not picked up by a large class of investors that use screens as a primary idea generation tool. Once the company releases several quarters of results the quants start to pick up on the story.
The best part of investing is that corporate actions don't necessarily have to be the focus of research or idea generation. Any time there is a structural reason for securities being bid up or sold off creates opportunity as well. Index rebalances, analyst initiations, financial duress of a large holder, or changes in foreign ownership laws are only a sample of events that change the dynamics of a market.
I suppose what I am really trying to say is that I usually have a blank look on my face when someone asks where the market is going. I have no idea. I also have no idea what the EPS of Wal Mart will be, or whether the PE multiple of Google will expand. I dont know the future, and I dont have to. As long as I can define the scope of my understanding about a specific situation and pay a price that warrants limited downside versus potential return, the rest will take care of itself.
Many market participants pontificate about what GDP growth will be, what Ben Bernanke will say in the next FOMC, when China will raise rates, what the forward PE
of the market is, and volumes of other data that investing professionals think is crucial to asset allocation. The truth is, any student of economic history knows that in aggregate people are horrible at forecasting the future of the economy. It has been shown by SocGen's Dylan Grice, Reinhart and Rogoff, and Nassim Taleb that asset price performance is highly nonlinear. There is a very simple reason for this: it is impossible to know the future! Even if you feel reasonably assured of the future, at least a range of possible outcomes, you will not realize a high return on your investment unless you pay a price for a security that ensures a high return. The price that ensures a rate of return whileminimizing downside risk is arrived at only through a bottom up analysis of a number of scenarios. The scenarios can be a number of company specific outcomes (i.e. will the company win a large new contract?) or macro outcomes (will oil be at $80 or $50?).
Purchasing a equity or debt security gives you legal claim on specific assets and cash flows associated with those assets. Although financial accounting is not perfect, audited financial statements and publically disclosed documentation give you
an assessment of asset value under a given set of assumptions. Historical financial statements also give you an idea of what cash flows the assets can generate under a variety of economic scenarios, if the asset base has not changed considerably. The problem is that consistent strong historical performance is easily recognized so the securities on such companies are often well picked over and fully valued on a risk reward basis.
It is critical that valuation is performed on an "a prioi" basis. Some of the best opportunities arise out of corporate events where 1) the asset base is completely different that prior reporting periods, and therefore has limited historical operating data (see my prior piece on Westaim's purchase of Jevco assets), or 2) claims on a companies assets have changed, either through recapitalization or emergence from bankruptcy (see Mega Brand bonds). There are a large number of other corporate actions that provide such opportunity, like spin outs, mergers, etc... Change is what creates opportunity, especially change that other investors feel is out of their expertise. Publically disclosed documents on corporate actions combined with good old fashioned scuttlebutt can give you an idea of what performance can be expected out of a new operating entity. This type of data is not uploaded into database that can be screened for valuation ratios or growth rates, so it is often not picked up by a large class of investors that use screens as a primary idea generation tool. Once the company releases several quarters of results the quants start to pick up on the story.
The best part of investing is that corporate actions don't necessarily have to be the focus of research or idea generation. Any time there is a structural reason for securities being bid up or sold off creates opportunity as well. Index rebalances, analyst initiations, financial duress of a large holder, or changes in foreign ownership laws are only a sample of events that change the dynamics of a market.
I suppose what I am really trying to say is that I usually have a blank look on my face when someone asks where the market is going. I have no idea. I also have no idea what the EPS of Wal Mart will be, or whether the PE multiple of Google will expand. I dont know the future, and I dont have to. As long as I can define the scope of my understanding about a specific situation and pay a price that warrants limited downside versus potential return, the rest will take care of itself.
Wednesday, January 19, 2011
Imris (7.25 last)
This is not my typical recommendation due to its high valuation on almost any forward or trailing metric. That being said. Imris could be a powerhouse growth story over the next 5 years due to an outstanding CEO, its widely acknowledged technological superiority, and current product penetration (less than 1%) in a massive market. Given that the stock trades at 3.5x book value and 4.5x sales, most "value" analysts would run from the story kicking and screaming. A more appropriate way of thinking about the story is looking at the existing management, the existing product, the successes to date, and the potential size of their end market.
Imris makes mobile Magnetic Resonance Imaging (MRI) platforms for hospitals and clinics that produce non-invasive images of soft tissue during complex surgical procedures. Since being founded in 2005, they have sold 41 of their systems worldwide. The flagship product, IMRISneuro (34 sold) has a $4mm-$7mm price tag and is used for neurosurgeries, primarily brain tumour removal. The second product, IMRISuv (3 sold) has a $7-$10mm price tag and combines MRI with real time x-ray images (flouroscopy). The third product (4 sold) called IMRIScardio sells for $8-$12mm and incorporates MRI and flouroscopy for cardiovascular applications such as the treatment of coronary artery disease. An interesting fourth product is a result of a joint venture between Imris and Varian Medical Systems can be expected in late 2011. The product will combine Imris's real time imaging with Varian's TrueBeam radiation therapy system. Its worth noting that Varian is a market leader, with a 60% market share in radiotherapy and radiosurgery accounting for $3.7B in annual sales and an install base of 6,000 units. The partnership is a strong vote of confidence in Imris's technology.
The key to Imris platforms is that the can be used for pre, intra, and post operating imagery. Existing platforms sold by GE, Siemens, and Philips are large and static. They require doctors to move the patient out of the operating room intra-operation, place the patient in an MRI machine, then bring the patient back to the operating room. During complicated and time-sensitive surgeries this movement is unacceptable. Imris's mobile MRI can be brought into the operating room on an installed track, image the patient without moving them, then be removed so that surgeons can get back to work. Hospitals like the Imris systems so much that Imris has a greater than 80% win rate in competitive bidding. Contract loses are not due to a deficiency in the product, but hospital budget issue as Imris systems cost more than their competitors.
One of the highlights of the story is CEO David Graves. Mr. Graves is a professional engineer and serial entrepreneur that started wireless telecommunications company Broadband Networks, which he sold to Nortel in 1998. From 1998 to 2005 he was CEO of venture capital company Centara Corp before starting Imris. Mr. Graves is the largest holder of Imris with 26.7%, while total insider ownership accounts for 35%. The management team is comprised of very technically astute individuals who have a reputation among clients for their knowledge and professionalism.
From a financial prospective, Imris estimates that the number of hospitals with expertise in neurosurgery is (the market for IMRISneuro) is 990 versus their current install base of 34. Wedbush estimates that there are 781 stroke centers in the US (IMRISnv) and 669 heart centers (IMRIScardio) that have high patient volumes and are experienced in handling complex cases. The total global market for each of their current three products, according to their research, could be nearly 5,200 centers. Compare this to the 41 systems they have sold since 2005. Regardless of what the total number of customers is, Imris is nowhere near reaching the limit. Sales of new units could easily double or triple, while they will also get recurring service and maintenance revenue from a widening install base. Sales backlog has grown 44% YoY to $120mm, of which at least 80% will be realized in the next 12 months.
The company may be trading at 2.3x 2011 EV/sales, but this is not Coke or Proctor and Gamble. Imris has a good shot at doubling their sales in the next 3 or 4 years. They have a strong management team with a big ownership of the business. There is no competitive threat as Imris has copyrights on their mobile technology until 2015. The downside risk is that Siemens supplies critical components in the Imris system, and are also a competitor. Sales are also choppy as single wins or losses greatly affect quarterly results when the company is small. Hospitals on mass could also cut budgets (unlikely as sales grew throughout 2008 and 2009) or regulatory approval for new products could be slower than usual. You risk selling down to a multiple of book (at which someone scoops the patents) or 1x sales, since thats how tech people like to look at it, say $3 on a complete fire sale. I view this as highly unlikely. You could lose 50% to make 2 or 3 times your money within 3 to 4 years. I view the bullish argument as a much higher probability given the competitive advantages and growth potential I mentioned above.
Imris makes mobile Magnetic Resonance Imaging (MRI) platforms for hospitals and clinics that produce non-invasive images of soft tissue during complex surgical procedures. Since being founded in 2005, they have sold 41 of their systems worldwide. The flagship product, IMRISneuro (34 sold) has a $4mm-$7mm price tag and is used for neurosurgeries, primarily brain tumour removal. The second product, IMRISuv (3 sold) has a $7-$10mm price tag and combines MRI with real time x-ray images (flouroscopy). The third product (4 sold) called IMRIScardio sells for $8-$12mm and incorporates MRI and flouroscopy for cardiovascular applications such as the treatment of coronary artery disease. An interesting fourth product is a result of a joint venture between Imris and Varian Medical Systems can be expected in late 2011. The product will combine Imris's real time imaging with Varian's TrueBeam radiation therapy system. Its worth noting that Varian is a market leader, with a 60% market share in radiotherapy and radiosurgery accounting for $3.7B in annual sales and an install base of 6,000 units. The partnership is a strong vote of confidence in Imris's technology.
The key to Imris platforms is that the can be used for pre, intra, and post operating imagery. Existing platforms sold by GE, Siemens, and Philips are large and static. They require doctors to move the patient out of the operating room intra-operation, place the patient in an MRI machine, then bring the patient back to the operating room. During complicated and time-sensitive surgeries this movement is unacceptable. Imris's mobile MRI can be brought into the operating room on an installed track, image the patient without moving them, then be removed so that surgeons can get back to work. Hospitals like the Imris systems so much that Imris has a greater than 80% win rate in competitive bidding. Contract loses are not due to a deficiency in the product, but hospital budget issue as Imris systems cost more than their competitors.
One of the highlights of the story is CEO David Graves. Mr. Graves is a professional engineer and serial entrepreneur that started wireless telecommunications company Broadband Networks, which he sold to Nortel in 1998. From 1998 to 2005 he was CEO of venture capital company Centara Corp before starting Imris. Mr. Graves is the largest holder of Imris with 26.7%, while total insider ownership accounts for 35%. The management team is comprised of very technically astute individuals who have a reputation among clients for their knowledge and professionalism.
From a financial prospective, Imris estimates that the number of hospitals with expertise in neurosurgery is (the market for IMRISneuro) is 990 versus their current install base of 34. Wedbush estimates that there are 781 stroke centers in the US (IMRISnv) and 669 heart centers (IMRIScardio) that have high patient volumes and are experienced in handling complex cases. The total global market for each of their current three products, according to their research, could be nearly 5,200 centers. Compare this to the 41 systems they have sold since 2005. Regardless of what the total number of customers is, Imris is nowhere near reaching the limit. Sales of new units could easily double or triple, while they will also get recurring service and maintenance revenue from a widening install base. Sales backlog has grown 44% YoY to $120mm, of which at least 80% will be realized in the next 12 months.
The company may be trading at 2.3x 2011 EV/sales, but this is not Coke or Proctor and Gamble. Imris has a good shot at doubling their sales in the next 3 or 4 years. They have a strong management team with a big ownership of the business. There is no competitive threat as Imris has copyrights on their mobile technology until 2015. The downside risk is that Siemens supplies critical components in the Imris system, and are also a competitor. Sales are also choppy as single wins or losses greatly affect quarterly results when the company is small. Hospitals on mass could also cut budgets (unlikely as sales grew throughout 2008 and 2009) or regulatory approval for new products could be slower than usual. You risk selling down to a multiple of book (at which someone scoops the patents) or 1x sales, since thats how tech people like to look at it, say $3 on a complete fire sale. I view this as highly unlikely. You could lose 50% to make 2 or 3 times your money within 3 to 4 years. I view the bullish argument as a much higher probability given the competitive advantages and growth potential I mentioned above.
Monday, January 3, 2011
Mega Brands 10% coupon first lien bonds (105.25 last ~8.5% YTM)
Mega Brands is a Montreal based company engaged in designing, manufacturing and marketing of two product lines: toys and stationary products. Between 2006 to 2009 the company had a slew of lawsuits and product recalls that left it teetering on the brink of bankruptcy, but after a recapitalization and the signing of new brand licenses Mega Brands is poised to be a prime turnaround candidate. While the stock should also do well, a large outstanding issue of in the money warrants will dilute the company's upside. The bonds on the other hand are reflecting a much higher risk profile than is warranted.
Before the company's troubles began, Mega Brands built itself from its humble beginnings as a toy distribution business run by the Bertrand family into a design and marketing entity with $550mm in sales in 2006. Part of this growth was through its 2005 acquisition of Rose Art, which is primarily responsible for its woes from then on. Rose Art's Magnetix line, representing 40% of the new acquisitions sales, was responsible for the death of a toddler from magnet ingestion. What ensued was mass product recalls, abandonment of the product line, and charge-offs totalling $123mm. In addition, the company engaged in costly litigation ($55mm set aside as loss provision) with the former owners of Rose Art regarding earn-outs on the acquisition. The resulting public relations nightmare caused sales to fall from $550mm in 2006 to $338mm in 2009, while at the same time the company was saddled with over $400mm in debt from the Rose Art purchase. It also did not help that these events coincided with the worst recessions in a generation.
In 2009 the company's independent directors met several times to discuss the possibility of recapitalization or the sale of some or all of the company's operations. They settled upon a complete recapitalization, in early 2010 cancelling existing debt with the issuance of $229mm of new equity, warrants, senior 10% coupon bonds, plus the establishment of a $50mm asset based credit facility (senior to the bonds) for working capital requirements. Existing holders Fairfax Financial, AIM Trimark and the Bertrand family all bought the issuance, which reduced total debt by $300mm and reduced interest expense by $30mm/year. Pro forma numbers suggest interest coverage (adjusted EBITDA to interest expense) increased to 1.3x from -4x for 2009 and 2.8x from -11.7x for 2008 post recapitalization. Not stunning numbers, but manageable even during years that were complete disasters.
A string of positive developments makes the recapitalization look like it will have a more positive effect than the pro forma historical numbers suggest. In September the company's legal battle with LEGO ended in Europe, freeing up Europe as a growth market for its traditional Mega Blok product. Mega Brand toys are now regaining shelf space at key retailers such as Wal-Mart, Toy's R Us, Target, etc... The company has seen strong sales of its proprietary Dragon's brand, as well as in its Thomas and Friends (named on the hot 20 toys of 2010 list), Iron Man II , and Halo licenses. In early December Mega Brands inked a new licensing agreement with Electronic Arts for Need For Speed. Q3 2010 toy sales were 18% higher YoY and the company is back in the black, earning $16mm on sales of $128mm.
What I am betting on is that Mega Brands can return to its previous profitability before the Rose Art fiasco. The company successfully built relationships with licensors and distributors, and was able to run a very profitable business of proprietary and licensed toys. The bad PR and litigation has battered the company, though if it can regain its past operating performance the recapitalized entity will vastly increase its interest coverage ratio and the now in-the money warrants will be exercised to repay the principal on the bonds. Management thinks that if they implement this turnaround they can reach $500mm in sales in 5 years with EBITDA margins in the mid teens in 3-5 years. The actions management have shown since recapitalization point to them being vigilant and hungry to return to what made them successful pre Rose Art. Even if they stumble, a base case scenario is a return to 2009 sales levels where pro forma numbers show that they will still be able to cover interest payments. I view that scenario as less likely given how quickly the chains have restocked Mega Brand products and the pipeline of upcoming products, plus management's undivided attention to the core business and not litigation or financial difficulties.
I am avoiding the common stock because of the dilution of warrant exercise. The warrant exercise is why the bonds look good, because the stock will be worth more than the $0.50 strike should the company prosper and the cash injection pays back the principal, regardless of whether the company is able to refinance the debt. Its not that I think the stock is a bad investment, I just like that the bonds are marginable and benefit indirectly if the stock does well. The street however is bullish on the stock, with 4 analysts with buys on the stock and a target price of 0.89 vs. 0.65 currently.
Before the company's troubles began, Mega Brands built itself from its humble beginnings as a toy distribution business run by the Bertrand family into a design and marketing entity with $550mm in sales in 2006. Part of this growth was through its 2005 acquisition of Rose Art, which is primarily responsible for its woes from then on. Rose Art's Magnetix line, representing 40% of the new acquisitions sales, was responsible for the death of a toddler from magnet ingestion. What ensued was mass product recalls, abandonment of the product line, and charge-offs totalling $123mm. In addition, the company engaged in costly litigation ($55mm set aside as loss provision) with the former owners of Rose Art regarding earn-outs on the acquisition. The resulting public relations nightmare caused sales to fall from $550mm in 2006 to $338mm in 2009, while at the same time the company was saddled with over $400mm in debt from the Rose Art purchase. It also did not help that these events coincided with the worst recessions in a generation.
In 2009 the company's independent directors met several times to discuss the possibility of recapitalization or the sale of some or all of the company's operations. They settled upon a complete recapitalization, in early 2010 cancelling existing debt with the issuance of $229mm of new equity, warrants, senior 10% coupon bonds, plus the establishment of a $50mm asset based credit facility (senior to the bonds) for working capital requirements. Existing holders Fairfax Financial, AIM Trimark and the Bertrand family all bought the issuance, which reduced total debt by $300mm and reduced interest expense by $30mm/year. Pro forma numbers suggest interest coverage (adjusted EBITDA to interest expense) increased to 1.3x from -4x for 2009 and 2.8x from -11.7x for 2008 post recapitalization. Not stunning numbers, but manageable even during years that were complete disasters.
A string of positive developments makes the recapitalization look like it will have a more positive effect than the pro forma historical numbers suggest. In September the company's legal battle with LEGO ended in Europe, freeing up Europe as a growth market for its traditional Mega Blok product. Mega Brand toys are now regaining shelf space at key retailers such as Wal-Mart, Toy's R Us, Target, etc... The company has seen strong sales of its proprietary Dragon's brand, as well as in its Thomas and Friends (named on the hot 20 toys of 2010 list), Iron Man II , and Halo licenses. In early December Mega Brands inked a new licensing agreement with Electronic Arts for Need For Speed. Q3 2010 toy sales were 18% higher YoY and the company is back in the black, earning $16mm on sales of $128mm.
What I am betting on is that Mega Brands can return to its previous profitability before the Rose Art fiasco. The company successfully built relationships with licensors and distributors, and was able to run a very profitable business of proprietary and licensed toys. The bad PR and litigation has battered the company, though if it can regain its past operating performance the recapitalized entity will vastly increase its interest coverage ratio and the now in-the money warrants will be exercised to repay the principal on the bonds. Management thinks that if they implement this turnaround they can reach $500mm in sales in 5 years with EBITDA margins in the mid teens in 3-5 years. The actions management have shown since recapitalization point to them being vigilant and hungry to return to what made them successful pre Rose Art. Even if they stumble, a base case scenario is a return to 2009 sales levels where pro forma numbers show that they will still be able to cover interest payments. I view that scenario as less likely given how quickly the chains have restocked Mega Brand products and the pipeline of upcoming products, plus management's undivided attention to the core business and not litigation or financial difficulties.
I am avoiding the common stock because of the dilution of warrant exercise. The warrant exercise is why the bonds look good, because the stock will be worth more than the $0.50 strike should the company prosper and the cash injection pays back the principal, regardless of whether the company is able to refinance the debt. Its not that I think the stock is a bad investment, I just like that the bonds are marginable and benefit indirectly if the stock does well. The street however is bullish on the stock, with 4 analysts with buys on the stock and a target price of 0.89 vs. 0.65 currently.