The equity markets continue to be rocky as August finished up, with the S&P 500 dropping 4.5%.  The Value Uncovered model portfolio followed the market down as well, dipping into the red for the first time since inception.

Stock Positions

August was another very busy month on the earnings front, as many stocks reported their results for the quarter ending June 30^th.

After turning in a great second quarter (including a nice special dividend of $1/shr), SPAN followed by reporting tough 3^rd quarter results.  The stock was the biggest loser in August, dropping below my initial entry point back in October of last year.

With dividends included, the position in SPAN is still positive and I expect a big fourth quarter.

Both APNC and TPCS reported solid results, with TPCS reporting a huge jump in revenue while APNC chugged along with another increase in quarterly net income.  ADVC continues to hum along as the tiny software company that nobody is talking about.

CHBU reported a ridiculous 300%+ growth in sales, and the stock still trades for less than net cash.

NOOF was the biggest gainer in August, up over 16%, as the stock finally rebounded from its 52-week low.  Another bout of insider buying helped add credibility, and the company finally seems to be turning a corner – NOOF is too cheap to remain below $2 for long.

Despite going through hundreds of financial statements, only one stock met my criteria for investment, as I added DIT to the model portfolio.  The stock is a great turnaround story, and I believe management will continue to consolidate and grow in a very competitive business.

Special Situations

FIS was another successful special situations investment that took advantage of a major recapitalization plan and self-tender offer.  The position netted a 4.69% gain in a little less than a month, for an APY of 81.8%.

However, another special situations investment is in big trouble – EMMS.  Jeff Smulyan, the company’s CEO, has run into all sorts of problems with taking the company private.

Details are still very sketchy, but the deal looks to be in serious jeopardy.  I find it hard to believe that Smulyan would let this same situation happen to him again (he tried to take the company private a few years ago and failed), but it looks like the market expects it to fall apart.

I will be monitoring the situation closely and may be forced to sell at a substantial loss.

Performance

The portfolio slipped into negative territory YTD, but is still ahead of the S&P benchmark.  Check out my holdings page for a full rundown.

As all of these investments are in micro-cap stocks, often with little or no liquidity, the market fluctuations can have significant impact on the portfolio’s return over a given month or even quarter.

Although I’m disappointed in the monthly results, it is more important to look at the portfolio over a longer time period.  I am constantly reevaluating my positions and will make changes as needed.

Final Thoughts

Also, I am considering slightly modifying the structure of the Value Uncovered portfolio to keep track of cash balances (see an example here from the wonderful blog, the SINLetter)

For a model portfolio, this new structure should provide a more accurate portrayal of real investment returns while allowing me to accurately represent position sizing.

I hope to make the changes soon.

Disclosure

Long SPAN, TPCS, APNC, ADVC, CHBU, NOOF, DIT, EMMS

Vicon Industries, Inc. (VII) sells private network video surveillance systems – think of the video cameras in shopping malls or retail stores to catch shoplifters and detect intruders.

With a market capitalization of only $17m, the business is in a heavily competitive, cyclical industry, leading to large variability in Vicon’s revenue and income.

Revenue Fluctuations

Since video network installations generally occur in newly constructed buildings (it’s probably pretty rare that a shopping mall rips out and replaces their entire network), the company is heavily dependent on new construction and the overall economy.

Here is a chart of the company’s sales over the past 15 years:

It is very clear from the chart that the company’s business is variable, with a ‘boom-and-bust’ cycle lasting approx 6-7 years. The latest upturn occurred from 2004-2007, followed by a sharp decrease in 2008-2009.

Fiscal 2010 sales will show a significant drop as well, as the most recent filing revealed that revenues are off 21%. The drop in revenue over the past three years looks very similar to the 2001-2003 time period.

Sales should level off as the economy rebounds.

Historic Financials

Vicon operates in a tough business with lots of competition from large multinational companies such as Panasonic, Sony, Bosch & GE Security.

In a tough environment, the company has done a great job improving its gross margin over the past 5 years, raising it from 38.8% in 2004 to 46.4% last year. Operating and net margins average 3% and 1.6% respectively.

Both ROE and CROIC are not the greatest, although the averages have improved to 9.8% and 8.2% respectively during the latest 3-yr upswing.

Balance Sheet Strength

It is difficult assigning a price tag on such a cyclical business, especially from an earnings & cash flow basis, so the best way to evaluate the company is through its balance sheet & assets.

The stock trades at almost half of its book value of $7.40.

VII trades at a significant discount to Net Current Asset Value (NCAV), and right around Net Net Working Capital (NNWC), a very conservative estimate of value if the company is liquidated:

These are very conservative valuations for a business that historically has traded right around book value.  However, these assume a ‘normal’ operating environment, but outside catalysts could severely affect the business as well..

Patent Litigation

One drag on the stock price is recent news regarding a piece of patent legislation originating from over 6 years ago. Back in May 2003, a company called Lectrolarm Custom Systems, Inc. filed suit against Vicon Industries regarding ‘camera dome’ pieces.

While VII does not break out sales by product category, the company reports that this product represents a significant amount of sales.

The original suit claimed damages of $11.7m, a substantial number for a company like Vicon with a market cap of only $17m.

As the suit made its (long & drawn-out) way through the USPTO system, most of the news went Vicon’s way. In a series of rulings in 2006 and 2007, the USPTO examiner declared all 5 claims invalid.

Lectrolarm re-filed the suit to the USPTO Board of Patent Appeals & Interferences (BPAI). Last week, the BPAI

“ affirmed the USPTO Examiner’s finding of invalidity of two of the claims and reversed the USPTO Examiner’s finding of invalidity of the other three asserted claims.”

This ruling reopens the patent infringement suit.

Based on the initial rulings back in 2006, Vicon seems to have a strong case to dismiss the claims, but obviously has to go through the proper channels to come to a final resolution.

It is very hard to determine a timeline for such a transaction. A negative ruling would seriously affect the stock price, while a positive verdict would remove a big weight off of the company.

In the mean time, this potential negative catalyst will put downward pressure on the stock price.

Conclusion

Based on the company’s history, business should start picking up with the global economy. As an investor, timing the very bottom of such a business cycle is extremely difficult .

However, several notable institutional investors continue to hold shares including Dimensional Fund Advisors (8.4%) and Renaissance Technologies (6.4%). According to a recent 13-G filing, another institutional investor picked up a 5% stake recently as well.

From an asset perspective, the company’s financial position remains very strong, providing the sort of downside protection that many value investors seek.

However, a prolonged recession could put the company in jeopardy and erode the margin of safety, not to mention the dark cloud of a possible patent verdict.

After experiencing three down years in a row, will VII manage to level out and start another upswing?

If so, the stock should appreciate considerably from its current lows.

Disclosure

No positions.

China Agri-Business Inc. (CHBU) has been holding in my Value Uncovered model portfolio since June, when the company was selling at a discount to its NNWC.

The company reported outstanding second quarter earnings 10 days ago, with the stock jumping over 20% on the news, before falling back over the last week.

CHBU remains in solid financial shape and is growing like crazy, and yet is trading for less than NNWC.

Financial Highlights

CHBU reported a huge increase in sales for the first half of the year on strength of the company’s “New Agriculture-Generator” initiative. Net revenues jumped an outstanding 325% to $4.99M compared to revenues of $1.17M in the prior year period.

For the second quarter, net income increased 206%, increasing quarterly earnings per share to $0.06.

Gross margin has dropped significantly compared to last year, from 73% to 35%, as the company undergoes a transformation to the new direct store sales model.

Despite the change in gross margin, both operating and net margin levels remain extremely high at 23% and 21.8% respectively (the company pays no taxes).

The company’s balance sheet is extremely solid, with a current ratio of 13.9 – with most of these assets being liquid.

Despite significant investments in equipment this year, CHBU continues to throw off cash, generating 757k in FCF for the year so far, more than doubling the amount from a year ago.

New Sales Model

Based on these results, the company is moving to an entirely new sales model going forward. Direct store sales now make up over 80% of the CHBU’s total revenues, as the traditional sales network becomes less of a focus.

Growth was largely driven by an expansion in the number of total stores, increasing from 250 to 346 in a single quarter. The company expects 500 stores by October 2010, several months earlier than previously forecasted.

Although the new model has much lower margins than the traditional network, the rapid growth like this is hard to ignore. Despite the impressive steps China has taken as a country overall, there remains a huge rural population that could benefit from the company’s products.

According to the press release,

“At the Company’s direct sales stores, farmers can purchase fertilizer products, including organic fertilizers made by China Agri, have access to the Company’s sales staff who are knowledgeable about the products offered, and receive services that include technical support. This will help farmers to increase their crop yields and productivity and, in turn, should encourage them to be loyal long-term customers for China Agri.”

Valuation

My original investment thesis was based on the fact that the stock was a Net/Net trading at less than net cash. Here are updated numbers for the past few quarters:

Based on the most recent closing price, the stock is currently selling at a 22% discount to NNWC.

Conclusion

It is not often that the market provides a growing, cash flow positive stock with a market cap less than the cash on the balance sheet. CHBU is a capital-light business with little debt and obvious growth potential.

As with many Chinese stocks, management and disclosure is always a concern. The company has limited experience running a retail operation and will assuredly run into growing pains as the torrid expansion eventually slows.

The company is also in line to purchase a large parcel of land to expand capacity, a transaction that will cut into the margin of safety on a NNWC basis.

However, if CHBU continues to report operating results like this quarter, the stock might be worth holding on to as an earnings/growth play, rather than just a value investment based on assets.

Disclosure

Long CHBU

Here are a few interesting value investment ideas from the past two weeks:

KHDHF.PK

Investment Analysis: KHD Humboldt Wedag International Ltd. (KHDHF.PK) – Purchase A Pile of Cash And Get A Competitively Entrenched, High Quality Cash Cow With Good Growth Prospects For Free

This is a thoroughly research post from AboveAverageOdds regarding a spin-off business, one of the special situations investment scenarios that has historically provided outstanding returns.

KHDFHF is an industrial business specializing in proprietary technologies for cement and mineral processing.

The company is obscure, and other factors (including only reporting financial results twice a year, located in Germany, etc) might serve to deter investors.  Despite the obscurity, the company appears to have a strong competitive position and a solid cash position to take advantage of future growth opportunities.

FURX

Furiex Pharma: Spinoff Trading at Net Cash - Continuing the spin-off theme with an analysis of Furiex Pharmaceuticals (FURX) over at OozingAlpha. FURX is a company in the drug discovery business and was recently spun-off from PPDI back in June.

Within weeks of the spin-off, the stock dropped from $18 to below $10, and has traded around there since.  Although the stock is currently trading around net cash, the business requires a high rate of cash burn while researching new drugs.

Several promising drugs in the pipeline could lead to future gains.

STRL

When All Problems Are Short-Term - Barel Karsan has a post on small-cap infrastructure company called Sterling Construction (STRL).  The company is in a very cyclical business, and appears it depends on budgets of state governments (many are struggling with tax & budget issues), resulting in margin pressure and revenue swings.

STRL doesn’t have the typical ‘value-oriented’ balance sheet, but has earnings potential for investors unconcerned with short-term results.

Net/Net List

Top Net/Net’s By Market Cap – In the spirit of Graham and other deep value investors, net/net investing has proven profitable over many years. Several recent investments here at Value Uncovered, including CHBU & ELST, were based on this methodology.

Cheap Stocks has a nice list of stocks trading at less then NCAV.  Several names on the list, such as VOXX, have been on these lists for awhile, so it is important to find those with some sort of catalyst.

Disclosure

Long CHBU & ELST

As I’ve analyzed on Value Uncovered before with the UBET/CHDN deal, merger arbitrage (along with other special situations investments like going private transactions and tender offers) can provide solid returns during periods of market uncertainty.

Over the past several months, I’ve kept my eye on a merger opportunity between two small community banks in Pennsylvania, Tower Bankcorp (TOBC) and First Chester County Corporation (FCEC).

If structured correctly, these special situations investments can provide ‘risk-free’ profits, but investors must read the deal terms very closely or find their ‘risk-free’ position is exposed or incorrect.

Merger Background

On December 12, 2009, Tower Bankcorp, a community bank with a market cap of 134M, agreed to purchase First Chester National Bank with an all-stock transaction valued at $65M.

The stock transaction was structured using a floating exchange ratio based on FCEC’s performance until closing – at announcement, the deal was valued at $10.22 per FCEC share.

Together, the two banks would have a combined size of $2.7B in assets, with a strong presence in key markets around Philadelphia and Harrisburg, PA.

As originally planned, the merger was supposed to close in Q2 2010, subject to the necessary shareholder and regulatory approvals.

Merger Complications

During the second and third quarter of 2009, FCEC suffered from a sharp increase in the number of impaired loans, with non-performing loans jumping to 2.84% in Q3 2009.

Two days after the merger announcement, FCEC sold $52.5M in residential loans to TOBC in order to ensure the bank complied with minimum regulatory capital requirements.

Also, as part of an amendment to the merger agreement in early March, FCEC agreed to sell off its American Home Bank mortgage division, with TOBC provided a $2M line of credit as needed, once again to stay above capital requirements.

To further complicate matters, after a review by the bank’s audit committee in early March, FCEC found material weaknesses in its internal control procedures for identifying problem loans, forcing the bank to restate financials for all of 2009.

Finally, due to First Chester’s inability to file reports in a timely fashion, the NASDAQ put the stock on notice of delisting.

These complications pushed out the timeframe for closing the deal, and caused further uncertainty in the markets on whether the transaction would be finalized at all.

On the Road to Recovery

Despite the struggles at FCEC during the first quarter, the banks seemed to have made significant strides towards completing the merger:

May 24 – The banks received a first round of regulatory approvals from the FDIC and PA Department of Banking.

June 30 – Federal Reserve of Philadelphia approves the transaction, satisfying all regulatory requirements

July 27 – FCEC files restated quarterly reports for 2009, along with its annual 10-K

August 11 – FCEC catches up on its quarterly report for Q1 2010

August 18 – FCEC files a quarterly report for Q2 2010, announcing that the bank’s financials are up-to-date

Terms of the Merger Agreement

According to the merger announcement, the shareholders of First Chester would receive 0.453 shares of TOBC stock for each share of FCEC. The exchange ratio was variable, using the following table:

Delinquencies were calculated for purposes of the merger as follows:

Inflated Exchange Ratio?

At first glance, the merger had a ridiculously high spread, leading to more investigation for a possible arbitrage opportunity.

As recently as two weeks ago, FCEC stock was trading over $8. With TOBC trading around $19, the market was implying an exchange ratio of approx. 0.420, signifying delinquencies in the $55 – $60M range.

After digging through FCEC’s latest 10-Q, as well as detail from the bank’s FDIC call reports, my calculations show a different scenario:

Apparently, other savvy investors have caught on, as FCEC’s stock price has fallen almost 35% in the last month, with a sharp drop occurring this past week.

However, even with the lower prices and revised exchange ratio, the stocks still appear to be mispriced:

A purchase of FCEC’s shares will result in a loss of almost 15% post-merger (assuming no change in the stock price of TOBC), a significant difference.

Additional Risks

Outside of the exchange ratio issues, there remains significant hurdles to the completion of the deal.  The transaction must still be approved by the bank’s shareholders – at current pricing levels, it would seem illogical for FCEC’s shareholders to approve the deal.

FCEC also announced that the outside date of the merger would be revised to November 20, 2010, potentially pushing out the completion even further.

Conclusion

As I mentioned at the beginning of this post, merger arbitrage can offer attractive annualized returns, but there remains definite risk for investors who aren’t diligent in their analysis.

In this case, a too-good-to-be-true return scenario led to a need for further digging, and revealed a transaction that the market continues to misprice.

*Hat tip to Cale Smith over at Islamorada Investment Management for sparking the discussion. And stealing my limelight with his post!

Disclosure

No positions at the time of this writing.