A collection of value investing ideas from the previous two weeks:

Contraction Expansion

Barel Karsan lays out the risk/reward for SIFCO Industries (SIF), a stock recently featured here at Value Uncovered (See: SIFCO: A Contrarian Investment). The stock appears to be very cheap, but management is rolling out an expansion strategy during a cyclical downperiod for the company.

The question remains whether the business is back on the upswing (and management is correctly anticipating) or whether the company will experience another down year or two (and potentially struggle by not conserving  cash).

Risk Arbitrage: The Battle for 3PAR

Hunter over at Merger Arbitrage Investing has a nice writeup on the bidding war between Dell Inc (DELL) and Hewlett-Packard Co (HPQ) for 3PAR Inc (PAR), the global provider of utility storage systems.

In a little over a month’s time, the bidding war increased the purchase price for 3PAR from $1.15B to $2.35B, as the mega-tech giants battled over control of the company.

While many special situations investments try to capture a thin, ‘risk-free’ spread, a good portion of long-term value arises from bidding wars between potential acquirers.

InfoSpace Inc.: Cash + Cash Flow + Big NOL = Cheapness & Change Agent

Featured at GuruFocus, Infospace (INSP) is a meta search engine that has suffered greatly since the dot-com bubble (the stock hit a split-adjusted price of $1,190/shr in March 2000 compared to a current price of $7.19/shr!)

From an value perspective, the company has $6.25/shr in net cash on its balance sheet, generates solid FCF, and has a huge ($815m) pile of Net Operating Loss (NOL) tax carryforwards that could potentially be valuable to a strategic acquirer.

Acquirer Buys Cash at a Discount

Barel Karsan has another great post on Qiao Xing Mobile (QXM), a mobile handset manufacturer in China. QXM has appeared on every Graham, NCAV, or NNWC screen over the past several months, as the company is sitting on over $265m of net cash.

A recent buyout offer from majority shareholders (usually a great situation that unlocks potential for value investors) values the company at only $206m, well under the net cash balance.

The situation shows how difficult it can be to unlock value for minority shareholders, even in a buyout/liquidation situations.

Class #1 – Introduction to Value Investing

While I usually feature specific stock recommendations on Weekend Values, I came across this series of class notes that was interesting enough to pass along.  The notes were typed up by an anonymous student at a graduate business school during various lectures from 2002-2007.

Browse through the related Scribd documents for even more insights.

Disclosure

No positions.

Pinnacle Gas Resources (PINN) is a micro-cap stock that holds natural gas properties in the Powder River Basin of Wyoming and Montana. The company leases approx. 406k gross acres of undeveloped land and 15 billion cubic feet (bcf) of proven natural gas reserves.

The company has reported large operating losses for the past three years, with 2009 being especially brutal. PINN reported a net loss of $68.75m as natural gas prices dropped significantly, from an average of $6.24/Mcf in 2008 to only $3.07/Mcf in 2009.

Strategic Going Private Transaction

On February 24, 2010, Pinnacle announced a going private transaction led by Scotia Waterous, the oil & gas M&A division of Scotia Capital. From the press release,

“The Special Committee considered a range of potential alternatives, including continuing to operate as an independent entity, possible sales of certain assets, the Company’s ability to issue additional equity in a public or private offering, and restructurings of the Company’s outstanding debt”

According to the board, this transaction was the best alternative for company shareholders.

Agreement Terms

The going private deal is a $0.34/shr cash offer, valuing the company at $11m. The merger required shareholder approval and the waiver of certain lending conditions of Pinnacle’s credit facility.

Under the merger agreement, shareholder approval had two parts: 1) a majority vote of all shares & 2) a majority vote of all shares not owned by DLJ Merchant Banking Partners III (DLJ) and the company’s senior executives.

On August 11 2010, PINN’s shareholders voted to approve the merger, with 72.6% voting in favor.

Credit Agreement Default

The last condition for the completion of the transaction is a waiver by the company’s senior lender, the Royal Bank of Scotland.

Pinnacle borrowed heavily in 2007 – the drop in gas prices and the poor performance of the business forced severe restrictions on the company’s credit facility.

The credit agreement was modified a total of 7 times on the $5.1m balance.

According to the latest revision, the Final Maturity Date was set at

“(i) June 15, 2010 or (ii) the date that is thirty days following the earlier of (A) the date the merger is withdrawn or terminated in whole or in part or (B) the date that the lenders have been advised that the merger will not proceed.”

The company missed payments on both July 1 and Aug 1, effectively breaching the agreement not only with the lender, but with Scotia Waterous as well.

However,

“Scotia has indicated at this time that it will not waive the default; however, it has not terminated the Merger. Accordingly, the Company and Scotia are proceeding with the Merger”

There has been no further info since the August 16 quarterly filing.

Risks

This is a tiny transaction, and there were several lawsuits (since settled) surrounding the management team and their relationship to the acquirer both pre and post merger.

Typically, these types of transactions close very quickly after shareholder approval, but the deal has been languishing for almost a month.

If Pinnacle does not receive a waiver from its lender, the full $5.1M becomes immediately due – since most of the company’s assets are tied up in natural gas (under the ground!), this would most likely force the company into bankruptcy.

Valuation

The stock dropped over 10% towards the end of the day on no news and slightly above average volume – amazingly, $0.29 has been the lowest price since the merger was announced over 6 months ago.

Conclusion

The drop in price at the close today is a very suspicious indicator, possibly indicating that the market does not believe that the company’s lender will give the go ahead.

Although the spread is very attractive, the downside risk is basically bankruptcy.

So, is the deal worth the risks? Any reason why the RBS would refuse a final waiver after such a long road?

Disclosure

No positions.

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