Fructivore Investments

You may recall that cheap and Chinese is starting to become a theme on this blog, and today is not an exception. This one, however, has nothing to do with food: it is China Security & Surveillance (CSR), which trades at an exciting P/E ratio of 5.44, although they did pay an unusually low amount of taxes last year, and if China’s statutory rate of 25% were applied it would be around 8. Like our other Chinese companies, this also has a short but very impressive growth history (and presumably one that is hardly sustainable at its present rate).

China Security & Surveillance is in the business of manufacturing, installing, and servicing surveillance products. Unfortunately, much of their sales comes from installations so it is difficult for them to get repeat business. But on the plus side, they are expanding into software and their servicing and maintenance operations. Furthermore, China instituted in 2004 an initiative that required 660 cities in China to have street surveillance, and they are a recommended vendor. Being on a government-approved list is always something you want to hear, but on the other hand they are highly dependent on their local government customers. For what it’s worth they have nearly a $200 million backlog as of the end of the last fiscal year.

Installation represented 3/4 of their total revenue last year. 15% of their income was from manufactured products that were not bundled in with installation.  The firm has a distribution network that covers all of the inhabited regions of China.

Turning to the balance sheet, the company is almost in a net-net situation; their current assets as of their last 10-Q came to $605 million, and their total liabilities were $345 million, producing a current asset value of $265 million. or 74% of the market cap of $356 million. Total shareholders’ equity is $491 million, but $133 million of that is intangible assets and goodwill.

Sadly, they have an offering of 15 million shares that has recently been amended to allow for an oversubscription to a total of 17.25 million. Their historical return on capital has been a reasonable 11.8% last year, but the offering price may well off below their current price of $5.07, and as stated above they have a price/book ratio of less than 1 so the dilution is going to be significant.

On balance, I do think the upside of a cheap Chinese firm that has the government stamp of approval outweighs the risk of an unattractive share offering, and I do think this is another cheap stock with a built in bet on the strengthening of the yuan.

I have gone over the details of Capstead Mortgage previously: that their exclusive concentration on adjustable rate mortgages insulates them almost completely from interest rate movements, and the blank check that Fannie and Freddie got from the government makes their loans absolutely safe, so the only thing to worry about is what premium to book value the current share price represents.

Apparently, no one has been listening to me, because lately the stock’s price has been dropping precipitously, perhaps owing to the lowering interest rate spreads or the anticipation of rising interest rates, or the fact that the company announced recently that Fannie and Freddie are buying out seriously delinquent loans and as a result the firm is receiving a great deal of cash back which, under the current market uncertainties, they are unable to prudently toss back into the market, causing the firm’s leverage ratio to decline. The issue with delinquencies is that, like prepayments, they result in the return of principal to the bondholder, which means that if the bondholder paid higher than face value for the mortgages, as would happen when dealing with guaranteed securities in a time of meltdown of the mortgage market, that premium evaporates.

As a result of this tendency, the market cap of Capstead Mortgage as of today’s close was $760 million at a price of $10.83, set against a book value of $1.008 billion according to their latest 10-Q. Capstead marks their mortgages to market, but fortunately for its investors, also discloses its principal value. The principal value of Capstead’s holdings is $7.287 billion, which are carried at a price of $7.560 billion. The difference is $273 million, which is only $33 million dollars more than the present discount to book value.

This means that right now there is a fairly small premium to principal value of their mortgages, and another 50 cent drop in the share price will eliminate it entirely. It’s not that simple; sadly; there is also preferred stock that has a $183 million liquidation preference, but it is nonetheless the case that the shares of Capstead Mortgage are less risky now than they ever have been, as the premium over book value is the only real risk that an investor takes, and that is nearly dealt with. So, despite the high prepayment rate, the diminished leverage, and the possibility of a sudden rise in interest rates, I see a bright future for taking a (larger) position in Capstead Mortgage right now.

I have recommended cheap Chinese stocks as desirable as a way to bet on the possibility that China will be forced to let the yuan float against the dollar, and of course, a cheap stock anywhere is a cheap stock, although markets outside of the first world should be given a higher equity risk premium. The ideal company would do all of its business in China but be listed on an American exchange and therefore subject to American accounting rules, which, AIG aside, are reasonably accurate. And I think I’ve just about found a good company, and a thematically appropriate one, with Skypeople Fruit Juice (SPU).

Skypeople is a company that prepares fruit juice concentrates and fruit drinks from specialty crops like kiwi, as well as pears and apples. They operate out of the fruit-growing regions of China, and last year 78% of their sales were to Chinese purchasers either for consumption in China or for export. This figure is up from 65% the year before, although they attribute some of that to the slowing global economy. The firm states that according to market research, consumption of fruit drinks is on the rise the world over, but China has historically lagged. The company views China as somewhat of an untapped market to develop. The firm also owns or has applied for several patents for fruit processing technology, and has made research and development expenditures to improve its operations.

The firm’s financial history has been a little murky; like American Lorain it started off as a US holding company that had bought and sold a couple of other companies beforehand, starting in the 90s. They acquired the firm that owns Skypeople in 2008 and changed the name. Their capital structure betrays some sign of their chaotic history; according to the latest SEC filings they have outstanding 3.21 million warrants at $2.55 a share, plus 1.32 million shares of preferred stock that is convertible into 880 thousand shares of common stock on top of 19.77 million shares of common stock. The firm is also considering making an additional offering of $40 million, or 6.5 million shares based on today’s closing price, in order to expand their sales range and product offerings in China.

At any rate, without taking into account the conversion privilege and the warrants, the firm has a market cap of $121 million, which works out to a P/E ratio of 8. The firm has a price/book ratio of about 1.8, so the share offering, if it proceeds at approximately the current price, will technically not be dilutive, and the firm’s historical return on assets of over 15% is promising as well so the equity offering might not be a negative for existing shareholders.

The major variable in their operations is the cost of fruit, which cannot easily be hedged, and because the firm focuses on specialty crops like kiwi and mulberry. But the firm claims to have excellent gross margins on its products, perhaps owing to their patents–Skypeople is apparently very proud of its ability to clarify juices–and so there is room to absorb some price volatility. And although a P/E ratio of 8 is adequate, not definitely cheap, because of China’s higher risk premium, the growth potential and the built in bet on the yuan makes this company highly desirable.

It was announced today that CenturyTel will buy Qwest Communications, subject to shareholder and regulatory approval, for $10.6 billion, or $6.02 per share, in an all stock deal. If you’ll recall, way back in June I recommended Qwest as a company with an ample free cash flow in excess of its reported earnings. At the time, Qwest was at $4.32, and so a $6.02 merger price looks not too bad.

But you may also recall that I think Qwest is worth upwards of $6.02, merger or not. Their free cash flow last year was $1.564 billion, and the year before that was 1.229 billion. In 2007 their income was distorted by a tax refund from net operating loss carryforwards, but taking that out their free cash flow was $1.454 billion. In 2006, $1.731 billion, and in 2005 , $673 million. So, the five year average was $1.330 billion, which capitalized at 10% would be $13.3 billion, or $7.55 per share.

Of course, it’s not that simple; the land line market is said to be in a decline that has been diagnosed as terminal, forcing these companies to pursue the broadband market. But Qwest seems to have been managing this decline gamely, and the large gap between depreciation and new capital expenditures was spinning off enough money for them to perform an orderly capital restructuring, such as the recent early redemption of $1.2 billion in debt and they do operate largely in rural areas where cell phone coverage isn’t that good anyway. So, even if their free cash flow is not entirely sustainable, they were in a position to whittle away at their debt burden enough to produce a stable long-term company.

Now, let us look at the acquirer, which has free cash flows of $867 million in 2009, $601 million in 2008, $610 million in 2007, $579 in 2006, and $451 million in 2005. Century Tel is an acquisitive company, having acquired Embarq less than a year ago, and the gap between depreciation and capital expenditures is smaller in absolute terms, but on a percentage basis is similar. This undercuts the possibility that Qwest was short-changing its capital expenditures in order to make itself more attractive to acquirers. But it has to be admitted that in terms of free cash flow Century Tel is is a much smaller company, and the same is true of its operating cash flows ($3.3 billion in 2009 for Qwest, 1.6 billion for CenturyTel) and even for the number of employees (30 thousand for Qwest, 20 thousand for CenturyTel).

To be fair, CenturyTel’s balance sheet looks a lot cleaner. On paper Qwest has negative equity (but without $10 billion in goodwill CenturyTel would have negative equity too), and moreover Qwest has covered its interest requirements a little less than twice while CenturyTel has covered it three times, but as I said above, an ongoing capital restructuring at Qwest could address that.

CenturyTel’s apparent financial strength has given them better multiples–price/free cash flow of 12.25 as opposed to 6 for Qwest even after the merger announcement–or perhaps the average analyst isn’t quite clear on the concept of free cash flow. However, this has resulted in CenturyTel’s market cap being higher, allowing it to eat a company that is larger than itself. Call it the AOL/Time Warner effect. Under the terms of the deal, CenturyTel shareholders would own 50.5% of the combined company, and Qwest shareholders 49.5%, when it is obvious from the above that Qwest is a much larger company and should be entitled to a much larger share.

Accordingly, I call on CenturyTel to bump up the purchase price, and I have rude things to say about Qwest’s board’s acceptance of this offer.

Much of the issues surrounding executive compensation is a concern that the manager’s interests should be aligned with the shareholders’. We have seen large cash salaries giving way to stock and options grants, and now the concern is that CEOs will do whatever they can to juice the price of the stock when their options vest or their sale restrictions end, and then let the price of the stock collapse as they retire or move on. In fact, the latest round of the shareholder arms race is a proposal to extend the restriction period for several years after the executive leaves the company.

Management pay packages are certanily the most public face of this issue, and it does lead to interesting bits of trivia, such as Jeff Bezos’ ownership of approximately 20% of Amazon, given the company’s P/E ratio of 70, means that he would actually lose money by paying himself more. However, this is only part of the issue, and the great Benjamin Graham himself noted that practically speaking, it is almost impossible to overpay good management, although it is trivially easy to overpay bad management, although the solution is not to cut to pay, but to fire them. A bigger issue is empire-building to feed the corporate ego, engaging in questionable mergers to make the company bigger but not better, and uneasonably witholding dividends to keep more assets under management.

But all this business of making managers “think like owners” might run into difficulties when they actually are. I have already talked about CCA Industries, run by the two old men who will not cough up their excessive cash holdings, and now I will point out Hallwood Group, a nifty little holding company that is 66% owned by Anthony Gumbiner. Hallwood Group’s only current subsidiary is a textile manufacturer that produces a line of breathable waterproof nylon fabric that is currently very popular with the US military. The Berry Amendment, which requires military procurement to give preference to domestic firms, is definitely an advantage in their business. The firm has previously been in the commercial property business and owned an oil and natural gas company that went bankrupt last year. The firm faces some lingering liability from a funding commitment to the energy company, but I don’t see that their liability is enough to explain the company’s P/E ratio which is an inconceivable 4.34, and that level of earnings is in theory sustainable, although when we do finally put out of Iraq and Afghanistan the military can be expected to go through a lot less cloth.

However, in the depths of despair in March and April of 2009, the company was selling for less than $10 a share, which is a forward P/E ratio of less than 1. Mr. Gumbiner saw an exciting opportunity to steal the company, offering a $12 buyout. He was forced to abandon this offer in June after the price moved to well above $14. He also proposed in 2007 to liquidate the company. But, even though the tender offer in 2009 would have been stealing the company, it was Gumbiner thinking like an owner, and an owner who wanted to own more. United States law protects majority shareholders from taking unfair advantage of minority shareholders, which presumably prevented him from just voting for the company to sell itself, but it is a perfectly natural instinct on his part that could be prevented only by the actual value of the company being perceived by the other shareholders. But these tricks do lead us to consider the nefarious possibility that he is intentionally trying to not maximize shareholder value because he has another tender offer up his sleeve. So, curiously, most managers should be made to think like owners, but people who are actually owners should be made to think like managers.

And if the P/E ratio has led you to run out and buy this company, be careful. Daily volume is on average 4500 shares, so purchases will have to be especially small and careful or the stock will shoot up. The share price is volatile enough as it is, thank you.

And don’t turn your back on Anthony Gumbiner.

As my loyal readers may recall, my verdict on Chiquita brands was “Cheap, but evil.” It turns out that the law firm of Boies Schiller agrees with me, since they have recently filed a class action on behalf of 242 Colombians who were the victims of a Colombian paramilitary group that was running a protection racket around Chiquita’s plantations. Damages sought are $1 billion, or roughly $4 million each. Perhaps Boies Schiller was emboldened by a similar lawsuit filed last week.

Not the kind of thing you want to see when you’re quietly accumulating a position, certainly, but let us consider what was actually going on. Unless Chiquita Brands is more evil than I thought, their payments to various rebel groups was not specifically so that the groups would go around murdering and kidnapping. As far as Chiquita was concerned, the paramilitary groups in question were a bunch of thugs demanding protection money, and Chiquita was paying them in order that their banana fields would not be burned down. Of course, the Colombian government and the US government has identified these groups as terrorists, but it seems to me that if the Colombians cannot keep a region of their own country free from rebels, they don’t really have grounds to complain when a company has to make their own arrangements, and why any of this is the business of the US government is beyond me.

But turning to the merits of the lawsuit itself, it seems to me that the plaintiffs are hoping to play the terrorism card and hope things go well, because under traditional tort law I believe these claims to be a non-starter. First of all, Chiquita brands was not complicit in any actions taken by the Colombian paramilitary groups, so any claim based on intent would be ineffective, which leaves us with a negligence claim. Negligence consists of duty, breach, causation and damages. Duty and breach are fairly simple; arguably Chiquita Brands has a duty not to pay protection money to terrorists and they breached that duty  (or so their settlement with the US government would seem to indicate).

But the question is one of causation. The customary test here is the but-for test: But for Chiquita’s paying protection money, would all of these kidnappings and murders have occurred? I would deem that rather a hard sell; paramilitary rebels don’t tend to keep audited financial statements, and although money is fungible it is virtually impossible to prove that Chiquita’s protection payments facilitated the acts in question.

I suppose the closest analogy would be a negligent entrustment situation, where, say, a defendant who lends a motor vehicle to someone he knows to be an unsafe driver may be held liable if the driver takes out a farmer’s market, but in this situation the but-for analysis is stronger; the unsafe driver would not have had the car without being lent it by the defendant, but here, again, it is not clear that the Colombian rebels would not have had the means to engage in their terrorism without Chiquita’s money.

This lawsuit also sets off a slippery slope that anyone who gets shaken down by a criminal is on the hook for any unrelated crimes committed by that criminal, as though by paying the money he becomes a conspirator. I don’t know of any cases that have reached that conclusion, and gangsters have been running protection rackets for centuries, at least since Alaric agreed to lift his siege of Rome for one and a half tons of pepper.  But is that really appropriate, where the connection between the purchases and the criminal activity is so attenuated? Are people who use petroleum products liable for Saudi Arabia’s human rights abuses? Some ethicists would say yes, but the law disagrees, and wisely so in my opinion. Chiquita wasn’t signing up on the side of the terrorists; the terrorists’ interests were actually hostile to those of Chiquita’s, and it seems a bit unfair that Chiquita should be in this kind of trouble for simply wanting their banana plantations not to be burned down.

Chiquita Brands no longer has any operations in Colombia, and considering the fallout from these events, I’m not surprised. The Colombian government, if it wanted Chiquita’s business, could have provided security for the banana plantations, and now Chiquita is expected to pay for the government’s failure. But I doubt that even a firm like Boies Schiller will be successful in making them do it.

One of the chief benefits of value investing is the pleasant feeling of smugness it incites in its practitioners. The impression created among value investors is that we are really the only people who know or care about valuation or fundamental analysis, or who have the slightest hope of achieving long-term investment success. Well, on Wall Street at least, because the high pay and unpleasant working conditions and in some cases the tournament-style hiring and promotion practice, careers tend to be pretty short. But Montier points out that everyone he knows who has lasted decades as a portfolio manager on Wall Street has done so as a value investor. And the psychic pleasure in knowing that is surely just as good as the financial rewards.

So, with this in mind, I thought I would review Damodaran’s Dark Side of Valuation, a book about how naively the typical analyst approaches difficult-to-value firms and all of the shortcuts they take. I am pleased to see people taking a critical eye to the sloppy practices of some analysts, but at the same time I’m not sure that his approach will solve the problem. For example, when dealing with startups, he advises that one possibility is working backwards from the mature company, estimating that the target market is, say $200 million a year and the firm under consideration, when it grows to a mature size, will capture 10% market share, and then to map out the course the company will take in order to reach maturity, and then apply a large discount rate to deal with the very likely possibility that the firm will fold or be acquired first.

The trouble, from a defensive, value investing standpoint, is the issue of garbage in, garbage out. Damodaran deserves credit for reminding us that growth for companies has to come from capital reinvestment, and that there is a limit to growth, but at the same time it is well known that analysts are unable to forecast last year what will happen this year, and so it would be better for them not to try. As a result, it is a very bold assumption to map out earnings and reinvestment for many years into the future.

And yet, isn’t that what value investors do? Yes and no. The effective value investor makes realistic projections of a firm’s earnings power, not its actual earnings, and with a very conservative view of growth (my personal preference is not to project growth at all).  But a company reinvests its earnings, not its earnings power, so the projectionist method is quite suspect. Generally, the value investor cannot find any value in startups or high growth companies without giving in to fatal optimism. Damodaran also embraces beta (the volatility of a stock relative to its index) as a useful measure of risk or input into valuation, when beta in many cases has only a tenuous relationship to the riskiness of an investment.

However, Damodaran’s book is a step in the right direction, giving readers sobering insights that growth is never free, that emerging market companies look cheap because of the risks of investing in them, and that growth cannot persist forever. He also recommends that the way to value stock options is to actually value them with an option valuation model and subtract that amount from the equity, taking into account how people tend to exercise these options early. His book is larded with useful statistical analyses, and one of the most useful one is an assessment of growth rates for high-growth companies that shows that the next Microsoft is, of course, an unspeakable rarity. Starting from the IPO, he found that the average new company has five years of excess growth before its growth falls in line with its sector’s. And it’s not five good years and then it hits the wall either; the excess growth starts at 15% and declines geometrically, and year 5 is on average only 1% ahead of the sector.

He also included the most useful chart I’ve ever seen, a device that allows investors to estimate the interest rate spread and a synthetic credit rating, from a firm’s interest coverage. This chart appeared in Damodaran on Valuation as well, but this one is more recent. Here it is (all rights reserved to original copyright holders, etc.):

This chart is coupled later in the book with a historical treatment of cumulative default rates, so if an AAA rating 20 years ago meant the same thing it does now (and outside of the mortgage derivatives arena I believe it does) we can look at default possibilities for even unrated, privately placed debt, which is a good thing.

So, I do recommend Dark Side of Valuation, and really Damodaran on Valuation and it together are a good introduction to the basic method of how to analyze companies quantitatively. But it cannot replace Security Analysis or Margin of Safety for identifying definitely underpriced companies. Armed with all of these, you can be as smug as Buffett or Klarman or even Nassim Taleb himself.

Now that Easter is over and the spiritual affairs of the world are in order, we may look again at temporal matters. And when it comes to temporal matters, a coming trade war with China is a big one. We now read that there is pressure on the administration to declare China a currency manipulator, and there are calls from the Obama administration for China to float its currency.

Now, as you may know, China manages its currency, the yuan or renminbi, in a fairly tight range based on a basket of other currencies including the US dollar. The Chinese government controls all yuan-dollar exchanges. Economists claim that based on purchasing power parity, the yuan is highly undervalued, by a little under half. The result of the currency peg is that China’s currency is kept artificially weak, which boosts its exports. Financial theory predicts that a nation that is a net exporter will see its currency get stronger and stronger until it is no longer economically viable for other countries to buy their goods, at which point the currency will reach an equilibrium, and a currency peg is said to obstruct this process.

(However, these would be the same free-market fundamentalists who almost destroyed Russia after the fall of communism and who gave Greenspan his “flaw.” The likes of Nassim Taleb, noted author and Wall Street critic, know that the real world is more chaotic and complex than economists would have us believe).

However, what would be the effect of letting the yuan float? It stands to reason that if China’s currency is artificially weak, then the US dollar is artificially strong, and as the United States has a global trade deficit, we benefit from that strength. China itself may have a rare trade deficit this March, but that is the deficit in their global trade, and they most definitely do not have a trade deficit with the United States. Well, so what, you say? China trades with the entire world, and if the yuan is devalued then every currency will weaken against China, but not necessarily against each other. But, after Europe the United States is China’s largest trading partner, so the effect should be proportionally greater in our currency. And, with the price of oil at about $87 at the time of this writing, when it had stayed in the $70-80 range for months on end, do we really want the dollar to weaken?

But I can’t see a piece of news without wondering what its effect on my portfolio would be. It reminds me of the fellow in Liar’s Poker whose first reaction to Chernobyl was “buy potatoes,” because if the fallout contaminated the European potato market, US potatoes should sell at a premium. In this case, I don’t say “buy potatoes;” I say “buy American Lorain.”

If you recall, American Lorain is a Chinese food company (by which I mean they’re a food company in China, not that they make Chinese food (although they do)).  When I first recommended the company, it was selling at a P/E ratio of 5.25, and it is still selling at 6.29, which is largely due to appreciation, as their earnings are basically flat as compared to last year. The reason they play a role in this affair is that the bulk of their sales are actually from China and in the yuan. Of course, under the current system of currency controls the United States can’t actually get the money out of there very easily, which could explain the low P/E ratio.

But if it is alleged that the rate should be 3.5 yuan to the dollar instead of just under 7, that means that American Lorain’s income stream should be worth twice as many dollars (they will be weaker dollars, of course, but not 50% weaker as to the rest of the world). So, by holding American Lorain, we hold a company that seems to be fairly priced based on China’s higher risk premium, that has growth potential, and that has a built-in option on China’s liberalizing its currency policy. And if there’s one thing a fructivore likes, it’s free optionality.

Sorry for the silly pun. United Online (UNTD) is a conglomerate of three online companies joined at the parent level. Their first, and oldest, company is a dial-up ISP that was created when Juno and NetZero merged. Their second segment is made of Classmates Online and Mypoints.com, which is an Internet marketing loyalty service. Their latest acquisition is the online segment of FTD, the floral company.

Their FTD operations are rather interesting; floral technology has advanced considerably since the time before there was any floral technology. One visits their website (or sometimes places an order over the phone) and one gets hooked up with members of the FTD network of florists who actually handle the arrangement and delivery. United Online takes a cut of the payments as its fee and sends the rest on to the network members.

The STC Wireless Router: Floral Technology

Their social networking site, classmates.com, charges a membership fee for premium services, and also earns advertising revenue. Their mypoints.com service allows members to earn points by responding to email offers, shopping online at the mypoints.com shopping portal, and using the mypoints toolbar and other activities. Points can be redeemed for gift cards.

Their dialup ISP segment works like an ISP segment, but they also have been purchasing and rebranding DSL in some areas, which they use mainly to bribe people who are cancelling their dialup accounts.

Their dialup revenues have been on the decline, as one would expect, from $320 million in 2007 to $211 million in 2009. The more scalable classmates.com and mypoints division has been slowly increasing sales from $193 million to $236 million over the same period, but has approximately doubled earnings over that period, from $28 million to $59 million. The FTD business was acquired in the middle of 2009, but it produced $545 million in sales in 2009. Earnings for the various sectors were $77 million from FTD, $59 million from classmates.com/mypoints.com, and $70 million from the ISP segment. Then, of course, there are taxes and parent-level expenses, as well as interest from the debt taken on to acquire FTD, bringing total earnings down to $70 million. The company has a respectable P/E ratio of about 10. It also pays a healthy (especially nowadays) 5.3% dividend.

But that isn’t the full story; United Online holds significant intangible assets,  which they identify as customer accounts, customer contracts and relationships, trademarks, technology, patents, and domain names, most of which relate to the FTD purchase. The value of these assets was written up by $7.5 million between 2008 and 2009, but the firm recorded $34.8 million in amortization over the same year. Since this amortization is a non-cash expense, it is a source of additional cash flow to the owner, although presumably the asset values listed and the amortization thereof are rationally related to earnings power.

The whole intangible asset picture is a little murky particularly since the diminution in earnings power could be related to the slow economy. The firm claims that FTD sales in 4th quarter 2009 were higher than a year before, and anticipates that this will hold true for future quarters as well. The firm estimates that they will make between 26 and 31 million in capital expenditures in 2010, as against $60 million in total depreciation and amortization in 2009. At any rate, $30 million in additional cash flow drops the company’s P/E ratio from 10 to 7.

Furthermore, the firm listed as an expense $65 million for technology and development. As Damodaran notes, technology and development (and/or research & development in some firms) generally produces advantages to the company that last longer than the year in which the work is done. However, because these advantages are nebulous in value, accountants require that the full costs be deducted in the year the money is spent. He thinks it would be more appropriate to capitalize these expenses to produce a “research asset” that is carried on the balance sheet and that is amortized in some logical manner that is rationally related to the lifespan of the results of this research, technology, and development. But since no analyst does this, no company releases information that would tell an analyst how to do it.

United Online is better than most, though. The technology & development figure is mixed, with product development and new technology and improvements mingling promiscuously with maintenance expenses and the costs of operating the company’s Indian facility, but they do capitalize costs relating to  software and amortize the same over its useful life, generally three years. However, they only capitalize these costs once the software has reached the application development phase for internal use software, or the technologically feasible phase if the software is to be marketed outside the company, which is later than Damodaran would suggest. Curiously, the company reports only the amount of costs capitalized ($10.6 million in 2009) for the internal use software, and only the amortization ($3.7 million in 2009) of the marketable software.

At any rate, United Online produces respectable earnings and more than respectable cash flow, and as such should be a candidate for portfolio inclusion.

Montier, in his Value Investing, spoke of the folly of looking at the price/sales ratio, which, considering the variety of earnings margins and capital structures, makes companies more or less incomparable with each other.  He described it as nothing more than a transparent attempt to go up the income statement until the company looks good. Bon-Ton department stores would be a good example of what he means; their price/sales ratio is 0.08, but because their operating earnings go almost entirely to interest, the ratio is useless, and in fact worse than useless because it makes a company look better than it is.

But Montier’s example is a little more extreme. He suggests that a company that sells $100 bills for $95 apiece would have the highest price/sales ratio in the world. Of course, you can’t find such a business that actually does such a thing, although certain mortgage lenders have organized their business plan under similar principles.

But if you can’t get such a deal from the company, maybe you can get it from the people who own the company. Value investing is said to involve buying a dollar for 50 cents, and on rare occasions that is literally the situation that an investor faces.

Endwave Corporation (ENWV)  is a manufacturer of RF modules, and  carries on their balance sheet $19 million in cash, $11 million in short-term investments, and $3 million in receivables, and $4 million in liabilities, total $29 million (there are $5 million in inventories and a little over $2.5 million of property and “other” as well).  The company’s market cap as of this writing is $26 million, meaning that  the company is selling for less than the cash inside it, and the rest of the assets inside are just a bonus.

Of course, few stocks sell for less than their net cash by chance alone, and Endwave is no exception. The company, it must be admitted, is not profitable. A large contributor to the situation is research & development expenditures which, properly speaking, should be treated more like capital expenditures than an out-and-out loss. Furthermore, the firm did take $2.4 million in restructuring charges last year, but even taking the most optimistic assumption possible, that their R & D did not amortize at all last year and that the restructuring is wholly nonrecurring, the firm still reported a loss of $3 million last year, so it is to be hoped that the savings from the restructuring are substantial.

However, what I find interest is that Endwave did recently take the curious step of redeeming all of its preferred stock for $36 million. The preferred stock was convertible into 3 million shares of common stock (worth about $8.1 million based on yesterday’s price), but had a liquidation preference of $45 million. The preferred stock paid no dividend, so it’s not as if there was any motive to preserve cash flow, so when a company redeems its preferred shares for no apparent reason other than saving its shareholders $9 million, I have to suspect that they’re up to something.