Gulf of Mexico oil drilling activities

(If you can't see the chart in your rss reader, you have to visit the blog directly.)

Looks like the region is back in business. e.g. See this report in Washington Post.



I am holding onto my CNRD. Repairing work should pick up.

Tilson and I

I just noticed Whitney Tilson and I have opposite opinions on three different companies:

• He shorts RIMM; I long it.
• He shorts NOK; I think it's likely it will come back. (No position.)
• He longs ACOM; I think its business practice is questionable. (No position.)

You can view his opinions and positions here and here.

Interesting...

I am still the easiest person to fool

I thought I discovered a gem when I spotted a company called Ancestry.com (ACOM).

It eventually turned out to be a dud but I learned a few important things along the way.

Key points:

• Beware of rationalising doubts with superficial reasonings
• Pride can cloud judgments
• Don't ignore the market
• Use a checklist
• Scuttlebutt is important
• Reflect and improve

As its name implies, it allows people to trace and discover their family trees and connect with family members. According to its website and annual reports, not only it maintains world's largest genealogy database, it has also been building up a huge collection of user-generated content about their family histories. Another website states that genealogy is 2nd most popular past time behind gardening. Ancestry.com has a subscription model. Users pay a monthly fee to access its database and connect with discovered family members.

Immediately, the following phrases popped up in my mind: "recurring revenues", "network effect", "zero margin cost", "moats",... A quick scan of its financial results brought up something too good to be true: A fast growing business with a market cap of $1 billion and ttm FCF yield at about 11%. Wow, a business with Facebook-like quality at a cheap price!

How could it not been discovered? I couldn't help but decided to look deep.

Then, I spotted something unusual. Short ratio was 10! That was nothing ordinary.  What was going on?

I found a couple of bullish articles on Barron's. Nothing looked alarming. I found some writeups on popular investing websites. It appears some investors questioned how much further it could grow and how long the users would keep their subscriptions once they had found what they were looking for. Could these explain the shorts?

Brushing the concern of the shorts aside, I decided to do a search on review sites like Yelp.com to see how satisfied the users were. Here I found my first lead of the real issue. This subsequently led me to more user reports on the Consumer Affairs website. The gist of the issue is:

• Ancestry.com always charges its users upfront for the entire year even though its website implies fees are monthly.
• They make it very hard, if not impossible, for you to cancel your subscription.
• Subscription fee kicks in immediately right after the 14-day trial period. Again, it's almost impossible to stop it.

It also appears Ancestry.com has engaged in this practice for many years.

No wonder their receivable turns are that short. No wonder the platform is sticky. It handcuffs your credit cards to its cashier. This is at the borderline of being a scam.

What are the lessons here?

I am the easiest person to fool. When I re-trace my thoughts, I see a few dangerous signs.

When I initially read the claim that genealogy was the 2nd most popular past time behind gardening, I had a flash of doubt. Isn't family tree discovery an one-off thing? How can it be addictive like World of War Craft or Facebook? Is there really "re-play value"? But Ancestry.com's financials seem to indicate otherwise. And its publications paint a very rosy business. I treated them as "proofs" and suspended my skepticism.

Second, I was too eager to uncover "hidden gems". Now think about it, it's impossible Ancestry.com was  under the radar. It's sponsored popular TV show "Who Do You Think You Are" in the States as part of its marketing campaign. My pride clouded my judgments.

Third, you got to wonder why Barron's and other investors were not aware of this questionable billing practice. Probably the sell-side analysts with Barron's had the incentive to turn a blind eye to this...

What saved me from losing more than just a few hours of my times?

• I didn't ignore the market. The market is usually very efficient. Re-assess my edge.
• I went through my checklist.
• I looked beyond the financials. I tried to understand the business from the customer's perspective.
• I reflected upon my past mistakes. This post itself is a reflection. It's so crucial to learn and adjust.   

(Disclosure: no position)

Thoughts on mobile platforms and ecosystems

I wrote in the RIMM analysis that the mobile platform battle among iOS, Android, Windows Phone and BB10 is a battle on courting application developers. The platform with the most number of applications wins. I'd like to explore this topic a bit further in this post. This won't be a rigorous dissertation or anything like that. This is just a collection of random thoughts loosely related to the competition.

Key points:

• Mobile platforms are not as sticky as PC platforms.
• Nokia can win back market shares by just being different. 
• The importance of the battle indicates HTML5 is still immature and may never be. Google's dual-bet -- Chrome OS and Android -- is a hedge for exactly this reason. 
• It is also a battle on distribution channels for digital contents

Stickiness

The history of PC gives us a good point of reference of the competition dynamics. However, I would argue that mobile platforms are not as sticky as PC platforms for the following reasons:

• Mobile apps is a couple of magnitudes cheaper than PC apps. The switching cost in pure monetary term is much lower. Not to mention a lot of the mobile "apps" are just games which have limited lifespan. (Do you still play Angry Birds? Do you still use Excel?)
• The primary users of mobile phones are consumers while business users make up a significant portion of the PC market. Businesses want consistency and resist changes. Consumers are more easily influenced by fad and fashion.
• Related to the 2nd point, mobile phones are more intimate personal items. They are a bit like watches. People want their phones to be an extension of their personality, their public persona.

Can Nokia come back?

Because of this, I think there is a fair chance Nokia can gain back its status as a key player in the mobile market. What Nokia has to do is just to be different -- different finish, different OS and different user interface.

Being different is a fashion statement. It's personal. It's cool.

Actually, Nokia's marketing department is on the same page with me.

(Well, but that doesn't mean Nokia will be a good investment though.)

Google's hedging strategy

In the ideal world, everything should just be cloud-based. Everthing should be implemented in HTML5, the latest and greatest web standard. Then, there will be no point to have a platform war. An HTML5-based app that works on iOS phone will work just fine on Android phone or any other phone.

However, it is not the case at the moment. This indicates HTML5 is still not mature enough. It is Ray Ozzie's observation that Google's dual-bet approach -- Chrome OS and Android -- is a hedging strategy for exactly this reason.

And if history is a guide, when a dorminant player emerges, it will have every incentive to cling onto its proprietary platform (i.e. the mobile OS platoform) and undermine the standard (i.e. HTML5). That means there is very high chance HTML5 will never become what it can become in the mobile space.

Digital contents 

But the prize of the battle is not the licensing revenues of the platform itself. The prize is the control of the distribution channel of digital contents. Amazon "gives away" Kindle in order to have a channel to send you books, videos and music. Google gives away Android in order to have a channel to send you advertisements (and potentially all sorts of stuff).

(Disclosure: Long RIMM, MSFT.)

Another housekeeping

About page updated.

Housekeeping

I notice images/graphs of my RIMM post didn't show up when read via Google Reader. Not sure why as images from other blog sites showed up fine.

So, if you didn't see any graphs, please view the post directly.

Research in Motion is absurdly cheap (RIMM)

(Ed: I'm flattered when someone plagiarised this post word for word after a full month I wrote it and published it on gurufocus. --18 May 12)

I don't think I need to introduce Research in Motion (RIMM), the Canadian maker of the Blackberry smartphones. RIMM is currently trading at around $13 with a total market cap of $6.8 billion.

A quick run down of RIMM's business: RIMM makes Blackberry smaretphones. Blackberry phones offer two distinct sets of features: (1) Blackberry Messaging (BBM) - This is basically instant messaging (IM) on  phones. (2) Blackberry Enterprise Server (BES) - This is a corporate solution which provides remote phone administration and secure email connectivity ("push" service). Both BBM and BES relies on RIMM's global network infrastructure. Both BBM and BES are valuable franchises. BBM exhibits strong network effect. BES is sticky in corporate settings. If we dissect RIMM's market along these two technologies, we can see that RIMM serves 2 distinct groups of clients: (1) youngsters who use BBM and (2) large corporations which use BES.

The problems RIMM facing are well publicized. It's been losing market shares to both iPhones and Android phones. New phone models have been delayed because of delay in getting 4G LTE chips from Qualcomm. And its tablet offer Playbook has been a flop. Future prospect looks grim.

I initially looked at RIMM half a year ago. At the time, I didn't know how to establish a valuation with conviction as its cash flow was deteriorating fast. Since then, RIMM has lost 50% of its market value. What got me interested again was the news that Fairfax's Prem Watsa had doubled down on RIMM (now owning ~5%) and acquired a seat on the board, and Greenlight Capital's David Einhorn has bought a small stake in RIMM instead of shorting it.

I'm amazed by what I found. It's possible RIMM is a sinking ship, but it's a sinking ship stacked with gold bars on the deck in plain sight.

Fire Sale Value

The golden rule of investing is "don't lose money". What is the worse case scenario here? What I'm interested in is how much RIMM is worth if it is dissolved today and sells off its assets and businesses.

RIMM currently has a book value of $19 per share and a net tangible asset (NTA) value of $12 per share. i.e. RIMM is trading at 30% discount to its BV and very close to its NTA value. However, both of them may not be good measurements of RIMM's net worth. It is because RIMM is a technology company. Hard assets may not reflect its true value. (What use is a manufacturing plant which makes Palm PDA today?)

Here is how I calculate its liquidation value. Actually I've cheated. You will see why later. (All figures in million $USD except per share figures.)

 

Current assets (consists of mainly cash and account receivables), long term investments and total liabilities are straight off its balance sheet.You may argue that inventories have to be marked down significantly. But on the flipside, I mark PP&E down to zero. We only need an appoximation here.

Patents are valuable these days as strategic assets to technology companies for both offense and defense purposes. RIMM has ~2500 patents filed in United States. How to value them? Reports from analysts value them as low as $1 billion to as high as 10 billion, with a valuation of $2.5 billion widely quoted. There are also a number of recent comparable sales: Microsoft's purchase of Novell patents values the patents at $510k/patent. Google's purchase of Motorola Mobility, assuming patents are the primary assets, values them at $310k/patent (after backing out the $3 billion cash and $1.7 billion net operating loss tax benefits). Microsoft's more recent purchase of AOL patents value them at $1,320k/patent.

There are big price variations. How can we sure they were not overpaid out of panic? Besides, the quality of the patents counts. How can we be sure RIMM's patents are of similar quality? I've randomly sampled some of RIMM's patents and Motorola's patents on USPTO. I couldn't come up with a conclusive answer.

But RIMM was part of the consortium which purchased Nortel's patents for $4.5 billion in mid-2011. RIMM's share is ~$750m. This is a more reliable figure. If RIMM needs to sell this block of patents, it will be easier for RIMM to convince the buyer the other four guys in the room also thought this was a fair price. More importantly, these patents have been (hopefully) evaluated by experts in the consortium. This gives us more confidence in the quality. By entering only $750m in the above spreadsheet, I have effectively mark RIMM's own two thousand odd patents down to zero!

Next, the BBM network. This consists of a user base and the underlying technologies and network infrastructure. The user base is still growing. Number of subscriptions grown from $50 million to $75 million last year. My first thought was this network was comparable to the Skype network. Microsoft paid $8 billion for Skype. Skype had about 170 million active users. BBM has about 75 million subscribers. Let's say BBM is only half as valuable as Skype on a per user basis. Then, BBM will be worth $2b. But this is very imprecise. (Half? Why half, not a quarter? And didn't people say Microsoft overpaid?)

Can we do better? BMM generates cash flow. Users pay a monthly subscription fee to use BBM. BBM provides annuity kind of incomes. I read elsewhere RIMM gets $2-4 per month per user. (I can't verify this as RIMM does not disclose its revenue details down to this level. One thing we know though is RIMM's service revenue grew by $1b last year. With a 25m user base growth, it works out to be about $6 per month per user. But I suspect this includes also BES revenue.) Let's say RIM is making $1 profit per user per month and the user base doesn't grow anymore. RIMM's gross margin on services is 85%. So this is implying a 25-50% net margin which is high but believable. Let's also assume RIMM can milk it for 3 years. With a 15% discount rate, I also get a $2 billion figure. [Ed: The 15% takes care of both time value of money and decline of subscriptions. A sign of laziness on my part...]

Now, if we simply stop here and add up what we've got so far, we have $12.76 per share liquidation value, effectively the current stock price. Not only we have marked down its handset business, which has been very profitable, to merely its inventory value on the book, we have also excluded two very valuable assets in this valuation: (1) RIMM's own patent portfolio and (2) RIMM's BES franchise.  And this is where I've cheated. I don't attempt to value them. And we don't have to if we are interested in finding out our downside. We have built up layers of margin of safety at every step. RIMM's true liquidation value should be higher than this. It's hard to see we won't get our money back in case RIMM fails as a company. (Did I mention RIMM has another 2000 odd pending patents?)

Upside

Stop for a moment and consider RIMM's business in the last 10 years.  It's been extremely profitable. Even the much hated 2011 result which included some material non-cash write downs (goodwill and inventories) still commanded a 12% ROE, without using any debt. ROE was 20-40% in the previous years. BBM user base is still growing. Handset sales is still going strong in emerging markets.

If we ignore the current noises, I think it's absurd RIMM is trading at the current price level. I don't know exactly what the upside is. And we don't have to know. When we watch our downside, the upside will take care of itself. But if you really want to push to speculate the possibilities, I would say, if RIMM can just maintain the current profit level, its stock price can easily double at a P/E of 12x. But we are looking at a trough year. If RIMM can fix its problems and improve its profitability, it will be a multiple-bagger.

Challenges and opportunities

It's understandable the market generally fears RIMM will fade in obscurity very quickly like Palm did a few years back. Besides, production issues have forced RIMM to delay the release of its new generation of phones powered by the brand new QNX OS. This damaged RIMM's its revenue and gave its competitors a window of opportunity to steal its loyal customers.

How likely will RIMM fade in obscuirty?

I think the comparison to Palm is flawed. RIMM has 2 franchises, BES and BBM, with lock-in power that Palm didn't have. They may not stop from RIMM fading into obscurity if the management doesn't do anything. But they can slow down the deterioration and give the management enough breathing space to fix their problems.

Besides, these franchise are immensely profitable. While service sales makes up only 24% of the revenue, it makes up 57% of the profit. Since service revenue commands way higher gross margin (85%) than hardware sales (20%), the significant drop in sales figures is masking the profit growth in the BES and BBM.

   

RIMM should give these 2 franchises 120% of its attention.

BES is a corporate IT solution. It doesn't have to be coupled to Blackberry phones. In actual fact, RIMM has introduced new technologies last year (called "Fusion") to make BES work with other phones. RIMM is a trusted brand and the biggest player in this space. If RIMM is to sell off this business, BES will be very valuable to people like Microsoft, Oracle and IBM. Not only the revenue stream, but also the client relationship.

While BBM is an instant messaging service, it shares the characters of a social network. BBM is popular in pockets of population. This shows its network effort among small social circles. It will be a strategic fit for any existing social networks: Google+, Facebook and LinkedIn. 

We may not be able to decouple it from Blackberry phones (i.e. offer it on other phones) without damaging both the phone brand and the BBM brand. At one point I thought RIMM may simply ditch its handset business and focus on its services, moving the BBM and BSE franchises onto other phone platforms. But it appears RIMM does have pockets of loyal customers. Its phones are actually selling well in Latin America and Asian countries. The falling sales data in United States and worrying trend in Europe are masking its growth in Latin America and Asian countries. 

   

The battle RIMM is facing at the moment is a battle on OS platforms, a battle on the ecosystems. With two ecosystems (iOS and Android) dominating the market, it's tremendously difficult to maintain a third one. We learned in the desktop OS battle that whoever commanded the biggest pool of the applications commanded the market.

I believe RIMM can actually sidestep this battle and the management can then give its full attention to strengthen its franchises. What they have to do is to make Android apps run natively on their phones. Technically, this may require re-implementing QNX to run on the top of Android. This may not be the only solution to its ecosystem problem. But this is the simplest. This is effectively what Amazon has done. Nokia is arguably going down a similar route too, with the exception that it's selected Windows instead of Android. (Whether it's a wise choice will be a topic of another post.)

But in reality RIMM is doing it the other way round. RIMM is making Android apps run on the top of its OS. While this is not my preferred choice, this may work too. And I won't fault their thinking. This will probably be too late to change course without causing damages both internally and externally. How well it will pan out will depend a lot on how trouble-free it is for both app developers and consumers to bring Android apps onto Blackberry devices. (At the moment, sadly, it's not.)

Catalysts

Co-founders Mike Lazaridis and Jim Balsillie resigned from their posts as co-chairmen of the board and co-Chief Executive Officers in January. This removed one obstacle for RIMM to break away from its engineering root and explore different strategic directions. (Don't get me wrong. It was no small task to grow RIMM into the current form. Both Jazaridis and Balsillie have done a very respectable job. It's just that being the founders makes it hard for them to decouple their affection from cool-headed decision-makings when the competition landscape has shifted.)  While the new CEO Thorsten Heins is largely untested, his promise to explore all strategic directions is encouraging.

We need to have the faith that the management won't destroy the value by burning its assets. Its history doesn't stack up well here. But it offers a bit of comfort that RIMM has started cost cutting initiatives.

Time is of essence here. While value in RIMM's patent portfolio and the value in BBM and BSE franchises won't evaporate overnight, they will deteriorate over time quickly. If RIMM can't fix its problems in a year, our investment thesis will quickly reduce to simply the liquidation scenario. It is good to see they now have a sense of urgency. We also have activists like Prem Watsa on the board (and on the strategy committee) to keep things in check. [Ed: I should've emphasized, the presence of Watsa is pivotal in the entire investment case. Without a strong capital allocator on the board, the company can forever lose its path.]

High uncertainty, low risk

This can be a bumpy ride. Profits can fall further in the next few quarters if hardware sales don't pick up. Stock price can fall further in tandem. Visibility is low and no one can predict what will happen to RIMM. Will it be broken up like Palm was? Will it sell off pieces of its businesses or assets? Will the Canadian government veto an acquisition by a foreign firm on national security ground? Will it form strategic partnerships with other big boys? Will it stay in one piece?

No one knows.

But the risk of permanent impairment to our capital is low because we can establish a pretty solid floor on the valuation. On the flip side, the stock price will pop if anything good happens to RIMM.

This is a classic "head I win, tail I don't lose much" risk/reward profile.

The market sentiment is at its maximum pessimism. Short ratio is at its highest. One really needs the nerve to believe one's facts are right and one's reasonings are right.

(Disclosure: Long RIMM, ORCL & MSFT)

My investment checklist

This is the general checklist that I go through each time when I examine an investment opportunity. This is long-winded and generic. This won't be exhaustive enough to cover all the possibilities nor specific enough to cover specific aspects of individual companies. Not all the points are applicable in all cases. Many are open questions of which the answers can mean opposite things in different circumstances.

The purpose of having this in place is to avoid silly mistakes, to slow myself down and to minimise the influence of my own emotion, laziness and blindspots. This will be a living document that I'll add or delete points when I have newer insights upon reflections.

Utilising a checklist is probably a Mungerism.

Discipline

• Am I thumb-sucking?! (some elaboration here and here)

Rebuild the history and the profile of the company

• Filings and public information
• 5-10 years of public announcements (financial reports, proxy statements, annual reports, tax filings)
• Differential analysis: what mgmt said in one year vs what happened in the next year; things said in different statements
• Recent new releases
• Industrial or government data and statistics
• Scuttlebutt
• Competitors, suppliers, customers and products
• Media coverage of company and mgmt
• Court cases?
• Background check: mgmt, accountant, lawyer, cross-holding parties

Financial Quality

•  Debt Health
• Interest cover
• Debt-to-asset and debt-to-equity ratios
• Maturities and covenants of loans. Fixed interest or floating?
• Off-balance sheet liabilities? (e.g. operation leasing, subsidiaries) VIEs?
• Capital structure 
• How open are the debt markets?
• Dependent on credit rating (which will put constraints on minimum equity)? 
• How is the financial health implied by the yield on the bonds and preferreds? 
• Cash Liquidity Health
• Quick Ratio
• Profitability
• Predictable long-term earning? What are its 10-year average earning and FCF?
• ROE
• Segment mix and margins
• DuPont analysis: Cash conversion rate x Net Margin x Asset Turns x Gearing = Cash ROE
• DCF if it's a runoff business or products with a defined lifetime (e.g. drugs with patents)
• Assets
• Mindful of the difference between liquidation value vs going-concern value
• Book value, NTA, NCAV
• Hidden values
• Properties, LIFO inventories, uncapitalised "intangible"assets
• Tax sheltering, semi-permanent accrual-vs-cash discrepancy
• Depreciation & amortization
• Operational efficiency and asset efficiency
• Cash Conversion Cycle = Receivables Turns + Inventory Turns - Payable Turns
• Capex vs Depreciation
• Capital Allocation
• Cash used in financing over the years
• Optionality
• Ability to raise capital or issue debt
• Insider
• Executive compensation & options, perks
• Related parties?
• Insider ownership

Business Quality

• Business understandable?  Corporate structure understandable? Capital/debt structure understandable? (How thick is the annual report?)
• Are the customers happy with the products enough to leave some cash crumbs on the table? 
• Competitive advantages and competition landscape
• Can I comfortably say how the industry/business will look like in 10 years?
• Moats / Porter's 5 Forces / Barrier to exit
• Concentrated clients or suppliers?
• Pricing power - can the company easily raise price by 10%?
• What is the megatrend? What's the macro business environment? 
• Counterparty risk
• e.g. Will customers default? Are the clients struggling? Are the clients making money?
• Management integrity? Irrational motives?
• Does the management show candor in its communications over the years? 
• Institutional imperative? (some elaboration)
• Where will growth come from? 
• How does capital allocation look like? 
• maintenance capex
• dividends, acquisition, share buyback, capex expansion
• Chance of capital raising?
• Only one hurdle to jump? Is the difficulty the company facing temporary?
• industry-level recession, market over-correct, one-off management mistake, war, one-off restructuring cost, out of favour 
• Any catalysts?
• Does the company have enough staying power while we are waiting for the value to realise?

Safety and Opportunity Cost

• Do I have enough downside protection and margin of safety?
• How does the business score under these metrics:
• Cheapness - Quality - Growth - Capital Allocation
• Pre-mortem: what can go wrong? 
• Why is the other side selling? Why is it cheap? 
• Remember the market is usually right. Where is my edge here?
• Short interest? What are their theses? Short money is smart money. 
• Not the right pitch? Wait for next pitch?
• Is it a mediocre idea?
• Would I buy the entire company? 
• Do I compromise my margin of safety or the quality/depth of my research because of lack of patience?
• Is it a too-hard basket case?
  
• Should I keep cash instead? Time is on my side.
• Should I wait for more evidence or better price?
• How does it compare to my previous best idea, cigarbutt or quality business?
• Can I say my primary reason to invest is because the business itself is undervalued?
• Does any measurement or figure look too good to be true? 
• How does it compare to industry average?
• Fraud??
• Recheck every assumption and every figure.  

Portfolio Construction

• Correlation with my existing portfolio
• Consider other securities for different risk/reward balance: preferred's, bonds, options
• Position sizing as per Kelly's Criterion. (some elaboration)
• Tax consideration - consider how the value will be realised. 
• Can my portfolio and my personal cashflow survive a once every one hundred years event?
• Is the general market overvalued? (Shilling PE10, Tobin Q-ratio, S&P500 Market Cap vs GNP)

Self Checks

• Have I studied the industry and its competitors?  
• Is my abstract reason backed up by concrete evidence? Or is it just an hypothesis without supporting empirical data?
• Do I have tunnel vision? Do I look for evidence only for confirmation instead of invalidation? Can I tolerate non-coherent evidence?
• Am I incorporating new information in a Bayesian way?  
• Am I rushing, losing patience, stressed, over excited? Or is my mood swung by the market direction?
• Am I anchoring?
• Overconfidence? There is no way to eliminate all the risks. There are always unknown unknowns. Don't overexpose in one position
• How would I feel if the stock loses 50%?  How would I feel if the stock gains 50% but I haven't bought any shares?
• Am I a price taker (red flag!), or a price setter? Should I ignore Mr Market?
• Is there any superficial reasoning? I am the easiest person to fool. 

Selling

• Re-examine the original thesis and fundamentals.
• Price/Value should be the primary reason. All other reasons (e.g. pruning, taxation) are secondary.
• 3 year rule - If visibility is poor, wait for up to 3 years
• Should I take profit in cyclicals?

[Last Update: May 2013]

A followup on GLG Corp

This is going to be a quick post.

I wrote about GLG Corp (GLE) last week. One thing that has kept me perplexed is: Why did they list in Australia? Australia ASX has arguably more strigent listing regulations than SGX in Singapore. (This was one of the contentions in the ASX-SGX merger talk back in late 2010.) Why the trouble? And what's the point of raising so little capital here? The CEO and founder still controls 75% of the company.  They were not in here for the money. But what?

Yesterday I met up with a Singaporean friend. He read my GLE post. He made this casual comment while he was cuddling his one-year-old daughter in his arm: "These people were here for the status in order to attract employees back in Singapore."

Wow, what a revelation! This makes a lot of sense. This fits the general mentality in Asian culture that status is important.

This taught me two things:

1. Local know-hows are all important.
2. Scuttlebutt is all important.

A followup post on Conrad Industries

Two days ago I wrote about Conrad Industries (CNRD). Nate at Oddball Stocks later jotted down his thoughts on Conrad in his recent post. Nate raised two important questions:

1. Why is Conrad cheap?
2. Is Conrad a cyclical business currently at the peak of its cycles?

These are important questions. These are excellent questions. I will try to address them here.

(I have to be carefully here not to do this for the sake of merely defending own investment decision. Otherwise, all sorts of nasty psychological biases will surface and cloud my judgments. But everyone has blindspots. "I am the easiest person to fool." It's always good to have a second opinion, particulary when the view is an opposite one. While investing by a committee is a dumb idea, having a sounding board forces one to examine and re-examine one's assumptions. "Always invert." Always in the outlook of contrarian views. That's why Warren Buffett and Charlie Munger make such a lethal team. A dialogue is beneficial to the participants.)

Knowing the History is Crucial

I believe to come up with an educated judgment of CNRD's value, it is instrumental to understand CNRD's history.

CNRD has been in the industry for very long time. It was founded in 1948 by Conrad Snr. It was listed in 1998 on NASDAQ and subsequently delisted in 2005. But the most important period for our discussion is from around the time it was delisted to now. I see 3 phases in this period:

• 2002-2004: Tough business environment. Lost money every year. Loan covenants were breached and renegotiated many times. Solvency was at risk. The management decided to delist the company in order to save $800k annual expense.
• 2005-2008: Management was replaced. Conrad Jr. took over as the CEO. Profitability improved every year. The client base was broadened.
• 2009-now: General economy was hit by GFC. Exploration activities were suspended in the Gulf because of the oil spill. Profitability took a hit. The management made efforts to reduce its dependency on the exploration activities in the Gulf. 

Keep this in mind. This will set the backdrop of the ongoing discussion.

Is CNRD is a cyclical business? 

We shouldn't have any delusion that CNRD is a defensive business like Coca-Cola or even ADVC which can maintain very consistent profits even in recessions. Instead, I would ask how cyclical CNRD is. CNRD's revenue used to be very dependent on oil/gas exploration activities. That was very cyclical. That was a key factor why CNRD got into trouble in 2002-2004. But the current management has successfully moved away from this. Offshore oil/gas industry used to account for 47% of CNRD's revenue in 2006. It has been falling in a linear fashion to 7% in 2011.

My take is, CNRD has become less cyclical over the years.

Were the turnarounds flukes?

Apparently, I've placed significant weight on the prudence of current management. In actual fact, my current investment thesis rests on the quality of the management. Ultimately, CNRD has no structural competitive advantage. (e.g. It doesn't have the kind of network effort Facebook enjoys. And it doesn't have the kind of brand loyalty Apple or Coca-Cola has.)

So, the improvements and turnarounds could just be luck but not skills, couldn't it?

One evidence that tells us the current management has indeed been a positive factor in CNRD's performance is the trend of its selling , general and administrative (SGA) expenses over the years. SGA was $4.8m in 2002. SGA was still $4.8m in 2010. It isn't that it hasn't moved. It did go up to $6.2m in 2009 and it was $5.4m in 2011. But this gives me the confidence that the management has been taking a very active role in lookinag after the business in tough times and successfully adjusting its cost structure.

What if I am wrong?

I agree with Nate 100% it's important to answer oneself why a company is cheap. Another question that I ask myself all the time is "What can go wrong?"

What if I am wrong? What if CNRD is still a cyclical business? What if the current high volume of non-exploration related revenues was a pure coincident, coinciding with the recovery of the US economy?

How bad is our downside?

The current management turned around the business in 2005. It was a breakeven in that year. Since then, it has been profitable every year in the last 6 years. In these 6 years, the lowest ROE was 13% in 2010. So, even if CNRD is indeed a cylical business, at the lowest point of it cycles it still managed a 13% ROE. And it was acheived with "negative leverage" (i.e. not only without debt, but with non-operational cash on the book). With that, I will think it deserves more than 1x BV, even for a cylical business.

Besides, as I already mentioned in my original post, I still expect exploration activities in the Gulf will recover. This gives us another wildcard of another up cycle.

(In actual fact, when talking about "what can go wrong", I am more worried about the possibility that the Jones Act will be abolished. Hence, I'm mindful of the size of my position. I'm managing this risk by position sizing.)

Why is CNRD cheap?

I can't be sure. What I have is a guess.

I think CNRD is cheap because investors were burnt twice in a row. The adverse period in 2002-2004 and the subsequent delisting must have left a sour taste in the investors mouth. Then, while seeing the business was picking up again in 2006-2008, it was hit hard again by both GFC and the oil spill. Investors must have concluded CNRD is so cyclical and dependent on gas/oil exploration activites in the Gulf that it shouldn't be worth more than its book value. Investors must also be skeptic of CNRD's pursuing of non-exploration related revenues.


One last thing. I do think the current high volume of non-exploration related revenues was a coincident, coinciding with the recovery of the US economy. Given the trend of its backlogs, I also expect revenue in 2012 will be lower. But I take a longer term view. When the management with a good tracking record thinks it's now good time to expand, I give them my trust.