Star Scientific (STSI)

A short primer: I don't short a lot. Right now the portfolio is short ~10%. Combine that with a 10% allocation to consumer loans and the end result is 80% net long. The process for finding shorts though is the exact same as longs. I look for things that don't make sense. If I can ask 1,000 questions and say "this business doesn't seem right''(whether it's under or overvalued) I feel as though I have a winner.

Finding a long that doesn't make sense is fairly straightforward and if you've done your homework averaging down is simply part of the process. On the flip side, shorting brings a whole new level of fun. ZIRP is making it expensive to short and there's the obvious factor of margin calls. I'm sure there has never been an "easy" time to short, but I would imagine today is especially onerous. Regardless, today I present Star Scientific.

Background

I found this idea on VIC (I'll briefly brag that I'm now a member) and the short case has been made by numerous other analysts (see here and here). I think the idea is better now than it was in the past, despite a much lower share price.

Here is the short thesis in a nutshell: the only thing that Star Scientific can sell is their stock. This isn't unusual for Jonnie Williams and team, they've been running sca....unprofitable, shareholder leaching, management-centric "businesses" for several decades. It took some time, but those other ventures eventually went to zero. (Oh yeah, he also can fit you with contact lenses on the cheap, no license needed!)

Anyways, the best piece of news to sell stock was when STSI sued RJ Reynolds for patent infringement. While they successfully received compensation from RJR, it is hard to argue that the $8.4M received was in the best interest of shareholders. We can see the original language in their license agreement from March 16, 2001. (SSI refers to Star and RCT refers to Regent Court Technologies).

8.2 SSI shall promptly notify RCT of any potential infringement of any of
the Patent Rights. In the event that a third party infringes on any of the
Patent Rights, SSI shall have the right but not an obligation to bring legal
action to enforce any such patent, including the right to bring suit in the name
of Star Scientific, Inc. If SSI exercises such right, SSI shall select legal
counsel and pay all legal fees and costs of prosecution of such action. In the
event that SSI shall choose not to take such action, RCT shall have the right,
at its option and at it own expense, to prosecute any action to enjoin such
infringement or to prosecute any claim for damages. The party prosecuting any
such action shall be entitled to retain any funds received as a result of
settlement or judgment of such action. The Parties may also agree to jointly
pursue infringers. After deduction and payment to the Parties of their
respective costs and fees (including without limitation reasonable attorneys'
fees) incurred in prosecuting any such actions, the net funds obtained as a
result of settlement or of judgment of any such jointly prosecuted action shall
be divided in the following manner: 25% of all net funds shall be divided
equally by the Parties and 75% of all the net funds shall be divided between the
Parties in the proportion to the amount of legal fees and costs incurred by the
Parties in the prosecution of such actions. 

STSI got to foot the bill and pay Regent Court Technologies a bunch of money. For Williams and company this has proven very lucrative. 

After "winning" this lawsuit, management decided that safe cigarettes weren't going anywhere. Eight out of 16 patents STSI holds will be expiring by the end of 2016 (pg 12 2012 10K), suing other tobacco companies and waiting a decade won't help them much. Thus, management has decided to shift their strategy again and market anatabine to consumers.

Anatabine

Anatabine is a minor alkaloid of tobacco. From a chemistry perspective it is simple and a synthetic process of isolating the compound has been known as far back as 1965. This was improved upon in 2005 (isolating optically pure substance in a method that should scale well). STSI came along and determined an even better way to synthesize the product. And guess what?

They could make kilos of the stuff and I doubt anyone would care. It has been known for decades that tobacco alkaloids are have some sort of pharmacological effect. These have been studied by other companies, some decades old.

So what does STSI think anatabine will cure in the future? Right now, ANYTHING dealing with inflammation.

Based on the overwhelming lack of evidence from reputable scientific sources I'd say that the company has a very low chance of success. I say this not because I'm an expert in pharmaceuticals, but because I believe, like investing, science is very hard. If it was easy, it's likely that it would have been discovered.

A search at PubMed for anatabine brings back 59 articles. There was only one article that gave details on the anti-inflammatory nature of anatabine. This was written by Daniel Paris from the Roskamp institute. The other articles not written by Roskamp associates were mostly analytical studies. It seems odd that no one, anywhere, has researched this small molecule. Unless of course it had no promise.

It's no secret that small molecule drug makers are finding few sources of new revenue. I would say that anatabine has been tested several times in various library assays for drug potential. Other companies probably think the chance of success is low and now so does STSI. This is despite the recent press releases that talk about medical studies on colitis (IR would not tell me who is actually running the study at UVA) the company seems to think the best chance for success lies elsewhere.

"Initially, marketing of Anatabloc ^® was directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who regularly deal with issues relating to inflammation." pg 6 2012 10K

So the company now believes it will make money from an overpriced, over-marketed, GNC product. There are 3 active ingredients in Anatabloc: vitamin A, vitamin D, and anatabine. Since it's been well established that vitamin A and vitamin D combat inflammation, where's the proof that Anatabloc is any better than multivitamin?

Discussions with physical therapists lead me to believe that in the past year the company was sending copious amounts of marketing material to medical professionals. Nobody bought the product except for one massage therapist who was referenced in a puff piece on STSI's press release page.

He got all of his information about the science from the company (he claimed to understand it but didn't know anything about the molecule when I questioned him). He heard about the company through a client...who was an investor in STSI.

Cash Burn

So what does it take to run a pharmaceutical lab investigating one of the greatest small molecules in the world?

In 2012 spent $4.5M on R&D. All that research obviously required a lot of publicity, which is why STSI spent $6.1M on marketing. Having worked at a venture backed company (chemical based) those numbers do not paint a pretty picture for innovation.

Regardless, the company burned through $17.4M of cash (FCF before working capital) in 2012, roughly in line with my estimated cash burn in 2011 and 2010.  Currently there is $23.1M of cash in the bank. Keeping a staff of scientists and their equipment hunting for the next breakthrough will be tough, especially with all that marketing spend and management incentives.

With a current burn rate of $1.4M ($17.5M/12 months) per month it seems likely that the company will have to:

A. Cut staff. This would drain resources from creating/selling product. Plus this is a very top heavy firm with set contracts and exit agreements. Every $40K tech they fire will only pay for 2 weeks of Williams salary.

B. Cut marketing. This would also drain resources from selling the product. The extra marketing spend (an increase of $3.6M from 2011 to 2012) was likely the only reason they increased sales to $6.188M in 2012 from $1.244M in 2011. I would imagine a lot of this is set too just to remain in GNC fliers.

C. Dilute shareholders.

Based on managements past, (C) seems most likely. Since 2010 share count has risen from 118.3M to 146.99M(8% growth per year). Further dilution is almost guaranteed unless Anatabloc catches fire. I guess there is a chance of this happening even though Anatabloc has been in GNC stores for more than a year now. Tom Dowd, a GNC executive, recently stated that "sales of Anatabloc continue to surpass expectations."

With sales of $6.188M in more than 4,000 GNC locations, GNC must have expected sales to be less than $1,547 per store per year, or 20 bottles/store per year($1,547 divided by $79.99 per bottle).  Since one bottle is only a months supply, there are 1.66 people per store buying Anatabloc(20 bottles/12 months in a year).

I'm being quite generous by saying all sales in 2012 took place in GNC, so the actual sales per store was probably lower. Even if my numbers were off (the wholesale price per bottle is ~$66 for a minimum of six bottles) it doesn't change the fact that barely anyone is buying this product despite endorsements, a national chain roll-out, and all the advertising that they can buy.

Conclusion

Star Scientific is a terrible company that doesn't make any sense. Now that the RJR lawsuit is out of the way it seems unlikely, if not impossible, that the company can grow their profits to match their ridiculous $190M market cap. With only $23M in the bank the company will have to exponentially increase sales to operate at breakeven operating margins.

Since they are already established in GNC I believe we are already seeing the best that they can do. In my opinion, the company is worth, at most, 2X book value(let's pretend that there is some value to the IP). With 146.99M shares outstanding and a book value of $24.98M(12/31/2012) this gives a per share value of $0.33/share compared to the current price of $1.33.

Even if some miraculous medical discovery happens, it will take years before the company is actually able to monetize anything. I believe that the large retail base and abhorrent management team makes this a timely and compelling short.

We are short STSI. This can change at any time.

Doral Financial DRL

Doral Financial (DRL) is a bank with two divisions, Puerto Rico and the USA. The company has had a slew of issues since 2004. The thought process behind examining this bank is simple: it's way to cheap if it's solvent enough to stay in business.

The table below shows just how cheap the company is compared to it's peers in Puerto Rico

Table 1. Silly Ratio Analysis

As the title indicates, the ratio analysis does little beyond tell you that the company is cheap. So let's look at the reasons it is cheap.

History

Like many fantastic organizations in the credit bubble, Doral took a very proactive stance to loan underwriting. By proactive I mean they would issue a loan to anyone with a pulse (and likely a few people without one).

Even better, the company was able to use creative gain-on-sale accounting to inflate income by almost $1 billion. The company also had managers who creatively valued interest-only strips. All this creativity caused the company share price to plummet.

All of this happened before 2005 and here we are in 2013 and the company is still dramatically cheaper than peers, who have all, in theory, improved their metrics. In fact, Doral ongoing struggles were even mentioned (not directly) in the Q4 2012 OFG Conference Call. Becoming a better bank rests on the belief that the newly created subsidiary, Doral Recovery, can manage the high number of non-performing assets and loans.

Doral Recovery

There are three main sections to Doral Financial. Doral Bank, Doral Insurance, and Doral Recovery. The corporate structure can be seen in the well-drawn flow chart below. My wife is an artist, I clearly am not.

Doral Corporate Structure

 

Doral Recovery was created in March of 2013 to manage

"The credit costs related to Puerto Rico TDRs and non-performing assets are the largest drag on our earnings. They need special attention, so we've established a special servicing capability; we call it Doral Recovery. The purpose of Doral Recovery is to isolate, manage, and resolve these assets." -Glen Wakeman Q4 2012 Earnings Call

 This isn't a new strategy, but what exactly are those assets?

Well from their Q4 presentation we can see that there is $699M of residential loans(43% of loans are performing), $525M of CRE, $127M of C&I, $111M of mortgage and Commercial OREO, and $147M of Construction and Land for a total of $1,609M in Recovery. The table below shows how they are performing. 

Doral Recovery Performing Loans

Therefore, there are at least $742M of non-performing loans in Recovery. On page 125/126 of their most recent 10K they list total non-performing assets and loans. Also on page 125 there are $111.9M of OREO NPLs. Grand total there are $894.8M of Non-performing Assets (NPA).

Clearly this is what the market is concerned about, and rightly so. But how much bad news is there?

Impact on Book Value

Book value was $835M at the end of the year. The allowance for loan and lease losses was $135.3M (pg 63 10K). Adding that non-cash figure back we get an pre-allowance BV of $1.011B. 

Let us assume that all non-performing assets are worth exactly zero. 

$1,011M - $894.8M = $116.2M (conservative) BV

That is BV to equity though and there is $352M of preferred shares out there (current liquidation value found on F-3 2012 10K). So in order for common equity to have any value the preferred needs to be made whole. Which means that Mr. Market thinks there is more than $236M ($352M-$116M) of value in those non-performing assets since the common shares are not a zero.

Just two weeks ago FBP announced a sale of loans to Lone Star Funds where they received 38% of their unpaid balance. This was for commercial and construction loans. Below I've shown a brief recovery analysis for Doral's NPA. 

Currently the common is $0.81/share, which implies a market cap of  $104M (128.44 shares outstanding). So Mr. Market believes that those loans will be able to recover $340, or 38%, of the NPA balance ($236M of preferred liquidation to make up and then $104M of common equity).

To me that says the market is pricing this well on the equity side and poorly on the side of the preferred, which are all trading below liquidation value. Next steps include understanding the preferred structure and determining a fair value for Good Bank Vs. Bad Bank.

Miscellaneous Thoughts

-Out of their $4.56B of deposits $2.12B are brokered deposits. I'm not a fan of it being this high.

Yellow Media (TSE:Y) Update

I believe buying Yellow Media(Y), either in the common shares or warrants, is an attractive investment today. Although the company was written up before, I thought I would expand my commentary.

The company has completed their recapitalization. Debt maturity was extended to 2018 and total debt was reduced by 54%. This will result in $45M less interest paid each year. The company is still generating significant free cash flow and even though the main business is dying there may be an overreaction by Mr. Market.

Effects of the Recapitalization

Overall the recap lowered debt by $1.5 billion. The company now has $800M (9.25%) senior secured notes and $107.5M of senior convertibles (8% per year or PIK 12%). All together they will pay $82.6M in interest per year.

Interest expense should drop though because the company has forced debt repayment. As mentioned in their filings, there is a bi-annual cash sweep that will be used to pay down debt. The minimum payment is $100M in 2013, $75M in 2014, and  $50M in 2015 for a minimum payment of $225M over the next three years in some fashion. So it should look something like this:

Interest expense is simply for senior notes. Total interest expense would add back $8.6M each year for the converts.

According to the covenants, this minimum will get paid as long as there's at least $75M in cash on the books. At the end of Q4 2012 they had $106.8M of cash on their books.

It has been mentioned twice (covenants and in the Q3 2012 Call) that there is a 75% excess cash sweep. So the real question is how much cash can the business generate?

Business Analysis

The business is divided into two segments, Print and Online. Obviously Print is not doing so well and is seeing double digit declines on an annual basis. It's tough to peg a firm number on decline rate. I'll try to estimate 2013 free cash flows.

1. In 2012 online revenues were $367.3M, up from $346.1M in 2011 or a 6% increase. Management has guided for growth of roughly 11% per year. It seems reasonable to conclude that with increased focus on the business the company can grow online revenues at least 4% and perhaps 11%.

Scenario 1(low): Revenue in this segment grows 4%. $367M*1.04 = $381.9M
Scenario 2(high): Revenue in this segment grows 11%. $367M*1.11 = $407.3M

2. Print. Ah print. This segment was declined considerably. In 2010 the print segment was doing $1,184M in revenue and it dropped to $740.7M of revenue in 2012. That's a drop of roughly 20% per year. Year over year I calculate that print dropped 24.5%(2011 had print revenues of $982M, this declined $241.3M). As another reference point, a decline of 20% per year is also what DEXO and SPMD forecast (Slide 13).

Scenario 1: Print declines by 35% next year(40% higher than this years decline): $740.7M *65% = $481.5M
Scenario 2: Print declines the same as it did this year (~25%) in the past two years. $740.7M*75%= $555.5M

3. Print revenues are expected to be 50% of total revenues by 2014, according to the Q2 2012 conference call. EBITDA margins are right around 50% and management expects this to go down into the 40's as they transition to online but they do not give a bottom figure. In the 2011 Annual Report (pg 29) Y states "most of our new online placement products contribute margins similar to those of our print products in our local markets."

I think EBITDA will go down but end up being somewhere between 40%-50%. In 2010 and 2009 online revenues were about 30% of revenues and EBITDA was over 54%. It seems reasonable that EBITDA margins will not drop much lower than 40%.

Scenario 1: EBITDA margins plummet to 40%
Scenario 2: EBITDA margins only drop 2% from 2012's average of 51% and end up being 49%.

Therefore in those two scenarios EBITDA will be...

Scenario 1: $381.9M + $481.5M = $863.4M*40% = $345.3M
Scenario 2: $407.3M + $555.5M = $962.8M*49% = $471.7M

(Both of these revenue and EBITDA calculations are below 2013 consensus. My hope is to come up with an independent assessment)

I think EBITDA will be between $345M-$471M. This is compared to a company that has $106M of cash and we know has $800M of long term debt and $87M of outstanding debentures. Enterprise value (assuming a market cap of ~$200M) is right around $1.0B. This implies a forward EV/EBITDA multiple of 2.8X-2.0X.

CapEx was $42.5M for 2012, and $68.8M for 2011.In the Supplemental Disclosure management breaks down CapEx. If we believe that 2012 is accurate due to the closure of Canpages, than CapEx could be around $45M in 2013(rounding up).

Interest is straight forward. They will pay up to $74M on the senior notes per year and $8.6M on the convertibles. Therefore Interest is at most $82.6M and will be less depending on the amount of debt paid off.

Taxes were guided to be $60M in 2013 and $80M in 2014 in the Q4 Supplementary Disclosure.

So cash available to pay down debt is:

Scenario 1: $345.3M-$45M-$82.6M-$60M = $157.7M

Scenario 2: $471.7M-$45M-$82.6M-$60M = $284.1M

75% of the excess cash is well above the minimum $100M required to pay off. Based on Scenario 1, I estimate that by Sept 2013(the second date of debt repayment) total LT debt should be less than $700M, reducing interest expense by $9M per year.

It's cheap, but so what?

The main reason one avoids a dying business is a lack of flexibility and inevitable squandering of capital by management to pursue "growth opportunities." The later is not as much of an issue because the new covenants force management to pay down debt and prevent management from taking on new debt. This should help prevent any large acquisitions. Good thing, if we use the Canpages acquisition as a template, management has proven to be poor capital allocators.

Discussions with IR indicate that there is more flexibility than one would think. Yellow Media does not own printing presses nor is it bound to them (see DEXO). Therefore if a business segment (say Montreal Yellow Pages print distribution) becomes unprofitable, management can shut it down and focus on segments that are still making money.

While there will be a slight lag (and thus a slight drop in EBITDA margins), management has shuttered unprofitable segments. I think the proof of this can be seen in the lower decline in EBITDA margins compared to print revenue declines. 

Downside

It would be sloppy to not address the potential downside here. I think the easiest way to imagine downside is to send the print business to zero and let online growth simply stay the same. I'll have to make a few vague assumptions here but my point doesn't change too much.

If print goes zero and online revenues stay the same, the result is revenues will be ~$360M. Management has told me there are few hard fixed costs. So I will assume that EBITDA margins come in at 40%. Even that is draconian compared to margins that have largely stayed the same.

So EBITDA is $360M*40% = $144M.

Interest would be $74M because the Senior Convertibles have a PIK toggle. If the print business goes to zero I'm willing to bet management would "toggle on."

CapEx would probably be cut to only "Sustaining Capital Expenditures" of ~$20M (this is just the annualized rate of sustaining Capital Expenditures on page 4 of the Supplementary Disclosure for Q3 2012).

So earnings before taxes would be $144M-$17.5M-$74M = $52.5M.  I can't imagine that much of any taxes would be paid. Either way it doesn't matter.

If this happens in the next three years they most likely default because they can't pay the mandatory minimum payments of $100M, $75M, and possibly $50M in 2013, 2014, 2015 respectively. Remember, they need to keep a minimum of $75M of cash in the bank. They've got $106M right now. So if print goes to zero TODAY they may survive for one year, but probably not two, and definitely not three.

Conclusion

It seems unlikely that the print business will go to zero over the next 3-12 months. Given the large number of subscribers (309,000) it's likely that the current rate of attrition can be extrapolated forward. I can only base this on what has happened the past couple of years and what similar companies (DEXO/SPMD) are predicting. Businesses can and often do fail faster than expected.

The million dollar question is: Will online revenues grow enough to transform a dying business with a small online segment into an online advertiser with a small dying print segment? I believe Q4 showed that print is going to die a slow death, one that hopefully can be milked. The company deserves a discount because cash flows may be squandered. At this price my models and research lead me to believe that Yellow Media is very undervalued.

I've also started to dig into DEXO/SPMD. The new company could offer an interesting hedge and/or investment I hope to dig deeper into the newly combined company over the next couple of months.

Blyth BTH

I'm sure many people heard about Bill Ackman's short thesis on HLF. If you haven't, do yourself a favor and check it out. It was phenomenal. I was mesmerized for the entire presentation and what was great was that all his research could have been accomplished by anyone will to work.

Time will tell if he is correct. Ackman, for all his glory, bets big and has failed even bigger in the past. I have zero intention of shorting HLF but I'm enjoying the discussion over the investment. I've examined MLM companies in the past and thought I'd write out a few quick thoughts on Blyth (BTH).

Background

I first discovered the MLM side of BTH at Roddy Boyd's newest webpage Southern Investigative Reporting Foundation(SIRF). I've always respected Boyd and thought his book on AIG was great.

Anyways, SIRF discussed the incredible growth of BTH, a story I won't rehash. There's plenty of internal dealings between ViSalus (the MLM group) and BTH. ViSalus also has it's fair share of odd insider activities. (Their white papers are literally about hearing loss! There's nothing to do with weight loss!) What I think makes BTH interesting is potential overlaps between BTH and HLF stories.

Similarities

1. Incentive to Recruit: On slides 246 and 247 of Ackman's presentation he shows the incentives that exist for promoters at Avon and HLF. The point that I thought was most informative is that Avon only pays you for three levels in a descending manner. Thus, there is no incentive to recruit and recruit.

Some MLMs do not have those limits, thus the incentive is to recruit and not sell. The compensation for ViSalus is designed to recruit very aggressively. If you don't believe me, check out their Summary.

2. Pop and Drop: Ackman shows several countries where HLF entered, saturated the market and dropped. Is ViSalus on the way there?

It is interesting to note that Q3 2012 had 110,000 promoters, down by 3,000 from the second quarter of 2012. The sustainability of the business could be shown over the next quarter or two depending on how many more promoters sign up or leave. This is simply something to watch.

ViSalus is preparing for international expansion in 2013. This could set them up for continued expansion and revenue growth. This too could be a similarity to HLF. 

3. Some similar faces at the top: The Chief Technology Officer and President of Visalus both hail from Herbalife.

Finally, some of the top distributors currently at ViSalus have worked for some....well, not so good MLM companies. I could list about a dozen people/companies that received nice cash bonuses to switch to or from Monavie, Limu, Momentus, ViSalus etc. It's seems to be a carousel.

So with those quick notes I think it's worth mentioning the other part of Blyth, the actual business.

The Decaying Core Business

Boyd hits on this in his article but I thought it was worth expanding. The core business is deteriorating and the only thing keeping BTH afloat is growth from ViSalus. The evidence is pretty clear in their filings.

Looking at last quarter we see that total sales were $269.8M. ViSalus contributed $169.9M (63%) of that. In 2011 BTH reported total revenue of $796.6M and ViSalus contributed $230.2M, meaning core BTH revenue was $566.4M. In the past nine months BTH parent revenue was $848.5M and ViSalus had $497M of revenue putting core revenue at $351.5.

Annualized this 9 month revenue figure works out to 2012 revenue of $468.6M, a one year decline of $97.8M or 17%. In 2009 BTH revenue figures came in at $913M, ViSalus represented only 2% of total sales at that point(Page 4).

So what is the Core Business worth?

To arrive at an estimation I looked back to 2011. My references were pg F-4 of ViSalus S-1A filed 09/17/12 and page 42 of BTH's 2011 10K.

I assumed that everything was consolidated (except for my calculated core profit #) because their ownership was over 57% for most of 2011 and over 71% during the end of 2011. As far as I understand everything up to operating profit is consolidated. My assumptions for interest and taxes should result in something more favorable towards BTH and thus a conservative (for bears) estimate of profit.

Core Revenue: $796.6-$230.186=$566.4M
Core Gross Profit:$473.99-$164.58M=$309.4M
Core SG&A: $424.32 - $129.35M= $294.97M
Core Operating Profit: $14.43M 
Core Interest Expense: $7.15 -$0.26M= $6.89M
Core Tax:$14.708-$9.87M= $4.83M
Core Profit: $2.71M


Even if we assume that sales and expenditures stay the same (extremely unlikely), equity for the core business isn't worth much besides residual asset value. With a current market cap around $258M (~16.6M shares outstanding after the recent buyback times $15.60/share) most of the value is being assigned to ViSalus.

Conclusion

I think that Ackman may have gotten a little ahead of himself here. He could end up correct, but to what degree he is right will dictate the success of this bet. With that said I think he makes some great points and his information is worthwhile.

I believe that ViSalus is similar to HLF and may see a pop and drop due to declining promoter enrollment, a trend that might be confirmed over the next quarter or two. This is not good for BTH due to the $229M payment in 2013(pg 11). This would wipe out all the cash on the balance sheet and leave BTH with a rapidly decaying business and an MLM arm. A significant cash crunch could occur if ViSalus doesn't continue to grow because BTH has ~$100M in bonds due in November 2013.

For now I will hold off and continue to research. Perhaps the best way to learn more is to make a visit to their Regional Event in NJ on the 19th. No position currently.

Gravity Co. LTD (GRVY)

Overview: 

Gravity is a company that creates and markets computer games. The most successful one is Ragnarok. The sequel, Ragnarok II (RO2), has been in the works for quite some time. With the company trading around a conservative liquidation value (cash+ST investments minus total liabilities) of $1.15/ADR (6.948M shares, 4 ADRs to 1 regular share) it could be an enticing buy or a value trap.

Investor Fatigue:

Just about nobody really wants to own a stock. The goal is to buy a company and sell it shortly thereafter. This universal renting of companies causes people and investors to lose patience and interest quickly. Some people are more patient than others. Value investors  tend to be more patient. For example, GRVY has been written up on the Value Investors Club four times total.   

"GRVY continues to trade well under net cash ($2.2 per share) with modestly profitable operations and a significant catalyst on the near-term horizon: launch of Ragnarok Online 2 (RO2) this summer. Company IR has now confirmed to me twice - including today - that RO2 will launch this summer (though there is some risk of further delays)."

That was in 2010. 

"But the catalyst for the stock, the release of the Ragnarok 2 (R2) multi-player online game, is now only months away."

That was in 2007. 

The statement "only months away" was true. RO2 was only about 60 months away from launch in Korea. If the analyst who wrote the article still holds shares, let me know. I'll buy you a beer for being so patient.

I'll do everyone a favor and not claim that RO2 is a catalyst. The continued deterioration of sentiment, poor management a few years back, and limited information means that GRVY often trades below cash. 

I like pessimism though. It creates something to launch off of. Five years of waiting creates a lot of pessimism, below liquidation value pessimism.

Are things really that bad?

Like I stated earlier, I have no idea when RO2 will be released across all countries. I think there have been some interesting developments though over the past 6 months. 

Q3 2012 BUSINESS UPDATES

Ragnarok Online II to be launched in two more markets in the first half of 2013

Gravity is planning to release Ragnarok Online II in North America and the Philippines in the first half of 2013 after its launch in Singapore and Malaysia in December 2012.

Steal Fighter to be launched in Korea in the first quarter of 2013

Gravity will launch Steal Fighter, an action real-time strategy role playing game, in Korea in the first quarter of 2013. Gravity entered into a license agreement with L-Time Games Co., Ltd., the developer of Steal Fighter, to publish the game in Korea in April 2012 and conducted closed beta testing in September 2012. The Company intends to launch the game in the overseas markets after its launch in Korea.

Ragnarok Online – Uprising: Valkyrie to be launched in China and Taiwan

Ragnarok Online – Uprising: Valkyrie, a mobile massively multiplayer online role playing game, will be released in China and Taiwan by the end of 2012. Gravity has entered into license agreements with local licensees in each market and the game will be available on iOS and Android platform. Ragnarok Online – Uprising: Valkyrie hits more than 600,000 cumulative downloads in Korea since its launch in May 2012.

Q2 2012 BUSINESS UPDATES 

Ragnarok Online to be launched in Singapore and Malaysia in the fourth quarter of 2012

Singapore and Malaysia are expected to be the first overseas markets where Ragnarok Online is to be released. 

The Company and AsiaSoft Online Pte. Ltd., the licensee of Ragnarok Online II in Singapore and Malaysia, have agreed to commercially offer the game in these markets in the fourth quarter of 2012.
 

Mr. Hyun Chul Park, CEO of Gravity said, “The performance of Ragnarok Online in Korea is below our expectations. However, I believe that we have overcome most of the technical problems in the early stages and that we are ready to release the game in the overseas markets where the game is eagerly anticipated.”
 

The service language of Ragnarok Online in Singapore and Malaysia will be English. The Company is also planning to launch the English version of the game in some other markets in the near future after localizing the content to tailor the game to local cultural preferences of each market.

Gravity strengthening its presence in the mobile game industry

Gravity has been enhancing its mobile game lineup by releasing more smartphone games with up-to-date technology, based on its flagship title Ragnarok Online. In particular, Ragnarok Online – Uprising: Valkyrie, a mobile massively multiplayer online role playing game for iOS and Android released in Korea is surging in popularity with more than 430,000 cumulative downloads in less than three months since its launch in May 2012. Ragnarok Online – Uprising: Valkyrie is a cross-platform game which allows users to play the game on one server regardless of their operating system.
 

The Company intends to release Ragnarok Online - Uprising: Valkyrie in other markets, such as China and Taiwan, in 2012 and more other smartphone games will be available later in 2012."

Okay, so in Q2 they said that RO2 would be launched with AsiaSoft in Singapore and Malaysia by Q4 2012. 

In Q3 they updated that the launch would take place in December in Singapore and Malaysia. 

Well on December 7, 2012 AsiaSoft is unveiling their next blockbuster free-to-play MMORPG. Looking through all AsiaSoft's nine other MMORPG titles it seems likely that release next week is Ragnarok II.  Maybe not though, we'll see.

I've seen some good reviews for ROII, and there are forums dedicated to when an English version of the mobile Ragnarok will be available. Whether or not this is indicative of future success is unknown to me.

Ragnarok Revenue Tail

Even without the release of RO2, the company is doing alright. They are similar to land line providers: dying, but very slowly. On page 8 of their most recent 20-F, the company claims that users for ROI peaked in the first quarter of 2005. They also supply a lot of information about their users. From an ARPU (Average Revenue Per User) basis, RO makes Farmville look pathetic. 


While ARPU has declined from $744 in 2009 to $313 in 2011, total Average Current Users (ACU) have increased. The largest user increases occurred in Taiwan/Hong Kong, while Japan has declined ~9-14% per year. This isn't good because the average Ragnarok user is worth about 18X more in Japan than in Taiwan. Even so, it's not as if Ragnarok revenues fell off a cliff.

Japan is very important to the long term success of GRVY and the Ragnarok franchise. In the short term Malaysia and Singapore are not that important, at least using backwards numbers. A successful launch could inspire confidence though. 

Perhaps the game is released and it does OK and they release to North America in 2013. If that happens, awesome. We've got a company that should produce positive cash flow. If not, well at least we have a lot of cash and a bunch of user who are still playing the game.

Is it Worth an Investment? 

I believe it is. The key here is that the player base is sticky and a conservative liquidation value has stayed (basically) the same (it was $1.20/ADR in 2010) for the past several years. It seems unlikely that a permanent impairment of capital could take place. 

The company as a whole has been able to expand beyond Ragnarok. Ragnarok was 88% of sales in 2005 and at the end of 2011 only made up 66% of sales. The company saw overall sales increase by 7% for the same period.

It could very well be a value trap and opportunity cost is real. Right now though a company that is trading for its liquidation value, still generating cash (admittedly from an attriting business) and someday may deliver on it's promises seems like a safe bet. I believe this is an asset play for now. If RO2 (or other games) get released more accurate valuations/exit price can be determined. As always, do your own research and come to your own conclusions. Long GRVY.

EVI EnviroStar

This will be a brief post as the story is simple and the investment has largely played out.

I've followed EVI for a couple of quarters but never purchased shares. They had a decent(profitable) business, large insider ownership, and good asset protection. I shoulda, woulda, and coulda bought when the company was trading below $1.30/share, but I didn't. Instead I waited for them to offer a special dividend of $0.60/share(not on purpose). Here's my thought process, all figures are from their respective 10Q.

As of 9/30/2012 there were 7.033M shares outstanding.  They had $10.397M of cash on the books with customer deposits of $4.997M. Net cash therefore is $5.4M or $0.76/share. They will pay out $0.60/share, or $4.2M as a special dividend in December.

Right now they have a tangible book value of $8.387M, paying out the dividend will reduce that to $4.16M, most of it will be working capital. 

So what's a fair value?

They have a four year average of generating $0.58M of free cash flow (net income plus D&A plus non-cash items minus CapEx). Slap a 10X multiple (arbitrary choice) on that and the operating business is worth between $5-$6M, or $0.71-$0.85/share. Sprinkle in BV of $0.59/share ($4.16M of post-dividend BV) and you get a post-dividend value of $1.30-$1.44/share.

With EVI currently at  $1.95, the post dividend share price should be $1.35, meaning we're in fairly valued territory now.

Is there more upside?

Potentially, yes. Backlog has increased to "historic levels" this quarter and I would be willing to bet owner-operators like the Steiner family could allocate capital efficiently. If the price of the shares pops again, I will likely be a seller. Should we hit my initial buy prices in the low $1.60's I would be willing to buy more.

This could be interesting to revisit post-dividend in case the market over-corrects to the downside. Long EVI

ADES Update

Charlie Munger has said that if an investor can't stomach a 50% loss they shouldn't be investing. I'm about half-way there with ADES and Munger's pain threshold. I thought now would be a good time to review the investment and determine future actions. In the efforts of full disclosure, funds I manage are long ADES. I have not backed the truck up though.

What's happened?

Well not much and that is the problem/reason. I think investors were expected a quick acceleration of profits. People are not seeing results and are clearly frustrated. I must admit that I thought things would be moving along faster as well.

Michael Durham highlighted this frustration in the Q3 call:

"But just the optics if you don't look beyond initial quarter what you see is that $3 a ton expense that leads to significant loss this year even though that is creating a $7.57 per ton cash benefit in the future. That doesn't show on this quarter. So if you look at an investor who is only looking at the headline they're going to miss that. So, I think until we get additional monetizations and you see that slip from the big expense to the big segment income and then an earnings the investment community is not going to understand the story."

The key point of frustration came with the company announced results this past quarter and once again it lost money. They failed to monetize two of their plants and several other plants are taking longer than expected. This was seen as a strike against management, and rightfully so. Management has promised to deliver for several quarters now.

The story is still confusing and management is losing credibility. If you listen to the Q3 conference call it's clear that several of the analysts asking questions are confused. And not just about simple things, but about the entire structure of ADES and Clean Coal Solutions(CCS).

Is Mr. Market right?

An investment in ADES is not going to be based on BV, safety of assets or something typical, which I think makes these issues all the more difficult to weather. Is the sell-off due to frustration and only a temporary hiccup, or is the business permanently impaired?

Based on the 12 plants that I have been able to track down and the numbers I have backed into, it doesn't matter if the company gets their RC facilities up today or in 24 months. A company that has an earnings yield of 25-60% is cheap with even the greatest discount over a two year period. There has been no change in the overall numbers, simply the time it will happen. Sixty million tons of RC coal should be processed and management is hunting for larger plants to process even more. So if they fail at 1/2 their plants they'll still process 30M tons. At $1.60/ton flowing through to ADES the company will still see $48M of EBIT.

This assumes that the entire Emissions Control business does nothing. Which is unlikely, they have >$100M of bids out there and were recently awarded a $14M contract for DSI systems and expect to announce several longer term ACI contracts soon.

Yes, coal is terrible and Obama is the coal Antichrist, but 42% of electricity generated in the US depends on it. Hurricane Sandy taught everyone on the East Coast just how valuable base load power is. It's not going away.

So right now this seems to be a time issue, and if the plants are monetized in the next couple of years it really isn't a big deal. The question is, how do we handicap the likelihood (or lack thereof) of monetization?

I don't have an answer for that question. It's a difficult one to answer but I can rely on some of my research to back my belief that monetization of RC facilities will occur.

We learned that the two plants that were supposed to be monetized by now, are not. These plants are actually costing CCS ~$3/ton in operating expenses. If they monetize them that's $18M of cash going into CCS(Q3 '12 Call). So that's the basic math there, approximately $7/ton difference between self-monetizing plants, and getting an outside monetizer(CCS sees over $3/ton go to them instead of booking a tax credit and a operating losses).

So why didn't Goldman or the other partner become the monetizer? We know that GS was expected to monetize these two plants. How?

"In October 2012, GS determined that it would not pursue leases on two particular RC facilities on which it had paid deposits totaling $4.7 million and concurrently gave notice for the return of the related deposits. "  pg 24 10Q Q3 2012

GS wants their money back, right?

"While, as previously noted, GS has given notice for the return of deposits in the amount of $4.7 million, which we are obligated to return by January 30, 2013, we anticipate that this amount may be offset by deposits for additional RC facilities that we expect to receive from GS in the near future." pg 33 10Q Q3 2012(emphasis added)

GS, a 15% owner in the CCS JV, decided not to pursue two facilities. Facilities which only add up to about 2-3 million tons of coal per year(per ADES management on the Q3 call). We know that CCS is pursuing gulf coast lignite (and pulverized) coal burning facilities that consume up to 8M tons of coal per year. Me thinks that GS is waiting for a bigger and better plant.

Another problem is getting a Private Letter Ruling(PLR). I wanted to figure out how much of a hassle these are so I chatted with a gentleman who has approved numerous Section 29 PLRs and at least five (that I was able to find) Section 45 refined coal PLRs.

"We aren't ruling on who benefits. The only question is does it qualify as refined coal?" -PLR reviewer IRS.

The reviewer wouldn't go into great detail but it literally sounded as simple as this: if the process qualifies as refined coal then the PLR will be granted. This has been done already at multiple plants with Arthur Gallagher/Chem-Mod and CCS.

We know that at least 14 plants have RC facilities built out by Helmkamp. I inquired about a facilities operator job at a PRB coal plant in North Dakota. Although I didn't get the job, I can confirm that there are real people on the phones interviewing people. Several environmental directors of utilities also said it works, they like it, and will keep on using it. These things indicate to me that all the facilities are real, working, and actually staffed.

Bottom Line


This looks like a "shoot first, ask questions later" reaction. Listening to the call I was confused too, mostly from the poor questions. It sounded like people have no idea what ADES does as a company. I was surprised that someone asked what kind of technology M-45 uses.With all that said, I also think management has done a poor job explaining how it all works to the community and tends to tell confusing numbers that you have to really dig into.

Overall, the call led me to believe that there are two inefficiencies here. The first is that people don't understand the technology and the structure of the company. That, in turn, leads to the second inefficiency. When things don't perform as expected (i.e. immediately when management says so) the only answer is to get rid of the "failure." I personally don't believe we have to believe in management to see success in this investment. All the wheels are in motion and the success of the projects are not dependent on management.

I think all signs point to good things, if the monetizations occur. I see no reason why they won't occur. Yes, it's taking longer than expected. That's what happens when investment bankers and utilities get together and play Let's Make a Deal. I believe the delay is ultimately for the better though. I believe that GS did not monetize two plants due to a lack of belief or failure, I believe they wanted to be part of better plants with better operating costs. Over the next quarter or two we will see if my belief is correct.

Of course, I could be missing something as well. It is obvious that management was overly optimistic but if the RC facilities aren't monetized the cash flows will never be realized. I have found no information to indicate that the eventual monetization won't occur. For me, this is about patience and reliance on my multiple sources. Long ADES and hoping for continued volatility.