Tii Network Technologies (TIII) is a small communications company that accepted an offer of $33 m from Kelta Inc on Monday. This offer values company’s shares at $2.15/share which is a 48% premium to the stock’s closing price on Friday.

Based on the assets, I feel that this acquisition is a good price for Kelta to pay, and Tii could have negotiated a better deal. However, the going forward revenue outlook for TIII is a bit murky and no doubt that has played on the management’s mind during the negotiations. Tii is also recovering from a past acquisition that has failed to live up to the promise. Kelta manufactures products for Tii on contract, so they are acquiring a complementary business. The resulting margin expansion creates synergies for the acquirer.

The acquisition is expected to close in Q3.

I have held TIII in the VSG portfolio for a long while, originally acquiring shares in 2009 at an average cost of $1.18/share. Over the years, I have sold a part of my holdings in a few different transactions, ranging from $1.7/share to $3+/share. I will be exiting the rest of my position in this stock this week.

There are a few more companies in my portfolio that are ripe for acquisitions. They are severely undervalued, and management is either looking or are highly motivated to sell the company for various reasons. Try the Premium service to find out more.

Credit crisis, mortgage meltdown, irresponsible risk taking and leverage, record bonuses and bailouts. Fast forward to today, and we have JPM with their “we were stupid” moment.

We all know what the problem is. Or do we? The large bonuses give the traders every incentive to load up on leverage and risk. Most of the time, these traders do not even know all the risks they are taking with their “synthetic” positions. But they do it anyhow.

Why? Is it because they are looking after the interests of their shareholders? Of course not.

What about the ever rising executive compensation? We often hear about the shareholder outrage, but time and time again, these proposals are simply rubber stamped at the shareholder meetings. What gives?

Theoretically, the shareholders own the company and have the power to influence corporate practices through their votes. In reality, majority of the shareholders are index funds and other large mutual funds, and they could care less about corporate responsibility.

Mutual funds have a fiduciary responsibility to vote with their shareholders

But mostly they don’t.

Reuters ran a good piece on mutual fund proxy votes last year and they found that for the votes cast between Jul 2009 and Jun 2010, the 26 largest mutual funds in the country supported an average of 80% of the executive pay proposals initiated by the management. Most of these proposals, you guessed it, were aimed at increasing the executive pay. On the other hand, these funds supported less than half of the proposals initiated by the shareholders that were aimed at gaining more investor input on the pay for top management.

They concluded one of the reasons this happens is that these fund companies have mutual funds to sell through corporate 401K programs and they do not want to ruffle feathers.

A cynical point of view? May be not.

I would also argue that for a fund that tracks an index, and aims to keep its expenses as low as possible, they probably do not consider proxy voting as one of their key fiduciary responsibility. After all, their shareholders invest in these funds to track an index, and are less worried about which companies make up the index and how they are governed. This is perhaps even more true for ETFs.

According to the 2012 Investment Companies Handbook, US investment companies (including Mutual Funds, ETFs, CEFs and UITs) own 29% of all the corporate equity with the rest owned by Hedge Funds and retail investors. This is a lot of shareholder influence that if not properly directed goes to waste.

What can be done about it?

A few things I will point out and there are many more that you can think of and add. My main goal with this article is to raise awareness and create conversations around this topic. Ultimately, this has to come from the shareholders like you and me – not the government or the credit agencies or any other third party that we are so fond of laying the blame on.

1. If you invest in mutual funds, choose funds that take activist approach to shareholder issues. One good site to find this is proxydemocracy.org. This is a non-profit organization that tracks how the funds vote on various shareholder proposals. For example, according to its data, you can find that the Vanguard Total Market Index Fund (VTSMX) has voted with the management on shareholder initiated proposals on executive pay 921 times while they have voted against the management on these issues only 62 times. On the other hand, Calvert Social Index Fund (CSXAX) has voted against the management 358 times and with the management 97 times on the same issues. If you are choosing between two similar funds, it is a good idea to check their voting history on behalf of the shareholders and compare them before you make your decision.
2. Even if a fund takes an activist approach to the shareholder votes, it may not necessarily be in line with the position that majority of its shareholders might take. If this is important to you, you should consider owning equities directly rather than through a fund.
3. Vote your proxies. Regardless of the size of your stake, your proxy vote is important. If majority votes their proxies, corporate governance will improve and swing the pendulum back in the shareholder’s favor
4. Finally, talk about this, create conversations, and cause debate. The dilution of shareholder influence on corporate governance is a serious issue and affects your wealth and legacy

Are you outraged? Does it bother you that banks lose billions and get bailed out by you and me while the executives take home millions in bonuses (Pay for non performance!)? Do you think there are other issues that have skewed the incentives for the managers? Do you have more ideas how this can be fixed? Please take a moment to note your thoughts in the comments below and let’s start a discussion.

For further discussion on Corporate Governance issues and initiatives please refer to CorpGov.net site.

I initially purchased UVV (Universal Corp) in the Value Stock Guide portfolio on Oct 13, 2011 at an average cost of $41.03/share and sold out of the entire position on May 10, 2012 at $45.72/share. Including commissions, the average capital gains amounted to 10.94%.

UVV has also paid $0.98/share in dividends in the interim. Including dividends, the total returns were 13.33%.

With 4.3% dividend yield and a reasonable valuation, the company remains a good stock for the long term income and capital growth. There are some headwinds for the leaf merchants such as Universal. Large tobacco buyers continue to side step the middlemen and make deals directly with the farmers. Revenues have also been affected due to the supply glut of the leaf tobacco. Although the glut will eventually work out, and the level of vertical integration is not too worrisome, the stock will likely be a slow grower for the near future.

UVV was one of the key stocks in the portfolio helping keep the portfolio volatility down. The stock was sold to make way for a new acquisition that has since been completed. Details of the new stock purchase has been sent to the premium subscribers.

It is 2:00 am Eastern time as I write this and about 9 hours past since the JPM conference call. The bank with the self professed “fortress” balance sheet fessed up to a bit of binging on the synthetic credit derivatives. $2 B in losses have been realized in April and Dimon expects another $1 B or so to come.

Ironically, these losses have occurred in its Chief Investment Office, which is in charge of managing risks.

The thing is, the ultimate damage in terms of losses is pretty much up for speculation. It was reported last month that “London Whale” trader Bruno Iksil has been making bets so large that it might be impossible for the firm to unwind its positions without roiling the markets and his trades were regularly moving the prices in that market. Now that this is out in the open, it will be significantly more difficult to unwind these positions. Other traders scent an opportunity and know what the company has to do. It is not going to be a fair trade.

All this of course is a result of fairly recent activities in the firm. Nothing here indicates that the company has been hiding mortgage related losses from the housing bust. But it does underscore the point that the banks of today are not the high yielding coupon stalwarts of the yesteryears.

Here is the thing. Banks are meant to be utilities for the economy. That is their chief goal. They are not supposed to take undue risks and then find ways to hedge these risks that they are taking. Every bank in this country (and globally) believes that they are so smart, they can find ways to get rid of the risk and keep the rewards, but they all forget that in the overall grand scheme of things, the risk and rewards go hand in hand. In a game of musical chairs, there are always many losers.

The problem with derivatives and synthetics is that after a while and beyond a certain level of abstraction, all this makes less and less real sense to the people making these decisions and they have to trust their models and computers. As a result, the perspective on risk is blurred and wrong decisions are more likely. And when the bets become large, it starts impacting not only the portfolio in question, but even other firms and the broader economy. Banking and trading functions need to be separated again. Until this happens, financials will continue to be un-analyzable and therefore remain a sector I will continue to avoid.

Now the Wall Street’s case against the Volker rule is weakened and the proprietary trading ban will crimp the profits too.

Consider Bank of America (BAC). Dick Bove has pounded the table and Buffett seems to believe that the company is investment worthy. The fact is, we still can’t be confident that its balance sheet, as it is reported, accurately represents the facts with any level of confidence. As far as I am concerned, financials are still to be avoided. I am open to taking risks as long as I understand them and the rewards are greater than the risk taken. When the risks are not known, I avoid the investment.

Have you ever looked at a product and wondered how in the world it makes the seller any money? Well, the Slate Card from Chase (JPM) is one of those products. It offers a 0% introductory APR on both purchases and balance transfers for 15 months and charges neither a fee for transferring a balance from another credit card, nor an annual fee. In other words, Chase incurs a significant cost in marketing this card, servicing its customers, and funding their loans without seeing anything in return for more than a year, at the very least. So, what does such a strategy tell us as investors?

Well, it would seem to indicate one of two things: 1) That the nation’s largest bank, based on outstanding balances, is desperate for the appearance of growth; or 2) That Chase is rolling the dice on a boom-or-bust revenue stream. Regardless of which theory you believe to be correct, from an investor standpoint, one thing is clear: Chase is having trouble expanding its credit card business, and that is worrisome.

Feigning Growth?

As we all know, it is common for investors to track outstanding credit card balances and credit card default rates in the course of evaluating banks. Doing so not only enables us to get a sense of whether a given bank’s credit card division is expanding or not, but also to gauge its sophistication. You see, a bank’s default rate speaks to the accuracy of its underwriting, which is how well it recognizes and accounts for risk. The bank with the most sophisticated underwriting is therefore able to make more money than its competitors while taking the same risks.

By adding a whole bunch of “unprofitable” credit card accounts, however, Chase is artificially increasing outstanding balances, decreasing default rates, and therefore making itself seem more appealing to investors in the short term than it truly is.

Risky Cross-Selling?

It’s conceivable that Chase is merely dangling its catchy free balance transfer credit card offer in front of consumers in the hopes that it is the carrot that will lure a multitude of cash-cow customers for its profitable suite of bank accounts and loan offerings. In addition, Chase may hope that its credit cards may eventually turn profitable by having a significant number of Slate cardholders stick around for more than 15 months, which frankly is not likely.

I say this because we routinely see consumers whose whole strategy is to move from one 0% balance transfer credit card to the next. What’s more, while switching bank accounts can be a burden given the painstaking logistics that come with altering automatic monthly withdrawals and the like, switching credit cards isn’t all that tough.

The point is, while we all know that the cost of funds is almost zero for a bank of Chase’s size, the cost of procuring new customers and providing them with customer service is significant and cannot be ignored. Is it possible to make it back via cross-selling? Of course. Is it likely? Of course not.

Conclusion

Ultimately, neither of the explanations for Chase’s behavior that are available to us as investors are encouraging. Instead of trying to offer cards that lack any clear revenue streams, Chase should focus on resurrecting the profitable sub-prime credit card business that it inherited from Washington Mutual. You see, the sub-prime space has always been highly lucrative, and it’s expected to become even more so due to lack of competition borne from the Capital One’s acquisition of HSBC credit card business. Bottom line, investors should keep a wary eye on Chase’s credit card business in the coming weeks and months.

Editor’s Note: According to the Author,

Chase’s credit card business accounts for more than 10% of their non-interest revenue. This is significant enough for investors to pay attention.

About the Author: Odysseas Papadimitriou is a former senior director at Capital One and is currently the CEO of Card Hub, a website that helps consumers compare credit cards. Views expressed in this article are his own.

As long as they are not given away.

Buffett seems to like the newspapers, according to his take on the industry in the Berkshire Hathaway (BRKA) shareholder meeting today. His purchase of Omaha World-Herald last year has been working out well and he is thinking of buying more. The recent trend of newspapers erecting paywall to monetize their online content is definitely in the right direction. A curious side effect of the pay walls is that New York Times has seen its daily print circulation increase. Interestingly, the long time Buffett holding, Washington Post, is a hold out on walling off its online content.

Earlier this year I changed my thinking on the “decline of newspapers” and recommended a media company for purchase to the premium members. It is now part of the VSG portfolio and I expect the company to generate significant returns for the shareholders over the period of next 2-3 years. Media companies have long been thought of as value traps, but “value trap”ism is not a chronic condition and can be cured by some structural changes in the industry, which is now happening.

The following is a list of some of the other insights from the meeting:

• Amazon (AMZN) is hugely disruptive to the retailers. I briefly touched on this in my post on competitive advantages and building a moat
• They believe that Google and Apple (AAPL) could be worth a lot more in 10 years time, but they would still not buy it. They would not short them either
• Berkshire will not pay a dividend
• Takeover of Berkshire Hathaway is extremely unlikely and Buffett remarked that even after he is long gone, his estate will continue to hold a large stake in Berkshire Hathaway
• Munger thinks a Value Added Tax is eventually coming and probably should

Is Florida Real Estate Market Rebounding?

Two of the savviest investors believe so.  Berkadia is a joint venture between Berkshire Hathaway and Leucadia National (LUK) formed to buy the mortgage lending business from the bankrupt Capmark Financial Group in 2009. In the 3 year since, Berkadia has grown to become the 3rd largest commercial and multi-family mortgage servicer in the country. Recently, Berkadia is expanding in Florida by buying banking assets and expanding its organization.

According to this Bloomberg report, sales of commercial properties in Florida are up 40% in the first quarter compared to last year.

This is further corroborated by the fact that one of the insurance companies we own in the Value Stock Guide portfolio has been buying up distressed commercial properties in Florida and has already seen the value of its portfolio increase significantly.

Perhaps the time for St. Joe (JOE) is finally nigh. Berkowitz has been patiently holding this stock for a long many years via Fairholme Fund and has suffered for his conviction. Time for redemption!

How is the real estate market in your neck of the woods? Did you attend Berkshire meeting? Let us know in the comments below

Reasonable valuation, matched with good growth used to be all the rage a few years ago. GARP, as this was commonly known, meant looking for growth at reasonable prices. This is still a great strategy and it makes sense to try and find these kind of stocks in the small cap asset class. After all, smaller stocks still have room to grow.

The following stocks were selected primarily for PEG ratio under 1, but also for a reasonable PE and Price to Book ratios. Additionally, we looked for the past 5 years of EPS growth in the top 40% of their respective industries. Even if the growth slows in the subsequent years, reasonable valuations should provide good downside risk protection.

1. Omega Protein Corp (OME Profile/Quotes): This company processes and sales fish meal, oil and other soluble products derived from menhaden, a herring like species of fish. The products are sold as feed ingredients to various pets and livestock meal products, as well as fertilizers. The stock has a PE of 7.7 and trades at 0.7 times the book value. 5 yr EPS growth has averaged 57%.

2. DFC Global Corp (DLLR Profile/Quotes): DFC is a check cashing and other banking service provider to the consumers who typically do not or cannot be served through regular banks. Yep, they have been doing great business through the great recession. 10.2 PE ratio looks very reasonable and for a service company, a 1.46 price to book multiple is not bad either. The company has grown its EPS at around 46% in the last 5 years. It is any one’s guess how long the growth will last, but the stock can certainly be a good hedge if you worry about economic conditions worsening.

3. Orbital Sciences Corp. (ORB Profile/Quotes): A company full of rocket scientists . They make small rockets and space systems for government, civilian and commercial uses. The stock has traded as high as $45/share in its hey day, but since has been earth bound. It can be bought today at 11 times earnings and 1.08 times book. The company has been growing its EPS at the rate of 15% and the pending launch of Antares can give its earnings additional boost in the years to come, so this is definitely worth to keep an eye on.

4. Kadant Inc (KAI Profile/Quotes): Kadant develops, makes and sells processing equipment used in the paper making, processing and recycling industries. With a PEG just under 1, and a PE ratio of 8, the stock is attractive, given that the company has delivered an EPS growth rate of 16% in the last 5 years. The company also has a fairly conservative balance sheet with significant cash.

These stocks command a market valuation between $131 million to $700 million. Even though they are small caps, these are reasonably well established companies with great market position.

Consider these stocks in greater detail to see if they meet your investment criteria and let me know in the comments below if you have a question or would like to add to this list.

These screens do not constitute investment recommendations. They are just a great starting place for further research.

I have been asked a few times why I do not invest in commodities. As a value investor, it is really hard to wrap my mind around the notion that commodities might be considered an investment. Here is why.

Commodities have no intrinsic value.

They have price. But the price is not the same as the intrinsic value.

This price is discovered in the market as the intersection of the demand and supply curves. “Investing” in the future movement of price is speculation. True investing lies in the potential that the intrinsic value of the underlying business will be enhanced. The price of the security eventually converges to the intrinsic value of the business. This is how investors can partake in the shareholder value that the business creates.

Reproducibility and Repeatability

In the latest shareholder missive, Warren Buffett talks about the concept of reproducibility. A pile of gold does not create additional value over time. Whereas a farm land or a business will continue to create value year after year with additional production. Investments are those that keep generating new value.

But how is this value created? Aren’t commodities produced by real businesses?

It is always a human endeavor. Designing, organizing, planning, manufacturing, servicing, scrapping, tilling, mining, distributing, etc are some of the ways the value is created or added to make a product. As you trace the lifecycle of production of any given product, you will see many different steps. There are also many different entities of stake holders at each step. These may be businesses or individuals. They all add something of the value towards making the product a reality. Each of these stakeholders are rewarded for the value they add. This is how businesses generate revenues.

When the product reaches the market, it is a commodity and has a price based on demand and supply. If the price is sufficiently higher than the input costs of the product, there are profits to be had, which are shared across the value chain of the product. Smaller the gap between the price and the cost, smaller the profits and less investment worthy are the businesses on the value chain (assuming the stock is fairly priced).

Sometimes, the gap between price and the cost is small, many times it may even be inverted. These occur in the industries where the pricing power is very low. These are your typical commodity businesses.

The trick is to find industries and businesses that throw off profits to the shareholders thereby creating shareholder value. It can happen in the commodity businesses, but only in some special scenarios where the business in question has some level of competitive advantage.

Investing in the product, or the commodity, on the other hand always leaves you at the whim and fancy of the market forces. No one has any special advantage, and ultimately it becomes a zero sum game.

A Commodity Business can be a Good Investment in Certain Cases

In many industries, scale gives certain economies that are not available to smaller players and where the barriers to entry are high enough to make new entry unprofitable. While smaller companies may have very small margins, larger producers might enjoy significant profits. Such is the case with Exxon or a Grainger. Or a South Korean or Chinese steel manufacturer might enjoy significantly lower employee costs. In other cases, branding may command a premium price, for example, for cereal manufacturers.

Any business may be a good investment if it is undervalued enough. For commodity businesses, and most businesses are commodity businesses since over time there is no competitive advantage, the undervaluation comes from the assets of the business. This is why most value investors start their analysis with the balance sheet first.

Valuing Business Assets – Are they not Commodities?

Value investors pay special attention to the tangible assets of the business. One can perhaps argue that plant, machinery, etc are all commodities because they are end products, and therefore assigning a value to them runs counter to my arguments above.

Not true.  These assets are valued, or priced, based on the utility and the return on assets they provide. Take away the utility, and a perfectly good piece of machinery is worth just the scrap value. Many times, an equipment is worth significantly more when in production, then it is in the market place.

A piece of gold, in most cases, does not provide any utility (there are some industrial uses, but by and large, gold is priced based on demand which is mostly driven by the “fear” or the “safety” factor). Same goes for oil and any other commodity.

Photo Courtesy: Alfredo-9
This post was included in the Self Directed Investing for Retirement Carnival

Westell Technologies (WSTL) designs and delivers carrier-class communications equipment used by service providers and industrial customers to meet their needs for point-of-demarcation transport and termination, digital transmission, remote monitoring, and power distribution.

The stock is currently trading at $2.34/share which puts its market value at $155.6 million.

What is interesting is the strong balance sheet that the company currently enjoys. A quick look at the following key numbers will paint the picture:

• Cash and Investments = $149.4 m
• Total Current Assets = $175.7 m
• Total Liabilities (Debt = 0) = $15.2 m
• Net Current Asset Value (NCAV) = $160.5 m

The stock is trading just below its Net Current Asset Value or NCAV.

Cash Windfall Due to Disposition of Assets

In 2011, Westell sold its Customer Networking Solutions (CNS) Division and ConferencePlus product for a pre-tax gain of $31.7 m and $32.8 m respectively. The CP sale resulted in a net cash inflow of $37.7 m and the CNS sale resulted in a net cash inflow of $36.6 m. As a result, the company is now a pure play Outside Plant Systems (OSP) provider to wireline and wireless companies such as AT&T, CenturyTel, Verizon, Qwest, etc. Its products now include Cabinets and enclosures, copper and fiber edge connection and protection, power distribution and remote monitoring, DS1, DS3, and Ethernet transmission plugs, and Custom Systems Integration services. The company is focusing on growing its wireless business with Ethernet-based cellular backhaul switches for Cellular Backhaul, Smart Grid and other integrated cabinet-based markets

Its Remaining OSP Segment is Profitable

A vast majority of net-net stocks have profitability issues, which is why they are valued so low in the market. For Westell though, the segment that remains is a profitable segment. In fact, OSP segment boasts of gross margins in excess of 40% compared to the CNS segment that operated at a gross margin of approximately 20%. So in essence, the company has chosen to sell off its lower margin business and focus on its higher margin business.

The OSP revenues in 2010, 2009 and 2008 were approximately 30% of the total revenues and ranged from $53 – $59 m/year. The company has not previously broken out R&D and other costs by divisions but a rough calculation estimates a forward annual eps of around $0.03 to $0.04 per share.

The selling off  of CNS and ConferencePlus cuts down the total revenues of the company by over two thirds, which means the stock is priced high compared to the earnings one can expect going forward. However, the management has significant cash on the balance sheet that it is trying to return to the share holders with share buy backs. The company is also looking for growth through organic means and through acquisitions.

How Should You Analyze the Stock

A quick way to consider the valuation of the earnings is to back out the excess cash from its Price and recalculate the P/E based on the expected EPS going forward.  I estimate that the company can, if it chooses, return $141 m or $2.13/share in cash to the shareholders (there is $7.4 m in restricted cash and about $1 m in cash that the company should maintain as part of its maintenance capital). That will leave it with an adjusted Price of $0.23/share. At a $0.03/share annual forward eps, the PE ratio is about 7.3 which indicates a fairly undervalued stock.

The strong balance sheet and share repurchases puts a floor on the stock price. The appreciation potential depends on Westell’s ability to grow its OSP business in new markets (wireless) either organically or through acquisitions as the current OSP earnings are too small to support a meaningful stock price appreciation. Until specific growth plans are developed, the stock may continue to tread water. The downside is fairly protected, so for an investor willing to invest and wait for the catalyst to arrive will be amply rewarded.

VSE Corp (VSEC) provides engineering and consulting services to the Federal government in the USA, primarily to the Department of Defense and the US Postal Service. These include maintenance of defense equipment, naval ships, logistics support, field engineering, IT support and consulting, and foreign military sales support. The company was founded in 1959 and is located in Alexandria, VA.

Why the Stock May be Attractive

The company is currently valued at $125 million in the market and the stock changes hands are about $24/share. Last year, the company delivered $3.93/share in earnings with the revenues of $618.6 million. This gives the company a trailing PE ratio of 6.08. The current expectations also peg the forward PE ratio at 5.33.

In the recent years the company has seen its revenues decline but has managed to keep its eps declines in check by improving its margins. A number of strategic acquisitions have helped the company expand its margins, while the revenue declines reflect the uncertainty inherent in Federal government business that depends on appropriations for funding.

However, it should be kept in mind that over the long term the company has done a great job of growing its revenues.

Why You may Want to be Careful

The balance sheet is not the kind that attracts a value investor. On surface, the book value is $144 m which gives the stock a price/book of 0.87. However, you will see that out of this $144 m, Goodwill and Intangibles amount to $205 million, so its Tangible Book Value is a –62m. The company also has a negligible cash on the books. A current ratio of 1.66, while not too bad, can be a stretch if they need to raise cash in a hurry. The company also loaded up on debt to fund its acquisition of Wheeler Bros Inc in June 2011 and the long term debt, due 2016, currently stands at $145 m.

Cash Flow: Since the company has pretty much zero cash on hand, it is interesting to see how the company generates and manages cash. For this reason I went back 10 years to 2002 and found the following:

• 2005 was the best year in terms of cash flow when the company added $12.6 m in cash
• This was also the best year in terms of net cash balance at $12.7 m

The company is very efficient in using up all the cash it has and it is not necessarily for the cause of paying dividends to the shareholders (current yield, 1.2%) or buying back common stock (net purchase in last 10 years = zero).

It just does not look like that this company is being managed to grow shareholder value.

Bottomline

There is a difference in growing revenues and eps versus growing shareholder value. Any business can grow in size by acquisitions and other means. However, if these acquisitions do not create additional value for the shareholders, they are meaningless from an investor’s perspective.

If you do consider investing in VSEC, make sure you pay attention to its balance sheet and review if the Wheeler Bros acquisition will generate enough EBIT to pay back the debt incurred during the acquisition by 2016. A lot will of course depend on whether you believe that the margin growth is sustainable or just temporary.

There have been reports of substantial insider purchases recently. Insider purchases are a signal, but just one of the signal. Insiders can be delusional.