Value investors know to look for cash rich companies, which are often undervalued by the market based on enterprise value (defined as market cap minus cash on hand net of debt; in other words, the "true" market value of the business in and of itself). While there are risks, a value stock can become a "value trap" with just one risky acquisition or misplaced initiative. Cash on the books can act as a floor for stock prices, offering a margin of safety for cautious investors.
One way to play cash rich companies is to sell cash secured out of the money put options on the underlying stock. The theory is that any risk to the downside in which case the put writer is delivered the stock at the option price is mitigated by the fact that the stock is delivered at a price close to the cash on books. We are then left with two options make a reasonable profit to the upside, or purchase the stock at a substantial discount to its present enterprise value.
Here are 7 companies worthy of playing this strategy. While we are obviously losing potential gains in these trades, it gives us the ability to hedge against market and sector risk. Beware, however, that these options are thinly traded, and liquidity is an issue. Be sure of your trade, because it may be too expensive to undo. And don't accept the bid; use limit orders to maximize your returns.
1. Tessera Technologies (TSRA)
Closing Price 7/15: $15.76
Cash Net of Debt (per share): $9.65
Enterprise Value (per share): $6.09
This long time value favorite is trading near 2-year lows after guiding 2nd quarter revenues downward, leading to a 9% gap down the following day. This follows similarly disappointing guidance for Q1 coming out of the company's year end results in January.
Much of the struggles (including layoffs announced in January) have come in the Imaging & Optics segment, which the company announced in April may be spun off or sold as part of a reorganization.
Despite the struggles, Tessera offers compelling value. Earnings on a trailing twelve month basis are $1.16, with FY 2011 analyst projections coming in at $1.28, according to Reuters Finance. The company has generated $70 million in free cash flow over the past 12 months, a strong performance from a company with an enterprise value in the range of $310 million.
There are a number of ways to play TSRA with put options. The January $2 put is bid at .60, offering a return of 5 percent (nearly 10 percent annualized). Our downside risk is owning TSRA with an enterprise value of about $2.25/share, or less than twice 2011 earnings (note that a loss on this trade would require a drop in enterprise value of 63 percent in just over 6 months).
Similarly, the December 13 bid at .65 offers a slightly higher return: 5.2% (12% annualized), with the downside enterprise value at $2.70. For higher risk/reward, traders can look to the January 15 put, bid at $1.50, an 11% return (about 21% annualized), with the downside at $13.50, or an enterprise value less than $4/share. If the option is exercised, we will own TSRA at 3x trailing cash flow and just over 3 times forward earnings.
2. Investment Technology Group (ITG)
Closing Price 7/15: $11.00
Cash Net of Debt (per share): $5.50*
Enterprise Value (per share): $5.50
*includes effect of purchase of Ross Smith Energy Group, which is not yet reflected in quarterly statements
ITG has plummeted to a six year low after announcing last week that it would take a goodwill impairment charge, lay off staff, and miss previous guidance for 2nd quarter earnings. As trading volumes have slumped considerably since the 2008-09 crash, ITG's revenues and profits have cratered, falling from $2.61 per share in 2008 to just 55 cents in 2010.
Yet ITG offers compelling technology, a strong client list, and, despite its struggles, strong fundamentals. Cash remains about half of market cap, despite recent acquisitions of RSEG and Majestic Research in October, both of which the company expects to boost forward earnings (the company expects 2012 earnings to rise .08 - .10 due to the Ross Smith purchase). And, despite a horrific 1st quarter, ITG still has generated one sixth of its enterprise value in free cash flow over the last twelve months. Enterprise value to earnings, even at these lows for earnings, still sits right at ten, with analysts expecting earnings growth going forward.
That said, traders looking at a short term chart may want to wait a bit before entering a position. ITG is a bit more risky than other similar plays. For a short term boost, traders can write the August 10 call, bid at 15 cents. It is only a 1.5% return, but with 30 days to expiration it offers an annualized return close to 20 percent. The October 10 is bid at .35, a 3.6% return (14% annualized), with a downside enterprise value of about $4.15, requiring a further 24% drop in enterprise value.
3. Infospace (INSP)
Closing Price 7/15: $9.35
Cash Net of Debt (per share): $6.73
Enterprise Value (per share): $2.62
Infospace offers Internet search solutions through a proprietary search engine, plus websites including dogpile.com, webcrawler.com, and mercantila.com. Earnings are flat but solid 39 cents per share on a trailing basis, with projections for .38 in 2011 and .40 in 2012, per Reuters Finance. This gives the company a rough EV earnings ratio of below 7. Cash flow numbers are even more impressive: $31 million on a trailing twelve month basis, over 30% of the company's enterprise value of about $97 million.
While Infospace may not offer great growth prospects, it has renewed deals with Google and Yahoo!, that account for much of its revenue. Management has mentioned the possibility of an acquisition to provide usage for the company's carry forward tax losses, but its patience (so far) should bode well for management's care of shareholder resources.
The January $7.50 put is currently bid at 30 cents (ask .45; last .40), which offers a 4.17% return (just less than 8% annualized). Our downside is owning INSP at $7.20, an enterprise value of 47 cents per share. (Second quarter earnings were guided strongly by the company at .04 - .07, which means the cash balance should grow between now and expiration.) While it is a small return, the stability of Infospace's earnings and the cushion from the cash balance makes this a low risk trade. Indeed, a loss on this trade would require the company's enterprise value to drop some 82 percent in 6 months!
4. Vanda Pharmaceuticals (VNDA)
Closing Price 7/15: $7.15
Cash Net of Debt (per share): $6.92
Enterprise Value (per share): $0.23
Would you like a free pharmaceutical company? Vanda Pharmaceuticals was actually profitable in 2010, thanks to a milestone payment from Novartis in conjunction with Fanapt, the company's first approved drug (used to treat schizophrenia). The company expects to swing to a loss over the next two years, as the company looks to bring tasimelteon to market. Vanda hopes the drug, targeted to treat insomnia in the blind, with possible additional usage for the broader depression market, will come up for FDA approval in the first half of 2013.
Despite the possibility of future losses, Vanda remains a good buy for value investors. The company is projected to lose 24 cents per share combined for the next 7 quarters, a burn rate hardly high enough to precipitate a large downward swing. A value investor may want to purchase VNDA directly, hoping to gain off a bounce from good stage III results for tasimelteon, or expanded prescriptions for Fanapt®, but given that there seem to be very few short term catalysts cash secured put(s) might be an interesting way to generate income and lower the cost basis heading into 2012.
Spreads are an issue for VNDA options, so limit orders are a must. The December 6 put, bid at .15 and last sold at .35, would be an interesting play at .30 (the current midpoint of bid/ask). This trade offers a 5.3% return (nearly 12% annualized) with a downside of owning the company well below its enterprise value, with plenty of cushion for the projected 18-month burn. The December $7 option (bid .50, last .75) offers at least a healthy 7.7% return (about 16% annualized), with a purchase price of $6.50 still offering us shares in Vanda below the value of cash on the books and the projected 2011-12 burn.
5. Cray Inc. (CRAY)
Closing Price 7/15: $6.38
Cash Net of Debt: $3.37
Enterprise Value (Per Share): $3.01
Cray, Inc. manufactures supercomputers for research, commercial and government clients. The company has earned 73 cents per share over the past twelve months, though earnings for the next two years don't look to hit that level. (Analysts surveyed by Reuters Financial see 29 and 34 cents, respectively, for 2011 and 2012.) The nature of Cray's business -- where a single transaction can account for 15% of proejcted revenue, as a pending sale currently does makes projections difficult. The company has only said that it expects to be profitable this year.
With the cash cushion, Cray looks to be an interesting play. Its January 5 option (put bid at .40; last sale .57) offers a delivery price of $4.60, a price the company hasn't hit since May 2009, coming out of the market crash. There, Cray is priced at an enterprise value of under four times expected forward earnings, with that enterprise value 59% off its current levels. On the upside, at the bid of .40, is a 8.7% gain (16% annualized), with a successful limit order only adding to the returns.
6. Tellabs Inc. (TLAB)
Closing Price 7/15: $4.12
Cash Net of Debt: $3.19
Enterprise Value (Per Share): $0.93
Tellabs provides network equipment to telecommunications providers worldwide. Networking equipment is a competitive industry, as witnessed by the struggles of industry leader Cisco, and Tellabs has struggled against its headwinds as well. Revenues have declined slightly, and a first-quarter loss disappointed investors, (Marketwatch's Chuck Jaffe lays out the full bear case here).
In addition, contract losses from major client AT&T have knocked down recent revenues. Even Tellabs CEO Rob Pullen admitted in the Q4 conference call that the company is in transition, as noted by networkworld.com:
So where is Tellabs today? We are managing a core business in secular decline," Pullen said. "That's also as we nurture the growth of new and more global business...We could be solidly profitable today if we have reduced our investment in growth technology and growth markets, but that's not the right thing to do for the long term.
That said, Tellabs retains a strong balance sheet, and excellent cash flow numbers (with the exception of Q1 2011, which showed a marked decrease in working capital). Enterprise value stands at just about $340 million. Even amid struggles, that seems cheap for a company that has generated nearly that amount of free cash flow in the past nine quarters, including the difficult first quarter.
TLAB bulls can write the December $4 put, bid at 35 cents (though 200 contracts were traded Friday at .40). This trade offers a solid 9.6% return (23.6% annualized), with a downside of owning TLAB at $3.55, an enterprise value of just 36 cents a share, a 61% drop from current levels. Earnings are expected to be roughly break-even for FY11 and FY12, according to Reuters Finance, so a purchase at the delivery levels here is essentially an option on Tellabs' ability to produce a turnaround and move succesfully into the mobile internet arena.
7. Oplink Communications (OPLK)
Closing Price 7/15: $17.95
Cash Net of Debt: $9.20
Enterprise Value (Per Share): $8.75
I'm kind of cheating here, as I've already covered the bull case for Oplink a couple of weeks ago in an article titled "Using Puts to Play Oplink Communications". But a small dip in the stock price has counteracted time decay, and the option opportunities listed there are still worth considering. In particular, the January 15 call is still bid at $1.40, offering a 10.3% return (19% annualized). The downside of the trade is owning OPLK at an enterprise value of about $4.40 a share, half of its current level, and less than four times trailing earnings.