At times like this, it's critical for people to understand how the environment impacts their stocks' risk to reward ratio. This is largely a function of the company's balance sheet (net tangible assets is a decent, albeit simplistic, measure) and ability to maintain profitability.
Basically, if the company can easily cut costs in the face of a recession (i.e. lower revenue) and its net tangible assets are a high percentage of its market cap, then risk is very low.
Looking at Zhone Technologies (ZHNE), the company’s book value (a.k.a. shareholder equity) is $45.7M as of June. Meanwhile, its market cap is only $40M…so on this measure, today’s investors are paying negative $5.7M for the company.
That being said, there are some adjustments and other things (some positive and some negative) that an investor should consider:
1. Some $33M of Zhone’s book value is tied up in inventory and property / plant / equipment. I discount these items to be conservative (though sometimes, PP&E needs to be valued higher. For example, when the company has a piece of real estate whose market value is higher than its value on the balance sheet). If you look at most companies’ 10Ks, there’s a breakdown of what PP&E consists of.
In Zhone’s case, there’s nothing special, so I’m going to discount the $33M down to 22.3M. That’s an arbitrary rough-guess as to how much this stuff might fetch in liquidation. It also brings the book value down to a nice even $35M.
Thus, at a $40M market cap, investors are really paying $5M for the business.
2. The company is losing about $2M of book value per quarter. I’d like to see this turn positive, but in the meantime we have to consider that as part of the risk in this investment.
3. Zhone has competitors. Many are larger and better managed. If I was one of them, I would LOVE to acquire Zhone at these levels. If you look at the income statement, you can see that the company spends $13M on R&D, Sales & Marketing, and G&A. If I bought them out, this number would be cut in HALF almost overnight because of overlaps with my business (still pretending that I own a large Zhone competitor). Marketing? Gone. Management team? Long gone.
This would cut operating expenses down to $6.5M, which would turn Zhone’s losses into a profit about $4M per quarter.
Better yet, Zhone has a near-infinite amount of past losses, which are now tax credits on future profits. Thus, its $4M in profits would largely be untaxed. So, we would have a company generating roughly $16M in annual net income. Even if we slap a tiny P/E of 6 on that $16M, we get a $96M enterprise value. Add back the $35M book value and we get a total buyout value of $131M or $4.27 per share. That's more than triple today’s levels. If we use a “fuller” P/E of 15, we get $8.97, which is nearly seven times today’s price.
I did this math with Occam Networks as the stock plummeted into the $4 range in mid-2010. I came to a similar conclusion and backed up the truck. Shortly thereafter, Calix (NYSE:CALX) announced that it would be acquiring Occam for $7.75 per share. Common sense merged with reality and resulted in great profits for those who paid attention to its financials, instead of its dropping stock price.
Speaking of which, at this morning’s Morgan Keegan conference, Calix announced that it expects the Broadband Stimulus program to result in $100M of revenue in 2012. Clearly, the stimulus program is starting to bear fruit and Zhone is a beneficiary. In a tough economic environment, this will be an advantage that most companies won’t have working for them. That's almost guaranteed revenue.
The Bottom Line: Almost 100% of Zhone’s market cap is covered by its book value. This means that an investor’s risk is very limited. Can the stock drop another 50%? Of course. But that won’t change Zhone’s book value. If your local store started selling dollars for 50 cents, would you sell your dollars for 50-cents or would you take advantage of the sale? Personally, I love when my low-risk stocks drop by 50%. I simply double my investment. That way, if the stock just gets back to where it was, I make a huge profit.
Thus, I don’t look at the stock price as the risk. The risk is the value of the company. From that perspective, there is only $5M of downside (16-cents), plus the $2M per quarter that the company is currently burning (6.5 cents). That takes care of the “risk” side of the equation.
On the “reward” side, this stock has a 52-week high of $3.24 and a 5-year high over $8. These numbers are pretty close to my buyout range of $4.27 to $8.97, so I believe these are good numbers to rely upon. This represents $3.00 - 7.60 of possible reward, compared to 16-cents of risk.
This is why we believe Zhone is a low-risk stock that is poised to triple.
Disclosure: I am long ZHNE.