Originally written on August 19, 2008

Horsehead Corporation (ZINC) is a major producer of zinc in the US, using as raw material EAF dust from steel mini-mills. EAF dust is a hazardous byproduct of steel refining, and environmental regulations in the US mandate that EAF dust be either recycled or carefully dumped in a sealed landfill. Horsehead gets paid to take EAF dust off the hands of steel refiners, extracts zinc from it, and then sells that zinc back to steel refiners for galvanizing iron.

ViroPharma (VPHM) recently acquired Lev Pharmaceuticals (LEVP.OB) for $443 million ($2.75 per Lev share), primarily for its orphan drug Cinryze, which is used to treat HAE (hereditary angioedema). There are additional payouts of $0.50 per share if Cinryze gets approved by the FDA, and another $0.50 per share if total sales of Cinryze reaches $600 million within a decade, which would make the total price $617 million.

ViroPharma was previously consistently losing money before it acquired the orphan drug Vancocin from Eli Lilly (LLY) for $116M. This turned out to be a stroke of genius, as ViroPharma was able to aggressively hike the price of Vancocin, resulting in annual revenues of $200M in 2007, and more than recouping the cost of acquisition in merely 2 years. I was hoping that the CEO would be able to repeat his past performance and use ViroPharma’s large cash hoard to make another brilliant acquisition. However, on examining the Lev acquisition, I believe that the CEO may have traded hard cash for a very risky endeavor this time around.

Despite having execution problems and ferocious competition (detailed in my last article), I still think NVIDIA Corp. (NVDA) will still be at least moderately profitable in the long-term, and the 30% drop in its stock price following one bad quarter is an over-reaction. NVDA has several factors in its favor.

NVDA is unlikely to lose market share, and might even gain some share. Both technological and market factors account for this. Technologically, GPU chips are second only to CPUs in complexity, meaning that competition from Asian fabs are unlikely, and the only competition is likely to remain ATI/AMD and Intel (INTC).

I recently took advantage of an overreaction in one of my favorite stocks to buy into a great company. Yum! Brands (YUM) is the second largest fast food restaurant operator in the US, after McDonald's (MCD), with brands such as KFC, Taco Bell, Pizza Hut, Long John Silver’s, and A&W. In recent months, its stock price has gradually trended downwards from $41, capped by a dramatic move to $33 when the company revealed in its second quarter’s report (see conference call transcript) that inflation has caused a decline in its US profits, despite same-stores sales rising 2%.

This is patently a ridiculous reaction to the news, since the company then raised its earnings forecast for 2008 by $0.02 to $1.89 EPS, on the back of KFC’s torrid growth in China, representing a 15% increase in EPS over the previous year. Furthermore, management reaffirmed its commitment to achieve at least 10% EPS growth year after year.

Following my previous article on the business model of LivePerson, Inc. (LPSN), I now present a financial analysis of the company.

In 2007, LPSN had revenues of $52.2 million, and the last quarter of that fiscal year includes revenues from the Kasamba acquisition. Of that revenue, $49.4 million is from its SaaS business, and $2.8 million is one quarter’s worth of revenue from Kasamba. This suggests that annual revenue from Kasamba will come in at $10 million, which agrees with the estimates in this article.

Intel’s (INTC) anti-trust problems are all over the papers recently. In South Korea, anti-trust regulators have just fined Intel $25.5 million for anti-competitive practices (a judgement that Intel will appeal). In Europe, the anti-trust regulators are expected to conclude their investigations and issue a judgement soon. And in the US, the FTC has just formally opened an investigation into Intel’s business practices, after sitting on the anti-trust case filed by AMD (AMD) back in 2005 for more than 2 years. Despite losing money hand over fist recently, AMD has not relented on its strategy of harassing Intel legally. AMD accuses Intel of selling its chips below cost to major PC manufacturers in order to induce them to boycott AMD’s products; Intel claims that it offered legitimate volume discounts to major PC manufacturers and have never sold its chips below cost. While offering inducements to customers to boycott a competitor’s products is a legally gray area, selling products below cost to gain market share is illegal in most countries, and the cases will probably turn on this last point.

I have previously written about Intel’s near-monopoly position as a long-term structural strength of the company that will allow it to earn returns above the cost of capital for a long time to come. Apparently, the price of this monopoly position is to be considered “guilty until proven innocent” by the government. While it is likely that more fines will be levied against Intel in the future, it is unlikely that this will dislodge Intel from its monopoly position. Microsoft (MSFT) had numerous anti-trust fines levied against it without affecting its market share. Anti-trust commissions are answerable to consumers, and are aware that consumers have been the chief beneficiaries in the recent Intel attempt to drive down AMD’s market share. Any large fine which causes Intel to retrench from the market, or attempts to force Intel to up its product prices, is likely to be viewed very dimly by the public.

The recent, dramatic gyrations in the stock price of First Marblehead (FMD) have prompted me to re-evaluate the company. FMD's stock price first declined when an FBR analyst delivered a report which stated that TERI may not have enough cash to cover its obligations in the face of losses which are running above expectations in some of FMD's previously securitized trusts. The stock price took a further dive when the CEO announced that a securitization is unlikely in the fourth quarter due to a challenging market and further cut FMD's dividend (the dividend has since been completely eliminated after the next quarter). Clearly, I have severely underestimated the market's reaction to the subprime crisis in my last analysis. I have failed to anticipate that the market will be scared off student loans, because I was misled by the fact that the latest securitization by FMD was a large one executed after the subprime crisis broke, and failed to consider that the terms were probably fixed before the crisis. A second development that I failed to foresee is the uptick in credit losses in the loan trusts; I had felt that the student loans were substantially different in nature from mortgages that the same crisis will not be repeated in the student loan market.

Generally, I tend to stay away from pharmaceuticals, because I find it difficult to accurately handicap the odds of drug trials. However, I have decided to make an exception in this case, because Viropharma (VPHM) has been so severely beaten down that it managed to show up in my very conservative stock screens, and on further examination, it seems to me that there is hidden value here.

Viropharma is a drug company with no research or manufacturing operations. The company licenses drug candidates in late-stage testing and already commercialized but undermarketed drugs from other companies, focusing on niche drugs used by physician specialists or in hospital settings. Large pharmaceutical companies usually pursue blockbuster drugs, and frequently drop drug candidates with a limited target population. Viropharma licenses these candidates and spends its own money to complete drug testing, before outsourcing the actual manufacturing of the drug to third-party pharmaceutical factories. This business model avoids heavy expenditures in basic research and manufacturing associated with traditional pharmaceutical companies, but incurs the risk of drugs failing in late stage trials. The company believes that it can build a business based on niche drugs and specialty marketing to a narrow patient and doctor pool.

Coleman Cable (CCIX) recently had its IPO and is now trading at a very low and attractive price. Coleman Cable makes electrical wire and cable products in small retail sizes for consumers, small-to-medium companies and governmental agencies in diverse industries in the US. This is in contrast to other larger cable companies (e.g. Belden (BDC) and General Cable (BGC)), which sell cables in bulk to large electrical utilities and telecommunication companies.

Coleman has more than 22000 stock keeping units, with significant brand recognition in many categories among end-users. Their customers are reasonably diversified, and include electrical distribution, OEM/government, heating, ventilation, air conditioning and refrigeration, irrigation, industrial/contractor, security/home automation, recreation/transportation, automotive etc.

First Marblehead (FMD) helps lenders design and sell private student loans, then packages these loans into securities for sale in the secondary market. It is a deeply misunderstood company, facing multiple uncertainties and with a revenue stream that has a complicated accounting structure. Because of these factors, the strengths of First Marblehead have been ignored by the market, and the stock has sunk to a ridiculously underpriced level.

A prospective college student has 3 sources of funds to cover tuition. Low income students can apply for federal Pell grants, which do not have to be repaid. Students can also apply for government-subsidized student loans, securitized by firms such as Sallie Mae (SLM) and Nelnet (NNI), at below-market interest rates, with the loans guaranteed by the government. However, these loans are capped at $3500 to $5500 annually, which means students must often obtain additional private loans from banks to cover the full cost of tuition, currently running at an annual cost of $12000 for a public university, and $20000 for a private one. FMD has acquired the loan database of TERI, a non-profit organization that has guaranteed private student loans since 1985, and uses the proprietary database to help banks correctly price their student loans. FMD makes its money by aggregating student loans from different financial institutions into a securitization trust stamped with the guarantee of TERI and resold in the secondary market. FMD's primary competitors are Sallie Mae, and the Servus Corporation, a division of Wells Fargo (WFC), offering substantially the same services, both of which are much better capitalized than FMD.

I came across Mothers Work, Inc. (MWRK) while reading this post at Fat Pitch Financials. I was intrigued by the thesis that MWRK could be falling below intrinsic value simply because Bear Stearns has a cash crunch and is being forced to liquidate stocks. Mothers Work is a niche retailer selling maternity clothes, and certainly seem to have many valuable brands.

Having rescued the company from near-bankruptcy in 2001, and done a remarkable job in the past few years, CEO William Council seems to now resent shareholder meddling in business affairs. My guess is that he views Advocat as an unfinished job, since there is still much room for improvement, in both patient mix and occupancy rates, and resents selling out to a buyer at this juncture. His case is not helped by the fact that he holds only 6900 shares, while the dominant shareholder on the board (Wallace Olson, with 1.2 million shares, some 20% of outstanding shares) has remained curiously silent during the entirety of the shareholder-management spat.

Fundamentally, Advocat is a well-run company, with some 43 nursing homes in Texas. Aging demographics dictate that nursing home usage will increase. Advocat has an occupancy rate of approximately 77% (most homes average 90%), and an unfavorable patient mix (most homes have 70% of patients covered by Medicare, which is more profitable than Medicaid or HMOs; Advocat has only 40% of patients on Medicare). Despite these disadvantages, operating margins are in-line with other nursing home operators, averaging above 7.7%. Management recently acquired an additional 7 facilities in Texas at a price of 4x EBIDTA, financed with a term loan with an interest rate of LIBOR plus 2.5%, which will also be used to retire other more expensive debts. This deployment of capital looks reasonable just based on financial metrics, and looks even more favorable given the synergies and market power that will accrue from the nursing homes being in the same area. Management appears to be divesting facilities outside of Texas (selling 11 nursing homes in North Carolina in May for $11 million), and employing a strategy of regional concentration of nursing homes for cost synergies.

What is the free cash flow of the business after taking into account its one-time gain? From its income statement, if you reverse out the one-time $4 million gain on refinancing, that will yield an income before taxes of $6 mil, and assuming a 33% tax rate, a net income of $4.5 mil. From its cash flow statement, the $11.4 million cash flow from operations already excludes the $4 million refinancing gain (which is a non-cash accounting gain). From this $11.4 million we should subtract $0.4 million for capital expenditures, $2.6 million of deferred taxes, $1.5 mil accounts receivable adjustment, and $2.5 mil inventory adjustment, to give $4.4 mil free cash flow. Thus, an analysis of both income and cash flow statements suggests that an EPS of $0.44 is reasonable. With a conservative PE of 10, CRWS should be worth $4.40.

The cash flow statement also shows that, for the past 3 years, the company has added $1.8 to $2.8 million annually to cash flow from operations through inventory reductions. In other words, management has managed to decrease the working capital required to support the current level of sales, and the excess cash savings is apparent from the cash flow statement and balance sheet. Excluding inventory, and after subtracting current liabilities, the company has $11 mil of excess cash. Long-term debt is now $5.78 mil. Assuming that working capital is adequate at present, or even excessive, as shown by the continual reduction in inventory levels, then the excess $5 mil is not required to support operations. This excess cash adds $0.50 per share, bringing the intrinsic value of CRWS to $4.90. These are some fairly conservative assumptions I am using, since gross profit margins continue to improve, and there is a decent chance of top-line revenue growth, the true intrinsic value of CRWS is probably somewhere north of $5.

The CPU market is a natural monopoly. CPUs are one of the most complicated chips to make, costing millions to research and design, and then millions more to build the fab plants capable of making the complicated designs. The manufacturer who has the largest market share is able to spread these enormous costs over a larger number of chips, attaining lower costs per chip, better brand recognition, and more funds for developing the next generation of chips. The second-place competitor has no chance against these staggering odds, unless the management of the leading firm is almost criminally negligent in running the company. Market share is of paramount importance in this industry.

Intel (INTC) has previously stumbled. They rested on their laurels, diversified into other lower-margin chip businesses, while incorrectly believing that consumers want ever more powerful chips regardless of power consumption. Advanced Micro Devices (AMD), their scrappy competitor, correctly divined that power consumption and heat dissipation are becoming key issues, and designed chips with those assumptions in mind, gaining market share in the server segment. Otellini realized the danger when he became CEO of Intel in 2005, and plunged Intel into a price war with AMD, while at the same time drastically changing the research direction of Intel’s new chips, and selling off non-core businesses to concentrate on CPUs. This price war has resulted in declining earnings and sharp drops in stock prices for both companies.

Chicken producers are cyclical commodity stocks and they always will be. They have minimal control over the market price of their products and the only thing they can do during a downturn is to cut back production and eat their losses while waiting for prices to recover, which is what all the major chicken producers did during late 2005 through 2006. Sanderson Farms nevertheless went ahead with plans to build a new processing plant in Waco, Texas. In 2006, all other chicken producers saw declines in revenues, while Sanderson Farms had flat revenues, suggesting an increase in market share.

The fortunes of the poultry producers have recently started to turn. Spurred by the huge profits in corn, farmers have reported to the USDA that they plan to plant corn wall-to-wall this year, with most agricultural economists are predicting a moderate drop in the price of corn. More importantly, the wholesale price of chicken (a common proxy is the Georgia dock price) has been continuously rising since Jan 2007, as have prices of all other major meats, especially beef.

CRWS once had a terrible capital structure, with lots of outstanding stock warrants. However, its solid cash flow allowed it to do a massive refinancing in the middle of 2006, which in one fell swoop eliminated all those stock warrants (thus abolishing the threat of massive stock dilution) and paid down debt, resulting in dramatic drop in interest payments. This caused the stock to jump from $0.65 to $2 in a couple of days. At the same time, the company shifted its manufacturing to Asia, and consolidated its distribution centers from two to one. Revenues dropped from $83 million in 2005 to $72 million in 2006, presumably because management was too preoccupied with the momentous restructuring in 2006, but operating income actually increased from $6 million to $7 million, a testament to the huge increase in operating efficiency and profit margin brought about by the restructuring.

In 2007, Crown Crafts has fully emerged from its restructuring as a much stronger company. The stock price has trended upwards from $2 in 2006 to $4 today. It has spun off its Churchill Weavers furniture business to focus on its core infant and juvenile product business, and has bought the Kimberly Grant brand of infant products to further strengthen its core business. In March 2007, Crown Crafts graduated from an OTC stock to a Nasdaq listing.