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David Trainer
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David is CEO of New Constructs (www.newconstructs.com), an independent research that specializes in unearthing key insights from the Financial Footnotes of Annual Reports. Having analyzed over 50,000 annual reports and their Financial Footnotes, New Constructs research regularly produces Hidden... More
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  • IDTI May Shoirt-Circuit Your Portfolio 0 comments
    Feb 1, 2011 11:39 AM | about stocks: IDTI, MSFT, ADI, AAPL

    NOTE: originally published here on 1/25/11.
    Our view of the tech­nol­ogy sec­tor is more pos­i­tive than most of the other sec­tors, but it still gets our neu­tral rat­ing because of stocks like Inte­grated Device Tech­nol­ogy, Inc. (IDTI). Of the 561 tech­nol­ogy stocks we cover, IDTI is one of the 77 that get our “very dan­ger­ous” rat­ing and one of the few that make our most dan­ger­ous stocks list for Jan­u­ary. The tech sec­tor is tricky because there are sev­eral large-cap excel­lent stocks (MSFT, ADI and AAPL) that make the sec­tor look very good and offer good hid­ing for some “very dan­ger­ous” smaller-cap stocks such as IDTI. For exam­ple, I rec­om­mended investors buy IBM, MSFT and ADI in pre­vi­ous “stock pick of the week” arti­cles. In addi­tion, in an inter­view on CNBC, we were very bull­ish on another semi­con­duc­tor com­pany, Intel (INTC), as one of our “most attrac­tive” stocks when it made the list for August 2006. IDTI does not mea­sure up to these other tech lead­ers and is rid­ing the coat­tails of the bet­ter tech stocks.

    Like all of our most dan­ger­ous stocks, IDTI has (1) mis­lead­ing earn­ings = account­ing prof­its are pos­i­tive and ris­ing while true, eco­nomic prof­its are neg­a­tive and falling and (2) high val­u­a­tion = very high expec­ta­tions embed­ded in the cur­rent valuation.

    Specif­i­cally on “mis­lead­ing earn­ings”, I refer to the fact that IDTI reported a $1,085mm increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $14mm (a dif­fer­ence of $1,099mm, about twice the company’s rev­enues) dur­ing the last fis­cal year. The major­ity of this dis­con­nect comes from two sources:

    1.     Asset-write offs of $1,385mm (most of which occurred in the last 2 years), which equals 215% of reported net assets and is greater than the mar­ket value of the com­pany. Given that man­age­ment is sup­posed to cre­ate value, not destroy it, writing-down $2.15 for every $1 on the company’s bal­ance sheet does not bode well for their abil­ity to cre­ate share­holder value. Our recent arti­cle on Man­age­ment Fail­ures explains why investors need to beware of large asset-write-downs like those incurred by IDTI.

    2.     Large non-operating charges taken by the com­pany in 2009 which drove down 2009 results so they com­pare well against 2010 results, which are boosted by non-operating income.

    Specif­i­cally on the stock’s high val­u­a­tion, I refer to our dis­counted cash flow analy­sis of the cur­rent stock price of $6.46, which shows IDTI must grow its rev­enues at over 20% com­pounded annu­ally for at least 20 years while also improv­ing its return on invested cap­i­tal from –1% to +5%. A 20-year growth appre­ci­a­tion period with a 20%+ com­pound­ing growth rate sets expec­ta­tions for future cash flow per­for­mance quite high. His­tor­i­cal growth rates are much lower. In addi­tion, the stock’s upward move­ment is hand­i­capped by the cur­rent, out­stand­ing stock option lia­bil­ity of $31mm or 3% of cur­rent mar­ket value. As the stock price climbs, that option lia­bil­ity grows larger as all the out­stand­ing stock options move more in-the-money and become more valuable.

    Our report on IDTI, avail­able here, has detailed appen­dices for you to see how we per­form all calculations.

    Over­all, the risk/reward of invest­ing in IDTI’s stock looks “very dan­ger­ous” to me. There is lots of down­side risk given the mis­lead­ing earn­ings while there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price.

    In a busi­ness where investors make money by buy­ing stocks with low expec­ta­tions rel­a­tive to their future poten­tial, IDTI fits the pro­file of a great stock to short or sell.

    Note: Stock pick of the week is updated every Tuesday.

    Stocks: IDTI, MSFT, ADI, AAPL
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