Asymmetric Allocation: 3 Reasons Why Flexible Solutions/BioAmber Is A Great Long/Short Story

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Includes: BIOA, FSI
by: Nelson Nguyen, CFA

Summary

Miracle Formula 2.0 Investing is based on the Magic Formula Investing principles taught by Joel Greenblatt.

Long FSI: ROC is 35.13% and earnings yield is 22.62%.

Short BIOA: ROC is -16.67% and earnings yield is -9.78%.

Long FSI: The fair value estimate is $3.77 with a current price of $1.32 (as of 1/13/17).

Short BIOA: The company appears to be overvalued with a fair value estimate of $4.64 with a current price of $5.79 (as of 1/13/17).

In my last article, I introduced to the world the Miracle Formula (a marriage of two ideas): 1) Magic Formula Investing, and 2) Market Neutral Investing.

I admit it was a premature baby that needed some additional care when applied to the real world of investing. I learned the following valuable lessons:

1. Include a third factor to the Miracle Formula (besides Quality, ROC and Value, Earnings Yield). Pick companies with no merger and acquisition news. You're better off putting M&A/special situations in the too hard or I'll pass pile like Buffett because M&A requires a level of knowledge, skill and ability that the average investor probably does not have. Try your hand at more predictable and high probability trades.

2. If you do want to speculate whether a merger will likely go through, then estimate your probabilities with the Herfindahl-Hirschman Index - HHI.

In this article, I write about a potential money-making market-neutral trade that consists of longing Flexible Solutions International, Inc. (NYSEMKT:FSI) at the same time shorting BioAmber, Inc. (NYSE:BIOA). In this article, I cover three key reasons why this is a high probability trade. Before we get into the three points, let me tell you more about the background of these two companies.

Companies

Flexible Solutions International, Inc. develops, manufactures and markets specialty chemicals, which slow the evaporation of water. To quote its website, the company is "an environmental technology company involved in research, development and manufacturing of products that increase crop yield, improve oil and gas operations, reduce the environmental footprint in cleaning and water treatment, save water and save energy."

FSI's products include:

  • Heatsavr™: Reduces heating costs and evaporation in indoor and outdoor pools.
  • WaterSavr™: Significant evaporation mitigation in all industrial applications, including agriculture and aquaculture.
  • Ecosavr™: A way to add the Heatsavr™ liquid to your outdoor and indoor pool.
  • NanoChem Solutions: Develops, manufactures and distributes a new generation of environmentally-friendly polymers, with applications in industrial, agricultural and consumer markets.

BioAmber, Inc., formerly DNP Green Technology, Inc., is an industrial biotechnology company, which produces sustainable chemicals. Per its website, the company's mission is "to be a fast growing producer of chemical intermediates that uses sugars instead of fossil fuels and sells competitively priced, sustainable chemicals with strong profit margins and the cleanest environmental footprint in the industry."

BIOA's products include:

  • Bio-based succinic acid: A renewable building block that can be used to make products found in everyday life.
  • Bio-based 1,4 butanediol: Used to make engineering plastics, polyurethanes, biodegradable polyesters, spandex and other specialty chemicals.
  • Bio-based disodium succinate: An all natural seasoning and flavor enhancer for foods.

Reason 1: Miracle Formula 2.0

My thesis is that you can create alpha (or excess return above the market return) by performing a market neutral trade longing Group 1 Magic Formula ranked stocks at the same time shorting Group 10 Magic Formula stocks in the same industry/sector with companies that have no M&A news. By longing the undervalued quality stock using the classic Magic Formula (the Group 1 stocks), you can find stocks that are heading to the heavens. By shorting the Anti-Magic Formula (the Group 10 stocks), you will likely find companies that will trade down to earth. Combining the long and short for no M&A stocks, you have the Miracle Formula 2.0 for market neutral investing. This is heaven on earth.

Let's continue with an example of how Miracle Formula Investing works with FSI and BIOA.

Comparing the two Magic Formula Investing factors, we find that FSI is more undervalued and has a better quality than BIOA.

FSI

BIOA

ROC: EBIT/(Net Working Capital + Net Fixed Assets)

35.13%

-16.67%

Earnings yield: EBIT/Enterprise Value

22.62%

-9.78%

M&A News

No

No

Because FSI ranks higher for both quality and value than BIOA, it is a better buy than BIOA.

Reason 2: Lazy Fundamental Analysis

F-Score

The Piotroski score (F-Score) is a discrete score between 0 and 9, which reflects nine criteria used to determine the strength of a firm's financial position. The Piotroski score is used to determine the best value stocks, nine being the best. Good or high score is 7, 8 or 9. Bad or low score is 0, 1, 2 or 3. In our case, FSI had an F-Score of 8 and BIOA had a score of 4. According to Piotroski, FSI is a better buy than BIOA.

Z-Score

The Altman Z-Score (Z-Score) is the output of a credit-strength test that gauges a publicly-traded manufacturing company's likelihood of bankruptcy. Z-Score < 1.81: distress zone. 1.81 < Z-Score < 2.99: grey zone. 2.99 < Z-Score: safe zone. Similar to F-Score results, FSI's Z-Score is 6.05, which means it is in the safe zone; BIOA's Z-Score is -1.40, which means it is in distress.

M-Score

The Beneish model (M-Score) is a mathematical model that uses financial ratios and eight variables to identify whether a company has manipulated its earnings. An M-Score of less than -2.22 suggests that the company is not an accounting manipulator. An M-Score of greater than -2.22 signals that the company is likely an accounting manipulator. FSI has an M-Score of -3.07 and BIOA has a score of 5.68. This indicates that BIOA may have manipulated its financial results - a bad sign - while FSI is not likely a manipulator.

Based on the F-Score, Z-Score and M-Score, FSI looks like a good long and BIOA looks like a good short. This is good for my market neutral thesis of FSI/BIOA.

Reason 3: Valuation and margin of safety

Relative valuations

Price-to-earnings valuation

The current PE multiple for the industry is 22.40. If we multiply it with earnings, we come up with a fair value estimate. For FSI, taking the one-year forward EPS estimate of $0.14 times 22.40 gives us a fair value estimate of $3.14. For BIOA taking one-year forward EPS estimate of -$0.84 times 22.40 gives us a fair value estimate of -$18.82, which is not as meaningful. Earnings estimates are based on average and median Wall Street analyst estimates found at Morningstar.

FSI

BIOA

Price-to-Earnings (TTM)

8.80

(8.04)

Price-to-Earnings (Forward)

9.43

(6.89)

Price-to-Earnings (Industry Average)

22.40

22.40

EPS

0.15

(0.72)

EPS Estimate

0.14

(0.84)

Implied Valuation (TTM)

3.36

(16.13)

Implied Valuation (Forward)

3.14

(18.82)

Implied Valuation (Average TTM & Forward)

3.25

(17.47)

Price-to-sales valuation

I modified the tradition price-to-sales valuation by adding a premium/discount factor based on net profit margin relative to industry average. I believe this is a better measure of value when you do relative price-to-sales valuation. A company should be worth more if its net margin is better than industry. At the same time, a company should be worth less if it has a lower than industry net margin because for every dollar of sales, it generates less earnings.

FSI

BIOA

Sales Growth Year over Year

(0.06)

40.76

Sales Growth Three-Year Average

(1.03)

(1.77)

Sales Growth Five-Year Average

6.71

N/A

Price-to-Sales

1.00

19.10

Price-to-Sales (Industry Average)

1.60

1.60

Sales per Share

1.33

0.32

Net Margin (Industry)

5.20

5.20

Net Margin

11.54

(229.56)

Premium/Discount

2.22

(44.15)

Implied Valuation (P/S)

4.73

(22.70)

Price-to-book valuation

The current PB multiple for the industry is 2.70. If we multiply it with Book Value per Share (BVPS) of $1.05, we come up with a fair value estimate of $2.84 for FSI. If we multiply the PB industry multiple with BVPS of $1.72, we come up with a fair value estimate of $4.64 for BIOA. The following is a summary of my analysis:

FSI

BIOA

Price-to-Book

1.30

3.40

Price-to-Book (Industry Average)

2.70

2.70

Book Value per Share

1.05

1.72

Implied Valuation (P/B)

2.84

4.64

Combined PE (TTM &Forward), PS and PB fair values

Combined fair value estimate for FSI is $3.61. Combined fair value estimate for BIOA is -$11.84

Enterprise multiple

The enterprise multiple is a ratio used to determine the value of a company. It looks at a firm as a potential acquirer would, because it takes debt into account (an item which other multiples like the P/E ratio do not include). The enterprise multiple based on EBITDA is calculated as enterprise value/EBITDA. The enterprise multiple based on EBIT is calculated as enterprise value/EBIT

Enterprise value = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

FSI

BIOA

Industry Enterprise Multiple (EBIT)

16.23

16.23

Industry Enterprise Multiple (EBITDA)

9.40

9.40

EBIT

3.00

(21.00)

EBITDA

4.00

(17.00)

Preferred Equity

-

-

Debt

-

55.00

Minority Interest

-

40.40

Cash & Investments

3.00

16.00

Shares Outstanding

12.00

28.00

Implied Valuation (EBIT)

4.31

(15.01)

Implied Valuation (EBITDA)

3.38

(8.54)

Average fair value estimate and margin of safety

FSI

BIOA

Combined P/E (TTM & Forward), P/S & P/B Valuations

3.61

(11.84)

Implied Valuation (EBIT)

4.31

(15.01)

Implied Valuation (EBITDA)

3.38

(8.54)

Average Fair Value Estimates

3.77

(11.80)

Selected Fair Value Estimate

3.77

4.64

Current Price as of 1/13/17

1.32

5.79

Margin of Safety

64.95%

-24.68%

Based on the selected fair value estimates, we find that FSI is undervalued and has a margin of safety of 64.95%. In contrast, BIOA is considered overvalued and has a margin of safety of -24.68%.

Conclusion

Are the valuations precisely correct? No one can give an exact value of a company, but you have a range of confidence. As Warren Buffett teaches:

"It is better to be approximately right than precisely wrong."

Please note that this weighted average fair value estimates relied primarily on relative valuations. Therefore, the numbers really express more of the relationship of price and value rather than a hard and fast number. However, if past performance is an indicator, then we find that FSI is a better-quality company compared to BIOA.

We analyzed the quality of these two stocks and came up with an estimate of fair value. Based on this fundamental analysis, FSI has a high probability of outperforming BIOA on a relative basis. This is the reason why I believe longing FSI and shorting BIOA is a great market-neutral trade.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

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