When buying cheap stocks and selling calls against them, we are far more focused on downside risk versus potential upside gain. The reason being is that when one sells an out of the money call for example against a long stock position, one is capping their potential gain. Therefore, why look for stocks with robust earnings power when it is not needed for this strategy? In essence, with this strategy, it is all about the downside. Yes, we can control a lot of this risk from how much we spend on our shares but we can also minimize our risk by investing in firms with really strong balance sheets.
From the above perspective, Magal Security Systems (MAGS) came across our desk as a suitable company for this strategy. Currently shares are trading just above the $5 mark meaning our initial risk would be approximately $500 less the amount we would receive from the front month out of the money call (usually we go for the 30-delta call).
From a technical standpoint, shares seem to be undergoing a long-term basing pattern which has been taking place for close to a decade now. Therefore let´s dig into the trends of some of Magal´s key financial metrics which we can find on its financial statements.
As mentioned, whereas the majority of investors focus on earnings growth, we try to focus on the “financial conditions” which can make growth possible. For this strategy, we do not need seering bottom-line growth today. By doing this, we believe we minimize risk especially if we focus on companies which have a significant margin of safety (Low P/B & P/S ratios).
The first major source of bottom-line growth is revenue. On the income statement, we can see that sales for the third quarter came in at $18.3 million which was a 17.7% decline over the same quarter of 12 months prior. Net-income of $0.6 million came in over 50% below the same period of 12 months prior. This means sales over the past four quarters comes in at $76 million which is well down from the 2019 top-line number.
Although sales growth has struggled since 2018, Magal´s 3-year average annual sales growth percentage still comes in at a healthy 8.58%. Many investors only fovus on recent results and ignore the long-term trend. Furthermore, operating expenses of $6.8 million was a 9% decrease over the third quarter of 2019. Suffice it to say, we like that the firm has been able to remain profitable in what has been a very difficult year for the sector in general. The backlog currently is at record levels and orders continue to be strong in both the Integrated division as well as the Senstar division.
Management stated on the recent earnings call that investment in R&D and new products were not slowed down due to the pandemic. This trend will enable Magal retain its competitiveness in this sector. Sales at present come in at 1.47 times the company´s market-cap which means Magal´s sales are 60% cheaper than the sector in general from a valuation standpoint. Suffice it to say, even if Magal trails the sector somewhat with respect to its profitability, it is starting from a very sound base as its sales are more than 60% cheaper than the sector in general.
The balance sheet (for our strategy) is critical as assets are essentially the roots that bear the tree when it comes to earnings growth. The more assets a company has (compared to its liabilities), the greater potential for sustained earnings growth. At the end of the third quarter, Magal Security reported $123 million of assets and $88 million of shareholder equity when we minus the liabilities. This equity returned net-profit of approximately $3 million over the past four quarters. The present market-cap of $117 million means shares are currently trading slightly above book value (P/B of 1.33).
Remember, for our strategy, we prefer companies with stronger balance sheets as opposed to firms with high growth levels. The above ROE of approximately 3% would not be high enough for many investors and we totally get that. What we are more focused on however is that shareholder equity continues to rise and that interest-bearing debt is negligible on the balance sheet. Trends such as these stack the odds in favour of only holding companies with limited downside.
Magal´s current assets have predominately increased from an increase in cash as well as inventory. Inventory ($14.4 million at the end of Q3) has been increasing faster of late than sales and earnings but the quick ratio of 3.18 still looks healthy due to Magal having far more of its assets in cash ($54 million) compared to its inventory. Intangible assets of $14.4 million make up under 12% of the total asset take so the possibility of a significant "write down" of Magal´s assets is slim in our opinion.
To sum up, we expect Magal Security to keep on growing the balance sheet by making use of that cash to acquire other companies. Over time, we expect future purchases along with continued R&D investment to improve the company´s present profitability metrics. At present, the trends or "financial conditions" are certainly there to facilitate sustained earnings growth. Let´s see what the fourth quarter brings.
Elevation Code's blueprint is simple. To relentlessly be on the hunt for attractive setups through value plays, swing plays or volatility plays. Trading a wide range of strategies gives us massive diversification, which is key. We started with $100k. The portfolio will not not stop until it reaches $1 million.
This article was written by
My name is Jack Foley and I primarily write and research investment commentary as well as trade the markets. I'm Irish but live in Madrid, Spain with my beautiful wife and 2 children. I believe to be successful at this game, one has to have real passion for the markets and be constantly reading and researching material. From fundamentals analysis to technical analysis, options or futures, income or capital gain, long term trading or day trading, there is something for everyone in the markets depending on one's respective goals. "Starting with the end in mind" is a great mindset to start your investment career with respect to ascertaining exactly what you want to get out of the markets. Write down what you want and how quickly you want it. Therefore depending on the capital you are starting out with, you will then know what levels of risk you need to take. Whatever doubt or query you may have, I'm here to help. Shoot me an email in the contact tab and I'll come back to you as soon as possible
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MAGS over 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.