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Geoff Gannon June 16, 2019 Free Articles 4 Comments

NACCO (NC): A Contract Coal Miner with Stable Inflation Linked Profit Per Ton, a P/E of 10, a Strong Moat, and No Leverage

by STEPHEN GAMBLE

Overview

 

NACCO is primarily a services company, in the guise of a coal mining company, deriving all of its revenues from its US operations. It provides the service of managing mines and delivering raw materials – coal and limestone – to several large customers on a cost-plus basis on long term contracts. It has mines in several southern US states, HQ in Texas, and its two largest coal mines by coal volume, are in North Dakota. In the Q1 19 earnings call, it changed its reporting structure, to now report its business in three segments:

  1. Coal Mining (coal extraction)
  2. North American Mining (limestone extraction, and one sand/gravel mine just opened)
  3. Minerals Management (oil and gas royalties)

Coal and limestone/limestone are mined in two distinct ways: Consolidated mining means that NACCO owns the mine, pays all the costs, assumes the liability for reclamation, and sells the coal on the open market and so is subject to the coal spot price. There is now only one consolidated coal mine: the Mississippi Lignite Mining Company (MLMC), after the shutdown of various mines under the Centennial Natural Resources subsidiary at the end of 2015. Unconsolidated mining means that NACCO operates the mine, and is paid a fee per tonne of coal/cubic yard of limestone mined, under cost-plus, inflation-linked long term contracts. The customers assume most of the risks and the long-term obligations of operating the mines, paying for equipment, mine reclamation responsibilities, and all other costs. Therefore, NACCO is not exposed to the coal spot price or the price of limestone under these contracts. The gross profit/tonne for these mines is very stable – less than a standard deviation of 6% over the last seven years. Most of NACCO’s profits come from unconsolidated mining, and most of these from coal mining rather than limestone mining. Other coal companies may hedge their exposure to the coal spot price: instead NACCO avoids this risk by selling to the customer for an agreed profit margin. This also reduces the price variations for NACCO’s customers. The image above shows the gross profit/ton of unconsolidated coal over the last seven years, and also the tons of unconsolidated coal mined/share, which has been increasing due to an expansion in unconsolidated coal mining.

In the last seven years, an average 76% of profits came from long term contracts for mining principally coal and limestone (unconsolidated mines), 15% of its profits from royalties for oil/gas extraction on land it leases/owns, and 9% of profits from consolidated coal mines. There are various types of coal: NACCO almost exclusively mines lignite, which is the lowest quality coal, with a low energy density per ton. Therefore, it does not pay to transport it any significant distance, so coal fired power stations tend to be co-located with the lignite mines. This is the case for most of the mines that NACCO operates. Coal is mined exclusively from surface strip mines – this creates large open scars in the landscape that have to …

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Geoff Gannon March 26, 2019 Free Articles 1 Comment

Ball (BLL): A Debt Laden, “Economic Value Added” Obsessed Organization with a Super Wide Moat

Write-up by Mister Compounder

 

The 3 most important variables to the Ball (BLL) investment thesis are:

  1. The industry structure and the symbiotic relationship with beverage companies, that naturally leads to “survival of the fattest”.
  2. The EVA approach that links interesting site economics to the creation of shareholder value.
  3. Credit risk (having the right level of debt).

 

Ball is one of the world’s leading suppliers of metal packaging to the beverage and food industry. The company has a long history and was founded in 1880. Through its entire history, Ball has been involved in close to fifty different segments. Today, the business is mainly based on delivering aluminum beverage containers to the beverage industry. The company’s business is about delivering aluminum cans to large consumer staple companies like: Coca Cola, Unilever and AB InBev.

This sounds like a really dull, capital intensive and boring business. So, why should it interest you?

 

Interesting Site Economics

The source of Ball´s competitive advantage is dependent on local scale and switching costs, resting on a highly consolidated industry among both producers and customers. The plants making the beverage container cans are huge. This is best illustrated by the size range of the production plants from about 100,000 square feet to around 700,000 square feet. The company’s largest site is the Findlay, Ohio plant (733,000 square feet) that produces both beverage cans containers and food containers.

 

To get an understanding of the underlying unit economics driving both revenue and profitability at Ball, it might be interesting to do some guesstimates on the profitability of the site locations.

 

In the North American segment, the beverage container industry represents about 110 billion units, where five companies dominate the market in the U.S, Canada and Mexico. For fiscal year of 2017, Ball produced 46 billion units, hitting a market share of 42%. This volume is served by 19 plants in the US, 1 in Canada and 2 in Mexico. They have also one joint venture production facility, but I have not included that one in this calculation. In total 22 plants, which means an average of 2.1 billion units per plant per year.

 

This means that – each year – the typical Ball plant should make:

  • 1 billion units
  • $190 million in revenues
  • $37 million in gross profit at a 19.5% gross profit margin
  • $25 million in operating profit at a 13% operating margin
  • Which is: $624 of revenue per square foot in and $81 in profit per square foot

 

Ball typically generates 9 cents in revenues per beverage can and 1.2 cents in operating profit per can. This is what generates sales and earnings at Ball. In other words, these are huge operations. Just like with distributors, it will be difficult to compete with a fully functioning and operative production plant. Given this, it is highly unlikely that a competitor would add excess capacity near an existing plant. It leads naturally to local markets as it does not make sense to transport the products …

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Geoff Gannon March 14, 2019 Free Articles 0 Comments

PRAP Japan (2449): Japan’s Healthiest Public Relations Firm – Trading At Just 4 Times EBIT

This article originally appeared on Kenkyo Investing, a value-driven service specializing in Japanese small and microcap stocks. Each month, Geoff will pick his favorite article from Kenkyo Investing and share it with you here at Focused Compounding. To read all of Kenkyo Investing’s articles, visit Kenkyo Investing’s website and become a member. Don’t forget to use discount code “FCPODCAST” to get 10% off.

 

Write-up By Kenkyo Investing

Thinking Points

  • PRAP Japan (TSE: 2449) is Japan’s fourth largest public relations consulting firm offering marketing communications, corporate branding, crisis communications, event management, and content production services to corporate customers in a variety of industries.
  • Compared to its competitors, PRAP has the healthiest balance sheet and has delivered business performance at a consistently elevated level.
  • Over the last decade, the company built its China business, which now accounts for nearly a third of consolidated 2018 revenues. Meanwhile, its Japan business has remained mostly stable, with modest growth. PRAP plans to expand in the Asia Pacific region going forward.
  • Despite its consistently strong business performance and industry-leading balance sheet health, PRAP trades at an adjusted 4.3 EV/EBIT, considerably lower than its peers, which trade between 9.7x and 25x.
  • Though there is no clear catalyst in sight, if investor sentiment shifts and PRAP trades at comparable multiples, investors can expect a three year investment CAGR of 21% with minimal business risk investing at today’s 1,599 yen per share price.

Introduction

PRAP Japan (TSE: 2449) is a public relations (PR) consulting firm offering marketing communications, corporate branding, crisis communications, event management, and content production services to corporate customers in a variety of industries. Founded in 1970, the company is among the older and established PR firms in Japan. Over the past decade, PRAP has increased its efforts in China, mainly targeting Japanese companies wanting to establish a presence in China.

Source: Company filings

 

Though PRAP offers a variety of services, it is a single segment company. As of 2018, PRAP is the 4th largest PR firm in the country by revenues.

 

The business & environment

The Public Relations Society of Japan (PRSJ) estimates that the PR industry size in Japan was 101.6 billion yen ($90 million USD) in 2016 (Japanese). Long term historical data isn’t available for the industry as it is still small. That said, PRSJ notes that the industry is rapidly growing:

Source: Public Relations Society of Japan

 

Over the last 8 years, the Japanese PR industry has grown at a 4% CAGR. In the last couple years, newswire services and video production and promotion services have fared particularly strong. The key players in the PR industry are:

Source: Company websites

 

Vector (TSE: 6058), Sunny Side Up (TSE: 2180), PRAP Japan, and Kyodo PR (TSE: 2436) are publicly traded. Dentsu Public Relations is under Dentsu (TSE: 4324), Japan’s largest advertising agency, and Ozma is affiliated with Hakuhodo (TSE: 2433), Japan’s second largest advertising agency.

Although Japan’s PR industry has been growing quickly, PRAP’s revenue growth pales …

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Geoff Gannon March 4, 2019 Free Articles 0 Comments

Universal Robina: A Good, Growing Filipino Branded Food and Drink Business – That’s Not Quite Cheap Enough for Value Investors

Write-up by Jayden Preston

 

Overview

Founded by John Gokongwei Jr., Universal Robina Corp. (URC) has come a long way since its humble inception as a corn starch manufacturer in 1954. Through decades of diversification, URC is now a leading producer of branded snacks and beverages in the Philippines. To a certain extent, URC is like a mixture of Pepsi Co. and Mondelez in Southeast Asia. While URC does not have a cola product, the Company, similar to Pepsi Co., does have a diverse portfolio of snacks, including potato chips and cheese rings, and beverages, such as bottled water and other ready-to-drink (RTD) beverages. URC also competes with Mondelez in the confectionery business through its products of cookies and chocolates.

In addition to its home market, URC also has presence in 12 other countries in Southeast Asia and Oceania. Its major international markets include Vietnam, Thailand, Indonesia, Australia and New Zealand.

 

However, URC is more than just a branded food producer. In the Philippines, URC has two other segments, Argo-Industrial Group and Commodity Foods Group. The former is engaged in hog and poultry farming, while the latter involves flour and sugar milling. This part of the business is similar to Seaboard Corporation.

 

URC is thus divided into 4 segments: 1) Branded Consumer Food Philippines (CF Philippines), 2) Branded Consumer Food International (CF International), 3) Argo-Industrial Group (AIG), and 4) Commodity Foods Group (CFG). (3 and 4 are collectively known as the Non-Branded consumer food segment. We will refer it as the Non-Branded segment, even though there are still some branded offerings within this segment.)

 

Segment Breakdown

CF Philippines is the most important segment for URC. It contributed 48% of revenue and 53% of EBIT in 2017. It is followed by CF International in terms of revenue contribution at 34%. Yet, the international segment actually has the lowest margins among all the segments. As such, only 19% of EBIT comes from this segment. In other words, while the Non-Branded segment only generated 18% of total revenue, it was responsible for 28% of EBIT.

 

In summary, in terms of operating profits, URC is roughly 3 quarters a branded consumer food company spanning in Southeast Asia and a quarter of a commodity foods producer in the Philippines.

 

 

Durability and Quality

 

Branded Consumer Food Segment

Branded snacks and beverages, with brand heritage, tend to score very highly on the scale of durability. The keys to the business are brand recognition and shelf-space availability. The more well-known your brands are, the more willing retailers are to stock your products; and, the more available your products are, the more frequent customers will come across your products. There is thus a reinforcing element in the equation that favors incumbent players.

This is not to say that there is no threat from new entrants. A major concern to the durability of well-established players in this space is the ongoing change in customer behavior, such as the trend toward healthy foods, …

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Geoff Gannon January 5, 2019 Free Articles 0 Comments

Inseego (INSG): A Uniquely Positioned 5g Company

Write-Up by Long-Short Value

  • With ZTE and Huawei recently shut out of the US and Canadian Market and likely most European Markets, Inseego is uniquely positioned to take advantage and gain market share in mobile connectivity at a crucial time in the 5g cycle. This Chinese OEM ban has pushed several customers to recently sign design and development deals with Inseego.
  • Inseego’s new management has a depth of experience in telecommunications equipment and has positioned the company for both the 5g Hardware cycle and to expand its Telematics Business (CTrack) into new markets
  • Inseego’s customer relationships with Verizon and close ties with Qualcomm make it the premier connectivity partner in the US and Canada.
  • Inseego has recently signed all Tier 1 Carriers in the US and several other carriers in the US, Canada, Australia, and Europe for either their 4G LTE, Gigabit 4G LTE, or 5G products. Several of these recent contract wins have yet to begin producing any material revenues and are expected to ramp up in 2019 significantly.
  • Inseego’s Enterprise SaaS business (DMS and CTrack) operate in an extremely attractive high margin segment. Recent wins for CTrack in the Aviation space will help propel the segment to high teens to low twenties revenue growth over the next few years.
  • My base case valuation of Inseego is $7.80 a share, Upside Case could be well above $10 a share if Verizon 5g Fixed Wireless is a success.

Inseego Summary

Inseego is a Telecommunications Equipment and Enterprise SaaS design and development company with products focused on the Internet of Things (IoT) and Mobile Solutions.  Inseego is one of the few US based companies that makes Mobile Connectivity products like 4G Hotspots that traditionally compete with Chinese companies like ZTE and Huawei.  Inseego is closely aligned with Qualcomm and Verizon highlighted by the new design center they opened across the street from Qualcomm and the recent showcasing of the Verizon 5g NR utilizing the Qualcomm Snapdragon chipset.  Inseego has undergone several recent management changes and a restructuring which started with the hiring of Dan Mondor as the new CEO in June of 2017.  Dan has a very solid background in the Telecommunications Equipment space with experience as CEO of SpectraLink and as CEO of Concurrent Computer Corporation (CCUR).  Dan has assembled a stellar team to position Inseego for the coming 5g Telecommunications Cycle.

Here is a primer on 5g (Mckinsey Link) as it is a key component of the thesis around Inseego.  5g will bring not only faster speeds to wireless but also lower latency, which is important in applications like medicine, connected cars, and many IoT applications.  I have done an extensive amount of research on 5g and I believe it is a much larger step change from both a performance standpoint and an infrastructure investment standpoint than the transition from 3g to 4g.

Inseego has two businesses, Mobile Connectivity Solutions Hardware (Mobile Solutions) and SaaS, Software, and Services (Enterprise SaaS).  Mobile Solutions is a hardware business …

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Geoff Gannon January 5, 2019 Free Articles 0 Comments

Future Bright: A Macau Restaurant Operator with Restructuring Potential

Member Write-up by André Kostolany

Future Bright is a Macau-based restaurant operator with a fascinating history of management missteps. Today, Future Bright’s main businesses are Food & Catering, Souvenirs and Property. The company is primarily owned and run by Chan Chak Mo, a local Macau legislator with deep roots in the region and connections to the casino operators. The company’s market cap is about 600MM HKD, it has 75MM of cash and about 350MM in debt. While some of my comments may seem offhand, I have been following this business for over five years.

 

Restaurant Business

In Macau, Future Bright runs an easy, toll-road like business built on cash flows from in-casino restaurants, university canteens and other near captive customers. During the good times in 2011, high-rollers easily spent >$200 for a quick meal in between gambling and the core business threw off >30% EBITDA margins. Then Xi Jinping came into power and the anti-corruption campaign happened in 2012. Less high-rollers frequented Macau, instead, they were replaced by tourists with more moderate budgets. In response, Macau attempted to transform itself to a more ‘family-friendly’ destination. While Macau visitor numbers have been consistently growing at a rate of ~7% per annum for the past 10 years, average meal spend per visitor has dropped below $100 due to the shift away from high-rollers, impacting restaurant margins.

When the anti-corruption campaign was announced, management began investing into opening up restaurants in competitive restaurant markets overseas. They have recently admitted failure in Mainland China and are closing down some of these restaurants. They are doing fine in Hong Kong and the judgement is still out whether their Taiwanese restaurants will perform. None of these new restaurants will, however, approach the economics of their existing core business in Macau.

The core restaurant business in Macau is mainly a good business because casinos need higher-end restaurants to accommodate their customers but have shown little willingness to fully manage and operate these themselves. With its experience in managing a wide range of Japanese, Chinese and Western Restaurant concepts Future Bright is a useful partner to the casino operators. Casino visitors are also relatively less price sensitive than your typical restaurant customers, which has led to Future Bright’s unusually high margins on its core business.

Future Bright currently runs 61 restaurants, 4 of which are food court counters. 16 of these restaurants have been opened in the past two years and they are currently planning on opening another 20 restaurants by the end of 2019. As restaurants take about 2 years to reach maturity, and as they are currently spending to shut down overseas restaurants, the restaurant divisions’ economics are currently somewhat obscured. Adjust for one-off charges and annualizing current numbers, one can see that the restaurant division has about 970MM in revenues and is producing an 8% cash margin. Macau restaurants have a cash margin of 14%, Hong Kong 6% and China -22%. While the division currently produces 80MM of cash flow, getting China …

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Geoff Gannon January 5, 2019 Free Articles 2 Comments

Sonics & Materials (SIMA): A Profitable Net-Net Building A Cash Pile

MEMBER WRITE-UP BY LUKE ELLIOTT

Quote: $8.00   

Shares Outstanding: 3.4 million  

Market Cap: $27.2 million

Sonics and Materials Inc. (SIMA) is an American company that was founded in the late 1960’s based on the discovery and invention of ultrasonic welding by its CEO, Robert Soloff.  Mr. Soloff patented the technique, and several years later, opened Sonics and Materials.  Now, fifty years later, the company has grown from 1 employee to 70 and is still operating in the ultrasonic space.  The company stopped reporting to the SEC in 2002 due to the financial burden and is now dark, but financials from the years 1996-2002 are still publicly available.  Ownership is closely held with Mr. Soloff owning around 70% of the company and thus, the float is small.

The company mainly sells two types of products to two markets.  The first is ultrasonic liquid processors (typically referred to as Sonicators).  Sonicators are primarily sold to research institutions, hospitals, laboratories, and pharmaceutical companies, where they are used in a variety of processing applications.  Some of these include: reducing the size of particles in a liquid, soil testing, production of biofuels, cell lysis, and much more recently, for nanoparticle dispersion and cannabis extraction (for edibles).  The subsidiary that sells the Sonicator product line is called Qsonica.

The second product line is ultrasonic welding machines, which use sound waves to quickly weld components together.  Ultrasonic welding is used in more applications than can be listed.  The technology is typically used with plastics but can be used to weld metal as well (more common with electronics).  Think the wires in your phone, the cap on the back of your sharpie, car headlights, etc. You can also throw ultrasonic sealing machines in with this category.  The sealing machines are an area the company has been spending more time and focus on lately.

My best guess is that the company’s revenues are split about 50/50.  It could be 60/40 or whatever, but there is some evidence that leads me to believe it’s in that range. The main point to take away is that the company appears to be the largest player in the Sonicator business by a substantial margin, even with only $11M or so per year in sales. Back in 2009, the company acquired the “Ultrasonic Laboratory Products” division from Misonix (MSON) for $3.5M and the Vice President of SIMA (and CEO’s daughter) stated on the record that “acquiring our largest competitor has given us much greater market share.” Furthermore, before this acquisition, the 2002 10-K states, “In the ultrasonic liquid processor market, the Company’s principal competitors are Branson and Misonix Inc.  Management believes that Sonics has the largest share of this market.” Competitors in this space appear to all be small and private. This is a key element in understanding the company’s durability.

The ultrasonic welding business faces competition from much, much larger players. Emerson (EMR) is just one example.  Mr. Soloff is a true inventor, and between himself and SIMA, holds something to the …

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Geoff Gannon October 31, 2018 Free Articles 1 Comment

Digirad (DRD): A Cheap Microcap Transitioning into a Holding Company

MEMBER WRITE-UP BY LONG SHORT VALUE

 

Summary

Digirad is an attractive microcap special situation investment because the valuation is extremely low, there is a high likelihood of the proposed acquisition closing, and the underlying value proposition of Holdco structure is compelling.  Digirad announced on September 10th that they would be converting to a Holdco structure and acquiring ATRM, a modular homebuilder and specialty lumber company with an investment fund segment.  The logic behind this structure change is to cut public company accounting, legal, management and board costs and potentially save millions of dollars that will flow to the bottom line of the joint company.  I believe these savings will be real and expect a large uptick in EBITDA delivered from a combined company.  Cutting costs especially the types proposed are usually an easy way to drive profitability.  My valuation of the company suggests in a central case shares could yield a 100% return over the next year, and in my high case shares could yield a return of 179% over the next year (see details in the valuation section).  This investment does not come without risk.  Major risks include deal risk, underlying performance risk of the operating businesses, and the risk of a dividend cut.

 

History

To fully understand the risks and potential rewards of Digirad you really need to understand the recent history.  This history is also largely the reason that this attractive opportunity exists.  Digirad itself was a promising small cap healthcare imaging company a few years ago.  The company completed a transformative acquisition on January 5th of 2016 by acquiring DMS Health Technologies which was poised to roughly double the revenue and EBITDA of the company.  The acquisition did not end up as attractive as it was originally held out to be.  Margins in the space were pressured and top line revenues struggled to grow as originally projected.  On top of a lackluster DMS Health Technologies acquisition, the company lost a major servicing and sales contract with Philips Healthcare in October of 2017, which materially impacted their revenues and profitability.  This eventually led to the sale of their MDSS services contract to Philips Healthcare in February of 2018 for a consideration of $8 million.  This was a major hit on the underlying business and the stock price crashed from $3.50 down towards its current price of $1.35.  This led to a bit of soul searching on what would be the path forward, as the remaining Digirad business was a stable cash flowing business, but lacked growth pathways.  That is in part where the idea of the proposed acquisition stems.

All of the companies involved in this transaction are companies that the Chairman of the Board, Jeff Eberwein, has been involved in.  This transaction seems to be Jeff’s brain child, to bring together a few businesses that he has financial stakes in into one corporate Holdco in which Jeff will be the sole capital allocator.  Jeff will retain the Chairman of the board position in the …

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Andrew Kuhn August 28, 2018 Free Articles 5 Comments

KLX Inc/KLX Energy Services Spinoff

Member Write-up by Yuvraj Jatania

Spinoff Background 

In May 2018, KLX Inc. (KLXI) announced an agreement to sell their Aerospace Solutions Group (ASG) to Boeing for $63/share in an all cash deal. 

The deal was based on a successful spinoff of KLXI’s Energy Services Group (KLXE) because Boeing had no interest in buying this part of KLX’s business. 

The management team led by founder, Chairman and CEO, Amin Khoury, initially tried to market the energy business for sale to trade and financial buyers. Bids were received from a mixture of competitors and PE houses in the range of $250-$400m but management felt very strongly that these valuations undervalued the potential of the business based on the rapidly improving market conditions, the higher market value of comparable companies and strong forecasted financial performance of the business. 

Instead they decided to initiate a spin off which would allow them to run the energy business as a standalone, publicly traded entity. 

Our investment opportunity lies in the spinoff of the energy business which will trade on the NYSE under ‘KLXE’. 

The spinoff is expected to take place before the end of Q3 2018. Not long. 

KLX Inc 

KLXI is a US listed company which used to be part of BE Aerospace (BEAV). 

BE Aerospace was founded by Amin Khoury in 1987 through an acquisition of an aerospace interiors parts manufacturing and services business with only $3m in revenue at the time. Khoury grew the business and sold the manufacturing side to Rockwell Collins in April 2017 for $8.6bn and retained and managed the services business which became known as ‘KLX Inc’. 

KLXI operates through two distinct and unrelated businesses: 

1. KLX ASG – Aerospace after-market services and parts/consumables for commercial and private aircrafts 

2. KLXE – Onshore oil and gas field services – focused only on serving North American onshore Exploration and Production (E&P) companies 

KLX Energy Services Group 

The energy business was founded through a quick succession of acquisitions in 2013-14 of seven regional oilfield services companies which each operated in the major shale basins in North America – the Southwest, Rocky Mountains and the Northeast. The execution and integration of the acquisitions was managed by Khoury and his executive team. 

The business provides well completion, intervention and production services and equipment to major oil and gas E&P companies. Their customers include Conco Phillips, Chesapeake Energy and Great Western amongst others. These companies drill and create wells in the shale basins looking for oil and natural gas. When they have a pump issue, equipment gets stuck or loss, a valve becomes faulty or loose, or any other well-related issues they call in technicians or equipment and tools from a company like KLXE. Historically, some of these players would resolve these issues by having an in-house team but now a majority of them outsource the support services to companies like KLXE as the work is considered non-core to their daily activities. 

One of the very attractive features of this type of business is …

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Andrew Kuhn July 12, 2018 Free Articles 0 Comments

LEAPS: The Joel Greenblatt Way to Bet on Entercom (ETM) and GameStop (GME)

Member Write-up by VETLE FORSLAND

Investing in companies with big upsides (and big downsides) with LEAPS, instead of common stock, to up your return (and minimize risk)

 

If you believe that a stock is excessively mispriced, and you want to buy that stock, there is a way for you to translate a say, 30% gain into a triple digit gain. It’s called LEAPS, or “Long-Term Equity Anticipation Securities”, and if used wisely, it is one the best ways to leverage your investment returns as a retail investor. Joel Greenblatt wrote about it in “You Can Be A Stock Market Genius”, where he described it as a tool that “has many of the risk/reward characteristics of an investment in the leveraged equity of a recapitalised company”. I recommend reading his bit on LEAPS, starting on page 213, as Greenblatt himself can show its pros and cons much better than I ever could. But, the strategy is basically buying stock options that expire 2 years down the road. Stock options are usually not attractive for long-term investors as they don’t allow sufficient time for a larger repricing, and are dependant on a short-term catalyst. However, as you can own LEAPS up till two years, chances are a stock that is severely and obviously mispriced will reach (or get close to) its fair value during your holding period.

 

Since, LEAPS are basically long-term options, how do options work? You can buy put options and call options, but in this case we will just look at calls, which is basically the right, but not the obligation, to buy a stock at a specified price within a specified time. For instance, let’s say you purchase a call option on shares of GameStop (GME) with a strike price of $16 and an expiration date of August 10th 2018. This option contract would give you the right to purchase 100 shares of GameStop at a price of $16 on August 10th, but as this right is only valuable if GameStop is trading above $16 on the expiration date, you risk expiring the option valueless. Right now, you can buy one call option on GameStop for August 10th for $0.50, which represents 100 underlying shares of stock, so the cost of a trade of 100 call options will be $5,000 (($0.50 x 100) x 100 shares. If by August 10th, GameStop trades at $17, the buyer could use the option to purchase those shares at $16, then immediately sell them for $17. Therefore, the option will sell for $1 on August 10th, and as each option represents 100 underlying shares, and our hypothetical trader bought 100 options, this will all total a sell price of $10,000. Because the trader bought this option for $5,000, the net profit equals $5,000 – comparably, a common stock buyer would have had to invested $160,000 to make the same profit from the same trade.

 

If, however, GameStop stock trades for $16.50 at the expiration date, …

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