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A Tale of Two Companies: The Importance of Monitoring Cash Flow in Net/Nets

June 13, 2011 | About:
John Emerson

John Emerson

141 followers
One of my readers recently sent me a personal message requesting that I discuss in detail my best stock purchase. I was on vacation in the mountains when I received the request so I had a good deal of time to reflect upon his question as I took long walks enjoying the majestic beauty of the mountains, beautiful songbirds, the emerging wild flowers, and the clean mountain air. Fortunately I did not encounter any "Timeshare Closers" or Real Estate Agents when I was having my Thoreau moment (the place even had a Walden Pond). Now that I am once again rooted in my boring Midwest reality, I am prepared to answer the question by telling the tales of a pair of Israeli AOI (Automated Optical Inspection) companies which directly compete in the world of printed circuit board (PCB) inspection.



For my money, the perfect scenario for a multibagger with limited long term downside, is a highly cyclical company in the midst of an earnings trough which is being exacerbated by an economic slowdown and a market sell off. Specifically one with a history of profitability and a strong balance sheet. The perfect candidate is one which trades at a discount to its net current assets (current assets less total liabilities is > than its market cap).

A perfect example of such a company was CAMT during the post 9-11 economic crisis of the early 2000s, a second example was ORBK following the financial crisis of 2008. Both scenarios were quite similar but one key element will emerge which will identify which one was actually the "best" purchase. Identifying the "best" purchase has nothing to do with the subsequent trading gains of a company, rather it has to do with the risk vs. reward scenario. In other words, the best purchase one can make does not reflect the potential upside so much as it reflects the potential upside as compared to the potential downside. For value investors Margin of Safety supercedes potential upside and monitoring the cash flow from operations as opposed to merely watching net earnings or EBIT (earnings before interest and taxes) is fundamental in accessing the margin of safety in a stock.

CAMT Post 9-11-2001

Camtek (CAMT) had IPOed in the Summer of 2000 near the tail end of the tech mania, several months later the stock had reached double digits. By October of 2002, the major market indices had bottomed but CAMT continued to drop in price per share well into the Winter of 2002 trading at prices of under .30 per share. I recall making small purchases of the stock as low as .25, I was able to acquire a fair size block of shares at 30 cents.

The stock was a perfect example of a broken IPO and by late 2002 it was a huge net/net proposition with a market cap of about 8 million and net liquid assets of around 30 million. The stock was now trading at less than .3 its net current assets, a true penny stock, passed off as virtually worthless in the eyes of investors, it was being dismissed as another dot com bust with zero long term value.

The difference between CAMT and most of the of the other technology IPOs was revenues. In 2001, the first full year that Camtek traded publicly, the company had recorded over 44 million in revenues. The company clearly had a viable product in the form of its PCB/AOI equipment which was able to inspect for defective circuit boards as they passed through the manufacturing process. The age of minimization of circuit boards had rendered visual inspection virtually worthless and the 21th century was ushering in a new wave of electronics which promised increasing demand for AOI systems. The temporary economic slowdown of 2002 was not going to put an end to a new era of electronics and the need for circuit board inspection, it was merely going to push back the sales and demand for Camtek's products temporarily.

By the end of 2003 the world economy and the demand for AOI units was picking up, so was CAMT's share price. In 2004 CAMT recorded over 67 million in revenues and nearly 11 million in after tax income. The share price soared to around 6 dollars per share by early 2004 as demand for AOI system returned and a bull market sentiment engulfed the entire market.

In 2005 Camtek's revenues swooned slightly and the share price retreated by around 50%, only to resurge as CAMT was about to achieve a record year in revenues and profits in 2006. Everything appeared well at CAMT, shareholders had good reason to celebrate the lofty share price but investors who monitored the cash flow statement for the company were not so enamored.

The following is the ten year summary for CAMT's Income statement:

Income Statement - 10 Year Summary (in Millions)

Sales EBIT Depreciation Total Net Income EPS Tax Rate (%)
12/10 87.78 3.37 0.0 2.82 0.09 16.51
12/09 53.52 -11.46 2.15 -11.84 -0.41 0.0
12/08 75.46 -8.79 1.95 -9.56 -0.32 0.0
12/07 70.97 -7.33 1.31 -7.69 -0.26 0.0
12/06 100.06 11.64 0.79 11.6 0.39 0.35
12/05 63.03 2.7 0.66 2.7 0.1 0.0
12/04 67.42 11.3 0.75 10.8 0.39 4.42
12/03 31.14 -1.34 0.79 -1.57 -0.06 0.0
12/02 22.59 -10.77 0.89 -11.29 -0.47 0.0
12/01 44.07 -3.56 0.62 -3.71 -0.17 0.0


Now contrast this information with the Cash Flow from operations:

2010 2009 2008 2007 2006
Period End Date 12/31/2010 12/31/2009 12/31/2008 12/31/2007 12/31/2006
Period Length N/A 12 Months 12 Months 12 Months 12 Months
Stmt Source N/A 20-F 20-F 20-F 20-F
Stmt Source Date N/A 06/07/2010 04/08/2009 06/30/2008 06/29/2007
Stmt Update Type N/A Updated Updated Updated Updated
Net Income/Starting Line 0.0 -11.84 -9.56 -7.69 11.6
Depreciation/Depletion 0.0 2.14 1.95 1.31 0.79
Amortization 0.0 0.0 0.0 0.0 0.0
Deferred Taxes 0.0 0.0 0.57 -0.06 -0.43
Non-Cash Items 0.0 1.42 1.0 0.94 1.43
Changes in Working Capital 0.0 12.23 3.14 4.22 -12.64
Cash from Operating Activities 0.0 3.94 -2.9 -1.28 0.75


Additionally, in 2004 net income was 10.8M, cash flow from operations was a negative (1.8M). Further note that the company raised over 15 million in a private stock issuance during 2006 which was the companies' best year in terms of net income and revenues, but resulted in a paltry .75 million gain in cash flows from operations. Translated, the company was burning cash but showing accrual profits while capitalizing on the opportunity to increase its liquidity by selling additional shares in the company. In reality, the income statement of the company for the last ten years bears little resemblance to its true profitability. Here are the complete numbers courtesy of GuruFocus: http://www.gurufocus.com/financials.php?symbol=CAMT

I suggest that all readers utilize the financials provided by Gurufocus, they are a terrific resource and provided free of charge.

ORBK Post 2008 Financial Meltdown

In the early 2000s, ORBK was the much larger and better financed rival of CAMT in the PCB/ AOI sector. The term rivalry hardly depicts the situation accurately unless one considers that a nail is a suitable rival for a hammer. CAMT was more of a pest than a rival and subsequently focused much of their R&D on semiconductor inspection instead of PCB inspection in deference to Orbotech (ORBK).

Year end 2007, ORBK had approximately 10 dollars per share in net current assets. In 2008 just prior to the financial meltdown they agreed to purchase Photon Dynamics for about 290 million dollars. At the end of 2008 following the purchase, ORBK still had roughly 3.5 per share in net current assets; with the addition of Photon Dynamics, they were now the dominant player in LCD/AOI equipment as well as the leading PCB/AOI equipment producer.

For an extended period in late 2008 to early 2009, the stock was available for sale on a regular basis for 4 dollars per share or less. Timely buyers were able to purchase the stock at around its net current asset price after the sale of Photon was consummated in late 2008. On a net/net basis it was not nearly as cheap as CAMT but a review of its earnings and cash flow statements indicated that it was a much higher quality company. The flowing financial summaries clearly reveal that fact:

Income Statement - 10 Year Summary (in Millions)

Sales EBIT Depreciation Total Net Income EPS Tax Rate (%)
12/10 529.36 50.4 23.67 42.86 1.2 14.68
12/09 359.33 -16.21 29.98 -16.01 -0.46 0.0
12/08 407.95 -96.88 21.24 -97.91 -2.92 0.0
12/07 349.53 17.97 1.12 14.48 0.44 15.61
12/06 415.83 68.94 0.0 60.48 1.81 11.45
12/05 379.92 48.91 9.26 43.26 1.3 11.45
12/04 315.17 33.68 8.34 29.49 0.9 12.9
12/03 228.39 -1.93 8.88 -2.96 -0.09 0.0
12/02 216.37 -16.66 10.1 -15.79 -0.49 0.0
12/01 301.9 1.06 14.58 2.03 0.06 -92.33


The cash flow from operation for ORBK told an even better story of the companies' profitability:

2010 2009 2008 2007 2006
Period End Date 12/31/2010 12/31/2009 12/31/2008 12/31/2007 12/31/2006
Period Length 12 Months 12 Months 12 Months 12 Months 12 Months
Stmt Source 20-F 20-F 20-F 20-F 20-F
Stmt Source Date 02/24/2011 02/24/2011 02/24/2011 03/26/2010 03/29/2007
Stmt Update Type Updated Restated Reclassified Reclassified Updated
Net Income/Starting Line 34.29 -19.76 -135.07 1.9 54.97
Depreciation/Depletion 23.67 29.98 14.71 12.2 7.75
Amortization 0.0 0.0 0.0 0.0 0.0
Deferred Taxes -3.87 -0.53 -2.65 -0.11 0.07
Non-Cash Items 7.16 3.03 137.81 13.75 12.35
Changes in Working Capital -12.14 40.29 -25.65 -19.56 -24.38
Cash from Operating Activities 49.11 53.01 -10.85 8.19 50.76


In direct contrast to CAMT, ORBK routinely understated its accrual earnings, "printing cash" during its up cycles without much capital expenditure requirement. Again I refer you to the Gurufocus 10-year trailing financial statements for a much clearer picture of the quality of Orbotech's earnings. http://www.gurufocus.com/financials.php?symbol=ORBK

At four dollars a share in 2008/2009, ORBK had a market cap of around 130 Million and a much larger future business with the addition of Photo Dynamics. The company probably had overpaid for Photon but the market was dramatically overreacting, currently valuing a company which had generated a four-year peak cycle free cash flow average for 2003 through 2006, of about 34 million per year. That impressive free cash flow was incurred without the benefit of Photon Dynamics which was certain to significantly increase the companies' free cash flow average in upcoming years, while reducing the choppy nature of the overall company earnings due to the bust/boom nature of the PCB/AOI sales.

In essence, the market was valuing ORBK as if the 290 million they had paid for Photon had been thrown into a sink hole and would result in losses for the foreseeable future. Even after the purchase was incurred, the company was trading at just slightly more than its net current assets for a six month period in late 2002 and early 2003.

Conclusion

In terms of the question, what was my best stock purchase ever?, the answer is clearly CAMT, right? It was purchased at less than one third of it net current assets and resulted in a multi-bagger in excess of 20 times the purchase price (had I sold it in 2004 or 2006). Wrong, clearly the better purchase was ORBK which was purchased at slightly over net current assets and has only resulted in slightly over a three-bagger.

You might ask how could that be? Twenty times trumps three times in spades! The answer lies in assessing the veracity of the financials while recalling Warren Buffett's three most important words in investing, Margin of Safety. The margin of safety in a stock is a direct reflection of the veracity of a companies' financial statements. While I have recorded much higher multi-baggers in other companies than ORBK, including a number of Chinese stocks, in reality I was unwittingly exposing my capital to excessive risk. You see, companies that utilize aggressive accounting as in the case of CAMT, or outright fraudulent accounting as in the case of many Chinese RTOS, provide no margin of safety, merely an illusion of one.

Companies such as ORBK who have a significant history of quality earnings in addition to a favorable price are clearly the better choices. After all, what good is a net/net discount if it is based upon inaccurate financial statements?

Disclosure, long ORBK

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 3.0/5 (12 votes)

Comments

Adib Motiwala
Adib Motiwala - 3 years ago
John,

thank you for taking the time to share this with all of us. It is much appreciated.

A few questions out of curiousity:

At what point did you sell CAMT and all along as it went up towards $6, what was the valuation like? Did you not trim your positions ?

I think you have the years wrong in this line about ORBK "_ [size=14px; line-height: 25px; ">

John Emerson
John Emerson - 3 years ago
Your are correct, disregard the top years of the ORBK cash flow chart. As far as CAMT, I was a classic moron in not recognizing the cyclical nature of the stock. I falsely believed that the cylical nature of the company was significantly lowered when they entered semi-AOI, plus the margins were so high compared to PCB-AOI, I thought the earnings would improve even if the revenues did not. Then suddenly the revenues drop, the margins lower and the stock price crashes before one can sell, so one tends to wait for the next cycle.

I held most of my shares until I switched them out for RTEC and ORBK (better companies in the same sector), using the ones that I purchased at higher prices for tax losses during the financial crisis. RTEC was a huge net/net at that point and after it ran, I switched my gains into ORBK. RTEC had also won a lawsuit for patent infringement against CAMT so that entered into my decision as well.

At that point I had accrued huge losses to carry forward particularly with my worst purchase of all time GTN, so it was like trading in an IRA instead of racking up short term gains.

The problem with foreign stocks is one does not generally get the statement of cash flow until the Summer of the next year when the annual comes out. I was also negligent in monitoring the cash flow until the stock was hammered by then of course the stock had dropped precipitiously and one wishes to hold it until the next cycle emerges. I now have preset targets as to a general time frame when I will sell when I hold cyclical stocks. I try to sell them when they still look cheap. For instance I had targeted ORBK to sell late this year or early 2012 if my tax bill was too high, now that they raised cash in a secondary I probably should just move on. Good management generally sells shares when they believe the company is getting expensive or the cycle is peaking.

Lastly, I was holding too many companies before the financial crisis and I was neglecting my smaller positions. CAMT was once a big position but when it dropped I did what dopes generally do, I just held it waiting for it to rise again.

The market plunge really straightened me away, since that time I hold fewer stocks and I pay closer attention. Frankly I got sloppy after my portfolio ran up starting in late 2002 until late 2007. I quit worrying so much about book value and I started getting to caught up on EBIT/EV or free cash flow valuations if the companies I bought were highly leveraged. I had been fully invested since about a month after 9-11, and it was getting difficult to find price to book plays, let alone net/nets.

I believe the crash of 2008/2009 made me better and more conservative investor and I try to practice more of what I preach. Apparently the crash in 2002 was to short to leave a lasting impression.

Thanks for the comments

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