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Should We Follow Seth Klarman on the Purchase of Targacept?

December 13, 2011 | About:
Any free fall in a stock price would signal investment opportunities for any value investors. The reason for the fall might be varied, from a pending law suit, a change in auditors, a resignation of key executives, to a miss in expected earnings, etc. Just recently, Targacept (TRGT), the biopharmaceutical company engaging in the design, discovery and development of neuronal nicotinic receptor (NNR) for the treatment of diseases and disorders of the nervous system, experienced a free fall in just a month. In the beginning of November 2011, the stock price was around $19, and it dropped 63% to $7. It is currently staying at $7.8 per share.

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And with that significant downfall in TRGT’s stock price, our famous value investor, Seth Klarman had initiated its position, along with other gurus’ trades such as Jean Marie Eveillard and George Soros; they had bought into this stock in the past for the same price. As we can see below, the price range that those gurus paid for the stock is around $7-$8 per share. Seth Klarman moved aggressively, taking more than 16% of company’s total shares outstanding. However, it is just 1.38% compared to the total dollar value of his portfolio.

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That was the guru trades. How about the insider trades in the same period?

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A very consistent and large share sale of company’s executives was detected in the year 2011, from its director to vice president, senior vice president, CFO and treasurer. But at that time, the price was very high, from $21 to $30 per share, and the stock price is now off 60%-70% from insiders’ average selling price.

So there are two questions appearing in our minds. Should we follow our guru to initiate a position in this stock? And if we follow Seth Klarman to purchase the shares, how much of our total portfolio should this position account for?

Let’s start with the fundamentals of the company. Like any biotech company, TRGT experienced a very high swing in its operating performance over the years. Operating income and net income have been mainly negative, and only positive in 2 out of 10 years. The same situation is reflected in its operating cash flow and its free cash flow over time.

USD million 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Operating Income -9 -21 -20 -24 -30 -32 -28 -40 13
Net Income -7 -21 -19 -24 -29 2 -28 -26 -39 11
Operating Cash Flow -25 -26 -10 25 -28 -24 138
Free Cash Flow -26 -26 -11 20 -30 -24 135


So it was hardly that Seth was buying in because of the company’s earning power. So it is mainly because of the asset plays. Let’s look at its asset value:

Balance sheet Sep-11
Cash 213
Receivables 1
Inventories
Prepaid expenses 3
Total current assets 217
Net property, plant and equipment 5
Equity and other investments 57
Total assets 280
Short-term debt 2
Accounts payable 1
Accrued liabilities 16
Deferred revenues 76
Long-term debt 2
Total liabilities 98
Common stock 0
Additional paid-in capital 399
Retained earnings -217
Total stockholders' equity 182


We can see the financial structure of TRGT is quite conservative, with D/A only at 35%, whereas 77.5% of the liabilities are in deferred revenue, with very little long-term and short-term debt. On the asset side, the main asset TRGT is holding is cash and short-term investments, up to $213 million, or 76% of its total assets. So when adjusting its cash and level of debt, the $264 million market cap becomes only $55 million in enterprise value. So the investor effectively pays $55 million for the marketable securities that the company is making, bearing some accrued liabilities and has deferred revenues ahead. The investment in marketable securities is rather safe, as it is mainly in U.S. Treasuries, some corporate debt instruments and certificate of deposits.

Clearly, it was a “cigar butt” purchase, and by putting out $55 million, the investors can get $57 million investment in marketable securities and nearly no bank debt ahead. It seemed to be quite cheap. However, with any “cigar butt” or asset play, a reasonable amount of diversification should be implemented. Even Seth acquired more than 16% of the company, but in his portfolio, this transaction was only nearly 1.4% in his total dollar value of his portfolio. Should any investors follow Seth, remember the ample diversification should not be ignored also.

This is the subjective viewpoint of the author, and it is not the recommendation to buy, hold or sell the stocks mentioned in this analysis. Anyone who wishes to buy, hold or sell the stocks has to do his/her own analysis at his/her own risk.

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


Rating: 3.9/5 (31 votes)

Comments

clm10
Clm10 - 2 years ago
...and you can get this company at 25% off today.
ken_hoang
Ken_hoang - 2 years ago
hi, and yes :) feel very excited about it. Gonna purchase it soon though

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