How to invest

Written by

Jae Jun

The pure play way to get into the Rare Earth market without the risk.

Rare Earth Elements (REE) Discussion

The misguided notion about rare metals is that, it is referred to as if is just one type of metal. This couldn’t be further from the truth. REE is actually comprised of 17 different metals. They each have different properties, different supply and demand and differ in cost.

You can then divide the group of 17 metals into two categories; light and heavy.

If you own a mobile phone, LCD/LED TV or Toyota Prius, have taken a flight or even pointed a laser at somebody, then you’ve used a product containing rare metals. These are just some of the products that need rare metals in order to function. Most of these items you probably can’t live without nowadays.

But it doesn’t end here. REE has an enormous range of uses from basic products to defense applications and the increasingly growing new energy segment. Without such metals, you’ll be using a phone the size of a brick, a laptop you need to haul around in a luggage case and a wide screen TV that takes up half your living room.

Just take a look at the table below and for now, note the green underlines.

Supply and Demand

Contrary to the world “rare”, all of the 17 metals are very common on the earths crust. Dig a little into the ground and you may possibly come across some rare metals.

The problem however, is that these metals are rarely concentrated into a single region for easy or economical mining. It is scattered throughout the world and the deposits that do exist are either financially impossible to mine and/or unsafe as rare earth mineral deposits contain thorium which is radioactive.

The US now imports 100% of its rare metals and it is likely to stay that way for several more years until Molycorp (NYSE:MCP) brings into production the reopened Mountain Pass property.

For any country in terms of politics, China producing 97% of the supply is a horrifying number, but since I’m talking about an investment here, this 97% figure could actually be a blessing.

China is playing its monopoly on REE extremely well. They have continually cut export quota driving up prices and profiting enormously. As long as China keeps its stranglehold on REE, don’t expect prices to fall. Remember that these are metals that cannot be replaced so companies must buy it.

Along with Molycorp, Lynas (ASX:LYC) is an Australian miner working to produce rare metals of its own. Both companies expect to be online within the next year or so, but there is a saying in mining that if there is something that can go wrong, then it will. Plus it gets even worse for rare earth miners because you can’t just dig up lumps of metal. These metals may be in the form of dust and grains when mined, and if there are 17 metals all mixed together in a heap, each metal must then be separated.

This means a whole lot of chemical processing and strong magnets are required for separation which only adds to the cost and complexity. That’s why investing in the rare earth miners is a big no no at the moment.

The current demand for REE is around 134,ooo tons per year with global production around 124,000 tons per year. The difference is covered by inventory as you can see in the above table, but as the world gets smarter, quicker, more efficient and more advanced, the demand will definitely rise. Demand is already projected to 180,000 tons by 2012 and by 2014, it’s expected that demand could exceed 200,000 tons a year.

However, the quotas do not differentiate between each of the REE’s and even China is finding it difficult to find heavy REE’s.

Source: Dacha Aug 2011 corporate presentation

In an effort by the Chinese government to crack down on mines exceeding the production permits, many mines have now stopped operations. There are reports that the 2011 quota of 93,800 tons has been reached and rare earth separation plants have already suspended production at the majority of its smelters in a bid to meet new environmental standards.

“The majority of rare earth separation plants have suspended production for around one month, and are upgrading their facilities and technology to meet the government’s higher standards,” a spokesman for the Jiangsu Rare Earth Association, surnamed Cai, told Reuters.” – Reuters

The Chinese government agency, the Ministry of Land and Resources, invoked a seldom-used mining law to take direct control of 11 rare earth mining districts in southern China. This has resulted in 30% of the mines in southern China ceasing operations. However, I still expect output to exceed the quota which is usually the case, but the demand is still going to be there with limited supply.

Most of the heavy rare earths come from an unusual geological formation that straddles the hilly, sometimes lawless southern border area of Jiangxi Province with Guangdong Province. According to geologists, it is the only known commercial deposit of rare earths in the world that has virtually no contamination from thorium, which is radioactive.

Many companies in the West indirectly depend on illegal mining and smuggling. Industry experts estimate that illegal production accounts for about a seventh of the supply of light rare earths in the world and as much as half of heavy rare earths. – Midas Letter

The end of the year is approaching which is when manufacturers start to increase production for Christmas as well as the new year, which will continue the demand for REE.

Light vs Heavy Rare Earth Elements

Getting back to those green underlines from the first table, let’s see what Molycorp and Lynas will produce in the REE group.

• Mines in China produces both light and heavy metals.
• Molycorp will produce light metals. In fact 99% of total production will be light metals.
• Lynas will produce light metals. 98% of total production will be light metals.

Notice something?

That’s right. Molycorp and Lynas will not produce any heavy metals. Unlike the light metal market that is likely going to get flooded by Molycorp and Lynas, heavy REE supply will continue to be dominated by China and companies like Samsung, Sony, Toshiba and Toyota will want alternative sellers.

Just as an example, Dysprosium (Dy) is a heavy REE that goes into the Toyota Prius. The Prius requires merely 100g of it which costs about $160 in a $24k+ car, but without it, there is no Prius.

Heavy REE applications are virtually impossible to replace.

Even if you’re not into mining and commodities, I hope you’ve grasped the potential of the Rare Metals industry, because this is where Dacha Strategic Metals (OTC:DCHAF)comes in.

Dacha: The Pure Play to REE

Dacha is an extremely easy to understand business. It strategically buys/accumulates heavy REE from the Chinese market and stores the physical oxide (powder form) and metal in its warehouses in China and South Korea. Dacha is able to trade REE with China due to a small Chinese trading company it bought in fiscal 2011.

That’s about as easy a business model as it gets. Dacha does not explore, mine, or produce any of its metals. The risk of the whole exploration and producing phases are non existent.

Another point that adds to Dacha’s undervaluation is that just until 2010, Dacha was mostly an investment holding company. The company lost money on its investments, decided that it wasn’t the next Berkshire Hathaway and proceeded to change the direction of the company. If you take time to go through the SEDAR (Canadian equivalent to the US Edgar), you will notice large losses which makes it seem like this is a deadbeat company.

You can read what they do in more detail from their corporate profile.

Who are the Insiders and are they Trustworthy?

When it comes to any commodity company, I’ve come to understand that management is crucial.

I have to admit that I am not the best judge of character when I’ve never met the people or spoke with them, but there is one person you need to be aware of, and that is Stan Bharti, the executive chairman.

Stan Bharti is the founder of a private merchant bank called Forbes and Manhattan (F&M) which invests in exploration companies and junior. What’s impressive is that F&M performs all of their analysis on potential companies in house. They have their own geologists, analysts, investment lawyers, M&A specialists, stock analysts and anyone else you would need to run a successful investment company, and by performing their own in depth analysis and field visits, F&M is able to decide which company has potential. Dacha just so happens to be one of those companies in their portfolio.

Stan Bharti and the current CEO Scott Moore came on the board after F&M’s private placement in Dacha. These two men decided there was more potential changing Dacha from an investment holding company to a REE holding company. Look at all the warrants and options they have, both these men are in it to win it.

Here’s a profile article on Stan. Like most articles, it’s all positive stuff, but it’s something to keep in mind.

One thing to be concerned about is that because Stan is on the board of so many companies and has a strong position in the company, there are related party transactions to know about. Dacha provided a loan back to F&M but from the wording in the filings, it looks as if Dacha doesn’t mind not being repaid.

During the year ended March 31, 2011, the Company extended the maturity date on the loan outstanding to FAMCo to April 30, 2011 and advanced an additional $118,625 under the facility. At March 31, 2011, the principal outstanding  was $3,056,118.  Subsequent to March 31, 2011 the loan was extend an additional six months, to October 31, 2011. FAMCo currently does not have sufficient current net assets to repay the secured debenture and has  no operating cash flow to service the interest payments. The payment of interest on the secured debenture and the repayment of the principal are dependent on FAMCo’s successful implementation of its business plan or the sale of its assets.

Dacha has the option, exercisable at any time, to convert the principal amount outstanding into 33% of the outstanding security of FAMCo as at the time of conversion. As at March 31, 2011, accrued interest of $440,203 (2010 – $77,090) related to the loan was included in amounts receivable. As at March 31, 2011, the Company has reviewed the recoverability of the FAMCo loan and has determined that no impairment is required.

Risk – What’s the Catch?

As good as Dacha sounds, it isn’t without risk. Dacha certainly isn’t for everyone.

1. Valuation is dependent on REE pricing. The price of REE has gone parabolic and you could believe that prices are inflated. If REE prices come down, so too does the value of Dacha.
2. Exchange rate risk. Dacha is a Canadian company and so the reporting figures are all in Canadian dollars.
3. Foreign operations in China could come under further regulation making it difficult for Dacha to stock pile the needed metals.
4. Although the company made $0.33 EPS profit, this could be a one time thing with the price of REE being so high.
5. Big concentration in metal portfolio. Terbium oxide: 30-40%, Dysprosium metal: 35-45%, Yttrium oxide: 5-10%, Gdolimium & Lutetium: 5-10%, and Europium: 10-15%.
6. Stan Bharti’s influence over the company.
7. Dacha could continue to be recognized more like an ETF of REE as opposed to a heavy REE metal buyer/seller.

Valuation

Like all commodities, valuation is dependent on the pricing of the metals. REE prices are quoted on Metal Pages and is one of two sources where Dacha and many of the companies in the industry get their pricing.

Here is the last quoted inventory value on Dacha’s website. (An updated price quote was released the day after I wrote this with the asset value being very similar.)

Based on this information and the numbers from the latest reports, I come up with the following valuation which shows Dacha to be 40% undervalued to its Net Asset Value on a fully diluted basis.

August is a typically a quiet month for REE’s and let’s say that the entire inventory value dropped 20%. Even still, Dacha is at a 26% discount to Net Asset Value.

Additional Opinions

Matt Gowing, Mackie Research (8/22/11) “Dacha Strategic Metals Inc. remains significantly undervalued. . .and the company has been successful in timing its rare earth purchases. As a result, Dacha has seen significant gains in its rare earth inventory (current inventory value of $150M versus $30M in December 2010); in addition, the company only has to pay a corporate tax of 2.5% due to its offices in Barbados. Hence, Dacha’s corporate structure will allow it to realize higher after-tax profits from its transactions.”

The Critical Metals Report Interview with Jon Hykawy (8/2/11) “Dacha is dealing with materials that are generally bought and sold in smaller quantities; a few tons at a time rather than hundreds of tons. They sell to a group of customers who typically buy their material on a regular schedule. It’s not the sort of material and not the group of manufacturers that are likely to sign a big-name offtake agreement. Dacha likely has a place in the market moving forward for a long time yet. . .So far, company management has done very well. . .Inside or outside of China, we’re likely to see continued price appreciation in the materials that Dacha holds through most of 2012.” More >

Dacha Capital: A Discussion With Patrick Wong by Gareth Hatch (7/22/11) “Well it’s not that our model includes or assumes some sort of price discovery. Our model tries to identify situations where risk is limited and upside price appreciation is much higher. Part of this is finding these ‘pinch points’, and the belief that the process of price discovery will create more efficient markets, and therefore a better recognition of value. We believe people may be getting price transparency and price discovery confused. Dacha views price transparency as a means of pricing data to be a true representation of the market at that time, while price discovery is the process of markets identifying or recognizing fair value for assets.” More >

Closing Thoughts…

China is in complete control of REE which has in turn become a political issue. At the moment, even the quickest production schedule isn’t expected until 2014, but even still, it doesn’t address supply for heavy REE’s, only light REE’s.

The world will continue to become more sophisticated. Smartphones are beginning to enter the 3rd world countries, LCD TV’s used to cost $10k but is now a commodity, and the demand for defense and green energy is high on the list.

The world needs REE’s and I’m betting that Dacha will be able to capitalize on this demand.

Disclosure

I hold shares of DCHAF at the time of this writing.

Written by

Jae Jun

You Don’t Want to Miss Big Profits by Ignoring BOLT

Part 1: The Business and Risk of Bolt Technologies

Quick Overview of BOLT as an Investment

My assessment of BOLT is summarized by the spider graph shown here.

Low Risk: The company financial statement is very easy to read and analyze. There aren’t any hidden derivatives or tongue twisting jargon to confuse you. The balance sheet is very strong with plenty of cash and liquid assets. The Seabotix acquisition was easily consummated for with the cash on hand and has not weakened the balance sheet.

When I first looked at BOLT, crude oil was in the low $70’s mark and as of July 22, 2011, it is now at $100. Like I mentioned in the first BOLT post, BOLT is a seller of equipment to help detect oil and so their profits do not increase in line with oil prices, but the increase in activity as oil prices increases is the catalyst for BOLT’s profits.

High Growth: Operating in a niche market, BOLT is not expected to have high growth. It grew substantially during the oil bubble in 2007 and oil is consistently near the $100 per barrel range which implies that the upside is still there. In terms of physical growth, BOLT grew its tangible book value by 17% from 2008- 2010. Going through multiple rolling time frames, this is the slowest rate that BOLT has grown over a 3 year period.

Undervalued: From the valuations that you will see below, BOLT is being priced at around a 30% discount.

Well Managed: People complain on the Yahoo boards that the management team is senile and out of touch. The numbers from my analysis suggests otherwise. Management could be all talk and no walk, but the numbers disprove this complaint.

Good Financial Health: No debt, plenty of cash, liquid assets. No worries.

Strong Moat: Within a niche there are not many competitors. Going through the financial statements, the numbers reveal that BOLT does indeed have a competitive advantage.

Financial Statement Analysis

Before going further, here are some links to help you master analyzing each of the financial statements and how to bring it all together.

• Master the Income statement
• Master the Balance sheet
• Master the Cash flow statement
• Detected competitive advantages through the income statement, balance sheet, and cash flow statement

Moving on, here are some noteworthy points from the latest 10-Q.

Balance Sheet Analysis

• $3.52 cash per share, which makes up 28% of the share price.
• Inventory increase of 22% from prior year, but if you analyze the inventory, most of that build up has come from purchasing raw materials. Because BOLT creates products once orders come in as well as supply parts to previous customers, BOLT does not hold much completed inventory. Work-in-progress makes up only 10% of total inventory. One way you can analyze inventories quickly is with the financial statement analysis spreadsheet you get with the premium package.
• The one bad thing that I see resulting from the SBX acquisition is the big jump in intangibles. It has from from approximately 12% of total assets to 30%. Looking at the results for SBX, BOLT seems to have overpaid.
• On the liabilities side, short term debt is $6.9m. Long term debt is zero. With a quick ratio of 5.7 and current ratio of 7.8, no need to even worry about the health of the company.

Income Statement Analysis

• Gross margin of 50% for the past two years, and an average of 45% for the past 10 years is extraordinary and unheard of for most companies. But BOLT being the leader it is and being recognized for it, can increase prices. Definitely has a competitive advantage in its industry.
• The clean structure of the company allows BOLT to enjoy net margins above 15%.
• Tax rate is consistent at the 32-34% mark, so compared to previous years, earnings are not inflated by paying less in taxes. This is a point you want to take note of when analyzing the quality of earnings.

Statement of Cash Flows Analysis

• Clean Cash flow statement
• Only number that sticks out is the acquisitions figure under cash flows from investing activities

How Much is BOLT Worth?

Discounted Cash Flow (DCF) Stock Valuation

The DCF stock valuation method requires some assumptions and while it isn’t the perfect method, it is a very reliable and accurate tool if you keep it on the realistic to conservative side. The reason people get into trouble is because they fail to understand both the business and the industry when assigning a growth rate. Feel free to download a free copy of the DCF spreadsheet today.

For the past 10 years, BOLT has always been FCF positive with no debt or one time extraordinary items. The company is consistently profitable and has grown FCF at a staggering rate of 122% over the past 5 years and a blistering 57% over the past 10 years. Obviously, no matter how small and profitable a company is, this kind of number is impossible to duplicate year after year. Using this type of FCF growth in the DCF would produce astronomical valuations and be completely off.

Over the past 5 years, by taking a rolling median (ie, comparing multiple timeframes rolling across different time periods and then taking the median), the CROIC (Cash Return On Invested Capital) is 11.5%. This means that for every $1 of cash invested in the business, BOLT has been able to generate returns of 11.5c . I like to see this figure in the 15% range, but 11.5% is still no laughable figure.

Another metric I like to use the FCF/sales. It shows how much of sales converts directly to the bottom line. In BOLT’s case, for every $1 of sales, 10% is converted to FCF. A company that has a FCF/sales above 5% can be considered as a good generator of FCF.

So not only is the business a money generator, management adds to the equation to make it even better.

Here are the assumptions to get a DCF intrinsic value.

• Starting FCF of $9 million even though 2010 brought in $12m
• 14% growth rate for the next 10 years with a terminal rate of 3%. Considering the strength and size of the company, these are very conservative numbers.
• 15% discount rate

DCF intrinsic value: $17.19. This is currently a 27% margin of safety based on conservative assumptions.

A reverse DCF valuation shows with the assumptions made above, the market is pricing BOLT with 6% growth.

Benjamin Graham’s Formula

This valuation is based on Graham’s formula from The Intelligent Investor, which I have made modifications to as shown below.

• Using a growth rate of 14% based on the median of normalized earnings
• EPS of $0.68 for the TTM EPS

the value comes out to be $19, which is a 34% discount from current prices.

Earnings Power Valuation

Based on Bruce Greenwald’s EPV method, the asset reproduction cost comes out to be approximately $6.29 per share which is an increase from $5.20 when I first wrote about BOLT. This is the value that a competitor will need in order to at least copy the assets to run a business similar to BOLT.

By calculating EPV, I get a value of $16, which is significantly higher than the reproduction value. This means that BOLT does in fact have a moat—the value of the business is worth more than the assets. If a company had no moat, the EPV would be roughly the same as the asset reproduction cost.

For more information on how EPV works and how to calculate it, be sure to read my EPV articles.

Asset Valuation

Net working capital is the approximate value the company would fetch in a fire sale or liquidation and can be considered to be the floor of the stock price.

A backtest on NNWC and NCAV stocks has shown how profitable net net stocks can be.

Use this free net net spreadsheet to calculate the net net value of BOLT.

• NNWC is $3.92
• NCAV is $5.19

Based on NCAV, the market is valuing the future of BOLT to be worth $7.44 (12.63-5.19=7.44).

Fair Value PE Model

In order to find a fair value PE using the absolute PE model, I’m deriving the number based on the earnings growth rate, dividend yield, business risk, financial risk and earnings visibility.

• Expected Earnings Growth: 14% (based on the values I’ve been using so far)
• Dividend Yield: 0%
• Business Risk: 0.9 (giving BOLT a 10% premium over competitors in this category)
• Financial Risk: 0.9 (giving BOLT a 10% premium over competitors in this category)
• Earnings Visibility: 1.1 (inconsistent EPS due to cyclic nature of the industry)

Compared with the current PE of 18.7, the fair value PE of 17.5 isn’t that far off, suggesting that BOLT could be fairly valued.

Comparing against 5 Competitors and Still on Top

Competitors compared against BOLT include:

• ION Geophysical Corporation (IO)
• Mitcham Industries (MIND)
• Dawson Geophysical (DWSN)
• Geokinetics (GOK)
• Baker Hughes Inc. (BHI)

By comparing the competitors side by side, you can see how well BOLT stacks up fundamentally against each one regardless of how big the competitor is. Compare the fundamentals of cash flow, FCF, margins, debt, current ratio and effectiveness, and BOLT beats every competitor hands down. It simply doesn’t get the love it deserves.

Time to Add it to the Watchlist

A lot of the times when I start writing an analysis for a company, I come across some glaring issues during the writing and I end up throwing the company in the rubbish pile. But every time I review the analysis for BOLT, I’m more than convinced that BOLT is an excellent company.

I sold back in April, but give the chance to add BOLT i nthe $10-11 range, I’ll be doing it in a heartbeat.

Disclosure: None.

Written by

Jae Jun

Back in early 2010, I started writing for Complete Growth Investor with my first article highlighting Bolt Technologies. Here is the link to the original BOLT analysis that started my investment in the company.

Bringing you up to date, I sold my entire position back in April of 2011, and while I wait for BOLT to fall back into the $10 – $11 range, here is an updated version of the investment thesis.

Focus on the business and value and you’ll realize what a gem of an opportunity BOLT could be despite the small market cap.

The analysis will be broken up into two articles. The first part will focus on the business and the risks. The second part will look at various quantitative analyses and comparisons.

Who is Bolt and How do they Make Money?

Aside from some technical terms, BOLT is very easy to understand and has the aura of a typical Buffett company.

An overview of the business can be found in the 10-K or the website, but to briefly sum it up, the company is broken down into three operating units (now four); Bolt Technologies (BOLT), A-G Geophysical Products (AG), Real Time Systems (RTS), and the recently added Seabotix (SBX).

1. BOLT develops and sells seismic air guns to the marine seismic industry.
2. AG develops and sells underwater cables, connectors, hydrophones, and other seismic related parts and equipment, as well as BOLT air guns.
3. RTS develops and sells air gun controllers/synchronizers, data loggers, and auxiliary equipment (think remote controls).
4. SBX is the fourth operating unit and added in Jan 2011 via an acquisition. SBX is a manufacturer of underwater remotely operated robotic vehicles. With the acquisition being so recent, there isn’t enough information on Seabotix to get a full understanding of its operational impact on Bolt’s financial statement. Future quarterly reports should provide more specifics.

Oil and gas drilling is not an easy task, nor is it cheap. With BOLT’s lineup of high quality products, explorers and drillers are willing to pay for such devices to increase the success rate of their digs.

What are Seismic Air Guns and Why?

The main revenues come from air guns, so a brief understanding of how air guns work will help visualize the business, operations, industry, and potential.

The purpose of an air gun is to create a 3D or 4D image of the sea bed by firing acoustic waves.

The image below represents an excellent illustration of how the whole process works. An air gun is attached to the ship called a survey ship, and fires waves aimed at the sea bed. The waves are reflected from the contours of the sea and ocean bed to the hydrophones, which collects information on the path, distance, strength and anything else related to the reflected wave.

This information is then used to create 3D or 4D model images of the layers of the ocean floor such as the image below.

From this brief intro to air guns and how they operate, think back to the four operating segments of BOLT.

• BOLT  = air guns
• AG = cables, connectors, seismic, and air gun accessories
• RTS = data gathering and controllers
• SBX = underwater remotely operated robotic vehicles

As you can see, all four operating segments are highly synergistic yet differentiated.

Bolt originally started with air guns and then AG was acquired in 1999, RTS in 2007 and SBX in 2011. BOLT acquired three companies in a span of 12 years. This is one clear indicator that management is extremely selective of choosing the best possible match for the company.

BOLT’s Current Situation

BOLT operates in a cyclical environment and is heavily dependent on oil prices and demand. To simplify things, when the cost of oil per barrel is high, exploration companies increase their spending on searching and drilling. When oil prices are low, exploration and drilling activities drop.

As long as oil prices remain above $80 per barrel, oil explorers will be able to produce profits from the oil they drill.

What are the Risks?

The fewer variables and risks you have to work with, the smaller the field of outcomes and the more likely the investment will work out successfully. Plus, it also makes the investment much simpler to understand. Understanding and conviction in your analysis are keys to capturing huge gains.

Getting back to the point, there are five risks outlined below, but I feel that the first four are the viable risks for BOLT. However, I don’t believe any of them to be the critical “don’t-touch-with-a-10-foot-pole-type” risk.

1. Highly dependent on oil and economy

The obvious risk is the cyclic nature of the industry. It’s a pyramid effect. Low oil prices mean, less demand in producing, less exploration and eventually less orders for oil discovery products.

2. Sales Dependent on Major Customers

In 2009, the majority of sales came from the following three customers

• Schlumberger Limited: 16%
• Compagnie Generale de Geophysique-Veritas makes: 15%
• Petroleum Geo-Services: 9%

In 2010, the majority of sales came from the following three customers

• Compagnie Generale de Geophysique-Veritas: 23%
• Bureau of Geophysical Prospective, Inc. (China): 11%
• Schlumberger Limited: 7%

A single customer makes up quite a large percentage of sales. You certainly do not want to lose such a customer. However, judging by how the major customers change dramatically year over year, I don’t mind concluding that BOLT has a diverse customer base and is capable of replacing customers with new ones. Who knew that a Chinese entity could make up 11% of sales?

3. Revenues from foreign sales

Revenues from foreign sales make up 78% of revenue. This can affect profit due to currency exchange rates and with all the Euro worries going on at the moment, the dollar has been rising against the Euro which will erode profits.

4. Deepwater Horizon rig Explosion in the Gulf of Mexico

News of the Gulf oil spill is long gone, but there could be further regulation and restriction on offshore drilling which could affect the sales of BOLT products.

5. Current management team age

The management team at BOLT are at the senior stages of their lives and could possibly retire any minute. Raymond Soto, aged 71, is the chairman, president and CEO. Three of the five members of the executive team, including Soto, are 68 and older, with the youngest being the vice president at 50 years old.

You could interpret this as a team that is very experienced and knowledgeable of the industry and business. Or if you are bearish, some have labeled this management as over the hill or senile. Seeing as how the company is rock solid, I’m going for experienced and shrewd.

If you look at Soto’s history, he has been CEO since 1990 but a director of the company since 1979. In total, he has been involved with the company for a mind boggling 32 years. The only way I can interpret this is that he has some serious passion for the job.

Awesome Niche Company

BOLT operates in a niche market where it is a leader. In the industry, its products are well known and as I go through a lot of the numbers in the following post, you’ll be able to get a better picture of how solid this company is and has been.

Disclosure: None

Written by

Jae Jun

Aggressive and Conservative Accounting Series

For previous articles in the series, click on the links below.

• Aggressive and Conservative Accounting Policies
• How to Detect Aggressive Revenue Recognition Policy
• FIFO LIFO Inventory Valuation Methods
• Straight Line and Accelerated Depreciation Methods
• Aggressive Accounting: Reserves, Allowances, Contingent Liabilities
• How Companies Misuse Capitalizing of Expenses

Definition of Cookie Jar Reserve

Cookie jar reserve is defined as

“allowances or reserves created or increased in a particular year in order to boost future years’ earnings”

How a Cookie Jar can Rot more than a Tooth

In order to meet the expectations of Wall Street, a cookie jar is extremely tempting for a company to manipulate. You saw it in full action during the bust of 2009 when companies started taking one time restructuring charges and “big bath” losses.

The benefit of taking such a special charge, even if it is only a one time occurrence, is that future operating income will be inflated because the future costs have already been written off.

Such large losses creates a liability on the balance sheet which becomes a reserve which is then used to reduce expense and increase income in future periods.

How a Cookie Jar Works

Since a liability typically has credit balances, it is a tool to inflate future profits. How it works is simple.

The company creates a fake liability with adequate credit balances and then whenever extra profit is needed, an accounting entry will be made to move the credit from the liability line to the expense line. This obviously has end results of increasing profits by reducing expenses.

A simple example would be where the company announces a restructuring charge where 1,000 employees are expected to be let go. This will create both a restructuring expense and an increase in severance liability.

But what happens if the company really only layoff half the intended staff?

The restructuring expense is reduced by half and the severance liability is also cut by half. Therefore since only half the intended amount is taken as a liability and expense, the remaining half will be added back to the future period, resulting in an increase of earnings.

Aggressive Form of Reserves and Allowances

Most companies will have a number of horrible customers who do not pay on time. To account for this, companies must write down accounts receivables each period by recording an estimated amount for likely bad debts.

This amount is recorded as a “bad debts expense” on the income statement and at the same time, the accounts receivables amount is also reduced on the balance sheet with an “allowance for doubtful accounts” which offsets gross receivables.

Under normal business conditions, the doubtful accounts will grow at a rate similar to the gross accounts receivables. If however, you notice a steep decline in the doubtful accounts compared to an increase in receivables, it is a sign that the company has failed to record enough bad debt expenses resulting in an overstatement of earnings.

On the contrary, the ideal situation isn’t having a high doubtful accounts. Having a high estimate of doubtful accounts, leans closer to earnings manipulation than aggressive accounting as the company is purposely planning to reduce earnings so that it can store it for a time when earnings may not meet expectations and requires an added boost.

Walking a Fine Line

All of these accounting practices walk on a fine line. Companies can play around with these policies so easily within GAAP rules without investors ever knowing. The only way to detect such practices is to read the footnotes of the annual reports and to always read it with an investigative eye. It is too easy to get suckered into a report and fall into the flow.

The legal and accounting jargon makes some of the reading extremely difficult to decipher, but that’s the lengths companies will go to in order to hide aggressive accounting policies.

I understand that shorts have to exist in the market to balance the equation, and let me first say that after having read “The Art of Short Selling” thoroughly a couple of times, I have the utmost respect for fundamental short sellers such as Kathryn Staley, Jim Chanos and David Einhorn.

China MediaExpress (CCME) is a Chinese company that I currently hold and is currently under heavy scrutiny as a fraud. Reports by boutiques specializing on shorts have been released, and while I must give credit to Muddy Waters for the work they have put in to their report, the main argument of the shorter’s report is that the numbers are “too good to be true”.

But I’m going to present a case for at least why the SEC filings are accurate.

Independent Auditor Required

The role of an independent auditor is crucial in protecting investors from dishonest management and has to be indifferent to the board. The auditor should not be a friend of the company and should work completely independently.

With so much buzz about CCME, there have been comments made about how Arthur Andersen failed in their auditing duties of Enron, and this is true.

However, if you take the entire story of Enron in context, Arthur Andersen had been Enron’s sole auditor for 16 years. Arthur Andersen not only performed the audits but also providing consulting services to Enron earning  $52m in 2000.

This is clearly not independent auditing. The relationship and the incentives were much too deep to be considered independent.

Which brings me to Deloitte.

Auditor for Bear Stearns

Deloitte was the auditor of Bear Stearns and it is true the auditor lacked judgement and overlooked red flags. But the red flags Deloitte overlooked when auditing Bear Stearns were not related to accounting gimmicks. All those red flags were related to risk and valuation for subprime. From an accounting standpoint and GAAP rules, Deloitte did nothing wrong.

But what about the point that the auditor of CCME is not Deloitte & Touche of the USA but in fact, Deloitte Touche Tohmatsu?

Deloitte Brought Down the “European Enron”

To to build on the case of Deloitte’s competence as an auditor, consider the case study of Parmalat.

Parmalat was once the largest Italian dairy company but is now classified as the “European Enron”. Parmalat is another case where the independent auditor missed the fraud in accounting.

Under Italian law, every company is required to switch auditors every 9 years. Parmalat changed their auditor from Grant Thornton to Deloitte & Touche and in the very first audit by Deloitte & Touche, offshore accounts were scrutinized and fraudulent offshore entities were exposed that were used to hide fake assets.

Deloitte Touche Tohmatsu Provided an Accurate Audit

What do these case studies have to do with CCME? The two main ideas are:

• Deloitte was recently hired as the auditor.
• Deloitte would have seen all documents and records from a fresh new perspective.

Deloitte Touche Tohmatsu, the auditor of CCME, is not 100% Deloitte & Touche, but Deloitte Touche Tohmatsu must operate under Deloitte & Touche rules and standards. To argue that just because Deloitte Touche Tohmatsu is auditing a Chinese company and thus open to manipulation and bribes is pure speculation and nothing but an opinion.

It would be equivalent to saying that Microsoft China is incompetent just because it operates in China and is subject to Chinese rule.

Conclusion: Accusations about the inability of Deloitte as an auditor debunked. SEC filings are correct.

Disclosure

Long CCME.

What do you think about Greece? With all the news about Greece and its debt problems, the Greek stock market has been rocked.

Can the Buffett rule of taking advantage of uncertainty and fear be applied to Greece?

The following post was brought up in the forum by Floris on Alapis SA (OTC: APSHF.PK), a Greek pharmaceutical company. I bring it up here because the investment idea offers compelling value in a devastated market, where opportunities are more abundant than the US. But you decide and share your comments.

Ratios

• Price/Book (Q3 2010): 0.075x 2009
• P/Op Cash Flow: 1.2x
• Price/Tangible Book (Q3 2010): 0.13x 2009
• P/E: 2.7x
• Debt/Equity Ratio (Q3 2010): 60%

Description

Alapis SA is the market leader in the Greek pharmaceutical industry.

It also has a leading position in a number of Balkan states as well as activities in Turkey and the UK. It produces and distributes both generic and brand name drugs to healthcare providers and hospitals in these target markets

It has long term license contracts with big pharma as well as production capabilities for generic drugs.

The firm is an amalgamation of different pharmaceutical companies in this region that have merged under the name Alapi in 2007.

Greece Situation

As is well known, the Greek government is facing a tremendous debt crisis, which many expect will result in either

• a) a default
• b) a major restructuring or
• c) leaving the euro zone.

I personally agree that the greek government will likely face either situation a) or b), I feel situation c) is politically unlikely.

Nonetheless this major debt crisis has caused a dramatic decrease in the stock prices in Greece as major institutional investors have fled to the exits.

This has led to a dramatic decline in the stock market of 30%. Moreover career-risk averse institutional investors are scared to death of being invested in any firm with even the slightest greek government exposure, and this is where Alapis enters in.

Why is it so cheap?

I believe Alapis has become the poster child for a ‘bad’ stock. I will now state all the reasons why I believe the stock has come down so dramatically this year.

• a) Both direct and indirect exposure to the greek government
• b) Relatively young record as a publicly traded firm
• c) 200-250m of hospital receivables outstanding
• d) 700m of debt that needs to be refinanced in 2012
• e) Major shareholder has liquidated its position
• f) Investors believe Greece will not ever do anything useful again
• g) Uncertainty about the prices of medicine

If you sum up all these reasons, one can run scared of this firm and never look back. I believe this is what has happened and what precipitated the fall of the stock over the past 3 months (from above 2euros in September to .48 cents in January). However..

Why should you want to own it?

Trading at an unbelievable 0.075x of invested equity capital, it is one of the, if not cheapest stock I have seen in years.

Furthermore, even in this environment it has remained profitable. The firm has booked profits of 18m euros from continuing operations in the first nine months of 2009 (to put this in perspective the firm earned 78m from continuing operations in 2008).

Considering the current government squeeze and lack of time to adjust to this new status quo, I believe this to be quite a feat.

The growth trends for this firm are also quite positive. As the Greek government cuts costs further, it will look for more generic medicine, which Alapis provides. As the leading player in the segment in south-eastern Europe it can use its scale to become the de-facto choice for the Greek government to buy generic medicine from.

While one may assume the Greeks will never pay for anything anymore (which the market assumes), I view this as somewhat unlikely. I expect 2010 to be a much better year as the Greek government adapts its pricing mechanism and the firm adjusts to the new reality. I believe it should start earning profits on par with 2008 (75m from continuing ops).

Furthermore a former large shareholder has recently reduced its stake from north of 20% to only 6%. From talking to various parties I believe this sale was due to a forced liquidation because of a lawsuit unrelated to Alapis requiring significant payment. This announcement has apparently caused further distress but this shareholder has been replaced by a private equity firm called Lambda partners which is run by a former head of Barclays Wealth in Eastern Europe. The fact that an experienced team is willing to buy at these depressed levels also gives me confidence.

Ridiculous valuation, but what are the risks?

A stock this cheap always has some hair on it.

A total failure of the Greek state and continued lack of payments would results in a bankruptcy.

Secondly the firm might not be able to refinance its debt in 2012 causing a large dilution (especially at these stock levels).

Thirdly the financials could be fraudulent (although audited by BDO).

Sure there are risks… but the risk/reward ratio is very appealing.

Trading at a 2009 P/E of 2.7x, Price/Operational Cash Flow of 1.2x and Price/book of 0.075, Mr. Market is exceptionally pessimistic about the state of affairs of the stock. Although there are some risks, I also believe the risk/reward is unparalleled. The stock could well return to January 2009 levels (roughly 4.5 a share).

Disclosure

The author (Floris) has a long position in ALAPIS.