Arohan’s investing life

This of course is not a new revelation. However, many readers and investors do not grasp the amount of risk that may be present in smaller companies. A big part of this risk may be just volatility due to illiquid nature of stock, but there are some other more basic risks that an investor needs to be cognizant of when investing in this asset class

To illustrate the points that I am making in this article, I will take an example of two stocks that the readers of this blog are already familiar with. Both these stocks have been discussed here in the past

Syntax-Brillian (BRLC)

This is a major egg on the blog author’s face. However, the case study on this company is worth reviewing to learn where we went wrong.

The rationale for investing in this company was many fold. Syntax-Brillian makes excellent quality HD LCD tvs (brand name Olevia) and sells it at a value price while maintaining great margins due to its optimized supply chain. The market for LCD TVs is growing and the future of the sector looks bright due to a potential for substantial increase in demand in the US due to forced HD conversion in 2009 as well as increased demand in China due to the upcoming olympics. Both markets where Syntax-Brillian is a significant player. The stock was trading at 10-11 PE when it was purchased and had just finished the year with triple digit revenue increases (YOY) and was on the verge of announcing two large big box retailers in US. So what could go wrong???

Well, plenty did go wrong. I would not dwell on BRLC’s history of missing projections to the street (after all if the stock is undervalued and still showing extremely high growth in business, why worry if the analysts estimates are missed. The stock price has to catch up to the potential, right!). No, the problem with the company was (is) really basic. It is in the execution and financial controls

Anyone who has owned a small, fast growing business, or for that matter worked in such business understands that growth requires working capital. If a company plans to grow (as an example) by 50% next year and sports 3-5% net profit margins, not enough cash is generated today to finance the growth for tomorrow. The shortfall needs to be made up by external financing (working capital)

Syntax-Brillian was constantly in need for financing to support its growth. The situation was made worse by the significant amount of business it did in China, where apparently the payment terms of 120 days is common place. This means that the product sold in China did not actually result in cash inflow until 120 days later. Meanwhile the company still has to pay its employees, its vendors (who are typically on a shorter payment term), etc.

And as the sales grew, the cash flow gap became wider and wider and recently it became so acute that one of the institution (Silverpoint)  funding Syntax-Brillian started the process to rein the company in by tightening the controls and increasing the cost of financing. The company, now it appear, has to review its finances on a weekly basis with its lenders and a lot of business planning discretion now no longer rests with the company executives

Ah, the pitfalls of debt financing!

It is not as if Syntax-Brillian did not try equity financing. Over the last 2 years, the equity holders were diluted numerous times to a total of greater than 50% dilution. A part of the stock price decline IS due to the dilutive effect of incremental equity sales.

In short, the company and the stock has been killed by extreme growth (I say killed, but the company is still solvent, although the future looks difficult)!

Generally a growing company picks a growth rate that is sustainable and can be funded either organically or even externally if the company is able to manage its fundamental ratios. But a steady and manageable growth rate did  not appear to be what the company was after as it raced to gain market share as the olympics and the forced HD conversion in US draw closer

There are only two outcomes that can be positive for a company in this situation. Slow the growth down and steady the ship, or, become a thorn in an incumbents boots so much that one of them choses to acquire the company. Sadly, enough shareholder value has already been destroyed before any of these possibilities can come to fruition

Growth at a reasonable price (GARP) is not enough. What we need is Sustainable Growth at a Reasonable Price (S-GARP)

I have exited this name with substantial losses

WSI Industries (WSCI)

This is a company in the metal service industry that we have discussed a few times in the past on this blog. As was reported earlier, the company had announced a significant increase in future business due to new customer acquisition. Subsequent to that, the company reported its quarterly earnings that bettered the estimates and more importantly, showed that the new customer has already started to become accretive to its earnings. The stock responded appropriately, jumping as high as $11s and finally settling down in the $8 range. This stock was purchased in $4-$5 range so there is a good capital appreciation already on my books. I am holding on to the investment for the time being

The important lesson from this is, when investing in micro/small cap companies, one needs to keep a close eye on the investments. The best rewards come to those who hold long term but it is also necessary to monitor the company’s business performance for signs of weakness and act accordingly

PS: Sorry for the brief unintended hiatus from posting! Sometimes life interrupts without warning! 

Syntax-Brillian (BRLC) hosted a conference call today to clarify its changes in the business model with respect to China and provide guidance on business performance

Highlights:

- Revenues for FY08 under the old business model would be between 1.1 to 1.3 B. The street was expecting about 877 million
- In the new business model for China, the revenues were guided to be between 650-685 million for FY08 EXCLUDING China
- Revenues for current quarter estimated to be between 155 to 175 million under the new model compared to the estimate of 303 million. The estimate has not been corrected to the change in business model for China

It is clear that if the guidance is adjusted for the change in business model and if an apples to apples comparison is made, Syntax-Brillian is actually guiding HIGHER

The Business Model Change

Syntax-Brillian is moving to a royalty based model in China from its earlier direct sales model. The direct sales model created a cash flow problem for the company as its accounts receivables were regularly strung out for 120 days or more. With the new model, BRLC’s exclusive distributor will manufacture the TVs directly in China with Syntax-Brillian’s specs under the Olevia brand and will pay Syntax-Brillian royalties. This helps Syntax-Brillian in many ways:

a. It limits the A/R exposure from 100% of the sales to just the amount of the royalties. All royalties go substantially to the bottomline
b. It frees up the working capital (and the associated financing costs), which can be significant as China generally represented 50% of Syntax-Brillian’s sales in the past
c. Associated risks on payables, capital expenses, etc are transferred to the licensed manufacturer, and,
d. It allows Syntax-Brillian to renew its focus on rest of the world including North America

Additionally, since the units sold in China are produced in China, if China were to re-value its currency, this model would limit Syntax-Brillian’s exposure to the currency risk

All in all, this is an extremely positive step for the company

Here is the original Press Release issued by the company

Media reaction

It is interesting and disappointing to watch how the financial media is reporting this guidance. Here are a few examples

a. Syntax-Brillian Dims Outlook
b. Syntax-Brillian Outlook Trimmed On New Business Model For China Market; Stock Slides
c. Syntax-Brillian sees Q2 revenues below street| Stock hit

There are a countless positives that can be taken from the PR and the conference call, but a vast majority of the media articles have commented on the lowering of the projected revenue. And while they mention the change in the business model, none of these stories come out and clearly state that the new guidance on revenues is an apples to oranges comparison. While members of the media are not professional analysts, they need to do justice to their calling by presenting the story fairly. I have seen this with other stocks, media outlook is generally negative as the stock is bottoming and generally gung-ho when the stock approaches the stratosphere. Madness of the crowds I believe. Could it be they are advocating the agenda of the large short interest in this stock? Naaah, that couldn’t possibly happen, could it

While we can rant about this bias, it is wiser to take advantage of the inefficiencies this creates in the market place.

If you think you are right, ignore the market. It is just noise

Editor’s note (11/29/2007):
It is the day after the conference call and as hoped for, atleast one of the media outlets have taken a deeper look into the business model change and revised their opinion. See the latest article from Motely Fool’s Value Investing column

The stock is down significantly since we wrote about it here and here. Today it was down to $3 per share. It is time we re-iterated our conviction that the stock is misunderstood and severely under-priced

Consider this:

- P/B is close to 1
- High growth rates (trailing yoy > 200%, next year about 80%)
- High margins
- PE, trailing < 7, forward PE around 5
- PEG ratio, 5 year forward estimated < 0.4, 1 year forward estimated around 0.1
- Next quarter revenues by itself should be greater than its market capitalization today

At this time we are adding more

Syntax-Brillian (BRLC), of which we have written earlier as possibly one of the best value plays in the market today, just reported its latest quarter. While on the first blush they appear to have missed the earnings estimates, these number include a 0.31 cents per share charge for disposition of their LCoS business

BRLC stock has been in the rut for some time due to concerns about them being able to finance growth as well as competitive pressures in this business. The earnings call addressed a lot of these concerns and it appears that the stock is finally going to start reflecting the excellent business performance the company is experiencing

Some of the key take aways
- The change in the CEO appears to have rejuvenated the company business as well as regain some of the credibility that was impaired under the previous CEO
- Olevia TVs could be on Best Buy shelves in time for the Christmas shopping season
- Currently the company is able to supply far less than the demand
- New financing is in place that will allow the company to increase capacity to meet demand
- The company appears to be executing the 120 turnaround plan ahead of the target
- The company is able to increase prices

2008 will be a key year for BRLC as revenues continue to grow and the cash flow situation improves. The stock will remain volatile, not the least due to the extremely high short position. However, a patient investor will do well in this stock if held for more than 1 year

Note: I am long in this stock

Syntax-Brillian (nasdaq: BRLC) stock has taken a beating over the last one year. This is in face of extreme growth and steady acquisition of market share. This blogger feels that the stock currently is severely undervalued and offers a very attractive price point for entry

The Market: The company produces lcd televisions which is a fast growing market segment. In North America, the rapid growth coupled with the planned obsolescence of regular television (by 2009 all broadcasts will be HDTV) assures significant demand in the next few years. The company also sells its Olevia brand of TVs in China and South America, both expanding markets. The Chinese market is even more attractive today as the 2008 Olympics will drive significant HDTV sales growth, a vast majority of which will be lcd tvs.

The Company: Syntax-Brillian has put up over 200% annual growth figures over the last year, is profitable and is trading at a ttm PE of below 10. The company also appears to be focusing on international markets including China and South America, as well as Europe with its acquisition of Vivitar that added a valuable distribution channel for the company The company has targetted sales of $1B in the FY 2008 that appears to be achievable. For the record, the current company market capitalization is hovering in the $400 million range

The Stock: Several factors seem to have contributed to the current undervaluation of the stock. Several secondaries in the last one year, a severe short position, troubles collecting receivables from one particular customer in the past, etc. In addition, the management team appeared to have little credibility (despite strong execution) in the past.

However, these problems are being resolved. The company does not plan to conduct any more secondary equity offerings any time soon (vowed to use debt). There has been a recent management overhaul including a change in the CEO and the CFO. There is a renewed focus on re-doing the way company does business in China. All these changes along with their 120 day action plan will help bring the investor confidence back in the stock. In this situation, the large short interest appears to be another attractive feature of the stock as with the improving fundamentals, the short shares need to be bought back and this will make the stock price improvement (to match the fundamental of the business) even more quicker

It would be interesting to watch how the stock performs through the next earnings report. Meanwhile this blogger is long and strong on the stock and may even add more on any further weakness