Jumping off the GSAT short train

If there is one thing I’m allergic to when I’m shorting a stock it’s a high borrow fee. When I started shorting Globalstar earlier this month the borrow rate was below 1%. Unfortunately that is changing and at the moment you already have to pay more than 5% to borrow to stock. Because of that I have exited my position today after already reducing it two days ago (when the borrow fee started to rise). My timing is a bit crappy compared to what would have been possible in this time period, but can’t complain with a 27% return in less than two weeks.

GSAT borrow feeDisclosure

No position in GSAT anymore

Awilco Drilling: back to square one?

I bought Awilco Drilling in the beginning of 2013 at 90 NOK/share, and after peaking at 162 NOK/share almost three months ago the shares are back to where they started. I was fortunate enough to sell a part of my position near the top, and the big question is of course: is it time to start buying again? Unfortunately the answer is not an easy yes since intrinsic value has been dropping as well. Oil prices are lower, and as a result day rates are also declining.

A glimpse of what is happening with day rates was offered by Transocean last Wednesday when they announced that the Transocean Leader was awarded a four year contract with a day rate of $335,000. The rig was previously operating for $400,000/day for Statoil in Norway on a contract that started in 2012. Since day rates have increased since early 2012 I’m afraid that Awilco’s day rates will drop more than the 16% implied by the new Transocean contract. Awilco is operating under contracts that were made in 2013.

To analyze the impact of various possible future day rates I have created a small DCF model. The two items that have the biggest impact on the calculated intrinsic value are future day rates and the discount rate. With a day rate of $275,000 and a 12.5% discount rate we get today’s share price ($13.80) as fair value:

Awilco Drilling DCF model

A $275,000 day rate is 30% below the current day rate. I think this is a bit pessimistic for Awilco since day rates in the UK remained at ~$250,000 even when oil dropped to $40/barrel in early 2009. With day rates at $300,000 the model spits out a value of $16/share while at a $325,000 (representing a 16% discount) fair value per share would be $18. I think using a $300,000 day rate is a reasonable base case. Unfortunately this means that Awilco is probably just slightly undervalued at ~$14/share. So even though the shares have dropped significantly the past months I wont be in a hurry to add to my position.

Disclosure

Author is long AWDR.OL

Joining the GSAT short bandwagon

Kerrisdale Capital presented their case for shorting Globalstar today with a lot of hype. The small asset manager took a page out of the Bill Ackman playbook and hosted a live presentation and webcast while also publishing a lengthy report on a brand new website. When a short case is made so public you have to wonder if it is possible to have an edge as a small retail investor who never knew the company existed until today. I obviously do think I have, but it’s quite possible that I’m overestimating my abilities in being able to play this game.

Dealbook describes the short case as complicated and relying on a lot of jargon which makes it difficult to summarize in a sound bite. I don’t think it is, although some technical knowledge is certainly helpful. My attempt to summarize the thesis in a single sentence:

WiFi congestion not a problem: limited value of a 4th 2.4GHz WiFi channel in the US

GSAT is trying to get FCC approval for using their 2.4GHz spectrum for this purpose. The other part of the company is a money losing mobile satellite services business, so monetizing their spectrum asset is crucially important. Their spectrum has some value, but it will be very though to monetize. In almost all cases there is sufficient free spectrum available on the 2.4GHz band, while newer devices communicate using the 5GHz band where an abundant number of free channels are available for high-speed WiFi.

At the same time it will take the company a lot of time to do anything with the spectrum even in a best case scenario. After they receive FCC approval they somehow need to get manufacturers of phones, access points and other equipment to support the new 2.4GHz WiFi channel. This is doable with just a simple firmware update. The reality however is that phone/tablet/notebook manufacturers prefer not to spent too much resources on older products while most consumers wouldn’t take the effort to upgrade their firmware. At the same time support for a 4th 2.4GHz band is irrelevant for new devices since they already have 5GHz support.

I don’t see how GSAT will be able to effectively monetize their spectrum. Their spectrum is a solution for a problem that never really existed and is already solved in the latest WiFi standard.

802.11ac Is Here Today and Will Dominate in the Future

Disclosure

Author is short GSAT

Conduril 2014 interim results

Conduril reported interim results for the first half of 2014 at the end of September. The business performed well. Revenue increased with 9.7% compared to the same period previous year while earnings increased with 6.6%. It’s a bit questionable if the company will be able to continue to grow revenues in the near future since the backlog decreased from €750 million at the end of the year to €600 million now. An overview of Conduril’s historical earnings:

Historical earnings Conduril (2014 interim report)What we see is that EBITDA decreased despite the growth in revenues, but earnings went up anyway thanks to a lower tax rate. Conduril has been paying lower taxes since the second half of 2013 because it is no longer double taxed on earnings from Angola: lowering the effective tax rate from more than 50% to a more normal ~30% rate. The fact that the nominal tax rate in Portugal was lowered from 25% to 23% also didn’t hurt.

The most significant development is however not found on the earnings statement, but on the balance sheet. A new entry is a €74 million asset classified as held for trading while outstanding debt increased with an almost equal amount (€67 million). These assets are certificates of public debt that Conduril received from the Angola government for past due receivables. Since Conduril has a large amount of receivables on its balance sheet this is both good and bad news. It shows that Conduril isn’t always paid on time for the public works they construct in Africa. But it also shows that the receivables are backed by the state so that the credit risk remains acceptable. Moody’s recently upgraded Angola’s credit rating from Ba3 to Ba2 with a positive outlook. Not the most solid rating, but not bad either. So don’t think it’s a big deal that it will take a bit more time to convert some of the receivables into cold hard cash.

Historical Conduril balance sheet (2014 interim report)Disclosure

Author is long Conduril

Stock price reflexivity

Investors learn the parable of Mr. Market early in their education. The lesson that Benjamin Graham tried to teach is that investors shouldn’t value a company based on what the – possibly irrational – market is telling them, but on their own merit. Taking the teachings of Benjamin Graham to heart many value investors more or less ignore market prices. While this is roughly right in a lot of cases it misses the reflexivity between intrinsic value and price. A business with a higher price is often worth more than an otherwise identical business with a lower price.

Stock as currency (in deals)

One reason for this phenomenon is that overvalued companies can use their stock as a cheap currency. This allows a company to do acquisitions that really add to the intrinsic value/share. Let’s say a hypothetical company is worth $10 million, but it is trading at $20 million with one million shares outstanding. It could double its share count and acquire a second business worth $20 million. The result would be an increase in intrinsic value/share from $10/share to $15/share while the overvaluation shrinks from 100% to just 33%.

And a fair question to ask in this case: is the stock really trading above intrinsic value if the company is able to do deals like this? And if it’s trading above intrinsic value, by how much? I would argue that the true intrinsic value – taking into account reflexivity – is higher than $10/share. But how much it is worth exactly depends on how long the music keeps playing. The company could in fact be worth a lot more than $20/share if it is able to do a bunch of favorable acquisitions. I would never be long a stock based on this idea, but it is worth thinking about when you are shorting!

Share based compensation

Closely related to the example above is the use of stock as a currency to pay management and employees. A higher stock price is better for investors because share based compensation is usually based on the monetary value of the underlying. If you invest in nano-caps (like I do) you might be significantly diluted because of the option package that is granted to insiders. It might not be an insane bonus in absolute terms, but when a companies market cap is minuscule a share based payment could be a quick way to see your stake shrink.

When a company is overvalued and you consider shorting a stock the share based compensation is also an issue to think about. Many web 2.0 stocks have a sky-high valuation and pay employees using their (according to some) overpriced stock. If they are able to continue that practice it makes the business better than it otherwise would be.

‘Low-ball’ offers

If you own a stock that you think is extremely undervalued there is a very real risk that you are unable to benefit fully from that insight. A stock that is worth $50/share but is trading at $10/share is a great target for a management buyout or an acquisition from some other party. If you are, as the acquiring party, able to offer a significant premium above the latest trading price there is a very high probability that you will be able to close the deal. If shareholders wouldn’t be happy to sell a $10-stock at $20 it wouldn’t be trading at $10.

This is one of the many reasons that I’m happy to share my investment idea’s on this blog. Once I have bought a stock I don’t think a dropping share price is just a great opportunity to double down. Doubling down might still be a great idea, but it is a double-edged sword since you also run an increased risk of a take-over at an unfavorable price.

Share repurchases

A higher share price does not always translate to a higher intrinsic value: the reverse is also a common occurrence. Some companies buy back stock irrespective of the current market price. When the market price is below intrinsic value this is great for remaining shareholders, but when the stock is overvalued this is not good news. In that case value is transferred from remaining stockholders to selling stockholders. A company with a smarter share repurchase policy is also more valuable when its stock is undervalued: it cannot create value if it doesn’t have the opportunity to repurchase undervalued shares.

Closing thoughts

While the reflexivity between price and value is an interesting phenomenon I don’t think you can do a whole lot with this knowledge. You still want to buy undervalued companies and short overvalued companies. But it should have a place in your process when you think about the risks and rewards of various investments. Both short and long investments offer less upside than you would have thought when taking reflexivity into account. How much? I don’t know.

Ring Mirror - Arnaud Lapierre