Outlook for the U.S. stock markets and interest rates
1999 Stock Outlook: Review and Update
Outlook for Ex-Soviet Equities
Outlook for Small- and Microcap Sectors
Outlook for Initial Public Offerings
Outlook for Global Stock Markets
1999 Stock Outlook: Review and Update
Sell Pohang on strength
Without question, Pohang Iron and Steel, or POSCO ADR (PKX-NYSE), is the strongest steel company in the world. Even before the Korean currency devaluation, PKX was one of the most efficient producers in terms of cast cost per metric ton of production. In terms of total production volume, PKX is the world's second largest integrated producer. That size translates into economies of scale -- and super-fat profit margins.
After the Korean won collapsed, PKX became the world's lowest cost steel producer. No major steel competitor can compete with PKX on a price basis. As a result, PKX's steel is flooding world markets -- squeezing out uncompetitive domestic producers.
A sign of the caliber of PKX's management is the company's record performance in the first half of 1998 (1H). Production rose 2.1% to 13,163,000 metric tons. Revenues rose 29% to a record US$4.2 billion. Earnings rose to US$496.1 million, or US$1.34 in earnings per ADR. These results are incredible considering the economic collapse in South Korea!
I estimate the PKX is trading at just 7x 1998 earnings (based on my estimates for Q4). Considering PKX's robust operational performance, rock solid balance sheet (the accelerate depreciation schedule has left PKX's rocket scientist-designed plants almost completely written off), and dominant global market position, this is a ridiculously low valuation.
However, PKX
will have difficulty climbing above US$18 over the next six months,
while the downside is a correction below US$14. The ADR is trading
at a huge 50% premium to the ordinary shares. That's too high
of a premium to pay for any ADR. Until the local shares catch
up with the ADR price, I am skeptical about the sustainability
of current trading levels.
Also, steel prices continue to erode for both hot rolled and cold rolled steel. I believe that steel will rebound, but PKX is unlikely to perform strongly in an environment of deteriorating steel prices. Since the Korean economy is still in terrible shape, PKX's domestic sales will also be weak.
Most importantly, a protectionist backlash is stewing against foreign steel in Western countries. The day after I downgraded PKX to an immediate "sell" on the Taipan Hotline, Clinton whined about "foreign steel dumping" on a national TV address. I am concerned about the possibility of a steel import tariff in the US-the kind of legislation that would immediately spread to Europe. This could spark a domino-like chain of anti-steel protectionism -- a scenario that would be catastrophic for PKX.
Sentiment towards PKX has improved since the Korean government clarified its plan for liquidating its 33% stake in the company. In Taipan's view, the less the government is involved with a private enterprise, the better. While brokers expect strong domestic and foreign demand for the shares, the flotation could have a depressing effect on the ADR price -- especially in the face a hostile macroeconomic environment and an excessive ADR premium.
Holders of PKX should immediately liquidate their entire position in PKX. While I maintain my 1999 target of US$24 for the ADR based on a projected US$400 enterprise value/metric ton of production, I no longer view the US$20s a realistic technical target for the ADR. After the new shares are placed on the market, you should be able to pick up PKX at a significantly lower price.
Sell PKX at the market if you missed the "Sell" recommendation on the Taipan hotline. The ADR could fall to the US$12-14 level. Taipan recommends returning as a strong buyer if the ADR returns to these low levels.
Kiwi Rising
The big picture in New Zealand is looking bullish. Short-term interest rates have plummeted from 10% to under 5%. This kind of drop in rates has to eventually help out the stock market. In fact, short-term rates haven't been this low in 25 years. Dividend yields on a number of stocks exceed what's available in CDs. Crazy!
The New Zealand dollar has rallied 15% off the low. Now that Japan is recovering (signaled by the historic short-term plunge in the dollar against the yen), the death spiral in Asian markets is drawing to a close. Over the next six months, massive sustainable rallies in Southeast Asian equity markets should materialize, supported by a flood of capital repatriation.
At current levels, Restaurant Brands (RBD-New Zealand Stock Exchange) is trading at 5x FY99 earnings and 3x FY00 earnings. Next year's dividend yield should be around 16%. You get 16% in cash, just for holding the stock! On an EV/EBITDA basis, RBD is trading at a super-low 3.7x.
A radical decline in rates...Unrelenting and universally shared pessimism towards stocks...No capital gains tax...No double taxation on corporate profits...A transparent and open economy...The fundamentals exist to support the emergence of a huge bull market in stocks.
Remember, RBD is the Kentucky Fried Chicken, Pizza Hut, and Starbucks franchise for New Zealand. If the economy starts to pick up, New Zealanders will start gorging on chicken and pizza. Regardless of the near-term outlook for the economy, RBD has tremendous brand equity that is not reflected in the share price.
Management has just renegotiated its chicken contracts. This will dramatically lower gross costs. Also, the fall in rates is significantly lowering the interest expense line. Better margins = bigger profits. But the stock's only trading at US$0.48...
The launch of the first Starbucks has been a tremendous success. The enthusiasm for branded coffee products has surprised the mass media. The exponential growth of the new Starbucks franchise will be a major driver of the stock in 1999.
Also, management is watching the launch of the first Taco Bells in Australia. If they perform well, then RBD will launch Taco Bell in New Zealand. If Taco Bell is successful, then RBD will have complete control of the branded faux-mex fast food market (even in the U.S., no other national chain threatens Taco Bell's hegemony).
Despite the low share price in US dollars, this is a very low-risk recommendation. The stock will pay a fat 16% dividend -- while the New Zealand dollar is likely to remain firm. Fast food is a great business. Over time, consumer stocks tend to be big winners.
RBD is a strong buy at current levels. I strongly recommend that you use Peter Schiff or Mark Anderson at Euro Pacific Capital (tel. 310-448-8000, tel. 800-727-7922, fax 310-448-8008) to buy this stock, or you could get screwed with an egregious bid/ask spread by the market maker.
Midas touch
Every time I grill the management of Ashanti Goldfields (ASL-NYSE), I like the company more and more. This is a world-class company. ASL has been around for 100 years. Whatever happens to gold, this company will survive and prosper.
These guys are geniuses. While everyone else is stuck with a gold price near or below production costs, ASL is selling gold at US$375 per ounce! The company has a huge seven million ounce hedge book. That's over six years of production!
Management continues
to bring down group cash costs. ASL is one of the lowest cost
producers in the world. This is one of the few gold companies
actually generating profits and positive cashflow.
ASL's recent acquisition of the Canadian company SAMAX was an excellent move-a few weeks after ASL announced the terms of the deal, gold stocks across the board had a big run up. By acquiring SAMAX, ASL was able to immediately expand its highly profitable Geita operation. Eventually, the strengths of ASL's management will be reflected in a significantly higher share price.
The reversal in the dollar against the yen is a big driver of the gold price. If my 1999 forecast of a 100 dollar/yen rate is achieved, then gold will sustain a much higher price. I also expect gold to benefit from money supply expansion from the central banks. The monster short position in gold is setting for an explosive upside move in the metal.
US$330 is a realistic 1999 target for gold. During this rally, ASL should trade as high as US$16.
ASL remains a buy at current levels. If you used the covered call writing strategy, you reduced your cost basis while retaining the shares. Given my short-term outlook for gold, I recommend suspending any further covered call writing against ASL.
Profits from the promised land
The Asian contagion is knocking down currencies, one after the other. The Israeli shekel was finally hit. The currency suffered a huge drop against the dollar. Bearish sentiment towards Israeli assets hurt the Tel Aviv Stock Exchange.
Devaluation is an unequivocal blessing for Israeli tech stocks. Since Israeli technology companies are net exporters, the devaluation will improve competitiveness and profit margins. While interest rates are moving higher, almost every Israeli company I know is debt-free, with substantial net cash in the bank. These companies don't usually use bank debt as a source of capital, so a domestic rate surge will have little impact on their businesses.
The positive impact of the currency devaluation will manifest itself over the next two to four quarters. Over the short-term, Israeli stock prices will be driven by sentiment, since a lot of Israeli money is in the float.
Playing Israel for all it's worth
The fundamentals of the Israeli economy are terrible. The country is surrounded by enemies...without the continued support of the U.S., the Israeli government would be bankrupt. Taipan takes a very skeptical view of the Palestinian peace process. Headline terrorist events will continue to panic the population-and foreign direct investors. The government is tightly involved with large sectors of big industry.
However, the health of the Israeli economy has little impact on the health of Israeli hi tech. The Israeli tech sector has flourished in every political and economic environment over the last three decades. The driver behind Israeli hi tech is the intelligence and technical know-how of the Israelis. Israel has more scientists and engineers per capita than any other country in the world. Throw mandatory military training into the pot and you get hundreds of fast-growing, tightly-run supertech outfits...
Watch for other Israeli deals...
Recent weakness in Israeli supertech stocks (triggered by the global financial panic and the shekel devaluation) has created tremendous opportunities for foreign companies to acquire cheap assets in Israel.
Every Israeli company I know has a balance sheet like a tank, with lots of cash, no debt, and low receivables. Despite their financial strength, these same companies trade 5x or 10x earnings against a 20% to 30% growth rate, or trade below net cash or Net Asset Value. And the profit margins are outstanding thanks to the low labor cost and tax rate.
Israeli companies with a strong market position, robust technology, and undervalued assets are all serious targets for takeovers. Given the high valuation paid for ELT's main businesses, it makes sense to review other companies for possible merger speculation.
The following is a list of Taipan's Israeli tech portfolio, handicapped for the odds of a partial sale or outright takeover:
| Strong buys | Price | 1999 target | Initial entry | Takeover odds** |
| Elron (ELRNF-NASDAQ) | US$14.50 | US$22.00 | US$10.00 | nil |
| Orbotech (ORBKF-NASDAQ) | US$38.87 | US$50.00 | US$33.00 | significant (A) |
| Speculative buys: | ||||
| Elbit Ltd. (ELBTF-NASDAQ) | US$3.00 | US$6.00 | US$3.00 | high (P) |
| Orckit (ORCTF-NASDAQ) | US$17.18 | US$30.00 | US$21.00 | significant (A) |
| Holds: | ||||
| Elbit Medical (EMITF-NASDAQ) | US$11.00 | US$15.00 | US$5.50* | high (A or P) |
| Elscint (ELT-NYSE) | US$10.81 | US$14.00 | US$7.00 | high (A or P) |
| Aladdin (ALDNF-NASDAQ) | US$7.50 | US$14.00 | US$14.00 | significant (A) |
| *Adjusted for cash dividend **For all (A) or part of (P) business | ||||
Israeli powerhouse
I have always felt a deep reverence for Uzia Galil, the 73-year old founder and CEO of Elron (ELRNF-NASDAQ). He's personally responsible for the birth of 20% of the electronics industry. A true taipan, Uzia created ELRNF in 1962 as a high tech incubator -- subsequently building up a billion-dollar empire of world class companies over the last three and a half decades.
Since I initiated coverage of the stock in 1996 as a "Strong buy up to US$10.25," ELRNF has traded as high as US$19.25. Several leading investment banks initiated coverage of ELRNF as a "Strong buy" after my initial recommendation. ELRNF has successfully unlocked the value in its subsidiaries through specific restructuring actions, raising both its own market value and that of its subsidiaries.
While I have had plenty of opportunities to recommend taking huge profits on ELRNF, I have retained my "buy" recommendation on the stock all the way up to US$17 (although I downgraded ELRNF from a "Strong buy" to a "Speculative buy" when it broke above US$15). The stock is highly correlated with the Dow during periods of extreme market volatility. Given the first-class management and depressed valuation, it doesn't make sense to be a seller below the US$20s -- whatever happens to the stock price in the short term.
ELRNF should be viewed as a diversified super-tech grab-bag. In my view, it's the best buy in Israel. You get exposure to a dazzling array of Israeli technology in a single stock. And unlike a passive mutual fund, ELRNF adds value to its subsidiary by providing managerial and financial guidance.
If you add up the value of the public and private holdings, you get a Net Asset Value (NAV) of US$20 per share. At current levels, ELRNF is trading at a glaring 30% discount to NAV. Based on my bullish outlook for some of ELRNF's public holdings, I anticipate a widening of the discount to over 50% by mid-1999. Since ELRNF adds value to its holdings, I believe that ELRNF deserves to trade at a premium to NAV, not a discount.
Since the holding company structure is confusing to potential investors, management is slowly moving ELRNF towards an operating company model. ELRNF's 100%-owned software business is booming. I anticipate ELRNF's software business will generate US$40 million in revenue in 1999. The most interesting product is an "Internet policing software" to warn managers when their employees are wasting time on pornographic (or sports, stocks, etc.) websites. While it will take at least three years for ELRNF to be viewed as an operating company, it will help support the long-term bullish trend in the stock.
Over the next twelve months, ELRNF
will be driven by specific corporate events in its major subsidiaries.
40%-owned Elbit Medical Imaging (EMITF-NASDAQ) will be
significantly higher by January -- popping ELRNF's stock price.
Elbit Ltd. (ELBTF-NASDAQ) will also be significantly higher
by the first quarter, supporting group NAV. The further sale
of Chip Express (Lucent already bought 10% for US$10 million)
will help generate interest in the stock. Also, the potential
flotation of NetVision, the AOL of Israel, would be very bullish
for ELRNF.
ELRNF's low stock price is absurd. Specific catalysts will propel the stock to fair value. As management continues to unlock shareholder value, the discount to NAV will shrink. At the same time, NAV will expand with the growth of the subsidiaries. ELRNF is a strong buy at current levels.
Discount to cash!
Since April 1997, I have been recommending Elbit Medical Imaging (EMITF-NASDAQ) as a ridiculously undervalued play on Israeli medical technology. When I initially recommended the stock, EMITF traded under US$6, with a market cap of only US$128 million. Since my initial coverage, EMITF has disposed of three subsidiaries for a total of US$600 million in cash. The stock moved up into the eleven dollar range -- after paying out a generous US$1 dividend.
While EMITF trades below net cash (and has other valuable assets), the company will soon start putting its cash to work. Investing all the cash on the balance sheet in a tiny country like Israel is not an easy prospect. EMITF will either pay a big premium for quality companies or invest in medical technology start-ups. In either case, it will take a long time to see a return on investment.
CEO Emmanuel Gill has stated that he wants to merge EMITF and ELT. The company will have to give shares to ELT minority shareholders. While EMITF will get ELT's remaining cash and remaining assets, there will be no cashflow stream to support the stock price-just cash. The dilution from new shares, the supply overhead from former ELT shareholders, and the lack of current earnings will overhang the stock. There's only one clear support for the share price: the possibility of large dividends.
If EMITF invests the cash balance in medical start-ups, net cash will decline -- as will the stock price. Don't get me wrong. I love these guys. Anyone who bought EMITF following my recommendation has made a lot of money. Management has proven that it is committed to creating shareholder value. In three or four years, the merits of EMITF's investment program could be reflected in a higher share price. But it's time to look for an opportunity to sell EMITF on strength.
Above US$14, EMITF is close to being fully valued. Sell EMITF over US$14.
Merger mania
Elscint (ELT-NASDAQ) has
been a big winner for Taipan subscribers. I initially
rated ELT as a Speculative Buy under US$7.50. Trading at a big
discount to book value and annual revenues, the stock was a no-brainer
-- if you knew that EMITF was committed to unlocking the value
in its subsidiaries. This contrarian value pick was so controversial
that a highly respected Israeli analyst on Wall Street called
me up to tell me I was nuts. Now that ELT is up 80% from our
initial entry level, the nuts on Wall Street are pushing the
stock!
ELT generated US$23 per share in gross proceeds from the transaction. Capital gains tax and restructuring charges will take a significant bite out of the cash. GE has a put option worth US$1.88 per share to buy out ELT's interest in the ELGEMS joint venture. ELT's remaining assets (excluding ELGEMS) are worth US$3-4 per share.
While ELT's assets add up to US$21+ per share, ELT is likely to trade at discount to Net Asset Value. The market has never generously valued ELT's business divisions, so it's doubtful that ELT's remaining businesses will be fairly valued by the market. At the same time, the net cash will be valued at a discount to the aftertax value of the cash, since the CEO has stated that the most likely scenario is partial dividend distribution and partial investment.
Since ELT and EMITF will probably merge in a stock deal, ELT shareholders will probably get a large dividend distribution plus EMITF shares. An excellent deal for anyone who bought ELT before the recent string of announcements.
According to my calculations, ELT is worth a minimum of US$13 and a maximum of US$18. That gives a median fair value target of US$15.50. Above US$15, ELT is close enough. Sell ELT over US$15.
Elbit Ltd. (ELBTF-NASDAQ)
The most intriguing Elron company is Elbit Ltd. (ELBTF-NASDAQ). Any growing high tech company is a bargain if it's trading below Net Liquid Assets. I don't know any US$3 stock that offers as much value as ELBTF.
Just by liquidating the company, you could extract US$5.50 per share in value. If you assumed that all of the private holdings were worthless, you could still extract US$3 per share in cash. Since ELBTF is only trading at US$3, there's almost zero risk to holding the stock.
Elron's hidden gem
ELBTF was spun off during the Elbit demerger in January 1997. Before the demerger, Elbit operated a confusing line of businesses, including defense electronics, medical imaging, and telecommunication technology. The whole mess was valued at a deep discount to the sum of the parts, since the market was unable to value each business separately. To create shareholder value, Elbit was broken up into a medical imaging company (EMITF-NASDAQ), a defense company (ESLTF-NASDAQ), and everything else (ELBTF-NASDAQ).
After the demerger, Elbit Ltd. became a telecommunications start-up with strong asset backing. Elbit also inherited a number of subsidiaries unrelated to the core telecommunications business. While EMITF and ESLTF have been picked up by Wall Street, ELBTF remains unsupported by institutions (Flemings initiated coverage of ELBTF as a "Buy" with a target of US$4.50, but they are not actively pushing the stock).
Why is the stock so cheap? The poor performance of a few non-core subsidiaries has killed the stock. Since Elbit is disposing of all non-core subsidiaries, the punitively low stock price is unwarranted. All of the non-core subsidiaries are sources of cash, representing hidden assets on the balance sheet. The realization of these assets over the next twelve months should trigger a re-rating of the stock -- even without any change in perception towards Elbit's core businesses.
The parent company
finds value in the stock. ELRNF has recently increased its ownership
of ELBTF from 40% to 42%. ELRNF purchased over 440,000 shares
on the Tel Aviv Stock Exchange. This not only demonstrates the
confidence that ELRNF has in ELBTF, but provides a technical
floor under the stock, since ELRNF's board has authorized a one
million share repurchase of ELBTF.
Cellular gold
ELBTF has a 16.5% stake in Partner, Israel's GSM operator. The first GSM phones are now being launched. While Partner will have to spend a lot of cash upfront to build up the network, the GSM license will become a printing press by 2001.
Israel is the world's fastest growing cellular market. From 1994 to 1997, the number of subscribers has grown by over 700%. Market penetration has reached 27% of the population -- a goldmine of 1.7 million subscribers! Based on this momentum, market penetration should reach 50% of the population. In a country like Israel, the market penetration could be even higher -- especially with the new GSM phones. By 2001, Partner should easily capture 30% of a 3 million subscriber market, or almost 1 million subscribers.
Cellcom is valued today at US$2,250 per subscriber. At this market cap/subscriber multiple, Partner would be worth US$2.25 billion. Assuming our projections are accurate, Partner should be awarded a similar valuation to Cellcom. Discounted back to the present with Israeli interest rates, Partner has a net present value of US$1.1 billion. Elbit's 16.5% stake of Partner is worth US$181.5 million, or US$8.48 per share. This is a huge premium compared to the US$3 market price for the stock!
While the Partner stake represents a tremendous investment, the cash required is basically known in advance. In my view, most Israelis would jump at the chance to trade up to a better phone -- especially one with international roaming capability.
As Partner rolls out the network and grows brand awareness, the perceived value of Partner will grow. This will be a key driver of ELBTF's stock price. ELBTF should start appreciation long before Partner is EBITDA-positive.
Unlocking shareholder value
In 1999, ELBTF will unlock the value in some of its major subsidiaries. I expect ELBTF's ATM business, HyNEX, to grow like crazy over the next twelve months. I also expect that ELBTF's CableTel business will be awarded a major contract in China. The combination of these bullish events should propel the stock into the US$5-6 range.
Also, any disposal of ELBTF's non-core assets, including the real estate, will help support ELBTF's stock price. As ELBTF exits unprofitable, non-core businesses (like EVSNF-NASDAQ), market sentiment towards the stock should begin to change.
Regardless of the exact timing of any of these bullish events, the stock is a steal at current depressed levels. 1999 should be an excellent year for ELBTF shareholders. Despite the projected operational losses through 2001, ELBTF represents a supercheap bet on Israeli telecommunications technology. ELBTF remains a speculative buy under US$3 with a 1999 target of US$5-6 and a 2001 target of US$17.
Optically inspect this:
Orbotech (ORBKF-NASDAQ) is one of the most undervalued tech stocks on NASDAQ. The company has a virtual monopoly in a hot growth industry, but a p/e ratio of only 11. Management has grown ORBKF from a tiny Israeli start up to global titan. The current low share price is a joke.
PCB revolution
Printed Circuit Boards (PCBs) are in everything. Computers...televisions...cell phones...cars...Almost any machine with circuitry contains PCBs. Basically, a PCB is a slab of epoxy that both physically houses and wires together microchips. The global PCB market stands at US$30 billion.
No matter what happens to Asia in the short term, the PCB industry will grow. The PCB industry is estimated to grow at 8% annually over the next decade. While there will be ups and downs, the long-term trend definitely will be higher.
But the PCB industry isn't just driven by unit growth. Demand continually grows for denser, more complex PCBs. The more connections you can squeeze into a given PCB, the greater its capability...Brand new markets are opening up as technological advancements enable engineers to cram more layers into a PCB. The market for high density PCB is projected to grow at a long-term rate of 14% to 16%.
PCB manufacturers need to check for mistakes. Otherwise, they're squandering a ton of money. If you don't have a system to detect errors, your PCBs will probably fail when you move into full scale manufacturing. Unfortunately, you can't just hire a busload of Indonesians to check for errors with magnifying lenses. And, thanks to an inviolable law of nature, the greater the complexity, the greater the likelihood of error.
As PCBs become more complex, the demand for automated inspection systems will grow exponentially -- and this will be the principal engine of growth for the booming PCB industry. That's where ORBKF comes in.
Dominant position in a growth industry
ORBKF controls 70% of the global
market for PCB automated optical inspection systems (AOI). The
market consists of the approximately 600 manufacturers that produce
higher end PCBs. Since AOI represents a production bottleneck,
manufacturers are more than willing to cough up for machines
that are fast and accurate. Industry insiders tell us that ORBKF's
AOI machines have the highest line-width resolution, the highest
throughput, and the most flexibility (in terms of both high and
low end requirements) in the marketplace. Together, ORBKF's competitors
(Dainippon Screen, Gerber, Lloyd Doyle, and CAMTEX) only account
for 30% of the market.
Leveraging its AOI technology, ORBKF has become a major player in the AOI market for Flat Panel Displays (FPDs). This is a burgeoning market. Currently, most FPD inspection is actually done manually. As the FPD industry grows, manual inspection will fast become obsolete. Most FPDs are Liquid Crystal Displays -- technologically difficult to inspect. ORBKF's machines blow away the competition. A single FPD AOI machines sells for US$750,000 to US$1,000,000.
ORBKF has a 30% market share of the PCB-CAM (Computer Aided Manufacturing) market. Applying its expertise in PCB optical inspection, the company has moved into the manufacturing process itself. You can use CAM systems to produce PCB templates. The PCB-CAM machines go for US$25,000 to US$100,000 -- and 70% of the potential market is totally untapped.
Like PCB-CAM, plotters are used in PCB manufacturing. To convert computer designs into physical reality (the template), you need a plotter. ORBKF's market share is approximately 25%. Orbotech's plotters run for US$200,000 to US$250,000.
Recently, ORBKF entered into the shadow mask inspection markets. Shadow masks are metal screens used in the cathode ray tube manufacturing process. Before ORBKF introduced its AOI product, manufacturers had to inspect the masks visually -- an absurd waste of time and money. Shadow mask AOI should be a material contributor to the top line in 1999.
Lock and load
Since I have been tracking the company, quarterly revenue has grown at a consistent rate, while profit margins have expanded rapidly. The result has been unbelievable earnings momentum -- and I expect the positive trend to continue. ORBKF has achieved higher profit margins by leveraging its existing sales force with new products. Also, fixed costs decline as a percentage of sales as the top line grows.
ORBKF's valuation is ridiculously low considering the company's tremendous improvements in profitability. The US$500 million market cap is cheap against annualized revenues of US$200 million. And ORBKF has firmed up its balance sheet, paying down debt and increasing shareholder equity. With a book value of US$12.50, US$76 million in cash, and almost zero long-term debt, ORBKF is in excellent financial condition. At 11x forward earnings, the market is valuing ORBKF like a distressed company. Considering the superliquid balance sheet, strong margins, and outstanding growth prospects, the stock is a steal at current depressed levels. The company's share buyback program should put a technical floor under the stock.
ORBKF is a strong buy under US$33. Above US$33, ORBKF is a hold with a 1999 target of US$50.
The xDSL Explosion!
"Digital Subscriber Line (DSL, referred to as xDSL because there are several flavors of the technology) is the future of premium home and small business Net access, as long as phone companies don't drop the ball. xDSL allows broadband access over existing copper lines, with certain restrictions. Long-term, it is better than cable.
That's why I believe James Passin's pick of the Israeli company Orckit as a play in xDSL technology is a solid long-term move. Orckit has successfully sold to US telcos just getting their feet wet in xDSL, including a deal to supply GTE with xDSL hardware. It's one of the few small companies that is positioned for the huge growth in the Internet infrastructure market."
Bill Sanders, Taipan Webmaster
Taipan, vol. 10, # 11
There's no question: the Internet is the most important new communications medium since the invention of the telephone. But the valuation of the big internet stocks is preposterous. The total market capitalization of U.S. Internet stocks is approaching US$200 billion -- more than the total market cap of Southeast Asia (ex Hong Kong) and Russia combined. At 2.5% of U.S. GDP, the internet stocks are insanely priced (it will take decades before 1 out of every 40 economic transactions in the U.S. are conducted online!).
While the lowest-grade, third-tier "Internet" penny stocks are soaring, Orckit Communications (ORCTF-NASDAQ) remains trapped in a trading range between US$13 and US$20. I find this incredible -- since high bandwidth modems are required for the continued growth of the Internet!
The race is on for the new standard in high speed modems. 56k modems and ISDN lines are dust. The future is between xDSL and cable modems. While cable modems work over cable TV, xDSL works over regular copper telephone lines.
Sentiment has been swinging back and forth between cable and xDSL. While cable modems are probably more reliable, cable is basically designed for one-way data transmission. The cable companies are more nimble than the telcos, but the telcos have deeper pockets. Almost all households have telephones, while only 40% of households have cable TV. Taipan believes that the coming market for high speed modems will be split evenly between xDSL and cable, with xDSL gradually gaining the upper hand.
Best of all: whether the market will be split 50-50 or 60-40, there's plenty of room for the xDSL companies to make a bundle of money. With the best technology on the market, ORCTF will dominate this emerging industry. ORCTF's award-winning modems are faster and more reliable than the competition's.
But ORCTF is not resting on its technological lead: the company has secured a dominant global market position in xDSL through blockbuster contracts with GTE (U.S.) Deutsche Telekom (Europe), and Lucent (Middle East/Africa). With Fujitsu as its U.S. partner, ORCTF is in an excellent position to lead the growth of the U.S. market.
There's a downside to ORCTF's recent successes: the company will lose money in FY98. FY99 is difficult to predict, but I expect ORCTF to come through with at least US$0.40 for the full year. The best way to value ORCTF is as a multiple of sales. At 3x FY99 sales, ORCTF is cheap for a dominant xDSL company.
ORCTF's stock price will be driven by public awareness of xDSL. Also, ORCTF will be re-rated at the revenues continue to grow at a triple-digit pace and as the company starts generating profits. Major shareholders have been significantly increasing their stakes. I would follow their lead. I rate ORCTF as a "buy" with a 1999 target of US$30.
Aladdin Knowledge Systems (ALDNF-NASDAQ)
Aladdin (ALDNF-NASDAQ) has been a painful disappointment. Good core business, bad stock chart...ALDNF has a 25% share of the global software security market. The company's main product, a software security lock called HASP, is a cash cow. It's hard to believe the company is only worth 7x earnings.
The problem is the failure of ALDNF's new security products to take off. All material revenues are generated from the hardware lock. While ALDNF's internet security protocol software is promising, sales are not materializing. At the same time, sentiment is turning against the old hardware-based locks, since the customer has to physically attach the lock to his printer port.
Also, ALDNF has been hurt by the company's persistent sluggish top line growth. Look at the last four quarters: US$9.4 million in sales in Q4 FY97; US$9.7 million in sales in Q1 FY98; US$8.8 million in sales in Q2 FY98; and US$8.0 million in sales in Q3 FY98. The top line is not growing fast enough to attract analysts!
I like the CEO and believe in the core business. But the anemic top line growth, new product failures, and poor stock price performance have me on edge. In my view, there needs to be consolidation in the fragmented software security industry. ALDNF should merge with a competitor.
Until the company can reinvigorate the top line through internal growth or acquisitions, I can no longer remain a supporter of the stock, even at 7x earnings. On the other hand, I don't recommend selling the stock at these low levels.
Major shareholders have been aggressive
buyers of the stock all the way down. ALDNF also has authorized
a 200,000-share buyback plan. With big buyers sucking in all
the supply on weakness, I am sanguine about the stock price from
current low levels. Since the company has US$22 million in net
cash and generates over US$2 million in free cashflow every quarter,
the downside is clearly limited.
ALDNF is a hold at current levels with a 1999 target of US$14. Until the top line is reinvigorated, I recommend selling on any big rally over US$14.
Truck, truck, truckin'
Williams Controls (WMCO-NASDAQ) is an excellent play on the trend towards drive-by-wire. In trucks, mechanical throttle controls have been replaced with electronic throttle controls (ETC). Cars are next. No one knows more about automotive ETCs than WMCO. WMCO has a 60% share of the market for trucks. I believe that WMCO will get a significant piece of the emerging market for automobile ETCs -- and that cashflow streams from this new business will eventually support a stock price above US$20.
Since I have been following WMCO, CEO Tom Itin has disposed of black holes like the low-margin Kenco subsidiary, cleaned up the balance sheet, and turned around the core Portland operation. WMCO is run by people committed to creating shareholder value.
The CEO, CFO, and other top managers have been buying shares all the way up. At current levels, the company is trading at 12x FY98 earnings from continuing operations and less than 1x revenues -- a dirt-cheap price for the business. If WMCO can hold up in the upper US$2s during a bear market for small caps, it will trade at much higher levels once small caps turn around.
WMCO's 18% stake in Ajay Sport (AJAY-OTC) may prove to have value. I personally picked up some shares of AJAY as a speculation, but I don't recommend the stock as a serious investment. AJAY's new internet sales strategy could turn the stock into an internet highflier (check out the website: usgolfshop.com; it's excellent).
At the very least AJAY deserves to trade at 1x revenues, or US$8.75 per share. At current levels around US$1.50, stock is intriguing. Most importantly, AJAY no longer represents a balance sheet issue for WMCO shareholders.
I believe that WMCO should continue to dispose of non-performing businesses. Hardee, WMCO's agricultural equipment business, is destined to be a sluggish, low-margin business. If WMCO didn't have to consolidate losses from Hardee, the company would do over US$0.30 in earnings this year. There's little hope of a turnaround in the near future. While the disposal of Hardee would result in a big one-time, non-cash charge against earnings, this would be bullish for the stock.
The big trucking companies are optimistic about unit sales next year. If they're right, then WMCO's Portland operation will continue to grow at a breakneck pace. Last year, Taipan projected that WMCO would come through with US$0.15 to US$0.20 in net earnings per share this year. WMCO will exceed this estimate by at least US$0.03 in eps (excluding any charges resulting from a potential disposal of Hardee).
My FY99 estimates are for US$0.28
to US$0.31 in eps. Projecting a very reasonable 15 p/e multiple,
you get a minimum price target of US$4.50 for the stock. If WMCO
continues to attract new institutional coverage, then WMCO could
trade at 20x to 22x earnings. This gives you a twelve-month target
range of US$6.00 to US$7.25 for the stock.
The significant level is US$5.00 Once WMCO is above US$5, the stock is marginable. Also, this would give WMCO a market cap above US$100 million -- attracting a new class of institutional investor. On a price/earnings or price/sales multiple, this would be a very realistic sustainable valuation for the stock.
WMCO is a strong buy at current levels.
Mother of all disasters
I don't know if the Year 2000 Problem (Y2K) is going to end civilization. I tend to doubt it. But I know this: lawyers are going to have a field day with Y2K-related lawsuits. When lawyers need an expert to investigate major engineering/scientific failures, they call Exponent (EXPO-NASDAQ).
As the world leader in failure analysis, EXPO will enjoy explosive growth in sales and profits from the Y2K disaster. Since these lawsuits will drag on for years, Y2K will lead to a material re-rating of EXPO. No one is talking about EXPO as a Y2K play, but it's the best one I know.
I am shocked by the persistent weakness in the stock following the explosive run up to US$13. While we enjoyed huge profits at the top, the stock has since returned into my initial recommended buying range.
EXPO is a solid growth company trading at a distressed valuation -- the kind of contrarian value play that I find compelling. EXPO's rock-solid international reputation in failure analysis translates into a robust franchise with significant brand equity. CEO Mike Gaulke's recent acquisitions have diversified the revenue stream while contributing to top and bottom line growth.
At current levels, EXPO is trading at 1x sales and under 1x book value -- an absurd valuation for the business. The only negative aspect of the business is the lack of predictability from quarter to quarter. EXPO has been hurt by some early project completions and general slowdown in business. However, the long-term growth trend is still intact. The stock has more than discounted recent weakness. I expect a full recovery by Q1 FY99.
The company has been repurchasing
shares with its surplus cash balance -- a sign that the management
is interested in creating shareholder value. The stock should
easily trade back into the teens after two consecutive quarters
of solid growth.
At any time, EXPO is vulnerable to an explosive rally. Disasters tend to capture the public's imagination. Considering the tight float, strong franchise, and low valuation, EXPO could explode upwards if any meaningful buyers enter the market. Y2k should be a catalyst for sustained recovery in the stock price.
EXPO is a strong buy at current levels.
Outlook for commodities
Commodity Trust Ltd. (CMT-LSE) is our pure play on the general level of commodity prices. CMT is a closed-end fund traded on the LSE. The fund managers try to match the performance of the Goldman Sachs Commodity Index -- with zero leverage. Considering the low prices of commodities, this is the most conservative recommendation I have ever made.
The fund trades at a glaring 15% discount to Net Asset Value (NAV). I don't know where else you can buy US$1 worth of commodities for 85 cents. While commodities are in themselves a bargain (since they are trading at multi-decade lows), CMT is a absolute steal.
While the majority of closed-end funds trade at discounts to NAV, CMT has a specific catalyst to shrink the discount to zero. At the Annual General Meeting on April 30, 2000, shareholders will vote on whether to wind up the fund or continue for another five years. If the discount persists, shareholders can vote to liquidate the fund. If you are a shareholder, you are entitled to full NAV. Goodbye, discount.
In the worst-case scenario, you would recapture the discount to NAV, or make a profit of 18%. Not a bad risk to take, since commodities are already at the lows.
But the 18% return assumes that there's no rebound in commodities. Taipan anticipates a 30% rebound in commodities by 2000. This will result in a 30% expansion in CMT's NAV. Since you can buy CMT at a 15% discount, your return on the fund rises to 53%. A 40% bounce in commodities would yield a 65% return on the fund!
A Y2k hoarding panic will erupt in late 1999. Since CMT's annual meeting is on April 30, 2000, CMT shareholders will reap tremendous rewards from a public panic. Since commodity distributors like to keep inventories as low as possible (the latest fad in management is "just-in-time inventories"), commodity prices would inflate to mind-boggling levels -- in a very short period of time! This would be very bullish for CMT's market price.
Warrants for the speculators
If you want to speculate on a rebound in commodities, the CMT warrants (CMTW-LSE) offer tremendous upside. Basically, the warrants are a leveraged bet on the market price of CMT by April 30, 2000. If our outlook for commodities is correct, than CMT could rebound by over 300%.
The only short-term downside is oil. My revised outlook for a one-time catastrophic shakeout in oil has temporarily downgraded my outlook for general commodity prices. The drop to US$9 per barrel will hurt the Goldman Sachs Commodity Index. However, strength in agricultural commodities should offset weakness in energy.
Contrarian value investors should build up positions in commodity plays for next year's explosive rebound. CMT is the most solid commodity play I know. CMT is a strong buy under US$1.30.
Sasol ADR (SASOY-NASDAQ)
Admittedly, my timing was terrible with Sasol (SASOY-NASDAQ). I tried to pick the bottom on the South African synthetic fuels giant -- with little short-term success. However, the inherent financial resiliency of the company will lead to a robust stock price performance over the next eighteen months.
SASOY is one of the largest industrial companies in South Africa. In fact, it is on the largest oil/petrochemical conglomerates in the world. SASOY supplies 41% of South Africa's liquid fuels. The fuel is refined from SASOY's massive coal reserves using the Fischer-Tropsch conversion process.
SASOY's coal mine at Secunda is the largest underground coal mining complex in the world. The company produces 44 million tons of coal per year. This represents 21% of South Africa's annual production. At the current rate of production, SASOY's reserves will last another 40 years.
If all the coal were converted to synthfuel, Sasol would have proven reserves equivalent to 2 billion barrels of crude. If you net the chemicals business out of SASOY's market cap, SASOY has an enterprise value/barrel of proven reserves of under US$1! This makes SASOY the world's cheapest major vertically integrated oil company.
Chemical rehab
The key driver for SASOY's stock price will be the growth of the petrochemicals business. Petrochemicals generate higher profit margins than synthfuel, but are generated from the same syngas feedstocks. As the petrochemicals business expands as a percentage of total sales, SASOY's margins will expand.
Unfortunately, petrochemical wholesale prices are still declining. This results from global overcapacity and muted demand in Asia. Fortunately, there is a light at the end of the tunnel: insiders at U.S. chemical companies have turned into aggressive net buyers over the last three months. Historically, net insider buying in chemical companies has foreshadowed a recovery in global chemical prices by six months to one year. With solid companies like SASOY trading at 5x earnings, the market has not priced in any recovery whatsoever.
Betting on synthfuels
Oil is collapsing in price (for now), so the idea of synthetic fuel production is not catching the imagination of mainstream investors. Synthetic fuels stocks as a group are performing terribly. But after the final cleansing capitulation, a sustainable bull market in energy will reemerge. The rapid depletion of global oil stocks will trigger a resurgence of activity in economically feasible synthetic fuel.
No one knows more about the Fischer-Tropsche
conversion process than SASOY. The company has been using the
process to economically convert coal into high quality synthetic
fuels for 48 years. Using a modification of the basic process,
SASOY can economically convert natural gas into synthfuel.
SASOY has a joint venture with Phillips and the Qatar republic to develop an offshore slurry phase distillate facility. Also, SASOY has a joint venture with Statoil in Norway to build offshore facility for the production of synthfuel from natural gas. In terms of real money contracts, SASOY is the only serious synthfuel play on any stock exchange in the world.
While I believe that the next oil crisis will be a trigger for a re-rating of synthfuel stocks, you won't have to wait that long. Oil and gas companies have an obvious incentive in finding ways to monetize natural gas reserves. In most cases, it's not economical to transport natural gas over long distances. Instead of flaring gas, oil producers could generate cash...It makes sense to me...
More immediately, as developed countries tighten standards for fuel emission, demand for high quality fuels will rise. Synthfuel generated from the Fischer-Tropsche process is so pure that there are very few pollutants left to contaminate the environment. Emissions from synthetic diesel exceed even the toughest environmental standards in California. The trend towards tighter emissions standards in the U.S., Europe, and Japan will ensure a growing market for synthfuels.
A massive and permanent bull market in synthetic fuel-related stocks is brewing. Any number of triggers could spark the initial re-rating. Once mainstream investors start buying into the synthfuel story, SASOY won't trade at just 5x earnings.
Like hunting in a safari
Aside from a hostile external environment for a synthetic fuel/petrochemicals company, SASOY has been hurt by internal political developments in South Africa. SASOY enjoys a modest tariff protection from the government. The tariff protection only became a negative issue when oil fell below US$16 per barrel. When oil was above US$16, no one cared about it. Now that the tariff actually helps SASOY, analysts view it as a negative.
Taipan is generally bearish towards state-protected industries. That said, the government is already planning to eliminate all tariff protection in three years. SASOY is already budgeting for the eventuality. And once oil recovers, this will a non-issue. Given SASOY's excellent financial position (more cash than debt, free cashflow every year since FY93), this concern is already built into the stock price.
If our long-term bullish outlook for oil is correct, then SASOY will be one of the world's best-performing energy stocks. But in the short term, SASOY is vulnerable to further drops in both oil and chemical prices. The final selling climax to US$9 per barrel could send SASOY back to the 52-week low. After the re-test of the lows, SASOY should climb to our 1999 target of US$16 per share.
Taipan recommend a "dollar-cost averaging" approach on severe weakness. SASOY remains a strong buy at current levels.
Avant Immunotherapeutics (AVAN-NASDAQ)
T Cell (the old TCEL-NASDAQ) and VRI (the old VRII-NASDAQ) have merged. The new company is called Avant Immunotherapeutics (AVAN-NASDAQ). If you held TCEL or VRII, you now own AVAN shares. AVAN has 48 million shares outstanding (fully diluted) and a cash position of US$22.6 million. With three products in Phase II trials and strategic alliances with five pharmaceutical giants, AVAN is in an excellent position to move products through commercialization.
In the short term, clinical and marketing events from the advanced products will drive the stock. AVAN recently announced an outstanding 90% efficacy in the Phase II rotavirus vaccine study. I anticipate a positive announcements from the TP10 program over the next three months. Over the long term, AVAN will be driven by the development of the early stage products, including the cholesterol vaccine (a vaccine that prevents hardening arteries) and Therapore (a cancer vaccine delivery system derived from anthrax).
AVAN's market cap of US$60 million
is ridiculous. The cholesterol vaccine is the biggest potential
blockbuster I have ever seen. Everyone is worried about high
cholesterol. With an aging baby boomer population both in the
US and Japan, the demand for a cholesterol vaccine can only grow.
Every year, US$8 billion is spent on cholesterol-reducing drugs.
A cheap, effective, non-toxic alternative to cholesterol-reducing
drugs would be a blessing for both patients and insurance companies.
The idea of controlling cholesterol without diet or exercise
is the kind of hot story that could win national media coverage
-- creating a buying frenzy in the stock. If it works, the cholesterol
vaccine is bigger than Viagra.
The other products are just as exciting -- and much farther along in clinical development.
CEO Una Ryan just announced a 40% reduction in overhead expenses. As a result of the cost-cutting measures, AVAN will have cash to last the company through FY99. There will be no need to do a dilutive equity offering at the current depressed market price.
AVAN is the best bargain I know for just over US$1 per share. Specific events should pop the stock into the US$4 to US$6 range by mid-1999. AVAN is a buy at current levels.
Shaman Pharmaceuticals (SHMN-NASDAQ)
Shaman (SHMN-NASDAQ) needs a voodoo dance for its stock price. From the late 1997 highs, SHMN is down 70%. It's been massacred. The selling has come from short sellers, dispirited smaller shareholders, and T Rowe Price. Apparently, a fund manager change left T Rowe Price with 1.4 million unwanted shares of SHMN. The shares were apparently dumped into the market. The endless flood of shares into the market coupled with some weird financing deals killed the stock.
CEO Lisa Conte's aggressive fundraising philosophy has kept the company afloat through rough times -- but also hurt the stock by putting the company in a difficult liquidity position (spend, spend, spend, and sell stock, sell stock, sell stock). In Taipan's view, SHMN should have partnered Provir immediately with a large pharmaceutical company. While SHMN would have to split royalties, it's better than grinding shareholders into the ground while the drug is still in the clinic.
If SHMN had relinquished its arrogance and partnered Provir for the U.S. and Europe (which I believe was a clear possibility, based on the outstanding Phase II results), SHMN could have concentrated on discovering new drugs in the rain forests, rather than priming the share printing press. I've been unpleasantly amazed at the increase in fully diluted shares outstanding-even for a development stage biotech.
But all this is now ancient history. Management's egregious errors in judgement have turned SHMN into one of the worst performing third-tier biotech stocks. NASDAQ has even been threatening to delist SHMN for failing to meet minimum tangible net worth requirements (the catalyst for the recent spate of exotic financings). Apparently, SHMN is now in the clear as far as the NASDAQ listing is concerned -- but the damage has already been done.
Back to the technology
Development-stage biotech always looks bad on paper. Bringing drugs through the clinic is a capital-intensive process. Since cash balances get depleted every time, development stage biotech necessarily involves capital raising. If you invest in biotech, you have to anticipate the most severe, gut-wrenching volatility.
Market valuations tend to radically
improve in front of the final stages of the FDA approval process.
Also, market valuations tend to improve in front of positive
clinical results. After the climactic sell-off to US$1, SHMN
has rebounded strongly. Despite recent financing deals, SHMN
is holding up. This suggests that the Phase III results will
be unequivocally positive.
Positive Phase III results will be the catalyst for a long-awaited rebound in the stock. The current market cap of US$56 million is ridiculous. Including pediatric and traveler's diarrhea, Provir is a US$500 million drug.
Assuming the Phase III results are positive, SHMN's Fast Track status for Provir for AIDS will accelerate the FDA approval process. Apparently, the FDA has agreed to review SHMN's NDA (New Drug Application) within six months after submission. SHMN could have a drug on the market by mid-1999. A biotech company with an NDA approval for a big market should be worth at least US$250 million, or US$10 per share. If the media hypes up the story, SHMN could easily trade at a premium to fair value.
What SHMN is worth today
You can measure biotechs as a multiple of cumulative R&D. If biotechs have any value, it's in the R&D. Considering the reputation of SHMN's top scientists ("Dr. Diarrhea" for example), SHMN's R&D has at least as much value as any other biotech company. SHMN's EV/5-year cumulative R&D multiple is dirt cheap at 0.8 vs. the industry multiple of 3.
To analyze how efficient SHMN is at investing capital, I look at R&D as a percentage of total cash burn. The higher the number, the leaner and meaner the biotech company. The lower the number, the more capital is being vaporized on corporate overhead. At 70%, SHMN is reasonably efficient in funding research. Before flagship biotech Gilead had any significant product revenue, R&D/burn was 76% -- not much higher then SHMN. Many of the popular biotechs score a much lower R&D/burn percentage (the best company I know on this measure is XOMA, with an 80% R&D/burn score). I expect this score to come down over the next year as SHMN spends more cash on marketing Provir (as a biotech company progresses to the revenue stage, this measure becomes less meaningful).
Hold for the news
While I'm not a big fan of her fundraising philosophy, I would not want to stand in the way of Conte. She is one of the most determined CEOs I have ever met. If there is value in Provir, she will eventually turn it into a higher stock price.
Considering the sterling scientific team assembled by SHMN, I believe it is probable that SHMN will get approval for the lead drug. Positive Phase III results followed by a favorable FDA review should support SHMN in the lower teens by mid-1999.
As a speculative buy, I recommend accumulating SHMN on severe weakness to lower your cost basis.