The collapse in the price of oil over the past two years has created a problem not only for oil producers but also for companies which provide products and services to the energy sector. In response, these companies have downsized and made efforts to diversify their customer base, but many of them are in violation of their borrowing covenants and several have audit footnotes which question their viability as a going concern.
For a value investor, where there is adversity there is opportunity, so I have been poking through the debris – buying stocks which are priced for extinction but which appear to have a fighting chance for survival. As a starting point, stocks which meet the iconic Ben Graham net-net working capital screen clearly qualify as value stocks with a margin of safety.
With its stock price down 75 per cent from its peak, Redline Communications is a prime example and a recent addition to my portfolio. To recap, the Ben Graham screen looks for companies where the stock price is below the value of the current assets minus all liabilities, with no value given to fixed assets or intangibles. The logic is that you could liquidate current assets at face value, pay off all liabilities at par and still have more cash per share than the current stock price.
Markham, Ont.-based Redline Communications develops and markets wide area network infrastructures for challenging applications and locations. These networks are used by oil and gas companies to manage onshore and offshore assets, and also by governments, the military and telecom service suppliers. A year ago, the energy sector represented over 60 per cent of revenues, but by the third quarter of 2016 this exposure had fallen to only 36 per cent of a significantly reduced revenue base. Although new orders are coming in from a variety of clients, including a 100,000-seat college football stadium, the energy sector is not completely comatose: 60 per cent of the backlog remains in this category and third-quarter energy revenues increased for the first time since the first quarter of 2015. For example, an oil and gas client recently awarded Redline a $1.4-million contract to install an offshore wireless network to replace an existing satellite system at a lower cost.
There may be light at the end of the tunnel for Redline Communications, but the company is still losing money. So why do I see it as a bargain and a survivor?
At the current price of $1.48, Redline trades at a small premium to net-net working capital of $1.36 and a discount to the book value per share of $1.60 as of Sept. 30. (The stock price on the TSX is quoted in Canadian dollars while the financial statements are in U.S. dollars: be sure to gross up balance sheet and revenue items by 35 per cent before calculating ratios.) Annual revenues are now at a run rate of $20-million (U.S.), down from a level in excess of $35-million only a year ago, so the company has a lot of ground to make up before it returns to profitability. But with $10.3-million in cash on the balance sheet, it has enough liquidity to keep the doors open for the immediate future. The only debt outstanding is a $2.9-million loan from the Province of Ontario with a repayment schedule currently under negotiation, so survivability is not an issue.
What is a major issue is trading liquidity. With only 17 million shares outstanding, the market cap is a trivial $25-million and two shareholders control 30 per cent of the float. When there is little trading in a stock, there is no incentive for a brokerage firm or an individual investor to research the company and it could remain a “value trap” indefinitely. This is a recurring problem for the deep value investor: most attractive candidates are microcap and illiquid. My solution is to accumulate slowly over time and to own a basket of candidates so that impatience doesn’t override the unfolding value thesis. Who knows, maybe the upcoming tax-loss selling season will generate supply from disenchanted growth stock investors!
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.Report Typo/Error
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