Saturday, April 11, 2009 0 comments

Purchase: Mathstar (PK: MATH)

I purchased Mathstar (PK: MATH), a company that is on the verge of liquidation. Unlike Comdisco, which had already been in liquidation for a long time, Mathstar has not announced any liquidation plans. This means that there is a remote risk that the company will not liquidate and management may consider buying other companies (however, there are a couple of no-name activist investors who have called for management to liquidate.) I am investing with the assumption that the company will liquidate.

I owe a big one to Greenbackd for bringing this investment to my attention. For those not familiar, Greenbackd is an amazing blog that focuses on liquidations, NCAV (net current asset value), and activist investments. The situations covered on that blog are perfect for small investors. A lot of the companies are microcaps and smallcaps and hence small investors have a huge advantage over large investors. The only downside is that these microcaps and smallcaps tend to trade on OTC or Pink Sheets so the stocks can be extremely illiquid and commissions/bid-ask spread/etc can be high. The model portfolio implemented by Greenback, and the strategy recommended by Benjamin Graham, is to buy a basket of NCAV stocks. I, however, am only looking at liquidations and making concentrated bets (hope they don't blow up.)

I am adding liquidations to my investment strategy toolkit. Mathstar would be my second liquidation play. It remains to be seen how well this works out. For those interested, do keep in mind that liquidations, similar to risk arbitrage, will likely underperform the market during strong bull markets. If we get a big rally in the stock market--we are actually undergoing one now but let's say it continues--then you may better of making a long-term buy rather than these special situation investments. Given how stock market valuations are quite low, you should think carefully before investing in any liquidation; you may get stuck if the liquidation takes a long time to complete.


Purchase price: $0.83
Investment Time Frame: Short (less than 1 year)


Investment Thesis

Mathstar (PK: MATH) is a fabless semiconductor company that has been unwinding its operations over the last year or so. It was developing some semiconductor FPOA integrated circuit but inability to sell the product led to management curtailing operations and deciding to shut down operations. Judging by the stock price action, the company really went nowhere from its IPO, with its stock price continuously declining over the last 4 years. Its stock price has declined 97%, from a peak of around $32 in 2005 to around $0.81 now. It is a microcap right now with a market cap of around $7.44 million.

Management started shutting down the company last year and the company is down to a bare-bones skeleton right now. The company presently employs one full-time employee, two part-time employees, and two contractors. The fact that management started shutting down operations gives me confidence that they are close to liquidating the firm.


Potential Return

Liquidations are pretty simple on the surface. It's definitely easier than common stock investing. It might even be easier than risk arbitrage because it is more quantitive (with risk arbitrage, there aren't any numbers to give you real confidence.) All one needs to do with liquidation investing is to figure out a conservative estimate of the liquidation value of a firm and only buy when the margin of safety is really large. Except for some complicated situations, which incidentally may provide the highest returns, all you need to do is to look at the financial statements.

The classic method to computing liquidation value is to use Benjamin Graham's suggestions. I'm not sure if modern acadmics, who are heavily influenced by efficient market theories, have better liquidation models than what Graham suggests. Another value investor, Martin Whitman, whose books I have not read yet, has suggested that certain elements of Graham & Dodd are obsolete. He has also suggested that one should pay attention to off-balance-sheet liabilities, environmental liabilities, pension liabilities, and so forth, that are not generally shown on the balance sheet. If you ever get into liquidation investing or even NCAV investing, make sure that you pay attention to these things. Benjamin Graham never says anything about these liabilities (from what I can gather) because, well, many of these issues didn't exist back then.

At the Greenbackd blog, you can find some thoughts from Benjamin Graham and Seth Klarman. Ideally you should read the various books by Graham, Klarman, Whitman, and others. I haven't really concentrated on liquidations, apart from a few articles here and there, and hence haven't really read any books on liquidation investing. I need to do a lot more work if I were to make this a greater part of my investing. As with any investing I do, I'm still a newbie in the learning stages and am not sure what I'm cut out for.

Greenbackd has performed a liquidation analysis for Mathstar (you can find the latest update here.) I will present my estimate below.

Greenbackd largely follows Graham's suggestions, with some minor tweaks with the percentages. Greenback's method is more robotic with a similar computation used on all the stocks he/she evaluates. I, on the other hand, am approaching this as a concentrated investor and hence am assigning haircuts as I deem fit. For instance, Greenbackd assigns 20% liquidation value to plant/property/equipment and long-term investments. I, on the other hand, am assigning a 10% value to plant/prop/equip, and zero to long-term investments. I am injecting my personal opinion into the estimates (e.g. I believe that plant properly isn't worth much; and the ARS securities may be worth nothing if the company wants to shut down everything tomorrow without waiting for the auction market to be revived.) I don't know if this is dumb or not but we'll see.

Greenbackd also does not seem to account for non-cancellable leases and non-cancellable software purchase. Greenbackd's view is that, in general, as long as the margin of safety is large, such matters do not need to be explicitly considered. In this case, this makes very little difference since the dollar amounts aren't very large.

I need to find a better and easier way to present the results but, for now, you can check out my liquidation calculation in the image below:



I pulled the latest balance sheet, which can be found in the 2008 annual report. I copied and pasted it into a spreadsheet and applies haircuts to the assets. In line with conventional think of value investors, I count all cash and liquid short-term securities at 100% of book value, and all liabilities at maximum value. All other assets, such as accounts receivable, prepaid expenses, long-term investments, and so on, need haircuts.

Mathstar has no off-balance-sheet obligations. However, it does have a non-cancellable operating lease that requires payments for the next three years. It also has some software purchase commitment. Both of these are deducted at 100% of their book value.

The only potential cost that is not counted is the cost of final winding down of the operation and possibly some severance payment for the remaining employees. I do not know what the proper procedure is in these circumstances--hopefully after going through with this and Comdisco I'll have a better idea--but I am assuming that there isn't any additional payments.

I estimate Mathstar's liquidation value to be $1.33 per share. If shares are purchased at $0.83, this represents an upside of 60.7%. I am guessing that the company would be liquidated within an year. But even if it takes two years, one is looking at an upside of around 30% per year. I consider this attractive.


Risks

There are some risks in this investment as follows:

The first risk, and probably the biggest one, is the possibility of management deciding not to liquidate the company. Unlike the Comdisco case, Mathstar has not indicated that it is liquidating. Management may decide to treat this as a blank check company or a sort of a SPAC (special purpose acquisition company). Instead of closing the company, management may decide to acquire other companies.

I feel there is a high probability of liquidation since the two main shareholders have called for liquidation. These two activist investors will likely pressure management to liquidate.

Furthermore, the remaining full-time employee, the CEO, holds quite a number of shares. It's probably not a whole lot for the executive--these guys are probably millionaires--but it is still several hundread thousand. The following table, extracted from the annual report, displays the main shareholders:



One might wonder why I took a position before the company announced it was liquidating. The reason is because the market may mark up the stock price once a liquidation announcement is made. There was another potential liquidation I was following and the stock price jumped 50% in one day, to the liquidation price, when the company announced it was going to hold a shareholder vote to decide if the company should be liquidated. Based on that observation, my feeling is that one needs to invest long before the company announces it.


Another risk is the possibility of this taking a while to liquidate the auction-rate securities or some other asset. Since these don't seem to be a lot of money, my feeling is that management may simply write off these assets or hand out most of the cash while waiting for these issues to be resolved. Management is also trying to sell the intellectual property and tools related to their technology so there may be delays in liquidating that. But if they can't find a buyer, they may simply write that off (it would be justifiable because if it cannot be sold, there is no chance of selling such specialized technology in the future.).

Even if there is a delay, I would be satisfied with my return as long as it happens within two years. Anything beyond that would turn this into a decent or average, instead of great, investment.



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