Free NPV

I should post a complete writeup either tomorrow or friday, but in the meantime, here is a screen shot of why Friedman Industries (FRD) is such a good margin of safety play. Even in a bankruptcy where they can only realize 25% of the carrying value of their Equipment and Machinery, they are still worth about $6 a share. The stock is only trading at 6.05. This is a pretty small amount of total downside risk with a lot of potential upside. More to come.

click here to enlarge the image

China Education Alliance (CEU) had a very strong quarter, with revenue up 33.7% vs the comparable quarter of 2009. This was driven by 35% growth in the online education segment and 45% growth in the training center segment. The revenue from the advertising segment, which is outsourced to an ad agency, fell 16% yoy. Management has said that they expect revenues from advertising to remain steady for the indefinite future. For the 6 month period, revenues were up 19% yoy. This weaker growth is due to the Q1 weakness that saw revenues up only 5% yoy.

Gross margins were very strong for the quarter at 83.5%. Management explained in the conference call that margins are driven by class participation rate, ie. If the classes at their training centers are full, they still pay the instructor the same amount hence higher margins. The same applies in their online business, where higher sales don’t necessarily translate into higher materials cost. Management has guided that gross margin should be closer to 80% in the future but might come in higher, as it did this quarter.

There were some changes to operating expenses during the quarter. Selling expenses, which include commissions to salesmen and marketing costs, were 32% of sales for the quarter up from 23% a year ago. This is caused by a new marketing push. Administrative costs actually decreased yoy. This is because the company accounts for the cost of options grants in this segment. Last quarter management promised no new options grants this year or issuance of stock warrants. If you remember, I was concerned that they would not hold true to this promise and investors may face further dilution. I am happy to see that management has been faithful to their promise so far this year .

Therefore net income is up 30% yoy for the 2nd quarter, and up 21% for the first 6 months of the year. This is positive as management had previously stuck to their forecast for 30% revenue and NI growth for 2010. They still maintain this forecast and it appears that they may be able to pull this off, despite the handicap of the slow growth from Q1 this year. To accomplish this goal, sales will need to grow 38% yoy in the second half of the year. With all the additional cash spent on marketing in the 2nd quarter, it makes sense that this will result in higher sales growth in the next few quarters.

In other new developments, they are currently constructing new training centers, with 2 set to open in the Beijing province in September and the other 2 expected to be complete within 9 months. This will be in addition to the 10 training centers for exam preparation CEU currently has running in northern China. This will require small amounts of cap ex, as each training center costs about 0.5 million USD to open.

CEU currently has built up a large cash position of about 75 million USD and much of the conference call focused on CEU’s intentions for this cash. Management has indicated that they will use a small amount for the cap ex noted above, and the rest they would like to keep on hand for acquisitions. They still maintain that they will only do acquisitions when it is favourable for them, at a multiple of about 7 times earnings. Right now most Chinese education companies are going for about 15 times earnings, so acquisitions may not be executed soon, though management claims to be actively looking.

There was a notable change in response to a question concerning share buybacks. In the past, management has said that they would like to keep their cash on hand for expansion and growth. However, this time they finally said that they agree the share price is very cheap and they have been talking internally about the possibility for a share repurchase plan. This is a good step and could act as a catalyst should management decide to initiate a share repurchase plan. Finally, when asked if CEU would consider switching to a big 4 auditing firm, the CEO stated that he recognises how switching to a big 4 firm could increase value, so they may consider it, but he would not like to discuss this on the conference call. This struck me as very positive, as if they company had something to hide or had no plans to one day switch to a more respected auditor, they would have disregarded the question by answering that they don’t need to because everything is ok.

All in all, this was a very successful quarter for CEU. Sales increased, net income increased, the company indicated that it is listening to shareholders in regards to auditors and share repurchases, and management kept their promise about not being dilutive to shareholders. I am more bullish on the company than I was in the past, and maintain my valuation of around $210 million, a 55% premium to the current price.

Furiex (FURX) lost money again this quarter, as expected. Revenues consisted of $7.5 million in milestone payments for bringing Nesina (Diabetes drug) to market in Japan, and $547,000 in royalty payments for sales of Nesina and Priligy. Obviously these sales numbers are low but Nesina was only on the market for a few weeks at the end of the quarter in Japan. It will be interesting to see the sales numbers next quarter, when it has been on the market for the entire quarter.

Expenses totaled 16.2 million. This was composed mainly of R&D costs as well as some SG&A costs. This cash burn rate is expected to continue for the next few quarters as FURX currently has 3 drugs in the research phase, which requires heavy uses of cash. Management has warned that these costs will come to between 30-40 million for the second half of the year. They also said that FURX has enough cash on hand to sustain itself through the end of 2011, as the cash burn rate will slow after they finish developing these new drugs.

Therefore for investors drawn to this company as a net cash play, be warned: the net cash market cap will most likely drop in half before it will rise again. The company may have quite successful drug patents in Nesina and Priligy but it is hard to determine at this point in time how successful they will be. Therefore I will keep a watchful eye on FURX but cannot buy at this time as I have little knowledge on when or how much future cash flows will be.

As an aside, it is interesting to note that David Einhorn, founder and manager of the hedge fund Greenlight Capital, recently disclosed that he has a new position in FURX totaling 490,000 shares or about 5% of the total float. It is interesting that he is buying since a 5% position amounts to only $5 million and his hedge fund has 3.3 Billion in AUM.

Oshkosh (OSK) came out with their Q3 numbers today and not surprisingly, due to the military contract for M-ATVs, they had huge numbers. However like I warned previously these sales will soon be completed and OSK’s other divisions will have to pick up the slack. OSK has now delivered 7039 M-ATV units out of a total order for 8079 units. Therefore after next quarter OSK will only have the service revenues from this contract which are a much smaller part.

Because of this I decided to look at OSK as if this 1 order didn’t exist. The military contract helps out OSK’s other division, Access equipment, through cross sales, but luckily management broke out how much of each division’s sales were from this 1 contract (1.08 billion for defense and 316 million for access equipment). Reconstructing the Q3 income statement assuming the same gross margin overall and stripping out the M-ATV contract we are left with total NI of about 20 million for the quarter. This is obviously troubling for a company with a market cap of 3.1 billion. This is a bit of an extreme case however as they will most likely win new contracts in the future, but it does highlight that it is important for OSK to turn their other divisions around.

The other 2 divisions reported conflicting results. Both were weak (but expected to be) so I was looking to backlog for a better view of the future. Fire and emergency posted a 10% decline in backlog compared to the year ago period. The company cited lower municipal spending as a cause (which I wrote would happen in the original write up). Since I don’t see a turnaround in municipal spending anytime soon, this division should continue to drag for the foreseeable future.

The commercial division saw an 8% gain in its order backlog. This is the division that makes cement mixers and other construction equipment. Personally I am of the opinion that this is a onetime gain caused by the housing stimulus bill, and as housing has been weak in the past 2 months and will likely be weak in the coming quarter or two, these orders could drop off again and remain at their trough levels.

Therefore the case on OSK remains weak. Management said in the release that they believe the defense segment will provide “a solid foundation to what we anticipate will be a gradual economic recovery.” Based on forward looking sales, this doesn’t appear to be the case and it doesn’t seem to be the right time to buy OSK just yet.

Interestingly, due to the beat on rev and income, OSK was trading up 5% premarket. However now it seems to have reversed those gains and is trading down 2% on the day. Maybe other market participants caught on to what I noticed.

Previous correction: In my earlier write up of OSK I mentioned that at march 31, 2010 debt levels yearly interest costs would be 120 million. This was wrong as I used net debt to figure out how much to allocate to each debt segment. Obviously, since interest earned on cash and equivalents is much lower than interest paid on borrowings (by about 600 bps) this underestimated OSK’s cost of debt. Based on the further reduced debt levels from this quarter and properly accounting for cash and equivalents, the yearly interest cost before taxes would be 130 million.