IPG Photonics – charts up to Q1 2015

Disclosure – I’m long IPG Photonics Corporation (IPGP).

There are a few remarks about particular issues, but I mostly let the charts speak for themselves. My sources are the SEC filings and the press release “IPG Photonics Reports First Quarter 2015 Revenue Growth of 17%” on IPG’s site.

Charts of quarterly data

In the first chart, for Q2 2015 “Net sales”, I used the figures for “revenue” in the guidance ($215 million to $225 million). “Revenue” is likely to mean the same as “net sales” because the earnings release gives similar figures for Q1 2014 “Revenue” and “Net sales” ($170.6 million and $170,575 thousand).

IPG results to Q1 2015 bars and line

In the short period charted, I’d say Q2 and Q3 look strong, but the 10-K for 2014 has –

    “Historically, our net sales have been higher in the second half of the year than in the first half of the year.”

IPG results to Q1 2015 stacked

IPG EPS to Q1 2015

IPG EPS growth to Q1 2015

I have not charted quarterly Other Comprehensive Income, but annual charts further down show a big OCI loss for 2014 due to “translation adjustments”, i.e. the effect of changing exchange rates on the U.S. dollar value of assets and liabilities. For Q1 2015, the OCI loss was $38,276 thousand, leaving comprehensive income of only $19,070 thousand.

Cash flow charts

In the cash flow charts below, cash from operations includes variation in current assets and liabilities, particularly inventories, accounts receivable and accounts payable. If I’d also shown cash from operations without those movements (still with depreciation, stock-based compensation, etc. added back to net income), the resulting chart might look smoother, but it’s a lot of work.

For some companies, it would be essential to use capex rather than cash invested, because cash put into short term investments is more like parking cash for a while than an investment in the company’s operations. Some long term investments can also have little to do with investing in operations.

In IPG’s case, there were “Purchases of short-term investments” of $25,451 thousand in 2011, and exactly the same amount was “Proceeds from short-term investments” in 2012, due to the investments maturing. (Financial activity in 2012 included a stock offering, a special dividend, and buying out a minority interest.) As a result of the short-term investment, the investment flow I’ve used overstates the cash invested in IPG’s operations in 2011, and understates by the same amount in 2012. I only use the charts to get a general impression and I’m not concerned by shifting a portion of old investment by a year.

The short-term investment accounted for 32.2% of the investment flow in 2011, and 46.1% in 2012. There were no purchases or proceeds from short-term investments in other years from 2009 to 2014. In 2013 there were “Proceeds from sale of investment”, but only worth $495 thousand.

For comparison, Net cash used in investing activities rose from $10,639 thousand in 2009 to $90,080 thousand in 2014.

The cash invested is dominated by investment in the company’s operations. “Purchases of property, plant and equipment” accounts for most of the investment flow ($88,601 thousand, or 98.4% in 2014). There’s also “Acquisition of businesses, net of cash acquired”, which hit $11.6 million in 2012, the highest amount in the past six years, and the “Purchase of intangible assets” of $2 million in 2014 also counts as an investment in the company’s operations.

IPG cash from ops against cash into investment

IPG cash from ops against cash invested per share

A more conventional chart of cash flow per share –

IPG cash from ops and cash invested per share

This chart is logarithmic, so the slope of a line corresponds to the compound growth rate –

IPG logarithmic cash flow - to 2014

The charts for growth in OCF between any two years are probably understood best if I show the spreadsheet first. Although there’s no “2014”, the table is up to date, for example the bottom row is for 2013, the only entry is “49.6%” in the column for 1 year ahead, and the increase from 2013 to 2014 was 49.6%. The figure in the top right shows growth of 30.2% (CAGR) between 2004 and 2014.

IPG CAGR CFO per share - spread

IPG CAGR CFO per share by year

Sometimes growth over five years is used as a metric. In the chart below, find the columns grouped above “5”, and you can see that growth measured over the previous five years has been over 20% for each of the past five years, i.e. for 2004 to 2009, 2005 to 2010 … up to 2009 to 2014.

IPG CAGR CFO per share by number of years

Sales, costs and profit charts

In some cases I’ve used a stacked and a non-stacked chart of the same data. If any subjective bias results from the way a chart represents data, a different type of chart might not produce the same bias.

In order to get the stacked charts, I needed to change the sign of expenses, which are negative in the 10-Ks (as indicated by brackets). For some years in some stacked charts there will be minor distortion due to the inclusion of a negative quantity, for example “Interest expense (income)” has mostly negative figures, but the absolute amounts have declined from about 5% of net sales in the early years, to 0.01% in 2014.

I changed some item-names, e.g. “OTHER INCOME (EXPENSE), Net:” in the 2014 10-K is “Other expense (income), net” in my charts, to make the name consistent with the sign change which was needed to get a stacked chart.

Interest expense is the only expense I found to be capitalized as investment, instead of charging it as an expense on the income statement. From the 10-K –

    “Expenditures for maintenance and repairs are charged to operations. Interest expense associated with significant capital projects is capitalized as a cost of the project. The Company capitalized $383 , $524 and $142 of interest expense in 2014 , 2013 and 2012 , respectively.” (thousands)

That compares to an expense of $77 and $1 for 2014 and 2013 on the income statements (i.e. not capitalized), and interest income of $319 in 2012 (all in thousands). The capitalization is small and probably conservative. The capitalization of expenses is too complicated a subject to explain in detail here, I’ll just mention that a few companies have taken it to fraudulent levels.

The items reported changed between 2006 and 2014, which presented problems. A few expenses were only significant or relevant in 2005 or in early years, for example the Series B warrants have not been relevant since 2007. 2006 is the earliest 10-K I used.

IPG sales breakdown by cost and income

IPG sales breakdown by cost and income as percent

In the next chart I’ve zoomed in and the detail is clearer, but some percentages for 2002 and 2003 are off the scale. The percentages are represented in the chart above, and they’re in the spreadsheet titled “Data as percentage of sales” near the end.

IPG income and cost as percent of sales

IPG sales costs and income

IPG operating expenses

IPG sales and profit

The following chart is unorthodox. It’s often supposed that a drop in margins warns of problems. When a company has pricing power, falling margins can warn of the erosion of pricing power through increased competition. Analysts are aware of other causes, such as variation in product mix, but it still occasionally happens that an officer at a company with high margins will remind analysts of just how high the margins are, when the analysts are probing a drop of 1% or 2%. The chart is intended to let you judge if margins predict results, as in sales, operating income, net income or cash from operations. By showing the quantities as a percentage of 2014 net sales, I got everything to fit the percentage scale on the left.

IPG margins and main results

I do not see evidence that a fall in margins predicts disappointing results, but this is a subjective exercise and you may interpret the chart differently. 2013 was a relatively poor year for margins, cash from operations, net income and operating income, but 2014 was a good year all round.

IPG earnings per share

IPG annual EPS growth

IPG Logarithmic chart of sales and profit

Comprehensive income charts

Other comprehensive income (OCI) in 2014 consisted mostly of an unusually large loss on Translation adjustments, of -$110,734 (thousand). The loss on translation adjustments was more than twice as big as the rise in net income in 2014, with a sharp fall in comprehensive income as a result.

“Translation” refers to the currency exchange rates at which assets valued in foreign currency are converted to U.S. dollar values. For the Russian operations, a low Ruble keeps costs low, and is good for net income, but a fall in the Ruble’s value against the dollar reduces the dollar value of Russian assets, which affects OCI. If the Ruble stays at a constant low level, there would be no further effect on asset values and OCI, while costs in Russia could continue to stay low, depending on inflation. I have not seen the impact of the Ruble broken out.

The impact of a low Yuan would be different. China is not a production center and does not have large long-lived assets (find “long-lived assets” below). It follows that local costs are likely to be small relative to sales in China, so there would be little benefit to costs from a lower Yuan, while the exchange rate would be bad for sales, although the size of the hit would depend on various factors including the price elasticity of demand and competitors’ costs. I don’t mean to imply that the Yuan is still falling – the Yuan’s big fall ended in January 2014.

Recently, the high U.S. dollar and low Ruble have dominated the currency effects, although the Ruble has partly recovered this year and the U.S. dollar index (DXY) has weakened since March.

25.45% of the $110,734 (thousand) translation loss is explained by the currency hit on Cash and Cash Equivalents. From the 10-K for 2014, in thousands –

    “EFFECT OF CHANGES IN EXCHANGE RATES ON CASH AND CASH EQUIVALENTS (28,180 )”

The 10-Q for Q1 2015 has a “Total other comprehensive loss” of $38,276, due to Translation adjustments of -$38,319.

This is from the 10-K, about valuing foreign assets, and where they put the cash –

    “Foreign Currency — The financial information for entities outside the United States is measured using local currencies as the functional currency. Assets and liabilities are translated into U.S. dollars at the exchange rate in effect on the respective balance sheet dates. Income and expenses are translated into U.S. dollars based on the average rate of exchange for the corresponding period. Exchange rate differences resulting from translation adjustments are accounted for directly as a component of accumulated other comprehensive loss.

    Cash and Cash Equivalents — Cash and cash equivalents consist primarily of highly liquid investments, such as bank deposits, marketable securities with original maturities of three months or less with insignificant interest rate risk and marketable securities with remaining maturities of three months or less at the date of acquisition.”

Don’t worry about bars you can’t see in the next chart. Charting an insignificant quantity is my way of demonstrating the insignificance visually.

IPG comprehensive income

IPG comprehensive income per share

Geography and sales breakdown charts

Russia is included in CIS, which is in IPG’s region “Other including Eastern Europe/CIS”. CIS is the Commonwealth of Independent States, which includes Azerbaijan, Armenia, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Uzbekistan and Ukraine.

IPG geography stacked

IPG geography stacked percent

IPG physical assets by location

    “Our major manufacturing facilities are located in the United States, Germany and Russia.” (10-K for 2014)

The three countries account for nearly all the long-lived assets. China accounted for 32% of net sales in 2014, but only 2.30% of the long-lived assets. (IPG have two application centers in China, in Shenzhen and Beijing.)

The evidence suggests that long-lived assets are dominated by manufacturing, and the relative size of long-lived assets by physical location is likely to be a reasonable proxy for relative production, although it is affected by foreign exchange rates and changes in them. There could also be differences in asset turnover, for example diode production is centered in the U.S., and the turnover is not necessarily the same as for other production.

IPG physical assets by location percent

IPG’s materials processing sales have grown, but other applications have not. Three small categories were consolidated into “Other applications” in 2012.

IPG materials processing and other

IPG materials processing and other - percent

Days Sales Outstanding and days of inventory charts

I fitted trend lines to DSO and days of inventory in the next chart. The DSO trend line formula shows that every year on average, DSO increases by 0.3771 of a day. However, the R-squared of 0.0707 shows the line only explains 7.07% of the variation. Taking the square root gives R, the correlation coefficient, of about 0.2659 which is low, with a 45.78% chance that there was no underlying linear trend, with random variation probably the most likely alternative. It’s conventional to reject a hypothesis with 5% or more chance of being false, as here.

The trend line formula for days of inventory shows that every year on average, days of inventory falls by 2.8046 days. The R-squared of 0.5212 shows the line explains 52.12% of the variation. Taking the square root gives R, the correlation coefficient, of 0.7219418, with only a 1.84% chance that there was no underlying linear trend. I’m wary of projecting the trend, for example a step change between the first five years and the last five years would also fit the data.

If you want to check the figures, there’s a calculator on The Chinese University of Hong Kong‘s site. Navigate – Stats toolbox Home / Correlation / Stat Sig of r. For the days of inventory, enter 10 for the sample size, and 0.7219418 for R. The results include “p=0.0184”, which translates to a 1.84% chance of the hypothesis being false.

IPG DSO and days inventory

Analysts and markets generally don’t like rising DSO or rising days of inventory. Some less sophisticated investors might even look at accounts receivable and inventory without adjusting for sales. There is some statistical evidence for the predictive power of the metrics, for example in Beneish’s work on his M-Score for earnings manipulation. If rises in DSO or days of inventory are a strong indication of trouble for IPG, the effect ought to be discernible in the next chart. I suggest looking at the chart and seeing if DSO or days of inventory predict anything for sales, income or cash from operations.

IPG DSO days inventory - sales income and CFO

So far as I can tell, rises in DSO or days of inventory have not foreshadowed problems, and neither have above average DSO or days of inventory. The only serious blip was in 2009, when IPG were affected by the recession which followed the financial crisis. I would not blame the results on the lengthening of IPG’s cash conversion cycle, especially as cash from operations was hardly affected. I would also not try to predict the next recession by looking for a rise in IPG’s DSO or days of inventory. The chart shows that the metrics fell along with sales and income in 2009.

Analysts will continue to probe any increase in DSO or days of inventory, some authors will take a gloomy view of any such rises, and so might the markets, but so long as the metrics don’t rise by or to unprecedented levels, I don’t see evidence that they predict trouble for IPG. I have not completed a full investigation, and in particular I have not looked at quarterly figures.

IPG hold high levels of inventory, keeping stocks of parts that can be assembled quickly when orders are received. This helps sales by giving customers low lead times, but the low lead times reduce the visibility of future sales. Given the high net cash and the good free cash flow, IPG might as well operate with high levels of working capital so long as it benefits sales. Growth adds to the need for inventory, and occasional preparation for higher growth and the launch of new models adds more. From the 10-Q for Q1 2015 –

    “Given our vertical integration, rigorous and time-consuming testing procedures for both internally manufactured and externally purchased components and the lead time required to manufacture components used in our finished products, the rate at which we turn inventory has historically been comparatively low when compared to our cost of sales. Also, our historic growth rates required investment in inventories to support future sales and enable us to quote short delivery times to our customers, providing what we believe is a competitive advantage. Furthermore, if there was a disruption to the manufacturing capacity of any of our key technologies, our inventories of components should enable us to continue to build finished products for a reasonable period of time. We believe that we will continue to maintain a relatively high level of inventory compared to our cost of sales. As a result, we expect to have a significant amount of working capital invested in inventory. A reduction in our level of net sales or the rate of growth of our net sales from their current levels would mean that the rate at which we are able to convert our inventory into cash would decrease.”

Balance sheet charts

The value of overseas assets and liabilities is affected by exchange rate movements, and for 2014 both will be lower than otherwise due to the higher dollar. The lower Ruble will have had an effect on asset values, particularly on Property, plant, and equipment, net. From an accounting perspective, the translation adjustments which dominated the negative Other Comprehensive Income in 2014 would have the effect of pushing asset values down (but that was more than offset by income pulling the value up). The translation adjustments imply that overseas assets are bigger than overseas liabilities. That’s to be expected as the overall assets are bigger than liabilities, and it’s common for an international company with head office costs in the U.S. to have its liabilities concentrated there.

The unrealized gain on derivatives in 2014 was only $172 thousand, and I found no indication of a realized gain on currency hedges in 2014. IPG report Cash Flow Hedges but they were for fixing interest rates, not hedging currencies. From the 10-K for 2014 –

    “We have no foreign currency derivative instrument hedges as of December 31, 2014 . We will continue to analyze our exposure to currency exchange rate fluctuations and may engage in financial hedging techniques in the future to attempt to minimize the effect of these potential fluctuations.”

The 10-Q for Q1 2015 has a similar statement with “We have no foreign currency derivative instrument hedges as of March 31, 2015 .”

IPG assets

IPG assets per share

IPG assets per cent of total

IPG liabilities and equity

Regarding the note in the graphic above, in the balance sheet spreadsheet at the end, the equity is called “Total IPG Photonics Corporation stockholders’ equity”. The name is used in 10-Ks for 2009 to 2014. My calculation agrees with Total liabilities for 2012 to 2014, but is greater than stated total liabilities for 2011 as my calculation includes minority interests. In 2010 the term “Total liabilities” was used but not on the balance sheet, and in 2006 the term was only used in connection with a covenant ratio.

There were many claims on assets in 2005, including series A, B and D, warrants, Notes receivable from stockholders, and Deferred compensation. Most of those items were gone by 2006, but I still preferred to use my simplification so I could take the charts back to 2005. The term “non-stockholder claims on assets” would have been more accurate, as my “calculated liabilities” includes liabilities, minority interests, and the variety of claims on the 2005 balance sheet.

IPG liabilities and equity per share

IPG liabilities cash and current assets

IPG liabilities as percent of cash

Spreadsheets

I don’t repeat the spreadsheet for cash flow growth which I’ve shown above. The only omission I know about is for the “Logarithmic chart, base 2, of sales and profit” (before the title “Comprehensive income charts”, above), where I don’t show the results or formulas of the logarithmic functions. The logarithmic formulas all have this format, with only the cell address varying –

    =LOG(P56;2)

IPG results to Q1 2015 spread

IPG cash from ops and into investment - spread2

IPG Photonics sales costs and profit - spread

IPG Photonics sales costs and profit - sign adj - spread

IPG Photonics sales costs and profit - sign adj - formulas

IPG Photonics sales costs and profit sign adj percent - spread

IPG Photonics sales costs and profit sign adj percent - formulas

IPG comprehensive income - spread

IPG comprehensive income - formulas

IPG sales breakdowns spread

IPG DSO days inventory - sales income and CFO - spread

IPG balance sheet spread
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That’s all.

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IPG Photonics – the hard-to-gauge reliance on their Russian operations

Disclosure – I’m long IPG Photonics Corporation (IPGP).

About this piece

This is about possible disruption to IPG’s vertically integrated supply chain, if political action restricts supply from the Russian operations to the rest of the company. If you are sure that sanctions against Russia won’t get worse, or that escalated sanctions would not hit IPG’s Russian operations, there isn’t much point in reading any more.

Company profile

    “As a pioneer and technology leader in fiber lasers, we have built leading positions in our various end markets with a large and diverse customer base.” (10-K for 2014)

IPG claim “significant competitive advantages” (2013 Annual Report) from having vertically integrated operations, which are likely to be a big part of why the company has industry-leading margins.

Main sources

I’ll be quoting from the 10-K for 2014, which you can find on IPG’s SEC page, where there’s also a link for the Annual Reports. For SEC filings in .htm format you could try these EDGAR Search Results (if that doesn’t work, try the EDGAR Company Search and put IPGP in the ‘Fast Search’ box).

Find “Conference Call” and “Q3 2014 Results” (below) for the transcripts on Seeking Alpha I’ve quoted from.

The risk

The bold highlighting is mine. From the 10-K for 2014 –

    “Recent events in Ukraine have resulted in the United States and the European Union imposing and escalating sanctions on Russia and certain businesses, sectors and individuals in Russia. The United States and the European Union also suspended the granting of certain types of export licenses to Russia. Russia has imposed its own sanctions on certain individuals in the U.S. and may be considering other sanctions on the U.S. and the European Union or certain businesses or individuals from them. We have a large manufacturing facility and research and development operations in Russia which supplies components to our U.S. and German manufacturing facilities and finished lasers to our subsidiary in China. In addition, we supply components from our U.S. and German manufacturing facilities to our Russian facility. To date, we have not experienced any material disruptions or impact from current sanctions. Should there be disruption of our supplies from or to our Russian operations, or should the United States, the European Union or Russia implement different sanctions, our production and/or deliveries as well as results of operations would be affected.”

Covered

An important question is, if the Russian operations were severely restricted and the company faced a shortage of components as a result, just how badly would IPG have to be affected before the statement above becomes too mild to protect management from regulatory consequences? The phrase “would be affected” does not imply an upper limit to the damage, so I expect that management are well covered by the statement, though I have no expertise in the area and I’d appreciate a comment if you know better.

IPG’s production sites

It would be nice to have some idea of how dependent the non-Russian manufacturing facilities are on components from Russia. I found nothing that settles the matter, but there’s some information in the 10-K for 2014. If you find –

    “Our main facilities at December 31, 2014 include the following:”

there’s a list of 13 locations. Five locations include “Components” under “Primary Activity”, and the other eight do not. I’ve extracted info for the five locations with component production, and included the two locations with other manufacturing. The locations I’ve omitted only have administration and service listed.

    Location
    Owned or Leased (with expiration date if leased)
    Approximate Size (sq. ft.)
    Primary Activity

    Oxford, Massachusetts
    Owned
    421,300
    Diodes, components, complete device manufacturing, administration

    Marlborough, Massachusetts
    Owned
    112,000
    Manufacturing, administration

    Mountain View, California
    Leased February 2015
    12,400
    Components, complete device manufacturing, administration

    Burbach, Germany
    Owned
    270,900
    Optical fiber, components, final assembly, complete device manufacturing, administration

    Fryazino, Russia
    Leased July 2016
    79,000
    Components, complete device
    Owned
    512,700
    Manufacturing, administration
    (I explain further down why I believe the activities are not split as shown between the Leased and Owned floorspace.)

    Manchester, New Hampshire
    Leased December 2016
    63,000
    Components, complete device manufacturing, administration

    Cerro Maggiore, Italy
    Owned
    33,000
    Complete device manufacturing, administration

    Total (Owned plus leased)
    1,504,300

    Total Russia (Owned plus leased)
    591,700

    Total Russia / Total (Owned plus leased)
    39.33%

    (Total sq.ft. occupied, including locations with no manufacturing: 1,647,900.)

There’s no reason to suppose that the proportion of the total floorspace in locations with manufacturing is a good guide to the dependence of the company on component production from a country. It’s a massive leap from the result for “Total Russia / Total” to say that about 40% of IPG’s component-production is in Russia, but I can’t see any better way to estimate it. The problem is not just that 39.33% is a lot, but that the true figure could be much more (although it could also be much less).

There may be some ambiguity about the “Primary Activity” in Russia. Either the activities are split between the leased and the owned floorspace as I’ve indicated, or all the activities listed for Russia are spread over both kinds of floorspace.

    Leased – “Components, complete device”
    Owned – “Manufacturing, administration”

The five other instances of “complete device” are all part of “complete device manufacturing” with a lower-case “m” in “manufacturing”. My guess is that “Components, complete device manufacturing, administration” applies to both classes of floorspace (for Russia), with no allocation of an activity to only one class of floorspace. I believe that’s supported by the long quote near the top, which includes “We have a large manufacturing facility and research and development operations in Russia which supplies components to our U.S. and German manufacturing facilities and finished lasers to our subsidiary in China.”. It does not necessarily matter if I’m wrong about that, as I explain in the next paragraph.

Most of the floorspace in Russia is owned, and here I’ll assume the activity is “Manufacturing, administration” (the activities on the same line as “owned”). If Manufacturing does not include components, then only 79,000 sq ft or 13.35% of the floorspace in Russia is for “Components, complete device”. That only works out to 5.25% of the “Total” (for all locations with some kind of manufacturing). However, I regard that 5.25% as even more tenuous than the 39.33% figure (as a guide to IPG’s dependence on Russian-made components), because there is no information for the overall percentage of floorspace used for making components (relative to the manufacturing floorspace, or in fact any class of floorspace).

I did not find much hard information about IPG’s reliance on components made in Russia. Without more information, points about the reliance are likely to be speculative and arguable. Unfortunately, that’s likely to be true for claims that the reliance is low, as well as for claims that the reliance is high, although I don’t want to pre-judge arguments which I have not seen or thought of.

Diodes all made in Oxford, Massachusetts

These are laser diodes, which are more like Light Emitting Diodes (LEDs) than the kind which only function as a ‘one-way-street for current’.

If supplies from Russia are disrupted, it’s good that diodes were not in Russia’s “Primary Activity” list. (There’s some risk in only making diodes in Oxford, Massachusetts, which suggests that economies of scale apply at IPG’s diode capacity, and they are big enough to outweigh the risk of concentrating production, or managements’ perception of the risk.)

More square feet

    “We plan to continue our expansion of our operations in Russia, Germany and the United States to meet the demand for our products and our sales and support needs. We believe that we will be able to obtain additional land or commercial space as needed. The additional expansion for Russia, Germany and the United States will provide an approximately additional 212,200 square feet, 114,500 square feet, and 191,200 square feet (excluding building and land purchases in 2014 for our California and Alabama locations), respectively once these additions are completed and occupied. With the amount occupied as of December 31, 2014, once all expansions are completed in 2015, we will have approximately 2.1 million square feet of occupied space to continue to execute on our planned strategies.” (10-K for 2014)

The “additional expansion”s listed sum to 517,900 sq ft, and Russia’s 212,200 additional expansion is 40.97% of the sum. Adding Russia’s additional expansion of 212,200 to my “Total Russia” figure of 591,700 (based on data “at December 31, 2014”), gives 803,900 sq ft, or 39.75% of the total floorspace in locations with some kind of manufacturing, after the additions referred to in the quote. That’s only slightly above the 39.33% I calculated using data “at December 31, 2014”. However, my calculations based on the “additional expansion”s are fairly rough, because locations are not broken out of countries, and the U.S. includes Novi, Michigan where IPG only list “Administration, service”.

Subsidiaries and the scope of sanctions

When sanctions against Iran were extended to cover overseas subsidiaries of U.S. corporations, a wind-down period was granted (see “U.S. Tightens Sanctions on Iran: Foreign Subsidiaries Wind-Down Period Ends March 8” (foley.com).). See also “Clarity for foreign subsidiaries of U.S. companies winding down Iran ops” (worldecr.com).

It looks like U.S. companies with Iranian subsidiaries would have been forced to divest, but I have not found an explicit statement of that. It would be a big blow if IPG is forced to sell its Russian subsidiary. It would also make many of my ‘if’s and ‘but’s irrelevant.

Finished lasers from Russia

    “We are subject to risks of doing business in Russia through our subsidiary, NTO IRE-Polus, which provides components and test equipment to us and sells finished fiber devices to customers in Russia and neighboring countries as well as finished pulsed lasers to China. Further, over 30% of our sales are to customers in China. The results of our operations, business prospects and facilities in these two countries are subject to the economic and political environment in Russia and China.” (10-K for 2014)

If IPG’s supplies of finished lasers from Russia dried up, I expect that to some extent the subsidiary in China could be supplied from other locations (although any shortage caused by not being able to export components from Russia to the U.S. and the E.U. would affect IPG’s global production of finished lasers). IPG are likely to have spare capacity after substantial investment (find “near finishing a round of investment” under “Nothing about Russian components in the Conference Call”, below).

The supply of finished lasers from Russia would be affected if IPG were unable to export their diodes from Massachusetts to Russia. So long as suitable diodes and other parts are available in Russia, components produced there could (possibly) be used in finished lasers for sale in China, the Russian home market, and many other countries even if the U.S. and the European Union tighten sanctions to include lasers (unless IPG would be punished for exporting from Russia, to China, for example). If sanctions caused a shortage of Russian-made components in the U.S. and the E.U., that could be offset by increasing Russian exports of finished lasers to countries where the trade is allowed (given the conditions: suitable diodes and other parts remain available in Russia, and IPG would not be punished in the U.S. for exports such as Russia to China).

The CEO has claimed that an auto product (presumably a laser or laser-system) has been made in Russia with Russian parts except for some metal parts which could be made in Russia if needed. From “IPG Photonics’ (IPGP) CEO Valentin Gapontsev on Q3 2014 Results – Earnings Call Transcript” Oct. 28, 2014 (seekingalpha.com) –

    “… our Russian company, really sales efficient Russian entity, which produced of auto product without any impact of the devices from outside of Russia. It’s all made in Russia from Russian components. Is only a few metal parts (indiscernible) we still import outside, but it is not — this is a part we can replace if need …”

The transcript also has management stating that Russian revenue was less than a twentieth of the total revenue (“Russian revenue” must be only for the Russian home market), although seasonal factors and expectations of strong growth in Russia are mentioned (find “It is less than 5%” in the transcript).

The ‘worst-case’ and the business model

I’ll assume here that sanctions stop the export of components from Russia, and the possible offset I just described is not enough to stop a shortage of IPG-made components. The only countries that I know have imposed sanctions against Russia are in North America and Europe, which is where IPG have their manufacturing. (In addition to the U.S. and the E.U., there’s Canada, where the sanctions seem to be mostly against named individuals and some entities, and Norway.)

If IPG don’t have enough components coming out of Russia, and that continues until stocks run out, they face a difficult choice – 1) Sell fewer lasers, or 2) Use the same sources as their competitors. The consequences of selling fewer lasers are likely to include lower revenue, customers not regarding the supply as assured, and lost customers who might be reluctant to return. About the downside of using the same sources as their competitors, from the 10-K for 2014 –

    “Our vertically integrated operations allow us to reduce manufacturing costs, control quality, rapidly develop and integrate advanced products and protect our proprietary technology.”

About the second item, “control quality”, would IPG say “Some of our lasers are not as good as they were.”? If they say “All our lasers are as good as ever.” it will be hard to claim a quality advantage from vertical integration when it’s restored. If they say nothing, there could be speculation about IPG’s sourcing of components which could force a statement, and customers who believed that IPG’s vertical integration resulted in higher quality would feel cheated. Obviously I can’t accuse IPG of a crime that’s in the future, I’m just showing how none of the choices available would be attractive. A reduction in quality would be bad, and if there’s no reduction in quality, the statement about vertical integration would look rather tenuous. A claim that standards were being maintained by thorough quality control could be met by competitors claiming that’s just what they’ve always done. On top of the hard choice, some quick redesigns may be needed if components from other suppliers can’t always be simply ‘slotted in’ to replace IPG components.

IPG say –

    “we design and manufacture most of our key components used in our finished products, from semiconductor diodes to optical fiber preforms, finished fiber lasers and amplifiers.” (10-K for 2014, the bold italic highlighting is mine)

That may leave some leeway for substitution if components can’t be shipped from Russia.

Competitors are unlikely to follow Grantland Rice‘s advice –

Instead, they’re likely to take maximum advantage of any weakness at IPG that results from sanctions. Any market areas where IPG have become weak, could be examined by competitors to see if they could dominate or address the areas profitably. IPG shareholders would be hoping that competitors settle for higher margins, rather than think strategically (see “What is strategy?” June 4, 2013 (build2think.wordpress.com).)

IPG reported Cash and cash equivalents of $522 million, compared to only $164 million of Total liabilities. It’s good to have a cash cushion if a crisis hits.

Is the ‘worst-case’ too crazy to happen?

You could argue that sanctions by either side which would affect IPG, would hurt both sides, without any measurable gain. However, in conflict a simple cost-benefit analysis is not necessarily relevant, any more than it applies to a game of ‘chicken’. The relevant branch of math is game theory, not the more direct methods of optimization.

For comment on geopolitics, you could try ‘Stratfor‘ (Strategic Forecasting, Inc.) who give free weekly Intelligence Reports. Their point of view tends to be based on the long term effect of geography, such as the lack of natural barriers which made Russia hard to defend.

Before World War I, many people thought that war in Europe was unlikely due to the interdependence of the European economies (possibly due in part to not understanding a book called “The Great Illusion“). It’s not the only war which demonstrated that mutually-advantageous trade links could be broken.

In less violent conflict, trade can be disrupted when it favors one side more than the other, and also when it’s believed that something needs to be done, and the alternatives are less attractive.

Resilience

Maybe IPG could quickly replace lost Russian component production by stepping up production in the U.S. or Germany, but there isn’t much information to base that on. IPG’s soon-to-be-completed round of investment suggests that there should be spare capacity, but not necessarily of the right kind to replace Russian component production.

Inventories for the latest quarter fell year-on-year (from $172,700 to $171,009, in thousands), so there’s no evidence there of increased production of components in Russia for stockpiling outside the country. While the effect on reported inventories might not be great if vital components are produced at low cost, the simplest explanation is that IPG were not stockpiling components made in Russia.

About resilience more generally, IPG were hit by the financial crisis/recession in 2009, and bounced back very quickly (see the Morningstar link at the top, and find the nine-year history on the ‘Ratio’ tab). The problem then was probably the recession causing low demand across the industry, which is different to a single company having a problem with supply.

Costs in Russia

Employment costs are probably lower in Russia. You could try finding “What is the Russian Middle Class?” on forbes.com. Doctors earn less in Russia than in other European countries, see “Russian Doctors Protest as Reforms Threaten Jobs” Agence France-Presse, November 18, 2014 (ndtv.com). That isn’t directly relevant, but google keeps thinking I want to know about sanctions when I’m trying to research staff costs. If employment costs are much lower in Russia, that could explain some of IPG’s superior margins. In any case, so long as a low Ruble translates to lower costs in Russia, news which is bad for the Ruble is good for IPG’s costs. Potentially, increased tension could increase IPG’s margins via a lower Ruble, at the same time as increasing the risk in various areas (to the Russian operations, the company’s revenue, the share price etc.).

Nothing about Russian components in the Conference Call

See “IPG Photonics’ (IPGP) CEO Dr. Valentin Gapontsev on Q4 2014 Results – Earnings Call Transcript” Feb. 20, 2015 (seekingalpha.com).

These are the Russia-related topics covered –

In Q4 2014, revenue from the “other products” category “decreased 47% year-over-year to $9.6 million”, the result of “a decline in system sales in Russia due to economic conditions and foreign currency devaluation there as well as having had a comparatively large system order” (in Russia) “in Q4 of last year”. The “other” category is volatile, and small compared to the quarter’s total revenue of $207 million.

Sales in Europe grew to $69 million, “partially offset by weakness in Russia related to the economic environment there” (and the year-ago system order mentioned previously).

There’s a paragraph about the effect of the strong dollar and weak Ruble on the value of inventory, which was about $9 million lower as a result.

The quarter’s revenue from Russia is described as “good” given the headwinds.

The company is near finishing a round of investment in Russia, the U.S., and Germany, which should provide enough capacity to double revenue (find “finishing the round” in the CC).

I saw no questions from analysts about the effect on the rest of the company if components can’t be shipped from Russia. Maybe they are wrong to ignore the risk, or maybe they have better information and regard the risk statement about Russia as legal boilerplate.

Corruption in Russia

Yukos (wikipedia.org). Oil giant Yukos was seized by the Russian government, over 2003 to 2007, under Putin’s leadership.

U.S. Investor’s Lawyer Dies in Moscow Jail by Gregory L. White, updated Nov 18, 2009 (wsj.com). Hermitage Capital were accused of not paying taxes. Hermitage claim they paid, but the taxes were pocketed by fraudsters. The company’s lawyer was jailed and denied medical treatment.

See Russia, Corruption Timeline (mapreport.com) and Corruption in Russia (wikipedia.org). I’ve read that IPG were developing their own distribution network in Russia, due to the corruption there, but I can’t find any evidence. Many of IPG’s management team were educated in Russia and some of them may be able to advise on how to avoid trouble.

All IPG say about corruption in the 10-K is that anti-corruption laws are complex and often difficult to interpret and apply, with penalties if they get it wrong. They comment on the risk associated with Russia and China –

    “The results of our operations, business prospects and facilities in these two countries are subject to the economic and political environment in Russia and China. In recent years, both countries have undergone substantial political, economic and social change. As is typical of an emerging economy, neither China nor Russia possesses a well-developed business, financial, legal and regulatory infrastructure that would generally exist in a more mature free market economy. In addition, tax, currency and customs legislation is subject to varying interpretations and changes, which can occur frequently.”

Miscellaneous links

IPG’s Management and Board of Directors (investor.ipgphotonics.com).

This article briefly mentions the proportion of IPG’s employees based in Russia – “IPG Photonics – Growth And Technological Leadership Offer Appeal” by The Value Investor, Feb. 23, 2015 (seekingalpha.com). (Some comments by myself repeat points I’ve made in this piece.)

I wrote positively (mostly) about IPG in my blog post “Three cash3 companies“, January 17, 2014 (on wordpress.com).

Balance

I’ve focused on the adverse possibilities, and it’s worth bearing in mind that maybe sanctions will not be escalated, or an escalation will not have much effect on the Russian operations, or the effect will mostly be limited to Russia, or a shortage will be dealt with by quickly by ramping up production of components outside of Russia. If the risk is material, management ought to have considered it, and plans could already be in place.

Thanks, SA

With thanks to Seeking Alpha for their policy about quoting from transcripts, which can be found at the end of the transcript.

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

Ubiquiti Networks – charting volatile revenue

Disclosure – I’m long Ubiquiti Networks, Inc. (UBNT).

Closing price February 17, 2015: $29.44

Short profile

From the company’s 10-K – “Ubiquiti Networks develops high performance networking technology for service providers and enterprises.” The service providers are typically Wireless Internet Service Providers (WISPs). “Our technology platforms deliver highly-advanced and easily deployable solutions that appeal to a global customer base, particularly in under-networked markets.” They are able to price disruptively due to their business model, which I describe later.

About this piece

This is mostly about illustrating the volatility of the company’s revenue, a peripheral issue which is not as important as the long term prospects, or even the prospects for launches and upgrades when they can have a significant effect on results. However you aren’t likely to find the product types and geographies charted anywhere else.

While anyone who has studied the company will know about the volatility, IMO it’s still worth charting the quarterly revenue from the geographic and product segments. The charts are more important than the writing, and the trendlines and R-squared values in the charts are secondary. In fact the R-squared values are low, indicating volatility and showing the trendlines can’t be projected reliably. There may be some irony in using quarterly charts to show you shouldn’t read too much into the latest quarterly change.

Before the quarterly revenue charts I look at mostly annual data for cash flow, revenue and earnings, for a longer and more comprehensive view.

Cash flow

The first chart is based on annual data from the cash flow statements. It tunes out most of the quarterly noise, but it has its own noise. The chart shows a recent dip in the operating cash flow (OCF) per share, which is still very high compared to the capital invested per share.

Ubiquiti cash walks per share to 2014
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The OCF dip is the result of big swings under “Changes in operating assets and liabilities:” –

($ thousands)
2014 ~ 2013 ~ 2012

Accounts receivable
(18,329) ~ 38,664 ~ (36,648)
Inventories
(33,764) ~ (8,996) ~ (2,266)

Those are the contribution to cash from the change over the previous year, and (33,764) is negative meaning Inventories increased by 33,764 ($ thousand). Big increases in Inventories and Accounts receivable can be warning signs of problems, but there are good explanations for the rises in Ubiquiti’s case. One factor is that with the CEO having a majority holding, and with the company having good net cash and cash flows, there’s no pressure on the CEO to manipulate earnings (some forms of earnings manipulation can lead to increased receivables).

Inventory is built up before product launches. There was also a decision to increase inventory to avoid stock-outs, which I wrote about in “Ubiquiti Networks – long term sense meets a short-sighted market” May 13, 2014.

My conclusion about the ‘changes’ part of cash flow is that receivables and inventories will not increase relentlessly, and for various reasons cash flow was effectively pulled into 2013. The drop in OCF in 2014 does not negate the underlying trend. The trend in cash flows is important and a one year blip is not, so long as the blip has a good enough explanation.

Ubiquiti’s fiscal year ends on June 30 and there have been two quarters reported since 2014 (the last point on the chart).

(thousands, except per-share quantities)
Q1 2015 ~ Q2 2015

Shares (diluted)
89,913 ~ 89,737
OCF
$46,942 ~ $32,676 (calculated for Q2)
Cash invested
$3,461 ~ $4,930 (calculated for Q2)
OCF per share
$0.5221 ~ $0.3641
Cash invested per share
$0.0385 ~ $0.0549
Annualized OCF per share (x4)
$2.0883 ~ $1.4564
Annualized Cash invested per share (x4)
$0.1540 ~ $0.2198

Cash flow has been affected by greater Days Sales Outstanding, as distributors who have built up a good credit history have been allowed to take longer to pay and bigger distributors have been signed up (who expect more time before they have to pay).

Distributors

Because I mentioned distributors taking longer to pay, I need to explain why Ubiquiti do not depend on distributors creating sales. About an internet forum refered to as the Ubiquiti Community –

    “Word of mouth referrals from the Ubiquiti Community generate high quality leads for our distributors at relatively little cost.” (10Q for Q2 2015)

That makes distributors keen to sign up, and with the pull from customers there’s no need to push the products through the channels, and no pressure to offer discounts to distributors.

Using the cash

With plenty of cash and low investment needs, it makes sense to use the cash to fund inventory and receivables, within reasonable limits, when it helps to increase sales. (See the earnings call transcripts on Seeking Alpha for more information.) One alternative – to use the cash for acquisitions – is limited by the low headcount which results from the lean business model. An acquisition candidate with half of Ubiquiti’s revenue is likely to employ far more staff than Ubiquiti, demanding more management attention and diluting the benefit from the business model.

Annual revenue 2010 to 2014

I’m about to investigate five years of annual revenue data using statistical methods. Given the short data set and the variation, I’m not surprised that the results were inconclusive. If you don’t mind negative results, or if you want to repeat the online test yourself, read on, otherwise skip to the three charts below.

In this short series of revenue data, 1 corresponds to 2010, 2 to 2011, etc. –

    ($ thousands)

    1 136,952
    2 197,874
    3 353,517
    4 320,823
    5 572,464

I fed the data into the Linear Regression Analysis page on The Chinese University of Hong Kong. You can repeat the exercise if you like, but you need to navigate via “Data modelling” and “Linear Regression”. Then put “5” into the “Number of rows” box, and copy and paste the data into the “Data …” box, and then click on the “Calculate” button. You should see the results –

    Model y = 99,397.3200x + 18,134.0800
    Pearsons product moment correlation Coefficient(r) = 0.9342
    Standard Error of Slope SE(b) = 21,922.3815
    t-test for the significance of the slope = 4.5341 Two-tailed probability = 0.0201
    95% confidence interval for slope 52,044.9763 to 146,749.6643

That means the low, mid, and high cases for revenue growth are approximately $52 million, $99 million, and $147 million (increase in revenue per year). The results imply only a 5% chance that the trend is for revenue to increase by less than $52 million or by more than $147 million, with a probability of 2.5% for each of the tails (the ‘out of range’ cases). The numbers can only reflect factors that have already had an effect on revenue, for example because Ubiquiti have not been affected by key personnel risk, the risk is not factored into the range of slopes (the slope of the graph is the increase in revenue per year). On the other hand, the period includes infringement of Ubiquiti’s IP, and Ubiquiti are now better protected against the risk.

The stats site reports using “Pearsons product moment correlation Coefficient” which is the standard method. It assumes a normal distribution which in finance is a standard but not necessarily correct assumption (it’s assumed in the Black Scholes equation for pricing options, and fractals-genius Benoit Mandelbrot didn’t approve). While the calculations take the low number of data points into account, for a sample size as low as five, the results are less reliable.

Even at the high-limit of $147 million, linear growth would eventually become a miserably low percentage growth, so I put the same data into the Exponential Regression page. I’m not confident about the results because they were a bit different when I replaced 1, 2, 3 … with 2010, 2011, 2012 …, and the rate of exponential growth should not depend on the period labelling (if you decide year zero was when Elvis Presley was born, it wouldn’t affect the growth rate of trees, corporations, or anything not Presley related). The relevant lines from China were –

    Linear Regression Model of the log10 transformed value is y = 0.1452x + 5.0134
    95% confidence interval for slope 0.0916 to 0.1989

I calculated the low, mid and high annual growth rates were 23.5%, 39.7% and 58.1%. I’m not confident about those, but the mid-range growth rate of 39.7% applied to the 2010 revenue of 136,952 would turn it into 521,620 by 2014, which is less than the actual figure of 572,464, but isn’t too far off and I wouldn’t expect a close match (all in $ thousands).

Even 23.5% annual revenue growth, at the bottom of the confidence interval, is a good growth rate, and given Ubiquiti’s margins it suggests good prospects.

The mid-case of $99 million linear growth only predicts annual growth of 17.3% in 2015 (from 99 / 572.464 = 0.173, not assuming any reversion-to-trend). But, the same $99 million growth would have been 72.3% growth over the 2010 figure of $136.952 million.

The Chinese University site does not show charts and only regresses linear and exponential functions. The problem is that the exponential function is concave-up, while other functions that could fit the data such as logarithmic are concave down.

In the chart on the right, below, the ‘concave down’ trendline implies growth that deteriorates faster than the linear trend, and the R-squared value is not far off the value for the ‘concave up’ exponential trend. If I’ve made statistics look indecisive, it’s better than being too sure about a trend. Five data points is not enough for very reliable results, meaning that even though a wider range of slope will be reported, the range is still less reliable. It would help if the points were all very close to the trend line, but that isn’t the case, and the three charts below confirm that it’s hard to fit a trend line with much confidence.

Ubiquiti - revenue - three trends
——————————————————————————————————————–

The fact that two very different trends fit about as well as each other, confirms my impression that while growth has been high, the data does not reliably indicate a likely rate of deceleration (growth companies usually slow down as they get bigger).

My long term expectation is that growth will hold up better than for most companies, due to the advantage of the business model, which can be applied to new products so long as ‘high-touch’ is not required and the forum can provide a useful function. The ability to stay lean and avoid bureaucratization is also a factor in delaying the onset of aging.

Revenue, earnings and margins

Ubiquiti revenue and earnings to Q2 2015

Ubiquiti margins to Q2 2015
——————————————————————————————————————–

Quarterly revenue, total and by geography

Quarterly revenue has been variable. The sharp dip in Q1 2013 was the result of widespread IP infringement. The situation was serious but effective action was taken and UBNT recovered.

Ubiquiti quarterly revenue total and by geography
———————————————————————————————————————–

The trendline has an R-squared value of 0.742, which means it only explains 74.2% of the variation. IMO few such trendlines can be extrapolated with confidence, and this one is no exception. If you believe the trendline, then fluctuations around it account for 25.8% of the variation. The results from the Linear Regression Analysis page at The Chinese University of Hong Kong (linked to above) were –

    Model y = 6,946.1300x + 58,165.7300
    Pearsons product moment correlation Coefficient(r) = 0.8616
    Standard Error of Slope SE(b) = 1,181.4866
    t-test for the significance of the slope = 5.8791 Two-tailed probability = 0.0001
    95% confidence interval for slope 4,394.1188 to 9,498.1409

My method was to test the correlation between the sequence 1, 2, 3, … and the quarterly revenue figures 79167, 87817, 91665 … (If you want to check the result, you’ll need the data, which you can get via a link at the end under “Tables and formulas” with instructions to ‘Paste special’ into a spreadsheet.)

The last line in the results implies that you can be 95% confident that the underlying trend in revenue is between an increase per quarter of $4.4 million and $9.5 million, with a ‘model’ mid point of $6.9 million. That’s slower trend-growth than the annual data gave, which could be because the quarterly data starts at Q1 2012, while 2012 was a good year with a big rise from 2011. The “t-test” line means you can be extremely confident that the growth in the period was not just the result of random fluctuations.

By not showing the total revenue, the next chart shows the revenue from the four regions more clearly.

Ubiquiti quarterly revenue by geography
—————————————————————————————————————

Every region has experienced volatile revenue. While the two largest regions have demonstrated obvious and signigicant growth, that’s not quite as clear for APAC, and it’s quite arguable for South America (with only incremental growth between the first and last points). Any two regions you pick are capable of moving in opposite directions for a quarter or two (I quantify the low correlation using R-squared values in charts further on). Here I’ve added trendlines and shown their R-squared values:

Ubiquiti quarterly rev by geog with trends
—————————————————————————————————————

The R-squareds show the percentage of variation explained by the trendlines – 64%, 65%, 21% and 54%. Taking the square root of the R-squared numbers gives R, the correlation coefficient (for a trend, the correlation is between the variable with the trend, and time, for example the end date of a quarter). The values are 0.800, 0.806, 0.458, and 0.7345. Putting the R values into a page on the University of Hong Kong site (linked to above) gave “p” values of 0.0006, 0.0005, 0.0996 and 0.0028 (navigate with “correlation” / “stat sig of r”). Taking the highest p-value of 0.0996 which is for South America, it means that there’s nearly a one-in-ten chance of no linear correlation (meaning revenue is not linearly correlated with time, and may just fluctuate randomly, possibly about a mean), whereas the p of 0.0005 for North America implies only one chance in 2000 that there’s no underlying growth. The p values do not give much idea of the variability, but I believe you can get some idea just by looking at the chart, and R-squared gives the proportion of variation which is ‘on trend’. (If you want the variability of the slope and don’t mind some work, find “You can get all the data” (above), follow the instructions, and find “I fed the data into the Linear Regression Analysis page” (above).).

All the R-squareds in the chart above are lower than the 74% for the total revenue. It’s expected that a total such as total revenue will have less variation than the parts it’s the sum of, provided the parts can fluctuate independently, because sometimes the parts will move in opposite directions, and they’ll tend to move at different rates. That’s why a big conglomerate will have more stable results than most other companies, although as well as the number of subsidiares, its results are smoother the more diversified its markets are, the more stable its markets are, and it helps if the subsidiares are about equal in size. Ubiquiti will become more diversified if it becomes more established in new areas. Machine-to-machine would be such an area, but there doesn’t seem to be much focus on it at the moment, and video is more promising in the near term.

Here’s a 3D view of the same data (no special glasses required).

Ubiquiti quarterly revenue by geography 3D
—————————————————————————————————————

Quarterly revenue by product type

The product type charts are complicated by the change in disclosure which you can see by comparing either side of the gap. (New platforms, Antenna’s/other etc. can split between the later categories “Service provider technology” and “Enterprise technology”.)

Ubiquiti quarterly revenue by product type
—————————————————————————————————————

The next chart is for “Service provider” and “Enterprise” only, with trendlines fitted, but six points is a small number to use in a statistical test, especially when the R-squared values are low. I saw no point in putting the data into any further statistical test. There are reasons to believe that ‘Service provider technology’ will grow, but there’s a big lack of evidence for it in the chart and the R-squared value of only 0.01.

Ubiquiti quarterly revenue by type with trends

—————————————————————————————————————

The stacked view of the same data lets you compare the revenue of a product type to the total revenue.

Ubiquiti quarterly revenue by product type stacked
—————————————————————————————————————

And in glorious 3D:

Ubiquiti quarterly revenue by product type 3D

While Service provider technology rose and fell, Enterprise technology fell then rose. It’s highly unlikely that there’s an underlying inverse relationship which would reliably predict movement in opposite directions in the future.

It’s not worth extrapolating a few quarters

While the overall growth of revenue is evident, the conclusion I draw from the quarterly ‘geography’ and ‘product type’ charts is that it’s hard-to-impossible to make a meaningful short-term prediction based on any of them. Analysts can put too much emphasis on the latest quarter’s results (maybe it’s in their job description), and some commentary can be knee-jerk over items like an increase in inventory in a quarter.

Currency and emerging markets headwind

While a dip in total revenue could easily be the result of the two product types happening to have a random dip at the same time, or the consequence of geographies happening to move down at the same time, there is currently a headwind. Much of Ubiquiti’s revenue is from emerging markets, especially where the telecoms infrastructure is not very developed. Those markets in particular could be affected by the strong dollar. Countries with an especially weak currency will be more affected, and countries that depend on oil exports or other depressed commodities are likely to have weak currencies and weak economies.

Ubiquiti are far from unique in being affected by dollar strength (Proctor & Gamble had a fair amount of publicity when their results suffered from it). I started warning on November 3, 2014 (before most of the Ruble’s fall) of the risk that a strong dollar and massive dollar-denominated debt could put some countires into crisis, with some similarity to the 1990s when Mexico, Asia and Russia were hit. That could still happen and is under-appreciated, but at least now there is general awareness that the strong dollar is a problem for exporters, and of weakness in emerging markets and primary producers, especially where the geopolitics has been in the news. Guidance seemed to build in a lot of downside for the effect of weak foreign currencies and weak emerging markets (my impression from the CC transcript), IMO leaving upside if Ubiquiti’s overseas markets are not hit as hard as feared, or if the company outpaces those factors. While the market is aware of the adverse factors (currency risk, low oil price, depressed commodities, weak emerging markets), the share price seems to indicate it is either not aware of the advantage of Ubiquiti’s business model, doesn’t believe it, or doesn’t care due to a short-term focus.

The business model

Ubiquiti concentrates on R&D, and outsources manufacturing. A vibrant forum gives feedback about products (especially new products), provides support, and evangelizes the product. By not needing a large staff for sales and support, the company can keep prices at levels that are disruptive for the competition, while still keeping a good net margin. Ubiquiti have a prototyping facility in China which CEO Pera described as a factory in an answer during the Q1 2015 CC, but he explained it was purely so they can introduce new products faster.

The business model is intact. So long as the model stays intact, the best time to buy is when a real or imagined problem sends the share price down. The net cash, cash from operations, low investment needs and disruptive pricing mean that Ubiquiti can ride out problems and emerge stronger, as they did after their IP was widely infringed.

Keeping it brief

I’m trying to stick to the subject and not say too much about related issues. There are good authors writing about Ubiquiti on Seeking Alpha and for a wider treatment I’ll refer you to “Ubiquiti Networks: A Rare Opportunity In An Overvalued Market” by Mingran Wang, Feb. 11, 2015 (seekingalpha.com). It’s reasonable to ask “How can the business model be intact when there’s no evidence of growth in the revenue of the largest product type?”. I suggest reading Mingran’s piece and then see what you think.

Abitrary categorization

The geographies could have been organized differently, e.g. Africa could have been included with South America instead of Europe and the Middle East, or there could have been three regions or five instead of four. A different categorization would have made the geography charts look different, but the volatility can’t be magicked away by regrouping, and the regions would always be more volatile individually than their sum.

The geographies move fairly independently

I could be criticized here for applying linear regression (with a trendline) to sets of points that don’t look linear. My excuse is that the points don’t suggest any better curve, and I’m quantifyng the lack of much relationship, rather than saying “This is the formula that relates the variables.”. The lines indicate the order of the points, which start at Q1 2012 in the bottom left and end at Q2 2015 on the right. The order of the points is not relevant to the trend lines or the R-squared values.

Ubiquiti quarterly revenue scatter chart EMEA
—————————————————————————————————————

The R-squared values in the chart above correspond to 37%, 32% and 68%. The first two of those percentages are low, and they imply that revenue in the second and third biggest regions (North and South America) fluctuates fairly independently of the revenue from the biggest region (EMEA). Putting the data for EMEA and North America into the Hong Kong site’s Linear Regression page got the result

    “95% confidence interval for slope 0.0911 to 0.9055”

In other words, on average, for every $100 million per quarter that EMEA grows by, North America would grow by at least $9.11 million and at most $90.55 million, with a 5% chance of being outside that range. (That’s about the uncertainty of the trend, not the noise around it.) The wide range reflects the 63% independent variation (from 1 minus R-squared), although the number of data points is also a factor. Common sense might suggest you can make the range narrower, but that brings in more information than the 2 x 14 array of numbers which went into the test.

Ubiquiti quarterly revenue scatter chart N America

The main point from the chart above is that the R-squared of 0.29 (or 29%) implies that revenue in the third biggest region (South America) fluctuates fairly independently of the revenue in the second biggest region (North America). With the previous result, all the regions except for the smallest (APAC) move fairly independently of each other. Although APAC has some dependence (statistically) on EMEA and North America, it’s still fairly low, and evidently not big enough to make EMEA and North America move in step.

Any time two quantities grow, there’s a statistical correlation between them, even when it’s obviously meaningless. For example, a baby walrus could happen to be growing at the same time as the economy of Japan, and statistically there would be a positive value of R-squared, very likely a higher value than some of the R-squareds above. The long term growth in Ubiquiti’s regions is clearly related, because it depends on factors like new product launches, the quality of the products, the business model that allows a low price point, and evangelizing on the forum (because the understanding of languages crosses over the regions). Without underlying growth, it’s likely that the R-squared values in the scatter charts would be even lower. In any case they are low enough to say that a short term upswing in one region can easily be accompanied by a move in the other direction for whichever other region you care to pick (though less so for APAC, the smallest region by revenue).

Regions can also move in the same direction purely through chance. As a hypothetical example, if there’s a 40% chance of any region having lower revenue in a quarter, and if the regions moved completely independently, then there’s a 16% probability of the two biggest regions both falling purely through chance, and a 6.4% probability of the three biggest regions falling purely through chance. Adjusting for the level of dependence would increase those probabilities.

If there was a 60% chance of any region having higher revenue in a quarter, and if the regions moved completely independently, then there’s a 36% probability of the two biggest regions both rising purely through chance, and a 21.6% probability of the three biggest regions rising purely through chance.

The subject raises the fairly tricky question, can the fluctuations really occur through chance when most people would agree that they have rational causes? My attitude is that, to the extent that you can’t predict the movements, they might as well be random (on top of a long term growth trend).

Ubiquiti would be more volatile if they only had one of the four regions, and the relative independence actually helps stability, just not enough to make revenue stable.

Limited evidence suggests the product types move fairly independently

Ubiquiti Enterprise tech on Service provider tech - scatter

The short data series for the current two product categories shows an inverse relationship (the slope of the trendline down to the right means that the more revenue it reads on one axis, the less revenue it reads on the other axis). The R-squared of 0.35 shows that 35% of the variation in Enterprise technology revenue is accounted for by the variation in Service provider technology. Apart from the fact that 35% is quite low and there aren’t many data points to base it on, it might not be a feasible relationship. Two explanations don’t seem likely – 1) customers with limited budgets who spend more on one product type have less to spend on the other (that probably fails because different product lines address different markets). 2) When Ubiquiti develop one product they have less resources for the other. Because Ubiquiti are not short of cash, the second explanation would have to mean a shortage of R&D staff or of management time for managing them, but it seems unlikely that either product type has been short of development effort. If there’s no underlying inverse relationship, the product type revenues are likely to be more independent of each other than the R-squared of 0.35 suggests.

While I don’t believe the product types have an underlying inverse relationship, it’s still true that they have tended to move in opposite directions, but that has not been enough to make the overall revenue very stable or stop it from falling since Q4 2014.

Why Ubiquiti’s revenue is volatile

Ubiquiti supply high-tech capital equipment, with significant sales to emerging markets. Revenue from new models is hard to predict. Upgrades are a relatively more reliable source of revenue, but there’s no recurring revenue. Given those factors, it’s remarkable how steady the growth in OCF has been, and it would have been steadier if the swings in inventory and receivables had been smaller.

Stock price volatility

The share price is also volatile, and probably over-reacts to results and headwinds. That may be understandable for a few reasons. The CEO holds most of the stock and is hanging on to it. The staff hold stock, and some customers who were impressed by the technology available for the price may also hold stock. Shareholders with experience of the company may be less likely to trade.

While the articles and comments on Seeking Alpha might not represent the attitude of small investors, there is general agreement in the articles and comments that Ubiquiti are a good long term investment. The investors there may add when the price is low, and a few might take some profit when prices are high, but the attitude seems weighted towards holding long term rather than trading.

With many of the shares effectively not for sale, the share price can move up fairly sharply. Lately the movement has been down (since September, with a small uptick after the Q2 results). The size of the slide may be greater because small shareholders are unable or unwilling to add much at lower prices, for whatever reason.

Another factor is that the company uses its cash to buy back shares, but only when the price is fairly obviously low. I don’t follow the short selling much, but the short % of float seems to be around 30% quite often. There’s info from NASDAQ, and the Morningstar link at the top gives the short % of float.

Also, while a results surprise or disappointment is likely to be temporary, there isn’t a clear trend for results to revert to, which could discourage traders who aim to ‘buy low, sell high’ rather than follow momentum. There will also be investors who add when the price is low, with the general expectation that the long term prospects are good (which is usually my approach).

Seeing patterns in randomness

It’s often said that people see patterns where no pattern exists. There’s a recent case concerning random playlists, with users believing they are not random and there’s some kind of conspiracy. The solution has been to tweak the results of the standard and well-founded algorithms to conform to common misconceptions of what a random sequence should be like. (I heard that on BBC radio but I can’t find it on the internet. The subject area is covered in the book “Fooled by Randomness” by Nassim Taleb. Also see “Patternicity” and “Apophenia“.) It seems at least possible that when analysts try to abstract something meaningful from quarterly results, sometimes they find it when it doesn’t exist. I could fall into the same trap myself, and it’s hard to ignore quarterly results.

Conclusion

Ubiquiti’s parts move fairly independently, but they are volatile enough that the sum of them is still volatile, though less volatile than any individual geography or product type. While volatility in the results and the share price creates opportunities for trading, it would be a waste of a good business model to only trade and avoid long term investment, especially when volatility has contributed to a good share price for entry or adding.

Tables and formulas

See “Spreadsheets for Ubiquiti Networks – charts and volatile revenue“.

Data in semicolon-seperated format with instructions to ‘Paste special’ into a spreadsheet, formulas not included – “Data for Spreadsheets for Ubiquiti Networks – charts and volatile revenue

This is fairly advanced. For each trend line, it would be nice to have a line above and a line below representing “regression channels” (aka “confidence channels”), which you might have seen in technical analysis. IMO the trend lines here have too much uncertainty about the slope for that to be more useful than potentially misleading. If you want to know more, try How do I calculate confidence channels above and below a trend line. Find “richdiesal2009-03-15 at 20:13:39” for the comment I think is most relevant.

A simple guide – “Using Linear Regression to Predict an Outcome” by Deborah J. Rumsey, PhD from Statistics For Dummies, 2nd Edition (dummies.com).

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

Three cash3 companies

Disclosure – I own shares in IPG Photonics Corporation (IPGP), Repligen Corporation (RGEN), and Ubiquiti Networks, Inc (UBNT). Also EMN, GE, HPQ, QCOM, TIBX (links to Seeking Alpha)

‘Cash3’ is my term for companies that pass three cash-related tests, intended to catch:

1) More cash than every possible liability
2) More cash from operations than cash going into investment
3) Free cash flow per share will grow at a faster than average rate

These three companies might qualify:

IPG Photonics Corporation (IPGP)
Repligen Corporation (RGEN)
Ubiquiti Networks, Inc (UBNT)

If you want to skip the theory, use the three lines above to search down and find my writing about the companies. Anyone too rushed to read can find “All the charts again” at the end.

Many investors will be unfamiliar with how companies massage cash-based figures, indemnify so widely that they are warned it might not be enforceable, have anti-takeover provisions that would make management unaccountable, can be exempt from audits of internal control over financial reporting, and more. That’s mostly what I write about until I get to the companies.

The tests in full are:

1) More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.
2) Cash from operations has to be positive and generally bigger than the cash that goes into investment.
3) A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

Other factors still matter

In math terms, I’m looking at cash and its first and second derivative, but in simpler language, it’s like reading the height, velocity and acceleration of a rocket that you don’t want to fall to earth. You still want to know about other factors like the guidance and communications systems and if it’s going to hit anything.

There’s a case for preferring ‘cash3’ companies (find “possible alpha” and “low-risk anomaly” below), but risks still count, such as dependence on government, customer concentration, a single supplier, new technology making products obsolete, management greed or incompetence, and increased competition.

Valuation still counts, and an overpriced cash3 company will not be a good investment, while a value-style investment or an excellent company at a fair price can be good investments without meeting cash3 requirements.

‘Cash3’ companies have cash available for investment, but the opportunities to invest will vary. If a company stops being cash3 due to a large investment, there will usually be more risk and more reward.

Make easy checks first

You don’t want all the work of checking the obligations, commitments and contingencies, and the relevant accounting policies, only to find that cash doesn’t exceed liabilities, or the company generally invests more cash than it gets back through operations, or the market is near saturation. The hard work belongs in test 1 logically, but leave it til last. Also see “Use information found already or found later” and “Read forms once and make notes” below.

If a company fails a test, it could still be worth further research, whether the research follows the cash3 framework or not.

Judgment, effort and confidence

Test 3, “A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.”, involves judgment, although some investors might formalize the test with projections.

Test 2, “Cash from operations has to be positive and generally bigger than the cash that goes into investment.” is not a mechanical test. A history of positive free cash flow will sometimes be enough, but not when major changes are imminent. The expiration of a significant contract or royalty stream will have a definite negative effect, but new sources of cash flow will usually be less certain.

The obligations, commitments and contingencies in test 1 present a problem. Some, like future lease payments, are usually easy to find, but knowing that you’ve probably found all the important items isn’t easy. Checking the accounting policies is hardly trivial. At some point the investigation has to stop, limits on time and experience have to be accepted, and confidence in the conclusions has to be judged. While it’s been said that investors should only invest in businesses they understand, I don’t think that meant every bit of every form filed with the SEC (Securities and Exchange Commission).

The research required to make the tests can be more important than the result. If you find something bad enough, it doesn’t matter if the company is cash3 or not, if you don’t want to invest in it.

In short, ‘cash3’ is not a mechanically determined condition, and getting the ‘cash3′ stamp is not all that matters about a company.

If you get through all of this piece and believe it makes sense, I suggest you assimilate the methods gradually. The concept is unproven, the research takes a lot of time, and I can’t be sure that the cash3 approach is an efficient use of investors’ time.

Next I describe some issues around making the tests, followed by ‘Reasons for the tests’.

Test 1, “More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figure.”

Checking that cash exceeds the Total liabilities only requires finding them in the balance sheet and comparing.

Obligations, commitments and contingencies

I’ve put “Finding obligations, commitments and contingencies” in the “REFERENCE SECTION” near the end. When I mention 10-K, 10-Q, 14A or S-1, they are company filings which I describe in “Forms filed with the SEC (Securities and Exchange Commission)”.

Starting with indemnification by the company, it’s usually impossible to quantify the risk or the maximum amount payable, but there are important differences between companies’ indemnification policies which can be noted. There are two main kinds of indemnification:

1) A distributor is sued for patent infringement, and the company pays for the legal defense and any award the distributor has to pay, because the patent is embodied in the company’s product. The same principle applies to other partner companies, such as contract-manufacturers.

2) A company officer (CEO, CFO etc.) or a director is sued or prosecuted, and the company pays for the legal defense and any award or fine the officer or director has to pay. The indemnity can be be extended to employees, agents and many more.

There should also be provisions for settlements (agreeing on a payment to drop the case).

That description misses out huge chunks, and a company’s indemnification can cover a few pages in an S-1.

1) is reasonable, for example you can’t expect a contract-manufacturer to bear the risk of patent infringement. What matters is not usually the details of the policy, but the exposure to litigation-happy business areas such as digital technology and communications.

2) is probably inevitable, but the terms vary. When the risk is not insured, it might be uninsurable or very expensive to insure, and the best that investors can hope for is information asymmetry, that management know the risk is small but somehow insurers can’t know the same information. It’s also possible that there could be doubt about the indemnification being enforceable (the SEC might dispute it), and there’s less point in paying for insurance that might be unusable. Companies routinely bear uninsured risks such as product obsolescence or a change in government policy, but because Ubiquiti insure their officer and director indemnity, the absence of such insurance by the other two companies indicates risk.

See under “Common failings” below, about the indemnification by the three cash3 companies.

Pensions – you might be lucky and find an unequivocal number for the pension commitment, or a clear statement of no pension liability, or no significant liability. Otherwise, for example, if the biggest number connected to pensions is half a million dollars paid in Sweden, it’s likely to be reasonable to ignore the pension commitment, even though a big commitment can’t entirely be ruled out.

Legal proceedings – A company that puts a conservatively high upper limit on the cost of a court case could fail the cash3 test 1 as a result, while a company that downplayed the risk or the maximum likely expense could pass, which isn’t ideal but you can only work with the information you can find.

I usually add the obligations, commitments and contingencies (OCCs) without discounting them to a present value, even though they can spread long into the future. That keeps the calculations simple, comparable, and avoids picking a discount rate. Investors can discount the OCCs if they prefer.

Off-balance sheet financing and special purpose entities

The condition “including material off balance-sheet items” is simpler when you find a statement like this, “We do not have any special purpose entities or off-balance sheet financing arrangements as of September 30, 2013.“, which is from Repligen’s 3Q 2013 10-Q. Otherwise, you need to quantify what you can, and avoid double-counting items already included under Obligations, commitments and contingencies. If there’s a significant amount of off-balance sheet financing, check that there’s a good reason for it being off the balance sheet, and that management are not afraid to mention the off-balance sheet financing, otherwise it signals that management want to hide it.

There might a good reason for any special purpose entities, but very often, little is disclosed. They can be used by multinational companies to pay less tax, to keep patent ownership secret, and sometimes have a role in securitization schemes. When Apple acquired the iPad trademark from Chinese company Proview, they used the British shell company Application Development Limited (IPAD Limited) to hide their identity and get a better price. (It went wrong and ended up in court.) If management say there are no special purpose entities, that’s clear, if they describe their special purpose entities, you have information to consider, and if they don’t mention special purpose entities, you can see if keyword searches pick anything up (‘entity’, ‘entities’, ‘special-purpose’, ‘vehicle’).

See “How Enron used the offshore system to hide millions” By Lucy Komisar, San Diego Union, Jan 23, 2000 (thekomisarscoop.com).

Dairy company Parmalat (Wikipedia) were sometimes called “Europe’s Enron”, and their fraud involved obscure offshore entities. Auditors Deloitte & Touche warned they were unable to certify some transactions involving the ‘Epicurum’ investment fund based in the Cayman Islands, in 2003. Parmalat would have made a loss if it wasn’t for the profit on a contract with Epicurum. Epicurum was “linked to Parmalat” (Wikipedia), or a fraudulent offshore entity according to other sources. Later, Bank of America stated that €3.95 billion in Parmalat’s bank account was forged. This related to Parmalat’s Bonlat subsidiary in the Cayman Islands. It became clear that Parmalat had huge debts instead of net cash. See also: “There Were Earlier Signs of Trouble at Parmalat” By DANIEL J. WAKIN, January 14, 2004 (nytimes.com)

It’s possible that auditors are now more aware of how shady entities can be abused, and that measures to counter money laundering have reduced the risk to investors, but I wouldn’t assume everything’s fine now.

Dubious accounting policies

The condition “and with no accounting policies that cause significant doubt about the cash figures” is fuzzy in the sense that investors will vary in their ability to detect and weigh dubious accounting policies, and experienced investors won’t all agree about the policies. Unfortunately, omitting it leaves loopholes.

I don’t want to be too strict, especially about common abuses. If the company seemed honest enough, I’d note the vagueness as a minor offense, rather than disqualify the company, because I haven’t found a perfect company yet. ‘Cash and cash equivalents’ illustrates this. It’s worth checking the definition, but the value of the check is reduced by the common use of woolly definitions. If a company included junk bonds (not investment grade) or anything with more than three months to maturity, the company ought to fail the test, but companies can avoid standing out by using a woolly definition instead. See under “Loose definition of Cash and cash equivalents” below.

If a policy raises some doubt but you think it probably isn’t too serious, check previous SEC filings to see if it’s new. I wouldn’t necessarily disqualify a company from being ‘cash3’ if the revenue recognition policy seemed a bit loose, but I’d need to check that cash from operations wasn’t inflated, and I’d note the policy and bear it in mind when making an investment decision. If the policy had been loosened in the latest quarter, it’s a very different matter, as it’s natural to ask why management would want to change it, with deception high on the list of motives. The same principle applies to other slightly dubious policies. See if they’re new, and if they are, ask why.

There’s more under “The trouble with cash” below, including links to cases and links about what to check.

The following headings are about checking for dubious accounting policies:

Audits of internal control over financial reporting
Cash and cash equivalents definition
Short-term investments definition
Revenue recognition policy

Audits of internal control over financial reporting

Having good accounting policies is no guarantee if the company lacks the internal financial controls that alert to policy breaches. Some companies are exempt from external audits of financial controls under the JOBS Act (JOBS – Jumpstart Our Business), and the lack of such audits increases risk to investors.

Open a company’s latest 10-K and find the auditor. Search for “Independent Registered” or “Accounting Firm”, or try these:

Deloitte
Ernst
PricewaterhouseCoopers
KPMG

Either search for the name until you get to the signature, like:

/s/ Deloitte & Touche LLP
Boston, MA
February 28, 2013

or search for “Independent Registered” until you see a heading like:

“REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM”

The auditor’s piece should be between the heading and the signature. The punchlines are likely to be one or two paragraphs above the signature, or not far below the heading. You want something like:

“In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of …”

While there, you might as well check the more general audit. You want to see something like:

“We have also audited, … the consolidated financial statements … and our report … expressed an unqualified opinion on those financial statements.”

Anything other than an unqualified opinion is bad, but auditors don’t always include the phrase ‘unqualified opinion’ when their opinion that the accounts are fair is unqualified. When you’ve got the big OKs, don’t bother reading the legalistic verbiage.

Like many things in finance, what’s bad is bad, and what’s good is not reliable. The big four auditors were the big five until Enron went bust and their auditors Arthur Anderson lost all credibility. There’s been plenty of audit failure since. The firm doing the audit has an incentive to keep or gain tax and consulting work.

So far as I know, that’s all you need. The audit committee might do vital work but I don’t see the point of reading about it. Don’t read the “Certification of Chief Executive Officer” because the CEO isn’t going to say the quarterly report is a load of garbage.

Cash and cash equivalents definition

Check the definition can’t include anything illiquid, unsafe or maturing in more than three months. Money market funds are probably alright. Apart from the U.S. government, securities should be spread across counterparties rather than risk one of them going bankrupt. I excuse woolly definitions because they are common (find “Loose definition of Cash and cash equivalents” below).

Short-term investments definition

Short-term investments don’t feature in the ‘test 1’ calculation, but they are defined near the Cash and cash equivalents, so you might as well check the definition. Check that only investments maturing within a year are included. Check the risk, as most companies shouldn’t be dealing in risky short-term investments. Companies without short-term investments don’t usually define them.

Revenue recognition policy

By itself a loose revenue recognition policy doesn’t usually affect any cash figures, but it can inflate cash from operations when Accounts receivable are sold or disguised (‘receivables’ represent cash not yet collected from customers). The key point with goods is that ownership should be transferred before revenue is recognized. If the customer can easily return the goods for a refund, or does not need to pay for a long time, investors need to be sure that this is a reasonable policy intended to encourage sales over the years, rather than bring sales forward to inflate results in the short term. Delivery to warehouses controlled by the company is a red flag if revenue is recognized at that point. That’s different to managing the customer’s inventory, which can be part of a customer’s ‘just in time’ policy, and helps to keep the customer. Some services and projects are supplied over a few years. Ideally, the revenue booked should be proportionate to how much of a contract has been delivered, but it’s common for the recognition of revenue from services to be weighted ‘up front’ rather than spread evenly.

Sometimes the usual terms of a sale are circumvented with a ‘side letter’, granting a longer payment period or broader rights to return products that aren’t wanted. While the recognition of revenue should be determined by the policy and not by a side letter, I wouldn’t rely on the revenue figure when side letters are used.

Recently-raised equity

A company can’t pass test 1 by borrowing, but it can do so by raising equity (issuing shares, including when warrants are exercised, through employee stock purchase plans, or when convertible loans are converted to shares). I wouldn’t normally exclude a company that only passed test 1 by recently raising equity, as the cash raised or the debt reduction is real. It might indicate that the company hasn’t generated enough cash, but that shouldn’t usually be a problem if the other two tests are passed, although there’s room for opinion about it.

Cash held overseas

Bear in mind that some or most of a company’s cash could be held overseas, and the company would have to pay tax if it repatriated the cash, e.g. to fund dividends. This might explain why some companies with plenty of cash still have debt. I ignore this and treat all the cash as the same in my assessments.

Test 2, “Cash from operations has to be positive and generally bigger than the cash that goes into investment.”

I would not exclude a company that made a big investment in the latest period, if the cash from operations generally exceeded cash into investment. My ‘walk charts’ of the two cash flows over several years, make this clear when there is enough history. A normal time-series chart of cash from operations minus cash into investment (one definition of ‘free cash flow’) would also show if investment produces more cash than goes into it, but with less information and less scope for identifying patterns. This is for IPG Photonics, up to 2012.

IPG walks for cash from ops and into investment

That’s from a blog post of mine: “IPG Photonics – growth, cash, markets and technology” September 27, 2013. Repligen is a different case, as the transition to bioprocessing means that old history is less relevant, so I’ve looked into recent income statements to check that free cash flow is sustainable.

Test 3, “A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.”

Sources and prospects

This is the test where the easy reading is most relevant, to gauge the company’s prospects. That includes presentations, transcripts on Seeking Alpha, articles, and often some technical background to understand the business. These sources might not say much about the competition. If there are no better leads, search the 10-Q and 10-K SEC filings for the “Competition” section.

Past and future

I like to see a solid foundation, such as a cash flow walk chart showing a history of free cash flow growth. Repligen don’t have that, and I make do with the growing bioprocessing market and other factors. I believe that a good history with no strong reason to expect it to stop is generally more reliable than reasons to expect a bad history to turn good, though it isn’t something I could prove.

Blips allowed

The expected growth doesn’t have to be relentlessly positive, every year. In the chart above, the distance of a point above the green diagonal line corresponds to cash from operations minus cash invested. There are years where the quantity was down or negative, but the overall growth was excellent.

I regard Repligen as passing the test, even though their cash flow will drop due to expired royalties, because they are now focused on bioprocessing where revenue and cash flow are likely to grow. Articles by Smith On Stocks on Seeking Alpha describe the business model and provide rough projections which indicate growing free cash flow.

Faster than average rate

I leave open, what the benchmark ‘average rate’ of growth of cash from operations might be. In the case of Ubiquiti, the recent growth rate is very high, my chart makes it obvious, and there’s no point in worrying about which rate the growth should be higher than. For IPG Photonics, the growth is less extreme, but I still expect growth of cash from operations higher than for the average company over a long enough period. I’m not too concerned with the growth relative to the sector. If I learned that a competitor achieved higher growth of cash from operations, and also higher margins, I would take a serious look at the competitor. IPG’s CEO has remarked on a trade-off between margin and growth.

Investors need to decide exactly how to implement test 3. In my case, it’s more ‘I know it when I see it’, which is highly subjective. Most of the cash3 considerations are subjective, with the risk that I’ll make the test fit the company if I already like the company too much, if I’m not careful.

Use information found already or found later

An investor should only give tests 2 and 3 a conditional pass, until the accounting policies have been checked. Those checks are logically part of test 1, but the hard work should be left to last. When considering if the revenue recognition policy is too loose, or when reading the Liquidity and Capital Resources section of a SEC filing, bear in mind that the reliability of cash flow figures could be affected. Also see “Read forms once and make notes” below.

A version of free cash flow

I could have shortened the definition of test 3 by using ‘free cash flow per share’ instead of ‘cash from operations minus cash invested, per share’, as free cash flow is often defined in that way, but it’s also defined as cash flow from operations above the investment needed to maintain the business. There can be a big difference between the investment needed to maintain the business, and what is actually invested. Warren Buffett has claimed that many companies reinvest too much of their cash from operations, and he likes to take them over and put the cash generated to better use. It’s also hard for ordinary investors to estimate the investment needed to maintain the business. To avoid confusion, I’ve avoided making test 3 shorter.

Reasons for the tests

Here are the tests again:

1) More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.
2) Cash from operations has to be positive and generally bigger than the cash that goes into investment.
3) A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

It’s fairly obvious that a company is better when boxes 2 and 3 are ticked, meaning that more cash comes in from operations than is required for investment, and the excess is expected to grow above the average rate. It’s also true that more cash in the bank is good, in the sense that you wouldn’t want any of it to just disappear, but there are complications around the question –

Should a company have net cash or net debt.

In favor of net cash, it’s a safety net, allowing unforeseen expenses to be paid with less pain, and allowing major restructuring in order to adapt to permanent changes, with no borrowing or less of it. When there’s a problem, net cash might help to prop up the share price, allowing some investors to get out at a better price.

Cash: Can A Company Have Too Much?” By Ben McClure on September 05, 2010 (investopedia.com)

One point Ben McClure makes is that cash can allow carelessness.

This is about a British company with a cash pile that was ruined after a management coup:

From blue chip to ‘right bloody mess’” July 08 2001

The manager who hoarded the cash was prudent, and it was the new management, not the cash, that caused the waste. For years people were asking “When will they spend the cash?”, and not “Will new management botch a radical restructuring?”, showing that sometimes the obvious question isn’t the right one.

This piece from 2010 is about how Hewlett Packard’s big buyback was meant to reassure investors that they weren’t going to squander the cash pile on ‘overpriced baubles’ …

HP tries big buyback to quell investor discontent” By Robert Cyran, August 30, 2010 (blogs.reuters.com)

… and in 2012 HP were suing, claiming they’d been misled into overvaluing their expensive Autonomy acquisition.

The lesson is that ‘cash3’ is not sufficient grounds for ‘buy and forget’ or ‘hold forever’, instead, watch out for squandering, and don’t trust new management too much when they can make a mark by splashing the cash. Over-hoarding is also not ideal.

It’s entirely normal for a company to fund investment by borrowing, when the return on the investment is expected to be sufficiently above the interest paid on the debt. I’m not saying all companies should stop that, or that investors should always avoid such companies, although there are risks and costs with debt-funded investment. Warren Buffett prefers companies which grow their cash flow with little requirement for capital and therefore no need for debt, although the growth of such companies tends to be steady rather than spectacular, and he also likes insurance companies which provide a ‘float’, which has been described as providing leverage. My cash3 tests allow high investment, and IPG Photonics fits cash3 even though they’ve invested a substantial amount of cash, because their cash from operations has generally exceeded the cash into investment, and has grown well over several years. In a sense, IPG Photonics provides the whole package, because the cash generated can be usefully reinvested to develop the business. While strategic acquisitions have been made to acquire technology or achieve vertical integration, there isn’t a pressing need to find a use for surplus cash.

There’s a case for loading up with debt in some circumstances, such as when earnings are predictable, but there could be a temptation to overdo the debt when interest rates are low, or in order to keep increasing earnings per share or dividends.

There’s currently some controversy in the UK over water companies where 70% to 80% of the balance sheet is debt. The debt reduces the tax bill because tax is paid on the income that’s left after paying interest, but there’s concern that with tighter price control their credit ratings will drop and they’ll lose their licenses. It’s alleged that the companies have become too cash-hungry, with poor customer service, a reluctance to invest, and low innovation. Innovation can have some risk and reward attached, and maybe investors have enough risk and reward already through the leverage. Management claim the only problem is getting the ratings agencies to understand why the risk is low. Maybe management are right, or maybe they kept improving the appearance of results by a little more debt every year and didn’t know when to stop. The companies started debt-free in the 1980s.

Accountants know the tax advantages of debt, including British insolvency specialists RSM Tennon Group plc, who were named ‘national firm of the year’ at the British Accountancy Awards 2011 for their build-it-on-debt strategy. They couldn’t pay the debt, and were sold in a “pre-pack” deal which left shareholders nothing, in August 2013.

Eastman Chemical are a case where earnings are not predictable, and their general lack of pricing power makes them vulnerable to rising input costs, although they have some protection through diversification. They have expertise (without super-high compensation), good cash flow and earnings growth, and a load of debt. In the event of a downturn, Eastman’s shares are likely to be hit by concern over their ability to repay debt, even if the company survives in relatively good shape. Although the debt has been coming down, it’s likely to increase to fund acquisition. I’m long Eastman Chemical, but because of the debt it’s a small shareholding which I regard as speculative.

Sometimes dividend-paying companies borrow to buy back their own shares, which reduces the total costs of paying the dividends. This usually makes more sense when the company expects the dividend to grow. The debt created might be justified, but I’d usually prefer to invest in a company that could buy back its shares without having to borrow.

Non-recourse debt is generally better than ordinary debt. It means that the lender has a claim on a particular asset or set of assets, but not on the company. SunEdison have financed some of their solar projects with non-recourse debt, and if a few of those projects fail, the remaining projects and other sources of income are not affected, although the financing of future projects could be difficult. The financing allows capital to be recycled more quickly to fund new projects. The use of non-recourse debt is only possible because the projects are seen as predictable and unlikely to fail. There’s more about this in my “MEMC Electronic Materials – Debt Fueled Growth Is Good” and “SunEdison still set for growth and profit” under the Index tab (MEMC changed their name to SunEdison). SunEdison has other long term debt.

If I found a company that would be cash3 if non-recourse debt was excluded, I would think of it as being in the ‘cash3 excluding non-recourse debt’ category, and check the details, including the use of such debt in recycling capital. If, as in SunEdison’s case, the non-recourse debt is not amortized as it is repaid, then the debt is overstated and an adjustment could bring a company into the regular cash3 category, although the adjustment could be hard to gauge.

The low-risk anomaly

‘Cash3’ might be supported by the ‘low-risk anomaly’, that low-risk companies give higher returns. Sometimes ‘risk’ is replaced by share price volatility (or ‘beta’), which is a complication, as I agree with Warren Buffett when he doesn’t equate risk with beta.

Risk and beta can be very different when a company loads up reserves in good years to draw down in bad years in order to smooth earnings, which is likely to make the share price less volatile (or ‘low beta’). I can’t find a brilliant example, but the state-backed Federal Home Loan Mortgage Corporation (aka Freddie Mac) attempted that when an earnings windfall from an accounting change threatened their slow-and-steady image. See “Freddie Mac, Four Former Executives Settle SEC Action Relating to Multi-Billion Dollar Accounting Fraud” Sept. 27, 2007 (sec.gov). They still reported unsteady earnings growth of 63% and 39% in 2001 and 2002. The company certainly wasn’t safe, needing a federal takeover when the financial crisis hit. It can be tempting for managers to smooth performance as a sharp improvement followed by a sharp fall somehow looks worse than if the results were smoothed.

For an analysis which is mostly beta-focused, see:

The Paradox of Low-Risk Stocks” subtitled – Gaining More by Losing Less, (PDF), by portfolio managers Kent Hargis and Chris Marx (I think), February 2012 (alliancebernstein.com)

How that applies to cash3 companies seems complicated. My opinion is that being cash3 is still good for companies in steady markets. In cyclical markets, cash3 companies are likely to survive downturns in better shape, and could emerge with fewer or weakened competitors depending on the competitors’ financial strength before the downturn.

Earnings manipulation

I believe that cash3 companies are likely to be less prone to earnings manipulation. Earnings manipulation might be rare, at least as measured by the number of companies the SEC takes action against, or require to restate their accounts. The best information I’ve found about the level and trend of SEC actions is in this –

Making Accounting Enforcement a Priority: The Case for an SEC Financial Accounting Fraud Specialized Unit” by Martin S. Wilczynski, April 29, 2013 (securitiesdocket.com)

The most up-to-date chart is the last one, from 1998 to 2012, for the SEC’s enforcement actions. There doesn’t seem to be a clear long-term trend in the number of companies that the SEC takes action against.

While restatements or SEC enforcement provides objective measures of financial reporting failures, they miss the effect of undetected cases, or various levels of manipulation below the SEC’s threshold. Messod D. Beneish, who devised the Beneish M-Score for earnings manipulation, claims that the M-Score predicts share price performance over a wide range of M-Scores (though not perfectly, obviously). I believe the claim suggests a wide range of levels of manipulation, including levels below the SEC’s threshold. (IMO, the M-Score is useful but flawed.)

This is where the possible alpha comes in. To the extent that fooling investors works, companies with less honest management are overvalued, and companies with honest management are relatively undervalued. If you believe a strong enough version of the efficient market hypothesis, then too few investors are fooled to inflate share prices, there’s no alpha here, and management have little incentive to fool investors (and pigs might fly).

If the Beneish M-Score is the best possible measure of management deception, then the ‘cash3’ concept loses some theoretical support. I don’t believe the premise, but the M-Score has statistical support, whereas ‘cash3’ and the other factors I look at, only have my opinion and reasoning.

Companies passing the first two cash3 tests have less need to raise capital, and therefore less pressure to manipulate their earnings. Cash3 companies are likely to have good GAAP results (GAAP is Generally Accepted Accounting Principles). When you can make a good case without fudging, it’s not worth spoiling it with fudge.

Because test 1 excludes non-cash assets, the test is not bypassed by inflating non-cash assets. For example, if a company inflates its earnings by under-depreciating physical assets, the net value of its physical assets will be inflated. No amount of such inflation can turn the company into a ‘cash3’ company, because the inflated earnings and asset values are not cash inflows or cash held. (I check the ‘Useful life’ used to depreciate assets, but the check is not part of the cash3 tests.)

A company can induce sales by taking on obligations. These might be unreasonably onerous in order to increase sales or bring them forward, to make the accounts look better. This can inflate cash from operations, but the extra cash held will be balanced by the obligations, which ought to be disclosed in a 10-K. The obligations should be found when making test 1, and the cash from operations can be adjusted for them, although the research should usually be stopped if there isn’t a very good reason for the policy.

Companies passing test 1 are likely to be strong financially, provided the off balance-sheet items are disclosed and found. Altman Z scores are likely to be high into the safety zone, and are almost superfluous.

Test 3 means we are considering growth companies. These are particularly prone to earnings manipulation when they need to borrow or issue shares to fund their growth, and need to keep up appearances in order to raise capital on favorable terms. That’s less likely for cash3 companies.

Until I write about earnings manipulation and supply links, some readers will need to do their own research to confirm or refute some of my claims.

The trouble with cash

People used to say “The camera never lies” without irony, long after Sir Arthur Conan Doyle was fooled by photographs of fairies (Wikipedia). Some day there might not be many investors left saying “Cash can’t lie.”. Fictitious cash flow dates back at least as far as the 1920s and 1930s, when McKesson & Robbins’ cash was circulated to create the illusion of cash received from customers (See “The Greatest Frauds of the (Last) Century” by Paul M. Clikeman, Ph.D., CPA, University of Richmond). When judging a company by cash, you need to be sure about the cash, which is why this section is long, and not long enough.

Some cases of deception involving cash can be found on the SEC’s site, and much of the material is fairly readable, after a paragraph or two of legal language, or after the word “alleges”. For instance:

“When Peregrine booked the non-binding contracts, and the customers predictably did not pay, the receivables ballooned on Peregrine’s balance sheet. To make it appear that Peregrine was collecting its receivables more quickly than it actually was, a senior officer entered into financing arrangements with banks to exchange receivables for cash. Peregrine improperly accounted for these financing arrangements as sales of the receivables and removed them from the company’s balance sheet. There were several problems with this. First, because Peregrine had given the banks recourse, and frequently paid or repurchased unpaid receivables from them, Peregrine should have accounted for the financing arrangements as loans and left the receivables on its balance sheet.”

That’s from the third paragraph of the first link in this list:

SEC charges PEREGRINE SYSTEMS, INC. 2002

SEC charges Adelphia Communications Corp and Rigas Family July 24, 2002.
Rampant self-dealing, hiding liabilities in off-balance sheet affiliates, etc.

SEC Charges Delphi Corporation and Nine Individuals Oct. 30, 2006
Charges include disguising a loan as the sale of inventory, which inflated cash from operations. Delphi’s non-GAAP “Operating Cash Flow” had little relation to GAAP Cash provided by operating activities. (When I use “cash from operations”, or “cash from ops” etc, I mean the proper GAAP measure.)

SEC charges Time Warner Inc. March 21, 2005
The charges against Time Warner involved “roundtrip transactions”, where the company funds the customer’s purchases. Such trades lack economic substance, and inflate cash from operations when the funding is included under financing or investment. The next two cases also involve “round-trip” trades.

SEC charges CMS Energy March 17, 2004

SEC charges Dynegy September 24, 2002. “… Dynegy portrayed as operating cash flow what was essentially a loan.”

SEC Sues Former Tyco CEO Kozlowski, Two Others for Fraud September 12, 2002
The CEO and others helped themselves to company funds. Acquisitions are an opportunity to manipulate earnings and cashflow, which Tyco took advantage of when they acquired over 700 companies.

SEC charges WorldCom June 27, 2002.
WorldCom pretended that operating expenses were investment, inflating cash from operations, and cash invested. They also exploited acquisitions, writing off the costs and creating reserves to draw down into income later. It all fell apart when their acquisition of Sprint was disallowed on antitrust grounds.

SEC charges Satyam April 5, 2011. (An Indian company, with American depository shares.)
Includes “… fraudulently overstating the company’s revenue, income and cash balances by more than $1 billion over five years.” and “Satyam employees created bogus bank statements to reflect payment of the sham invoices.”

There’s plenty more on “Accounting scandals” (Wikipedia). Many of them will be more about non-cash fraud. The list shows a peak in 2002, possibly due to the fallout of the earlier Dotcom crisis. I don’t believe the lack of notable recent U.S. cases means we can trust management and relax.

There are a few tips on spotting the fakery here: “How Companies Fake It (With Cash Flow)” by Matthew Argersinger, Jul 27th 2011 (dailyfinance.com)

If you can bear Investopedia’s adverts, this has a few tips – “Detecting Financial Statement Fraud” By Arthur Pinkasovitch on September 28, 2011 (investopedia.com)

This link is a bit old and on a horrible marble background. FORENSIC INVESTING: RED FLAGS

Where to find cash info

Get the latest form 10-Q or 10-K.

The cash flow statement is the obvious place to start.

Read the “Liquidity and Capital Resources” section.

Search for “Cash flow information” or “Cash flow disclosure” (in a 10-Q or 10-K form), to find variations on “SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:”. The heading varies, and might not exist or only be a few lines in the cash flow statement.

Search for “Non-cash”, “Noncash” etc. to find “Non-cash transactions” where you might find payment by installments that makes expenses or investment look like repayment of debt.

Search for “promissory” (as in promissory notes), “trade” (trade accounts), or “notes receivable”, to see if the company has transformed Accounts receivable into something else, like short term investments.

Search for “customers request”, and look out for variations. Looking after customers is good, but the phrase is a multipurpose excuse, and is more suspicious when attached to anything that involves cash.

The income statement can have information about unsustainable income, one-off charges, etc. Some of these will affect cashflow, although the cash might not be collected or paid yet.

Some of the searches above will often lead to the same information.

Note anything which might be suspicious and see if there’s a good reason for anything odd.

I don’t mean the rest of the form can be safely ignored. Please feel free to copy this part for reference if you like.

Revenue and receivables

It’s generally easier to spot earnings manipulation when cash is not manipulated, as a non-cash asset on the balance sheet is likely to bulge, or (less often) a non-cash liability will shrink. If all the company does is to use inducements to stuff the sales and distribution channels, with easy returns and long payment periods, the fakery in the income statement shows up as increased accounts receivable, and revenue not matched by cash flow. If they also sell receivables (at a discount) with recourse (keeping the liability when the cash isn’t collected), the receivables are kept at a reasonable level and the figure for cash from operations gets closer to the revenue figure (find “When Peregrine booked”, above). The balance sheet bulge and the cash shortfall disappear, and to find the manipulation, you have to find disclosures about the sale of accounts receivable and the sources of cash. See “Where to find cash info” above.

When a company has more cash than its liabilities and OCCs, and generates cash, management might be under less pressure to create fake revenue, or to sell receivables to hide the effects of fake revenue, but it’s still possible that management could do this to meet expectations or trigger bonus payments. The practice would not help a company to pass the cash3 test 1, because the increase in cash held would be matched by the obligation to pay when the receivables sold aren’t collected.

That check fails when the good part of the receivables is sold without recourse. This means that the buyer (usually a bank) is satisfied with the credit-worthiness of the customers, and the terms regarding collection, and if a customer doesn’t pay on time, the bank suffers the loss, with no recourse to the company. In this case, there is nothing in the cash3 test 1 calculation which directly identifies the manipulation or compensates for it. The extra cash held is real, and there may be no extra cash obligations. The company could fail part of test 1 (“no accounting policies that cause significant doubt about the cash figure.”), due to its revenue recognition policy, or the terms offered to customers. Those terms are not officially an accounting policy, but they can signal the problem I’ve described. Check for a recent loosening of revenue recognition or terms offered to customers.

If the problem described above is not picked up in test 1, it should be picked up in test 2, “Cash from operations has to be positive and generally bigger than the cash that goes into investment.”, and test 3, that the excess cash flow should grow (see “Use information found already or found later”, above). That’s because selling receivables is not a sustainable cash flow. Look for sales of accounts receivable. See “Where to find cash info” above. The next step is to add the receivables sold to the receivables remaining, and see if the Days Sales Outstanding (DSO) calculation (below) gives a higher than usual figure. If there are different categories of receivables, make sure they’re all included. Likely categories are current or billed, accrued or unbilled. and long-term or installment. Then, if for example the total receivables (sold plus remaining) is $100 million higher than would be expected if DSO had stayed the same, subtract $100 million from the revenue and from cash from operations, to get figures adjusted for excess receivables. In some cases it’s reasonable to decide the company is not a safe investment, and finish the investigation without making all the calculations. Otherwise, bear in mind the company’s policies and the adjusted figure for cash from operations when making tests 2 and 3.

Days Sales Outstanding or DSO is usually calculated with the formula:

DSO = Number of days in the period * Receivables / Sales in the period

For a quarter, that’s usually DSO = 91.25 * Receivables / Sales in the quarter.

If you can’t remember the formula, these are closer to common sense:

Sales per day = Sales in the quarter / 91.25
DSO = Receivables / Sales per day

or replace the first formula with:

Sales per day = Sales in the year / 365

The result is more reasonable when any week in the quarter is just like any other week in the quarter. Otherwise, $100 million of receivables could be 90% dating from the last week in the quarter, or 90% dating from the first week of the quarter. Although that’s an extreme possibility, for the same level of sales, the two cases would give the same result for DSO, even though the collection of cash from the customer has already taken many days longer in the second case. In practice, a big jump in calculated DSO is a red flag that needs looking into, but it could be reasonable for a company with lumpy sales, after making a big sale late in a quarter.

It’s a similar situation when companies encourage customers to swap a bill from the company for a loan to the customer or a security from them, which could appear as investments instead of in Accounts receivable. This is hard to detect. See “Where to find cash info” above, particularly the search for “promissory”, “trade” (trade accounts), and “notes receivable”.

Ideally, the change in obligations, commitments and contingencies (OCCs) between the start and end of the accounting period, would be looked into and calculated, and a big jump would need investigating. Unfortunately it’s a lot of work to calculate OCCs, and I don’t think finding them twice for each company is practical for many investors.

Quarterly manipulation cycle

It’s possible that the “Liquidity and Capital Resources” section could reveal a pattern that repeats each quarter, which minimizes the appearance of being short of cash. I can’t find a confirmed case, so this is hypothetical, and could be more extreme than anything you are likely to see.

1) Buy inventory at the start of a quarter and run it down, aiming to end the quarter with as little inventory (and as much cash) as possible.

2) Offer customers terms that allow payment near the end of the quarter, until the payment period becomes unreasonably short.

3) Payment of suppliers might as well be prompt at the start of a quarter, or early if a discount is offered. Further on, delay payment until the start of the next quarter.

4) Near the end of the quarter, offer attractive terms to customers, including payment near the end of the next quarter.

5) Near the end of the quarter, sell receivables (at a discount, or no-one will buy). The best quality receivables could be sold without recourse. Selling receivables with recourse allows more to be sold, but some investors will spot “with recourse” and realize that the transaction is a loan dressed as a sale.

The cycle boils down to three end-of-quarter aims: getting cash in, not letting cash out, and booking revenue even on poor terms. Because business operations can be conducted fairly normally for much of the quarter, there is less damage than if the company operated a cash-starved regime all the time.

The maximum distortion actually requires cash to fund it, and as the companies under the most pressure to distort won’t have the cash, you might never see maximum use of all five items at once. They still illustrate some of the methods and principles of an area of manipulation.

The possibilities show how the accounts provide limited information. Because accounts don’t show the action within the quarter, investors can’t always understand the flows from the income statement and the cash flow statement, or understand the balance sheet ‘snapshot’ fully, when they only read the accounts. The flows reported are sums over the period, and the balance sheet only shows the state at the end. The problem with both is that management know the dates. A balance sheet taken on a random date could not be manipulated in this way, but that’s not a practical proposition.

You won’t see anyone admit they manipulate inventory to report higher cash and low inventory in the quarterly accounts, but you might see a disclosure that higher cash and low inventory were the result of the company’s business cycle. A genuine quarterly business cycle only seems likely when a company’s customers have a quarterly business cycle.

Diverting cash flow from investment to operations

There are ways for management to divert cash flows into the category they prefer. If a shipping company sold a ship and recorded the sale as revenue, when the cash came in it would contribute to cash from operations, when it’s really cash from investment. That would be serious enough to disqualify the company from being ‘cash3’, even if the tests would be passed if the error was corrected. The transgression might be found by finding a disclosure about the sale of the ship, rather than by finding an accounting policy that allowed the practice. See “Where to find cash info” above.

Diverting cash expense to investment

This can be done by simply capitalizing an expense such as R&D, turning it into investment and inflating cash from operations. A more complex method involves ’roundtrip transactions’ where revenue or cash comes back to where it started, through reciprocal purchases, or “You buy our stuff and we’ll buy yours.”. This inflates revenue, but the unwanted purchase can then be classed as investment. It wouldn’t be practical to take delivery of anything bulky or toxic, but unwanted software is an ideal purchase when a company wants to disguise funding a customer’s purchases as legitimate investment. Sales, cash from operations, and investment are all inflated, but the dodge can’t create an excess of cash from operations over cash into investment (one definition of free cash flow). See “Where to find cash info” above. In my cash flow walk charts, reciprocal purchases would move a point ‘north east’, but would not affect the free cash flow shown (which is how far up minus how far right a point is, when the axes are scaled equally). That would stay true even if a ring made detection harder (A sells to B sells to C sells to A).

Diverting cash investment to finance

A particularly devious trick inflates the excess of cash from operations over cash into investment. Imagine a car-hire company which buys cars and pays in installments over a few years. The payments are classed as repayment of debt, and reduce the net cash flow from financing. There’s no outflow that reduces cash from operations, or increases cash into investment, and the effect is to increase cash from operations (if the car-buying would have been an expense), or to decrease cash into investment (if the buying would have been an investment). Either way, the practice fakes-up an excess of cash from operations over investment.

The trick can usually be ruled out as a serious concern when the amounts under Non-cash transactions are small. Anything like “Demonstration units transferred from inventory to other assets” is OK as it’s an internal transfer with no cash to pay in the future.

If you see “contingent consideration” there, it should be OK, as any payments shouldn’t be classed as debt repayments or go under the financing heading. These are usually part of the terms of an acquisition where extra payments are made if targets are hit. Possible targets include sales and R&D milestones such as a successful clinical trial.

The trick tends to be used when purchasing intangible assets such as intellectual property and contracts. It’s possible that the rights to a drug which hasn’t completed clinical trials could be bought in installments, combined with milestone payments, so “contingent consideration” isn’t necessarily a complete ‘all clear’.

Genuine revenue or profit-sharing partnerships are OK, for instance if a patent troll monetizes a patent with a “you give us the patent, we’ll split the royalties” deal, because it would look odd if the payments were treated as repayment of debt.

The Non-cash transactions will often be part of the “Consolidated Statements of Cash Flows” and nowhere else, but could be mentioned in a Note to the accounts under something like “SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION”. In the Note, look for “long-term” in front of “obligation” or possibly “commitment” or anything that boils down to paying much of the price over a few years, with unconditional or minimum amounts. Big amounts, and repeated use of a dubious policy, magnify any red flags.

When significant expense or investment could be diverted into finance, my cash flow walk-charts may be less reliable. Below I argue why the charts will still be good when the cash3 test 1 is passed with a big excess of cash, and the company has had substantial growth. If the installment obligation is big enough, the company will fail my cash3 ‘test 1’ anyway. When the policy is obviously dubious and the amounts are significant, it will usually not be worth continuing the investigation. If there’s doubt, the free cash flows need to be confirmed by evidence that the company could have accumulated the cash.

Confirming growth of free cash flow with ‘before’ and ‘after’

It’s blindingly obvious that CPU-maker Intel has grown enormously since it was a start-up, and the growth couldn’t have been all due to fakery. While obvious, it’s not a directly useful observation because it doesn’t say anything about the last five or ten years, and companies can go bad. Fortunately, the argument can be scaled down to shorter periods. There’s no fixed period here, because ten years of 20% growth p.a. might be as hard to fake as 30% p.a. over five years, and there are other factors like how much of the growth was organic (as opposed to through acquisitions). The argument is tightened by looking at free cash flow per share. Here are two statements:

1) The company is bigger, better, and better per share, than it was several years ago.
2) Free cash flow per share has seen high growth over the same period as in 1).

When each statement seems to be reliable, they confirm each other. See “Ubiquiti’s big size change” below, for an example.

Customers request …

Think about anything which “customers request” if the main impact is financial or on the accounts, because “customers request” is a multipurpose excuse. Consider if the accounts would be distorted if the company was pushing the option on to customers. If customers are requesting delayed payment or financing, they could be in poor financial shape and likely to default, or the company could be offering generous terms to make up a sales shortfall, and claiming falsely to be responding to customers’ requests.

Unsustainable cash flows

The “Net cash provided by operating activities” is usually arrived at through a reconciliation where Net income is adjusted to give the cash from operations. This should include changes in non-cash working capital items such as inventories and accounts payable. When the non-cash working capital goes down, there’s a contribution to cash from operations. That might indicate increased efficiency, and the cash gain could be repeated in the next period, but it can’t be repeated indefinitely (except in a few business areas where negative working capital is normal). Therefore the cash gain shouldn’t be regarded in the same way as a cash gain which dropped down from revenue growth.

Some of Ubiquiti’s recent cash flow increase has been due to lower days sales outstanding. Management expect DSO to return to the higher target range. I adjust the latest quarter’s cash from operations under “Ubiquiti Networks – test 2 and 3”.

Asset sales such as selling subsidiaries or real estate can’t be repeated indefinitely. Such sales ought to reduce the cash flow into investment, which increases free cash flow (by the ‘from-ops minus into-investment’ definition), and investors who don’t identify the source won’t realize the free cash flow is unsustainable. The investing cash flows should be broken down to categories like “Purchases of property, plant and equipment” and “Acquisition of businesses, net of cash acquired” under a heading like “CASH FLOWS FROM INVESTING ACTIVITIES:” in the cash flow statement. Also see “Where to find cash info” above.

Disclosures missing from the cash flow statement

The income statement can’t be ignored because disclosures could appear in the income statement and not in the cash flow statement. This includes sources of cash which are one-off or unsustainable, such as jury awards. For other places with info about cash, see “Where to find cash info” above.

The problem is that in practice, cash from operations is calculated by adding non-cash charges back to Net income and subtracting non-cash gains from Net income (a reconciliation known as the ‘indirect method’), rather than itemizing and summing the cash inflows and cash outflows (the ‘direct method’). Investors who aren’t careful won’t realize when an increase in cash from operations is not sustainable.

In 2004 Microsoft settled an antitrust case and paid Sun Microsystems nearly $2 billion, $1.6 billion of which went into Sun’s Net income. In Sun Microsystems’ 10-K for the year ended June 30, 2004, if you search for “Settlement income”, it’s clearly stated as $1,597 million in “ITEM 6. SELECTED FINANCIAL DATA”, which is what they called their income statement. There, it’s obviously a one-off, and if an investor saw it and didn’t know what it was, searching for “Settlement income” would easily find the explanation. That’s all fine, but there’s no mention of the settlement in their “CONSOLIDATED STATEMENTS OF CASH FLOWS”. At the bottom of the cash flow page, the “Supplemental disclosures of cash flow information” includes the payment of $26 million net interest, but there’s still no mention of the $1.6 billion settlement.

An investor who only looked at Sun’s cash flow statement wouldn’t realize that $1.6 billion of the $2.2 billion cash from ops was a one-off from the settlement. The pitfall wouldn’t exist if companies used the ‘direct method’ where the sources and uses of cash would be listed, but that’s not going to happen.

The information needed could be hidden in a footnote. IBM sold their Global Network business in 1999, and the $4 billion sale was somehow included as a reduction in their Sales, General and Administrative expense. That inflated their Net income. See “IBM’s Accounting Tricks” By Whitney Tilson, February 20, 2002 (fool.com). I haven’t checked IBM’s cash flow statement, but if any company pulled that trick and received cash in the same period, there would be no non-cash gain to subtract from the Net income when arriving at cash from operations.

Unsustainable cash flows in a chart

Any unsustainable cash flows in a period, wherever they are disclosed, would affect the period’s point in a chart showing cash flows, but it’s less likely that free cash flow growing over several years could be the result of a series of increasing ‘one-off’ gains (see “Confirming growth of free cash flow” above). A thorough check would be to read the relevant parts of several previous 10-K forms. That’s a lot of work, and there might be less need for it when rising free cash flow is broadly matched by Net income, or when the operations and investment cash flows in the latest 10-K and 10-Q aren’t dominated by one-offs or unsustainable sources. Look for positive items under “Cash Flows From Investing Activities” or negative items under “Cash Flows used in (provided by) Investing Activities” (the heading varies), then check the income statement for one-off gains, and then it’s most of the rest under “Where to find cash info” above.

Once found, it’s usually obvious that unsustainable cash flows coming in are unsustainable, but I’d be wary of adjusting for frequent one-off or temporary cash flows in the other direction, at least until I found a good reason like exiting the business area that threw them up.

The trouble with underinvestment

Defining free cash flow as cash from operations minus cash into investment, management can create rising free cash flow by under investing, with consequences later when they fall behind the competition. Research and Development is usually accounted for as an expense, and cutting the R&D budget increases free cash flow through cutting the expense. The same consequences flow later if they fall behind the competition. You need to know there’s a good reason for cutting either investment or R&D. Repligen’s R&D cost has fallen due to the recent focus on bioprocessing and cutting the R&D in other areas, by reducing the R&D in each area until a partner is found who will fund it. So long as Repligen don’t underspend on R&D for bioprocessing, the increased cash flow is a positive result.

Poor capital allocation

British retailer Tesco plc invested heavily in large out-of-town stores. Then they invested overseas and neglected the domestic operations. Tesco have since pulled out of Japan and the U.S.A. They used to be the most successful British retailer, but now many of their stores in Britain are too big and in the wrong place. With hindsight, if Tesco had returned cash to shareholders instead of committing to expansion in Japan, China and the USA, it’s likely they would have managed their domestic operations better. This shows:

1) Success can fade due to poor capital allocation (even when a chart objectifies a history of success).
2) Low investment and low management attention can undermine the ability to adapt (as for the British stores).
3) Low investment can undermine a business segment even when total investment is high.

Investors need to be sure that a new direction or the next stage of expansion will produce a sufficient return on cash, rather than be a permanent cash drain, even when the market thinks management can walk on water.

Readers Digest may have followed a similar path, annoying readers with intensive marketing while neglecting their core magazine, although it was probably going out of fashion anyway.

When all the cash from operations is reinvested

A company which reinvests all its cash from operations can be worth buying shares in, but it’s not as clear as when there’s a positive and growing excess of cash from operations over cash into investment. There might be more clarity if the investment is in marketable securities, real estate or anything with a more reliable value than acquisitions or capital equipment. Otherwise, as a minimum, total reinvestment should generally produce obvious and high sales growth over at least a few years.

Sometimes companies have low capital expenditure needs, and investment is hard to distinguish from expense, for instance when new sales staff are hired and it takes a few years for them to build relationships and reach a normal level of sales. Then, total reinvestment looks like revenue growth which is not matched by income or cash from operations (like Enron Corp.’s results, but they were faking, not reinvesting).

In both cases, one question to ask is, could the company make a profit and have net cash coming in, by reducing the investment. Sometimes there’s a race to be the biggest, when there are economies of scale such as a network effect, and reducing investment would risk losing the race. That’s a subject in itself, but probably more knockouts are delivered by the model than in a race between near-equals. It can pay to bet on the winner, even if the company invests heavily to get ahead, but IMO it’s generally safer to invest in a cash3 company, provided it isn’t in such a desperate race or isn’t likely to lose.

Other considerations

Here I ignore the common and obvious considerations such as financial ratios and different approaches to valuing a company, which are well covered by many sources. I’m not saying that investors should ignore conventional measures, but they are more likely to be in the share price already, and I give links for getting up-to-date Altman Z scores which indicate bankruptcy risk. My list is generally unorthodox and I don’t know of any data which might support it, although some items such as related-party transactions feature in writing about fraud.

The headings I use for each company are:

Off-balance sheet financing and special purpose entities *
Cash and cash equivalents definition *
Short-term investments definition
Revenue recognition *
Audits of internal control over financial reporting *
GAAP only
Related-party transactions
Useful life (that physical assets are depreciated over)
Visual exaggeration in charts
Potential CEO dominance
Governance
Poison pills and severance

* Items marked like this * are logically part of the cash3 test 1, but it’s convenient to have a single list of the qualitative things to hunt for in the SEC filings. The Short-term investments definition does not relate to cash3 tests but it’s easy to check while checking the cash definition.

Off-balance sheet financing is included in test 1, but it belongs here with a different focus. The question here is, are management trying to hide liabilities.

The checks might seem over-cautious or distrustful, but I like to know when I’m speculating rather than investing. Warren Buffett has said he has no more good ideas than other investors, just fewer bad ideas, and that’s motivation for finding unattractive indications in areas where management don’t expect investors to look.

The likely result of these checks is to show that a good company is well off being perfect. Digging for dirt is probably more interesting for short sellers, who can pick companies likely to be hiding plenty of it. It’s less fun when you check a cash3 candidate while hoping there’s little to find. I think of this stuff as the company undergrowth, which I see as in-between the main accounts and scuttlebut.

GAAP only

GAAP is Generally Accepted Accounting Principles.

non-GAAP is more or less whatever management prefer, usually omitting stock-based compensation and some ‘one-off’ items. The non-GAAP ‘EBITDA’ measure is Earnings Before Interest, Tax, Depreciation and Amortization. Non-GAAP metrics usually make earnings look bigger or smoother.

There are some limits to non-GAAP, as the SEC objected to Delphi Corporation’s misleading non-GAAP “Operating Cash Flow”, but that’s a rare case and the SEC might not have bothered if Delphi hadn’t committed other offenses.

While non-GAAP measures have their uses, I believe that one of those uses is to frame the information that investors use to evaluate the company, in the same sense that a stage magician frames the audience’s attention. Some managements risk manipulating GAAP quantities, and it’s likely that there’s more deception in non-GAAP measures where management can use the definitions they find most convenient, with little risk from regulators. Argument about non-GAAP metrics is unlikely to be resolved soon or by facts. I haven’t checked for changes in the non-GAAP metrics, and it signals trouble when management change the ruler so they can read off the number they want. Out of the first three companies I’ve identified as cash3 possibilities, two (IPGP and RGEN) stick to GAAP, which is intriguing, although a sample of three is too small to draw a conclusion. Ubiquiti’s non-GAAP only excluded stock-based compensation and a tax adjustment, which is minor compared to many companies, such as door maker Masonite International (for example) who’s Adjusted EBITDA magics loss into profit with a long list of exclusions.

Ubiquiti’s older non-GAAP reconciliations had higher share counts which are more accurate when used to calculate fully diluted per-share quantities. Find “higher share counts than are used in the income statements” below. This shows that useful information can be put in the reconciliation, although IMO it would have been better to include fully diluted figures in the income statement.

Related party transactions

Check related party transactions for anything big and suspect. There could be more information in a Schedule 14A filed with the SEC. There ought to be a policy for conducting ‘arms-length’ related party transactions. You want to see something like:

‘… which were ordinary course of business transactions conducted on an “arm’s length” basis with the Company …’

for each material related party transaction.

Useful life

Checking the ‘Useful life’ assumptions in the 10-K could reveal manipulation of earnings by under-depreciating physical assets. I’m less interested in the Useful life of buildings, as this is long and variable, and the condition of some buildings can depend on design and maintenance rather than age. ‘Useful life’ doesn’t affect cash, but it’s a quick and easy check for aggressive accounting.

Visual exaggeration in charts

Designed to mislead

I like to see if a company’s charts are an insult to the intelligence of investors. The exaggeration is not a crucial or a conventional indicator, but I can’t help noticing it anyway when I look at a presentation. Charts in presentations often give an exaggerated impression of growth by starting the Y-axis well up from zero, and when only two vertical bars are shown, a one percent rise in the figures can be a massive rise visually, limited only by the number of vertical pixels used.

Door maker Masonite International are far from being cash3, and they have a chart which makes a 25% rise look like a 247% rise. (I counted the pixels and did the math.) You can get the truth by reading the narrow-font numbers on the chart, but if you have to do that, what’s the point of the chart? The chart is for Adjusted EBITDA, on page 12 of the Q2 2013 Earnings Presentation Final pdf. You’d think that all the exclusions in Adjusted EBITDA would be enough, but apparently not.

For comparison, I checked a presentation from IPG Photonics (Needham conference, August 2013), and of the 16 charts with a Y-axis, every one of them starts with Y set to zero where it meets the X-axis. Apart from one minor offense by IPG Photonics, I haven’t seen any misleading charts for the three possible cash3 companies, although in Ubiquiti’s case, I didn’t find any charts with axes to fiddle.

Potential CEO dominance

By ‘Potential CEO dominance’ I don’t mean a CEO who is overbearing personally, which I wouldn’t usually know about. A CEO who is a founder, long serving, has seen the company through a crisis or a period of high growth, has high ownership, or holds too many offices such as chairing the company or also being the CFO, is more likely to be hard to disagree with, and able to get their own way when they shouldn’t, although they might never take advantage of their excess power. When they’re good, there’s a ‘key personnel’ risk, especially when they’re old.

In my own experience, companies with potential CEO dominance have generally done well (Acacia Research was an exception), but that’s based on a small sample.

One risk to watch out for when the CEO is very dominant, is the CEO becoming more interested in a ‘new baby’ or smaller company which allows the CEO to revert to a more entrepreneurial style. It could be more than just the CEO’s attention that walks. Key staff could move, and I’d pay close attention to related party transactions and anything that affected both companies. I see no immediate cause for concern for the three companies I’m writing about, but it’s generally a risk to watch out for rather than a risk that can be ruled out for years ahead.

Incorporation

Nevada, Delaware and sometimes Wyoming are supposed to offer greater secrecy and tax advantages to companies incorporated there, than other states. Delaware is popular for many kinds of company, and this article argues that it’s not a particularly lax state for company registration, although incorporation is quick and easy.

Nevada ups the ante on Delaware’s tax status” by Michael Knigge, April 16 2013 (dw.de).

IPG Photonics, Repligen and Ubiquiti are all incorporated in Delaware.

Going by the last two paragraphs of the article, incorporation in Nevada is a huge red flag to investors, as company officers and directors have major exclusions from liability when they don’t act in the interests of shareholders. (That applies to the company you invest in rather than the subsidiaries they own.)

The article is light on the Delaware laws that allow anti-takeover provisions.

When states compete for incorporation business, it’s about tax advantages, ease and speed of incorporation, and allowing management to get away with more. Imagine that competing to make management more accountable gained more incorporations, and you’re imagining a very different world where shareholders have more power.

In practice, checking ’14A’ forms and finding disclosures about the Certificate of Incorporation and the Bye laws, is likely to be more useful than just finding the state of incorporation, although it’s a lot of work and you’re likely to find that a company is as bad as most (see ‘Common failings’, below). Searching a 10-K for ‘Delaware’ or whichever state, can turn up some of the things that a company doesn’t brag about.

This article shows how complicated the legal situation is, if nothing else: “Delaware must fix state takeover law now, law professor warns” by Frank Reynolds, Nov 26, 2013 (blog.thomsonreuters.com)

Searching a 10-K for “Incorporation” sometimes finds ‘get-outs’ that undercut claims about the standard of governance, such as IPG Photonics being able to have a board with only one director.

Poison pills

Technically, it’s the broader category of anti-takeover provisions that I look at, although I find the provisions poisonous enough.

The provisions are usually triggered when a shareholder accumulates a set percentage of the company’s shares, normally in the range 15% to 25%. When the provisions are triggered, the board is typically authorized to issue stock (usually preferred stock), and the stock won’t be issued to the shareholder who triggered the provisions. Various provisions make the board unaccountable to shareholders, and there can be a provision requiring a ‘supermajority’ to change the provisions, meaning that 51% of shareholders won’t be enough.

Two academics show evidence that companies with more anti-takeover provisions are likely to be more transparent and more honest about earnings (providing the market with more information, and with higher earnings quality, one measure of which is Cash from Operations / Net Income). “Anti-Takeover Provisions and Corporate Disclosure” by Huijing Fu and Mark H. Liu, May 2008 (gatton.uky.edu). That’s different from the effect on shareholders if the poison pills are taken, and the paper doesn’t show that the provisions encourage good management in other ways.

Anti-takeover provisions might limit the influence of activist shareholders (Wikipedia), because without voting power all they can do is litigate and irritate, but I can’t find evidence. The activists seem to be popular with investors, and I approve when they want to cut undeserved CEO compensation, or fix other wrongs, but they can want a short term gain that could cause long term damage, such as cutting R&D. Some investors are hoping that an activist will make big data company Tibco Software Inc. spin-off the Business Optimization unit, with the corporate engineering needed to preserve the software stack. I prefer management to stay focused on strategic issues and the details that matter without distractions.

This is a short balanced piece about the inventor of the ‘poison pill’ challenging supporters of activism: “Lipton Takes on Bebchuk over Shareholder Activism” by Gregory J. Millman, September 30, 2013 (blogs.wsj.com). My opinion is I’m not convinced by pro-activist statistics, or by assertion from the opinionated poison pill inventor. Management can be self-serving but care about the long term, while activists can want a short term profit that some investors are happy to share. An activist is no substitute for good management.

I haven’t found any good examples of shareholder losses due to anti-takeover provisions being triggered, probably because the provisions effectively deter hostile takeovers. The cost to shareholders will be the cost of entrenched management, with the power to negotiate agreed takeovers that suit themselves if they want to. I also believe the anti-takeover provisions and the policy on indemnification of officers, directors and others, says something about management’s attitude to themselves and shareholders.

There’s more under “Anti-takeover provisions against shareholders’ interests” and to be found by searching for “Poison pills”.

Severance payouts

It would be consistent to include the maximum possible severance payouts in the obligations, commitments and contingencies, but I don’t think it’s a good idea in practice. I believe the severance terms for executive officers are worth checking, mostly to see if they are excessive in the event of the company being acquired, and I use the sub-heading ‘Poison pills and severance’. In the case of Costa, Inc., payouts relating to management incentives were at least big enough that an author felt the need to explain the effect on the offer price. The article is now behind the ‘Alpha Rich’ paywall. “Costa Buyout Price Is Too Low, Fair Value $24-28” by Dr Hugh Akston, Nov 11 2013 (seekingalpha.com).

Choose your factors

There are many other factors which could be considered, and investors are likely to have their own favorites.

Diligence

It’s possible that when a company ticks the cash3 boxes, some non-cash quantities in the accounts are not quite as important, at least in comparison to companies with net debt, negative cash from operations, or negative free cash flow. Bear in mind that ‘one-offs’ adding to cash from operations will probably be disclosed in the income statement and not in the cash flow statement. Ratios like the quick ratio or current ratio don’t seem relevant to cash3 companies, and the quality of earnings ratio (Cash from Operations / Net Income) looks less relevant. However, I’m wary of saying that anything can be safely ignored, even though investors have limited time, because in the worst cases management can be very slippery.

Boilerplate

I’ve quoted some risks from Form 10-Ks in my writing about companies below. The risk section of a 10-K usually contains a tedious list of every possible eventuality, and readers need to decide if I’m making too much of the risks I quote. Something I haven’t done, purely because I don’t have the time to do everything, is compare each company’s risk lists to earlier versions. A new risk or an amended risk could signal trouble, if it isn’t obviously reasonable, but I think you are more likely to see the risk-change red flag for a company with cash trouble than for a company which is cash3 or not far off.

About gurufocus’s scores

There are links to gurufocus for each company. I once happened to notice their scores changing a lot over a weekend without any news I could find, although it was for quite a small and controversial company with an OTC listing (Ecosphere Technologies). I suggest checking the chart at the bottom for the M-Score and Altman Z score, as well as the number. They also have an explanation of the M-Score. The service is free but you can’t do much without getting a sign-up page which you need to close. I also think they are probably too enthusiastic about red flags, which you can’t find out about without signing up.

Common failings

Wide indemnification

Find “There are two main kinds of indemnification” for a general description of companies’ indemnification. If needed, refer to “Forms filed with the SEC (Securities and Exchange Commission)”

IPG Photonics and Repligen seem to indemnify anyone and everyone for everything, and hold no-one liable for anything, then put in exceptions, then complicate it. Sometimes the indemnification looks simpler and more reasonable in a 10-K than on other SEC filings (usually S-1 forms, sometimes when they have the Certificate of Incorporation), but I don’t feel particularly reassured by the 10-K. If the end result is that management can do what they like without personal consequences, it doesn’t stop companies from bragging about high standards of governance. See ‘IPGP – Indemnification’ below, for how indemnification can be so extreme that it might not be enforceable. IPG claim:

“We believe that these provisions, the indemnification agreements and the insurance are necessary to attract and retain qualified and experienced directors and officers.” (S-1 SEC filing, November 14, 2006)

I found no evidence of such insurance in IPG’s latest 10-Q and 10-K filings.

Ubiquiti’s indemnification looks wide enough, but unlike the other two, apart from business partners such as distributors and OEMs (which is reasonable and necessary), they seem to only indemnify directors and officers, and “have a director and officer insurance policy that limits our potential exposure.” I can’t be sure the other two companies don’t have equivalent insurance just because it’s not mentioned (or I missed it) in recent 10-Q and 10-K SEC filings, but if they don’t insure, and it’s because the insurance is unavailable or very costly, it suggests that the associated risk is either very high or too hard to estimate.

While indemnities and not holding persons liable, add to the contingencies-risk, in practice it isn’t quantifiable. Statements that the liabilities have been minimal are not a reliable guide to the future, because the first big case or wave of cases will be a shock, unless the company has a very bad history. Banking is the most obvious area where the cost of managers’ lack of ethics and diligence falls on many parties including shareholders but not much on themselves. This is on advert-intensive Investopedia: “10 Most Shameful Bank Scandals Of 2013” By Investopedia on December 31, 2013.

This famous case shows how impulsive management can be: “Head of AOL fires employee during conference call” By Jena McGregor, August 12, 2013 (washingtonpost.com).

This is old, British, and about a private company, but it’s relevant because while the gaffe nearly sunk the company, it was not committed in bad faith, and illustrates the kind of disaster that would not be excluded from indemnification: Gerald Ratner (Wikipedia) made disparaging comments about his jewelery firm’s products, not realizing how much publicity he would get. His remarks included that some of the earrings were “cheaper than an M&S prawn sandwich but probably wouldn’t last as long.”.

Companies claim that indemnification is needed to attract quality, but somehow much of private equity gets along with the low quality people they have to make do with as a result of offering less indemnity. See “For Executives Seeking Absolution, a Double Standard” By STEVEN M. DAVIDOFF, November 23, 2010 (dealbook.nytimes.com)

Anti-takeover provisions against shareholders’ interests

IPG Photonics and Ubiquiti Networks have anti-takeover provisions that seem potentially bad for shareholders, beyond the effect of deterring acquisition attempts. It’s not clear if Repligen Corporation replaced the anti-takeover provisions in their Shareholder Rights Plan which was due to expire last year. Anti-takeover provisions MIGHT work out well if a 15% stake results in all the other shareholders getting stock, which effectively takes some of the 15% ownership and spreads it around. But, I haven’t seen anything that I would like to rely on, to indicate anything other than potential harm to the interests of ordinary shareholders.

Readers with the time and interest can use links I provide to start looking into the indemnification and anti-takeover provisions.

Loose definition of Cash and cash equivalents

IPG Photonics say “Cash and cash equivalents consist primarily of highly liquid investments …”. The ‘highly liquid investments’ get a safe definition, but what does ‘primarily’ mean in practice? Would the person responsible have any regrets if ‘primarily’ turned out to mean 51%, or 50%, or 49%? Probably not, because if there isn’t enough wiggle-room in the word, everyone is indemnified and no-one is held liable, as above. IPG’s short-term investments have ‘remaining maturities greater than three months’, in other words they might not be short-term at all and still meet the definition. IPG bought $25.5 million short-term investments in 2011 and they matured in 2012, so they weren’t long term, but the definition still leaves leeway for future use. I give IPG the benefit of the doubt because they seem reasonably honest by other measures, but there’s room for opinion.

Ubiquiti also use “primarily” in their definition, and leave a loophole (see “UBNT – Cash and Cash Equivalents definition” below).

Repligen at least say “high credit ratings” without fudging the issue with “primarily”, but there’s no information about maturity or what exactly the “financial instruments” are. See “RGEN – Cash and Cash Equivalents definition”.

Companies seem incapable of just saying what cash and cash equivalents are, and that nothing else qualifies.

It’s cash3. What’s next?

After all the research, an investor should have a good understanding of the company, and if anything bad enough had been found, the research should have been stopped.

A summary like the ones I’ve made for each company might be useful.

Apart from saying that valuation needs to be considered, I don’t want to tell anyone how to make their investment decision.

At this point, it’s worth thinking about asset sales that would add value. The assets could be unused or underused real estate, or part of the business that could be spun off. The critical factor here is that the capital could be allocated better, and there should be a reason to expect the reallocation to happen, or a rough estimate of the probability (as in possible, likely, probably etc.). The same principles apply to possibilities other than sales, such as employing the assets in joint ventures or licensing technology.

Another category that can add to the value of a company is ‘spare liquid assets’ such as marketable securities. Assessing the value added means deducting the value of any income the securities produce from the market value, or possibly an estimate based on the likely return if the cash was reinvested in the business, including buying back shares. Marketable securities don’t need a catalyst or a plan to have their market value, and anything else sufficiently liquid to have that characteristic can be included in the ‘spare liquid assets’ category if it could be sold without affecting the normal business operations.

Obviously these considerations would be too restrictive for companies focused on the value of assets such as real estate, but those companies aren’t going to be ‘cash3’. The considerations exclude the value of capital assets used in normal business operations, such as machinery. I explain why with a model –

Suppose companies A and B have results as identical as possible, except that company A has $1 billion of plant, property and equipment (PPE) while company B only has $1 million of PPE, and for both companies all the PPE is needed for production. Company A has the biggest liquidation value, but for growing businesses the liquidation value is (hopefully) irrelevant (except for the ability to provide collateral for debt). Company B’s advantage is that it can expand production with much less capital.

If you don’t agree about the potential of that advantage to translate into growth, see the walk charts under “Ubiquiti Networks – test 2 and 3”. There are counter-arguments, such as high capital costs are supposed to deter entry (although steel, shipping etc. regularly have over-capacity). If IPG Photonics had a vast land bank they could sell, I’d be interested, but if the fair value of all IPG’s PPE increased by 20% next year, there wouldn’t be much cash benefit, and if the increase was the result of general global price movements, expansion would be more expensive and reduce the return on investment.

IPG would have got nowhere without high capital expenditure, and capex increases the PPE value, but it’s even better when high growth can be achieved with low capital expenditure, which IMO is why a high PPE can’t be assumed to add to the fundamental value of a company.

If company C was like my hypothetical company B except it owned and used a building worth $50 million, and could move to a cheaper building costing $20 million without affecting its business except for $1 million moving costs, then it’s potentially worth $29 million more than company B. How you include or discount the the $29 million is another matter, but you’d need to know how likely the move was to actually happen.

~

IPG Photonics Corporation (IPGP)

Share price $74.23, Market cap $3.8 billion, Price/Earnings (ttm) 25.3, No regular dividend. As at January 17, 2014. The figures are approximate.

IPG sell lasers and laser systems. In “IPG Photonics – growth, cash, markets and technology” September 27, 2013, I looked into their long term cash flows, and their liabilities, obligations, commitments and contingencies.

To get up to date to 3Q 2013:

IPG Photonics Reports Record Revenue Achieved in Third Quarter 2013
IPG Photonics’ SEC filings (ipgphotonics.com)
IPG Photonics’ CEO Discusses Q3 2013 Results – Earnings Call Transcript” Nov 1 2013 (seekingalpha.com)

Read this if you like but I don’t think it’s very relevant “Insiders Are Selling IPG Photonics” Oct 25 2013 (seekingalpha.com)

Seeking Alpha’s “Is IPGP a buy?” page.

(“IPG Photonics – Power To The Last Mile” is a Seeking Alpha ‘pro’ article, for subscribers only.)

Beneish M-Score for IPG Photonics (IPGP) (gurufocus.com)
Altman Z score for IPG Photonics (IPGP) (gurufocus.com)
See “About gurufocus’s scores” above.

IPG Photonics have grown mostly by developing fiber lasers for industrial use. Competitors were skeptical about the progress of fiber lasers, but have been forced to reconsider and develop their own fiber lasers in recent years. IPG have the advantage of a high degree of vertical integration. One growth area is high power fiber lasers, where IPG are rapidly increasing the power. Although the power is dwarfed by super-lasers (e.g. used for fusion research), these don’t have the commercial potential of IPG’s lasers.

The seam-stepper laser system used for welding could have growing sales in automotive production, with the advantage of not needing an expensive light-tight safety cell. IPG expect good demand for new ultraviolet lasers with semiconductor-related applications. The company has supplied lasers used in additive manufacturing for several years, with the growth of metal-based applications recently outpacing the plastics applications. Further growth is expected as IPG’s higher-power lasers are used to additively manufacture bigger metal parts.

IPG are also competing more at the low end, where cheap lasers from China are used for marking. The company expects new low cost fiber lasers to replace some YAG lasers, which are cheap to buy but require frequent lamp replacement. There are possible threats from emerging laser technologies (see my piece on this site, linked to above). IPG’s gross margin is kept in the 50% to 55% range, well above competitors’ margins.

IPG Photonics – test 1

Test 1 – More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.

From the 3Q 2013 10-Q, as at September 30, 2013, in thousands:

Cash and cash equivalents $398,355

Total current liabilities $105,807
DEFERRED INCOME TAXES AND OTHER LONG-TERM LIABILITIES $16,635
LONG-TERM DEBT, NET OF CURRENT PORTION $11,667
Total liabilities $134,109

+ $398,355 Cash and cash equivalents
– $134,109 Total liabilities
= $264,246 Cash and cash equivalents net of Total liabilities

Next I see which possible future costs not already included, can be quantified and included in obligations, commitments and contingencies.

Obligations, commitments and contingencies

    IPGP – Indemnification

Wide indemnification and holding harmless isn’t unusual, but this shows how far IPG go:

“We also maintain general liability insurance which covers certain liabilities of our directors and officers arising out of claims based on acts or omissions in their capacities as directors or officers, including liabilities under the Securities Act. Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers, or persons controlling us pursuant to the foregoing provisions, we have been informed that in the opinion of the SEC such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable.” (my italics) (Form S-1 dated November 14, 2006)

In other words, IPG’s indemnification has gone so far that the SEC believes it couldn’t be enforced. While the quote is old, it’s not the kind of thing that gets updated regularly.

The only ‘insurance’ I found in the 10-K for 2012 was under “Environmental Regulation” and nothing to do with indemnification. The rest of this part is fairly standard.

From “EX-3.2 FORM OF SECOND AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF THE REGISTRANT” (sec.gov), which is old but is referenced from the 10-K for 2012:

“SIXTH: Indemnification and Advancement of Expenses

Section 6.1. Right to Indemnification. The Corporation shall indemnify and hold harmless, to the fullest extent permitted by applicable law …”

just about anyone … “director, officer, employee or agent of another corporation or of a partnership, joint venture, trust, enterprise or nonprofit entity, …”

However there are so many ‘ifs’ and ‘buts’ I lose track of whether a nested clause means more or less indemnification.

An old S-1 dated November 14, 2006, lists exceptions to the indemnity and holding harmless, for directors:

http://www.sec.gov/Archives/edgar/data/1111928/000095013506006933/b61608a3sv1za.htm

“breach of the director’s duty of loyalty to us or our stockholders, (2) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (3) in respect of unlawful dividend payments or stock redemptions or repurchases or (4) for any transaction from which the director derived an improper personal benefit.”

I can’t promise that’s still current. IPG admit:

“These provisions may also have the effect of reducing the likelihood of derivative litigation against directors and officers, even though such an action, if successful, might otherwise benefit us and our stockholders” and investors are hit “… to the extent we pay the costs of settlement and damage awards against directors and officers …”. (the S-1).

The indemnification of OEMs against third-party infringement claims is reasonable (going by the 10-K for 2012).

    IPGP – Legal proceedings

Under “12. COMMITMENTS AND CONTINGENCIES”, IPG are being sued,

“… for misappropriation of certain trade secrets, unfair trade practices, and correction of inventorship on a patent owned by the Company related to beam couplers and beam switches. The plaintiff seeks damages in an unspecified amount, double damages for misappropriation of trade secrets and treble damages for unfair trade practices. The Company has filed to dismiss the trade secret misappropriation claims. The Company intends to vigorously defend the claims. At this time, no loss is deemed probable and no amounts have been accrued in respect of this contingency.”

I can’t put a figure on the legal action, so it doesn’t feature in test 1. Nothing else is mentioned under the section.

    IPGP – Pension commitments

I found no mention of pension commitments. Only a 401(k) retirement savings plan and the employee stock purchase plan (at a discount) are listed under ‘EMPLOYEE BENEFIT PLANS’. I regard them as expenses rather than commitments, and for 2012 the 401(k) cost $848 and the benefit plans corresponded to $452 of compensation (in thousands). From the 14A dated 04/15/2013, about the top five officers, “None of our Named Executive Officers participates in or has an account balance in qualified or nonqualified defined benefit pension plans sponsored by us.” They say they might adopt a defined benefit pension plan in the future, but might only be leaving open a remote possibility.

    IPGP – Interest obligations

To get the interest obligations associated with long term debt, I use the 10-K figures to calculate the Long-term debt and subtract it from the debt + interest (in thousands):

LONG-TERM DEBT, NET OF CURRENT PORTION $14,014
Current portion of long-term debt $1,505
LONG-TERM DEBT = $15,519 (from adding the figures above)

Long-term debt obligations (including interest) $16,127
– LONG-TERM DEBT $15,519
= $608

which is fairly negligible.

Some of the interest on the debt is variable. Under the ‘MARKET RISK’ section, “we do not believe that a 10% change in market interest rates would have a material impact on our financial position or results of operations.”, so it’s unlikely that IPG are vulnerable to interest rate rises, especially as they have much more cash than debt. (It would be odd if they were contractually unable to pay off long term variable-rate debt without a big penalty, when they hold so much cash, although I haven’t checked where the cash is held).

Note, the figure for ‘Long-term debt obligations (including interest)’ can’t be used directly, because the debt is already in the ‘Total liabilities’ figure.

    IPGP – Contractual Obligations

From the 10-K for 2012 (in thousands):

Operating lease obligations $11,774
Purchase obligations $8,921
(commitments to buy)

From the 3Q 2013 10-Q (in thousands):

Contingent consideration $375
(payments to previous owners of acquired companies, depending on performance)

The Contingent consideration might be on the balance sheet but I saw no specific indication. From the 10-K for 2012:

“Total possible additional payouts under these earn-outs are $18,500. The Company has accrued a liability of $2,452 related to these contingencies.”.

I could say, the liability is accrued so it should already be on the balance sheet, or I could say, the most conservative estimate is the 2012 “Total possible additional” $18,500. The consideration fell massively between the 10-K and the 10-Q, and the $18,500 maximum might have fallen proportionately. I’m going to stick with $375, but feel free to adjust my figures if you disagree. The $18,500 maximum is small compared to the $242,568 ‘test 1 surplus’ I calculate (still all in thousands).

    IPGP – Quantified obligations, commitments and contingencies

See “IPGP – Interest obligations” and “IPGP – Contractual Obligations” above. Most of the sum is from the 10-K from 2012.

(in thousands)

Interest obligation $608
Operating lease obligations $11,774
Purchase obligations $8,921
Contingent consideration $375

Total obligations, commitments and contingencies = $21,678

    IPGP – Cash, net of everything quantified

To sum up for IPG Photonics (in thousands):

$398,355 Cash and cash equivalents
$134,109 Total liabilities
$21,678 Total obligations, commitments and contingencies

and

$398,355 Cash and cash equivalents
$264,246 Cash and cash equivalents net of Total liabilities
$242,568 Cash and cash equivalents net of Total liabilities, Obligations, commitments and contingencies

That’s over $242 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify. This isn’t easy, and please feel free to check my deductions and look for more.

See also “IPGP – Unquantified” under “IPG Photonics – Summary”.

IPG Photonics – test 2 and 3

Test 2 – Cash from operations has to be positive and generally bigger than the cash that goes into investment.
Test 3 – A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

IPG cash from ops and into investment - spread

IPG walks for cash from ops and into investment

IPG walks per share for cash from ops and into investment

The height of a point above the green diagonal corresponds to cash from operations minus cash into investment, which is one definition of free cash flow. The second set of charts are per share, because it’s easy to increase free cash flow by raising equity and investing it with a low return, but raising equity dilutes the free cash flow per share.

I would describe the competition in IPG’s markets as serious, but with IPG’s gross margin over 50% it’s hardly cut-throat on price. I don’t see any reason for the market for industrial lasers to stop growing, although any kind of equipment used in production is likely to see sharp falls in demand during major economic downturns. Therefore I see no likely reason for IPG Photonics to have negative cash from operations, or to slow to permanently below average growth of cash from operations minus cash into investment. My cash flow walk charts show positive cash from operations every year, with only one year of decline. The cumulative free cash flow was much more positive by 2012 than it was negative in 2007 and 2008. Negative free cash flow is often taken as a warning sign, or even a sign that cash flows are being manipulated, but in IPG’s case the performance after 2008 shows that the investment produced a good return.

My “IPG Photonics – growth, cash, markets and technology” September 27, 2013 (already linked to) has a table showing the compound annual growth rate (CAGR) in cash from operations per share for any pair of different years from 2004 to 2012. The growth between 2004 and 2012 is equivalent to 39.1% CAGR (compound annual growth rate), with a -60% blip down from 2006 to 2007. Growth has not tailed off, with 89.6% from 2011 to 2012.

In recent quarters, increased R&D, inventory, and SG&A have affected results. I believe that given their history and their statements, the most likely reason is that IPG are investing for growth, which is not all through capital expenditure or accounted for as cash into investment. There’s a risk that I’m wrong, and a risk that demand won’t materialize to justify the investment. IPG hold a lot of inventory because they test their lasers and laser systems thoroughly, which adds to the expense ahead of expansion, and to the cost if the expansion doesn’t materialize, although I’m confident that it will.

IPG Photonics – other considerations

This is a selection, not ‘everything else’.

    IPGP – Off-balance sheet financing and special purpose entities

IPG don’t declare they have no off-balance sheet financing or special purpose entities (as Repligen helpfully do), but I didn’t see any sign of either. I searched the 10-K for 2012, and the 3Q 2013 10-Q, for key words and phrases, with no hits for ‘off-balance’ or ‘off balance’. The word ‘entity’ had some innocent uses, with nothing worse than a small related party transaction in 2010. The only ‘entities’ were customers such as universities, ‘special-purpose’ meant equipment, and ‘vehicle’ was the kind you drive.

IPG list thirteen subsidiaries, with none of them in the Cayman Islands. The incorporation locations are Delaware, U.S.A. (twice), Germany, United Kingdom, Russia, Italy, Japan, India, South Korea, Hong Kong, China, Alabama, U.S.A., Turkey, and all are 100% owned by IPG. The list corresponds to IPG’s operations and the locations of acquisitions. I’d like to know what IPG Investment Corp. Delaware, U.S.A. do, but there’s no explanation in the 10-K (companies don’t have to break down their activities by subsidiary).

    IPGP – Cash and cash equivalents definition

As mentioned above, “Cash and cash equivalents consist primarily of highly liquid investments …” contains the vague word ‘primarily’.

    IPGP – Short-term investments definition

As mentioned above, IPG’s short-term investments don’t have to be short term to meet the definition.

    IPGP – Revenue recognition

“We recognize revenue in accordance with Financial Accounting Standards Board (“FASB”) Accounting
Standards Codification (“ASC”) 605. Revenue from orders with multiple deliverables is divided into separate units of accounting when certain criteria are met. These separate units generally consist of equipment and installation. … Equipment revenue generally is recognized upon the transfer of ownership which is typically at the time of shipment. Installation revenue is recognized upon completion of the installation service which typically occurs within 30 to 90 days of delivery. Returns and customer credits are infrequent and are recorded as a reduction to revenue. Rights of return generally are not included in sales arrangements.”

(from the 10-K for 2012)

That’s probably acceptable, although I doubt if anyone would be jailed if “generally is recognized upon the transfer of ownership” turned out to mean only 60% of the time. ‘the time of shipment’ is not the same as when the equipment is on the customer’s premises, but that shouldn’t matter so long as ‘transfer of ownership’ has occurred.

    IPGP – Audits of internal control over financial reporting

“In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, …”

Deloitte & Touche LLP

IPG also get “an unqualified opinion on those financial statements.”, the best review accounts can get from auditors.

    IPGP – GAAP only

IPG stick to GAAP, and I’ve only seen them use EBITDA when disclosing information about covenants. Lenders usually insist on borrowers agreeing to covenants, where the terms change if the covenants are breached. It’s common for covenants to involve EBITDA.

    IPGP – Related-party transactions

Related-party transactions are not big enough to be a major concern, in my opinion. The biggest figure (in thousands) is in “The payments made for such services totaled $3,973 of which $3,967 were made prior to that outside director being appointed to the Company’s board.”

    IPGP – Useful life

Asset category / IPG Useful life in years
Buildings / 30
Machinery and equipment / 3 to 5
Office furniture and fixtures / 3 to 5

To show how conservative that is, here’s door maker Masonite International’s numbers:
Buildings / 20 to 40
Machinery and equipment / 5 to 12
Fixtures and fittings / 10 to 12

    IPGP – Visual exaggeration in charts

The only graph I’ve seen by IPG with Y above zero where the X axis met the Y axis, was for gross margin, in a Schedule 14A. The numbers were clear and the offense isn’t serious.

    IPGP – Potential CEO dominance

From the 10-K for 2012, the CEO, Dr. Valentin P. Gapontsev, is also the chairman, and through three trusts he created and a UK company, he controls about 35% of the votes. Dr. Valentin P. Gapontsev is also the key founder of the company. For more, find “and have a significant influence on the outcome of director elections” in the 10-K.

    IPGP – Governance

“We endeavor to maintain high governance standards with respect to the oversight of our executive compensation policies and practices.” (the 14A dated 04/15/2013).

From the 10-K for 2012:

“The Company’s Certificate of Incorporation provides that the size of the Board may be from one to eleven directors.”

See also ‘IPGP Indemnification’, above, and ‘IPGP Poison pills and severance’, below.

IMO the best guarantee shareholders have is that the CEO benefits financially from his large shareholding.

From “Valentin Gapontsev, Worcester’s aging billionaire” By Peter S. Cohan, Dec 2 2012, (telegram.com), Valentin was 73 years old then.

    IPGP – Poison pills and severance

From the 10-K for 2012:

“Anti-takeover provisions in our charter documents and Delaware law could prevent or delay a change in control of our company, even if a change in control would be beneficial to our stockholders.”

“These provisions include:

• authorizing the issuance of “blank check” preferred stock;
• establishing a classified board;
• providing that directors may only be removed for cause;
• prohibiting stockholder action by written consent;
• limiting the persons who may call a special meeting of stockholders;
• establishing advance notice requirements for nominations for election to the board of directors and for proposing matters to be submitted to a stockholder vote; and
• supermajority stockholder approval to change these provisions.”

It’s presumably management’s interests that are above stockholders’ interests when they admit “… even if a change in control would be beneficial to our stockholders.”

The word ‘include’ means that shareholders who are heavily invested in IPG should look for more, possibly starting with the S-1/A document I link to below.

The key questions are who would be offered the preferred stock, on what terms, are the terms fair to all shareholders except the would-be acquirer, and do all the answers depend on whatever management decide. I don’t know the law well enough to say. Please comment if you can clarify the situation.

The provisions and the CEO’s control of 35% of the votes are probably enough to deter any hostile acquisition of IPG.

This may be intended to cover the retirement or death of the CEO:

“Provisions of our certificate of incorporation and by-laws, including certain provisions that will take effect when Dr. Valentin P. Gapontsev (together with his affiliates and associates) ceases to beneficially own an aggregate of 25% or more of our outstanding voting securities, may discourage, delay or prevent a merger, acquisition or change of control, even if it would be beneficial to our stockholders. The existence of these provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock.”

The quote doesn’t tell me exactly how shareholders will be affected when Gapontsev’s gone, and I don’t find it reassuring.

This S-1/A document from 2006 describes the classified board (the second provision) on page 70. If a shareholder reaches 25% ownership, only a third of the board is re-elected each year, meaning a hostile acquirer can’t get control as quickly. There’s also a fuller description of the provisions under “Anti-Takeover Effects of Provisions in Our Certificate of Incorporation and By-laws” on page 92. My interpretation is that in practice the board ceases to be accountable to ordinary shareholders, due to consequences such as the necessity and impossibility of calling meetings.

I can’t promise the S-1/A is up to date, but it’s referenced from the 10-K for 2012. “AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF IPG PHOTONICS CORPORATION” (sec.gov) (already linked to). It has details I haven’t seen elsewhere, but is very legalistic.

From the Schedule 14A Definitive Proxy Statement filed 04/15/2013, there’s a column showing the payments to executives that would have been triggered if a change in control (take-over) had happened on December 31, 2012, headed “Termination Without Cause or For Good Reason Following a Change in Control”. The payments add up to $16,096,225, with the CEO getting less than half the average of the other four officers included. The figures are based on the end-of-year share price of $66.65. If IPG had been acquired then, it would have been at a higher share price, increasing the payout to management. The CEO’s main benefit would be from his shareholding, which aligns his financial interest with shareholders (he won’t be there forever, though). I wouldn’t expect payments of the type included, to deter a take-over, or drastically reduce the price offered or agreed.

The benefits comprising the payouts are: Salary, Severance and Benefits Continuation; Incentive Plan Severance; and Equity acceleration. The Equity acceleration seems to include restricted stock units and options. (Options that management are rewarded with are usually delayed, but ‘vest’ or become active immediately if IPG are acquired.)

The over $16 million payout, even if doubled to cover a large share price rise, is not massive compared to the $242.6 million cash ‘net of everything’ which I estimated, and if triggered would be small compared to the market capitalization.

Directors also benefit from the immediate vesting of options. That isn’t included in the payout figure.

IPG state “no payments are automatically made to executives upon a change in control (i.e., “single-trigger” arrangements)”, as one of fourteen bullet points under “Corporate Governance Highlights Relating to Compensation”. If automatic payments are a possibility that IPG have chosen to rule out, it suggests the possibility of payments that are not automatic but may be authorized, at least until a relevant limitation is known.

Some companies give existing shareholders more shares without giving any shares to the shareholder that triggers the anti-takeover provisions. That increases the ownership of ordinary shareholders. The situation is sometimes disclosed clearly (although I can’t promise ‘accurately’). If IPG’s blank check preferred stock is fair, or increases the ownership of ordinary shareholders, they ought to disclose the situation clearly.

Slightly off-topic, the CEO is encouraged to use company provided aircraft for security. He reimbursed the company for $268,839.

    IPGP – Not on the list

Under “Liquidity and Capital Resources”, IPG say they received cash for a 10% interest in their Russian subsidiary in 2011, and repurchased a 22.5% redeemable noncontrolling interest in it for $55.4 million in 2012. That might have been to fund investment in Russia in the short period between the sale and repurchase, without international transfers of cash. I’m only mentioning it because to me it looks like the least ‘business-as-usual’ item in the section.

    IPGP – WELCOME ABSENCE

I’ll choose “The 2006 Plan, as amended, expressly forbids the repricing or cancellation of underwater stock options.” (the 14A filed 04/15/2013)

IPG Photonics – Summary

Note – the summaries are selective and are in my own opinion.

$242.6 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify.

Long term growth is most likely to continue.

The anti-takeover issuance of “blank check” preferred stock is an unknown risk to most investors, until it’s adequately explained.

IPG admit “… even if a change in control would be beneficial to our stockholders.” about anti-takeover provisions.

‘generally is recognized’ makes the revenue recognition policy for equipment loose.

‘primarily’ is vague in the definition of Cash and cash equivalents.

IPG’s definition of short-term investments does not require they are short-term.

The CEO could potentially dominate.

    IPGP – Unquantified

The $242.6 million ‘net of everything’ excludes: Alleged trade secrets theft and unfair trade practices related to beam couplers and beam switches. The risk of infringing intellectual property. The potential cost of indemnifying OEMs against third-party claims of intellectual property infringement. General generous indemnification and not holding liable, with exceptions. Defined severance for senior management.

Possible errors include obligations, commitments and contingencies (OCCs) I didn’t find, double-counting an OCC which is included in liabilities, and I might have missed a clear statement that all indemnities are fully insured.

~

Repligen Corporation (RGEN)

Share price $12.63, Market cap $403 million, Price/Earnings (ttm) 18.1, No regular dividend. As at January 17, 2014. The figures are approximate.

You can get the ‘Repligen Presentation at Piper Jaffray Healthcare Conference 12/3/2013’ here. (BTW I could only view the PDF in Firefox.)

Repligen – My Projections For The Income Statement: 2013-2019” by Smith On Stocks, Nov 24 2013 (seekingalpha.com)

How Will the Bottom Line Change for Repligen in 2014?” By Maxx Chatsko, January 11, 2014 (fool.com)

Repligen’s SEC filings (repligen.com) with useful short descriptions of what each form is about.

Repligen Management Discusses Q3 2013 Results – Earnings Call Transcript” Nov 7 2013 (seekingalpha.com)

Seeking Alpha’s “Is RGEN a buy?” page.

Beneish M-Score for Repligen Corporation (RGEN) (gurufocus.com)
Altman Z score for Repligen Corporation (RGEN) (gurufocus.com)
See “About gurufocus’s scores” above.

Life-science company Repligen used to be more focused on developing novel therapeutics and an imaging agent, which was a cash-consuming and uncertain business, with possible high rewards. In 2012, Repligen changed their focus to selling products used in the production of biopharmaceuticals, a market with a more reliable income, high margins and good growth.

Once a therapeutic product has passed clinical trials, changing the production method could mean that long and expensive trials have to be repeated. The risk isn’t usually worth any savings, so the customer is very likely to keep ordering the same inputs for the lifetime of the product. Because of this, Repligen’s market is described as ‘sticky’.

Currently, most of Repligen’s sales are for several forms of ‘Protein A’, used to separate and purify monoclonal antibodies. The other main market is for chromatography columns.

    RGEN – Reducing non-bioprocessing costs

In 2012, Repligen out-licensed their spinal muscular atrophy (SMA) program to Pfizer, who will bear most of the costs of the clinical trials and getting approval from the U.S. Food and Drug Administration (FDA). Repligen have completed their obligations, which included a stage of a Phase I trial.

Repligen are looking for partners to support (and fund) their “HDAC” program (class I histone deacetylase inhibitors targeted at Friedrich’s ataxia). In a Phase 1 study, one of their HDAC compounds showed a dose-dependent improvement observed via a disease biomarker, but produced compounds which could be metabolized into toxins, and one of their other HDAC inhibitors might be better.

Their imaging agent RG1068 is a synthetic human hormone. It’s for patients with pancreatitis (and possibly other diseases of the pancrease), and leads to better results from magnetic resonance imaging. The FDA wanted “additional clinical efficacy” and safety trial data. Repligen expect that any additional development will be mostly funded by someone else.

The FDA’s response about RG1068 was in 2Q 2012, and some time later in 2012 the FDA said what they’d require in an “additional registration study”. Repligen seem hopeful that the information will help them get support from a partner. “additional clinical efficacy” looks like a lack of evidence that the agent is good enough to justify the risk of using it. If anything happened in 2013, it hasn’t made it into the 3Q 2013 10-Q. I won’t be surprised if Repligen don’t find support for the imaging agent, but that’s just my two cents and I’m only going by the disclosures in the 10-Q and 10-K.

A submission to the European Medicines Agency in the first quarter of 2012 was withdrawn due to the focus on bioprocessing.

There’ll be scientists disappointed that their hard work and enthusiasm for RG1068 is going nowhere, but Repligen are doing the right thing and if the imaging agent really has promise, they’re likely to get backing, as much of the work has been done.

    RGEN – Royalty expiration

Repligen’s results will be hit by the loss of royalties that expired on December 31, 2013, and were approximately $12,956,000 for the nine months ended September 30, 2013. From the 3Q 2013 10-Q:

“The expiration of the royalty payments under the Bristol Settlement is expected to have a material and adverse effect on our revenue and operating results. If we are unable to replace the royalty revenues with alternative sources of revenue, we may need to use our existing cash on hand to finance our operating activities, which will have a material and adverse effect on the liquidity of our operations.”

In my opinion, the ‘if’ isn’t all that likely, given the investment case around bioprocessing. If I’m right, and if Repligen are conservative or quiet about their prospects, there may be a better buying opportunity soon, due to the royalty expiration. That depends on various factors which I can’t predict. I don’t know how analysts will react, how long they will take, how well-informed investors are, or if short sellers will be brave enough or see investors stop-losses that encourage them to short-sell the shares. (If the price drops enough, I’ll probably add to my holding.)

The ‘if’ in the quote above isn’t actually contradicted by this quote from the 10-Q, but may be tempered by it:

“Absent acquisitions of additional products or intellectual property, we believe our current cash balances are adequate to meet our cash needs for at least the next 24 months. We expect operating expenses in the year ending December 31, 2013 to decrease as we invest less in therapeutic drug development and simultaneously improve gross margins through greater optimization of our two production facilities and other process improvements we have developed internally.”

The quote is followed by an outline of probable investment in bioprocessing.

Also see “How Will the Bottom Line Change for Repligen in 2014?” By Maxx Chatsko, January 11, 2014 (fool.com) (already linked to)

    RGEN – Customer concentration

From the 10-Q, Bioprocessing Customers A, B and C accounted for 28%, 10%, and 20% of revenue. The now-expired royalties accounted for 26% of revenue, and the expiration will tend to increase the concentration of remaining customers. The percentages for Customers A, B and C varied a lot year on year, for either the third quarter or ‘Nine months ended September 30’, but the overall concentration stayed high. Find “Revenue from significant customers” in the 10-Q for more detail. This is described under ‘Concentrations of Credit Risk and Significant Customers’, and the risk of a big customer ordering less or nothing is acknowledged in the 10-K for 2012 (find “a limited number of customers”). The Piper Jaffray presentation spins customer concentration as a positive which reduces costs (on page 5).

The risk may be less than the customer concentration suggests, due to the advantages of the OPUS range, the need to avoid changing the production process, and long term supply agreements (which it’s likely that customers insist on before using the products).

    RGEN – Chromatography

Chromatography works on the principle that different compounds diffuse through a medium differently. Back when people used ink and blotting paper, this could be demonstrated by dropping black ink onto blotting paper, and seeing different colors round the edges as the blot spread. The technique is used with an appropriate medium to separate substances such as proteins, usually with several stages needed to reach the required purity. From the 3Q 2013 Form 10-Q:

“In the expanding area of flexible biomanufacturing technologies, we have developed and currently market a series of OPUS® (Open-Platform, User-Specified) chromatography columns for use in clinical-scale manufacturing. These pre-packed, “plug and-play” columns are uniquely flexible and customizable to our customers’ media and size requirements.”

“uniquely flexible” may be true, but I’ve seen exaggerated product claims often enough from various companies. If the uniqueness is genuine, there’s no guarantee how long it will last.

The columns can also be swapped in and out to minimize disruption to production.

A column for liquid chromatography is like a pinball machine designed to let a particular kind of ball pass straight through, while other balls get stuck. There are four main kinds of columns, and sometimes mixing them helps to get a higher purity. ‘Affinity’ uses the fact that some things stick together, like antibodies and antigens. In ‘ion exchange’, the acidity of the solution can be tuned to speed either positively or negatively charged proteins through the columns. ‘Hydrophobic’ exploits the tendency of parts of a protein to move out of water if they can. ‘Size exclusion’ means small proteins pass through pores in the matrix and get stuck, while big proteins carry on down the column.

The solution can be pumped into a column or gravity-fed, and a few columns use spin. One trend in analysis is for porous particles in the medium to get smaller, with higher pressure needed to get the solvent into the column at the same rate. There are also columns used for analysis where the medium consists of particles with a porous shell around an impermeable core. There seems to be more variation in chromatography used for analysis than for production, and more written about it, possibly because more substances need to be detected and measured than are produced in quantity, or due to lower concentrations sometimes going into the columns.

This is partly conjecture, and I only write it because small investors might not get anything better on the subject for free. It’s my impression that new techniques are pioneered at small scales and adopted by pharmaceutical scientists, then used in quality control, and later some are applied to production depending on the economics of scaling up. If so, the fact that Repligen’s range starts at ‘bench’ level is an advantage (though not unique), as new techniques can be applied there and moved up the scale as far as is feasible. Advances published in the scientific literature are likely to provide a pipeline of techniques that Repligen and their competitors in chromatography can borrow from, and some new techniques could be available for a license. If the field is as dynamic as I think it is, Repligen will need to keep up its chromatography R&D to win new business in the future.

Here’s some science. I expect less plain English the more academic references there are at the end, and I believe these pieces are surprisingly clear in places considering the number of references.

Newer Developments in HPLC Impacting Pharmaceutical Analysis: A Brief Review” by Michael W. Dong, Ph.D. and Davy Guillarme, Ph.D., July 05, 2013 (americanpharmaceuticalreview.com). 43 references

Protein Purification” by Caroline Ritchie Ph. D., Iowa State University (labome.com). 126 references

Chromatography software is especially useful for optimizing the process, due to the many variables to optimize over. OpenChrom is Open Source, with customization and support provided with the Enterprise version. Like much chromatography software, it’s integrated with mass spectrometry. OpenChrom can handle various data formats, including proprietary formats, and to the extent that OpenChrom is good enough, the need for each chromatography column supplier to provide or develop their own software is less pressing. Relatively cheap, comprehensive, and easy to use software would probably help smaller facilities to optimize their chromatography, reducing the economies of scale and reducing the incentive to outsource column-packing. I haven’t found any software offered by Repligen.

    RGEN – Chromatography competition

Repligen acknowledge “The bioprocessing market is intensely competitive, …” in the 10-K for 2012.

This is essential reading:

Disposable Chromatography: Options Are Increasing” by Eric S. Lange, Dec 10, 2013 (genengnews.com)

I won’t give away genengnews’s figures, but Repligen are number two in market share, well behind the leader, though reasonably well ahead of the rest.

Biggest market share first:

GE Healthcare ReadyToProcess columns (gelifesciences.com). GE Healthcare like to talk about “start to finish technologies” for biopharmaceutical manufacturing.

Repligen OPUS columns (repligen.com) with assurances about performance after shipping. You can attend ‘Dr. OPUS’s Column Fitting Class’, and download a poster if you give some details including company name, and answer a question about what makes changing to disposable chromatography difficult.

Atoll Bio MediaScout columns (atoll-bio.com)

If you google “Scalable Method for Packing Chromatography Columns” you should get to a PDF poster (you’ll see plenty of other results and adverts). I’m not sure how cool the poster would look on a wall, but the method is suggested as useful for clinical and manufacturing scale, though currently it might only be used with Chromabolt columns for early clinical stage manufacturing. The Chromabolts are on castors, and EMD Millipore make much of the ergonomics and testing that the units survive shipping. EMD like massive URLs that don’t work as links.

As the second biggest supplier, Repligen would be the obvious beneficiary of the requirement for a second source of supply, but I haven’t seen such a requirement mentioned during my research. It’s possible that dual sourcing could add some complication to clinical trials.

    RGEN – General competition

“Many of our competitors are large, well-capitalized companies with significantly more market share and resources than we have.” (10-K for 2012)

“We have limited sales and marketing capabilities.” (10-K for 2012)

That wouldn’t matter so much if Repligen had a business model or other factor which gave them a sustained competitive advantage. I’d be glad to learn of an ‘economic moat’, but I don’t see one, apart from management and staff that seem capable. While their sales are ‘sticky’ and their market is growing, that doesn’t guarantee increased or steady market share in the long term.

    RGEN – Pre-packed chromatography columns – prices, margins and competition

Efforts to reduce healthcare costs might make customers more conscious of the cost of their inputs. The pressure on costs could include legislation, following the America Affordable Health Choices Act of 2009. Lower prices erode margins, but would also encourage potential customers to give up in-house column packing in favor of pre-packed disposable columns. If so, then Repligen’s efforts (with some success) to increase production efficiency will become more important.

Against the possibility of future pressure on margins, there’s less incentive for established suppliers to reduce prices generally, as they’ll have customers locked-in for some of their end-products. It’s hard to be sure that suppliers could compete on price for new business while keeping prices up for locked-in customers, and it could depend on the terms of long term supply agreements.

GE Healthcare dominate and have more profit to lose if they compete on price, but may bundle products if it’s not too obviously anti-competitive. Intellectual property rights can get complicated, and GE Healthcare might be in a position to sue Repligen over patents. Repligen may need to sue GE Healthcare over intellectual property, and I wouldn’t be overjoyed to hear it.

However, it’s my impression that General Electric’s industrial segment (i.e. not the financing arm) is more focused on cutting costs and improving margins than on market share. A sufficient return on investment or return of capital to shareholders is also a priority. This may be partly because the CEO was in charge when GE Capital (the financing arm) suffered huge losses. The previous CEO, Jack Welch, was Fortune magazine’s ‘Manager of the Century’, and a tough act to follow. Targeting market share at the expense of profitability wouldn’t go down well. But, GE are keen on new product introduction, which they call NPI and repeat many times. In particular they like to shorten development time (and use the time saved to talk about it 🙂 ). You can download a GE presentation from here (December 18, 2013).

So long as Repligen doesn’t threaten the GE Healthcare profit, GE Healthcare seem likely to stay focused on their profitability and on their “start to finish technologies” for biopharmaceutical manufacturing. With most of the disposable chromatography column market, GE Healthcare might be cautious about anything that could trigger antitrust action. In an expanding market, there will be room for at least the two biggest suppliers to grow profitably, though obviously I can’t guarantee that GE won’t get aggressive.

Investors should still consider the risk of chromatography columns becoming low margin commodity products. Complexity alone is not enough to keep margins up (e.g. many digital devices), but I believe the business-critical nature of the product, the customization and supporting services, and generally high margins in the sector suggest that margins should stay high. I don’t put much faith in sustained product differentiation. I don’t know of a product which Repligen’s columns could purify and GE Healthcare’s columns could not purify, and I can’t be sure that Repligen will have a technical lead over GE Healthcare in chromatography in five or ten years time.

    RGEN – The monoclonal antibodies market

The chart on page 6 of the Piper Jaffray presentation shows how Repligen expect double digit growth of the monoclonal antibodies market over three years, from existing products, with additional growth from any new products. That’s a market where Repligen supplies some of the inputs. IMO Repligen’s Protein A products aren’t likely to fall short of the market growth by much, although I haven’t checked for future patent expirations. I expect increasing market penetration for the new OPUS chromatography columns. Market research estimated that monoclonal antibodies were about 32% of the $160 billion biologics market in 2011 (from the 2012 10-K).

    RGEN – Protein A

Protein A is used to separate and purify monoclonal antibodies because it binds readily to antibodies. I haven’t found a good simple description of Protein A, but this description of antibody binding is fairly simple: “What Is Antibody Binding?” (wisegeek.com).

“Since some of our U.S. patents covering recombinant Protein A have expired, we may face increased competition, which could harm our results of operations, financial condition, cash flow and future prospects.” (10-K for 2012)

However, in the same 10-K Repligen claim trade secrets and know-how relating to the manufacture of recombinant Protein A. The U.S. patent “Nucleic Acids Encoding Recombinant Protein A” was granted in 2010 with a term extension that keeps it in effect until 2028. In living cells, sections of DNA act as templates for making RNA sequences which produce specific proteins. Repligen’s patent looks like it’s for a molecule which does RNA’s protein production job, and the protein is a well known Protein A molecule used in bioprocessing.

GE Healthcare used to make Protein A under license from Repligen (or that’s how it looks), until 2010 according to this old agreement: “Repligen and GE Healthcare Expand Protein A Supply Agreement“.

In “Protein A ELISA Kits” Repligen claim to be the only Protein A maker to provide kits for enzyme-linked immunosorbent assay (ELISA) (Wikipedia), a test that uses antibodies and color change to identify a substance..

    RGEN – Expanded production

Repligen Completes Expansion of U.S. Manufacturing Facility” Company Release – 11/01/2013 07:30

The expansion more than doubled the capacity for producing OPUS pre-packed chromatography columns, with space to expand various activities.

    RGEN – See other sources

Repligen and it’s situation are described well in the Piper Jaffray presentation, Smith On Stocks’ articles on Seeking Alpha, the “MANAGEMENT’S DISCUSSION …” section of the Form 10-Q, and in transcripts on Seeking Alpha. (Smith On Stocks also has a website with some free material about Repligen, but the new pieces are only available to subscribers).

Repligen Corporation – test 1

Test 1 – More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.

From the 3Q 2013 10-Q, as at September 30, 2013, in thousands:

Cash and cash equivalents $42,244

Total current liabilities $8,784
Other long-term liabilities $2,696
Total liabilities $11,480 (my addition)

+ $42,244 Cash and cash equivalents
– $11,480 Total liabilities
= $30,764 Cash and cash equivalents net of Total liabilities

Repligen also have $24,851 of Marketable Securities, with $20,747 due in 1 year or less, and $4,114 due in 1 to 2 years, at fair value (all in thousands).

Next I see which possible future costs not already included, can be quantified and included in obligations, commitments and contingencies.

Obligations, commitments and contingencies

    RGEN – Indemnification

Repligen indemnify Pfizer regarding a licensing agreement for the spinal muscular atrophy program, which Pfizer are now funding, in relation to Repligen’s employees and other matters (with some indemnity from Pfizer in return). I can’t put a limit on the amount.

Repligen “indemnify any and all”, which seems to be directors, officers, employees and agents, “to the fullest extent” permitted by Delaware law. I found nothing about this being insured in the 3Q 2013 10-Q, or the 10-K for 2012, SEC filings. (‘insurance’ only crops up regarding the deal with Pfizer, and a licensing agreement with Families of Spinal Muscular Atrophy.)

Technically, this isn’t indemnification, but it’s about not claiming from directors who’s actions cost the company or its shareholders. I had to go back to a 10-Q from 1999 to get the details for this and the indemnity above. While this looks bad …

“EIGHTH. A director of the corporation shall not be personally liable to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director,”

… the exclusions look good. Paraphrasing, directors can’t get away with disloyalty to the company or shareholders, deliberately not doing things they know they should do, and getting an improper personal benefit. Another exception would need more research. In full, this carries on from the previous quote:

“except for liability (i) for any breach of the director’s duty of loyalty to the corporation or its stockholders, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of the General Corporation Law of the State of Delaware or (iv) for any transaction from which the director derived an improper personal benefit.”

However, directors can be let off the hook by changing the provisions, but can’t be made liable for previous wrongs by changing the provisions.

I found the 10-Q because it contained the Certificate of Incorporation I was looking for. Find “This is how I found Repligen’s Restated Certificate of Incorporation” below (under “Forms filed with the SEC (Securities and Exchange Commission)”).

It’s likely that the old 10-Q is up to date about the Certificate of Incorporation, as it was referenced from the 10-K for 2012, but I can’t promise.

    RGEN – Pensions etc.

I haven’t included any figures for obligations to staff. The 10-K for 2012 lists $532 thousand paid, regarding a pension plan in Sweden, and not much else.

    RGEN – Legal proceedings

Repligen expect to win a tax dispute with the Commonwealth of Massachusetts, and have not recorded a reserve. If they lose, appeals could take several years. The cost of losing is estimated at $2.5 million, there is no specific reserve for it, and I include the figure in my OCC calculation.

Apart from the tax dispute, Repligen aren’t aware of any proceedings or claims that would have a material adverse effect on their business, finances or operations. The only ‘lawsuit’ I found was the patent case they started, and settled in 2008.

    RGEN – Contractual Obligations and Off-Balance Sheet Arrangements

All from the 3Q 2013 10-Q –

“We do not have any special purpose entities or off-balance sheet financing arrangements as of September 30, 2013.”

Under “Contractual obligations” (In thousands):

Operating lease obligations $14,537
Purchase obligations $2,978 (mostly raw materials)
Contingent consideration $1,593

The Contingent consideration relates to acquisitions. It’s recorded in accrued expenses and long term liabilities on the balance sheet, so I won’t include it in the sum here. Adding the lease and purchase obligations gives $17,515.

    RGEN – Possible omissions

It’s possible I’ve missed an obligation connected to licensing agreements, or a material penalty if clinical trials are discontinued.

    RGEN – Quantified obligations, commitments and contingencies

(In thousands)

Operating lease obligations $14,537
Purchase obligations $2,978
Tax dispute $2,500

Total obligations, commitments and contingencies = $20,015

    RGEN – Cash, net of everything quantified

To sum up for Repligen (in thousands):

$42,244 Cash and cash equivalents
$11,480 Total liabilities
$20,015 Total obligations, commitments and contingencies

and

$42,244 Cash and cash equivalents
$30,764 Cash and cash equivalents net of Total liabilities
$10,749 Cash and cash equivalents net of Total liabilities, Obligations, commitments and contingencies

That’s about $10.75 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify. This isn’t easy, and please feel free to check my deductions and look for more.

In addition, Repligen hold $24.85 million of Marketable Securities.

See also “RGEN – Unquantified” under “Repligen Corporation – Summary”.

Repligen Corporation – test 2 and 3

Test 2 – Cash from operations has to be positive and generally bigger than the cash that goes into investment.
Test 3 – A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

My claim that Repligen passes test 2 is not supported by the history since 2003, as you’ll see in the charts. 2012 saw an excess of cash from operations over cash invested ($13,440 – -$2,841 = $16,281 – in thousands) and with three quarters in, 2013 is on track to beat 2012. My cash flow walk chart shows an encouraging recent results-breakout (from a meandering walk), but this is partly the result of recent growth in royalty revenue which expired on December 31, 2013. The latest quarter, 3Q 2013, also benefits from “… favorable changes in various working capital accounts, in particular the collection of $5 million due from Pfizer pursuant to our collaboration agreement.” (the 10-Q). You shouldn’t extrapolate a mixture of normal revenue and milestone payments in the same way you might extrapolate normal sales. This shows the weakness of focusing on cash flow over short periods, and I include charts showing recent revenue and costs after the cash flow charts.

If all goes well, milestone payments from Pfizer are expected for Phase I, II and III clinical trials and then for successful commercialization. A milestone from an early stage trial could be reached late in 2014, but that’s from an old transcript: “Repligen Management Discusses Q4 2012 Results – Earnings Call Transcript” Mar 7 2013 (seekingalpha.com). (Search the transcript for ‘Pfizer’ or ‘milestone.) Success all the way through to commercialization is far from guaranteed, and it’s safer to regard any milestone payments as a bonus rather than a basic part of the investment case.

In the spreadsheet below, everything is in thousands except for ‘per share’ amounts and dates. (Repligen’s transition document gives two end dates for 2011, and I hope I’ve understood the document correctly.)

Repligen cash flows to 3Q 2013 spread
……………………………………………..

Repligen does not have a steady history of cash flow growth, and to include recent quarters, the cash flow walk chart shows quarters 1, 2 and 3 after multiplying by 4 to approximate an annual equivalent (which I admit is a bit dubious).

Repligen cash walks per share to 3Q 2013
……………………………………………..

This time series chart shows the quarters with and without annualization.

Repligen cash flows per share to 3Q 2013
……………………………………………..

The peak in 2008 was probably the result of settling a patent case against ImClone Systems for $65 million, or about $40 million net. Removing that one-off would make the recent improvement an even bigger contrast to previous performance.

Repligen acquired bioprocessing operations from Novozymes at the end of 2011. The acquisition doesn’t make a spike in the chart at the ‘Nine Months ended December 31’ 2011, because the $26.9 million cash impact was closely matched by the $26.3 million sales of marketable securities. This shows how charts of the broad cash flow categories don’t reveal crucial details about the nature of cash invested, although they still show the general effectiveness of investment. Big acquisitions affect financial results, and even with the best of intentions, the working capital acquired can affect cash flow, increasing it for a while when positive working capital is acquired.

I’ll repeat that the cash flow charts are deceptive due to royalty revenue which has now expired, and high cash collection that’s unlikely to repeat.

Repligen recent revenue and costs - spread

Repligen recent revenue and costs

Ignoring 2011 and the royalties revenue, the clearest trend is the declining R&D. The decline contributes to income and cash from operations, but I’d be concerned to see it reduced by much more. The chart is consistent with growing revenue from bioprocessing, but I’m wary of concluding much from a series showing two ups and one down of about the same size. I made a ‘walk chart’ to see if a relationship between bioprocessing revenue and cost can be observed.

Repligen walk chart of product cost against revenue

The three quarters in 2013 so far have each had higher bioprocessing revenue and margin than the 2012 average, although the latest quarter was a step in the wrong direction. There’s a limit to what you can conclude from just a few points. The chart is consistent with profitable growth in bioprocessing since the acquisition, but isn’t shouting about it, at least not at this point. The gross margin on bioprocessing is shown by the angle of the line from a point to the origin. It’s likely to have been affected by the product mix, costs which stay fixed as revenue increases, increases in efficiency, and currency movements.

The investment case is about reasons to expect bioprocessing revenues to grow, with expanding margins and relatively low needs for capital expenditure. While it’s expected that Repligen could accumulate cash (if they wanted to), they are likely to combine some organic investment with acquisitions. The quality of future acquisitions will be a major factor in Repligen’s future value. The Piper Jaffray presentation gives the kind of synergies Repligen expect from acquisitions, which also indicates that they are likely to stick to bioprocessing.

Repligen Corporation – other considerations

This is a selection, not ‘everything else’.

    RGEN – Off-balance sheet financing and special purpose entities

“We do not have any special purpose entities or off-balance sheet financing arrangements as of September 30, 2013.” (3Q 2013 10-Q)

    RGEN – Cash and Cash Equivalents definition

(figures in thousands)

The Cash Equivalents are not obviously defined, but seem to be or include $9,189 of money market funds. Find “fair value hierarchy table” in the 10-Q, where the other two items add up to the Marketable securities figure of $24,861, which is separate from the Cash and Cash Equivalents of $42,244. I expect the money market funds are safe enough.

Most of the Marketable securities ($19,179 of them) is in Corporate and other debt securities, the valuation of which is complicated but I saw nothing suspicious.

From the 10-K: “… cash equivalents and marketable securities are invested in financial instruments with high credit ratings and credit exposure to any one issue, issuer (with the exception of U.S. treasury obligations) and type of instrument is limited.”

Repligen don’t hedge their foreign exchange risk, and the 10-K says they have no investments with foreign exchange risk. The operations of Repligen Sweden create exposure to the Swedish kronor, British pound sterling, and the Euro.

I hope I’m not being gullible for saying the cash looks safe, even though they don’t explicitly define cash equivalents beyond ‘high credit ratings’ and the statement about exposure.

    RGEN – Short-term investments definition

There’s no specific mention of short-term investments, but $20,739 thousand of Repligen’s marketable securities are classed as short term and are due in one year or less. I’ve written about marketable securities under ‘Cash and Cash Equivalents definition’ above.

    RGEN – Revenue recognition

The policy is reasonable and uncomplicated.

“… The Company’s product revenues are from the sale of bioprocessing products to customers in the life science and biopharmaceutical industries. Revenue related to product sales is recognized upon delivery of the product to the customer as long as there is persuasive evidence of an arrangement, the sales price is fixed or determinable and collection of the related receivable is reasonably assured. … The Company has a few longstanding customers who comprise the majority of revenue and have excellent payment histories and therefore the Company does not require collateral. The Company has had no significant write-offs of uncollectable invoices in the periods presented.”

“… Sales returns and warranty issues are infrequent and have had nominal impact on the Company’s financial statements historically.”

    RGEN – Audits of internal control over financial reporting

Repligen get a clean bill of health for their internal control over financial reporting, and their accounts, from auditors Ernst & Young, in the 10-K for 2012:

“In our opinion, Repligen Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.”

“We also have audited, … the consolidated balance sheets … and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity, and cash flows … of Repligen Corporation and our report dated March 15, 2013 expressed an unqualified opinion thereon.”

The statements covered various relevant periods.

    RGEN – GAAP only

I’ve not seen Repligen use non-GAAP figures.

    RGEN – Related-party transactions

“There were no related party transactions during the fiscal year ended December 31, 2012.” (10-K)

    RGEN – Useful life

Leasehold improvements – Shorter of the term of the lease or estimated useful life
Equipment 3 to 8 years
Furniture and fixtures 3 years

I’d say that’s reasonable and conservative.

    RGEN – Visual exaggeration in charts

I only checked the ‘Repligen Presentation at Piper Jaffray Healthcare Conference 12/3/2013’ I mentioned above (which you can get here). The only relevant chart (on page 6) was OK, with y=0 where the X and Y axis meet.

    RGEN – Potential CEO dominance

This is all based on the Form 14A dated 5/9/2013, and is ‘as of March 22, 2013’.

Walter C. Herlihy, Ph.D., held numerous research positions at Repligen from 1981 to 1993, becoming Senior Vice President of Research and Development before leaving to join Glycan Pharmaceuticals, where he was President and CEO. He stayed President and CEO when Glycan and Repligen merged in 1996. Repligen also has a Chairperson (and a CFO and Chief Accounting Officer). Herlihy owns 1,844,253 shares, or 2.3% of the Common Stock.

The CEO is required to acquire shares equal to his base salary, over five years. His base salary is $433,000 (11% below the 50th percentile). Assuming the share price matters in the calculation, at $10 the CEO needs to own 43,300 shares, and at $20 he needs to own 21,650. His ownership of 1,844,253 shares is well above the requirement. Other insiders have different minimum shareholding requirements, and insider ownership isn’t high, at 6.3%.

The only co-founder of Repligen I can find is Alexander Rich, M.D.

Overall, considering that the CEO has overseen a successful (so far) transition to bioprocessing, with the integration of the Novozymes Biopharma Business, I’d say he’s in a position to dominate if he wanted to, although he’s not in as strong a position as the CEO’s of IPG Photonics and Ubiquiti who were more obviously involved in founding the company, and who have much bigger shareholdings.

    RGEN – Poison pills and severance

Repligen may have a ‘Shareholder Rights Plan’, which means that if a shareholding reaches 15%, other shareholders would get new shares. It’s in old 10-Ks under ‘Stockholders’ Equity’ / ‘Shareholder Rights Plan’. The sentence “The Rights will terminate upon the earlier of the date of their redemption or March 2013.” means the plan can’t exist without having been amended, and there’s nothing like it under ‘Stockholders’ Equity’ in the 2012 10-K. However, the form has this:

“Provisions in our certificate of incorporation and by-laws may delay or prevent an acquisition of us or a change in our management. These provisions include the ability of our board of directors to issue preferred stock without stockholder approval.”

What really concerns me is the word ‘include’, which I believe management generally love when they aren’t keen about disclosing, although there could be cases when it avoids tedious details. For comparison, IPG Photonics itemize seven of their anti-takeover provisions.

To find details of the board’s powers to issue preferred stock, find “This is how I found Repligen’s Restated Certificate of Incorporation” below (under ‘Forms filed with the SEC (Securities and Exchange Commission)’). If necessary, the board can indemnify and remove liability after the fact, presumably within some legal limits.

In practice, any effective anti-takeover provisions give management the power to agree a takeover either on terms that suit shareholders or on terms that suit themselves.

A disatisfied investor in 2011 claimed the Shareholder Rights Plan made management look ‘entrenched’ and discouraged institutional investors. If so, I think institutional investors have the right idea, at least generally. The investor, Ronald L. Chez, is Repligen’s biggest, with 9.2% of the Common Stock as of March 22, 2013. Maybe the plan was allowed to lapse due to embarrassment about it or pressure from the biggest investor, but not finding anti-takeover provisions isn’t the same as knowing there aren’t any.

From the Form 14A dated 5/9/2013:

“Upon termination of employment, with or without cause, or upon a change in control of the Company, 50% of the unvested stock options held by such executive officers shall vest immediately.”

(For ‘vest immediately’, find “accelerated vesting” in Vesting (Wikipedia).)

The 50% vesting seems reasonable and is probably ungenerous to management compared to other companies. If a change of control and termination had taken place on December 31, 2012, the benefit would only have been $96,000, compared to $6,153,000 Salary Continuation Upon Termination.

There’s more under ‘Equity Awards’, which I believe to be favorable to management, but I don’t know if they’re more favorable than the usual, or significant to shareholders.

The terms regarding salary seem reasonable, so far as I can tell.

    RGEN – Not on the list

Repligen have used stock promoters several times, with May 2012 the latest date. If this long URL doesn’t work, go to stockpromoters.com and put ‘RGEN’ in the ‘Search by Symbol’ box. Personally, I associate stock promotion with pump’n’dump shares. Maybe there’ll be no more stock promotion, as Repligen shouldn’t need to raise capital. If the share price is pumped up through stock promotion, it might be time to take some profit, with a chance of buying back at a lower price when the promotion wears off. If stock promotion raises the share price, it might also affect the value of stock-based compensation, although I’m sure that management keep to any rules that might apply in this area.

    RGEN – WELCOME ABSENCE

I’ll just mention the lack of related party transactions.

Repligen Corporation – Summary

Note – the summaries are selective and are in my own opinion.

$10.75 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify. In addition there’s $24.85 million of Marketable Securities.

Repligen are focused on a growing market with ‘sticky’ sales, probably with good management, but I haven’t seen reasons to believe there’s an ‘economic moat’ to protect growth.

The investment case is forward looking, without a long or striking history of success.

Future performance depends on the use of cash, and the quality and execution of acquisitions. I also believe that R&D around chromatography columns is a vital factor to drive market penetration and avoid falling behind competitors, especially GE Healthcare.

While there are operational risks, and government efforts to reduce the cost of healthcare, the biggest risks are probably from the dominant competitor, GE Healthcare.

Substantial royalties expired at the end of 2013.

Some of the U.S. patents covering recombinant Protein A have expired. (Listed as a risk in the 10-K for 2012)

I don’t know what happened regarding anti-takeover provisions that became outdated.

The CEO could potentially dominate, but he’s not an obvious founder or a major shareholder.

Relatively low insider ownership.

Some investing professionals and big investors will be able to talk to customers and competitors to find the scuttlebut, especially on GE Healthcare, Repligen, and their products.

    RGEN – Unquantified

The $10.75 million ‘net of everything’ excludes the potential cost of indemnifying Pfizer, and generous indemnification and not holding liable of directors and officers, with exceptions for particularly bad behavior (which can be removed later).

Possible errors include obligations, commitments and contingencies (OCCs) I didn’t find, double-counting an OCC which is included in liabilities, and I might have missed a clear statement that all indemnities are fully insured.

Repligen Corporation – A chart

There’s a spreadsheet and 3D chart showing the net present value of Repligen shares, based on various assumptions. I don’t give much weight to the chart, and generally prefer the overall investment case, but if you want to see it, it’s at the end of my “Discounting future value with a real example“. It’s based on two numbers, projected cash and projected income, from an article by Smith On Stocks, “Repligen Promises To Be A Cash Flow Machine” Apr 2, 2013 (seekingalpha.com). Smith On Stocks makes it clear that Repligen are unlikely to just hoard the cash, and explains his reasons for projecting cash as if it will be accumulated. The projections were probably conservative at the time, and since then the prospects for the OPUS columns have improved. The numbers will also become too low as time goes on and there is less time to discount each future figure over. There’s a link for downloading the spreadsheet, but it might be easier to set one up from scratch than to download and adapt it.

~

Ubiquiti Networks, Inc (UBNT)

Share price $43.77, Market cap $3.8 billion, Price/Earnings (ttm) 36.4, No regular dividend. As at January 17, 2014. The figures are approximate.

Ubiquiti’s SEC filings (ubnt.com)

Ubiquiti Networks Management Discusses Q1 2014 Results – Earnings Call Transcript” Nov 7 2013 (seekingalpha.com)

This was good but it’s gone behind Seeking Alpha’s “pro” paywall: “Ubiquiti Networks: Another Big Year Ahead, Get In Now On The Short Term Sell-Off” by Matthew Dow, Dec 7 2013 (seekingalpha.com)

The most recent freely available article on Seeking Alpha: “Bull Of The Day: Ubiquiti Networks” by Zacks Investment Research, Nov. 14, 2013

Seeking Alpha’s “Is UBNT a buy?” page.

Beneish M-Score for Ubiquiti Networks (UBNT) (gurufocus.com)
Altman Z score for Ubiquiti Networks (UBNT) (gurufocus.com)
See “About gurufocus’s scores” above.

Quoting from their Q1 2014 CEO/CFO Commentary, “Fiscal first quarter 2014 revenues were up 28% from the prior quarter, and up 111% over the same period in the prior year.”.

Ubitquiti’s revenue is mostly from communications equipment designed to use unlicensed spectrum, which needs techniques to cope with interference from cordless phones, baby monitors, microwave ovens etc. The use of unlicensed spectrum is particularly suitable for remote locations and countries which are less developed or have large sparsely populated areas. Ubitquiti can provide solutions for less developed countries where ‘the last mile’ is a problem that would normally require heavy investment.

    UBNT – Products

Ubiquiti’s product info

Service Provider Technology platforms (73% of revenue, 1Q 2014)

airMAX – outdoor wireless with a firmware architecture (find “firmware” below).
CASE STUDY – Sling Broadband. One event featured is the Volvo Ocean Race, Miami.
airMAX accounted for 47% of total revenue in 1Q 2014. The revenue share used to be above 50% but newer products have grown faster.

airFiber – radio platform for backhaul, with high throughput (1.4 Gig/second, range up to 13km). Backhaul connects to a more central network, usually the Internet backbone (Wikipedia).

EdgeMAX – routers

Enterprise Technology platforms (27% of revenue, 1Q 2014)

UniFi – indoor wireless LAN, with a software controller (instead of the traditional hardware controllers). The CEO believes that wireless networks can replace wired networks “everywhere but the data center”.

mFi – machine to machine (there’s more below)

airVision – surveillance system with a web-based interface. Can be monitored with the airVision interface on iOS or Android mobile devices. You can connect Ubiquiti’s IP (Internet Protocol) cameras to the airVision system.

    UBNT – Business model

Ubiquiti outsource production and sales, and concentrate on research and development, marketing, and engaging with end users through a user community on the internet with forums, a wiki and a newsletter. The community provides support, and users discuss what they need and what needs to improve. The feedback and Ubiquiti’s flexibility mean that designs can be iterated quickly, and if a product isn’t good enough, a much improved version is likely to be on the market before too long. The ‘quickly to market’ strategy has risks, and Ubiquiti recalled their Titanium Rocket products early in 2013. The business model allows Ubiquiti to sell cheaper than competitors while keeping good margins, and allows growth driven by R&D and user enthusiasm without the need for high capital or marketing expenditure. From the latest 10-Q:

“Our business model is driven by a large, growing and highly engaged community of service providers, distributors, value added resellers, systems integrators and corporate IT professionals, which we refer to as the Ubiquiti Community.”

“Word of mouth referrals from the Ubiquiti Community generate high quality leads for our distributors at relatively little cost.”

Ubiquiti’s user forum is mostly very technical, but there’s a ‘Business Talk’ area under ‘General Discussion’, with this topic as an example “UBNT vs Competitor. Excerpt from Credit Suisse Annual Tech Conference 2013” started by jaf.

    UBNT – The Ubiquiti World Network initiative

The Ubiquiti World Network initiative should help to make WISPs (Wireless Internet Service Providers) more aware of Ubiquiti by helping them with their marketing, at a relatively low cost of about $1 million per quarter.

    UBNT – Marketing chief quit

There are well-informed comments under this short Seeking Alpha market-currents story: “Ubiquiti slumps after disclosing marketing chief’s departure” Monday, Nov 25 (seekingalpha.com). The marketing chief was probably brought in to market the airVision surveillance system, a small part of Ubiquiti’s business. The dip shows how the share price can be vulnerable to any bad news after a sustained rise.

    UBNT – Thinking about the future

Looking far ahead, at some point, Ubiquiti are likely to hit what I’ll call ‘model saturation’ in their current markets, although this could mean slower growth with the market, rather than no growth, if Ubiquiti stay within their existing markets. To attempt to maintain high growth, Ubiquiti could either change the model or target new markets where the model can be applied, though neither will be easy.

While users like universities are usually happy to pay a low price and use the community for support, big corporations generally require support and are used to paying for it. That seems unlikely to change. The problem might not be from increasing performance, which doesn’t necessarily mean that new answers are needed for new questions, so much as changing technology and new communications standards. In addition, tech-users generally use a variety of equipment, and frequent software updates can affect how the parts of a system work together. However, it’s because support is necessary that the company gains from the support available on the Ubiquiti community. Providing vendor-support to big enterprises could make Ubiquiti too much like other companies, with no obvious advantage over competitors already selling to the big enterprises. If Ubiquiti take that route, it’s likely to be with some reluctance over the expense, and because they believe their products are sufficiently superior.

Breaking into a new market could be difficult if it’s not an adjacent market. It needs to be a market where support is required, with potential customers who prefer the combination of low price and support from a community, without the need being met well enough already. There also needs to be very little chance of a competitor disrupting the market with products requiring minimal support.

    UBNT – Risks of new markets or changing the model

Under “Our profitability may decline as we expand into new product areas.” (10-Q):

“As we expand into new product areas, such as enterprise WLAN, video surveillance equipment, wireless backhaul and machine-to-machine communications, we may not be able to compete effectively with existing market participants …”

“We may also be required to add a direct sales force and customer support personnel to market and support new or existing products, which would require us to accept substantially lower product margins or increase our operating expenses. … and may not be successful.”

I see the “new product areas” mentioned, as being reasonably adjacent to the old product areas. Bigger problems with expansion could occur further into the future, but a high valuation needs a lot of growth to justify it, after which Ubiquiti would be much bigger. Many companies fail to diversify successfully when a new market is too big a leap, and companies often fail when they stray from a successful business model (insurance company GEICO is a classic case from the value-investment literature). If Ubiquiti are able to apply the model to new markets, they will maintain high growth for longer, until growth slows as model-saturation in their addressable markets is approached (when they can’t sell much more without a sales force). The CEO is enthusiastic about the model and I expect that new markets are more likely than a sales force.

    UBNT – Machine-to-machine

The machine-to-machine (m2m) market is fragmented and I have to admit I find it confusing. There’s General Electric pushing the Industrial Internet, which might be machine-to-cloud rather than m2m. Google have recently acquired Nest Labs who make innovative smoke alarms and thermostats, which apparently belong in the ‘Internet of Things’ category. Texas Instruments abandoned competing with Qualcomm’s chips for phones to concentrate on embedded processing and analog, using their big sales force to sell tailored products into the fragmented market. Telecoms companies want their slice, with Canadian telco Rogers Communications providing a selection of m2m solutions including home automation, and Vodafone wanting to monitor drivers so careful drivers can get cheaper insurance. There’s Arduino, Zigbee (Wikipedia), and Xbee which I think cater for school projects and small projects, but Texas Instruments takes ZigBee (at least) seriously as an industrial standard, in the low-power RF (radio frequency) bracket. The hobby and small-scale end seems to be well served by forums, and I’d guess Atmel’s AVR Freaks community isn’t aimed at mega-corporations, judging by the T-shirt. In the 10-Q, EnergyHub, Motorola and AlertMe.com are listed as the main m2m competitors. (See EnergyHub’s grinning management here.)

Google’s Motorola want modular phones where you click-in a third party module and you’ve got a medical scanner or other device. “Motorola’s Project Ara: The Age of Modular Computing” by Doug Mohney, November 22, 2013 (mobilitytechzone.com). You’ll need to click away the unwelcome screen.

Ubiquiti’s mFi platform probably doesn’t make up much of the 27% of revenue that comes from the Enterprise Technology segment, but there’s plenty of potential if the model works in that area. Their machine-to-machine page has plenty of pictures, graphics and screenshots. It looks like mSensors plug into mPorts and incoming data can result in power from mPower sockets being switched on or off, according to rules set through the intuitive front end of mFi software. The mSensors sense motion, temperature, current and open doors or windows.

The Ubiquiti device reviewed here allows mains power from three sockets to be switched on or off over a wireless network, and the power usage monitored:

Ubiquiti Networks mFi mPower Wi-Fi Power Strip Review” by Ganesh T S on November 21, 2013 (anandtech.com)

The conclusion is on the 5th page, here. It’s a favorable review, with ‘Excellent value’ in the first ‘pro’ point. Some points from the comments are (in my words): It’s no good because TVs and other devices have a low standby current / It’s more use in the enterprise / It’s hackable so I can write code for it to control a fishtank / If you’re going to write code, why not just get a microcontroller board. Other suggestions for things to turn on and off remotely include space heaters, and power-cycling a crashed server.

Wi-Fi might not be ideal for low data rate, short range and low power needs. It’s hard to be sure due to variation in the various wireless standards, and technical progress.

This gets technical: “Difference between Bluetooth and WiFi” (engineersgarage.com).

This (by Stacey Higginbotham, August 30, 2013. gigaom.com) is like a review of ZigBee, and with the comments there seems to be quite a few minor standards or protocols.

The piece “Qualcomm gets serious about Low-Power Wi-Fi with new chips” by Lee Ratliff, September 6, 2013 (isuppli.com), is about the Atheros chipset which Ubiquiti depends on, and the low-power needs of some Internet of Things applications. Atheros features hostless operation and a wake-up manager, which can reduce the average power requirement.

There are some technical points raised in this topic on Ubiquiti’s mFi forum:

What is the mFI end goal? Here are some of my thoughts and questions

    UBNT – The counterfeiting crisis

Ubiquiti had a big problem with counterfeiting in 2012, which Matthew Dow described in his first article about Ubiquiti:

Ubiquiti Networks: Significant Upside Potential In 2013” Jan 20 2013 (seekingalpha.com)

The 10-K for 2013 has a paragraph headed:

“We have experienced, and may in the future experience, reduced sales levels and damage to our brand due to production of counterfeit versions of our products.”

but it doesn’t say much except they are now more vigilant and legal action will cost money. Ubiquiti have made an impressive recovery.

    UBNT – Growth problems

Ubiquiti occasionally have problems keeping supply up with demand. One problem is that demand can rise quickly but with little visibilty to allow preparation. It’s possible that resellers and distributors don’t keep enough margin to encourage them to keep much stock. Because low cost is a feature, there isn’t an easy solution, but when customers reserve their orders the kit usually gets made and distributed without a huge backlog building up. This is confirmed to some extent in the topic “Re: Serious UBNT stock problems ?” but with a lot of chit-chat.

Most hitches and glitches are harder to sort out when growth is high and the visibility of future demand is poor. It might be harder to maintain quality control, and counterfeiting could re-emerge as a serious problem, although those are more tenuous risks than delivery problems. Ubiquiti acknowledge that enforcing IP is often difficult in China and South America. Also, from the 4Q 2014 10-Q:

“We rely on a limited number of contract manufacturers to produce and test all of our products, …”

“… contract manufacturers, which are primarily located in China …”

“… it would take approximately three to six months to transition manufacturing … to new providers. Relying on contract manufacturers for manufacturing and quality assurance …”

This might be efficient but it concentrates risk: “Beginning in the quarter ended December 31, 2012, we began using a third party logistics and warehousing provider in China to fulfill the majority of our worldwide sales.”

“We have limited experience and personnel to manage our supply chain, our contract manufacturers and our third party logistics services provider, which may cause us to experience lower product margins, impair product quality and result in our inability to fulfill demand for our products and solutions.”

As I said near the top, you have to decide to what extent the risk section in a 10-K is just legal boilerplate. To ensure quality, Ubiquiti have ‘internal quality assurance resources’, and development involves the sites of selected contract manufacturers, with full scale production at the same sites when quality reaches a satisfactory level.

There’s a risk that the Ubiquiti World Network initiative is extremely effective at a time when supply is already tight, resulting in frustration and disappointment. Then maybe analysts and investors will be very understanding and see the high demand as positive, or maybe some would question the business model and the lack of control over the supply chain, or more likely question the wisdom of timing an excellent marketing push when supply is tight. Management have a difficult task trying to hit a moving target, and overproduction also has costs.

    UBNT – Six risks for Ubiquiti

1) Dependance on a single supplier, Qualcomm. From the Safe Harbor: “… our dependence on Qualcomm Atheros for chipsets without a short-term alternative;”. Qualcomm won’t want to abuse their power in any way that would deter customers, but it would still be better if the chips could be dual-sourced. To check the power Qualcomm’s customers might have, I looked at the customer concentration. In 2012, Samsung Electronics accounted for more than 10% of Qualcomm’s revenue, and so did “Hon Hai Precision Industry Co., Ltd./Foxconn, its affiliates and other suppliers to Apple Inc.” (from the Qualcomm 10-K filed 11/07/12. Check here for a more recent 10-K).

Qualcomm usually report some customer concentration, with changing names each year. In 2011 and 2010, HTC and LG Electronics accounted for over 10% of Qualcomm’s revenue. None of those are major competitors to Ubiquiti, and in any case, Qualcomm have the size, profitability and intellectual property that makes them hard to push around. If Ubiquiti ever get on Qualcomm’s 10% list they’ll be even safer. The worst that Qualcomm are likely to do on purpose is to raise prices or push Ubiquiti towards a higher priced successor to Atheros, but they’re not likely to risk alienating Ubiquiti or pushing them to a competitor. Many programmable logic chips feature onboard digital signal processing (and ARM processors, if needed), although that might be a last resort.

2) Ubiquiti’s kit uses unlicensed spectrum, and in the U.S., big companies that benefit from licensed spectrum lobby for more of it. See:

The Underdog Internet Providers Head to Washington” By Brendan Greeley, November 21, 2013 (businessweek.com)

At the same time, consumer devices make increasing use of the unlicensed spectrum, and Ubiquiti’s devices would presumably interfere with each other in some circumstances. Ubiquiti has expertise in coping with interference, but there are limits and trade-offs involving range and throughput.

3) There’s a key-personnel risk as it’s hard to know how well the company would perform without the CEO, operationally and strategically.

4) Don’t rely on incumbents only competing on price and performance if they have other options. From the 10-Q:

“increased competition from providers of wireless broadband equipment may result in fewer vendors providing complementary equipment to our products, which could harm our business and revenues. Broadband equipment providers or system integrators may also offer wireless broadband infrastructure equipment for free or as part of a bundled offering, …”

As a possible guide to Cisco’s style, according to Maureen O’Gara in “Dell Joins OMG to Eclipse Cisco’s Daylight” March 15, 2013 (soa.ulitzer.com), Cisco got some big names into a consortium to develop software defined networks, stitched them up with an agreement not to join any similar consortium, shut them up with non-disclosure agreements, started their own secret project called Insieme, and left the original consortium to rot. The consortium found a way out, which you can read about in Maureen O’Gara’s blog. BTW if software defined networks are a growth area, traditional routers (including Cisco’s) will lose sales. Ubiquiti’s UniFi platform replaces some hardware with software, and the AirMAX platform uses firmware (Wikipedia), which is a bit like software in a chip so it doesn’t need loading but can still be modified or updated.

5) Government regulation for safe electromagnetic emissions and privacy could be difficult to comply with or increase costs. However, the World Health Organization doesn’t seem too concerned about Base stations and wireless technologies, and believes Electromagnetic hypersensitivity [December 2005] is not caused by wireless technologies.

6) The two biggest customers, probably distributors, each accounted for 10% of revenue.

There are other risks in the Safe Harbor, and more in the Form 10-K under the heading “Risk Factors”.

    UBNT – Normal acquisitions are unlikely

From “Ubiquiti Networks Management Discusses Q1 2014 Results – Earnings Call Transcript” Nov 7 2013 (seekingalpha.com), the CEO is well aware that a normal acquisition makes no sense, as most companies of about the right size would have many more staff but less revenue and income than Ubiquiti. However, he says “There might be some opportunities for acquisitions overseas, but they would not be traditional acquisitions. They’d be more out-of-the-box type of things.”. Unbelievably (or perhaps not), analysts didn’t ask what kind of out-of-the-box type things. (If they want ‘out-of-the-box’, maybe they should find the ‘tricorder’ link in my “IPG Photonics – growth, cash, markets and technology” piece [already linked to].)

    UBNT – Good news

Gartner believe Ubiquiti’s UniFi revenue has jumped over 200% from the previous quarter. December 27, 2013 (seekingalpha.com)

Ubiquiti: Street Likes Ingram Deal; JMP Dismisses Block Trade Concern” By Tiernan Ray, January 15, 2014 (blogs.barrons.com)

    UBNT – My investment approach

I like Ubiquiti a lot, but there are risks and I’ll take some profit if they hit a sky-high valuation. I might follow a ‘buy low, sell high’ (relatively) strategy, to make some gain from volatility, while keeping at least half my original investment, for as long as it seems reasonable. I don’t want to have no shares so long as there’s a reasonable chance of the model driving high growth. I’m not saying anyone should copy me.

If I had no shares in Ubiquiti now, I would only buy a little, and add if the shares got cheaper. That risks a lower profit if the price keeps rising, but I’d prefer that to the risk of a large buy followed by a big fall. Investors will have their own style and shouldn’t be too influenced by this section. I’ve no wish to convince an investor who doesn’t like the shares at the current price or a lower price.

Ubiquiti Networks – test 1

Test 1 – More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.

From the 4Q 2014 10-Q, as at September 30, 2013, in thousands:

Cash and cash equivalents $279,729

Total current liabilities $67,810
Long-term taxes payable $12,385
Debt – long-term $69,874
Deferred revenues – long-term $2,514
Total liabilities $152,583

+ $279,729 Cash and cash equivalents
– $152,583 Total liabilities
= $127,146 Cash and cash equivalents net of Total liabilities

Obligations, commitments and contingencies

Next I look into possible future costs which aren’t already included. The only significant quantified costs are below under ‘Contractual Obligations and Off-Balance Sheet Arrangements’, after I describe some possible costs which I can’t quantify.

    UBNT – Illegal export to Iran

Under “Export Compliance Matters”, there’s a complicated case about illegal export to Iran. Ubiquiti are cooperating and there seems to be little dispute about the facts. It looks easy to accidentally break the regulations by not communicating properly with logistics companies and distributors, which they seem to have done twice. They also failed to keep adequate records for the required five years, which probably happened when they switched to NetSuite software for order management and financial processes.

The original case was closed with a warning, after which Ubiquiti filed a voluntary self-disclosure with the U.S. Department of the Treasury’s Office of Foreign Asset Control (“OFAC”).

The upper limit of any fine is twice the value of the transactions involved, with a $250,000 minimum. Ubiquiti are waiting to hear from OFAC, “… and we cannot currently assess the nature and extent of any fines or other penalties, …”.

I’m not putting a figure on the maximum liability, but it seems to be limited to twice the value of Ubiquiti’s exports to Iran from 2008 to March 2011. They recorded an expense of $1.6 million in 2010, when only one violation was known.

Compliance generally is easier for big companies than small companies growing fast, but Ubiquiti are aware of the need, for instance in 2011 they hired an employee who makes sure spectrum use requirements are complied with.

    UBNT – Risk of infringing intellectual property

From the 10-Q for Q1 2014: Under ‘Item 3. Legal Proceedings’ / ‘Intellectual Property’, Ubiquiti are “subject to” legal proceedings over intellectual property. I think that means generally rather than right now, although letters asserting patents (claiming infringement) are frequent. Communications IP is a patent-rich area where aggressive patent assertion and litigation is common. They also say “There are numerous patents and patent applications …” before explaining why they don’t usually conduct patent searches. This affects many companies that Ubiquiti deal with, including suppliers, OEMs and distributors. Find “We operate in an industry with extensive intellectual property litigation.” in the 10-Q. There’s a trend in the U.S. for legislation to limit the activities of ‘patent trolls’ which could reduce some of the risk.

This 81 page pdf is UK-centric and not an easy read, but it pulls many studies together: “A Study of Patent Thickets” commissioned by the Intellectual Property Office, 2013 (ipo.gov.uk). Using the density of ‘triples’ (where each of three firms have prior art which limits the claims in patents held by the other two), telecoms is a thicket-infested zone (not their term!) with over fifteen thousand triples. Digital communication and computer technology have thousands of the triples, and basic communication processes have nearly five hundred. See the table on page 41 of the pdf for the triples in 33 areas of technology. A model gives the counter-intuitive result that opposition to a patent after it is granted is actually lower inside a patent thicket, but high on the fringes, and empirical support is claimed. Ubiquiti’s patents could be on the thicket fringes, but I can’t give a useful opinion about it.

When patent trolls spot infringement, they’ll usually assert their patents through a letter from an obscure patent-owning LLC where the ultimate ownership is hidden. Then they could wait for years letting uncollected royalties pile up before starting legal action. This is particularly likely for narrow patents that could be designed around.

There’s plenty about patent assertion and litigation in the second half of my Acacia Research – a privateer, and what happens at sea May 22, 2013.

A cash-pile is a deterrent against litigation, or at least a cash shortage makes a company vulnerable. If Ubiquiti had to repatriate cash to pay legal costs or settlements, they would have to pay tax.

    UBNT – Indemnification

From the 10-Q for Q1 2014: Ubiquiti are likely to indemnify distributors and OEMs without a limit, regarding liabilities for patent, copyright or trademark infringement. This seems like accepting normal business risk, as partner-companies can’t be expected to take on such liability when they aren’t responsible for design.

Ubiquiti indemnify directors and officers for any kind of actual or threatened proceeding, with some exceptions. From the 10-Q: “We have a director and officer insurance policy that limits our potential exposure.”. Insurance policy premiums are an expense which belongs in the accounts, not here. The potential exposure is not disclosed, and the rest of this part might not be very relevant, depending on the remaining exposure.

Under “ARTICLE VIII – INDEMNIFICATION”:

“… the corporation shall indemnify, to the fullest extent permitted by the DGCL …” a director or officer. (Then it gets complicated about who else is covered.) But only “… if such person acted in good faith …”

There’s no indemnity …

For “disgorgement of profits”.
If Ubiquiti want a bonus returned.
For anyone suing Ubiquiti or anyone connected with Ubiquiti (with exceptions, including ‘unless authorized’).
If the indemnity would be illegal.

The indemnity doesn’t stop when a director or officer leaves Ubiquiti (but only for things done or not done while at Ubiquiti).

That’s inexpertly condensed from four pages in this: “EX-3.2 3 dex32.htm FORM OF THIRD AMENDED AND RESTATED CERTIFICATE OF INCORPORATION” (sec.gov) (originally filed June 24, 2010), under “ARTICLE VIII – INDEMNIFICATION”.

Historically the costs have been low, but I don’t expect such costs to be stable or predictable. From the 10-Q: “Based upon our historical experience and information known as of the date of this report, we do not believe it is likely that we will have significant liability for the above indemnities at September 30, 2013 .”

The indemnity seems to cover less than for the other two companies, but it’s complicated.

    UBNT – Shareholder Class Action Lawsuits

Ubiquiti are accused of “… issuing false or misleading statements regarding the sale of counterfeit versions of our products.” My impression is that any time a company has bad news or the share price dives, some shareholders are likely to get lawyers involved, or maybe some lawyers are likely to get shareholders involved. Ubiquiti claim the case is without merit, and because the case is at a very early stage they can’t estimate the cost if they lose.

    UBNT – Tax uncertainty

Most of Ubiquiti’s cash is held overseas.

“As of September 30, 2013 , we held $253.8 million of our $279.7 million of cash and cash equivalents in accounts of our subsidiaries outside of the United States and we will incur significant tax liabilities if we decide to repatriate those amounts.” (the 1Q 2014 10-Q)

That’s a little odd as about 25% to 33% of the revenue has come from North America since 2011, nearly all of it from the United States (search the 10-Q and 10-K for “North America”). Working backwards from 2013, the ratio of Ubiquiti’s Provision for income taxes / Income before provision for income taxes, has been 12%, 17%, 20%, 204%, and 45% tax. While the pre-tax income grew 311%, the provisions for tax grew 40%. One possibility is that some cash is not in the United States due to tax management (possibly involving the subsidiaries in the Cayman Islands), although some of the cash in the United States will be consumed by HQ expenses, which will be more than the expense of overseas sites.

In any case, Ubiquiti warn “The final determination of our income tax liability may be materially different from our income tax provision.” and say “Significant judgment is required in determining our worldwide provision for income taxes.” in the 10-K for 2013. International taxation is complicated (and controversial), with opportunities for paying less or little, but with the risk of getting a big unexpected tax bill. That might be the explanation for the 204% tax provision in 2010, but I haven’t checked.

    UBNT – Contractual Obligations and Off-Balance Sheet Arrangements

These are in thousands (Ubiquiti forgot to say so, on the 1Q 2014 10-Q, page 24).

Operating leases $7,154
Debt payment obligations $75,000
Interest payments on debt payment obligations $4,806

The Debt payment obligations ought to be on the balance sheet already. To check:

From the 1Q 2014 balance sheet:
Debt – short-term 5,015
Debt – long-term 69,874
total debt = 74,889 (my addition)

which is close enough to $75,000. As there’s no material discrepancy, the Debt payment obligations will be on the balance sheet as they should be, so they aren’t included in the OCC calculation (see “Quantified obligations, commitments and contingencies”, below).

Some of the interest on the debt is variable. From “Interest Rate Sensitivity” in the ‘Market Risk’ section, a 2% increase in interest rates would cost $1 million over 12 months if they didn’t react. It would be odd if they are contractually unable to pay off long term variable-rate debt without a huge penalty, when they hold so much cash, although there’s the tax they would have to pay if they moved some cash to the U.S.. As they hold cash, have low capex requirements, and their options for acquisitions are limited, it’s unlikely that Ubiquiti will be vulnerable to interest rate rises. Regarding the return on their cash holdings: “The fair value of our cash and cash equivalents would not be significantly affected by either a 10% increase or decrease in interest rates due mainly to the short-term nature of these instruments.”

There’s some foreign currency risk because sales are in dollars and operating expenses are in currencies local to the operations. In 4Q 2014, a 10% movement in the dollar’s rate of exchange would not have had a material impact.

    UBNT – Possible omissions

I don’t think Ubiquiti have any off-balance sheet tax liabilities, but you can find the short paragraph with “$12.3 million of unrecognized tax benefits” to start your own investigation.

    UBNT – Quantified obligations, commitments and contingencies

(In thousands)

Operating leases $7,154
Interest payments on debt payment obligations $4,806

Total obligations, commitments and contingencies = $11,960

    UBNT – Cash, net of everything quantified

To sum up for Ubiquiti (in thousands):

$279,729 Cash and cash equivalents
$152,583 Total liabilities
$11,960 Total obligations, commitments and contingencies

and

$279,729 Cash and cash equivalents
$127,146 Cash and cash equivalents net of Total liabilities
$115,186 Cash and cash equivalents net of Total liabilities, Obligations, commitments and contingencies

That’s over $115 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify. This isn’t easy, and please feel free to check my deductions and look for more.

See also “UBNT – Unquantified” under “Ubiquiti Networks – Summary”.

Ubiquiti Networks – test 2 and 3

Test 2 – Cash from operations has to be positive and generally bigger than the cash that goes into investment.
Test 3 – A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

Ubiquiti is fairly obviously a cash generating company with high growth expected unless something goes badly wrong.

In my spreadsheet and charts for Ubiquiti, the cumulative figures might be superfluous as the excess of cash-from-ops over investment is clear. I accumulate first, then divide by the number of shares. The charts use the diluted share count in the non-GAAP reconciliation which is bigger than the count in the income statement, until 2013. Find “higher share counts than are used in the income statements” below.

Ubiquiti cash walk to 2013 spread

Ubiquiti cash walks per share to 2013

Comparing the latest quarter to previous results:

Period ~ Cash from operations ~ Cash into investing ~ Weighted-average shares (diluted) (in thousands)

1Q 2014 ~ $51,880 ~ $460 ~ 89,473
1Q 2013 ~ $23,695 ~ $2,349 ~ 92,925
2013 /4 ~ $32,973 ~ $1,341 ~ 90,259 (2013 average per quarter)

There are a few accounting complications here, which are likely to occur when looking at cash flow over short periods. Part of the increase in cash from operations will be the result of faster cash collection, with a record low Days Sales Outstanding of 25 days. Ubiquiti expect the DSO to move back to their 45 to 50 days target range, which will tend to reduce the cash flow. The cash effect of the difference of 20 to 25 days is roughly a quarter of a quarter’s revenue, but Ubiquiti seem to imply that the DSO will increase gradually. See under “Balance Sheet” in the 1Q 2014 CEO / CFO Commentary.

In thousands, with 1Q 2014 revenue = $129,687
revenue per day = $129,687 / 91.25 = $1,421.227 per day
50 days revenue = $71,061
25 days revenue = $35,531

Calculating 2013 DSO using DSO = Number of days in the period * Receivables / Sales in the period
2013 DSO = 365 * 35,884 / 320,823
2013 DSO = 40.8

The DSO for 1Q 2014 was 25 days, and if it had been 41 days (as for 2013), that’s an extra 16 days, worth 16 * $1,421.227 = $22,740, and the quarter’s cash from operations would have been:

(in thousands)
$51,880 – $22,740
= $29,140

which is less than the 2013 quarterly average of $32,973 (dividing 2013 cash from operations by 4).

However, while it’s the DSO that stands out, and the Chief Financial Officer draws attention to it, it’s better to look at all the non-cash working capital.

Ubiquiti non-cash working capital 2013 - 1Q 2014 spread

Non-cash working capital fell from $6,363 to -$4,038 (from end 2013 to end 1Q 2014), a fall of $10,401. When non-cash working capital can swing from positive to negative, it makes less sense to calculate a normal requirement of non-cash working capital / revenue, for a short-term calculation. Instead, I’ll adjust the 1Q 2014 cash from operations by the absolute fall of non-cash working capital.

Adjusted 1Q 2014 cash from operations = $51,880 – $10,401 = $41,479

Period ~ Cash from operations ~ Cash into investing ~ Weighted-average shares (diluted) (in thousands)

1Q 2014 ~ $41,479 ~ $460 ~ 89,473 (cash from operations has been adjusted)
1Q 2013 ~ $23,695 ~ $2,349 ~ 92,925
2013 /4 ~ $32,973 ~ $1,341 ~ 90,259 (2013 average per quarter)
2013 /4 ~ +25.8 % ~ -65.7 % (increase from 2013 average per quarter)

That’s a 25.8% increase in cash from operations, from the 2013 average to the 1Q 2014 amount adjusted for the absolute change in non-cash working capital. (The share count also reduced slightly.) The 25.8% increase is not per year, it’s per 7.5 months (taking the mid-points of the periods) and is the same compound rate as 43% per year (because both result from 0.09786% per day).

Because there are some complications around the cash figures and I’ve written about a short-term change, it’s worth giving income-based figures.

Earnings per share (diluted)
1Q 2014 $0.45
1Q 2013 $0.14
2013 $0.89
2012 -$0.12
2011 $0.07
2010 -$0.08

Although the history is short and there are some accounting complications, Ubiquiti generates cash from operations well above investment needs, with fast growth.

Ubiquiti’s big size change

The fact that Ubiquiti was a lot smaller and had less per share confirms the free cash flow growth, because there’s no feasible other way they could have gained their success. I’m not using this to check Ubiquiti so much as illustrating the principle, because Ubiquiti’s growth is obviously real.

(in thousands)

Ubiquiti’s cash from operations was $131,891 in 2013, and cumulatively $250,536 since 2010.
Subtracting cash into investment, free cash flow was $126,528 in 2013, and cumulatively $240,769 since 2010. Ubiquiti have $279,729 Cash and cash equivalents, and above I found that they have $115 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify.

Those are very big numbers compared to older numbers:

Total assets 2010 $82,090, 2008 $12,820
Cash and cash equivalents 2010 $28,415, 2008 $5,936
Revenue 2010 $82,404, 2008 $10,942
Net income 2010 -$5,456, 2008 $4,697
Cash from operations 2010 -$25,985

Meanwhile the share count has gone down:

Weighted average shares Diluted 2013 90,259, 2010 105,109
(Using the diluted share count in the non-GAAP reconciliation. Find “higher share counts than are used in the income statements” below.)

I included 2010 because that’s when the cash flow figures start.

The difference between Ubiquiti in 2008 or 2010 and now is massive. That difference, and the growth in free cash flow, support each other as being genuine, and it’s very hard to imagine it’s all fake. I’d be less confident if I based a comparison on revenue, for example Enron Corp. had suspiciously high revenue growth for a few years, without much growth in cash from operations.

Using cash net of Total liabilities and OCCs closes loopholes that could allow cash to be increased at the expense of greater OCCs, which would not show up in the liabilities or the share count. The $115 million ‘net of everything’ is more than Total assets in 2010 ($82.1 million), and more than the 2010 revenue ($82.4 million). That’s big solid growth which couldn’t be faked through manipulation. Any company could fake fantastic numbers if they are prepared to forge documents on a massive scale, but that’s very risky and understandably rare compared to the various tricks I’ve mentioned.

Ubiquiti Networks – other considerations

This is a selection, not ‘everything else’.

    UBNT – Off-balance sheet financing and special purpose entities

“As of June 30, 2013 and 2012 , we had no off-balance sheet arrangements other than those indemnification agreements described above.”

I described the indemnification earlier.

Ubiquiti have two subsidiaries in the Cayman Islands, Ubiquiti Cayman Limited and Ubiquiti International Holding Company Limited, with no further information in the 10-K. It could be something to do with tax, and with no off-balance sheet arrangements there shouldn’t be anything to worry about. I found nothing listed as a special purpose entity or anything similar.

    UBNT – Cash and Cash Equivalents definition

“The Company considers investments purchased with a maturity period of three months or less at the date of purchase to be cash equivalents. … The Company deposits cash and cash equivalents with financial institutions that management believes are of high credit quality. The Company’s cash and cash equivalents consist primarily of cash deposited in U.S. dollar denominated inter-bearing deposit accounts.”

“inter” looks like a typo for “interest”.

The statement “All investments with a maturity period of three months or less are cash equivalents” does not imply that all or even 1% of cash equivalents are investments with a maturity period of three months or less, any more than “all tigers are animals” implies that many animals are tigers. “The Company considers investments …” leaves open whether it’s some or all the investments maturing in 3 months or less, that are C&CE. Maybe management expect form-readers to breath in the mood music and ignore logic.

If ‘primarily’ means 50% or more (is deposited in U.S. dollar denominated interest-bearing deposit accounts), the worst case is that half of the C&CE is the riskiest thing that can be deposited with financial institutions of high credit quality, with no other upper limit on maturity.

The best reassurance for the maturity of the portion not covered by ‘primarily’ is not from the definition, but under “Interest Rate Sensitivity” in the 1Q 2014 10-Q:

“The fair value of our cash and cash equivalents would not be significantly affected by either a 10% increase or decrease in interest rates due mainly to the short-term nature of these instruments.”

A large holding of bonds with a long time to maturity would be sensitive to interest rates.

    UBNT – Revenue recognition

The “Recognition of Revenues” section in the 10-K is too long to quote in full, but seems reasonable so far as I can tell. It includes:

“We recognize revenues when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and the collectability of the resulting receivable is reasonably assured.”

Customers have no “… provisions for cancellation, returns, inventory swaps or refunds that would significantly impact recognized revenues.”, which should mean that revenue figures are reliable.

    UBNT – Audits of internal control over financial reporting

The auditors, PricewaterhouseCoopers, give the accounts and the internal controls a clean bill of health, with “… in conformity with accounting principles generally accepted in the United States of America.”, and “Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2013.”.

That’s good enough, and it isn’t Ubiquiti’s fault that the auditors don’t use “unqualified opinion”, and complicate the fact that they found the accounts to be fair. If only they could say ‘The accounts are true and fair in our unqualified opinion. The internal control over financial reporting is adequate. BTW we checked the Cayman Island companies.’

    UBNT – Non-GAAP reporting

Ubiquiti use non-GAAP reporting. In my opinion, the level is mild, and the reconciliation in the 1Q 2014 10-Q only deducts Stock-based compensation from GAAP Net income, and adjusts for the tax effect, to get non-GAAP Net income. Here I’ve summed their compensation breakdown:

1Q 2014 (in thousands)

GAAP Net income = $40,528
Stock-based compensation = $1,167
Tax effect of non-GAAP adjustments = -$467
Non-GAAP net income = $41,228

If stock-based compensation is a necessary cost, it shouldn’t be magicked away.

“Income from a coexistence licensing agreement” would also be excluded if any existed.

The non-GAAP figures are often shown near the GAAP figures.

The CEO and CFO Commentary statement that “Reconciliations of the adjustments to GAAP … are provided below.” is not true, unless “below” means “in another document”. It’s a common trick, but even Masonite International who are low on my trust-list managed to put a proper reconciliation at the end of a presentation.

Ubiquiti’s non-GAAP reconciliations have higher share counts than are used in the income statements, until 2013. The higher share counts include Series A convertible preferred stock (which paid interest and could be converted to shares). Because Ubiquiti had been buying in their Series A stock, the share counts in the reconciliations have been generally coming down, whereas the amount of common stock has generally gone up. By 2013, all the Series A stock had been bought in or converted. While including the Series A stock improves the trend of the non-GAAP ‘per share’ figures, it’s justified. I don’t know why they couldn’t include “fully diluted” numbers in the income statement.

    UBNT – Related-party transactions

Ubiquiti had no related-party transactions in 2013 exceeding $120,000, as at October 28, 2013. That information was hard to track down, and would cover a hundred transactions for $120,000 each, with no information for investors to judge if they were appropriate, although I expect it meets the SEC’s requirements to the letter. See “CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS” in DEF 14A filed with the SEC 10/28/2013.

    UBNT – Useful life

Testing equipment 3 to 5 years
Computer and other equipment 3 to 5 years
Furniture and fixtures 3 years
Leasehold improvements shorter of lease term or useful life

IMO that’s very conservative yet not too short. With only two years leeway on the first two categories, and none on the third, there’s little scope to manipulate earnings to fall earlier or later.

    UBNT – Visual exaggeration in charts

None – I haven’t found any charts.

    UBNT – Potential CEO dominance

Robert J. Pera is the CEO and founder of Ubiquiti, and has seen the company through high growth and a crisis. He owns 65.40% of the common stock, as of September 30, 2013.

Officers and Directors own 73.80%, for details see “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT RELATED STOCKHOLDER MATTERS” in the 14A I linked to earlier.

The CEO gets zero Total Compensation, including Salary, Bonus, Stock Awards, and Option Awards. For comparison, the CFO, Chief Marketing Officer, and General Counsel and Vice President of Legal Affairs, get $1,994,043, $1,596,506 and $1,474,515.

    UBNT – Poison pills and severance

“Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.

… These provisions include:

§ providing for a classified board of directors with staggered, three year terms;
§ authorizing the board to issue, without stockholder approval, preferred stock with rights senior to those of our common stock;
§ prohibiting stockholder action by written consent;
§ limiting the persons who may call special meetings of stockholders; and
§ requiring advance notification of stockholder nominations and proposals.”

In other words, just as bad as IPG Photonics, even though the young CEO has a majority shareholding. I didn’t notice any sign of these in the latest 10-K, but traced them through the Exhibits in the 10-K. “… preferred stock with rights senior to those of our common stock” means that without finding further information, the common stock could be worth less, with no obvious limit on how much less. The other question is, who gets the preferred stock, and on what terms.

There might be more information in these legalistic filings:

EX-3.4 5 dex34.htm FORM OF AMENDED AND RESTATED BYLAWS OF UBIQUITI NETWORKS, INC.” (sec.gov) (initially adopted on June 25, 2010)

EX-3.2 3 dex32.htm FORM OF THIRD AMENDED AND RESTATED CERTIFICATE OF INCORPORATION” (sec.gov) (originally filed June 24, 2010) (already linked to above)

S-1 1 ds1.htm REGISTRATION STATEMENT ON FORM S-1” (sec.gov) (As filed on June 17, 2011)

The “Potential Payments upon Termination or Change of Control”, “Within 24 Months After Change of Control”, add to $4,045,070 (i.e. over $4 million). Most of that is to Craig L. Foster, including $1,929,400 of Acceleration of restrictive stock units. $2,806,400 of that depends on the share price and was based on $17.54 per share in June 30, 2013. The price is currently $43.77 and could be a lot higher if the company was acquired. This all affects the price an acquiring company would pay. Overall, management would probably not be rewarded above average, and the CEO gets nothing automatically. His majority shareholding prevents a hostile acquisition, and his financial interests are aligned with shareholders. He also seems to be committed to the company, and I’m not keen on seeing Ubiquiti acquired.

    UBNT – WELCOME FACTORS

The director and officer insurance policy that limits potential exposure. It’s good, but without hard information I don’t know how good.

The voluntary self-disclosure about illegal export to Iran could be an indication of honesty. Not doing so would have been very risky after a warning for a previous case, but having read about some appalling management I expect some companies would have kept the matter quiet.

Ubiquiti Networks – Summary

Note – the summaries are selective and are in my own opinion.

$115.2 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify.

The definition of Cash and cash equivalents has a logical loophole.

Potential for many years of growth, and high growth for some of them.

Not easy to satisfy growing demand with low visibility.

In a contentious area regarding patents.

Non-GAAP reporting, but only excluding stock-based compensation.

Reporting of related party transactions leaves questions.

The CEO could potentially dominate.

    UBNT – Unquantified

The $115.2 million ‘net of everything’ excludes illegal exports with guilt admitted, a Shareholder Class Action, some uncertainty about taxes, and the potential cost of indemnifying distributors and other business partners.

Possible errors include obligations, commitments and contingencies (OCCs) I didn’t find, double-counting an OCC which is included in liabilities, and I might have missed further information about the indemnity insurance.

~

Different models

IPG Photonics and Ubiquiti Networks have opposite business models. IPG are highly vertically integrated, while Ubiquiti Networks outsource production and sales. Both companies have been very successful, which shows the importance of having a model which fits the market (or targeting markets which fit the model), although other factors are involved than just the business model. Repligen has no over-arching model that I can see, but they are completing an astute move from the glamor of life sciences to the steadier ‘picks-and-shovels’ business of supplying bioprocessing inputs. The three companies which I identify as being ‘cash3’ are diverse on many levels, but share real financial strength.

Closing thoughts on cash3

Many growth companies consume more cash than they generate. This pushes the return of cash to shareholders into the future, and creates financial risk, which in turn produces pressure to ‘accentuate the positive’ (lyrics and ringtone) through everything from manipulated cash flows to the horrors of adjusted EBITDA. Companies that pass the cash3 tests still have market risk and other risks, but the financial risk is minimal. Management could still tweak the financial results to increase their compensation when their interests are not aligned with shareholders, but the pressure to deceive to survive or to generate unrealistic optimism before raising capital, is absent, at least until circumstances change. Because deceit results in overvaluation, honesty is relatively undervalued.

The pressure to keep up appearances is also pressure to make short term gains at the expense of strategic objectives.

Cash3 companies have the resources to survive setbacks and avoid a permanent loss of capital for their shareholders, but they are not invulnerable, and new management or new circumstances could result in the cash being spent unwisely. None of the arguments in favor of the cash3 approach amount to empirical evidence.

Trying to be fair

While I aim to be fair and accurate, I’ve covered some complex areas and it’s likely that I’ve been unintentionally unfair to a company or office-holder. Relevant facts and opinions are always welcome in the comments, but here I especially welcome a factual correction to any unfair remarks I’ve made.

~

REFERENCE SECTION

Read forms once and make notes

The aim here is mainly to avoid looking through a 10-Q or 10-K form too often.

Start with headings in a text document. For my list find “The headings I use for each company are” above, or make your own list. Then make notes under the appropriate heading as you read, adding new headings if anything stands out that needs one. If you find something really bad, there’s no point in continuing, just reject the company. Also see “Make easy checks first” above.

Competitors

This is to help with further research.

IPG Photonics (from the 10-K for 2012)

High-power CO YAG and disc lasers – Fanuc, Rofin-Sinar Technologies, Inc., Trumpf GmbH + Co. KG
Mid and low-power CO solid-state lasers – Coherent, Inc., GSI Group Inc., Newport Corporation, Rofin-Sinar Technologies, Inc.
Direct diode lasers – Laserline GmbH
Fiber lasers – Rofin-Sinar Technologies, Inc., Trumpf GmbH + Co. KG, GSI Group Inc., Coherent Inc., Hypertherm, Inc., Newport Corporation, The Furukawa Electric Co., Ltd., Keopsys SA, Mitsubishi Cable Industries, Ltd., Miyachi Unitek Corporation, Raycus Fiber Laser Technologies Co. Ltd., Maxphotonics Co., Ltd., JDS Uniphase Corporation

“Several competitors recently introduced fiber lasers or announced plans to introduce fiber lasers that compete with our high-power products.”

In the communications market –
Mid-power fiber amplifiers and DWDM systems – Oclaro Inc., the Scientific-Atlanta division of Cisco Systems, Inc. (Scientific-Atlanta), Emcore Corporation, JDS Uniphase Corporation and MPB Communications Inc.

In the materials processing, advanced and medical applications markets, IPG also compete with end users that produce their own solid-state and gas lasers as well as with manufacturers of non-laser methods and tools, such as resistance welding and cutting dies in the materials processing market and scalpels in the medical market.

Repligen Corporation

GE Healthcare.

Repligen don’t name their competitors. The 10-K for 2012 ‘Competition’ section includes “… range in size from large, multi-national companies to small, private emerging growth companies.”, before warning of the risk of existing and new products being made obsolete.

The legal boilerplate has “We face competition from numerous competitors, most of whom have far greater resources than we have, …” and much more of the same, but some of it might be a hangover from before the focus on bioprocessing.

For more useful info but only about chromatography, find “RGEN – Chromatography competition” above, and the first link there has more names.

Ubiquiti Networks, Inc (from the 1Q 2014 10-Q)

Integrated radio – Motorola, Trango
Integrated radio 900MHz – Cisco, Proxim
Embedded radio – Mikrotikls, Senao
Backhaul – Ceragon, DragonWave, Mikrotikls
Microwave backhaul – Cambium, DragonWave, SAF Tehnika, Trango
Customer Premise Equipment – Mikrotikls, Ruckus, TP-LINK
Antennas – PCTEL, Radio Waves
Enterprise WLAN – Ruckus, Aruba Networks, Cisco
Video surveillance – Vivotek, Axis Communications, Mobotix
Machine-to-machine communications – EnergyHub, Motorola, AlertMe.com

Sources of financial information

I divide the information needed into 1) prospects, 2) financial, and 3) OCCs, accounting policies and governance. The most reliable and comprehensive sources are the forms which companies are required to file with the SEC, though less so for 1) prospects. The SEC filings are described in the next section.

1) The prospects part provides the easiest reading, including presentations, transcripts on Seeking Alpha, and articles, although it could involve making your own projections if you already do that. The information feeds in to ‘test 3’, which is about growth.

2) The financial part is at least easy to find in the annual 10-K and quarterly 10-Q forms filed with the SEC, available from their archive of historical EDGAR documents. The forms are also nearly always available on the company’s website. The financial part is simplified by focusing on cash, with less need to examine quantities like inventories or accounts payable, although the income statement can reveal unsustainable sources of cash. Some history of cash flows will usually be relevant to tests 2 and 3, about free cash flow and its growth.

3) OCCs, accounting, rules and governance – this is the beast. The information applies to the tricky phrases in test 1 – “obligations, commitments and contingencies, including material off balance-sheet items”, and “with no accounting policies that cause significant doubt about the cash figure”. Like the financial part, this draws on the forms filed with the SEC, but requires more types of form, and exhibits, each of which is associated with a form. Even when the form is found, getting sense out of it isn’t always easy.

I also use 3) for some of my ‘Other considerations’, which are not an integral part of cash3. Delving further into the accounting policies and governance etc gives me some idea of how far I can trust management. Also, I might as well make further use of the sources I’ve found for the cash3 tests, for example the 10-K is usually needed for test 1, and the “Related-party transactions” are in the same 10-K.

Forms filed with the SEC (Securities and Exchange Commission)

The forms are available from the archive of historical EDGAR documents (already linked to) and are nearly always on the company’s website.

10-K
Annual financial filing, with the accounts, notes to the accounts, and more. When I say “10-K for 2012” I mean that 2012 is the fiscal year the form covers. It could have a filing date in early 2013, if the company’s fiscal year matches the normal calendar year.

10-Q
Quarterly financial filing, like a 10-K but shorter.

14A
Proxy statement, which invites shareholders to attend the annual meeting, and has information relating to the company’s officers and directors.

S-1
IPO Registration (IPO is Initial Public Offering). It contains a prospectus for a public offering of shares. The prospectus has information to help an investor decide if they want to buy the shares.

/A
An amendment, so S-1/A means it’s an amendment to the previous S-1.

I’ve kept it simple. A company will file different forms if it was incorporated on a Thursday (I’m joking, but it gets a bit like that). See “Guide to SEC Filings” (research.thomsonib.com) and “SEC filing” (Wikipedia)

Much of the accounting policies and governance information is in the Form 10-K in the notes to the accounts, but some could be in a more recent 10-Q.

Also see “Where to find cash info” (in 10-Qs and 10-Ks). It’s above, but it’s quicker to search down.

Exhibits, and how to find them

Sometimes the information needed is in an exhibit, such as the Certificate of Incorporation, which you hunt down by finding an associated form. The exhibit can be included in the form, or have a link on the same page as the form, on the SEC’s EDGAR database. Exhibits are usually legalistic and can be even harder to make sense of than 10-Ks and 10-Qs.

This is how I found Repligen’s Restated Certificate of Incorporation. I searched their 10-K for 2012 for “Incorporation”, and found this in the “Exhibits” section:

“Restated Certificate of Incorporation dated June 30, 1992 and amended September 17, 1999 (filed as Exhibit 3.1 to Repligen Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999 and incorporated herein by reference) (SEC File No. 000-14656).”

It might have been easier to get the 10-Q from Repligen’s site, but I found it from here. Then I searched the 10-Q for “Incorporation”, until I found “EXHIBIT 3.1 RESTATED CERTIFICATE OF INCORPORATION”, the title for four pages. That’s followed by amendments, about the number of shares Repligen can issue.

It’s likely that the old 10-Q is up to date about the Certificate of Incorporation, as it was referenced from the 10-K for 2012, but I can’t promise.

The last part of the method doesn’t always work, because sometimes the exhibit is not included in the form (the 10-Q in the above case). For example, Ubiquiti’s S-1 dated 06/17/2011 did not include the exhibit 3.4. Following the link in the search results on EDGAR, the S-1 was the top item in a list, like this except the headings (in bold) were column headings in a table:

Seq 1
Description REGISTRATION STATEMENT ON FORM S-1
Document ds1.htm
type S-1

The document with exhibit 3.4 was listed like this, on row five:

Seq 5
Description FORM OF AMENDED AND RESTATED BYLAWS OF UBIQUITI NETWORKS, INC.
Document dex34.htm
type EX-3.4

To find the By-laws (for example): search a 10-K for ‘By-laws’ until you find a clue to follow, such as an entry under ‘EXHIBITS’ which gives a form-code and a filing date. If that doesn’t work, try earlier 10-Ks, or ask the company’s Investor Relations. The filing date won’t always be an exact match, and you might have to check more than one file to make sure you have the right document. The trail can usually be followed for any search that ends up in EXHIBITS on a 10-K. There are exceptions, for instance Repligen’s 10-K for 2012 reproduces an agreement with Pfizer, with confidential provisions omitted, so you get the document immediately instead of a trail to follow.

Finding obligations, commitments and contingencies

This might sound too demanding, but if you have the time, go through the 10-Q first (if it’s more recent) and make notes, then go through the 10-K and add anything relevant that wasn’t in the 10-Q.

As a guide for what to look for, the Obligations, commitments and contingencies (OCCs) I’ve written about for the three companies are:

Quantified –

Interest obligations
Operating lease obligations
Purchase obligations (commitments to buy)
Contingent consideration (but they could be included in liabilities already)
the liability if a tax dispute is lost

Unquantified –

Indemnification
Legal proceedings (intellectual property / Illegal export to Iran / Shareholder Class Action Lawsuits)
Pension commitments (probably minimal)

They don’t each apply to all three companies.

Three of the ‘quantifieds’ will usually be under a head like (or starting with) “Contractual Obligations”, they are:

Operating lease obligations
Purchase obligations
Contingent consideration (likely to be already included in liabilities)

Under the same heading, you might also see “Long-term debt obligations” which should be already included in liabilities. This: “Long-term debt obligations (including interest)” can be used to calculate the interest obligation if it isn’t disclosed separately.

There are five time-saving principles, but they are specific to the cash3 approach and specific to only getting the Obligations, commitments and contingencies, and I can’t be sure they’re safe. a) Avoid irrelevant sections. b) Skip trivial amounts. c) Assets are irrelevant. d) Liabilities on the balance sheet are irrelevant. e) If debt is low, ignore anything about the period’s income or cash flow.

For a), irrelevant sections include any general description of the business, and the regular accounts. The cash flow statements concern the other tests (2 and 3).

For b), note what the Cash provided by operations is (find the cash flow statement or search for “Cash provided”) and decide on a threshold below which amounts are too too trivial to bother with. If cash from ops is $100 million, and you set your threshold to $0.5 million, remember that $600 could be ‘in thousands’, i.e. $600,000. (This would scale up for a big company). This could fail if too many figures are below the threshold.

For c), the value put on inventories, buildings etc. has nothing to do with the OCCs.

For d), if liabilities are understated, that comes under “accounting policies that cause significant doubt”, or shows up as a matching obligation (if there aren’t any clues, something is seriously wrong).

For e), if debt is significant, the income statement matters and so can the cash flows. The reason is that debt usually comes with covenants (agreements which lenders insist on), with conditions, and penalties such as higher interest. A common condition is that an income measure like EBITDA should not fall below a threshold amount. Search the 10-K for ‘covenant’ or check the “Liquidity and Capital Resources” section. If the covenants are based on EBITDA, check that EBITDA looks healthy enough. This example from IPG is based on cash flow: “The debt service coverage covenant requires that we maintain a trailing twelve month ratio of cash flow to debt service that is greater than 1.5:1. Debt service is defined as required principal and interest payments during the period.” With their cash and cash flow, the covenant is not a serious concern, although it’s when a big shock causes a covenant to be breached that the penalty is particularly unwelcome.

At this stage, the income statement should already have been checked for ‘one-off’ gains which could be included in cash flow, and the relevant cash flows should already have been found and considered (see “Make easy checks first”, above).

Please note, I can’t be sure that a) to e) are safe. I’m trying to take investors’ limited time into account, but (as I’ve said) in the worst cases, management can be slippery.

Indemnification is an awkward OCC because it’s safest to look for it in the 10-Q first (if it’s more recent than the 10-K), and then in the 10-K (which might have more detail), and then outside the 10-K, probably in either an S-1 or the latest version of the Certificate of Incorporation.

I’ll repeat that this section is specific to getting the Obligations, commitments and contingencies. Outside of that, ideally, most of the 10-Q and 10-K should be read. I didn’t read much of Repligen’s long contract with Pfizer. I don’t bother with the audit committee because I just want the auditor’s opinion. I skip anything about company officers certifying documents.

Signing off

No-one has endorsed this blog post and I’m the only person who’s checked it before posting. A piece this big is bound to have mistakes. According to IBM, 5.2% of spreadsheet cells contain errors (see under “Spreadsheets and reliability” in my Correlation and regression with a real example July 16, 2013). I hope I’ve done a lot better than that.

I haven’t systematically compared forms filed with the SEC to previous forms. Looser accounting policies and new risks are red flags, and I hope to compare forms when new 10-Ks are filed, if I have the time.

Thank you for reading this piece. If you read most of it – very well done!

sinksmith

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Amendments

January 18, 2014 – I’ve made small changes and added some paragraphs. There are no factual corrections or changes of opinion. To find paragraphs added or changed, find:

Many investors will be unfamiliar
One risk to watch out for when the CEO is very dominant
UBNT – Tax uncertainty
Closing thoughts on cash3

January 19, 2014 – Matthew Dow’s December article about Ubiquiti has gone behind Seeking Alpha’s paywall, so I’ve removed most references to it and described the key personnel risk myself.

All the charts again

IPG cash from ops and into investment - spread

IPG walks for cash from ops and into investment

IPG walks per share for cash from ops and into investment

Repligen cash flows to 3Q 2013 spread

Repligen cash walks per share to 3Q 2013
……………………………………………..
In Repligen’s cash flow charts, the recent rise is partly the result of recent growth in royalty revenue which expired on December 31, 2013. The latest quarter, 3Q 2013, also benefits from changes in working capital that can’t be sustained.

Repligen cash flows per share to 3Q 2013

Repligen recent revenue and costs - spread

Repligen recent revenue and costs

Repligen walk chart of product cost against revenue

Ubiquiti cash walk to 2013 spread

Ubiquiti cash walks per share to 2013

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.