Arrhythmia Research Technology Inc (AMEX:HRT) is a tiny but profitable net net stock with a plan to buy back stock. At its $2.25 close yesterday the company has a market capitalization of just $6.1M. We estimate its pre-buy back liquidation value to be more than 100% higher at around $12.7M or $4.68 per share. If the buy back is completed at the current stock price, we estimate that the company will buy back around 10% of the outstanding stock, which will cause HRT’s per share liquidation value to increase to almost $5.00, around 120% higher than the present stock price.
About HRT
HRT develops medical software that acquires data and analyzes electrical impulses of the heart to detect and aid in the treatment of potentially lethal arrhythmias. HRT’s wholly owned subsidiary, Micron Products, Inc. (Micron) is a manufacturer and distributor of silver plated and non-silver plated conductive resin sensors (sensors) used in the manufacture of disposable integrated electrodes constituting a part of electrocardiographic diagnostic and monitoring instruments. Micron also acts as a distributor of metal snap fasteners (snaps), another component used in the manufacture of disposable electrodes. The company’s investor relations website is here.
The value proposition
In a rarity for a net net stock, HRT is currently profitable. Although it didn’t pay a dividend in 2008, it has paid dividends in the past. In the 12 months ending December 31, 2007, the company earned $1.29M after tax and generated cash from operating activities of $1.47M. The balance sheet looks healthy enough (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):
HRT’s balance sheet value is predominantly in its property, plant and equipment, to the tune of $16.1M, which we’ve written down by half to $8M or $2.96 per share. The company also has receivables of $3.9M, which we’ve written down by 20% to $3.1M or $1.15 per share, and inventory of $3.7M, which we’ve discounted by a third to $2.5M or $0.91 per share. Deducting liabilities of $3.3M (including $0.7M in debt) from the written down asset value gives us a liquidation value for HRT of around $12.7M or $4.68 per share.
The catalyst
HRT has announced a stock buy back program, which authorizes it to buy back “up to $650,000 of the Company’s common stock from time to time, subject to prevailing conditions and price levels.” No shares have been acquired to date, but we would like to see the company put the buy back into operation. Buy backs effected at deep discounts to intrinsic value, and particularly at deep discounts to liquidation value, create lots of value for remaining stockholders. They also demonstrate that management is alive to the plight of the shareholders’ in a company with a stock languishing at a discount to liquidation value. With the stock at these levels ($2.25), $650,000 buys back around 289,000 shares, which is a little over 10% of the 2.7M shares outstanding. The effect of such a buy back is demonstrated below:
The buy back reduces HRT’s total liquidating value from $12.7M to $12.0M, but increases the per share liquidating value from $4.68 to $4.97.
Conclusion
At $2.25, HRT is trading at a 48% discount to its liquidation value of $4.68. If the company undertakes and completes its buy back at the current stock price, HRT’s per share liquidating value will increase to $4.97, which is 120% higher than HRT’s close yesterday. We think HRT is worth a punt at these levels, and we’re adding it to the Greenbackd Portfolio.
Take care with these thinly traded stocks and always use limit orders to buy stock.
HRT closed yesterday at $2.25.
The S&P500 Index closed yesterday at 871.71.
[Full Disclosure: We do not have a holding in HRT. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]
[…] Specifically, readers have asked why we include property, plant and equipment in our valuation, and why we only discount it by half, as opposed to a higher figure (two-thirds, four-fifths, one-hundred percent). They are concerned […]
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Thanks for your response.
I’ll speak to two issues:
First, HRT may be cheap enough to have a sufficient margin of safety with its PPE valued at 0%, 20%, or 50%. I’d really need to dig through the filings to make a reasonable judgment though. You are right that liquidation value should be added to earnings power value to get a fuller valuation.
Secondly, and more broadly, when I use Graham’s ‘net-net’, liquidation model for valuation, I really try to discipline myself to think like Graham. This forces me to value things like PPE much more conservatively than I think is necessary. I do find this useful because it gives me a wider margin of safety than I am naturally inclined to seek. I have, after all, lived primarily during one of the longest bull markets in history.
But the crux here is–how much margin do I really need to be safe? I do know that when Buffett worked for Graham-Newman, that many of the cigar butt ideas he pitched to Graham were passed over. When Graham wrote his article ‘Are Equities Worth More Dead than Alive?’, greater than 50% of the DJIA traded below their liquidation value. But he didn’t invest in them all.
In the end, I would like to replicate Graham’s returns, but know that I must be discriminating, even with his model. That is, to invest like him, I need to seek an even larger margin of safety than his ‘net-net’ model produces.
Thus, I really try to keep the model conservative (PPE at 20% or less) and then rigorously justify exceptions. Maybe that provides more safety than I need, but it has been a useful discipline.
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Me too,I think the recet valuations of the companies were too high. I don’t see much margin of safety for hrt…
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Chad, Potax
We’ve set out our process here. You might be right. We’ve got no special insight into HRT that makes us think that 50% is more likely than 20%. 20% would seem to be a more conservative – and therefore better – valuation. Our experience is that a 50% discount provides a sufficient margin of safety in most – but not all – situations.
Here’s a few perspectives on HRT:
1. If we write the PP&E to zero and carry everything else at book value, HRT is worth around $2.67, which, while not enough of a discount to get excited about, still offers a 16% margin of safety. In that scenario, the current assets pay for HRT at $2.25 per share and give change of 42 cents, and then you get a free hit at $16M or $5.93 per share in PP&E. Even if the PP&E is only worth around $3.2m (which is a 20% valuation), it’s still another $1.19 per share.
2. HRT’s book value is around $8.60 per share. You’re paying $2.25 for that book value (around 26%) and you get a profitable and operating cash flow positive business that has previously paid dividends, and probably will again.
Any thoughts?
Greenbackd
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Thanks for this write-up.
You are estimating the liquidated value of property, plant, equipment to be 50% of carrying value here. This strikes me (and probably other Grahamites) as rather high. Could you add some color here to defend your estimation? 20% of PPE in liquidation seems the more standard and conservative route.
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