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Archive for March, 2009

Avigen Inc (NASDAQ:AVGN) has filed its assessment of the cash portion of the MediciNova Inc (NASDAQ:MNOV) proposal.

We’ve been following AVGN (see archived posts here) because it’s a net cash stock (i.e. it’s trading at less than the value of its cash after deducting all liabilities) and specialist biotechnology investor BVF has been pushing it to liquidate and return its cash to shareholders. MNOV has made an offer for AVGN that we think represents a clever way for AVGN’s stockholders to receive cash equivalent to that which they would receive in a liquidation (less $7M to be paid to MNOV) with the possibility for “an extraordinary, uncapped return” if MNOV is successful post-merger. The stock is up 72.3% from $0.65 to close at $1.12 yesterday. We estimate AVGN’s net cash value to be $37M or $1.24 per share (BVF estimates $1.20 per share). The net cash estimate does not take into account AVGN’s AV411 assets and program, which could be worth considerably more, perhaps as much as $5M to $20M or between $0.15 or $0.60 per share.

The text of AVGN’s press release is set out below:

In filings with the Securities and Exchange Commission on March 10, 11 and 18, 2009, Avigen disclosed that it had assessed the cash portion of the MediciNova proposal described in those filings at approximately $0.91. Avigen arrived at this assessment by taking the estimated net cash and securities at the end of June 2009 to be sequestered by MediciNova of approximately $27.1 million, and dividing it by the approximately 29.8 million shares of Avigen common stock outstanding.

The estimated net cash and securities at the end of June 2009 was arrived at by taking the audited cash and securities balance at the end of December 2008 of $56.8 million, and subtracting therefrom, an estimated:

* $7.0 million in debt,
* $3.1 million of accrued liabilities at December 31, 2008,
* $3.1 million of remaining building lease obligations, net of potential subleases,
* $2.2 million of estimated severance for Named Executive Officers,
* $5.0 million of estimated operating expenses for the six months ended June 30, 2009,
* $2.3 million of estimated winddown and other transaction costs,

and

* $7.0 million that MediciNova would take in exchange for the issuance of 1.75 million shares of MediciNova stock at $4.00 per share, that as of March 13, 2009 were valued at $1.59 per share or $2.8 million in the aggregate, resulting in an immediate loss of $4.2 million of value.

In assessing the adequacy of the offer presented by MediciNova, the Board of Avigen also obtained an opinion, dated March 17, 2009, from RBC Capital Markets Corporation (“RBC”), that, as of the date of such opinion, and subject to certain assumptions, qualifications and other considerations set forth in its written opinion, the consideration being offered by MediciNova in its proposal to acquire Avigen is inadequate, from a financial point of view, to the stockholders of Avigen. RBC’s opinion was provided for the information and assistance of the Board of Avigen. RBC expresses no opinion and makes no recommendation to any stockholder of Avigen. All advice and opinions (written and oral) rendered by RBC were solely for the use and benefit of the Avigen Board and may not be used or relied upon by any other person.

RBC’s opinion does not address the merits of the underlying decision by Avigen to accept or reject the MediciNova offer or the relative merits of the MediciNova offer compared to any alternative business strategy or transaction in which Avigen might engage. RBC does not express any view on, and RBC’s opinion does not address, the fairness, from a financial point of view, of the consideration offered by MediciNova.

A copy of RBC’s opinion is filed below. You are urged to read this opinion in its entirety.

RBC’s analysis included, among other analyses, an assessment of MediciNova’s proposed offer on a per share basis as of the date of the analysis which was based upon certain assumptions and information both publicly available and provided by Avigen management. Such analysis was further limited by the fact that RBC did not have access to any of MediciNova’s non-public financial information (including forecasts) and, as result, valued MediciNova’s common stock solely based on the closing price for such stock on the Nasdaq Global Market on March 13, 2009. The following sets forth a summary of such assessment:

avgn-rbc-mnov-valuation

(3) Black-Scholes calculation based upon certain assumptions for Convertible Security including: MNOV stock price of $1.59 as of March 13, 2009; convertible security exercise price of $4.00; assumed risk-free interest rate of 0.44%; one-year term for convertible security; and standard deviation volatility assumption of 69% based upon MediciNova’s 10-K filed March 17, 2008.

The above assessment of MediciNova’s proposed offer was one of several analyses performed by RBC in connection with its opinion and should not be regarded as critical to the overall conclusion RBC reached. Such assessment has inherent strengths and weaknesses, and the nature of the available information may further affect such assessment. The overall conclusions RBC reached were based on all the analysis and factors presented, taken as a whole, and also on application of RBC’s own experience and judgment. Such conclusions may involve significant elements of subjective judgment and qualitative analysis. RBC therefore gives no opinion as to the value or merit standing alone of the above analysis.

(1) Based upon 29.8 million Avigen shares outstanding per 10-Q filed on November 10, 2008.
(2) Based upon information provided to RBC by Avigen management as of March 15, 2009.

RBC’s summary valuation is set out below:

March 17, 2009

The Board of Directors
Avigen, Inc.1301 Harbor Bay Parkway
Alameda, CA 94502
Members of the Board of Directors:

We understand that MediciNova, Inc., a Delaware corporation, (the “Offeror”) has made a non-binding, publicly disclosed offer (the “Offer”) to acquire, pursuant to a proposed merger transaction, all of the issued and outstanding shares of common stock, par value $0.001 per share (the “Common Stock”) of Avigen, Inc., a Delaware corporation (the “Company”), in exchange for the Consideration (as defined below) pursuant to letters sent by the Offeror to the Company dated December 22, 2008 and February 9, 2009 (the “Letters”), which letters are contained in the Offeror’s Current Reports on Form 8-K filed with the Securities and Exchange Commission (the “SEC”) on December 23, 2008 and February 9, 2009, respectively.

You have requested our opinion as to the adequacy, from a financial point of view, of the Consideration to the holders of the Company Common Stock (the “Stockholders”).

The Letters provide, among other things, that each Stockholder would receive (i) a pro rata portion of 1.75 million shares of the Offeror and (ii) a convertible security that would allow each Stockholder at their election to either (a) convert each share of such convertible security into shares of the Offeror at a conversion price of $4.00 per share at certain pre-specified accelerated conversion dates or the later of March 31, 2010 or 12 months from the closing of the proposed merger transaction (the “Final Conversion Date”), or (b) have the convertible security redeemed by the Offeror on the Final Conversion Date for cash in an amount per share which represents each Stockholder’s pro rata interest in the Net Cash Assets (as defined below) of the Company (items (i) and (ii) above, together, constituting the “Consideration”). Pursuant to the Letters, “Net Cash Assets” means the amount of the Company’s cash remaining after the completion of the Company’s wind-up activities, including satisfaction of all of the Company’s obligations by way of indebtedness, severance and related liabilities (provided that the Company will retain all intellectual property assets for the combined companies), minus $7 million in cash that the Offeror will receive in exchange for the stock portion of the Consideration described in item (i) above.

RBC Capital Markets Corporation (“RBC”) is a global, full service securities firm engaged in securities trading and brokerage activities, and providing investment banking, investment management and financial advisory services. In the ordinary course of its trading, brokerage, investment and asset management and financial activities, RBC and its affiliates may hold long or short positions, and may trade or otherwise effect or recommend transactions, for its own account or the accounts of its customers, in debt or equity securities or loans of the Company or any other company that may be involved in a transaction with the Company. Further, in connection with its merchant banking activities, RBC may have made investments in the Company or any other company that may be involved in a transaction with the Company. As a global, full service financial organization, RBC and its affiliates may also provide a broad range of normal course financial products and services to its customers (including, but not limited to investment banking, commercial banking, credit derivative, hedging and foreign exchange products and services), including companies that may be involved in certain transactions with the Company.

We are acting as financial advisor to the Board of Directors of the Company (the “Board”) in connection with its consideration of the Offer and pursuant to an engagement letter between the Company and RBC dated January 13, 2009 (the “Engagement Letter”). We will receive a fee for our services upon delivery of this opinion, which is not contingent upon the Offer being accepted or rejected by the Company. For our services as financial advisor to the Company, if a Transaction (as defined in the Engagement Letter) is successfully completed we will receive an additional larger fee.

We have also been engaged to advise the Company in connection with an unsolicited third party offer to merge with, acquire or purchase the common stock of the Company, and will receive a fee for such services regardless of the outcome of such unsolicited offer. In addition, the Company has agreed to indemnify us for certain liabilities that may arise out of our engagement and to reimburse the reasonable out-of-pocket expenses incurred by us in performing our services (subject to a limit which may not be exceeded without the Company’s written approval). In the ordinary course of business, RBC may act as a market maker and broker in the publicly traded securities of the Company and/or Offeror and receive customary compensation, and may also actively trade securities of the Company and/or Offeror for our own account and the accounts of our customers, and, accordingly, RBC and its affiliates, may hold a long or short position in such securities. RBC may also provide investment banking and other financial services to the Company, Offeror and their respective affiliates in the future, for which we may receive compensation.

For the purposes of rendering our opinion, we have undertaken such review and inquiries as we deemed necessary or appropriate under the circumstances, including the following: (i) we reviewed the financial terms provided in the Letters and other correspondence between the Offeror and the Company; (ii) we reviewed and analyzed certain publicly available financial and other data with respect to the Company and the Offeror and certain other relevant operating data relating to the Company made available to us from the internal records of the Company; (iii) we reviewed publicly available equity research reports and Thomson One Analytics consensus estimates regarding the potential future performance of the Company and Offeror as standalone entities; (iv) we reviewed financial projections and forecasts of the Company (“Forecasts”) prepared by the management of the Company; (v) we conducted discussions with members of the senior management of the Company with respect to the business prospects and financial outlook of the Company as well as the value of the Company’s assets as a standalone entity; (vi) we reviewed the reported prices and trading activity for Company Common Stock and the Offeror common stock, including their trading relative to one another; (vii) we have taken into consideration that the Company has been approached by, and has initiated contact with, other parties who have expressed interest in exploring a transaction involving the Company; and (viii) we considered other information and performed other studies and analyses as we deemed appropriate, including recent developments with respect to the Company’s business.

Several analytical methodologies have been employed and no one method of analysis should be regarded as critical to the overall conclusion we have reached. Each analytical technique has inherent strengths and weaknesses, and the nature of the available information may further affect the value of particular techniques. The overall conclusions we have reached are based on all the analysis and factors presented, taken as a whole, and also on application of our own experience and judgment. Such conclusions may involve significant elements of subjective judgment and qualitative analysis. We therefore give no opinion as to the value or merit standing alone of any one or more parts of the analyses.

In rendering our opinion, we have assumed and relied upon the accuracy and completeness of all the information that was publicly available to us and all of the financial, legal, tax, operating and other information provided to or discussed with us by the Company (including, without limitation, the financial statements and related notes thereto of the Company), and have not assumed responsibility for independently verifying and have not independently verified such information. We have assumed with your consent that all Forecasts provided to us by the Company were reasonably prepared on bases reflecting the best currently available estimates and good faith judgments of the future financial performance of the Company, as a standalone entity. We express no opinion as to such Forecasts or the assumptions upon which they were based.

In rendering our opinion, we have not assumed any responsibility to perform, and have not performed, an independent evaluation or appraisal of any of the assets or liabilities of the Company, and we have not been furnished with any such valuations or appraisals. We have not assumed any obligation to conduct, and have not conducted, any physical inspection of the property or facilities of the Company. We have not investigated, and make no assumption regarding, any litigation or other claims affecting the Company. Our opinion does not address any legal, regulatory, tax or accounting matters.

Our opinion speaks only as of the date hereof, is based on the conditions as they exist and information which we have been supplied as of the date hereof, and is without regard to any market, economic, financial, legal, or other circumstances or event of any kind or nature which may exist or occur after such date. We have not undertaken to reaffirm or revise this opinion or otherwise comment upon events occurring after the date hereof and do not have an obligation to update, revise or reaffirm this opinion.

The opinion expressed herein is provided for the information and assistance of the Board in connection with the Offer. We express no opinion and make no recommendation to any Stockholder with respect to the Offer. All advice and opinions (written and oral) rendered by RBC are intended solely for the use and benefit of the Board and may not be used or relied upon by any other person, nor may such advice or opinions be reproduced, summarized, excerpted from or referred to in any public document or given to any other person without the prior written consent of RBC. If required by applicable law, this opinion letter may be included in any disclosure document filed by the Company with the SEC with respect to the Offer; provided, however, that this opinion letter must be reproduced in full and any description of or reference to RBC must be in a form reasonably acceptable to RBC and its counsel. RBC shall have no responsibility for the form or content of any such disclosure document, other than this opinion itself.

Our opinion does not address the merits of the underlying decision by the Company to accept or reject the Offer or the relative merits of the Offer compared to any alternative business strategy or transaction in which the Company might engage. Our opinion addresses solely the adequacy of the Consideration, from a financial point of view, to the Stockholders, as of the date hereof. We do not express any view on, and our opinion does not address, the fairness, from a financial point of view, of the Consideration. We also do not express any view on, and our opinion does not address the adequacy or fairness of the amount or nature of any compensation to be paid or payable to any officers, directors or employees, or class of such persons, whether relative to the compensation proposed to be paid to the public Stockholders or otherwise.

We do not express any opinion as to the price or range of prices at which the Company Common Stock or the Offeror’s common stock may trade at any time.

Our opinion has been approved by RBC’s M&A Opinion Review Committee.

Based upon and subject to the foregoing, including the various assumptions and limitations set forth herein, it is our opinion that, as of the date hereof, the Consideration is inadequate, from a financial point of view, to the Stockholders.

Very truly yours,

RBC CAPITAL MARKETS CORPORATION

[Full Disclosure:  We have a holding in AVGN. 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.]

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Biotechnology Value Fund (BVF) has increased its tender offer for Avigen Inc (NASDAQ:AVGN) from $1.00 per share to $1.20 per share contingent on the election of BVF’s nominees to the board of AVGN.

We’ve been following AVGN (see archived posts here) because it’s a net cash stock (i.e. it’s trading at less than the value of its cash after deducting all liabilities) and specialist biotechnology investor BVF has been pushing it to liquidate and return its cash to shareholders. MediciNova Inc (NASDAQ:MNOV) has made an offer for AVGN that we think represents a clever way for AVGN’s stockholders to receive cash equivalent to that which they would receive in a liquidation (less $7M to be paid to MNOV) with the possibility for “an extraordinary, uncapped return” if MNOV is successful post-merger. The stock is up 77% from $0.65 to close at $1.15 Friday. We estimate AVGN’s net cash value to be $37M or $1.24 per share (BVF estimates $1.20 per share). The net cash estimate does not take into account AVGN’s AV411 assets and program, which could be worth considerably more, perhaps as much as $5M to $20M or between $0.15 or $0.60 per share.

The text of BVF’s press release is set out below:

BVF Acquisition LLC Increases Tender Offer Price for Avigen, Inc. to $1.20 Per Share

Friday March 20, 2009, 8:00 am EDT

Why does Avigen refuse to guarantee $1.20 per share in cash?

NEW YORK, March 20 /PRNewswire/ — BVF Acquisition LLC (the “Purchaser”), an affiliate of Biotechnology Value Fund L.P. (“BVF”), which has commenced a cash tender offer to purchase all of the outstanding shares of Avigen, Inc. (Nasdaq: AVGN – News; “Avigen”), announced today that it is increasing its cash tender offer price from $1.00 per share to $1.20 per share. The offer is currently scheduled to expire at 6:00 p.m., New York City time, on Friday, April 3, 2009. The key condition to the offer is the election of BVF’s nominees.

BVF is offering all stockholders $1.20 per share in cash. Why won’t Avigen do the same? Without this protection, how can Avigen be trusted?

BVF has repeatedly called on the Board to guarantee downside protection for stockholders, rather than gambling the remaining stockholder money. This Board has repeatedly refused to commit to proceeding only with a transaction that offers quantifiable downside protection, in cash, of approximately the Company’s liquidation value. The MediciNova merger provides for this; why not Avigen directly? The Board’s refusal to do so should be cause for great concern and suspicion. For example, is Avigen about to give away millions of dollars in “break-up” fees in a flawed, unprotected merger, with full knowledge that stockholders oppose it? BVF has offered stockholders the option to tender their shares for $1.20 per share in cash or participate with BVF in the future of Avigen. BVF’s objective is to protect and maximize its investment in Avigen stock; management’s incentive is to maximize salaries and fees, and to trigger their multimillion-dollar “golden parachute” agreements.

To tender your shares and receive $1.20 per share in cash, BVF’s nominees must be elected. Importantly, should stockholders fail to remove the current Board and replace them with BVF’s stockholder-oriented representatives, the tender offer will expire and no shares will be accepted. Is it possible that Avigen’s stock price could fall significantly without the support of the outstanding BVF tender offer?

We urge stockholders to vote the GOLD proxy to remove the current directors and elect BVF’s stockholder-oriented nominees. BVF believes its nominees offer the best opportunity for stockholders to protect their investment in Avigen. All stockholders are encouraged to act now to protect their investment and vote the GOLD proxy card today.

MacKenzie Partners, Inc. is the Information Agent for the tender offer and any questions or requests for the Offer to Purchase and related materials with respect to the tender offer or the special meeting may be directed to MacKenzie Partners, Inc.

[Full Disclosure:  We have a holding in AVGN. 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.]

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Wes Gray’s Empirical Search Strategies (ESS) has proclaimed its support for a “downside protection” measure described by the Biotechnology Value Fund (BVF) in the Avigen Inc (NASDAQ:AVGN) proxy fight. ESS is the beneficial owner of approximately 2.3% of AVGN’s outstanding common stock.

We’ve been following AVGN (see archived posts here) because it’s a net cash stock (i.e. it’s trading at less than the value of its cash after deducting all liabilities) and specialist biotechnology investor BVF has been pushing it to liquidate and return its cash to shareholders. MediciNova Inc (NASDAQ:MNOV) has made an offer for AVGN that we think represents a clever way for AVGN’s stockholders to receive cash equivalent to that which they would receive in a liquidation (less $7M to be paid to MNOV) with the possibility for “an extraordinary, uncapped return” if MNOV is successful post-merger. The stock is up 77% from $0.65 to close at $1.15 Friday. We estimate AVGN’s net cash value to be $37M or $1.24 per share (BVF estimates $1.20 per share). The net cash estimate does not take into account AVGN’s AV411 assets and program, which could be worth considerably more, perhaps as much as $5M to $20M or between $0.15 or $0.60 per share.

The text of ESS’s press release is set out below:

CHICAGO, March 20 /PRNewswire/ — Empirical Search Strategies, LP. (“ESS”), the beneficial owner of approximately 2.3% of the Avigen, Inc.’s (Nasdaq: AVGN – News) outstanding common stock, has proclaimed their support for a “downside protection” measure described by the Biotechnology Value Fund (“BVF”). ESS believes a clearly articulated downside protection measure is beneficial to all shareholders for the following reasons:

* First, offering downside protection guarantees shareholders an opportunity for liquidity. Without a liquidity option, shareholders who decide to exit their Avigen position for individual reasons (or those who view the final transaction unfavorably) will be forced to sell shares into an extremely illiquid market environment. It is not uncommon to see a 5% bid/ask spread in Avigen stock on any given day.

* Second, there is currently excess cash on the balance sheet of approximately $35mm (which includes a healthy, but unwelcome burn rate of approximately $10mm and an estimate of required capital/miscellaneous costs of roughly $2mm throughout 2009). This excess cash is not needed to sustain the sale of AV411 or to pursue the Genzyme partnership. To ensure agency costs are limited, management should publically state they will either (i) distribute this excess cash immediately, or (ii) structure a deal similar to the MediciNova deal that offers shareholders an exit option for a specific amount and at a specific time in the future.

* Third, Avigen is not a bank. Management should focus on selling their value-proposition: experience and know-how in the AV411 program, and continuity and understanding of how to maximize value from the Genzyme partnership. It may seem sensible to bargain for a “good deal” from an acquirer who is in financial distress by offering them a pile of cash. However, if a potential buyer is strapped for cash in this environment, it’s probably not a company Avigen shareholders want to own–even if they offer a slight premium. As a matter of fact, the very thought of owning a distressed company is the main reason ESS values a downside protection measure that is clear and transparent from the beginning.

In conclusion, ESS believes it is not impossible that in a year from now Avigen shareholders will find themselves experiencing a bout of deja vu. We worry that we will be holding a biotech company that is burning cash, selling at .5x liquidation value, and paying management salaries of $500,000 to $1,000,000 a year during the worst economic environment since the Great Depression. In the end, ESS believes the following statement from Avigen (or anything even resembling this statement) would maximize the utility of all Avigen shareholders, and cause BVF to IMMEDIATELY drop their proxy fight, which will save shareholders the fees associated with the proxy battle:

“Dear Avigen Shareholders:

Regardless of the deal we choose to pursue, we will guarantee a downside protection option for all shareholders. Specifically, we will offer all shareholders the opportunity to exchange their shares for $1.10, six months following the closing of a deal. If shareholders find that the NewCo is simply burning cash and providing no value, they will have a 30 day window to exchange their shares for $1.10 per share. If shareholders believe the NewCo is worth more than $1.10, they can maintain their ownership in NewCo and participate in the future of the company.

We believe this arrangement will provide downside protection to shareholders who are risk-averse in the current economic environment, and at the same time, this deal will offer NewCo management an opportunity to prove their worth and earn shareholder trust.

Sincerely,

Avigen Management”

Wesley R. Gray, ESS Portfolio Manager, stated, “I really appreciate the steps management has taken to maximize shareholder value and I value their hard work. I just wish they would listen to shareholder requests more diligently. For the vast majority of shareholders I have spoken to, downside protection and a decent chance for reasonable upside beats the outright ownership of a distressed biotech company–especially in this investment environment.”

[Full Disclosure:  We have a holding in AVGN. 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.]

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Rackable Systems Inc (NASDAQ:RACK) has filed its 10K for the year ended January 3, 2009.

We’ve been following RACK (see our post archive here) because it is an undervalued asset play with a plan to repurchase almost 40% of its stock. The stock is up 10.1% from $3.56 when we added it to the Greenbackd Portfolio on March 11 this year to close yesterday at $3.92. The company now has a market capitalization of $117.2M. We initially estimated the company’s liquidation value to be 46% higher at $171.6M or $5.74 per share. We’ve now had an opportunity to review the 10K and see no reason to vary our initial estimate. If the buy back is completed at the current stock price, the company’s per share liquidation value will increase by 17% to $6.69, which presents considerable upside from the present price.

The value proposition updated

RACK has had a tough year, burning through $15.7M in the 12 months to January 3, 2009. The company’s value resides in the huge amounts of cash and equivalents on its balance sheet, much of which is from the $138.5 million follow-on public offering completed in March 2006. Set out below is our estimate of the company’s liquidation value (the “Book Value” column shows the assets as they are carried in the financial statements, and the “Liquidating Value” column shows our estimate of the value of the assets in a liquidation):

rack-summary-2009-1-3We estimate the company’s liquidation value to be around $171.6M or $5.74 per share, which is predominantly cash and equivalents in the amount of $172M or $5.75 per share. RACK’s net cash value is around $118M or $3.95 per share.

Off balance sheet arrangements and contractual obligations

According to the 10K, the company has no off-balance sheet arrangements. The contractual obligations as at January 3, 2009 were around $17.1M, around $9.5M of which falls due in the next 12 months. Those committments are $2.0M minimum lease payments under the company’s operating leases and $7.5 in purchase obligations. The company also had purchase committments in the amount of $7.6M in total.

Catalyst

According to the 10K, RACK plans to buy back almost $40M of its own stock:

In February 2009, our Board of Directors authorized a share repurchase program of up to $40 million of our common stock. The duration of the repurchase program is open ended. Under the program, we are able to purchase shares of common stock through open market transactions and privately negotiated purchases at prices deemed appropriate by management. The timing and amount of repurchase transactions under this program will depend on market conditions, corporate and regulatory considerations, alternative investment opportunities, and other relevant considerations. The program may be discontinued at any time by the Board of Directors. Shares we repurchase will be held in treasury for general corporate purposes, including issuances under employee equity incentive plans.

Conclusion

We like it when a company recognizes that its stock is deeply undervalued and takes radical action to capitalize on it. If the market is pricing a company’s stock below its liquidation value, the company’s priority should be investing in its own stock. With its stock at $3.92, RACK has a market capitalization of $117.2M, which means it’s trading at a discount to both its net cash value of $118M or $3.95 per share and its liquidation value of $171.6M or $5.74 per share. The cash burn is a risk, but we’re going to retain RACK in the portfolio.

[Full Disclosure:  We do not have a holding in RACK. 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.]

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Today we complete our series on Seth Klarman, the founder of The Baupost Group, a deep value-oriented private investment partnership that has generated an annual compound return of 20% over the past 25 years, and the author of an iconic book on value investing, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor

Following on from our earlier posts, Seth Klarman on Liquidation Value, and Seth Klarman on Catalysts, we present Seth Klarman’s application of liquidation value investment principles to a specific case: the City Investment Liquidating Trust (from Chapter 10 Areas of Opportunity for Value Investors: Catalysts, Ineficiences, and Institutional Constraints):

Investing in Corporate Liquidations

Some troubled companies, lacking viable alternatives, voluntarily liquidate in order to preempt a total wipeout of shareholders’ investments. Other, more interesting corporate liquidations are motivated by tax considerations, persistent stock market undervaluation, or the desire to escape the grasp of a corporate raider. A company involved in only one profitable line of business would typically prefer selling out to liquidating because possible double taxation (taxes both at the corporate and shareholder level) would be avoided. A company operating in diverse business lines, however, might find a liquidation or breakup to be the value-maximizing alternative, particularly if the liquidation process triggers a loss that results in a tax refund. Some of the most attractive corporate liquidations in the past decade have involved the breakup of conglomerates and investment companies.

Most equity investors prefer (or are effectively required) to hold shares in ongoing businesses. Companies in liquidation are the antithesis of the type of investment they want to make. Even some risk arbitrageurs (who have been known to buy just about anything) avoid investing in liquidations, believing the process to be too uncertain or protracted. Indeed, investing in liquidations is sometimes disparagingly referred to as cigarbutt investing, whereby an investor picks up someone else’s discard with a few puffs left on it and smokes it. Needless to say, because other investors disparage and avoid them, corporate liquidations may be particularly attractive opportunities for value investors.

City Investing Liquidating Trust

In 1984 shareholders of City Investing Company voted to liquidate. The assets of this conglomerate were diverse, and the most valuable subsidiary, Home Insurance Company, was particularly difficult for investors to appraise. Efforts to sell Home Insurance failed, and it was instead spun off to City Investing shareholders. The remaining assets were put into a newly formed entity called City Investing Liquidating Trust, which became a wonderful investment opportunity.

Table 2

table-2-margin-of-safetyAs shown in table 2, City Investing Liquidating Trust was a hodgepodge of assets. Few investors had the inclination or stamina to evaluate these assets or the willingness to own them for the duration of a liquidation likely to take several years. Thus, while the units were ignored by most potential buyers, they sold in high volume at approximately $3, or substantially below underlying value.

The shares of City Investing Liquidating Trust traded initially at depressed levels for a number of additional reasons. Many investors in the liquidation of City Investing had been disappointed with the prices received for assets sold previously and with City’s apparent inability to sell Home Insurance and complete its liquidation. Consequently many disgruntled investors in City Investing quickly dumped the liquidating trust units to move on to other opportunities. Once the intended spinoff of Home Insurance was announced, many investors purchased City Investing shares as a way of establishing an investment in Home Insurance before it began trading on its own, buying in at what they perceived to be a bargain price. Most of these investors were not interested in the liquidating trust, and sold their units upon receipt of the Home Insurance spinoff. In addition, the per unit market price of City Investing Liquidating Trust was below the minimum price threshold of many institutional investors. Since City Investing Company had been widely held by institutional investors, those who hadn’t sold earlier became natural sellers of the liquidating trust due to the low market price. Finally, after the Home Insurance spinoff, City Investing Liquidating Trust was delisted from the New York Stock Exchange. Trading initially only in the over-the-counter pink-sheet market, the units had no ticker symbol. Quotes were unobtainable either on-line or in most newspapers. This prompted further selling while simultaneously discouraging potential buyers.

The calculation of City Investing Liquidating Trust’s underlying value in table 2 is deliberately conservative. An important component of the eventual liquidating proceeds, and something investors mostly overlooked (a hidden value), was that City’s investment in the stock of Pace Industries, Inc., was at the time almost certainly worth more than historical cost. Pace was a company formed by Kohlberg, Kravis and Roberts (KKR) to purchase the Rheem, Uarco, and World Color Press businesses of City Investing in a December 1984 leveraged buyout. This buyout was profitable and performing well nine months later when the City Investing Liquidating Trust was formed.

The businesses of Pace had been purchased by KKR from City Investing in a financial environment quite different from the one that existed in September 1985. The interest rate on U.S. government bonds had declined by several hundred basis points in the intervening nine months, and the major stock market indexes had spurted sharply higher. These changes had almost certainly increased the value of City’s equity interest in Pace. This increased the apparent value of City Investing Liquidating Trust units well above the $5.02 estimate, making them an even more attractive bargain.

As with any value investment, the greater the undervaluation, the greater the margin of safety to investors. Moreover, approximately half of City’s value was comprised of liquid assets and marketable securities, further reducing the risk of a serious decline in value. Investors could reduce risk even more if they chose by selling short publicly traded General Development Corporation (GDV) shares in an amount equal to the number of GDV shares underlying their investment in the trust in order to lock in the value of City’s GDV holdings.

As it turned out, City Investing Liquidating Trust made rapid progress in liquidating. GDV shares surged in price and were distributed directly to unitholders. Wood Brothers Homes was sold, various receivables were collected, and most lucrative of all, City Investing received large cash distributions when Pace Industries sold its Rheem and Uarco subsidiaries at a substantial gain. The Pace Group debentures were redeemed prior to maturity with proceeds from the same asset sales. Meanwhile a number of the trust’s contingent liabilities were extinguished at little or no cost. By 1991 investors who purchased City Investing Liquidating Trust at inception had received several liquidating distributions with a combined value of approximately nine dollars per unit, or three times the September 1985 market price, with much of the value received in the early years of the liquidation process.

That concludes our series on Seth Klarman.

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We cast our proxy votes on-line today in support of Biotechnology Value Fund’s (BVF) proposal to remove the board of Avigen Inc (NASDAQ:AVGN).

We’ve been following AVGN (see archived posts here) because it’s a net cash stock (i.e. it’s trading at less than the value of its cash after deducting all liabilities) and specialist biotechnology investor BVF has been pushing it to liquidate and return its cash to shareholders. MediciNova Inc (NASDAQ:MNOV) has made an offer for AVGN that we think represents a clever way for AVGN’s stockholders to receive cash equivalent to that which they would receive in a liquidation (less $7M to be paid to MNOV) with the possibility for “an extraordinary, uncapped return” if MNOV is successful post-merger. The stock is up 65% from $0.65 to close at $1.07 yesterday. We estimate AVGN’s net cash value to be $37M or $1.24 per share (BVF estimates $1.20 per share). The net cash estimate does not take into account AVGN’s AV411 assets and program, which could be worth considerably more, perhaps as much as $5M to $20M or between $0.15 or $0.60 per share.

BVF’s task is a difficult one. Why? Let’s turn to the proxy material, which states as follows:

To be approved, the Board Removal Proposal must receive “FOR” votes from the holders of at least two-thirds of all of Avigen’s outstanding shares entitled to vote either in person or by proxy at the Special Meeting. If you do not vote or “ABSTAIN” from voting, it will have the same effect as an “AGAINST” vote. Broker non-votes will have the same effect as “AGAINST” votes.

This is an incredibly high threshold. For BVF to unseat the board, it requires two-thirds of all of AVGN’s outstanding shares entitled to vote. This means that BVF’s enemy is likely not stockholders voting against BVF’s proposal, but stockholders not voting at all, because failing to vote has the same effect as voting against BVF. Let us say that again: failing to vote has the same effect as voting against BVF’s proposals. If 10% of AVGN’s voters fail to vote, BVF requires almost three-quarters of the votes from those actually voting.

If the purpose of voting at stockholder meetings is to give voice to the majority (or, in this case, the supermajority) of the stockholders, surely the process should be designed to reflect that will. At present, it is not. The deck is stacked heavily in favor of the incumbent board. At least two-thirds of all of AVGN’s outstanding shares must be voted for BVF. The real threshold is actually higher than two-thirds, because failure to vote equates to a vote against BVF. If even a small proportion of stockholders neglect to vote, BVF’s threshold is proportionately that much higher. Each obstacle reduces the chance that a stockholder votes along with BVF, and that’s a shame. The corporate voting process should function to reflect the will of each stockholder and it does not presently do that.

The special meeting is to be held next Friday, March 27, 2009. If you hold stock in AVGN, you must cast your vote before that date. If you wish to support BVF, you must vote GOLD card.

[Full Disclosure:  We have a holding in AVGN. 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.]

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Following on from our earlier post, Seth Klarman on Liquidation Value, we present the second post in our series on Klarman’s Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.

As we discussed in our first post, Klarman is the founder of The Baupost Group, a deep value-oriented private investment partnership that has generated an annual compound return of 20% over the past 25 years. Klarman detailed his investment process in the iconic Margin of Safety. The book is required reading for all value investors, but is long out-of-print and notoriously difficult to obtain.

In today’s extract, drawn from Chapter 10 Areas of Opportunity for Value Investors: Catalysts, Ineficiences, and Institutional Constraints, Klarman discusses the importance of the catalyst in the investment process:

Once a security is purchased at a discount from underlying value, shareholders can benefit immediately if the stock price rises to better reflect underlying value or if an event occurs that causes that value to be realized by shareholders. Such an event eliminates investors’ dependence on market forces for investment profits. By precipitating the realization of underlying value, moreover, such an event considerably enhances investors’ margin of safety. I refer to such events as catalysts.

Some catalysts for the realization of underlying value exist at the discretion of a company’s management and board of directors. The decision to sell out or liquidate, for example, is made internally. Other catalysts are external and often relate to the voting control of a company’s stock. Control of the majority of a company’s stock typically allows the holder to elect the majority of the board of directors. Thus accumulation of stock leading to voting control, or simply management’s fear that this might happen, could lead to steps being taken by a company that cause its share price to more fully reflect underlying value.

Catalysts vary in their potency. The orderly sale or liquidation of a business leads to total value realization. Corporate spinoffs, share buybacks, recapitalizations, and major asset sales usually bring about only partial value realization.

Value investors are always on the lookout for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits. Furthermore, the presence of a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced. In the absence of a catalyst, however, underlying value could erode; conversely, the gap between price and value could widen with the vagaries of the market. Owning securities with catalysts for value realization is therefore an important way for investors to reduce the risk within their portfolios, augmenting the margin of safety achieved by investing at a discount from underlying value.

Catalysts that bring about total value realization are, of course, optimal. Nevertheless, catalysts for partial value realization serve two important purposes. First, they do help to realize underlying value, sometimes by placing it directly into the hands of shareholders such as through a recapitalization or spinoff and other times by reducing the discount between price and underlying value, such as through a share buyback. Second, a company that takes action resulting in the partial realization of underlying value for shareholders serves notice that management is shareholder oriented and may pursue additional value-realization strategies in the future. Over the years, for example, investors in Teledyne have repeatedly benefitted from timely share repurchases and spinoffs.

Tomorrow we present the final installment in the series, Seth Klarman on Investing in Corporate Liquidations.

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Avigen Inc (NASDAQ:AVGN) has sent a letter sent to its stockholders saying that Glass Lewis, a “leading independent voting advisory service” has reviewed the Biotechnology Value Fund (BVF) proposal to remove AVGN’s board and has recommended that stockholders vote against the proposal. Glass Lewis make the recommendation on the basis that “…shareholders would be best served by allowing the current board to continue its competitive sale process and to negotiate the highest value agreement for this Company… . We also make this recommendation knowing that there are multiple parties interested in the Company and given the board’s commitment to return value to shareholders by year end 2009 in the event that no strategic agreement is negotiated.” Our two cents? While AVGN has taken steps to crystallize the value of AV411, engaging financial advisors and receiving “seven written proposals” for AVGN or AV411 (we’re not sure which), we believe that much of the credit for this should be properly laid at the feet of BVF. It’s difficult to imagine AVGN taking these steps without BVF’s presence on the share register, and we suspect that it would have been “business as usual” if BVF had not agitated so forcefully for change. We’re supporting BVF.

We’ve been following AVGN (see archived posts here) because it’s a net cash stock (i.e. it’s trading at less than the value of its cash after deducting all liabilities) and specialist biotechnology investor BVF has been pushing it to liquidate and return its cash to shareholders. MediciNova Inc (NASDAQ:MNOV) has made an offer for AVGN that we think represents a clever way for AVGN’s stockholders to receive cash equivalent to that which they would receive in a liquidation (less $7M to be paid to MNOV) with the possibility for “an extraordinary, uncapped return” if MNOV is successful post-merger. The stock is up 68% from $0.65 to close at $1.09 yesterday. We estimate AVGN’s net cash value to be $37M or $1.24 per share (BVF estimates $1.20 per share). The net cash estimate does not take into account AVGN’s AV411 assets and program, which could be worth considerably more, perhaps as much as $5M to $20M or between $0.15 or $0.60 per share.

The text of the letter is set out below:

Leading Independent Advisory Service Urges Avigen Stockholders to Reject BVF’s Proposal

Avigen’s Board Narrows Focus on Strongest Improved Bids Through Ongoing Competitive Process

Dear Shareholders,

We began building the current Board in early 2006 and have consistently followed core principals that reflect fiscal discipline and sound drug development strategies. These characteristics, along with the decisive actions taken last fall to safeguard the company’s resources, have put your Board in a position to serve the interests of all stockholders and maximize the value of your investment.

Since completing the sale of our hemophilia program for $7 million in mid-December, Avigen’s stock has appreciated 50% and we believe that the Board’s current strategy will continue to add value through an open and competitive process to evaluate potential merger transactions and a commitment to bring the strongest deal, if any, to stockholders for a vote.

Leading independent advisory service is recommending stockholders vote AGAINST BVF’s Board removal proposal

Glass Lewis is one of the nation’s leading independent voting advisory services and has reviewed the BVF Proposal to remove the current Avigen Board. As a firm that reviews many contests for control, Glass Lewis believes that an independent and knowledgeable Board is often in the best position to assess a company’s strategic alternatives for the benefit of all its stockholders. In Avigen’s situation, Glass Lewis recommends that “…shareholders would be best served by allowing the current board to continue its competitive sale process and to negotiate the highest value agreement for this Company… . We also make this recommendation knowing that there are multiple parties interested in the Company and given the board’s commitment to return value to shareholders by year end 2009 in the event that no strategic agreement is negotiated.”

The Board is listening to all stockholders and working to find a balance that reflects the range of preferences they have expressed. Avigen’s Board values all stockholders’ perspectives in defining an optimal deal structure and has encouraged BVF to consider accepting board seats or other observers rights that would allow it to participate directly in the process. This would allow the current competitive process to continue uninterrupted and without jeopardizing the most promising opportunities on the table.

Your Board now has several proposals that offer significant “downside protection” and is focusing on evaluating their upside potential

Since issuing our December 22, 2008 letter to stockholders, your Board has maintained its commitment to implement a straightforward strategy to get more value for stockholders than the company’s current cash assets. After initiating an orderly and competitive process to review strategic merger opportunities, your Board has received multiple written proposals that significantly value Avigen above its current stock price.

Your Board believes it is in the best interests of stockholders to pursue a flexible deal structure and bring the most attractive opportunity to a vote of stockholders as soon as possible. In the current environment, we believe investors are most attracted to companies with later-stage products and a lower risk profile. In the last two months we have identified several opportunities that meet these criteria. The strongest proposals received to date include most of the following:
(1) commercial or near commercial products;
(2) revenue or near-revenue generating opportunity;
(3) potential for sustainable operations without the need for equity financings;
(4) sales and marketing support from a strong commercialization partner;
(5) reduced remaining regulatory risk;
(6) attractive growth potential; and
(7) willingness to provide liquidity to Avigen stockholders who need or prefer cash.

Your Board has recently invited all bidders to provide an enhanced competitive “best” offer so that the Board and management can narrow their focus on the strongest proposals and accelerate the next stage of diligence. Several parties have improved their original offers, demonstrating unequivocally the soundness of this strategy and the likelihood that your Board’s efforts will result in greater value for stockholders.

We intend to bring to stockholders the strongest proposal. All proposals contain a significant liquidity option (i.e., “downside protection”) for stockholders that were attracted to that feature in the MediciNova proposal which was publically supported by BVF but, importantly, value Avigen above its current stock price. The Board’s focus is now on identifying which proposal best fits the criteria above and is most likely to provide the greatest upside potential for Avigen stockholders.

BVF’s public support for the MedicNova proposal overlooked the potential for improving the value through competitive negotiations

By unconditionally supporting the MediciNova proposal on December 29, 2008, and encouraging the Board to bring the proposal to “a shareholder vote as soon as practical,” BVF may have overlooked other elements of the proposal that did not fully value all of Avigen’s assets. By taking a measured approach, your Board recognized five factors that it would like to address in negotiations to enhance the value to Avigen’s stockholders:

* MediciNova is an early-stage development company that, in our opinion, is highly likely to need to raise significant additional capital in approximately the next year.

* MediciNova was trading at $1.60 per share on the day of the public statement, and yet proposed that Avigen stockholders to spend $7 million to buy MediciNova stock at $4.00 per share, taking an immediate LOSS of approximately $4.2 million.

* MediciNova proposed holding Avigen’s remaining cash for over a year, in the hopes that Avigen’s stockholders would buy more MediciNova stock at the same fixed price of $4.00 per share or 250% of its then trading price. In other words, the first $25 million in stock appreciation due from Avigen’s other assets (AV411 pain and addition program and the Genzyme milestone) would accrue to MediciNova without providing any upside benefit to Avigen’s stockholders.

* Most likely, these terms would lead to a cash payout to Avigen stockholders in June 2010 or later estimated at approximately $0.91 per share from their original Avigen holdings. During that year, Avigen’s cash would be at risk to MediciNova’s creditors if the company became insolvent, potentially leaving Avigen stockholders with much less.

* Finally, MediciNova is an extremely illiquid stock that most Avigen stockholders would find difficult to trade in the open market without significantly depressing the price, which warranted concessions. For example, during the fourth quarter of 2008, MediciNova traded less than 1,000 shares per day on 48% of the 64 trading days during the quarter and zero shares on 10 of those days.

In short, while recognizing the value of some elements of the MediciNova proposal, your Board was working first to establish an open and competitive review process in which to hold direct negotiations to evaluate and improve those terms. While respecting BVF’s enthusiasm for downside protection, we believe their aggressive early support undermined the ability of your Board to engage MediciNova in an orderly process and may have prevented MediciNova from offering its “best” proposal for all of Avigen’s assets.

Avigen’s Board urges stockholders to reject BVF’s proposal to remove the Board and avoid re-starting the competitive process or jeopardizing the strongest proposals currently under review

BVF made a shrewd investment when it recognized that Avigen’s assets were severely undervalued after the negative clinical trial results reported last October. This allowed BVF to acquire a 29% stake in Avigen at an estimated average price of approximately $0.58 per share which they understandably want to protect. Their best intentions, however, are handicapping the Board’s effort to maximize value for BVF and all stockholders and now risk losing several written proposals by recommending removal of the full Board.

Your Board has reduced expenses, preserved resources and monetized one of the company’s assets. Your Board is also increasing the upside for all stockholders through its efforts to partner or sell Avigen’s AV411 pain and addiction program and in running an open and competitive process designed to identify strategic merger opportunities that we believe ALL stockholders will find attractive.

In the end, your Board is committed to bringing the best transaction, if any, to stockholders for a vote and providing a liquidity option for stockholders that would prefer to redeem part, if not all, of their shares for cash. This process is not intended to extend beyond the fourth quarter and could progress much sooner.

Your Board would like to work with BVF to ensure that all stockholders get the very best outcome for their investment. We encourage stockholders to support this effort and vote AGAINST the BVF proposal on the WHITE proxy card today. Your Board is representing the interests of all stockholders and is in the best position to complete a value maximizing transaction.

Respectfully,

Signed for the Board of Directors
Zola Horovitz, Ph.D. as Chairman of the Board
Kenneth G. Chahine, Ph.D., J.D. as Chief Executive Officer

[Full Disclosure:  We have a holding in AVGN. 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.]

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Seth Klarman, the founder of The Baupost Group, an exceptionally well-performed, deep value-oriented private investment partnership, is known for seeking idiosyncratic investments. The Baupost Group’s returns bear out his unusual strategy: Over the past 25 years, The Baupost Group has generated an annual compound return of 20% and is ranked 49th in Alpha’s hedge fund rankings.

Klarman detailed his investment process in Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, an iconic book on value investing that is required reading for all value investors. Published in 1991, the book is long out-of-print and famously difficult to obtain. According to a 2006 Business Week article, The $700 Used Book: Why all the buzz about Seth Klarman’s out-of-print investing classic?:

The 249-page book is especially hot among those seeking jobs with value-oriented investment firms. “You win serious points for talking Klarman,” says a newly minted MBA who got his hands on a copy prior to a late-round interview with a top mutual fund firm. “It’s pretty much assumed that you’ve read Graham and Dodd and Warren Buffett.” (Benjamin Graham and David Dodd’s 1934 work, Security Analysis, is a seminal book on value investing, while Buffett’s annual letters to shareholders are considered gospel.) “The book belongs in the category of Buffett and Graham,” says Oakmark Funds manager Bill Nygren, a collector of stock market tomes.

In the book, Klarman carefully explains the rationale for an investment strategy grounded in the value school. He also discusses at some length several sources for value investment opportunities. Why is the book germane to Greenbackd’s ongoing discussion of liquidation value investment? One source of investment opportunity identified by Klarman is stocks trading below liquidation value.

Klarman’s attitude to liquidation value investment closely accords with our own, and so we’ve reproduced below the relevant portion of Chapter 8 The Art of Business Valuation in Margin of Safety, in which he provides the basis for making such investments and outlines his approach to assessing liquidation value:

Liquidation Value

The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment.

A liquidation analysis is a theoretical exercise in valuation but not usually an actual approach to value realization. The assets of a company are typically worth more as part of an going concern than in liquidation, so liquidation value is generally a worst-case assessment. Even when an ongoing business is dismantled, many of its component parts are not actually liquidated but instead are sold intact as operating entities. Breakup value is one form of liquidation analysis, this involves determining the highest value of each component of a business, either as an ongoing enterprise or in liquidation. Most announced corporate liquidations are really breakups; ongoing business value is preserved whenever it exceeds liquidation value.

How should investors value assets in a liquidation analysis? An orderly liquidation over time is virtually certain to realize greater proceeds than a “fire sale,” but time is not always available to a company in liquidation. When a business is in financial distress, a quick liquidation (a fire sale) may maximize the estate value. In a fire sale the value of inventory, depending on its nature, must be discounted steeply below carrying value. Receivables should probably be significantly discounted as well; the nature of the business, the identity of the customer, the amount owed, and whether or not the business is in any way ongoing all influence the ultimate realization from each receivable.

When no crisis is at hand, liquidation proceeds are usually maximized through a more orderly winding up of a business. In an orderly liquidation the values realized from disposing of current assets will more closely approximate stated book value. Cash, as in any liquidation analysis, is worth one hundred cents on the dollar. Investment securities should be valued at market prices, less estimated transaction costs in selling them. Accounts receivable are appraised at close to their face amount. The realizable value of inventories – tens of thousands of programmed computer diskettes hundreds of thousands of purple slippers, or millions of sticks of chewing gum – is not so easily determinable and may well be less than book value. The discount depends on whether the inventories consist of finished goods, work in process, or raw materials, and whether or not there is the risk of technological or fashion obsolescence. The value of inventory in a supermarket does not fluctuate much, but the value of a warehouse full of computers certainly may. Obviously a liquidation sale would yield less for inventory than would an orderly sale to regular customers.

The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flows, either in the current use or in alternative uses. Some machines and facilities are multipurpose and widely owned; others may have value only to the present owner. The value of restaurant equipment, for example, is more readily determinable than the value of an aging steel mill.

In approximating the liquidation value of a company, some value investors, emulating Benjamin Graham, calculate “net-net working capital” as a shortcut. Net working capital consists of current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year.) Net-net working capital is defined as net working capital minus all long-term liabilities. even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors. Ongoing business losses can, however, quickly erode net-net working capital. Investors must therefore always consider the state of a company’s current operations before buying. Investors should also consider any off-balance sheet or contingent liabilities that might be incurred in the course of an actual liquidation, such as plant closing and environmental laws.

A corporate liquidation typically connotes business failure; but ironically, it may correspond with investment success. The reason is that the liquidation or breakup of a company is a catalyst for the realization of the underlying business value. Since value investors attempt to buy securities trading at a considerable discount from the value of a business’s underlying assets, a liquidation is one way for investors to realize profits.

A liquidation is, in a sense, one of the few interfaces where the essence of the stock market is revealed. Are stocks pieces of paper to be endlessly traded back and forth, or are they proportional interests in underlying businesses? A liquidation settles this debate, distributing to owners of pieces of paper the actual cash proceeds resulting from the sale of corporate assets to the highest bidder. A liquidation thereby acts as a tether to reality for the stock market, forcing either undervalued or overvalued share prices to move into line with actual underlying value.

We’ll continue our discussion on Seth Klarman and his approach to liquidation value investment later this week.

Buy my book The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market from on Kindlepaperback, and Audible.

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Network Engines Inc (NASDAQ:NENG) has announced that it is reinstating its stock repurchase program.

We’ve been following NENG (see post archive here) since January 13 when it was trading at $0.38, which gave it a market capitalization of just $16.5M. The stock is up 10.5% since our initial post to $0.42, giving it a market capitalization of $18.1M. We estimate the company’s liquidation valuation to be around 40% higher at $23.8M or $0.55 per share. In November 2007, an activist investor, Trinad Management, pushed the company to “immediately [implement] a share buy-back program.” The company demurred and saw its stock sink to all-time lows. The company has now reinstated that stock repurchase program, which presents the possibility of increasing the company’s per share liquidation value above our $0.55 per share estimate and is good news for stockholders.

The company’s press release is set out below:

NEI RE-INSTITUTES STOCK REPURCHASE PROGRAM

CANTON, MA – March 16, 2009 – NEI (Nasdaq: NENG), a leading provider of application platforms, appliances and services for storage, security and communications software developers, today announced that its Board of Directors has authorized the re-institution of the Company’s stock repurchase program. This program, initially launched on June 12, 2008, authorizes the repurchase of up to $5 million of NEI’s common stock from time to time on the open market or in non-solicited privately negotiated transactions. During 2008, the Company had repurchased approximately $1.1 million, or 1,256,801 shares.

The timing and amount of shares repurchased will be determined at management’s discretion, depending upon its evaluation of market conditions and other factors. The Company plans to use existing working capital and future cash generation to finance the repurchases. On December 31, 2008, NEI reported a cash balance of $13.2 million and had approximately 43.2 million shares of common stock outstanding with a book value of about $1.25 per share.

“The Board’s decision to re-initiate the repurchase program strongly validates its confidence in and the prospects for the Company’s future,” said Greg Shortell, President and Chief Executive Officer of NEI. “We believe that the repurchase of our common stock at this time is an effective use of our capital based on current market conditions and the price of our stock relative to the Company’s balance sheet and enterprise value.”

[Full Disclosure: We do not have a holding in NENG. 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.]

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