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Archive for the ‘Share buy-backs’ Category

LCV Capital Management and Raging Capital Management are running an activist campaign against ModusLink Global Solutions(TM) Inc (NASDAQ:MLNK) calling on MLNK to immediately implement a $50 to $75M share repurchase program and align executive compensation with performance. The two fund managers, calling themselves “The ModusLink Full Value Committee,” say that the full potential of MLNK is not being realized due to shortcomings in MLNK’s “operational and capital market strategies” and has “concerns regarding the Company’s corporate governance practices.”  The committee has nominated a slate of three independent director nominees for election to the board at MLNK’s upcoming annual meeting of shareholders.

The full text of the letter follows:

THE MODUSLINK FULL VALUE COMMITTEE
Raging Capital Management, LLC254 Witherspoon Street

Princeton, New Jersey 08542

LCV Capital Management, LLCFifteen Churchill Road, Suite 1000

Pittsburgh, Pennsylvania 15235

October 7, 2010

The Board of Directors

ModusLink Global Solutions, Inc.

1100 Winter Street

Waltham, MA 02451

To the Board of Directors of ModusLink:

The ModusLink Full Value Committee (“The Committee”) owns approximately 5.5% of the outstanding shares of ModusLink Global Solutions, Inc. (“ModusLink” or the “Company”).  We are well informed, long-term investors who have met with senior management and several board members on numerous occasions since representatives of The Committee began investing in ModusLink in 2008.

As we have communicated to you, we believe that the full potential of the Company is not being realized due to shortcomings in the Company’s operational and capital markets strategies.  We are concerned about the Company’s strategic direction, approach to capital allocation, and weak governance oversight.  In our opinion, these factors are key contributors to ModusLink’s lackluster stock price performance over the past several years.

Our view is that ModusLink has a tremendous opportunity to unlock and drive substantial shareholder value.  The Company’s $174 million in cash and investments are equal to approximately $4.00 per share, and working capital on hand exceeds $220 million, or 80% of the Company’s current market capitalization.  Yet the Company’s enterprise value totals just $120 million, or less than three times its Fiscal 2010 EBITDA of $46 million.  Unfortunately, the Company will likely continue as a chronic underperformer in the marketplace until change is implemented.

IMPROVE CAPITAL ALLOCATION AND OPERATING FOCUS; DIVEST NON-CORE ASSETS

Shareholder value has been destroyed via a series of poorly timed and poorly executed business acquisitions by ModusLink.  Since 2004, ModusLink has spent more than $315 million on acquisitions, including $87 million on three separate businesses acquired since 2008.  The Company has since taken material goodwill impairment charges on the bulk of these acquisitions in the last two years.  With a current enterprise value of $120 million, it’s fair to say that the return on deployed acquisition capital over the past six years has been abysmal.

Instead of making additional acquisitions, we believe the Company should focus on optimizing and streamlining existing operations, while divesting underperforming and non-core assets.  We believe a simpler, more transparent business would be easier for management to operate and for investors to comprehend and support, thus leading to improved operating results and shareholder returns.

Furthermore, given the relative stability of the cash flows of the Company’s core business, the significant discount to intrinsic/replacement value that the stock currently trades at, and the strength of the balance sheet, we believe ModusLink should immediately implement a $50 to $75 million share repurchase program.  This would be highly accretive to shareholders and magnify the potential upside of any improvement in the Company’s operating results.

INSUFFICIENT CORPORATE GOVERNANCE AND INSIDER OWNERSHIP

We have also communicated to you our serious suggestions to improve ModusLink’s corporate governance shortcomings. While many publicly traded companies have prudently separated the respective roles of Chairman and CEO, ModusLink continues to operate under an archaic structure where the Chairman also holds the position of CEO and President.  This structure fails to provide the appropriate checks and balances needed between the Board and management and engenders a harmful and value-destroying perception by the market of a general lack of accountability.

We are also deeply concerned that this Board has failed to align executive compensation with performance.  According to the Company’s 2009 proxy statement, ModusLink paid out more than $13.8 million to its top three senior executives over a period of three years while Company’s market value declined by hundreds of millions of dollars. This is not acceptable to us as active and concerned shareholders.  It is noteworthy that we are not alone in our opinion on this matter: At last year’s annual meeting, one of the leading corporate governance and proxy advisory firms recommended that shareholders withhold their vote against the election of the chairman of the compensation committee because of the Company’s propensity to overcompensate management for an underperforming stock.  We firmly believe that, in accordance with its fiduciary obligation to shareholders, it is imperative that the Board aligns compensation with the enhancement of shareholder value, since shareholders are the true owners of the Company.

We propose that part of the failure to align compensation with performance can be traced to the low level of stock ownership held by senior management and the Board.  In fact, excluding ModusLink’s Chairman & CEO, the other six members of the board own approximately 35,000 shares in total, or less than one tenth of one percent of the Company.

NEW SHAREHOLDER REPRESENTATIVES ARE NEEDED TO UNLOCK VALUE

As significant shareholders, our objective is to see the full value of our shares and the shares of all other owners of this Company be recognized in the marketplace.  We are committed to working on behalf of all shareholders to ensure that shareholders’ interests are represented in the boardroom.

As you know, we have nominated three individuals to fill the director positions up for election at the Company’s next annual meeting.  All three of our nominees have the appropriate skills and fortitude to implement the significant changes necessary to benefit all ModusLink shareholders and we believe they will be valuable additions to the Board.

We continue to welcome an open dialogue with you but to date we have been unable to reach an understanding with the Company that will result in the Company immediately taking the necessary steps to unlock shareholder value.  Our sincere hope is that this Board will take a fresh look at the opinions we have outlined above and take immediate action to embrace change rather than engage in a protracted and costly proxy contest in an effort to preserve the status quo.

We remain open to speaking with you at any time.

Sincerely,

/s/ Lodovico C. de Visconti

_____________________________

Lodovico de Visconti

Managing Member, LCV Capital Management, LLC

/s/ William C. Martin

_____________________________

William C. Martin

Managing Member, Raging Capital Management, LLC

The company responded in a press release yesterday:

WALTHAM, Mass.–(BUSINESS WIRE)– ModusLink Global Solutions(TM), Inc. (NASDAQ:MLNK), today issued the following statement in response to the public letter from dissident hedge funds, LCV Capital Management, LLC, Raging Capital Management, LLC and certain of their affiliates:

ModusLink values the opinions of all stockholders and strives to maintain an open dialogue with them. To that end, members of ModusLink’s senior management have met with LCV and Raging Capital representatives on numerous occasions, and throughout the discussions the Company gave these dissidents every indication that their concerns could be resolved in a manner that would be beneficial to all stockholders.

ModusLink’s directors, six of seven of whom are independent, are all highly qualified and committed to represent the best interests of all ModusLink stockholders. Consistent with their fiduciary duties, members of the Board’s Nominating and Corporate Governance Committee have interviewed each one of the dissident nominees and are in the process of evaluating their qualifications.

ModusLink recommends that stockholders defer making any determination with respect to the letter from LCV and Raging Capital, which distorts the Company’s record on a number of matters, until they have been advised of the Board’s evaluation of the dissident’s nominees and proposals.

ModusLink remains firmly committed to creating value for all its stockholders through the successful execution of the Company’s strategy. The Company’s Board and management have taken actions to improve the financial and operational performance of the Company and create value for stockholders, including:

  • Investing $55.3 million to repurchase shares since early fiscal 2008. In total the Company has purchased 5.6 million shares, which represents 12% of the fully diluted outstanding share count at the time the program was first announced.
  • Effectively managing through a very difficult economic environment, taking decisive actions to reduce expenses and maintain a strong balance sheet.
  • Focusing on maximizing profitability, resulting in record free cash flow from operations in fiscal 2010.

It’s an interesting situation worth watching. The record date is next Friday, so stock buying will have to be complete by Tuesday for trades to clear in time for votes to count at the annual meeting.

No position yet.

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Empirical Finance Research Blog has a review of a new paper, Repurchases, Reputation, and Returns, which finds that long-run stock returns are higher for companies announcing buybacks that had substantially completed a previous buyback. In other words, companies with a track record for following through on announced buybacks enjoy higher returns following a subsequent buyback announcement than companies that did not follow through on a previously announced buyback. While that might seem obvious, the paper makes two observations that we find particularly interesting in the context of our investment strategy:

  1. Past buyback completion rates are predictive of future buyback completion rates.
  2. Stocks with high completion rates but low stock returns following previous buybacks enjoy abnormally large returns following a subsequent buyback announcement.

It’s worth remembering that a buyback announcement does not bind a company to undertake a buyback, a situation we encountered recently: RACK suspends buyback and enters agreement to acquire Silicon Graphics; Greenbackd exits position. Companies frequently fail to follow through on announced repurchase plans. Empirical Finance Research cites a 1998 study by Stephens and Weisbach that found that firms on average repurchase only about 80% of the sum announced.

Empirical Finance Research summarizes the paper as follows:

This author measures the level of completion of previous buybacks, as measured by the shares bought as a fraction of the amount specified in the announcement, then uses this to explain how well various stocks do after subsequent buyback announcements. What she finds is that companies that had low completion rates on a previous share buyback experience much lower returns upon the announcement of another buyback. She interprets this as evidence of the company’s credibility, that investors don’t really believe a company about a share buyback when the company has failed to complete one in the past.

First the author confirms that past buyback completion rates are predictive of future buyback completion rates. Next she shows that the stock returns to a company making a buyback announcement are much higher for those with high past completion rates. Companies in the 90th percentile of past completion rate see returns 2.5% higher than those in the 10th percentile of past completion rate in the three days after a the new announcement.

Despite the size of these returns, this isn’t a very good trading strategy, because buyback announcements are clearly unexpected. However, in the next part of the paper the author finds that long-run returns are also reliably higher for repeat buyback companies with high past completion rates. Two year returns are 13.64% for those companies with above-median past completion rates versus 7.43% for those below the median. We should be leery of these results, however as they are not statistically significant.

Next the author splits her sample of repeat buyback companies into quintiles based on the return to the stock during the previous buyback. The two-year abnormal returns to companies in the lowest quintile (those with the lowest returns after their last buyback) are 17.33% after their subsequent buyback. This result is very statistically significant too.

But if we split this quintile in half based on past completion rates, and buy only those stocks with above-median past completion rate, the returns explode to 27.13% for the two year period.

Empirical Research Blog’s takeaway?

The value of this paper is not necessarily in a specific investment strategy but rather in the insight it provides in to a trading strategy we already knew about. I would be hesitant to implement this stand-alone for the practical difficulty in doing so. But any trading strategy that already uses share buybacks as a signaling factor might benefit from an augmentation that accounts for past buyback completion rate.

(Emphasis added)

Quite.

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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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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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Rackable Systems Inc (NASDAQ:RACK) is a new undervalued asset play with a plan to repurchase almost 40% of its stock at current prices. At RACK’s $3.56 closing price yesterday, the company has a market capitalization of $106.4M. We estimate the company’s liquidation value to be 60% higher at $170.3M or $5.74 per share. If the buy back is completed at the current stock price, the company’s per share liquidation value will increase by almost 25% to $7.00. We’re adding RACK to the Greenbackd Portfolio.

About RACK

RACK is a provider of servers and storage products for data centers. The company was founded in 1999 and is based in Fremont, California. The company’s investor relations website is here.

The value proposition

RACK, as its CEO points out in its earnings release, has had a tough year, burning through $15.7M in the 12 months to January 3, 2009. The company does still have a huge amount of cash and equivalents on its balance sheet (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

We 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

The company hasn’t disclosed any off-balance sheet arrangements in its most recent 10Q. The contractual obligations as at September 27, 2008 were around $10.2M, around $2.1M of which falls due in the next 12 months. Those committments are minimum lease payments under the company’s operating leases. The company also had purchase committments in the amount of $30.9M to the end of 2008. We’re not sure what these committments are for the next 12 months.

The catalyst

RACK has announced a radical buy back plan to repurchase $40M of its stock. From the press release:

“2008 was a tough year for our industry and for Rackable. Given our strong financial flexibility with $181 million in cash and investments, we plan on making key investments for 2009,” said Mark J. Barrenechea, president and CEO of Rackable Systems. “First, we plan to invest up to 10% of our cash to expand our product offerings and our sales and service capabilities. Second, the company announced a $40 million share repurchase program today. We believe this is an ideal time to invest in Rackable and that these investments will place the company in a stronger competitive position to gain market share as the economy recovers.”

We estimate that that such a buy back at the present prices will increase the company’s per share liquidation value by almost 25% to $7.00. This is a substantial upside to the current stock price.

Conclusion

It’s great to see company recognizing that its stock is deeply undervalued and taking radical action to capitalize on it. If the market is pricing your stock below its liquidation value, there are bargains to be had by investing in that stock, and we believe it should be your priority. With its stock at $3.56, RACK has a market capitalization of $106.4M, 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 think RACK is a good bet at this level.

RACK closed yesterday at $3.56.

The S&P500 Index closed yesterday at 719.60 (!).

Hat tip to manny.

[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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Ken Squire argues in a feature article in this week’s Barron’s magazine, A Golden Age for Activist Investing (subscription required), that the “political climate, shareholder sentiment and opportunities available to activists” means that “the sun, the moon and the stars have moved into alignment for activist investing.” Squire believes that the knowledge that investors “can’t rely on the markets to create value, so they will have to create it themselves” will turn many formerly passive investors into “reluctant activists.”

Squire makes some interesting points:

1. We are witnessing “the largest spreads ever between price and value”

While we don’t accept that we are yet witnessing “the largest spreads ever between price and value,” we believe that we are getting close. On long-term measures of value (for example, Graham’s 10-year trailing P/E ratio and corporate profits as a proportion of GDP) market prices are well below average and approaching all time lows (See Future Blind‘s post Market Valuation Charts prepared in October last year when the S&P500 was around 1160). More on this at a later date. (Note that this is not a declaration that we are nearing the bottom. We think there’s a good chance the markets will over-correct to the downside and stocks will be undervalued for an extended period).

2. The “economic and political climate will make it much easier for activist investors to succeed”

Squire argues that the “economic crisis has eroded confidence in boards and corporate leadership” and “[shareholders] have less patience for laggard management, indecisiveness and missteps, and are more likely to support an activist.” We don’t disagree with these points, but we dispute that this necessarily translates into success. Incumbent directors have a huge advantage over alternate slates. See, for example, Carl Icahn’s argument that boards and managements are entrenched by state laws and court decisions that “insulate them from shareholder accountability and allow them to maintain their salary-and-perk-laden sinecures.”

3. The “impaired credit markets will make it difficult to implement financial-engineering solutions”

Squire believes the environment will force activists to “focus on operations, strategy and governance, rather than stock repurchases and special dividends”:

There are many companies whose operations or strategy fell short, and activists will identify them and implement plans to improve operations, cut costs and redirect investment.

This is a particularly interesting point. It’s clearly more difficult for an activist investor to articulate to stockholders the benefits of improvements in operations or a redirection of investment than it is to simply promise a dividend or a buy-back, which should in turn reduce their chance of getting on the board. This might suggest that impaired credit markets actually reduce an activist investor’s chance of success.

4. We will see a “significant increase in corporate/strategic acquisitions”

Squire argues that “corporate acquirers have a low cost of capital” which will “compensate in part for the void in private-equity buyouts”:

Activists not only will be open to discussing potential transactions with strategic acquirers, but often will seek them out. The activist-investor board member will want to be involved in negotiating the transaction to assure that stockholders receive the best value.

5. Companies with net cash will attract activist investors

Squire writes that activists will target exactly the type of investments Greenbackd favors:

Given today’s backdrop, many activists are expected to emphasize net cash as an inducement to invest. Large amounts of cash give a company the financial flexibility to withstand economic stress, and make it a more attractive takeover target. Abundant cash also may be an indication that the stock is mispriced. In many cases, price/earnings ratios have been gravitating toward 10, without regard to cash balances.

Based on the foregoing, it’s hard to disagree with Squire’s conclusion that 2009 will be “a busy and exciting year for shareholder activism.” It’s certainly very good news investors like us. Lest we get a reputation for being blind cheerleaders for activist investment as an end in and of itself, we’d like to emphasize that Greenbackd’s focus is undervalued asset situations with a catalyst and we’re almost agnostic as to the source of the catalyst. Our ideal situation is a management prepared to recognize the discount of price to value and undertake some step to unlock that value or remove the discount. We remain ever optimistic that all directors – including those of smaller companies outside the glare of the analyst coverage and the mainstream media – fully embrace their fiduciary duties to stockholders. Our experience is that this doesn’t often happen in the absence of an agitating stockholder. This is the real reason that formerly passive investors become “reluctant activists.” Not because they “can’t rely on the markets to create value” but because they can’t rely on some boards and managements not to destroy value.

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Warren Buffett took the opportunity Friday to lend his considerable intellectual weight to the debate about buy backs, saying, “I think if your stock is undervalued, significantly undervalued, management should look at that as an alternative to every other activity.”

We’ve been banging the drum for buy backs quite a bit recently. We wrote on Friday that they represent the lowest risk investment for any company with undervalued stock and we’ve written on a number of other occasions about their positive effect on per share value in companies with undervalued stock.

In a Nightly Business Report interview with Susie Gharib, Buffett discussed his view on stock buy backs:

Susie Gharib: What about Berkshire Hathaway stock? Were you surprised that it took such a hit last year, given that Berkshire shareholders are such buy and hold investors?

Warren Buffett: Well most of them are. But in the end our price is figured relative to everything else so the whole stock market goes down 50 percent we ought to go down a lot because you can buy other things cheaper. I’ve had three times in my lifetime since I took over Berkshire when Berkshire stock’s gone down 50 percent. In 1974 it went from $90 to $40. Did I feel badly? No, I loved it! I bought more stock. So I don’t judge how Berkshire is doing by its market price, I judge it by how our businesses are doing.

SG: Is there a price at which you would buy back shares of Berkshire? $85,000? $80,000?

WB: I wouldn’t name a number. If I ever name a number I’ll name it publicly. I mean if we ever get to the point where we’re contemplating doing it, I would make a public announcement.

SG: But would you ever be interested in buying back shares?

WB: I think if your stock is undervalued, significantly undervalued, management should look at that as an alternative to every other activity. That used to be the way people bought back stocks, but in recent years, companies have bought back stocks at high prices. They’ve done it because they like supporting the stock…

SG: What are your feelings with Berkshire. The stock is down a lot. It was up to $147,000 last year. Would you ever be opposed to buying back stock?

WB: I’m not opposed to buying back stock.

You can see the interview with Buffett here (via New York Times’ Dealbook article Buffett Hints at Buyback of Berkshire Shares)

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We’re often banging on about stock buy backs to anyone who’ll listen. We like them because they represent the lowest risk investment for any company with undervalued stock. The S&P500 peaked at 1,576.09 on October 11, 2007. It’s now off a lazy 47% to 827.50. It’s probably fair to say that the average stock is better value now than it was before the financial crisis began (Note: We are not saying that we think the average stock is good value, just that it’s better value than it was 15 months ago). One might think that this relatively better value would result in a surge in buy back activity. One would be wrong (click to enlarge):

buy-backs

(Source: Bloomberg via Market Folly).

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MEMSIC INC (NASDAQ:MEMS) is a deeply undervalued net net stock and the second installment in our Catalyst Wanted series. At its $1.64 close yesterday, MEMS has a market capitalization of $39M. We estimate its liquidating value to be around 86% higher at $72M or $3.05 per share. Its liquidating value is predominantly cash, so much so that MEMS has net cash of around $62M or $2.60 per share, which is around 60% higher than its stock price.

About MEMS

MEMS provides semiconductor sensors based on micro electro-mechanical systems. Its accelerometers are used to measure tilt, shock, vibration and acceleration in a range of mobile phones, automotive safety systems and video projectors. The company’s investor relations website can be found here.

The value proposition

Like TRID yesterday, MEMS has an veritable treasure trove on its balance sheet (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):

mems-summary

According to its most recent 10Q, MEMS’ cash and equivalents are invested in money market funds and auction rate securities. As of September 30, 2008, MEMS’ investments included $5.8 million of auction rate securities. Auction rate securities are generally long-term fixed income instruments that provide liquidity through a Dutch auction process that resets the applicable interest rate at pre-determined calendar intervals, typically every 7, 28, 35 or 49 days. These investments have high credit quality ratings of at least AAA/Aaa. Due to recent liquidity issues, certain of the auction rate securities MEMS holds have failed at auction, meaning that the amount of securities submitted for sale at auction exceeded the amount of purchase orders. If an auction fails, the issuer becomes obligated to pay interest at penalty rates, and all of the auction rate securities MEMS holds continue to pay interest in accordance with their stated terms. However, the failed auctions create uncertainty as to the liquidity in the near term of these securities. As a result, MEMS has classified the $5.8 million of auction rate securities it held at September 30, 2008 as long-term investments. We have applied an 80% discount to those securities.

MEMS not have any off-balance sheet financing arrangements other than property and equipment operating leases, the value of which is not disclosed in the financial statements. It does not have any transactions, arrangements or other relationships with any special purpose entities established for its benefit.

The catalyst?

None. MEMS is using the cash on its balance sheet to construction a facility in Wuxi China. The company expects to complerte the first phase in the first quarter of 2009 at a total cost of $6M. The company expects to complete the second phase within three years at a total cost of $30M. Other significant cash outlays primarily consist of salaries, wages and commissions.

The construction of the Wuxi facility, and in particular the second phase of the Wuxi facility, seems to us to be an investment that carries significant risk in the present environment. We’d suggest that a better use for the cash at this time would be to buy back the company’s stock given the huge discount to its cash backing. If the company was to redirect the $30M to stock repurchases at the present stock price, we estimate that the company’s value would increase more than 150%. It might not be realistic to complete the buy-back at this level. If we were to assume a more realistic number, say $2.50, which is 50% higher than the current stock price but still at a discount to its per share cash backing, the balance sheet looks like this:

mems-summary-post-buy-back2

If the $30M buy-back is completed at $2.50, the liquidating value of the company increases around 20% from $3.05 to $3.60. If we assume that the stock price trades up to the new liquidating value as a result of the company’s new shareholder-oriented management, investors buying in at the present $1.64 stock price see the stock appreciate 120%.

Conclusion

Without a positive catalyst, MEMS will probably remain as a net cash stock for a long time. Despite its deep discount to its cash backing, MEMS is no real bargain without more shareholder-oriented management. This is another stock we’ll keep on our watchlist and let you know if anyone takes it on.

MEMS closed yesterday at $1.64.

The S&P500 Index closed yesterday at 840.24.

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