Sunday, October 5, 2008

Value Play Potential: GSI Group Inc.

Benjamin Graham wrote about "net-net value plays" as situations where a company's current assets minus all liabilities (the result is called net current asset value or NCAV) is worth more than the current market capitalization of the stock. Provided that the value of current assets is accurately stated on the balance sheet and are realizable (read more about about net-net plays here), net-net plays can afford considerable protection of capital to new investors. One potential problem with investing in a "net-net" stock is if the operations of the company are net depleting assets and eroding the balance sheet to the point where the NCAV is no longer positive.

One currently available net-net play in the stock market is with GSI Group Inc. (Nasdaq: GSIG). This company designs, develops and manufactures precision laser systems for customers in the electronics, medical, semiconductor and aerospace industries. This stock was brought to my attention by an article posted on the Yes and Not Yes site which referenced one of our articles.

GSIG looks like a very interesting situation for value investors since the ratio of NCAV to market capitalization (including impact of operating leases) works out to 1.79, indicating that the current share price of $3.11 is selling at a 44% discount to the company's net current asset value.

Cash and accounts receivable make up 72% of current assets while inventory represents 19% and tax assets and other assets make up the remainder of current assets. It's encouraging that liquid assets such as cash and accounts receivable comprise such a high percentage of the total current assets, and it adds confidence to the concept of protection of capital with this investment.

However, an eroding balance sheet could quickly put what appears to be solid onto shaky ground, so it's important to take a look at what has been going on with the company's operations. To answer that question I charted operating earnings and operating cash flows with figures taken from the annual reports during the period of 2003-2007. I didn't include adjacent prior periods since management was actively divesting of non-strategic operations during that time. So my implicit assumption in this chart is that operations from 2003 and onwards will be more representative of future operations than if we included periods prior to 2003.

From the chart, we observe that operating earnings have been mostly positive and importantly, that the relationship between operating cash flows and operating earnings is behaving in a consistent manner. We see that as operating earnings rise and fall year over year, cash flows move in a similar direction. The magnitude of percentage change year over year is not identical, but at least on the surface, it appears that there is no reason to disbelieve that the companies operating earnings are sustainable.

From this preliminary analysis, it appears that not only is GSI's stock price selling at a significant discount to the net current asset value per share, but also if history is a barometer for the future, then the company does not seem to be in any immediate danger of burning up assets to fund operating deficits.

Would I go out and buy this stock right now? Of course not. There are many other company aspects to consider including analyzing all of the company specific risks. Even after due diligence was completed and if the investment still looked good, we would need to ensure this investment would fit into our portfolio diversification strategy!

At this point, I conclude that GSI appears to be a promising value play and warrants further analysis.

Thanks Doug.


Doug the Second said...

Good analysis and thanks for the link!

Anonymous said...

I would also suggest looking into Sycamore Networks (SCMR). I am conducting some preliminary research on the company. TAVF recently purchased it for its value fund. It currently trades slightly above the cash amount, net of liabilities.


Anonymous said...

I looked into GSIG a bit, and the attractive cash balance is going to go poof when they acquire Excel Technologies. They are also taking on some debt for the transaction.

Anonymous said...

Two other possible net-net value plays are liquidation World and Daniel Leather. Both trade on the TSX and are retailers. The only problem is that inventory is the biggest asset in the current asset account and it is difficult to determine what the appropriate discount factor to use. Any suggestions?

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