The Remarkable Story of Mind CTI – Fundamentals insanity and dividend speculationPosted: August 14, 2012
This posting discusses investments, and, therefore, I urge you to review the disclaimers laid out in the About section. You should already have reviewed these disclaimers, but, as they are subject to change without notice, you should do so again.
As I will (probably!) be writing about in another, later post, I believe that — in spite of the constant messaging from the financial industry that there is no room for retail investors, stock-picking, and individual analysis — there are significant investment opportunities for retail investors in equities that, for reasons having nothing (or very little) to do with the fundamentals of the underlying companies, have temporarily fallen out of favor with the market, resulting in a very low per share price, and will eventually recover to their intrinsic (or higher) per share price level. These investment opportunities are characterized by, among other things, being discrete in time, and difficult to time-box.
One such opportunity is centered around MIND CTI Ltd. (Nasdaq: MNDO,) a software company out of Israel that is a global provider of billing and customer care solutions for voice, data, video and content services. MIND has a quite good Wikipedia entry, which you may want to read by way of background.
In summary, the company was founded in 1995, had an initial public offering in 2000, and grew its yearly revenue base from approximately $8 million (with net income of approximately $1.5 million) in 1999 to more than $15 million (with net income of nearly $4 million) in 2000. From 2007 through 2009, the company encountered significant difficulties with the investment of a large part of its assets in auction rate securities (ARS,) forcing the write-off of approximately $20 million in investments during the period. However, these write-off were eventually offset through the settlement of an arbitration action against Credit Suisse Group AG, causing MIND to receive a settlement payment of approximately $18.5 million.
The story of how MIND ended up investing, losing, and recovering approximately $20 million is detailed in the Wikipedia entry and is quite interesting as it is a near text-book example of the machinations that went on in the financial industry in the first decade of this century. However, this is not the focus of this posting, and, so, we will just note that upon what showed to be bad — or fraudelent – advice MIND invested a large portion of its available cash in an investment vehicle called Mantoloking, lost it all, and, through sheer tenacity, clawed the majority back.
Mantoloking, by the way, is ritzy beach area on the Jersey shore, with the claim to fame of over the last decade having been the the wealthiest borough in New Jersey and having had median house prices of $2.5 million — althought this is not as much of a giveaway as the now infamous financial vehicle names Chewbacca and Deathstar of Enron fame, clearly there was a hint here.
MIND has an unusual dividend policy in that it pays out ordinary annual dividends amounting to approximately the company’s net income for the previous year. From 2003 the company has issued both ordinary dividends and extraordinary dividends, including a significant one-time dividend ($0.80 per share) paid out after company received the settlement payment from the ARS arbitration.
Fundamentals Insanity — Making a killing on fundamentals — eventually
As a consequence of the ARS issue and the associated gradual, forced write-off of approximately $20 million from the balance sheet, the MNDO equity gradually lost market value, touching a low per share price in the $0.60 to $0.70 range in early 2009, in spite of the fact that MIND had healthy operating fundamentals, very nice and consistent free cash-flows, and a stellar balance sheet with no debt.
As a reference point for better understanding the extremity of this range, the equity’s per share price prior to the full unfolding of the ARS issue was above $3 per share and prior to the commencement of the issue, the per share price moved in the $4 to $6 range.
Certainly, some reduction in market value was justified in 2008 and early 2009 given that there could be no assurance that the company would be able to recover its failed investment (and, so, $20 million had to be moved off the balance sheet,) but clearly, given that the scope of the failed investment was fully understood and contained (it could, for instance, never exceed the total invested capital,) a drop in market capitalization amounting to approximately 85% of the pre-failure level, reducing the company’s capitalization from an estimated $70 million, computed on the basis of approximately 21.5 million outstanding shares prior to the failure, to an estimated $12.5 million, computed on the basis of approximately 18.5 million outstanding shares at the crux of the crisis, was the manifestation of a gross over-reaction by the market. In effect the market issued a capitalization penalty of more than $35 million in excess of the actual loss of approximately $20 million in spite of all other fundamentals remaining unchanged.
Moreover, the extent of this penalty was, in fact, somewhat tempered by an aggressive move by the company to, at the highpoint (or, perhaps more appropriately, lowpoint) of the crisis, repurchase in excess of 3 million of its, then, hugely discounted shares in the open market.
The market’s over-reaction was, of course, a case of fundamentals insanity resulting from the market participant’s singular focus on the bottom-line of MIND’s earnings and balance statements from 2007 through 2008, which showed a clear and rapid deterioration of the balance sheet and — because of accounting guidelines’ requirements that the write-off on the balance sheet had to be balanced out somewhere — corresponding massive negative earnings – in spite of a stable or growing top-line (the earnings per share averaged $0.23 from 2003 through 2005, but swung to a loss of $0.55 in 2007 and a loss of $0.30 in 2008 — while revenues grew from an average of $15.5 million per year from 2003 through 2005 to an average of $19 million from 2007 to 2008).
The earnings picture in particular caused a wholesale flight to safety by investors, which rapidly and markedly accelerated as the size of the write-offs grew and even more investors fled. Simply put, MIND, a healthy operating company with zero debt and ample cash reserves, fell out of investors’ favor and its equity became dirt-cheap.
With the recovery of approximately $18.5 million in an arbitration settlement in 2009, the situation reversed, and the per share price for the MNDO equity eventually approached $3.50, before experiencing a set-back and settling in to a current price-range of between of $1.65 and $1.75 per share with regular dividends yielding in the 15 to 20% range and one extraordinary dividend with a yield somewhat north of 50%.
Spotting the Opportunity
Had you followed the general litigation and arbitration wave around the specific ARS investments that MIND had gotten itself entangled in, you would have noted a distinct pattern of settlements and you would at the highpoint of the crisis have been able to form a reasonable expectation that the outcome of MIND’s arbitration case would be positive for the company.
Moreover, if you had a good understanding of arbitration and the time-lines involved, you would have been able to — pretty accurately — time-box the resolution, and, so, your only problem would be to figure out when the market would notice this resolution and would reverse its position on the MNDO equity — which, as we know, is an impossible problem to solve. If you did not, however, concern yourself with the exact timing of the reversal, simply accepting that a reversal was going to occur, and, instead, focused on the timing of the arbitration, you would have a fair chance at buying MNDO at a near-optimum price in 2008 and 2009, but you would have to accept that for some period the per share price of the equity would fall further, and that the timing and the reversal would be arbitrary and, so, you might have capital tied up for a considerable — and indeterminate — period. You could, however, be reassured of the safety of your capital by MIND’s share repurchase program, under which the company in 2009 repurchased more than 3 million shares at an average per share price between $0.62 and $1.62.
As it happens, the MIND arbitration case settled very quickly with a significant and near-immediate compensation payable to the company, and — most importantly — the company immediately turning around and distributing the substance of this compenstion to the shareholders on record. This yielded an immediate bonanza for any investor that had accumulated a position after the announcement by MIND of its filing of an arbitration claim related to the ARS issue. My calculations are raw, but the upshot is that if you had invested $100,000 at the $0.65 (or so) per share price level in 2009, and since 2009 had reinvested 50% of the post-tax dividend yield from MIND into acquiring additional MNDO shares between 7 and 30 days after the ex-dividend date (retaining the remaining 50% of the post-tax dividend for, if you will, shopping-around money,) then your portfolio of MNDO shares would by February of 2011 be worth an astonishing $730,000 or more (at a price of $3.35 per share) and you would have collected more than $81,000 in shopping-around money.
Ironically, if you had abandoned the ship, so to speak, at the $3 per share price level in early 2007, you would have been proven right when the price went below $1 per share in 2008 and 2009. However, if you had confidence in the company, and retained your investment, you would in 2010 and 2011 be able to demonstrate a capital gain and also have dividend yield of at least 50%.
Dividend Speculation — Creating a new fundamental opportunity — right now
Normally, the story would have ended here, with MNDO recovering to the $3.50 per share price level and stabilizing at the $3 to $4 per share price level, in which case investments in the MNDO equity would yield only somewhat quite pedestrian investment opportunity, yielding gain opportunities only through a combination of regular dividends and moderate share price appreciations as the result of growth in the business and overall market improvements.
However, speculators and the uninformed investors were to play their hands — and, yet again, impact upon the per share price of MNDO.
The extra-ordinary dividend of $0.80 per share was indeed extraordinary. For a brief moment in time, prior to the announcement of the arbitration settlement and the associated dividend, you could buy MNDO shares for less or near what they would pay out in an extraordinary dividend occuring shortly after you acquired them, effectively getting these shares for free (we ignore taxes for now — a suitable move given the extraordinary advantageous dividend tax situation in place in the United States through 2012.) And not only could you secure a near unlimited number of shares for free (with almost no buyers in the market, the number of shares that you could secure was more or less constrained only by the capital that you would be willing to put at risk,) but, also, you would over the next two years, or so, receive additional dividend payuouts of more than $0.75 per share — effectively collecting twice the amount of dividend that you paid for the shares.
Predictably, after the arbitration award and the associated divident payout, the per share price of MNDO climbed.. and climbed… and climbed — nearly touching the $3.50 level in early 2011. Something was bound to happen — and it did. First, this extraordinary development — and in particular the extraordinary dividend of $0.80 per share and a subsequent dividend of $0.20 per share — made a new group of retail investors and retail traders pay attention to the MNDO equity, and MNDO became the subject of intensive speculation around the dividends in 2010 and 2011. Second, Lloyd Miller, the largest outside investor, who had taken a significant position in 2008 and 2009, liquidated his entire position in early 2011, realizing an estimated gain of 500%, but, also, flooding the market with almost two million shares.
While the effect of Lloyd Miller’s near perfect execution and timing of disposal of his position of MNDO shares was temporary, the effect of the dividend speculation was — and is — lingering.
Mr. Igor Novgorodtsev wrote about the speculation in Seeking Alpha article, noting that MIND’s dividend payout in isolation is attractive in the zero interest rate environment that we are now finding ourselves in, that MNDO’s price gyrations around the time of dividend is inexplicable unless it is viewed through a prism of investors’ fundamental lack of understanding of how dividends work (dividend payment and capitalization being, of course, in lockstep,) and that there is an opportunity inherent in the per share price gyrations around the time of dividend and, specifically, there is an opportunity to “stock up” after the time of the dividend.
What Mr. Novgorodtsev had discovered, of course, is a classic effect of speculation, whereby there is a perceived opportunity in an event, X, which leads to increased volume and a run-up in price, followed by a dramatic drop in volume and price post-X — frequently to levels that are lower then pre-X, and — on a side-note — what he postulated was that this speculation was the function of idiocy or ignorance, which should not surprise anyone who have studied trading bubbles.
As value investors we tend to not concern ourselves with speculation and its effect except to the extent that it allows us to buy shares at a significant discount to their intrincic value. Although, for reasons that we will not dwell on here, the MNDO equity is not a perfect candidate for this particular valuation method, computation of the Graham number for MIND is a fair to good way for us to compute intrinsic value. Using financial numbers for 2011 and 2010 (numbers for 2009 are not suitable because of the earnings skewing inherent in the arbitration outcome) the intrinsic value of MNDO comes out at almost $3 on a revenue-growth neutral basis, implying that the current, post-X, per share price, which is around $1.65, yields a stong buy opportunity (Mr. Novgorodtsev’s comment in his article is that “MNDO is priced absurdly low (about 3-4 times EV/EBITDA),” and I tend to agree,) with a revenue-growth neutral price outlook of up to $3.50 per share and a revenue growth price outlook in excess of $5 per share.
In the case of MIND and the speculation its dividend policy has fostered we are indeed interested in speculation — or rather the aftermath of speculation — because it has created the very opportunity that we were looking for: A severe over-reaction that caused an equity underlying a company with strong operating results and a strong balance sheet to become available at a bargain price. Given that the majority of speculators lose money, our hypothesis is, of course, that the speculation wave will eventually die out (since speculation is a zero-sum game based on the premise that there are willing losers, and since this pool of willing losers is finite, the list of willing losers will shrink from speculation iteration to speculation iteration, ultimately causing the speculation to not occur,) giving way to a general, sustainable appreciation of the per share price of the MNDO equity.
The case of MIND and its MNDO equity highlights a category of opportunity for investors who are loyal, so to speak, to companies and equities that fall out of favor in spite of strong consistent operations and — importantly — are outside the focus of institutional investors and traders because of volume, timing , or per-share price limitations, and are able and willing to dilligently and accurately parse financial data and regulatory filings and rules to form an accurate picture of the company’s situation.
On a side-note, for reasons that are not entirely clear (although we do have a working hypothesis,) it is not unusual for the same equity to appear as an opportunity two or more times over the years, such as it is the case with MIND. This is a particular attractive scenario since we understand the fundamentals and since we have an improved understanding of the path the reversal will take. In MIND’s case, for instance, the current low per share price for MNDO has already prompted the company to announce another round of share buy-backs, consistent with the decision that the company made in 2008 and 2009, providing a nice cushion under us and a trampolin for accelerating the pace of the reversal.
Chasing the Deflating Bubble
What is ironic, I think, is that most investors chase high-performance, high-growth, high-risk companies when there are low risk, revenue and earnings stable micro-caps that have the potential to handily out-compete these on a revenue-neutral basis, and, additionally, have significant upside if they can demonstrate some revenue growth.
Graham referred to this type of companies and their associated equities as cigarette butts, but I have never liked the underlying simile, because it implies that the company is somehow in a terminal stage and the best you can do is get a couple of more puffs out of it. I much prefer to refer to them as garage-sales finds, because they, to the untrained eye, is trash, but, to the trained — and accurately prepared — eye, they are gems.
The reason for this, of course, lies in the three-way equation between risk, time, and return. With garage-sales finds you may know with reasonable certainty that there is an excellent balance of limited risk and significant return, but your exit is dependent on an event entirely outside your control — the return of the horde that previously rejected the garage-sales finds as junk. Risk and return may be completely understood, but timing is entirely unknown and uncontrollable. This, however, is exactly why one can make a living with this sort of investment! While institutional investors are not — in my opinion — risk averse and not, ultimately, unable to dig through regulatory filings and press-releases (although they appear to — frankly — be too lazy to do so in most cases,) they generally abhor investing money in ventures with indefinite, indeterminate, and possibly infinite timings.
Moreover, since institutional traders cannot make significant earnings from trading in this type of equity, since the trading volume is insufficient, we find ourselves in an environment where we do not have to concern ourselves with the competition with players who have an inherently unfair advantage.
At this point you will probably have inferred that our investment paradigm involves targeting cash-flow positive companies with strong balance sheets, and, further, you will probably have inferred that a history of strong revenue and earnings growth are not of critical importance to us. Sometimes, however, these garage-sale finds surprise us, exhibiting operational growth that significantly increases and accelerates our return. For MIND, for instance, there is a genuine opportunity to over time, on the basis of its superior operations results, grow its business in a measured way, yielding a higher and higher top-line without losing control of its expenses.
There are a number of companies and equities that warrants our attention under this paradigm — in fact there are far more of these than we can reasonably capitalize on given capital and time constraints. For instance, Click Software Technologies (Nasdaq: CKSW), another Israel based company with global scope, positive cash-flow, no debt, and a healthy amount of cash in the bank, is trading a $7.50, down from approximately $12.50 earlier this year, having been subject to wholesale investor flight in the earlier part of this year.
As usual, the event that caused the massive flight by investors had nothing to do with fundamentals (we will not dwell on the event here — it suffices to say that it was a manifistation of how investors think in quarters, while enterprise companies think in years,) and the company’s guidance for the 2012 year is essentially unchanged from what it was when the company’s shares were trading at $12.50.
The intrinsic value of Click Software is certainly above $11 on a neutral revenue-growth basis, and, the company is, in fact, continuing to exhibit significant revenue growth, and so, the CKSW equity, yields a significant opportunity for folks like us.
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