Financial Jungle

Last week on BNN, I caught a sound bite of renowned Canadian value manager, Irwin Michael, who manages a string of sensational mutual funds. Most notably, the ABC Fundamental Value Fund, which returned a stellar 18.8% since inception 16 years ago. What I love about Irwin Michael is his uncanny ability to uncover diamonds in the rough while the shortsighted market is too busy chasing yesterday’s hottest stocks. Visit Irwin’s ABC Fundamental Value and note the propensity to divest from the market return over his 16-year tenure as the fund manager. Remarkable isn’t it?

Irwin Michael shares his wisdoms monthly on his website. I think my all time favourite has to be his contrarian take on exuberant market in December 1999. Here are a few excerpts:

This TSE index performance has been led by anything related to high technology, telecommunications or Internet whereas most other sectors such as financial services and resources, for instance, have languished most of this past year. …

Although we do not dispute the economic importance of high technology, telecommunications or e-commerce, many of the public companies associated with these sectors are outrageously expensive. …

We are particularly attracted to the natural resource and cyclical sectors which have become virtual investment pariahs. Especially cheap are oil and gas, forestry, metals and mines which have significantly under performed the popular stock averages for the past 6 months. Many companies trade at huge discounts to net asset value with low P/E and cash flow multiples. …

We are especially optimistic with regard to the Canadian dollar. …

Don’t you just love contrarians? If I didn’t know any better, I would hail Irwin as the genuine oracle of the stock market.

Okay, enough sucking up to him. What I wanted to discuss is his pick of the segment: KeyNote System. This is more of a quantity analysis, as I’m not terribly familiar with their business, but according to their website:

Keynote is the leading provider of on-demand test and measurement products for mobile communications, VoIP, streaming, and Internet performance. Connected companies will know precisely how their Web sites, content, and applications will perform on actual browsers, networks, and devices long before their customers and business is impacted.

Keynote is recently trading at around $14. They just delivered their Q3 results, and they are awesome to say it professionally. The company is debt-free and has $103.1 million in their vault. Divide that by the number of diluted shares, that’s $5.48 money-in-the-bank per share. We’re not done yet. Besides the cash, the balance sheet records $35 million worth of real estate value. This understates the true value immensely, because the figure already endured 6 years worth of capital depreciation for the purpose of tax savings. You see, Keynote bought their headquarter for $85 million back in 2000. Assuming 6% annualized appreciation, their real estate is worth $120 million today, or $6.38 per diluted share.

So when you buy Keynote for $14 per share, $11.86 is backed by cash and real estate. Not only that, it still has another $1.50 per share worth in computer equipments, software, leasehold and property improvements. All these assets validate Keynote an attractive take-over target notwithstanding the prevailing credit crunch. According to Irwin Michael, any high tech giant can absorb Keynote, use its $103 million to foot the bill, and occupy the 60% vacant space in Keynote’s mortgage-free head office.

Suffice to say, you’re getting the Keynote operations for next to nothing, and the business itself isn’t too shabby either. Revenue growth is 10% over the previous 5 years. According to Irwin Michael, Keynote should reap the rewards of its operating leverage very soon:

Once a platform has been built; incremental revenue is usually highly profitable, and the market is willing to look forward to future earnings growth. We believe Keynote is close to reaching this threshold. Management believes that if revenue can reach $100 million [FJ: it’s current at $65 million], its EBITDA margin would increase to 23% from 5% currently. This would essentially double Keynote’s free cash flow [FJ: $0.72/share over previous 4 quarters], and could result in significant investor interest.

For a non-dividend paying stock, it sure whets my appetite. For disclosure, I don’t own the stock nor have an entry price. We might be witnessing the infancy of an explosive growth, but just to be on the safe side, I want to make sure that the margin expansion materializes over the next few quarters.