[ Intermediate/Long-Term Investment Pick: PERLF ]
It seems that an Inefficiently Priced security has found its way into my portfolio.
There are quite a few factors I found interesting about the company, and I will attempt to address them in categories, including the Balance Sheets, my conversation with management, the earnings outlook, and the T.A. to round off the analysis.
The company is called Perle Systems, and has the following Business Overview from Hoover's:
Perle Systems' remote-access connectivity products get your AS/400 in gear. The company makes hardware and software products that allow remote access to networks run by IBM's superfast AS/400 midrange computer. It also produces network and workstation controllers, protocol converters, and LAN Remote Access Servers that allow customers' computer networks to interact. The company competes directly against IBM's own AS/400 network products in a market where Perle claims to control more than 30%. Products for the AS/400 account for 90% of sales, with substantial revenues going to develop its own LAN remote-access servers. Perle has 29 sales offices in 15 countries on five continents.
The Fundamentals: The Value Approach
As many of the Rational Analyst readers may know (and others who knew me before), I have been quite interested in searching for stocks that I felt were undervalued and were inefficiently priced according to the company's fundamentals. Forget the Efficient Market Hypothesis, especially for the small cap arena. There are just too few eyes out there to catch all the goodies. It's not like a blue-chip company where there are so many analysts that even the CEO stubbing his toe is known. And so it is to the small-cap investor's advantage to concentrate on finding the fundamentally sound, inefficiently priced businesses. And sometimes, you just might find one, like I believe I have with PERLF.
As a part-Value Investor, I am looking for stocks that are selling at prices near the vicinity of their book values. If you liquidate the company at that point, the assumption goes that you will be able to recover at the least the value of the company's net total assets, so there is a correspondingly larger Margin of Safety as the stock trades lower and lower relative to the Book Value. However, a stock with a low Price/Book ratio alone is not a sufficient enough criterion for investment purposes, at least in my opinion. The lower the Price/Book ratio, the better, but only as long as the fundamental health of the business is undamaged. It is at the (Price/Book = 1.0) level and below that averaging down makes sense to me.
What did I find attractive about PERLF? First, the Balance Sheets are attractive. The company has a 0% debt/equity ratio and a Current Ratio of 2.49. Given the nature of the company's recovery, return on equity is at the low end, at 6.35%, and the profit margins are thin, at 1.9% as of late November 1997. In addition, the company has a Book Value of $1.96, which is 17% higher than today's closing price of $1.625, for a Price/Book ratio of 0.83. For me, finding a company trading below Book Value that is (1) maintaining profitability and is (2) expanding upon sales, is rare. More on the sales later.
Sales per share stands at $4.26, for a 0.38 Price/Sales ratio. If I recall correctly, the conclusions from What Works on Wall Street show that stocks that traded at less-than 1.0 Price/Sales were attractive candidates, and that the less-than 1.0 PSR was one of the most important value criteria that led to superior investment returns. Regardless of the potential flaws in the statistical procedures used to outline the conclusions (I believe Dave Horne addressed the issue), the 0.38 Price/Sales ratio is still an impressive and attractive number in and of itself.
Also, the company has $0.65 cash per share, worth approximately 40% of the stock's price. Taking that into consideration, the effective price of the stock is $0.98, if you follow the reasoning that Peter Lynch outlines in his best-selling book, One Up on Wall Street, and subtract the company's cash position from the price of the stock for the "net" stock price.
The Business Fundamentals
That was a look into the company through its the balance sheets. Now, we have to consider the health of the business itself. Before I spoke to the management of the company, I wanted to be sure that I did my homework first. I saw a weak stock, and with it, the following earnings picture for 1996 to 1997:
'96 - '97
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Q1: (-0.25)
Q2: (-0.33)
Q3: (-0.04)
Q4: (-0.12)
.yet sales were growing at about 14% from 1993 to 1996 (from $22.7 million to $33.8 million). But then sales stalled and pulled back by 6% for 1997. Note that at this time, the company was making vast investments from the latter half of 1995, 1996, and 1997 to bring out a new product line (which has been already introduced). I believe a majority of the poor earnings can be attributed to the investments the company was undertaking at the time (Also, look at the stock price, and note how the investment period roughly matches that of the stock's decline).
For the whole of 1997, the company had total revenues of $31.9 million. Upon the release of the new product line, sales began to accelerate, and by only the second quarter of the current fiscal year, the company had already locked in revenues of $31.7, nearly the total amount of last year's sales. Look what happened to the earnings afterward, and the subsequent projections made by an analyst (Richard Sherman of Pennsylvania Merchant Group, (610) 260-6435) who initiated coverage of the company:
'97 - '98
-------------
Q1: 0.01
Q2: 0.04
Q3: 0.05E
Q4: 0.07E
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EPS: $0.17 (equivalent to 9.6 times this year's earnings, and over 120% EPS growth )
With the investments behind them and the new product line out, the CFO, Doug Langford, believed quite firmly that the period of losses was behind them and that they expected to remain in profitable territory from now on. He expressed his comfort with the current earnings projections of $0.17/share. The focus now is turned to expanding the sales of their new remote access server products, which maintains a small market share, but "is growing on a monthly basis."
The new products they sell are very high margin products, and because of this, the company, since the release of the new product line, has experienced an expansion in gross margins and now ranges from 65% to 69%. In addition, the company has implemented a program to keep the formerly excessive Selling, General, and Administrative expenses in line with the sales growth from their new product line. That program is also contributing to the earnings momentum the company is now currently beginning to experience.
With that momentum in place, the earnings picture is projected as follows:
'98 - '99
-------------
$0.03E
$0.05E
$0.07E
$0.12E
--------------
EPS: $0.27 (6 times '98-'99 earnings and a 69% growth over previous year's EPS)
.and management expressed that such earnings projections were "not unreasonable."
The main competitors are: Shiva (SHVA), Cisco (CSCO), 3Com (COMS), and IBM (IBM)
The geographic breakdown of the sales is as follows:
55% in the Americas (Canada, USA, Latin America)
30% in Europe
15% in Asia (50% is in Japan, 25% in Australia, and 25% in the relatively vulnerable SE Asian regions.)
The Technical Picture
A quick glance at the chart shows that the stock is currently caught in an Intermediate Term downtrend that it has yet to shake itself from (an intermediate term breakout will occur with a close above $2.00). But a greater consideration should be taken for the Long-Term trend. If you switch from a daily to a weekly chart, you will notice that the long-term decline from September 1995 was broken in late September of 1997 (using Victor Sperandeo's guidelines in drawing trendlines). Since then, the price has "based." This base is the area where astute investors will begin their accumulation of the stock (Look at the Accumulation/Distribution indicator, and you will note the Bullish Divergence there).
The breaking out of the long-term downtrend is significant. That is the most important technical criteria I require when considering a purchase of a technically weak issue. In addition, there is another factor to consider, and that is Momentum.
Momentum
The theory with the momentum oscillator is that it has a tendency to peak or trough before major market tops or bottoms. It can tell us when the price advance is about to stall, or when a price decline is likely to cease. I use these momentum oscillators and filter them with the requirement that the price must close above (or below) a given moving average (like the 50 day average, for example) for a confirmation of a possible trend change. But for me, I like to use the trend analysis in conjunction with the Momentum concept to determine potential trend reversals.
And that is exactly what has happened with PERLF's chart. The weekly, 100-bar smoothed momentum has touched its trough and has actually moved up from it, indicating a bottom. In addition, for the first time since the stock's long-term decline, on the weekly chart, the 30 day moving average has crossed above the 50 day moving average, which again is another signal that the trend has potentially reversed.
There are some interesting long term implications of the chart's recent activity, and based on both the strengthening chart and the company's fundamentals, I do not believe that this issue should trade below book value. If the management is able to execute on its vision, (and given the investments the company has made to achieve it, it seems likely) it would seem reasonable to have a target price of $4.50 for a 12-15 month timeframe. I therefore believe that a position accumulation up to the $2.00 range (to roughly approximate the book value) can provide both a margin of safety and the potential for superior investment returns to the long-term holder of the company stock.
It looks like we have indeed found a Gem with Perle Systems.
Regards,
Rainier Trinidad |
