As a trader that focuses primarily on fundamental analysis, I love to look for stocks that are undervalued.  One way to do this is to use a tool called a stock screener that allows you to create customized formulas, looking for stocks with the characteristics that might indicate they are undervalued. 

I recently ran a very simple scan, looking for companies with a low debt/equity ratio and a book value per share that was higher than the current market price.  I took the most attractive looking opportunity from those results, did some background research and financial analysis, and finally looked for ways to enhance the return of the investment using options.

You might be surprised at just how many companies there are right now that are selling at less than their net worth, or even the amount of cash they have in the bank.  For those that read my article on the Price/Book ratio, the scan specifically looked for companies whose Price to Book ratio is less than their current market price.  I’m sure part of the reason this has happened recently is because of the collapse of the mergers and acquisitions market.  Another is that in a weak economy, managers tend to look inward and focus on their operations.  Finally, the many accounting scandals, and attendant loss of investor confidence has made many managers more risk averse. 

How else can you explain why serial acquirers like Cisco or JDS Uniphase, who constantly bought hundreds of companies over the last few years, now sit on huge cash hoards doing nothing?  The same kind of companies they spent huge amounts to buy a couple years ago can now be bought for just pennies on the dollar now.  I personally find it hard to believe that none of them have products (or patents and research) that will come in handy once the economy recovers.  If nothing else, you can get rid of a few competitors for a small cash outlay now.

Before I go on, I want to stress that this type of scan is not designed to look for companies that would normally be considered “undervalued”.  It will not find the kind of companies a typical value investor would look for, because it completely ignores earnings.  And anyone that understands the methodology used by famous value investors, such as Benjamin Graham and Warren Buffet, know that earnings are a key component to identifying undervalued stocks. 

All I looked for with this simple scan were companies that were relatively debt-free.  Then from that group, I looked for companies whose value, if it were broken up and sold today, was more than the current market capitalization.  After running the scan, I found about a dozen that looked interesting. 

Most were very small cap firms, with market caps of $60 million or less.  For example, Insweb Corp (Symbol: INSW) has virtually no debt, and a Price/Book per share of $4.50.  It closed today at $1.55, giving it a Price to Book ratio of .32.   But its market cap of $10.9 million means it is too small to trade options.  And as I mentioned, this scan ignores earnings.  Insweb has none.  In fact, it is burning through cash fast.  At the current “burn-rate”, it is unlikely to last more than a year or two. 

But while this is no slam-dunk investment, it does have some of the qualities I look for when considering speculative investments, such as a decent management team, realistic business plan, and a reasonably well-established and respected brand name. 

The fact that the company has $31 million in cash and short term investments (as of the September 30, 2002 balance sheet) means they have time to fix the business.  Plus there is always the possibility of the company being taken over for a premium.  Any corporation could buy them for a small premium, say $15 million, shut the company down (or just keep the brand and website), and pocket the other $16 million in cash.

But I was looking for a larger cap company that also traded options, and one that looked like it might be worth further investigation was Alliance Semiconductor (Symbol: ALSC).  The company has a market capitalization of $156 million, and currently trades at $4.30 a share.  It has $56 million in debt, with the debt/equity ratio showing up as .17.  The Price/Book ratio was listed as .61.  

The first thing I needed to know was what they did.  The “semiconductor” in its name was big clue of course, but it turns out that Alliance Semiconductor is closely allied to the memory market.  The company's main products are its static random-access memory chips (SRAMs) and dynamic RAMs (DRAMs), specializing in storage capacity, fast access times, and low power consumption.  Their products are used for high-performance memory storage in PCs, multimedia, networking, and telecommunications devices.  Their top customers include 3Com, Lucent, Sony, IBM, Toshiba, Acer, Alcatel, Nokia, Solectron, Jabil, General Instruments, Seagate, and Pioneer.

Alliance is what is known as a “fabless” semiconductor company.  Fabless companies focus on the design and development of their products, and do not manufacture their own chips.  Alliance outsources its manufacturing to a variety of chip makers in the US, Asia, and Israel.  They market their products through a combination of a direct sales force, manufacturers' representatives, and a network of third-party distributors.

Looking back at the history of the company, I saw that after Alliance was formed in the mid 1980's by N. D. Reddy and his brother C. N. Reddy, it went bankrupt after huge losses.  Part of the reason may have been from mismanagement, but it looked to me like the main failure occurred because they were unable to successfully manufacture its own semiconductor chips.  Alliance (still under the Reddys) was reorganized in 1991, but with manufacturing now handled by overseas foundries.  The most important of these was United Microelectonics (Symbol: UMC), which supplied Alliance with more than 70% of its products.

Alliance suffered further losses in fiscal 1992, but due to the strong cyclical upsurge in the semiconductor industry, they earned a small profit ($.18 per share) in fiscal 1993 and went public via an initial public offering underwritten by Hambrecht & Quist and Needham & Co which raised $18.6 million. 

Since then, it has remained a fabless chip company and has adopted an equity investment strategy to ensure capacity during periods of strong demand.  The major foundries they work with now are United Microelectronics, Chartered Semiconductor, and National Semiconductor. 

Another important part of the company is its venture capital arm, Alliance Venture Management.  Through this vehicle they have invested in networking, communications, Internet, semiconductor, and infrastructure market startups.  As of June 30, 2002, a combined total of $116.1 million was invested in 47 companies. 

With recent declines in average selling prices and end-user demand, the company has diversified its product mix, to focus on additional, value-added products. In line with this strategy, in January 2002, ALSC acquired PulseCore, Inc., a provider of electromagnetic interference (EMI) suppression integrated circuits (ICs) to manufacturers of computer peripherals and digital consumer products, for $5.1 million. The company is also developing ICs that accelerate the transmission and switching of data, video and voice in performance and bandwidth intensive networking, storage, and server markets.

ALSC's development strategy is to leverage its proprietary design modules, which are scaleable in size and can be used as building blocks for new products, thereby shortening design cycles. The company believes this design strategy also enables it to maximize the performance, yield and cost advantages of its basic designs and sustain them over time in successive generations of higher performance and density products. ALSC has also noted that the physical sizes of its complete unpackaged memory circuits are smaller than those of competing products, providing a key competitive advantage.

They announced in October of 2002 that the company has agreed to acquire Chip Engines, Inc, a leading fabless supplier of silicon solutions for next generation Metropolitan Area Network (MAN) platforms.  Chip Engines was an Alliance Venture investment in 2001.  The transaction is expected to close by the end of January, and has been approved by the board of directors of both companies.  The say that the Chip Engines product line will be instrumental in the development of next generation products, while enhancing the capabilities of their current product offerings.

I mentioned earlier that a company’s earnings are an important part of determining if it is truly an undervalued company.  And Alliance fails this test.  For the six months ended 9/30/02, revenues fell 51% to $8.4M.  One bright spot was that approximately 18% of the quarter's revenues were attributed to the non-memory product business units, versus 10% in the first quarter fiscal 2003.  Another positive sign was that their Net Loss (before accounting changes) fell 83% to $36.9M.

The Company reported revenues of $4.1 million, compared with $4.3 million in the first quarter of fiscal 2003 and $5.1 million in the second quarter of fiscal 2002.  That shows that things are at least improving somewhat.  In October of 2002, the company also announced a worldwide workforce reduction of about 10%, with remaining employees getting their salaries reduced by 5%-15%.  That shows that at least management is serious about trying to reduce costs to fit their current revenue prospects.

Management also has a significant stake in the company, with roughly a third of the shares owned by insiders.  That shows that the interests of management and shareholders are aligned.  In the past 6 months, there have been eight insider sales for a total of 497,000 shares, with no insider purchases.

I also like to look at institutional ownership, and 52% of Alliance shares are owned by institutions.  That is in with the typical institutional percentages in the semiconductor industry (and compares to an average 62% for the S&P 500).  Looking at the fund statistics, I also saw that the largest purchaser recently has been the DFA US small cap value fund (Symbol: DFSVX).

This small cap fund purchased 100,000 shares last October, bringing their total ownership to 1.74% of the company.  The fund is designed to look for small cap value stocks, and they have a solid reputation in this area.  While the fund did perform in the bottom 10% of its category for September, they received three stars from Morningstar.  It does specialize in extremely small issues though, and therefore is more volatile than is typical even for most small cap funds.

Finally, what makes the Price/Book ratio so low at .62?  I already mentioned the venture capital arm, Alliance Venture Management.  I also mentioned that the company has a strategy of taking stakes (primarily marketable stock) in semiconductor manufacturers to ensure production capacity for their products.  It is those stockholdings that comprise the bulk of the company’s assets.  The largest holding is 298 million shares of United Microelectronics, but they also have holdings in Chartered Semiconductor (Singapore), Tower Semiconductor (Israel), Broadcom, Vitesse Semiconductor, PMC-Sierra, Adaptec and Magma. 

I took the time to revalue all their holdings at current market prices and came up with a value of $275 million.  Many of these shares are issued on foreign exchanges, and quoted in the local currency.  The company has also entered into a number of OTC collar agreements with various banks on many of these stock holdings (if you are not familiar with collars, refer to my article on Using the Collar Trade). 

After all this analysis, I came up with a Book value for the company of roughly $396 million.  Minus the $56 million in debt gives it a simple Net Worth of $350 million.  Divide that by the 36,123,000 shares outstanding, and I would say they have a Book Value per share of $9.70.  Compare that to the current stock price of $4.30, and you get a Price/Book ratio of .4433.

Keep in mind a couple of things before rushing out to buy this stock.  First, their fortunes are obviously tied to the semiconductor industry, not only as its primary business, but in terms of its marketable holdings.  In fact, it looks a lot like investing in a mutual fund specializing in semiconductors.  You are, in effect, making a bet that the industry will recover.  If you are not sure how speculative that might be, go back and check on the performance over the past couple years for most funds specializing in technology companies.

Second, don’t forget that there are a lot of people that are saying the company is worth less than its Book Value.  That means they feel the company destroys value with every passing day (since they are not making profits, but showing a loss).

Finally, I would caution you to read the footnotes to their financial statements.  (Hopefully you read my article Don’t Skip over those Footnotes!).  In addition to some of things I mentioned previously, the footnotes to Alliance’s financials detail the restrictions limits placed on many of these stock holdings.  So while these are all publicly traded shares that could theoretically be sold, they probably will not be.  Many of the investments were made with the companies directly, and the deals included limits and rights along with the stock.  For example, if Alliance sells more than 50% of its original holdings of Chartered Semiconductor, the company will start to lose a proportionate share of its wafer production capacity rights, which could materially affect its ability to conduct its business.

Still, the value of its holdings gives an indication of what kind of floor there should be to the stock price.  And the Book Value of $9.70 is more than double the current stock price of $4.30.  And of course we could simply buy the stock, with 1,200 shares costing a total of $5,160 (plus commissions).  But I wanted to mention how you might be able to enhance returns using options.  After all, it might take a while for the semi industry to recover from the current slump.

You can simply looking at the Matrix of options that are currently available using the MarketVue Tools in this site.  The obvious choice in a situation like this would be the covered call strategy.  At $4.30, there are not a lot of options available that are currently trading.  But there is some premium to be found at the $5.00 strike price.  In particular, the July 5 Calls currently have a bid price (the price you can sell them at) of $0.60.  For that same $5,000 investment that allowed us to buy 1,200 shares, we could instead buy 1,400 shares of stock and sell 14 of the July 5 Calls.  The total investment in this case would be:

• 1,400 shares x $4.30 = $6,020
• Sell 14 July 5 Calls @ $0.60 for a credit of $840
• Giving us a total cost of $5,180 for the trade

Below is a graphic analysis comparing the return of this trade versus the simple stock purchase:

The first thing I notice is that if the covered call does better than the simple stock purchase at every price below $5.82.  In other words, if you think the stock will jump past $5.82 (a 35% increase) by July 19th, just buy the stock.  Otherwise you are better off selling the calls.

If the stock drops at all, you will immediately have a loss with the stock purchase.  But with the covered call, your breakeven becomes $3.70.  The stock could drop 14% and you would still break even.  Finally, look at the yield.  The covered call has a yield of 35% in just 194 days (almost 70% annualized) if the stock makes it above $5.00.

Naturally nothing will help if the stock price collapsed, but at least you should be shielded from the possibility of such a collapse happening by its high Book Value.  In fact, it would be better for you if somebody bid for the company at a premium, or it was simply broken up, soon after you did the trade.  All in all, it seems like one of those possibly very good, but highly speculative, trades that I occasionally like to gamble on.