Marketdepth

Norsat International - Spotting Value

If ever there was a golden age of the capital markets, surely history will record that the late 1990’s was such a time.  Investment funds launched to net inflows of over a million dollars per day.  Headhunters couldn’t find enough MBA’s to fill seven-figure investment banking jobs.  And if you were lucky enough to have a connection to an initial public offering you did not ask impolite questions.  You just subscribed for the maximum share allotment and then readied yourself to count profits.

 

It was during this illustrious heyday that this post’s subject, Vancouver-based Norsat International (TSX:NII), was momentarily capitalized by the stock market at more than a billion dollars.  Such enthusiasm has long since faded.  From a tech bubble peak of $45 per share in January 2000, Norsat has declined more than 98% to close recently at 72 cents.  However, as dark as the past decade has been, the view for Norsat on a go-forward basis appears attractive to me now.  As they used to say back when VHS still reigned supreme, we initiate our coverage with a “Buy.”

 

Figure 1: Houston…I believe we’ve spotted Value

 
 

 

Company Background

 

Norsat International Inc. began operating in 1977 with founder Rod Wheeler’s simple idea; to build the first affordable consumer satellite dish.  For many years the company lost small amounts of money, unable to align its product with a market opportunity large enough to bear the heavy research and development overheads needed to bring Wheeler’s idea to life.

 

The tech bubble resulted in bigger losses as a succession of managers pursued a series of bet-the-company plays that failed.  Finally, in the aftermath of a near bankruptcy in 2006, Norsat’s board and management set visions of grandeur to one side and focused on the more humdrum goal of making money.

 

 

Figure 2:  Stock Price Chart – Norsat International

 

Led by the realistic Dr. Amiee Chan, Norsat quickly rationalized its cost base. It also focused its resources on two key product segments:  the strongly profitable satellite dish electronics business where Norsat had emerged as the market leader, and the growing solutions business in portable satellite data networks. 

 

Growth Drivers

 

The portable satellite-based data network, currently a $14 million annual business for Norsat, has exhibited strong double-digit growth rates despite the recession.  Here we find a number of customer groups that are not subject to economic cycles, most notably military buyers. 

 

Militaries increasingly require data networks to be established quickly in remote locations in order to facilitate their operations.  Simply put, armies now need networks almost as much as they need fuel and water.  And it is not only armies, Norsat systems were amongst the first relief deployments in Haiti in the aftermath of the recent earthquakes and are also used by a variety of companies in the media, resources and maritime industries.

 

Sourcing components globally, but designing and manufacturing in Richmond, BC, Norsat has emerged as the global market leader in a small but attractive niche.  Despite competing head-on with units of much larger military equipment suppliers and networking companies, Norsat succeeds based on flexibility, design and responsiveness.

Investment Considerations

 

On top of the fundamental demand growth, one finds many other key investment strengths in Norsat.  The company’s balance sheet is clean, with no debt and $7 million in cash.  And a tax loss carry-forward of $20 million should render the business free of tax for many years to come.

 

Figure 3: Key Operating Statistics

US$ millions	2006	2007	2008	2009E
Revenue	$13.4	$16.4	$18.0	$22.5
y-o-y growth	(26%)	22%	10%	25%
Pre-tax income	(4.4)	1.4	2.2	2.7
Diluted sharecount (MM)	46.7	55.8	53.3	58.6
eps	(0.10)	0.03	0.04	0.05

 

The stock is priced in the low double-digits as a multiple of earnings. 

This seems too low to me for one of the few companies trading on Canadian exchanges that has a reasonable shot at maintaining double-digit earnings and cash flow growth over the next five years.  If widely-held Norsat is successful in fending off takeover bids, the current $0.72 share price may easily reach $1.40 to $1.80 within a few years.

 

An old boss of mine liked to say, “Success begets arrogance, begets

failure.”  And surely this was the case with many turn of the century sensations, Norsat included.  However I have observed that the corollary is sometimes also true.  Failure (or very-near failure) appears to beget humility, which in turn can lead to success.

This Curve Also Rises

A few months ago I posted a piece that highlighted the difference between the hedgehogs and foxes of the investing world.  It is still a cult hit amongst animal lovers cruising for pictures of hedgehogs.  But the key point was that there are two different kind of investors.  There are foxes who chase every bit of news in the hopes of outwitting the market in the near term, and hedgehogs, who have one big idea that if correct will more than compensate for the lack of near term detailed information.  In the animal world, the hedgehog’s big idea is that no predator, howsoever hungry, wants a mouthful of quills.

 

The hedgehog-ish investing idea I posted on back in June was that investments made at low prices tend to result in superior returns.  To this rather simple insight, I add a corollary: investments acquired at high prices tend to result in inferior returns.  It is this second point that I comment on today.  I sit as a prickly hedgehog type observing the big bubble of our era – the bond market – and ask myself, what can possibly stop long-term interest rates rising?

 

Figure 1: The Sun Rises over Vancouver – Will Rates Follow?

 

 

The Interest Rate Cycle

 

Changes in the 10-year Treasury yield have been the pre-eminent driver of our economic lives.  What has the trend been in Canadian interest rates, Swiss equity multiples, Seoul house prices, or even global business school enrolments?  Generally speaking, these values are mere derivative functions of the US Treasury yield curve.  As rates have fallen, asset prices became pumped up.

 

The most telling picture with respect to the rate cycle is the 50-year chart depicting the yield-to-maturity of the 10-year US Treasury bond (arguably the world’s most important interest rate).  Here we observe a parabolic increase in rates that started gently in the 1960’s and culminated with spikes in the early 1980’s.  This uptrend was followed by a rapid decline in rates that began during the early years of the Reagan presidency and continued with a moderating decline to December 2008, where a low of 2.1% was hit in aftermath of the Lehman collapse.

 

 

Figure 2:  US 10-Year Treasury Bond Yield 1960-2010

 
 

I offer a few observations on this chart above.  First, it appears to the hedgehog in me that there is not very much room on the chart for rates to continue to fall towards the x-axis.   If I knew nothing about the fundamental drivers of government borrowing costs (OK – I hear you, but I can’t stop now) then I would be inclined to believe that mere mean reversion might apply.  And mean reversion would suggest that over the next several years the US government may come to pay an interest rate two or three times higher than it does today.

 

The second observation I make is more technical in nature.  If you look very closely, one can see that the trendline over the past five years is essentially flat.  The great James Grant, whom I would follow into battle even if he were wrong just because he is such a great read, emphatically called a bottom on this curve in 2003 when the 10-year yield hit 3.1%.  Clearly he was wrong.  But a good market – and US treasuries were a good market – often gives you a long time to get out.  Let me follow up Mr. Grant by calling the post-Lehman 2.1% yield the second part of the yield curve’s “double bottom.”

 

The third observation is more fundamental in nature.  I am at a loss to explain why government bond prices are so high when the likelihood of eventual repayment (in real inflation-adjusted value terms) has rarely been as low.  The internet offers no shortage of treatises on the unsustainable debt of the United States and I shall not add to these here.  But my investigations into sovereign credit quality of Japan and Canada suggests that the other major sovereigns aren’t much better.  Add to this equation the fact that the largest purchasers of government bonds are not profit-seeking individuals but the governments themselves and it is hard to see how today’s bond market differs at a conceptual level from the sort of scheme being run by Bernie Madoff.

 

 

Figure 3: US 10-year Treasury Yield

Date	Yield to Maturity
Jan 1, 1960	4.72%
Jan 1, 1970	7.08%
Jan 1, 1980	12.64%
Jan 1, 1990	8.65%
Jan 1, 2000	6.02%
Jan 1, 2010	3.81%
Average during period	6.78%

 

 

Practically speaking, central bankers are equipped with the full policy arsenal available to a modern state.  Therefore, I doubt we will soon fall into a real take-to-the-streets economic crisis.  But playing Ben Bernanke’s role looks to me like trying to win a chess game against Bobby Fisher with only king and a pawn at one’s disposal.  We know what the outcome will be – rates will rise – the only question is when?

 

 

Investing Themes for Rising Rates

 

And what do we do as rates rise?  A rising interest rate environment is a different kind of investing landscape, but one with many identifiable opportunities that investors can exploit.

 

The first opportunity arises from the increased volatility that occurs in a rising rate environment.  The debts that get piled up when interest rates are low are harder for companies and their customers to bear when rates turn the other way.  For this reason it is worthwhile opening up long/short and option eligible accounts and being prepared to take significant short positions following rallies such as the one which has lasted from March to December of 2009.

 

The second opportunity is in long-term ownership of asset classes which perform well in a rising interest rate environment.  I have noted silver as a particular favourite, but commodities as a group possess characteristics which make them resilient in such circumstances.   Growth-type equities which, like commodities, are not valued off current yields should outperform equity indices now dominated by dividend payers.  I would not buy too many now, but these might be great investments to make in moments of turmoil.

 

Another successful strategy for a world with rising rates has simply been rolling over short-term deposits.  Remember, to win in investing, you don’t need to put up big numbers if others are making losses.  Short term paper will outperform long-bonds in a rising rate world and will also provide the flexibility with which to buy assets at opportune moments.

I recognize that the foregoing list contains very few of the well-loved and traditional components of most investor portfolios.  But in investing there are no permanent friends or enemies, just a persistent imperative to grow capital.  The music of interest rates appears to be changing.  Therefore, it is time for all good hedgehogs to adjust their dance steps.

The Shoeshine Portfolio - 2010 Edition

 

When I was a kid growing up in Kelowna, we used to have a summer fair called the Regatta.  Originally oriented around sailboat races, by the 1970’s the Regatta’s main attraction was its fairground rides.  Long lines always formed in front of the huge red and white Salt and Pepper Shaker, which towered over City Park.  I can still remember clinging to my seat straps – in complete terror – as the Salt ‘n’ Pepper Shaker’s passenger capsule plunged towards the earth while spinning, before rocketing back skywards.

 

 

Figure 1: The Salt ‘n’ Pepper Shaker Towered over City Park

 

 

 

As an investor looking into 2010, this scary ride is brought to mind unaided.  No doubt we will survive this coming year just as we survived the questionably maintained fairground rides of the 1970’s.  However, I make no promises about our condition upon exit.  Given the economic turbulence that appears likely to come our way in 2010, losing our lunch strikes me as a definite possibility.  The trick, as always, will be to avoid losing our shirts.

 

Avoiding Real Estate, Seeking Liquidity

 

For next year, a critical strategy will be to insulate oneself as much as possible from a long-overdue housing bust north of the 49^th parallel.  Forget the bloggers, warnings about a Canadian housing bubble are now coming from bank presidents.  Adding urgency, the federal Minister of Finance now seems intent on kicking out the legs from under the housing market by reducing the mortgage credit availability that drove prices into the stratosphere in the first place.

 

A second key theme for the 2010 portfolio is liquidity.  In the long run asset prices rise, driven largely by growth in money supply.  But in order to prosper in the long run, one must first survive a succession of short runs.  There are too many people in Canada between 30 and 50 years old who have some home equity, a lot of mortgage debt and precious few other assets.  In order to make it through to the “other side” of a housing bust these folks need to line up liquid assets or sources of guaranteed borrowing that could see them through a rocky patch.  Insolvency (owing more than you are worth) is unpleasant, but it is not financially fatal unless combined with illiquidity (having no cash).

 

Shoeshine’s 2010 Portfolio

 

As for what to own, I offer the Shoeshine Portfolio, a hedge fund in a box.  I have covered many of these securities in recent posts and present a summary rationale here.

 

Figure 2: The Shoeshine Portfolio for 2010

Category	Symbols	Name	Weight
Cash and Equivalents	C$, US$, HK$	N/A	30%
Precious Metals	NYSE: SLV NYSE: PTM NYSE: GLD TSX: CEF.A	i-shares Silver Trust E-TRACS Platinum SPDR Gold Central Fund	60%
Inflation-Protected US Treasuries	NYSE: IPE	SPDR Barclays TIPS	10%
Equities (Long)	TSX:COA TSX: SVM NYSE: CSH NASDAQ: CSCX NASDAQ: GPC HK: 341	Coastal Contacts Silvercorp Cash America Cardiac Sciences Genuine Parts Café de Coral	50%
Equities (Short)	TSX: XFN	iShares CDN Financial	-50%
Total			100%

 

 

Cash is not held for a return at these rates, but because it may come in handy.  I prefer US dollars to Canadian cash these days for the simple reason that a US dollar has more purchasing power without a materially worse fiscal position.  Cash in fundamentally undervalued currencies pegged to the US dollar (like the HK$) also looks sensible here. 

Precious metals in the long run will be worth much more than cash and so deserve a bigger weight.  My value favourite in this category is silver, but all should do well.  US inflation-protected Treasuries are an alternate means to preserve capital.

 

And as for equities, I’m happy to own a boatload, provided I offset my favorites against short positions in the handmaidens to Canada’s housing bubble that populate iShares Canadian Financial index.  In their stead, I propose a selection of businesses that earn money from online contact lens sales, silver mining, pawn broking, auto repair and fast food meals in China.  For good measure I add a Washington state business (Cardiac Sciences) that trades well below cash value.

 

Are you ready for the Salt ‘n’ Pepper Shaker of 2010’s financial markets?  Hold on tight, it should be quite a ride.