No. of Recommendations: 1
Hi Sean,

Thanks for challenging me on this. Honestly. It gives me a chance to think further and to explain my reasoning more fully than a limited-space article provides.

I am enjoying following your portfolio; I like the strategy, and I find it easy to understand. So first of all, thanks and keep it up!

Thanks a bunch and I fully intend to keep this up. It's a learning process for me (I find investing other people's money to be different from investing my own in some significant ways).

That being said, I am a bit surprised by this sell decision on NTE. First of all, I am confused by the timing, which is coming over a month after (and at a 10% lower share price) the Q1 release, which--if I understand correctly--provided the reason for the sale.

Actually, I can see where that might have confused you. When I posted my look at Q1 results further up this board, that was the first time I'd had to take another look at the company since just before the second purchase. And reading through the results (and the June 1 press release), I realized that I had bought the second tranche for what were almost certainly the wrong reasons.

Sure, I made a good argument for the second purchase, pointing out that it had an even bigger messed-up expectation than before (due to the Japanese earthquake and tsunami), but a big driver of that was "cheaper price, has to be a better deal."

On further reflection after posting those Q1 notes, I realized that I actually was less comfortable than I should be feeling for a second purchase. I don't know China very well, I don't know tech very well, yet here I was buying more of a company that was in at least two ways a bit outside my circle of competence.

The point of buying the companies in thirds in the MUE port is not to have a set amount that I'm working up to and I'm simply averaging down or up, but to control the risk level of the portfolio. For the first position, I'm willing to take a bit of risk because if it blows up on me, then I haven't lost very much to it. But for the second, and especially the third, position I've got to be more confident in the company and its prospects, and its ability to show the market that it was wrong to have expected so little. More confident, not just as confident as I felt with the first purchase. And when I asked myself if I was more confident, I answered "No."

Then it was a matter of correcting the mistake by reducing the position size back down to a 2% position.

Second, I found the June 1st press release, announcing that the earthquake effect will be minimal and limited to Q2, to be really good news for the company (much better than I expected).

Oh, no doubt. That was huge and probably saved the company from being completely removed from the MUE port.

Third, at $5.30 per share, the stock is trading at 0.75x book value, and of which 70% (nearly the entire share price) is cash. In light of that, I don't understand why you think the divvy is in so much danger--to the contrary, it looks very safe to me, and NTE looks like a good value from a P/B and P/[net cash] perspective.

When I look at a company, I'm not looking at cash per share and seeing it as a cushion. My reasoning is that as a shareholder, I'll probably never see that cash if the company goes down the tubes because 1) management will use it to try to save the company or 2) people with a higher claim than shareholders will be paid off first. Yes, Nam Tai doesn't have any debt, but it does have $107 million in accounts payable and deferred expenses and another $6.7 million in other liabilities. The inventory on hand probably wouldn't fetch much if sold at a fire sale, the buildings and equipment wouldn't fetch much as they're near the end of their useful lives (of $256 million worth on the books, $167 million or two-thirds has already been depreciated). And so on. Shareholders are last in line when it comes to being paid off in a bankruptcy and usually end up with nothing.

The reason I'm concerned about the dividend is two-fold. First is the payout ratio, which I specifically referred to in the sell article. The company has made $7.3 million over the past two quarters and has paid out $2.2 million in dividends with another $2.2 million going out at the end of this month. That's a 60% payout ratio. If we look at Q1 alone, its actually a 110% payout ratio (it only made $2.0 million and is on the hook to pay out $2.2 million in dividends).

A healthier ratio is down at 40% or below. If it cannot significantly increase net income (and the lower gross margins they'll be having going forward is no help), then it's going to have to reexamine the dividend policy. It's a pretty bad sign if it has to dip into its cash reserves, money needed to operate the company and pay for new buildings and equipment, in order to meet the dividend.

The other reason is what I see as a need for growing capex. Looking a bit more closely at the fixed assets, it has about $256 million gross on the books, as I said above. It's annual depreciation expense is right around $25 million, meaning that these fixed assets have about a 10-year lifespan. Currently, they're being carried at $89 million (after depreciation), which means that they have only about three to four more years of life. Buildings (mostly) and office equipment can be used past their depreciation lifetimes, but manufacturing equipment, especially in high tech, probably cannot. Nam Tai is going to have to spend quite a bit of money over the next couple of years to upgrade its fixed assets. However, capex has, until Q1, been nearly non-existent. With capex having to go up, will it really have the resources to pay the dividend?

And where is it going to expand? That regional government still hasn't released the land, despite the company saying it's jumped through all the hoops (a "Chinese" risk, which I called out). I believe management mentioned another site it could expand to, but at the moment, I cannot remember if it can actually do so real soon or it has to wait for local governmental approval.

One last point of concern is the situation with accounts receivable. For three of the last four quarters, A/R has increased at an average of about $17 million per quarter. In the last Q4, it decreased by $15+ million, but that's outweighed by the three other quarters of the TTM period where some revenue was showing up as A/R instead of cash. For comparison, in the three TTM periods before the latest one (e.g. years ending Q1 '10, '09, and '08), A/R actually declined instead of growing. Now is not the time we want to see Nam Tai starting to have trouble collecting the cash it is owed.

So for the next quarter or two, I'm going to be keeping a pretty close eye on three things: margins, A/R, and capex. If sales grow as well as they did this past quarter, then they can recover and likely do well. But if these trends continue and it cannot make enough money to cover what it has to do, then I'll almost certainly unload the remaining 55 shares the MUE port owns.

We'll just have to see.

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