12/22/04

As this newest research report indicates, we are expanding our scope here at Cheap Stocks. We'll continue publishing our research on companies trading below their NCAV's, but we'll also report on other value investing techniques, and topics.
feeback to:cheapstocks@earthlink.net



Off The Beaten Path
Micro-Cap Value Strategy
Going Private: Getting Around Filing with the SEC and Avoiding Sarbanes-Oxley in the Process


There is an interesting phenomenon happening in the markets these days in the micro-cap arena. Many of these tiny companies, which tend to have a small number of shareholders, are recognizing the growing costs of being publicly traded. It is relatively expensive for smaller companies to follow the reporting requirements under the Securities Exchange Act of 1934: add to that the additional costs associated with Sarbanes-Oxley. For some of these companies, $100,000 in expenses related to filing, mailing shareholders reports and proxy’s, and paying accountants to help them comply with Sarbanes, may be the difference between a profitable and unprofitable year. And now some are opting out.

How is that possible? Well, the Securities Exchange Act of 1934 allows companies with fewer than 300 shareholders to terminate reporting obligations. This also effectively ends their need to pay up for Sarbanes-Oxley. The trick is to get below the magic 300 level. That takes effort, but may not be as hard as you might think.

One way to get below the proverbial shareholder “Mendoza Line” is to initiate a reverse stock split, say 1 for 100, where shareholders owning less than 100 shares receive cash, in lieu of fractional shares. In essence, these odd-lot shareholders are paid in cash for surrendering their shares, thus reducing shareholder rolls. Everyone else gets 1 share for every 100 held, and the price of the stock adjusts accordingly. For a variety of reasons many of the companies who are candidates for this action have a large number of odd-lot shareholders, so it’s not difficult to dramatically reduce the number of shareholders.

Typically, reverse stock splits are undertaken by companies that are near death; their stock price having fallen below the magic $1.00 mark. It usually is not time to celebrate in this situation: the reverse split may be the last breath of a former high flying company seeking to stay exchange listed. The phenomenon of companies utilizing a reverse split solely to reduce the number of registered shareholders puts the notion of a reverse split in an entirely new light.

There may be as additional motivation, aside from cost-cutting, for companies to go this route: the company itself may be sitting on some valuable assets, and reducing the number of shareholders essentially is a step toward taking the company private, or at least giving large insiders a bigger piece of the pie, and more control. The act of buying back shares from odd lot holders requires company cash, but in return, remaining shareholders own a proportionately larger stake.

Such a transaction, however, will lower a company’s liquidity in the trading markets, liquidity which was probably already on the low side. Volume which was light on a daily basis before the reverse stock split, will now be light on a weekly, monthly, or even quarterly basis. It is not inconceivable that the stock will trade just a few times a year. Bid/Ask spreads will be huge, so new investors wanting to get in will have to pay dearly, assuming they can even find a seller. Furthermore, not having to file with the SEC will lower a company’s profile, so access to capital markets will be limited. This all sounds negative, but, from the perspective of current owners, who may realize their company’s true value, this is not so bad.

How do you tell the difference between motivations for initiating a reverse split? You can first identify those splitting because their stock price needs to meet a minimum in order to stay listed. While this information can be inferred from a very low stock price (typically below $1.00), companies will also disclose (in their proxy statements) their reasons for splitting. (Reverse splits typically need shareholder approval.) Likewise, companies wishing to initiate a reverse seemingly to cut costs and avoid Sarbanes-Oxley, will also state this in their proxy, often in great detail.

Recent Examples: Splitting to Reduce Number of shareholders
This was the approach taken this past May by Winter Sports Inc (ticker WSPO, market cap $20 million), operator of a ski resort in Whitefish, Montana. The company initiated a 1 for 150 reverse stock split, where shareholders owning less than 150 pre-split shares were paid in cash. The purpose of and reasons for the split were best described in the company’s 2004 proxy statement: (Schedule 14A)

Purpose. The primary purpose of the Reverse Split is to reduce our number of shareholders of record to fewer than 300, thereby allowing us to terminate our reporting obligations under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the Sarbanes-Oxley Act of 2002. In the event that there are fewer than 300 shareholders following the transaction and Winter Sports is eligible to file to deregister its common stock, Winter Sports intends to file a notice of termination of registration with the Securities and Exchange Commission to deregister its common stock under federal securities laws. As a result, Winter Sports would no longer be subject to the costly and time-intensive annual and periodic reporting and related requirements under the federal securities laws that are applicable to public companies…

Reasons. We are considering the Reverse Split, and the board of directors has recommended that you approve the Reverse Split, as a means to eliminate various expenses associated with remaining a “public company,” by which we mean a company whose stock is registered under, and which files reports in accordance with, the Exchange Act. In addition to direct financial savings, we expect that the going private transaction will free substantial management time and attention that currently is devoted to Exchange Act compliance, allowing management to focus more closely on Winter Sports’ core business operations. An ancillary benefit is that the Reverse Split would allow us to reduce costs by reducing the number of shareholders with whom we communicate. Because administrative and mailing costs accrue on a per-shareholder basis, those costs are disproportionately high for shareholders who hold only a limited number of our shares when considering their stake in Winter Sports. In the aggregate, we expect these cost reductions to reach approximately $200,000 in the first full fiscal year following the Reverse Split. We also believe the Reverse Split will provide liquidity to shareholders who hold fewer than 150 pre-split.

To put Winter Sports estimated cost savings ($200,000, before tax) into perspective, the company reported a net loss of $570,000 in 2003, and net income of $1,600,000 in 2002, so $200,000 is material. Once shareholders approved the reverse split, the company’s next move was to file a Form 15-12G, which essentially serves as notice to the SEC that they will no longer file reports, having met the number of shareholders criteria. In Winter Sports case, the number of shareholders was reduced to 167, as stated in this filing.

Since the Split
The company now has less than 7000 shares outstanding, shares which rarely trade. The last trade (12/1/04) priced the shares at $3000, up nearly 15 percent since the reverse split. The most recent bid/ask however, was 2000/3200, representing a huge spread. Any potential buyers of this stock will pay handsomely (if they are fortunate to even find a seller); while sellers risk getting crushed if they place a market order. For holders, this situation represents the ultimate long-term play. The value may be in the 900 acres the company owns near and around the base of the ski-resort it operates. Only time will tell.

Avoca Inc
The latest example, Avoca Inc , a royalty trust, (ticker AVOA, $23 million market cap) owns and manages 16,000 acres, which comprise the bulk of Avoca island, situated 90 miles west of New Orleans. The company’s main source of income is royalties from oil and gas leases. Avoca currently yields about 10.3 percent, based on the 2004 annual dividend.

The company’s story is very similar to Winter Sport’s. Avoca declared a 1 for 100 reverse split on 12/1/04, and filed its 15-12G on 12/16/04. The company has yet to trade since the split, but traded in the $28.00 range prior to the split, and odd lot shareholders were paid $28.00 for their shares.

Besides estimated cost savings of $50,000 from no longer having to file, why would management have made such a move? Could it be that the natural gas reserves under the island are not adequately valued? Does the land (16000 acres, of which 2/3 are actually under water) have some potential future use not yet disclosed? Or, is it that the current yield will increase once the 2005 dividend is declared, pushing the valuation higher? Maybe a combination of all three?

Whatever the story, it was compelling enough for the author to purchase 100 pre split shares. I now own 1 of 8000 or fewer shares outstanding (exact figures are unavailable). This strategy is not without great risk. There is virtually no liquidity in the stock, but I believe the assets are far undervalued, which may ultimately lead to the company going private. In the meantime, I am happy to collect a nice fat dividend.

Finding other candidates
First, find out which companies have declared, or are seeking shareholder approval for a reverse stock split. For those with very low stock prices, look no further, they are probably splitting because they want to stay listed. If there’s any doubt, read the company’s Proxy statement (DEF 14A) to determine whether the split is an attempt to reduce the number of shareholders. Once you find an interesting candidate, find out all you can about the company. Proceed with caution: once you get in, it will be tough to get out. If you find a company you want to buy, purchase shares before the reverse split, and buy enough (in Avoca’s case it was 100, Winter Sports, 150) so that you are not one of the shareholders whose shares are converted into cash.

To find out which companies have filed form 15-12G (companies who will no longer file reports with the SEC), check the SEC
website.

Final Thought
It may be a coincidence that both example companies main assets are real estate related…but don’t bet on it.


Postcript
Avoca Inc. finally declared their annual dividend on 12/16 (that was the declared date, but was not disclosed until 12/22), payable on 1/31/05.....the amount? $350.00 per share. That raises the current yield based on the last trade to 12.5 percent. Stay tuned.

feedback to:cheapstocks@earthlink.net