Net-Nets Too Cheap to Ignore

 | Mar 28, 2013 | 4:00 PM EDT
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One of the regular screens I run looks for stocks trading near or below net current asset value. This is an approach successfully developed by investment guru Ben Graham and has been tested by many practitioners and academics for decades. Finding stocks that trade for two-thirds of NCAV is rare these days, but a few trade cheaply enough compared to the value of current assets minus all debt that they are good candidates for enterprising value investors.

When I ran the screen this morning, I found two interesting stocks worth buying because they have simply become too cheap not to own. Both are former growth stocks that have stumbled and now trade for around the value of the cash, inventory and receivables on the balance sheet. Interestingly, both are in the data storage business. Continued delays in corporate IT spending, as well as the dominance of companies such as Seagate (STX) and EMC (EMC), have hurt the companies, but the long-term future of the data storage business is bright and I expect both to recover over time.

In 2009, STEC Inc. (STEC) was one of the very few stocks Wall Street was excited about. The stock rose tenfold in a very short of time as growth-momentum investors piled into the shares. The company has since stumbled badly as demand for its flash memory and solid-state drives fell off sharply. The stock crashed back to earth, reversing the entire momentum drive upward, and has languished in the single digits for more than a year.

Business hasn't gotten any better in recent months. The company saw revenues decline by 40% in the last quarter of 2012 and the loss was larger than analysts had anticipated. Management had high expectations for a transition away from being entirely OEM driven, but in the short term lowered guidance below what Wall Street was expecting and the shares now trade near the lows for the year. The poor performance has attracted the attention of activist hedge funds that are staging a fight to replace the board of directors as well as the CEO.

The stock is cheap on a NCAV basis. At the end of the fourth quarter, the company had $158 million in cash and total current assets of $244 million. Total liabilities at STEC add up to just $58 million, so we have a net current asset value of $186 million. This assigns no value to any of the other assets, including the company's patent portfolio or a 210,000-square-foot facility the company owns in Malaysia. The market cap is just $209 million. The activist shareholders believe that's too cheap and the company should consider putting itself for sale to unlock value.  I agree, and I believe a sale of STEC could easily fetch more than twice the current stock price.

The other stock that stood out is one I already own. I have done very well with shares of Xyratex (XRTX) so far after buying at around $7. The stock has run up to $10 and we collected a $2 per share special dividend in December. The data storage company is still very cheap.  After adjusting the balance sheet for the special dividend, Xyratex still has net current assets of $240 million and the market cap is just $272 million. Again, this assigns no value to the company's operations or intellectual property portfolio. The valuation has attracted the attention of Baker Street Capital, an activist investor that now owns 22% of the company. They believe the company is worth something close to $19 a share and management needs to seek strategic alternatives and rework its business plan.  I agree, and I believe the stock still has quite a bit of upside from the current level.

Searching for stocks trading below net current assets can be a futile exercise after an extended market run-up, but these stocks trade near net current assets and have decent underlying businesses. They are both being pressured by activist investors to improve the valuation or simply sell the company at a premium. Both are attractive investment candidates and are too cheap not to own.

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