To make money in the market, you have to be a good stock picker. Successful investors are the ones that flip over as many stones as possible.

But the truth is that too many retail investors are busy with everyday life and lack the time to study and discover new methods of uncovering hidden gems that the market undervalues or has glossed over.

The following list of screening criteria have been modeled after well-known investing gurus. I hope that it will make your stock search and selection easier.

1. Benjamin Graham – Father of Value Investing

Strategy: Buy cheap cigar butt companies with a margin of safety.
Based on: The Intelligent Investor
Stock Picking Criteria:

• * PE is less than 15 over three-year average or current PE, whichever is higher
• * No financial stocks
• * Sales greater than $340 million
• * Current ratio is greater than 2
• * Long-term debt is less than Net current assets (current assets – current liabilities)
• * 10-year EPS growth is greater than 30%. Must not be negative within 5 years.
• * PB ratio must be reasonable. i.e. (PB ratio) x PE = less than 22

Related Links: Another method of searching stocks Graham style. Benjamin Graham Guru Checklist Screen

2. Peter Lynch – Cheap Growth Investor

Strategy: Cheap growth stocks that are easy to understand.
Based on: One Up on Wall Street

Stock Picking Criteria:

• * Classify the company into six categories
• * PEG ratio = less than 1
• * Sales should be greater than $1billion with PE less than 40
• * EPS growth rate should be between 20% & 50%
• * Total Debt/Equity Ratio should be below 50%
• * FCF Yield greater than 20%

Related Links: Peter Lynch Investing Philosophy and Checklist

3. Martin Zweig – Momentum Growth Investor

Strategy: To be fully invested in the market when the indications are positive and to sell stocks when indications become negative.
Based on: Winning on Wall Street
Stock Picking Criteria:

• * PE > 5, but < 3x market PE & < 43
• * Revenue growth can’t be significantly less than earnings growth
• * Quarterly revenue growth > previous quarter
• * EPS > 0
• * EPS 1 year ago > 0
• * EPS over 5 years > 0
• * EPS growth over 5 years > 15%

4. David Dreman – Contrarian Investor

Strategy: Find unloved stocks trading at low multiples
Based on: Contrarian Investment Strategies
Stock Picking Criteria:

• * EPS increase from previous quarter
• * 1 year EPS growth > 0
• * PE in bottom 20% of market
• * P/CF in bottom 20% of market
• * P/B in bottom 20% of market
• * P/Dividend in bottom 20% of market
• * Current ratio > 2
• * Payout ratio > 0
• * ROE in top 1/3 of large caps
• * Dividend Yield > market yield
• * Total Debt to equity < 50%

5. James P. O’Shaughnessy – Growth + Value Investor

Strategy: 2 investment strategies: “Cornerstone Growth” and “Cornerstone Value”
Based on: What Works on Wall Street

Stock Picking Criteria:

• a. Cornerstone Growth
• * Market value > $150 million
• * Price-to-sales ratio < 1.5
• * EPS over 5 years increasing

• b. Cornerstone Value
• * Market cap > $1 billion
• * Revenue > 50% greater than mean of market’s 12 month sales
• * Cashflow per share > average publicly-traded company
• * Dividend yield: companies with highest dividend yield selected.

One thing that all five gurus have in common is that all the criteria are easy to use. There are no complex formulas. The real work lies in going through as many companies as you can to see whether they pass the method that you prefer.

All five gurus have had huge success, and while mimicking them doesn’t guarantee results, the foundation is there to build upon.

This is part two of Identifying Durable Competitive Advantages by Analyzing Financial Statements.

The information provided in this article can be found in the book Warren Buffett and the Interpretation of Financial Statements.

Before you proceed, you may be interested in a primer on analyzing the balance sheet. Now let’s begin.

How to Identify Competitive Advantage through the Balance Sheet

Assets

Current Asset Cycle: Cash – Inventory – Accounts Receivable – Cash
Cash and Equivalents: Cash is king.

A high number means either:

1) The company has competitive advantage generating lots of cash
2) Just sold a business or bonds (not necessarily good)

A low stockpile of cash usually means poor to mediocre economics. There are 3 ways to create large cash reserve.

1) Sell new bonds or equity to public
2) Sell business or asset
3) It has an ongoing business generating more cash than it burns (usually means durable competitive advantage)

When a company is suffering a short term problem, Buffett looks at cash or marketable securities to see whether it has the financial strength to ride it out.

Rule: Lots of cash and marketable securities + little debt = good chance that the business will sail on through tough times.

* Test to see what is creating cash by looking at past 7 yrs of balance sheets. This will reveal which way it was created.

Inventory

* Some companies have the risk of inventory becoming obsolete
* Manufacturers with durable competitive advantage have the advantage that the products they sell do not change, and therefore will never become obsolete. Buffett likes this advantage.
* When identifying manufacturers with durable competitive advantage, look for inventory and net earnings that rise correspondingly. This indicates that the company is finding profitable ways to increase sales which called for an increase in inventory.
* Manufacturers with inventories that spike up and down are indicative of competitive industries subject to boom and bust.

Net Receivables

Net receivables tells us a great deal about the different competitors in the same industry. In competitive industries, some attempt to gain advantage by offering better credit terms, causing increase in sales and receivables.

If company consistently shows lower % Net receivables to gross sales than competitors, then it usually has some kind of competitive advantage which requires further digging.

Total Current Assets & Current Ratio

* Current ratio greater than 1 = good
* Current ratio less than 1 = bad
* However, a lot of companies with durable competitive competitive advantages have a current ratio less than 1 (e.g. PG = 0.77). For companies with moats, their earnings power is so strong they can easily cover current liabilities. These companies also have no problem securing cheap short term commercial paper if needed.
* Another reason for the low current ratio is that these companies also pay big dividends  and repurchase stock thus diminishing cash reserves
* Current ratio is useless in identifying durable competitive advantage.

Property, Plant & Equipment

A company with durable competitive advantage doesn’t need to constantly upgrade its equipment to stay competitive. The company replaces when it wears out. On the other hand, a company without any advantages must replace to keep pace.

Difference between a company with a moat and one without is that the company with the competitive advantage finances new equipment through internal cash flows, whereas the no advantage company requires debt to finance.

Producing a consistent product that doesn’t change equates to consistent profits. There is no need to upgrade plants which frees up cash for other ventures. Think Coca Cola, Johnson & Johnson etc.

Goodwill

Whenever you see an increase in goodwill over a number of years, you can assume it’s because the company is out buying other businesses above book value. GOOD if buying businesses with durable competitive advantage.

If goodwill stays the same, the company when acquiring other companies is either paying less than book value or not acquiring. Businesses with moats never sell for less than book value.

Intangible Assets

* Intangibles acquired are on balance sheet at fair value.
* Internally developed brand names (Coke, Wrigleys, Band-Aid) however are not reflected on the balance sheet.
* One of the reasons competitive advantage power can remain hidden for so long.

Long Term Investments

Long term investments are carried on books at the lower of cost/market price. This means a company can have valuable assets on its books at a valuation below its market price.

It can tell us about the investment mindset of management. i.e. do they invest in durable competitive advantages or those in highly competitive markets.

Other Long Term Assets

Doesn’t tell us anything e.g. Pre paid expenses, tax recoveries

Total Assets & Return on Total Assets

* Measure efficiency using ROA
* Capital is barrier to entry. One of things that make a competitive advantage durable is the cost of assets needed to get in. This is why we calculate the Asset Reproduction Value along with the EPV.
* Many analysts argue the higher return the better. Buffett states that really high ROA may indicate vulnerability in the durability of the competitive advantage.
* E.g. Raising $43b to take on KO is impossible, but $1.7b to take on Moody’s is. Although Moody’s ROA and underlying economics is far superior to Coca Cola, the durability is far weaker because of lower entry cost.

Current Liabilities

Includes accounts payable, accrued expenses, other current liabilities and short term debt.

* Stay away from companies that ‘roll over the debt’ e.g. Bear Stearns

When investing in financial institutions, Buffett shies from those who are bigger borrowers of short term than long term debt.

* His favorite ‘Wells Fargo’ has 57 cents short term debt for every dollar of long term
* Aggressive banks (like Bank of America) has $2.09 short term for every dollar long term

Durability equates to the stability of being conservative.

Long Term Debt coming Due

Some companies lump their yearly long term debt due with short term debt on the balance sheet. This makes it seem like there is more short term debt than the real amount.

Rule: Companies with durable comparable advantages need little or no LT debt to maintain operations.

Too much debt coming due in a single year spooks investors and can offer attractive entry points.

However, a mediocre company in problems with too much debt due leads to cash flow problems and certain bankruptcy.

Total Current Liabilities & Current Ratio

* The higher the ratio, the more liquid. The greater its ability to pay current liabilities when due.
* Useful in determining liquidity in average business
* Durable competitive advantages do not require ‘liquidity cushion’ so the ratio may be less than 1.

Long Term Debt

Buffett says that durable competitive advantages carry little to no LT debt because the company is so profitable that even expansions or acquisitions are self financed.

We are interested in long term debt load for the last ten years. If the ten yrs of operation show little to no long term debt, then the company has some kind of strong competitive advantage.

Buffett’s historic purchases indicate that on any given year, the company should have sufficient yearly net earnings to pay all long term within 3 or 4 year earnings period. (e.g. Coke + Moody’s = 1yr)

Companies with enough earning power to pay long term debt in less than 3 or 4 years is a good candidate in our search for long term competitive advantage.

* BUT, these companies are targets for leveraged buy outs, which saddles the business with long term debt
* If all else indicates the company has a moat, but it has ton of debt, a leveraged buyout may have created the debt. In these cases the company’s bonds offer the better bet, in that the company’s earnings power is focused on paying off the debt and not growth.

Rule: little or no long term debt often means a Good Long Term Bet

Deferred Income Tax, Minority Interest, Other Liabilities

* No help in search for durable competitive advantage

Total Liabilities & Debt to Shareholders Equity Ratio

* Debt to shareholders equity ratio helps identify whether the company uses debt or equity (includes retained earnings) to finance operations.
* Company with a moat uses earning power and should show higher levels of equity and lower level of liabilities.
* Debt to Shareholders Equity Ratio : Total Liabilities / Shareholders Equity
* Problem with using as identifier is that economics of companies with durable competitive advantages are so great they don’t need large amount of equity or retained earnings on the balance sheet to get the job done.

Treasury Share Adjusted Debt to Shareholder Equity Ratio

* Wrigley 0.68, Goodyear 4.35, Ford 38.0

Financial institutions like banks, have a much higher ratio. This is why Buffett says they are highly leveraged operations. Exception is M&T (his favorite) is 7.7

Rule: if the Treasury Share Adjusted Debt to Shareholder Equity Ratio is less than 0.8, the company has a durable competitive advantage.

Shareholder Equity & Book Value

* Net worth = Book Value = Shareholders Equity
* Shareholder equity is under the heading capital stock, which includes preferred and common stock, paid in capital, and retained earnings.

Preferred + Common Stock: Additional Paid in Capital

In search for durable competitive advantage, we look for absence of preferred stock in the capital structure.

Retain Earnings: Buffett’s Secret

Net earnings can be paid out as dividends, used to buy back shares or retained for growth. To find net earnings to be added back we take after-tax net earnings and deduct dividends and stock buy back.

If the company loses more than it has accumulated, retained earnings is negative.

One of the most important indicators of durable competitive advantage

* If a company isn’t adding to its retained earnings, it isn’t growing its net worth.
* Rate of growth of retained earnings is good indicator whether it’s benefiting from a competitive advantage.
* Mergers pool earnings together
* Microsoft is negative because it chose to buyback stock and pay dividends
* The more earnings retained, the faster it grows and increases growth rate for future earnings.

Treasure Stock

* Carried on the balance sheet as a negative value because it represents a reduction in shareholders equity.
* Companies with moats have free cash, so treasury shares are hallmark of durable competitive advantages.
* When shares are bought back and held as treasury stock, it is effectively decreasing the company equity. This increases return on shareholders equity.
* High return is a sign of competitive advantage. It’s good to know if it’s generated by financial engineering or exceptional business economics or combination.
* To see which is which, convert negative value of treasury shares into a positive and add it to shareholders equity. Then divide net earnings by new shareholders equity. This will give the return on equity minus effects of window dressing.

Rule: presence of treasury shares and a history of buyback are good indicators that company has competitive advantage

Return on Shareholders Equity

Net earnings / Shareholders Equity = Return on Shareholders Equity

* Companies moats show higher than average returns on shareholders equity (Coke 30%) (AA 4%)
* High returns on equity means company is making good use of retained earnings.
* This will add up and increase the underlying value, which will eventually be reflected in the stock price.
* Note: some companies are so profitable they don’t need to retain any earnings, so they pay them all out to shareholders. This sometimes shows up as negative equity. Danger is that insolvent companies also show negative equity.
* If the company shows a history of strong net earnings, but shows negative shareholders equity, there is a durable competitive advantage.

Leverage

Leverage can make the company appear to have some kind of competitive advantage when just using debt. Avoid businesses that use a lot of leverage to generate earnings.

Next in the Series

Cash Flow Statement and the set of criteria to determine durable competitive advantage.

A reader of my site recently emailed me with some comments, and we began talking about about investing, BOLT, and his take on valuation methods. He has graciously allowed me to edit his notes on Durable Competitive Advantages (DCA) and the set of criteria he uses to identify companies with durable competitive advantages.

Finding Durable Competitive Advantages

The concepts that you find in this article are from the book Warren Buffett and the Interpretation of Financial Statements, and addresses Warren Buffett-type investing ideas and methodology.

This is not a book review, but notes from the book to discuss and identify durable competitive advantages.

The Exceptional Company

The exceptional company has a durable competitive advantage differentiated by the following:

• –Unique product/service
• –Low cost buyer AND seller of a product which public needs consistently

The exceptional company has durability.

• –Consistency in product = consistent profits
• –Consistent: high gross margins / low debt / low R&D exp. /strong earnings / earning growth

Analyzing the Income Statement

When it comes to analyzing the income statement, it’s important to investigate further and drill down to detect what the quality of earnings are made up of, and what the numbers interpret.

Revenue: Analyze expenses

Cost of Goods Sold:  investigate what the company includes

Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins

• –Durable competitive advantage creates  a high margin because of the freedom to price in excess of cost
• –Greater than 40% = Durable competitive advantage
• –Less than 40% = competition eroding margins
• –Less than 20% = no sustainable competitive advantage
• –CONSISTENCY is KEY

SG&A: Consistency is key.

Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit

• –Less than 30% is fantastic
• –Nearing 100% is in highly competitive industry

R&D: if competitive advantage is created by a patent or tech advantage, at some point it will disappear.

• –High R&D usually dictates high SG&A which threatens the competitive advantage

Depreciation: Using EBITDA as a measure of cash flow is very misleading

• –Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit

Interest Expenses: Companies with high interest expenses relative to operating income tend to be either:

1) in fiercely competitive industry where large capital expenditure required to stay competitive

2) company with excellent business economics that acquired debt in leveraged buyout

• –Companies with durable competitive advantages often carry little or no interest expense.
• –Warren’s favorites in the consumer products category all have less than 15% of operating income.
• –Interest expenses varies widely between industries.
• –Interest ratios can be very informative of level of economic danger.

Rule: In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.

Gain (Loss) Sale Assets and “Other”: For non-recurring income or losses, remove from calculations of net earnings

Income Before Tax: Buffett uses this number when calculating his return. It allows for comparison with other investments types. E.g. Equity and bonds.

Income Taxes Paid: Helps figure out who’s window dressing

• –Check SEC docs and see what they are paying in income tax.
• –Take pre-tax operating income and deduct tax rate (USA 35%)
• –Compare with reported income tax paid

Net Earnings

• –Look for consistency and upward long term trend.
• –Because of share repurchase its possible for net earnings trend to differ from EPS trend.
• –Preferred over EPS
• –Durable competitive advantage companies report higher % net earnings to total revenues.

Rule: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.

• –If less than 10%, likely to be in a highly competitive business
• –Exception – Banks and financial companies where abnormally high ratio of net earnings to total revenues usually means poor risk management.

Earnings Per Share (EPS)

• –Look for at least ten-year period showing consistency and an upward trend.
• –Consistent earnings is usually a sign that the company sells products that doesn’t need to go through costly process of change.
• –Upward trend reflects the company is strong enough to allow it to make expenditures to increase market share through advertising and expansion.
• –Or a company could use financial engineering like stock buybacks to increase EPS
• –Avoid erratic earnings pictures

Next in the Series

Stay tuned for the next part of the series that will look at analyzing the Balance Sheet.

I last left off discussing the impact of the British Petroleum (BP) oil spill and the level of revenues generated by business in the Gulf of Mexico. Don’t expect much development on this particular issue from one month ago. The damages from the spill still cannot be quantified, and the moratorium is still in effect, causing the entire industry to suffer.

While BP has rallied nicely with the help of big endorsements by hedge funds, the geophysical and marine seismic industry remains challenged. However, I remain confident that the market inefficiency of BOLT Technology Corp. (BOLT) will be realized.

Fundamentals remain strong. I hold mostly micro to small caps in my portfolio, and I’m accustomed to volatility and sudden changes in valuation, but I believe BOLT to be a solid holding.

The latest press release of the annual results shows the company to have increased cash to $39.5m. Consider the fact that BOLT’s market cap is $79.6m. Cash makes up over half of the company, and this number continues to increase quarter over quarter.

Growth and business is slow, but management has been able to steer the company towards profitability for over 10 straight years.

BOLT’s current financial situation is comparable to 2006 levels, when it also traded between $8 to $10.

The difference between 2006 and 2010, however, is the company’s growth and financial position. In 2006, BOLT was looking like a growth company with growing demand for its products as oil prices continued to peak. But 2010 results show the complete opposite. Growth has slowed dramatically, yet the financial strength of the company is growing.

Take a look at the financial statement, and compare BOLT side by side to where it was in 2006 and in 2010.

In my eyes, the income statement is virtually the same, while the balance sheet and cash flow statement has matured incredibly well.

Cash is at an all-time high and the company is run conservatively without having taken on debt. Everything is funded by the cash from operations.

If a new person was oblivious to the current situation, and based their valuation with 0% growth and on the numbers alone, I don’t see how she would come up with the same stock price.

We’re seeing decline in demand, pressures on the entire oiling industry, and depressed oil prices. In other words, we’re in the middle of the cyclic trough. It’s a great time to hold on and wait out the inevitable return to normalized market conditions.

In addition to the lack of growth, selling of shares by mutual funds and hedge funds is causing pressure on stock prices.

This graph displays the results of fund transactions quarter over quarter. Clearly you see the decline in shares purchased versus shares sold by funds.

The number of funds that sold shares of BOLT from Mar 2010 to Jun 2010 jumped to 44. Such big jumps in sell transactions are never pretty with low volume stocks but, thankfully, it doesn’t have anything to do with the fundamentals.

As Graham said, over the long run, the stock market is a weighing machine. Let the funds vote themselves out in the short term, but in the long run, price meets value.

Disclosure

I own shares of BOLT at the time of writing.

I wanted to share some quantitative data and information regarding the new addition to the portfolio, in order to help you with your own analysis and final decision.

Since Ragu and the Value Focus team have already laid out Kirkland’s (KIRK) story, I’ll go through the numbers to see how they stack up.

Financial Statements

Income Statement

Things have definitely picked up over the past few years at Kirkland’s. Gross profit has picked up considerably to reach $168.5million from a stagnant $125 million from 2002-2005, mostly due to the big reductions in cost of goods sold (COGS).

Being a retailer, selling, general and administrative expenses (SG&A) eats up most of the profit, but it looks like the SG&A percentage to revenue is declining to the low 26% compared to 27.4%.

Increasing revenues in tandem with cost reduction is a successful recipe for any company, but one thing to keep an eye on is the tax rate for KIRK, which was 1.5%, 7.9%, and 26.4% for 2008, 2009, and 2010, respectively. The tax rate is far too low, and it’s expected that taxes will return to the norm of roughly 40%, which will reduce the earnings per share (EPS).

Had the tax rate been 40% in 2009, EPS would have come out $1.43 per share, or $1.39 on a diluted basis.

Balance Sheet

Cash growth has been marvelous. More than double from 2009 to 2010.

Inventory levels are consistent, which is a good sign. I wouldn’t want to see inventory jumping by 25% as it did in fiscal 2005.

You all know that KIRK has no long-term debt, and nothing else jumps out from the balance sheet to raise any concerns.

Cash Flow Statement

After a spending freeze in 2008, as denoted by the $2.7 million in capital expenditures (capex), 2009 saw the company expanding and spending some money for growth. Total capex came out to $10.3 million in 2009.

To calculate growth capex, take the change in property plants and equipment (PPE) as a percentage of sales, the change in sales, and then multiply to give you the growth capex.

In KIRK’s case, PPE as a percentage of sales in 2009 was 9.1%. KIRK also increased their sales by $14.9m in 2009.

$14.9 x 9.1% equals $1.36 million spent as growth capex.

Keep in mind that capex is expected to range from $25 to $28 million for the next year.

Financial Data

Most importantly, free cash flow (FCF) is positive and looks to be increasing. With the expected ramp up in growth capex, FCF will continue to increase in years to come.

The last fiscal year margin shows gross margins to be at 41.5% and net margin at 8.5%. This is the best the company has ever done in its history.

Cash return on invested capital (CROIC) is also at a staggering 33%. This means that for every $1 of cash invested, the company has made a return of 33 cents.

FCF/Sales is also at 10%. I like this metric because it shows that for every dollar of sales, 10 cents is converted to FCF.

KIRK has an amazing inventory turnover at well over six times. Other competitors only manage two to three times turnover. With the improvement in margins and high inventory turnover, this can only be recognized as good news for the company.

Earnings Adjustment

From the last 10-K:

“Depreciation and amortization expense was $14.5 million, or 3.6% of total revenue, for fiscal 2009 as compared to $18.7 million, or 4.8% of total revenue, for fiscal 2008. The decrease in depreciation and amortization was the result of a smaller store base in fiscal 2009 as compared to fiscal 2008 as well as extensions of certain store leases beyond their initial terms where the related leasehold improvements are generally fully depreciated, the large reduction in capital expenditures during fiscal 2008, and the relatively low amount of capital expenditures during fiscal 2009.”

Basically, expect depreciation and amortization (D&A) to increase soon.  If it does increase, also expect earnings per share (EPS) to be lowered to reflect this change.

Had D&A remained at $18.7 million, 2009 EPS would have to be adjusted from a diluted $1.71 per share to $1.57 per share.

Adjust the EPS to include the tax rate of 40%, and EPS would have come out to $1.53 diluted.

Valuation

On a conservative basis, KIRK is trading at just below its intrinsic value. Because the company has been able to turn it around the past couple of years, my valuation is based on current figures.

If you believe that growth is certainly there, that would definitely increase the intrinsic value.

Discounted cash flow (DCF) comes out to $17.65

Ben Graham formula is $19.80

Earnings Power Value shows $23.21

Attachments

• –KIRK-dashboard-2010-07-11
• –KIRK-valuation-2010-07-11
• –KIRK-health-2010-07-11
• –KIRK-DA-2010-07-11
• –KIRK-competitors-2010-07-11
• –KIRK-charts-2010-07-11

All the media and focus is turned to British Petroleum (BP) at the moment, and rightly so. The mess of the oil spill has sent shivers throughout the entire oil industry, and virtually every oil-related company has seen their stock price fall.

Quick thoughts on BP

Whitney Tilson is calling his long position in BP a contrarian bet but at, this point in time, there is too much uncertainty and risk. In my mind, there’s a clear distinction between uncertainty and risk –  uncertainty does not equal risk. Mohnish Pabrai spoke of capitalizing on uncertain situations in The Dhando Investor.

Whitney Tilson has bought BP with the belief that the depressed stock price is due to uncertainty, but I believe there is much more risk involved with BP. It doesn’t just lie within the company itself — there are far too many external variables that BP cannot manipulate. A controlling US government, political motives, oil spill directly affecting the US coast, and population, are all factors that add to risk rather than uncertainty.

During the whole process, a position of mine, Bolt Technology Corp. (BOLT), has been hammered lately, as well. Discussions have been going on regarding BOLT in the forum, but I wanted to address a few questions here.

Deepwater drilling moratorium

I’m not really into politics because it never really is for the people. Usually, it’s just for the people running, so I was very pleased to hear that Judge Martin Feldman overthrew the six-month ban on deepwater drilling, which was just another knee jerk political decision without sound reasoning.

Although BOLT is not a deepwater driller, and is not directly affected by the ban, the seismic equipment that the company sells certainly aids in the discovery of deepwater wells, so the ban lift is welcome news.

Are any of Bolt’s major customers affected by the ban? Yes, but see below.

BOLT major customers

If BOLT is not affected by the ban, then what about its customers?

A quick look at the annual report reveals that a majority of its sales are to foreign companies.

During fiscal 2009, 2008, 2007 and 2006, approximately 85%, 80%, 78% and 78% of sales, respectively, were from shipments to customers outside the United States, or to foreign locations of United States customers.

Here is a list of the major customers from the 2008 fiscal year.

• – Compagnie Generale de Geophysique-Veritas – 17%
• – Schlumberger Limited – 15%
• – Petroleum Geo-Services - 10%
• – Wavefield Inseis – 7%
• – SeaBird Exploration – 6%

In fiscal 2009, the major customers were

• – Schlumberger Limited – 16%
• – Compagnie Generale de Geophysique-Veritas – 15%
• – Petroleum Geo-Services – 9%

Schlumberger Limited has operations in the Gulf of Mexico. In fiscal 2009, oilfield services from the Gulf of Mexico attributed to 3.5% of revenues. WesternGeco is a geophysical segment of Schlumberger, and saw 1.8% of total 2009 revenue from the Gulf of Mexico. BOLT most likely does business with WesternGecoby, providing them with the required equipment.

As you can see, operations in the Gulf do not materially affect the overall results of Schlumberger or the business potential of BOLT.

Compagnie Generale de Geophysique-Veritas is a French-based geophysical services company and is not affected by the events of the Gulf oil spill.

Petroleum Geo is a Norwegian geophysical services company. I think it is safe to say that a Norwegian firm performing seismic data analysis in the Gulf of Mexico is unrealistic.

BOLT Products

It wouldn’t be a surprise if the government introduces new laws and safety standards in how oil wells are drilled. But after reviewing the products, I see that BOLT doesn’t offer any products that could capitalize on this potential.

BOLT intrinsic value

I’ve been tempted to try and put a price tag on BOLT based on short-term events, but realize it doesn’t serve much purpose. At less than $9 a share, the company remains too cheap to sell.

There’s plenty of fear, but the balance sheet and free cash flow (FCF) numbers show that BOLT is perfectly healthy.

The TTM Piotroski score is 6, MRQ Altman score is 27.93, and Beneish model gives -3.53. All three measures clearly indicate that BOLT is no difficult condition. Makes it easier to sleep at night knowing that the company’s balance sheet is very strong.

In 2009, FCF – not owner earnings — came out to $9.3m. As of 3rd quarter 2010, FCF is currently already at $9.7m. This is despite the big 50% decline in earnings from previous comparable quarters. This is another reason why it’s important to refer to FCF as the true profitability of a company.

I’m expecting FCF in the range of $11m to $12m for the full fiscal year.

• – The low case scenario of 0% growth with a 15% discount rate yields an intrinsic value of $14.39
• – Normal case of 10% growth with 15% discount rate results in an intrinsic value of $19.59

With declining revenues and negative short term catalysts, looks like the short term 0% growth intrinsic value is $14.

BOLT stock valuation pdfs

Below are several pdfs of BOLT stock valuation.

• BOLT Dashboard June 27 2010
• BOLT DCF Valuation
• BOLT Earings Power Value EPV
• BOLT Graham Formula Valuation
• BOLT Competitors
• BOLT Piotroski Altman Beneish

Disclosure

Long BOLT at time of writing.

Right now, there’s clearly a lack of value in the market. A barometer that I use to make such observations is viewing the number of net nets available in the market.

During the crash of ’08, the market was brimming with cheap companies trading for less than their liquidation value. However, as of today, there are five net nets by Ben Graham’s definition.

When the market is either fairly- or over-valued, the quality of the investment matters. Low-quality stocks have risen substantially, and the downside to such stocks cancels out any margin of safety that may remain.

Quality of the business, discussed by Piotroski’s Score, is a factor to consider when searching for such investment opportunities.

To determine the quality of the business, Joseph Piotroski devised a simple nine-point system — a discrete score between 0 to 9, which reflects nine criteria used to determine the strength of a firm’s financial position. The Piotroski rating is used to determine the best value stocks, nine being the best. The score was named after Stanford University accounting professor Joseph Piotroski, formerly of the University of Chicago, who devised the scale according to specific criteria found in the financial statements. For every criteria (below) that is met, the company is given one point. If it is not met, then no points are awarded. The points are then added up to determine the best value stocks. (Investopedia)

Profitability

1. Positive return on assets in the current year (1 point)
2. Positive operating cash flow in the current year (1 point)
3. Higher return on assets (ROA) in the current period compared to the ROA in the previous year (1 point)
4. Cash flow from operations are greater than ROA (1 point)

Leverage, Liquidity, and Source of Funds

5. Lower ratio of long-term debt in the current period compared to value in the previous year (1 point)
6. Higher current ratio this year compared to the previous year (1 point)
7. No new shares were issued in the last year (1 point)

Operating Efficiency

8. A higher gross margin compared to the previous year (1 point)
9. A higher asset turnover ratio compared to the previous year (1 point)

How to Interpret the Piotroski Score

Obviously, the higher the score, the better. A company that achieves a score of 9 is fundamentally very strong. Any company that has a score of 8 and above is considered excellent.

Free Piotroski Spreadsheet for CGI Members

For CGI members, I’ve created a free spreadsheet for you to calculate the Piotroski Score for any company. This is an unrestricted version, offering the last five years of Piotroski Score.

The limitation is that financial companies can’t be calculated with the spreadsheet, as their financial statements are different and the required line items do not exist.

Requirements

• Windows only. Sorry, no MAC support.
• Microsoft Excel 2000 and above.

How to Use

If you have never used my free and premium spreadsheets before, you’ll need to install a free Microsoft Excel add-in called “SMF,” short for Stock Market Function. This add-in will allow you to retrieve data automatically from the Internet rather than having to manually plug it in.

1. Download and install the SMF_Add-in_Standalone_Install.exe file that I created.

2. Download and open the OSV_Piotroski_F_Score_CGI.xls file.

3. You will likely see a prompt displaying “This workbook contains one or more links that cannot be updated.” Then go to page 5 of the manual titled “Second Part of Installation” to finish the install.

4. Enter any non financial company ticker into the yellow box, press enter, then click on calculate and bingo!

Download Links

SMF_Add-in_Standalone_Install.exe

OSV_Piotroski_F_Score_CGI.xls

Spider Graph and Business Valuation Overview

My assessment of BOLT is summarized by the spider graph above.

Low Risk: The company financial statement is very easy to read and analyze. There aren’t any hidden derivatives or tongue twisting jargon to confuse you. The balance sheet is very strong with plenty of cash and liquid assets. Even if an acquisition is announced soon, it won’t raise any red flags on the balance sheet.

BOLT is down purely affected by oil prices rather than fundamentals. When I first looked at BOLT, crude oil was around the low $70 mark and as of February 22, 2010, it is now $80.

High Growth: Being in a niche market, BOLT isn’t expected to have high growth. It grew substantially during the oil bubble, but with oil flattening above the $70 mark and growth to stabilizing to a consistent level, I’ve assigned a 2 out of 5 for the growth aspect.

Undervalued: From the valuations that you will see, BOLT has a margin of safety of 50% or more.

Well Managed: People complain on the Yahoo boards that the management team is senile and out of touch. The numbers from my analysis suggests otherwise. Management could be all talk and no walk, but BOLT itself is no talk but all walk.

Good Financial Health: No debt, plenty of cash, liquid assets. No worries.

Strong Moat: Within a niche where there aren’t many competitors, it’s hard to exactly pinpoint the moat. But both the outperformance compared to peers and the higher returns suggest that a moat does exist.

Financial Statement Analysis

Balance Sheet Analysis

• $4 cash per share, which makes up 37% of the share price
• The lowest level of accounts receivables since 2006. Shows the company can collect money in hard times.
• Inventory decreased from the prior year by 18.5%, but what is so great about BOLT is that they are a custom shop, so all the inventory is made up of raw materials and not finished goods. Work-in-progress makes up only 10% of total inventory.
• I’m never a fan of intangibles, so it’s very good to see that intangibles only make up 1.5% of total assets. However, goodwill represents 10% due to the acquisitions of A-G Geophysical Products, Inc (A-G) and Real Time Systems Inc (RTS).

Income Statement Analysis

• Gross profit is above 40% and has been increasing since 2003. So the top line has been managed very well even before the oil boom.
• Despite a big drop in revenue, expenses were cut, which produced consistently high net margins above 20%. A very profitable company.
• Tax rate is consistent at the 32% mark, so compared to previous years, earnings are not inflated by paying less in taxes.

Statement of Cash Flows Analysis

• Cash flow statement is clean.
• BOLT has been collecting receivables and selling inventory to bring in cash.
• Small purchases of equipment have been purchased.
• For such a small company, BOLT throws off huge amounts of FCF and with all the cash generated by operations, there’s no need for debt.

Intrinsic Value Calculations

Discounted Cash Flow (DCF)

The DCF method requires some assumptions and while it isn’t the perfect method, it is a very reliable and accurate tool if you keep it on the realistic to conservative side. The reason people get into trouble is because they fail to understand both the business and the industry in order to assign a growth.

For the past 10 years, BOLT has always been FCF positive with no debt or one time extraordinary items. The company is extremely consistent and has grown FCF at a rate of 80% over the past 5 years and 20% over the past 10 years. But if I were to use this type of FCF growth in the DCF, the valuation would be astronomical and completely off.

Over the past 5 years, by taking a rolling median (ie, comparing multiple timeframes rolling across different time periods and then taking the median), the CROIC (Cash Return On Invested Capital) is 21.5%. This means that for every $1 of cash invested in the business, BOLT has been able to return $0.215. This is an outstanding achievement by management.

Another metric I like to use the FCF/sales. It shows how much of sales converts directly to the bottom line. In BOLT’s case, for every $1 of sales, about $0.20 is converted to FCF. So not only is the business a money generator, management adds to the equation to make it even better.

Here are the assumptions to get a DCF intrinsic value.

• Starting FCF of $9 million
• 14.8% growth rate for the next 10 years with a terminal rate of 3%. Considering the strength and size of the company, these are very conservative numbers.
• 15% discount rate

DCF intrinsic value: $20.17. This is currently a 48% margin of safety based on conservative assumptions.

Benjamin Graham’s Formula

This valuation is based on Graham’s formula from The Intelligent Investor, which I have made modifications to as shown below.

Using a growth rate of 14% based on the median of normalized earnings and an EPS of $0.93 to more than price in the slowdown, the value comes out to be $18.57, which is at a 43% discount.

Earnings Power Valuation

Based on Bruce Greenwald’s EPV method, the asset reproduction cost comes out to be approximately $5.20 per share. This is the value that a competitor will need to at least copy the assets in order to run a business similar to BOLT.

However, by calculating EPV, I get a value of $17.01, which is significantly higher than the reproduction value. This means that BOLT does in fact have a moat—the value of the business is worth more than the assets. If a company had no moat, the EPV would be roughly the same as the asset reproduction cost.

For more information on how EPV works and how to calculate it, be sure to read my EPV articles.

Asset Valuation

Net working capital is the approximate value the company would fetch in a fire sale or liquidation and can be considered to be the floor of the stock price.

For more details, you can see the performance of NNWC and NCAV stocks from a backtest study I performed.

For BOLT:

NNWC is $5.07

NCAV is $6.11

This means that half the value of BOLT is made up of highly liquid, tangible assets while the remaining half is what the market is valuing as the future business. A crazy lowball valuation.

Competitor Comparison

Competitors compared against BOLT include:

• ION Geophysical Corporation (IO)
• Mitcham Industries (MIND)
• Dawson Geophysical (DWSN)
• Geokinetics (GOK)
• Baker Hughes Inc. (BHI)

By comparing the competitors side by side, you can see how well BOLT stacks up fundamentally against each one regardless of how big the competitor is. From an earnings standpoint, it’s on par with the other companies, since BOLT earnings dropped quite a bit, but earnings are always temporary setbacks. Compare this to the fundamentals of cash flow, FCF, margins, debt, current ratio and effectiveness, and BOLT beats every competitor hands down.

IO and GOK have been the best performers but remember that in 2009, low quality stocks were hit the hardest but also rose the fastest, while quality and sound investments rose steadily.
BOLT Competitors

Summary

BOLT Stock Snapshot

Disclosure

Long BOLT

As a value investor seeking to make great returns, I focus on small to micro caps. Many people aren’t comfortable investing in tiny market cap companies, but Bolt Technologies (BOLT) is a company that has all the characteristics of a large cap.

Focus on the business and value—not on the market cap—and you’ll realize what a gem of an opportunity BOLT is. I’ll break this analysis into two sections and both will probably be lengthy as I try to go over as much as possible in detail and try to make it easy to follow.

Business Summary

Aside from some technical terms, BOLT is very easy to understand and has the aura of a typical Buffett company.

An overview of the business can be found in the 10-K or the website, but to briefly sum it up, the company is broken down into three operating units; Bolt Technologies (BOLT), A-G Geophysical Products (AG), and Real Time Systems (RTS).

1. BOLT develops and sells seismic air guns to the marine seismic industry.
2. AG develops and sells underwater cables, connectors, hydrophones, and other seismic related parts and equipment, as well as BOLT air guns.
3. RTS develops and sells air gun controllers/synchronizers, data loggers, and auxiliary equipment (think remote controls).

Oil and gas drilling isn’t an easy task, nor is it cheap. With BOLT’s lineup of high quality products, explorers and drillers are willing to pay for such devices to increase the success rate of their digs.

What are Seismic Air Guns and Why?

The main revenues come from air guns, so a brief understanding of how air guns work will help visualize the business, operations, industry, and potential.

The purpose of an air gun is to create a 3D or 4D image of the sea bed by firing acoustic waves.

The image below represents an excellent illustration of how the whole process works. An air gun is attached to the ship called a survey ship, and fires waves aimed at the sea bed. The waves are reflected from the contours of the sea, ocean, or whatever bed to the hydrophones, which collect the information on the path, distance, strength etc. of the reflected wave.

This information is then used to create 3D or 4D models of the layers of the ocean floor.

From this brief intro to air guns and how they operate, think back to the three operating segments of BOLT.

• BOLT  = air guns
• AG = cables, connectors, seismic, and air gun accessories
• RTS = data gathering and controllers

As you can see, all three operating segments are highly synergized. AG was acquired in 1999 and RTS in 2007. BOLT acquired two companies in a span of eight years. This is a clear indicator that management is extremely selective of choosing the best possible match for the company.

BOLT’s Current Situation

BOLT is a prime example of inefficient markets. In 2008, the stock fell further than most of the other stocks due to a steep simultaneous decline in oil prices.

BOLT no doubt operates in a cyclical environment and is heavily affected by oil prices. When oil was above $100, exploration companies were desperate to find and dig as many wells as possible and vice versa when oil was at a ridiculous price of $40 per barrel.

Although BOLT has risen from its lows, it was mostly buoyed by the market more than pricing in its phenomenal fundamentals.

I’m not an oil or a commodity investor, but this is a play on where you think oil is headed. If you believe oil will increase to the $80s and higher, this is a great opportunity. If not, then a better entry point could be around the corner.

Risks

At the beginning of 2009, I lost my discipline with risk management in a merger arbitrage and I ended up losing 50% of that investment overnight. Ever since then, I’ve worked to eliminate as much risk from any investment. The fewer variables you have to work with, the smaller the field of outcomes. It also makes the investment much simpler to understand, and understanding and having conviction are key to capturing huge gains.

I feel that there are four risks to be considered with BOLT but I don’t believe any of them to be critical, don’t-touch-with-a-10-foot-pole-type risk.

1. Highly dependent on oil and economy—oil service companies will deplete their inventory if oil prices are low, which would reduce the demand for seismic services
2. Majority of sales come from three customers
   1. Schlumberger Limited makes up 16%
   2. Compagnie Generale de Geophysique-Veritas makes up 15%
   3. Petroleum Geo-Services makes up 9%
3. 85% of revenues from overseas—revenues will fluctuate due to current exchange rates
4. Current management team nearing retirement(?)

Another point to know is that BOLT recently filed an S-3. An S-3 is typically filed when a company wants to offer stock, preferred stock, debt securities, warrants, and units. In BOLT’s case, it is up to $50 million.

We may offer and sell from time to time in one or more offerings our debt securities, common stock, preferred stock and warrants, and units compris[ing] one or more debt securities, shares of common stock, shares of preferred stock and warrants in any combination, up to a total public offering price of $50,000,000.

This could mean either a ramp-up in capex will be necessary or they have a new acquisition in sight, which will require additional capital.

Seeking Acquisition

Previously I mentioned that BOLT had made only two—yet highly synergized—acquisitions. I believe these two mergers to have been very shrewd and well planned. A company focused on growth and stock price will make acquisitions to inflate their EPS. But I don’t believe this to be the case with BOLT.

The CEO has held his position since 1990 and chairman since 1997 but a director since 1979. At the age of 70, he is still in charge and his management team is just as experienced.

While it is a fact that the CEO may retire, being involved with a company since 1979 and staying at the helm for 20 years proves to me that he loves his company and his job. If someone loves their job, you want to see it grow and prosper. Keep in mind that this is just a personal opinion as I couldn’t find enough information on the CEO.

Awesome Niche Company

It is business as usual for BOLT. There is no fundamental flaw or warning sign that this company is distressed. BOLT operates in a niche market where it is a leader that is supported by its numbers. Using price as a tool and not as an indicator, BOLT fits the criteria for low risk and high return.

In the next article, I’ll go through all the valuations in just as much detail as this first part.

Disclosure

Long BOLT