The equity markets continue to be rocky as August finished up, with the S&P 500 dropping 4.5%.  The Value Uncovered model portfolio followed the market down as well, dipping into the red for the first time since inception.

Stock Positions

August was another very busy month on the earnings front, as many stocks reported their results for the quarter ending June 30^th.

After turning in a great second quarter (including a nice special dividend of $1/shr), SPAN followed by reporting tough 3^rd quarter results.  The stock was the biggest loser in August, dropping below my initial entry point back in October of last year.

With dividends included, the position in SPAN is still positive and I expect a big fourth quarter.

Both APNC and TPCS reported solid results, with TPCS reporting a huge jump in revenue while APNC chugged along with another increase in quarterly net income.  ADVC continues to hum along as the tiny software company that nobody is talking about.

CHBU reported a ridiculous 300%+ growth in sales, and the stock still trades for less than net cash.

NOOF was the biggest gainer in August, up over 16%, as the stock finally rebounded from its 52-week low.  Another bout of insider buying helped add credibility, and the company finally seems to be turning a corner – NOOF is too cheap to remain below $2 for long.

Despite going through hundreds of financial statements, only one stock met my criteria for investment, as I added DIT to the model portfolio.  The stock is a great turnaround story, and I believe management will continue to consolidate and grow in a very competitive business.

Special Situations

FIS was another successful special situations investment that took advantage of a major recapitalization plan and self-tender offer.  The position netted a 4.69% gain in a little less than a month, for an APY of 81.8%.

However, another special situations investment is in big trouble – EMMS.  Jeff Smulyan, the company’s CEO, has run into all sorts of problems with taking the company private.

Details are still very sketchy, but the deal looks to be in serious jeopardy.  I find it hard to believe that Smulyan would let this same situation happen to him again (he tried to take the company private a few years ago and failed), but it looks like the market expects it to fall apart.

I will be monitoring the situation closely and may be forced to sell at a substantial loss.

Performance

The portfolio slipped into negative territory YTD, but is still ahead of the S&P benchmark.  Check out my holdings page for a full rundown.

As all of these investments are in micro-cap stocks, often with little or no liquidity, the market fluctuations can have significant impact on the portfolio’s return over a given month or even quarter.

Although I’m disappointed in the monthly results, it is more important to look at the portfolio over a longer time period.  I am constantly reevaluating my positions and will make changes as needed.

Final Thoughts

Also, I am considering slightly modifying the structure of the Value Uncovered portfolio to keep track of cash balances (see an example here from the wonderful blog, the SINLetter)

For a model portfolio, this new structure should provide a more accurate portrayal of real investment returns while allowing me to accurately represent position sizing.

I hope to make the changes soon.

Disclosure

Long SPAN, TPCS, APNC, ADVC, CHBU, NOOF, DIT, EMMS

Vicon Industries, Inc. (VII) sells private network video surveillance systems – think of the video cameras in shopping malls or retail stores to catch shoplifters and detect intruders.

With a market capitalization of only $17m, the business is in a heavily competitive, cyclical industry, leading to large variability in Vicon’s revenue and income.

Revenue Fluctuations

Since video network installations generally occur in newly constructed buildings (it’s probably pretty rare that a shopping mall rips out and replaces their entire network), the company is heavily dependent on new construction and the overall economy.

Here is a chart of the company’s sales over the past 15 years:

It is very clear from the chart that the company’s business is variable, with a ‘boom-and-bust’ cycle lasting approx 6-7 years. The latest upturn occurred from 2004-2007, followed by a sharp decrease in 2008-2009.

Fiscal 2010 sales will show a significant drop as well, as the most recent filing revealed that revenues are off 21%. The drop in revenue over the past three years looks very similar to the 2001-2003 time period.

Sales should level off as the economy rebounds.

Historic Financials

Vicon operates in a tough business with lots of competition from large multinational companies such as Panasonic, Sony, Bosch & GE Security.

In a tough environment, the company has done a great job improving its gross margin over the past 5 years, raising it from 38.8% in 2004 to 46.4% last year. Operating and net margins average 3% and 1.6% respectively.

Both ROE and CROIC are not the greatest, although the averages have improved to 9.8% and 8.2% respectively during the latest 3-yr upswing.

Balance Sheet Strength

It is difficult assigning a price tag on such a cyclical business, especially from an earnings & cash flow basis, so the best way to evaluate the company is through its balance sheet & assets.

The stock trades at almost half of its book value of $7.40.

VII trades at a significant discount to Net Current Asset Value (NCAV), and right around Net Net Working Capital (NNWC), a very conservative estimate of value if the company is liquidated:

These are very conservative valuations for a business that historically has traded right around book value.  However, these assume a ‘normal’ operating environment, but outside catalysts could severely affect the business as well..

Patent Litigation

One drag on the stock price is recent news regarding a piece of patent legislation originating from over 6 years ago. Back in May 2003, a company called Lectrolarm Custom Systems, Inc. filed suit against Vicon Industries regarding ‘camera dome’ pieces.

While VII does not break out sales by product category, the company reports that this product represents a significant amount of sales.

The original suit claimed damages of $11.7m, a substantial number for a company like Vicon with a market cap of only $17m.

As the suit made its (long & drawn-out) way through the USPTO system, most of the news went Vicon’s way. In a series of rulings in 2006 and 2007, the USPTO examiner declared all 5 claims invalid.

Lectrolarm re-filed the suit to the USPTO Board of Patent Appeals & Interferences (BPAI). Last week, the BPAI

“ affirmed the USPTO Examiner’s finding of invalidity of two of the claims and reversed the USPTO Examiner’s finding of invalidity of the other three asserted claims.”

This ruling reopens the patent infringement suit.

Based on the initial rulings back in 2006, Vicon seems to have a strong case to dismiss the claims, but obviously has to go through the proper channels to come to a final resolution.

It is very hard to determine a timeline for such a transaction. A negative ruling would seriously affect the stock price, while a positive verdict would remove a big weight off of the company.

In the mean time, this potential negative catalyst will put downward pressure on the stock price.

Conclusion

Based on the company’s history, business should start picking up with the global economy. As an investor, timing the very bottom of such a business cycle is extremely difficult .

However, several notable institutional investors continue to hold shares including Dimensional Fund Advisors (8.4%) and Renaissance Technologies (6.4%). According to a recent 13-G filing, another institutional investor picked up a 5% stake recently as well.

From an asset perspective, the company’s financial position remains very strong, providing the sort of downside protection that many value investors seek.

However, a prolonged recession could put the company in jeopardy and erode the margin of safety, not to mention the dark cloud of a possible patent verdict.

After experiencing three down years in a row, will VII manage to level out and start another upswing?

If so, the stock should appreciate considerably from its current lows.

Disclosure

No positions.