PSB Monthly Issue October 2008

| October 7, 2008

October 2008


Everyone knows it.  The future of global energy production can’t be trusted to fossil fuels.  While oil and gas will continue to play an important role for years to come, future growth is in alternative energy.

Wind, solar, tidal, geothermal… the number of ways to generate alternative energy is amazing.

Global demand is skyrocketing.  The U.S. Department of Energy estimates energy needs will double between now and 2030.  In emerging economies the demand’s growing even faster.

Wind and solar power are two of the fastest growing forms of electricity generation in the United States.  Wind power’s expanding faster than 20% per year.  Demand for solar is growing by more than 30% per year.

It seems like everything’s electronic these days.

Sophisticated electronics like computers and cell phones are everywhere. Think of the power requirements your average home has.  Refrigerators, microwaves, TVs, DVD players, VCRs, the list goes on and on.

Increasing demand is pushing the cost of electricity ever higher.  Naturally, consumers are demanding more power and greater energy efficiency.

There are two big problems however.

First, the production of electricity, especially from alternative energy sources, is inconsistent.  The second problem is regulating power use in the electronics themselves.  Power reliability and conservation needs to be improved.

The solution is power semiconductors.


We found a small penny stock specializing in designing and building these power semiconductors.  They’re able to generate profits now and I’m expecting them to continue to grow at an exponential clip.  Their products are necessary for alternative energy production.

The company is IXYS Corporation (IXYS).

They design and manufacture power semiconductors, mixed signal integrated circuits, application specific integrated circuits, and radio frequency power semiconductors.

The part of their business I find the most exciting is the power semiconductor business.

So, what are power semiconductors?

The actual technology’s incredibly complex.  We don’t have enough space to describe it all.  Here’s the important stuff you need to know.

Power semiconductors take electricity from a source (like a windmill or solar panel), process it and then convert it into the same type of power used on the power grid.

These semiconductors perform several different functions.  They can convert alternating current (AC) into direct current (DC) (which is used by most electronic equipment).

They can also convert DC voltage to different levels.  And finally they can invert DC power to the higher frequency AC power.  These systems are often called inverters and rectifiers.

Essentially, they’re systems that manage electrical voltage.

Some of the fastest growing uses of power semiconductors are in wind turbines and solar energy systems.  Power semiconductors are also used in all types of electronic devices like motor drive controls, medical electronics, and plasma TVs, to name a few.

When power semiconductors are combined with other management systems, energy use is optimized.  These types of systems are often used in electronic components to make them more efficient.


Recent financial results for IXYS have been great.  The company recently reported financial results for the quarter ended June 2008.  Revenue hit record levels of $79.3 million, up 4.5% from last year.

Not only was revenue strong, but the company backlog was up to $116 million.
Gross profit was $24.8 million, which was an improvement for the third quarter in a row.

Net income was a solid $5.5 million, or $0.17 per share.  Up 53% year over year.
IXYS’s products are in high demand, and they’re able to generate really strong cash from operations.  $12.2 million last quarter alone.

This brought the company’s cash position to $70.5 million.  Now, the company does have about $18.8 million in long term liabilities.  I think it’s a reasonable amount of debt given the company’s financial performance.

On top of all this positive news the company even pays a dividend of $0.03 per quarter (very rare for a penny stock).


Great cash management.  The company recently announced a special dividend of $0.07 per share.  Any company that offers up a special dividend in this type of market is clearly generating strong cash flow.  It’s not often you see this type of activity in a penny stock.

Stock repurchase plans.  In addition to returning cash to shareholders, the company’s also aggressively buying back stock.  So far this year they’ve purchased 4.3 million shares.  Another positive sign.

Ownership.  This company is a great example of strong management ownership.
Top management owns approximately 28% of the company.  This aligns management with the best interests of the shareholders.

In addition to management ownership, two other big institutional investors, Security Investors, and Columbia Wagner Asset Management own an additional 17% of the company.  Again, a great sign for the business.


As always, no company is without risks.

With IXYS their biggest advantage is also their biggest risk.  They’re supplying product for an aggressively growing alternative energy industry.  Should the alternative energy industry growth slow at all, the company’s performance will be negatively impacted.

The other big risk for the company is their reliance on outsourcing.  The company subcontracts other companies to produce their products.  If these manufactures have problems with production IXYS financials could be impacted.


IXYS has a number of competitors in the semiconductor industry.  Altera (ALTR) andXilinx (XLNX) are very comparable.

Industry Financials

Company         Size ($mm)    Dividend Yield       P/S      P/E
Altera (ALTR)     $4,500              1.3%            3.4x     13.1x
Xilinx (XLNX)      $4,500              3.5%            2.3x     12.4x
IXYS (IXYS)       $283                2.0%            0.6x       8.1x

As you can see from the table above the company’s greatly undervalued.
Based on P/S ratios (Price to Sales) IXYS is valued at only 25% the value of Xilinx… that means IXYS stock could quadruple before being valued on par with Xilinx.

With P/E ratios (Price to Earnings) IXYS is undervalued by 40% when compared to Altera.  That means the stock could almost double and it would then be trading on par with other industry participants.

Remember, the company’s reaching record revenues and growing its earnings.  You could argue they should be receiving a premium valuation for that.

Clearly this stock is undervalued.  I believe it could jump by as much as 50% to 100% in the near term.


IXYS Corporation (IXYS) is trading at $9.01, BUY up to $10.00.

Use a stop loss of $5.50 on this position.

Don’t forget your position sizing and stop-loss rules.



Leverage.  I’m using that word very cautiously these days.  With the ongoing global credit crisis, that word has become very dirty.  It seems everyone’s afraid of leverage.

This strikes me as strange.

Anyone who’s ever borrowed money to buy a house or a car has used leverage.  If you’ve ever used margin in your stock trading account that too is leverage.

When used appropriately, leverage can be very, very profitable.

Want proof?

Just look at your local bank.  For centuries banks have profited from borrowing money at cheap rates (interest paid to depositors) and lending it out at much higher rates.

The banks profit by capturing the difference in interest rates.  This is known as the “spread.”

For every $1 in deposits, a bank can lend out anywhere between $2 and $10 (depending on the risk profile in their loan portfolio).

This leverage allows a bank to put more money to work “earning” interest… earning the spread.

There’s a business that takes this model to the next level.

They use money invested by shareholders and borrow even more.  All the money gets invested in low risk bonds.  The company’s able to generate great profits, most of which gets sent to the shareholders every quarter.

I’ll tell you more about their financials in a moment . . . but first let me introduce you to the company.


Ever hear of a company called MFA Mortgage Investments (MFA)?  I’m not surprised if you haven’t.  The company flies below the radar of many professional investors.   MFA was founded in 1997 and runs their entire business out of their headquarters in New York.

They’ve built a great business on based on a simple model.

They take money invested by shareholders and go out and borrow more money.  This big pool of cash is then invested in low-risk bonds.  The company keeps the spread.

That’s the difference between what they borrow money at and what types of investment returns they get on these bonds.

You see, the company’s been able to borrow money very cheaply.  As such, they generate great earnings for shareholders.

A little more on leverage.

MFA takes everything they have (cash and assets) and uses it to borrow money.  As of the end of the second quarter the company was able to borrow about $9.4 billion.

Their stockholders equity is $1.4 billion.  That makes the leverage ratio 6.7x. (debt divided by equity).  To put it simply, for every $1 invested, they borrow $6.70.  It’s a very conservative number as we’ll learn in a minute.

All of this borrowed money is then used to buy assets.

What bonds are being bought?

MFA is conservative in their investment objectives.  They limit most of their purchases to government-backed securities like: Government National Mortgage Association, Federal Home Loan Mortgage Corporation, or Fannie Mae bonds.
These bonds are called mortgage backed securities (MBS).

These are some of the safest real estate backed securities in the market (despite what you hear in the news).  The company notes 99% of their assets are “issued or guaranteed by an Agency of the U.S. government or a federally chartered corporation.”

The business is that simple.

The management team then sits back and collects the payments made on the bonds.  They pay their bills and make their debt payments.  Everything left over goes to the shareholders.  The company keeps operations trim by limiting overhead.


One of the big advantages MFA brings to the table is its REIT status.  What’s that mean?

REIT’s are companies formed under IRS guidelines.  By being a REIT, the company doesn’t pay corporate taxes.

Now there’s lots of other regulations and requirements… but I don’t want to bore you with lots of legal mumbo jumbo.

The important thing to understand is this, the business pays no taxes. They’re also required to send at least 90% of all earnings to shareholders.

Any way you slice it, the best part of being an owner in the company is the big earnings flowing into your pocket as dividends.


As you’ve discovered, the business of MFA is very simple.  So are the financial statements.

Last quarter, the company generated interest income of $120 million and their borrowing costs were $76 million.  The difference, $44 million, is what the company uses to pay operating costs and other expenses.

Everything else gets sent to shareholders as a dividend.  For the second quarter ended June the company earned $0.20 per share.  They sent $0.18 to the shareholders.

The company is so confident in their business they raised more money in June.  Keep in mind how bad the markets were.  It was a horrible time to be raising money… the fact they were able to complete the deal gives them a gold star in my book.

They put just over $300 million in new cash on their books.  With this cash, they were able to acquire more than $2.4 billion in new mortgage backed securities.

The thing to watch with MFA is their portfolio spread.

It’s a fancy way of saying the difference between their interest earning bonds, and their cost of borrowing money.

Last quarter it was 1.38%, up from 0.90% the prior quarter.  Obviously the bigger the number the better it is for the company.

Now, this business strategy isn’t risk free.

Like any security, the price of these bonds fluctuates.  If they’re forced to sell at the wrong time, they’ll have to take a loss.

That’s exactly what happened earlier in the year.  Because of the credit crisis, the company decided to reduce their leverage.  This meant they needed to sell some assets.  As a result they took a loss of about $25 million.

Of course that impacted results and the company posted a loss in the first quarter.


There’s lots of little things at MFA which bode well for the company.

First, the big capital raise instills confidence.  As I mentioned above, the company recently raised $300 million in a very difficult market.  This is a huge positive for the company.

Clearly they have a strong business otherwise why would professional investors give them so much new capital?

Second, a solid institutional investor base.  Fourteen of the top 15 shareholders in MFA have added to their positions in the last quarter.  That’s almost 30 million shares new shares bought up by these smart investors.

Third, a simple business model.  The business is straight forward.  You could describe it in a few sentences if you wanted to.  This gives confidence that management can successfully run the business and maximize returns.


As always, no company is without risks.  MFA faces several different types of risk.
Their biggest is leverage (it’s a double edged sword).  The business model is focused on borrowing money cheaply and investing it for bigger returns.

If the credit crisis gets worse, or their ability to borrow money is compromised, the business will suffer.

The next biggest risk the company faces is the selection of investments.  All of the borrowed money needs to be invested wisely by the management team.

Selecting the right mortgage backed securities is no small feat.  The company is conservative in their investment strategy.  That means the yields won’t be the highest, but their default rates should be lower.

Market conditions.  Since the company is so closely tied to their investments the conditions of the market can adversely impact the business.  Big volatility isn’t good for the company.


MFA’s an undervalued company.

MFA has a Debt to Equity ratio of around 6.7x.  This is very conservative compared to an industry average well over 10x.  Many of the high risk hedge funds had debt to equity ratios of closer to 30x!

The lower the leverage ratio the safer the investment.  In today’s tough credit market, lower leverage should command a better valuation.

Too, dividend yield shows just how undervalued the company is.  I like to look at dividends because they’re tough to fake.  You either have the money to pay a dividend or you don’t.

MFA’s paying a dividend close to 15%.  Now compare that with the financial industry which is averaging 6%.

You can quickly see MFA’s undervalued by almost 50%.

Of course this assumes they’re able to keep their dividend stable (and I think they can.)

You won’t see Price to Book Value used very often.  It’s a comparison of the value of a company to book value.

Sell off all the assets and pay off the debt.  What you have left over is book value to return to shareholders.

Right now, the book value is 0.85.  That means you’re buying $1 in assets for $0.85. This is the famous “Margin of Safety” Warren Buffett so often speaks about.

Any way you slice it, the stock is poised to move higher.


MFA Mortgage Investments (MFA) is trading at $6.08, BUY up to $6.75.

Use a stop loss of $3.50 on this position.

Don’t forget your position sizing and stop-loss rules.


Category: PSB Monthly Issues

About the Author ()

Comments are closed.