The Wonderfully Bloated Electronic Exchanges

I guess this post could be part 2 of how quickly we forget series. Have you ever seen a company with $8M technology be valued at $2.4B? Ofcourse there are other things of value within this company. There are customers and market share in a rapidly growing business. There is a new world buzz and an exciting looming take over by a venerable institution. As many of you have guessed i am talking about Archipelago Holdings - an electronic communications network that enjoyed a 5x move up in price since it's IPO in August 2004.

But let's try to think about what this company is really worth. Unfortunately for the holders of Archipelago shares i truly believe that it is much closer to $8M than to $2.4B that the company is currently valued at. The stock enjoyed a tremendous rise in value at the same time when most of its major customers are trying to figure out how to avoid its services in the future. Citigroup just announced a purchase of it's own ECN.Morgan Stanley, UBS ,CSFB, Merrill and Citadel are investing into Philadelphia Stock Exchange ECN. Citigroup, CSFB, Lehman Brothers and Fidelity have bought a stake in a new electronic equity market to be created by the Boston Stock Exchange. Nasdaq is improving its ECN capabilities with purchase of Instinet and American Stock Exchange is in a process of transforming itself into an ECN as well.

I do not know much about intricacies of electronic trading but i do know a commodity product when I see one. Over time as more and more exchanges offer opportunity to avoid such stalwarts like NYSE and NASDAQ we are bound to see margin and earning erosion for all of these companies. Obviously not every exchange customer will have their own ECN but all of them will have multiple options on where to trade their shares. At the end stock trade is a stock trade is a stock trade. If hedge funds or anyone else for that matter could achieve same execution they will always opt for a lower price.

Ridiculous valuations have been known to stay high for a long time. The .com bubble has lasted for at least another year after most investors have agreed that it is in fact a bubble. It is impossible to bet on when Wall Street will realize that its paying 250 times as much as Citigroup did for essentially the same thing. Quick check of option chains shows that latest put expiration available for NASDAQ is June 2006. However it is possible to get a Jan 2008 Leap Put for Archipelago. I strongly recommend buying a $55 or $50 put and patiently waiting for the AX that will become NYX to come back to its true valuation.

As always questions or comments are welcome.

How quickly we forget

I don't normally follow bond markets but an article in December 14th Economist cought my attention. Emerging Market bond yields compared to US Treasury rates are pretty much at all time lows. Given current economic growth and the budget surpluses for many of the countries that have defaulted on their debts in the past it is not completely unexpected. However, I am surprised by lack of weight given by markets to historical data. Argentina, Mexico, Brasil have all defaulted on their debt multiple times. Everybody remembers Argentina's default in 2001 which left holders of over $100 billion worth of debt struggling to get their money back. However that was preceded by similar collapses in Mexico in 1982, Brazil in 1998 and many other occasions before that.

Currently the region is going through a period of relative stability, but there are signs that things will not remain that way forever. Most obvious one is increasing influence of Hugo Chavez and recent wins by other leftist populist presidents like Evo Morales in Bolivia. In fact almost all the countries in the region are dealing with popular demands of increasing support of lower income households. In the past these trends resulted in governments running significant budget deficits which eventually caused a debt default during economic downturn. To use Argentina again as an example only four years after its debt default the government spendng is rising faster than its revenue income. Their budget surplus is shrinking and could turn negative again within next couple of years. Mexico is already running a slight budget deficit which could get much worse if populist mayor of Mexico gets elected as president in next year's election.

It is too early to say where and when the next Latin American debt crisis will strike. Right now the economies are doing well and Brasil and Argentina both took steps to pay down their IMF debts. Yet these countries still have significant amount of debt outstanding - Argentina's total debt to GDP is 78%, Brazil is 27 % and Mexico is 18.8%. Economic and political turmoil risk which brought these countries down in the past is not out of the question and should be compensated by higher yield spreads than right now.

Possis Medical

Possis medical is a manufacturer of specialty medical devices used to destroy blood clots. The company’s product AngioJet is a machine that uses highly pressurized saline solution pumped through proprietary designed catheters to destroy blood clots safer, more effective, and cheaper than any other technology on the market. I believe that this stock is worth $17 which represents a 70% upside from the current market price.

Reasons to Buy:
§ Company is able to realize over 70% gross margin and a history of achieving over 20% gross margins.
§ Company’s margins are protected by a patent, which does not expire until 2019. This creates a natural moat and a competitive advantage over other solutions on the market.
§ Reliable annuity from single use catheters. Company does not depend on sales of base units for its cash generation.
§ Company has been generating significant free cash flows from operations that have been used to repurchase shares. Since 2002 they have repurchased over $28M of shares (more than 10% of current Mcap) and have current authorization to repurchase another $15M.
§ Growth within the franchise through new product development for other procedures like Deep Vein Thrombosis and Pulmonary Embolism. The company came out with new products within last few month which have been exceeding their sales goals.

Risks:
§ Competitors may develop products that are more effective at destroying blood clots
§ European Study may show AngioJet ineffective in reducing the size of a final infarct (hear attack)

Catalysts:
§ As new evidence on the effectiveness of the device comes out through current studies, the device utilization will improve to historic (or above levels) significantly improving company’s cash flows.
§ Multiple lottery tickets within the company:
o Significant growth in Europe. European market is the site of the new study where AngioJet had limited exposure so far. In the last few quarters sales of AngioJet base units in Europe have significantly exceeded expectations.
o New applications for AngioJet in combating Deep Vein Thrombosis and Pulmonary Embolism (increasing the size of potential market by 20%)
o Increased sales through sales force expansion – company has been spending to increase sales force by 33% (from 60 to 80). This could result in higher sales of base units and utilization of product going forward.
o New AHA codes make it easier for doctors to get reimbursed for using AngioJet increasing utilization
o New Angiojet Ultra system (coming to market in about a year) would make it much easier to set up the machine in the operating room, increasing utilization.

The stock price fell from over $30 in Sep 04 to $8 as a result of AiMI study that showed that the company’s product is not effective in reducing the size of the final infarct. However the study did not require for the patients to have a visible blood clot and did not require to doctor to use AngioJet before stenting. Since AngioJet is designed specifically to destroy blood clots, having no visible blood clot (most likely a very small one) already renders device ineffective. Stenting procedure expands the size of the artery which often releases the blood clot further into the blood stream. Not requiring the doctors to use AngioJet before stenting once again causes the device to be ineffective. The company recognized the problems with these methods and there is another study now in Europe that will show that device is effective for removal of medium and large blood clots (exactly what doctors are using it for now 95% of the time).

Some detail on Valuation:
If we simply take a current install base of 1509 machines. Assume that the company does not sell anymore machines going forward and increases its product utilization to 38 times a year (below historical norms), this would result in an Operating Income of 13M or 8% cap rate. While this does not pass a 15% hurdle it shows that the floor for this stock is around $10 per share, with a current price of $12.
Company estimates that market saturation for machines in US is around 3500. Currently there are 1500 machines installed and the company has proven to be able to sell over 200 machines per year with lower than current sales force levels. Company has also been able to increase the cost of their catheters by $40 or more dollars per year. With significant new (more advanced) products it is safe to assume that the company would be able to increase the prices of their products by $20 per year. It is also safe to assume that the company would be able to increase their machine install base by 100 machines (half the long term average). This does not include the fact that they have a new machine coming out in a year that a lot of the hospitals that already using AngioJet would want to replace their old systems with. Given that the price of the machine is low ($25,000) compared to the costs of each procedure (over $1400 per procedure), Possis should see sales that are significantly higher than that. But even with these conservative assumptions, Possis would be able to generate $27.4M of operating income or 17% cap rate.

This is how i come up with valuation of $17. Potentially this stock is worth much much more, but their lottery tickets must work out before we can count on that upside.