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Watch Out for the One-Time Revenue Effect

MagicDiligence adheres to the Magic FormulaŽ Investing (MFI) strategy invented by hedge fund manager Joel Greenblatt and described in his book The Little Book that Beats the Market.

The simplicity, elegance, and logic of the strategy, as well as the past performance, is what attracted me to it in the first place. Instead of a complicated, convoluted mess, it is very simple. Rank all stocks by their combined earnings yield and return on tangible capital, and buy the stocks that have the highest combination of each. Stocks with high earnings yield are priced cheaply relative to their demonstrated ability to make money. Stocks with high returns on tangible capital have great business models or competitive advantages that allow them to earn a lot of money without having to spend a lot of money. Stocks with both are the holy grail - great companies available at cheap prices. That's what we want to buy!

After nearly 5 years of following the strategy, I've seen the screens do a great job of pulling up many companies that offer those very characteristics. It finds unknown small-caps, like Mediware (MEDW), an undervalued healthcare IT company that was just this week bought out at a 40% premium. It finds excellent but out-of-favor big caps at just the right time to buy, too. Apple (AAPL) was on the MFI screens briefly early this year, and if you bought then, you've enjoyed a 45% run-up since.

However, there are some kinks in the armor, too. One that I run into all the time is what I call the "one-time revenue effect". This usually happens when a small company happens across a short-term (often one-time) windfall that delivers a huge shot of revenue, generating a giant quarter of profitability. This makes return on capital figures robust, but the market knows that it is not a sustainable earnings level, so the stock price remains low, elevating the earnings yield. BOOM! A perfect recipe for being screened by MFI.

These are generally not the kind of companies MagicDiligence likes to buy. As mentioned, these one-time revenues do not represent stable and ongoing earnings power. Often times, these firms in "normal" quarters are minimally or unprofitable. While the revenue shot can certainly improve the balance sheet by adding a lot of cash, in many cases it is completely uncertain if the company will be able to invest that cash effectively. Simply put, we're looking for high earnings yields against sustainable earnings levels when digging around for Top Buy picks.

One quick way investors can identify potential one-time revenue stocks is through our Statistics Calculator. Any stock with an unlikely high earnings yield or return or capital is tagged as "Suspiciously High", which often means the stock is in MFI due to unsustainable phenomenon.

Aside from that, here are 4 current MFI stocks that exhibit the "one-time revenue effect" and why those earnings levels are not sustainable going forward:

LML Payment Systems (LMLP): LML is ostensibly a payment processing firm. But the reality is that nearly 70% of trailing twelve month revenues and essentially all of profits stem from several settlements for violating LML's 5 patents in electronic check processing. However, the patents expire in January and pretty much all of the biggest banks have paid up. Without these settlements, LML has been minimally profitable and looks to return to that going forward.

Maxygen (MAXY): Small bio-tech research firms are the most common case of one-time revenue effects. In Maxygen's case, a $30 million payment from Bayer for the sale of hematology assets last quarter is the culprit. Before that, Maxygen had not booked more than $560k in any of the previous 4 quarters, with 3 of those generating no revenue at all! With a single drug candidate and 7 employees, I'm not so sure the future for Maxygen is one I'd take a claim on.

Metabolix (MBLX): Metabolix's windfall was 2 quarters ago, a $39 million payment from the unexpected termination of a joint venture with Archer Daniels Midland (ADM) for Telles, a bio-plastics effort. Without this, MBLX usually generates under $500k in revenue and has generated operating losses of nearly $10 million in 4 of the past 5 quarters.

Pozen (POZN): Pozen is a pharmaceutical company with some interesting products, but is in MFI due to a $75 million up-front securitization of future profits in Treximet, applied in Q4 of last year. Aside from this, revenue run-rates have been under $2 million a quarter and the firm is unprofitable.

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Posted by cluniac on 2012-09-24 00:20:02

Hi Steve,

in general i agree with your point that you cannot just blindly trust the magical formula screen, as there are some red flag companies that show up, and sometimes have inflated numbers for one time events which will not be reoccuring.

However in the example of LML Payment Systems, when I researched this company I came to quite different conclusions than you. They have an eCommerce payment processing product Beanstream which is growing quite rapidly (~30%/yoy the past few years) and based on this subsidy alone I believe the company is undervalued. You can do some basic DCF analysis, ignoring the other parts of the business where they received the one time revenues from legal actions, and you can still quite justifiably see intrinsic values >3.50/share. I'm not in the speculation market for buyouts, but also its a very real possibility due to mergers and consolidation in payment processing, especially with growth of mobile payments in the next few years that they could be bought out for a significant premium.

So in this case I really think the company is a hidden gem with great potential.

Disclosure: Long LMLP

Posted by Steve on 2012-09-24 04:24:17

Sure, analyzing stocks is not a hard science and there is always room for differing opinions. In LMLP's case, the argument in this article is that it is in the screen because 70% of revenue and effectively all of operating income stems from non-recurring royalty payments on their patents, which expire early next year. It is hard to make an argument that this would be a Magic Formula stock without those payments.

I wrote a full analysis on LMLP not too long ago and thought the stock was worth about $2, or roughly where it trades today:

Posted by cluniac on 2012-09-24 12:16:07

Well funny coincidence.... Buyout was announced today for 3.45/share

Posted by Steve on 2012-09-24 13:25:34

You were closer than me!

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