The Potential of Binary Plays

By Michael Todd Price - March 1, 2012 | Tickers: APL, BBRY, KSWS | 0 Comments

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Everybody knows about Warren Buffett’s decree that if he still managed less than $1,000,000 he could return over 50% per year. One way I believe individual investors can strive to achieve this lofty goal is through devoting a typically small part of one’s portfolio to a form of speculation I call Binary Plays.

I call them this because the company’s stock usually hinges on a single event that will either clear the air and cause the stock price to surge or confirm investors’ worst fears and send the company to bankruptcy court. Thus, there are two (binary) possible outcomes: way up or way down. The event could be anything from the settlement of a lawsuit to the success or failure of a new product, from governmental approval of a product to the restructuring of a organization following the firing of ineffective management.

Below is one Binary Play that worked out for me in the past, as well as two new ones that investors may find intriguing.

Atlas Pipeline (NYSE: APL)

In early 2009 I was still recovering from the carnage that had occurred over the preceding year and a half and decided to take a look at the new lows in an attempt to find an attractive new buy opportunity. The first name that caught my eyes was a Master Limited Partnership called Atlas Pipeline.

I first discovered MLPs on the Foolish Collective discussion board in 2005. MLPs (typically companies that own oil or natural gas pipelines) are similar to REITs where if they pay out a certain percent of net income as distributions they do not have to pay taxes on it. I had purchased APL in my dad’s portfolio in 2005 to take advantage of the fat yield that came from the tax advantage paying out its net income produced. We then sold the company a year later to free up cash for more promising investments.

When I came across it again in 2009 the stock price had collapsed from highs above $50 to less than $3 per share. The company’s management had a bullish view on natural gas prices and had taken on boatloads of debt to finance the building of pipelines and then engineered contracts that paid it based on the profit the natural gas companies using its lines achieved. This is a great idea if the price of natural gas is going up, but when it crashed with the rest of the market in 2008 Atlas had no cash flow to make its debt payments and the market started to fear it would go bankrupt.

At that point its expected distribution for the year was around $1.5, which was more than half the current price. I liked the management from research I had done on the company before and believed the natural gas price would recover enough for the company to survive so I took a small position when the stock was at $3.43 per share.

The distribution was suspended and management had to sell the rights to various pipelines to pay off debt, but when the general market turned the stock skyrocketed. After a little over a year I sold half of my original investment for $18 per share and ended up selling out the rest above $24. It turns out I even sold early as the current price is around $37.

K-Swiss (NASDAQ: KSWS)

I've had a moderately creepy affinity for K-Swiss ever since it was one of the first stocks I picked as a teenager. At that time K-Swiss’s classic shoes were experiencing a (lucky) upswing in the tastes of teenagers. Its revenue was growing, its balance sheet was pristine and it boasted the best returns in the industry. Add to that the fact that it was trading at multiples lower than the industry and any creative analyst could have easily found a margin of safety using a DCF analysis.

It turns out K-Swiss was the typical value trap. As soon as the recession hit, revenue nosedived, falling from highs over $500 million in 2005-06 to less than $270 million today. Not surprisingly, the stock price followed suit, plummeting from over $35 to $3.40 where it sits today.

K-Swiss CEO Steven Nichols is no stranger to having to engineer turnarounds at the company. Since a leveraged buyout in 1986 for $20 million the company has endured two similar crashes in revenue and stock price, and both times its balance sheet secured it and it turned around a stronger company.

This time around the turnaround is leveraged totally on the company’s new Tubes brand. Nichols used the massive cash hoard that was built up during the last upswing to invest in creating and now marketing the new brand, using the character Kenny Powers from the popular HBO show Eastbound & Down as a pitch man.

This is where it becomes a crapshoot. I fully admit I don’t have any idea how successful the Tubes will be. The fact is the market has depressed the company so far that if they are in any way a success, an investor can easily earn a few hundred percent return on the investment. To accentuate this point I’d like to point out that K-Swiss current market cap, $118 mln is less than the company’s net net current assets (Current Assets – Total Liabilities) of $127 million.

Research in Motion (NASDAQ: BBRY)

When I was a junior in high school I wrote an article for the school newspaper exclaiming that ever since Internet Explorer had murdered Netscape, no new web browser had entered the market until Firefox did. It is likely that the smart phone market will mirror this same transition, with RIM’s Blackberry representing Netscape, the iPhone representing Internet Explorer and Android representing Firefox. This fact is well-known by Mr. Market and I believe he may have overplayed this point. Currently Research in Motion trades for just 3.3 times earnings.

Let’s take a look at the upside. To this point, the world has made the assumption that the iPhone and Android phones will totally overpower their forerunner, Blackberries will then go the way of the horse and buggy, and Research in Motion will only be worth the amount it can get in a fire sale for its core assets.

But this ignores the fact that many very large corporations still have their employees use Blackberries. I see two main reasons for this: first, the Blackberry email application is still a lot better than its iOS and Android counterparts, and the marginal utility a corporation derives from having employees use iPhones or Android phones instead is nowhere near the hassle it would take to switch everyone over to a new phone and teach them a new OS.

These two facts alone could make RIM somewhat of a cash cow for at least five-ish years, but there is one more possible catalyst: Prem Watsa. The so-called Warren Buffett of the North has a huge stake in the company, one that currently amounts to over $180 million. Watsa was instrumental in removing the co-CEOs who drove the company into the ground and has a great record of returning value to shareholders.

Conclusion

I believe that most investors should devote a portion of their capital to more risky plays such as the two mentioned above because they can work out like Atlas, but I do not believe this should be taken as a license to do little work on these investments. On the contrary investors should take more time learning the situations of these plays to know exactly how the stock price will be affected by changes in the business. It will then take constant vigilance by investors to minimize the damage done by plays that move in the wrong direction.

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