Most readers know I’m a lawyer who works in small company finance. Clients come to us in their earliest development stages and upgrade to a larger law firm when they need more comprehensive service than a boutique firm like ours can offer. As a result, I’ve spent over 30 years guiding entrepreneurs through the “Valley of Death,” an exhilarating, treacherous and often terrifying period in the life of every business that begins with the signing of incorporation documents and ends when cumulative cash flow turns positive.
Most companies that enter the valley of death don’t emerge. For the fortunate few that do, the difficult times usually last far longer than anyone expected. The one character trait all entrepreneurs share is unbridled optimism. The three character traits all survivors share are determination, focus and fiscal restraint. The following is a stylized view of the valley from Osawa and Miyazaki.
The next graph comes from the Gartner Group and presents a stylized view of the Hype Cycle, a well known but poorly understood market phenomenon that typically leads to overvaluation during the early stages of a company’s development followed by extreme undervaluation in later stages when the major development and commercialization challenges have been overcome, cash flows are about to turn positive and early stockholders have grown so impatient that they’re willing to sell at distressed prices despite improving business fundamentals. It’s the second most popular story in the financial world – the elephant that got away because I sold too soon.
The two graphs aren’t perfect overlays, but they’re darned close. Simple logic dictates that two best entry points are the innovation trigger and the trough of disillusionment. After a 30-year career as a guide in the valley of death, I know to a certainty that there’s no better investment risk in the world than a company that’s spent several years in the valley of death and survived the trek to the trough of disillusionment. It’s a target rich environment for elephant hunters.
With the exception of Enersys (ENS), which was just plain undervalued when I bought it at $6, all of my picks and pans over the last couple years have been based on valley of death analysis. I’m negative on stocks that have a long road to travel before they hit the trough of disillusionment and positive on stocks that are close to the trough or have already arrived. My goal is to buy as close to the trough as possible, when stocks are at their most depressed level, and hold through the transition from negative to positive cash flow until the market finally recognizes the inherent value of determination, focus, fiscal restraint and execution.
A couple years ago, Exide Technologies (XIDE) was a classic example of valley of death analysis. It had emerged from Chapter 11 in the summer of 2004 but was far from healthy. Exide’s management spent the next four years restructuring and streamlining operations, a process that punished current earnings but paved the way for consistent future earnings. By the time the crash hit in the fall of 2008, Exide had absorbed most of the restructuring pain and a stock that traded in the mid-$20s in the summer of 2004 had been beaten down into the mid-$4s. Then, to add insult to injury, a hedge fund that that was a large holder of Exide’s stock suffered heavy losses in the crash was forced into a wholesale liquidation of its holdings. That drove Exide’s stock price down to a low of about $2. For old stockholders it was a tragedy. For investors who took the time to consider my valley of death analysis and understand the underlying dynamics, it was a tremendous opportunity. Exide’s business had never been healthier and its stock price had never been weaker. The investors who bought Exide at $2 are up almost 400%. If Exide’s earnings and stock price continue to improve, which seems likely at this juncture, it will be a true elephant.
Another classic example of valley of death analysis was Active Power (ACPW) one of the last big IPOs before the tech bubble burst in 2000. From an IPO price of $17, Active Power ran up sharply and then began a slow downward decline into the $2 range as its technology development, validation testing and market development took far longer than anyone expected. By the time the dust settled after the 2008 crash, Active Power’s stock price had fallen to a low of $0.26. The collapse had nothing to do with business fundamentals and everything to do with investor fatigue. Sales were building at solid rates and the installed product base was performing admirably. For existing stockholders it was a catastrophe. For new investors who took the time to consider my valley of death analysis and understand the fundamentals, it was another great opportunity. The business had never been healthier and the stock price had never been weaker. Investors who bought Active Power at $0.26 are up over 800%. If Active Power’s cash flow and stock price continue to improve, it will be the kind of story hucksters use to sell newsletters.
A good example of an unsuccessful valley of death analysis was C&D Technologies (CHHP.PK). Like the others it was an $8 stock that got beaten down to $2 in the crash and fell into the $1 range after it got dropped from the S&P 500. Unlike the others, C&D’s debt burden was high and the due date was dangerously close. While I believed that C&D would have enough time to turn the corner before its debt became problematic, I was caught flat-footed by management’s decision to take a huge intangible asset write-off that wiped out stockholders equity. That decision forced a restructuring where debt holders got 93% of the company by converting $115 million in debt to equity. It was terrible for existing stockholders and investors who went elephant hunting too early. It was also a stark reminder that debt is an intolerable burden for all but the strongest of companies that need to traverse the valley of death. Given the number of shares that C&D issued in the restructuring, it will take a long time climb back into the $1 range. A price of $0.40 to $0.60, however, is not an unreasonable goal once the impact of the restructuring becomes clear. There are too many shares outstanding for C&D to be a true elephant, but a double or triple from the current price seems like a pretty fair bet.
ZBB Energy (ZBB) went public at $6 a share in the summer of 2007 and promptly began a slow slide into the $1 range. For most of the last year ZBB traded in the $0.60 range while its management continued to exercise fiscal restraint and implement their business plan. In early December something changed and ZBB’s stock price has climbed from $0.57 to about $1.50. It’s too early to say for sure whether ZBB has hit the bottom of the trough and started a sustainable climb back toward its IPO value, but the indicators look solid. ZBB’s principal product has successfully completed a three-year validation test by Australia’s equivalent of the DOE and it’s been successful at obtaining working capital when needed at reasonable prices. ZBB is on a run and it looks like the stockholders that gave up hope over the last year are finally out of stock. I’d be reluctant to guess how far ZBB will run before pausing to catch its breath, but this is a fun time for courageous investors that took the time to consider my valley of death analysis when ZBB was trading closer to $0.60.
My current short-list of valley of death buys includes Beacon Power (BCON), Kandi Technologies (KNDI) and Axion Power (AXPW.OB). All three have reached levels of maximum stockholder weariness despite impressive progress in their core business activities. All three have adequate working capital and all three are on the cusp of revenue streams that will either slow the bleeding significantly or reverse it entirely. I can’t forecast dates, trigger events or upside potential, but 30 years experience as a guide in the valley of death tells me that further price declines are unlikely and when the trigger events occur the price charts will turn like hockey sticks.
I’m frequently harsh with Tesla Motors (TSLA), A123 Systems (AONE), Ener1 (HEV), Valence Technologies (VLNC) and Altair Nanotechnologies (ALTI) for one simple reason. They’re still at an early stage of their journey into the valley of death and far too optimistic about the time needed to move from today’s exciting product launches to future market success and positive cash flow. It may look like a brief span of time on the Osawa and Miyazaki chart, but it took eight hard years for Toyota to turn the corner with the Prius. At some point my outlook for the survivors will change as it recently has for Beacon. Until I can identify a looming inflection point, however, I have to believe the market prices for these companies will follow a long and painful path to the trough of disillusionment.
Disclosure: Author is a former director of Axion Power International (AXPW.OB) and has a substantial long position in its common stock.