con·vic·tion [kuhn-vik-shuhn] noun: a fixed or firm belief.

When I make an investment I try to do so with conviction. I use a screening criteria, I reference case studies, formulas and graphs that serve to feed my analytical thinking. I use all these tools to build a case for investment and conviction of my assessment.

But what happens when I see my investment fall below my buy-in price and those red numbers show up on my holdings summary?

My conviction wavers.

My current worry is Walgreen. Walgreen Co., together with its subsidiaries, operates a chain of drugstores in the United States (and now Europe?).

If you are not aware of the past few days’ activity you must live under a rock. Just check out the news, articles and opinions from my favorite source for investing ideas and information.

My history with Walgreen started with what I call a BAD NEWS BUY. I Purchased Walgreen near a 52 week low based on the Express Scripts debacle. I liked it in the $33 dollar range and believed that the problem with Express Scripts was fixable and would be fixed in a matter of time.

After yesterday’s announcement of a deal to buy 45% of Alliance Boots for $6.7B the stock has dropped nearly 6%.

It is clear the Market is not happy with the acquisition. On the surface it looks like the biggest concerns are the exposure to the European economy, the price Walgreen paid for its stake in Alliance Boots and the company’s blind eye to the domestic issues it is facing.

The Numbers

WAG vs. the BWB screen requirements:

Revenue greater than 100M – This is a slam dunk for WAG. Since 2002 revenues have grown at a CAGR of 10% with an average margin of 29%.

Current Ratio greater than 2 – As of this writing WAG has a ratio of 1.55. This falls short of our criteria and will change after the dust settles from this acquisition.

Price to Book Ratio of less than 1.5 – As of this writing WAG is at 1.75

P/E Ratio – Using the last three year average EPS the P/E ratio comes in at 12.20, below the required 15.

Dividend Growth rate – 28% (5 year average.) WAG has paid dividends since 1933 and has a history of 37 years of increasing their dividend.

EPS Growth and positive earnings in the last 10yr period – WAG has been in the black for the past ten years and grown at an 11.5% CAGR, well above the required 3%.

WAG Price Data and Estimates:

A price range of $35.94 to $63.81 has been established by the above methods of calculation. Price history of WAG ranges from a low of $22.09(2009) to $49.96(2006) for the last ten year period.

My Conviction

I liked WAG in the $33.00 range and I like it now at an even lower price.

With a long term investment horizon, I believe WAG will return to its historical price levels and grow beyond. At an estimated future growth rate of 7%, WAG could provide a return of 5% annually if it reaches the FVDCF Price of 63.81 in the next ten years.

However, I will be watching the developments of this acquisition closely and researching it on a deeper level (with a follow-up article).

Bottom line – I believe WAG is a better company with this move and has the ability to make the most of it. Also, I have not lost the sight of reconciliation with Express Scripts on the home front.

Disclosure: I am long WAG.

Additional disclosure: I have strengthened my position on the news about Alliance Boots and the resultant price drop.

Market and Business

The demand for electricity has no intention of slowing anytime soon; consider these facts from the EIA Energy Outlook Report for 2011:

“In the IEO2011 Reference case, electricity supplies an increasing share of the world’s total energy demand, and electricity use grows more rapidly than consumption of liquid fuels, natural gas, or coal in all end-use sectors except transportation.”

 “From 1990 to 2008, growth in net electricity generation outpaced the growth in delivered energy consumption (3.0 percent per year and 1.8 percent per year, respectively). World demand for electricity increases by 2.3 percent per year from 2008 to 2035 and continues to outpace growth in total energy use throughout the projection period (Figure 72).”

Also, growth varies by country. Those countries with an established grid and infrastructure sustain continued electricity growth and upgrades but are quickly outpaced by countries that have off grid locations that are being developed.

The chart below shows the expected generation growth through 2035 by country:

This is where Jinpan International comes into play. Jinpan (JST) is a manufacturer of cast resin transformers and switchgears, unit substations. Also, over the past eight years JST has grown its exposure to wind energy distribution products and entered into the OEM market for wind farm suppliers.

JST is one of only two cast resin transformer manufacturers in the world to achieve UL recognition.

Working in the Electric Generation Industry myself, I can vouch for the advantages of cast resin transformer vs. oil filled and VPI type as listed on the JST web site:

“Lower cost of ownership than oil-filled

• Less maintenance – Cast resin transformers don’t have oil that needs to be checked or refilled, or seals to replace.
• Lower up-front construction costs – Cast resin transformers don’t need expensive catch basins.
• Cheaper to decommission – Cast resin transformers contain no hazardous waste, and thus cost less to decommission.

Safety

• Cast resin transformers are fire resistant – as opposed to oil-filled transformers, which are highly flammable and potentially very dangerous.
• In the case of a short circuit, cast resin transformers won’t cause catastrophic damage. Because cast resin has better structural integrity, it will withstand a short circuit much better than oil-filled or VPI transformers.

Environmental Friendliness

• Unlike oil-filled transformers, cast resin transformers contain no contaminants that could leak or otherwise escape into the environment.
• Cast resin never requires expensive cleanup.

Efficiency

• Cast resin is very efficient — equal to or greater than 98% — and especially more efficient than VPI.
• Cast resin transformers are air-cooled, so they have considerably lower losses.

Advantages of JST’s transformers over other cast resin transformers:

• JST uses the original “May-Christie” (barrel winding) design, which offers maximum efficiency.
• During casting, we use a static mixing process. This results in better uniformity during curing, ensuring a higher degree of structural integrity in the final casting.
• Our fan package uses a stainless steel squirrel cage air delivery system. JST’s fans give you 50% “additional capacity” — the highest in the business.”

JST clearly states the key elements of its business strategy in the annual report and provides proof of adherence of this strategy:

1. Continue to focus on China’s growing electric infrastructure market.
   In fact, China was the largest market for JST in 2011, accounting for 88% of revenues. China represents the largest expanding market for power generation and infrastructure expansion in the coming future.
2. Invest in new, state-of-the-art facilities to increase our manufacturing capacity and efficiency.
   JST has been expanding its production facilities steadily since 2006. With the completion of the latest facility (scheduled for late 2012) JST will have grown production capacity from 14 to 26 Million Kva for the Cast Resin Transformers.
3. Promote and develop high-margin products for new markets.
   R&D for JST is proving to be a business driver for the future. An example would be the latest news for JST “Jinpan International Successfully Develops Large-Scale Cast Resin Dry Type Transformer.” (I especially like the ‘high margin’ part of this goal.)
4. Leverage our relationships with major OEM customers to expand our global reach.
   By qualifying to be OEM manufactures for global power generation products JST will expand its global reach. Currently a qualified suppler for 3 OEM manufactures JST is aggressively pursuing more opportunities for the future.

The Numbers

JST vs. the BWB screen requirements:
Revenue greater than 100M – JST comes in above this requirement since 2007, with the 2011 year at 224M. Revenue has grown at a clip of 23% annually over the last 10yr period with an average margin of 38%.

Current Ratio greater than 2 – As of this writing JST has a ratio of 2.29

Price to Book Ratio of less than 1.5 – As of this writing JST is at 0.62

P/E Ratio – Using the last three year average EPS the P/E ratio comes in at 5.4, well below the required 15.

Dividend Growth rate – 3% (5 year average.) JST has paid dividends since 2003 and currently yields approximately 2%

EPS Growth and positive earnings in the last 10yr period – JST has been in the black for the past ten years and grown at a 20% CAGR, well above the required 3%.

JST Price Data and Estimates:

A price range of $8.04 to $35.08 has been established by the above methods of calculation. Price history of JST ranges from a low of $0.76(2002) to $24.51(2010) in the last ten year period.

Investment Thesis

I believe JST to be a solid investment opportunity in a growing market at the right price.

Strong, consistent revenue growth coupled with the highest margin vs. industry competitors (ABB and SI) puts JST in a positive light.

Also, JST has set itself apart based by being one of two producers with UL recognition and the superiority of its cast resin products vs. traditional oil filled. Successful development of new large scale cast resin transformers, and continued R&D projects seeking high margin product look favorable for the company.

Although the bulk of the revenues come from the China market (which is the largest growing market), JST continues to present its products globally. By becoming an OEM manufacturer for wind energy products it has successfully exposed itself to countries with established electrical infrastructures that are now looking to alternative generation methods.

Inventory and Net earnings have had a corresponding rise (26% and 23% respectively) over the last ten years, while accounts receivable has only grown at a CAGR of 3% vs. revenues.

Retained earnings have grown at 27% annually over the last ten and Treasury Stock is Present.

The latest ROA and ROE on owner earnings are 19% and 13% respectively.

At current prices (Sub $8.00) and a long term growth estimate of 8%, which I consider to be very conservative, JST could provide a 14% annual return over the next ten years if it were to reach its FVDCF price of $28.07.

At this writing I am long JST

1. Adequate Size
I look at companies that have annual revenue larger than 100M preferably for the majority of the past ten years. This keeps us out of small cap territory, but exposes us companies with growth potential.

2. A Sufficiently Strong Financial Condition
Current ratio greater than 2

3. Earnings Stability
Some positive EPS earnings in the past ten years.

4. Dividend Record
Dividend payout for at least ten years is stellar, but not mandatory, A dividend is required though.

5. Earnings Growth
EPS has grown at least 33% over the last ten-year period.

6. Moderate Price to Earnings Ratio
P/E ratio using the last three years avg EPS.

7. Moderate Ratio of Price to Assets
Price/Book ratio less than 1.5

On the surface this looks like a basic value screen, but digging deeper shows us some things

The earnings stability requirement is the first bottleneck. This eliminates any negative earners over the past ten years.  With the bad year everybody had in 2008/2009 this really drops out companies that could not stand up to the recession.

Earnings growth is one that surprises me from time to time. 33% over ten years sounds pretty easy (a CAGR of 2.89%) but it still knocks a few out. We want companies with steady growth; if it can’t grow at least 3% a year is it really that good.

P/E ratio less than 15 is a value stalwart. But we add the twist of using the average of the last three years earning instead of the TTM data. The average data makes this a little tighter (usually my P/E ratio run higher than the TTM).

Finally, the dividend record drops off the companies without sufficient cash and financial stability to pay shareholders on a consistent basis, or perform share buybacks.

After running a basic screen at my broker, I run the results through the BWB analysis sheet to see who makes the cut.  The last group was cut from 45 to 2 stocks that made the cut. Not the cut for automatic investment, just the cut for further research.

Remember, this is a slow methodical process. To get the returns desired from our investments, we are looking for select companies at fair (or undervalued) prices.