Taking Profits on one ... giving up on another

Just a quick note to post some changes in my portfolio -- after watching MEMC Electronic Materials grow into one of my larger holdings on the back of near-300% gains, I decided to give in to some of my misgivings about the company's valuation and take profits on about 40% of my holdings.

I'm still holding the balance of my WFR shares, and I do think that it's certainly possible that they will continue to climb -- but there is significantly more risk in the equation now that we're dealing with a trailing PE of 31.

The polysilicon shortage that helped to fuel WFR's rise, on the back of strong pricing, a huge ramping of demand from solar cell manufacturers, and continued strong demand from semiconductor companies, is now getting quite long in the tooth. It was part of my initial buy thesis in this stock when I bought it a little over two years ago. That means that MEMC and their competitors have had plenty of time to see the demand curve rising and put into place plans for dramatic increases in production -- which nearly all producers have done, with some increased production already online.

I'm not enough of an expert on this industry to know whether or not the "big four" polysilicon suppliers will overplay their hand and oversupply the market as their new supply continues to come online over the next year -- so given the boom and bust history of this sector, I'm hedging my bets, taking enough profit off the table to be comfortable holding the balance and watching the supply/demand dance play out. I sold 40% of my WFR position at $60.02, and will continue to hold the rest pending future developments.

And my other recent move, which was long overdue, was to clear the decks of my holdings in Cryo-Cell (CCEL.OB). I was impressed with this cord-blood banking operation when I first picked up shares back in November of 2005, and thought that they were on the cusp of a few good things: potential relisting on a major exchange, transition to a consistently profitable operation thanks to their ongoing relatively high-margin income from storage fees, and possibly increased public interest in their product as stem cell "miracles" come to light.

Well, how's 0 for 3? I should have listened to Yehuda Fruchter and sold my shares a while back when it began to be clear that management was either "competency challenged" or not aligned with common shareholders.

Instead of transitioning to a high-margin, solid growth company with good steady income from storage fees, Cryo-Cell has gone through a few different high risk product "near launches" that seem to have not gone well, notably for Plureon placental stem cells, an innovation that appears to still be in search of a market. They've also invested heavily in marketing, and in upgrading and/or fixing their facilities, which they had said before were already state of the art, and now appear to be trying to develop yet another higher margin (and higher risk) maternal stem cell product of some kind. Ballooning costs led to a bitter challenge for board seats that's still underway, but I don't see this ending well ... at least not in the near term ... so I'm clearing out my shares at about a 40% loss.

Thankfully this remained a relatively small investment for me (and a shrinking one, of course), but I'll take it as a lesson that what seem to be great business plans from microcap operators can quickly turn if management doesn't think the same way you do. I've had similar results so far from my other "microcap with a promising business plan," MMC Energy, but I'm willing to be a bit more patient with that one.

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Catching up on MMC Energy (MMCN)

MMC Energy (MMCN.OB) had an investors' update conference call late last month, and recently announced a significant bit of stock-related news, so I thought I'd catch up a bit on this company.

MMCN is a small scale power plant acquisition company, with the goal of acquiring small electrical power generating facilities in high demand areas. They came public last summer, just in time to put a couple of their plants online for the Southern California heat wave, and are at this point unprofitable and -- they hope -- at a very early stage of their growth.

I wrote a bit about MMCN when I first purchased shares, and the shares I own are still under water. Largely, that's because most investors, myself included, have a hard time putting a value on this company until we know how many acquisitions -- and which acquisitions -- they'll be able to make. They also had some insider selling, and a delay of their stated goal of listing on the AMEX by the end of 2006, both of which I think depressed the share price.

The interesting thing about MMC, in my opinion, is not so much that they're acquiring power plants -- which most people agree are in very short supply, with many high growth areas routinely undersupplied -- but it's the way they make money from these plants.

They own only three operating plants right now, but they've shown with these three and indicated for future acquisitions that they are not really aiming to be in the business of selling electricity.

Odd, eh? Instead, they essentially use their power plants to sell insurance. Now don't get me wrong, they do sell the electricity when their plants are operating, and they do make some money from those sales, but the vast majority of their revenue is from "reliability sales."

The company employes what they call a "Reliability Asset Model," whereby they recognize that the primary value of their small power plants is the capacity they provide -- not necessarily the actual watts spit out at any given moment.

You see, utilities as part of their regulatory burden are required to show that the have the capacity to handle peak power demand, and that they have a margin of safety of additional demand above and beyond that capacity.

And MEMC sells them the promise of that capacity. So far for 2007, for example, they have agreed to what are called in California "resource adequacy contracts" for all of their generating capacity for the year.

That means, before they even fire up the turbines they've made $3 million for this year. And this money is theirs to keep even if the plant never operates, so you can imagine the very high margins these sales represent. In exchange, they agree to have their plants ready and willing to fire up at ten minutes notice to supply the grid during peak demand times.

So most of the time, their power plants aren't operating. When they are called upon, they still get paid an additional amount at some kind of market rate for generating whatever electricity is required.

I just love this model.

Now, the bad news is that although they've executed these forward reliability contracts for several years out for much of their capacity, they still can't make it as a going concern without significantly more acquisitions -- their SG&A expenses and the recommissioning expenses for each plant take too much of a bite out of the firm when they've only got three tiny plants in their portfolio, so growth is necessary.

And while they have enough cash to get through the year, they don't have enough to make acquisitions -- so there will be some significant amount of financing, probably dilutive equity financing, that has to be done as soon as they're ready to make more acquisitions.

Which is why the bit of news they announced this week stands out as significant: shareholders (myself included) voted to approve a reverse split in the shares, and the board has determined that it will be a 10:1 reverse split to get the share price up to the neighborhood of eight or nine dollars.

Now obviously splits and reverse splits don't usually mean anything -- but this one is significant, because it will supply the last key criteria to meeting the listing requirements for the major exchanges. Now, as soon as the board feels like it, they can apply for a listing on the AMEX (or possibly the Nasdaq, I suppose).

And that major exchange listing will be a key financial development, since it will make their shares available to institutional investors and provide a much broader market for them when they do make any secondary offerings required in order to finance their acquisitions. The company believes that there is significant demand for institutional investment in the energy generation space, and hopefully a major exchange listing will help them to bring in those investors in secondary offerings without causing too much damage to the share price.

Though I bought shares at an inopportune price, in retrospect, I do think this model makes a lot of sense going forward and I'm confident that management is at least trying to build the company in the right way. If you look at their financials for 2006, the $6 million loss on the year included more than $4 million attributable to one-time items -- administrative costs related to their IPO and financing, and recommissioning of their newly acquired plants. If those costs hadn't been there, they would have been profitable for the third quarter last year thanks to the heat wave ... so there is some promise that this model works if they can scale up a bit more. I'm not buying any more shares just yet, but I am watching this one with some interest.

Update: About an hour after I finished this post -- the shares dropped 20%. At the moment I have no idea why, but it looks like someone might not like the reverse split very much.

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Risky moves in 2006 -- my worst decisions

I haven't yet done the math on my whole portfolio, but I expect overall I puttered along somewhere near in line with the S&P in 2006 -- I'll update that here in the coming weeks to continue my full disclosure.

But I do know what some of the smartest and dumbest things I did with my money this year were. Or, to be more charitable, my best and worst decisions.

My worst investment decisions this year all related to the riskiest moves I made -- investing in OTC stocks and buying after hours, both things that I would probably be better off not getting involved with (but sometimes, I just can't resist).

I own three OTC stocks (and a couple pink sheet listings, though those are for big companies that happen to be based overseas and not actively traded here), but only one of them was purchased in 2005. I've owned SpaceDev (SPDV) and Cryo-Cell (CCEL) for well over a year now, and they are two of the worst performers in my portfolio, so they might qualify as big mistakes for 2005, but not 2006.

The worst timing this past year was my purchase of MMC Energy (MMCN) -- shares of which I bought in early December at $1.24, and could now buy for about 80 cents.

MMC Energy shares have been declining because of a big registration for insider selling, which generally wouldn't worry me that much in a brand new company (it doesn't bother me when venture capitalists and insiders want to get paid for their work) ... but in this case, it's a LOT of shares, and a company with a very small float, and those two facts combine to mean that the shares are likely to be under pressure for a while. Add that to the fact that MMC is not yet on the AMEX, an event they predicted to occur by the end of the year, and the steep decline is not that shocking, even in the absence of any bad news about the company's actual operations.

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Regardless, while I still think the rule to avoid penny stocks is generally a good one because of volatility like that experienced by all my OTC shares, I still have hope for all three of these companies -- SPDV and CCEL should be profitable in 2007 if things work moderately well for them, and MMC Energy is in a capital-intensive growth phase that I think has a solid chance of building a good company.

I also know, however, that all the money I put up for these companies is at risk and might all be lost -- that's the price you pay for investing in a tiny company with potential, and I'm willing to be quite patient as these stories play themselves out.

And my second worst investing decision last year was buying shares of a company that reported terrible news in the after hours session. I thought -- and this shows you how smart I am -- that the beating that Imax (IMAX) took following their announcement that they hadn't found a buyer was terribly overdone, so following the news I picked up some shares in the after hours session at about $6. It's never even gotten close to returning to that level since.

So what are the lessons for me?

When investing in OTC stocks that are notoriously hard to value, especially new ones, go in with your eyes wide open and the expectation that you might lose all your money. At this level, you're really investing in business plans and management and potential most of the time, all of which can be a bit ephemeral. I'll continue to wait on these stocks, and to keep them a tiny portion of my diversified portfolio.

And the second lesson, learned after making this mistake several times, is to never ever ever trade in the after hours or pre-open trading. For the few times when an informed investor can make money in these sessions with some lucky timing, you pay with the many times that you had the wrong conviction which, given the time frame allowed for this kind of trading, is almost always going to be based as much on emotion as anything else.

I've learned lots of other things from my mistakes and victories in the past year, but these two risky areas stand out in terms of what they've cost. I'll share some of the better decisions I made, and what I might have learned from those, in the days to come.

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Looking at MMC Energy (MMCN.OB)

I mentioned a couple months ago, when looking into the potential gains to be had from California environmentalism, that I had come across an interesting power plant aggregator called MMC Energy (traded over the counter at MMCN.OB). I've since taken a little time to look at this company in more detail, and I'm ready to open a small exploratory position.

What is MMC Energy? It is a very small company (just about 75 million market cap at this point) that invests in small power plants in high demand areas. So far, they've got plants in California (two in San Diego which are online now, one in Bakersfield that they're recommissioning and hope to have online in January), and they continue to focus on acquiring what they call "deep value" generation assets in all the areas where high population growth and significant NIMBYism make it hard to build new power plants (mostly California, Texas, and the Northeast and Mid-Atlantic regions).

The San Diego plants, for example, were bought for about $30/kw, versus construction costs for those plants of closer to $700/kw in 2001, according to the company. They backed out of a deal to buy a plant in Utah, for reasons I'm unaware of (though it certainly doesn't fit into their stated geographic focus, so perhaps that's reason enough). Though electricity distribution is a near-monopoly in many places, deregulation and other factors in recent years have led to there being literally hundreds of very small independent (or owned by utilities but "expendable") power generation assets in just the high-growth areas that MMC targets, so they have lots of potential acquisitions (their own estimate is a minimum of 900 plants in their target market).

The small plants they're now acquiring are natural gas-powered plants, and in the case of the San Diego plants they're both trying to expand the plants with additional turbines, and pre-sell power or enter into supply contracts to be available for peak usage times. For their newest plant in Bakersfield they're also considering further partnerships with the local Chevron assets to possibly sell steam and excess energy to them.

The idea of the Resource Adequacy Contract is interesting, because in the case of these smaller nat gas powered plants, MMC can basically make a pretty good amount of money just contracting to be available at a moments' notice (typically, more like ten minute notice) to fire up the turbines to supply power during peak demand periods, typically in the summer, and prevent blackouts. Utilities are required to have extra capacity available to them, and they use these contracts essentially as insurance. MMC will then get paid for the power they generate as well as for their general availability, including daily sales of excess capacity that are auctioned in the spot market, but much of the time it appears that these smaller plants can be run remotely and only used for a portion of the year.

I'm still learning more about the business, but I like the management team and their years of experience in the electric power industry, and I'm very encouraged that they've contracted with Bear Stearns to manage their power sales -- I may be reading too much into this, but that tells me that they have some significant growth in mind, and that Bear is interested in growing along with them (their current asset portfolio doesn't necessarily seem like enough to warrant having someone else manage their power sales for them).

Finally, as some icing on the cake, MMC has applied for an AMEX listing and expects to be listed there by the end of the year, which would still leave them in the small time but would at least move them off the bulletin board and make thet shares a little easier to trade (and more palatable for the institutions).

MMCN is on the verge of being profitable, and should have a good year next year as they've pre-sold resource adequacy contracts for their two main San Diego plants for close to $3 million to provide some nice baseline revenue even before they generate a single watt of electricity -- but with all the expansion they have planned, it's very hard to come up with a reasonable valuation for the company. At these prices near all-time lows for them (not that big a deal, since they've been public less than a year), and before the AMEX listing that will give them significantly more visibility, I'm willing to take my first bite. I'll post the actual price I pay once the purchase goes through.

Update: I bought shares of MMCN at $1.24 on Monday, December 11.

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Making Money from a Cleaner California?

Probably everyone saw or heard the news about California passing new emissions rules a week ago -- there was an interesting editorial on it in the Salt Lake Tribune recently, and the Washington Post ran a more detailed article when the bill passed. The Financial Times ran a story on the political debate, and the possible business impact on our most populous state.

So what does this mean for investors? Is there money to be made on the tails of this initiative to clean up California's air over the next 20 years and push toward reaching the standards of the Kyoto Protocol?

California already gets most of its energy from relatively clean sources (if you ignore transportation), compared to many states. You can see from this CA Energy Dept. summary how the citizens of the left coast get their energy -- coal is pretty low, renewable sources fairly high.

But they're committing to reducing emissions over the next 20 years even as their population may be expected to grow significantly ... so what companies might benefit from that?

I think there are a few categories that might be worth looking at:

1. Natural Gas. The biggest impact on the electricity market in California is that the state will essentially no longer accept power from the current coal-generated plants. This accounts for about 20% of in-state generation and an unspecificied but probably significant part of their imported electricity (as the Utah story referenced above would indicate, the plants that rely on cheap Rocky Mountain coal and sell electricity interstate will be cut out of the CA market).

To me, that means natural gas will be in higher demand in California because it is the only efficient, relatively clean power source that's likely to be able to take up much of the slack as coal plants go offline. Who benefits? You've got the big natural gas producers like Chesapeake (CHK) or XTO (XTO), the drillers like Nabors (NBR), which has some gas exposure, or Grey Wolf (GW), which is focused entirely on gas.

You might also look to the pipeline companies, since most of California's natural gas is going to have to come in via pipeline from the key producing areas in the Southwest and the Gulf. Here's a map of the pipelines that currently serve the state, you can see that they've got excellent distribution from the big basins already ... but volume should grow, which is how pipelines make money. I'd guess El Paso's (EP) western pipelines are probably among the biggest beneficiaries, but I haven't looked at it in detail.

2. Coal Scrubbers. Alternatively, instead of boosting natural gas usage for electricity generation, you might see an aggressive push for cleaning up coal plants. That says to me that the engineering and construction companies that build and retrofit power plants, and the manufacturers of emissions scrubbers for coal plants, might get some additional business. That could be a lot of folks, but URS (URS) is probably more focused on coal scrubbers than the other big E&C guys, though most of the coal scrubbing I've heard of is focused on removing sulfur dioxide, not carbon dioxide which is the bigger issue here.

It might even be possible to see some of the coal technology companies climb, too, if coal gasification or newer clean coal technologies might get a boost from this renewed focus on emissions -- that could perhaps be folks like Sasol (SSL) with their coal liquefication system, or Headwaters (HW) with their various coal technologies, for example, though I can't claim to know much about that business.

3. Power plants that already run on natural gas. This could conceivably allow for some significant rate hikes in California, if the demand for energy continues to grow but the suppliers shrink. That tells me that the folks who are already online with environmentally friendly or natural gas-powered power sources will have a competitive advantage (as much as the market remains competitive, at least).

PG&E is the big provider here, but I'm not so interested in getting involved with a huge company like that with a checkered history and significant regulatory risk. I've looked a bit lately at a tiny company that might benefit down the road, MMC Energy (MMCN.OB) is a small OTC stock that recently went public (and is moving soon to the ASE to attract more institutional buyers). MMCN is building a holding company for the small power plants that have been divested by larger (and sometimes bankrupt) utilities in high-growth areas ... and they're planning to refurbish and expand those plants with new natural gas turbines to serve peak overload periods at peak rates.

They came to my attention because they recently bought two natural gas power plants in San Diego (Chula Vista and Escondido) that were offline (they're also buying a decommissioned plant in Bakersfield, and have a letter of intent to buy a Utah plant that's under construction) [September 13 update: MMC Energy yesterday terminated their letter of intent to buy the Utah plant], and got them online for summer peak season, with plans to expand at least one of them. This is certainly a risky company, and it's largely unknown so far (though it has been touted heavily by Energy and Capital, a service I know nothing about ... which makes me nervous). I've read the company's filings (if you're interested, please read at least the 10-QSB) and didn't see any red flags, but it's going to continue raising lots more money to buy and upgrade or restore plants so I'd say there's a good chance of significant dilution in the near term.

4. Renewable Energy Companies. This is the sector that immediately comes to mind for most folks when we talk about reducing emissions, though CA will be hard pressed to replace their coal-fired electricity with solar or wind power within the next 20 years. They are, however, trying very hard to subsidize the growth of renewable energy ... as are other states to lesser degrees, and as are several other countries (notably China and Germany).

This is good news for lots of companies, but there aren't many profitable, reasonably priced renewable energy companies ... even though prices are much more reasonable now than they were last winter in the peak of our oil and natural gas panic.

The wind energy bets are few and far between -- you could throw your money at GE, which makes most of the turbines, but wind energy isn't going to move their needle. Or you could look to the composite-materials companies like Hexcel (HXL) or Zoltek (ZOLT) that make or engineer the materials required for efficient windmills.

Solar energy is a much more wide-open business, and with state and local governments also pushing for more rooftop solar cells in new housing production and subsidizing solar implementation elsewhere, demand for photovoltaics should continue apace, with or without California's new emissions rules. You can look at MEMC Electronic Materials (WFR), which I own, as the supplier of the silicon wafers that go into solar panels, or you can look at the manufacturers like Suntech Power (STP -- my favorite among these with their Chinese connection), Evergreen Solar (ESLR) or SunPower (SPWR -- or look at CY to possibly buy control of SPWR on the cheap).

Will California's plan really fly, or will this plan move to other states? It's way too soon to tell, but the California auto emissions rules certainly had a massive impact on the rest of the country and on auto manufactureres worldwide, and as one of the largest economies in the world you have to accept that state decisions really matter (CA is somewhere between the fifth and 10th largest economy in the world, right up there with Italy and France if treated as an independent nation -- just how big depends on who you ask).

I don't know whether they can pull off an emissions trading scheme with just one state, but it's certainly possible -- and they can definitely cut off all "dirty" power supplies, which will impact the energy business writ large across the Western US in a big way ... whether any of these companies, or others, will actually benefit is certainly an open question, these are just the initial ideas that came to my mind.

In the interest of full disclosure, at the moment I own shares in WFR, preferred (series D) shares in CHK, and call options on CY, and I've been toying with the idea of buying MMCN and may do so soon.

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