The Long Shot: Sizzling Returns Likely

Real Money's Long Shot column is dedicated to trading ideas that are highly risky, but which present an opportunity for significant payoff if they work. Such ideas are sometimes characterized as "lottery tickets" and are for only the most risk-tolerant investors, as the potential for 100% loss is high.

Today's "Long Shot" idea has all the ingredients of a classic special-situation idea: a checkered past; a discarded and hated stock to which no one is paying attention; a compelling valuation situation; a potentially explosive turnaround strategy; and a catalyst to cause near-term value realization. I will discuss how all of these elements are bound to combine to create an attractive upside opportunity -- but first let's review some necessary background.

Background: Specialized Technology Resources, or STR (STRI), was once the leading producer of encapsulant for solar panels. Encapsulant is a thin plastic-like film that is laminated over the electronics of the panel in order to protect it from the elements. The quality of the encapsulant can determine whether a panel lasts five years or 20, so it is critical to the quality of the panel and to the internal rate of return (IRR) of a project.

STR had large market share in Europe and the U.S. five years ago, but it was not well-established in China as the panel business migrated there. As its European and U.S. customers went bankrupt, the company's sales shrunk severely, along with its market capitalization. From a peak of $650 million, the market cap is now a paltry $31 million. Sales in 2013 were $32 million, down from $230 million in 2011. Analyst coverage went from 10 solar analysts to one lone holdout, the insightful Eric Stine at Craig-Hallum.

Source: Yahoo! Finance

Turnaround Strategy: In August, STR announced it would sell 51% of itself to Zhenfa New Energy, a large solar developer in China with annual sales of more than $1 billion. The deal, which has yet to close, would infuse some capital into STR -- capital that is actually is not needed and would be returned to shareholders as a special dividend. But the more notable aspect of the pact is the strategic leverage it would give STR for penetrating the China panel market. Zhenfa is a very large purchaser of panels from nearly all the manufacturers, and it would be able to specify STR encapsulant in its purchases. That customer leverage would directly drive sales at STR, in addition to creating more familiarity for the manufacturers with STR product.

STR is so confident of the sales upside to result from the deal that it reversed a decision to close its Malaysia factory last spring. The company expects to eventually run Malaysia at capacity, and anticipates the same for a new factory just starting production in Suzhou, China. I expect that the strategy will work, and that sales could double, or rise even more than that, in the next 12 to 18 months. At the current sales run rate of $9 million, the company is running slightly below its breakeven for earnings before interest, taxes, depreciation and amortization (EBITDA), so there is significant operating-leverage potential as the top line recovers.

Valuation Situation: This is where the story gets interesting. STR had cash of $1.21 per share as of Sept. 30, and the stock currently trades around $1.19. As part of the deal the company would issue new shares to Zhenfa, raising $0.78 per share, so that it will have $1.42. STR will then pay a special dividend of $0.85 per share to only the current shareholders. After the dust settles, STR will have $0.57 per share in cash.

The mystery is how the market is valuing STR's ongoing business. Today, the business appears to be valued at a negative $0.03 per share -- basically worthless. That's not necessarily a bad judgment, considering that STR is still burning some cash and has a negative gross margin. If the stock behaves "normally" ex-dividend, it will drop by $0.85, the payout amount, to $0.33. That would create a huge valuation discrepancy with the $0.57 of cash. Alternatively, the stock might adjust to the cash plus, current imputed value of the business: $0.54, after you subtract $0.03 from $0.57. In either case, you are left with a deep-value stock that is in a far stronger position for its business to recover.

One other alternative is that the market is "taxing" the cash that would be paid out in the special dividend. Most taxable investors will pay 20% on the dividend income, so taxing the full cash balance would leave "cash" of $0.97, thus an imputed business value of $0.21. If the market is doing this, the post-deal stock price could be the $0.57 in cash not paid out plus $0.21 of business value, or $0.79.

The table below summarizes the valuation scenarios. The conclusion is that there are several reasonable scenarios in which you would be getting a business for free, or at a very inexpensive price, that would be in a far stronger position than where it had been before this deal had been announced.

Catalyst: The catalyst is coming in the form of this deal being consummated, the dividend being paid, and Zhenfa starting to deliver rising sales for STR. As results recover, the stock would struggle more to be noticed, but having a smart and credible analyst still covering it will be the conduit for value realization.

Risks: Turnaround efforts such as this always carry substantial risk, so please dig deep before you establish a position. In the near term, the deal is highly likely to close, but it has not closed yet, and unforeseen circumstances can always arise. One longer-term risk is that Zhenfa would not follow through on its sales support -- though that seems unlikely given the company's exposure to upside in its ownership position in the stock. Another is that Zhenfa could use its control position to somehow cheat current shareholders. Or the strategy may simply not work. The panel makers have huge volume outside of Zhenfa, so they could simply ignore Zhenfa's requests.

Other considerations lie in the question of whether to buy now or to wait until after the special dividend. If you buy today, you are basically "buying" the dividend, but you will only get 80% of your cash back. For most taxable investors, it could make sense to wait until after the special. Another consideration is whether STR would do a reverse stock split in order to maintain its listing on the NYSE, as is specified in the deal terms. The company intends to do so, but this is not a requirement, based on the deal structure. That said, I consider the risk low that STR won't execute the reverse split.

I am today adding STR to my list of Best Five Ideas.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider STR to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Dvorchak had no positions in the stocks mentioned.