Schuff International (SHFK): Cheap, Ugly, and a Potential Multi-Bagger

Fellow blogger Nate Tobik recently had a great write-up on Schuff Steel calling it a potential 10-bagger. I really respect Nate and enjoyed the write-up, so I decided to take a deep dive into the company:

Investment Overview

Schuff International is cheap at less than half of book value, ugly as a cyclical and highly levered construction company, and a potential multi-bagger with the continued recovery in construction spending. While casual onlookers of the stock may view it as extremely risky— high debt load, big debt maturity in 2013, and a nano-cap with limited disclosure, this risk is misunderstood, creating an extraordinary cheap stock for current investors. The company’s management seems to agree—having retired over half of the shares in the past year at a huge discount to book value.  I believe the stock is a great risk/reward at current levels and is conservatively worth ~$20, nearly a double from current prices.

Key Metrics

  • Market Cap: $42.5, EV: $90.69M
  • Price/Book: 0.48
  • Price/Sales: 0.11
  • EV/EBITDA: 6.85
  • Quarterly Revenue Growth: 77.20%
  • Debt/EBITDA: 4.22
  • Altman Z-Score: 2.82 (within the safe zone)

Business Overview

Schuff International is the largest steel fabricator/erector in the United States. For those unfamiliar with industry, this essentially means that they take steel and alter it to fit the needs of a particular construction project. This is a very fragmented industry because it is very costly to ship large amounts of extremely heavy steel, which is why a $45 mm mkt cap company can be the largest player in the U.S. Schuff operates in Arizona (company headquarters are in Phoenix), Florida, Georgia, Texas, Kansas, California and the New York City area. They typically are paid with a “cost-plus” model and do not have significant customer concentration risk with their largest customer representing 11% of sales in 2011 and no other customers over 10%.

This business is very cyclical, but should be profitable throughout an entire cycle. For example, as recently as 2008, the company made over $97 mm in EBITDA, greater than twice their market cap, and $57 mm in net income. However, the 2008 crash really hurt construction and their latest annual EBITDA and net income is $13.2 mm and ($5 mm) respectively. With such a cyclical industry, investors have seemingly been scared by the company’s high debt load and sold the stock from its $35 high to just over $10, which represents half of book value.

I believe this massive sell-off is undeserved for three reasons:

1) While the company is certainly cyclical, it is also very profitable

From “trough to trough” in the construction market (2003-2011, see chart below), the company’s average unlevered FCF was $20.48 mm, which makes the normalized FCF yield over 22%. Furthermore, the company’s costs are highly variable, which allows them to cut employees and close plants during tougher times in the construction market and thereby avoid disaster years. The company has not had a single year of negative EBIT since 1995 (as far as my data goes back).

2) The cyclicality is somewhat predictable and is currently near a trough

Using national data from the Census Bureau on construction spending, I developed a regression model to forecast Schuff’s quarterly EBITDA. Inputs: Nonresidential Construction Spending and Total Construction Spending. This model is actually very effective in explaining SHFK’s quarterly EBITDA with an R squared of .84

Key Takeaway: Schuff’s quarterly success is so cyclically-based that it is possible to predict their EBITDA using only “national” data suggesting their cyclicality is simply a product of the industry, which should snap back, rather than company specific downturns.

While SHFK has zero analysts covering the stock, is extremely illiquid, and does not offer annual guidance, one can use the model above to predict their EBITDA based on readily available estimates for national construction data. As seen below, analysts are predicting a strong rebound in Nonresidential construction growth in 2012 and 2013.

Below, I include the same model, but it includes a two year projection for EBITDA based on the consensus estimates for national construction data.

3) The EBITDA prediction model, the company’s incredibly aggressive buyback, and the company’s recent moves suggest its debt is manageable and shares are deeply undervalued

The company has nearly $56 mm in debt, which represents over 4X EBITDA. This is a large amount for a cyclical company, leading some people to believe bankruptcy is possible.

Aggregate debt maturities are as follows:

2012: $26,413,000

2013: $4,000,000

2014: $5,000,000

2015: $19,000,000

2016: $1,410,000

First, realize that the debt repayment schedule is somewhat unusual given its lumpy nature. SHFK has over $7 mm in cash on the balance sheet and the EBITDA model predicts $22 mm and $32 mm in 2012 and 2013 respectively, which would be more than adequate to cover debt requirements.

Perhaps even more importantly, the company’s revenue is also tied to a small number of contracts, giving the company much more visibility into future revenue than any investor, especially since the company only files results once per year.

This is why it is so incredibly significant that the company took on MORE debt last year in order to retire 57% of their shares outstanding at less than book value!

Why would management, which owns the majority of the stock, do this if they were worried about their interest payment one year from now? They would be sued, perhaps file bankruptcy, and have their family name and business tarnished.

President and CEO Scott A. Schuff had this to say about the buyback:

“By completing this transaction, we are taking advantage of a unique opportunity to enhance stockholder value while demonstrating confidence in the long-term outlook for our business…Every Schuff International stockholder now owns a greater percentage of the company by a factor of nearly 2.5. The reduction of the total outstanding shares as a result of this repurchase implies a greater share value for the holdings of our stockholders. We believe that the commercial construction market is at or near the bottom, and we are confident that our strategic vision and the disciplined cost controls we instituted nearly two years ago are allowing us to capitalize more quickly on new projects we see in the pipeline”

Also providing further credence to this idea of a bottom, the company recently re-opened their Orlando plant citing demand in 2013: http://finance.yahoo.com/news/schuff-steel-utilizes-downturn-construction-234248740.html

“We are seeing signs of increased market activity and plan on re-opening our Orlando plant in the first half of 2013,” said Ryan Schuff, President and CEO of Schuff Steel. “We have also centralized our Southeast operations and revamped our executive management team by adding and transferring some key employees to our newly renovated Orlando office.”

Furthermore, the company has an Altman Z-Score of 2.82, suggesting bankruptcy is very unlikely:

Altman Z-Score: 2.82 (within the safe zone)

  • Formula for predicting bankruptcy
    • Z > 2.6 (“Safe” zone)
    • 1.1<Z<2.6 (“Grey” zone)
    • Z<1.1 (“Distress” zone)

Finally, the company’s balance sheet should protect them from any downturn, making their debt load much less of a concern. Trading below tangible book value, with over $60 mm of that book value in land and buildings is pretty reasonable.

Therefore, while the debt load is a risk and something to watch, everything I have examined suggests it is manageable.

If this sell-off is unwarranted, how much are shares worth?

Valuation Method #1—Value based on mid-cycle FCF

-Note that 2003-2011 was chosen because it represents the last “cycle” from trough to trough (in chart above).

2003-2011 Average Unlevered FCF  $20.48
Discount Rate 15%
Earnings Power Value  $136.51
Value of Debt $55.82
Equity Value  $80.69
Total Shares Outstanding 4.15
Value/share  $19.44
Current Value/share  $10.25
Premium 90%

Valuation Method #2—Value based on mid-cycle earnings

  • From 2003-2011, average net income = $19.2 mm
  • I believe 5-10X earnings is reasonable for a mid-cycle cyclical company
  • Implied valuation: $23- $46/share, 128%-356% upside

Risks

  • Management interests may not be aligned with minority shareholders.
    • The family may be trying to take the company private, and in doing so, may be deliberately trying to lower the share price by performing their own LBO
    • Should the company default on all of its debt within a year or two, lawsuits would definitely be filed and shareholders would have strong claims
  • The Schuff Family offered a lowball takeout price in 2006 that was rejected.
  • Very illiquid (Average daily volume 1,600)
  • As a OTC stock, files financial reports only once/year

Conclusion

  • Company is deeply undervalued at .4x book value, 2.2X mid-cycle earnings, and 4.5X EV/ Normalized FCF.
  • Industry is very cyclical (currently near trough) with construction spending projected to grow dramatically. This cyclical company should not trade at trough multiples at trough earnings
  • Management, who is most knowledgeable about the financials, was incredibly aggressive using debt to buy-back stock at a large premium to the current price, indicating how undervalued they consider current shares.
  • The company represents a compelling risk/reward and is conservatively worth ~$20

Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.

Noble Roman’s Inc. (NROM): Simple Growth for Free

Today I want to tell you about a little company called Noble Roman’s (NROM), a stock I recently researched with other members of my Special Opportunities Group—Peter Chase, Eric Hendey, Chaodan Zheng, and Rob Boling. On the surface, it’s a micro-cap pizza company trading for less than $1 that was nearly sent into bankruptcy after defending itself against frivolous lawsuits from its failed franchisees. However, on closer inspection, it’s a simple, sticky business model with high returns on capital and an underfollowed growth opportunity. I believe shares are worth at least $1.13, ~50% above recent prices.

For basic background info not covered here, see company presentation: http://www.nobleromans.com/pdfs/2012%20Presentation%20PDF.pdf

The Metrics

  • Market cap: $14.64 mm
  • EV: 20.09 mm
  • P/B = 1.34
  • P/E = 22.06
  • EV/EBITDA = 6.20
  • ROE = 12.27%

Company Background

  • Began in 1972 as a small Indiana pizza operator
  • In the 1980’s and 90’s phased out of the operating store business
  • In the 1990’s and early 2000’s, the company morphed into a franchising and supply chain pizza business
  • In 2008, the company was sued by many of their franchisees who accused Noble Roman’s of fraud as a result of the dramatic failure of most the of the franchises
    • The company spent  a couple million in legal payments company and is currently trying to recoup up to $5 mm in counterclaim payments.

The Business Segments

  • Non-Traditional Locations (62% of revenue)
  • Take-N-Bake (18% revenue)
  • Traditional Locations (12%)
  •  Other (8% of revenue). I won’t cover other as it is insignificant (consisting of some company owned stores for testing purposes)
    • As I describe the business segments, realize all of them have very few costs due to the licensing business model. I think it is therefore appropriate to try and best model out the revenue and assume a 35% operating margin. Note that operating margin has been very stable and generally higher (for five out of last 6 years) than this 35% figure so it should prove to be a bit conservative
  • Non-Traditional Locations (62% of revenue), very sticky business
    • This is basically convenience stores/ gas stations. Noble Roman’s sells stores the equipment to make Noble Roman’s pizza (upfront fees) and NROM takes a % of sales as a royalty fee. This is a high margin segment for the locations and a great proposition for Noble Roman’s as well.
    • This is a very sticky business with essentially no costs. Once a location has the equipment, they have little incentive to switch. This makes the segment very easy to value
    • Below are the results from this segment (2012 full results estimated)
             2010             2011      2012
non traditional roy fees            4,425,822          4,023,177    4,340,000
  • Take and Bake Business (Grocery Stores): ~18% of Revenue, growing
  • This is the company’s growth vertical. They started selling “take-n-bake” pizza to grocery store chains in September 2009. The Company has signed agreements for 1,206 grocery store locations to operate the take-n-bake pizza program and has opened take-n-bake pizza in approximately 945 of those locations.
  • Again, the company has essentially no costs associated with this segment as they are licensing their brand. The company develops distribution agreements with grocery store distributors, sign licensing agreements with Grocery distributor customers, and service them through foodservice distributors
    • This clearly only has value to the extent that customers “value” the Noble Roman’s brand
    • Given their profitability and growth in number of grocery stores (see below), the NROM brand clearly has value
      • It is likely that this value is geographically bound
2010 2011 2012
Grocery Stores operated 452 833 912

-The above numbers are only for operated stores. The number of “signed” stores is higher since there is a time delay between stores signed and operated. Still, the company has doubled the number of grocery stores operated from 2010 and this segment is now a significant driver of value.

  • A key question in the valuation is how many grocery stores NROM can sign/year and when the growth will stop. I asked Ian Cassel this question. He is very knowledgeable on the company and wrote a great article on them here: http://seekingalpha.com/article/853531-noble-roman-s-inc-who-knew-pizza-could-be-so-profitable?source=yahoo
    • He said, “I think they had 10 distributors at YE 2011, and now have 13. So the question would be how many grocery stores do these 13 distributors represent? When I talked to the company a few months back (when they had 11 distributors), I think they represented 4000-5000 stores. So this would be a good starting point for guestimation”
    • This is an important and difficult estimate in the valuation, but I think this is a reasonable way to frame the scenarios
    • This is clearly a growth segment that should have a long runway given the existing relationships with grocery distributors
  • Traditional Locations (~12% of revenue), has been in decline
2010 2011 2012
traditional locations revenue 1,460,709 1,368,883 922,000
  • The traditional franchise locations have struggled recently. However, one would expect the worst locations to close over time and eventually for the company to be left with only the best locations. In either case, it is best not to be too optimistic when valuing this segment going forward, but at 12% of revenue, it is not a huge value driver.

Other Valuation Considerations

  • In June 2008 the company was sued by former franchise owners for Fraud. In December of 2010, a court issued a summary judgment in favor of Noble Roman’s and all appeals were rejected. Noble Romans’ countered sued claiming the franchise owners had breached their contracts and owe substantial damages. $3.6M for damages and $1.4M for legal expenses
    • This claim has been granted summary judgment but the final amounts are pending.
    • It’s unclear how much, if any, of this will be recovered. However, this only represents upside (and considerable upside relative to the approximate $15 mm mkt cap)
  • Deferred Tax Assets
    • The company has over $9 mm in deferred tax assets that will keep it from paying taxes for ~4 years, a considerable source of value
  • The company has plans to franchise stand alone take-n-bake stores. “Papa Murphy’s” has been quite successful with these types of stores with over 1000 nationwide. The company seems excited about this initiative. I think it is too early and speculative to factor this into the model, but its success would obviously provide upside.

Valuation: Three Scenarios, 10-year DCF

  • I think the easiest way to approach this would typically be to look at the three segments. Non-traditional should be flat at worst, traditional location is going to continue to decline, and take-n-bake should grow. Given the current size of these segments, the overall effect should be net positive revenue growth. I think it is very hard to make a case to the contrary given how fast they are signing new grocery stores.
    • If we assume net positive revenue growth, then valuing them at a “no-growth” earnings power valuation should be conservative.
    • Taking estimated full year 2012 revenue of $7.46 mm and applying a 35% operating margin results in $2.61 mm. Normally, I would apply an ~40% tax rate to get to $1.56 mm in NOPAT, divide by a discount rate of ~10% to get to $15.60 mm in run rate earnings power value, subtract their $4.9 mm in debt and arrive at a value of ~$0.54/share.
      • However, because of the deferred tax assets, the 40% tax rate is not applicable for the first four years. Currently, EBIT = FCFF. However, looking at these unrealistically pessimistic assumptions shows the limited downside. Even in this scenario, downside is only 28%. That’s zero growth, no tax advantages, no legal payments, no benefit from new franchise concept. Now let’s look at a few more realistic scenarios that incorporate the tax advantages:
  • Worst Case: $.72 (-6%)
    • 0 grocery stores per year added
    • Flat non-traditional stores
    • Precipitous 35% decline in franchise stores
    • No legal payout
  • Base: $1.13 (46%)
    • 100 grocery stores added per year
    • Non-traditional stores growing at inflation (3%)
    • Franchise stores declining at 20% per year
    • $1M out of $5M in legal payout
  • Best: $1.67 (116%)
    • 400 grocery stores added per year
    • Non-traditional stores growing at inflation (3%)
    • Franchise stores staying flat
    • $4M out of $5M in legal payout

I think the base case of $1.13 is pretty conservative and that anything less is a real bargain.

Why does the opportunity exist?

  • The company trades for less than $1 and has a market cap < $20 mm
    • No research coverage, institutions prevented from buying
  • The company does not screen well
    • P/E > 20, which does not look cheap at all. However, on a Market Cap/Lev FCF basis it is extremely cheap at         ~8X with growing FCF.
      • This is due to the deferred tax assets that will prevent it from paying taxes for ~4 years
  • Company has been bogged down by frivolous lawsuits which have harmed results, threatened the existence of the company, and distracted management from growing their business
    • This is largely behind them and is now a potential catalyst (repayments) rather than a liability

Summary

  • This is not a sexy stock. It’s a pizza franchising company. However, the main source of revenue (non traditional franchises) is very sticky, there is a strong growth vertical (take n bake), and it has some very valuable deferred tax assets. Even assuming no growth in grocery stores/year, the stock has very limited downside. I think fair value is at least $1.13 and that this is a very low risk bet that should handily outperform the market for patient investors.

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Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.

Harvard vs. Einhorn: Chipotle Mexican Grill (CMG)

On September 24th-25th, I traveled to Ithaca, New York with two Harvard classmates, Linxi Wu and Jared Sleeper, to compete in the Cornell Undergraduate Stock Competition.

The Rules: There were six teams total, each comprised of three members. Teams from Harvard (us), Wharton, Cornell, MIT, Columbia, and Dartmouth were represented.

One week before the competition, we were given the stocks to analyze. For the first round, everyone had to analyze Chipotle (CMG). You could recommend a buy, hold, or short. Presentation time was 10 minutes with 5 minutes of Q&A from the judges from Fidelity and Putnam Investments. Three of the six teams would be selected to compete in the final round where each team was given a choice among four education stocks: DV, COCO, APOL, and BPI.

Our CMG pitch earned us a spot in the final round along with the teams from Wharton and Cornell. Our pitch on DV earned us first place overall in the competition with Wharton in 2nd and Cornell in 3rd.

I went in thinking we would probably go short CMG. After all, it’s a restaurant stock at 20X EBITDA and 40X earnings.. cmon right?! The inner value investor in me cringed at that type of valuation. However, as we really dug in every night and tried to understand the business and build out our valuation model, I really came away much more bullish on CMG with a price target of $406.50 (~45% undervalued).

Recently (and after our pitch), David Einhorn came out recommending a short of Chipotle based primarily on increasing competition from Taco Bell combined with its high valuation. Einhorn is one of my favorite investors (if not my favorite), but I was very surprised by his pitch. It honestly seemed so much less sophisticated than his excellent short call on Green Mountain Coffee (GMCR).

The GMCR short pitch was a 100+ page PowerPoint presentation focused on accounting issues that other investors were not properly accounting for. The CMG pitch is just: high valuation + increased competition from Taco Bell? Really?

High Valuation: I also thought 20X EBITDA was way too expensive… until I really dug into the numbers. CMG is less than halfway to reaching U.S. market saturation and I think they are likely to grow into their valuation over time. As you can see in the presentation and the model assumptions, 20X EBITDA is not always expensive. As we point out in our presentation, CMG was trading at an even higher P/E ration in 2006 (44.5X) and has returned 37.6% annually, crushing the market. Just looking at a single metric just doesn’t cut it for such a high growth company.

Taco Bell and their new Cantina Menu: Taco Bell has been around for decades and they are just now putting their emphasis on the Cantina Menu. Why? Because it’s not that great of an idea! If it was such an easy sell and market opportunity for them, this would have come out years ago. While it may have some success, I don’t think anyone is going to start confusing Taco Bell for Chipotle. When we analyzed this issue, we likened this to McDonald’s rolling out their McCafe coffee. Sure some people buy their coffee now from McDonald’s, but this has not cannibalized SBUX or their long-term prospects.

Here is the PowerPoint presentation for CMG:

I am a special situations oriented value investor, so high growth stocks like Chipotle normally don’t find a place in my portfolio. That being said, if I had to go long or short, I’d go long from these levels and I think going short is way too risky. Shorting a strong business is a loser’s game in my opinion. Even if you are right (which I don’t think Einhorn is here), momentum can kill you. Should be interesting to see how this plays out.

Here is the PowerPoint presentation for DV (there will be a separate post later).

Don’t forget to subscribe to my blog, like the Facebook page, and follow my Twitter for more updates!

Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.

Steinway Musical Instruments (LVB): Strong Brand, Hidden Value, Multiple Catalysts

Steinway Musical Instruments (LVB) has many of the attractive elements I look for in an investment: a dominant market position in its core business, solid downside protection, hidden asset value, smart and incentivized insiders, and several foreseeable catalysts all rolled into a small-cap, underfollowed stock. I believe this $25 stock is worth ~$47 (88% upside) and that there are several probable catalysts (as early as Q3 this year) that could drive the share price closer to my estimate of intrinsic value.

Since its founding in 1853, Steinway has dominated the high margin, high ticket ($130,000+) concert piano market by making the finest pianos in the world. They also have a “band business” which sells non-piano instruments, which is a less lucrative, more commoditized business. Finally, they own two properties in NYC that are listed on the balance sheet at ~$3 mm and $26 mm, but were appraised at $200 mm and $100 mm respectively during a debt refinancing in 2006. This stock has always traded at a discount to the sum of the parts because the company formerly had a dual class share structure that prevented activism. With management that did not have the urgency, willingness, or experience to realize the full value of their assets (particularly their real estate assets), a discount to the sum of the parts was appropriate.

However, in 2007, ValueAct Capital began building a significant position in the stock. ValueAct is a very successful activist hedge fund that has averaged ~13.5% returns since 2000 (versus an almost flat S&P). Their process typically entails building a large position in a stock, divesting non-core assets, and ultimately, negotiating sale of the business. Just in the last year, ValueAct successfully sold BigBand Networks to ARRIS Group (Nasdaq: ARRS), Immucor to TPG Capital, and S1 Corp to ACI Worldwide (Nasdaq: ACIW). ValueAct has been involved with Steinway since 2007 and it appears this investment is following their typical script. Current investors have an opportunity to invest at a lower cost basis right before several key catalysts, which should drive a tremendous IRR.

On June 2, 2011 ValueAct along with Samick Instruments, a Korean instrument company, purchased the Class A voting shares from the former CEO and Chairman of the board at $56/share, which was a 100%+ premium to the common share stock price at the time. As part of this process, ValueAct and Samick took control of the company and board, placing Private Equity veteran, Michael Sweeney, as Chairman and CEO. ValueAct currently owns 9.6% of the stock and Samick, which is a Korean instruments company, owns 32.31%.

The stock currently trades at $25, which is roughly the same price as in June 2011 prior to elimination of the dual class share structure. I believe that this discount is no longer warranted, especially given the high probability of multiple value driving catalysts over the next year. These potential catalysts include:

A sale of the lower-margin band business, which would allow them to focus all of their efforts on their dominant Steinway brand and other piano operations. The company reached a tentative deal with Kyle Kirkland and Dana Messina, the two former directors who had previously owned the voting rights. While negotiations are still ongoing, the company was reportedly seeking around $76 mm for this division.

Monetization of their NYC real estate properties. Their 450,000 sq. foot Steinway Factory was opened in the 1870’s and is listed on the balance sheet for only $3 mm, but was appraised for $200 mm in 2006. Their 217,000 sq. foot showroom in Midtown Manhattan is only carried on the books at $23 mm, but was appraised at $100 mm in 2006. These are prime real estate assets (look here for street view of Steinway Hall: bit.ly/RBbYwh). It is a waste for the company to own an 18 story building in the heart of Manhattan where it occupies only a fraction of the building and manufacture their Steinway pianos at such a valuable waterfront Queens property.

A sale of the main piano business to Samick or other interested buyers. Samick paid a huge premium to gain control of the company, owns over 30% of the stock, and has their CEO on the board of Steinway for a reason. Adding the dominant piano brand worldwide into their portfolio is the next logical step. With a sale of the band business and the real estate, Samick could more easily bid for the whole company. This would also fit right with ValueAct’s typical strategy of using a sale of the business as an exit strategy.

• On the latest conference call, Chairman and CEO, Michael Sweeney (the PE veteran), said, “The special committee has been very active in evaluating a variety of strategic alternatives, and we expect the committee to complete its work during the third quarter. We will have an announcement as soon as possible.” ValueAct has been in this stock since 2007 and Sweeney has been working actively on this since 2011. I think that current investors have an opportunity to maximize their IRR by investing right before the culmination of this 5-year process by ValueAct is readily apparent to the market.

Of course, this opportunity is only attractive if the sum of the parts discount still exists. I think there is overwhelming evidence to suggest that it does. Before digging into the numbers, I think it is important to note that the stock price has essentially not moved since the dual class share structure was eliminated in June of 2011 despite very solid results from operations. That decision by Mr. Market does not make much sense to me, especially since management is suggesting that there will be an announcement about strategic alternatives soon. Perhaps this opportunity exists because there is very little analyst coverage and investor relations to publicize the several sources of hidden value to a largely retail investor base (e.g. see this recent seekingalpha article that says the 61 P/E is too expensive but mentions nothing of ValueAct or their real estate holdings, which are clearly pertinent to the investment: bit.ly/RBjHL0).
Here is how I think about the low and high valuation components for Steinway. I tried to err on the side of conservatism even for the high valuation.

1) Piano Business: I took the 4-year avg EBIT for this division. This is a pretty good division with strong margins (especially for their premium Steinways). Revenues and operating income have been increasing and there is still a significant growth opportunity in Asia. I chose 8X EBIT for the low estimate and 12X EBIT for the high estimate. I think both of these are fairly conservative, especially considering rival Yamaha trades at ~13X EBIT. Steinway’s core businesses have been slow growers with ~10% EBITDA margins and boast the world famous Steinway brand. Yamaha has had slightly negative top line growth, ~5% EBITDA margins, and is a more commoditized brand. Given these factors, I think giving Steinway’s Piano Business a Yamaha-like multiple is, if anything, conservative.

Piano Business EBIT 4-yr avg (mm) $19.90

Multiple   Value (mm)

6             $119.40
8             $159.20
10           $199.00
12           $238.80
15           $298.50

2) Band business: The company is in serious negotiations to sell this business, and they were reportedly seeking $76 mm. I used this for the high estimate and took a 50% haircut on that valuation for the low estimate. Note that this business does ~$130 mm in sales/year, so the high and low estimates are about .6X and .3X sales respectively. Those do not seem too aggressive for a pretty consistent and profitable business.

3) Real Estate: As mentioned, Steinway Hall and their West 57th Street manufacturing facility were appraised for $200 mm and $100 mm respectively in an 8K filed February 10, 2006.

I used the 2006 appraised values of $200 mm for the Steinway Factory and $100 mm for the West 57th Street building for the high estimate. I took a 50% haircut to each of these values for the low estimate. I think both of these are pretty conservative given that most rent prices in Midtown NYC have actually increased since 2006 (~30%) and the Steinway Factory could be worth multiples of the appraised value if the company was able to get it rezoned to a residential area.

Item                        Low Value      High Value

Piano Business          $159.00         $238.00
Band Business           $38                $76

Steinway Factory        $100               $200
West 57th Street         $50                 $100

Net Cash                    ($31)               ($31)

Value                             $316               $583
Value/Share                  $25.44            $46.94

Upside/Downside (%)    1.77%            87.76%

I think the assumptions made in the Low Value Scenario are pretty draconian. With a buyer lined up for the band business (former directors Messner and Kirkland with a tentative deal), a logical buyer for the core piano business (Samick) that paid $56/share to take control, and a proven activist in ValueAct to maximize the real estate value, I think the market price should be much closer to the “high value” scenario than the low value scenario, which the market is currently implying with the $25 stock price. Furthermore, the assumptions made in the “High Value” scenario are far from aggressive:

• The 12X EBIT for the Piano business is below competitor Yamaha’s valuation, even though Yamaha is a less attractive business.

• NYC midtown asking rent prices are up ~30% since the 2006 appraisal values (which I used in the “High Value” estimate), which should make the West 57th street property more valuable.

• The Steinway Factory could potentially be reclassified as a residential area, which would more than double the value of the waterfront Queens Steinway Factory real estate.

• I am giving zero value to their 221,000 sq. foot manufacturing facility in Hamburg, Germany: This factory was opened in 1880 and is carried on the books at $1MM but is probably worth substantially more today.

For all of these reasons, I think the “High Value” estimates are very reasonable.

Steinway is trading almost exactly where it was a bit over a year ago, but the investment is undoubtedly much more attractive today. ValueAct and Samick have showed a significant vote of confidence and “tipped their hand” as to their intentions by paying $56/share to remove the dual-class share structure and investors today have an opportunity to invest below their average cost basis. This move, along with the appointment of a PE veteran as CEO and Chairman are a game-changer for the stock. I think it no longer deserves to trade at a discount to the sum of the parts with ValueAct and their history of success leading the way to value realization. I think the stock with very reasonable assumptions is worth much closer to the “High Value” case of $46.94/share than the current price of $25.

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Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.

Screening 100 Microcaps: Two that Missed the Cut

I mentioned in my last post that I recently went through ~100 microcaps. Before I get into the results, I want to briefly summarize some thoughts I have recently had about stock screens.

While many investors do stock screens, I think it is very important to always screen for a purpose. It is not enough to just enter the “perfect” screening criteria for stocks– high revenue growth, high ROE, low PE, etc.. Once you start entering too many criteria, you start generating results that look very cheap quantitatively, but often are cheap for a reason.

I prefer to screen for a purpose. Screen for a particular type of result, then search for something among those results. This allows you to really focus on what you are looking for (again, this comes down to having a clear investment philosophy and sticking to it - see my post on risk and eliminating investing mistakes).

Sometimes I screen for insider buying– often these stocks will look horrible, but if I can find a reason why an insider is buying a significant amount of stock before the market catches on, maybe I can get an edge. For example, in my recent screen for insider buying, I found that after a steep stock decline, nine insiders bought Kemet (KEM) stock in May 2012 for a total of $430 K:

I don’t know much about capacitors (their main product), but a screen like this might make me want to find out more (and if you happen to know anything about them or the stock, please comment on the post!).

Sometimes I screen for beaten down companies with lots of pessimism priced into the stock (crazy cheap valuations). Then I search for something positive. I start asking, “Is the market being overly pessimistic with this company/industry/sector?” Are there emotional sellers? This recently led me into the for profit education space, where I believe some stocks, such as Career Education (CECO), have been punished too hard by the market (this may be the subject of a future post). Lisa Rapuano of Lane Five Capital agrees.

Sometimes, like last weekend, I am screening for high quality companies that may be under the radar or underappreciated by the market. In this particular case, I was looking for microcap companies with greater than 15% ROE and greater than 20% ROC in the last twelve months with reasonable capital structures (I hate debt) that were within my circle of competence. While a plethora of these 100 stocks were really interesting, many of them were outside of my circle of competence, and I ultimately determined that only six of them were worth a deep dive. Of these six, I found that three were particularly interesting to me as an investor.

1) The stock that actually had me most intrigued was called Groupe Athena (OTCPK: GATA). The company claims to be a consulting company that helps Indian medical companies obtain FDA approval for their devices/ pharmaceuticals for sale in the U.S. This seemed like a pretty interesting niche—certainly a simple business model I could understand. Here were my initial notes:

Groupe Athena (OTCPK: GATA)

  • $6.6 mm mkt cap, $3.1 mm EV
  • 0.5X EBITDA, 1.6X P/E, 0.7X TBV
  • Revenues grown 100% yoy the past two years, ttm EBIT is $4.9 mm
  • Higher than I would expect capex has led to negative FCF
  • They provide testing and regulatory consulting services to help Indian and Southeast Asian medical companies obtain regulatory approval and facilitate exports of pharmaceuticals to the U.S.
  • Based in Mumbai, India
  • http://www.ceocfointerviews.com/interviews/GATA-GroupeAthena12.htm

Questions

  • Number of customers?
  • Capex?/machinery?
  • Auditors?
  • Stock Split, dividend, buybacks?, increased IR?

You don’t find too many consulting businesses growing revenue 100% yoy two years in a row at .5X EBITDA and half the market cap in cash. With a $6.6 mm mkt cap, it was definitely worth doing more digging because at this point, I just wanted to find out if it was a fraud. With those metrics, if it wasn’t a fraud, it was likely to be a multi-bagger.

I contacted management of the company and they got back to me rather quickly. I started to ask many questions—about their auditor, their customers, their management, their buyback strategy, increased IR etc. As my questions became more detailed, however, they stopped answering some of my questions. For example, they claimed one of their managers worked at Johnson and Johnson for 12 years. This was a pretty important fact to me—this is something that could be verified and if someone left a reputable job at J&J after a decade, starting a small-time fraud in India seems unlikely.

However, when I followed up and asked who worked at J&J for 12 years, he said, “the name you are looking for is Ms. Pooja Rajpurohit.” However, this person graduated from Rutgers in 2007 and therefore could not have worked at J&J for 12 years.

Other red flags:

  • I could find no information surrounding Allianz Atlantis Partners, their largest and founding investor, who has been selling stock aggressively lately
  • Their website includes generic pictures from around the web
  • The listed website and email address of the accounting firm listed on their financials did not work. They now have a new website with new contact information, but when I contacted them, they refused to answer whether they were the auditor for any other publicly traded companies

I could go on and on as I studied this for a better part of a week, but I was very disappointed with the conclusions from my digging: they are most likely a fraud, and certainly something I am not comfortable investing in. While these are my initial takeaways, I am certainly open to continuing a dialogue with management if they continue to do so and are willing to answer all of my questions with clear responses.

This is just part of microcap investing. You have to do your due diligence and occasionally you will find a gem that is truly under the radar.

2) The second stock I found interesting was  Vapor Corporation– (VPCO). Here were my initial notes:

  • $12 mm mkt cap, EV
  • 0.6X Revenue
  • Vapor Corporation designs, markets, and distributes electronic cigarettes in the United States. The company’s electronic cigarettes are battery-powered products that enable users to inhale nicotine vapor without smoke, tar, ash, or carbon monoxide
    • Very interesting, potentially lucrative market
  • Company has grown revenues tremendously over last few years. In 2008, they had less than $1 mm in revenue, but in ttm, nearly $20 mm
  • Company has never been profitable, but could on the verge of profitability with increased scale. There is also very little volume—would be difficult to establish a meaningful position
  • Insiders own 51% of stock

I liked a lot about this company: extremely high revenue growth, interesting (and addictive) market, and very much under the radar. However, the company has never generated FCF and I see very little long-term competitive advantages. It is unclear to me how the electronic cigarette market will unfold and even if it does take off I am not confident they will capture the economics. Ultimately, this is a company I will keep on my watch list. If they are able to continue to grow top line, but somehow build their brand and improve margins, then maybe it will be worth another look. With no evidence to suggest a competitive advantage, no meaningful FCF, and an uncertain business environment for their products, I’m not sure the stock deserves to trade much higher than its “cheap” revenue multiple. This could change, but it does not quite look like a “no-brainer” to me.

It’s getting late and this post is already getting long. There are two stocks that did make the cut that I will write about hopefully tomorrow, but I feel they deserve their own post. Don’t forget to subscribe to my blog and follow me on Twitter to make sure you don’t miss the next update.

 

Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.

Focus on Risk and Eliminating Mistakes

“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor” — Howard Marks

Investors are always looking for great stocks. You will find blogs, newsletters, and fund managers touting their favorite ideas. While finding great ideas is obviously important, avoiding bad ones is arguably even more important. I think that most investors (including myself) too often forget this fact, abandon their discipline, and allow mediocre (or bad) ideas into their portfolio.

When I recently reviewed my investment performance, I found that while I have had good overall performance, my returns were seriously dragged down by big losers. It is incredibly disappointing to put so much work and effort into finding a great stock, coming up with a clear and accurate thesis, and then making one rash mistake that cancels out all of, or most of, the previous gains. In this way, building an investment track record is kind of like building a reputation. It takes a long time to build, but it can be destroyed by just one terrible mistake. Therefore, while I have tried to learn from all of my investing mistakes, one would be wise to heed Eleanor Roosevelt’s advice: “Learn from the mistakes of others. You can’t possibly make them all yourself.”

With this in mind, I recently read two books that both focus on the importance of eliminating big investing mistakes. I read “The Most Important Thing Illuminated” by Howard Marks. I had already read the regular version of the book, but decided to read the illuminated version that included notes from Joel Greenblatt, Bruce Greenwald, Seth Klarman, and other respected investors. I also read “The Billion Dollar Mistake” by Stephen Weiss. It is also a worthwhile read about the worst investing mistakes of some of the most famous money managers. I highly recommend both books.

My overarching takeaway from these two books can be summarized as: the best way to avoid huge investment mistakes is to have a clear investment philosophy and maintain the discipline to pass on stocks that don’t fall into this investment criteria.

Howard Marks describes it well when he says, “A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources. One cannot develop an effective philosophy without having been exposed to life’s lessons. In my life, I’ve been quite fortunate in terms of both rich experiences and powerful lessons.” My investment philosophy has changed over time as I have learned more about investing and more about myself. Your investment philosophy is not supposed to be a rigid straitjacket, confining you to a single type of investment. However, there is simply so much “noise” in the investing universe — one can easily read 100 different stock ideas per day, and an investment philosophy helps you understand at any given point what you are trying to accomplish and how you are trying to accomplish it.

An investment philosophy loses its value if one succumbs to the temptation to abandon it. This may seem pretty basic, but some of the world’s greatest money managers have lost a lot of money because of this mistake. An example of this from Steve Weiss’ “The Billion Dollar Mistake” was Bill Ackman, one of the greatest investors in the world, and his investment in Borders and Target. Avoiding too much financial leverage was always one of Bill Ackman’s investment tenets, however he abandoned this core principle in his Borders investment where he decided that it was “good enough” and took the risk. In his analysis of this huge mistake, Steve Weiss puts forth, “perhaps it was the zeal to do so that made him bend, perhaps even waive, the selection criteria discipline he had so carefully and assiduously created. Whatever the reason, the deviation from discipline laid the groundwork for that unforced error in the book business and for a very big loss in the big-box megastore sector [Target]…And it had always been part of the Ackman discipline to avoid leverage– whether on the balance sheets of companies he invests in or on his own balance sheet. Ackman’s billion-dollar mistake, therefore, is that he departed from his own investing discipline. The differences in how this detour from discipline played out between Borders and Target are just variations on a theme.”

In my own investing experience, I often see many good write-ups on stocks that I almost immediately pass on because they simply do not fit in my investing style. For example, stocks like Best Buy, Radioshack, and other long-term secular decliners are simply not interesting to me. While they are admittedly potentially good investments, they just are not for me and it is always okay to “pass.” As Warren Buffet says, “In investments, there’s no such thing as a called strike. You can stand there at the plate and the pitcher can throw the ball right down the middle, and if it’s General Motors at $47 and you don’t know enough to decide General Motors at $47, you let it go right on by and no one’s going to call a strike. The only way you can have a strike is to swing and miss.”

Therefore, stocks that are outside my circle of competence such as bio-tech, mining companies, and most energy companies are also immediately discarded. One day, perhaps, I will learn enough about these industries to analyze them, but for now, it makes more sense for me to say “pass” and move on to ideas where I feel like I have the potential to gain an edge.

This past week I spent a lot of time going through about 100 growing micro-caps with strong returns on equity and capital. I was looking to find a few diamonds in the rough, and these principle reminders about discipline proved to be extremely helpful. While a plethora of these 100 stocks were really interesting, many of them were outside of my circle of competence, and I ultimately determined that only six of them were worth a deep dive. Of these six, I found that three are particularly interesting to me as an investor. I have reached out to the management of each of these three firms and will have an update to post by the end of next week (at the latest). I’m really excited about this update because these stocks include:

  • A foreign consulting business that has carved out a very profitable niche, is trading for less than 1X EBITDA, is growing over 100% yoy, has a strong net cash position, and has high insider ownership.
  • A medical device company with a strong competitive advantage that has led to 30%+ ROC, is growing over 20%/year, and is trading for less than 5X EBITDA
  • An innovative company in an old, stable business that is currently under the radar with breakeven operating results. With continued strong top line growth (revenue is up ~20X since 2008), this company could be on the verge of strong profitability that will force a re-rating in the stock (currently trading for .6X revenue)

I think it will be fascinating to find out more about these stocks through further research and from speaking to management. So, make sure to subscribe to the blog and follow me on Twitter to be notified of this update! In the meantime, remember: investors would be wise as Howard Marks notes to focus more on controlling risk and avoiding big losses, because ultimately the upside will take care of itself.

 

Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.

The Variant View: Reading International (RDI)

 

Many value investors that I respect have been attracted to Reading International (RDI). Whopper Investments, Jae Jun, Andrew Shapiro, and now, a recent Barrons article, have all highlighted hidden value in the company well in excess of the current market value. RDI has previously been one of my largest positions, and I even won a Harvard stock competition with a friend pitching a sum of the parts story. While I agree that RDI is substantially undervalued when compared to its assets, I disagree that it represents a particularly compelling investment today because of management’s disregard for minority shareholders. I recommend small investors take advantage of the recent “no news” Barrons article pop to sell shares and buy into cheap businesses where management is more properly aligned with shareholder’s incentives.

For those unfamiliar with RDI, the story is rather simple. It operates a cinema business and owns real estate. It sells below what is a massively understated book value (their land is worth well in excess of the value held on the balance sheet). In other words, this ~$6 stock is conservatively worth over $10 (see presentation) if management wanted to unlock the value. However, they don’t. There is a dual class share structure with all of the voting power concentrated with James Cotter, the CEO and Chairman of the firm. This ensures that minority shareholders can have no say in what actually occurs at the company or any strategic direction.

I knew all of this before I pitched the company for the Harvard competition, so what has changed since?

First, shortly after my pitch, Capstone Equities made a $100 mm bid for two of RDI’s New York Properties, Union Square and Cinema 1, 2, 3. Note that these properties only have a combined gross book value on the balance sheet of $32 million. Capstone, a minority shareholder, repeatedly tried to negotiate with RDI but claimed their management was unresponsive (their letter is worth a read). This was an excellent opportunity for management to unlock value for shareholders, many of whom have put up with poor share price performance for many years. However, they again showed an unwillingness to sell their core properties and unlock value, saying they wanted an option to co-participate in any development.

The second thing that changed my mind is when I recently visited with the company’s CFO at their Los Angeles office. While he was very nice and I thank him for meeting with me, I must say that I was disappointed as a minority shareholder in many of the things he had to say. I think all minority shareholders deserve to understand the mentality of this management team.

When asked about share buybacks for such a clearly undervalued stock, the CFO basically did not have an answer. He acknowledged that the company is incredibly cheap and that buybacks would make sense, but clearly articulated that a meaningful buyback program is not in the works. This is just poor capital allocation. A real company without a dual class share structure would consider the opportunity cost of any capital allocation decision. When you are clearly selling below the value of your real estate, buying more real estate, rather than share buybacks, is an indefensible capital allocation strategy. The only explanation is that they care more about building a family-owned real estate empire than they do about minority shareholder interests.

When asked about asset sales, he admitted that the company often has an emotional connection with some of their properties that makes them less willing to sell. As an investor, I simply cannot put money with a management team that is emotional with my money—especially one that cannot be held accountable by shareholders because of the dual class share structure.

The recent Barrons article said nothing new—the company is cheap. I agree with that and all of the other investment sites I mentioned earlier agree with that. After all, it is hard to make a case they are not extremely undervalued. However, whether something is undervalued or whether it is a good investment is not always the same question. In this case, the stock is extremely cheap relative to its assets, but it should be (and has for many years)! Why should the company trade at full value when management is emotional with shareholders money and is clearly misallocating capital?

There are really two risks in investing in stocks. The first is what you are buying is worth less than what you are paying. There is almost zero risk of this with RDI. The second, less talked about risk, is that it takes too long for fair value to be realized, which dilutes your IRR on the investment. This risk is tremendous with RDI given management’s mentality. I fully understand why some investors might choose to stay in RDI and try and bet on the gap between the current value and fair value closing, but that is really speculation in my opinion. The company has owned these assets for many years now and I have no idea when management will decide to do the right thing for shareholders, but after my meeting with the CFO, my gut says the answer is not very soon.

Therefore, when I look around at the investment universe and ask myself whether RDI is one of the best opportunities in the market, I have to pass. While it could easily work out given the discount you are paying to fair value, the risk that the price flounders around over the next ten years as management continues to buy assets and never unlock value is too great in my opinion. If you are interested in learning about some of my favorite ideas that are both cheap and have a clear path to realizing value, subscribe to my blog, like the facebook page, and follow my twitter (all are found on the right-hand side).
 

Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.