A Trio of French Bargains

Six years into a bull market in nearly all productive assets, “traditional” value stocks are a rare breed. By traditional, I mean obvious opportunities like profitable businesses with solid balance sheets trading at very low multiples of earnings and cash flows. Most of the value opportunities still out there require some real digging to discover. However, there is one market where I still routinely find perfectly good companies trading at 4-7 times earnings: France. I am not exactly sure why so many small French companies trade at these tiny multiples. It does seem that continental investors are loathe to invest beyond large, well-known companies, and the liquidity of many French micro-caps is extremely limited. The resulting neglect may be responsible for the plethora of value opportunities. Today I’d like to present brief profiles of three of these companies.

Docks Petroles D’Ambes: DPAM

“Docks” has operated a storage terminal at the port of Bordeaux on the west coast of France since 1934. The location and function of the terminal have long been considered strategic; the RAF bombed the facility in 1944 to hamper the Nazi supply chain.

Actual mission photo. Bombers from the RAF’s No. 514 Squadron attack the oil storage depot at Bec d’Ambes on August 4, 1944.

The business model is as simple as it sounds. The company collects fees for storing hydrocarbons, plus grain and wood products. Docks links refineries with consumers in the region. Docks also owns a petroleum pipeline. Results do vary somewhat as storage volumes change, but the company is consistently profitable and carries only modest debt. Docks generates a solid return on capital, but unfortunately its opportunities for reinvestment are quite limited. More than half of Docks’ shares outstanding are owned by a larger petroleum storage company, Entrepots Petroliers Regionaux. Another 30% are owned by various refiners and pipeline companies, leaving only 12% of the shares in the public float.

Docks has a market capitalization of Eur 23 million. At a share price of Eur 235, Docks’ P/E is 7.0 and its dividend yield is 6.4%. The high dividend yield is actually a drawback for many foreign investors, because France withholds dividend payments at a 30% rate. It is unlikely that Docks Petroles d’Ambes will experience any significant earnings growth, but it could be an attractive holding for those looking for a low-risk income stream.

Installux SA: STAL

Installux manufactures metal building components. Working mostly in aluminum, the company produces pieces for use in windows, doors, awnings and many other structural elements. Installux’s results depend on the level of construction activity, and on the prices of its aluminum and steel inputs. 50% of the company’s shares are owned by CEO Christian Canty, with another 15% owned by the respected French value investing firm Amiral Gestion.

Installux is not a fast growing company, but it has managed to increase revenues and profits at a modest pace. Nearly all of the company’s revenues are earned in France. Installux’s balance sheet is strongly over-capitalized, to the point where 27% of assets are cash and the current ratio is 3.5.

Installux’s market capitalization is Eur 74 million. The P/E ratio is 9.0. But, the company carries over Eur 20 million in excess cash. Net of that cash, the company’s P/E is just 6.0. Installux shares last changed hands at Eur 244, and the company has a dividend yield of 3.3%. While Installux’s core business is profitable, stable, and efficient, future returns will be strongly influenced by the company’s use of its huge cash reserves.

Graines Voltz SA: GRVO

Graines Voltz is a grower and distributor of seeds, mainly bulk ornamental flower seeds, but also some fruit and vegetable seeds. The company sells its seeds in continental Europe, plus the Middle East and Asia. The company offers hundreds of different varieties, many suitable for mass planting in public parks and landscaping.

As an agricultural business, Graines Voltz experiences large swings in its margins. Unpredictable factors like weather, pests and disease will always influence results. But the company has managed to increase its revenues at a respectable pace, from Eur 46.4 million in 2009 to Eur 73.1 million in 2014, a growth rate of 9.5%. Earnings per share reached a record Eur 4.22 for the twelve months ended March 31, 2015, up dramatically from Eur 0.95 per share in 2009.

The company’s striking success makes its valuation that much more of a shock. At a share price of Eur 16.40 and a market capitalization of Eur 22.5 million, Grain Voltz’s P/E is just 3.9. Its price to book value ratio is 0.8. The company does carry debt, but the majority is low-cost seasonal borrowing used to finance inventory. 2014 EBIT was over six times interest expense in 2014, and greater for the trailing twelve months. Return on equity has exceeded 15% each year since 2010.

It’s possible that Graines Voltz’s results are unsustainable, the result of temporarily decreased competition or unusually benign growing conditions. But I suspect the actual causes of Graines Voltz’s extraordinarily low valuation are its tiny float and practically non-existent liquidity. As of 2013, 10% of the company’s shares are owned by American grower Ball Horticultural, another 10% for European grower Florensis, and 64% by Voltz family members and company employees. In all, only 16% of Grain Voltz shares with a market value of Eur 3.6 million are freely-floating. Average trading volume rarely exceeds a few hundred shares per day, making accumulating a worthwhile position a difficult feat.

While I view each of these companies as distinctly undervalued, please be aware that my French is rudimentary and I made heavy use of translation services in evaluating their financial statements and press releases. It is entirely possible that I have missed some important bit of information that is material to the value of these companies. As always, please do your own in-depth research if you are considering purchasing any of these stocks.

Alluvial Capital Management, LLC does not hold shares of Docks Petroles d’Ambes, Installux SA, or Graines Voltz for client accounts or those of principals. Alluvial may buy or sell shares of Docks Petroles d’Ambes, Installux SA, or Graines Voltz  at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.


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A Boston Real Estate Empire at a Discount – New England Realty Associates, LP: NEN

New England Realty Associates, LP is an NYSE-listed real estate partnership that trades at a 30%+ discount to a conservative estimate of asset value. “NERA” is lead by Boston real estate magnate Harold Brown. The partnership has produced exceptional returns for its partners since inception. Though the market has begun to wake up to NERA’s substantial value in recent years, the partnership remains undervalued due to its small size, limited liquidity and confusing structure.

New England Realty Associates, LP (ticker NEN) was founded in 1977 and currently owns 24 properties in and around Boston, Massachusetts. Of these properties, 17 are residential buildings, 4 are mixed use, 3 are commercial buildings and 1 property is comprised of individual units within a condo complex. as of June 30, the partnership owned 2,412 apartment units, 19 condo units and 108,043 square feet of leasable commercial space. Additionally, the company owns partial interests in another 9 properties, a mix of apartments, commercial space and a parking lot.

NERA’s properties are located in central Boston and in surrounding affluent suburbs. The partnership got its start in Allston, and four of the properties are located there.


I’ve done some poking around on various apartment rental sites, and NERA seems to target young professionals and students to fill its rentals, many of which are located in busy settings near universities. Rents seem on par with the local market, and NERA (via Hamilton Company, which manages its properties) gets good reviews as a landlord. (This may be a recent development. There is no shortage of older articles criticizing the company’s property management practices.) NERA’s properties boast occupancy rates near 100%.

Like many realty partnerships, NERA’s ownership structure is made up of multiple classes of units. NERA has two classes of limited partnership interests, Class A and Class B, plus General Partnership Units. Class A units have an 80% ownership interest, Class B unitholders own 19%, and the General Partner owns 1%. None of these units are publicly-traded. What is publicly-traded are depositary receipts that are the equivalent of 1/30th of one Class A Unit. Class A units themselves are not tradable, but may be converted into depositary receipts at a 30-to-1 ratio at any time, then traded. Because of the odd depositary receipt structure, many financial data providers do not accurately report NERA’s market capitalization or units outstanding. This lack of good data contributes to NERA’s mis-valuation.

NERA has a long history of profitable operations. The company does not always report a GAAP profit, but does produce consistent and growing funds from operations. As I’ve mentioned many times before, GAAP net income is a terrible metric for evaluating real estate companies. Non-economic expenses like depreciation and accounting for partial interests obscure actual profitability. What matters is distributable cash flows, and NERA excels at creating these. Here’s a look at the partnership’s historical results. Results are in millions and are taken from the partnership’s annual reports, without any adjustment for restatements or amendments.


NERA’s annual funds from operations have more than doubled since 2008, while gross rents rose 39%. That’s a nice result. But the truly impressive achievement is NERA’s tax efficiency. From 2008 to 2014, the partnership recorded a sum of just $5.0 million in continuing net income for its partners. Yet it produced $77.4 million in funds from operations, a very close proxy for distributable cash flow. What’s clear is that NERA’s management understands the “secret sauce” of real estate investing: leverage and depreciation. Reasonable leverage allows a partnership to control a large asset base while the associated interest expense creates a tax shield. So long as the cap rate on the assets acquired is below the cost of the associated debt, positive cash flow results. The second part of the equation is to continually add new properties to the roster, bringing in fresh depreciable assets to further shelter cash flows from taxation. Because high quality real estate tends to appreciate over time, this depreciation is merely a “phantom” expense and a valuable tax shield.

On a trailing basis, NERA produced nearly $16 million in funds from operations. This figure will almost certainly increase as rents rise and as the company continues to pay down debt. Also, the company just closed on the purchase of another rental complex, the 94 unit Captain Parker Arms in Lexington, Massachusetts. The purchase price was $31.5 million, 79% of which the company funded using its Keybank line of credit. The partnership has also begun converting the parking lot it owns into a 49,000 square foot, 48 unit apartment building. Both of these projects will contribute substantial cash in years to come.

There’s one other area where NERA excels: buying back its units. Since inception, NERA has repurchased a full 30% of its issued units. In the last twelve months, the company reduced its fully-diluted units outstanding by 1.9%, and is set to continue buying back units. In March, the board of directors approved an expansion of the unit repurchase program sufficient to repurchase an additional 13.2% of outstanding units within five years.

But what is NERA worth? The answer to the question depends on determining the proper multiple of net operating income for Boston-area apartment properties. While NERA also holds some commercial properties and condos, the vast majority of its assets are invested in apartment assets. Unsurprisingly, the average cap rate for class A Boston apartment assets is extremely low. The Boston real estate market has long been one of the tightest in the country, and cap rates reflect this. Recent transactions have been done at cap rates as low as 4%! More typical transactions have crossed in the 5% range. For anyone interested, there are a number of market reports available via a little Googling. Here’s one.

For conservatism’s sake, I’ll use a cap rate of 6%/16.7x net operating income to estimate the value of NERA’s properties. The chart below lays out the value of NERA’s fully owned properties and its stake in equity-accounted projects, net of debt.


It’s very easy to get to value of over $255 million for NERA’s properties and investments, net of debt. Using market valuations for the Boston metro yields an even higher value. The chart below shows the values of New England Realty Associates, LP depositary receipts at various cap rates.


At a 6.0% cap rate, NERA depositary receipts are worth just over $70, 48% higher than the current trading price. This value does not include the increased cash flow from the newly-acquired apartment complex, or the value to be created by developing the parking lot into a residential property. If we assign even modest value to those new assets and nudge the cap rate down just slightly, the fair value of NERA’s depositary units approaches twice the current trading price. At NERA’s current trading price, I think it’s fair to say the market is valuing the company’s holdings at a cap rate of around 7.5%, well above market cap rates.

NERA’s valuation is compelling, but potential investors must be aware of a few potential risks. First, NERA’s two largest unitholders, Harold and Ronald Brown, are quite elderly. These men together own over 40% of NERA’s units. In the not distant future, NERA may face succession challenges. NERA also holds many highly appreciated properties, and unitholders may find themselves with an large tax bill should the partnership ever be wound down for any reason. And finally, because NERA is a pass-through entity, unitholders must be sure to handle the associated tax complexity carefully, including paying state taxes to Massachusetts.

For those unconcerned by these risks, NERA could be a great way to create a portfolio of quality Boston properties at a cap rate unheard of on the ground.

Alluvial Capital Management, LLC does not hold shares of New England Realty Associates, LP for client accounts. Alluvial may buy or sell shares of New England Realty Associates, LP at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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The Fight for Warrnambool – WCB:ASX

Before I get into this post, I’m happy to say I’ll be a panelist at The Microcap Conference, a new conference taking place in Philadelphia on November 5. It will be a great opportunity to hear from some promising small companies, meet with company management, and network with other analysts and investors. Anyone interested can find more information at microcapconf.com.

Fair warning: my subject today is so thinly-traded that building a meaningful position is next to impossible. So, I present the situation mainly as a profile in corporate gamesmanship, of multiple competitors sparring to achieve complete control over a valuable asset. The asset in question is a real mouthful: Warrnambool Cheese and Butter Factory Company Holdings Limited.


“WCB” is Australia’s oldest dairy company, founded in 1888. From the very beginning, WCB was export-oriented, first sending a shipment of butter to London in 1893. The company grew by leaps and bounds in the 20th century, overcoming a disastrous fire in 1929 and forming many joint ventures and licensing agreements with major world cheese and dairy brands. Over time, the company’s footprint increased to encompass many different categories of dairy products, as well as many supply chain inputs. The company listed on the ASX in 2004.

Dairy prices can be volatile and WCB’s results are not immune, but on average the company has been profitable. Here are annual results from the company’s listing in 2004 to fiscal 2014.


Like I said. Hardly consistent, but generally profitable and moving in the right direction. Over this stretch, WCB caught the eye of other Australian dairy businesses looking to expand. WCB’s international distribution and valuable partnerships were enticing for other operators looking to achieve higher margins through increased scale and improve their market share.

The first company to propose an outright acquisition of Warrnambool was Murray Goulburn, an Australian dairy co-op. Murray Goulburn approached WCB in late 2009 but was rebuffed. The WCB board viewed the proposal as opportunistic, and to a degree it was. WCB suffered heavily amidst the global financial crisis, and 2009’s results were very poor. Though Murray Goulburn would raise its offer multiple times, they were repeatedly turned down and ultimately withdrew their offer in June, 2010. Still, they began a creeping takeover of WCB, announcing they had purchased nearly 5% of WCB’s shares in early 2010. Through continued purchases, Murray Goulburn increased its stake in WCB to just under 10% by late 2010. WCB, for its part, brought in another competitor as a substantial shareholder. Through a rights offering, Bega Cheese purchased a 15% interest in WCB.

The games would continue, with various competitors quietly building their stakes in WCB. By mid 2013, Murray Goulburn had built its ownership to 16% of WCB, and Bega held 17%. Bega was the next to attempt to acquire WCB, offering the equivalent of $5.78 in cash and Bega Cheese stock. Again, WCB’s board recommended against the offer. Finally, after nearly a year of warring press releases and attempts to rally shareholders for or against the deal, Warrnambool found itself a savior in a white knight: Saputo, Inc. The large Canadian dairy company stepped in with a superior offer of $7.00 per share, payable in cash.

However, Bega Cheese and the Murray Goulburn Co-Op were far from done. Murray Goulburn returned with a bid of $7.50 per share, while Bega Cheese maintained that its offer was superior in that it allowed WCB shareholders continued participation in an Australian dairy company. Saputo fired back with an improved offer of $8.00. Meanwhile, a previously unknown player crept in and began accumulating WCB shares in earnest. On October 29, 2013, Lion Dairy went on a massive buying spree and bought up 9.99% of WCB’s shares outstanding. Lion Dairy is a subsidiary of Japanese beverage giant Kirin Holdings. Lion Dairy had long had a partnership relationship with WCB, and now had a substantial financial investment as well.

On and on it went, with the three bidders increasing their bids in turn. Murray Goulburn’s offer would eventually reach $9.50 per share. Meanwhile, Saputo took matters into its own hands and began buying WCB shares aggressively. In the end, it was Saputo that won out. Bega Cheese capitulated and sold its holdings to Saputo and Murray Goulburn did the same. Through its various open market purchases and the takeover offer, Saputo managed to increase its ownership of WCB to 87.92%.

That might be the end of the story, were it not for Lion Dairy. One of Saputo’s explicit goals in offering to purchase WCB was to obtain a shareholding of over 90%. Saputo even offered an additional 20 cents per share if its offer succeeded in achieving 90% ownership. Why is the 90% threshold a big deal? Well, under Australian corporate law, a purchaser can force remaining shareholders to sell if the purchaser can achieve 90% ownership. Lion Dairy’s stake is now just over 10%, and it represents a blocking interest than prevents Saputo from taking full ownership of WCB. It also prevents Saputo from delisting WCB from the Australian stock exchange, forcing them to continue paying additional listing and auditors fees.

In essence, what Lion Dairy now possesses is a valuable intangible asset via its ability to prevent Saputo from fully achieving its goals. If Saputo wants to achieve complete ownership of Warrnambool, it will likely have to pay Lion Dairy (and all remaining minority shareholders) a premium for the remaining shares. The companies are not exactly adversarial at this point (witness the recent transaction where Lion Dairy sold an entire division to WCB) but Lion Dairy and Kirin Holdings are certainly aware of the strength of their position. Saputo cannot force a merger, nor can it delist WCB, nor can it directly dividend cash back to Saputo without sending 10% of it to Lion Dairy.

Perhaps Saputo will play a waiting game. If a recession rolls around, Lion may become more willing to sell its blocking interest to Saputo at a lower price. On the other hand, Lion Dairy’s asking price may only increase if WCB does well under Saputo’s ownership. Warrnambool Cheese and Butter recently traded at just under Saputo’s acquisition price. Anybody interested in aligning with Lion Dairy and taking part in the next round of corporate soap operatics might enjoy owning a few shares just for the entertainment value, with upside if WCB’s operations perform well. But purchase carefully. Warrnambool’s stock may be one of the world’s most closely-held listed companies, with a free float of less than $6 million on a market capitalization of $522 million.

Alluvial Capital Management, LLC does not hold shares of Warrnambool Cheese and Butter Factory Company Holdings Limited for client accounts. Alluvial may buy or sell shares of Warrnambool Cheese and Butter Factory Company Holdings Limited at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.


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What’s New With Retail Holdings NV? – RHDGF

Long-time readers may remember previous posts on Retail Holdings NV. “ReHo” is one of my longest-held and sadly, most stubbornly lackluster performers. Still, I remain convinced that Retail Holdings’ collection of profitable and growing Asian businesses and large discount to NAV will eventually result in substantial appreciation. ReHo recently published its first half 2015 results. Let’s take a look at how they did, and how the company’s earnings and NAV have developed.

Reho’s semi-annual report (available here) reveals a few major changes in the company’s assets and operations. First, Singer Thailand is no longer a Singer Asia subsidiary. In June, Singer Asia sold its 40% stake in Singer Thailand for $44.8 million. In CEO Stephen Goodman’s words,

“The sale reflects the unique circumstances of Singer Thailand: the Company only had a 40% stake compared to the very much larger, majority stakes in the Company’s other operations, and Singer Thailand employs a very different, direct selling business model, as compared to the retail and wholesale business models employed elsewhere.”

Mr. Goodman went on to say there are no plans for any immediate disposition of the company’s remaining subsidiaries, and the use of the proceeds of the Singer Thailand sale is yet to be determined.

The second major revelation is a large writedown in the value of the SVP notes that ReHo holds. These notes have been distressed for a long while and have undergone multiple restructurings. In June, SVP failed to make a full cash interest payment on the notes, and Retail Holdings moved to classify the notes as impaired, writing down their value from $25.9 million to $13 million. This large impairment necessarily took a toll on ReHo’s reported EPS for the half year. I must admit that the degree of the writedown surprised me. I had long valued the notes at less than par, but declaring the notes impaired by a full 50% indicates a great deal more financial difficulty at SVP than I had expected.

Operational results were good. ReHo’s consolidated revenues rose 14.3% year over year in US dollar terms. Retail Holdings’ two largest subsidiaries (via Singer Asia) are Singer Sri Lanka and Singer Bangladesh, and their fortunes moved in opposite directions. Revenues at the Sri Lanka company soared 26% with pre-tax income up 66%. The Bangladesh division struggled with the country’s continued political and economic instability, and revenues declined 7.6%, dashing earnings. Nonetheless, Singer Bangladesh remained profitable. Singer India also turned in a profit, while Singer Pakistan and the newly-established Singer Cambodia lost money.

ReHo’s reported first half EPS was $1.13 compared to $0.73 a year ago, but the figures are hardly comparable due to the SVP notes impairment and the gain on the Singer Thailand sale.

There are two ways to evaluate Retail Holdings NV’s worth: via its assets and via its earnings power. These are, of course, just the two sides of one coin. Still, a separate look at each is useful. Evaluating Retail Holdings from an asset perspective is easy. Retail Holdings owns 54.1% of Singer Asia, which in turn owns five business units in Asia, four of which are traded on local stock exchanges. Additionally, both Retail Holdings and Singer Asia hold unencumbered cash at the company level and Retail Holdings holds high yield bonds, the SVP notes. Neither Retail Holdings nor Singer Asia has any company-level debt.

Here’s a look at ReHo’s current NAV breakdown.




At a current mid-point of $18.63 or so, ReHo shares trade at a 38% discount to NAV. No surprise. This discount has persisted for years in various degrees. Now let’s take a look at the underlying earnings of Retail Holdings’ subsidiaries. The chart below presents trailing twelve months results for the various Singer entities, divided between the profitable and unprofitable segments.


By buying one share of Retail Holdings, you’re purchasing $1.22 in attributable earnings from Singer Asia’s profitable subsidiaries. The losses of the Pakistani and Cambodian subsidiaries can be ignored because they are separate legal entities that Singer Asia is not obligated to support. After backing out the value of the enterprise’s corporate cash, the SVP notes, and the stock market value of the loss-making Pakistani subsidiary, you’re paying a very reasonable multiple for these fast-growing and profitable businesses, Singer Sri Lanka in particular.

As if there weren’t enough tedious explanations in this post already, here’s the breakdown of the components of Retail Holdings’ share price.


Just to emphasize, Retail Holdings’ share price implies a 9.3x earnings multiple on profitable subsidiaries growing at well over 10% annually with no slowdown in sight. The Sri Lankan subsidiary in particular is attractive. The Sri Lankan economy is one of the world’s fastest-growing following the end of the decades long civil war in 2009.

With all that said, one question remains: why? Specifically, why does Retail Holdings NV trade at 62% of NAV and under 10x the earnings of its fast-growing subsidiaries? I don’t think the answer is difficult to find. ReHo’s corporate configuration could hardly be more awkward. What sensible company would be headquartered in a Caribbean tax shelter, operate solely in South-East Asia, and have its stock traded only in the US? On top of that, Retail Holdings’ stock is highly illiquid and the company is not an SEC filer. The cherry on top is repeated broken promises by management to IPO Singer Asia, only to see the IPO process abandoned each time.

I do have some small amount of sympathy for management. It seems that each time the company begins preparing the Asian operations for an IPO, some market or political crisis erupts that torpedoes the IPO market. But the fact remains that Retail Holdings NV is not likely to achieve its full value until an IPO is achieved.

If all Retail Holdings had going for it was the hope of a future convergence to NAV via an IPO of its Asian operations, I would not be interested. There are hundreds of holding companies that trade at a discount to NAV, and many times these discounts persist for decades. But in Retail Holdings’ case, the NAV is growing rapidly and will continue to grow as the Asian subsidiaries grow revenues at 10-15% annually. It doesn’t take long for serious value creation to result at those rates of growth. 9.3x earnings is a silly valuation for companies on this trajectory.

For that reason, I am happy to hold Retail Holdings for as long as its subsidiaries’ values continue to build. The Singer brand remains exceedingly strong, especially in the company’s primary Sri Lanka market. In the mean time, ReHo will continue to pay out most of its free cash flow in annual distributions, with the possibility of special distributions from asset sales, like Singer Thailand.

Alluvial Capital Management, LLC holds shares of Retail Holdings NV for client accounts. Alluvial may buy or sell shares of Retail Holdings NV at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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Undervalued Quality – Nathan’s Famous Inc.

Where did the summer go? After quite a long break from the blog, I’m back to talk about the newest stock I’ve been purchasing for Alluvial’s clients: Nathan’s Famous Inc.


Nathan’s will be a familiar name for any New York natives (which I am not, but I know many blog readers are.) Founded in 1916, the company has never deviated from its business of selling hot dogs made with its proprietary blend of spices. These days, the company focuses on franchising and branding revenues. There are around 300 franchised Nathan’s Famous locations around the world, and five company-owned locations. Nathan’s branded hot dogs and other foods can be purchased at many supermarkets and wholesale clubs, and the company sponsors the annual hot dog eating contest at their flagship restaurant on Coney Island.

I’ll go into detail below, but the crux of my thesis rests on a simple assertion: Nathan’s is a premium business, therefore it should command a premium valuation. Nathan’s trades at a very pedestrian valuation. Therefore, Nathan’s is undervalued and is an attractive investment. Just what qualities a “good business” possesses has been explored at length by better investors than I, and I won’t waste words on that topic. Instead, I’ll illustrate the ways in which Nathan’s business characteristics demonstrate its quality.


Nathan’s has a strong history of growth, and there is more to come. Over the last ten fiscal years, Nathan’s revenues grew at 11.5% annually. Nathan’s trailing revenues surpassed $100 million for the first time in the most recent quarter. There is no reason to expect this growth to halt any time soon. At $100 million in revenue, Nathan’s is still a tiny, tiny player and will not run into issues of market saturation for many years. Furthermore, in 2014 the company signed a new product licensing agreement with the world’s largest pork processor, Smithfield. The agreement replaces a previous licensing agreement and provides hugely improved economics for Nathan’s. The new agreement more than doubles the gross sales royalty Nathan’s receives for Nathan’s branded products and features high and increasing minimum annual royalty payments.

Then again, any company can grow. All it requires is a willingness to commit capital, whether through internal investments or external acquisitions. Growth in itself is not inherently good if it requires excessive additional capital. What makes Nathan’s special is its ability to create sustained growth with minimal capital commitment.

Pricing Power/Brand Value

From fiscal 2010 through fiscal 2015, Nathan’s experienced torrid growth and an associated increase in operating income. Revenues rose 95%, from $50.9 million to $99.1 million. Operating income rose more, jumping 135% to $20.0 million from $8.5 million. And what did Nathan’s have to invest to grow operating income by $11.5 million in five years? Very little. Assuming operating cash of 2% of revenues, invested capital increased by just $2.3 million over the stretch.

When a business is able to produce significant profit growth without a corresponding increase in its capital base, it indicates pricing power. Now, investors must distinguish between illusory pricing power that is the result of cyclicality, such as the increased earnings that commodities producers can show when demand growth outstrips supply growth, and authentic pricing power that is the result of brand strength. Seeing as the demand for summertime comfort food remains relatively stable from year to year, it is highly unlikely that Nathan’s results are attributable to some hot dog super-cycle. Rather, Nathan’s strong brand and popular products allow it to command price increases year after year and to achieve better terms on licensing agreements as they come up for renewal.

Operating Leverage and Margin Expansion

Quality businesses find ways to do more with a dollar as they grow, and Nathan’s is no exception. The growing revenue base allows the company to spread its fixed costs over a large base, and the ongoing move into licensing revenues over restaurants sales has resulted in high and higher contributions to the bottom line. Compared to other revenue sources, royalty streams have nearly no associated costs. As a result, Nathan’s operating margins have surpassed 20% and are set to continue their increase. Compared to just five years ago, nearly an additional nickel of every dollar of sales falls to operating income.

Free Cash Flow 

Quality businesses produce copious and consistent free cash flow. Some may reinvest the majority of it into the business in order to further drive growth (above and beyond that which is naturally created by pricing power) but many return most or all cash flow to shareholders. Nathan’s is one of these. In the ten years ended in fiscal 2015, Nathan’s produced total free cash flow of $55 million. Of that $55 million, Nathan’s spent $49.6 million to repurchase shares. How many companies can devote 90% of free cash flow to share buybacks and still triple revenues over the same period? Better yet, the majority of the share repurchases were done in 2008 and 2009, when Nathan’s shares traded at depressed levels. With little need to innovate and minimal capital needs for expansion, Nathan’s appears set to continue returning nearly all cash flow to shareholders in a tax-efficient manner.


I think I’ve made a case for Nathan’s as a “premium” business. There’s more I could talk about, like the company’s astronomical returns on capital and its highly incentivized insiders, but let’s move on to valuation. What is the proper price for an “average” business? It depends on a number of things like interest rates, capital structure, industry growth rates, and margins. But in general, I think the average publicly-traded business is worth at least 10x operating income, assuming a normal economic growth outlook. I usually think I’m getting a good deal if I can pay 8x or less. Premium businesses, on the other hand, can and should command a premium valuation. I don’t hesitate to pay 12, 14, or even 15 times operating income for a business that can truly produce excellent growth with modest investment, while increasing its margins at the same time. I find that the market systematically undervalues these rare companies.

The market currently values Nathan’s at just a hair over 10x adjusted trailing operating income. Before getting further into that, let’s take a look at how the market values Nathan’s competitors. I’ve ranked the chart by historical revenue growth. The calculations are my own.


I don’t mean to say that all these business are directly comparable to Nathan’s. In fact, most are traditional restaurant operators, not licensors. Rather, I provide this chart simply to point out that despite superior growth, margins, and asset utilization, Nathan’s valuation is the lowest I can find among American restaurant companies. Of the companies included in the chart, DineEquity is the most similar to Nathan’s. Despite actually shrinking by 14.3% annually and becoming more asset-intensive along the way, DineEquity trades at a 39% valuation premium to Nathan’s.

So why does Nathan’s trade at this large discount to its peers, most of which are distinctly less attractive from a business perspective? I believe the biggest reason is the large leveraged dividend recap that Nathan’s just did. In March, Nathan’s took on $135 million in senior secured debt at 10%, due in 2020. Nathan’s used the proceeds of the debt offering to pay a $25 per share dividend. Since the dividend was paid out, Nathan’s shares have fallen 36%. Post-transaction, Nathan’s finds itself with very high headline leverage, and also set to see its net income drop substantially year-over-year, neither of which most investors like to see. The $135 million in debt will reduce annual net income by almost $1.80, and now the company appears to have EBIT/cash interest expense coverage of just 1.5x.

To a casual observer, Nathan’s may now appear leveraged to the hilt, with deeply impaired earnings power. However, things are not  as they seem. Despite its large debt load, Nathan’s has $60 million in cash and securities on its balance sheet. The company also has well over $200 million in guaranteed cash flows it will receive between now and 2032, and will probably receive a great deal more. The licensing agreement with Smithfield specifies minimum annual royalties of $10 million in the first year of the contract, growing to $17 million by the last year. Simply put, Nathan’s risk of encountering financial difficulties due to its leverage is practically zero.

I also expect Nathan’s earnings power to be restored in short order. Powered by the new licensing agreement, I expect the company’s growth to continue with an associated gradual increase in operating margins. Earnings rise quickly as leveraged firms grow. Nathan’s interest expense, while high, is fixed, and incremental earnings will flow to equity owners.

So what do I think Nathan’s is worth? It’s hard to say, exactly, because much depends on how successful the company is in increasing its royalty revenues, and how much of that $60 million sitting on the balance sheet is used to repurchase stock. But I do expect Nathan’s to continue to grow its operating income at a double digit rate, and that will quickly result in an increased business value. Sooner or later the market will realize the dividend recap hasn’t permanently crushed Nathan’s earnings power. I expect substantial appreciation from Nathan’s Famous shares in the coming years.

Alluvial Capital Management, LLC holds shares of Nathan’s Famous, Inc. for client accounts. Alluvial may buy or sell shares of Nathan’s Famous, Inc. at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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Why Be Unlisted?

An OTC stock is one that is unlisted and doesn’t trade on an exchange. For some, being unlisted indicates a company that is extraordinarily risky with high potential for fraud. In other words, uninvestable. But for others (like me) unlisted stocks are merely a different category of stocks with their own advantages and disadvantages. Still, those of us who consider unlisted stocks part of our investing universe should ask ourselves just why a publically-owned company would choose to remain unlisted. After all, the norm for companies with a significant number of shareholders is to list on a national exchange. Listing on the NYSE or NASDAQ is costly, but the cost is surely more than covered by the benefits of increased liquidity and the higher valuation afforded listed companies.

Allow me to present a brief list of common reasons why companies remain unlisted and trade OTC, from the most benign to the most sinister. I have seen each of these reasons time and time again across thousands of unlisted stocks, both in the US and abroad.

No Need for Capital

This is perhaps the best reason for a company to remain unlisted. Recall that listing on a national exchange typically boosts a company’s valuation to a higher multiple of revenues or cash flows. This indicates a decreased cost of capital, which is extremely beneficial for companies that rely on a flow of fresh capital from investors, especially equity capital. At higher valuations, equity raises result in a smaller percentage of the company being sold in secondary offerings, which benefits existing shareholders.

However, for investors in a company that produces excess capital, a higher valuation can reduce long-term returns. A responsible company will return excess capital to shareholders either through cash dividends or through share repurchases. In either case, a lower valuation is beneficial to long-term holders as they reinvest dividends or as their ownership increases proportionally via buybacks.

A good example of this process in action is Computer Services, Inc. Investors in Computer Services have enjoyed a 12.7% compounded annual return over the last decade, seriously outpacing stock indexes. Computer Services generates substantial excess capital and routinely repurchases stock and increases its dividend. Since 2005, the company has repurchased 16.2% of its shares outstanding. This large decrease would have been muted if the company’s shares had traded at a higher average valuation during the period. Reinvested dividends and share repurchase programs would have netted far fewer shares.

Sadly, these types of companies are all too rare. I can think of only a handful of unlisted companies that regularly generate excess capital and return it to shareholders. Most companies that enjoy these characteristics are either privately owned or have long since by bought by larger competitors.

Small Size

Some companies are simply too small for an exchange listing to be viable. I have seen various figures thrown around for the cost of maintaining an exchange listing, but most estimates indicate that an NYSE listing costs close to $1 million annually when the reporting and compliance costs are included. A NASDAQ listing is cheaper, but both are prohibitive for companies earning only a few million in operating income. Some of my best investments have been in companies earning only $2-10 million per year, and the cost of an exchange listing would have been a material drag on earnings.

Companies too small to support exchange listings are a fruitful market segment for value investors. Because they are both tiny and unlisted, many of these companies receive little press and go under-researched, leading to frequent mis-pricings. Some of these companies possess a valuable option that can result in big returns: uplisting. Many of these tiny companies grow rapidly, and will eventually seek to list. Investors who bought in prior to the listing often do very, very well. I’m almost always thrilled when one of my small holdings announces an uplisting, because I know the increased exposure will result in a higher valuation.

Can’t Meet Listing Standards

The NYSE and NASDAQ require a level of disclosure that some businesses either can’t or won’t meet. Sometimes businesses in the midst of restructuring or restating are unable to file timely financial reports, eventually disqualifying them from listing. And sometimes companies simply do not want to provide the detailed reporting that standard filings require.

This lack of disclosure is a mixed bag. Sometimes important details are left out, but often the incomplete filings provide opportunities for value investors willing to do additional legwork. In the absence of standard filings, some investors conclude the elevated risk of fraud is enough to disqualify a company for investment. That’s fair enough. But I don’t automatically exclude a company from consideration for not disclosing every detail down to its receivables aging schedule. I know of many companies that choose not to release fully-detailed filings simply because of the expense and effort involved.  (Others, of course, provide incomplete disclosure in order to obfuscate and distract from untoward actions. But that’s the next topic.)

In cases where business details are easily verified, incomplete disclosure may be sufficient. I know of a few real estate companies trading OTC that reveal little about the details behind their operations. Yet the holdings are easily verified through public tax records and the assessments and reassessments listed there are invaluable in estimating the real estate’s value.

Shady Insiders

Sometimes companies choose to remain unlisted because the behavior of insiders would never stand up to the increased scrutiny that comes with listing. Excess compensation, empire-building, entrenched management and rampant self-dealing are common in companies of any listing status, but are much easier for unethical management teams to accomplish off-exchange.

There are numerous companies that walk the line between ethical and unethical treatment of shareholders, and some that engage in outright abuses. For example, some years ago I became a shareholder (one share only) in a company that refused (and still refuses) to provide any financial information to shareholders unless they would sign a non-disclosure agreement indicating the shareholder would not share the information with anyone else, including other shareholders. Seeing no alternative, I agreed to this demand and signed the agreement. Sure enough, management’s rapacious actions were obvious soon as I saw the financial statements. Though the company did over $100 million in revenues per year in an industry with reasonable operating margins, operating profits were positive in only one of the previous five years. The reason? Management saw fit to pay themselves over $8 million annually. The board was clearly there only to approve management’s demands, and were paid handsomely for providing effectively no responsible oversight. There is nearly no hope that this company will ever change its ways, and management likes it that way.

Companies like these are probably best avoided by smaller investors, even if the financial metrics look promising. In these cases, management represents a huge intangible liability that offsets any potential under-valuation.

Ramifications for Investors

When evaluating an unlisted stocks, investors should consider the company’s motivations for remaining unlisted and incorporate their conclusions into their subjective opinions of company and management quality. Sometimes remaining unlisted indicates a high quality company with a shareholder-oriented management team. After all, why list if you don’t need capital and you want to maximize returns for shareholders in the long run? Listing might produce a short-term gain at the expense of long-term returns. And in cases where a company’s economics can’t support the expense of a listing, doing so would only be a vanity move meant to bolster management’s prestige at the expense of shareholders.

On the other hand, there are plenty of instances where a company remains unlisted for bad reasons, and investors should approach these companies with caution. When management is a liability, investors should incorporate the liability into their estimate of intrinsic value.


Alluvial Capital Management, LLC holds shares of Computer Services, Inc. for client accounts. Alluvial may buy or sell shares of Computer Services, Inc. at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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When Ownership Structure Creates a Bargain – Schuler AG

I like companies where a highly concentrated ownership structure leaves only a small percentage of shares in the public float. In this way, sometimes even relatively large companies can be nearly uninvestable for firms of any meaningful size. Now and then this can lead to significant mis-pricing, as market participants who would ordinarily take advantage of the opportunity cannot act.

A prime example of a situation like this is Schuler AG. Schuler is a German metal forming company, just one of Germany’s plethora of successful small-to-medium-sized enterprises often called Mittelstand. These companies share a number of characteristics, among them a focus on efficiency, mastery of niche products and/or processes, a partnership model of owner/employee relations, and a focus on exporting.


Schuler produces the massive, complex and incredibly expensive industrial presses used in many manufacturing processes like automotive manufacturing, coin minting and many others. Recently, Schuler has introduced a line of energy-efficient presses. The company has also made large investments in China. In fiscal 2014, Schuler’s revenues were 1.2 billion Euros while operating income surpassed 100 million Euros for the first time. Because Schuler’s products represent major capital expenditures for its customers, Schuler’s results tend to be cyclical. Still, the company’s revenues have grown by a healthy 7.8% over the past decade. Over the course of the decade, Schuler’s operating margins show a general uptrend. A cyclical company’s operating margins should never be examined in a vacuum; one year’s results say little about normalized margins. But I think it’s safe to say that Schuler has a enjoyed a sustainable increase in operating margins in tandem with its top-line growth. The three year period from 2012 to 2014 produced real Eurozone GDP growth of a cumulative 2.3%. During this period, Schuler’s operating margins averaged 8.3%. The years 2004 through 2006 produced real Eurozone GDP growth of 8.1%, but operating margins for that period averaged a miserable 1.3%. I think it’s safe to assume modern Schuler is not the same company it was a decade ago and future operating margins will look more like those of recent years.

In addition to its operating improvements in recent years, Schuler has undergone a balance sheet transformation. At the end of 2009, Schuler had Eur 51.9 million in cash against Eur 298.1 million in debt and pension liabilities for net debt and pension liabilities of Eur 246.2 million. A mere five years, later, Schuler has piled up a cash balance of Eur 482.5 million. Debt and pension liabilities have fallen to Eur 211.0 million for a net cash balance of Eur 271.5 million. This remarkable change was almost entirely the result of free cash flow generation. From 2010 to present, Schuler raked in Eur 459 million in free cash flow.

Let’s imagine you’re a financial buyer, say a private equity firm. What would you pay to buy Schuler? Using any of the various reasonable approaches to valuation, you could come up with a wide range of fair values. But I guarantee any reasonable bidder would pay quite a bit more for Schuler than its current trading price suggests. Schuler’s market capitalization is Eur 877.9 million. Subtracting the net cash results in an enterprise value of Eur 606.4 million. Schuler shares are being valued at just 5.9x trailing EBIT and 4.9x trailing EBITDA. Shares go for 13.2x trailing earnings, while net cash represents over 30% of Schuler’s market capitalization.

So why does such a successful company trade so cheaply? Schuler has great cash flow and is substantially over-capitalized. The product line is advanced and demand for industrial presses should only grow as the world economy expands.

One reason: ownership structure. Over 95% of Schuler shares are in the hands of Andritz AG, a large Austrian industrial holding company. Andritz had been buying up Schuler shares for years, including those owned by Schuler’s founding Schuler-Voith family. Andritrz brought its ownership to over 95% in early 95% following a buyout offer in early 2013. Following Andritz’s purchase, Schuler shares delisted from the major German exchanges but remain listed in Munich. Trading volume has declined, but over 1,000 Schuler shares still trade hands daily.

Because less than Eur 45 million worth of Schuler shares are in public hands, the company is completely uninvestable for mid-sized or larger institutions. But smaller investors can easily build up a meaningful position if they view Schuler’s value proposition as attractive.

There is a catch, and it’s the chief risk of owning shares in a company that is dominated by a single shareholder. It’s the possibility of a forced merger by the controlling shareholder at an unfair price. I am not a lawyer, and my interpretation of German securities law should be viewed as only a layman’s opinion. But it appears that a company that owns over 95% of another is able to execute a mandatory squeeze-out, purchasing the remaining shares outstanding for cash. The acquiring company sets the buyout price, which is reviewed and approved by independent external auditors. The minimum price is the 3-month average trading price of the target company’s shares.

Schuler’s 3-month average trading price is just 2% below the current price, so shareholders are not currently at risk of a takeunder. I also must assume (and not having any sense of the German legal system, this is only an assumption) that the external auditors in charge of evaluating any takeover by Andritz would not look kindly on a buyout price below the current trading price. And it’s not like paying remaining shareholders a price above the current trading price would be burdensome for Andritz. For example, a 40% premium to the current price would cost only an extra Eur 17 million, a rounding error for a firm of Andritz’s size.

Nonetheless, Schuler shareholders could lose their shares to squeeze-out done at well below fair value. Investors should weigh this risk against the potential gains from investing in a company of Schuler’s quality at a rock bottom valuation.

Alluvial Capital Management, LLC does not hold shares of Schuler AG for client accounts. Alluvial may buy or sell shares of Schuler AG at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.


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Podcast Pitch: Command Center, Inc.

The other day I participated in an investing podcast hosted by Fred Rockwell of TheBulldogInvestor.com. We discussed a variety of investing topics germane to the micro-cap world. Anyone interested in listening to the podcast can find it here or on iTunes.

At the end of the podcast, I described a stock that I like a lot and have purchased for Alluvial Capital Management clients. The stock is Command Center, Inc. The stock ticker is CCNI. As I type, the stock price is $0.70 and the market capitalization is $46.2 million. Frankly I believe I described the stock fairly well in the podcast but I’ll summarize my views below.

Command Center is a temporary labor provider to blue collar industries like light construction, hospitality, various trades and others. The company has 55 storefronts in 22 states. A number of factors combine to make Command Center stock attractive at these price levels.

Savvy Leadership/Improved Operations

Over the past few years, Command Center has turned itself from an unfocused and struggling company to a well-run and very profitable operation. Management focused on winning high-margin business, controlling operating costs and making each company store responsible for its own profitability. The result has been rapid growth in operating income even as top-line revenue has contracted. CEO Frederick “Bubba” Sandford deserves a lot of credit for the company’s recent success.

Strong Balance Sheet

The company’s success has resulted in a lot of cash flow, and Command Center has used that cash to all but eliminate its debt and build up a substantial cash cushion. Excess cash is around $6 million, or 13% of market capitalization.

Low Valuation

Command Center trades at just 6.2x operating income and 5.7x EBITDA (I may have said 7x operating income on the podcast, so please excuse my memory lapse.) The company has a small NOL balance but will likely become a normal taxpayer in 2016. Those are low ratios for any industry, but especially for the staffing industry where low capex requirements and growth potential leads investors to assign high valuations. Command Center’s larger competitors trade at an average of 10.1x EBITDA per the company’s March 2015 investor presentation. Were Command Center to trade at 9x EBITDA, shares would reach $1.05.

Opportunities to Reward Shareholders

Command Center has indicated it will use its cash either to repurchase stock, or to conduct small acquisitions or open new storefronts. The company has approved a $5.0 million share repurchase plan. On the topic of acquisitions, the company notes that many smaller competitors are “mom-and-pop” type operators that can be acquired for only a few times cash flows. Either returning capital to shareholders or investing it productively would be positive outcomes that would benefit shareholders.

Here’s a link to the company’s recent investor presentation, which does a good job illustrating the company’s turnaround and future opportunities. I believe Command Center shares are worth far more than the current trading price and I look forward to seeing what company management can do in 2015 and beyond.

Alluvial Capital Management, LLC holds shares of Command Center, Inc. for client accounts. Alluvial may buy or sell shares of Command Center, Inc. at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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Lessons Learned

In the comment left on my last post, a reader suggested I discuss what I’d learned from the performance of the stocks mentioned in my earliest blog posts at the beginning of 2012. I thought that was a good idea. With the benefit of hindsight, it is clear where my analysis of the various stocks contained solid reasoning and great foresight, and where it most assuredly did not. I present five lessons I have taken from my progress as an investment practitioner.

Normalize, Normalize, Normalize

Nearly every value investor has a story of discovering a company trading at low, low multiples of cash flows and earnings and buying in, only to see earnings and cash flows begin a steep decline. What looked like a bargain based on current profits was actually fairly-priced or even over-valued based on forward-looking profit measures. Conversely, nearly every investor can remember passing on a company due to high valuation multiples, not realizing that earnings and cash flows were about to explode as the company’s economic outlook improved. These cases illustrate the risks of valuing cyclical companies using peak or trough results. Great danger lies in assuming good times will last indefinitely, and also in assuming bad times will do likewise. Excepting cases where demand for the company’s goods or services is likely to remain in decline (newsprint, wireline telecom, most types of coal) or likely to grow at an above-average rate for long periods to come (healthcare, data and data services) investors are well-served to estimate mid-cycle earnings and cash flows and use those as the basis for valuations, not current results. Homebuilders, shipbuilders, construction, and semiconductors are all examples of industries that deep boom and bust cycles, and estimating earnings power based on only a short part of the economic cycle is hazardous to one’s wallet.

Knowing this was what lead me to successfully identify Schuff International as an attractive security, though current earnings and cash flows were weak. The financial crisis took an immense toll on construction spending, but I was reasonably sure that Schuff’s profits would eventually rebound. In 2011, Schuff earned only pennies of operating income per dollar of assets employed, but I knew it had once earned far more and believed it would again, one day. As the economy recovered and companies and governments once again launched major building efforts, Schuff’s profits rocketed and so did its share price.

Don’t Sit Across The Table From Management

Not every company I invest in has a stellar management team. Some seem half-asleep, content to let cash pile up on the balance sheet without any clear plan to use it productively. Some have their hands stuffed a little deeper in the cookie jar than I think is fair, and pay themselves excessively. Others are unfocused, choosing to pursue distracting side ventures rather than concentrate on the company’s strong core offerings. All of these I can forgive, so long as the company’s operations are going well and shareholders are being treated fairly. What I can’t accept is when management acts in opposition to shareholders, scheming to deprive them through abusive related-party deals or absurd compensation. I also cannot accept when managerial compensation is totally divorced from performance, allowing management to profit even from outright failure.

I overlooked this possibility when I was analyzing Webco Industries. The company’s financial statements disclosed little, making it difficult to see just how richly management was rewarding itself from quarter to quarter. Furthermore, I failed to see that management had chosen to “bet the firm” on a massive and costly expansion when other steel companies were struggling with weak demand and pricing. Since my post, Webco has struggled to produce sustained profits and remains saddled with a great deal of debt. Despite the poor results, management continues to grant themselves thousands of additional shares each quarter, a huge number for a company with under 1 million shares outstanding. Since my write-up, Webco’s management has granted itself shares worth between $2.4 and $4.5 million, depending on the share price at the time of the grants. In a time period where the share price has been cut in half, management has seen fit to transfer ownership of 4.5% of the company from shareholders to themselves. I’m not saying Webco would have been a successful investment without this compensation. The challenging economics of the steel industry would likely have prevailed. But knowing how management treated shareholders at the time of my investment might’ve made me question just who would reap the benefits of any future profits.

Beware Of Customer Concentration

If a company depends on just a few customers for the majority of its revenues and profits, those customers have significant bargaining power over the company. These customers may be able to win price discounts or better payment terms. If the worst case scenario occurs and these customers end their relationships with the company, financial results can fall off a cliff. This risk is elevated with micro-cap companies, many of which depend on a limited customer base in a small geography.

QEP Company was severely affected by the loss of a major customer. I rationalized the loss as manageable, believing the company would be able to replace the lost revenues in short order. I should’ve run for the door. Several quarters have gone by and the company has spent millions of shareholder wealth on acquisitions, yet results have not recovered. If I’d properly discounted my estimate of QEP’s worth for its high customer concentration, I may have avoided a costly mistake.

Perception Lags Reality

The stock market is very efficient. New information is almost immediately incorporated into stock prices. The biggest exception to this general efficiency I’ve found is the market for micro-cap and thinly-traded stocks. Information seems to move at a trickle in these market niches, leading to opportunities for sharp-eyed investors. At the smallest and least liquid end of the market, stock prices seem oddly tied to out-dated perceptions of company health and value. Once-distressed companies that have cleaned up their acts trade at low valuations long after the turnaround is in full swing. On the other hand, once healthy companies with trouble on the horizon often retain premium valuations well after the stormclouds have arrived.

When I found Alaska Power & Telecom, the company was only a few years removed from a brush with bankruptcy. The company had shutdown its loss-making operation and had secured new financing, and was making progress in reducing its leverage. Despite this progress, the company traded at a dismally low multiple and offered great value. As the market’s opinion caught up, shares appreciated to a more realistic valuation. Now, who’s to say I wouldn’t have made the same mistake as the market if I’d known of the company in 2010 and 2011? Perhaps the company’s prior difficulties would have colored my analysis and kept me from investing. As investors, we must strive to keep out estimates of value forward-looking and avoid being anchored by past company failures or successes.

Investing Doesn’t Take Place In A Vacuum

As much as some of us would wish it, investing is so much more than a numbers game. Beyond the figures on the financial statements, uncountable factors can influence the success of an investment. Leadership changes, technological and demographic changes, government actions, even weather will influence the companies we buy in profound ways. While many of these impacts cannot be anticipated, investors should attempt to incorporate those that can be into our estimates of company value. Luckily, the SEC requires companies to help us in this task. I am convinced that one of the most valuable sections of any SEC-filer’s annual report is the “risk factors” section. Yet, it is perhaps the least-read section. It’s easy to understand why, as this section is typically full of legal boilerplate and bland, generic verbiage. Yet companies will often disclose threats their business faces that are discussed nowhere in the remainder of the filing or in quarterly earnings calls.

Another early post of mine discussed a metals supplier, Empire Resources. My investment in Empire Resources worked out well, but it would have worked out much better except for government action. When the government failed to renew the General System of Preferences in mid-2013, it resulted in substantial cost increases on raw materials imported from the company’s main suppliers. I gave little thought to the possibility of this negative government action. After all, the company didn’t seem to express much concern in quarterly earnings presentations. But there it is in the company’s 2012 annual report under risk factors:

“During 2011 and 2010 approximately 54% and 42%, respectively, of our purchases of aluminum products were from countries that were considered developing countries whose exports were eligible for preferential tariff treatment for import into the U.S. under the generalized system of preferences or duty free. There can be no assurance that any of our suppliers will continue to be eligible for such preferential tariff treatment or that the generalized system of preference will be renewed after its expiration on June 30, 2013.”

I should’ve built this risk into my estimates of future earnings for Empire Resources. Perhaps I wouldn’t invested anyway, but perhaps some other stock would have looked relatively more attractive, and I could have made more by investing in it instead.

Hopefully this list of concepts and their explanations will be helpful in your quest for the next great stock. Investing is a never-ending learning process, and I owe a great debt to other investors who have taught me lessons along the way.

Again, I’ll be in Toronto April 14-16 for the Fairfax shareholders’ meeting and would enjoy meeting any blog readers who will be in town.

Alluvial Capital Management, LLC may hold shares of securities mentioned for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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A Look Back

The other day I realized it’s been three years since I started writing OTC Adventures. That’s a long time in the life of a blog! When I started, I had no idea that my writings on micro-caps, illiquid stocks and other obscurities would find an audience, let alone eventually allow me to launch my own RIA practice. These days nearly all my time is spent in seeking out great investments for my clients, but I still enjoy writing here when I can.

In recognition of how far this blog has come since those first posts, I’d like to look back at the first companies I’ve profiled and see what’s become of them. I’ve learned and grown as an investor since I wrote these posts, but I like to think these early analyses hold up well.

Today I’ll tackle the first five stocks I wrote about.

QEP Company

I wrote up QEP Company on January 17, 2012, when the company traded at $14.25. In the post, I expressed optimism that the company’s strong results would continue and the company would benefit from deleveraging. Well, that’s not exactly what happened. The company wound up losing a major contract and with it, much of its future sales and profits. QEP attempted to make up for the loss with a succession of acquisitions, but as yet, all efforts to return to growth and grow profits have been for naught. Margins are under pressure and trailing EBIT has declined to $5.31 million, down 70% since my post. Perhaps somewhat surprisingly, the stock has risen 18% since my post.

Schuff International Company

My post on Schuff went live on January 29, 2012, when shares changed hands at $9.00. At the time, I cited the company’s large share repurchase, low multiple of normalized earnings and improving industry conditions as reasons the shares would move higher. Shares soon dipped all the way down to $6.50, but then began a steady march higher. Improved operating conditions provided a tailwind, but the biggest gains came when company management sold their majority stake to Phil Falcone’s HC2 Holdings for $31.50 per share. A follow-up tender offer took HC2’s stake to over 90% and it seems like the end of the road for Schuff shareholders, even as many believe the company’s shares are worth twice as much or more than HC2’s purchase price. (Meanwhile, any holders who jumped over to HC2 following the buyout have seen returns of 180% atop the already healthy returns from Schuff shares.) In the end, Schuff shares returned 250%.

McRae Industries

Next, I tackled McRae Industries, writing about the company on February 5, 2012 when class A shares went for $12.77. The family-owned bootmaker was attractive due to its strong balance sheet, healthy demand for both its work/military and Western/fashion boots, and a modest valuation of current earnings. Since the post, McRae’s revenues and earnings have risen at a healthy pace and the stock has followed, though shares still trade at very low multiples, especially considering the more than $20 million in cash and investments the company has accumulated. McRae shares have provided a total return of 168%.

Webco Industries

The Webco Industries post went live on February 14, 2012. (Can you tell I was single at the time?) The stock price at the time was $125. I deemed Webco attractive based on a track record of profitable growth, expansion efforts, and a deep discount to tangible book value. Sadly, it seems that the discount to book value was warranted. Webco finished a major expansion only to find the anticipated demand absent, and profits have been scarce since. Weak steel prices, high leverage and an ever-increasing share count have lead to returns of -48% since my post.

Alaska Power & Telephone

I wrote up APTL on February 23, 2012. At the time, shares went for $17. I was attracted to the company based on its low valuation. By my estimate, the combination of stable telecom and utility assets ought to have merited a much higher valuation. I also appreciated the company’s efforts to clean up its balance sheet and restore credibility following some unfortunate efforts to expand into construction. APTL executed its business plan, paying down debt and restarting a dividend. The company now plans to construct a new hydro-electric plant and build out its data offerings. Shares have provided a total return of 32% to date.

On average, the first five stocks I wrote about returned 84%, which holds up well against the return of the iShares Micro-Cap ETF (IWC) which returned 55% since the end of 2012. As usual with any basket of stocks, a few produced dynamite gains, a few gave a respectable return, and a few were duds.

In many ways, 2012 was an ideal time for micro-cap investors. The immediate danger of the financial crisis had passed, but the market still priced many of these companies for failure, or at least as if they would never grow again. The virtuous cycle of increasing earnings and expanding multiples has provided many investors with excellent gains, but it has also left the ranks of obviously cheap stocks looking very thin. Finding the remaining bargains requires investors to search more broadly, perhaps in foreign markets and unusual securities, and more deeply, picking apart financial statements and industry news to find the value beneath.

In a few days I’ll take a look at how the next set of stocks I wrote about way back when has performed, before returning to “regular programming.”

On another note, I’ll be in Toronto on April 14-16 for the Fairfax Financial shareholders meeting and associated festivities. I’d enjoy meeting blog readers and fellow value investors of any stripe. Let me know if you’ll be in town.

Alluvial Capital Management, LLC holds shares of McRae Industries, Inc.  for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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