Spindletop Oil & Gas – SPND

Spindletop Oil & Gas operates as an explorer and producer of oil and natural gas. Spindletop’s reserves are mainly located in Texas, but the company owns interests in wells spread across 15 states. The company has been producing oil and natural gas since the 70s and has existed in its current state since a reorganization in 1985. The company also owns 26.1 miles of natural gas pipelines in Texas.

The company is controlled by husband and wife Chris and Michelle Mazzini. Chris Mazzini is a successful oilman and serves as chairman of the board and president. Michelle Mazzini is a lawyer and serves as the company’s chief counsel. Together they own 77% of the shares outstanding. Another 9.2% of shares outstanding are owned by Nadel and Gussman Energy, LLC, leaving only a little over one million shares in the hands of all other shareholders.

Spindletop is reminiscent of another exploration & production company I have written about before, Reserve Petroleum. Both companies have long histories of successful exploration and profits, huge cash reserves and modest valuations. Like all nearly all commodities producers, Spindletop’s product is completely undifferentiated from its competitors’. Energy producers are price-takers, lacking the market power to determine the pricing of their own product. Their only hope for earning excess profits is to operate more nimbly and more efficiently than competitors through superior knowledge and execution, anticipating changes in market conditions and keeping costs down. Spindletop has this to say about its competitive strategy in the latest annual report.

“We believe that a major attribute of the Company is its long history with, and extensive knowledge of, the Fort Worth Basin of Texas. Our technical staff has an average of over 20 years oil and gas experience, most of it in the Fort Worth Basin.

…From the 1990s through 2003, the Company took advantage of the lower product prices by cost effectively adding to its reserve base through value-priced acquisitions. We found that through selective purchases we could make producing property acquisitions that were more cost effective than drilling.

During this time period, the Company acquired a large number of operated and non-operated oil and gas properties in various states.

From 2003 through the fourth quarter of 2008, we returned our focus to a strategy of development drilling with a focus on our Barnett Shale acreage. Since 2009, we split our focus by looking for value-priced acquisitions combined with development drilling prospects. In the current economic climate, we are continuing our efforts to acquire producing properties and taking a more conservative approach to development of our leasehold acreage. We are looking at growth through acquisitions and limited drilling. With current lower natural gas prices and high costs to produce, we believe that it makes sense to carefully evaluate all our options and make sure that each transaction can be supported in today’s lower price environment.”

This flexible approach to reserve development and production has produced consistent profits and cash flow. The company has earned a GAAP profit in each fiscal year since 1999.

Spindletop has used its steady profits to add to its oil and gas wells and properties. At the same time, the company’s cash reserves have reached $8.41 million. The company’s strong reserves enable it to act opportunistically to acquire attractive new wells and properties, and also to reduce production during periods of low energy prices without jeopardizing financial stability.

The company has compounded its book value per share admirably over the past decade, going from $0.40 per share at the end of 2002 to $2.24 at present. Return on equity averaged 19.73% over the time period.

Despite consistent profits and attractive returns on its equity base, Spindletop trades at a discount to book value and at depressed multiples of earnings and EBITDA. With 7.661 million diluted shares outstanding and a recent share price mid-point of $2.02, the company’s market capitalization is $15.48 million. On trailing earnings of $2.42 million, trailing P/E is 6.40, extremely reasonable for a highly profitable, well-capitalized explorer & producer.

On an Enterprise Value/EBITDA basis, the company is even cheaper. With $7.63 million in net cash, the company’s enterprise value is a paltry $7.58 million. Trailing EBITDA is $2.91 million, yielding an EV/EBITDA ratio of 2.60. Any way you look at it, Spindletop is extremely cheap.

The company’s valuation is supported by its assets. The company has $6.84 million in net working capital and $11.29 in net oil and gas properties and equipment, as well as over $1 million in equity in its corporate headquarters building. Non-current liabilities total just $4.08 million against this $19+ million in assets for net asset value of at least $15 million, slightly under the company’s market capitalization.

Spindletop shareholders have had a rough ride in recent years. As oil prices raged higher in early 2008, the company’s share rose to a peak of $10.25, giving the company a market capitalization of $78 million. Trailing P/E stood at 28.2. At the time, the company’s book value was just $10.69 million. Yes, the company’s assets became more valuable as energy prices rose, but 7.3 times more valuable than their stated worth? Investors must be wary of investing in commodities companies when manias lead market values to decouple from accounting values.

Since the peak, the company’s book value per share has increased from $1.40 to $2.24, even as the share prices has fallen by 81%. It’s strange that investors who were once willing to buy in at 7.3 times book value and 28.2 times earnings now value the same company at 90% of book value and 6.4 times earnings.

Longer-term shareholders have done well. In 1995 and 1996, Spindletop’s share price bounced between $.01 and $0.10. While investors who purchased at $0.01 have made a king’s ransom, even investors who bought in at $0.10 have made over 20% annualized since 1996.

Spindletop’s future success will depend on the company’s fortunes in adding reserves at attractive prices and managing production to realize the highest revenues. Mr. Chris Mazzini and his team have done an admirable job thus far and at only 54, Mr. Mazzini seems likely to lead the company for many more years. Investors looking for a cheap, stable exploration & production company may find a lot to like with Spindletop.

 

Disclosure: No position.

Abatix Goes Private – ABIX

One of the challenging aspects of investing in unlisted securities is the lack of good, timely information from companies regarding their business prospects and developments. Many of the smallest, insider-controlled companies are content to communicate with the outside world via occasional one or two page press releases, never bothering with investor conference calls or presentations.

Of course, the very opacity and silence that keeps most investors away is what can create such great opportunities for investors who do the work necessary to discover and track these same companies!

I wrote about Abatix Corp. back in May, highlighting the company’s modest valuation, propensity for repurchasing stock and unique “disaster insurance” business model. Today, Abatix announced a reverse stock split that will cash out minority investors at $14.75 per share, a 39.2% premium to the previous closing price. Abatix gave investors no indication that it was considering any sort of going-private transaction. The only indications were the company’s shrinking share count and shareholder list.

While the end of the line for Abatix as a public company is close, a look at the company’s story over the last five years shows that good things can happen to investors who buy obscure but profitable companies with strong balance sheets. Abatix deregistered its stock in September, 2007, moving to the pink sheets. At the time, shares of Abatix traded for around $7. Over the next five years Abatix ticked along making consistent profits and paying off all debt. With this going private transaction, an investor who bought in September 2007 will have made about 111%, or 16.1% annualized. Over the same time period, the S&P 500 index had negative return.

That’s not to say I think the cash-out price is a home run for minority investors. $14.75 is just 96% of book value per share, and only 9 times average earnings for the last five years. The company is overcapitalized, making the effective price paid for the shares a little lower still. That said, $14.75 probably qualifies as “fair” for such a small, illiquid company.

With the stock trading at $14.60, investors should take their gains and look for the next opportunity. There are dozens and dozens of other tiny gems on the OTCBB and pink sheets registries, and I have several write-ups in the pipeline. As always, thanks for reading!

ALJ Regional Holdings Makes Progress – ALJJ

Back in August I wrote about ALJ Regional Holdings, a leveraged equity situation with high return potential. Shortly after I wrote the post, ALJ released its June 30 quarterly report which once again showed the company turning a healthy profit and reducing its debt load.

For the quarter ended June 30, 2012, ALJ made $2.52 million in net income and produced EBITDA of $4.07 million. Operating cash flow for the quarter was $6.74 million, driven by strong operating results and decreased net working capital.

ALJ used this cash flow to make further reductions to its subordinated debt, cutting it by 17.8% from last quarter. The result is a continued strengthening of the company’s balance sheet and a reduction in net debt to trailing EBITDA.

Total interest-bearing liabilities were reduced by 13.33% from a quarter ago. At 2.38 times trailing EBITDA, the company’s net debt load is the lowest it has been since beginning operations in 2006.

Despite this progress, the market has not rewarded ALJJ. Since my post, shares are down 12.1%.

ALJ Regional Holdings now has an enterprise value of 3.69 times trailing EBITDA, compared to 4.16 times when I originally wrote about the company. If the company continues to operate profitably and work off its debt, sooner or later the market will wake up and give the company some credit for the path it’s on.

For now, I view the dip in the share price as an opportunity to get in on a rapidly transforming company at an even higher expected return than when I first wrote about it.

 

Disclosure:  No position.

 

Paradise Inc. – PARF

Ever receive a fruitcake during the holidays? Or at least see one in a grocery store bakery? Chances are, the candied fruit inside was produced by Paradise Inc. The company believes its products account for the large majority of candied fruit sold in the US. Paradise dominates its niche, but that niche is a small one. In 2011, sales of candied fruit accounted for 68.9% of the company’s revenue, or a little over $17 million dollars. The company also produces molded plastic baskets used primarily in food packaging and occasionally grows and sells strawberries when market conditions are attractive. Paradise is controlled by CEO Melvin Gordon who owns 37.1% of the shares outstanding.

While Paradise turns consistent profits selling candied fruit, the market is not growing. Sales have varied little over the past decade.  In 2002, Paradise managed 8.04 cents of revenue for every person residing in the United States. In 2011 it managed 7.98 cents per person. While it may not be growing, the candied fruit industry does not seem likely to disappear any time soon. So far as I know, candied fruit is still delicious and still used by bakers all over. There are advantages to dominating a stagnant but stable industry. Because the market is so small, it is unlikely that a larger competitor will enter the market and muscle Paradise out. The small size of the market also limits innovation, reducing the chances that a competitor will introduce a cheaper or tastier product.

Paradise’s operations are strongly seasonal. Inventories rise beginning in late summer as the company prepares for September, October, and November, when over 85% of its candied fruit sales occur. The company finances its investment in inventory by drawing down its cash balances and tapping a bank line of credit. After the sales rush, cash pours in and the company pays down its line of credit, ending the year swimming in cash. Then the process begins again.

Here’s a look at Paradise Inc.’s recent results:

While revenues have been flat, the company has managed to double operating margins since 2007. Trailing net income of $1.33 million is the highest since 2000 when the company earned $1.31 million.

The company has a stable balance sheet to go along with its stable income statement. Because a balance sheet is a “freeze frame” of a single moment in time and Paradise’s operations are so seasonal, averaging working capital values over a full year is more analytically rigorous. Using averaged working capital figures, Paradise has a net asset value per share of $37.56, 95% higher than market value. Even applying conservative discount figures to all of the company’s assets yields a net asset/liquidation value of $19.93 per share, a 3.3% premium to market value.

There is reason to believe these value are understated. The company’s plant was built in 1961 and the company purchased 5.2 acres of adjoining property in 1985. These properties have almost certainly appreciated in value since.

At a recent bid/ask mid-point of $19.30 and 519,600 shares outstanding, Paradise Inc.’s market capitalization is a tiny $10.02 million. The company’s valuation is similarly modest at a P/E of 7.5 and just 51% of book value.

There are a variety of reasons why a company will trade at a fraction of its balance sheet book value, but one of the most common is an inability to earn its cost of capital. This is certainly the case with Paradise. Over the last ten full fiscal years, the company averaged a pitiful 4.19% return on equity. If the company had liquidated a decade ago and bought a run-of-the-mill bond mutual fund with the cash, shareholders would be better off today. A company earning 4.19% on equity is worth more dead than alive.

But let’s propose a scenario. Say a private equity firm were to take a look at the company with an eye toward improving results and optimizing the balance sheet. Could Paradise Inc. be worth more than the $10 million it fetches on the marketplace right now?

Here are a list of steps my own (totally imaginary) private equity firm would take. For beginning net income and EBITDA figures, I will use the trailing 12 months figures of $1.33 million and $2.71 million, respectively.

1. Offer to purchase all shares of Paradise Inc. for $30 each, a premium of 55.4% to market price. Complete the transaction for a total outlay of $15.54 million.

2. Address executive compensation. In 2011, Paradise’s four highest-paid executives took home $1.44 million. I am willing to bet I could find two highly capable managers to perform the same job functions for $250,000 each, plus possible equity compensation. That’s a handsome salary and plenty of upside potential. While I am not claiming that current management is incompetent, the truth is that CEO Melvin Gordon is 78 and probably does not have the same fire for the business he once did. Reducing executive compensation by $940,000 annually would increase pro forma EBITDA to $3.65 million.

3. Rationalize working capital. Over the past year, Paradise had an average cash balance of $3.54 million and an average line of credit balance of $700,000 for an average net cash figure of $2.84 million. The company would immediately draw an additional $2.84 million on the line of credit and dividend the amount to the private equity company, reducing average net excess cash to zero. Collateralizing the line of credit should not be an issue as average inventory was $9.49 million over the last year. Assuming 5% interest, this additional draw of $2.84 million on the line of credit would cost the company $142,000 per year, pre-tax. I imagine other optimizations would be possible within working capital management, but I’ll leave at that to be conservative.

4. Assume term debt. A stable company like Paradise can benefit from a lowered cost of capital by taking on reasonable amounts of debt. Term debt of $3.65 million (1x EBITDA after reduced executive compensation) and an interest rate of 7.5% would cost the company $274,000 per year, pre-tax. The cash inflow from the term debt would also be dividended back to the private equity firm.

5. Incentivize management. After spending $15.59 to acquire the company, offset by the dividends from the line of credit and the term debt, the net cost to acquire the company would be $9.04 million. Pro forma EBITDA would be $3.65 million and pro forma net income would be $1.67 million. New management would be granted options equaling 10% of company equity, assuming certain targets are met. A reasonable target in a stagnant industry might be 3% growth in EBITDA and free cash flow per year.

6. Wait. Allow five years for management to grow the company. Assuming management hits its targets, EBITDA will grow to $4.23 million on a trailing basis in five years. Along the way, free cash flow can be paid out to the private equity firm. Capital expenditures and investments in working capital will be needed, but I think it’s safe to assume 80% of net income is free cash flow and grows at the same 3% rate as EBITDA. At this point, the private equity company’s schedule of cash flows looks like this:

7. Sell. At the end of year five, forward EBITDA is projected to be $4.36 million. Assuming a conservative 5x EBITDA multiple and $3.65 million in net debt, Paradise would have a private market value of $18.15 million. 10% of that is due to management, who worked so diligently to meet their targets. The private equity firm nets $16.34 million. The result is a nice internal rate of return of 25.66% over the time period.

Now of course, this is all pie (or fruitcake)  in the sky. But there is nothing stopping the company from taking similar actions to benefit shareholders. Also, Melvin Gordon and his family may not want to own the company forever and when they decide to step aside, a buyer will perform projections much like the above to arrive at a bid. It’s not hard to derive a valuation materially above the current trading price. In the mean time, investors get paid to wait. Paradise’s 13.3% earnings yield and strong balance sheet should serve to support the stock in a down market, and the potential for a buyout or other accretive corporate action provides upside potential.

For anyone interested in knowing more about this interesting little company, I found a few good newspaper articles here and here. I’d also enjoy hearing from shareholders who may have more insight into the company’s history and prospects than I do.

 

Disclosure: No position.

 

 

 

Siem Industries Revisited – SEMUF

I originally wrote about Siem Industries here in April, noting the extreme divergence between the company’s trading price and the market value of its publicly-traded equity investments. Since then, the company has released both fiscal 2011 and first half 2012 reports.

Despite progress at the company, the valuation gap remains. Here are some highlights from the previous two reports:

– At the time of the original post, book value per share stood at $86.69. Halfway through 2012, book value has increased to $129.79 per share. The majority of the increase is the result of a write-up in the carrying value of Siem Industries’ investment in SubSea 7. SubSea 7 merged with Acergy SA in January 2011, triggering the revaluation. The $601 million write-up that resulted was accounted for as a deferred gain and is, according to the company, free of any tax consequences.

– Shares outstanding have decreased by 70,330 or 0.46% since the the time of my post. While modest, it is encouraging the company continues to repurchase shares far below their intrinsic value. Each time the company shells out $65 or $70 to repurchase one of its own shares, it buys a portfolio of public holdings worth $122 or so.

– On the subject of public holdings, the company’s portfolio has seen some changes. STAR Reefers was renamed “Siem Shipping Inc.” and the company now has a 21% interest in Veripos Inc., spun off from SubSea 7 in late July.

The value of the company’s public holdings has declined somewhat, though part of the decline is due to an $48.1 million dividend received from SubSea 7 in July 2012. The value of the company’s equity portfolio still substantially exceeds the company’s market capitalization.

– In May, the company recorded a gain of $81.4 million ($5.33 per share!) from the sale of its claims against Lehman Brothers International (Europe). Simply put, the company had loaned several million of its SubSea 7 shares to Lehman Brothers as part of a bond marketing effort. When Lehman went under, the shares went with it. Siem Industries sold its right to any eventual recovery from Lehman in return for cash upfront.

– After adjusting for the special dividend and Lehman recovery income, the company’s pre-tax profits increased from $26.15 million to $92.08 million in the first half of 2012 compared to ayear earlier.

All in all, the most recent reports paint a picture of a healthy, profitable company.

Subsequent to releasing its first half 2012 report, Siem Industries announced a $400 million exchangeable bond issue. The bonds are due in 2019 and pay 1% annual coupons. While the bonds are subject to a variety of call and put provisions, their most interesting feature is their exchangeability for shares of SubSea 7 that the company owns. The bonds are exchangeable for SubSea 7 shares at $29.00 per share, 25% above where the shares currently trade. The bond issue can be looked at as a hybrid traditional debt/covered call transaction where the company trades some upside on its SubSea 7 holdings for access to substantial capital at nearly no cost. The $400 million bond issue will cost the company just $4 million annually and give the company substantial firepower for acquisitions or any other corporate purpose. Just what Siem Industries is planning is an open question.

Despite a small gain since my first report, Siem Industries remains a compelling value, trading at just over half the value of its publicly-traded equity holdings alone. The company also owns significant private assets. While there is no readily identifiable catalyst on the horizon (with the possible exception of the recent bond issuance), time can be catalyst enough in deep value situations.

 

Rockford Corp. – ROFO

Rockford Corp. manufactures and distributes car audio systems, both under its own brand names and under licenses from other companies. Rockford Fosgate is the company’s flagship product line. The company’s products can be found in new Nissan, Suzuki and Mitsubishi automobiles. Despite continuing sales and earnings growth, the company trades at a trailing P/E ratio of 6.3.

Rockford is a great example of a firm that was once highly profitable, then made serious errors that lead to years and years of losses. Rockford made money hand over fist through the late 90s, peaking in 2000 at $8.01 million in earnings. However, in each annual report from 1999 to 2003, the company makes mention of weak or declining sales in its core Fosgate product line. Rather than investing in revamping its core line of business, the company proceeded to acquire businesses and brands including Lightning Audio, Q-Logic, MB Quart, NHT and SimpleDevices. In the process, the company took on substantial debt. Unfortunately, the acquired assets failed to live up to expectations and the company was forced to either write off or sell most of them in the mid ’00s.

In 2005, the company took significant steps to reduce costs and eliminate low margin products. Though revenue fell 15.7% from 2004, gross profit actually increased by 24% as gross margins rose from 19.75% to 29.08%. In 2006, the company appointed William R. Jackson as the company’s new CEO, which he remains. Over the next few years, Rockford fought to reduce costs and improve gross margins as sales continued to fall. The company also concentrated on repairing its balance sheet and succeeded in eliminating all its debt in 2010.

2010 brought a resurgence for Rockford, as Fosgate audio products finally showed a sales increase. Cost reductions made in previous years allowed the company to produce a record operating margin of 11.01%. Accumulated losses allowed the company to shield virtually all income from taxation and record a profit of $2.71 million, the highest since 2002. Since then, Rockford’s revenues have continued to increase and earnings have leaped to $7.38 million in the twelve trailing months, or $0.86 per share.

Rockford CEO William R. Jackson continues to express optimism in the company’s quarterly reports, noting that the company has recently signed an exclusive agreement to distribute Blaupunkt mobile electronics in the US.

Despite its successful turnaround, Rockford’s shares trade at $5.45 (+/- $0.05), only 6.3 times trailing earnings. The company’s management is aware of the discounted valuation and has announced a tender offer for up to $8.4 million at up to $5.60 per share. Rockford’s largest shareholder group owns 2.9 million shares and has agreed to tender 1.5 million of them. Because of this, the tender offer is guaranteed to be fully subscribed. After the transaction, Rockford will have about 7.06 million fully-diluted shares outstanding.

The company is funding its $8.4 million tender through its existing asset-based credit facility with Wells Fargo. The interest rate is currently around 4.5%. Because the spread between the interest rate and the earnings yield on the shares to be repurchased is so large, the transaction will be highly accretive to remaining shareholders. 1.5 million shares, each yielding $0.86 in annual earnings per share amounts to $1.29 million. The interest expense on $8.4 million in debt at 4.5% is $0.38 million. (The tax shield created by interest expense will not apply for several more years, as the the company works through its net operating losses.) After deducting interest expense, the tender offer results in an additional $910,000 or 13 cents per share in annual earnings for remaining shareholders. This might not seem like much, but it increases earnings yield from an already generous 15.8% to 18.2%.

I submit that a modestly indebted, growing company should not trade at an earnings yield of 18.2%.

Another important effect of the tender offer is the resulting changes in the shareholder base. 3K Limited Partnership, lead by Peter Kamin, is currently the second-largest shareholder and will become the largest by purchasing shares from another board member and seeing 1.5 million shares extinguished by the tender offer. Mr. Kamin is a respected value investor who has a long career with ValueAct Capital and now 3K. 3K describes its investment approach here. After the tender offer is complete, 80% of shares outstanding will be held by the three largest shareholders.

Risks to Rockford’s future success include the state of the economy and the popularity of custom care audio systems. As a highly discretionary item, audio system sales can be strongly affected by factors like wages, unemployment and consumer confidence. Additionally, the allure of vehicle ownership has diminished among the younger adults who make up the core of the car audio system market.

From an investment perspective, Rockford is exclusively a growth and multiple expansion thesis. The company’s market value is several times its book value, so investors should not look to the company’s physical assets to limit downside.

If the company can successfully maintain sales momentum, it seems likely that the market will eventually grant a higher P/E multiple. Even an increase to 8 times trailing earnings after accounting for the tender offer would yield a stock price of $7.92, a 45% increase from current levels.

 

Disclosure: No position. May add.