IEH Corporation – IEHC

IEH Corporation is a manufacturer of connectors for electronic systems. These connectors and other components are used mainly for military and medical applications. The company employs a technology known as the “hyperboloid connector,” which is explained in a very helpful video on the company’s website. The company is based in Brooklyn, NY and was founded by Louis Offerman in 1937. Today, Michael Offerman is the company’s CEO and largest shareholder. Notably, value investor Paul Sonkin’s Hummingbird Management, LLC owns 13.2% of the company.

IEH has been extremely successful over the last ten years, compounding book value per share at 26.8% annually and increasing revenues at 11.4% annually over the period. The company was profitable in every year.

As the company grew its profits, it deleveraged its balance sheet and retained earnings. The company’s current ratio of 12.12 and equity-to-capital ratio of 92.68% are decade highs.

Despite its recent history of growth and profitability, IEH trades at an extremely depressed valuation of 5.16 times trailing earnings and an EV/EBITDA of 2.25. Price to net current assets is 0.78 and price to tangible book value is 0.64.

Over the last six months, IEH’s share price has plummeted 41.25%.

So, why has the company’s stock fared so poorly? One reason may be the company’s relatively poor recent results. Since peaking in 2010, revenues have declined 4.6% to $13.18 for the trailing twelve months. Net income has been battered by a combination of shrinking revenues and gross margins and is down 38.9% from the 2010 peak. In my opinion, investors are suffering from recency bias, placing far too much weight on the company’s current results and ignoring its history of sales growth.

A big storm cloud hanging over the company is the threat of large cuts to the defense budget. In the year ended March 31, 2012, 60% of the company’s sales were to the military market. Should the US congress fail to reach a compromise, the “fiscal cliff” could send the company’s revenues over a cliff of their own.

Another significant risk is the company’s poor working capital management. Despite producing $7.35 million in profits in the 8.5 years since 2002, the company produced just $1.32 million in free cash flow. Capital expenditures accounted for only $2.13 of the difference. The rest was consumed by continually increasing investment in net working capital, inventory in particular. Since 2008, the company’s rate of inventory turnover, net working capital turnover and asset turnover have steadily declined.

Continually declining turnover is a very troubling sign that indicates the company is using its assets less and less efficiently. As inventory turns decline, inventory is held longer on average, increasing the possibility of obsolescence and write-downs. Also, declining asset turnover hurts return on equity, ultimately reducing the company’s market value relative to its book value.

Reducing net working capital to 2008 levels relative to sales would free up $3.87 million in cash, equal to 73.9% of the company’s entire market capitalization. Even a more modest increase of one net working capital turn (achieved by reducing net investment in working capital) would free up $2.37 million in cash. Disinvestment in net working capital can be achieved by reducing current assets like accounts receivable and inventory, or by allowing current liabilities like accounts payable and accrued expenses to increase. The latter seems doable, as current liabilities are at their lowest in the past decade.

Another possibility for the company would be to take on a small amount of debt and use the proceeds to repurchase shares or pay a special dividend. Even taking on $1.1 million in debt, equal to 0.5 times trailing EBITDA, would enable the company to pay a special dividend of 47.8 cents per share, or repurchase 21% of shares outstanding at current prices.

IEH faces a difficult future with uncertainties around the military budget and its recent decline in revenues. However, the company is statistically cheap enough that patient investors may see a lot to like. IEH’s excellent balance sheet and discount to net asset value should provide downside protection while investors wait for the company to get back on the right track.

 

Disclosure: No position.

ALJ Regional Holdings Sells Kentucky Electric Steel – ALJJ

Today ALJ Regional Holdings announced an agreement to sell its sole operating subsidiary, KEC Acquisition Company,  to Optima Specialty Steel for $112.5 million. After paying off all debt, ALJ Regional Holdings will have about $51 million in cash, or $0.86 per share.

This is an extremely impressive accomplishment for the company and a great result for shareholders. In Mr. Ravich’s own words:

“I am very proud of what we have accomplished today for our stockholders. When the current members of the board joined ALJ, it had no operating business, less than one million dollars in cash, liabilities of over $14 million and an accumulated deficit of over $340 million. Through the hard work of the board, the support of our lenders and the amazing job of our employees and management company, Pinnacle Steel, LLC, pro forma for the merger, ALJ will have over $50 million in cash, no debt and stockholders’ equity of over $50 million.”

I first wrote about ALJ Regional Holdings back in August, when the company was trading at 43 cents per share. At that time I made the case for ALJ being significantly undervalued under even the most pessimistic assumptions. Under the scenarios I laid out, a simple continuation of the deleveraging process and a gradual re-rating to a market average multiple would result in an IRR north of 20% over the space of a few years. Turns out investors won’t have to wait that long and will instead see a huge return on their investment in just a short time.

In addition to announcing the sale of its operating company, ALJ Regional Holdings unveiled plans to tender for 50% of shares outstanding at a price of 84 to 86 cents per share. Mr. Ravich, owner of more than 23% of shares outstanding, will not be tendering his shares.

Following the tender offer, ALJ intends to use its remaining capital to seek another acquisition target. The company will still possess millions in valuable tax loss carryforwards. The company cautions that finding a viable acquisition candidate may take a while, or may not happen at all. Investors must decide if they want to stay invested under Mr. Ravich’s leadership, or take the cash and look for another opportunity. I am willing to bet Mr. Ravich can repeat his success.

The sale transaction is scheduled to be completed in December, after which the tender offer will executed. Optima Specialty Steel still must line up deal financing, but ALJ Regional Holdings does not seem to view this as a big risk.

I will be transferring ALJ Regional Holdings to the “Inactive Ideas” section of the blog, where it will join Abatix Corp. as an example of an OTCBB/Pink Sheets that has produced market-beating returns for investors.

Disclosure: I own shares in ALJ Regional Holdings, but not as many as I wish I did! I am still assessing whether or not I will tender any or all of my shares.

Mexican Restaurants, Inc – CASA

Mexican Restaurants, Inc. owns and operates 52 Mexican (surprised?) restaurants in Texas, Oklahoma and Louisiana, and operates another 13 via franchisees. The company’s brands include Casa Olé, Crazy Jose’s, Mission Burrito, Monterey’s Little Mexico and Tortuga Mexican kitchen.

MR delisted from the NASDAQ in early 2011 after running into problems caused by over-expansion, excess debt and weak consumer spending. Since then, the company has closed unprofitable restaurants, paid off debt and sought to improve operating efficiency. These efforts are paying off and the company returned to profitability this year.

The market has yet to appreciate the company’s turnaround. MR trades at rarely-seen ratios and multiples. On a twelve trailing month basis, the company’s enterprise value to adjusted EBITDA ratio is 1.46. (I have adjusted EBITDA to account for one-time expenses like restaurant closings and losses on assets sold.) The company’s market capitalization is $3.82 million versus common book equity of $10.30 million. Free cash flow yield is 33.4%. Here’s a look at the company’s results for the past few years. EBITDA and operating income are adjusted for one-time items. Net income is not.

Revenues troughed in 2010, rebounding slightly since. Revenues are unlikely to regain previous highs any time soon, as the company has shut down multiple poorly-performing locations since 2008. The company reported a small profit over the twelve trailing months for the first time since 2007, earning $0.28 million or 6.5 cents per share. The company had a total of $3.8 million in federal tax credit carryforwards and net operating loss carryforwards which will shield the company from federal taxation for years to come.

The company’s reported trailing profit understates earnings power due to a few one-time items that affected MR in the past year. In the four trailing quarters, the company recorded an asset impairment of $471,730 related to two under-performing owned restaurants. The company also recorded a loss on the sale of equipment of $26,017, a restaurant closing expense of $9,491 and a bad debt charge of $150,426. MR did not experience any bad debt losses in the previous two years, so I think it is safe to label this expense a one-time item. These one-time items sum to $657,664.

Due to the company’s large loss carryforwards, these items can be added to the bottom line without accounting for federal tax. Assuming these figures are reasonable, Mexican Restaurants’ adjusted trailing net income is $0.94 million, or 21.6 cents per share. Evidence for this much higher adjusted net income figure is provided by free cash flow, which totaled 29.4 cents per share over the same time period.

As the company has made operational headway, it has also progressed in deleveraging its balance sheet. MR has a line of credit with Wells Fargo and has remaining obligations related to lease settlements on closed restaurants. Since 2008, the company has reduced these debt and obligation balances from $8.10 million to $2.14 million. The company’s line of credit current has a balance of $2.00 million and expires in mid-2013. MR is in negotiations with Wells Fargo to extend the credit line. Once the company finishes up the debt reduction process, substantial cash flow will be freed to reward shareholders via investments in new restaurants or dividends and share repurchases.

There is a wrinkle in the company’s capital structure. In 2011, the company sold 800,000 shares of preferred stock to officers at $1.25 per share, as well as 125,000 warrants. These preferred shares are convertible into common stock on a 1 to 1 basis and bear interest at 8%. Interest on these shares accrues in the form of additional shares until May 15, 2013. I have included these shares in diluted shares outstanding. The warrants were issued with a strike price of $2.00. Since insiders already owned a majority of shares outstanding, this transaction had the effect of solidifying management’s control over the company.

Mexican Restaurants, Inc. trades infrequently and at a large bid/ask spread, currently $0.75/$1.00. At the price mid-point of $0.875, the company’s pro-forma P/E is 4.05 and price to free cash flow is 3.82. If the company can continue to improve operating margins and extend its line of credit, investors may be looking at an extremely cheap stock.

It should be noted that MR, like many retail and restaurant operators, has large off-balance sheet operating lease obligations. Many of these leases are noncancelable.  In ordinary environments this may not be an issue, but a steep economic downturn could leave the company scrambling to make rent. Many companies have been done in by lease payment obligations. Mid-market Mexican restaurants are not as economically sensitive as say, a jewelry store or classy steakhouse, but they still depend on consumers opening their wallets for a discretionary purchase. Quality of management is a risk as well. One hopes the company’s insiders were chastened by the disastrous over-expansion of the mid 2000s, but the possibility remains that history will repeat itself.

Disclosure: No position.

Advant-e Reports Record Earnings, Tells Small Shareholders to Get Lost – ADVC

Advant-e released strong third quarter results yesterday. Revenues rose 5.3% from last year and net income rose 22.1%. Earnings for the four trailing quarters rose to $1.93 million, a record. The company’s cash on hand now tallies $5.11 million. Advant-e now sports a trailing P/E of 9.2 and an Enterprise Value/EBIT ratio of 4.4. Advant-e remains cheap, growing and over-capitalized. The company’s Edict Systems subsidiary has momentum behind it and gross and operating margins are hitting new highs.

Just as the company’s future looks brighter than ever, management has chosen to give small shareholders the boot. On Monday the company revealed plans to execute a 1 for 10,000 reverse split and cash out investors owning fewer than 10,000 shares at 27 cents per share. Following the reverse split, Advant-e will execute a 100 for 1 forward split and deregister its shares. Approval of the reverse split is a foregone conclusion, given CEO Jason K. Wadzinski’s ownership of 54.8% of shares outstanding. Following the split, Advant-e will cease reporting to the SEC.

In its 8-k filing describing the transaction, Advant-e does not detail the process it used to arrive at the 27 cents per share valuation. Often in the case of reverse splits, companies will hire a third party advisor to place a value on shares to be cashed out. The motivation is to avoid accusations of abusing small shareholders with a low-ball offer. The cash out price is usually set at a material premium to market price. Small Advant-e shareholders will not receive a material premium. The 27 cents per share represents only a 4.1% premium to the 30 day average trading price and a 7.9% premium to the average trading price. Less than two months ago, Advant-e traded up to 28 cents. The company plans to release a 14c statement describing the terms of the reverse split. It will be telling to see how the company determined such a paltry price to be fair to small shareholders.

I don’t call the price “paltry” lightly. A simple examination of the company’s financial results reveals how inadequate a sum of 27 cents per share is.

Growth and Earnings – Advant-e has grown its revenues at 9.5% annually since 2007. Earnings have grown by 18.5% annually over the same period. The company’s trailing net income of $1.93 million is 2.9 cents per share. Annualizing the latest quarter’s results yields earnings per share of 3.3 cents.

Free Cash Flow – The company’s free cash flow generation has been exceptional. Since 2007, free cash flow has been positive each year and has exceeded total net income by $0.53 million. Advant-e turned an amazing 17.1% of revenues into free cash flow in the period.

Capitalization – Advant-e has $5.11 million in cash on its balance sheet against zero debt. This cash amounts to 28.6% of the company’s market cap, or 7.7 cents per share. Assuming the company can operate normally with a current ratio of 2.0 (and nearly every company can) at least $3.85 million of this cash is excess, or 5.8 cents per share.

So, what is a growing company with 3.3 cents per share in annual earnings and 5.8 cents per share in excess cash worth? First, let’s assume that Advant-e’s growth immediately slows to 3% annually and remains there indefinitely. Second, let’s assume the company has a cost of equity of 15% given its small size and limited liquidity. Finance theory provides a formula for the present value of a company with a consistent rate of growth and cost of equity: next year’s earnings, divided by the cost of equity less the growth rate.

Under these assumptions, the present value of Advant-e’s earnings is $0.283. From there we can add excess cash to arrive at a full value per share of $0.341. This value is 26% higher than the company’s 27 cent reverse split value. And this valuation is extremely conservative. If the company can grow at 4% and the cost of equity is 12% rather than 15%, a share of Advant-e is worth $0.487, 80% more than the company’s offer.

In the November 5 8-k filing, CEO Jason W. Wadzinski characterizes the reverse split as a positive for smaller investors, saying the reverse split provides liquidity for smaller investors not wanting to continue holding shares in a non-reporting company. Mr. Wadzinksi goes on to say:

“We became a public company in 2000 to raise capital to help us complete our transition from a software provider to an Internet-based supply chain services provider. We are very grateful to our investors who risked their capital to enable us to execute our business plan.”

Translation: “You took a big risk in investing in us when we were much smaller and barely profitable. Now that we are bigger and more profitable than ever, I want my company back. Kindly accept this token payment for your shares and go.”

Mr. Wadzinski’s control over Advant-e will be solidified via the reverse split, and by the $2 million worth of shares the company plans to purchase in advance of the reverse split. Between the reverse split and the share repurchase, the company can expect to retire around 8.7 million shares at 27 cents. Mr. Wadzinski’s stake will rise from 54.8% to about 63%.

Smaller shareholders’ prospects of receiving fair value for their shares have not vanished entirely . Based on my readings of Delaware corporate law and related case law (and fair warning, I am NOT a lawyer) it appears that shareholders who are to have their shares canceled by a reverse split may exercise dissenters’ rights and receive an appraisal in Delaware chancery court. However, this process involves sending letters to the company notifying them of the investor’s wish to exercise these rights, providing proof of ownership, then waiting for the legal system to work. Even if the courts settled on a valuation of 50 cents per share, the investor would see a maximum benefit of $2,300 if a full 9,999 of their shares were to be canceled. While some investors might time the time and effort worthwhile, I suspect many more will simply accept the terms and move on.

An account I manage has a small position in Advant-e shares. Small enough that the entire position will be canceled in the reverse split. I am interested in hearing from other investors who have gone through a similar situation and what (if any) strategies may be employed to improve the chances of receiving fair value for these shares, beyond exercising dissenters’ rights.

 

 

Retail Holdings NV – RHDGF

Retail Holdings NV is a holding company with a market capitalization of $119.9 million. The company owns stakes in publicly-traded subsidiaries and also holds debt securities and some excess cash. The total asset value of the company’s underlying holdings is at least $142.2 million, 18.6% higher than the company’s market capitalization.

Singer Asia Limited

Retail Holdings’ primary asset is a 54.1% stake in Singer Asia Limited. Western investors may associate the “Singer” brand name with sewing machines. However, in Southeast Asia, Singer is an extremely well-known and successful retail chain that sells consumer durables like washing machines, televisions and kitchen appliances. Singer Asia owns hundreds of retail centers and also sells through thousands of wholesalers in India, Thailand, Bangladesh, Sri Lanka and Pakistan.

It should be noted that Retail Holdings once did own the Singer Sewing Machine Company, but sold it to a private equity firm for cash and promissory notes in 2004. (More on the promissory notes later.)

While Singer Asia itself is not publicly-traded, its subsidiary companies are.

While their values fluctuate with stock market movements, Singer Asia’s ownership interest in its subsidiaries has a public market value of $232.96 million. Singer Thailand is the company’s most valuable subsidiary, followed by Singer Sri Lanka. At December 31, 2011, Singer Asia had no debt and $2.6 million of corporate cash.

While some of the subsidiaries have appreciated in value recently, others have declined. On the whole, the value of these subsidiaries seems likely to grow in coming years as the Southeast Asian middle class grows in size and wealth. Singer Asia as a unit posted a 25.4% growth in revenues in 2011. Year over year revenues for the first six months of 2012 rose another 7.1%.

SVP Notes

In 2004, Retail Holdings sold its Singer Sewing Business and Singer Sewing trademark to KSIN Holdings for $134.6 million. Retail Holdings received $65.1 million in cash, transferred about $47 million in debt to KSIN Holdings and received the balance of the payment in unsecured, subordinated promissory notes with a principal value of $22.5 million, bearing interest at 10%. The notes were originally to be due one-third on September 30, 2010 and the balance one year later.

KSIN, subsequently renamed “SVP,” paid the interest on these notes dutifully until 2009 when the financial crisis put stress on the Singer Sewing business. Retail Holdings agreed to restructure the notes, extending their maturity and increasing the interest rate. This process has been repeated multiple times. The notes are now due in February 2014. On June 29, 2012, Retail Holdings announced a pay down of $5.0 million on the promissory notes at a 15% discount to notional value. This action reduced the principal value of the remaining notes to $21.6 million. While SVP continues to pay interest on these notes, the repeated difficulties suggest that SVP’s default risk is high and the notes should be treated as junk-level credits. If Retail Holdings were to sell the notes, receiving 100% of par value is not certain. Neither is final payment of the notes. Investors may be wise to assign a discount to par value when determining a valuation of Retail Holdings on the whole.

Retail Holdings NV Valuation

Retail Holdings owns 54.1% of Singer Asia Limited, yielding a market value of $126 million. Given the repeated extensions and restructurings afforded the SVP notes, a 25% discount seems warranted. The $126 million Singer Asia stake and the discounted SVP notes with par value of $16.2 million combined to equal $142.2 million. Retail Holdings and Singer Asia Limited each hold excess cash at the corporate level, but I have chosen to ignore these amounts for the sake of conservatism.

Retail Holding’s current market capitalization of $119.9 million represents a significant discount to asset value. Still many investors will ask: what’s the catalyst? What will cause Retail Holdings stock to appreciate to the value of its underlying assets? I believe fervently that value is its own catalyst. Retail Holdings has in fact appreciated from a low of around $13 in early 2011 to its current price of $22 and change. I have been lucky enough to participate in most of the rise. For investors who are not willing to wait around for convergence to intrinsic value, there are two factors that will accelerate Retail Holdings’ returns.

1. Dividend policy – Retail Holdings has been exceptionally generous in paying out its earnings to shareholders. Annual dividends in recent years have been well in excess of 10% of the share price. As free cash flow from Singer Asia and interest and principal payments on the SVP notes flow in, Retail Holdings has not been reluctant to distribute the excess to shareholders. Here are recent years’ dividend amounts per share:

2012 – $2.50

2011 – $2.50

2009 – $0.80

2008 – $0.75

2007 – $1.00

2. Long-Term Liquidation – CEO Stephen H. Goodman has repeatedly expressed his intention to liquidate the company over the medium term. Singer Asia has been gradually decreasing its stakes in its subsidiaries over the years. Singer Asia itself was rumored to be for sale in late 2011, but a transaction never transpired. Singer Bangladesh was under contract to be sold in 2010, but poor market conditions scuttled the sale. Mr. Goodman and his spouse together own 25.2% of shares outstanding, leaving him highly incentivized to maximize value.

Disclosure: Retail Holdings NV is my portfolio’s largest holding

 

Power Solutions International – PSIX

I was making another pass through the ranks of pink sheets and OTCBB stocks this week when I came upon on unfamiliar company with a healthy stock price of around $15, Power Solutions International. When looking at unlisted stocks, share prices over $5 or so immediately draw my attention. In my experience, the companies behind these stocks are far more likely to possess real revenues and profits than companies with share prices of $5 or lower. Plenty of companies with investment potential can be found trading below $5, but the hunting quickly becomes difficult as ones moves down the price scale. The ranks of companies with share prices below $0.50 or so seem to be populated almost entirely of zero-revenue “development” companies or those with operating income stuck perennially in the red.

But anyway, back to Power Solutions International. PSI designs and manufactures alternative fuel engines. The engines run on natural gas, propane or biofuels. They power a variety of machines such as generators, forklifts, oil&gas equipment and others.

In news that should surprise absolutely no one, the market for alternative fuels engines is growing by leaps and bounds. The low price of natural gas, especially, is driving demand for alternatives to traditional gas engines. Power Solutions international did $83 million in sales in 2009, but $186 million in the four trailing quarters. That’s a 38% annual revenue growth rate. What’s more, unlike many alternative energy companies, PSI is profitable! The company produced $6.1 million in operating income in 2009 and grew the figure to $11.37 million in the four trailing quarters.

Revenue in the second quarter of 2012 hit an annualized run rate of just over $200 million.  For such a rapidly-growing company in a hot industry, PSI’s valuation is very conservative. With a market cap of $131.6 million, PSI trades at 11.6 times trailing operating income and 9.7 times the most recent quarter’s annualized results. As revenues and profits continue to grow, these multiples will drop rapidly.

There are reasons to believe revenues will continue to rise. The potential of natural gas-powered engines is only just beginning to be recognized. As infrastructure is created to support natural gas-powered machines and engines, these engines will become a more viable choice for businesses and eventually consumers. The government plays a role in encouraging cleaner-burning natural gas engines too, by creating demanding emissions standards. PSI’s recently-introduced 8.8 liter engine is designed for use in both off and on-road markets. Previously the company competed almost exclusively in off-road markets. The company is also moving into the hybrid engine market.

Despite the company’s remarkable growth and consistent profitability, Power Solutions International flies almost entirely under the radar due to its unlisted status. While PSI languishes at 0.70 times trailing 4 quarters revenues, but unprofitable NASDAQ-traded competitor Westport Innovations is valued at 3.8 times revenues.

At present, SEC rules prevent companies that went public through reverse mergers from listing on a national exchange until 12 months have passed and at least one fully-audited annual report has been filed. (Power Solutions went public via reverse merger with a shell company. PSI itself has been in business since 1985.) PSI should fulfill these requirements after the December 31, 2012 annual report is filed. At that point, I would not be surprised to see an uplisting. As a quickly-growing, profitable company in a niche market space, I expect PSI to attract a lot of attention and quickly be granted a higher multiple.

What I present here is only a quick summary of Power Solutions International’s investment potential, but there’s a good deal of information out there for investors wanting to know more.

A recent presentation given by the company

A great write-up at Microcap Club

The usual caveats apply. PSI is a small competitor in its industry and may not have the research capabilities or bankroll of larger companies. Natural gas prices could rocket and make natural gas engines uneconomical. The company’s shares are illiquid.

No position.

And now for a few housekeeping matters. First, I’d like to apologize for the low volume of posts lately. The old day job has been especially demanding. I appreciate your readership and I hope you will follow this blog via email or Twitter. Both are linked in the sidebar to the right.

As a result of an onslaught of spam comments over the last two weeks, I have been forced to install a captcha system for comments. Yes, captcha is annoying, but so is clicking “spam” on 100 comments advertising pharmaceuticals.