Value Investing Strategy and Unlisted Securities – Part 2

Now for part two of my series on my investment philosophy, asset-based/low expectations investing. In part one I described how investing in excellent companies and letting them compound over time can produce very attractive returns. Problem: these companies are very rare. Much more common are middling companies with middling competitive positions earning middling returns on equity. And then there are the underachievers: companies with eroding revenue bases, bloated operating structures, foolish or greedy management or a complete lack of concern for shareholders. This part addresses these unattractive companies.

Profitable, growing business are typically valued by the market at some multiple of annual income or cash flow. Weak, loss-making or shrinking business are often valued by the market at the resale or liquidation value of the company’s assets less all liabilities. Let’s use an analogy.

A strong business is like a healthy orchard of fruit trees. Each year the orchard produces a crop. The size of the crop varies from year to year with the weather, but over time the size of the crop increases as the trees grow and mature. The value of this orchard is the present value of all future crops (less expenses), just as the value of a healthy company is the present value of all future free cash flows to equity.

On the other hand, a weak business is like an orchard full of old, diseased or dying fruit trees. These trees do not produce a crop large enough to justify occupying valuable land. The typical buyer will not look at this orchard and try to value future crops. Instead he will survey the orchard and estimate how many cords of firewood the trees would make.

While an investor would value the health orchard using an earnings-based approach, he would value the unhealthy orchard using an asset-based approach.

In the first post of this series, we examined the fictional “Widgets ‘R Us Company,” an extremely high-quality, successful manufacturer. Now let’s examine “Sprockets ‘N Stuff,” WRU’s competitor. SNS has been in business since 1950 and has weathered many business cycles and changing markets, but at last seems to have run out of tricks. SNS’s plant and equipment is old and prone to breakdowns. Its chief product line is losing market share to WRU’s more innovative and better-made alternatives.  SNS’s management is disengaged and spends as many hours on the golf course as in the office. What’s more, the company faces a class-action lawsuit from retired employees alleging exposure to toxic chemicals during their employment. Because of these issues and others, the company has not managed a profit in three years and sales are down 30% from their peak. Without any new products in the pipeline and with WRU competing more fiercely each quarter, SNS’s prospects are very dim.

Over the past year, SNS shares are down 75% to $1.50. With 20 million shares outstanding, the company has a market capitalization of $30 million. Here’s the company’s balance sheet:

SNS balance sheet

Though SNS has little value from an earnings-based perspective, it looks very strong from an asset-based perspective. SNS is financially healthy, at least for the time being. Current assets are more than three times current liabilities and total debt equals total cash. Liabilities make up just 20% of the total capital structure.

Is $50 million an attractive price to pay for SNS’s “firewood” potential? Investors should recognize that financial statements rarely tell the whole picture in a liquidation scenario. Unless otherwise noted, company financial statements are prepared on a going-concern basis that assumes the company will operate indefinitely. Balance sheet values can suddenly look very different when liquidation comes into play.

Let’s make some necessary adjustments to SNS’s balance sheet to better reflect a liquidation scenario. The notes to a company’s financial statements are absolutely essential reading. In them, a company often reveals critical information that can dramatically change an investor’s calculation of a business’s value. Let’s say we carefully examine SNS’s financial statement notes and have come up with the following relevant items.

Inventories – SNS has $25 million in book inventory, but the company reveals a $20 million LIFO reserve in the notes. LIFO (last in, last out) is an accounting treatment available to US manufacturers that essentially increases cost of goods sold, decreases taxable income and artificially deflates the book value of inventory. A detailed explanation is available here. Companies that have operated and grown for many years in an environment of increasing inventory costs can have substantial LIFO reserves.

Real Estate – Net of depreciation and amortization, SNS has $65 million in property, plant and equipment on its books. In its notes, the company reveals this amount breaks down to $10 million in land, $5 million in buildings and improvements and $50 million in equipment. Under US GAAP, the value of company land is recorded at cost. Because land has tended to appreciate over time in many areas, the market value of land is often higher than its book value. Looking back at older financial statements, it appears this $10 million in land was purchased some time in the 1970s. Assuming a 1975 purchase date and 2% annual appreciation, this land how has a market value of $21.2 million. This value may still be understated given the periods of high inflation that have occurred in the interim. Regardless of the exact figure, this appreciated land is a source of hidden value.

Investment in Equity-Accounted Associate – SNS’s notes include a discussion of a 10% stake it owns in an affiliated company, SNS Europe. Because SNS’s stake in SNS Europe is small, the company uses the equity method of accounting for its investment, recording its cost and then adding its proportional share of SNS’s Europe’s profits to its book value each year. Last year this amount was $1 million because SNS Europe’s yearly profit was $10 million. SNS Europe is a healthy company with none of the issues facing SNS, and is probably worth at least 10 times earnings, or $100 million. Although SNS’s stake in SNS Europe is carried on the balance sheet at $7 million, the stake could likely be sold for $10 million or more.

There are many sources of hidden value that don’t appear at first glance. However, there are also hidden liabilities. SNS notes a few of those as well.

Litigation – While SNS is being sued by former employees, it has not recorded a liability on its balance sheet because it “believes the allegations are without merit and intends to mount a vigorous defense.” Though the company seems confident, investors without some advanced knowledge of the strength of the claims (that is, virtually everyone) should be cautious and assume the company will bear at least some liability. SNS notes the suit against it is claiming $5 million in damages, and investors should include at least the majority of this amount in any calculation of liquidation value.

Take or Pay Contracts – SNS notes that because its input costs are volatile, it has entered into contracts with several suppliers guaranteeing prices for the next three years on $12 million of inputs. These contracts are “take or pay” contracts, meaning SNS is responsible for payment even if it does not take delivery of the inputs. In a liquidation scenario, SNS will be responsible for paying off or otherwise discharging these contracts. Perhaps the company could sell these contracts to a competitor or otherwise settle with the suppliers, but investors should conservatively assume a negative outcome.

Golden Parachutes – In SNS’s proxy statement it discloses certain benefits due to management if for any reason the company ceases to operate or otherwise undergoes a restructuring resulting in termination of management’s employment. If management is terminated (with or without cause) then $11 million in deferred compensation accelerates and all management’s stock options vest immediately. This stipulation may seem egregious given the size of the company, but arrangements like this are all too common, especially in companies with poor corporate governance and absentee boards of directors.

Having looked at potential hidden assets and liabilities, here is SNS’s adjusted liquidation value.

adjusted liquidation

With a market capitalization of $30 million, it seems as though SNS is trading at a steep discount to liquidation value. Not so fast! This analysis assumes that if all the company’s assets were sold off, full book value could be realized. Unfortunately, this is rarely the case. Liquidation analysis take these issues into account by applying discounted valuations to a company’s assets. Assets with good liquidity like cash and accounts receivable are given small discounts, while illiquid assets such as equipment are given large discounts. Intangible assets like goodwill are usually given no value at all.

Let’s set about applying discounts to SNS’s assets.

discounted adjusted liquidation

After applying reasonable discounts to SNS’s assets, it appears the company trades at a 37% discount to liquidation value. Keep in mind that we still have not included possible expenses like legal fees, auction fees or taxes due on the sale of appreciated real estate or securities. What’s more, liabilities have a nasty habit of inflating when a company is on its way to oblivion. When it comes to liquidation analysis, conservatism is the name of the game. When valuing companies on the basis of net assets, investors should seek to buy in only at a significant discount to a conservatively estimated value of net assets.

There are several other factors that investors must consider when investing based on an asset-based/liquidation thesis.

Time – When investing in high-quality, compounding companies, time is one’s friend. With every month and year that passes, a high-quality company will be generating free cash flow, making solid investments and building its brand. Low-quality companies, on the other hand, are destroying value by generating losses, burning through working capital or simply meandering along at break-even and tying up valuable investor capital. Because each day represents a loss of economic value and/or an opportunity costs, investors in low-quality companies are hoping and praying for a change to come sooner rather than later. The longer things go on without a change in strategy, management or economic conditions, the greater the likelihood of a permanently-impaired investment.

Management – Like time, management is the friend of the investor in high-quality companies but often the foe of investors in low-quality enterprises. After all, there is often a human reason for a company’s poor performance, be it a foolish acquisition, ignorance of customer needs or sheer repeated boneheaded decisions. Investors in low-quality companies should assess the likelihood that management can be persuaded to shift course or if activist investors could be successful in replacing the worst of the worst. The more entrenched management is and the weaker the board, the less likely that investors can hope for change.

Certainty – The composition of a company’s assets and liabilities is tremendously important. Companies with large cash balances and lots of liquid assets are typically safer than companies with balance sheets dominated by depreciated equipment. Companies that are primarily-equity financed are generally safer than those with high liabilities to assets. Investors should adjust the “margin of safety” they demand for the composition and quality of a company’s assets. Riskier liquidation scenarios require much larger discounts to net asset value.

The Pain Factor – Holding low-quality, continually wheel-spinning companies can hurt. Just as high-quality companies are reporting higher book values and profits, low-quality companies will frequently be reporting yet another profitless quarter and dubious product launch. It’s easy to question the logic of investing at all. However, those with patience and confidence in these companies’ asset values may find themselves rewarded down the line.

So, what now? Can a strategy based on investing in companies trading at a fraction of conservatively-estimated liquidation value and then waiting for liquidation to occur provide attractive returns? The truth, as it usually is in life, is more complicated. Perhaps the biggest problem is one of finding opportunities. Just as only a small set of companies truly can compound value for decade after decade, surprisingly few companies actually liquidate. Sure, failing companies go through the bankruptcy process regularly, but many of these companies restructure and emerge once again as going concerns. Others liquidate, but yield nothing to equity investors as senior claims dwarf assets. Only a tiny number of companies go through the liquidation process and make distributions to shareholders.

But, here’s the thing. When investing in companies on an asset-based or liquidation basis, you shouldn’t actually hope for liquidation. Sure, sometimes liquidation works out well, but more often it represents the failure of a company to regain its health and profitability and results in a total loss for shareholders. Rather than hoping to gain through the liquidation process, an investor should hope to gain through low expectations and mean reversion.

Companies that trade at a fraction of their liquidation values all have one thing in common: low expectations. These companies, with their loss-making operations, eroding revenue streams, bumbling management and demoralized employees are expected to go on doing the exact same thing until they reach bankruptcy court. Nobody is surprised when a quarterly report comes in and the company reveals continued losses and no reasonable hope of better things to come. That’s why whenever one of these companies does reveal a positive development, their shares can respond dramatically. It’s the reverse of the phenomenon often seen with high-profile growth stocks like or Netflix. Investor expectations for these companies are sky high. When releases quarterly earnings and revenues are up 20%, the share price may not move because everyone expected a great performance. On the other hand, if reports quarterly growth of only 10%, shares plummet because the market hates to be disappointed when expectations are lofty.

Let’s go back to the orchard analogy for a moment. One day a wise investor goes out and examines 10 orchards full of diseased and dying trees. After examining each orchard, she offers to buy each for $10,000 dollars, having estimated that chopping down the trees would yield $15,000 per orchard after all expenses. Meanwhile, a healthy orchard goes for $50,000. She spends $100,000 buying these 10 orchards. All of her investing friends laugh at her behind her back. This crafty investor is unfazed because she knows that in a worst case scenario, she can profit $50,000 by “liquidating” the orchards. However, she also knows that some of these orchards have life left in them, that some of them will recover their vitality and resume producing crops. Which ones, she is not sure, hence the purchase of 10 orchards. A year goes by. One of the orchards fights off the fruit blight that was afflicting it and becomes an unusually productive orchard worth $75,000. Another two orchards regain a portion of their health and produce a small crop, raising their value to $25,000. Five of the orchards experience no change in their conditions, leaving their value unchanged at $10,000 each. And finally, two of the orchards are inundated when a river changes course, putting them under water and wiping out their value completely. The investor sells all of the properties she bought last year for proceeds of $175,000, earning a substantial profit.

What the investor used to her benefit was the phenomenon of mean reversion. In economic terms, mean reversion describes the tendency of companies (and a lot of other things) exhibiting extreme characteristics to revert to average (mean) characteristics over time. A multitude of studies have recorded the tendency of companies producing high returns on equity to produce returns on equity closer to the industry average in following periods. By the same token, companies recording poor returns on equity have a tendency to see their returns on equity increase as time passes. The reasons for this tendency are many, but they include the effects of competition as competitors enter high-return businesses and exit low-return businesses.

Investors can accomplish the same by purchasing baskets of securities that are priced at a fraction of liquidation value. While a few of these companies will likely be total wash-outs as net asset value declines to zero, a few of these companies are likely to turn around and produce outstanding returns. It is extremely difficult to determine in advance which will languish and which will thrive, hence the basket approach recommended by Benjamin Graham. While SNS may or may not recover, a basket of firms in different industries also trading at a discount to liquidation value will very likely contain some big winners.

Opportunities like these are available within the ranks of unlisted securities. In fact, I think they are relatively more abundant than among the ranks of NYSE and NASDAQ-listed companies. I cover several hundred unlisted stocks, most of which are profitable and have solidly positive book values. Of these, over one hundred trade at a discount to book value. I suspect many of these have hidden assets much like our fictional SNS.

An even more conservative measure of liquidation value uses a methodology known as “net current asset value.” “Net-nets,” as they are called, are stocks which have a market value that is less than the value of their current assets less all liabilities. The theory behind this methodology is that current assets tend to be liquid and their value more or less objective. Purchasing a company for less than the value of these current assets less all liabilities entails receiving all non-current assets for free. Benjamin Graham recommended purchasing these securities at 66% or less of their net current asset value and waiting for convergence. Unfortunately, the years-long market rally has all but eliminated these opportunities. Whereas there were hundreds of net-nets at the end of 2008, I now know of only 50 or so that trade on the pink sheets or the OTCBB.

In my experience, the returns of asset-based/low expectations tend to be cyclical. The greatest returns come at the beginning of economic expansions as companies that were once left for dead show signs of life. Most investors will benefit from some strategy diversification in their portfolios. Owning both high-quality compounding companies and baskets of low-quality mean reversion can provide some protection during contractions as well as some enhanced upside during expansions, so long as one has the courage to invest in low-quality companies just as things seem the darkest.

Thanks for reading! I will be back next week with the third and final part of this series on my basic investment philosophy – Information Flow Investing.


International Wire Group Is Cheap, But Is It Safe? – ITWG

My series on investing strategy will continue next week. Until then, let’s examine an aggressive manufacturing company, International Wire Group.

International Wire is the largest bare wire and copper wire products manufacturer in the United States with revenues of $870 million in 2011. International Wire is an aggressive acquirer. Beginning in the late 1990s, International Wire began acquiring numerous smaller companies and divisions in the US and Europe. Unfortunately, this acquisition spree lead to lead to excessive debt and the company was forced to seek bankruptcy protection in 2004.

International Wire Group shed hundreds of millions in debt in the bankruptcy process and emerged from bankruptcy in 2005. Since then, the company has been on a tear. From the beginning of 2005 to the end of the third quarter of the 2012, the company produced total net income of $84.5 million and free cash flow of $218 million. The company has used its staggering free cash flow to pay multiple large special dividends and repurchase stock, paying out nearly $250 million to shareholders since emerging from bankruptcy. (This $250 million is nearly 2.5 times the company’s present market capitalization.

While it has been extremely successful and generous to its shareholders, International Wire has taken on more and more debt to fund distributions. Since hitting a low of $80.25 million in 2009, International Wire has tripled its debt to more than $250 million. In December, the company used $60 million to repurchase 3.67 million shares of its stock, fully 37.4% of diluted shares outstanding.

After the repurchase, International wire has about 6.37 million shares outstanding and trades with a bid/ask mid-point of $17.75 for a market capitalization of about $109 million. Trailing net income is $21.6 million for a trailing P/E of 5.0. Present net debt is around $270-$275 million, per estimates by Standard & Poor’s. (Subsequent to quarter’s end, the company issued $250 million in debt due 2017 at an 8.5% coupon and used the proceeds to redeem all previously outstanding term debt and fund the stock repurchase. The company is expected to have funded debt redemption beyond the limits of the new debt issue by drawing on its revolving credit facility. The company also is expected to have $10-$15 million in cash on hand at the end of 2012.) The company’s enterprise value is about $379-$384 million, or about 5.0 times trailing EBITDA.

On current earnings and EBITDA, International Wire seems attractively valued. After all, a 20% earnings yield is nothing to scoff at. Net debt is worryingly high at 3.8 times EBITDA and 4.9 times operating income, but the interest payments are still easily covered. Unfortunately, International Wire Group operates in a cyclical industry and extrapolating current levels of revenue and income would be foolish. As recently as 2009, the company managed revenues of just $450 million and adjusted operating income of just $18.7 million. $18.7 million is not enough to cover the interest expense of the company’s new $250 million debt issue. Should economic conditions take a multi-year turn for the worse, International Wire might quickly find itself in some trouble. Standard & Poor’s apparently agrees, having assigned an extremely speculative rating of “B” to the company’s new debt issue.

So why does International Wire Group choose such an aggressive capital structure policy? The reason may have something to do with Chairman of the Board Hugh Wilson. In addition to being chairman of International Wire, Mr. Wilson is a managing partner of Tennenbaum Partners, an investment company that focuses on debt financing for small and mid-tier companies. Tennenbaum Partners is the investment advisor for publicly-traded TCP Capital, a business development company that held International Wire’s older debt securities and now owns a portion of the 2017 8.5% notes. TCP Capital also owns 1 million shares or 15.7% of International Wire’s shares outstanding. With Mr. Wilson at the board’s helm, International Wire would perhaps chart a more conservative path in regards to its capital structure having seen the effects of excess debt in 2004.

Depending on pricing and demand for its products, International Wire may perform exceptionally well, gracing its shareholders with additional large special dividends and continued share repurchases. Highly-leveraged companies usually do extremely well in strengthening economies.

On the other hand, the company may struggle if the economy retrenches and interest expense takes a bigger bite out of operating income.

Being right could make an investor a lot of money. However, I am simply not confident enough in the company’s ability to withstand adverse conditions should they arise. Yes, the prospect of buying into a company with a history of large distributions to shareholders at 5 times earnings is attractive. But I have a list of other growing companies trading at 5-7 times earnings without a giant debt load. Knowing that, International Wire goes on the watch list for now. The company might be a great buy in the middle of the next recession when the market is acting like no one will ever buy copper wire again. In late 2008/early 2009, International Wire Group traded all the way down to $8.50 per share, only to distribute $15.52 per share in the dividends in the three following years!


Disclosure: No position.

Value Investing Strategy and Unlisted Securities – Part 1

Note: What follows is the first entry in a multi-part essay on my basic investment philosophy. If you’re here mostly for individual stock commentary, let me save you some time by telling you to come back next time you see a post with a ticker in the title. As always, thanks for reading!

I have come to believe there are only two basic strategies for succeeding in long-term value investing, and a third strategy that is a combination of the two. By “long-term value investing” I mean attempting to buy companies for significantly less than their intrinsic value, then holding until the market recognizes this value or until it becomes apparent that actual intrinsic value is far less than the investor’s original estimation.

Strategy One: I’ll refer to this strategy as “Quality Compounding.” The idea is to buy excellent companies at a fair price and let compounding work for you. The best-known advocate of this strategy is one Warren Buffett, who has created billions in value for himself and his shareholders by buying excellent companies and then simply letting them run. A truly excellent business has characteristics like high gross and operating margins, sustainable pricing power, high returns on capital, little or no need for financial leverage and the ability to retain and reinvest earnings at high rates.

For example, let’s imagine a fictional “Widgets ‘R Us Company” that produces a variety of specialized industrial components. “WRU” is known for the high quality and reliability of its products and so they command premium prices. These products are also essential components that must be replaced regularly for factories and facilities to function, so WRU enjoys the ability to raise prices at least as quickly as inflation. WRU’s efficient operations and proximity to customers make it the low-cost producer and allow it to produce a return on equity of 20% without using any debt. Furthermore, let’s assume WRU’s small size and penchant for innovation will allow it to maintain this 20% return on equity for many years to come while retaining all profits.

Clearly, this fictional company is exceptional. How many companies possess all these characteristics at once? Companies that possess at least some of these characteristics are often identified as having a “moat,” a set of unique properties that (much like a castle’s water feature) will allow them to fend off competition and continue to reap substantial excess profits. True economic moats are rare, and investors have a tendency to see them where they aren’t actually present. Many once-dominant companies have seen their empires crumble. Investors should be cautious when assessing the presence of a moat, remembering perceived moats have a distressing tendency to evaporate nearly overnight. (Although in a way, every profitable company has at least a small moat. Every dollar of profit a company makes is a dollar another company is not making. A business’s sheer existence provides some momentum.)

Back to WRU. If the company truly does have a moat and can maintain its return on equity over the long run, returns for shareholders will be exceptional. Let’s say WRU has a book value of $100 million. At a return on equity of 20%, WRU will earn $20 million this year. Let’s also assume the market recognizes WRU’s exceptional prospects and currently values WRU at 5 times book value, or 25 times forward earnings.

If WRU can maintain a 20% return on equity while retaining all earnings for the next two decades, book value will grow to $3,834 million. At this point, WRU’s market valuation will depend on the market’s assessment of its future prospects. If WRU seems likely to maintain all the original characteristics that lead to its success, the market may award a valuation similar to the original of 5.0 times book value. If on the other hand WRU’s prospects now seem more limited, perhaps the market will value the company at only 2.0 times book value. The chart below illustrates various valuation multiples and the 20 year compounded returns for each scenario.


Clearly, investors will do spectacularly if the market’s perception and valuation of WRU is unchanged after twenty years. On the other hand, investors will still do impressively well if the market is only willing to pay twice book value in 20 years, a 60% reduction from the present valuation. The lesson is this: long-term investment returns are driven primarily by business performance, not by market opinion. This is Buffett’s famous “the market is a short-term voting machine, long-term weighing machine” analogy. And it’s not just folk wisdom, it’s math.

Another important observation pertains to WRU’s initial valuation. At 5 times book value and 25 times forward earnings, many “value” investors would not give WRU a second glance. However, in WRU’s case, 25 times forward earnings was actually far too cheap! Even if WRU’s valuation declines to 2.0 times book value over the twenty years, an investor at the beginning could pay 57 times forward earnings and still earn a 10% compounded annual return.

Could successful investing really be this simple? Identify an excellent company, pay almost any price and enjoy eye-popping returns over the next several decades? The answer, of course, is no. Part of the problem is the difficulty of identifying ex-ante which companies will be capable of earning a high return on equity and reinvesting these profits at high rates over the long run. Companies enjoying high returns on equity in the present have a sad tendency to experience mean reversion as competitors enter the fray or as customer needs and tastes change or as rising input prices cannot be passed on to customers. In short, moats tend to be temporary and illusory.

Another problem is the tendency of companies to run short of reinvestment opportunities with size. As companies near the end of their high growth phases, they tend to behave either wisely or stupidly. Wisely often means paying dividends, making prudent share repurchases or small, accretive acquisitions that add pricing power and growth potential. Stupidly often means engaging in reckless, wildly optimistic mergers, attempting to enter new lines of business where management has no expertise or advantage or simply engaging in empire building. (For an example of all three, see Hewlett-Packard.)

Yet another issue is the fact that companies displaying all of these qualities are exceedingly rare, and the best are unlikely to ever go public in the first place. As the owner of an exceptional business, why would you ever sell a portion to the public if your returns from other investments are unlikely to outperform the shares you are selling? And on the other hand, if you are a CEO of a large company that has identified a smaller company with all these characteristics, why would you not buy the smaller company outright and reap all the rewards?

So then, how does one go about finding these rare jewels? Very carefully, and with a skeptical eye. The qualities of a true compounding champion have been explained far better than I can by people much brighter than I am, so I’ll refer you to the writings of investors like Warren Buffett or Murray Stahl of Horizon Kinetics for a the broad view.

I look at history. I like to see a long history of increasing revenues and profits. But not profit at any cost; I want to see growth in revenues and profits at least equaling and preferably exceeding growth in assets and equity. Declining turnover indicates declining profitability and declining return on equity. And, I want to see management substantially invested in the company, their own fortunes riding on the company’s successes. I think investors substantially underestimate the effects of principal-agent conflicts. I don’t want to see management betting the firm in hopes of a big year-end bonus, but nor do I want to see management lounging around, content to collect fat paychecks while the company languishes. Knowing the management’s net worth is substantially determined by the company’s net worth eases my mind. Lastly, I want to see some structural advantage that greatly enhances a company’s profitability and is highly unlikely to go away. Like the Jones Act for shipbuilding companies like Conrad Industries. Or the sheer impossibility of building another major rail line in the US for railroad companies. Engrained structural advantages, whether the result of law, geography or human nature are a great help in achieving sustainable excess profits.

All this discussion leads to the question: are there any unlisted companies that embody all these qualities? I’m not sure, but I have written about multiple companies that embody many if not most of them: Computer Services Inc., Armanino Foods of Distiction Inc., AutoInfo. The OTC market operator itself, OTC Markets Group looks promising and has been written up by other bloggers.

To find other unlisted securities that exhibit the qualities of an excellent business, I would start by thinking of business models that are resistant to competition and price wars and go from there. What about smaller banks that exhibit healthy ROEs, conservative lending practices, growing deposit bases and a willingness to make smart acquisitions? Or small software companies earning large margins with low client turnover? Even among cyclical businesses there are some manufacturers that consistently manager to profit handsomely during upswings and buy up distressed competitors at the cycle’s nadir. And of course there are numerous, numerous unlisted companies controlled by insiders with every motivation to increase their company’s value.The advantage to finding these companies now, while they are small, is the possibility of enjoying years and years of compounded growth before any of these companies is large enough to be included in some sort of market index or even catch a mutual fund manager’s eye.

But of course, if you’re more Benjamin Graham and less Warren Buffett, I’ll have more soon on another investing style: Asset-Based/Low Expectations investing.

If you have thoughts to share on the “Quality Compounding” (or whatever you may call it) style of investing, please feel free to share them in the comments or drop me a line at

Disclosure: I own shares of Conrad Industries, Computer Services, Inc. and AutoInfo.



Great Lakes Aviation Is Not Your Typical Airline – GLUX

Great Lakes Aviation is a regional air carrier serving 47 airports and operating 34 aircraft. Though Great Lakes is strongly profitable and produces copious free cash flow, the market values the total company at a mere 2.16 times EBITDA and the equity at just 3.38 times free cash flow.

The market’s dim opinion of Great Lakes is precipitated by the historically abysmal economics of the airline industry and by the company’s recent brush with bankruptcy. However, the actual significance of each of these factors is greatly overblown.

The airline industry is well-known for chronic over-capacity, labor issues, commodity cost shocks and ultimately, bankruptcies. Warren Buffett (himself having lost money on airline investments) is unequivocal in his opinion of airlines, writing:

“If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in.”

Despite the poor results of most airlines companies, Great Lakes has an excellent track record. Great Lakes profited in every year since 2002, averaging a 6.40% operating margin and a 11.8% EBITDA margin. Free cash flow was positive in each year, averaging 7 cents on each dollar of revenue.

A chief reason for the company’s relative success is its extensive participation in the Essential Air Service (EAS) program, a government initiative that subsidizes flights to and from remote, rural locations. This program allows Great Lakes to operate flights to places like Devils Lake, North Dakota and Show Low, Arizona. The EAS was enacted in 1978 following airline deregulation to ensure certain rural communities would not lose access to air travel. The EAS has faced criticism as wasteful spending and it very well may be. However, the existence of the EAS has been reauthorized by the US senate and congress through September 30, 2015. The future of EAS is uncertain, but I would bet on rural senators and representatives going to bat for the program after 2015, seeing it as a relatively low-controversy way to “bring something home for constituents.”

At present, Great Lakes derives more than 40% of its revenues from EAS routes, but the company is making efforts to rely more on passenger revenue and less on government subsidy.Here’s a look at the company’s route map as of its last annual report. Since then, the company has added a few new routes and cut a few others.


Despite Great Lakes’ strong operating profits, the company skirted bankruptcy in 2011. In the early part of the 2000s, Great Lakes was massively over-leveraged, at one point owing over $130 million to Raytheon Aircraft Credit Corporation and losing buckets of money. Great Lakes slowly fought its way back to profitability, gradually reducing debt through using its operating cash flow or through structured debt forgiveness agreements. One such agreement on December 31, 2002 resulted in Raytheon Aircraft Credit Corporation owning 36% of Great Lakes’ shares. In the decade that followed, Great Lakes paid down debt and built book value per share from negative $3.12 in 2002 to $2.00 in 2010. This remarkable turnaround lead shares of Great Lakes to rally 900% from the end of 2002 to November, 2010. However, the company still owed millions to Raytheon Aircraft Credit Corporation. Raytheon informed Great Lakes that it had no intention of refinancing the remaining $32.67 million in debt due June 30, 2011, leaving Great Lakes scrambling for alternative financing. After multiple debt maturity extensions, Great Lakes finally found lenders willing to refinance its debt and provide a line of credit. Raytheon accepted a payment of $27 million for full satisfaction of the company’s remaining debt as well as all 5.37 million shares of Great Lakes owned by Raytheon. As a result of the transaction, Great Lakes Aviation’s shares outstanding declined by 37.5%.

Great Lakes Aviation found a savior in its new lenders, GB Merchant Partners and Crystal Capital, but its salvation came at a cost. The four-year, $29.5 million term loan executed with GB Merchant Partners bears interest at LIBOR plus 11% with a minimum of 15.5%. The line of credit provided by Crystal Capital bears interest at LIBOR plus 8% with a minimum of 10.5%. These rates are punitive, but not unheard of for asset-based lenders, which extend loans based on the value of hard assets, not against a company’s potential profits or cash flows. Asset-based lenders lend primarily to distressed companies with few alternatives. The GB Merchant Partners term loan provides for yearly principal reductions funded from the company’s “excess cash flow.” The first of these was made in the amount of $2.1 million in November, 2012. This forced amortization will greatly reduce interest expenses in future years. Still, Great Lakes Aviation would be well-advised to seek traditional financing at more reasonable interest rates at the earliest possible junction. Simply managing to reduce interest rates on the term loan and line of credit to 10.5% and 5.5% would increase earnings per share by 9.7 cents. A refinancing will become easier as the company continues to reduce its debt load and contractual pre-payment penalties on the term loan decrease.

Operating conditions for the Great Lakes have been favorable, and the trailing four quarters saw the company produce its highest ever revenues. EBITDA and operating income rose but remain slightly below highs set in 2009.

GLUX Income

Fuel costs are the biggest reason for the lagging EBITDA and operating income. In 2009, aircraft fuel costs accounted for 21.9% of revenue. In the twelve trailing months these costs rose to 30.2% of revenue. The future course of fuel prices is unpredictable and Great Lakes does not hedge its exposure to fuel costs. Fortunately, Great Lakes remained profitable even as fuel costs rose to record highs in 2008.

Great Lakes Aviation’s balance sheet is the strongest it has been at any point in the last decade. The company’s net debt of $20.84 million is 1.20 times trailing EBITDA, compared to net debt to trailing EBITDA of 3.91 in 2007. The Q3 2012 cash and debt figures are adjusted for the November 2012 $2.1 million principal payment.

Balance sheet

Great Lakes produced 55 cents in free cash flow in the trailing twelve months. With a share price of $1.86, this free cash flow is being capitalized at a whopping 29.6%. A more reasonable capitalization rate of 12-15% would indicate a share price of $3.67 to $4.58, well above current levels. A large part of this cash flow is earmarked for debt reduction, but shareholders will benefit greatly from the deleveraging process. Each dollar devoted to reducing principal on the company’s term loan increases after-tax income by slightly more than 10 cents and increases equity’s claim on the total enterprise value by the full dollar.

Being conservative, let’s imagine that Great Lakes can maintain constant EBITDA of $15 million and free cash flow of $4 million per year. Each of these figures is a material decrease from actual trailing results. If the company uses all of its free cash flow to pay down debt for the next three years, shares would have to appreciate by 40% just to maintain today’s EV/EBITDA ratio of 2.16. But that’s ridiculous. A 2.16 EV/EBITDA ratio for the company that is not either massively over-leveraged or experiencing precipitous declines in revenues and EBITDA is in no way justifiable. What if we look at the same scenario but assume that the company trades up to a more reasonable 4.5 EV/EBITDA over three years? In that case, shares would appreciate by 249% or 51.6% annually.

Despite Great Lakes Aviation’s potential, risk is high. Fuel costs could roar higher and pressure the company’s margins. GB Merchant Partners could refuse to refinance the company’s term loan in four years (though hopefully the company will find alternative financing by then). CEO Douglas Voss controls nearly half of shares outstanding and effectively controls the company. Investors must trust him to make good capital allocation and business decisions. Perhaps most worryingly, cuts to the EAS program could destroy the profitability of many of the routes Great Lakes flies.

Despite these risks, Great Lakes looks attractive on a risk-adjusted basis. If Great Lakes can navigate these operational risks and continue to improve its capital structure, shareholders could be looking at a much more valuable company in just a few years.

Disclosure: no position.

Tropicana Entertainment Inc. is the Cheapest US Casino Operator – TPCA

Tropicana Entertainment Inc. was formed from the remnants of Tropicana Entertainment, LLC which went bankrupt in 2008. Famed investor Carl Icahn brought the company out of bankruptcy in 2010 and used a company subsidiary to purchase the Tropicana Casino in Atlantic City, which had earlier been lost to creditors. As part of the reorganizing process, an entity associated with Mr. Icahn provided $150 million in exit financing (at a healthy coupon of 15%!). After selling or closing a few under-performing properties, Tropicana now owns and operates seven casinos across the US as well as one in Aruba. Carl Icahn owns 67.89% of shares outstanding.

I don’t write this post to encourage investing in casino companies. Many investors (myself included) choose to avoid the sector for reasons of ethics and social consciousness. I present this post more as a case study in how large unlisted companies can remain cheap and over-looked, especially post-bankruptcy.

Since exiting bankruptcy, Tropicana has operated successfully, generating GAAP profits totaling $22 million and free cash flow of $46.9 million for fiscal 2011 and the three quarters since. The company successfully refinanced its exit facility, replacing it with a $175 million term loan facility from UBS as well as a letter of credit facility. The new term loan facility is LIBOR/corporate base rate-based with a 7.50% floor, quite an improvement over the previous 15% rate. Interest savings from this refinancing are not fully reflected in trailing four quarters earnings, so I present a pro forma trailing four quarters income statement below. Revenue, sales and operating costs are actual historical figures, while interest and tax expenses have been adjusted for current balance sheet figures. All one-time items have been removed.

TPCA pro forma income statement

Tropicana’s balance sheet is strong, with $79.2 million in net cash. This is notable when most of Tropicana’s competitors in the casino industry are heavily debt-burdened. Many of these competitors paid the price during the last downturn with firms like Las Vegas Sands falling to less than $2 per share on fears of bankruptcy.

Tropicana shares go for around $15, giving the company a market capitalization of $395 million and an enterprise value of $316 million. On an adjusted EBITDA of $87 million, the company’s EV/EBITDA ratio is a scant 3.63. Tropicana produced $33.65 million in free cash flow in the last twelve months for an 8.5% free cash flow yield.

Ratios like these often point to a promising investment, but it’s usually prudent to suss out the market’s opinion of a company’s quality and prospects by comparing its valuation with its competitors. I found 11 public competitors that operate mainly in the US, ranging from giant Las Vegas Sands to tiny Nevada Gold & Casinos. First, a look at profitability ratios. How efficient are Tropicana’s operations, compared to competitors? The chart below compares revenues to EBITDA and operating income, each of which are adjusted for one-time items like goodwill impairment.

Competitors Profitability

From this comparison, it’s easy to draw a few conclusions.

1. In the casino industry, there are some benefits to scale. Revenues and EBITDA margin are correlated at 0.47. Tropicana’s largest competitor, Las Vegas Sands, converts 31.07% of its revenues to EBITDA. At the other end of the spectrum is Nevada Gold & Casinos which converts only 10.84%. Interestingly, operating income is much less predictable with a correlation of 0.32. The difference in depreciation & amortization as percentage of revenue may have to do with the relative ages of casino properties. A newer, expensively built casino will have a higher depreciation figure than an older, cheaper casino, even if their revenues and operating expenses are similar.

2. Tropicana is a mediocre operator. Tropicana’s EBITDA margin of 13.67% falls below the median figure of 18.60%. Tropicana’s operating margin of 8.64% fares better but still falls below the median figure of 9.57%.

Why are Tropicana’s operations sub-par? The company’s segment data from the most recent quarterly statement shines some light on the issue.

Segment Data

Tropicana’s East Coast operations are the heart of the problem. While all other regions produce results ranging from acceptable to excellent, the Tropicana Atlantic City performs poorly. It’s not a surprising result. The Atlantic City gambling industry’s struggles are well-documented, with a declining and aging clientele and increasing competition in nearby Pennsylvania and New Jersey. What’s more, damage from Hurricane Sandy was extensive and the city and industry face a long road to recovery. For the trailing 9 months, revenues from the Tropicana Atlantic City made up 44.5% of Tropicana’s total revenues, but only 19.1% of operating income before corporate-level expenses.

While Tropicana is not a a premier operator, it is also not the worst. And it has arguably the strongest balance sheet in the industry. Despite this, Tropicana has the market’s lowest valuation ratios, and not by a little!

Competitors Valuations

The mean and median EV/EBITDA ratios for Tropicana and its competitors are 9.65 and 9.34, respectively. (And 10.20 and 9.65 if Tropicana is excluded!) Tropicana’s trailing EV/EBITDA of 3.63 represents an incredible 60+% discount to these average valuation metrics. The market is giving Tropicana no credit at all for its large excess cash balance and improved operations.

If Tropicana were to trade up to a market average 9.50x EBITDA valuation, its shares would go for $34.42, 129% higher than current levels. Then again, there are good reasons why Tropicana should not be valued at the industry average including its illiquid shares, single controlling shareholder and its weak Atlantic City operation. However, even valuing Tropicana at 6.65x EBITDA, a 30% discount to the industry average, would yield a share price of $25, 67% upside.

Much depends on what Carl Icahn intends for the company and especially how he chooses to invest the company’s cash. Mr. Icahn’s Icahn Enterprises Holdings purchased 733,047 shares of Tropicana in November, 2012, bringing Mr. Icahn’s ownership up to 67.89% from 65.01%. Perhaps he will engage in an acquisition strategy, rolling up smaller casinos and building scale. Or maybe he will eventually increase his ownership of Tropicana to 80%, qualifying for the dividend received deduction and using the company’s free cash flow to make distributions to his holding company.

Disclosure: No position.

Quality Products Inc – QPDC

Hello and happy 2013! To start this year off right, I present to you a high quality unlisted industrial company – Quality Products Inc.

Quality Products is a true rarity: a tiny company that manages enormous gross and operating margins, high returns on capital and consistent free cash flow. Even better, the company uses its prodigious cash flow to repurchase shares and pay large special dividends.

Quality Products operates two subsidiaries: Multi-Press and Columbus Jack. Multi-Press manufactures and services a variety of large industrial presses like this and this. Multi-Press has been in business for 65 years and was acquired by Quality Products in 1989. Columbus Jack manufactures and services many types of aircraft jacks and other runway equipment for commercial and military customers. Columbus Jack was founded in the 1940s and purchased by Quality Products in 2001. Both these subsidiaries are located in the Columbus, Ohio area. Quality Products also owns nearly $5 million in investments including private equity and real estate.

Both of Quality Products’ subsidiaries are profitable and growing, but Columbus Jack is the real gem. Between 2004 and 2012, revenues for Columbus Jack rose 151% while revenues at Multi-Press rose 49%. Over the time period, Columbus Jack’s gross margin rose to an incredible 50.30%, a nearly unheard of level for a manufacturing company.

QPDC Growth


While Quality Products’ long-term revenue growth is high, recent revenue growth has slowed. Profit growth since 2007 has largely been realized through improvements in gross margins, as well as income from royalties related to government defense projects and gains on the company’s private investment portfolio. 2009’s record profits benefited from the reduction of a valuation allowance on the company’s net operating losses from previous unprofitable years.

QPDC Income

While the company’s bottom-line profits may have retreated slightly from the 2009-2011 period, earnings per share have been buoyed by the company’s aggressive share repurchase program. Since 2006, the company has reduced shares outstanding by 43.6%.



From 2007 to 2012, Quality Products produced total free cash flow of $34.7 million, exceeding its net income by $5 million. In addition to its share repurchases, Quality Products paid large special dividends in each of the past three years, funding them through its operating cash flow, proceeds from its investment portfolio and its line of credit.

QPDC sp div


Quality Products’ total debt and pension obligation stands at $5.90 million, less than 1x trailing EBITDA. This debt is offset by $7.63 million in cash and investments. Clearly, the company’s debt load is manageable and could even be increased to fund future share repurchases or dividend without endangering the company’s stability. The company’s current ratio is 3.49, indicating solid near-term liquidity.

The company makes excellent use of its assets, achieving a return on equity of 34% in 2012. This figure was earned via a profit margin of 21.25%, asset turnover of 1.11 and assets/equity of 1.44. Pre-tax return on assets was 36.3%.

Despite Quality Products’ robust margins and high earnings quality, the company trades at a very modest valuation. With a share price mid-point of $14.25 and a market capitalization of $34.2 million, the company has a trailing P/E ratio of 7.8. Free cash flow yield is 13.4%. The company trades at a substantial premium to book value, but its consistently excellent profitability and strong financing helps to justify the premium. The company’s large non-core investment portfolio also provides upside potential as these investments produce gains or are liquidated and the proceeds used to repurchase shares or pay dividends.

The biggest risks facing Quality Products Inc. are the possibilities of reduced military spending and the usual risks that accompany being an illiquid, insider-controlled company. Columbus Jack’s revenues are highly dependent on sales to military customers, which provide the majority of its revenues. In each of the last few annual earnings reports, the company has warned that it does not consider the Columbus Jack segment’s gross margins to be sustainable. It is worth monitoring the US government’s budget discussions to determine any possible impact on Quality Products’ revenues.

Shares of the company are highly illiquid with less than 1% of shares outstanding changing hands in the last three months. Trading prices have exhibited some wild moves, peaking at $42 per share in January 2012. Caution should be used in buying and selling. Quality Products is controlled by insiders. The last complete annual report filed with the SEC (2004) lists 37.5% of shares as controlled by insiders and one additional shareholder. Due to share repurchases, these same shareholders now control 63.4% of shares outstanding assuming they did not sell any.

Disclosure: No position.