JLM Couture

JLM Couture designs, makes and distributes bridal gowns and bridesmaids dresses. The company offers nine different collections from various designers including Alvina Valenta, Hayley Paige, Jim Hjelm, Lazaro, and Tara Keely. JLM Couture’s products are distributed through around 800 retail locations domestically and internationally.

Being A) a man and B) not especially sartorially gifted, I don’t know the first thing about the bridal industry. I don’t know what competitive trends are affecting JLM Couture, where on the price and quality spectrum JLM’s products fall or if their designers are actually well-regarded. A little googling shows retail prices for their dresses in the mid four figures, which I would guess is well above average.

Truth is, I don’t care much about JLM’s competitive position or business strategy because the company is so, so cheap compared to the assets it owns. At a recent stock price of $1.90, JLM Couture has a market cap of $3.37 million. Book value is $9.85 million for a price-to-book value ratio of only 34.2%.

One of Ben Graham’s most famous and successful investing strategies is the “Net Current Asset Value” or NCAV method. This method involves computing the value of a company’s current assets less all liabilities per share and comparing that figure to the company’s stock price. Graham recommended purchasing securities with stocks prices at least one-third lower than their net current asset value. JLM Couture easily satisfies this condition. At a share price of $1.90, JLM trades at a 60% discount to NCAV of $4.37 per share.

JLMC NCAV

Net current asset value is among the most conservative valuation methods, because it attempts to compute liquidation value, the value that would remain for shareholders if a company were wound down and all its liabilities were satisfied. Furthermore, NCAV ignores the value of non-current assets like real estate, machinery, brand names and other non-liquid assets.

But for many analysts, the NCAV calculation is not conservative enough. After all, a liquidation scenario is rarely simple and the full book value of even the most liquid assets can rarely be achieved. Many analysts prefer to apply discounts to a company’s current assets. These discounts range from small for assets that can quickly be converted to cash (like cash itself and receivables) to large for current assets that are less easily sold (like inventory and pre-paid expenses). Even this more aggressive computation results in NCAV of $2.37 per share, 25% above JLM’s trading price. I assigned a 100% discount to JLM Couture’s pre-paid expenses because this current asset is entirely pre-paid advertising costs, and pre-paid advertising for a company that will no longer exist is as close to worthless as it gets.

JLMC NCAV adjusted

It’s pretty clear that JLM Couture trades at a substantial discount to liquidation value. But what good is that if the company has no plans to liquidate? Turns out, liquidation is not the only way to realize value on a company that trades at a discount to NCAV. Mean reversion is a well-recognized phenomenon, and the tendency (on average!) of companies trading at extreme valuations to revert to more moderate values is well-established and has been observed in a number of academic studies. Investors in NCAV bargains can simply wait around for market opinion to change, trusting in current assets to take care of any downside risk.

Many companies that trade at a discount to net current asset value are “melting ice cubes,” companies that are on track to eventually burn through their current assets through operating losses and poor investments. In these cases, investors must hope for mean reversion to kick in before NCAV disappears. JLM Couture, on the other hand, is profitable! The company earned 33 cents per share in 2012, giving its shares a trailing P/E ratio of 5.8. Sales were up 10.7% and operating income rose 341%. Unfortunately, JLM Couture’s history does not show consistent profitability. Earnings in 2012 were a mere shadow of what they were a decade ago, and margins have fallen considerably since then. The company was completely dark from 2005-2007.

JLMC results

Still, profits are profits. A successful 2013 would increase JLM Couture’s NCAV value and widen the gap between NCAV and its share price.

The market may eventually recognize the value of  JLM Couture’s net current assets, or it may assign a higher multiple on the company’s earnings. It might not be soon, but companies tend not to trade at such extreme discounts for long.

I own shares in JLM Couture.

Schuff International Updates Shareholders

Schuff International was one of the first companies I wrote about when I started this blog way back in January, 2012. Since then Schuff stock is up a bit over 10% but not without a lot of volatility along the way! Shares fell to as low as $6.00 in July, 2012, representing an amazing buying opportunity for anyone familiar with Schuff’s track record.

When I last discussed Schuff, the company had just undergone a recapitalization, taking on debt in order to buy back 57.7% of shares outstanding. I wrote about how the recapitalization, if timed correctly by management, would result in a gigantic increase in earnings per share once the construction cycle eventually turned and Schuff went back to its days of burgeoning profits.

Since its recapitalization Schuff has been silent, claiming that issuing quarterly reports would give away valuable pricing information to competitors. Shareholders had been left wondering if Schuff’s fortunes were on the mend until this week, when Schuff released its 2012 annual report.

Schuff’s 2012 results are as mixed as they come. Revenues, operating profit and net income were all up, and debt was cut almost in half. Free cash flow was strong and leverage decreased. But gross margins hit a decade low, backlog fell to levels below those of year-end 2011 and the company’s accounting was aggressive, billing in advance of costs on work to be completed.

SHFK 2012 results

Schuff provides little explanation for the gross margin pressure it is facing. Rising costs for raw materials may play a role, but I suspect competition is the biggest reason. The construction cycle still has not entered a robust phase (as evidenced by Schuff’s revenues which are still 40% below their 2007 peak) and too many firms may be chasing too few projects with the result being lower profit margins for all. Until the demand for new steel construction picks up, Schuff will not be able to win contracts that allow a gross margin in the mid-teens or higher.

Free cash flow production was a bright spot for Schuff in 2012. Free cash flow was driven by a $20 million disinvestment in non-cash net working capital, . This aggressive reduction in non-cash net working capital was largely caused by changes in Schuff’s accounting entries for billings and costs/earnings on uncompleted contracts. Costs/earnings in excess of billings are a current asset, while billings in excess of costs/earnings are a current liability. Costs/earnings in excess of billings decreased, while billings in excess of costs/earnings increased. Remember that a decrease in a current asset is a source of cash and in increase in a current liability is also a source of cash.

Schuff Billings

By becoming much more aggressive in its billing practices, Schuff was able to create over $30 million in cash flow in 2012. Unfortunately, cash flows created through aggressive working capital management are rarely sustainable or repeatable. Schuff’s 2013 cash flow may suffer if clients push back on payment timing and the net billings/costs/earnings figure swings back toward zero. Another large source of cash flow in 2012 was depreciation and amortization, which ran nearly $5 million higher than net capital expenditure. This is also unsustainable over in the long run.

Schuff used essentially all of its free cash flow to pay off debt associated with the recapitalization. During 2012, the company’s entire $24.4 million bank revolving line of credit was extinguished, and the company made a $3 million principal payment on its GB Merchant Partners real estate-secured note. (Side Note: GB Merchant Partners is the same lender that is currently scalping Great Lakes Airlines for 15%. I still struggle to understand how secured lenders can charge these obscene rates while banks will extend ordinary business loans at LIBOR+5% or so.) Subsequent to year’s end, Schuff paid off the $1.4 million 13% PIK note owned by an inside shareholder.

These actions will substantially reduce Schuff’s interest expense in 2013. Schuff paid $6.48 million to service its debt in 2012, which will drop by more than a third in 2013 assuming no increase in letters of credit outstanding. This calculation does not include the effects of amortizing the GB Merchant Partners real estate-secured note. A $2 million decrease in interest expense will drop another 30 cents per share or so to the bottom line, assuming a 35% tax rate.

After such an aggressive debt reduction effort, Schuff’s solvency and liquidity ratios look good. Net debt now stands at 1.2 times trailing EBITDA and 9.5% of assets less cash, compared to 3.6 times and 19.3% in 2011. The current ratio improved to 1.4 from 1.3 in 2011.

Schuff’s 2013 outlook can be guessed at via the backlog figures disclosed in the annual report, and it’s not encouraging. Total backlog at the end of 2012 was $195 million versus $259 million in 2011. The cycle will eventually turn, but it doesn’t look like 2013 will be the year.

Even though it does not seem that a sharp rise in profits is imminent, Schuff still represents great value. In my initial post on the company, I estimated Schuff’s normalized operating income to be in the neighborhood of $25 million. The $25 million figure was driven by a pre-tax return on invested capital estimate of 15.58%, a 30% haircut from actual historical results. Even if we assume normalized operating income of just $20 million, Schuff’s normalized net income falls somewhere around $10 million after conservatively assuming $5 million in interest expense and a 35% tax rate. At current prices, Schuff still trades for 4.9 times normalized income. Of course, normalized earnings calculations represent an assumption that normal business cycles will continue unimpaired. The next construction boom has not yet appeared on the horizon, but I am willing to bet Schuff will still find opportunities in a nation and world with more people and need for infrastructure than ever.

Until then, Schuff investors enjoy the protection of $21.96 in book value per share, 87% above Schuff’s trading price. Any further share repurchases by the company at today’s prices would create tons of value for remaining outside shareholders.

I own shares in Schuff International.

Bonal International: Boring Products and Amazing Margins – BONL

Bonal International is a tiny Michigan-based manufacturing company that dominates its niche. Bonal creates products that use”Meta-Lax Vibration Stress Relief Technology” to reduce internal stresses and extend the life of metal components. According to Bonal’s website, the vibration treatment provides 80-90% of the benefits of traditional heat treatment, but saves 65-95% of the time and expense of heat treatments. The company boasts an impressive list of customers including Northrop Grumman, Boeing, the US Army and Navy and more.

62% of Bonal’s shares outstanding are owned by the Hebel Family or a trust for the benefit of the CEO, A George Hebel III. The Hebels recently attempted to sell the company, but the offer was insultingly low and shareholders rejected it. At 70 years of age, it seems Mr. Hebel is looking to sell the company and provide liquidity for himself and his family members. Perhaps an improved offer will forthcoming? Regardless, Bonal’s valuation and market position make it an intriguing company and possibly an attractive investment.

First, a look at recent results. Dollar amounts are in millions.

BONL results

Aside from tough years like 2008 and 2009, Bonal produces consistent profits and free cash flow. That’s great, but the truly astounding statistic is Bonal’s gross margin. In the five trailing full fiscal years, Bonal averaged a 76.2% gross margin. That’s practically unheard of! By comparison, Apple’s gross margin this year was 38.6%. Tiffany & Co.’s was 59.0% and Coach’s was 72.1%. Bonal’s products retail for more in comparison to production costs than stylish computers or designer jewelry and handbags.

The fact that Bonal’s customers will pay such a markup really says something about their faith in the products. It also indicates the Bonal faces practically no competition and does not have to compete on price. But will these margins endure? Who’s to say another company will not roll out a competing product that costs 30% less and destroy Bonal’s margins? It’s unlikely, and the reason is simple. The market for Bonal’s products is not growing. Sales over the last twelve months were up from fiscal 2012, but are still slightly lower than 2008’s figures. Given the limited size of the market, it’s probably not worth the trouble for another company to invest in a new product line in order to capture not even $2 million in gross margin. Bonal is likely to hum along for years to come earning excess these incredible margins, but unable to increase gross profit significantly in dollar terms.

Another notable line item is Bonal’s capital expenditures, which are absurdly low. In fiscal 2012, Bonal spent only 0.3 cents per dollar of revenue on capital expenditures. This has been the pattern for several years, resulting in lower and lower book value for the company’s property and equipment. As of the third quarter of fiscal 2013, Bonal showed only a net $48,609 in property and equipment versus a cost basis of $389,964. Bonal’s fixed assets are 88% depreciated, yet production continues. The extent of this book value depreciation is probably exaggerated, yet it seems Bonal will eventually have to shell out for new machinery. Free cash flow has averaged 11% of sales since 2008, but will be pressured if Bonal’s capital expenditures increase in coming years.

Onward to the balance sheet. Bonal’s assets total just $1.77 million, $1.48 of which is equity. The company holds just under $1 million in cash and near-cash investments and carries no debt. Liquidity is excellent, with total liabilities at just 17% of current assets. Bonal has long carried large cash reserves and eschewed debt, resulting in a balance sheet that is as pristine as they come. Despite the large amount of excess capital on the balance sheet, Bonal still produces great returns on equity, averaging 22% since 2008.

The market gives Bonal little credit for its excess cash or high returns on assets. As of the close of trading on March 20, Bonal’s market cap is $2.40 million. Trailing P/E is 6.5 and price to book value is 1.6. Assuming half the company’s cash is excess, an acquirer at the current price is paying just 5.2 times earnings for a highly profitable operator.

Bonal’s biggest challenge is its limited opportunities for reinvestment in the business. Rather than engage in poorly-planned investments or mergers, Bonal has an excellent record of returning cash to shareholders through dividends. Since fiscal 2006, Bonal has paid out over half its market capitalization in dividends, 30 cents per share in 2012 alone.

As a niche operator with excellent margins and an aging CEO and founding family, Bonal would make a great acquisition for a smaller manufacturing company or even a wealthy individual. Bonal’s consistent free cash flows could be harvested for reinvestment in other productive businesses. Whether or not an acquisition happens in the near future, investors will benefit from Bonal’s continued profitability and dividend habit.

 

Disclosure: I hold shares in Bonal International.

Alerus Financial is a Growing Financial Services Company Hiding Behind a Bank – ALRS

Alerus Financial has provided banking services to North Dakota residents since 1879 as the second bank chartered in the Dakota Territory. In 2000, Alerus began expanding beyond traditional banking into wealth management, retirement planning and mortgage origination. Today, over 60% of revenues are generated by these non-traditional activities. Alerus’s physical footprint now includes Minnesota and Arizona in addition to North Dakota.

Traditional Banking

Alerus provides banking services to individuals and businesses, including small business and agricultural loans. The importance of loan quality can hardly be over-estimated and Alerus’s loan book is pristine. Bauer Financial’s September 30, 2012 report on Alerus showed a Texas ratio of only 5.03%, indicating a vanishingly low risk of failure. Non-performing assets as a percentage of total assets were 1.51%.

Alerus’s loan-to-deposit ratio is in line with its peers at 80.5%. Alerus does have high exposure to commercial real estate and commercial/industrial loans which make up 58.4% of the total loan book. However, the bank’s strong asset quality figures argue for the quality of these loans. Alerus’s deposit base is not dependent on brokered CDs or balances. Alerus is well-capitalized, with an equity to total asset ratio of 11.0% at September 30,2012.

Perhaps the strongest argument for Alerus’s continued success in lending is the rosy economic condition of the bank’s largest markets. North Dakota’s unemployment rate is the lowest in the nation at 3.2% and Minnesota’s is benign at 5.4%, compared to the national average of 7.7%. Alerus’s clients are in far better condition to meet their loan obligations than their peers in other regions.

While Alerus’s traditional banking operations no longer account for the majority of the company’s revenues, it does not mean the business is being neglected. On the contrary, Alerus is opportunistic, acquiring deposits and loans from several failed banks over the last few years and executing loss-sharing agreements with the FDIC. The result (in tandem with organic growth in deposits) is annual deposits growth averaging 12.1% since 2004. While they are technically liabilities, deposits are the “fuel” that allow banks to increase the size of their loan books and increase profits. Net loan growth has averaged 8.7% since 2004.

Net interest income after loan losses reached a record $46.41 million in 2012, more than doubling since 2004.

Wealth Management

Alerus’s assets under management and administration reached a record $11.2 billion as of December 31, 2012, up 14.9% year over year. This figure benefited from the February, 2012 purchase of PensionTrend, Inc and PensionTrend Investment Advisors which added $720 million to assets under management and administration. Alerus Financial’s wealth management practice has been a growth area for the company, with fees rising from $15.44 million in 2004 to $39.39 million in 2012. Alerus manages retirement plans for clients in 49 states.

Wealth management is a great business model and a natural addition to a bank’s core operations. Wealth management is extremely capital light compared to regulated banking, and features very high operating margins. For the price of a some additional personnel, computer systems and some marketing dollars, a bank can build a wealth management practice based on its existing relationships with depositors and borrowers. A wealth management business’s growth is two-pronged: through increasing account sizes through investment returns and through adding new clients.

Mortgage Origination

Alerus’s newest growth business is its mortgage origination group, begun in 2009 with the purchase of Residential Mortgage Group in the Twin Cities. In 2012, mortgage origination revenues reached $32.08 million, almost double that of 2011. Loans originated by the mortgage group are resold to other banks or agencies.

A Non-Bank Bank

Over the last decade, Alerus has transformed itself from a small but successful North Dakota community bank into a fast-growing diversified financial services company with a national footprint. In 2004, traditional banking accounted for 50.7% of revenues, declining to 36.7% in 2012. Expanding into lucrative wealth management and mortgage origination businesses has allowed Alerus to improve its asset turnover. In 2012, Alerus produced 10.94 cents in revenue for every dollar of assets on its balance sheet, compared to 7.32 cents in 2005. Return on average common equity hit 15.32% for 2012.

Income from traditional banking will likely continue to decline in significance as Alerus’s other businesses grow. However, all of Alerus’s lines of businesses have experienced remarkable growth in revenues. The chart below provides annualized figures.

ALRS growth

The high growth in net interest income shown in recent years is an anomaly. Falling short-term rates have allowed banks to earn increased spreads on loans versus deposits. In the long run, growth in net interest income will converge to growth in deposits, as can be seen in the five year figure.

High Growth, Low Valuation

While Alerus has transformed into a high-growth financial services provider, investors are still valuing the company like a sleepy community bank. Alerus has a five year compounded earnings growth rate of 11.5%, yet the company trades at only 9.0 times trailing earnings. Alerus was profitable all through the financial crisis and more than doubled its dividend over the last decade.

ALRS record

Alerus trades at 1.12 times total equity and 1.31 times common equity. 1.31 times common equity may seem dear at a time when many small banks trade well below book value, but Alerus’s trouble-free loan book, attractive non-bank businesses and exceptional return on equity more than justify the premium to book value.

Investors in Alerus have done well. At today’s bid/ask mid-point, Alerus stock produced a total return of 33.8% for the last five years, compared with 27.3% for the S&P 500. And yet, Alerus’s modest valuation leaves plenty of room for Alerus to rise.

Disclosure: I own shares in Alerus Financial.

The Marketing Alliance is a Tiny Compounding Machine – MAAL

The Marketing Alliance is a tiny company with an outstanding record of capital allocation and value creation. From fiscal 2002 to fiscal 2012, the company achieved a laundry list of feats:

  • Grew sales by 5% annually.
  • Grew operating income by 10.5% annually, increasing operating margins from 10.3% to 17.1%.
  • Grew net income by 13.9% annually.
  • Achieved average return on equity of 71% (32% over the past five years).
  • Increased shareholders’ equity nearly tenfold, from $1.15 million in 2002 to $11.3 million in 2012, while paying annual dividends.
  • Reduced assets/equity from 6.6x in 2002 to 1.7x in 2012.

With stats like these, you may be wondering what wonderful line of business The Marketing Alliance is in. As is so often the case with successfully compounding companies, The Marketing Alliance’s core line of business requires little capital investment and generates significant intangible assets in the form of business relationships and network effects.

The Marketing Alliance (“TMA”) provides a platform for independent insurance brokers to aggregate their purchasing power. The Marketing Alliance negotiates on the behalf of these independent brokers with large insurance companies, helping them to obtain better commission rates. The Marketing Alliance also provides assistance with practice management and support. In return for these services, TMA receives a cut of the commissions generated by these brokers.

Like nearly all great businesses, TMA’s insurance platform generates capital beyond what is needed for reinvestment. Excess capital creates opportunities for growth. The Marketing Alliance has chosen to invest its capital beyond its core business into other lines of business. The man in charge of directing TMA’s capital allocation is Timothy M. Klusas, appointed president in 2005. Mr. Klusas has a background in corporate development and strategy at Eaton Corporation.

In July, 2011,  TMA purchased the assets of JDC Construction. JDC does erosion control, conservation and other construction services. The price was not disclosed, but the transaction seems to have been a successful one. In the five full quarters following the acquisition, JDC produced $1.44 million in operating income.

TMA’s latest venture is the acquisition of two “Monkey Joe’s” family entertainment centers located in the St. Louis area. Time will tell if this latest venture will be a success, but the centers were profitable in the most recent quarter.

The Marketing Alliance’s revenues, operating income and net income hit record highs in the four trailing quarters as of the second quarter of fiscal 2013 ended September, 2012. The company does not publish a schedule of cash flows.

MAAL Income

Commissions revenue in the quarter ended September 30, 2012 was up 7% over the same quarter of 2011. Construction revenue rocketed 41% from a year ago, reaching 11.9% of total revenues. While TMA’s earnings have reached new highs, the company still has plenty of “dry powder.”  Cash at quarter’s end was $5.42 million. Assuming the company requires cash balances of 5% of revenues for working capital purposes, TMA is holding $4 million in excess cash. TMA also holds $4.19 million in marketable investments. The nature of these investments are not disclosed by the company. However, given the size of gains and losses on these investments in prior years, it can be assumed they are equities.

Gains and losses on the company’s marketable securities portfolio influence net income from year to year, so comparing market capitalization or enterprise value to operating earnings/EBIT is a more consistent method. On that basis, The Marketing Alliance looks very reasonably valued.

MAAL Valuation

TMA’s annual depreciation expense is a small fraction of operating income, indicating an EV/EBITDA ratio just slightly lower than EV/EBIT.

6.69 times operating income (unadjusted for excess cash and securities) seems quite a fair price for a company with The Marketing Alliance’s record of growth and compounding. The company offers a 3% dividend yield.

As with any company, TMA has its share of risks. The biggest is the possibility that the company’s core insurance services platform will cease growing or shrink. Americans are buying fewer life insurance policies than before. What’s more, many of the insurance brokers in TMA’s network are older than 50 and at or past their peak earnings years. It remains to be seen if TMA will be able to replace retiring brokers with others at the same level of annual commissions.

Even if TMA’s roster of brokers can be maintained, competition could reduce profits. While it has been successful, The Marketing Alliance is a still a very small, regional company without the deep financial resources or national base of other insurance brokerage services providers.

Capital allocation is also a risk. Thus far, Mr. Klusas has shown skill in dedicating capital to profitable acquisitions and has also seen fit to return capital to shareholders through dividends. However, Mr. Klusas has been at the helm for not quite a decade and still has plenty of time to make mistakes or develop an ego or get lazy. Here’s to hoping he doesn’t, but it’s possible.

If, on the other hand, The Marketing Alliance can maintain and grow its core business and invest excess capital in profitable side projects, investors could continue to see the intrinsic value of their investment compound for years to come.

Disclosure: No position.

AutoInfo Sells Out – AUTO

AutoInfo has announced a sale to Comvest Partners at a price of $1.05 per share. The transaction is expected to close by the end of the end of June.

While I applaud the decision to sell, I am extremely disappointed by the price. $1.05 represents a trailing P/E of 8.5 and a trailing EV/EBITDA of 6.2. In reality, the valuation is likely lower. AutoInfo’s last financial statement was for the quarter ended September 30, 2012 and the company has very likely grown and generated cash since then.

An 8.5 P/E is a price you pay for a no-growth, medium-quality business, or a cyclical business more than halfway through its growth phase. 8.5 times earnings is not what you pay for a business that averaged 24% sales growth over the past five years through the a vicious recession.

Why not sell to a competitor rather than a private equity firm? While Comvest Partners will likely find ways to increase efficiency, a competing transportation services firm could find far more. AutoInfo’s legal, IT, finance and marketing functions could all be managed by an acquiring transportation services firm’s existing departments, greatly increasing operating margins.

In the last four quarters, AutoInfo had $41.8 million in operating costs. Reducing these by just 10% would create additional after tax-income of $2.7 million, increasing net income to $7.2 million. The same 8.5 P/E multiple on the post-synergies net income would be $1.70 per share. Was it really impossible to find a larger competitor willing to pay a very conservative multiple of easily achievable post-synergies earnings?

I’d like to know what AutoInfo’s fund investors, Kinderhook Partners, Baker Street Capital and Khrom Capital Management think of the deal. Or what James T. Martin, the company’s largest non-insider shareholder thinks. Together, these shareholders own 48.3% of shares outstanding, enough to exercise de facto control. If these investors haven’t already affirmed the deal, perhaps they’ll make some waves when the time comes for the shareholder vote.

I own shares in AutoInfo and I plan on keeping them at least through the shareholder vote, on the off chance of a higher bid.