Can Ohio Art Sketch Out a Turnaround? – OART

Remember the Etch A Sketch? That shiny red toy that allowed one to create line art as intricate as one’s patience would allow and then clear the slate with a shake? While I can’t remember picking one up in many years, I do recall being engrossed by the one my grandparents had when I was a child. Try as I might, I could never quite translate what was in my head onto the screen via those two knobs and that unforgiving line.

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Investors may be surprised to learn that the maker of Etch A Sketch, The Ohio Art Company, is public and trades on the pink sheets. Ohio Art is a dark company and does not report any news or financial information to the public. The company has two divisions: toys and lithography.

I bought one share in August 2011 and received my first annual report in May 2012. I opened the report with excitement, hoping to learn of a strong balance sheet and healthy profits. Unfortunately, what I saw told a very different story. In 2012, Ohio Art reported a loss of $616,150, or 71 cents per share. Free cash flow was even worse at negative $2.70 million, or $3.09 per share. Book value per share fell to negative $1.62. The company was unable to roll over its Wells Fargo line of credit and was forced to borrow against its inventory at an obscene 16.8% rate. The company’s pension plan was underfunded to the tune of $4.28 million. The only bright spots for the company were a sales increase of 23.5% and positive net working capital.

In its notes, the company explained that disappointing sales had lead to a buildup in inventory and sharply negative cash flow. Seeing only losses, a negative net worth and growing debt, I assumed Ohio Art would soon enter Chapter 11 and leave shareholders with nothing. I put the annual report on my bookshelf and mostly forgot about the company.

When I received this year’s annual report, I flipped through without much interest, expecting only to see another year of losses, negative cash flow and even more debt. Instead, I saw the total opposite! For fiscal 2013, Ohio Art earned $1.57 million or $1.81 per share on a sales increase of 22.5%. Free cash flow was $1.82 million, $2.09 per share. The shareholders’ deficit was eliminated and total debt was cut by 82%. Net working capital increased, giving the company a current ratio of 1.43. Even the pension deficit was reduced to $3.91 million.

How could I have missed the signs? And what was it that allowed Ohio Art to execute such a dramatic turnaround? Ohio Art’s revenues are up 51.2% in two years, so clearly something is working. I failed to anticipate this growth and the fact that operating leverage could lead to big profits. I also failed to examine Ohio Art’s product lines and the potential of each. Clearly, the market for Etch A Sketch is small and likely to continue shrinking in the long run. While a few nostalgic parents may still buy one, today’s children are much more likely to be drawing on an iPad on a long car trip. That rules out Etch a Sketch as the source of Ohio Art’s revenue growth.

Ohio Art’s other major toy product is nanoblock. Originally created in Japan, nanoblock is a Lego-like brick building toy, only even smaller. Hundreds of models are available including famous buildings, landmarks and animals. Compared to more traditional brick building toys, nanoblock requires much more dexterity and time to complete.

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Ohio Art acquired the exclusive right to distribute nanoblock in the US in December 2010. The company seems to have a real winner with nanoblock. Do a search on Amazon.com for “Ohio Art nanoblock” and you will find dozens of different models with excellent customer ratings. A look at Google trends shows a steady rise in interest in nanoblock since 2009, peaking each year during the holiday season. (Interest in Etch A Sketch, by comparison, is completely flat going back a decade, with the exception of a spike in interest after its 2012 mention by Mitt Romney.) The company has put together a nice web site advertising nanoblock, complete with upcoming models and buildings videos.

Ohio Art also has a non-toy division which achieved near record profit and record sales volume in fiscal 2013. The company’s lithography division provides printing services to many large corporations like Starbucks, Altoids and Disney. Lithography is a process used to print graphics onto smooth surfaces like paper, metal or plastic.

According to the company’s financial statement notes, toy sales accounted for 55% of 2013 revenues and lithography for 45%. However, the company letter to shareholders on the first page of the annual report lamented thin margins in the toy division. If the company can continue to grow its nanoblock line and achieve higher margins in the toy division, profits could rise substantially.

Ohio Art’s valuation looks extremely modest. With a share price mid-point of $6.40, trailing P/E is only 3.5. Trailing free cash flow yield is 32.7%. Adjusted for working capital changes, the trailing free cash flow yield is 26.2%. However, the company’s capital structure remains weak with nearly zero equity against $8.8 million in liabilities. While its 16.8% interest inventory borrowings are nearly extinguished, the company has not managed to secure another line of credit on reasonable terms.

What’s more, the company’s market capitalization is only $5.6 million and the majority of shares are owned by the Killgallon family. No compensation information is disclosed in the annual report. It is possible that executive compensation is excessive. The pension deficit is equal to almost 70% of the company’s market capitalization and while the pension is frozen, it also has an aggressive return assumption of 8%.

Ohio Art’s low valuation and growth potential through nanoblock are enticing, but they must be weighed against the company’s weak balance sheet, tiny size and potential governance issues. If profit declines at the lithography division or if nanoblock proves to be a fad, investors will not be protected by a strong balance sheet. Ohio Art does not have the luxury of making mistakes and for that reason, I am sitting out for now.

I own 1 share of Ohio Art.

Brazil Fast Foods Corp. Is Emerging Markets Restaurants At A Discount – BOBS

Brazil Fast Food Corp. is a rapidly-growing fast food franchiser in one of the world’s most promising emerging markets, Brazil. From 2002 to 2012, the company grew revenues at an average annual pace of 15.6% and grew its operating margins from -3% in 2002 to a record 12.2% over the four trailing quarters. The company also transformed its balance sheet along the way, achieving a net working capital surplus and reducing leverage to the lowest point in the last decade.

Despite its outstanding record of growth and value creation (a 40% annualized return for investors since 2003, excluding irregular dividends) the company trades at only 8 times earnings and an EV/EBITDA multiple of 4.4.

Brazil is one of the world’s largest democracies, with a population of nearly 195 million. For many decades, Brazil’s story mirrored many other South American countries, complete with military coups, rampant corruption and runaway inflation. The worst of this period ended in 1985 with the first free elections since the 1960s. But transitioning to a democratic system did not bring a resolution to Brazil’s economic woes, and the country was plagued by inflation until the execution of the “Plano Real” in 1994. The plan instituted a new currency and gradually succeeded in bringing inflation down to First World levels in the single digits. Not to say there weren’t hiccups along the way, but the plan was a rousing success on the whole. Over the next two decades, the resulting stabilization helped foster a great increase in Brazil’s wealth and ranks of its middle class. Brazil’s growth rate has slowed in response to challenging world economic conditions and weakness in commodities prices, but the country’s young demographics and increasing per capita income still make it a promising market for investment. Brazil’s economic history and the genius of the “Plano Real” are topics worth studying in their own right. NPR’s Planet Money has an intriguing broadcast on the plan that can be found here.

Company Profile

As of March 31, Brazil Fast Foods owns or franchises a whopping 1,049 restaurants in Brazil, Chile and Angola. (The Chilean and Angolan restaurants account for only twelve of these units and their value is immaterial, per the company.) Of these 1,049 points of sale, roughly 42% are kiosks or express concepts offering a limited menu. These units are located inside convenience stores or similar locations. The other 58% of the company’s restaurants are traditional units.

Franchisees operate 972 of the company’s restaurants, while the company operates 77 locations. For several years, the company has been making efforts to reduce the number of company-operated restaurants and increase its ranks of franchisees. Brazil Fast Foods manages five different brands,  some of which are Brazilian brands and others are well-known American restaurant concepts.

Brazil Fast Food’s main line of business is Bob’s. The company operates 39 locations and an additional 922 are operated by franchisees. Bob’s serves a classic fast food lineup centered on hamburgers and milkshakes. Bob’s was founded in the 1950s by an American-Brazilian tennis player named Robert Falkenburg as the first Brazilian fast food chain. A typical Bob’s looks much any ordinary American fast food establishment.

Bob's

Bob’s franchisees pay Brazil Fast Foods 4% of monthly gross receipts.

In 2007 and 2008, Brazil Fast Foods expanded its operations by opening KFC and Pizza Hut franchises. The company operates 14 KFC restaurants in Rio de Janeiro and 22 Pizza Hut units in Sao Paulo. Revenues from these American brands are growing rapidly and making up more and more of Brazil Fast Foods’ turnover.

In 2008, Brazil Fast Foods obtained the right to operate the Doggis brand in Rio de Janeiro from a Chilean company.

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As the picture suggests, Doggis is a fairly traditional hot dog restaurant. The company once operated these restaurants itself, but has since converted all 11 of the units into franchised restaurants.

Finally, Brazil Fast Foods owns Yoggi, a frozen yogurt concept. The company acquired Yoggi in May, 2012, and has 39 franchisees.

Brazil Fast Foods notes that all of its Brazilian restaurants are located in Southeastern Brazil, the country’s richest and most populated region.

Operating Results

Trailing twelve months and five fiscal year results are presented below, converted into USD at today’s exchange rate of $0.493 USD per Brazilian Real. Operating income is more indicative of profitability, as net income figures include the effects of selling off company-owned restaurants.

Income

Despite a rocky world economy, Brazil Fast Foods has thrived. While revenue growth has been impressive, the company has compounded the effect by converting an ever higher proportion of revenues into operating income. Part of this success is due to the company’s franchising efforts. Franchising is a high-margin business that requires little marginal investment.  The company’s main expenses in its franchising business are advertising campaigns, quality assurance and supply chain management for its franchisees. By contrast, the company-operated restaurant segment must pay for service employee salaries, food costs, occupancy costs and many more costs that the franchising business escapes.

The company provides very helpful financial comparisons between its franchising and company-operated restaurant segments. Again, I have converted all figures to USD at the current exchange rate.

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Though revenues from its company-operated stores make up 79% of total revenues, franchising operations contribute 62% of total operating income. Its easy to see why the company is eager to grow its franchising arm. At the same, the company-operated segment is putting up better numbers than ever. Operating profit is over seven times what it was only five years ago, largely on great results at the company’s KFC and Pizza Hut restaurants.

The long-term revenue decline at the company’s flagship Bob’s locations may seem troubling, but the decline is due to a gradual reduction the number of company-operated Bob’s restaurants. On a same-store basis, revenues actually increased 27.3% from 2007 to 2012.

Brazil Fast Food’s consistent profits have allowed the company to repair its balance sheet, which was in sad shape a decade ago. As successful as the 2000s were for the company, the 1990s were the polar opposite. At that time, the company’s sole line of business was operating Bob’s restaurants. The company’s franchising business was in its infancy. In 1997, for example, the company had only 56 contracted to franchisees, compared to over 900 now. Operating costs were out of control and the company was repeatedly forced to offer shares and obtain additional capital. Despite its troubles, the company finally hit on a good business plan and has been thriving since. Book value per share in USD has grown from -$0.33 in 2003 to $4.41 at March 31, 2013.

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Brazil Fast Food’s cash on hand is over twice its debt. Most of the company-operated restaurants are subject to leases with terms of up to five years, and these lease obligations do not appear on the balance sheet. These could present a risk if sales were to decline significantly. However, the company’s operating margin on these restaurants is healthy, which reduces the risk of these lease payments becoming an issue. At year end, these lease obligations total $22.9 million.

Valuation

Brazil Fast Food’s last trade price was $11.60 for a market capitalization of $94.3 million. Trailing P?E is 8.0, though this includes one-time gains from converting company-operated units into franchised restaurants. The more useful EV/EBITDA metric stands at 4.4.

It’s tough to find a direct competitor for comparison purposes, but Arcos Dorados’ business model is similar enough to facilitate a comparison. Arcos Dorados is the largest franchiser of  McDonald’s restaurant in South America and Latin America, and has a substantial presence in Brazil. Brazil Fast Foods and Arcos Dorados have similar opportunities in emerging markets and operate similar restaurants, but their valuations could hardly be more different. While Brazil Fast Foods trades at 8x earnings, Arcos Dorados trades at 28x. Arcos Dorados’ EV/EBITDA is 10.2, more than twice Brazil Fast Foods’ valuation. 10.2x EBITDA for a high-growth emerging markets company may or may not be a good value, but 4.4x very likely is.

If Brazil Fast Foods Corp. traded up to 7.1x EBITDA, just 70% of Arcos Dorados’ valuation, shares would rise to $17.93, a gain of 55%.

Risks

Like any other emerging markets country, Brazil Fast Foods faces special political risks. Brazil has enjoyed a multi-decade period of stability, but that doesn’t mean the country is out of the woods entirely. Problems of corruption, income inequality and inflation remain. On the other hand, the country’s recent oil discoveries and significant foreign currency reserves will provide surer economic footing. Brazil’s dollar-denominated debt rating was raised to BBB by Standard & Poor’s in 2012.

Part of Brazil’s legacy of instability is a frequently-changing and often arbitrary tax system. Brazil Fast Foods has a long-term disagreement with the Brazilian government over taxes owed by the company’s Venbo subsidiary. Though the company disputes these tax assessments, claiming they were calculated incorrectly, the company lists a potential liability for the disputed amount of $3.2 million on its balance sheet.

The company is also embroiled in a dispute over taxes on the royalty payments it receives from franchisees. The company believes these payments are not subject to the municipal tax on services received, but the city of Rio de Janeiro believes otherwise. The matter is in court, but the company lists a possible liability of $4.3 million.

Investors in Brazil Fast Foods Corp. must be comfortable buying into an insider-controlled company. Mr. Rômulo B. Fonseca and Mr. José Ricardo B. Bomeny together own 57.7% of shares outstanding, and other insiders own an additional 3%. In 2010, the company executed an agreement to sell all eight of its owned real estate properties to these investors. The company states these sales were done at fair market value and the company realized a gain on the sales. 64 of the company’s restaurants are franchised to Mr. Fonseca and Mr. Bomeny. These units pay the same royalties as all other franchisees. No other related-party transactions were disclosed in the 2012 annual report.

In Summary

Brazil Fast Foods represents an opportunity to invest in a fast-growing company that operates in an attractive industry and economy. Upcoming events like the 2014 World Cup in Brazil and the 2016 Olympics in Rio de Janeiro will put Brazil in the spotlight and could drive sales. Until then, continued improvement in operating margins and growth at the company’s operated restaurants and franchisee roster could further increase revenues and profits, making Brazil Fast Foods’ valuation look better and better.

I have a position in Brazil Fast Foods Corp.

Awilco Reports Record Earnings, Initiates Dividends

The Awilco Drilling thesis has been generating some buzz, at least among the small contingent of value investors who can’t help but keep buying into obscure and illiquid companies. There’s a spirited debate going on over at the Corner of Berkshire and Fairfax forum and Alpha Vulture did a write up that is much more detailed than mine. I highly recommend reading it.

Amidst all the bluster, Awilco released stellar first quarter earnings.

  • Revenue of $53.4 million, up 1.1% from the previous quarter.
  • EBITDA of $33.9 million, up 4.0%.
  • Net income of $24.7 million, up 7.9%. EPS was $0.82.
  • Revenue efficiency (revenue achieved vs. maximum revenue potential) was 91.2%, down slightly due to poor weather and a stoppage for minor repairs on WilHunter.
  • Net debt of $66.4 million, down substantially from last quarter’s $97.7 million.

Even better, Awilco’s management followed through on its intentions and declared a $1.00 quarterly dividend! If this quarterly dividend can be maintained (and perhaps it can, given rate increases on the horizon) then investors are looking at an incredible yield. Shares are up 10% since my original write up, but the potential yield is still in excess of 20%.

This might be the shortest post in my blog’s history, but it’s also probably the shortest I’ve ever had to wait to see an investment thesis confirmed. That’s not to say Awilco’s current successes will continue forever, but for now favorable economic conditions, the company’s great execution and the generous dividend could continue to drive shares higher.

I have a position in Awilco Drilling.

Awilco Drilling’s Upcoming Double Digit Yield – AWLCF

Awilco Drilling Plc owns two semi-submersible drill ships that operate in the North Sea. Awilco acquired these ships from Transocean in 2009 and spent the following years completing upgrades on the ships and signing contracts with oil drillers. Now that its fleet is fully utilized, Awilco has announced it will begin paying out all free cash flow to investors. At the current share price, this could represent a yield of over 20% and may lead to substantial appreciation.

The first of Awilco’s rigs is the WilHunter, pictured below.

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The WilHunter was built in 1983 and upgraded in 1999 and 2011. The ship is capable of operating in water depths of 1,500 feet and can drill 25,000 feet. WilHunter is contracted to Hess until November 2015, with options to extend the contract another 275 days. The dayrate is $360,000, increasing to $385,000 in May 2014.

Awilco’s second rig is the WilPhoenix.

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The WilPhoenix was built in 1982 and upgraded in 2011. It can operate in water depths 1,200 feet and drill 25,000 feet. WilPhoenix is contracted to Premier Oil until May 2014, with options to extend the contract another 180 days. The day rate is $315,000, increasing to $351,000 in October 2013, then returning to $315,000 in March 2014.

Awilco is highly profitable at current dayrates, but tight rig supply and persistently high oil prices may bring even higher rates in years to come. When WilPhoenix’s contract ends in mid or late 2014, it will be one of the few rigs available. In its April 2013 presentation to shareholders, Awilco included a chart illustrating the supply situation.

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The company also provided a helpful chart showing historical dayrates and supply trends.

trendIf these images are difficult to read, simply click for the full-sized versions.

Awilco’s performance in the fourth quarter of 2012 was its best yet, based on higher dayrates and full utilization of its fleet. For the quarter, the company earned $0.76 per share on revenue of $52.8 million and produced $32.6 million of EBITDA. This EBITDA figure included $3.56 million in provisions for doubtful debt, which will presumably not be a repeating expense. EBITDA excluding the charge was $36.2 million.

With its rigs fully contracted for the next year, its not stretch to assume Awilco can produce earnings of at least $3.04 per share and EBITDA of at least $144.8 million. I say “at least” because these figures exclude the increased dayrate WilPhoenix will earn beginning in October 2013. These projected earnings also exclude benefits from debt reduction and the absence of future doubtful debt charges. Earnings in future years could be even higher if rig supply remains constrained or if oil prices rise.

In the face of these projections, Awilco’s valuation is extremely low. (Again I’ll emphasize these projections are not pie in the sky figures based on breathlessly optimistic assumptions, they are based on Awilco’s actual signed contracts with oil majors.) Awilco has 30,031,500 shares outstanding. The recent trade price of $14.10 yields a market capitalization of $423.4 million. Net debt is $97.7 million. P/E based on conservatively estimated $3.04 per share earnings is 4.6 and EV/EBITDA based on EBITDA of $144.8 is 3.6.

Using these projections and assuming free cash flow approximates net income, Awilco’s annual dividend will be $3.04 per share for a yield of 21.6% on the current share price. Now, the dividend may not reach these heights immediately. Awilco has said it will retain a $35 million cash buffer for operational and capex needs, and it may take time to build this reserve. The company also indicated it will not allow the dividend policy to keep it from pursuing worthy growth opportunities, but said it will continue to pay a healthy dividend even if it engages in an acquisition or another initiative.

Cheap stocks are great, but cheap stocks with a catalyst are better. In a yield-starved world, a 20%+ yielder that is not an MREIT or a wasting asset like a royalty trust will turn some heads. Awilco will pay its first dividend in the first half of 2013. At that time, the company will no longer fly under the radar.

Awilco Drilling does bear substantial risks. Chief among them is the company’s concentration. Because it has only two drill ships, the company is vulnerable to a host of potential issues like operational problems, damage or disputes with the contracting oil companies. With only two revenue streams, a disruption in either would affect earnings severely. Awilco is also exposed to mid-water dayrates, over which it has absolutely no control. Rates have been very strong, but high rates may eventually attract competitors. Alternatively, oil prices could crash and dayrates could tank.

Another issue Awilco faces is the age of its ships. Though they were upgraded in 2011, each ship is three decades old and won’t last forever. In its 2011 annual report, Awilco lists the expected life of each ship as 20 years. As they age, these ships may command lower dayrates or require expensive upgrades.

Awilco’s illiquidity should also be considered. Though it has a market capitalization of $423.4 million, only just over $50 million worth of shares are available for trading. The remainder are held by a variety of banks and pension funds. A related company, Awilco Drilling AS, holds 48.73% of Awilco Drilling. Awilco’s US ADR is traded on the grey market, with a few thousand shares trading hands on a typical day. The company’s primary listing is the Oslo Exchange, where it is slightly more liquid.

I have a position in Awilco Drilling.