Teton Advisors: Attractive Business Model and Rapid Growth – TETAA

Teton Advisors Inc. is an asset management company with $1.4 billion under management that was spun off from GAMCO in 2009. The company retains close operational ties with GAMCO, and is majority-owned by Mario Gabelli. Teton has been extremely successful in increasing its assets under management and earnings.

The Asset Management Business

The business of managing mutual funds and separate accounts is a great one for several reasons. Returns on capital are outrageous because capital requirements are so low. No expensive factories or physical storefronts are required, just some office furnishings and software. An asset management company’s greatest assets are its employees, brand name and relationships, none of which appear on the balance sheet.

The asset management business is also scalable at little marginal cost. Unlike a manufacturer or retailer, which must build additional capacity in order to increase revenues, asset managers can increase assets under management by the hundreds of millions without significant capital expenditures. What’s more, the additional revenue drops to the operating income line at a high rate, since operating costs do not increase proportionally.

That said, asset management has some drawbacks. Investors can be fickle, chasing a hot manager and abandoning a poor performer. Even a short period of underperformance, which all asset managers will occasionally experience, can lead to huge client withdrawals and declining assets under management. Retail investors in particular tend to be pro-cyclical, withdrawing assets during down markets and reinvesting during up markets.

Asset management companies are often strongly dependent on a few key staff, such as a star investment manager or team. The high demand for investment talent (or, let’s be honest, talks-a-good-game-on-CNBC talent) gives rise to extremely personnel costs. Employee compensation is typically an asset management company’s biggest expense.

Teton Advisors Products

Teton Advisors currently manages seven open-end mutual funds, in partnership with Westwood Funds. Four of these are equity funds, one is fixed income and the other two are blended. Teton also manages separate accounts.

products

The chart above shows Teton’s offered mutual funds, with performance for the institutional share classes. Clearly, the Mighty Mites fund is Teton’s flagship product. Performance has been exceptional and the fund has been managed by Mario Gabelli and Laura Linehan since 1998. The Equity, Balanced and Intermediate Bond funds are sub-advised by Westwood.

Teton assumed management of the other funds more recently. The small size of the other funds may be by design: many companies will seed a small fund with their own money and hope performance is solid. If it is, the fund is heavily advertised and promoted through distribution channels. Inflows eventually increase the fund’s AUM to to point where it is profitable. A small, poorly-performing fund is eventually quietly liquidated or merged with another fund.

Growth In AUM

Teton’s assets under management have increased from $449.8 million at the end of 2008 to slightly more than $1.4 billion at March 31, 2013. $556.5 million of the increase has come from net inflows, and $421.5 million is the result of market returns.

AUM

This increase in assets under management equates to 31.2% annualized growth since the end of 2008. Stripping out market gains, net inflows have created annualized growth in assets under management of 20.9% annually.

AUM chart

Results

Teton’s continued increase in assets under management has resulted in serious earnings growth. In 2008, earnings per share was $0.55. For the twelve trailing months ended March 31, 2013, earnings per share was $1.53.  Because of Teton’s swift growth, looking at the twelve trailing month period underestimates Teton’s earnings power. For the most recent quarter, revenues were up 29.2%, leading earnings to increase 13.3% year-over-year to $0.49 per share. (Teton bought back a large block of shares in 2012, leading EPS growth to outpace net income growth.) Assuming assets under management and costs remain stable, Teton could earn $1.96 in 2013.

Teton’s operating margin in the most recent quarter was 30.2%, a decrease from 34.6% a year before. The culprit was compensation expense, which rose 72.3%. Even if these elevated compensation expenses are ongoing, a 30%+ operating margin is still outstanding and shows just how profitable an asset management practice can be.

Teton’s balance sheet is barely worth mentioning. At quarter’s end, Teton’s total assets amount to $2.38 million, with $0.98 million in equity. The company has no debt and nearly all assets are current.

Valuation

Teton Advisors shares have traded between $16.80 and $25.00 over the last six months. The current bid/ask is $19.00/$32.00. Assuming a share price of $25, Teton trades at about 12.8 times forward earnings. 12.8 times earnings represents an earnings yield of 7.8%, fairly appropriate for a low-growth company. But Teton’s history shows it is anything but low growth.

Teton will have a more difficult time growing its AUM at 30%+ over the next several years. After all, going from $500 million to $1.4 billion in assets under management is a lot easier than going from $1.4 billion to $5 billion. However, a more reasonable rate of growth is certainly achievable. Teton’s historical growth rate due to net inflows is 20.9%. Achieving just under half of that, 10%, plus 5% annual market returns would push assets under management to $2.8 billion in 5 years. Assuming earnings doubled right along with AUM, Teton’s EPS at that point would be $3.92. The same 12.8 P/E ratio would mean a share price of $50.18.

Teton’s 2012 dividend was $0.60 per share. Assuming dividend growth tracks earnings growth and the share price in five years is $50.18, investors buying at $25.00 would make an attractive annualized return of 17.7%.

Again, some of these assumptions are very conservative. 10% annual growth in AUM from net inflows is less than half the historical rate, and a 5% annual market return is also below historical averages. Also, Teton will likely reap from efficiencies from higher revenues, which could increase margins and speed earnings growth.

Other Considerations

Teton Advisors remains tightly interwoven with Mario Gabelli and GAMCO. The two firms’ relationship is extensive, with many related-party transactions disclosed in Teton’s reports. (The transactions are mostly reimbursements for funds distribution and outsourced corporate functions, and do not seem untoward.) To some extent, Teton’s fortunes are intertwined with Mr. Gabelli’s and GAMCO’s.

I view the tie-in with Mario Gabelli as a positive. Mr. Gabelli’s long-term record as an investor is exceptional, and another company with high ownership by Mr. Gabelli (LICT Corp.) is one of the largest positions in my portfolio. I expect him to make money on LICT and Teton Advisors, and I’m happy to invest alongside.

Investors should also weigh the long-term outlook for the actively-managed mutual funds industry. The certain advantages of ETFs and other cheap, passive investments are well known and the eventual death of retail investor-focused active funds management has been predicted by many. On the other hand, every additional dollar invested in indexing strategies increases the opportunity set for active managers with true skill.

Teton Advisors is fairly illiquid, but a patient investor may be able to pick up shares at attractive prices by waiting for an impatient seller.

No position, may add opportunistically.

Retail Holdings Plans an IPO, Awilco Drilling Gets Big Contract

Good news from two companies I’ve written about: Retail Holdings and Awilco Drilling.

Retail Holdings – RHDGF

Retail Holdings NV is a holding company with a fully-diluted 54.1% stake in Singer Asia, a consumer goods conglomerate operating in South-East Asia. Singer Asia’s various subsidiaries are publicly-traded, making it simple to determine their value to Singer Asia and ultimately to Retail Holdings.

Retail Holdings’ objective is to liquidate, selling its investment in Singer Asia and returning cash to shareholders. Recently, the company announced it is considering an IPO of Singer Asia, renaming the company Sewko Holdings Limited. Retail Holdings would retain an equity stake in the company. The company’s chairman, Stephen H. Goodman, cautioned investors that the IPO might not happen for some time, if ever. Despite the uncertainty, the fact that the company is considering monetizing its main asset is a positive for investors.

A sale of most of Retail Holdings’ stake in Singer Asia would go a long way toward closing the significant gap between Retail Holdings’ trading price and the market value of its assets.

singercos

 

Singer Asia’s various subsidiaries have a market capitalization of $464 million USD, of which $146.53 million is attributable to Retail Holdings, or $27.59 per share. Retail Holdings also holds $4.24 per share in distressed debt, as well as some cash at the holding company level. Even haircutting the debt by 50% and excluding the holdco cash gives a per share net asset value of $29.71. The closing price of $19.60 represents a 34% discount. An IPO or other strategic transaction could close this gap, yielding a big gain for shareholders.

Awilco Drilling -AWLCF

Awilco Drilling owns two semi-submersible drillships that are contracted to oil companies drilling in the North Sea. Despite good revenue visibility and a management team committed to returning capital to shareholders, Awilco trades at a dividend yield of over 20%. One factor that may be holding down Awilco’s shares is persistent rumors that Awilco will contract for newbuild drillships. Awilco’s investor relations denied these rumors last time they came up, but that does not mean the story could not change. Ordering new rigs would obviously impair Awilco’s ability to pay dividends and would be reason for reviewing the entire investment thesis. A link to Awilco’s denial is here, but in Norwegian.

Yesterday Awilco announced the signing of a letter of intent with Apache and Taqa for Awilco’s WilPhoenix drillship. The contract will commence in the second half of 2014 and will employ WilPhoenix through mid-2017, with an option for two years of additional service.

The dayrate for the new contract is about $387,000, 22.9% higher than the current contract. With the signing of the letter of intent, both of Awilco’s drillships are fully booked for the next 29 months. Assuming a 10% marginal tax rate and that the company can maintain 90% revenue efficiency, the revenue increase from the new contract will contribute an additional 71 cents per share to Awilco’s bottom line each year once the contract begins.

 

I own shares in Retail Holdings NV and Awilco Drilling Plc.

 

Maxus Realty Trust’s Steep Discount to NAV – MRTI

The companies I write about typically fall into one of four categories: companies trading at a low multiple of normalized earnings, high-growth companies trading at low-growth multiples, improving capital structure plays, or liquidations. Fruitful territory, but hardly the only effective investing styles.

Maxus Realty Trust is none of the above. Rather, it is a REIT that trades at a steep discount to its net asset value. The company’s substantial worth is obscured by a complex financial structure and the vagaries of GAAP accounting.

Maxus Realty Trust (formerly known as Nooney Realty Trust) was founded in 1984 in Kansas City, Missouri. The company has focused on owning and operating apartment complexes as well as occasional retail and light industrial facilities. At present, the company owns 4,434 apartment units and 40,412 square feet of retail space in Missouri, Arkansas, Oklahoma, Kansas and Texas. Maxus has an outstanding track record. Over the last 20 years, shareholders have earned 13.0% annually, compared to 8.7% for the SPDR S&P 500 ETF. $1 invested in Maxus in June, 1993 is now worth $11.58, assuming reinvested dividends. Maxus deregistered from the NASDAQ in 2008, but has continued to update shareholders through regular quarterly and annual filings.

Maxus Realty Trust uses an “umbrella REIT” structure that allows property sellers to save on taxes by accepting partnership units in lieu of cash or common stock. The structure probably helps achieve better purchase prices for Maxus, but also makes evaluating the company a difficult task. Essentially, Maxus conducts its real estate operations through a partnership. A wholly-owned subsidiary, Maxus Realty GP, Inc., serves as general partner of the partnership, the Maxus Operating Limited Partnership, “MOLP”. Maxus Realty Trust owns 90.484% of the partnership’s limited partner units. Management owns another 7.556%, with the balance held by parties who have sold properties to MOLP. All of the properties Maxus Realty Trust controls are wholly-owned by MOLP, with the exception of some recent purchases where MOLP owns 52% and various outside investors own 48%.

Here’s my attempt at an entity chart, including Maxus’ various properties.

Entity flowchart

The important takeaway is that investors in Maxus Realty Trust, Inc. do not have a 100% claim on the residual cash flows of underlying properties. The equity claims are divided among various external parties. These non-controlling interests greatly complicate Maxus’ financial statements. A great deal of adjusting must be done to determine the value of common shareholders’ equity claim.

We can start by taking a look at Maxus Realty Trust’s various properties and their ownership structures. On its most recent quarterly statement, Maxus lists real estate with a gross cost of $257.60 million. Net of accounting depreciation, the figure is $222.25 million. These figures do not include any allowance for minority claims by non-controlling interests.

Balance sheet real estate requires special treatment. Unlike cash or accounts receivable, the economic value of balance sheet real estate often varies considerably from its GAAP book entry. Real estate, like other fixed assets, is recorded at the lower of cost or market value. Even if the real estate was purchased decades ago at a fraction of its current market value, the cost basis is what appears on the balance sheet.

Another unusual feature of real estate’s accounting treatment is the role of depreciation. One of commercial real estate’s most attractive qualities is the ability to deduct depreciation expense, whether or not any economic loss of value has occurred. Unlike vehicles or factory equipment, real estate tends to increase in value over time, not lose value. The rate of increase is not high, generally approximating inflation, but the effect can be great over time. The accounting treatment of depreciation allows many REITs to show significant accumulated depreciation on their balance sheets, yet the value of their real estate holdings has not declined at all and may have even grown.

Despite showing roughly $35 million in accumulated depreciation on its balance sheet, it is extremely unlikely that Maxus’ properties are worth less than their cost. In fact, many of the properties are likely worth far more. Apartment complex values have benefited from twin tailwinds: falling vacancy rates (source: WSJ) and some of the lowest cap rates on record (see page 5 of this PDF from the Pension Real Estate Association). In the most recent quarter, Maxus’ units were 94% occupied.

Although many of Maxus’ apartment complexes have likely appreciated significantly, I think assuming appreciation has tracked with inflation is a conservative estimator of current value. If I had the time or resources, I’d love to get some ground-level intelligence on the properties and estimate their worth properly. The inflation-adjusted approach will have to suffice for now.

Inflation-Adjusted

(The cost I’ve derived does not line up precisely with the cost on Maxus’ financial statements because I excluded some closing and transaction costs.)

Adjusted for inflation, Maxus’ real estate with a cost of $255.87 million would have a current market value of $277.73 million, an increase of $21.86 million. This figure does not include any benefit from capital improvements or the previously mentioned tailwinds of falling vacancies and cap rates.

Combined with the $35 million of “false” depreciation, that’s nearly $57 million of extra value that will never show up on the balance sheet, barring property sales or an outright sale or liquidation of the entire trust. But of course, it’s not that simple. Remember how Maxus Realty Trust only owns 90.485% of MOLP, the legal owner of the sub-entities that own all the properties? What’s more, some of the properties are 48%-owned by unaffiliated investors. Clearly, there is more work to do.

First, we’ll reduce the real estate value for the portion of individual properties owned by outside investors, then we’ll reduce it again for the 9.515% of MOLP’s LP units that are not owned by Maxus Realty Trust.

To outside Investors

Many of Maxus’ more recently-purchased and expensive properties are those that are 48%-owned by outside investors. Accounting for this minority ownership reduces MOLP’s real estate value by almost $70 million, to $208.16 million.

The last step requires reducing this amount by 9.515% to account for the portion of MOLP’s LP units not owned by Maxus Realty Trust. Doing so produces a final value for Maxus’ real estate of $188.35 million.

Now we must repeat the same process for Maxus’ mortgage debt. Like nearly all real estate companies, Maxus carries a substantial amount of mortgage debt at the property level. Borrowing at a low rate to buy a property with a higher cap rate allows for a positive cash flow and equity creation as debt is paid down. This equity can then be borrowed against to acquire additional properties.

Maxus’ properties carry $198.18 million in mortgage debt. Just like before, adjustments must be made for the properties that are less than 100% MOLP-owned.

Debt Summary

After accounting for minority ownership, MOLP’s property debt declines to $146.81 million. Reducing this figure for the non-owned 9.515% of MOLP’s LP units yields a final property debt figure of $132.84 million attributable to Maxus Realty Trust.

Netting $132.84 million in property debt against adjusted real estate value of $188.35 gives a net asset value of $55.51 million for Maxus Realty Trust, or $42.70 for each share. Almost there.

Maxus Realty Trust’s financial statements also show sundry assets and liabilities, the most significant of which are $8 million in notes payable and $5.87 million in unencumbered cash. The notes payable are recourse to the trust and are guaranteed by trustee/CEO/Chairman/President David L. Johnson. It is impossible to tell whether the cash shown resides at the trust, at MOLP or at any of the property subsidiaries level, so some discount to its value is appropriate, say 50%.

Excluding cash, net working capital comes to $880,000. Unable to determine the relative claims on this working capital, I will assume this has no value. I will also assume the intangible assets of $292,000 on the balance are worthless. Maxus also has $353,000 in equity-accounted investments in other real estate entities, which I will assume are worth their balance sheet value, though they could be worth significantly more.

adjusted balance sheet

After all that work, we arrive at a conservative estimate of Maxus Realty Trust’s net asset value per share: $38.02. As a check on adjusted balance sheet derived figure, we can look at Maxus’ adjusted funds from operations over the last year. The company calculated FFO at $9.95 million for the twelve trailing months, but that includes distributions to non-controlling interests (the 48% property owners). Reducing FFO by the amount of those distributions leaves FFO of $8.32 million. Capital spending for the trailing twelve months was $4.83 million, leaving adjusted FFO of $3.49 million. Adjusting once again for the 9.515% of MOLP not attributable to Maxus Realty Trust shareholders leaves AFFO to shareholders of $3.16 million, or $2.32 per share.

$2.32 per share in AFFO is a yield of 6.10% on the NAV of $38.02. Other apartment REITs I looked at had AFFO yields ranging from 3.17% to 6.58%, so it seems NAV of $38.02 is a decent proxy for Maxus’ fair share price.

Shares of Maxus most recently changed hands at $35. Move along, nothing to see here. Or wait, is there? That $35 trade was actually a complete anomaly. Right now, Maxus has a bid/ask spread of $19.00/$22.00. Now that’s a discount to net asset value!

Though you’d never know by looking at the balance sheet, $22.00 represents a giant discount to the company’s true asset value. But before jumping in, investors should consider a few things.

Leverage – Total debt of $206.18 million versus total estimated property value of $277.73 million represents a loan-to-value of 74.2%, which is very aggressive. Other apartment REITs I looked at averaged only 48.5% LTV. Maxus’ higher leverage allows for higher potential earnings, but also increases the risk of running into a financial crunch down the road. All of Maxus’ property debt is fixed rate and has an average maturity of over five years, but refinancing risk remains.

Dividends – Many investors choose to purchase REITs for their healthy dividend yields, but investors in Maxus are unlikely to see a dividend for some time. Maxus’ aggressive leverage and large recent investments result in high annual depreciation and interest expenses, which reduce GAAP net income. Low or negative GAAP income results in no need for Maxus to pay a dividend. REITs are required to pay out 90% of net income to retain REIT status, but 90% of $0 is $0. What’s more, Maxus has over $6 million in tax loss carry-forwards, none of which expires before 2018. CEO David L. Johnson seems more than happy to continue to retain capital and build net asset value rather than pay dividends. Income seekers should look elsewhere.

Management – To invest in Maxus is to invest in David L. Johnson. After all, Mr. Johnson is CEO, trustee, Chairman and President all at once. Mr. Johnson’s track record speaks for itself, but investors should always tread carefully when asked to trust one person with so much power and responsibility. Maxus discloses some substantial related-party transactions with entities affiliated with Mr. Johnson and other company insiders. A company owned by Mr. Johnson serves as property manager for many of Maxus’ units, the Maxus has purchased properties from Mr. Johnson in the past. I did not notice anything blatantly untoward in my review, but that does not mean it isn’t there. Mr. Johnson is 55 and could lead the company for decades to come.

Maxus also faces the standard risks common to real estate companies. Rising interest rates would not have an immediate impact on Maxus’ cash flow, but could take a toll when it comes time to roll over debt, as well as decrease property valuations via rising cap rates. A faltering economy could send real estate prices tumbling. On the other hand, a rosy economy could increase homebuying activity and decrease demand for rentals.

Investors will have to decide for themselves if a to 42-50% discount to net asset value is enough to compensate for Maxus’ risks. I’ve made up my mind.

I own shares in Maxus Realty Trust.

 

Power Solutions Is A Rocket Ship, But How High Is Too High? – PSIX

Last November I wrote about Power Solutions International, a high growth natural gas engine company trading at a very reasonable price. Since then, shares have rocketed 150%.

Growth has been strong since I wrote, but multiple expansion is responsible for most of the gain. In November, PSI traded at 11.6x trailing operating income. Now the company trades at a much loftier 27.4x trailing operating income.

In my original post, I noted Power Solutions would be eligible for an uplisting after filing its 2012 annual report. Sure enough, PSI wasted no time, announcing a listing on the NASDAQ in late May.

But enough self-congratulation from me. The question on my mind is: what now? Is Power Solutions International’s huge increase in value justified by its business performance and outlook? Or is this rise predicated more on hype?

In November, at 11.6x trailing operating income, Power Solutions didn’t have to keep growing at 30%+ annually to justify its valuation. Plenty of solid companies growing at 8-10% per year trade at that level or higher. So long as the company continued to operate profitably and make good decisions, investment profits were likely. Even at 15% growth, less than half of what PSI had historically achieved, a 11.6x trailing operating income multiple falls to 7.6x in three years. At some point, the stock price of a successful, growing company has to rise, else its valuation multiple will compress to the point where the company will be irresistible to a competitor or a private equity firm.

27.4x trailing operating income, on the other hand, is an entirely different story. At that multiple, Power Solutions absolutely must maintain its torrid growth to justify its valuation. If revenue growth were to slow for any reason, the resulting multiple compression could spell a very sharp decrease for PSI shares.

Valuation multiples are expressions of expectations. The higher the multiple, the higher the expectations and vice versa. When a company with a low valuation multiple (and low associated expectations) experiences slow growth or loses market share or takes a restructuring charge, its share price is usually not punished severely. It’s like playing dodgeball: nobody expects the kid picked last to last long. On the other hand, a high valuation multiple company that misses a revenue forecast or whose product is rejected by consumers can fall a long, long way.

It’s about risk. No matter its valuation multiple, Power Solutions International faces the very same risks. Natural gas prices could rise, derailing the trend toward natural gas engines. Competitors with larger R&D budgets like Westport could out-innovate. A product recall could destroy confidence in PSI’s engines. At a low valuation multiple, a disappointment is just a bump in the road. At a high valuation multiple, a disappointment is a disaster, a reason for questioning a company’s entire story.

Maybe Power Solutions International will continue to perform flawlessly and the share price will rise to $50, $60 or even higher. But at 27.4x trailing operating income, the risk is just too high. A single setback could send the share price tumbling.

Power Solutions International is a success story that has gotten ahead of itself. I’ll be moving it to the “Inactive Ideas” section and going looking for the next cheap, growing and unlisted company!

No position.

 

The Cycle Turns for Smith-Midland – SMID

Smith-Midland Corporation is a Virginia-based manufacturer of precast concrete components for the construction and architectural industries. Smith-Midland provides a broad array of products including building exteriors and panels, highway safety barriers and sound barriers, precast buildings and more. Smith-Midland trades at 78% of book value and has recently been targeted by activist investors.

The precast concrete product market is heavily cyclical and tracks with construction activity, both private and governmental. Revenues are dependent on the construction of new buildings and roadways, as well as investment in repairs and upgrades to existing infrastructure.  The market for these products would be completely commoditized but for the fact that concrete products are extremely heavy and bulky. The high cost of transport limits competition to a local level.

Smith-Midland’s largest-selling products are its wall panels, which made up 22% of revenues in 2012. Barrier sales, including the company’s patented J-J Hooks® highway safety barriers, accounted for 13% of revenues. Easi-Set Precast Buildings, also with a patented design feature, were another 13% of revenues. The remaining revenue consisted of royalties on product lines licensed to other companies, barrier rentals, miscellaneous product sales and transportation and installation revenue.

Smith-Midland’s results have been volatile. Revenues and profits peaked in 2010, only to plunge precipitously in 2011. Gross margin fell by nearly 40% as several profitable contracts were completed and could not be replaced. Results rebounded in 2012.

Results

Despite challenging economic conditions, the 2008 to 2012 period resulted in three of Smith-Midland’s five highest-selling years. For the period, Smith-Midland averaged earnings of $0.20 per share and free cash flow of $0.23 per share.

Book value per share grew by 12.1% annually from 2007 to 2012, adjusted for a 5 cent special dividend in 2012. Smith-Midland’s balance sheet is very strong, with a current ratio of 4.81 at year’s end and more cash than debt.

balance sheet

While 2012 was a tough year for Smith-Midland’s bottom line, there is evidence that the cycle is turning in Smith-Midland’s favor. First quarter 2013 results were significantly improved over 2012, and management included very positive language on market conditions in its 2012 annual report.

quarterly

Revenues leaped 15% for the quarter ended March 31, 2013, and gross margin increased by a whopping 938 basis points based a 27% increase in wall panel sales and a 29% increase in royalties, rental and transport/installation revenues. Operating leverage resulted in a huge swing in operating income and a nearly 9 cent per share increase in net income.

The outlook for the rest of 2013 is rosy as well, according to management’s comments in the 2012 annual report.

Wall Panels – “The Company was recently awarded a large Slenderwall™ project in New Jersey that will start in the second quarter of 2013 and could significantly increase Slenderwall™ sales in 2013.”

Easi-Set® Buildings – “Bidding activity for buildings increased somewhat during 2012, leading management to believe building sales could continue to increase in 2013. To aid in the continued increase in building sales, the Company hired two new building salespersons with the first starting in December 2012 and the second starting in February 2013.”

Utility and Farm Products – “The Company will be bidding on a large vault project in the first quarter of 2013, which management believes it has a reasonably good chance to prevail. The Company is also seeing more bidding opportunities for utility products as of late and believes this, and the large vault project, may lead to increased sales in 2013.”

Also, in an 8-k filing dated May 17, management indicated it was exploring the possibility of buying back shares. Buying back shares below book value is typically an excellent use of capital when debt levels are already low and expansion opportunities are limited. Smith-Midland’s intangible assets are minimal, making a repurchase even more likely to create value.

At the end of the first quarter of 2013, Smith-Midland’s book value per share was $2.28. A solid year in which the company earns 30 cents or so per share could push book value per share over $2.50 or higher. At some point, the company’s discount to book value will become too wide for the market to ignore, and I would expect Smith-Midland to head higher.

On the other hand, Smith-Midland’s share price could follow the path of so many other unlisted stocks and languish despite solid performance. I consider that unlikely, given the recent attention given Smith-Midland by multiple activist investors. Two hedge funds have bought up 16.2% of Smith-Midland’s shares outstanding and have succeeded in bringing about positive changes, including the payment of a special dividend and leading management to allow a shareholder rights plan to expire. (Shareholder rights plans span a variety of strategies that purport to protect shareholders from abusive takeover offers, but usually serve only to entrench management and discourage acquisition bids.) With the shareholder rights plan out of the way, the company is more likely to be acquired by a competitor or financial bidder. These hedge funds, Henry Partners and JCP Investment Partnership, will certainly keep a close watch on management’s activities.

On the topic of management, management compensation takes a large bite out of operating income. CEO and board chairman Rodney Smith co-founded the company’s predecessor in 1960 and holds 15.8% of shares outstanding. Mr. Smith’s son, Ashley Smith, serves as president and holds 3.4% of shares. In 2012, the father and son team took home $325,225 in compensation. In 2011, they earned $639,477. Rodney Smith also receives $99,000 annually for use of his patents and $24,000 rent on land he leases to the company. If not for these payments to the Rodneys, Smith-Midland’s 2012 operating income would have been 78% higher.

Despite high management compensation, Smith-Midland could be ready to rise. Recent results are trending much higher than 2012 and the company is projecting further contract wins. Smith-Midland’s already high cash balances could increase further, and JCP Investments and Henry Partners will be watching to make sure management uses it well.

I hold shares of Smith-Midland in an account I manage.

Belk Inc. Offers Good Value…If You Can Find Shares – BKLIA/BLKIB

Belk Inc. is a department store chain with over 300 locations throughout the American South. Belk has been in operation since 1888, when it was founded by William Henry Belk. Since nearly ceasing to exist in the 1990s, Belk has been restored to health and has embarked on an aggressive expansion, remodeling and rebranding legacy locations and expanding into new markets.

Today, Belk’s finances and growth potential are at least as good as its competitors, yet the company trades at a substantial discount to its peers. Despite being one of the largest unlisted companies, Belk stock is highly illiquid. Belk family members and associated entities control over 90% of shares outstanding.

Founded in Monroe, North Carolina, Belk quickly spread throughout the Carolinas and into neighboring states. Belk introduced new retailing practices uncommon at the time, such as clearly marking prices to prevent haggling, accepting only cash rather than extending credit, and allowing returns or exchanges. By the time of founder William Henry Belk’s death in 1958, the company owned nearly 400 stores in eighteen states and Puerto Rico.

As time went on, Belk fell victim to the same issues that beset most multi-generational family businesses. As the original owners passed away, their stock holdings became diluted among many children and grandchildren, most of whom did not work in the company and were only interested in their regular dividends. These heirs formed partnerships and companies to manage their share holdings, and some sold shares to Belk’s competitors. Belk’s corporate structure grew more and more convoluted. Even some of Belk’s stores were owned by multiple parties, giving rise to many hyphenated properties like Belk-Leggett and Belk-Hudson. By 1960, Belk consisted of an incredible 362 independent corporations, lacking any cohesive strategy or discipline.

The following decades saw relentless jostling and deal-making among family members over Belk companies and stocks. Some family members had financial motivations, while others were attempting to preserve prestige and influence for them and their children. Gradually, however, John and Tom Belk (sons of founder William Henry Belk) achieved majority control of most Belk corporations and set about merging them. 1989, the number of independent corporations had been reduced to 112. The process was rancorous, involving many lawsuits, court rulings and appeals along the way.

While Belk’s complexity had been reduced greatly, John Belk realized Belk had no chance against ever more competitive national department stores under what was still a highly unwieldy and unmanageable structure. Uniting as a single corporation was the only way, though it would be several years before that goal was accomplished.

Finally, in 1997, a full consolidation of the company was ready to be enacted. Bankers and lawyers worked thousands of hours to put a value on each of the 112 remaining corporations and determine what portion of the new enterprise each of over 500 shareholders would own. When all the work was done and the SEC gave its stamp of approval, the modern Belk, Inc. was born. (For anyone interested in the behind the scenes inter-family and financial workings that went on during the process, Belk’s site has an entire free book on its history. It’s an entertaining read, if you’re into that kind of thing.)

Consolidation complete, Belk went about modernizing and expanding, eventually buying 47 stores from Saks in 2005. Belk’s expansion is ongoing. In Spring 2014, Belk will open a three-story flagship store in Dallas, replacing Saks. Also in 2014, Belk will open a Huntsville, Alabama store and expand or remodel seventeen other stores.

Belk brought in nearly $4 billion in revenue and $188 million in profit in 2012, both records. Belk’s revenue growth has surpassed its competitors, both recently and over the last decade.

Sales Growth

 

Belk’s financial position is among the strongest of its competitors. Belk is both more liquid, as measured by its current ratio, and less leveraged, shown by its high degree of equity financing and lower debt/EBITDA and debt/assets ratios.

Fiscal Strength

Despite its superior growth rate and stronger financial health, Belk trades at a large valuation discount.

Valuation

 

 

The P/E comparison is less useful, due to Macy’s’ unusually high trailing P/E. The EV/EBITDA and EV/EBIT values, on the other hand, show that Belk is heavily discounted by the market.

On one hand, the valuation discount is entirely legitimate given Belk’s extreme illiquidity and wide bid/ask spread. Acquiring shares is extremely difficult and may get tougher given Belk’s appetite for its own shares. Over the last decade, the company bought back 25% of shares outstanding. In the long run, however, Belk will almost certainly become more liquid. The liquidity may show up suddenly through a buyout or slowly, as Belk’s shares once again become diluted as ownership passes to the next generation. A look at some of Belk’s form 4 filings reveals that extensive estate planning schemes have been put in place. The elder members of the Belk family are using an extensive array of trusts to pass on shares to their children and grandchildren. Simple math precludes all of these heirs from becoming involved in the business, and opportunities to acquire shares may arise as they sell their holdings.

Belk is definitely not a company for short-term investors. However, investors with a truly long time horizon might find a lot to like. Unlike some of its competitors, Belk is still very much a regional operation with plenty of opportunities to expand into new markets. Belk may be able to maintain its superior revenue growth for years to come.

Of course, that assumes rosy outcomes. What happens if the economy sputters or Belk’s merchandising strategy misses a major shift in tastes? Belk is better positioned to handle such a disruption than most other retailers. Belk owns a great portion of its stores, rather than leasing them. (I’ve been searching for the exact number, but in vain.) Owning rather than leasing much of its real estate lowers Belk’s operating leverage, decreasing the possibility of hemorrhaging cash in a bad economy. For an example of what over-dependence on leasing can do to a retailer in a crisis, pull up stock charts for Foot Locker or Tuesday Morning.

I don’t plan on making Belk a large part of my portfolio. Even if I wanted to, the shares are simply tough to acquire. However, one could do worse than holding a cheap, well-financed and quickly growing retailer like Belk. After all, a company that has been in business for 125 years is doing something right!

No position, may add opportunistically.

Rocky Mountain Dealerships – RCKXF

Rocky Mountain Dealerships, Inc. is a rapidly-growing, modestly valued agricultural and construction equipment dealer operating in Canada’s prairie provinces. Since 2008, the company’s first full year of public ownership, RMD has increased annual revenues at a 23% annual rate and has grown adjusted net income at the same pace. The number of company locations has grown from only 12 at the beginning of 2008 to over 40 now. RMD is a serial acquirer, focusing on rolling up smaller operations and integrating them under its Rocky Mountain Equipment brand.

RMD’s dealerships sell both new and used farm equipment such as tractors and combines, and construction equipment such as the large trucks and excavators used for infrastructure, home construction and oil & gas applications. Within agriculture, RMD primarily deals Case New Holland equipment. Case New Holland manufactures the world’s second and third leading agricultural equipment brands, trailing only Deere & Co. Rocky Mountain Dealerships is the largest Case New Holland Vendor in Canada, and second worldwide.

The Canadian provinces of Alberta, Manitoba and Saskatchewan where the company operates are Canada’s breadbasket, producing staggering amounts of wheat and other crops. They are also home to a well-established and growing petroleum industry. Not surprisingly in a food and energy-hungry world, these provinces have experienced GDP growth rates above those of other Canadian provinces.

GDP-growth

While healthy GDP growth within its economic territory has provided a tailwind, RMD’s greatest growth engine has been its unrelenting purchases of smaller dealerships. In 2011 and 2012 alone, RMD purchased (the dealership assets thereof or outright) Agritac Equipment, J&B Equipment, Camrose Farm Equipment and Houlder Automotive at a total cost of $21.5 million CAD.

A roll-up strategy can be highly successful in a fragmented industry. Aggregating smaller dealership entities under the Rocky Mountain Equipment name provides opportunities for cost reduction through eliminating duplicate corporate functions. RMD’s stated goal is to keep SG&A costs under 10% of revenues, and the scaling strategy seems to be bearing fruit. In 2012, SG&A expense was 9.6% of revenues, compared to 11.2% in 2008.

Lower inventory costs are another benefit to scale. With nearly $1 billion CAD in annual revenues, RMD can almost certainly achieve better inventory terms than small independent dealers can.

In an April 2012 presentation, the company provided a map of its locations across the three provinces. Since then the company has acquired a few more.

locations

 

Rocky Mountain Dealerships’ results since 2008 show torrid growth achieved without sacrificing margins. Even in the midst of the 2008-2009 financial crisis, RMD kept right on growing and profiting. Despite its intense growth, RMD was free cash flow positive in four of the last five years. Operating income in the chart below has been adjusted for one-time items, but net income has not. Figures are in millions CAD.

results

Despite significantly increased operating income in 2012, net income was nearly flat. This is due to a $4.2 million charge the company took related to the repurchase of all its convertible debentures. The repurchase reduced diluted shares outstanding by 17%.

RMD’s impressive free cash flow in the face of such a high growth rate is partially the result of smart working capital management. Net working capital to sales reached a high of 20% in 2010, but has since been reduced to 16.4%. Smart working capital management frees up cash that can be used for acquisitions or debt reduction or any number of other actions that increase equity value.

The chart below shows balance sheet figures since the company’s IPO, again in millions CAD.

balance sheet

At first glance, RMD’s balance sheet may seem stretched. Total assets come in at 4.5 times equity. However, the picture is better than it seems. 77% of the company’s liabilities are “floor plan payables.” Floor plan payables are amounts owed on inventory the company holds. The interest rates on these payables range from 0% to prime+4.3% as of December 31, 2012. These floor plan payables are secured by the inventory only and have no recourse to the company. They come due when the inventory is sold or transferred or at 48 months maximum. Floor plan financing allows the company to take on a lot of inventory at a low cost, without tying up its own capital.

Excluding the total floor plan payables figure and an equal amount of inventory, RMD’s equity-to-capital ratio rises from 22.36% to a much more comfortable 55.7%. The company’s non-floor plan payables debt (what I have termed “non-operating debt”) net of cash comes in at $34.2 million CAD, or 0.7 times EBITDA. That’s a very comfortable figure, especially considering the company’s resilience even through the worst days of the financial crisis.

Despite its 20+% growth rate, healthy finances and strong market position, Rocky Mountain dealerships trades at only 9.6 times earnings and an EV/EBITDA of 6.5. Amounts below are converted to USD, since I am using the ADR’s share price.

valuation

Rocky Mountain also trades at a significant discount to its competitors, despite its superior growth rate.

peers

For RMD to trade at a peer average P/E ratio, shares would have to appreciate to $16.30. For a peer EV/EBITDA ratio, shares would trade up to $17.73.  A peer average valuation seems conservative, given the company’s small size and attractive geographic location.

RMD recently raised its annual dividend to $0.40 CAD, yielding 2.9% at current prices.

Management has significant skin in the game with RMD, owning 22% of shares outstanding. This high ownership comes from RMD’s origin: Current CEO Matt Campbell and current President Derek Stimson merged their former companies and took the resulting company public as Rocky Mountain Dealerships. The surviving company does engage in ongoing related-party transactions, though these seem to be on fair terms.

The biggest risks for investors in RMD are the unpredictable commodities markets and the possibility that Canada’s economy will stumble. A decline in wheat or oil prices could greatly reduce demand for expensive combines and trucks as farmers, builders and drillers delay capital expenditures and choose to use existing equipment for longer. There are rumbles that Canada’s hot housing market could come to an ugly end, but that is far from a certainty.

US investors also need to be aware of currency risks. A strengthening US dollar could reduce returns for US investors.

Risks aside, investors could be looking at a great growth stock at a very reasonable price in Rocky Mountain Dealerships. How many US companies offer 20% or more annual growth, yet trade at under 10 times earnings?

I own shares in Rocky Mountain Dealerships.