A Thank You, An Update, and Some Thoughts on 2013’s Ideas

2013 is drawing to a close and I have a little travel ahead, so this will likely be my last post this year. I’d like to take the time to thank all of you readers who make this blog such fun to write. Your thoughtful comments and e-mails have both informed and challenged me, and I am grateful. I hope you will continue to include OTC Adventures on your reading list in 2014, because I have plenty more to talk about!

I am pleased to announce that the process of opening my RIA practice is progressing well, and I should be ready to accept investors in late January. I appreciate the patience that many of you who are interested in my practice have shown, as the state approval process is complicated and lengthy. I am currently working on a website and informational presentation for my new firm, which I will share as soon as I can. In the meantime, I can always be reached at otcadventures@gmail.com with any questions or comments.

In the course of this year I wrote about more than 30 different companies. Many of these have performed extremely well, some of them reaching or exceeding my opinion of fair value. Others have performed well but have plenty of potential left. A few…..let’s just say I wish I’d never learned their names. I’d like to highlight a few companies that still offer compelling value in my estimation. Hopefully 2014 will see the market come to appreciate the value these companies offer and their share prices will respond accordingly.

Quality Products Inc. – QPDC

Quality Products’ shares lagged in 2013, even as the company continued to profit and expand. In April, the company announced the acquisition of Pacific Press Technologies, a manufacturer of hydraulic presses. The acquisition compliments Quality Products’ existing Multipress business and was funded mainly by debt. Quality Products recorded a bargain purchase gain of a little over $200,000 on Pacific Press, likely indicating the assets were acquired for less than fair value.

For the twelve trailing months, Quality Products earned $1.86 per share for a trailing P/E of 7.9 on today’s bid/ask mid-point of $14.37. The company continues to be stunningly profitable, recording a return on equity of more than 50%. I am mystified as to why Quality Products continues as a public company, given the infrequent activity in its stock and its high insider ownership. For the present, anyway, Quality Products offers the chance to invest in a high quality industrial enterprise at a very cheap price.

Regency Affiliates, Inc. – RAFI

Regency Affiliates shares handily out-paced the S&P 500 (when using the current bid/ask mid-point rather than last trade) since my February write-up, but the stock continues to trade far below any reasonable estimate of intrinsic value. Regency’s real estate holdings continue to pay down debt, increasing earnings and cash flow and hastening the point at which Regency will be able to re-finance the mortgage and fund a large cash distribution to the parent company. Regency’s steam power generation asset’s earnings have leapt and its debt is also being reduced steadily.

On a trailing twelve month basis, RAFI earned 97 cents per share, for a trailing P/E of 10.3 on a share bid/ask mid-point of $9.95. Earnings should continue to rise as debt is reduced, and the company’s real estate holdings and excess cash are likely worth the current market capitalization without even considering the steam power asset.

Regency Affiliates initiated a quarterly dividend in September and now pays out 20 cents annually.

Awilco Drilling Plc – AWLCF

Awilco has had a great year, with a total return of nearly 70% since my first write-up in May. As predicted, the company has used its free cash flow to pay a total of $3.10 in dividends since, and is poised to continue rewarding shareholders with large payouts. The company’s rigs are contracted for years to come at higher rates than now. The company has announced some planned capital expenditures for rig upgrade and the UK is contemplating some tax increases, which seems to have reduced investors’ enthusiasm for the shares.

Still, management has been making the right moves and keeping its promises. Capital expenditures and tax increases may reduce the cash flowing into Awilco’s coffers somewhat, but will not make nearly enough of a difference to justify Awilco’s current price or dividend yield. I continue to view fair value as somewhere in the $30s, and plan to hold on until fair value is reached and to enjoy a healthy stream of dividends along the way.

Visteon Corporation – VC/VSTOW

Visteon continues to execute a quiet transformation from a low-growth, domestic auto supplier to a high-growth market leader focused on Asian nations. The company plans to return one quarter of its current market cap to shareholders in the form of buybacks in the process. Still, the company trades at a discount to competitor valuations, particularly those operating in similar geographies.

Visteon closed on the sale of its automotive interiors joint venture yesterday, receiving $840 million, with another $181 million to come.

Retail Holdings NV – RHDGF

Despite its underlying businesses setting earnings records and paying out a large dividend, Retail Holdings stock produced a pitiful return in 2013. Fears of currency devaluations and slowing economic growth in South-East Asia caused investors to mark down companies doing business in the region, disregarding fundamentals. For the twelve trailing months, Retail Holdings earned $2.46 per share, for a trailing P/E of 7.7. Consolidated revenues for the six months ended June 30, 2013 were up 7.8% from the same period in 2012, while parent company earnings grew 24.7%. The performance of the company’s financing divisions continued to be strong, with low credit losses and minimal accounts in arrears.

In additional to being cheap on an earnings basis, Retail Holdings continues to trade at a large discount to the value of its subsidiary companies, all of which are publicly-traded and so can be priced by direct observation. The market values of the subsidiaries held by Retail Holdings sum to $26.83 per share. Adding the debt that Retail Holdings holds adds another $4.29 per share for a total net asset value of $31.12 per share. At a recent trade of $19.05, Retail Holdings trades at a discount to net asset value of 38.8%.

Retail Holdings made moves to divest its subsidiaries through an IPO this fall, but those plans fell through in the face of stock market weakness in many South-East Asian economies. The company is intent on receiving full value for its shares, and is willing to wait for the right moment to sell. Until then, I am happy to own a growing emerging markets company at a single-digit P/E and a large discount to NAV.

A Quality Company That Merits A Premium, At A Discount – Neurones SA

Now and then I like to spend some time searching for “quality” companies. Simplistically, I consider a quality company to be one that is likely to earn excess returns on its capital for a long period of time. So long as these excess returns on capital can be maintained and earnings can be retained and reinvested at these rates, attractive shareholder returns are nearly a foregone conclusion. A company that can invest existing capital and the retained portion of future earnings at attractive rates will see its intrinsic value rise, and the share price will follow in the long run.

Besides returns on capital, I employ a few other filters while seeking quality companies for investment.

Cash Generation – Quality companies consistently generate cash flow from operations. Ideally, cash flow from operations exceeds net income over the cycle, indicating a low level of accruals. (Consistently lagging cash flow from operations may indicate that a portion of reported earnings are illusory, or that a company requires a high level of investment in working capital.) I also like to see companies that pay out cash to their capital providers and don’t require equity increases or take on debt to fund operations. Companies that are self-financing from cash generated by operations are less sensitive to external factors like interest rates and equity valuations.

Conservative Capital Structure – As an equity investor, it is important to remember where one falls in the order of claims on earnings and assets: dead last. Employees, suppliers, lenders, lessors, the government and others all get paid before equity investors ever see a dime. For that reason, I look for companies with low debt and solid operating margins. Low debt reduces the chances that equity investors will be diluted or extinguished should the economy take a tumble and the company find itself short of funds. Low debt also increases a company’s flexibility, allowing a company to make continue making productive investments when competitors are financially stressed and holding back. High operating margins increase the chances that a portion of sales revenue will still fall to the bottom line when sales are down or expenses are up.

Differentiated Product – Most companies that offer un-differentiated commodity products will not earn excess returns on capital through the full economic cycle. A prime example is producers of basic materials like iron ore or pulpwood. The moment that prices of these inputs rise to the point that producers begin making excess profits, competitors enter and a flood of new supply drives down prices to the point where no one captures excess returns on capital. Investors can do well by waiting for the inevitable bust and then picking up shares in companies left for dead, but holding these companies through multiple economic cycles will not typically be rewarding. Commodity companies blessed with talented management or unusually efficient operations may fare better, but these are the exception.

Companies that can differentiate their product offering in the marketplace stand a better chance of earning excess returns in the long run. Superior product features or service create a positive customer experience, which in turn creates customer loyalty and pricing power. Alternatively, a company’s products can be so essential or ingrained in essential processes that switching costs are high. Companies like these also have pricing power, because it is easier for a customer to swallow a 2-3% annual price increase to than risk a business interruption by switching providers.

With all that said, why spend time looking for companies like these? For one, quality companies are more forgiving of investor mistakes. Probably most of us have made the error of buying into a moderate or even poor quality company at too high a price and felt the pain of seeing our investment permanently impaired. When buying into businesses of moderate or lower quality (and statistically, that’s most of them) price is paramount. Buying at a substantial discount to intrinsic value is the only means of earning excess returns, because that intrinsic value may or may not grow and may even decline. Quality businesses, on the other hand, stand a good chance of growing their intrinsic values over time, making the purchase price less important. Consistent growth in book value per share year after year covers over a multitude of mistakes!

Before this turns into an essay, let me talk about a company I recently discovered that meets all my quality company criteria. This company has massive cash reserves and no debt. It generates free cash flow year after year, and invests this free cash flow at high rates, driving growth. It provides essential services and enjoys long contracts with high-profile clients. What’s more, 78% of this company’s shares are owned by the founder and the firm’s employees. Despite all these characteristics, the firm’s valuation is modest.

Neurones SA is a French IT provider. The company trades on the Euronext Paris exchange with the ticker NRO. Neurones and its staff of 4,000 provide all manner of technology services to France’s A-list companies, including Societe Generale, Unilever, Lafarge and hundreds of others. These services include technology consulting, integration, infrastructure and applications. Neurones is a true entrepreneurial success story, begun by one man in 1985 and projected to earn $470 million in revenues in 2013.

Neurones’ growth has been nothing short of spectacular. From 2002 to 2012, revenues grew at an average rate of 13.2% and operating income grew at 12.9%. Recent growth has cooled a little, but the company is still experiencing high single digit increases year over year. Here’s a look at Neurones’ last decade. All figures on the chart (and throughout the remainder of this post) have been converted to USD at 1 EUR: 1.38 USD.

Neurones Revenue Growth title2

As it has grown, Neurones has maintained its profitability. The company’s 2012 EBIT margin was a shade above the ten year average. It’s worth mentioning that Neurones’ impressive growth record was achieved during a very challenging stretch for the French economy and for the world in general. Neurones grew right through the severe recession and looks to keep going.

Everybody likes to see growth, but growth is really only valuable if it results in increased earnings and free cash flow. Neurones passes the test, having increased its net income in tandem with its revenues. While cumulative net income to the parent company for the last decade was  $134.45 million, free cash flow was $127.13 million. This indicates superb capital efficiency, as nearly none of Neurones’ net income got tied up in non-cash investments in net working capital or fixed assets. Instead, Neurones’ was able to use nearly all its earnings to add productive resources like additional staff, or to make small add-on acquisitions to increase its expertise and service offerings.

In the last decade, Neurones purchased and integrated more than a dozen smaller companies. These acquisitions have been an unqualified success, based on an examination of historical returns on invested capital.

Neurones Historical ROIC

From 2003 to 2012, Neurones’s return on invested capital averaged 26.90%. This figure has held up even as the firm has nearly tripled its revenues and asset base, indicating consistently strong capital allocation policy and opportunities for reinvestment.

For the first nine months of 2013, Neurones’ revenues are up 8.3% from the same period in 2012. EBIT margin rose to 9.3% compared to 8.6% for 2012.

The company also reported holding cash balances of $123.8 million against zero debt. That speaks volumes to Neurones’ fiscal strength. Neurones has historically held significant cash balances and maintained a zero debt policy. While some would argue that avoiding leverage to this degree hampers returns, I think Neurones’ strategy has provided it with the ability to operate through business downturns completely unperturbed, and to make opportunistic investments while other firms struggled with debt covenants and liquidity crises. At the end of 2012, cash and equivalents made up 36.2% of Neurones’ total assets.

Neurones has strong potential for continued growth, excellent returns on capital and an ironclad balance sheet, but these qualities are not reflected in its market value. Neurones closed yesterday at €11.89/$16.41, with a market capitalization of $394.1 million. Net of cash, Neurones’ enterprise value is $263.3 million.

Determining trailing EBIT takes a little more legwork. 2012 EBIT was $38.7 million. Based on the reported revenues and EBIT margins for the first three quarters of 2013, trailing EBIT has increased by $4.7 million to $43.4 million. However, a material portion of Neurones’ income is attributable to minority interests. In 2012, minority interests’ claim was 13.1% of Neurones’ total net income. Being conservative and assuming that 15% of Neurones’ EBIT is attributable to minority interests yields trailing parent company EBIT of $36.9 million.

Neurones Value

With an enterprise value of $270.3 million, Neurones trades at an EV/EBIT multiple of 7.3. That’s far too low for a company managing 25%+ returns on capital and growing at a high single-digit rate, with its entrepreneurial founder still at the helm.

Part of the humble valuation may be due to Neurones’ relative illiquidity; despite its market capitalization, only about $87 million worth of share are free floating. On average, fewer than 8,000 shares changed hands daily for the last three months. Still, that’s plenty of volume for a patient investor to build a sizable position over time.

The more significant factor in Neurones’ low valuation is likely a perception of the French economy as troubled and struggling to grow. When investors mistakenly paint entire economies as “low growth,” the actual high-growth companies within that economy can sell at unjustifiably low multiples. These perceptions do not last forever, and astute investors can take advantage by purchasing quality companies on the cheap.

Not many companies can truly grow profitably, but those that can are worth paying for. The long-term growth in book value per share that these firms can produce can reward investors with multiples of their original investments, without stressing about whether one has invested at a sufficient discount to an intrinsic value, the trajectory of which is anyone’s guess. When one can invest in a quality company without paying up, so much the better!


No position. May initiate in the next 30 days.

FirsTime Design Inc.’s Successful Turnaround – FTDL

Firstime Design Inc. is a fast-growing and profitable reseller of clocks and other home decor items. Firstime sells its products to many leading retailers, including Kohl’s, Bed Bath & Beyond and Kroger. The company is purely a marketing operation; all Firstime products are manufactured by overseas suppliers. Firstime is based in New Berlin, Wisconsin.

The firm has a market capitalization of $5.7 million, just in case anyone was wondering whether I had lost my taste for the smallest of the small.

Firstime Design has a bumpy history. The current business is the surviving division of the former Middleton Doll Company, which hemorrhaged red ink for years before selling its doll manufacturing operations to a private equity firm in 2010. Middleton Doll was engaged in making and selling creepily realistic infant and child dolls so popular with…..I don’t know whom.

After disposing of the doll division and going through further restructuring, the company changed its name to Firstime Design and set about cutting costs and growing sales in its remaining clock and home decor business. Results have been excellent. Quarter after quarter the company has reported record revenues.

TrendSince shedding its doll unit in 2010, quarterly sales have more than doubled, and continue to rise. The most recent quarter showed revenues up 11.8% from the previous quarter and up 17.1% from the same quarter a year ago. Cost control has been impressive. Despite doubling revenues, quarterly operating expenses have held steady and even declined.

Healthy sales growth and close attention to costs have resulted in positive operating income since the beginning of 2011. In the most recent quarter, operating income hit a record $0.24 million.

Operating IncomeNearly all of Firstime’s operating income drops straight to the bottom line because of a substantial hidden asset: millions in net operating losses built up over time from the failing doll business. These NOLS do not appear on the balance sheet because they have been fully reserved against, but the company’s return to profitability gives the NOLs significant economic value. The gross amount of the net operating losses is listed as $22 million in the 2012 annual report. Some of the NOLs may expire before they can be used, but recent increases in the NOLs from the doll business’s losses should shield Firstime Design from taxation for at least several years to come.

Firstime has double-digit revenue growth trends and a clean balance sheet, yet the company trades at a single digit multiple of trailing earnings.

valuationThese valuation metrics should contract rapidly as revenues and margins continue to grow.

Firstime’s valuation is well-supported by its assets. Firstime’s tangible book value per share is $2.66. This book value consists almost entirely of current assets. Net current asset value is only slightly lower at $2.60 per share. Compared to its previous structure as a doll manufacturer, the new Firstime Design is both liquid and conservatively-financed.

Firstime is not without its share of risks. As a “middleman” business, there is always a chance that its customers could choose to purchase directly from its suppliers. Firstime’s revenues are also highly concentrated. In 2011, only two customers accounted for 65% of sales. And there is the possibility that FirsTime will mis-judge consumer tastes and find its products languishing on retailer shelves.

If FirsTime can succesfully manage these risks and continue to grow its sales and margins quarter after quarter, shareholders could see a nice return as FirsTime’s value grows.

No position.