ELXSI Corp. has been on my radar screen for years. The company’s primary subsidiary is a fast-growing, very profitable business in an industry with a great demand outlook. The company’s less-profitable subsidiary is winding down and becomes less and less relevant as time goes by. Gross margins, operating margins and returns on capital are all reaching new heights, and the company has built a solid cash buffer. With all those positive dynamics in place, just what is it that has kept me out of ELXSI? The answer is one word, the same word that keeps me out of many otherwise attractive small companies: management. ELXSI’s history is riddled with exploitative related-party transactions that have resulted in a massive value transfer from ELXSI’s minority shareholders to company insiders. More on that in a bit. For now, let’s examine ELXSI’s corporate history.

A decade ago, ELXSI was a struggling restaurant operator with minor manufacturing operations in Florida and a retail store installation business in Illinois. The company had purchased 30 Bickford’s and Howard Johnson’s restaurants from Marriott Family Restaurants, Inc. in 1991, but changing trends in the restaurant industry and ballooning costs caused the company’s operating income to erode, turning negative in 2004. Realizing that most of its restaurants were beyond rehabilitation, the company spent the next several years shutting down or selling off properties. In 2007, the company shut down its retail installation business after losing a significant client.

Today, ELSXI operates only six restaurants in Massachusetts and New Hampshire, and leases three restaurants to third parties. Restaurant revenues accounted for 62.9% of total turnover in 2004, but only 11.1% in 2013. While the restaurant segment is a shadow of its former size and importance, the company’s manufacturing operation has become a force. Cues Inc. is the name of the business, and its success has completely changed the picture for ELXSI. Cues manufactures robots and systems for use in inspecting pipelines, especially sewer lines, water lines and industrial process lines. Cues has grown its top line at 5.9% annually for the past decade, and now accounts for the great majority of ELXSI’s revenues, earnings and assets.

The outlook for Cues’ products is bright. American water and sewer infrastructure has suffered under-investment for generations and is approaching a critical state. Water mains one hundred years or older are still in use in many areas, and some cities still rely on pipes made of obsolete materials, even wood . (In all fairness, it seems that wooden pipes actually have quite a long useful life, though they require quite a lot of expertise to repair.) In my view, products that enable inspectors, engineers and others to evaluate existing infrastructure will be more necessary than ever in coming decades. Of all the various types of infrastructure, water delivery and treatment systems are among the most critical and most need of investment, and Cues will benefit from that trend.

Cues’ success and the winding down of the unprofitable restaurant segment has allowed ELXSI to more than double its EBIT since 2007, even as sales fell 10.7%. Never underestimate the power of expanding margins! Indeed, ELXSI posted an EBIT margin of 7.7% in 2013, a great improvement over the 1.2% EBIT margin “achieved” in 2007. Here’s a look at ELXSI’s results for the last decade.

As ELXSI’s profits have risen, so has its efficiency. The company now generates a respectable NOPAT/Average Invested Capital ratio of over 15%, compared to a the single digit or negative figures of years past. The company’s balance sheet is strong, with net cash of $2.4 million.

Despite the greatly improved profitability and healthy outlook, the market affords ELXSI only a modest valuation.

There’s a lot to like about ELXSI. Improved and improving operating measures, a conservative balance sheet and a bright revenue outlook, all at a bargain basement valuation. However, there’s more to the story. I believe the company’s low market valuation is largely due to a large perceived off-balance sheet liability: the possibility that management will continue to extract value from the company that rightfully belongs to shareholders. Just take a look at a few of management’s past actions:

• Loan number 1: ELXSI loaned $1.16 million to ELX Limited Partnership, an entity wholly-controlled by ELXSI’s chairman, president and principal shareholder, Alexander M. Milley. ELX used this loan to purchase 369,800 shares of ELXSI stock from a third party (famed investor and businessmen Peter Kellogg.)
• Loan number 2: ELXSI loaned another $909,000 to ELX, to be used to purchase 110,200 shares of ELXSI Corp, again from Mr. Kellogg.
• Loan number 3: ELXSI loaned $2 million to Cadmus Corporation, an Alexander M. Milley-controlled corporation.
• Loan number 4: ELXSI loaned another $6.73 million to Cadmus corporation.

In total, ELXSI loaned $10.8 million dollars to entities controlled by its chairman, in part so the chairman could purchase company stock. That is a LOT of capital used to enrich the chairman at the expense of shareholders. And guess what? ELX and Cadmus never even paid the minimal interest expenses accrued on the debt. In 2013, ELXSI forgave the entire balance, both principal and accrued interest, in return for 486,990 of its own shares worth $4.55 million. For those keeping score, that’s a net loss to shareholders of $6.25 million, not including millions in accrued interest and opportunity costs.

In return for the loan forgiveness, Cadmus Corporation also agreed to terminate its management contract with ELXSI. Oh, did I forget to mention the management contract? Since 1989, Cadmus and ELXSI had an agreement specifying an escalating management fee, payable in years where ELXSI’s operating income exceeded $4 million. ELXSI had not paid the management fee for the last few years, letting it accrue. In 2013, ELXSI paid Cadmus $3.12 million to settle the accrued fee and terminate the contract. You read that correctly. Despite shorting ELXSI $6.25 million in principal value on the debt settlement, Cadmus and ELX  somehow still received $3.12 million in cash to settle the accrued management fee.

As a final insult, on January 1, the company agreed to issue Alexander M. Milley 80,000 shares of stock in each of the next five years, providing the company earns at least $4 million for the year. As a result, Mr. Milley is likely to receive back nearly all of the shares his companies conveyed to ELXSI for debt settlement.

Perhaps the days of the worst shareholder abuses are past, but the potential remains for additional value transfers to management at the expense of minority shareholders. For that reason, I’m staying away from ELXSI. It’s a shame, really. I’ve love to own some shares. But when I invest in a company, I need to be confident that my proportional share of earnings and cash flow will accrue to me. With ELXSI, I simply can’t be sure.

Alluvial Capital Managment, LLC does not hold shares of ELXSI Corp.  for client accounts.

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