Goodheart Willcox FY 2020 Annual Report

We've mentioned educational publishing company Goodheart-Willcox (GWOX) a number of times in the past. Nate first wrote about it on the blog way back in October 2012 when shares were trading for about $72. We did three update posts last year; in March about the tender offer, in June with the tender offer results, and in July about the FY 2019 annual report.

This week we received the FY 2020 annual report, showing that sales and net earnings were down from the prior year. We will have more analysis and commentary in the upcoming 31st Issue (August 2020) of the Oddball Stocks Newsletter.

If you are curious about the Oddball Stocks Newsletter, we've added a couple low-risk ways that you can try out what we are about. First, there are our back Issues. The most recent June one was Issue 30. The issues before that are available à la carte: Issues 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, and 29.

We also compiled a collection of Highlights from the back catalog which is available as a "Highlights Issue". If you have been curious about the Newsletter, then this is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

GWOX FY 2020 Annual Report by Nate Tobik on Scribd

Next generation of Warehimes at Hanover Foods?

We noticed this recent obituary,
John Alan Warehime, aged 82, passed away on March 11, 2020. He was born on November 17, 1937 in Hanover, to the late Alan R. and Rosedrey (Rohrbaugh) Warehime. He is survived by his wife of 57 years, Patricia (Mosebrook) Warehime, their children Jennifer (Warehime) Carter and husband Michael, Jeffrey A. Warehime and wife Amy, and J. Andrew Warehime and wife Michelle, and seven grandchildren.

Mr. Warehime graduated from Massanutten Military Academy in Woodstock, Virginia and Penn State University with a Bachelor of Science degree in Agricultural Economics. He was Chairman of the Board of Hanover Foods Corporation since 1990.
What will the future hold for Hanover Foods? See our recent posts about quarterly results and the Hanover annual report.

Interested in trying the Oddball Stocks Newsletter?

If you are curious about the Oddball Stocks Newsletter, we've added a couple low-risk ways that you can try out what we are about.

First, there are our back Issues. The most recent June one was Issue 30. The issues before that are available à la carte: Issues 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, and 29.

We also compiled a collection of Highlights from the back catalog to demonstrate what the Newsletter is, or what it hopes to be: topical, philosophical, talking about companies that the market ignores, pounding the table for value investing while grappling with problems like rapacious managements that are consuming value.

The "Highlights Issue" is available here for purchase as a single Issue. If you have been curious about the Newsletter, then this is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

This is a "highlight reel," but it is not a victory lap or a tout of what we have written about. A lot of these highlights are our thinkpieces: on shareholder rights, on banking as a business model, on value investing. There are pieces about companies that got taken out at a premium but also about ones that are trading lower now some years later... of course, those may be the most interesting to pay attention to now. There are two companies – Scheid Vineyards and Enterprise Diversified (formerly known as Sitestar) – where we warned about significant risks that ended up materializing.

We have also posted some Newsletter excerpts over the past year to give a taste of the Oddball writing and coverage style - but just remember that the most interesting content is for subscribers only. The excerpts were on The Coal Creek Company, Tower Properties, Bank of Utica, small banks, Avalon Holdings, Boston Sand and Gravel, Conrad Industries, and Sitestar / Enterprise Diversified.

Don't miss our recent Oddball Stocks blog posts on:
Finally, if you want to be completely immersed in the Oddball universe, be sure to follow Nate Tobik and the Newsletter on Twitter.

Interpreting the Scheid Vineyard 2019 Results

This week shareholders in Scheid Vineyards received the annual report in their email inbox. They've had a few rough years, but this year was a wallop to the gut for shareholders. Initially I was going to break down their results in a Twitter thread, but decided a blog update was more appropriate. Let's dive in...

Scheid Vineyards ($SVIN) is an over-the-counter micro cap that owns and operates vineyards and wineries in California. They produce both bulk grapes and cased wines under a variety of brands.

The company reported a loss for 2019 of $12.8m on revenue of $51m. Revenue was down from $58.5m in 2019. The primary driver of revenue decline was a decline in bulk wine sales. This is important because historically their business was built on selling bulk grapes.

Most wineries do not grow their own grapes. Like most industries wine making consists of compartmentalized functions and various suppliers, with everyone balancing the advantages and disadvantages of vertical integration to come up with a model that they think is optimal.

Wine makers tend to enjoy making wine, that is blending yeast and grapes. Wine making is very different from farming grapes. Because of this it is rare for a winery to both specialize in growing and blending. Wineries that do both bottle and sell what are called "estate wines". The estate wine designation means the grapes in the wine were grown on site.

A quick trip to the local liquor store to browse wine will confirm that most wine is not estate wine, but rather blended from bulk grapes. This isn't a bad thing, it's just how it works. A wine maker can choose the type of grapes they want so they can control the taste and quality of what they produce.

When you're running a bulk wine operation you're running a company similar to a corporate farm.  There is a lot of land involved, and expensive machinery to harvest and package grapes for sale.  Contrast this to a winery that only needs a building to store the wine in process that they're producing. This is why most wineries that you might have visited all have a similar resemblance.  They appear to be a warehouse with a tasting room attached and a few rows of grapes growing outside for decoration.

A company can capture a lot more margin selling bottled wine vs bulk wine. Like anything, the margin on the raw material is small compared to the margin on the finished good. With this Scheid decided a few years back to focus on selling bottled wine vs bulk wine sales. They would be completely vertically integrated, from growing to blending, to bottling. In this way they should be capturing the entire margin from making wine.

For years the business did well, it even traded for a few times earnings when I first wrote about them in July of 2013. They were selling for 63% of book value and 6x earnings. Shares were trading for around $31 at that point and had just earned $4.59 per share. A year earlier the company earned $9.13 per share. There was a lot to like about the company!

Shares eventually skyrocketed from $31 to $108 on the back of solid earnings and a great narrative about value and future growth. Subsequently shares crashed as earnings turned negative and losses accelerated.

I initially tempered my bull case to Sheid with the quote 

"Scheid Vineyard’s flaw is found in their balance sheet -more specifically, their debt. The company is highly levered, and is exposed to both agricultural cycles and market cycles. The wine market cycle peaked right before the 2008 recession and has slowly recovered. The company produced a record harvest this past year that requires capital to process, but should also result in higher earnings next year. The company’s bank is Rabobank, which an industry contact related is known throughout the industry as the best bank for wineries. They are willing to work with wineries when downturns occur, and will drag their feet on calling loans until there are no other options. So while their debt could be a stumbling block for investors there is a small silver lining in that Scheid’s bank is very winery friendly."

It turns out that this quote was quite prescient. We wrote another post last summer about developing concerns with the Scheid results.

In 2020 the company had $83m in long term debt, and $30m in operating debt, for a whopping $113m in total debt against equity of $30.3m.  

The company earned $51m in revenue and had $41m as cost of goods sold for a pre-write down gross profit of ~$10m. The problem is interest costs were $4.7m, or 47% of gross profit. This past year the company wrote down $4m of inventory leaving them with a GAAP gross profit of $5.6m, meaning interest costs along were 83% of gross profit. To say that's concerning is an understatement.

A retort could be that GAAP gross profit isn't a cash number, so this isn't a true picture of their ability to serve their debt. The problem is when you look at their cash flow statement it's even more ominous.

The company had a negative $4m in operating cash flow, $5m in cash interest expense and had to borrow an additional $14m to make ends meet.

The sad thing here is the company does have true value. They mortgaged their land for $100m to Prudential Financial. The problem is the land is generating a negative return for shareholders, and to fund that negative return the company needs to continually increase their debt load.

If Prudential were to take the land and sell it off they would almost surely realize more than $100m.  Unfortunately shareholders would get nothing.

So what's the bull case here? It would be that the company increases their case sales at a really high rate while figuring out a way to manage their debt. IF they can pull this off and start to pay down debt this becomes a private equity type scenario where as the debt is repaid the equity becomes more valuable. Additionally as the debt is paid down earnings would accelerate as interest costs were reduced.

The bear case is that the pandemic hits their sales hard and they have to restructure. In the company's annual letter they noted that sales are down and they are expecting a difficult year. I'm not sure the Prudential credit team should be sweating much, but shareholders sure should. Scheid's financial statements disclose that their debt has financial covenants, including "debt service coverage ratios, and the amount of total liabilities to tangible net worth." From what I've heard, Scheid is not willing to tell people what the threshold ratios are or how close the company is to tripping them.

On the bright side I believe shareholders still qualify for discounts at the company tasting rooms, and tasting rooms opened June 12th. I'm not sure the discount will compensate for shareholder losses, but maybe you wouldn't feel as bad about them afterwards...

Disclaimer: I own a single share of the stock

Is the market expensive or cheap? What the small cap net-nets are telling us...

Imagine you're on a trip driving through a distant city.  You take a wrong turn and find yourself in a seedy and industrial part of town.  It isn't bad per se, but gritty, grimy and full of buildings that look like they were last taken care of before the computer age.  You find yourself thinking "I couldn't be paid enough to own a building like that in a place like this..."

That's most people's thoughts.  But what if you found out one of those buildings was for sale.  And inside the building was nice and clean, a bit outdated, but orderly.  On top of that there was a file cabinet with a drawer full of stock certificates.  The lower drawer of the cabinet was loaded with cash.  There were also some piles of coins that had questionable value along with some machinery that could be worth a lot to the right buyer.  All told the value of the cash and stock certificates alone were far in excess of the list price for the building.  Would you purchase it then?

That's the situation some small cap investors find themselves in when digging through the forgotten names of the OTC market.  Names that are a little dusty, in the wrong parts of town, but full of cash and valuables that exceed their listed price.  The technical term for companies like this is a net-net.  That is, a company whose cash, receivables, securities and inventory minus all liabilities is greater than its market cap.

Net-net's were popularized by the father of value investing, Benjamin Graham.  Value investing is a historic type of investing that was popular when stocks traded on fundamental metrics such as revenue or profits.  These days if a modem can't dial into your company's website on the information super highway then why even invest?  Or maybe the phrase is "if your company hasn't figured out how to turn capex into opex though software subscriptions while burning cash then don't invest."  I sometimes get my bubbles mixed up..  

The market has shifted from valuing companies based on fundamentals to valuing them based on their story.  If a company can tell a great story they trade with a nice valuation.  If a company is run by stalwarts who care about things called margins and cash then they might as well be worthless, or even less than worthless!  The market will pay you to buy shares in some of these companies.  

Historically purchasing a basket of net-net stocks has outperformed the market.  The reason for this is simple.  These companies are left for dead and trade for less than being dead.  When they inevitably show signs of life investors become excited and bid up their price from less than dead to dead, or maybe they appreciate all the way to "we might be a viable concern."

A second reason that these stocks work is because in theory their downside is limited.  If you are trading for less than dead it is really hard to fall much further.  Someone will always argue that at any level your stock can fall even more.  But as you fall the valuation gap increases, and at some point that gap becomes so crazy that the valuation itself can become a catalyst.

The problem around net-nets is the narrative.  They're already viewed as less than dead.  Most are probably still advertising on MySpace or in the YellowPages.  There are a lot that enter the net-net stage as they are falling towards a terminal value of zero.  The ones heading to zero are affectionately called "melting ice cubes."

You can sometimes invest in a melting ice cube and get out before it totally melts, but it's rare.  Don't waste your time.

There are other times, like now, when you can invest in a handful of companies that are net-nets, that have been around for decades, are profitable, and some are even growing.

While the overall market appears to be wildly expensive given the state of the economy there are a handful of net-nets that are crazy cheap.  Crazy cheap as in trades for less than net current assets and for 3x EV/EBIT.

In the most recent issue (our Thirtieth, published yesterday!) of the Oddball Stocks Newsletter we covered half a dozen of these. Some were covered on the blog in the past but are back to trading at discounts, thanks to the Oddball bear market inside of the bull market. (Or biggest bubble of all time?) This happens with the net-nets: they round trip it and back again. If you subscribe to the Newsletter you can see the latest batch.

The point of this post isn't to pitch my product, it's more about what the resurgence of these names says for the market.

When markets are high there are usually no net-nets to be found.  Everything is elevated including companies that probably should be trading for less than net current assets.  And when markets crash there are dozens to hundreds of net-nets as investors give up and sell everything they can.

In Japan post 1992 crash there have been periods where hundreds of profitable, well capitalized and growing companies trade for less than net current assets.  Investors who purchased baskets of these (myself included) and sold when valuations went from horrible to not-so-bad did especially well.  Investors who kept holding didn't do as well.

In the US there were hundreds of net-nets in the wake of the 1929 market crash.  Since then we've had periods where there might be a dozen or a few dozen.  In these periods investors who dipped their toe into the net-net pool, or into slightly higher quality small stocks trading at low book values did especially well against the market as whole.

What's different this time is there are green shoots in the net-net space at a time when the market as a whole appears overvalued.  One possibility is that an investor buying a basket of net-nets and shorting the indexes could crush the market if history repeats.  Of course this time seems different than most times and it's possible the growing group of net-nets will simply expand as more small companies fall in price as investors move to larger tech names.

It's impossible to know the future.  But what I do know is that personally I've been rewarded for buying profitable net-nets in bulk when they start to appear in the market.  I don't know if the future will be anything like the past, but I know where I'll be placing my bets..