Just Published: Issue 25 of the Oddball Stocks Newsletter

Happy Friday to all Oddballs!

Just a quick note that we have published Issue 25 of the Newsletter this afternoon. If you are a subscriber, it should be in your inbox right now.

If not, you can sign up right here.

Small Companies (like Small Banks) As "Jobs Programs"

In Part I of this series, "What is an Oddball Stock?", we mentioned that the pattern of Oddball opportunity over the market cycle goes from just cheap to cheap assuming activism or a "one day" type of liquidity event. Recently there have been quite a few of the one-days happening: Paradise, Inc., Vulcan International Corp, Stonecutter Mills Corp, Randall Bearings, and so forth.

Unfortunately, a lot of the remaining Oddballs that have not had their "one day" are continuing along earning low returns on equity, cheap relative to the liquidation value of their assets - but that asset value has to be discounted because they function as jobs programs for insiders.

What do we mean by "jobs program"? Well, we would describe those as companies that are earning low returns on equity for shareholders but paying quite a high percentage of assets or shareholder equity as salaries.

In a recent Issue of the Newsletter we wrote about a small rural bank: Southern Community Bancshares, Inc. (OTC: SCBS), the holding company of First Community Bank of Cullman. That is a small town of about 15,000 people located 50 miles north of Birmingham, Alabama that was ranked among Businessweek's "50 Best Places to Raise Your Kids" in 2012. This is one of the dwindling number of small banks still trading at substantial discounts to tangible book value. The current offer for the stock is $8.55 (bid is $8.30), and with the 505,592 shares outstanding that makes for a market capitalization of $4.3 million. Meanwhile, the stockholders' equity is $10 million, up from $9.7 million the previous year, for a price-to-book ratio of 0.43x.

There are no intangible assets on the balance sheet, nor is there goodwill. There are a surprisingly small amount of investment securities (U.S. government agency, municipal, corporate, and mortgage backed): only $6.3 million of which $5 million is maturing within five years. The bank had huge loan growth over the past year, from $58 million to $90 million (a 55% increase!). This was funded by a $20 million increase in interest bearing deposits and a $7.5 million increase in borrowings from the FHLB.

Interest income grew 52% and interest expense almost tripled, so net interest income after providing for loan losses only increased by 34%. But the amazing thing is that net income was actually down year over year, falling from $398k to $374k – a sub-4% ROE both years. The reason was a big increase in non-interest expense, primarily salaries and employee benefits. Possibly, someone made (and perhaps deserved) a big commission on the $22 million in new loans (which if so would be a one-time expense).

However, the other gotcha if an investor is looking at this from a P/B perspective (and since ROE is so low how else is there to look at it?) is that there is over $5 million of property and equipment on the balance sheet, which feels like quite a bit for a bank with only $10 million of equity. Looking at the footnotes, this is mostly land and buildings/improvements, so we are guessing that we must be seeing the balance sheet effect of the building depicted below:

Another cupola! Perhaps we need to start a Bank of Utica Small-Town Bank Headquarters Hall of Fame? Having half of the bank's equity tied up in premises makes the 57% discount to book value feel much less generous.

According to the Form FR Y-6 filed by the holding company in 2017, there is an employee stock ownership plan that owned 25% of SCBS. Other insiders are reported owning significant stakes as well (the company does not provide ownership figures in the notice of annual meeting). So the insiders have significant skin in the game. They must be really bullish on rural northern Alabama real estate to have spent half their equity on this building. We will have to stop and see the town next time we are in the area. (One other odd thing is that they still have $326k of "occupancy expenses" despite owning $5 million of real estate and apparently having only one branch.)

But it underlines the absurd business model of small banks, which we have been harping on for the past year. Imagine if you were going to take $10 million in equity to start a fixed income closed end fund – or maybe a business development company. What if someone foolishly offered to guarantee your liabilities so you could borrow really cheaply and lever up ten times. Wouldn't you hope to earn more than four percent on the equity after all that? And would you spend half the equity on a headquarters?

Like many small banks, maintaining this as a going concern seems to be of dubious value to shareholders, compared to the immediate return (and opportunity to redeploy capital) that they would get if the bank were sold. Instead, its purpose as a company might perhaps be better understood either as a jobs program ($1.65 million of salaries) or as civic monument with a copper cupola.

One could look at the non-interest expenses is as percentage of assets or as a percentage of equity (which is obviously multiplied by the leverage of the bank). So, the $3.1 million of total non-interest expense for 2018 was 2.7% of the year-end total assets.

If the bank can maintain its net interest margin (which may be tricky with short term rates higher than what they paid on deposits last year), this situation might continue indefinitely, even though it may not be the most efficient use of shareholders' capital or the most efficient way for society to provide deposit and lending services to rural northern Alabamans.

Oddball Stocks Newsletter - Also Available à La Carte

Just a quick note that there are two different ways to become a true Oddball: subscribe to the Oddball Stocks Newsletter, or purchase one of the limited number of back Issues that we have published à la carte.

You can see a full list of à la carte Issues, but they are Issues 19, 20, 21, 22, and 23.

The June 2019 Issue (#25) of Oddball Stocks Newsletter covering the 2019 annual report season will be published shortly, and the only way to get it is to be a subscriber.

Some comments from happy subscribers:
  • "You need to raise the price!"
  • " I think you guys are selling yourself short on your company visits. Saying that you are visiting or reporting from a company in your marketing, doesn’t give justice to the insight and analysis you are providing."
  • "The quality of the writing (even including your new contributors) is really top-drawer."
  • "Great newsletter! - you guys are either providing too much info or not charging enough..."
We also posted some excerpts 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 Tower Properties, Bank of Utica, small banks, Avalon Holdings, Boston Sand and Gravel, Conrad Industries, and Sitestar / Enterprise Diversified.

“What is an Oddball Stock?”

The philosophical subject of “What is an Oddball Stock?” frequently comes up and we thought that we should share our thoughts on the question.

Oddballs are small companies. From time to time we talk about companies with larger market capitalizations or balance sheets (most always dark, OTC-listed ones) but an Oddball is much more likely to be a $1 million company than a $1 billion one.

Oddballs are opaque. We are always disappointed if we find a company's financial statements readily available because that means the company is much less likely to be inefficiently priced. So the opacity comes from being OTC traded and therefore not SEC-reporting. Oddballs have all different letters of shareholder friendliness and communication, from the detailed presentations of Pardee all the way down to a company like Vulcan International. Besides the paucity of information provided to shareholders by management, the Oddballs do not generate news. Time goes by with not a peep heard from them or about them.

Of course, that paucity of information is why the Oddball Stocks Newsletter serves such a valuable function for subscribers. Even though we make no "recommendations," we help investors in this space figure out what is going on. By the way, the dearth of information that the owners of Oddball companies have about them reminds us of something in the book Panic by Andy Redleaf:
What modern capital markets do very well is raise large amounts of capital from a broad base of investors who are persuaded to give their money to perfect strangers with precious little idea of what these fortunate recipients are going to do with it. In order to keep the money coming in under such admittedly odd circumstances, liquidity and the universal, instantaneous "price discovery" that financial markets offer with a glance at a computer screen are essential. The public investor, knowing so little about what he is buying, must be able to tell himself he can get that money back (or what's left of it) pretty much whenever he likes. [...] Public securities markets, and especially equity and derivative markets, are bad markets because their knowledge base is thin (at least compared to the sum of what could be known about the underlying companies if shareholders were allowed to know it, or inclined to learn it). 
Compared to bigger public companies, most Oddballs are illiquid. This comes from being small and also from having a small float. Many of the most interesting Oddballs are heavily insider-owned or at least owned by investors with a long time horizon who do not “trade” their stock. So, as small as the market capitalizations are, this makes the effective investible size of the companies even smaller.

Oddballs are older companies. You have probably noticed a number of companies that we have written about that are in the “Century Club,” having been around for a hundred years. And related to this, the Oddball companies are in simple and prosaic businesses. We hear a lot these days about “disruption,” but we think there is something interesting about companies that have been around for a century; especially if they are trading for less than 10x earnings. Also, because the Oddball businesses are older, they tend to be asset intensive. That is, they employ tangible assets that show up on the balance sheet, not intangibles or human capital. And because of this we are often discussing their valuations in terms of book value metrics.

The factors above tend to lead to inefficiency and underpricing of Oddballs because many investors systematically avoid these factors in their investing. Meanwhile, we have noticed that Oddball investors tend to prefer different subsets of investment theses. For example, some like the “cashbox” or negative enterprise value. Some like a very low EV/FCF ratio along with buybacks, so that the company can take itself private quickly if price stays the same. Most Oddball investors seem to prefer overcapitalization and shun debt. Also, Oddball managements seem to want their companies to be overcapitalized, which drives return on equity lower and therefore price-to-book lower.

The pattern of Oddball opportunity over the market cycle goes from just cheap to cheap assuming activism or a "one day" type of liquidity event. Recently there have been quite a few of the one days happening: Paradise, Inc., Vulcan International Corp, Stonecutter Mills Corp, Randall Bearings, and so forth.

Unfortunately, a lot of the remaining Oddballs that have not had their "one day" and continue along earning low returns on equity, cheap relative to the liquidation value of their assets, but which asset value has to be reasonably discounted because they function as jobs programs for insiders. More about that principal-agent problem in Part Two...

Another Oddball Stock Retrospective

We did a retrospective the other day on PC Connection, finding that it compounded at 24% (counting dividends) from the time it was mentioned in September 2010.

Another early Oddball Stocks post was Ingram Micro in September 2011. (In addition to the Oddball blog writeup, it was also presented at the Value Investing Congress in 2011.)

This is another boring business - not consumer facing and not a "compounder" - but let's see how it did over time. First, here was Nate's thesis on the blog back in 2011:
Valuation
Here are a few quick valuation stats:
-P/E of 9.69
-EV/EBIT 3.08
-EV/FCF 5.52

So on a few simple metrics the company is coming up cheap. What might be an appropriate valuation for Ingram Micro? The industry average P/E is 10.5, which if IM traded at that level they would be at $19.11, not much upside.

A P/E of 10.5 plus cash results in a price of $27.75 per share.

If the company traded at an EV/EBIT of 8 the price would be $32.34 which is quite a bit higher than $17.66.

Conclusion
Ingram Micro is trading at a very cheap discount to net assets, and the business is trading cheaply as well. Even with both of those factors I don't have a good feeling about Ingram Micro. The company has a decent amount of debt and operating leases, and earnings are extremely lumpy. I also don't know how much valuation expansion exists. Clearly the company is cheap, but how much cheaper than peers. And for an industry that has bad margins maybe a P/E of 10 is warranted. If the market values based on P/E they are already close to full value. This is going into my consider further, and re-consider if it drops bin.
What ended up happening is that in February 2016, Ingram Micro announced that it would be acquired by a Chinese company for $38.90 per share, cash. The deal ultimately closed in December of that year. Counting a couple of small dividends that were received in 2015, that was a compounded IRR of 16.3%.

It is often hard to find charts of stocks that have stopped trading, but Barchart.com has one for IM up until it was acquired.

Paradise, Inc. Is Liquidating! ($PARF)

Well, it looks like another "one-day" stock has had its day:
Dear Fellow Shareholders:

We are pleased to inform you that on April 15, 2019, Paradise, Inc. (“Paradise” or the “Company”) entered into an Asset Purchase Agreement (the “Purchase Agreement”), with Gray & Company (the “Buyer”) and Seneca Foods Corporation (the “Parent”). Subject to the closing conditions included in the Purchase Agreement, including most importantly approval by you as our shareholders, the Company will sell to the Buyer the assets of its glacé fruit product business (the “Fruit Business”). If approved and closed in accordance with its terms, the sale of the Fruit Business (the “Asset Sale”) would be for an aggregate purchase price of approximately $10.9 million, consisting of cash consideration of approximately $9.4 million and assumed liabilities of approximately $1.5 million. Approximately $0.9 million of the purchase price would be held in escrow for six months after the sale to satisfy indemnification obligations of the Company. We ask for your approval of the Asset Sale as described in further detail in the accompanying proxy statement.

In addition, our Board of Directors has determined that the best course of action following the Asset Sale is the orderly sale of our remaining assets, including our molded and thermoformed plastics business (the “Plastics Business”) and the real property on which we operate our businesses (the “Real Estate”), as part of a Plan of Complete Liquidation and Dissolution (the “Liquidation Plan”). As a result, we are also asking in the proxy statement for the approval by our shareholders of the Liquidation Plan.
That is from a proxy statement that was filed with the SEC. It goes on to give an estimate of the liquidation value:
Assuming shareholder approval and closing of the Asset Sale, the Board estimates that the aggregate amount of distributions to shareholders as a result of the Asset Sale and Liquidation Plan will be between approximately $18.0 million and $25.0 million, or approximately $35 to $48 per share based on 519,600 shares outstanding...
Paradise was a net-net idea that Nate posted way back in July 2012 - so seven years ago. At that point, shares were trading at about $18. Commenters actually gave the idea a bit of a hard time, for example:
Your investment in a business like PARF has costs -- the returns that you could have earned in treasuries, bonds, ETFs, or some other stock.

If one invests $100 in PARF's assets, one can expect 6% back per year; if one invests the same amount in the S&P or some other index, one can expect ~9% back a year. Every year one holds PARF, one loses 3% of the value of one's investment via opportunity cost.

That's why the business has negative economic value for the investor. Everyone else, -- employees, suppliers, customers, tax authorities -- are quite happy with PARF.As for the private investor,given that PARF's under-performance is built into the business (tremendous amount of working capital required to generate very little in terms of profit), why would a rational person -- private buyer or Mr. Market -- want to pay full price?

I don't think they would: the'd pay 2/3 of the price of the assets, just in order to break even.

And that missing 1/3, the proxy for value destruction, has a value of ~$5-$6 million, which, not coincidentally, is the value of the excess cash.
Over the years the company paid a paltry $0.92 of dividends, but with the liquidation announcement there is now a $38.52 bid for the shares. That represents an IRR of a little over 12%. If the liquidation were to result in $45 in proceeds a year from now, the IRR might end up being 13% compounded for eight years. (It should be noted that this is about the same as the total return of the S&P 500 over the same seven year time period.)

Regarding the acquisition, one Tweeter commented, "Seneca Foods is buying Paradise inc. candied fruits business for $9.4 mln, ~0.6x last year's sales and somewhat over 3x operating earnings. That's a nice buy for Seneca and a shitty sale for Paradise investors, a perennial OTC asset play."

In fairness, the proxy statement describes a very long lasting marketing process by Paradise's bankers, and apparently this was the highest offer. It would be interesting to know the real reason that nobody stepped up willing to pay more for this segment.

Another Tweeter observed that Paradise "announced in Feb18 it was exploring strategic alternatives. Didn't disclose until 12/7/18 that it had entered into a retention agreement effective 10/31/17 with CFO with $75K bonus paid when company sold."

The proxy statement is well worth reading. The negotiations with the eventual buyer lasted from March 2018 until April 2019. One thing that is a little ominous is that the buyer wanted the fruit business but not the plastics and especially not the real estate. See this little tidbit:
On January 3, 2019, the Parent terminated negotiations with the Company regarding a merger but communicated its willingness to purchase only the Fruit Business of the Company under an asset purchase. The Parent did not give any reason for this termination at this time, but later told the Company that it did not want to acquire the stock of the Company based on the preliminary results of the Phase 2 study. 
Apparently the buyer was emphatic that they did not want "to be in the 'chain of ownership' for the Company’s real estate property"! The way that this was resolved is that Paradise is doing an asset sale of just the fruit business; not a merger or sale of the whole company.

Here is the detail from the proxy statement on the estimated proceeds after the asset sale of the fruit business:
After execution of the Purchase Agreement, the Company will have an estimated remaining asset value net of liabilities of approximately $14.0 million (with the Plastics Business and Real Estate being valued at net book value). Given that, estimated future proceeds to shareholders are calculated as (1) the cash consideration from the Asset Sale; plus (2) the net tangible value of remaining assets less liabilities; less (3) transaction-related fees/expenses and severance ($4.2 million); plus/minus (4) operating profits/losses between the date of closing of the Asset Sale and the date of full liquidation of the Company (assumed to be break-even) — totaling $19.2 million of estimated proceeds.
Payments of severance and a special bonus are going to be an eye-popping $3.2 million -that is over $6 per share.

One wonders what the real estate is going to bring... It seems like management should have elaborated a bit on the problems revealed by the Phase 2 environmental study. Is it a Superfund site or what?