Just Published: Issue 26 of the Oddball Stocks Newsletter

Happy Friday to all Oddballs!

Just a quick note that we have published Issue 26 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.

"What is an Oddball Stock?" with Nate Tobik on SNN Network

Nate had an appearance on SNN Network talking about our recent post, "What is an Oddball Stock?"

DuArt Film Laboratories, Inc. Annual Meeting on Tuesday

FYI: the DuArt Film Laboratories, Inc. annual meeting is being held in New York this Tuesday at 10:30 a.m. If you are attended and interested in meeting other Oddballs, get in touch with us.

DuArt sold its Western Broadcasting of Puerto Rico subsidiary in November. The sales proceeds were $3 million versus a book value of $391k of the assets sold.

Boston Sand & Gravel Company - 2018 Annual Report

See our earlier post that contains an excerpt from Issue 21 of the Newsletter (published last August) about Boston Sand & Gravel Company (BSND). The company announced that the annual meting was going to be held in Boston on July 25th, which was very short notice. Highlights from the annual report:
  • They sold a 12 acre intermodal site in Everett, MA for $14.3 million. That is 24% of the market capitalization of the company. The gain on sale was $14.16 million, so the book value had significantly understated the value.
  • "Capital additions for the year totaled $4.5 million as the Company focused on reinvestment in its ready mix plants and fleet, as well as continuing to improve the infrastructure for its short line railroad." Both this year and last year, capital expenditures exceeded depreciation.
  • "The first quarter of 2019 has gotten off to a slow start as several downtown projects have been stalled coming out of the ground. The much discussed federal infrastructure spending package has not come to fruition, so our Company continues to rely heavily on large downtown high rise projects funded primarily by strong foreign investment."
  • A dividend of $30 per share was declared and paid in January 2019. 
  • Gross profit was up slightly but SG&A was up more, resulting in a decline in operating profit from $5.6 million to $4.8 million (-14%). 
At a share price of $600 and 100,327 shares issued and outstanding, the company's market capitalization is $60.2 million, compared to a book value of $54.5 million. The company has $29.2 million of cash and short term investments and $22 million of total liabilities, so the balance sheet is strong. There is also $9.6 million of real estate under development.

We'll have more about this one in the upcoming August Issue of the Oddball Stocks Newsletter. Until then, make sure you see Issue 25 of the Newsletter, and if you are missing any back Issues, you can get them here.

Oddball Update: "Pardee Authorizes Share Repurchases"

Just announced by the company:
PHILADELPHIA, July 10, 2019
Pardee Resources Company (OTC: PDER) (the "Company") announced today that its Board of Directors has authorized the repurchase by the Company of up to $3.5 million of its outstanding common shares in 2019. This stock repurchase program may be carried out through up to $1.5 million in privately negotiated transactions and through up to $2 million in open market purchases. This program provides the Company with the flexibility to repurchase shares opportunistically from time to time based on market and business conditions, stock price and other factors. The Company is not obliged to repurchase any of its common shares and there can be no assurance as to when, or whether, any shares will be repurchased under this program.
Share repurchases were a big topic at the recent annual meeting in May. The most recent Issue (#25) of the Oddball Stocks Newsletter has a detailed account of that meeting as well as thoughts about the valuation and management's incentives to maintain the size of the company rather than sell assets at good prices and return capital.

The non-stop machine

I find failure utter fascinating.  Why did a particular thing fail? Why was it that thing and not something else?  Failure is especially important in investing, but also in other aspects of life.  While there are a ton of article (and a number on here) about failure in the personal or professional sense I want to talk about failure in the mechanical sense.

It's fun to think about really hard problems and try to back of the napkin a solution.  Things like "how would you stretch a single piece of string around the world?"  Or "could you design a machine that never fails?"

The second question is realistic, and one that I had a discussion about with a friend that spurred this post.  She helped invent the ATM system and was describing the challenge of building a robust system that never lost a transaction.  And that set me on a journey thinking about mechanical failure.

In a physical system failure can usually be reduced to the weakest link.  The weakest part will break down first.  But the ultimate failure might not be that part, in some systems it's possible for a weak part to fail and the machine to continue, but the failure increases stress on another part that ultimately fails.

Think of an engine, a simple $30 head gasket kit is the difference between a functioning engine, and sitting on the side of the road.  You rarely hear of a piston failing, it's a head gasket that cracks, a simple seal that goes bad.  But that failure creates a cascading effect.  A cracked gasket allows coolant into the oil, and a coolant oil mixture gunks up the pistons and ultimately the engine seizes.  That $30 part can create a multi-thousand dollar repair.

So what about critical systems?  This is where things get exciting.  If a non-critical system fails the system is down until a replacement part can be procured.  We see this all the time in life.  A gas pump will have an out of order sign, or we'll be told "that machine isn't working today."  But what happens when it's a ventilator that goes bad? Or a core banking system? Or the guidance system for aircraft?

The usual solution is to build in redundancy.  This is what Boeing is facing with their 737 MAX.  The aircraft had a critical sensor, a single critical sensor that if it had a bad reading could result in an error situation.  The obvious fix is to add a second or third sensor and correlate data between them to ensure no errors.  In aircraft redundancy is key.  Planes have multiple engines multiple pilots, multiple electrical systems etc.

In an aircraft you can make most things redundant because it is a completely isolated system.  An airplane has everything it needs itself when in the sky.

This redundancy concept is also used in computers.  Instead of a single hard drive put in multiple drives that mirror themselves.  Or put in multiple computers that mirror themselves.  All the way up to double everything, power, cooling, machines, everything into a massive distributed system.

The concept of massively distributed systems are what dominate our computing now.  The Google idea of having millions of generic computers that when they fail can be replaced without disruption is popular.

But this concept of massive distribution, or clustering hasn't always been the only way.  My friend who built the ATM network worked at a financial service provider along with some banks.  Their concept of "no failures" was quite different, and something I find utterly fascinating.

In the 1970s a company named Tandem was formed.  Tandem built computers that ran non-stop.  Once booted they never stopped.  In the late 90s Tandem was purchased by Compaq, which in turn was purchased by HP.  And like the computer systems this division has continued non-stop as well.  Now HP has non-stop computers.

The concept behind a non-stop computer is simple.  The entire system is designed for resiliency.  Everything is engineered to last as long as possible and built in a modular fashion.  This means when anything fails it can be removed and replaced without having to shut the machine off.  You can remove ram, or a processor all while the computer is running.  You can even swap out the motherboard of the machine while it's running all without losing a single transaction.

And just like anything can be swapped for failure it can be swapped for an upgrade too.  I was told it isn't uncommon for these machines to be in continuous operation for 35+ years.  To me that's astounding.  Someone turned on a machine 35 years ago and it hasn't turned off or had any downtime since.

The reason these machines work so well is because they share nothing.  Each component is like the airplane, completely self contained.  Components talk to each other, but if a single one fails it brings down nothing else.

What I've noticed is in a lot of newer clustered or fault resistant systems there are a lot of shared components.  And this shared-ness is usually the cause of a cascading failure.  Truly fault tolerant or resistant systems have hard barriers between all aspects and failure is isolated and don't cause issues anywhere else.

It's interesting to think about this at a higher level.  Obviously almost everything in life is interconnected.  And everything is going to fail as well.  But I wonder how often we consider both of those things together and make sure whatever systems (or processes are built) handle and isolate failure to the smallest and most replaceable component?

I think the reason we don't do this is because it's expensive.  It's expensive to design for failure in mind and expensive to build out redundancy.  But there is a cost to failure, and we are ignorant if we don't think things are going to fail.

The best systems are the ones where the designer sat down and said "how can this break?" before designing the final solution.

The same failure design thinking that goes into computers or machines can be extrapolated to systems, processes, businesses, or really anything.  You need to consider what can go wrong first, then build out redundancy and ways to isolate the failure before you can have a robust system.

There are too many things in life that work until they don't.  And the "they don't" is a result of short term thinking or expecting things to always just work.  If you can't envision failure it's impossible to ensure long term success.

Goodheart-Willcox Company ($GWOX) 2019 Annual Report

Earlier this month we published an update on the Goodheart-Willcox Company tender offer (also, previously). With 52k shares being taken off the market, the stock is even less liquid now, and is bid $120 and offered $199 (but the stock hasn't traded since April 30th).

The bad thing about the GWOX tender offers, from an outside shareholder perspective, is that they have been done by the ESOP and not by the company itself. Even worse, the company has loaned the ESOP money at low interest rates to do the buybacks.

These buybacks by the ESOP also make the outstanding share calculations a little wonky. The company had 446,542 shares outstanding as of April 30, 2019, but it likes to use a lower number (410,542) which excludes shares that are in the ESOP but unreleased and held in a suspense account. We think that it makes more economic sense to use the higher share number, especially since dividends on the unreleased ESOP shares go to paying back the loan from the ESOP to the company.

The result is that the market capitalization, based on 446,542 shares, is $53.6 million at the bid and $88.9 million at the offer. The company had $43.75 million of cash and securities at April 30, 2019 against $27.6 million of total liabilities. However, $23.3 million of the liabilities are deferred revenue.

At the recent tender offer price of $150, the market capitalization is $67 million. Using that figure, the enterprise value is therefore somewhere between $27.5 million and $50 million depending on how you treat the deferred revenue in the enterprise value calculation. According to Note C of the financials, the deferred revenue is coming (as you would expect) from the sale of digital online content, which revenue is then recognized over the subscription periods. Given that this revenue should have very high incremental profit margins it seems reasonable to haircut it substantially and derive an enterprise value figure at the low end of the range.

By the way, it is notable that so much of the balance sheet is funded by deferred revenue. This is a company that is actually very capital light and all of its $27.6 million of liabilities seem to be trade liabilities; i.e. non-interest-bearing.

So what do we get for a ballpark of $30 million enterprise value? Here is a snapshot of the relevant metrics:

Fiscal 2019 2018 2017 2016 2015
Total Average
Net Income 3,564 8,287 1,637 866 1,928
16,282 3,256
D&A 998 941 789 809 822
4,359 872
CapEx -506 -1,645 -1,035 -722 -557
-4,465 -893
FCF 4,056 7,583 1,391 953 2,193
16,176 3,235









Sales 29,257 41,162 24,151 20,684 22,032
137,286 27,457
NI % 12% 20% 7% 4% 9%
12%
FCF % 14% 18% 6% 5% 10%
12%









Book Equity 36,532 36,328 32,202 31,199 31,095

33,471
ROE 10% 23% 5% 3% 6%

10%

Some things to notice over the past five years: the net income reliably translates into cash flow at an earnings margin of about 12 percent on sales. If you figure that the business has $3 million of annual earnings power, then the stock is not exactly cheap or expensive either. (However: management's projections in the tender offer document have net income growing from $3.2 million in 2020 to $8.4 million in 2024, a total of $30 million over the five year period, which would earn back the entire estimated enterprise value.)

The return on book equity understates the quality of the business because there is so much excess cash on the balance sheet. It actually looks as though an owner could dividend out cash greater the book equity, which would mean the business could operate entirely with free external financing. (It would then have negative book value, and profitable companies with negative book value outperform.)

This is all somewhat academic because (a) the shares are so illiquid now and (b) management is allocating capital more to its benefit than to shareholders'; but it is also instructive. These return on capital and asset figures could hardly be more different than the other business we looked at this week - Scheid Vineyards. There are some quality businesses in the Oddball space; they just rarely come paired with quality managements and good prices.

We believe it is important to study and monitor Oddballs over the market cycle so that you are already familiar with them when big market dislocations happen.

We will have more about this (GWOX and educational publishing) in upcoming Issues of Oddball Stocks Newsletter. Our next Issue (#26) will be out in August. Until then, make sure you see Issue 25 of the Newsletter, and if you are missing any back Issues, you can get them here.