Wednesday, May 16, 2012

The cheapest stock I've ever seen, and why I'm not buying it

Wow, what a title, really the cheapest stock ever?  Let me quote a line from the annual report "However, if the impact of LIFO was excluded, the Company would have generated income before income tax of $1,745,692"  That profit before tax mentioned equals $4.04 a share, or more than double the current price of $1.95.

Most readers probably won't believe my claim that this is the cheapest company I've ever stumbled across, especially considering turn over a lot of left for dead stocks looking for cheap companies.  I'm going to lay out the bullish case first before I explain what I don't like about this company.  Please don't stop reading after the bull thesis summary, there is more to this story, and incredible numbers alone aren't a good reason to invest.


I will note here, if you have the capital to buy this company outright it appears there are a lot of inefficiencies that could be eliminated.  In addition if you can buy on the open market the barrier is low, maybe $1.6m of total capital for a bid 100% more than the last trade.

  • Book value of $5m against a market cap of $820,000, if you add in the LIFO reserve a book value of $8m.
  • Cash flow in 2011 exceeded the market cap.
  • 2010's free cash flow almost exceeded the market cap
  • LIFO adjusted earnings of $2.83 per share
  • An adjusted P/E of .67
  • Growing margins, operating and net margin both grew 2010 to 2011
  • ROE of 12%
  • NCAV of $8 a share and book value of $18 a share.
Background

So who is this mystical company?  It's Randall Bearings (RBRG) a company I dredged up in the Walkers Manual. I purchased a few shares and left a number of messages to get the annual report mailed, all without luck.  Then this week the company mailed all of their shareholders the 2011 annual report, and since I still held my shares I received a copy.  It was like Christmas morning, tearing through the packaging to find a....eh, not exactly that exciting.... 

Randall Bearings is a small Ohio company that makes bronze and metal bearings for various purposes.  The company can also do custom machined parts at a customer's request.  The company has a long history being founded in 1918 as a foundry, and eventually selling off all their non-core divisions until they were left with the bearings company.

The company has 431,680 shares outstanding, and shares have generally traded for less than $2 over the past year.  With such a low share price I figured the company was losing money, but I put in a small order anyways, the Walker description was interesting enough that I wanted to know more.

Why not invest?

Liabilities

The first thing I did with Randall once I realized they were selling at such a discount to their assets was plug their 2011 figures into my net-net worksheet:



I noticed two things right away, the first was that if I didn't include the LIFO inventory reserve the NCAV was something like $.38 a share, and the second thing was that the discounted NCAV and discounted book value were both negative (highlighted in yellow).

It's easy to fixate on the upside, the NCAV of $8.33 or the tangible book value of $18.74, but as long time readers know I'm always worried about losing money.  I want a margin of safety, and in some sort of liquidation event it doesn't seem like anything would be left over for shareholders.

It's easy to plug numbers into a spreadsheet and have a formula spit out a value, and just because the spreadsheet says there's nothing left for shareholders, does it mean it's true?  In the case of Randall I believe so.  The reason for this is found in the notes on their capitalization structure where the company discusses their debt.  Here are the lines that make me nervous:

"Note payable bank, collateralized by all business assets.."
"Note payable bank, collateralized by real estate..."
"Note payable bank, collateralized by all business assets.."
"Note payable SBA, collateralized by equipment.."
"Note payable bank, collateralized by all business assets.."
"Note payable Mercer County, collateralized by real estate, equipment, and stockholder guarantees.."

So what isn't guaranteed to the banks?  Seems like the real estate is, the equipment is, all of the business assets are, and if that's not enough Mercer County wanted shareholder guarantees!  Granted the Mercer County loan is only $13,069, but if they required that much assurance to give away less than $15,000 it makes me a bit worried.  The reason I'm worried is because maybe the value of the assets and stated book value aren't correct.  If a bank lending officer who can visit the plant, walk the grounds, and examine the inventory and requires collateral containing all the company assets it makes me think that the financial statement values are probably a bit overstated.  Or at least they won't be able to be liquidated in a timely manner and realize their book value.

Management

If the liability situation isn't bad enough I was doing some Googling on the CEO and found a shareholder lawsuit from a few years back.  It seems the company tried to issue 200,000 shares of stock at par ($.001) to the CEO and CFO.  They then engineered it so that the company would pay for the taxes on the issuance.  This is a company with 431,680 shares outstanding, issuing 200,000 shares increases the share count by 50%, and gives two officers control of 31% of the company.  In addition they signed an agreement with a shareholder who owned 20% of the company which stated that the shareholder would always vote along with management.

For $200 the CEO and CFO engineered a way to take control of the company!

The plan was killed, and the company still has the same amount of stock outstanding (minus 9,000 shares) as they did in 2001.

Reincorporation

When I received the annual report in the mail the first thing I noticed was how big it was, it had some serious girth for a small company.  Most unlisted company reports run about 10-15 pages at the most, Randall was in the 50 page range.  The reason for this is they included a proxy for shareholders to vote on a reincorporation from Delaware to Ohio.

The reason they gave was that Ohio relieved directors of a specific fiduciary duty and limited their liability at the corporate level.  They also gave a lot of stock reasons like they do business in Ohio so they want to support the state.  Normally I wouldn't think much about this, but in light of the offenses mentioned above something just didn't seem right.

I noticed a few things, first off the company already re-incorporated in Ohio, they included scans of the filings in the annual report.  They took action before shareholders approved it.  Second I noticed that the par value of the shares was removed meaning there is now zero cost for the company to issue new shares.

I'm not an expert in corporate governance, but my guess is there is some nuance between Delaware and Ohio that gives the company more latitude in Ohio and mutes shareholder rights.  Given management's previous power grab I have to wonder what the real purpose of the re-incorporation to Ohio is.

Summary

On the surface Randall Bearings has the marks of a great asset investment, buy a dollar for a dime.  The problem for me is I'm not comfortable investing with managers who try to take control for $200.  Some readers might question me on this point because I own shares in Hanover Foods where there is a CEO who isn't exactly working for shareholder interests.  The difference between Hanover and Randall is that Hanover has real actual assets in far excess of the current price giving me a margin of safety.  Randall has assets that exceed the current price but they're all spoken for by bank's whose place in line is much better than my own as a shareholder.  While the price is cheap I can't get over the issues that Randall has, while the actual company seems fine, that doesn't qualify it as a good investment.


Disclosure: I own a token position, enough to receive annual reports.  No plans to increase it.

16 comments:

  1. Hi Nate,

    Cool post, if only for the oddity factor.

    That manual you have, I assume they print them every year? What kind of info do they list?

    Have you ever found something investable in there? And why doesn't RBRG come up on NCAV screens?

    There's a reason some companies are unlisted... guess you picked a few out on this one!

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    1. Taylor,

      The Walkers Manual last printed in 2003 which is the edition I have. Probably 40% of the companies have gone totally private or out of business, the rest are still around. It's nice to have the book because I can see how the company did in previous years. The book has a basic summary of the company along with summary financial statements and information about the company officers.

      If you can find a used copy I'd highly recommend it. If not a local library usually has a copy.

      I've found a lot of companies that are investable in there, Hanover Foods is from Walkers Manual. I have some others in the pipeline that I want to post about at some point too.

      The reason these company's don't come up on a screen is that they don't list with the SEC, so the data providers and screening companies don't have access to the data. To get access to the data you usually need to buy 1 share and call the company requesting the annual report.

      Nate

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  2. Good post Nate.

    Its unbelievable what you sometimes find with small companies.

    I once invested in a £5m market value company in the UK called Invocas which management took private without an offer to minorities, arguing listing costs were too high.

    Luckily an activist took a big stake in the company and I was able to get out as a small profit.

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    1. Tim,

      I agree, sometimes a very small company can have a very shareholder friendly management, but other times the mangers seem to run the place for themselves with complete disregard to outside shareholders.

      You really lucked out with your situation, it's a shame management tried to strong arm minority shareholders. At least in developed countries you have the law on your side, but you'd really need to own a big enough position to make it worthwhile.

      Nate

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  3. The vast majority of the time a company that small will need to pledge its assets and guaranty its bank debt. Non-recourse loans for a small operating business are far and few between.

    Looks like a permanent discount due to non-liquid stock and no catalyst.

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  4. Andy,

    Good points, thanks for the comment. I agree that a lot of their cheapness is linked to the smallness and illiquidity discount, but I think the management factor also plays a role.

    Nate

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  5. Nate,

    I see. I guess I don't get what the difference is between "unlisted" and "pink sheets". I thought pink sheets were "unlisted" (with respect to the major exchanges) so that's what I wondered why an "unlisted" stock wouldn't show up in a screening tool.

    Will look more into the Walkers Manual. Know of any other resources like that?

    It'd be great to find Walkers Manuals or old Moody's Manual-style publications for foreign markets. Hard to get access to all that data in one place!

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    1. Taylor,

      There's different levels of listings on the pink sheets from no information (unlisted) to full sec reporting, but not on a major exchange. A lot of the unlisted companies operate like they're private but they happen to have shareholders. These are a lot of the stocks I write about, information is hard to find, but when you get it you're at a huge informational advantage compared to other investors.

      As for paper resources, I think S&P did a handbook for the US market, but it's mostly major stocks.

      Foreign publications for unlisted stocks...the holy grail! I've spent considerable time on this, I found a book the Japan Stock Market Handbook which costs $150/quarter but it's only listed issues. I found some resources on New Zealand unlisted/small cap stocks but you can only get it from a university library there in person so I'm out of luck. If you or anyone else can find manuals on small caps I'd love to buy a copy. I'll even buy it if it's in a foreign language (romance language preferred) as long as the data is good and reliable.

      Nate

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  6. Hi Nate,
    I received the annual report as well and read it eagerly, since I'd heard the company's tangible book value was far above its trading price.

    What struck me most is just how much more profitable the company could be than it actually is. Together, the President, VP of Manufacturing and CFO paid themselves $1.21 million last year, more than the company's entire operating income! Without those expenses, the company could have earned about $3.20 per share, not even accounting for the LIFO expense.

    I think the most likely scenario here is that that management continues to pay itself handsomely for many years before eventually selling the company to a strategic buyer or a PE firm. I think they will realize many times the current market price on that sale, but it may take decades and shareholders shouldn't expect dividends in the interim.

    Despite the sleazy management, I bought a few hundred shares after receiving the report, hoping that the gigantic discount to asset value will be margin of safety enough. Still, I would never make this company one of my core holdings.

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    1. I saw the same with with management pay, but didn't mention it because I felt like it would be just piling on. Yes, $500k in cash for the CEO, COO, and 150 for the CFO, living large in Lima Ohio.

      If you reduce the exec pay, strip out the LIFO this is a company that has about $5 a share in earnings power trading for $2. I think you're right that a buyout is the most likely course. Sometimes these companies are great, other times very frustrating. Patience is the key with unlisted stocks.

      Nate

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  7. Great post... OTC Adventures has a great point. If shareholders are not diluted (a very big if here).... the Company could fetch $21 (PE of 7 on "Owner's Earnings).

    Even if you have to wait 20 years...that would still be a decent return.

    My question: Is management adding value? Is sales growing. Even if management is over compensated, if they are building value over time.... I can see taking a small postion here.... I will be getting my "token" shares.

    Thanks again for a great post.

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    1. You raise a good point, management does seem to be doing something right, sales have been growing, and margins expanding. So while they aren't exactly running the company for shareholders they are generating shareholder value.

      The question I have to ask myself is do I have the patience to wait 20 years for a return? I've held stocks for 10 years, but I haven't been investing for 20 yet, so I just don't now. Presumably if it just sits there without needing much attention I don't see why not.

      Nate

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  8. OH has an anti-takeover provision that is very generous. Management might be afraid that there gravy train will come to an end. Here is an article: http://dealbook.nytimes.com/2010/12/23/abercrombies-ohio-express/

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  9. Great link on Ohio incorporation. A big negative for shareholders.

    On a worst case scenario (or at least one of many here), it would appear this will make it easier for RBRG to pick its aquirer. Given the shady past dealings, a possible scenario has them selling to "A Cubed" (whom I believe own 200,000 shares they bought from Dickerson)at pennies on the dollar.

    Of course, management would not agree to this unless there were contracts to this unless somehow they were included in the looting. Perhaps employment contracts.

    That the BOD would not have to adhere to the Revlon Rule (http://www.investopedia.com/terms/r/revlon_rule.asp#axzz23vHtEEQy) is a travesty in corporate law (at least to those of us who invest as minority shareholders).

    Does anyone know if Gary Sample is still a shareholder? I am guessing he incurred significant legal costs to mount a legal case against the dilution. A hero here if there is one.

    Nate - another great lead. That RBRG is selling at such a steep discount to an arm's length transaction, makes this one to follow closely. Thanks.

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  10. I checked out Randall Bearings on yahoo finance. Theirs not a lot of infomation available about the company on yahoo finance. I could not find anything under the company profile on yahoo either. Talk about a really cheap stock that I once came across. Get this The company is amcon distributing company. They distribute mostly food and tobbaco products. Symbol {DIT} the stocks currently trading around 63 dollars a share. I think it trades on the amex they supply for the most part gas stations with candy and and tobbaco products. This is a one billion two hundred million dollar company. About seventy percent of their sales are tobbaco products. The shares or I should say the marketcap of the shares was just 6 million dollars in june of 2006. Thats less than 1 percent of what the company did in annual sales eight years ago. I think they were doing around 800 to 900 billion in annual sales in 2006. Now the company did go off track a little they bought a water bottling company in hawaii. But they divested that division a year or two later once they realized that it was a mistake. The company was never involved in a bankruptcy or anything like that. I think the main reason that the companies marketcap is so low its still very low today just 39 million on sales of one billion two hundred million is their involvment in tobbaco products. Their some potential liability there. This company has been profitable for years. They also have paid a dividend for years a good sign its currently 1 or 2 percent not sure around that. Now although their profit margains are between one half and one percent of sales they could improve that over time. I still think this is a great value stock thats really been overlooked. So I just thought I would bring the stock to everyones attention. This stock seems to qualify as a real oddball stock.

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  11. The part of the world I come from - India, on seeing the CEO/CFO doing a deal like that for $ 200 to take control of the company, we would run for the hills. Irrespective of what the margin of safety is, if there is a risk to your capital itself as you rightly pointed out, you should'nt even think of investing. Of course except for US, the law enforcement too is very weak - so chances of you salvaging your money if you've got the wrong end of the stick are zero. A very interesting post nevertheless !

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