Tuesday, May 15, 2012

Does this company deserve to hover just above net-net status?

I love unloved sectors in unloved countries with unloved markets, so it only makes sense that HF Company would be attractive to me.  If there's fear in the air, and a company's perceived to be on the brink of extinction Oddball Stocks is probably investigating.  Of course the facts in this case don't quite line up exactly, here's what I mean.  HF Company has been profitable for the past ten years, they're debt free, and hovering right above NCAV.  If you use a liberal definition of a net-net HF Company surely qualifies.  So what gives?  Why is a "decent" company selling as junk?

HF Company is a technology parts conglomerate, they manufacture and distribute little bits of technology that are essential to a finished product, but are also a commodity.  This means they churn out parts like GSM receivers, HDMI adapters, home security systems, ADSL TV reception equipment, and DSL filters among many other things.  HF Company is a price taker, and if the price of their product rises a consumer or manufacturer will just substitute a competitor product.  Obviously consumers aren't very brand conscious in this market, I remember buying DSL filters once back in the 90s, I browsed for the cheapest ones on the shelves.  I'm guessing I'm not alone in shopping like that, most consumers figure the products all work the same so buy the cheapest.

I think it goes without saying that the market for these devices in Europe is pretty rough right now.  In a world of austerity upgrading to the latest and greatest TV probably isn't the top priority of most Europeans.  It's not only the large European macro elements at play, HF Company expanded internationally which meant to Southern Europe.  In addition they've been squeezed in the last year on raw materials, a double whammy.  They saw sales drop off 1.5% and operating income drop 55%.  Clearly this is a company with an enormous amount of operating leverage, the knife cuts both ways.  In good times results are great, but in bad times a slight bump in the road can be disaster.

With all this in the background the investor needs to consider, do these problems merit such an undervaluation?  First let's take a look at the napkin investment thesis:
  • Market cap of €18m with an enterprise value of -€6m, yes a negative EV stock in Europe.
  • Book value of €72m
  • 3.78% ROE 2011, 8.68% in 2010
  • Generous 11% dividend covered amply by earnings
  • P/CF 2.79x
  • P/FCF 5.82x
  • P/E of 5.39
Just looking at the simple thesis this is the sort of stock I love to buy, slapping a P/E of 10 on HF Company gives an investor a 50% gain right out of the gate.  If the stock ever decided to trade at book value this is a four bagger.  But even with those potentials I'm a bit cautious this time, I'll explain below.

I wanted to show my net-net worksheet for HF Company:



As you can see the company has no discounted net current asset value because the liabilities outweigh the discounted assets.  A lot of this is because HF Company's liquid assets are composed of receivables and inventory which while liquid might not bring full book value in a liquidation.  Of course I don't expect HF Company to liquidate so NCAV can be used as a reasonably conservative downside estimate, and book value a possibly optimistic assessment.  Although it's worth noting that HF Company did trade above book value back in 2008, so getting back there isn't out of the question.

The stability of earnings

I've talked in the past about the two pillars of an investment, book value and earnings power.  I'm not original in this, Ben Graham talked about this back in 1951 as well.  With a company like HF Company they have a book value of €20 a share, with a most recent earnings power at a 10x multiple of €7.3 a share.  It's generally wise to use the lower value, but both these numbers worth together, they reflect a potential value much higher than the current price.

Additionally if you look at the last ten years of earnings HF Company has proven they're able to turn a profit in all sorts of markets, the sign of a flexible company that's able to survive.

At this point if you've actually read this far you're probably wondering why I'm not head over heals for HF Company.  The company has a solid asset value, they have a record of earnings power that far exceeds their current price, and they're paying a generous dividend of 11% that appears well covered.  Why don't I like this stock?

The number for me was the 1.5% drop in revenue corresponding with a 55% drop in operating profit.  Here's the income statement, I didn't translate it because only two items matter which I describe below.

Chiffre d'affairs - Sales
Achats - COGS
Charges externes/de personnel - SG&A


The company doesn't have a lot of room to work to face the pressure of increasing raw material costs, and decreasing sales.  The operating margin was 3% in 2011, so another 1.5% sales decline and a 1.5% raw material increase and suddenly the company is facing losses.

Companies with low margins aren't necessarily bad, I own some Japanese companies that have almost no margins, they make everything up on volume as does HF Company.  The concern is with such low margins and cost pressures a small item can bump the company from profit to a loss.  The item which concerns me as well is 'Variation de stocks' (change in inventory).  It appears in 2010 they had a gain from inventory which really accounted for most of the difference in profit between the years.  Unfortunately profit based on inventory adjustments isn't the highest quality earnings.

In conclusion while HF Company has a solid discount to tangible assets, and considerable earning power I'm questioning the margin of safety.  I'm not entirely confident about HF Company, mostly due to earnings quality and the high operating leverage.  I'm passing for now, although with some really good evidence I could probably be persuaded to buy a small position.  If I was limited to just buying value stocks in France I would be adding HF Company for sure.

Ticker: HF.PA
Website - English available

Talk to Nate about HF Company

Disclosure: No position

1 comment:

  1. Hello Nate
    Good analysis.
    I couldn't resist the low price and I bought some shares early 2012. I agree that the business has no apparent moat.
    One of the strengths they claim to have is a good knowledge of the retail distribution (supermarkets and diy chain stores mainly).
    From 2005 to end 2011 sales and results were boosted by digital TV transition in France. Switchover is now complete.
    The share tanked further in march/april after the 1st quarter 2012 results.
    The message was "the return to a normal/nominal margin will be delayed" and was somewhat different from the end 2011 comment which was rather upbeat on the 2012 prospects.

    So yes the stock is cheap for good reasons. But it's down 20 % in 2012, 60 % in 1 year, 78 % in 5 years.
    At this point I decided that it was worth taking the risk, considering the low debt and the fact it's almost a net net. But I wouldn't "bet the farm" on this one.

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