Wednesday, August 22, 2012

Chromcraft, a net-net, but not a buy..at any price?

I spend a lot of time writing about companies that are potential candidates for a long position in a portfolio.  What I don't do is spent much time writing about is companies I've avoided or pass on, so this post is a bit different.  Just because a company is a net-net doesn't always mean it's a good investment.  There are plenty of companies trading below NCAV that I wouldn't touch at any price, unfortunately Chromcraft Revington is one of those.

Chromcraft Revington falls into the category of what Jon Heller calls a perennial net-net.  These are companies that always seem to appear on net-net screens year after year.  A cigar butt that's just a little too soggy for the last puff.  Chromcraft manufacturers and sells office furniture and waiting room furniture for health care institutions.  To say this isn't a great business is a bit of an understatement, Chromcraft hasn't turned a profit since 2005.  What would compel someone to invest in a company that hasn't profited for the past seven years?  Probably the fact that it's trading at $.72 against a NCAV of $1.92 and a book value of $3.22.

So what we have is a company that can't turn a profit yet is trading at such a substantial discount to NCAV that investors can't help but turn their heads and consider the company, I understand the attraction.  Here is a quick snapshot of their balance sheet as seen through the eyes of my net-net template:


The losses at Chromcraft are an issue, but they're really not the reason I walked away from this company.  There were two items that were troubling enough on the balance sheet that once I saw the continued and sustained losses I decided to pass.

Structure of assets

The structure of assets is important for a net-net.  A company with a high amount of cash relative its NCAV might be safer with a smaller discount to NCAV.  Likewise a company with a high receivables or inventory balance might need to trade at a substantial discount to NCAV to be considered as "safe" as a cashbox company.  In all cases safety is defined as a minimized risk of investment loss.

In Chromcraft's case their asset structure is a little bit scary.  The company holds no cash but has significant receivables and inventory.  What's unfortunate is the lack of cash isn't a recent occurrence.  As far back as I can see (last 5 quarters) the company hasn't had any cash, at year end 2010 they had $4m, but that appears to have been spent trying to remain afloat.

When a company doesn't have cash they need to either liquidate inventory or receivables to pay for expenses or borrow against said current assets for working capital.  Chromcraft has done both, borrowed on a credit line, and liquidated a portion of receivables.

The lack of cash and reliance on credit to fund day to day operations introduces a level of risk that I'm not comfortable with as an investor.

Structure of liabilities

As mentioned above the company has a credit line that they use for working capital needs.  Chromcraft's credit is all short term, presumably because the company has posted negative operating income and is unable to secure anything longer term.  The rest of the company's liabilities consist of payables, a small deferred compensation item, and $200k in a long term note payable.

If the point hasn't come across yet, Chromcraft has a very risky capital structure.  The structure is so risky in fact that they're in breach of a covenant on their revolving credit line as of the last quarter.  The company has promised to make amends, and the bank waived the covenant for now.  The lender is Gibraltar Business Capital, a group that says they are creative in finding solutions for small and middle market companies that find credit hard to access.  There is only one reason credit is hard to access, the borrower is in a precarious financial state.  The borrower with pockets full of cash and the ability to repay doesn't have any problem finding credit.  The borrower with losses as far as the eye can see and a shaky balance sheet needs a creative lender.

Is it worth anything?

Some readers might look at the above and say "who cares?"  The company is trading below NCAV so in a liquidation the bank would liquidate the receivables, inventory, PP&E, pay off the note and give the rest to shareholders.  First off a liquidation is unlikely, it seems current management is happy to run this beast into the ground.  They're currently not that far from impact, and they have shown no signs of pulling up.  To continue the airplane analogy it seems the landing gear has sheered off and sparks are starting to fly, yet management is still walking around taking drink orders.

The problem I have when thinking about a theoretical liquidation is I'm not sure the slug of unsold office furniture is really worth all that much.  If we discount both receivables and inventory as my worksheet does above the discounted NCAV figure becomes $.17 p/s, and discounted tangible book value $.30 per share.  What the per share figures hide is the low absolute figure which in this case is important.  Discounted NCAV is $877,000.  That's not all that much money, and a small expense such as a lawyer or bankruptcy expert could suck that up quickly billing at $200/hr.

After looking at all the factors above I just don't see any margin of safety in Chromcraft at any price.  Management has shown no indication of trying to do anything other than increase sales.  The value of the assets is murky, and the company has some significant liabilities including a credit line that's in breach of a covenant.

I could be proven wrong, and the company could turn around earning $1.66 per share as they did in 2005, but then again if not in 2006,2007,... or 2011, why now?  Chromcraft is a pass for me, and hopefully other investors can find this post educational.

Talk to Nate about Chromcraft

Disclosure: No position

4 comments:

  1. I've always seen net-net analysis as liquidation analysis.

    In which case the costs of bankruptcy -- 5% of assets for professional fees, 3x rent or 1/3 of forward lease obligations -- should be counted in the liabilities column.

    Seen in that way, I CRC may not be a net-net at all.

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  2. I basically avoid inventory-heavy net-nets as well - just too much risk without having a clear understanding of how valuable the inventory would be in a liquidation.

    red, where are you pulling the average cost of bankruptcy numbers? Would be curious if there are additional rules of thumb to follow when adding non-balance sheet related costs into the liquidation equation..

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    1. Damodaran has a piece (and a spreadsheet, I think) somewhere in his website about bk costs. 4% to 5% of assets is normal for small firms, less for larger firms. He cites studies which I chased down at the time but whose titles I now forget.

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  3. I Nate,

    Imagine the company goes bankrupt, is there any enough collateral for a good return?
    I mean, this company looks better dead than alive.
    Property could be sold at market value and not at book value. I don't know if this strategy could work

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