Saturday, October 20, 2012

Is EnviroStar worth a speculation?

Investors are often encouraged to seek out safe and boring investments.  While I'm sure industry insiders are excited about technological advancements, for the rest of us the industrial dry cleaning equipment business qualifies as both sleepy and boring.  If a dry cleaning machine had a competitive advantage would an investor have any way of knowing?  This post is unique in that usually I'm looking at the downside for a stock, in EnviroStar's case I want to look at what this company is potentially worth.

I came across this idea in the comments section of the Whopper Investment blog.  I mention this because I think some readers believe I have a super natural ability to find great bargains in unknown stocks.  I don't, I'm out scrounging for ideas like everyone else.  The commenter stated an activist hedge fund had purchased a large stake in EnviroStar, and had been successful at unlocking value in the past. This is essentially the thesis, an activist hedge fund has taken a stake, and there is the potential for a substantial gain, if they're successful.

What is EnviroStar?

When I first saw that the ticker EVI (what was mentioned in the comment) went with a company named EnviroStar, my first thought was that this was a penny stock company with high hopes, little revenue, and a fanatical message board.  The company is nothing like this, they are a dry cleaning equipment distributor, and the franchisor for Dryclean USA stores.

Most of the company's revenue comes from the sale of commercial and industrial dry cleaning equipment.  These are items ranging from washers, dryers, and entire systems, to small components.  The company states that prices range from $5,000 to $1,000,000.  The company additionally services the machines they sell, and sells replacement parts.

In addition to being a distributor, they are also a franchisee for the Dryclean USA brand.  The brand has stores in four states, as well as locations internationally, mostly in Latin America.

Valuing EnviroStar

The first thing I wanted to consider is the hedge fund that acquired a stake in the company. Have they been successful, and will they repeat that success with this company?  Zeff Capital is the name of the fund, they purchased a 5.9% stake in the company, which was reported recently.  I did some Googling and found press releases related to acquisitions Zeff Capital had done in the past.  I also found some of their holdings from back in 2005/2006, and most of those companies appear to be private now as well.  My goal wasn't to dig into Zeff's past exhaustively, but just to confirm that this fund has in fact made whole company purchases, and unlocked value for shareholders.

What makes EnviroStar interesting from a valuation point of view is that nothing stands out right away. I pulled up the stock, and saw a P/E of 20x, and a P/B of 1.25x.  I thought maybe they were really growing revenue or earnings, but both of those have been flat the past five years.  I couldn't quickly identify what Zeff sees in EnviroStar.  After reading through the 10-K I was able to identify three areas of potential hidden value.

Understated book value

An argument could be made that EnviroStar's book value is understated.  The first area of understatement is an overstatement of liabilities.  Almost 50% of the company's liabilities consist of customer deposits.  These are deposits from customers for equipment not yet delivered.  According to accounting rules a deposit is a liability because the revenue hasn't been earned yet, and the company might have to give the deposit back if they can't fulfill the order.  While deposits are technically a liability they're also a cash advance to the company, money the company uses to buy the equipment, essentially a cheap form of financing.

The second aspect of the understated book value is hidden in the value of intangibles.  Most investors consider goodwill, or intangibles to be worthless, and disregard them.  This might be the case for a serial acquirer that continually writes downs goodwill, but EnviroStar is a bit different.  The company's intangibles consist of their franchise brand, and related franchise items.  This is the intellectual property that goes with a franchise operation.  A franchisee buys in with EnviroStar so they can market their dry cleaning retail outlet as Dryclean USA, a known brand with a good reputation.  The intangibles are held on the books for $65,890.  Yet these intangibles are responsible for $381k in franchise licensing revenue, and $44,193k in operating profit.

Deep in the notes the company has identified $594k in assets related to the franchise operations, presumably the offices and equipment used by employees to managing the franchising.  This division has a lot of operating leverage, it's doubtful that they'd need to increase their tangible assets much to expand the franchising.  If so intangible assets are surely worth more than $65k, considering those intangibles produced almost $45k in operating profit.

Potential for earnings growth

As mentioned above earnings have been flat for the past few years, but this doesn't mean that they couldn't jump under new ownership.  The easiest way to boost earnings would be to cut the CEO's pay.  The CEO currently makes $552k, which if reduced to a more modest $250k would increase earnings 50%.  I also find it curious that the Chairman of the Board makes $180k, yet the other Board members only make $5,000 or $10,000.  Reduce the CEO's salary, and eliminate the outrageous Chairman compensation and earnings are close to doubling.

The second way earnings might start to grow at EnviroStar is if they can increase their franchising.  Franchising is an asset-lite business, where expansion requires almost no additional assets, or employees, yet results in substantial cash flows.

Hidden business value

The two items I mentioned already are areas of potential, but I think the reason Zeff is attracted to EnviroStar is for their hidden business performance.  If you take out the $6.5m in cash, the company's equity drops from $8.2m to $1.76m.  With earnings of $511k, the company's ROE ex-cash is 28.8%, pretty incredible.  The company's book value has grown at 4.7% annually over the last five years.  My guess is Zeff would take out the excess cash as a dividend, and let the business grow off the small capital base.

Is it worth a buy?

The short answer for me is no.  The reason for this is there are too many assumptions and things that would need to go right for this investment to work out.  I try to find investments that minimize assumptions needed for a return.  When buying a profitable cash box for 50% off not many assumptions are needed for the investment to work.  As long as the company survives, and the cash isn't squandered investors will do ok.  EnviroStar is different, for this investment to work the hedge fund has to either convince the company to pay a large dividend to expose their true business value, or fire the CEO and convince the Chairman to lower his salary.  I doubt either with agree with that plan unless they're getting a sizable payday in return.  While EnviroStar might have some hidden value, I don't think they have enough hidden value, coupled with certainty to make this a good investment, at least at this price.

Talk to Nate about EnviroStar

Disclosure: No position

No comments:

Post a Comment