Bonal: A failed merger and an unbelievable high ROE

A sudden press release, screams of undervaluation; the dreaded take-under.  How can investors protect themselves?  Often they can't and they're at the mercy of management or controlling shareholders with ulterior motives.  Mistakenly many investors believe take-unders are a feature of small or micro-cap stocks.  The storyline goes:"I won't invest in a tiny company because management will steal it" is probably the most touted strawman argument for avoiding tiny stocks.  Take-unders aren't a feature of small stocks, they're a feature of any stock with a less than genuine controlling shareholder.  For evidence of this just take a look at Michael Dell's offer to purchase his namesake company, if that's not a take-under I don't know what is.

A take-under rarely falls through giving investors a second chance, like the one Bonal International (BONL) shareholders are receiving.  For anyone looking for a great background on the company I'd recommend reading the post at OTCAdventures.  If you don't read OTCAdventures yet I'd highly recommend adding it to your weekly reading.  I'm friends with the author who unfortunately needs to remain anonymous due to his job, otherwise I'd post it here to get the word out.  If you're ever in Pittsburgh drop me or him a line, we'd love to meet up to talk cheap value stocks.

The quick two minute synopsis on Bonal is that they sell a patented metal stress test technology.  The technology was patented by the Chairman and now CEO (story on that later) decades ago.  The level of current patent protection is ambiguous, they might have a newer related patent, but I'm not sure.

As a result of their patents, their sales, or their niche the company has incredible margins, and has recently been growing substantially.  Here is a glimpse at their current results:

The company is earning 20% and greater returns on equity.  This is even more impressive when one realizes that most of equity is made up of cash and investments that aren't actually needed to generate any of their income.  I have a field called ROE-adj on my spreadsheet showing the company's return on equity employed to generate the returns, the numbers are unbelievable.

The company is selling for close to 2x book value, but given that they lease their premise, and don't have many fixed assets this isn't an unreasonable multiple.  The correct way to view Bonal is as an income stream.  On that note they're trading for close to 10x earnings which is probably a low multiple for such a profitable company.  The company has earned $.18 per share this year so far, if things continue on track it isn't a stretch to assume they could make $.20 per share.  At a 10x multiple on earnings, plus the excess cash of $.56 per share the company's value is close to $2.50 at the low end.  Additionally the company pays a generous dividend giving the stock a current yield of 15%.  

Given what we know about the company's growth and margins it should come as no surprise to hear that shareholders were outraged when they received an offer on Feb 8th to merge with DePierre Management & Manufacturing for $.86 per share, plus a special dividend of $.20-30 per share.  Backing out cash the deal valued the company at about 3x earnings.

It seemed like there was no way for the deal to fail with the founding family owning 65% of the company, except that it did, so what happened?

It's important to realize that the controlling shares don't reside with any one person, they're spread across a trust and five relatives.  Together these family members own 65%, but individually no one controls more than 24% of the shares.

I believe the key to understanding why the deal failed is buried in the press release announcing the deal itself.  Towards the end of the release there is a small paragraph mentioning that two Board members resigned, and the CEO was relieved of his duty and is now in charge of the marketing department.  The Chairman and former CEO has reassumed the role of CEO.

I want to put forth a theory that could explain this, it seems reasonable to me, but I don't have any solid evidence to back this up besides conjecture.  My guess is three of the Board members didn't want to do the deal and were working to stop the transaction.  Somehow the Chairman forced two of them to resign and demoted the third removing them all from the Board.  By doing this he was able to vote to accept the transaction with whatever yes men were left.  The transaction itself is a bit suspicious, the company agreeing to merge happens to have the exact same address as Bonal itself.  This appears to be a Chairman take-under that's going private.

Private shareholders were rightfully surprised and incensed at the proposed merger, and along with the three ousted Board members there were enough votes to block the merger from taking place.

The strange turn of events places the company in a very unique position.  The Chairman clearly wants control of the company back, yet minority shareholders, and other family members are unwilling to sell the company at the price he's willing to pay.  Right after the company announced their take-under they also announced record quarterly earnings.  Earning momentum is headed in the right direction, and as long as the results are sustainable this is a fast growing little company.

I'm not sure where things go from here, but at this point minority shareholders appear to be in control.  This is a story I'm going to continue to watch.

Disclosure: No position

First Aviation, a catalyst wrapped in a mystery

Luck is often described as where preparation meets opportunity.  I'd like to consider myself lucky with my First Aviation Services (FAVS) investment, but it's really too early to know.  I prefer simple investments if possible, they're easier to understand, and eliminate opportunity for mistakes.  But often opportunities lies in hard to understand or complicated situations, First Aviation Services qualifies as both.

Sometimes I get emails asking where I find my ideas, some readers believe I have a secret source for finding undervalued ideas.  Unfortunately I don't, I just do simple things often enough that I eventually become lucky.  Wednesday I was browsing the website and noticed on the front page under that a OTC - Limited Information company had sold a division.  I clicked the news link and noticed that the stock hadn't traded any shares, and the price was unchanged.  I smelled opportunity.

After reading the news release I started to realize why there was no quick market reaction to the divesture news.  The release had no price information, and it was difficult to understand exactly what was being sold.  Beyond that the company never broke out any historical sales information making it even harder to guess what the specific division might be worth.  I took this as a challenge, with the company selling for less than half of book value, and for less than NCAV I realized there might be considerable value with the company selling a division.

The history

Before estimating what the Aerospace Products International (API) division might be worth we need to go back a little in time and look at how the company became what they are today.  In some cases history is important, with First Aviation understanding their history is vital.

First Aviation is an aviation company, they specialize in parts supply and repair.  The company is really three independent subsidiaries, Aerospace Products International (API), a parts and service distributor.  Piedmont Propulsion (PPS) the last remnant of Piedmont Airlines, they specialize in aircraft overhaul and maintenance based out of their North Carolina location.  The third subsidiary is Aerospace Turbine Rotables (AeTR), which designs and manufacturers aviation components such as landing gear, wheels, brakes, and other components for propeller aircraft.

When most people think of propeller aircraft they think of recreation aircraft, it's worth noting that First Aviation's market is mainly turboprops and smaller corporate propeller aircraft.  They are not selling parts to the recreation flyer, but rather airlines and companies with corporate aircraft.  The company recently was certified to work on the Bombardier Dash-8 turboprop (Q400).

Up until 2009 the company was only the Aerospace Products International division.  Towards the end of 2009 they entered into a transformative transaction, from which we can extrapolate details regarding the division sold.

In 2009 the company entered into a transaction with a company familiar to most readers TAT Technologies (TATT).  TAT purchased $750k worth of First Aviation preferred shares, and 288,333 shares of class B non-voting stock.  In exchange for the investment First Aviation received Piedmont Propulsion.  The transaction is a little unusual but at this point it's still straightforward.  Here are where things get strange, simultaneously as the company entered into the transaction with TAT they also entered into another one with Kelly Aerospace.  The company used the TAT investment as guarantee for a loan to purchase the AeTR division from Kelly.

Let me recap the last paragraph if your head is spinning.  First Aviation purchased PPS from TAT, but didn't pay right away.  Instead they issued new stock and preferred shares to TAT that have to be held for five years.  Then they took that equity injection and used it to guarantee a loan to purchase AeTR from Kelly Aerospace.  The end result of the financial engineering is First Aviation before March 20th.

The terms of the deal in 2009 provided a balance sheet for PPS, AeTR, and API.  From that balance sheet here are the equity values for each division:
API is on the left, PPS in the middle, and AeTR on the right.

At the time of the merger API had a book value of $13m, PPS of $7.9m and AeTR of $4.8m, keep in mind that API is what's being sold currently.  When I looked at this stock First Aviation had a market cap of $8m.

The results haven't been all that great since the 2009 merger, demand fell off 59% over the past three years and the company went from profitable operations to reporting losses.  Additionally the company discovered that PPS's results were overstated at the time of the merger.  The company thought they were buying a profitable company but were stuck with a loss making division instead.  The current management has been in fire fighting mode but their efforts have been successful with the company reporting profits the past two years.

So what is Aerospace Products worth?

Given everything above the task is to consider what is API worth, and at the current price (or the price I paid) is it a savvy buy?

Before looking at what API is worth I want to highlight why this is worth a reasonable speculation.  The company was trading below NCAV meaning that my investment was protected by liquid tangible assets.  Even with the complicated capital structure, and the outstanding debt if the company were to sell all of their current assets the amount received would have been greater than the level I invested in.  From that foundation I knew that my investment was protected and that most likely whatever value the company receives for API is greater than what I paid.

My starting point was the equity amount for API from 2009, which was $13m.  The company hasn't performed up to expectations since then, and assets have been depreciated over the past four years.  After considering that I thought that API had to be worth at least $6-8m.  I speculated that the company would receive at least 50% of it's marketcap in cash from this deal.  And given that the company will continue to own the two most profitable divisions after the sale things were looking up.

The company's book value is $23 per share, and it was trading at $9 when I purchased shares.  I estimated at $9 and below NCAV I had a hard time going wrong buying.  The company is probably worth book value, but this transaction will at least help unlock some of that value.

The company has been paying down debt at a rapid pace and I would presume proceeds from the sale would be used to pay down more debt thereby increasing book value.  Investors will own a company with a vastly improved balance sheet, and will continue to own the remaining two profitable divisions and hold a small equity interest in API.  The purchaser of API is a private equity group from Cleveland Ohio that specializes in aviation turnarounds.  If they are successful the equity interest that First Aviation holds could become increasingly valuable.

Of interest to likely no one but myself is that the private equity firm buying API is located one street away from Ancora Advisors, the fund that has purchased an activist stake in Solitron and is pushing for a $1.50-2.00 p/s dividend.

In the end I picked up a small position in First Aviation, I'm now patiently awaiting updated financials showing what the company will look like post-sale, and what the price of the sale was.  It's worth noting I've contacted the CFO asking when we might expect to see the updated financials and I'm still awaiting a response.

Talk to Nate about First Aviation

Disclosure: Long First Aviation

A name brand at a cigar butt price

What investor wouldn't want to own a piece of a name brand company?  Selling an investment story on a recognizable name is much easier than selling the story on Murphy's Midwest Muffler Repair, no matter how cheap the company is.  Harry & David (HARR) is unique in that they have a well known brand and the company is cheap being newly issued equity from a bankruptcy re-organization.

For anyone who isn't familiar, Harry & David sells specialty gift baskets.  The company's known for gift baskets that include their Royal Riviera pears.  For anyone doubting the power of their brand just browser their catalog, they sell nine pears in a nice box for $24!  Like with most things it would be much cheaper to assemble a gift basket oneself, but that would defeat the point.  Gift baskets are an easy way for someone to pay a small fee and send a message to person that they're appreciated (or they appreciate their business).  The company has a variety of baskets for holidays throughout the year, but the Thanksgiving to Christmas period is when the company sells most of their baskets.

The majority of the company's sales are through their catalog and the internet.  They also operate 55 stores located throughout the country.  The stores accounted for 12% of sales last quarter.  The company also operates orchards to grow their famous pears.  The company's orchards contain 725,000 pear trees located in the Rogue River Valley of Oregon.

In a cyclical business that's highly levered a small downturn in demand can result in a company tripping their debt covenants; which is what happened to Harry and David in 2011.  The company experienced reduced demand in Q2 2011 and the result was a default on a $105m loan.  The company went through bankruptcy and restructured their balance sheet resulting in $276m worth of pre-petition obligations settled and wiped clean.  The company now has no long term debt, and no pension liabilities.  The company does have a few settlement payments left to the PBGC, but they will be completely satisfied in 2014.

Out of the bankruptcy re-organization senior note holders were offered rights to purchase 76% of the newly issued common stock.  As part of the restructuring process the company qualified for fresh start accounting.  This means the entity was revalued given a specific point in time coinciding with the emergence from bankruptcy.  The valuers looked at the company from the perspective of what might they be worth in a sale today?  Here is a picture of the valuation, and the numbers that went into it:

What makes Harry & David interesting is not their story but their valuation, their market cap is $84m.  The current balance sheet had $89m in cash, and if an enterprise value were calculated off their last balance sheet it would be close to $4m.  And based on the most recent quarter they have a EV/EBIT of .07x.  As I mentioned above the company is extremely seasonal, they make most of their money around the holidays then steadily lose money the rest of the year.  This year was no different, they made $41m in the last quarter, and will most likely lose $10m in each of the other three quarters.

I have a spreadsheet with results going back to the emergence from bankruptcy below.  A general note, if you try to add the quarterly numbers for 2011 together to match the fiscal numbers they won't match.  One of the quarters had different dates from the fiscal year meaning the time periods aren't the exact same.  That detail doesn't matter specifically, I put this together to grab the seasonal trend.

The trend in the results is clearly apparent.  The company makes a haul at Christmas and then steadily spends down the cash and loses money the rest of the year.  If the losses are less that what they made at the holidays they turn a profit at the end of the year.

A side effect of this feast and famine cycle is as the company spends down their cash each quarter they end up in a position where it becomes hard to finance working capital.  Especially in preparation for the holiday season.  Because of this the company carries a revolver which they tap each June to December.  In January the revolver is paid back and the company operates on a cash basis until June.

Valuing Harry & David

When I'm looking at a company's earnings I like to use the EV/EBIT multiple because it cuts through extra cash, includes financing and shows what I consider core earning power.  This metric is especially useful when looking at little cash boxes, something I do often.

Calculating an accurate enterprise value for Harry & David is difficult, what point in time should an investor use?  Should we extrapolate a $12m loss forward for the next two quarters and use a projected $65m cash balance for the end of the fiscal year?  Figuring out earnings or EBIT is much easier because the proper way to view them is over the entire year.

I re-valued the company using the same methodology that was used when they emerged from bankruptcy but I used figures from the latest quarter:

While I've never tried to value a company with this method before it's nice to see that the number it generated is very close to the company's book value for the last quarter.  If nothing else the fresh start valuation methods reinforce the company's book value.

One other item worth noting is the company's liabilities could be potentially overstated as they carry $36m in deferred revenue on the balance sheet.  It's likely they will recognize this revenue considering they received most of the cash for it already.

Worth it?

The company appears cheap, they're trading at 71% of book value, or 60% of adjusted book value taking into account the deferred revenue they've received as cash.  On an asset basis the company certainly merits consideration as an investment.

Unfortunately for me the story stops there, while the company has considerable brand power, and is trading at a large discount to asset value there is an intangible that I can't ignore, their financing decisions.  Due to the nature of the company's business they are forced to continue the same patterns that led them into bankruptcy the last time.  They still have a revolver they tap in the summer and pay back after New Years.  If sales were to decline again like they did in 2011 the company could find themselves in a position again where they might be in breach of a debt covenant.

The other issue I have is while the company has a profitable niche that's all they have.  Unfortunately their cost structure for this niche doesn't leave much profit left over for shareholders at the end of the full year.  The company has pushed harder into the online marketplace, but they've had to reduce prices to push volume impacting margins.

I think Harry & David holds a lot of potential for many value investors, but for me it's a pass.

Disclosure: No position

Quantitative Value: Insightful, but more questions than answers

I finished reading Quantitative Value a few days ago, a friend read it, liked it and sent me a copy asking my thoughts.  The book has been making the rounds on value blogs and the subject tied into something I wrote about recently on quantitative investing.  As you'll see in my review the book was extremely thought provoking, yet by the end I had more questions about the approach than answers.  I haven't seen anyone pose these questions, and I thought they might be worth posing to readers for consideration.  This review is broken into two parts, first is an overview of the book, and second are my specific quibbles, or questions.


The book is written by Wesley Gray and Toby Carlisle both managers of hedge funds.  Toby used to write daily on the Greenbackd blog which I read habitually when he was posting about net-nets and deep value stocks.  That site along with others motivated me to investigate these strange creatures called "net-nets".  I am indebted to Toby for illuminating such a lucrative area of the market for me.

The authors originally set off to understand why they couldn't replicate the results from the Magic Formula investment system.  The Magic Formula is a system to high high quality stocks at low prices.  Joel Greenblatt the author of the system wrote about it in The Little Book That Beats The Market.  The results shown in the book are simply unbelievable, and unfortunately no one has been able to replicate them either.

Carlisle and Gray like the concept of buying the highest quality cheap stocks.  They present a lot of evidence that supports the notion that buying the cheapest stocks outperforms glamour stocks.  They they consider whether they can improve upon the notion of just buying cheap and eliminating frauds and accounting manipulators (you can).  They also look into why certain types of glamour stocks perform the way they do.  One observation I found fascinating was that the quality metric that the Magic Formula is based on actually picks the wrong time of quality (high priced glamour vs high quality) which in turn drags down the Magic Formula returns.

As the authors walk through their model they show their research into each metric they decided to use.  For me most of the value of the book lies in these chapters.  There were lots of fascinating points that prompted me to think about my approach.


1.) Does the quality metric really measure quality?  The authors posit that the best metric to measure the quality of a business is gross margin divided by total assets.  This formula is supposed to eliminate company financing decisions and focus on companies that earn the highest gross margins on the smallest invested capital.

I spent a long time thinking about this equation and my conclusion was it would bias quality towards franchisers, software companies, and any service company where personnel not fixed assets generate a return.  The equation also fails to capture lease expenses, so given two of the same companies one that leases all of their assets would be considered higher quality over the one that owned all of their assets.

I also thought about what I would prefer as a business owner, a company with high gross margins that has significant SG&A expenses or a low margin product that has almost no marginal costs.  The low margin product in this case would result in more profits but would be captured by the formula as low quality.

2.) Who is the intended audience?  Throughout the book the authors appeared to be writing to investors who wished put their investment theory into practice.  They discuss portfolio considerations with regards to small and illiquid stocks.  Yet later in the book the authors disregard certain types of stocks because they aren't considered academically pure.  As an investor I want the highest returns regardless of if they are respected by academics or not.  One of the authors Wesley Gray is a professor at Drexel, and I presume decisions like this are the influence of his academic finance background.  There are a few other academic finance-isms scattered throughout the book that detracted from the main story.

3.) Why ignore small caps?  There are two specific places in the book where the authors mention strategies that far outperform both the market and Quantitative Value, yet they're both dismissed almost immediately as uninvestable because they deal with smaller stocks.  The authors maintain that any stock below a market cap of $1.4 billion is a small cap.  They categorize small caps as almost impossible to trade.

The first strategy they discussed was one where an investor would buy all of the stocks trading below book value and divide them into two parts based on F_SCORE (a measure of financial strength).  The investor would buy the stocks with high F_SCORES and short the ones with low F_SCORES.  This strategy outperformed the market by an astounding 23% during the period tested.

The second discarded strategy is one near and dear to my heart, Graham's net-net strategy.  Graham maintained that an investor could earn north of 20% a year investing in a handful of net-nets.  The book confirms this and then goes on to say that net-nets are near impossible to find and invest in.

While I understand that pension funds, and large mutual funds can't invest in smaller stocks I would wager that most investors, and professional investors are actually working with sums of money that could easily invest in stocks at the $1.4b level and below.

Paradoxically the book shows over and over that smaller stocks have higher returns over any test they run, yet the book pushes readers towards larger cap stocks.  The website associated with the book only lists stocks $10b and larger.

4.) How is performance compared to fundamental indexes?  The Quantitative Value strategy appears to be a different type of fundamental index.  It would have been nice to see the strategy compared to the Research Affiliates or WisdomTree indexes.  The Quantitative Value approach seems like a costly approach (transaction costs/taxes) especially if there is an fundamental index that performs closely.

5.) Is there more?  The book went to great lengths to describe the authors strategy and thesis, but unfortunately they didn't touch on how anyone would actually implement it short of investing with them.  Both authors run hedge funds that are out of investment reach by everyone outside of institutional and accredited (wealthy) investors.  If an investor with $500k wanted to implement Quantitative Value the book doesn't give much detail on where to start.

The biggest issue with implementation is gathering and crunching the data.  My sense is that an investor would need a Bloomberg or CapitalIQ to gather the required data to implement this strategy.  Maybe the authors plan on unveiling a product similar to Formula Investing and that's why they were light on implementation details.


This review is probably sending a mixed message; parts of the book are great, yet there are some fundamental issues I had as well.  While I don't think investing is as easy as programming this formula into a computer and sitting back as the money prints, there is a lot that's worthwhile in this book.

While I'm not quantitative value practitioner I did recognize that I apply some of the patterns discussed in the book.  I will find pools of the market that are cheaper than the rest and fish accordingly.  I try to watch for fraud and accounting manipulation, and I buy as cheap as possible in quantity.  I'd rather own five cheap semiconductor stocks rather than the best cheapest semiconductor stock.

I also realized as I read the book that I've applied a psuedo-quant strategy to parts of my portfolio.  I've purchased Japanese net-nets based on a simple formula, less than 2/3 NCAV, profitable, pays a dividend, and is a business that will be around in 10 years.  I've invested in other areas like this as well.

I enjoyed reading the book, it was quick, and it made me think.  I also had some lively discussions with some friends about concepts in the book.  On the whole if one approaches the book as Gray and Carlisle's thesis on their investment method I think a reader will be satisfied.  If one approaches the book looking for something that could be applied to their own portfolio I think they'll be left wanting, at least until the QuantitativeValueApplied fund launches.

Talk to Nate

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There are two types of net-nets...

This post was inspired by a comment and a tweet about my last post on Micropac.  Two readers asked why I would even consider earnings when looking at a net-net.  I look at earnings because I believe there are two types of net-nets, some that are piles of assets, others are operating businesses selling at too low of a value.

The idea behind investing in net-nets is that a business shouldn't be worth less than their net current assets (NCAV).  Net current assets is defined as current assets minus all liabilities.  If such a business were to liquidate investors would realize a gain beyond their initial investment.

The idea of a net-net first appeared in Graham and Dodd's 1934 edition of Security Analysis.  At the time the market was littered with companies selling below NCAV, some estimate almost 40% of the market sold below NCAV at one point.  Today not as many net-nets exist in the US, most are smaller cap stocks with questionable businesses.  Many market historians claim net-nets don't exist anymore, or are out of reach for most investors.  While the US market isn't full of net-nets a variety do exist worldwide with the biggest concentration in Japan.  Japan's current market is similar to what the US was like in the 1930s.  Many companies in Japan trade below NCAV, companies with solid business models, long histories of profits, and sound management.  There are always a number of reasons investors try to justify why a company is selling below NCAV but whatever the reason it seems strange.  Investors who are managing hundreds of millions of dollars might be precluded from investing in net-nets, but for any investor managing less than $30-40m there are plenty of opportunities globally.

Forget the financial markets and for a moment imagine a local business with one location on a sparsely travelled secondary road.  The owner has run the business for years and has done ok for themselves, but the business isn't growing, and the location is in need of updates.  The owner has been prudent and saves most of the excess cash and has no debt.  Now imagine walking into the business and offering to purchase the entire business for less the cash and inventory and receivables.  The owner would laugh you out of the place, but this is what many net-nets are like.  The wallpaper needs to be replaced, the seats need new cushions, and the pictures from the 1980s need to go.  Some net-nets are the equivalent of walking into the local business and offering to buy the company for less than the cash on hand.  Making an offer like this would be insulting no matter how marginal the business is.  Yet in the financial markets stocks trade like this every day, and even worse investors somehow trick themselves into justifying these low valuations.

The premise of Graham's original net-net investment thesis was that a reasonable company shouldn't be worth less than NCAV.  He recommended investors purchase net-nets at 2/3 of their NCAV or below and sell them when they reached 1x NCAV.  On the basis of this investment process alone he claimed 20% annual returns.  In Security Analysis Graham discusses that a prudent net-net investor should prefer companies that are profitable and that do not exhibit an eroding NCAV.

Based on the Graham criteria it should be fairly simple to value a net-net.  Take the current assets, subtract all liabilities and invest when the price is below 2/3 of NCAV.  When the price eventually rises above NCAV sell the stock.

While this is a simple and sound strategy the truth is the market doesn't evaluate companies based on their asset values.  This is why companies sell below book value or NCAV in the first place.  The market is earnings and future focused.  This isn't a new phenomenon either, Graham himself discusses it in Security Analysis.

I have explained in posts over the past few years that I separate net-nets into two categories:

Asset net-nets - These are companies with a pile of assets where the investment value resides within those assets.  The goal with asset net-nets is to buy ones with businesses that aren't destroying the asset value.

Operating net-nets - These are companies that sell below NCAV but their value isn't found in their assets, but rather their operating business.  An example of this type of company might be an industrial company with marginal operations and a large inventory and receivable balance.

Valuing asset net-nets is simple, calculate NCAV and buy when the price is less than 2/3 of NCAV, the same as Graham preached.

Operating net-nets are viewed differently, while these companies are selling below NCAV they do have value beyond their asset value.  Net-nets of this type could be companies that fell on hard times and their earnings suffered.  Or companies that are experiencing cyclical slowdowns.  Eventually earnings will recover.

Because the value in an operating net-nets is found in the business not the NCAV valuing them should be done the same way one might value any other business.  The NCAV in this case provides a margin of safety.  If the company were to hit hard times it's reasonable to think they could liquidate and the investor would still realize a positive return.  The investor isn't investing on the basis of a liquidation, they're investing with the hope that the company's results will eventually recover, or the market will warm up to the company.

Determining the best way to value a net-net means determining what the investment thesis rests on, asset value or an operating business.  Of course it would be hard to go wrong simply following Graham's original strategy of buying below 2/3 NCAV and selling at 1x NCAV.  The reason to view an operating net-net as more than a pile of assets is because some businesses are such, and once the market realizes this NCAV might become a distant memory as the stock rises.

I own both types of net-nets, I don't discriminate or have a favorite type.  Asset net-nets are more of a sure thing in terms of safety, whereas operating net-nets seem to have more of an upside.  Both are worthy additions to a value investor's portfolio.

Talk to Nate

Micropac, worth another look?

It's tough writing a blog at times.  I've written about a number of companies and I'm always striving to bring something new and fresh for readers.  Yet the reality is outside of a few fanatics (and I love you guys) most people haven't read the blog from start to finish.  So if I wrote about a company two years ago most readers are unaware of it.  The challenge is writing updates to old companies in a way that's engaging for newer readers and is still informative for readers who remember the first post.  Micropac is a company I wrote about almost two years ago.  They're a net-net that's still trading below NCAV.  I received the annual report in the mail today (yes, I love receiving hard copies) and after reading all 29 pages I felt that they were worth a new post.

For the uninitiated Micropac is a electronics manufacturing company located in Garland Texas.  They develop electronics for the defense, aeronautics and space industries.  You'll immediately notice their biggest customers are all government related.  The company's products are split with 35% being custom designs and 65% being commodity designs.  The company hopes that many custom designs will eventually become useful in creating new commodity designs, but it's far from certain that this will ever happen.

When I first wrote about them the company they were much more attractive.  Earnings and margins were much higher than they are now, although NCAV was lower then.  So in the past two years the company earned $.64 p/s last year, and $.18 p/s this past year.  They've grown NCAV from $5.86 to $6.17.  Here is the net-net worksheet:

The company is still selling for a discount to their NCAV, although with the recent earnings drop a solid argument could be made that maybe they're not worth NCAV.

The company is closely held with directors owning 76% of the company.  This number is a bit misleading, there is one shareholder, a German industrialist who owns 75% of the shares.  It's unclear what his relationship is to the company, but apparently years ago he spotted something he liked in Micropac and purchased most of the company.

The company's earnings fell due to lower sales volume in their high margin space related product.  Without the higher margin items the company needs to boost their sales level if they want to bring earnings back to what they'd been in years past.  The concerning aspect of this is that 65% of the company's sales are to the DoD and NASA, two organizations that aren't exactly experiencing a growth phase right now.

Most of the company's clients are defense contractors, meaning that Micropac's revenue will ebb and flow with government spending.  As of this post it's mostly an ebb and not much of a flow, although that could change.

Even with reduced earnings the company is still profitable, although this past year there was some cash drain.  The company ate into almost $1m worth of savings investing in plant, paying dividends, and letting receivables expand.

The good news is that Micropac has a backlog of $9m in orders that they expect to fill in 2013.  This means they only need another $8m in new sales throughout the year to equal 2012's performance.  If they can kick their sales team into high gear they could maybe notch revenue back up to the $20m plus range where earnings per share would be over $.50 again.

The investment case when Micropac was selling below NCAV with loads of cash and selling for a P/E of 8x was much easier to make than now.  This past year the company has burned down some of their cash reserves and earnings fell off a cliff.  They now have a P/E of 32x and a EV/EBIT multiple of 6.9x.

I'm re-evaluating what I want to do with my Micropac position.  If earnings continue at the pace they were at for 2013 I would consider selling them at NCAV or NCAV plus PP&E.  If earnings recover to the pace they were at over the past few years I would hold on for a sale price close to $10.  So right now I'm just continuing to be patient, but I do have one finger on the trigger pending the next few quarters results.

Disclosure: Long Micropac

Solitron proxy fight, my thoughts

I've posted about Solitron Devices (SODI) many times on this blog.  They're an undervalued electronics manufacturer located in Florida.  The company is a perennial net-net that froze investor dollars in place for years at a time.  The undervaluation is due to two factors, a complicated bankruptcy in the 1990s with associated environmental liabilities and corporate governance issues.

I took action and wrote the company a letter urging them to resolve the undervaluation, and in response the company repurchased some shares and announced the intent to hold an annual meeting this year.  It wasn't as easy as writing a letter, my letter woke up the sleepy shareholder base.  Once the company realized people actually cared about them, and were watching their every move they started to take action.

It seemed things were moving in a good direction, the company was resolved to hold an annual meeting, and with environmental liabilities finally settled maybe cash would be returned.  Then out of no where a small hedge fund (Furlong Fund) in DC filed a lawsuit against the company.  You can read the actual suit here on Jeff's blog.

The lawsuit appears strange to my non-lawyer eyes.  It's really a mix of a few items.  First, the fund is suing to compel Solitron to hold their annual meeting in April.  Second, the fund is trying to force Solitron to pay their legal fees, and finally they bundled a proxy with this whole thing.

To the first argument the fund states that Solitron hasn't picked a date for their annual meeting yet and they want the Delaware court to force them to hold a meeting in April.  The company responded that this wouldn't give them enough time to release their annual report before the annual meeting and they'd prefer to hold it in June.  I am personally in favor of June because I plan on spending a few extra days in Florida around the annual meeting swimming and sitting at the beach.  While the water is acceptable in April I prefer June.  Further I would prefer to attend an annual meeting where the company could discuss their full year results.

I believe the reason the fund wants the meeting in April is so they can speed along their proxy agenda.  They are pushing the company to change bylaws and push through their slate of directors.

The third item is concerning as a shareholder, and a little strange.  If this fund wanted to maximize their investment in Solitron they wouldn't sue the company and then ask for the legal fees.  Any legal costs Solitron pays diminishes what they could ultimately receive from the company.  Solitron could play the scorched earth strategy and spend all of their excess cash on lawyers defending themselves.

The fund's position is small, they own 18,000 shares worth $67500.  If they spend $45k in legal fees a 100% return on investment becomes a ~25% return for fund shareholders.  If Solitron doesn't pay the fund's legal fees it's hard to imagine them earning a good return at all.  I am wary of an investment thesis which includes suing a target company and the company paying legal expenses for things to work out.

As for the proxy I would encourage all shareholders to read the filing here with the descriptions of directors.  If this fund got their way they would effectively control the company after buying 18,000 shares and filing a suit.  If the fund is serious about Solitron I don't know why they don't put their money where their mouth is.  For filing a suit I'd expect at least a 5-10% position if not more.  Either this fund isn't serious, or they don't have much money, I'm not sure which it is.

I'm worried this fund is using Solitron as something to build their resumes.  The problem is as a shareholder they're using my money to build their resume, not something I take lightly.  I've talked with some of the major holders of Solitron and can say they aren't exactly warm to the proposals either.

There have been indications that Solitron was moving in the right direction on their own without costly lawsuits and some simple prodding from shareholders.  Holding a company accountable doesn't require an appearance in a Delaware court.  Many CEO's are reasonable people, Saraf included, and with some prompting and discussion do the right thing.

Talk to Nate

Disclosure: Long Solitron