Tuesday, September 17, 2013

Hammond Manfacturing, boring, cheap and very attractive

There's a common market perception of net-nets.  These companies are perceived to be failures, or on the bring of failure.  The market with its great predictive power has deemed these companies worthless, and it's just a matter of time before reality catches up with the market's vision.  At times the perception of net-nets does happen to be true.  There are many net-nets bleeding cash that are on their way to see a judge, but there are many that don't fit the mold either.  Some companies find themselves in a position where being smaller and at best average leads to investor neglect.  Couple investor neglect with a large inside holder and eventually shares become illiquid.  Small, illiquid, and boring can lead to an undervaluation, which is the case with Hammond Manufacturing (HMM/A.Canada).

Hammond Manufacturing is a Canadian company located near Toronto, Ontario.  The company's address is in a small town, but appears to be about five freeway exits from the suburbs.  They have locations worldwide including the UK, Australia, and Taiwan.  The company produces enclosures, such as electrical box enclosures, enclosure racks, outlet strips and electrical transformers.  The business qualifies as boring, I can't imagine anyone getting excited about industrial electrical box enclosure technology.  I'm not even sure the word technology should be used, most of the company's products are bits of metal twisted in different directions.

Anyone looking for a moat isn't going to find it with Hammond, their net margin is around 2%, and I'd be surprised if there wasn't a Chinese competitor who manufactured each of their products.  Yet in the face of producing a commodity item the company has been able to remain profitable in recent history, with the exception of 2009.  In 2009 the company reported a small, $44k loss.

I pulled the company's sales, earnings and book value from their earnings releases on their website going back to 2007:


If Hammond were trading at book value or above the company wouldn't attract my attention, their results are average at best.  But with the stock trading below book value, and below NCAV I'm much more interested.


The company's current assets consist mostly of inventory and receivables.  The company's inventory is almost entirely finished products, presumably waiting to be shipped to customers or distributors.  The company doesn't have much cash on hand, but this isn't surprising given that they also have some debt.

The company is selling for 88% of NCAV, a strictly mechanical investor might consider this over priced since it's selling for more than 2/3 of NCAV, and would potentially sell at NCAV.  I'm not mechanical by any means, and I can see that there's a lot of opportunity here besides a straight NCAV play.

The company has a fairly sizable property holding, they hold almost $9m worth of land and buildings at cost.  They also own a 50% equity stake in a piece of property in Georgetown, ON.  The Georgetown property is undergoing environmental remediation, but they company plans on developing it when finished.

The company's assets are like the rest of this company, nothing spectacular, but worth much more than the market is pricing them at.  The assets, especially the current asset coupled with the company's profitability history is what gives Hammond value.

Hammond has earned respectable profits since 2007, sales took a dip during the crisis but have recovered and grown.  The company's profits have remained mostly flat, but they've been able to grow book value.  I've discussed in the past how an average company with a growing book value can be a great investment, Hammond qualifies in that regard.  The company has grown book value at 6.7% over the past six years.  On the surface that figure isn't all that impressive, but investors have the opportunity to invest at 44% of book value.  Investors are buying $2.71 worth of assets for $1.19, meaning their 6.7% growth is actually 15% growth on an investment at the current price.  If the company performs in the future like they have in the past I will own something that is appreciating on my investment at 15% a year, a return I'm satisfied with.

While the company has a considerable margin of safety in regards to both market price to NCAV and book value, any discussion of the company should include a look at their liabilities.

The company carries $10m of bank debt which they use to finance their inventory.  They also have a number of operating leases on their factories and warehouse locations.  For the first six months of this year the company's interest costs were covered 10x by operating earnings, which is a considerable buffer.

In summary there is nothing spectacular about Hammond except for their price.  The company is profitable and has been growing book value consistently, yet the market seems to believe they're only worth 44% of stated book and 88% of NCAV.  Even with a liquidity discount, and an insider ownership discount it's hard to justify a low valuation like this.  I'm happy with the discount the market is handing out, and I picked up shares when I first discovered the company.  Hammond Manufacturing fits well in my portfolio. 

Disclosure: Long Hammond

24 comments:

  1. I'm a fan of this one too. From four months ago: http://www.barelkarsan.com/2013/05/hammond-manufactures-value.html

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    1. Good post, I forgot to mention the 40% interest in the supplier. You have some good comments on your post as well. I would argue with the commenters that while there is a dual share structure, and management might not be maximizing value it still shouldn't be this cheap.

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  2. Nate and Saj,

    I get an average maintenance capex of at least 2.4m for the last three years. (I took the numbers form from page 11 of the 2012 AR and page 9 of the 2011 AR, and left out the land purchase and the capex the company indicated was for growth.)

    That maintenace capex of 2.4m compares is about the same as the average operating cash flow for the past four years. So maybe the company doesn't make any money, and the growth in book value only means that the company, as the Red Queen put it, needs to do a lot of running to keep in the same place. If so, the discount to BV might well be worth it. What do you think?

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    1. This is a good point, but it doesn't concern me much for a few reasons.

      1) If the company were not profitable and merely break-even I would still be interested. I'm interested in the assets not the earnings.
      2) It's debatable whether all of the maintenance capex is truly necessary. There are often things an acquirer could cut out that a current owner often thinks is 'necessary'.

      As with all net-nets the goal isn't to invest based on earnings, but on the assets. Consider this as a private market transaction, even with cash feeding the business there is no way this would sell so cheap. Companies just don't sell this cheap in the private market, and private market value is essentially what a fair value is.

      As with all net-nets if you search hard enough there's often a way to "justify" the valuation or see why it should never trade up to NCAV. But I like to point out that these companies revert to the mean, there are no permanent net-nets.

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    2. Thanks for answering, Nate.

      Regarding net-nets in general, I agree: they're awesome. But when investing in one that hasn't been making money is a while, which might well be Hammond's case, I prefer a big discount to NCAV (not the case with Hammond), or high quality net assets (not the case with Hammond, where 2/3 of current assets are inventory).

      Net-net investing is about buying for less than liquidation value. Suppose in Hammond's case you could sell land and buildings for the full $8.4m they cost, sell receivables for 75% of the 12.7m on the books, and inventory for 50% of the 25.3m on the books. Subtract the 23.6m in liabilities and you get $7m, which is a lot less than the marketcap.

      I guess it all comes down to how much you expect to get from the inventory in a liquidation - do you suppose you could get more than 50%?

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    3. A few things came to mind as I thought about your comment. First are my comments on inventory. I think a commodity supplier's inventory has more value than say a Duckwall Alco's inventory.

      I'm not sure if you do DIY home repairs or not, I do quite a bit of home improvement. When I go to Home Depot or Lowes and am looking for an electric box that is nailed into a stud I'm looking at the form factor and the size. They're all blue plastic, they probably are all from the same manufacturer, but they might not be. I don't care either way. If the manufacturer switched tomorrow it wouldn't make a difference, and Lowes wouldn't be running a going out of business sale. They'd simply sell through the old stuff and start to stock the new stuff. This is more common than you'd think. I have a number of junction boxes that I picked up over a period of time, from the exact same spot on the shelf for the same price that were made by different companies. They all look almost the exact same with slight differences.

      I guess that's a long way to say that a company like Hammond could conceivably sell through most of their inventory without taking a haircut. Maybe they have some obscure parts, or made to order items they'd take a loss on, but overall I think the inventory is probably worth something greater than 50%, probably 75%, or possibly higher.

      On net-nets and liquidation value. I understand your point, and know where you're coming from, but I disagree. A company like Hammond isn't liquidating, most net-nets don't. The point is that a liquidation value, or really any price under NCAV has fallen into a category of irrationally priced. Companies don't sell for less than NCAV in the private market for the most part. A net-net is essentially a way to find stocks that are irrationally priced. Something below NCAV, and something profitable below BV should be worth a number closer to BV, maybe not BV exactly, maybe 80%, but not below NCAV.

      Here's another way to look at Hammond. You say they aren't making money, my guess is they're overstating maintenance capex first off, but that point aside. If you were looking to buy the company I'm sure you could come in, look at operations and spot a few ways to increase profits. It might be laying off people, outsourcing certain tasks etc. That hidden profit would be realized.

      For many family controlled companies profit maximization isn't the top priority like Wall Street wants. Wall Street would cut an operation to bare bones, under invest, show large profits for a few years and sell out. Owners of small companies don't think like that. They have employees who have been there for years, they are friends, they're not going to be cut to improve a number that serves no purpose. Some of these places hire gearheads who love to have the latest and greatest equipment even if it's not necessary.

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    4. Very convincing point on the value of Hammond's inventories. I now agree with you, Nate - it could be sold for well above 50%.

      I agree that most net-nets don't liquidate and are cheap. But I disagree with equating the value of break-even net-nets controlled by lethargic management with the company's private transaction value. I think the former require a bigger margin of safety, which is another way of saying they're worth less.

      There's a great scene in "Annie Hall" where Woody Allen pulls Marshall McLuhan out from behind a movie sign to help him win an argument. I'm just going to do the same here and quote Buffett:

      "Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all...Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost..."

      However, if you buy Buffett's hypothetical business for $3 million, the investment will not disappoint, even if you wait the 10 years. That's why I think businesses like Hammond, which only break-even and are controlled by unworried management, should only be bought when there's a very big discount to high quality NCAV.

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  3. Any thoughts on the company Hammond Mfg. spun-off in 2001 - Hammond Power?

    It also looks cheap on a variety of metrics.

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    1. Someone sent me a research report on them after this post, I haven't had a chance to read it yet, but it does appear cheap.

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  4. Robert Frederick Hammond, Chairman of Hammond Manufacturing, is a control person with almost 64% of all voting rights. So the fate of your investment is in his hands.

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    1. Correct, that's no different than most of my investments. A majority of what I invest in is smaller family/founder controlled companies.

      There is significant research that these controlled companies outperform over the long term.

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  5. Nate,

    I think your blog is great. So please take the following as constructive criticism. But I've seen you make the following conceptual error on many occasions, in many different posts, so I think the following is a point worth discussing.

    You wrote, "The company has grown book value at 6.7% over the past six years. On the surface that figure isn't all that impressive, but investors have the opportunity to invest at 44% of book value. Investors are buying $2.71 worth of assets for $1.19, meaning their 6.7% growth is actually 15% growth on an investment at the current price. If the company performs in the future like they have in the past I will own something that is appreciating on my investment at 15% a year, a return I'm satisfied with."

    There is a flaw in your logic. You're ignoring the value-destroying capital allocation decisions that management is making, and that's too important to ignore. If the company were using its profits to pay out dividends, or to repurchase its own undervalued shares, *then* you would be earning a 15% annual return on your investment. But they're not, so you're not.

    Here's one way to look at it. Let's say you hold your investment for N years. How much incremental book value was created? Well, final book value is 1.067^N times initial book value, so we can say (1.067^N - 1) times initial book value was generated in "profit". Your initial investment was 0.44 times initial book, so you've made (1.067^N - 1) / 0.44 times your initial investment as "profit". Therefore, your Compound Annual Growth Rate (CAGR) is [1 + (1.067^N - 1)/0.44] ^ (1/N) - 1. For N=1, you're correct that CAGR = [1 + 0.067/0.44] - 1 = 15.2%. But what happens for large N? For N=10, CAGR = 11.9% per year. For N=30, CAGR = 9.4% per year. In the limit of N->infinity, CAGR approaches 6.7% year (i.e., the company's ROE).

    Regards,
    aagold

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    1. aagold,

      When I read your post it reminded me of another commenter who made the same argument in a post a year or two ago. I need to either build an Excel spreadsheet around this again or dig that post up. I'll respond to this though.

      Nate

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    2. Look at the comments to this post: http://www.oddballstocks.com/2012/08/how-average-business-can-be-great.html

      The same issue is discussed. If the discount persists forever then yes, I am getting 6.7% growth as well. The point is that I'm not expecting the discount to persist forever, that's why I'm investing, and when the valuation gap closes the math works out.

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    3. Also meant to say thanks for the criticism, it's always welcome!

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    4. I agree with aagold. It's true when the valuation gap closes you get a one time extra return, but you have to spread it out over the amount of time it takes for that to happen. Your reasoning only works when the gap closes after exactly one year.

      Gr, Vince

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    5. Nate,

      Yes, I remember seeing that prior discussion, but in later posts you continue to repeat your original idea that the company's ROE should be multiplied by (Book/Price) to derive the investor's effective rate of return (as you did again in this post). It seems like, at the end of the day, you're sticking with that basic way of thinking about things, so I tried to derive the CAGR in a different way (which sidesteps the whole issue of how long it takes the valuation gap to close) to convince you that you're missing something important. I think I failed in my attempt, however, so let me try another tack.

      I think everyone would agree that if a company earns a 6.7% ROE, and it pays out all earnings as a cash dividend, then an investor who buys stock at 44% of book is earning a 0.067/0.44 = 15.2% return on his investment. That seems pretty obvious.

      So if we both agree that the very shareholder-friendly version of Hammond I've described above *is* earning a 15.2% return for an investor buying in at 44% of book, isn't it clear that the real world shareholder-unfriendly version of Hammond, which reinvests all profits at a 6.7% ROE, is *not*? By sticking with your basic description, and internally thinking about it that way, you're making it seem irrelevant that management is screwing over its shareholders by perpetually reinvesting company profits internally at a 6.7% ROE despite there being many better uses for this cash.

      Regards,
      aagold

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    6. Aagold,

      I think I understand what you're saying. Since management is reinvesting earnings back at 6.7% eventually given a long enough time range my 'investor return' will converge with the company's return on incremental profit.

      That makes sense, and it makes sense on another level which is the longer it takes for an investment to revert to the mean the lower the IRR becomes.

      This is the school of Buffett, you're better off finding a business growing at 15% a year and hanging on for the ride than buying a cigar butt and hoping it eventually works out. I will take the cigar butt because given a large enough group math and mean reversion does work, at least it has for the past 100 or so years.

      Good discussion!
      Nate

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    7. Nate,

      I also like ugly, boring investments that I can buy at a deep discount to liquidation value. I guess the main thing I'm trying to add is that management's capital allocation decisions are extremely important. That's why shareholder activism is such a powerful partner to deep value investing. Imagine how much more valuable Hammond stock would be if a shareholder activist could force management to stop perpetually reinvesting profits at such a low ROE and instead pay out company profits as dividends. I realize that's not possible in this case, due to the chairman being the controlling shareholder, but I just mention it to emphasize how important capital allocation is to a stock's fair value.

      - aagold

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  6. The average returns on equity, assets, capital, etc, don't seem to justify it selling at book... Perhaps 0.55-0.70 times book. The prospects, as you said, don't really justify a P/E greater than 12, and I'm more of a mind that 10 is proper. If they starting paying a dividend instead of just trying to grow the business, the value would be greater, I think, and a P/E of 12 would be proper.

    Well, anyways, it's interesting to see how much the stock price skyrocketed after you made this article public. Just goes to show how little attention people were paying to this company.

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    1. Jack,

      You bring up a great point, and it's a point that Graham made as well, that sometimes a smaller illiquid stock is fairly valued at 80% of book value or so. That's in the market though. I'd be shocked if this sold to a private buyer for less than 1x book value.

      A general note that your comment reminded me of, it's interesting to see P/E compression. I have always preferred to use a P/E of 10 or so, but I know years ago that was considered unreasonably low, something like 12-15 would have been considered more appropriate. I don't see how you go wrong valuing a company at 10x earnings, if the market gives you more take it, but 10x is reasonable in almost any environment.

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  7. Nate, HMM.A has been one of my key holdings for a couple years. I attended the annual meeting this spring. Robert Hammond made it very clear that the company is being run for the benefit of all stakeholders, not just shareholders. Their capex bulge from last year is related to a capacity expansion and modernization (higher factory roof), so they are not just mechanically ploughing every cent of earnings back into the physical plant. Also they have incurred higher than normal sales costs recently trying to gain market share to help fill the spare capacity. They are not keen on share repurchases and not likely to raise the sporadic ~ 2 cent dividend. Their key strategy is to eke out incremental efficiency improvements ... for example, the Chairman described a cost-saving redesign of a cardboard pack. Most of the sales are to the USA, and the margins have been pole-axed by the Canadian dollar rising to par. Margins of 6-8 percent and a return of economic profits might be achievable if the dollar falls from 97c to 90c. BTW I trimmed my position at $1.20 not realizing you had finally stumbled onto this gem and published this post. I was hoping to make a case to the Chairman to start a buyback program, but with the big gains of the past week this is looking like a hard sell.

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  8. Hi Nate

    I'm from Switzerland and regularly read your blog. This article was so inspiring, that I tried to evaluate Hammond by my own:

    Company Research: Hammond Manufacturing

    Also I like your idea, I didn't invest. Mainly because the ROE isn't high enough for me.
    However, keep up the good work. I will continue to read it.

    TS

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  9. Hi Nate,

    I recently pitched Hammond to the student fund that I'm a part of, and got pushback on two things. 1st, Hammond has traded at cheap valuations (well below P/B of 1) for the past 5 years, and there doesn't seem to be any reason for it to suddenly start trading at book value. 2nd, Hammond's management is not very shareholder friendly - their "IR" is not very knowledgeable, and they seem to have no intention of buying back stock at this cheap valuation.

    I was wondering if you could respond to these concerns, which I now share as well.

    Thanks,
    Dean

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