Back in January I wrote a small post about a company named Costar (CSTI), the post was fairly concise and to the point. I researched the company and found some things that made me uneasy, the sum of the uneasy items led me to pass on investing. That was when the stock was at $2.02 a share, it trades today at $8.25, and hit $10 two days ago.
I wanted to review the investment with the benefit of hindsight, the most cruel type of review possible. Decisions that look sound at the time appear foolish in hindsight, and decisions that were foolish and reckless can appear to be genius in hindsight. The purpose of looking at Costar again is a examine my initial reasoning. If my initial conclusions were made on a sound basis, and because I can't know the future I will be satisfied that even with a missed investment gain that I made the right decision.
The reasons I passed on the company were fairly simple, I was worried their profits weren't sustainable, I didn't like that it took them five years to turn the business around, and I didn't like their debt and cash situation. All of those items combined led me to pass on investing in the company at 46% of NCAV.
When I wrote Costar up they had a book value of $8m, $203k in cash and $1.4m on their credit line, trailing earnings (9mo) were $.45 p/s. Fast forward to today, they have $2.5m in cash, $10m in equity, no debt, and trailing 9mo earnings are $1.43 p/s.
I made a bold claim at the end of my previous post on Costar, I believed they were fairly valued at $2, because I felt their inventory might be overstated, and I was concerned their profitability was a mirage. I had good reason to believe that as well, the company had earned $.45 in the first three quarters of 2012, but in Q3 they were essentially break-even earning $2,000.
With the benefit of hindsight I look like a moron, I was worried about earnings disappearing, and instead they more than tripled. There was no way to know earnings would suddenly explode, when I looked at the company they had their first reported profit in years, and then suddenly a quarter later they were operating at break-even again. It appeared at the time that their earnings were temporary, and were back onto a normal declining trajectory. On the earnings front I feel like my decision at the time was the right one.
When reviewing my decisions regarding the balance sheet I'm much more mixed on whether I made the right decision. The company reported in 2012 that they had trouble securing a credit line, they were able to secure one from a lender with a high rate, and low underwriting standards. This was a concern, I felt that going to a lender like this was an indicator of the quality of the company.
I've had a number of conversations with bankers and small business owners recently that casts doubt on my conclusion over Costar's debt. I've come to find that financing for a small company with the income history of Costar is almost nonexistent at a traditional bank right now. Banks are only interested in loaning a million dollars to a guy with two million in his account. Large banks are lending to large companies, and large companies have no problems issuing debt, but the financing market is still difficult for small companies, especially ones that aren't pristine.
My myopia on their lender prevented me from seeing that the company had aggressively paid down debt. Management was serious about eliminating debt and finally did so in the past few months. The cash the company was using to pay off their debt has now started to pile up on the balance sheet.
Overall I'm mixed on Costar, if I were to look at them again today as they were in January it's possible I'd make the same decision. If I had known more about the small business financing market I might have cut them more slack. With a net-net the balance sheet is the starting point for an investment, if confidence in the balance sheet is lost the investment is lost. I didn't have confidence in Costar's balance sheet, and while earnings recovered nicely there was simply no way of knowing it would happen.
What does the future hold for Costar? I don't know, they earned $.72 p/s this past quarter, annualized that's $2.80 in earnings for the year, for a whopping 40% ROE. Unfortunately one of my key questions remain, are these earnings sustainable? If so then Costar is probably a bargain at these prices, if not then look out below.