Wednesday, January 30, 2013

Not very glamorous, but cheap, Creighton's at 56% of NCAV

I've heard it said that intuition is really just a fancy name for pattern recognition.  After seeing hundreds or thousands of patterns a person can recognize certain things intuitively.  It might sound funny, but when I first took a look at the Creighton's financial statements my heart skipped a beat.  I knew exactly what I was looking at, the type of net-net I like to hold in my portfolio.  Sure they aren't perfect, they have a bit of debt, and less cash than I'd like, but then again nothing's perfect is it?

Creighton's is a beauty supply company located in the UK.  They make skin cremes, moisturizers, and other personal care and beauty products. The business is not all that glamorous, and without setting foot in the UK or knowing consumer trends I'd guess they make just another bottle of shampoo, or just another bottle of lotion on store shelves.  Consumers do have preferences, and some consumers prefer to purchase Creighton's products what whatever reason.  This company doesn't have a moat or any product differentiation, they note a risk is that Asian products are in direct competition with their own.  The beauty product market is very price competitive, but that doesn't mean that it's unprofitable either.

I'll start with the negatives on the company first.  If any of these negatives are too much to get past save yourself five minutes and stop reading. My biggest complaint against the company is the low amount of cash they hold, and in turn the financing for working capital expansion.  I prefer companies with lots of cash and no debt, but I'm also flexible with what I invest in.  Creighton's has £786k worth of debt against £4,103m in equity for a debt to equity ratio of 19%.  This debt is necessary because the company only has £33k in cash on hand.  Unless the company suddenly starts to generate a lot more cash flow they will continue to be in a vicious circle where they don't have quite enough cash to pay suppliers at the time of order.

What Creighton's doesn't have in cash they have in other assets, here is my net-net worksheet:

The company is loaded with receivables and inventory.  Many investors look at these accounts with suspicion and give the values a large hair cut.  The non-discounted NCAV is 4.9 GBp, whereas a discounted NCAV is .59 GBp, a large difference, all attributable to the lack of cash.

In this company's case I think both receivables and inventory could be turned into cash fairly quickly.  The receivables could be factored and the company might receive 80-90% in cash for the receivables now.  The inventory doesn't go out of date.  If the company were in a liquidation scenario I doubt consumers would know their favorite brand of face lotion was going out of business, they would happily continue to purchase the lotion at the grocery at normal prices until suddenly the shelf is empty.  Considering that both receivables and inventory could be liquidated at values close to NCAV I am using the unadjusted NCAV as the bogie value for my thesis.

The company has a market cap of £1.58m against a NCAV of £2.951m, they're selling at almost 50% of NCAV at current prices.  The company is also fairly profitable with growing sales and earnings.

The company earned £223k last year, or .37p p/s, which is a 7.43x multiple at current prices.  The company's revenue grew 16%, and profits grew 65% over the past year.  The difference between the revenue growth and profit growth shows the operating leverage imbedded in the company's operating structure.  If revenue is able to continue to grow net income will grow at an even faster pace, with incremental pound revenue falling straight to the bottom line after the fix costs are taken care of.  Some of the revenue growth is attributed to better inventory management, and higher inventory turnover.  The company has also repositioned itself away from the end of the year Christmas market to more calendar stable products year round.  

The metrics alone for Creighton's make the company a tempting investment, but it wasn't just the numbers that pushed me into buying some shares.  It was another factor, the management contract between the company and the CEO.  The company's employment contract (renumeration if you're searching) is very straightforward, the CEO is paid a bonus based on certain profitability targets.  But there's a second incentive which provides the CEO a bonus if he's able to dispose of the toiletries business for £1.5m or more.  Unfortunately the company doesn't break out segments so it's impossible to know how much of the company's business toiletries entails, but at the most simple level they're looking to divest toiletries, not the entire business for £1.5m.  The market is selling the entire company for £1.5m, which means that either the directors are valuing a division of their business too highly, or the market has the pricing wrong.

For a simple company like Creighton's, with a simple investment thesis there isn't much else to say.  The company is cheap, small, and ignored.  I could never imagine making this a large position, but I couldn't resist picking up some shares recently.  This is the type of net-net that I'm looking for a good puff from, I would sell this at or near NCAV if the opportunity arose.


Disclosure: Long

Saturday, January 26, 2013

Turnarounds: cut expenses, or increase volume?


I don't generally think of myself as a turnaround investor, yet when I look at some of my investments they are clearly predicated on business conditions improving.  Even with all their warts many value stocks are priced for imminent death.  The attraction of many of these stocks is that with such negative sentiment if the future is only bad, instead of terrible the share price could rise, and rise dramatically.  

I've been thinking about turnarounds a lot recently, maybe because there aren't as many opportunities available anymore without a lot of problems as the market continues to rise.  Someone left a comment on a post in the last year that was extremely insightful regarding turnarounds, they mentioned a company that merely needs to cut costs has a brighter future than one that needs volume to increase.  I don't know who left it, probably someone anonymous, but thanks, it's had me thinking for months.

Many companies classified as in a turnaround state have followed a similar storyline.  The company was doing well for a period and then suddenly something changed, often something external, the housing bust or an industry shift.  The company couldn't, or didn't shift quick enough and they began to lose money.  At first management thought they could continue to do what they'd always done and the market would return.  Companies with a lot of cash on their balance sheet they can whither away much longer before management is forced into a corner.  Companies short on cash are often forced into a corner quickly, and usually restructure the quickest.  For some companies cutting costs is enough to bring stability, other companies require the market to turnaround.  When a company is waiting on the market the company needs to have a sizable cash hoard, or readily available line of credit.

I looked at two companies this week that each had compelling aspects, but the thought lingered as I passed on each: "They only need sales to increase a little bit.."  The first was a bank, deposits had been falling and costs appeared to be cut to the bone.  The problem was the bank's loans were rolling off, and the money to loan against was leaving quickly forcing their loan book to shrink.  It's hard to increase lending on a shrinking deposit base.

The second company was one a reader mentioned to me, Continental Materials (CUO).  The company is essentially the story of the American housing boom, they were earning between $1.34 and $1.72 from 2003 to 2007 before the bottom fell out.  Since 2007 the company hasn't been able to turn a profit.  Continental Materials makes roofing supplies, asphalt sheets, fiberboard, roofing nails, and bizarrely kitchen mops.

So how has the company survived with the continual losses?  They've whittled $3m in cash down to $600k and have become heavily reliant on credit lines and financing.  In other words they've exhausted their own capabilities and are now leaning on banks to make it through the housing bust.

Sales have drifted downward to $112m from a high of $168m in 2007.  The company has been able to raise prices, the only news on their site is nicely worded messages to their clients that asphalt roofing supply prices will be increasing 5-8%.  The news releases are once or twice a year; as while input costs have risen the company is passing them along nicely.  

To the point about turnarounds at the top of this article Continental Materials is the second type of turnaround, they need volume to increase.  The company's SG&A is $18m, which is slightly down from $20m in the boom years, but it's remained steady.  I don't know if their level of staffing is appropriate, but this isn't a services business that can be temporarily run out of a Starbucks in a pinch.  The company's gross margin has actually increased as manufacturing costs have been cut, but with falling sales the ever steady SG&A has come to consume a larger part of revenue moving from 12% to 16%.  The change from 12% to 16% doesn't seem that significant, but let me put things in perspective.  If the company's SG&A was back at 12% they would have earned $1.89 p/s for the TTM rather than losing $1.29 p/s.  

What made me take a look at the stock initially was the reader mentioned they had a $24m market cap, and just won a lawsuit that will result in a ~$6m settlement after taxes and fees.  A cash infusion equal to 25% of the market cap gets my attention.  Initially I thought maybe the company could use the cash to clean up the balance sheet and provide some stability.  Unfortunately the company needs more than just the elimination of interest expense to get them in the black.  Even if they paid off most of their debt they would only save $500k in interest expense, and when operating income is -$2.5m it's easy to see why the cash will be nice, but won't be a panacea.

This might be a nice stock to hold if you think housing, and roofing will be recovering anytime soon.  A 10% increase in sales would bring the company to break-even.  Anything above 10% would start to fall to the bottom line quickly.

The biggest risk is the $6m provides enough of a shot in the arm that management continues to wait out a housing recovery instead of investigating ways they can change their company to be more competitive.  Maybe that's why they diversified away from roofing into kitchen mops...


Disclosure: No position

Monday, January 21, 2013

Thoughts on quantitative value investing

I want to start off by saying that the goal of this post is to get a discussion going.  The topic is something I've been thinking about for a while and I wanted to formulate my thoughts, but they're not set in stone.

There has been a lot of talk recently about quantitative value investing, for some reason in the last year this concept has gained a lot of traction.  A former deep value blogger Toby Carlisle has even written a book about the concept.  I haven't read the book, but his presentation at UC Davis is very convincing.  Joel Greenblatt has been pounding the pavement for the past few years first promoting magic formula investing, then formula investing, then his new mutual funds based on these concepts.  Along with this is the proliferation of value weighted index funds.

It seems all of these products are trying to capture the value investing returns that appear in academic back tests.  It's no surprise to readers of this blog that value based strategies work, and work over long periods of time. Graham's own net-net strategy has been working since first published in the 1930s, other low value measures work as well, low P/E, low P/B, and low almost anything.  The fact that buying a number of low metric stocks will outperform the market over the long term is a well established academic fact.

My thought is, what do we do with this knowledge?  If beating the market is as simple as running a program to buy all the low P/E stocks wouldn't everyone be rich?  Why hasn't some 17 year old in Utica written a program that buys low P/E, or P/B stocks systematically without human input and programmed himself to riches?  It's not because these ideas are undiscovered, most of Wall Street knows cheap anything out performs.  If beating the market is as simple as programming a computer why hasn't anyone done that yet?  Any why are there people working 80 hour weeks in finance when they could be sitting at home drinking scotch and letting the computer do the work?

Benjamim Graham often gets classified as a quant, modern investors boil his 800 pg Security Analysis down into a few terse statements such as "buy all the net-nets" or "buy low P/E stocks".  The implication is that he was conducting some rudimentary quantitative investing back in the 1940s and 1950s.  I've read Security Analysis a number of times, and I've come away with a distinctly different impression.  When people mention that net-net investing only works when buying all available net-nets I think of the following quote: (emphasis mine)

"There is scarcely any doubt that common stocks selling well below liquidating value represent on the whole a class of undervalued securities.  They have declined in price more severely than the actual conditions justify.  This must mean that on the whole these stocks afford profitable opportunities for purchase.  Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category.  He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above.  Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset protection, e.g., satisfactory current earnings and dividends or a high average earning power in the past.  The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so. " Graham. Security Analysis 6th ed. p 569.

That quote to me doesn't sound like Graham is advocating buying all net-nets, he's actually very clear that his recommended course of action is to only buy net-nets that either have high past earnings, are currently profitable and paying a dividend, or have a high past record of earnings.

I recognize that Security Analysis is dense, but it's well worth the read.  Each time I re-read it I come away with the impression that Graham was an absolute genius.  Rather than the stereotype of a statistical investor Graham advocates evaluating business prospects of potential investments, and even offers advice on how to buy franchise companies in the 1962 edition.

So is value investing really as easy as setting up a computer program and then counting the money?  There are a few pitfalls that investors could identify as potentially the reasons that these quant methods exist.  The first is that many of the stocks that turn up on a net-net or cheap screen are simply too small or too illiquid for anyone to invest in.  I'm an investor in many of these stocks, and I'm guessing many readers are as well.  I have no idea who reads this blog, so maybe a few billionaires do, but my guess is most readers are either individuals or work at smaller funds.  Having a small capital base is an asset, not a disadvantage.  Use this to your advantage by buying small stocks at ridiculous valuations that large funds could never purchase.  There is a reason most funds don't beat the market, they're all investing in the same 500 stocks or so, and due to the small pool those funds become the market.

A second reason I've seen quoted in books is that most of these stocks are hard to purchase on a behavioral basis.  Cheap stocks always have problems, they're never on the Forbes Best 2013 Stocks list.  Yet this argument breaks down when considering that a computer has no emotion.  If these strategies work and a computer could execute them who cares what's in the portfolio?  Why is there any human bias taint?  Let the computer run day and night buying and selling as some formula dictates.

I really don't think it's all that easy.  The computer buying net-nets would have purchased all of the China frauds back in 2010 and 2011.  The computer buying all of the Magic Formula stocks would have had a different performance from the one Greenblatt advertises because so far no one has been able to reverse engineer his formula.  Of course that's the problem, what formula do you program the computer with?  The formula is subject to human tinkering, and at some point enough tinkering creates a human driven computer executed fund.  What is the P/E cutoff? Is it 10x and below? Is 8x cheap enough?  What about cyclical companies, do those get excluded?  

I discovered the Magic Formula back in 2007, the book was a solid read and convincing, but I'm glad I never pulled the trigger.  I found a Yahoo! Group based on the investing technique, and after reading through all the messages I came to find out that the real life performance diverged greatly from the book.  I still skim the messages in the group every few months, and there are plenty of people who followed the formula exactly and have trailed the market by a lot.  Greenblatt's own funds have trailed the market since they were launched in 2009, arguably the best time to invest in distressed assets.

Concluding this post is difficult because I don't really have a conclusion, I'm unsettled.  On paper investing on a quantitative basis seems great.  The returns are easy, require nothing more than a computer and some rudimentary programming skills.  Yet the fact that the best value investors aren't computer programmers but are deeply inquisitive and thinking types convinces me there's more to the story.  Many great value investments come from human judgement, being able to identify the intangible.  A net-net that's always lost money but hired a new CEO who's known to sell companies could be a great potential investment, but how do you program that formula into a computer?

What are your thoughts?

Thursday, January 17, 2013

More is better? How much information is really needed to invest?

Information is comforting in investing, having more information, even useless information acts as a security blanket to an investment thesis.  The more information we can find to reinforce our view on a stock the better we feel about making the investment decision.  But how much information is truly necessary to make a prudent investment decision?

I came across this question recently while researching an unlisted stock.  Readers are probably aware that I'm fascinated, and intrigued by unlisted stocks.  The unlisted market place is a lot less efficient, and there are some good companies selling at cheap prices, but that's not what ultimately attracts me to the market.  Pure curiosity is what attracts me to unlisted stocks.  For some reason the idea of Googling for hours trying to find little bits of relevant information is a challenge I enjoy.  At some levels investing in an unlisted company is like making a small private equity investment.  The investor needs to be willing to be patient and lock up capital potentially for years.  Buffett's comments about buying companies that investors would be willing to hold if the market was closed for 10 years is very relevant with some unlisted stocks.  Some of these stocks only trade a few times a year forcing an investor rely on the long term approach.  But with that long term approach can come some rewards, there are unlisted companies selling with P/E's of 6x and ROE's of 20% or more.  Other companies are piles of high quality assets selling for next to nothing.

I purchased shares of a company which will remain unnamed, because of a document I signed mentioned further down.  I have a $7.80 position, enough for a few shares, which legally give me the right to financials as a shareholder.  I contacted the CFO and requested a copy of the annual report, which they denied.  Instead I was sent a proxy statement for the past two years and a terse email stating that since this company was now "private" they didn't need to send annual reports to shareholders.  The CFO was incorrect in stating this, but it isn't uncommon the management at some unlisted companies to be standoff-ish to shareholders, and treat a company as private even when it is not.

After going back and forth with the CFO he agreed to answer a few questions about the balance sheet only if I signed an NDA.  He refused to send the annual report, but did answer some things I had asked for.  I want to mention, I hate NDA's, and hate management that refuses to be transparent, but I also want to find good investments, sometimes compromise is necessary.  This brings me to the question in the title of this post, what does an investor really need to know?

Here's how I approached this challenge.  The company is a services business, and a note in the proxy detailing related transactions mentioned that the company leases facilities from the CEO and Chairman. Based on this statement I could presume that they don't own property, and they don't have any inventory, so I am fairly certain that assets consist of cash, receivables, and marketable securities.  Assets, no matter how great, or high quality don't matter if they're dwarfed by liabilities.  The most pertinent question regarding the balance sheet is what are the liabilities?  I asked this to the CFO; the company has payables, and the lease expense mentioned in the proxy, but they have no debt.  Knowing that the assets are un-encumbered the next relevant piece of information was "what is book value?"  The CFO sent me the book value figure, which is above the current market cap.

Knowing that the balance sheet is strong, and stable my attention turned to the income statement.  The company is extremely protective of the income statement.  I was told that competitors have purchased shares and sued for information which they used to figure out the company's pricing model.  They then used this information against the company.  Given this history I can understand the company's anxiety towards giving out an income statement.  With this particular company I have a slight advantage, I have consulted in their industry, and am very familiar with the pricing formulas and pricing data.  I don't know specifics to this company, but I know the industry is very commoditized, and their margins are in a tight band with other industry players I'm familiar with.

Of course knowing industry pricing and standard profit margins isn't of much use if the company's revenue can't be determined.  I was able to triangulate the company's revenue from a strange note found in the proxy.  The CEO of this company is not technically an employee, they are a contractor, and their company gets paid based on certain revenue targets per month.  The company disclosed how much was paid to the related party, because the CEO is the son-in-law of the Chairman, and from that value I was able to figure out the company's revenue for the past year.  Knowing revenue and estimated profit margins I have a good idea of their profitability.

Probably the most vital financial statement is the cash flow statement.  If a company has a great balance sheet, but they are eating cash the balance sheet will eventually disappear.  In this particular case it's impossible to generate a cash flow statement estimate based on the few figures I could find, but I had something else that was even better than a cash flow statement, dividend history.  The company has been paying sizable and increasing dividends for the past three years.  The stock yields north of 10% at current prices.  Based on revenue the company's dividend margin is 2%.  I know the company doesn't pay out all of their earnings as dividends because book value increased at a 12% clip over the past decade.  Some of the company's earnings are being re-invested, and others are being paid out in cash.

After piecing together all this information it became very easy to put together an investment thesis.  Would I consider buying shares in a company that:

  • Is selling for less than book value, is debt free and has a high quality balance sheet.
  • Has had increasing revenue and profits over the past three years.
  • Has grown book value at 12%+ annualized over the past decade.
  • Pays a solid dividend currently yielding 10%+.
When framing the company as I did above they really look attractive, and the lack of further information might not be much of a problem.  What additional information would make this a better thesis?  Would knowing an exact P/E, or EV/EBIT make the company more attractive?  Would knowing the exact value of the FCF yield matter when they are paying a 10%+ dividend?

The biggest dings against the company are inside ownership, and the related party transactions I'm already aware of.

Benjamin Graham states that you don't need to know a man's exact weight to know that he's fat, in a similar manner I don't think an investor needs to know exact details to know that this particular company is cheap.  

I haven't increased my $7.80 position, and I'm not sure that I ever will, but I have thoroughly enjoyed researching this company, and it really made me think long and hard about what information is absolutely necessary to make an investment decision.  Of course like all investors I want the security blanket of an annual report, even if there is nothing new to add to my thesis I would like the opportunity to read it.


Find financial information on 70+ unlisted companies on unlistedstocks.net.  The subscription price will pay for itself with some of the opportunities uncovered on the site.

Monday, January 14, 2013

CIBL is undervalued again, is the valuation gap enough?

Getting to know a company is much like getting to know a person.  At first two people are acquaintances, knowing surface level facts about each other.  As the relationship develops those small facts and experiences add up and join with the person's character until each person knows each other, not just knows about each other.  And just like when two old friends get back together and get up to speed quickly getting back up to speed on an old investment is similar.

A reader mentioned in the comments somewhere that I should take a look at CIBL (CIBY) again.  I posted about CIBL a year ago here.  You're welcome to read the old post, but I'll do a Reader's Digest summary for those with limited time.  CIBL was a spin-off from LICT, a Mario Gabelli controlled telecom company.  Gabelli is on the Board of CIBL, and signaled to shareholders he was serious about realizing value for them.  The company owned two TV stations in Iowa, and cell towers inside of a joint venture in New Mexico.  The company's annual report repeatedly mentioned they had received an offer to purchase their cellular interests for a price greater than the company's market cap.  Even with this explicit signal the efficient market failed to adjust CIBL's price upwards.  The company did end up selling the wireless interests for a price that far exceeded the market cap, and the shares finally ran up.

I ended up selling my shares when I received the proxy for the sale in the mail, I ended up making 50% on my purchase in a few months.  I wish all my investments worked out that well and that fast, but if they did I wouldn't be writing this, I'd be sipping a drink by a pool somewhere tropical.  Instead I'm sitting in my basement office at night scouring markets for opportunities, and writing about it.  I enjoy this, but if someone is willing to offer me the tropical gig I'm all ears.

A lot has happened since I sold my shares.  The company decided to return cash to shareholders in the form of a dutch auction.  The company offered to buy 7,000 shares of their stock at a price of up to $860 per share.  Only 2,460 shares were tendered, so while shareholders were happy the company sold the cellular interests, they are also happy to let Gabelli make capital allocation decisions instead of themselves.

After the dutch auction CIBL then went on a buying binge, they purchased 40% of ICTC Group (ITCG) which is another Gabelli spin-off from LICT.  ICTC Group is a rural telephone carrier in North Dakota with 2300 lines and 600 DSL customers.  The company also runs an ISP which services 1000 customers.  The 40% interest was purchased in two parts, 20% was purchased as a private placement, and the second 20% was purchased through a tender the company offered to ICTC Group shareholders.  Of all the things CIBL has done in the last year this is the one that fails the sniff test for me.  Gabelli's company LICT spun-off both CIBL and ICTC Group, and now CIBL purchased part of ICTC Group back in a private placement.  My suspicion is that CIBL was used to cash out Gabelli's position in ICTC Group.  If this is true there might be a note in the annual report in a few months.

The company also increased the authorization to buy back their own shares, and acted on that authorization.  There are still a few shares available to buyback, but not enough to move the needle at this point.

I created a small spreadsheet showing the changes to CIBL's balance sheet since Sept 30th with all the cash movement:


At the end of the year the company had $17.41m in cash available to use.  Because the company is essentially a holding company they don't have any liabilities except for taxes.  I reduced the cash balance by taxes the company is expected to pay out in periodic payments over the next year.

Valuing CIBL

Valuing the company is relatively easy considering they're not much more than a pile of assets.  The company does have earnings from equity interests but only the relevant subsidiary should be valued on an earnings basis, not the entire holding company.  The best way to value CIBL is a sum of the parts.  The only piece of their holding that's difficult to value is their TV station interests.  In my prior post I took a stab at valuing them based on the information in the annual report.  After that post and upon further research I think my valuation of the TV stations was on the high side.  The two stations earned $185k in the last quarter, but the company noted this was higher than normal due to political ad spending.  The TV station interest is held on the balance sheet for $519k which is on the low side considering that $519k generated $185k in earnings.  Based on the earnings the stations generated last year, and the low salability I took them at 4x of last year's earnings.  This value might seem low, but there is some debt attached to the stations, and for indebted marginally profitable local TV stations I think a low multiple is appropriate.

Here is how the valuation breaks down:


Based on this estimate CIBL is selling for 25% less than the sum of the parts.  Most readers will spot that this valuation is extremely sensitive to the value of the TV stations.  Purchasing at the current price gives the investor $965 p/s in cash and investments, plus the TV stations for free.

While a valuation is sensitive to the value of the TV stations the biggest wildcard for me is what comes next.  If CIBL was simply returning cash to shareholders and planning to sell the TV stations it would be very attractive at this price.  Instead the company coffers are full of cash and management has indicated they are looking to make substantial acquisitions.  If the company is a savvy acquirer with a competent manager CIBL could work out well for shareholders.  My concern is that this isn't the case, they have acquired 40% of a marginal rural telco that isn't creating a lot of economic value for CIBL shareholders.  The shares of ICTC Group were purchased below book value, but the company isn't contributing all that much in terms of earnings or cash flow.  In other words CIBL took liquid cash, and tied it up into something that ultimately needs to be sold to generate value, the holding pays no dividends, and doesn't have much free cash flow.

While the valuation gap is compelling, I've decided to wait this out for now.  If CIBL drops significantly I would be a buyer once again, but for now this will have to wait.


Disclosure: No position


Thursday, January 10, 2013

How I passed on Costar

I apologize for the delay in blogging, I had some urgent family matters to attend to, and investing hasn't crossed my mind for a number of days.  Things have stabilized and I wanted to get back into researching and writing.  For anyone wondering I didn't abandon the blog, I have no intention of joining the long list of value bloggers who've disappeared.

I realize a fundamental flaw of this blog, and many stock blogs is they mostly highlights companies that are worth researching.  If I look at a company and decide to stop further research readers will never know that I looked at the company, or why I decided to pass.  Because of this an important part of my investment process is kept out of view.  From time to time I'll come across a company that I wouldn't invest in for a variety of reasons, and the company is easy to write about, Costar is one such company.  As a result I want to take readers through a journey as to why Costar was worth researching, and why I won't be investing with them.

I found Costar (CSTI) through a very dubious screen of OTC net-net stocks.  I say dubious because a number of unlisted companies I'm very familiar with appeared on the screen as net-nets, none are net-nets.  And as the operator of Unlistedstocks.net I know there are a number of net-nets on my site that didn't appear on this screen.  Even with the junky data it was a starting point.

Costar manufacturers and distributes video surveillance systems for retail and industrial uses.  The company buys parts from Asian suppliers, assembles them and then sells the video systems as a complete package to customers.  The videos and systems the company sells are familiar to most readers, ceiling mounted black cameras, standard CCTV cameras, and recording systems.  The market is large, and the company is small, I really have no idea who their target customer is.  If I had to venture a guess it'd be local retailers and industrial users who are too small to move the needle of Honeywell or a similar competitor.

The biggest draw to Costar is that they're a net-net trading at a significant discount.  At the most recent price of $2.02 they're trading at a 42% discount to NCAV, which is less than the magical 2/3 of NCAV that Graham advocated purchasing below.  Here is their net-net worksheet:


Most of the company's assets are receivables and inventory, which isn't surprising given the line of business they're in.  The company's website had a PowerPoint deck showing some pictures of their offices, assembly areas, and warehouse.  The amount of inventory is staggering, $4.7m of hard drives, wires, cameras, and electronic components.  Electronics inventory is hard to value, to Costar the parts have a value, and if parted out individually on eBay each component could probably fetch close to cost.  While the company isn't planning on liquidating, the liquidity, and resale value of inventory are important to keep in mind.  Costar has high liquidity, and high resale value, but due to the high volume of pieces some sort of discount needs to be applied.

My first concern before I left the balance sheet was that the company is running very light on cash.  The balance sheet at the last snapshot had $203,000 held in cash, but previous periods had the amount as low as $90,000.  I wondered what business dynamics put them in a position where they had large working capital requirements, but no cash to speak of.  The answer is located in the liabilities section the heading: line of credit.  The company has been aggressive at paying this item down, but at various times in the past it's clearly been used to fund working capital needs.

Debt alone isn't usually a concern, for a net-net with a shaky business I'd prefer no debt, but it's not an ultimate rule.  But Costar is the exception, in the CEO's letter to shareholders he mentioned the difficulty the company had in obtaining a new credit line for 2012/2013.  We don't have any statements since the company opened the new line of credit to know how punishing the interest rate is, the company ultimately went with Briar Capital to fund the line of credit.  

When I'm looking at a potential investment, I want things to fall into place for the good or bad like puzzle pieces.  One item of data leads to another which leads to another, etc.  I don't generally read statements in a top to bottom fashion, I follow a story through them, either looking at the balance sheet and what it says about the company, or what the cash flow is saying.  In Costar's case the comment about Briar Capital led me to the income statement.

Briar Capital is an asset based lender, they talk at great lengths on their website about how cash flow isn't needed to obtain a load, good collateral is enough.  Banks are asset lenders for real estate, but for businesses they are usually income lenders.  If a company can show a consistent income pattern over months or years a bank will extend capital.  Costar had trouble with banks because they haven't had a history of profit.  The company has been chronically unprofitable for years before deciding in 2009 to execute a turnaround.

The company sold off a large division, and re-focused on the camera market.  The company has worked to increase productivity, and margins.  The company reported $688k in revenue per employee in 2011 verses revenue per employee figures for competitors ranging from $160k to $560k.  The numbers are impressive, but you can only squeeze so much juice from a lemon.  At some point the company is going to want to grow their volume, and that'll require extra personnel to build the systems, sell the systems, and manage the implementations.  My gut feeling is at this point the company is operating with the absolute fewest workers possible, and the addition of new employees to support growth could sink income into the red again.

In a PowerPoint on the company's website management lays out their turnaround strategy for the company which extends to 2014.  Clearly things are changing because the company finally reported a profit, I'm just weary of a turnaround that takes five years to execute.  At the five year mark it's unclear whether management actions had an effect, or if the market just recovered on its own.  I'm inclined to say that the market is recovering, and Costar is a beneficiary at this point.

I've talked around the income statement and cash flow statement.  The company has reported alternating periods of strong cash flow, then strong negative cash flow roughly equaling what they had brought in during strong periods.  All free cash flow is consumed by repaying the line of credit when possible.  For all the management talk about investing for growth not much cash has been needed, in the latest quarter the company spent $14,000 on capex.  The company isn't resource intensive, but it's not resource light either, they are a light-manufacturing company.

The company reported their first profit this past year, before that they broke even, or reported losses.  

If you've made it this far in the post you're probably wondering what the nail in the coffin was for this company, the problem is there wasn't one nail, it was a combination of all of the things mentioned above.  The company has an average balance sheet loaded down with receivables and inventory, and a sprinkling of debt.  They don't earn enough cash to fund their working capital needs, and alternate between drawing down the line, and paying it back.  The company is working on turning around operations, but it seems like they just cut their workforce to the bone and are experiencing some sales growth as the economy recovers.

None of the above items alone was enough for me to walk away, but the combination of all of the above was it for me.  Some readers will ask the question "Since this is a net-net, aren't those problems expected, and shouldn't you just invest by the numbers anyways?"  My answer to this is bold, I think that Costar is probably fairly valued at this point.  If I were privy to the books I'd guess that inventory is overstated some, and receivables aren't going to be collected completely.  The company isn't making any money either, so with an overstated balance sheet, and no earnings, trading at a discounted NCAV is probably appropriate.


Disclosure: None