Saturday, February 15, 2014

A template for a perennial net-net: Alco Stores

When most investors think of a net-net they're thinking of Alco Stores (ALCS), knowingly or unknowingly.  A chain of retail stores that could be described as the modern day general stores.  Where else can you buy a tablet computer, a mattress, and yarn supplies at the same time?  The company's stores are located in towns too small to merit a mention on an interstate exit sign.  If a stuck-in-time business model isn't enough the company has traded near or below NCAV ever since the financial crisis.

Many investors avoid net-nets because they fear being stuck in an investment like Alco Stores.  A company headed nowhere with a management whose heads are stuck in the sand.  With a dour story and low valuation investors lose hope as their IRR trends towards zero.  This is the what many people envision when they think of a net-net.

The company's story started to get exciting in July of 2013 when management announced a going private transaction at $14 a share.  The going private offer was 63% higher than where shares had traded previous to the offer.  The only problem was shareholders didn't quite see the deal as fair.  Management's $14 per share offer valued the company for slightly more than NCAV, a classic take-under.

Two things happened in the ensuing three months.  The company's management sent a number of notices to shareholders reiterating that institutional proxy companies endorsed the deal.  But more importantly observers were offered a glimpse of what investors thought the company was worth.  Much more than $14 per share.  The vote to go private failed with only 39% of shareholders voting for the deal.

The company is currently trading for $33m against a NCAV of $29.4m and a book value of $84m.  Substantially all of the company's current assets are comprised of inventory.  There only other asset of note are their storefronts.

It's not hard to see why this company is a net-net.  Their balance sheet consists of inventory and real estate, most in less than desirable rural locations.  Their earnings are spotty and inconsistent.  The company's biggest problem is their gross margins have been trending downward.

With a going private transaction off the table shareholders now have two paths forward.  The first is the company continues business as they have and hopefully generate consistent profits at some point in the future.  The second is that some of the larger shareholders get involved in the company and force an acquisition or sale at a much more equitable price for shareholders.

I wanted to show how even a very small change with the company's gross margins or SG&A could result in a much higher valuation.  I've been playing around with ThinkNum the past few days.  The site is an online DCF tool that's free to retail investors.  I put together two models, the first is what happens if nothing changes for the company in the future:



Under a nothing changes model the company's stock is worth $9.37 according to the DCF calculator.  I then adjusted SG&A expenses.  If the company were to reduce their SG&A expenses 6% the valuation jumps to $32 a share.


Likewise increasing their gross margin to 33% gives them a value of $36 a share.


A DCF model is prisoner to a number of assumptions, but the model is useful in showing that even a very small change in in the company's cost structure could result in a much higher share price.

The company's management sees value in what they're running, otherwise they wouldn't have tried to purchase the company.  Heartland Advisors, a value based fund also sees potential, they've build an 11% position in the company.

Where things go from here is anyone's guess.  The company's SG&A, a significant expense this past year, have been slowly shrinking.  Maybe expenses can't be cut anymore, although I somehow doubt that.  Director compensation alone ran $300k last year.  Executive compensation for the three named executives topped $1m.  Those are quite large pats on the back for merely staying in business.  I would imagine there are other expenses that could be cut if management had the will to do so.

The good news is that management knows shareholders are alert.  They can't try to buy the company on the cheap.  I'm not sure that Alco Stores is worth book value, but do know they're worth more than 54% of book value, which is what management offered.  Is Alco in play now as value investors start to get interested?  Or will it continue to amble along and remain in the market's dustbin?  It remains to be seen...

Disclosure: No position

9 comments:

  1. The buyout offer was from Argonne Capital, not ALCO mgmt. The mgmt team is clueless...why they keep opening new stores when their stock is valued below NCAV is beyond me.

    I think last quarter's results included the proverbial kitchen sink. Maybe by moving the HQ to Dallas they can attract some decent mgmt.

    I own a small bit purchased after the merger was voted down.

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    1. Kevin,

      Thanks for the details on the purchase. When I started this post I had the thought in the back of my mind that someone else tried to acquire them. But when I read through some of the proxies and 8-K's I was left with the impression it was the management team that wanted the deal, and them that proposed it.

      I agree on the most recent quarter's results, although the downtick in gross margin was concerning. I'm not sure what they could be throwing into COGS that might be a one time cost.

      I can see owning a position here. I was partially convinced after writing this, going to sleep on it for a few days.

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    2. Management was in favor of the merger (although I think it would have cost them their jobs) and gave themselves a bunch of options before it was announced.

      If you believe mgmt., the gross margin was impacted by discounting...from the transcript, "During the third quarter, the company took $5 million in onetime markdowns to liquidate slow-moving and discontinued merchandise." Of course, if they do this every year, then it's not really "onetime".

      I think there's a definite niche this company can fulfill. I'm not sure if this management team is up to it. I believe the CEO lived in Boston, while the company HQ were in the middle of Kansas. I cringe when I hear stuff like that (reminds me of Ron Johnson living in CA while JCP's HQ is in Dallas)....kind of hard to lead when you're 2,000 miles away.

      Going back through the old 10-ks, it seems their targets keep changing (or at least they don't reach the targets they set for themselves).

      It's cheap though and I think the upside potential is worth the risk. One decent thing mgmt. did was buy back a good sized chunk of stock at $6.xx a year or two ago.

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  2. Well, this is a half-assed proxy "contest"

    http://finance.yahoo.com/news/concerned-alco-stockholders-announces-intent-133000936.html

    Not sure what the point is....either run a proxy contest or don't.

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    1. Thanks for posting the link. I agree with you. They say management is doing the right thing, but maybe a director or two needs to be replaced. If it's a simple tweak then why run a proxy?

      I think they're afraid of making management mad and management taking some drastic value destroying action. My view is this, management is already doing drastic value destroying things. Go straight for the action and run a full proxy. Shareholders voted down the deal, maybe they'll vote for a takeover board. Don't just dip a toe in the pool, jump in.

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    2. I went back and glanced at the financials since the current CEO took over at the end of FY 2010).

      His first letter said he wanted to reduce debt, grow sales, and reduce expenses. He never mentioned reducing debt again.

      He has been an epic failure. During his tenure (through FYE 2013...so ignoring the last 9 months which have been another disaster), inventory increased $26MM, total assets increased $49MM, revolver balance increased $25MM, total liabilities increased $52MM, sales DECREASED $2MM, and profit was cut in half.

      So to make it simple, they've invested an additional $50MM in the business the last 3 years and have absolutely nothing to show for it. Meanwhile, their market cap is a whopping $35MM.

      I'd support anyone that wants to kick these guys out of the business.

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    3. So the guys running the proxy hold a whopping 36,724 shares of ALCS. 2 of the 4 guys don't hold any stock.

      Why in the world would you go through the expense of a proxy contest when you own less than 1.5% of the stock? They'd make about the same in director fees (about ~$45k each) as they'd make if the stock moved up 50%.

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  3. Classic net-net, also a classic value trap... I looked at it for someone a few months ago (before the take-private offer); below are my comments from that time. Most of these still stand. The punch line was that, as a going concern, it's worth $8 if things go well. If margins decline just by 60 bps, the stock is worthless.

    ----

    ALCO covers a wide store footprint (23 states, covering about half the area of the Lower 48) from a single distribution center in Kansas, which supplies about 80% of all merchandise. This is highly inefficient and leads to:
    - Significantly lower margins relative to peers (EBITDA margins of 2.5% over the past 5 years vs. 4-10% for broad line comps and 9-14% for dollar store comps)
    - Stores having to carry excess inventory. Inventory turns for ALCO for the past 5 years have been 2.3x vs. 8.8x at WMT, 6.8x at TGT, 4.0x at BIG and ~5.0x at the three big dollar chains. ALCO’s cash conversion cycle is a whopping 140 days (only Sears, at 70 days, even come close among peers; WMT is 9).
    - An effective cap on further profitable expansion – the above trends should only exacerbate as ALCO expands its footprint further away from Abilene.

    ALCO has attempted to mitigate these issues by improving efficiency within the existing system (dock-to-dock loading, outsourcing some distribution to AWG, etc.) but these measures have not been enough to offset the deterioration in efficiency metrics over the past few years. I believe that, absent another 1-2 distribution centers, core profitability cannot improve and any further expansion will likely be value-destroying. Furthermore, with only ~3 million in cash (and a fairly restrictive revolver), ALCO simply does not have enough capital to invest in a distribution center. Also, as a result of the above, ALCO is heavily exposed to increases in transportation / fuel costs.

    A cursory earnings quality analysis betrays a number of worrisome signs that, at a minimum, need to be investigated very carefully:
    - In 2012, ALCO changed its inventory accounting from weighted average cost method to retail method, which resulted in a $2.6 million increase in pre-tax income (or $0.67 / share).
    - A one-time insurance payment boosted ALCO’s EBT by a further $2.3 million in FY2012.
    - ALCO’s DSO increased from less than 2 in FY 2007 to nearly 9 in FY2013, a very significant number for a retailer with no credit card or B2B operations.
    - ALCO’s been quietly cutting discretionary expenses (e.g. cutting 401(k) matching in 2010).
    - ALCO recorded significant “one-time” charges in each of the past 8 years, averaging $500k / year (even taking into account the aforementioned insurance payment).
    - ALCO has been increasingly drawing on its revolver.
    - Some recent investments (stores in urban areas, web store) are firmly outside of ALCO’s core competency.
    - ALCO adopted a poison pill in May, which reduces the attractiveness of the business for a potential buyer or an activist investor.
    - After taking capex and working capital investment into account, ALCO’s free cash flow is virtually non-existent.
    - Lastly, ALCO is highly leveraged at 5.2x EBITDA. The terms of the facility appear lenient (low interest rate and no total leverage covenant) but they do leave relatively little room for error.

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  4. Why is revenue projected to remain the same?

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