One of the hallmarks of my investing style is that I usually invest in closely held companies. A closely held company is one where a shareholder, often a founder, or founding family owns a controlling stake. The idea is that with a closely held companies minority shareholder interests are aligned with the controlling holder's interests. There is a lot of research to back up this assertion and shows that family owned and closely controlled companies have outperformed the market over the long term. But long term outperformance doesn't mean there won't be a few duds along the way. While it's always nice to talk about and tout investment successes I think it's also important to look at our failures as well.
I wrote about First Aviation (FAVS) in last March. When I found them they were selling an unprofitable division for more than their current market cap. I've found that investments like that often end successfully. This is mostly because the profitable division's hidden value is exposed to investors. The company also has proceeds from the sale that can be used to fortify their balance sheet. When an investor can purchase a company for less than the proceeds from the sale and get a profitable business for "free" it makes sense to invest.
What took place at First Aviation didn't quite follow usual the divest your way to profits playbook. The company is an aviation parts supplier and outsourced maintenance vendor. They specialize in commercial propellor planes, the ones that are used on short haul commercial flights. The company's majority shareholder is an aviation focused private equity group located in Connecticut. I mention the location on purpose, the aviation company's facilities are in North Carolina, Wichita, and Texas. Yet the company leases their office space from the private equity group's headquarters. This was an item that gave me a bit of caution, but wasn't enough of a red flag to pass on the investment. It's hard for executives to manage a company remotely.
In the last year the company has done exactly what it said it would do, they used the proceeds from their division sale to pay down debt and their profitable division's profits have grown nicely. The company reported earnings last week where they reported they earned $.32 in the first quarter. Extrapolated out for the year the company could earn $1.20 a share or more, significant considering their shares trade at $8.40. They aren't only cheap on an earnings basis, they also trade for 68% of a growing book value.
The problem is shareholders aren't going to be the beneficiaries of this growth story. Management decided they'd prefer to take the company private by engaging in a 10,000 for 1 reverse stock split. Any shareholder who owns less than $84,000 worth of stock will be forced out of their shares and paid $8.40 per share in cash. The 10,000 share limit is significant in that it's a much higher amount than normal for a reverse merger. Most likely the company is squeezing out all but a few large shareholders by setting such a high threshold. The company is already a non-SEC reporting entity meaning they have less than 300 shareholders of record. This corporate action isn't an effort to stop filing and reduce costs, it's a way to eliminate all but larger shareholders.
When I purchased the stock shares were priced at $9, so this take-under won't be a huge loss, but it's still a loss. What hurts most about this transaction is that my initial thesis was, and still is correct. I would classify First Aviation as an investment failure, but not an investment mistake.
Unfortunately in the case of First Aviation having a significant controlling shareholder didn't help minority shareholders, it hurt them. I suspect this is because the majority holder is a private equity group who is only watching out for themselves and their (the PE investors) shareholders, not everyone. Private equity doesn't have a great reputation for being shareholder friendly. At times investors can profit investing alongside private equity firms, but it's not a relationship of equals. It's more like the minority shareholder is the bird riding on the rhinoceros' back. You can get a free ride, but if you're in the wrong spot you're likely to be crushed without regard.
I think it makes sense in response to this investment failure to consider whether I'd do anything differently? I'm not sure I would. If this company weren't going private I'd be happy to be a buyer at this price today, especially with how their results have improved. The lesson I've taken away from this investment is that even when everything works out according to a plan it's still possible to experience an investment loss. The problem is as a minority shareholder I am tagging along on all of my investments. I can't control what a company's management does to outside shareholders. If management decides to take action which is detrimental to shareholders I can experience a loss even if my investment thesis is correct.
My experience with First Aviation has made me wary of the recent news out on Schuff Steel, a company I wrote about in 2012. The Schuff family sold their controlling stake to a private equity group. Schuff has the potential to play out in a manner that's similar to First Aviation. The company's results have been recovering dramatically but it's possible outside minority shareholders won't get to enjoy the reward associated with the results.
Disclosure: Long FAVS, SHFK