Monday, July 28, 2014

Hammond Manufacturing revisited, still cheap at 54% of BV and 6.2x earnings

If I have one weakness on this blog it's the failure to follow up on companies I've previously posted about.  To readers my process appears to be the following: research a company, write them up, never mention them again.  I tend to keep up with most of the companies I post about, if not intimately at least from a distance.  The shame about my lack of updates is that many companies remain attractive far after I've posted about them, and unless someone reads the initial post or searches the blog they would ever know.  I plan to change that today with a post on Hammond Manufacturing.

The last time I wrote about Hammond Manufacturing (HMM.A:TSX) was in September of 2013 when the company was trading for 88% of NCAV, and 44% of book value.  At the time they had a book value of $2.71 per share, and had earned $.15 per share in 2012.  I made the case that the company was worth at least NCAV, but more likely book value.

The company is located outside of Toronto and manufactures industrial electrical box enclosures.  Earnings have been volatile ranging from $0 in 2009 to $.20 per share in 2013.

In the last 10 months the shares were flat did mostly nothing until recently.  Hammond Manufacturing released results of a great second quarter and the stock started to move.  Even with the recent move up the company remains cheap.  In the past 10 months book value has increased from $2.71 per share to $3.10 per share.  The last time I wrote about them they were selling for 44% of book value, with the run up they're now at 54% of book value, hardly overvalued.

Besides the discount to book the company has shown considerable earning potential in the past year.  On a trailing twelve month basis they earned $.27 per share, giving them a P/E ratio of 6.2.  Management noted in their second quarter letter that sales are finally showing signs of recovery, which could indicate that their quarterly EPS of $.10 run-rate could continue.

Given Hammond Manufacturing's valuation there are only two scenarios I can think of, either I'm wrong, or the market's wrong.  As an investor in the company I clearly think the market's wrong, but I want to put that aside for a minute and consider what I could be missing, let's look at the company's negatives.

The company finances their inventory with debt, they have about $10.6m in debt outstanding, their debt is a negative, but not large enough for their valuation discount.  They also have two classes of stock, the publicly traded A shares, and the privately held B shares.  The controlling family owns the B shares and controls the stock through these shares.  Markets don't like controlled companies, especially ones that have so much control that an activist (theoretically) can't take the company over.

There is also an issue of a potential environmental liability.  The company had a suit filed against them in 2013 alleging that contaminants from a property they once owned have leaked onto a nearby, but not adjoining property.  The company isn't sure whether the contaminants were from their property or somewhere else.  They note that a scenario exists where they need to pay $2m to have a barrier erected between the properties.  If the company lost the lawsuit and were required to pay the full $2m their book value would be reduced to $2.92 a share from $3.10.  While a legal loss and resulting environmental remedy is not ideal it hardly justifies the valuation.

The comments on my last post give additional insight as to why investors, and the market think this company should be cheap.  Someone thought that a company that doesn't generate at least a 10% ROE shouldn't be worth book value.  Someone else claims that the closely held nature is the reason for the discount.  Another claimed if they paid a dividend they would be worthy of a higher valuation; the company did pay out a dividend and shares barely budged.  Lastly, my favorite response is someone who said the stock has always been cheap and it should remain that way.

In a market where investors are claiming there is no value to be found I would tout Hammond Manufacturing as the exception to that rule.  This is a profitable company with recovering earnings selling for 54% of book value.  Maybe they're only worth 80% of book value, but if that were the case investors would still earn an acceptable return from this investment.  For myself I voted with my cash and have been holding onto my position.

Disclosure: Long Hammond Manufacturing

7 comments:

  1. Each company must earn their cost of capital and that number is usually 10%. If a company can only earn 5% then it will trade a .5x book value. If it can earn above 10% then it will trade above book value, and the amount premium over will depend on how much can be reinvested at the higher rates.

    Buying cheap companies with horrendous ROIC with the hopes of flipping it at a higher price works, but if you want to make the real money then look for companies that can compound at amazing rates and buy them at a fair price or cheap. Heck you can pay a very high multiple (20x) and still make 10x your money in a 10 year period if you bought something with economies of scale and pricing power that becomes known later on (aka railroads). This strategy requires more reading and thinking about how the individual industries in the economy works together.

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  2. WNMLA could be very cheap at 33% of book value or so too.

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    1. Yes, especially given the Ravenswood court decision recently. I hope more information comes out soon, especially financials.

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  3. Hi Nate, I am relatively new to asset-based investing and have found your blog to be very interesting and tremendously helpful in understanding how various investment concepts are applied.

    I have a question on a company's "fair value". How do you determine if a company trading below NCAV (or BV) should be worth NCAV (or BV)? You mentioned that in the previous post, you made the case that Hammond should be trading at least at NCAV. But when I went back to it, it wasn't clear to me what those reasons are. Is it because most of NCAV are in inventory and receivables and the assumption is that we can sell both of these today to get NCAV?

    Apologies if I've missed the obvious here. Just wanted to clarify.

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    1. Great question, probably the subject of an entire post.

      I like to think that a company's "real" value is their private market value. This is what a seller and a buyer would negotiate and agree on. There's a large private market for companies, and it's worth spending 30m on the phone with someone who values private companies for a living.

      When a private company is approached by a buyer they sign an NDA and the buyer gets to pore over the books of the potential acquisition. A valuation firm, or a CPA will be involved and the parties will negotiate a fair price. In the world of private businesses buying something on the cheap is extremely rare. Someone usually acquires someone else because they believe they have unique operational capability that will enhance the results of the target company.

      So to your question, unless a company's assets are absolutely terrible in a private purchase a company is going to be worth their NCAV. Usually a company will sell for book value if it's asset heavy, or some multiple of earnings. Around 5-6 EV/EBIT is a typically buyout value.

      My main goal is to determine that NCAV or BV isn't junk. If it is then a discount might be warranted, but if it's comprised of quality or average assets then to a private buyer the company should be worth at least book value.

      Hope this helps.

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  4. Thanks for your explanation Nate. That's very helpful.

    If I may ask, how do you usually go about doing that (determining NCAV or BV isn't junk)? Any tips you can share?

    I'm trying to determine exactly that for one of the companies I'm looking at but I find it's pretty hard to do unless you have some kind of experience/knowledge in the relevant industry.

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  5. Nate- Good post. What about a revisit of Stanley Furniture? Seems like they're getting close to profitability with the closing of Young America and the Robbinsville plant. Lotta cash, cheaper, supposedly profitable Stanley line.

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