Oddball Update: "Pardee Authorizes Share Repurchases"

Just announced by the company:
PHILADELPHIA, July 10, 2019
Pardee Resources Company (OTC: PDER) (the "Company") announced today that its Board of Directors has authorized the repurchase by the Company of up to $3.5 million of its outstanding common shares in 2019. This stock repurchase program may be carried out through up to $1.5 million in privately negotiated transactions and through up to $2 million in open market purchases. This program provides the Company with the flexibility to repurchase shares opportunistically from time to time based on market and business conditions, stock price and other factors. The Company is not obliged to repurchase any of its common shares and there can be no assurance as to when, or whether, any shares will be repurchased under this program.
Share repurchases were a big topic at the recent annual meeting in May. The most recent Issue (#25) of the Oddball Stocks Newsletter has a detailed account of that meeting as well as thoughts about the valuation and management's incentives to maintain the size of the company rather than sell assets at good prices and return capital.

The non-stop machine

I find failure utter fascinating.  Why did a particular thing fail? Why was it that thing and not something else?  Failure is especially important in investing, but also in other aspects of life.  While there are a ton of article (and a number on here) about failure in the personal or professional sense I want to talk about failure in the mechanical sense.

It's fun to think about really hard problems and try to back of the napkin a solution.  Things like "how would you stretch a single piece of string around the world?"  Or "could you design a machine that never fails?"

The second question is realistic, and one that I had a discussion about with a friend that spurred this post.  She helped invent the ATM system and was describing the challenge of building a robust system that never lost a transaction.  And that set me on a journey thinking about mechanical failure.

In a physical system failure can usually be reduced to the weakest link.  The weakest part will break down first.  But the ultimate failure might not be that part, in some systems it's possible for a weak part to fail and the machine to continue, but the failure increases stress on another part that ultimately fails.

Think of an engine, a simple $30 head gasket kit is the difference between a functioning engine, and sitting on the side of the road.  You rarely hear of a piston failing, it's a head gasket that cracks, a simple seal that goes bad.  But that failure creates a cascading effect.  A cracked gasket allows coolant into the oil, and a coolant oil mixture gunks up the pistons and ultimately the engine seizes.  That $30 part can create a multi-thousand dollar repair.

So what about critical systems?  This is where things get exciting.  If a non-critical system fails the system is down until a replacement part can be procured.  We see this all the time in life.  A gas pump will have an out of order sign, or we'll be told "that machine isn't working today."  But what happens when it's a ventilator that goes bad? Or a core banking system? Or the guidance system for aircraft?

The usual solution is to build in redundancy.  This is what Boeing is facing with their 737 MAX.  The aircraft had a critical sensor, a single critical sensor that if it had a bad reading could result in an error situation.  The obvious fix is to add a second or third sensor and correlate data between them to ensure no errors.  In aircraft redundancy is key.  Planes have multiple engines multiple pilots, multiple electrical systems etc.

In an aircraft you can make most things redundant because it is a completely isolated system.  An airplane has everything it needs itself when in the sky.

This redundancy concept is also used in computers.  Instead of a single hard drive put in multiple drives that mirror themselves.  Or put in multiple computers that mirror themselves.  All the way up to double everything, power, cooling, machines, everything into a massive distributed system.

The concept of massively distributed systems are what dominate our computing now.  The Google idea of having millions of generic computers that when they fail can be replaced without disruption is popular.

But this concept of massive distribution, or clustering hasn't always been the only way.  My friend who built the ATM network worked at a financial service provider along with some banks.  Their concept of "no failures" was quite different, and something I find utterly fascinating.

In the 1970s a company named Tandem was formed.  Tandem built computers that ran non-stop.  Once booted they never stopped.  In the late 90s Tandem was purchased by Compaq, which in turn was purchased by HP.  And like the computer systems this division has continued non-stop as well.  Now HP has non-stop computers.

The concept behind a non-stop computer is simple.  The entire system is designed for resiliency.  Everything is engineered to last as long as possible and built in a modular fashion.  This means when anything fails it can be removed and replaced without having to shut the machine off.  You can remove ram, or a processor all while the computer is running.  You can even swap out the motherboard of the machine while it's running all without losing a single transaction.

And just like anything can be swapped for failure it can be swapped for an upgrade too.  I was told it isn't uncommon for these machines to be in continuous operation for 35+ years.  To me that's astounding.  Someone turned on a machine 35 years ago and it hasn't turned off or had any downtime since.

The reason these machines work so well is because they share nothing.  Each component is like the airplane, completely self contained.  Components talk to each other, but if a single one fails it brings down nothing else.

What I've noticed is in a lot of newer clustered or fault resistant systems there are a lot of shared components.  And this shared-ness is usually the cause of a cascading failure.  Truly fault tolerant or resistant systems have hard barriers between all aspects and failure is isolated and don't cause issues anywhere else.

It's interesting to think about this at a higher level.  Obviously almost everything in life is interconnected.  And everything is going to fail as well.  But I wonder how often we consider both of those things together and make sure whatever systems (or processes are built) handle and isolate failure to the smallest and most replaceable component?

I think the reason we don't do this is because it's expensive.  It's expensive to design for failure in mind and expensive to build out redundancy.  But there is a cost to failure, and we are ignorant if we don't think things are going to fail.

The best systems are the ones where the designer sat down and said "how can this break?" before designing the final solution.

The same failure design thinking that goes into computers or machines can be extrapolated to systems, processes, businesses, or really anything.  You need to consider what can go wrong first, then build out redundancy and ways to isolate the failure before you can have a robust system.

There are too many things in life that work until they don't.  And the "they don't" is a result of short term thinking or expecting things to always just work.  If you can't envision failure it's impossible to ensure long term success.

Goodheart-Willcox Company ($GWOX) 2019 Annual Report

Earlier this month we published an update on the Goodheart-Willcox Company tender offer (also, previously). With 52k shares being taken off the market, the stock is even less liquid now, and is bid $120 and offered $199 (but the stock hasn't traded since April 30th).

The bad thing about the GWOX tender offers, from an outside shareholder perspective, is that they have been done by the ESOP and not by the company itself. Even worse, the company has loaned the ESOP money at low interest rates to do the buybacks.

These buybacks by the ESOP also make the outstanding share calculations a little wonky. The company had 446,542 shares outstanding as of April 30, 2019, but it likes to use a lower number (410,542) which excludes shares that are in the ESOP but unreleased and held in a suspense account. We think that it makes more economic sense to use the higher share number, especially since dividends on the unreleased ESOP shares go to paying back the loan from the ESOP to the company.

The result is that the market capitalization, based on 446,542 shares, is $53.6 million at the bid and $88.9 million at the offer. The company had $43.75 million of cash and securities at April 30, 2019 against $27.6 million of total liabilities. However, $23.3 million of the liabilities are deferred revenue.

At the recent tender offer price of $150, the market capitalization is $67 million. Using that figure, the enterprise value is therefore somewhere between $27.5 million and $50 million depending on how you treat the deferred revenue in the enterprise value calculation. According to Note C of the financials, the deferred revenue is coming (as you would expect) from the sale of digital online content, which revenue is then recognized over the subscription periods. Given that this revenue should have very high incremental profit margins it seems reasonable to haircut it substantially and derive an enterprise value figure at the low end of the range.

By the way, it is notable that so much of the balance sheet is funded by deferred revenue. This is a company that is actually very capital light and all of its $27.6 million of liabilities seem to be trade liabilities; i.e. non-interest-bearing.

So what do we get for a ballpark of $30 million enterprise value? Here is a snapshot of the relevant metrics:

Fiscal 2019 2018 2017 2016 2015
Total Average
Net Income 3,564 8,287 1,637 866 1,928
16,282 3,256
D&A 998 941 789 809 822
4,359 872
CapEx -506 -1,645 -1,035 -722 -557
-4,465 -893
FCF 4,056 7,583 1,391 953 2,193
16,176 3,235









Sales 29,257 41,162 24,151 20,684 22,032
137,286 27,457
NI % 12% 20% 7% 4% 9%
12%
FCF % 14% 18% 6% 5% 10%
12%









Book Equity 36,532 36,328 32,202 31,199 31,095

33,471
ROE 10% 23% 5% 3% 6%

10%

Some things to notice over the past five years: the net income reliably translates into cash flow at an earnings margin of about 12 percent on sales. If you figure that the business has $3 million of annual earnings power, then the stock is not exactly cheap or expensive either. (However: management's projections in the tender offer document have net income growing from $3.2 million in 2020 to $8.4 million in 2024, a total of $30 million over the five year period, which would earn back the entire estimated enterprise value.)

The return on book equity understates the quality of the business because there is so much excess cash on the balance sheet. It actually looks as though an owner could dividend out cash greater the book equity, which would mean the business could operate entirely with free external financing. (It would then have negative book value, and profitable companies with negative book value outperform.)

This is all somewhat academic because (a) the shares are so illiquid now and (b) management is allocating capital more to its benefit than to shareholders'; but it is also instructive. These return on capital and asset figures could hardly be more different than the other business we looked at this week - Scheid Vineyards. There are some quality businesses in the Oddball space; they just rarely come paired with quality managements and good prices.

We believe it is important to study and monitor Oddballs over the market cycle so that you are already familiar with them when big market dislocations happen.

We will have more about this (GWOX and educational publishing) in upcoming Issues of Oddball Stocks Newsletter. Our next Issue (#26) will be out in August. Until then, make sure you see Issue 25 of the Newsletter, and if you are missing any back Issues, you can get them here.

Do the Disappointing Scheid Vineyards Results Show a Bad Business in Decline?

Scheid Vineyards is an idea that was posted on the blog exactly six years ago (July 2013) when shares were trading for about $25. Here was the simple thesis at the time:
Earning $9.13 a share is significant given their most recent share price of $24.23.  Not all of the company's recent earnings can be attributed to continuing operations, the company reported a $5.7m gain on a $7.5m sale of a 238 acre vineyard. Backing out the one time gain lowers operating income to $4.5m or $5.17 per share.  The company's operating cash flow was $4.08m which tracks nicely with their adjusted income, meaning this company is trading with a P/E of 4.68.
The stock hovered around $30 a share for several years after that before exploding higher during the summer of 2017. So it has been a good investment when purchased at opportune times. David Tepper owned it in certificate form in the late 90s when he was posting on The Motley Fool.

Scheid stock reached a peak of $108 in March 2018, but has lately collapsed and after announcing results on June 26th it is down to the $60 range. (The summer of 2017 was when a fund called Maran Capital Management published a short write-up of the idea. In January 2018 they published a much longer and more detailed presentation.)

Opening the shareholder letter last week, our eyes jumped to the sentence, "it was not for the faint of heart to take this leap" which appeared in a section discussing Scheid's efforts to become "a fully vertically integrated company and [producing] our own estate branded wines for the national and international marketplace". Uh oh. Here was the upshot:
The wine grape harvest of 2018 was larger than average throughout the state of California. This contributed to depressed grape and bulk wine prices which represent about half of our sales. It also reduced the value of our unsold bulk wine inventories. We decided to write down of those inventories by $2 million in order to reflect more accurately its true market value. These events contributed to our loss for fiscal 2019.
Was it a warning sign that Pardee Resources, a hard commodity producer, had gotten into agricultural investments including grapes? We decided to do a reality check on the quality of the business, taking into account the past fifteen years from the end of 2003 until present.

The shareholders' equity was $38 million at the end of 2003 and it's $43 million now. They haven't paid any dividends. In 2003 they had 449,751 outstanding A shares and 645,223 outstanding B shares (reverse split-adjusted; a total of 1.09 million) and now they have 735,617 of the A and 147,469 of the B (total of 883k). So, no dividends but they have shrunk the float by 19% - about 1.27% per year. Certainly some capital has been returned.

But here is what seems crazy to us. In 2003, they had sales of $26 million, gross profit of $12 million, and pre-tax income of $5 million on an asset base of $68 million. Most recent fiscal year, they had sales of $58 million, gross profit of $12 million, and an $11 million pretax loss - on an asset base of $159 million.

Sales/assets has remained somewhat steady (but low), but gross margin has fallen from 46% to 20% over 15 years. And it is not clear why their asset turns are so low when they are selling low (and falling) margin bulk wine. Bulk wine and grapes were 44% of revenue last fiscal year versus all of revenue fifteen years ago - some how gross margins are lower despite deploying significant capital into the cased wine business.

So because of the lower gross profit, higher SG&A, and lower incomes, return on equity has fallen even as leverage has gone up! In 2003, equity/assets was 56% and now it's only 27%. In fiscal years 2018 and 2017 (since the company had a loss for FY 2019) the annual net incomes were less than $3 million, which was less than the 2003 level.

Look at the Scheid Vineyard writeups by other investors and they seem to focus on the sum-of-the-parts asset valuation. And we do not doubt that Scheid could be liquidated or sold at a profit. But they aren't going to sell or liquidate, just as Pardee is not going to sell or liquidate its overpriced timber. That leaves investors with just the earnings power, not asset value.

Nobody who has done an asset valuation writeup of this has commented on the deteriorating profitability and margins, or the fact that management has responded to it by taking on more leverage to make much bigger investments in the business.

At December 31, 2003, they had $67 million of gross investment in PP&E. At February 28, 2019 (most recent), they had $174 million of gross investment. Inventories have increased from $7 million to $50 million. But the gross profit is lower and net income is lower!

Let's look at the inventory. At the end of 2003 they had $1.9 million of bulk and bottled wine inventory followed by $5.7 million of bulk wine sales the following year. At the end of fiscal 2018, they had $40 million of bulk and cased wine inventory versus $47 million of sales the following year. And that understates the slowing inventory turns because in 2003 and 2004 more of the sales were of raw grapes, which are sold when harvested.

Here is the acid test of whether this is a good business or not: how did they fund that massive asset expansion from $68 million to $159 million? (Those are the figures net of depreciation; which required over $150 million of gross investment.) Did they bootstrap with cash flows, denying shareholders dividends but building the business with retained earnings?

The answer is that total liabilities grew from $28 million in 2003 to the present level of $116 million. And in case you think that this was low cost float from vendors or something (almost none of their liabilities are this type) the truth is that long term debt went from $13 million to over $100 million. That is why book value is flat; that is why retained earnings plus treasury stock repurchased was $27 million at the end of 2003 and is $44 million today.

So what happened here, really? Is this a nine-figure malinvestment, and if so why did it happen? One of our astute correspondents writes in,
Most of these firms [like Pardee and Scheid] exist because of institutional loyalty and for no other reason. If they were rational, they would have sold to better, larger, more scaled operators long ago. Managements here lack vision and ambition, but get to work with their friends and they value that highly.

Also there is much more stature in owning the local "big business" than just being a local rich guy. There is much more power in owning the local business with employees who depend on your firm for their livelihoods. Chances to sponsor local sporting events and attend various "power broker" meetings. Rich people are not respected. Business people are.
We will be writing about this theme in much more detail for subscribers of the Oddball Stocks Newsletter. Also see our June post, Small Companies (like Small Banks) As "Jobs Programs".