York Corrugating Company Reverse Split $YCRG

Be sure to read a great post this morning by Value Investing Blog on a YCRG reverse split squeeze-out:
Every now and then I like to highlight a transaction that to me looks unfair to minority shareholders. For example, two years ago, Waxman Industries tried to buy out shareholders at a ridiculous price that amounted to just 12% of book value. Apparently so many shareholders asserted their appraisal rights that the company ended up cancelling the whole deal about a year later.

This week I received the financial statements of York Corrugating Company (OTC:YCRG). The company is a manufacturer of precision metal components and sheet metal products. [...]

In previous years I only received financials and the notes to the financial statements. There was no letter from the CEO describing how the business performed that year. This year there suddenly was a letter. It was even titled “Important Letter to Shareholders”, so that made me curious.

Unfortunately the letter announces an attempt from the company’s management to cash out the remaining minority shareholders. They plan to do this by way of a reverse split at a ratio of 2960-for-1. Every shareholder holding less than 2960 shares will see their fractional shares (post-split) cashed out at a price of $308 per share, determined on a pre-split basis.

The company has obtained a valuation from Baker Tilly Virchow Krause LLP to deterimine the “fair market value” of the minority shares. Their report is not included, nor is there any explanation offered why this price is deemed fair.

The company only had 20,841 shares outstanding as of December 31, 2019. At a price of $308, the Board of YCRG thinks that $6.4 million is a fair valuation for the company. Looking at the balance sheet and the company’s recent earnings, this valuation looks much too low.
He did not post a copy of the letter to shareholders, but we are trying to track it down.

York Corrugating Co. is a classic Oddball (it's in the Century Club) although we have not written about it on the blog before. It is based in West York, PA; a half hour or so from the headquarters of Hanover Foods, but pretty close to little York Airport where Hanover keeps its Cessna Citation jet!

Whatever is in the water in southeastern Pennsylvania does not seem to promote friendliness to minority shareholders. In fact, in looking for case law on squeeze-outs, we see some old friends: a 2012 Supreme Court of Pennsylvania opinion in Mitchell Partners, LP vs Irex Corporation:
Mitchell Partners, L.P., was a minority shareholder of Irex Corporation, a privately-held Pennsylvania business corporation. In 2006, Irex participated in a merger transaction structured so that some minority shareholders would be “cashed out” and would not receive an equity interest in the surviving corporation, a wholly owned subsidiary of North Lime Holdings Corporation. Mitchell objected to the acquisition, as it viewed the transaction as a “squeeze out” of minority interests at an unfair price. The merger proceeded nonetheless, and Irex commenced valuation proceedings in state court, per Section 1579 of the BCL, to address the dispute with Mitchell.

Meanwhile, Mitchell pursued common law remedies in a diversity action in federal court, naming as defendants Irex, its directors, most of its officers, and North Lime. The complaint asserted claims for breach of fiduciary duties, aiding and abetting breach of fiduciary duties, and unjust enrichment. The defendants sought dismissal on the ground that, under Section 1105 of the BCL, judicial valuation is the sole remedy available to dissenting shareholders in the post-merger timeframe.
Notice that the Irex merger closed in October 2006, Mitchell sued in federal court October 2008, and the case went to the federal court of appeals and the Supreme Court of Pennsylvania, because the federal court certified a question of state law for them to answer. The 2012 state supreme court opinion was a victory, establishing a legal precedent in Pennsylvania: "shareholders [can] bring a non-appraisal action, after the closing of a merger, asserting fraud or fundamental unfairness."

Good for Mitchell for fighting so long and hard - Irex paid a big tax for not asking for minority shareholder blessing of what it wanted to do before doing it. But that 4+ year battle points to something important.

In his post, Value Investing Blog alludes to a problem that minority shareholders have in these situations: a high fixed cost of fighting what the management and/or controlling shareholders are trying to do. It can be a significant cost in terms of time and attention, and for someone to rationally pay that cost upfront he would have to anticipate a higher expected benefit. An appraisal action is likely going to require dissenting shareholders to have an expert report.

That suggests something important for corporate governance theory. The ownership structure of a company matters, and can be very important for the ultimate returns of shareholders. At the limit, if a company were to be owned by a large group of shareholders each holding a single share of de minimis value, it might be possible for the management to convert all of the company's equity to their benefit and rational for the shareholders to acquiesce. (In theory, the shareholders could resist as a class, but in practice those efforts have to be initiated and organized by a shareholder with an economic incentive to do so.)

Speaking of reverse splits, yesterday's post was about shareholder activism at Life Insurance Company of Alabama. On the Concerned Shareholder website, there is mention that LICOA was considering a reverse stock split in 2015 and met with state regulators about it. No word on what happened with it though (or why it didn't happen).

Shareholder Activism at Life Insurance Company of Alabama

We posted in November 2019 about Life Insurance Company of Alabama (LICOA), a micro cap insurance company with two share classes, one of which (LINS, the fully voting shares) trades at a modest discount to book value and the other of which (LINSA, with limited voting rights) trades at a gigantic (70%) discount to book value.

As we mentioned in that post, the State of Alabama Department of Insurance periodically examines the insurance companies that are licensed there and publishes a report about them, and the examination report on LICOA from May 2005 had some interesting revelations on the conduct of the family that controls and manages the company. In particular, we thought it was amazing that the report referred to "an issue with nepotism" and said that "this issue stands to harm the Company due to potential shareholder and/or policyholder lawsuits".

Well, there are now two lawsuits against the company and directors by LICOA shareholders. The first one was filed on August 28, 2019 in the US District Court for the Northern District of Alabama and it is Trondheim Capital Partners LP et al v. Life Insurance Company of Alabama et al.

The second lawsuit was actually a proposed complaint in intervention filed on April 29, 2020 in the same case; it has claims by a second group of LICOA shareholders that includes Mitchell Partners, LP and Jeffrey Herr. The company did not oppose the complaint in intervention and the court has ruled that it will proceed. Here is an excerpt from the opening of that second complaint:
This lawsuit arises from the gross mismanagement and nepotistic practices of the Director Defendants and their oppression of the shareholders of LICOA and suppression of share values for their own purposes. Plaintiffs now sue to enforce their statutory rights, for breaches of fiduciary duty, for securities law violations, and for dissolution of LICOA. [...]

As detailed below, these massive salaries that cripple LICOA’s income are part of sham “compensation structure” that is really a family jobs program for LICOA’s Directors and their families. They are unqualified and wasteful and these salaries are completely unjustified. Moreover, they have purposefully overcapitalized LICOA to keep share value down so they can repurchase them cheap and to keep a nest egg to perpetually fund their exorbitant salaries, luxury offices, and lifestyle while the LICOA shares do not even trade at liquidation value.
There is also a website with information called Concerned Shareholders of Life Insurance Company of Alabama with all kinds of details. The shareholders discovered that the company paid $4,787 for a "desk chair" for President and Chairman of the Board Clarence Daugette last year.

One very interesting thing mentioned on the website was that "LICOA has made offers to settle litigation with some of the plaintiffs via buying them out. In March 2020, they offered some plaintiffs the equivalent of $25 per LINSA share." The LINSA shares are currently offered for $12.00 per share on the OTC...

Obviously there is no way of knowing whether that deal is still on the table or not, or whether it would apply to all comers or not. But it is interesting. Presumably it was not taken because the shareholder plaintiffs thought it was a "lowball" offer.

This reminds us of a dynamic we have seen in micro cap activism, which is that shareholders are rarely well-served by sitting passively on the sidelines while these things are going on. One thing that can happen is management will settle with unhappy shareholders by buying them out, and the remaining shareholders will be stuck in the company. At that point, they have fewer potential allies, and management will probably view them as oblivious or acquiescent.

We'll have more on this situation, and other activist investing situations, in the upcoming June Issue (#30) of the Oddball Stocks Newsletter.

Pardee Resources Company - 2019 Annual Report

We've mentioned Pardee Resources before on the blog in The Problem With "Sum of the Parts", "What is an Oddball Stock?", and a brief mention last year of their share repurchase. Pardee was the main idea that Nate wrote up in Issue 1 of the Oddball Stocks Newsletter. We write about them fairly frequently in the Newsletter and they were in our recent Highlight Issue.

Pardee is normally a great annual meeting to go to - the only one that serves lunch - but it won't be happening in person this year. The virtual meeting is scheduled for Friday, May 22nd.

According to the proxy statement, there were 654,191 shares outstanding on April 1st, which was up from the year-end count of 649,448.

The increase is from stock compensation. Pardee has high SG&A cost some of which seems to stem from compensation. The non-employee directors of the Company get a board retainer of $50,000, and equity award of $50,000, and $3,000 for each board meeting. There are seven non-employee directors. The non-executive chairman receives a retainer of $125,000 and an equity award of $50,000. That's a total of $875,000 not counting the meeting fees and other additional retainers paid to committee chairs.

At a share price of $123, the Pardee market capitalization is now $80.5 million. So the board compensation alone is a 1% annual drag.

Stay tuned for the June 2020 Issue (#30) of the Newsletter coming up next month where we will share more thoughts about Pardee.

The Coal Creek Company - 2019 Annual Report

The Coal Creek Company (CCRK) annual report for 2019 is now out. Coal Creek shares have declined and are currently trading at the same level they were in the summer of 2006. Book value per share was $134 and marketable securities per share were $76 as of year-end 2019.

This is a company that land aficionado Oddballians like, but which happens to have a lot of exposure to the pandemic crisis. Of its $6.8 million of 2019 revenue, almost all of it is vulnerable: rental income, recreational fees, general store income, and gas and oil royalties. It will be important for them to have cut their $5 million of operating expense rapidly as sales fell.

They likely lost money on their $7.2 million securities portfolio as well, which underlines the point we made a year ago about how these small company equity portfolios compound the macroeconomic risks and are a poor safety cushion.

We will have our full commentary on the 2019 results in the upcoming June 2020 Issue of the Oddball Stocks Newsletter. (Previously, we published an excerpt from Issue 25 (June 2019) about The Coal Creek Company.)

Who Cares About Profits Anyways?

Have you ever had a moment where it felt like all the pieces of a puzzle fell in place?  Where suddenly a number of things that previously didn't make sense came together into a beautiful picture?  I had that moment years ago when a venture capital friend of mine explained their valuation model.  At that moment everything clicked.

My friend explained that valuations were anchored to information.  To obtain the highest valuation you had to have no revenue.  Without revenue a VC could value the company based on their imagination.  But once you had a dollar of revenue you were suddenly valued on sales, which would always be dramatically lower.  If a startup was crazy enough to earn an operating profit their valuation could fall again once they were measured on this metric.  And if a startup wished to just shoot themselves in the foot they'd report net income, a ghastly number that would force them to be valued on an earnings multiple, just like those old world public companies.

When I looked at the world through this lens it made sense for companies to give their products away for free in return for users or hits.  Just imagine the sales from all those users, and those imaginary sales are extremely valuable!

The name of the game appeared to be to raise equity capital from venture capitalists who saw these metrics and dreamed of sales one day.  Founders could continue to grow their vanity metrics while being funded from equity and eventually sell out to an old world company that saw the same vanity metrics and same imaginary sales.  Sometimes it worked, sometimes it didn't.

What always fascinated me though was why did startups raise funding via equity?  Equity is the most expensive form of financing available.  The answer of course is that most startups fail and banks aren't willing to underwrite github repos and sticker covered Macbooks as collateral for a loan.

But for me the wheels started to turn.  According to the Modigliani-Miller theorm the most efficient capital structure for a company is 100% debt financed.  What if someone could create a company that was perfectly efficient.  It would be funded entirely by debt, and they would ensure that they didn't earn a cent more than their operating expenses and interest expense.  It would be finance-theory efficient and also tax efficient.  Without profits it could be valued like a startup as a high multiple of sales.  It would be the perfect machine. 

Of course shareholders would own nothing because the capital structure was entirely debt based, but maybe some clever lawyers could create tracker shares that legally owned nothing, but allowed people to speculate on the value of the company.  Then we could merge the perfect machine with the perfect investment.  The perfect investment being a legal claim on nothing but market appreciation.

Obviously my perfect investment is very tongue in cheek.  An "investment" like this bears a strong resemblance to sports gambling in Las Vegas.  It's purely speculation.

What's fascinating to me is how the stock market, and general investment environment seems to desire companies like this vs a company that is focused on selling items for more than they cost, or generating a cash return on investment.

If the stock market continues to appreciate forever then owning shares will always be a profitable endeavor.  Of course the US market has always gone up and to the right, and no one can imagine anything else, but what if.... What if there were a period of time when stocks fell and didn't recover a few days later?  What if we hit a sideways market for a decade?

The market used to reward companies paying dividends to shareholders out of profits.  A company might pride themselves on decades of unbroken dividends.  Employees would be granted shares in retirement accounts and dividends on company shares were a sort of bonus.  They were also an incentive to work hard for their employer.  Any improvement in efficiency could lead to larger personal bonuses themselves.

The idea of dividends fell out of fashion once executives learned they could buy back shares while issuing options to themselves and get rewarded by the market.  There are a few companies that are net buyers of shares, but it's really hard to eat buybacks. 

It's fascinating that when someone enters into business themselves on a small scale that they are expected to make a profit very quickly.  One a small scale if a company can't generate profits they can't stay in business.  A landscape company might not be wildly profitable, but if they expect to stay in business for more than a season they need to be slightly better than break even.

At scale the market doesn't care about profits or dividends anymore.  Shareholders don't care about receiving a portion of the profit themselves as long as shares appreciate, or management announces they will repurchase shares.  As long as things are up and to the right the system continues to work.

In a sense venture capital is a cheat code for small businesses to escape the shackles of profit expectations and play in the larger market playground.

Maybe I'm old fashioned, but it seems to me that this might not be the healthiest system.  Instead it seems to be a fragile system built on slights of hand and confidence.  That doesn't leave me sleeping well at night!

There's a part of me that longs for the "old days" when companies were focused on earning money, and then rewarding shareholders with a cash return for holding their stock.  I doubt those days will ever return, but I can imagine..

Podcast: "Finding Oddball Stocks with Nate Tobik"

Bank of Utica Results for Q1 2020

In yesterday's post, we mentioned a very small bank trading at 41% of book value and a 20% earnings yield based on trailing twelve month earnings. The caveats are that half of book value is in that bank's headquarters, and it is not clear how sustainable the earnings are.

Another perpetually cheap (relative to book value) bank that we write about is the Bank of Utica. If you are not a Newsletter reader, you can check out a sample that mentioned BKUT a couple of years ago. We also posted about the 2019 annual results, and investors' reactions, back in February. One thing we missed in the Tweet roundup was this one: That is a healthy amount of BKUTK for someone to own. The Q1 2020 call report is out, so we can see how much money their portfolio lost through March 31st. (Call report is embedded below.)

Total interest income was up from $7.7 million in Q1 2019 to $8.5 million this quarter. Interest expense went from $3.3 million to $3.9 million, so net interest income went from $4.4 million to $4.6 million. Total non-interest expense went from $3 million to only $2 million, which is a big drop. Digging into that further, the 2019 Schedule RI-E "explanations" showed $1.1 million of "Donations". Poor shareholders...

In Q1 2019, the bank's net income was $7.8 million. This quarter, it was negative $11 million, thanks to a $17 million unrealized loss in the portfolio. The bank's equity capital is $230 million, which is slightly lower than the $232 million where it stood a year ago.

The securities portfolio increased from $947 million to $993 million, funded by an increase in deposits. So it looks as though BKUT bought the dip in... whatever kind of securities it owns.

The non-voting BKUTK shares are offered at $370. There are 200,000 non-voting shares and 50,000 voting (BKUT) shares, so the market capitalization is $93 million at the BKUTK offered price. That is 40% of book value.

We generally like to subtract the book value of BKUT's premises and other assets, which lowers book value per share and makes the BKUTK price more like 45% of adjusted book value.

It would be an absolute no-brainer to buy back stock. They are overcapitalized and their stock is a far better investment than the debt they own. 

This type of situation (and it occurs often) is a serious philosophical puzzle for Oddball investors. What are shares in a company like this worth?

Is This Tiny Bank A Buy At 41% Of Book And A 20% Earnings Yield?

We wrote about Southern Community Bancshares, Inc. (OTC: SCBS), the holding company of First Community Bank of Cullman, in our post last year Small Companies (like Small Banks) As "Jobs Programs". We thought we'd update since the 2019 results are out, and the loan growth, earnings growth, and share repurchases were surprising.

Last year we noted a market capitalization of $4.3 million with stockholders' equity of $10 million, for a price-to-book ratio of 0.43x. The caveat was that the bank's property, plant and equipment were $5 million of the equity, making SCBS a strong contender for the Bank of Utica Small-Town Bank Headquarters Hall of Fame. Having half of the bank's equity tied up in premises made the 57% discount to book value feel much less generous.

This year we notice that assets have grown from $115 million to $127 million, with more than 100% of the increase coming from loan growth. Deposits grew by only $4.5 million; most of the asset growth was funded by FHLB borrowings. The loan portfolio is 92% real estate mortgage loans.

Shareholders' equity grew from $10 million to $10.7 million, while at the same time the bank shrank its share count from 505,592 to 488,296. (A 3.4% reduction.) Book value per share is now $21.90, so the price to book is now 41% instead of 43%.

For 2019 the bank had $883,000 of comprehensive income. Interest and fees on loans were $5.65 million on a portfolio that started the year at $90 million. Interest on deposits were $1.2 million on interest bearing deposits of $86 million.

With the 59% discount to book value and resultant $4.4 million market cap, the 8% return on equity now translates to a 20% ttm earnings yield!

It is somewhat amazing that with $10.7 million in equity, or $5.6 million if you exclude the value of premises and equipment, they have levered up to own $127 million of assets. (Or if you exclude the premises and the investment securities, $117 million of assets.) Only with a government guarantee would a 21x leverage scheme like this be possible.

Also interesting is that SCBS does not lack for competition. Their competitors just in Cullman, Alabama (town of 15,000) are Family Security Credit Union, Traditions Bank, Premier Bank of the South, Regions Bank, Merchants Bank of Alabama, Citizens Bank & Trust, Cullman Savings Bank, Peoples Bank of Alabama, Wells Fargo Bank, BBVA Bank, EvaBank, and Woodforest Bank. That is about one bank per thousand people.

A question for a bank sleuth - how did SCBS grow its loans from $58 million to $103 million in two years? Is this level of interest and fees on the loan portfolio size sustainable?