Gencor, selling below net cash, but is there more than meets the eye?

Gencor (GENC)

Price: $7.00 (10/25/2011)

I saw this idea posted over at the ST Report, plugged the numbers into my net-net worksheet and realized this is a company selling for less than net cash in the US.  I have to admit, at first glance when I saw this I was excited, it seemed like the type of company I like to hold, selling for less than cash and profitable.

Basically every single net-net has a problem, it could be a small problem that looks big, or a big problem that looks small.  The trick is identifying companies where the problem appears big but is really small or manageable.  The first red flag for me was that Gencor didn't appear to have an obvious problem, when I see this I get worried.

I want to examine this stock by looking at both the bull and bear case.

Bull Case


The bull case is pretty simple, the company is selling for less than cash and marketable securities net all liabilities.  Here is my net-net worksheet:

In addition to having a fortress balance sheet the company has a good record of profitability.  Here is a look at their profits and a few select margins for the past ten years:

Source: MSN.com

One criticism against the history of profitability is that a lot of the profits come from the marketable securities and operating profits are a bit spottier.  I can accept this argument, but since this is a net-cash stock we're discussing I think any profits are acceptable.

So in summary the stock is extremely cheap, and has a positive ten year history of earning money.  For the past ten years the balance sheet has only grown stronger.

To put a conservative value on the stock I think it's fair to take the cash and securities at face value and add a 8x multiple to earnings.  Taking this approach we have EPS of $.71 at 8x ($5.68) plus the $7.61 in net cash giving a value of $13.29, almost a double from this point.  This is a true dollar selling for fifty cents!

Bear Case

One thing I've really been concentrating on when examining investments is looking at why a company is cheap, and what sort of margin of safety exists.  In the case of Gencor the margin of safety is the discount to the liquid assets, and the fact that the market is valuing the operations at nothing.

The first thing I did was go Googling for why Gencor was cheap and most of the reasons I saw on the internet tied to the fact that the operating company had a spotty history of profitability and the business was a generally poor one.  I can accept this argument but I think it's a bit too simplistic.  There are many poor businesses selling with high multiples, there are even many more businesses that have never turned a profit that are selling well above asset value.

I believe there are multiple reasons behind the valuation discount at Gencor, I want to break each down individually.  First off I want to state that the bear case has been made much simpler thanks to American tax payer dollars, the SEC has asked extensive questions of the company all recorded through EDGAR. Some of the questions are basic, others dig into nitty gritty accounting details.  

1) What exactly is happening with the CFO? - This might not be the most important issue, but it raised the biggest red flag for me, in the past three years the company has had a total of five people in the CFO position, two actual CFO's, two interim CFOs, and one acting CFO.  

Here is a table breaking down the personnel changes:

I should also note that the company failed to file an 8-k on multiple occasions when a CFO or acting/interim CFO left.  

It's odd to me that none of the interim CFO's became full time, and the length of tenure is frightening.  I don't know many people who are hired at a company and feel that in five or six months they've made such an impact that they're ready to move on.  Usually people who move on quickly do so because they realize they are not a good fit at the company, or they feel they're unable to fulfill the role.  

There could be a perfectly valid reason for each CFO leaving, but in total there appears to be a pattern here that's concerning to a potential investor.

2) What is the purpose of the cash? - For any company that is cash rich there is always the possibility that management could squander the cash on failed acquisitions or just plain bungle things destroying shareholder value(MSFT...).  

In a response to the SEC the company states that "The “Acquisition Fund” is an amount of cash accumulated over years by the Company and intended to support its operations, as well as to be used in and when an appropriate acquisition becomes available." 

A response like this is concerning because my margin of safety is the fact that the company can liquidate and return cash in excess of my purchase price.  If the company is planning on using the cash to purchase another company my margin of safety could be destroyed by bad capital allocation.  This is a big risk, and while an acquisition hasn't happened yet it doesn't mean that it's impossible either.

3) Is Gencore an investment company? - In a few of the letters the questioning from the SEC revolves around the idea that Gencor should be classified as an investment company.  The company responds saying they have an engineering bent, and are focused on driving operations.  The SEC response is that while it's nice Gencor is focused on operations a potential investor isn't getting an engineering company they're actually purchasing an opaque securities portfolio.

What's interesting on this point is the SEC says they disagree with the company's classification and basically say they aren't going to argue the point further.  This is a potential risk, investment companies have much different and more stringent regulations than public companies.  Any sort of action by the SEC to classify Gencor as an investment company might force management to unload the marketable securities portfolio; a possibility is a dividend, or a terrible acquisition.  Based on the companies stated purpose for the cash I'd wager a shotgun acquisition is more likely.

4) Questionable receivables accounting - Each of the above items I was able to somewhat justify away but when I hit this item it killed the thesis and shed some light on a possible reason why the company has been through five CFO's recently.

The company claims in filings that "the majority of company sales require payments of cash before shipping" and then go on to claim that approximately 47% of accounts receivable are flagged as a doubtful accounts.  

So right now something should be clicking saying that if customers are required to pay in cash upfront how can 47% of receivables be in question?  I'm not exactly sure, and the company never fully explained it to the SEC's satisfaction either.  Either the majority didn't actually pay upfront in cash, or 100% of the non-majority hasn't paid at all.  Given that 47% is less than a majority I'm leaning towards the notion that most or all of the non-prepaid customer have paid a dime.

That brings us to the next issue which is the status on the doubtful accounts.  Gencor claims to extend credit to clients in the form of receivables financing.  What this means is that a customer can contract for a job and not pay until the job is done, or after the job is done and pay a small interest charge to Gencore.  For Gencore this is considered an account receivable, and as noted above most of those receivables financed are outstanding and according to the filing notes are 90 days past due.  The company states that they are slow to write down bad debts because they continue to hold out hope that the client will eventually pay.  And if they think the client will pay eventually it shouldn't be considered a bad debt.

The logic of this defies me, the company seems to believe the if a client hasn't paid in 180 days but claims the check is in the mail that the receivable is money good.  

Edit: I forgot to put this in the article originally but from the most recent annual report the auditors did not review internal controls whereas in the past they had.  Management was asked by the SEC to include a note to this effect and to certify according to management that the internal controls were sound.

I know there are more items lurking in the accounting, and a few of them are detailed here, here and here in the SEC letters.  But after hitting the four above items I decided to move on from Gencor.  I recognize the company is cheap but I think there are very good reasons for the cheapness, and I think the margin of safety is an illusion with Gencor.

I'm interested in hearing holes in my thinking or answers to the bear questions.  

Talk to Nate about Gencor

Disclosure: No position

Timber as an investment

I love the woods, I love walking in the woods, camping in the woods, and just being in the woods.  Often when I'm in the woods I consider timberland as an investment, I've been looking at timber on and off since probably 2006.  This past weekend was no exception, as I backpacked in Dolly Sods Wilderness with a friend of mine I started thinking about buying timberland again.

Timberland is an interesting vehicle for investment, as an asset class it has returns of about 7% a year and is an excellent inflation hedge.  In addition the land owner has optionality on when to sell, if prices are depressed they can avoid harvesting for a few years and wait for a rebound.  When the timber is harvested the sale is considered a long term capital gain (in the US) even if the land owner has owned the land for less than a year.  With all these factors timberland seems to be the perfect investment, put all your money in timberland, do a bit of hunting and camping on the land and retire rich.

The problem with that scenario is timberland is a very hard asset to own.  The problem is often tracts of land that support timber production are large and aren't easily broken apart.  Often pension plans and institutions will buy into a large timber tract and contract for harvesting.  There are a few REITs that own land, but none are actual pure plays on land.  This leave an investor with an option to either buy land directly which could cause some portfolio management (and time management) problems, or buy through some sort of exchange vehicle.

As I've mentioned earlier I've had my eye open on small plots of land in Pennsylvania, West Virginia, and southern NY for the past few years.  I haven't purchased yet for a few reasons, the first is the hands on nature of the investment.  I just don't have the time at this point to spend time prepping the land, planting, visiting to make sure everything is ok (i.e. no hunting, no atv trails, no dumping).  The second reason is the difficulty with finding the "right" plot.  If I buy too big of a plot my portfolio is out of balance, at this point I don't feel like I'm ready to bite off 40 acres of woods.  Yet I would need at least 10 acres before I could make any money.  The problem with small plots is they are usually viewed as a lot for building instead of raw land for timber.  This means that small plots carry prices in the $10k/acre price vs the $1200-1400 going price for timber acreage.  Paying anything more than $1400 makes it very difficult to turn a profit.  Finding a small plot for a cheap price is difficult, trust me, I've been looking for the past five years.  If anyone knows of a 10 acre plot in WV or PA for around $8500 or less, let me know!

So what does a piece of land actually look like?  Here is 44.8 acres of land in southern NY for $36k, which comes out to $850/acre; while this is a good deal (includes mineral rights) the problem is the size and maintenance.  For anyone with less than a $720k portfolio this piece of land would be a 5% or bigger position size.  Maintenance costs would probably be low, but a small continual cost, in addition if the owner doesn't live close there would be travel costs as well.

If you give a small tree 10-15 years to grow they can fetch about $500 for pulp, and mature trees (age 25-30 years) 4-5k an acre at current prices.  So at a purchase price of $36k, sitting for 25 years and selling the wood for $225k ends in a return of about 6.7%.  Factor in the ability to sell the land for probably close to the purchase price and we have a 7.2% gain over the life of the investment.  There is probably also a value to the mineral rights which I'm not including.  This is a great number for something completely uncorrelated with the markets.

The downside is an investor now has $36k tied up in Ripley NY, what happens if that plot gets hit by a tree disease, or has the soil go bad, or a multitude of other things?  This is a large concentrated risk, and an investor needs to hold for a long time 25-30 years to make a decent return, not something many people have the fortitude to do.

So what's the alternative to owning small plots directly?  I found two closed end timber funds that are about as pure play as possible, they both operate in the US but trade on the London Stock Exchange.  And as expected for something posted on this blog, both funds are trading at a discount to net asset value.

The table below breaks down each fund:

Buying at the current prices the investor is getting timberland cheaper by buying Phaunos.  The caveat with Phaunos is that some of the plots they are a minority holder whereas with Cambium they own the acreage outright.

Phaunos is a bit of a strange fund, the fund trades on the LSE in dollars which is something not all brokers can trade easily.

Owning timber in a fund is a bit different from a direct holding.  In a fund the managers are constantly working to manage the land holdings to ensure a return for shareholders.  In the direct scenario nature takes it's course and the return materializes as the trees grow and are eventually cut down.

One risk I haven't mentioned yet is the risk that these funds could be a fraud.  Recently there was a story of a Chinese timber company Sino-Forest which falsified the size of their land holdings.  This could be true with both closed end funds as well, and is most likely the reason for the discount to NCAV.  

I enjoyed reading the filings for both companies, but would prefer a direct holding of timber personally.  If the land is close enough I can enjoy it while waiting on investment to grow, something I can't do with a fund.

Talk to Nate about timber

Disclosure: No positions

PostNL spinoff opportunity in the parent

PostNL (PNL.Netherlands, TNTFF)

Price: €3.21 (10/13/11 intraday)

This company might sound familiar to readers, I discussed the divested division a few months back with a post on TNT Express.  Let me back up a minute, up until May of this year there was a Dutch company TNT which operated express shipping and local delivery of parcels and mail.  Mail delivery was in the Netherlands, parcel delivery in Germany, Italy, Netherlands and UK, and Express delivery worldwide.  At the end of May Express was spun out which PostNL retained a 30% stake.  PostNL is the non-express local mail/parcel delivery in the Netherlands.

The reason that TNT Express was spun off was that Express and PostNL had grown into two different businesses, one struggling with growth, the other decline.  The directors realized this and split the companies, as the company itself states Express is now a growth stock and PostNL a value stock.  PostNL has been hit by selling due to European fears, in addition they've been hit with selling as investors dump their shares in a seemingly dead or declining business.

I first want to look at the volume decline assumption that PostNL will experience such a precipitous drop in mail that they'll go bankrupt.  While this is possible I don't think it's probable.  PostNL expects mail volumes to drop in the mid single digits over the next three years, and in the low single digits five years out.  Coupled with the decline in mail volume they are estimating an increase in both parcels and international mail.  All of these numbers together volume estimates are running break even for the next three years, and slowly growing five years out.

It's important to note that the volume estimates are provided by the company itself, and naturally they are optimistic.  What's also important to realize is the estimates were made this summer when Europe was in the same financial uncertainty that they're currently in, which gives creedence to the fact that the volume estimates might be somewhat accurate or at least not wildly optimistic.

Value Proposition

The thesis for this investment is really very simple and I don't feel it needs to be broken down in a lot of excel files or charts.

TNT Express has a market cap of €2.808b and PostNL a market cap of €1.286b.  PostNL owns 29.9% of Express, so if we back out that value we are left with the market valuing the business of PostNL for €446m.  Let me break down how low of a valuation this is, PostNL earned €120m in net income in Q1 of this year on a 8% slide in post volume.  They had €84m in operating cash flow in the first quarter alone!  In Q2 they experienced a loss and operating cash flow for the half year was at €69m.  The loss in Q2 was due to a writedown in the value of the Express asset.  The company expects to have €170m in cash operating income at the year end, giving the company a 2.62x multiple of business to cash operating income.

In addition the company plans to pay out €150m a year in dividends which is currently a 11.6% dividend yield.  If we assume the yield is only on the PostNL business it's more like a 33% yield.

The Risks

So what are the risks?  There are a few, and I'll try to talk through each.

The first risk is that the Express holding will continue to be marked down impairing the profits of PostNL.  I think this is one of the bigger risks that has market participants wary.  A writedown will depress net income, but cash flow is unaffected.  In my analysis above I looked at what the value of Express is today, not the book value, so we've already accounted for any sort of writedown.  I don't think this aspect is that big of a deal.  Stand alone Express is already trading below book value, and looks cheap, I highly doubt the company is worthless.

The second risk is the decline in volumes I mentioned earlier.  This is truly the biggest risk for an equity investor, if volumes continue to slide 8% YoY eventually fixed cost will loom large and PostNL won't be able to service their debt and will become bankrupt.  The current view is that mail is dead or close to dead and this death will kill PostNL slowly as volumes drop.  While this is a valid view PostNL is working on growing parcel service in Germany, UK, and Italy and parcel volume is growing.  To counter act the mail volume dropping PostNL has been downsizing operations to pace with the volume decline.  As mail volume has been declining expenses related to mail volume has been declining as well.

The next risk is the pension, PostNL has a nice sized pension plan which will require €125m in contributions in 2011 alone.  The pension is currently 112% funded which isn't much of a concern, the concern is that the contribution amount can be viewed as a fixed debt payment.  PostNL needs to continue paying €125m each year or the pension will become unfunded and will be a liability in front of equity holders.

The last risk is the European risk, which is that somehow with Greek or Portuguese defaults people will stop buying from Amazon, stop receiving birthday cards in the mail, and life in general will completely stop.  I know I'm minimizing some, but defaults or not PostNL will continue to operate, and in this rough environment so far they've been executing at an acceptable level already.  I think this is a risk in the sense that no one knows the outcome, but at the same time this is the reason we're presented with such an investment opportunity.

Here is a link to the latest half year results which include the financial statements: HY and Q2 results

Talk to Nate about PostNL or TNT Express

Disclosure: Long TNT Express, considering a position in PostNL

Examining why Addvantage is cheap

ADDvantage (AEY)

Price: $2.26 (10/3/11)

After reading the bull case over at Whopper Investments blog the story seemed too good to be true, a company selling for less than NCAV and with excellent ROA/ROE.  Whopper doesn't discuss why the company is trading at a discount so I thought I'd take a stab at it myself.

The reason I'm doing this is because I believe most or all value investments have a problem, a big visible problem.  Value investing is determining that the visible problem doesn't matter as much as the market thinks it does, and can look beyond it.

Whopper has a great overview on the company and some financial details.  I will highlight a few points which are key to understanding the rest of this article.
-AEY trades at $2.26 against a NCAV of $2.57/sh
-The company buys and resells used router equipment and used cable tv equipment.
-They carry a large inventory of older or obsolete inventory as a value proposition to clients looking to replaced a failed device without needing to upgrade.
-The routers are sold without software, or the brain center of the router.
-AEY recently entered into a new reseller agreement with Cisco redefining the terms of their agreement.

So why is this company cheap?

Is is misunderstood? - This category has been my bread and butter of net-net situations, a company will have poor earnings but have a large slug of cash or marketable securities that the market is missing.  The market will focus on the earnings story missing the fact that the company is trading at a discount to liquid assets.  This isn't the case with AEY, they have a nice amount of cash and inventory but there are no hidden assets here.

Cable TV subscriptions declining - Call this the Hulu/Netflix effect, households are canceling cable and signing up for streaming services.  I know this is true in our house, we don't have cable, just Netflix.  I don't know how strong of an effect this will be in the long term, but it seems to be popular currently.

The real reasons

Sales have fallen off a cliff - As of the most recent quarter revenue was down 35% YoY and new equipment sales were down 41%.  In addition refurbished sales fell 23% in the most recent quarter.

It's difficult to understand or know exactly why revenue is down, management blames the drop on the weather, frozen capex at clients and the new partnership agreement.  I'm dubious of a management that blames poor router sales on the weather.  I don't know of any companies that postpone sales due to severe weather, it's actually the opposite.  If clients were in severe weather areas I would expect to see an increase in sales replacing damaged equipment.

The sales numbers are terrible in light of the fact that Cisco's sales have been increasing over the same period of time.  The conclusion I draw is that Cisco has the cream of the crop customers while AEY has some of the bottom rung customers who's wallets are still tight.  This leads into our next point..

Limited ability to sell to certain customers - As part of the new partner contract the company agreed with Cisco to not sell to certain customers.  The documents don't outline exactly who those customers are but from my experience the limitations are usually on bigger accounts.  So Cisco would service the Time Warners and Comscasts while Addvantage services smaller regional cable companies.

In addition to the limitation on certain customers Addvantage is also limited in their geographic range, the new agreement limits their ability to sell internationally.  I'm not sure how big of an impact this is but management called it out specifically in the notes mentioning that they had previously sold outside of the US and this would no longer be possible.

Change of business strategy resulting in higher costs - As part of the new partnership agreement Addvantage will no longer have to carry as big of an inventory which is a good thing, the side effect is equipment costs will be higher going forward.  The higher equipment cost will cut into margins and is a permanent change not something temporary that will reverse.  Like many of the other things the impact of this isn't broken out exactly.

Why buy Addvantage when you can buy Cisco?

As I looked into Addvantage it became very clear to me that the company lives and dies by Cisco, if something were to happen to Cisco I'm not sure they would be able to survive.  Secondly Addvantage is selling Cisco routers without any routing software which is the brain center of the device.  A router is nothing more than a collection of ethernet cards, the software determines efficient routing of data and the feature set available to a user.  Anyone can build a cheap router with an old Linux computer and some discount NIC cards, but the reason people pay Cisco so much money is for their IOS software that runs the router.   Customers purchasing from Addvantage still need to purchase IOS and license the software from Cisco before they have a working item.

In thinking about this I decided to put together a few stats of Addvantage side by side with Cisco:

Addvantage is clearly cheaper than Cisco, and this begs the question for me, would I rather own Cisco at a 25% discount or Addvantage at a 50% discount.  I'm not sure, and don't own either, but I'd love to hear thoughts either way.

Talk to Nate about Addvantage or Cisco

Disclosure: No positions

FormFactor selling for close to cash

FormFactor (FORM.Nasdaq)

Price: $6.45 (9/27/2011)

I was going through a list of net-nets by market cap and stumbled upon FormFactor, what intrigued me about FormFactor was that I noticed looking at the balance sheet that they're selling slightly more than cash value, something rare for an American company. 

What does FormFactor do?

Like many companies currently trading below net current asset value (NCAV) FormFactor is involved in the semiconductor business.  FormFactor designs and manufactures silicon wafer test probes.  The probes are used to test integrated circuits.  The company states that their technology moves wafer burn-in and sort upstream to increase chip yield.  I'm not exactly sure what that means in technical terms but in laymen terms FormFactor builds equipment that improves the chip manufacturing process.

Balance Sheet

The balance sheet is the highlight of FormFactor, they have $324m in cash and marketable securities against $44m in liabilities.  They also have $50m in receivables and inventory, my net-net worksheet is below which gives a great overview of the balance sheet position.

I show the Property Plant and Equipment account on the worksheet but don't include the value as a part of NCAV.

Profitable?

As with many net-net stocks FormFactor isn't profitable and claims to be in the midst of a turnaround plan.   FormFactor violates one of my rules for net-net investing which is that the company needs to be profitable or at least cash flow positive.  FormFactor has been losing money since 2008 and eating into their cash pile, although the cash burn as slowed down recently.

A company's plans for profitability usually consist of two factors, reduced expenses and increased margins.  Usually a good situation is one where a company only needs to focus on one factor to turn operations around, in the case of FormFactor they have problems with both factors.

Reading through a smattering of press releases it seems that management would want investors to believe a turnaround in profitability hinges on revenues, in which part it does, but that's not the whole story.  The company has a gross margin of 21% (most recent quarter) which is up being negative for most of the past two years.  The real problem though is expenses. In the latest quarter SG&A and R&D expenses were double the gross profit.

While costs have come down some since 2009 they haven't come down enough, the company is spending $10m a quarter on R&D.  To operate at break even the company would need to increase revenues by around 20% a quarter or about $40m a year to about $240m.  The company only achieved this revenue number twice in the last ten years in 2006 and 2007 the last two years they were profitable.

To get back to profitability the company either needs to double their gross margin, increase revenues to record levels or make deep cuts in expenses.  I'm not sure of the feasibility of any of these but until one or more is accomplished the company will continue to burn through their cash holdings.

I have attached an imagine of FormFactor's comon-sized income statement from Morningstar.  The graphic really highlights the problems with their margins and how out of control expenses are.

Summary

The issue for an investor considering FormFactor is they need to consider the probability of either revenue increasing rapidly, expenses being cut, or management slowly burning the cash pile trying to accomplish either item.  I don't really know what the most likely option is, but I do know from watching a lot of net-net's that most of the time management will see the cash pile as a bit too tempting and use a portion of it on an acquisition with the idea that an acquisition will turn things around.  Even with the great balance sheet the turnaround risk is real and there isn't enough of a margin of safety for me to invest in FormFactor.

Talk to Nate about FormFactor

Disclosure: No position

Comparing Railroads

Whenever I think of a business with a moat I think of a railroad as having the ultimate moat.  I can't imagine a new railroad trying to build tracks through an urban area today without a ton of NIMBY opposition.  In addition to the opposition there is the expense, where I live the public transit authority in the process of completing a two mile subway/light rail extension at the cost of close to $500m.

I was curious to see how different railroads compared so I put together this spreadsheet.  I realize that lumping large freight with small railroads with foreign passenger railroads is comparing apples to oranges but I don't really care.  I just wanted an overview of investable railroads.

(click on the picture for a bigger view)

The biggest thing that jumped out to me when putting this together is that the market often gets things right.  The better operated railroads trade at a higher multiple, whereas companies that have trouble earning their keep trade low.

Notes:
-Genesee & Wyoming isn't a single railroad, they run a number of short line railroads in the US and Australia.
-Guangshen has both freight and passenger service in China
-Both Florida East Coast and BNSF are privately held but continue to report.  Florida East Coast has publicly traded bonds.
-East Japan and West Japan Railroads should probably be compared as well.

I'm interested in knowing about publicly traded railroads worldwide to add to my comparison matrix, if you know of any I've missed please email me.  If there is any interest in the actual spreadsheet I'll make the Google Docs link public for download.

Talk to Nate about the railroad industry

Disclosure: No positions

Is Delta Galil a magic six stock cheap?

Delta Galil (DELT.Tel Aviv, DELTY.Pink Sheets)

Price: 18.20 NIS or $4.64 (9/22/11)

This is a post about another "magic six" stock, but based on some feedback from the post on Molins I want to take this post in a different direction.  In the previous post the issue was raised in the comments that it would be unusual to find a great company trading so cheap and there must be a reason for the cheapness.  This comment really honed in on the heart of the matter for these stocks.  We already know they are cheap, and a magic six isn't a net-net where I'm worried about the tangible book value.  The most important thing is knowing why the stock is cheap and if the reason for the low price are justified or not.  So instead of digging into the components of a magic six (P/E < 6, P/B < 60%, Div > 6%) I'm doing to look at the reasons why Delta Galil is trading at a low price.  A low prices doesn't always equal a cheap stock.

Delta Galil is a Israeli company that designs and manufactures intimate apparel for both men and women.  Based on their site I would say they tend to focus more on women's apparel.  The company sells most of their goods through major retailers worldwide such as, Marks and Spencer, Carrefour, Victoria's Secret, GAP, J Crew, Banana Republic, and JC Penny among others.  Clothes are sold both as private label and with their own brand.  The company is one of the largest undergarment manufacturers in the world, and the largest textile manufacturer in Israel.

As with all magic six stocks on a valuation basis the stock is very cheap, a P/E of 4.98, 53% of book value, and a dividend yield of 13% on a TTM basis.

Why is it cheap?

There are a lot of potential reasons for Delta Galil to be trading at a depressed valuation, I'm going to quickly go through each and discuss whether the issue is a driver for true undervaluation or an issue that doesn't really affect the business value.

Mideast violence - This is the first reason I think most western investors might take a flyer on Delta Galil, the company operates in a very volatile part of the world and the volatility has affected company operations in the past.  During the Arab Spring the company's factory in Egypt had to be shut down for a period of time due to unrest.  While this is a real risk I view it as a headline risk, the company is used to operating in the environment has has found a way to be successful.  I don't see why this would change going forward.  Side note, there is a great article in Businessweek about the Palestine Stock Exchange and how they are able to operate with constant disruptions.

Small cap, illiquid - This is a favorite reason for undervaluation, a neglected un-tradeable stock, and I have to admit I've used it as justification a few times myself.  Delta Galil has a $108m market cap and trades in an emerging market which means not a lot of visibility to foreign investors.  With that said the company operates globally and is part of the Tel Aviv market index.  As for illiquidity the US ADR shares are pretty illiquid, but the ordinary shares traded in Israel seem to have a decent amount of volume.

Family owned and controlled - The CEO owns 54% of the company which could scare off potential activist investors or investors who hope to push management for change.  I tend to prefer family held companies because I feel that my interests are aligned with the management.  My number one interest is safety of capital, which for most tightly held companies is a priority for them as well.  If a closely held company is a fantastic business the market will reflect that with a P/E higher than 5, I don't think this is a reason for the undervaluation.

I believe there are actually two very big reasons that the shares trade at such a low price.

The first is that the company doesn't have a very good track record of profitability.  The company has been profitable recently stating that they have had nine straight quarters of increasing profitability in a soft market.  It is good to see an upturn in business but investors might not believe the upturn is sustainable.  The company recorded a loss in both 2007 and 2008 on revenues similar to the current run rate.  In addition to this the US market segment has been operating at a loss for the year 2011, the company states they believe this will turn, but who knows.

The company is currently operating profitable the biggest component of their expenses was on a tear most of this year, the price of cotton.  The price has dropped recently but it is still above the long term "normal" price range.  Cotton accounts for 30-50% of the cost of goods sold.  In the past they have tried to adjust their product lines to accommodate higher cotton prices, but this introduces a fashion risk.  An apparel item that uses less cotton might not be as desirable to consumers.

The second major reason the shares are at a low price is that the company is very sensitive to currency fluctuations, both in USD and EUR.  I have included the two charts the company uses to show the potential impact of currency changes in USD and EUR:

The first thing to notice on this chart is that fair value is 1.425 EUR/USD, at today's mark the EUR/USD was 1.346 which puts the company in the 5% decrease category from the balance sheet presented.  This results in a loss of value on the cash and receivables mostly.

This second graphic shows the impact of the USD/NIS exchange rate on swap contracts the company holds to hedge their NIS debt in USD.  As of today the USD/NIS stood at 3.72 which is in the 5-10% increase range.  This will result in somewhere between a $3m and $5.8m loss if the exchange rate persists.  To put this in perspective in 2010 net income was $22m, which means the swap loss at this point is about a 20% hit to net income.

Are these real reasons?

Are any of the reasons I presented above legitimate reasons to avoid investing in Delta Galil?  I think any of them potentially could be but realistically the variability of the company's operating performance on the price of cotton and currency markets is enough for me to avoid an investment for now.

The reason I say this is that I have no idea if the price of cotton falling recently is due to macro-economic trends which could be temporary or if it's some sort of mean reverting change which would help the company going forward on a permanent basis.  What's clear is that Delta Galil doesn't have much if any pricing power which means they could get squeezed if cotton rises again and their buyers refuse to pay higher prices.  I should note that both of those things mentioned in the last sentence happened at the end of 2010, it's just at the moment they've reversed.

Contrary viewpoint

This post wouldn't be complete without the bullish viewpoint which I think I could probably sum up in a few bullets:
-The company is trading at a big discount to book value.
-The price of cotton has declined almost 50% in the past few months
-The company has restructured after the 2007/2008 losses and turned a profit in a tough economy
-Most of the profits are paid out as dividends giving a shareholder a cash return
-The company's bonds are trading very close to par or at par depending on the day meaning bondholders believe their investment is safe.

The bottom line

If Delta Galil was a net-net where all I was worried about was the quality of the balance sheet and a return to NCAV I would probably feel somewhat comfortable investing in the business.  But that isn't what this investment is about, this is about a low margin textile business that is trading at a low price due to very volatile and uncertain inputs to their business.  I think the price is probably too low, but I'm not sure what the exact level of discount should be given the risk factors.  So while Delta Galil is cheap I don't think it's safe, and there are many other safer cheap stocks available to pick from.

Talk to Nate about Delta Galil

Disclosure: No position