When to sell a net-net

Of all the stocks I look at I tend to enjoy investing in net-net's the best, I enjoy them because they are usually simple to understand, and as a result it should be easy to know when to sell.  It's often said of investors that the buy decision is the easiest while the sell decision is the toughest, and I would agree.

The idea behind investing in net-nets is an investor has the ability to buy a company for less than working capital.  The idea is to buy the company for a discount to the asset value and wait until the market recognizes the undervaluation and sell when the stock reaches its asset value. 

I have a simple rule I try to use when selling:

1) Sell when the price of the issue is at or above NCAV

2) If operations improve evaluate the company on a cheapness basis compared to other cheap stocks in the portfolio.  If the operations are not cheap compared to existing holdings or potential holdings sell.

Why did I buy?

I think there are usually two reasons to buy a net-net; the first is that the assets are being undervalued, the second is the business is undervalued and the assets provide a downside.

It's very important to know the reason on why the stock was purchased.  If it was purely an asset purchase then evaluate selling on an asset basis.  For a stock purchased with the net-net value as a downside protection for a cheap business evaluate selling based on the cheapness of operations.

What if the business improves? 

I think the biggest impediment to selling a net-net for most investors is what to do if/when the business results begin to improve.  During the time spent waiting for the market to recognize the value of the cigar butt management works to turn operations around.  Eventually the company begins to post respectable earnings and solid free cash flow.  The stock begins to climb and the investor begins focusing on the earnings growth story instead of the asset value realization.

This scenario is where the second portion of my rule comes into effect.  If I find myself looking at the operations of the company verses the asset value I need to refine my focus.  I will evaluate the company on an operations basis alone and compare the cheapness and quality of operations against other holdings in my portfolio and potential holdings.  If the company doesn't meet my criteria for being cheap I need to sell the holding.

A few examples

Dainichi

I recently went through this exercise Dainichi which I highlighted on the blog here and here.  When I first posted the stock was trading at ¥632, I purchased it for around that price.  I recently noticed that the price was in the ¥800 range and above, it prompted me to take a look at Dainichi again.  When I purchased the stock I evaluated the NCAV to be ¥828.

So what did I do when I noticed the rise above my estimated NCAV?  I re-evaluated my thesis, I took a look at the updated filings for Dainichi to determine if there was any new information out that could materially change the thesis, and there actually was.  The company consumed a lot of its cash and receivables to build up inventory in the most recent period thus lowering the NCAV calculation.  To me this was a no brainer, the NCAV value had dropped and the price was above my target.  I ended up selling for ¥844 a share.  It was tough, the stock drifted higher eventually reaching ¥873, but I can't call the top exactly, my thesis had been met, it was time to sell.

SGI

SGI was one of the first net-net's I invested in a few years ago.  Before I discovered the joys of net-net investing I was more of a good company at a cheap price type of person (I still invest a lot of my money this way).  When I first took a look at their balance sheet I added and re-added the assets and subtracting the liabilities convinced I had made some sort of mistake, but I hadn't, the company was trading for less than working capital.

I purchased the stock around $5 a share and at the time the company had about $7 in working capital.  I held the stock for a while and eventually it started to rise quickly passing $7 a share.  The results of the business were pretty poor and I didn't understand why the stock jumped so I sold.  At times I kicked myself because the stock ran up to $12 about three months after I sold, and eventually hit $22 a year and a half after my sale.  But I had no confidence in the SGI business, I was purely buying assets cheap and I kept my discipline by selling when the asset value was realized.

George Risk

I wrote about George Risk here, this was a net-net stock that I purchased below NCAV but I liked the operating value of the business.  I guess you could say I purchased George Risk on an operating basis with the NCAV as downside protection.  I knew this when I purchased, and worked up my valuation based on what the business should be valued at from an operating stand point.  I still hold George Risk even as has traded above NCAV, I consider the stock to still be cheap.

PC Connection

This is another stock I profiled on the blog, my first post actually.  I bought PC Connection on the same basis as George Risk, that the business was cheap and the NCAV provided downside protection.  I purchased PC Connection for $6.91 last September and it's currently trading at $8.91 well above NCAV, but on a operating basis still cheap.

Final Thoughts

One thing I haven't mentioned at all in this post is tax considerations, I didn't mention it because I don't consider them as much as others.  In the case of Dainichi I held the stock for about three months resulting in a short term gain.  The reason I don't focus on taxes is because tax considerations can muddle an investment thesis.  If I had held Dainichi for the long term gain I would have been holding a stock that was trading well above a diminished NCAV.  I would also be holding on a speculative basis to avoid a possible tax hit, it's not worth it in my opinion.

Talk to Nate about selling net-net stocks

Disclosure: Long George Risk, PC Connection

Is Flexsteel actually a cheap stock?

Flexsteel (FLXS)

Price: $14.84 (8/28/2011)

This is a company that I saw mentioned in a Globe and Mail article about value investors snapping up shares of cheap companies.  Flexsteel was mentioned towards the bottom of the article as a company selling for less than working capital without any debt, in otherwords to most investors an insanely cheap company.

I decided to take a look at Flexsteel again, I had previously looked at them and passed on investing about eight to ten months ago.

The company is identified in the article as selling for less than working capital.  In a raw sense that is true, current assets are $128m and current liabilities are $27m resulting in $101m in working capital against a market cap of $98m.  I prefer to look at the net-net value of a company with a little stricter lens, for Flexsteel this means ignoring the deferred income tax (which couldn't be used in a liquidation) and factoring in liabilities such as operating leases.  Here is the net-net worksheet I have for Flexsteel:

As you can see the company's net-net value is a bit lower than the current share price, at $12.36 verses $14.64 for the latest close.  But either way it's close enough to be valuable, I would consider the net-net value or the discounted net-net value to be the downside for this stock. 

What is Flexsteel?

When I first saw the name Flexsteel in a screener list my first thought was that this is some sort of steel products company, or a business related to the steel industry...I was wrong.  Flexsteel is a furniture manufacturer that makes home furniture, RV furniture, and hospitality furniture.  Home and RV furniture accounted for 76% of sales in 2011, the commercial (hospitality) segmented accounted for 24% of revenue.

The company sells residential furniture through local furniture dealers.  I entered my zipcode and 13 dealers came up within close driving distance, so the furniture appears to be widely available.  In addition they offer a large selection of furniture, their website has a lot of pictures and configuration options.

Operating Aspects

Flexsteel isn't selling for below my calculation of liquidation value, but that isn't terrible considering the company is profitable and has been improving their operations.  I will list some operating stats below, but one aspect I want to point out is the following.  In the year 2007 the company's revenue peaked and resulted in $9m in net income which was produced by 2290 employees.  This past year the company earned a net profit of $10m on a lower revenue amount with 1300 employees.  This says two things to me, the first is that the fat has been cut, and the second is that margins are unlikely to expand going forward.

Margins

     -22% gross

     -4.67% operating

     -3.07% net margin

ROIC - 9.7%

ROA - 6.4%

ROE - 8.46%

Additional Aspects

One thing I found very fascinating and odd is that Flexsteel has $12m in current assets labeled as "Other Assets".  In the notes Other Assets is defined as a deferred compensation plan for executives that is invested in something called a Rabbi Trust.  The Rabbi Trust is a fund that invests in stocks and bonds.  The trust can't be used for general corporate purposes only for compensation, and in the even of a credit event the trust is considered a creditor to the company.  Deferred compensation plans are nothing new, but currently 12% of the current market cap is tagged as compensation for execs, eyebrow raising at the least.

The company pays a dividend of $.30/sh an increase from $.20/share the previous year.  It appears the company first started paying a dividend in 1992 and has paid it continuously until the depths of the financial crisis when it was suspended.  The dividend is currently a reasonable 20% payout ratio, and management seems inclined to continue increasing it.

As for valuation the shares are reasonably cheap, but not extremely cheap.  The company is trading at a EV/EBIT of 5 and an EV/FCF of 7.14.  While those are decent metrics I feel there are much cheaper companies available with the same or better downside protection.

Summary

I'm glad I took a look at Flexsteel again, this is a company I would consider purchasing if it falls below NCAV again, but at the current price the business doesn't seem cheap enough to excite me.  When considering the entire investing universe Flexsteel appears cheap, but considering the deep value, and small cap universe Flexsteel just appears to be slightly cheap.

Talk to Nate about Flexsteel

Disclosure: No position in Flexsteel

Another undervalued asset manager

Charlemagne Capital (CCAP.UK, CNLMF.PK)

Price: 16p (8/22/11)

In the theme of undervalued asset managers I wanted to talk about Charlemagne Capital, a UK asset manager.  The company manages a variety of emerging market focused funds including mutual funds, hedge funds, pooled accounts, and institutional funds.  The company is listed on the AIM, trades in GBP but lists its accounts in USD.  This idea was presented to me by a blog reader in the comments of my previous post on Argo group.

Charlemagne runs the following products/funds:

• Magna Mutual Funds
• Magna Africa Fund
• Magna Eastern European Fund
• Magna Emerging Markets Dividend Fund
• Magna Global Emerging Markets Fund
• Magna Latin American Fund
• Magna MENA Fund
• Magna New Frontiers Fund
• Magna Russia Fund
• Magna Turkey Fund
• Magna Undervalued Assets Fund
• OCCO Eastern Europe Hedge Fund
• Charlemagne Emerging Markets Pooled Fund for institutions
• Closed End Funds
• Charlemagne New Frontiers Fund
• European Convergence Development Company
• European Convergence Property Company

The company sells its products to investors in Europe, the mutual funds are listed for sale in the following countries: Austria, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Singapore, Sweden, Switzerland and the UK.

I had trouble getting specific fund performance from the company because a login is required to view performance stats.  I attempted to register but have a feeling it was rejected because I put "USA" in my address.  What I did find was impressive, the OCCO hedge fund has returned 83% verses a 10% index return over the past five years.

As of June 2011 Charlemagne Capital had an AUM of $3.29b. A breakdown of AUM across products is show below.

Valuing Charlemagne Capital

The first step I took was to plug in the numbers from the 2010 annual report into my net-net worksheet.  Charlemagne Capital isn't trading at a discount to NCAV but I like the worksheet because it gives a nice picture of the absolute downside risk as well as a good overview of the capital structure.  Here is the worksheet:

The first thing I noticed is that 35% of the company's market cap is held in cash and securities.  The second aspect is that the only other aspect of NCAV is receivables, being an asset manager there is no inventory.  This is good, cash and receivables are most likely to be liquidated at full value.

Asset managers are valued as a percentage of AUM plus cash and investments, I discussed this in a previous post about Argo Group.  Here is an expanded spreadsheet showing some comparisons to other asset managers.  All values below are in USD.

Charlemagne is clearly trading at a very cheap multiple, 2.24% of AUM, the cheapest of managers in the comparison set.  I put together a small spreadsheet showing a range of valuations for Charlemagne:

I get a downside of 6p which I consider unlikely considering the company is profitable and an upside ranging from 20p to 42p.  Even valuing the company at 2% of AUM plus cash and investments gives a 25% upside.  I have the top value of my range at 5% which is still a bit on the low side, but I think a realistic value.

In addition to the cheap valuation I think there are some other things going for the company:

• -Directors own 33% of the company
• -AUM has slide 5% since January but is up 20% YoY
• -Management fees up 16%
• -Just raised $120m for the hedge fund

Summary

I think Charlemagne Capital has the potential to be a very good investment, the company is clearly undervalued compared to other asset managers.  In addition they are profitable and earning performance fees from the funds they manage.  At the current valuation emerging market assets don't even need to grow for an investor to realize value in Charlemagne capital.  Charlemagne Capital provides emerging market exposure indirectly to an investor which could be a good diversifier.

In addition to the valuation tail winds the directors own 33% of the company and management is actively fund raising and promoting the funds.

Talk to Nate about Charlemagne Capital

Disclosure: No position

A way to play the UK housing recover? MJ Gleeson

MJ Gleeson (GLE.UK)

Price: 100.25p (8/18/11)

This is a post for a contrarian, I'm going to highlight a company that most people would rather not invest with a company in the UK housing sector, MJ Gleeson.  The company has two divisions, a renovation division and a land division.

The renovation division takes brownfield areas and redevelops them into residential subdivisions.  I was a little surprised at the difference between a British subdivision and an American one, the homes were nice modest brick homes near city centers.  Contrast this to McMansions on the outskirts of cities, but I digress.  The company has a few programs to help buyers design and purchase their dream home.  MJ Gleeson appears to be the note holder of certain buyers as well.

The land division seems to be more of a land banking operation.  MJ Gleeson buys options on pieces of land and then improves the plots with the hope of making resale easier. The company prefers to buy land without the correct zoning and work to develop a master vision for parcels. 

Value Proposition

The company is a net-net ignoring the value of their land, they are also profitable (barely) and cash flow positive.  The following is the net-net worksheet:

With the price at 103p the shares have a 50% upside to NCAV from here.  Before discussing where value might exist with MJ Gleeson I want to take a look at a few operating notes:

• The home renovation division contributed 83% of the revenue but actually operated at a loss.
• The land bank division is 17% of revenue but accounts for all of the group's profits.
• The land bank group has a 47% net margin.
• The company sold one piece of land in 2010 verses two pieces in 2009.

So where is the value? The main investment thesis is that eventually the UK housing market will turn around making the renovation division profitable, in addition to increased land sales.  The problem is there is no idea on when the timing might be for a turn around.  MJ Gleeson has touted that sales in the renovation group are up but the profit hasn't come alongside it yet. 

The good news is that there is a margin of safety, the company is trading for less than the value of its cash, inventory and receivables.  This estimate of value doesn't take into account any consideration for the loans it holds, or the profitable joint venture interest.  So an investor who wants to bet on a UK recovery can buy MJ Gleeson at a significant discount and wait things out.  The company has been limping along and is cash flow positive meaning that there is a good chance the margin of safety won't become impaired.  The other good news is that once the market ticks upwards there is a good amount of operating leverage built into the business which could give a great boost to earnings. 

Concerns

Although this seems like a decent investment I have my reservations.  The first is that it is often hard to realize land value, while the land might be appraised at a certain value it's almost impossible to liquidate quickly and get anything close to book value.

The second concern is of profitability, the company's current period profits come from the interest in a join venture, and in the past in the height of the bubble the company's earnings were very lumpy as well.  I appreciate the discount MJ Gleeson is trading at, but I would need a silly cheap price to entice me to buy in.

Talk to Nate about MJ Gleeson

More Information:
MJ Gleeson Website
Financials

Disclosure: No position in MJ Gleeson.

Argo Group Revisited

Argo Group (ARGO.UK)

Price 15.25p (8/15/2011)

I wrote a post about Argo Group here and it garnered a lot of attention, a lot more attention than I expected at the time.  There was some great information captured in the comments regarding some valuation methods that I wanted to discuss, secondly I wanted to talk about some new developments in the troubled Argo Real Estate Opportunities Fund.

Argo Group previous post link

Valuation

One of my readers Wexboy posted a comment

btw my valuation approach to asset management companies is to generally value them at Cash & Investments plus X% of Assets under Management. If you look at asset manager purchases, this X% approach is far more relevant than evaluating revenues, operating margins, eps etc. (although in most cases these can be used to support the valuation anyway) - this makes perfect sense, as the economics of any fund management business can often be changed radically/quickly after a purchase, i.e. a small fund management business that is breaking even, can quickly achieve the same operating margins as the rest of the purchaser's business, for a number of reasons but mostly, to be blunt, by firing people

I have been thinking about this a lot and it's a great way to model out asset managers.  This view was further confirmed later in the comments along with a quote referencing the same framework in Barrons a week or two ago.  I went back and put together a small spreadsheet showing different asset managers and the percentage they're currently trading at after learning about this valuation method.

The comparison is interesting, the spread goes from around 3.80% for Fortress up to 14% for Och Ziff.

One really interesting data point is RAB Group who's trading at 9.28% of AUM.  What's interesting about RAB is that they've been hemorrhaging assets, they've lost 50% of AUM this year alone, and they're down 93% since 2007.  RAB is facing a delisting from the AIM and yet still trades at double the percentage that Argo trades at.  RAB also is trading at a discount to NCAV but I would make the argument that Argo is probably a much better investment considering AUM is stable.

The commenter also suggested the best way to value a company such as Argo is cash + investments + % of AUM.  Using the current trading metric for Argo I get the following value:

$44.9m + $18.4m = $63.6m or £38.66 which equals .55p per share

While this amount seems a bit on the high side I think it's interesting that management granted options that exercise at 24p/sh.  What I like about the 24p/sh is that this is the same value as NCAV per share which I think is realistic, a company shouldn't trade for less than NCAV.  While I'd be happy with 55p/sh I will also take 24p/sh as well.

Real Estate Developments

I noticed a RNS for Argo mentioning a share offering for the Argo Real Estate fund.  To give some background the Real Estate fund purchased some shopping centers in Eastern Europe (Romania, Ukraine, Moldova) at inflated prices and now that real estate has crashed the fund is experiencing some problems.  Argo is the manager of the Real Estate Opportunities Fund.

The problems are really two fold, the first is that asset values are down which has been impairing the NCAV of the fund and preventing the high water mark from being hit.  The second is that the tenants have been asking for rental concessions (and Argo is granting them) which is putting a crimp on the operating income of the fund.

The management of the fund believes that the NCAV has bottomed, and that the real estate market has hit bottom in Eastern Europe as well which is good.  The hope is that they can dig out of the hole they're in.  Looking at the past interim statement for the fund they are slightly cash flow positive.

So why all the background?  Management released a circular (proxy?) stating a few things:

• A secondary offering doubling the size of share capital
• The purchase of two shopping centers in Romania
• The revision of the Real Estate fund highwater mark downward to .15/share (current NAV is .12/sh).  This makes it more reasonable that management will be able to get the performance earn-outs in the next few years.
• A proposal to extend the life of the fund five more years.

In addition the circular also includes some details with regards to the working capital constraints the real estate fund expects to hit in June 2012.  The notes indicate that Argo has provided a letter of credit which they hope to be sufficient to get £4m in borrowings, and if that doesn't pan out Argo themselves will lend the £4m.  While this isn't ideal it also doesn't seem like an endgame scenario for Argo.

My take is that the Real Estate fund management is hoping that the market will turn enough that they'll be able to work out their financing problems by possibly an asset sale.

Hopefully the two items in this post are helpful to a prospective Argo shareholder. 

Talk to Nate about Argo Group

Disclosure: I ended up purchasing a small position after my previous post.  I haven't decided on if I want to increase my position yet, I'm still digesting some of the circular notes.

Treasury Wine Estates an attractive spin-off

Treasury Wine Estates (TWE:AU, TSRYY.OTC)

Price (A$3.16, $2.90) - note that you can buy the ADR for less than the AU share

Treasury Wine Estates is an Australian wine producer with wineries worldwide, the company was spun out of Fosters Group back in May.  The good news for a potential investor is sampling the product could be a worthwhile undertaking, invite some friends over and "research" the Treasury brands.

Company Background

Treasury owns 54 brands spread across three continents.  Prominent brands include, Beringer, Lindemans, and Penfolds among many others.  The company has annual sales of A$1.9b a year, the biggest markets are Americas, ANZ, Europe and Asia.  Asia is the fastest growing market for Treasury.  The company produced 35.6 million cases of wine in 2010.

I'm not going to re-hash the entire prospectus, if you're interested in reading more about the company here is the spin-off filing.

Reason for Spin-off

Fosters stated that the reason for the spin-off was that each company would be able to focus on the individual products (beer/wine) with greater intensity.  While that might be true I think there were other drivers at play.

The first driver was that Fosters spend around AU$8 billion to build out the Treasury portfolio.  The portfolio didn't exactly play out as Fosters expected and they ended up writing down a large portion of their investment.  The problem was that as Fosters was building out a wine portfolio other companies were doing something similar, the end result is a large glut of capacity at Australian wineries.

The second driver is a bit more interesting, Fosters received an unsolicited bid for Treasury at a price between A$2.3b and A$2.7b which Fosters turned down as too low.  Fosters has also been the subject of a takeover bid from SABMiller as well.  It seems that management broke the companies apart with the idea that each company as a pureplay would be a much simpler takeover target.  This is good news for an investor, the catalyst is built in.

Investment Catalyst

There are a few catalysts as I see them for investment into Treasury.  The first is that the company is a spin-off and management is motivated to improve operations which is a similar thesis to all spin-offs.

The second is that the company is trading below book value, currently the shares trade around 25% lower than book value.  Book value should be pretty accurate considering Fosters took a lot of write downs pre spin-off.

The biggest catalyst is that the company is a takeover target, this was part of the motivation for the spin-off and it appears there is a potential buyer in the wings.  Rumors started to float about a month ago that Chinese Brighthouse Foods was considering a bid for Treasury.  As of this post nothing has materialized but Brighthouse is in the market.  There have been some other market rumors that a few private equity groups are interested in acquiring Treasury as well.  I think with the recent decline a sizable bid is even more likely.

The last catalyst is that the strong AUD has been a bid of a headwind for Treasury.  They produce and sell a lot of wine in the US and EMEA and then bring the currency home to Australia.  In doing so they've been able to buy less and less Australian dollars which hits the bottom line negatively.  While the company is profitable a weaker AUD will have a large impact on profit for Treasury.

I should also point out that often an investor is able to buy the ADR shares for less than the AU shares.  I ended up purchasing the ADRs myself after noticing this.  For a while the ADRs were selling for almost 15% less than the AU shares, but the spread really depends on the day. If an investor doesn't buy into the Treasury story they could still make money buying the ADRs and converting them to AU shares and making the spread.

Risks


-The biggest risk is that there is overcapacity in the wine market currently.  While this is currently an issue the company is still profitable and should be able to weather the storm.
-If the AUD strengthens the impact could result in losses for Treasury Wine Estates.
-The buyout thesis could fail to materialize, although I'm happy to own the company stand alone.

Resources

This is a great article about Treasury from Bloomberg
Company Website

Talk to Nate about Treasury Wine Estates

Disclosure: Long Treasury Wine Estates

National Presto a Ben Graham NCAV stock is cheap again

National Presto (NPK)

Price: $87.01 (8/8/2011)

This is an idea that I read about in Barrons, the company seemed my speed, industrial, conglomerate and cheap.  I apologize for the lack of depth in this post, I want to jot down a few thoughts on a few different stocks this week as I'm looking to deploy cash.  I'm not sure how long prices will remain depressed, and I know there will always net-nets laying around but better stocks tend to appear and then disappear quickly during panics.  If I can get a quality business on the cheap I'd much prefer that to a net-net.

National Presto is a diversified manufacturer located in Eau Claire WI.  The company has three divisions: Housewares/Small Appliances, Defense Products, and Absorbents.  Housewares and Small Appliances are things like pressure cookers, skillets, and coffee makers.  The Defense Products division manufactures ammunition which it sells to the DOD.  The Absorbents division manufactures private label adult diapers.

National Presto has some allure with value investors, the company was mentioned in the Intelligent Investor as a NCAV stock with great ratios.  National Presto again traded below NCAV back in 2001 following the dot-com bust.  It seems an investor could buy close to NCAV in 2009 but not below.  We're far off from that now, but I think the stock is still compelling.

Quick Investment Thesis
-EV/EBIT 5.12 TTM
-P/E ex-cash of 7.65
-$15.20 cash and securities per share
-No debt
-A declared $1/sh dividend, management has typically declared a special dividend paying out almost 100 % of earnings.  This past year they paid out $8.14 vs $8.99 in earnings per share, a 90% payout ratio.
-17% ROA, 20% ROE
-ROIC of 14%
-There is a $329m order backlog for the defense segment, this is orders that have been received where revenue can't be recognized yet.
-There are still two wars (along with Libya) and soldiers who need bullets.
-There is a longer term demographic trend of aging baby boomers of which a small percentage will need adult diapers.  As the proportion of the population grows in age this should be an expanding market.

Risks
-TTM cash conversion of 67%
-The most recent quarter saw a 25% decrease in defense sales although attributed to timing it's still concerning.
-National Presto is spending $30m to upgrade the absorbent machinery.  This segment has one customer which accounts for 12% of consolidated sales.  The customer is building out their own facility which can make similar products, they have told National Presto they expect to continue purchasing from them, but this is a concern.
-The product mix is eclectic and can be viewed as a diversifier, at the same time if the US is heading into a recession there could be reduced demand for small appliances as well as reduced defense spending.
-30% of revenue is derived from consumer spending, appliances aren't necessary purchases.
-Wal-Mart accounts for 11% of National Presto's sales.

Final Thoughts
-I like National Presto, they have been growing sales, cash flow and net income steadily for the last decade.
-The company seems cheap on a multiples basis, with a rough DDM I get $114 a share.
-I don't like that absorbents is capital intensive and only became profitable in 2009, there isn't a lot of great history there.  While things seem great now if there is a bump in the road I worry about this segment sucking up cash.
-If we continue to see a downdraft in oil prices that would boost the bottom line of absorbents.  Steel pricing and aluminum pricing affect the houseware and defense segments.
-NCAV is $39 a share, book value is right around $40 a share as well.

Disclosure: I am looking to build a position near this price or at a lower price.

George Risk, ignored yet very cheap

George Risk Industries (RSKIA.OTC)

Price $6.40 (8/2/2011)

George Risk (GRI) is a holding I've had for a while that I originally picked up as a net-net and have continued to hold as the business has recovered.  This probably won't be a very long post because GRI is a very simple company.

The company was founded in 1967 and is located in Kimball Nebraska they are what I would consider a public private company.  I say this because Ken Risk the CEO owns 58% of the company and runs things like a small town operation.  The company is small, with a market cap of $32M, here is their facility in Kimball.  The company makes small electronic switches and sensors, additionally they also make pool safety sensors.

The company states that 88% of their revenues are from the security alarm segment.  The security segment has over 4,000 customers of which 42% are sold to through one distributor.  This is one of the biggest risks I see for the company, the loss of the distributor.  The company states that they feel safe with the distributor because they have had a good working relationship for years.  While this sort of thing might fly out in Kimball NE it doesn't exactly give me a warm fuzzy feeling.  The good news is GRI and the distributor have a 3 year agreement in place outlining purchasing terms, prices, product delivery schedules and terms for termination.  This agreement is found in the SEC filings here.

Value Proposition

As I mentioned earlier I originally purchase GRI at a discount to NCAV, the net-net worksheet is below:

The big items to note is the large amount of cash, and the $19m securities portfolio which is a net $4.72 per share or 73.8% of the current market value.

A serious look at GRI also merits examining the investment portfolio.  Management states in the filing that they view the securities portfolio as a way to put money to work that can't be used in the business, and provide a boost to earnings in down markets such as 2010.  In the 10-K GRI shows the breakdown as follows:

Municipal bonds          $ 9,426,000
Corporate bonds          $    84,000
Equity securities        $ 8,576,000
Money Markets and CDs    $ 1,426,000
Total                    $19,512,000

The portfolio is managed by an advisor.  The equity holdings are split across the following types of mutual funds, growth, growth and income, and foreign stocks.  I'd love to know where exactly the money is invested as the equity portion has stayed between flat and a slight loss since 2009 which is a bit surprising.

With a company trading with a large amount of cash and close to NCAV the presumption would be that the business is in the dumps with little hope of recovering, in actuality the opposite is true.

Operations

Here are a few quick stats when looking at GRI's profitability:
-EV/EBIT of 4.47
-EV/FCF 4.22
-47% gross margin, 19.9% operating margin, 22.8% net margin.
-ROIC of 39%, this is incredible but keep in mind the company can't continue to invest at this rate which is why they've built up a stash of securities and the fixed plant has remained stable.

GRI earned $.40 per share in 2011 (April 2010 -April 2011) verses $.30 a share in 2010.  Part of net income is derived from dividend and investment income.

The business took a hit when the housing market crashed but has recovered nicely.

Valuation

I think the simplest way to value George Risk is a simple cash plus earnings power.

Upside
$4.72 + $.40 x P/E of 10 = $8.72
$4.72 + $.40 x P/E of 15 = $10.72

Downside
NCAV of $5.40
Net cash of $4.72

Risks
-As stated above GRI has a distributor who accounts for 42% of sales, losing this distributor would impair the business.
-Ken Risk the CEO owns properties which the company leases from him.  In addition the company leases a small plane from Ken.  While the amounts are small and everything seems above board it reinforces the impression that management is running the company as a family operation.
-The stock is illiquid, it goes days without trading.
-The marketable securities could be mismanaged destroying a valuable portion of the NCAV.

Disclosure: Long George Risk