Webco: cheap, but is it safe?

My last post was on the topic of niches, so it's only appropriate that the company that's the subject of this post operates in a niche.  I actually didn't plan for this sequence of posts to happen, I was turning over rocks today and stumbled on Webco Industries (WEBC) selling at close to 50% of BV.  The discount to book value along caught my attention, and their history of significant past earnings encouraged me to continue researching them.

Webco Industries is a metal tube manufacturer.  The company really is that simple, they manufacture a variety of metal tubes to specifications for different industry applications.  One thing I spotted on their website is they are the only supplier of full line welded boiler tube in the United States.  Maybe this is a big deal, or maybe it's the equivalent of someone being the best athlete in a town of 200, I don't know enough about the industry to know the difference.

The company operates out of Oklahoma, but also has manufacturing locations in Pennsylvania and Illinois.  They have a market cap of $81m, and their shares trade for $103.  I like when companies have high share prices, it seems to discourage investor interest, a high share price often indicates a higher likelihood of an undervaluation.

Here is a spreadsheet I put together with the company's results over the past eight years:

Long time readers will probably notice that I usually don't post large spreadsheets on the blog.  If anyone's curious as to why I don't, it's often because I don't create them for many of my investments.  I know the stereotype for Graham investors is that we buy anything that's cheap, but that's not the case for myself.  I don't have an unlimited amount of capital, and I'd be killed by trading costs if I was trying to pick up everything trading for less than book value, I'd have a bunch of $4 positions scattered around my portfolio.  Rather I start by looking at cheap companies and then I become picky, a company needs to fit certain criteria before I'll invest in it.  If a company meets most of my criteria, but not all I will pass.  While I'm not a concentrated investor by any means, I also don't just swing wildly at any pitch that's coming somewhat near the strike zone.

When I buy a company I want them to be brain dead cheap, and an obvious slam dunk.  Many of the companies profiled on this blog fit that description.  Take for example Conduril, they were trading at 40% of NCAV, and at 2x earnings, after some investigation I determined a margin of safety existed and confirmed they were cheap.  With something like that I don't care what their results were five years ago, or what their ROE is, if they even start to revert to the mean at all my position will do well, which is incidentally what has happened.  Even more amazingly Conduril's results have been outstanding and even with the move up the company is still cheap.

How does this tie into Webco?  As I was reading their annual reports I didn't get an obvious cheap feeling about the company, instead I started to feel a desire to accumulate more and more data points with the hope that somehow the data would give me an answer as to whether I should invest.  In essence it did, because when I feel the need to accumulate more data it's a sign that I'm not looking at something obviously cheap, possibly only marginally cheap.

I discuss the exact reasons on why I passed on Webco below, but first I want to discuss a few positive aspects of the company.  The company clearly has a history of profitability, and at times tremendous profitability.  They have also shown the ability to turn their earnings into cash flow.  Over the past eight years operating cash flow has outpaced earnings by $10m.

The company's earning history is volatile, but when they are able to push through higher margin products at high volumes the company has significant operating leverage as seen by them earning anywhere from $18 to $31.98 a share in their good years.

And lastly the most attractive aspect of Webco is their valuation, they are trading at a 51% of book value, which is mostly equipment and inventory.  Second to this is their ability to compound book value at 8% a year, during very difficult economic conditions.

There are a number of issues that could potentially scuttle an investment in Webco, but I want to focus on the two that turned me away from them.  The first is their debt.  The company carries a significant debt load, yes they have ample earnings coverage, and yes they seem to operate just fine with it, but it could be a ticking time bomb.

What you don't see in my spreadsheet is the current/non-current breakdown of the company's debt each year.  The company doesn't have much long term debt, it's been steadily declining and was $12m at the end of their latest fiscal year.  This means the company has $78m in short term debt that is coming due this year.  If one looks at their financial statements through the years there isn't a significant capital expenditure use, the cash just appears to mysteriously vanish.  Of course it doesn't really, but where it goes is very unclear.  The bottom line is the company appears to roll forward a large amount of short term debt year to year, most likely on a line of credit.

Before you think I'm an idiot I want to discuss the second point, which is tightly tied to my first concern.  The company is very forthright in providing an income statement and balance sheet, yet they only provide three line items regarding their cash flow, operating cash flow, depreciation, and capex, nothing more.  The problem with this is that seeing the company's cash flow statement is vital to understanding how the other two financial statements work together.  I recognize that I could construct a cash flow statement from the balance sheet and income statement; I haven't spent the time.  I'm not sure it's necessary either, it's very strange to me that a company would intentionally neglect to provide information on the flow of cash in their business and at the same time provide abundant information on their balance sheet and income statement, including a lengthly writeup describing them.

The amount of short term debt, and the company's lack of a cash flow statement didn't put my fears over their debt to rest.  Instead it did the opposite, it fanned the flames and encouraged me to move on.  When the market is high and good ideas are hard to find the last thing I want to do is lower my standards and invest in marginal companies because there is nothing else out there.  Companies that look great, and appear safe at the top of the cycle can often lead to portfolio disasters in a downturn.

I'm glad I spent time investigating Webco, but this won't be a name that finds its way into my portfolio.

Disclosure: No position