A version of this essay appeared in Oddball Stocks Newsletter Issue 26. Stay tuned for the upcoming Issue 27 in about a month.
In a finance Twitter discussion about investment theses that revolve around sum-of-the-parts (SOTP) valuations, one astute person pointed out a big problem with these SOTP ideas: the “sum” rarely subtracts the net present value of the corporate overhead.
We have been seeing this problem with a lot of Oddballs recently. For example, Pardee Resources is focused on (mis)-allocating capital to new investments to justify their high SG&A expense, rather than selling timberland at once a millenium high cash flow multiples, cutting SG&A, and buying back stock. The result won't be pretty. Pardee's SG&A expense, meanwhile, is almost $7 million. Is this a perpetuity paid to headquarters staff? What is the appropriate discount rate to capitalize it? Whatever variables you plug into the calculation, the NPV is an unfortunately high fraction of Pardee's asset value.
Or take Avalon Holdings, which we have written about in the Newsletter before. The market capitalization of $7.8 million is only 21% of the book value of $37 million. Avalon is cheap relative to book value, but its assets don't produce much in the way of earnings. The balance sheet shows $73.1 million of assets (of which $46.8 million is property and equipment) financed with $13 million of debt, $21 million of current liabilities, and then the shareholders (and non-controlling interests') equity. These assets only produced $51,000 of operating income (EBIT) for the first six months of 2019!
The pattern at Avalon is that the company has been acquiring properties (like the Boardman Tennis Center last year for $1.3 million) and putting them in a vehicle whose equity trades at 21 cents on the dollar (of book value) and where the cash produced is eaten up by SG&A expense.
In general, these companies at discounts to sum-of-the-parts values (but not cheap based on dividends or cash flows) are suffering from an incentive alignment problem. Managements could stop buying assets, sell overpriced (i.e. low earnings relative to purported asset value) ones to third-parties, and return capital to shareholders. But managements need to own assets to justify being paid. And managers with bigger empires get paid more. (See our post, Small Companies (like Small Banks) As "Jobs Programs".)
With valuations at all-time highs and interest rates at all-time lows, there has never been a better time to sell assets and probably never a worse time to buy them. In Issue 26 of the Oddball Stocks Newsletter, one of our guest writers pointed out reason for the problems at diversified holding companies run by "capital allocators". We are at a cyclical extreme in what people are willing to pay for income generating assets, which explains the dearth of attractive “opcos” for capital allocators to buy. That is ultimately why the book value of Enterprise Diversified dropped to $10.7 million from $19.4 million a year ago.
We continue to see Oddballs – whether land-heavy companies, small banks, or other kinds – that trade for prices below liquidation value if managements sold and yet above the present value, at a reasonable interest rate, of the distributions that shareholders will likely receive over time.
Another problem we see is that investors have abdicated from supervision of their hired managements. Frankly, they are too cheap to engage in “activism” (as shareholder supervision is now known) because they had good results in the past without having to exert control over their investments.
This too shall pass. In the next bear market, micro-cap funds established post-crisis that take too much risk, older investors, and over-leveraged companies themselves will be forced sellers of Oddball shares at much lower prices. That is when it will pay to have studied and read about these companies.
Looking for value in the overlooked margins of the market.
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Looking at the Hanover Foods Corporation Annual Results for 2019
Hanover Foods is a classic Oddball that has been written about on this blog a number of times over the years: the original posts (parts 1 and 2) back in 2012, and an update in 2013, among other mentions.
Over the past year and a half we've been writing about Hanover Foods Corporation (HNFSA/HNFSB) pretty frequently in the Oddball Stocks Newsletter. Will anything ever change there? Will value ever be realized? Both of its classes of stock have been in a slump and are back to where they were in 2011-2012. (Of course they have each been paying a small dividend of about $1.10 annually along the way.)
The annual report for the year ending June 2, 2019 just arrived in the mail. The market capitalization is now about $60 million, compared with net current assets of $127 million and common shareholders' equity of $229 million.
The common shareholders' equity is now $320 per share. This is up from the $250 per share when the idea was first written about on Oddball Stocks. Even ignoring goodwill and intangible assets the book value would be $309 per share - almost four times the price of the nonvoting A shares.
However one of our concerns has been that the Hanover business seems to be deteriorating. For this fiscal year, gross profit was $31.8 million, down from $40.8 million the prior year - a decrease of 22 percent. Operating profit dropped from $7 million to only $354,000.
Looking at the cash flow statement, the company had $17 million of depreciation and amortization over the two most recent fiscal years, but spent $25.3 million on purchases of property, plant, and equipment. That $8 million dollar difference was paid for essentially by liquidation of inventory over the most recent fiscal year.
Why was Hanover's profitability so poor? We know from the report that frozen and canned vegetable sales were up a little bit, but snack sales were down from $51.6 million to $44.6 million. Perhaps this segment was higher margin. It seems to consist of snacks like pretzels and cheese balls.
The annual report mentions that last June the company impaired the full amount of the goodwill associated with its snack foods reporting unit. Hanover also "ceased operating its direct store delivery business," resulting in an additional impairment of $2.1 million of intangible assets. These noncash charges drove up administrative expense and so are responsible for a fair bit of the year-over-year decline in profitability.
Hanover's business just seems to be in steady long-term decline. Between 2000 and 2004 sales were lower than today but gross margin was much higher, resulting in some decent profits. Hanover's market capitalization probably wouldn't be $60 million if it were still earning $10 million like it did in 2003 and 2004.
From 2000-2004, Hanover earned an average net income of almost $9 million: higher absolute profits on revenues that were only three-quarters of the current levels. One wonders how much of the declining profit margin is secular business decline and how much (if any) is coming from excessive insider compensation or expenses being run through the business.
On the plus side, since the market capitalization is only 26% of its shareholder equity, the low return on equity transforms into a shareholder earnings yield almost four times higher. (Of course there is the risk that the current, low profitability levels will deteriorate further or become losses...)
We have seen in the past that “one-day” good events can happen for shareholders of companies where the market price is too dislocated from asset values. And we have also seen low returns on equity turn into respectable IRRs for shareholders who buy in at very big discounts to book value. And one other thing worth mentioning – Hanover was probably the most hated Oddball at our Newsletter meetup this year. There was only one gentleman willing to raise his hand to say he had not given up on it!
We have written about Hanover in a number of recent Issues of the Newsletter (back Issues are here) and will continue to do so going forward.
Over the past year and a half we've been writing about Hanover Foods Corporation (HNFSA/HNFSB) pretty frequently in the Oddball Stocks Newsletter. Will anything ever change there? Will value ever be realized? Both of its classes of stock have been in a slump and are back to where they were in 2011-2012. (Of course they have each been paying a small dividend of about $1.10 annually along the way.)
The annual report for the year ending June 2, 2019 just arrived in the mail. The market capitalization is now about $60 million, compared with net current assets of $127 million and common shareholders' equity of $229 million.
The common shareholders' equity is now $320 per share. This is up from the $250 per share when the idea was first written about on Oddball Stocks. Even ignoring goodwill and intangible assets the book value would be $309 per share - almost four times the price of the nonvoting A shares.
However one of our concerns has been that the Hanover business seems to be deteriorating. For this fiscal year, gross profit was $31.8 million, down from $40.8 million the prior year - a decrease of 22 percent. Operating profit dropped from $7 million to only $354,000.
Looking at the cash flow statement, the company had $17 million of depreciation and amortization over the two most recent fiscal years, but spent $25.3 million on purchases of property, plant, and equipment. That $8 million dollar difference was paid for essentially by liquidation of inventory over the most recent fiscal year.
Why was Hanover's profitability so poor? We know from the report that frozen and canned vegetable sales were up a little bit, but snack sales were down from $51.6 million to $44.6 million. Perhaps this segment was higher margin. It seems to consist of snacks like pretzels and cheese balls.
The annual report mentions that last June the company impaired the full amount of the goodwill associated with its snack foods reporting unit. Hanover also "ceased operating its direct store delivery business," resulting in an additional impairment of $2.1 million of intangible assets. These noncash charges drove up administrative expense and so are responsible for a fair bit of the year-over-year decline in profitability.
Hanover's business just seems to be in steady long-term decline. Between 2000 and 2004 sales were lower than today but gross margin was much higher, resulting in some decent profits. Hanover's market capitalization probably wouldn't be $60 million if it were still earning $10 million like it did in 2003 and 2004.
From 2000-2004, Hanover earned an average net income of almost $9 million: higher absolute profits on revenues that were only three-quarters of the current levels. One wonders how much of the declining profit margin is secular business decline and how much (if any) is coming from excessive insider compensation or expenses being run through the business.
On the plus side, since the market capitalization is only 26% of its shareholder equity, the low return on equity transforms into a shareholder earnings yield almost four times higher. (Of course there is the risk that the current, low profitability levels will deteriorate further or become losses...)
We have seen in the past that “one-day” good events can happen for shareholders of companies where the market price is too dislocated from asset values. And we have also seen low returns on equity turn into respectable IRRs for shareholders who buy in at very big discounts to book value. And one other thing worth mentioning – Hanover was probably the most hated Oddball at our Newsletter meetup this year. There was only one gentleman willing to raise his hand to say he had not given up on it!
We have written about Hanover in a number of recent Issues of the Newsletter (back Issues are here) and will continue to do so going forward.