Tag Archives: LGL

Finding the right Net-Net

I would assume that the majority of the followers of this blog understand what a net-net is and why investing in them is supposed to generate superior returns. The theory is easy to understand, at least the way I interpreted it anyway. Buy something no one else wants (based on a discount to some sort of liquidation value) and wait patiently for “something good” to happen to sell your shares into. Risk is low as valuation is already so depressed, that all the “bad news” is supposed to be factored in.

I have not had great luck with net-nets. Maybe it’s because I try to take a look under the hood rather than just mechanically buy shares based on valuation. I am going to profile a few net-nets I have held. It should be noted that it may be too early to call each example a winner or loser, but all of them have tested my ability to remove emotions from investing. The real test with any net-net is likely patience, as they tend to be dinky little businesses with no real competitive position. As the market grinds higher, you have the sense that you are missing out and hold an illiquid little company that no one really cares about. It’s certainly not sexy.

To be clear, I have nothing against net-net investing as I continue to hold shares in companies that trade at a discount to NCAV. I am just stating some of my experiences.

ADDvantage Technologies Group, Inc. (AEY)

I bought AEY way back in Q2 & Q3 2011. I sold over 6(ish) months in 2012. Average performance was a loss of 16%. To be fair I bought mostly at NCAV, not at a discount to NCAV (which is what Graham was doing and is recommended). A quick summary of the stock at the time:

  • about 50% of assets were in inventory
  • major debate as to true value of inventory as they carried quite a bit and sales were weak
  • heavy insider ownership
  • working towards a net cash position (cash – debt)
  • end users (major cable companies) were hesitant to engage in major projects
  • recent change in agreement with Cisco was likely negative and creating uncertainty
  • Family owned and controlled, though compensation was reasonably fair and insiders where incentivized to realize larger profits

All of these factors led to a stock at NCAV. FWIW management seemed to “get it” for the most part as far as executing a business potentially in decline and one that definitely that had a ton of uncertainty in front of it.  They made a small acquisition to push some slow moving product through, they mentioned not chasing revenue but profit, and paying down debt. What they didn’t get (as is true with most net-nets) is capital allocation. No desire to buy back shares below NCAV, no special dividend, no marketing of the story to increase valuation.

After a few painful conference calls, I decided to sell. I have moved on and haven’t really looked back until today. I was sure that the top line wasn’t going to move anytime soon and figured the inventory would eventually be written off, which would remove my margin of safety. The inventory has not been written down since I let go of the shares, but the top line has struggled.

Here is what it would have looked like had I held onto the shares since my original purchase or if I had bought (and held onto) an ETF that tracks the S&P500.

AEY_vs._SPY

LGL Group (LGL)

I still own a small position in LGL Group. As with AEY, I bought most of my shares at NCAV, not at a discount to NCAV. This sums up the stock at the time of my original purshase (Q3 2012):

  • discount to NCAV
  • stable backlog, dropping top line
  • major markets for products were soft
  • 30% of total assets in cash
  • 13-15% of total assets in accounts receivable
  • 18-20% of total assets in inventory
  • some PP&E on the books that may hide additional value
  • significant owners of the stock that may pressure for management action
  • CEO that owned very little of the company

Since purchasing there were some positives to show that management was willing to right size the organization to survive. A reorganization was done to reduce costs, a strategic review was conducted, and moderately stable gross margins.

The issue was that the continued weak top line and small reduction in what was likely a very bloated expense line has led to operating losses. I am currently underwater by about 20% on the name and undecided what to do. The strategic review did nothing to close the gap between the share price and liquidation value. The following chart sums up the recent poor performance.

LGL_asset_values

The valuation has bumped around 1x NCAV, while NCAV has fallen. My margin of safety continues to erode. Recently the CEO resigned and there have been some board changes. Maybe this will be the catalyst to unlock value, but I am considering this one an (expensive) lesson.

Bri-Chem (BRY.to)

I had watched BRY for about a year or so before taking the plunge after a 30% drop over the course of a year, (I still own). Here’s a summary:

  • CEO owns about 5%, about 2 years salary
  • Director & former President to a subsidiary (Brian Campbell) owns 25%
  • Essentially 2 companies: one fast growing (fluids) and majority of revenue and one slow growth (steel pipe) and dragging down consolidated results
  • high debt load, no cash
  • 45-50% of assets in inventory
  • 30% of assets in accounts receivable

Since my purchase I am down about 8%. Several things have happened to change the story. First of all due to them being debt heavy and light on cash, they issued shares (fairly dilutive) at a discount to NCAV. A couple of things have brought encouraged a more scrutinized look at the balance sheet (strategic review and LOI to purchase the manufacturing facility of the steel pipe division) have brought down NCAV from almost $2/share to just over $1/share now. Yikes.

BRY_asset_value

I also bought the shares with an idea that they were trading at a discount to the sum-of-the-parts. The fast growing fluids division was growing steadily with increased oil & gas activity in the US and steady activity in Canada. There was some organic growth and some acquisitions. Both seemed to require capital and I never paid attention to how cash strapped the company was.

The steel division consisted of manufacturing and distribution. I didn’t pay enough attention to how poorly the business was performing and how little management (or analysts) seemed to care. Here are the last 9 quarters of sales versus production.

BRY_steel_production

They obviously overestimated the likelihood of success with this venture and were slow to respond to lack of demand for their product. They stated a 25-30% gross margin target in late 2012, then 20-25% in Q3 2013 and 15-20% now.

There may still be value here. The fluids division has a current run rate of about 10 mil in EBIT vs. the enterprise value of 100 mil. As mentioned there is a LOI to purchase the steel manufacturing division, but not the distribution part of the steel pipe division. Though management was confident both would go in the sale. Depending on the price, we could see some cash freed up for further fluids expansion and a re-rate in the company valuation to peer level. Even though the top line is extremely seasonal, I am holding my small position until there is some more color on the steel pipe division sale.

Sangoma Technologies (STC.v)

I wrote up STC here. Currently I am up about 40%. Most of this is due to the recent attention the company received from this blog. Here is a quick summary:

  • 23-25% of total assets in cash
  • 25-29% of total assets in accounts receivable
  • 17-18% of total assets in inventory
  • former CEO owns 20% of company
  • current CEO (from Q2 2011 until present) owns very little
  • transitioning from old legacy product to new products. split between revenue 50-50
  • CEO made it apparent that top line growth is priority 1
  • revenue is lumpy
  • small player in a large market
  • at the very least they have been break even from a cash flow standpoint over the last few years if you just include maintenance capex

STC_TB_&_Rev

They actually took a large write-down since I purchased shares, but it was all Intangibles and Goodwill, so my margin of safety was never compromised. I continue to hold and might even add as I think the lumpiness in revenue has the market spooked. But they are slowly executing on transitioning to more and more “new products” and with 65% gross margins, there is quite a bit of operating leverage.

Conclusion

What seems to be a large disconnect between investors and management in the land of asset based investments is timeframe. The CEO should be looking out several business cycles and making strategic business decisions based on all sorts of inputs. What levers to pull are more important than the markets current perception of the organization. Investors (generally) want to make a quick buck. They seem to be more interested in liquidating or putting lipstick on a pig to sell to an institution. Which isn’t a bad thing per se, it’s just a different set of priorities. The CEO is losing his source of income and I don’t think it would look good on his/her resume or LinkIn profile to say that the last job was something that was pressured to break up or liquidate because even after 10 years at the helm, the company was worth more dead than alive.

Many times these net-nets are family controlled and have been in the family for several generations. They are more precious to this family than a 1963 Corvette in mint condition. It’s their legacy.

So whether it’s right or wrong to try and cherry pick net-nets, I will be at least putting even more time to do some detailed research on them. I should note that I haven’t mentioned all net-nets I have interacted with, but just pointed out 4 examples of what you could be getting yourself into if you purchase a net-net.

So far I would like to see at least:

  • growing sales or at least flat sales
  • some cash position (preferably the largest current asset)
  • no cash burn from operations

Anyone have any thoughts on net-nets they would like to share?

 

Dean

1 Comment

Filed under Investing Lessons

The LGL Group, Inc.

I recently picked up shares in the LGL Group (LGL). I stumbled on them when I was researching a competitor (CTS) who hit a 52 week low. Of course, as soon as I purchased shares, the price declined by 10%. They just reported numbers and they were essentially what I was expecting, but the market may push this one down at the open tomorrow. We will have to see what is said on the conference call tomorrow. Here is a (somewhat) detailed analysis.

Overview

CTS operates in 2 major segments. Components & Sensors and EMS (Electronics Manufacturing Services). Here is how the two segments have been performing.

We can see that the two divisions have different dynamics. I should note that I have not removed corporate expenses from the division results as I am just looking for data on how the divisions are performing.

Components and sensors have better top line performance over the period and margins are also better.

Here is a picture of a slide from the CTS investor presentation. It lets you know some of the other players in the respective markets.

Sensors and Actuators are controlled by a couple of major American and Japanese players and then a fragmented rest of the market.

In the Frequency Products we see LGL’s major division Mtron. Another company I took a look at was RFMD.

Here is a quick look at RFMD’s operating performance.

To round out some numbers I also looked at AVX Corporation (AVX). Though not a direct competitor, they have similar characteristics.

As you can see EBITDA margins and ROC fluctuate wildly through the cycle. Right now the industry has entered a slowdown and is likely part way (maybe 1/3) through the cycle. The market has anticipated this and contracted share prices accordingly. The next slide really sums up the industry…

It shows the year end ROIC numbers for CTS. It visualizes what you need to know about this industry as an investor. You are not getting anything with franchise value. Over a 10 year period you are likely to get return on capital equal to cost of capital.

Now you understand the industry lets look at some of the current valuations in the industry. We are not looking at earnings as they are depressed. We want to see the balance sheet numbers and potentially the top line, but remember with this little product differentiation the top line is volatile too.

 Competitor Valuation
 P/TB  NCAV  Ev/Sales
 CTS         1.23         4.80            0.51
 RFMD         2.22         3.93            1.06
 AVX         0.92         1.42            0.76
 ANAD         0.83         1.82            0.49
 LGL         0.57         0.85            0.24

Most companies offer valuations similar to CTS and AVX. They trade near or below tangible book. Some trade under, but for the most part tangible book is decent enough.

LGL stands out as the cheapest company. To be fair, it has a lower ROC than it’s competitors. Here is a look at LGL’s business performance.

Here is a look at the income statement.

We can see that revenue and margins have been flatish until the recovery after the recession in 2010 and 2011. EBITDA has been nearly break even for almost 6 of the last 8 years.

What immediately scares me at first is how can a company survive with break even or negative ebitda, unless they are constantly raising capital? Though share count has increased over the years, it is mostly due to options. TB/share is around $9.50, flat from the start of 2011 and double from the end of 2009. The major reason for this is that capex has outstripped depreciation over the years. It’s only recently that the company has spent more than maintenance expenditures. This is likely from two sources: 1) the CEO (Greg Anderson) has only been with LGL from 2009 and seems to want to grow top line numbers and 2) the company’s products have gained some share in the market as the spend to increase the number of cell phone towers (where some of LGL’s products are placed) and timing devices has risen.

Here is the valuation the market has placed on LGL over the years.

As you can see we are near the valuation seen during the great recession. This means the market is expecting around the same out of LGL as it did during the great recession. Furthermore there is reason to believe that LGL is trading at less than liquidation value (or NCAV).

Before I get too carried away, we need to look at all the pieces that make up NCAV. Listed below are the % of total assets and then % of NCAV.

Cash – 36.5%, 50%

Accounts Receivable – 13.5%, 19%

Inventory – 18.1%, 25%

Other – 3%, 6%

This gives me comfort to know that LGL is not piling up (obsolete) inventory or giving credit (accounts receivable) for the sake of higher sales. See below for a breakdown of the CCC.

Days Inventory Outstanding has crept up over the years, but I don’t believe it would instigate a write-down.

There is $9.51 worth of tangible assets on the balance sheet. This is nice because if I am wrong about using NCAV as the liquidation valuation, I could have an additional $3 per share in margin of safety.

Risks
Of course there are risks. Just like many NCAV stocks, the biggest risk is likely lack of a catalyst. Sure the company is cheap, but it can stay cheap (or get cheaper). You don’t get paid to wait either, that would be nice.

The CEO owns about 50% of his annual salary worth of the company. That may not be enough to push him into returning some cash to shareholders or investing in the business when it needs to be.

The board is independent with Marc Gabelli being the Chair since 2004. There is of course some bad news regarding Marc. Though he does own 13% of the company. Mario Gabelli owns about 16% of the company. There is no shareholder rights plan.

The business could also be changed permanently and actually eat significantly into the balance sheet or what I am using as my margin of safety.

Let me know your thoughts.

Dean

Disclosure: The author is long LGL at time of writing.

9 Comments

Filed under Company Analysis