Category Archives: Watch List

MEA in 2 minutes

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MEA is an industrial company operating in 3 segments, scrap metal recycling, platinum and other minor metal recycling, and lead fabrication. At its most basic level, their business is buying scrap metal, processing/stripping it, and then selling it to steel mills for ferrous materials, and other end users for higher end metals. On the surface this sounds like a straight commodity business, and the fact that the market is defined by over 500 independent recyclers operating 1,000 locations lends evidence to this thought.

While historical ROEs average out to ~10% making MEA at best a marginal business, MEA can make claims to having somewhat of a geographic moat due to the low value to weight ratio of most ferrous metals and the company’s geographic concentration (operating primarily in Western NY, Pennsylvania, and Northern Ohio). Additionally, MEA is able to maintain lower supply costs than their competitors because they own a network of scrap yards directly.

That being said, it may be premature to consider MEA a true low cost producer. While their recent management presentation points to their “industry leaning margins,” the metric they choose to measure is EBITDA. Unfortunately, interest expense costs are very real, and potentially fatal for a companies in cyclical businesses.

For some time the stock posted impressive growth through acquisitions, however the stock has been cut in half in the last few months and is down almost 66% in the last year and change thanks to commodity businesses as a whole suffering from fears of a Chinese slow down, continued depressed utilization in the steel industry, and no real evidence that the commercial construction or auto sales are about to take off. These demand side issues are compounded by supply side issues such as driver reluctance to upgrade their vehicles (old cars are a major input), growth in the number of yards bidding for scrap, and an expansion in total metal shredding capacity.

The auto upgrade cycle will work itself out eventually, but currently low oil prices are compounding the delay as driver’s are more tolerant of holding on to older gas guzzlers. The growth in the number of yards biding for scrap and the expansion in metal shredding capacity are more secular issues to which MEA is exposed.

MEA is not a good business and thus should be valued on a Book basis. I first noticed the stock because it is trading at .55 book, but ~30% of that asset value is goodwill and other intangibles, meaning that the company is trading for 1.3x tangible book… more than I would pay for this business.

However, what is interesting to me is that MEA is a roll up. With more than 20 acquisitions since the company was founded, they have greatly increased the number of facilities in their portfolio over the last 15 years. Each of these facilities is fairly liquid and could be sold to raise cash in the event of a distressed type situation.

If the operating environment remains challenging in the near to intermediate term, investors will become increasingly wary of MEA’s ability to meet their debt payment obligations and debt covenants, and it is not hard to imagine a scenario under which the company trades like it is extremely distressed.

In this situation, I could see the stock trading down another 30-50% from these levels. At those levels the stock would likely be very attractive as the assets could be sold to payback creditors. Adding to my watch list and hoping for a distressed type situation.

IM in 2 minutes. Watch List.

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Ingram Micro is the largest wholesale distributor of information technology products in the world.  The company has been around since 1979, and completed over 20 acquisitions in the last 10 years focusing primarily on global expansion.   According to their 10K, they add value to their customers through adding visibility to the supply chain allowing resellers and suppliers to improve their execution.

I first noticed the stock because it is a net net: current assets – total liabilities > market cap.

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Electronic Arts – Watchlist

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I first thought about EA when i was looking into WWE and gaining a better understanding of the value that sports have in terms of content. Basically with sports you have content that is only really relevant in real time and a passionate fan base. A great combination.

I started thinking about how this content was distributed, and remembered the EA Sports video games like Madden Football and NHL Hockey. I reasoned that these were strong franchises with dedicated customers that likely upgraded every few years if not every year to keep their gaming experience relevant to real world sports. For example, players being traded, new rookies making a splash in the league, and other changes to real world sports will all motivate consumers to purchase the new game each year regardless of technological advances in the games themselves.
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ICON – watch list

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Iconix (ICON) is an asset light brand manager. Basically they have no inventory, no manufacturing, few employees, and very little in the way of capex, but license their brands out to manufacturers of clothing, coffee mugs, bumper stickers, and anything else you can think of. They own the rights to 28 brands now, some of which are enduring like the Peanuts brand, some of them which are more dated and of questionable longevity like Ocean Pacific, or OP, and some of which are more modern with less of a track record like Rocawear.

The company has been growing at a rapid clip as it aggressively acquires brands with revenues increasing from $160M in FY07 to $370M in FY11. The company has taken on debt to help fuel this growth which I don’t love, but their asset light model allows most of net income to drop to FCF, so interest is well covered.

This morning they reported EPS of .43 vs .45 estimates and revenue of $88.5M vs estimates of $95.1M. Additionally they guided FY12 to $340-350M vs previous guidance of $370-385M and street estimates of $377.5M.

On their call management blamed a change in their Royal Velvet brand license with JC Penney and weak sales from men’s brands, specifically Rocawear and Ecko for the disappointing quarter, and a $10M hit to guidance. The company also pointed to changes in planned international initiatives which they no longer expect to complete. They had been hoping to buy complete control of some joint ventures, but they now consider gaining control to be too costly, resulting in a $20-25M hit to guidance. Investors focused on the next quarter or year are clearly not happy about this, but for an investor who is focused on the long term, this is a tremendous positive as it shows management’s discipline in allocating cash – very important for a company with gobs of cash, high debt, and planned growth. I’d rather see the stock trade off then see them waste cash and destroy value by over paying for near term revenue juice.

I don’t want to give them too much credit at this point b/c I haven’t looked past the headlines, but at a glance it also looks like in 2008 the company was buying back stock at prices below $10, and then later issued shares in mid 2009 at $15. This may have just been luck, but it may have been shrewd. Something to look into further.

While the company remains focused on the long term for their acquisition strategy, they are focused on the short term in SG&A and have identified ~$10M in cuts that will offset the above mentioned challenges. Importantly these cuts are not coming on the marketing end.

The company plans to continue its expansion and seems to have the cash flow to do it, although critics point to a diminishing number of available brands. They do have a $287.5M convert coming due at the end of june, but they have a revolver they can access to pay that off if needed.

On the negative side, management ownership is limited, and they haven’t been buying shares in recent memory, although they do get shares as compensation which disincentives them from buying in the open market. Additionally, while it looks like cash flow is pretty even, at a glance it seems as if their licensing agreements are up for renewal on a fairly regular basis, and anyone of them could be cut off at the knees on fairly short notice… and despite the “value” of these brands, they are really only worth what you can make from them in most cases so without licensing deals in place its not like they are a rock on the balance sheet. I suppose this helps explain why the company trades at below book value – something rarely seen in a branded business. Basically the brands as a whole are not all that strong, but most asset light businesses can earn a high ROE fairly easily and this business should trade above book in my opinion.

As for another valuation thought… the company is forecasting $180M in FCF for 2012 which as of now translates into a 17% FCF yield. Cheap if you believe the forecast.

Also worth noting the – company does have a share repurchase plan in place. As of 10/11 it was $200M and it has $146M remaining.

Argentina… YPF, WTF? and special situations?

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Last week, the government of Argentina announced they were appropriating the assets of YPF, the Argentine oil company, which was mostly owned by Spanish company Repsol. Repsol had bought the company from the Argentine government in 1999, and since that time has been victim to the whims of Argentina. Argentine President Christina Fernandez de Kirchner has justified the move by noting that every country has a right to its own resources and claiming that YPF was mismanaged by Repsol.

The world is now concerned that Argentina will not stop with YPF, and other publicly traded Argentinian companies are at risk of nationalization. As a result, other Argentinian companies have sold off hard in recent weeks.

However, despite these very real risks, market disruptions by outside forces often lead to opportunities as sellers sell their positions as quickly as possible.
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USAK – Still Watching…….

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VAN BUREN, Ark., April 19, 2012 /PRNewswire/ — USA Truck, Inc. (NASDAQ: USAK)
today announced base revenue of $97.8 million for the quarter ended March 31,
2012, a decrease of 1.8% from $99.7 million for the same quarter of 2011. We
incurred a net loss of $4.9 million ($0.47 per share) for the quarter ended
March 31, 2012, compared to a net loss of $2.7 million ($0.26 per share) for
the same quarter of 2011.
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USAK – terrible business – good price?

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Trucking is in general a terrible business. It is highly fragmented, highly competitive, and there are basically no barriers to entry.

As a segment within trucking, long haul is even worse than average in today’s market. As gas/diesel prices have gone up and the cost to ship by rail has come down, the long haul segment has basically been made obsolete as intermodal (part truck, part train) is more cost efficient and only slightly slower.

That being said, bad businesses can be too cheap, and with a price/book of .58, this may be the case with USAK.

USAK has traditionally been a long haul truckload carrier (truckload = point to point for one customer rather than less than truck load which is basically distribution center to distribution center with a mixed cargo that has been grouped together geographically) and their results have suffered from it. As of their 2011 10K, they operated 2,250 tractors, and 6,250 trailers, which makes them larger than all the mom and pop outfits out there, but smaller than the big boys in the trucking industry.

However, in 2008 the company announced their “Vision for Economic Value Added (VEVA)” plan which they believed would help the company adapt to the changing realities around them. First, the company aimed to move to shorter hauls as 4 out of 5 truckloads in the US now are less than 500 miles and moved to make this core business more efficient.

Average haul in miles
Year ended December 31 2011 2010 2009
Total Company …………………………………………………… 532 560 599
Trucking service offerings:
General Freight ………………………………………………….. 544 569 618
Dedicated Freight …………………………………………….. ….396 433 471

As the company has moved to concentrate their routing between major metropolitan areas – focusing on less than 1,000 lanes. Additionally, there is a new push toward efficiency, with the goal being to have each tractor in their fleet loaded and unloaded 4 times per week. In order to help drive this move toward efficiency the company slimmed down its management structure and brought in an outsider with substantial operationally experience from JBHT.

Additionally, the company is going through a major technology upgrade in order to maximize efficiency in their routing and turn around times. Previously the company was reliant on antiquated internally developed operating systems that were internally hosted on main frame systems. Now the company is using 3rd party software and network servers allowing better coordination and business planning. This includes satellite tracking of cargos and trucks. This upgrade has not been without hiccups though, and the company points to difficulties in integrating the new system leading to a loss of confidence from customers and resultant business decline in Q3’11. This trickled down to higher driver turnover, at a time when the industry is suffering from a lack of drivers. Again, this is a terrible business where competition is based on price and service, so this temporary disruption is a big deal.

Furthermore, the company has moved to trim their cost centers, including reducing their executive team from 9 to 5 people, while simultaneously bringing on people with experience in more regional and asset light markets rather than their traditional long haul markets. The company estimates that the cost control efforts will lead to $5.6M in cost savings for 2012, and they continue to look for more opportunities.

Second, the company began to develop business lines that would allow them to be better partners for the increasingly sophisticated needs of their customers – namely an asset light “strategic capacity solutions (SCS),” which is basically a brokerage business, and an intermodal business.

Their plan is for SCS to represent 25% of their total base revenue, and in 2011 it represented 16.3%, up from 2.1% in 2007. This was on revenues of 67,085 vs 34,918 in 2010, so it seems as if they are making nice progress there. This is important b/c the asset light truckers trade at much better multiples than traditional truckers for the obvious reasons that there capex needs are much lighter. Capex for truckers is very high as maintenance costs for rigs grow exponentially after only 3-4 years of service.

While the company appears to be making the right long term moves and the recent tech upgrade appears to have been a temporary problem, it isn’t yet clear that the company will be able to successfully transition its business model. On one hand, as I said earlier, trucking is a terrible business which should make it easier for USAK to make inroads vs competitors in shorter haul, asset light, and intermodal. At the same time, as a terrible business the competition likely comes down to price as a function of economies of scale which they do not have, and service, which they have not yet gotten right. It isn’t clear how easily they will be able to win back business they lost during their tech upgrade.

That being said, there are some positive aspects to USAK – such as the fact that management owns 13% of the company and that 6 different insiders have been buying in the last few months at an average price of 8.29… 15% above recent prices. Additionally, in October of 2011 Celadon (CGI) announced they had bought 6% of the company at an average price of 7.08 and were interested in speaking with management about a possible merger. USAK management rejected the invitation much to the dismay of short term holders, but it is helpful to know that industry pros saw value at the 7.08 level (basically where the stock trades now) not long ago. Also comforting – GAM International bought almost 10% of the company at prices above $8 in March. I don’t believe GAM International is related to known value investors Gabelli Asset Management, but i will look into it.

The company reports on 4/20 and if it is clear that they have made progress in adapting their business model and increasing their efficiency while continuing to trim costs, USAK may be worth a deeper dive.

Sutron (STRN)

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GENERAL

Sutron is a good but not great business protected by a moat defined by customer familiarity more than customer necessity.

At their core they are a scientific device maker that produces water, weather, and ocean monitoring devices and systems that are able to transmit data via satellite. While the company does anonymously cite several competitors in their 10K, as with other scientific instruments, I think it is reasonable to assume a certain level of customer loyalty (moat) as customers will not want to have to learn to use a new system. Additionally, the company seems to have some “Hidden Champion” characteristics. Specifically, the annual report has a clearly defined “Vision and Mission Statement” that speaks toward “continually offering state-of-the-art products that meet or exceed our customer’s needs and expectations.”

The R&D section of the 10K details other recent advancements and developments. The company spends a fair amount of money on R&D – almost $1.9M in 2010 vs $23M in revenues (>8%). Interestingly, they don’t bother with patents believing that the rate of change in the industry makes patents less valuable.

While R&D and product advancements at a company like SUTR are not similar to upgrades at a company like AAPL where customers will be lining up for the latest and greatest, technological advancements should help develop a somewhat recurrent revenue stream. This will be helped by the fact that data collection and analysis is inherently tedious, and the fact that SUTR customers – mostly Federal Government (36% in 2010) – and also University grant programs etc – are frequently improperly incentivized to spend the maximum that their budgets will allow as a way to build a future defense against budget cuts. (ie Dept head says, “well, they didn’t even spend what we gave them last year, so we can give them less this time.”)

Also of note, insiders own almost 25% of the company, including the Chairman / President / CEO who owns ~16% of the company.

BALANCE SHEET

With $9.21M in cash (almost $2/share) and no debt, the balance sheet is solid. The lack of debt is comforting – minimal operational leverage is a plus for a company that is dependent on a small number of contracts that come and go on an irregular basis – especially when many of them are tied to government spending in the current fiscal environment. However, the company has indicated that they are looking for acquisitions – and were close to completing one in 2010 so the cash should not necessarily be expected to be there. Sutron’s last acquisition was for a data collection software company and was done at just over 1x revenues – which seems reasonable although financials on the target are not available. The company does have access to a $3M line of credit that may be used when bidding on contracts requires a bid and performance bond – note that this is further evidence that the company needs to access to liquidity on must keep cash on hand and the excess cash on the books is not likely to be kicked out to shareholders any time soon. Furthermore, the share count has increased over the last several years due to an options compensation plan. Options issuance does not seem to be excessive, and share count has increased significantly slower than revenues.

As with any company that has a technology angle there is risk of inventory obsolescence, but I can’t imagine that scientific data collection devices evolve at the pace of consumer technology – at least not the physical aspects of them – and the software side of the devices can likely be updated rather easily if necessary as it is unlikely that a new operating system would be developed – rather just an old one may be tweaked.

Inventory levels and accounts receivable have remained essentially flat for the last several years while revenues are up more than 25% in the same period indicating that management isn’t cutting prices and trying to push inventory out the door to fluff the revenues.

QUALITY OF EARNINGS

Gross margins have historically hovered around 40%, with net margins at a glance appearing to normalize around 11%. ROE has ranged from a low of 4% in 2008 to a high of 32.5 in 2004 when the company was significantly smaller. At a glance normalized ROE looks to be somewhere around 15%… mind you this is not at all scientific – this is just me looking at a row of numbers and picking what feels like the appropriate blend of those numbers.

Regardless of the “normalized” ROE or margins, the key take away is that earnings are lumpy.

A dupont analysis shows that the ROE is primarily generated by profit margin rather than by asset turn or leverage. As I said previously, the lack of leverage is comforting in such a lumpy business, but given the cash heavy nature of the balance sheet at present the asset turn ratio can be a bit misleading and helps explain why ROE decreased from 32.5% in 2004 when the asset turn was 1.9x to 16.5% in 2010 when the asset turn was only 1x.

The key point here though is that Return on Invested Assets may be a useful valuation tool.

If we (lazily) consider the normalized ROIA to be the average of the last 7 years we can call it about 19%. If we assume a required rate of return of 10%, that’s means we would value the company at 189% of its invested assets (19%/10%) plus the cash. Running the math here gives us an intrinsic value estimate of ~$34M for the market cap, which is about 17% higher than where the stock is trading right now.

17% is not near wide enough of a margin of safety. For a micro cap with lumpy earnings I’d probably want at least a 40% margin of safety, meaning I might want to buy around $4.40

On an earnings basis, the company trades at about 15x the average of the last 5 years which may be a low end eps proxy given that the company has grown over this period. At the same time, FY11 EPS was .31 implying an almost 20x multiple to the current price, so the 5 year average of .40 might be on the high end. However, think .40 is probably a safe estimate of normalized annual earnings.

Either way, even though I believe the company has growth potential, I would not pay a 15x multiple for a company with a lumpy earnings history and a likely lumpy earnings future. Maybe I’d pay 12x .40 or 4.80 / share. Maybe.

For now, I won’t worry about that, but I will make a note to dig deeper if the price comes down to that level.