A forgotten diamond in the blind

Inaction is action. It's easier said than done.

By the same token, boring is rewarding. But it's hard to get oneself excited about boring stuff.

It's very satisfying to hunt for and uncover undervalued stocks. The thrill is hard to resist. But the goal of investing is not to indulge one's adventurous soul or to satisfy one's ego. The goal is to compound one's wealth. Very often, the real gems are something we already know. It's boring to recycle old ideas. Yes. But being boring makes money. It compounds.

I wrote about Advant-e (ADVC) in 2012. That was actually the first post on this blog. (Now looking at my records, I realise I actually started buying ADVC in 2011.) I won't repeat all the details here. You can go back to read about it yourself. At the time, I believed ADVC was a quality business, a hidden champion. It should comfortably deliver 15% return per annum for very long time. In a more favourable business environment, it wouldn't be a stretch to get 20% p.a. return. Share price was then $0.20 and P/E was about 10x.

Fast forward to today. Price is $0.40 and it is still trading at a multiple of 10x. In between, ADVC has distributed some very generous dividends. My total return (on a constant currency basis) is about 100%. Annualised return is about 30% p.a.

Numerous value bloggers have written about ADVC over the years. The most recent spike of blog posts was seen towards the end of 2013, when ADVC decided to stop filing statements with SEC, coupled with a reverse-split and a force cash-out for the investors with less than 10,000 shares. Some investors were pissed off, believing the entire exercise was unfair towards minority shareholders. When the CEO Jason Wadzinski controlled over 50% of the company, they had reasons to worry. Eventually, the company went dark as planned but the reverse-split was called off, of which the true reason will probably never be known.

Since then, the company has been forgotten.

I hold a different opinion. In 2012, I said Wadzinski was shareholder friendly. My stance hasn't changed throughout the going-dark incident. Remember this is effectively his company. If he wanted to pay himself big salaries but distribute no dividends, he could have done so. But he hasn't. From ADVC's history, what Wadzinski has said and what he has done in the past, he strikes me as someone with integrity.

When a company goes dark, apart from being less liquid, the worry is: what will happen to its dividend policy and reporting policy? Now we have the answer. On April 28th ADVC sent its shareholders a letter from the CEO with a condensed annual report, declared a 5% dividend and announced a share buyback up to ~6% of its market cap below $0.37.

While the company is definitely less transparent than it was, my assessment of its business hasn't changed. Its moat in its own turf in the grocery market is solid. And it's slowly making inroads into the automobile market and the healthcare market.

Monish Pabrai said in a recent interview the holy grail of investing is to identify compounders with hidden moats. That's superior to buying cheap assets at 40c on a dollar. He didn't elaborate why. But it's self-evident. Instead of constantly and actively searching for your next preys, you collect money from a compounder when you are snoring.

ADVC is one such little compounder. It is my benchmark (or in Buffett/Munger's vocab, my "cost of capital") when I assess other investment opportunities. "Should I buy XYZ, or should I buy more ADVC?" This is my way to avoid making further stupid mistakes.

Indeed, I've bought more.

p.s. I respect the company's decision not to make their financials public. If you want to have a glance of their 2013 numbers, you can simply buy a few shares and ask the company for a copy.

p.p.s. ADVC trades over-the-counter and is very illiquid. Be wary of pump and dump promoters. Be wary of bullish articles like this very one you've just read. :-)

(Disclosure: Long ADVC)

Is HGL Limited a cigarbutt?

HGL Limited (HNG) is an Australian microcap listed on ASX with a market cap of $22m. Its current share price is $0.44. It has virtually no debt. Insiders own about 40% of the company. Its history traces back to First World War. It was originally founded in 1898 as Hancock & Gore, a timber mill operator.

Between 1985-2010, it was under Kevin Eley's leadership. Without a better word to describe it, I would call it a "micro-conglomerate". Eley copied Warren Buffett's Berkshire Hathaway model with 2 distinct operations: (1) investing in public listed companies and (2) buying and operating a group of private businesses. However, since 2009, HGL has shifted strategy and gradually exited its equity investments. In 2010, Eley stepped down and was replaced by then COO Michael Mahoney. HGL is now a pure operator of a bunch of unrelated businesses. (Eley remains to be a board member.)

While its businesses are largely unrelated with no syngery, they all follow a common theme: they are branded products and services operating in their very narrow niches. These niche markets are usually fragmented and allow HGL to exert some pricing power. HGL don't manufacture their products. Effectively, It is an importer/distributor.

HGL's wholly owned businesses (sale figures are FY2012's, in AUD):

• SPOS - point-of-purchase marketing services ($23m)
• JSB Lighting - high-end lighting ($15m)
• Leuteneggar & XLN Fabric- fabrics for home sewing and craft ($17m)

Businesses with 50% ownership:

• Anitech - large format printer products and services ($29m)
• Mountcastle -  school uniforms and headwears for police and defence forces. ($12m)
• BOC - ophthalmic equipments ($7m)
• BLC Cosmetics - skin care ($10m)
• Biante Model Cars - collector model cars ($5m)

Business was tough in 2012. Persisting high Australian dollar caused price deflation and consumer sentiment was the worst since GFC. Both SPOS and JSB suffered huge setback. Management at SPOS had misjudged demand. It suffered large writedowns and impairments. HGL's revenue fell 28% and its net profit was negative. Excluding the writedowns and impairments, EBIT margin was 0.3%, effectively breakeven, while historically it was in the range of 7-9% in the previous 5 years.

Our investment thesis is based on a simple idea: reverse to mean.

Between 2008 and 2011, HGL's average ROE was about 10%. However, HGL has goodwill from its past acquisitions on its book. Use HGL's own preferred measurement, EBIT / Capital Employed averages close to 20%. HGL has never lost money in the past 10 years. HGL is an above average business. If HGL manages to control its costs and achieve a typical 5% net margin, using the 2012 trough revenue of $118m, it can achieve a net profit of $5.9m. With a conservative P/E multiple of 8.5x, each share will be worth $0.68, 50% above the current price. If revenue returns back to historical average of $160m and net margin 6%, with a more "normal time" multiple of 10x, it will be worth $1.3 per share, 200% above the current price.

(HGL has non-controlling interests on its book who have a claim on HGL's profits and assets. All the above figures except EBIT and Capital Employed have been adjusted to reflect what equity holders get. All figures are in AUD.)

How likely can HGL turn around its business?

The catalyst that is helping us out is a swift improvement of consumer sentiment in the first 3 months in 2013.

(source: tradingeconomics.com, Westpac Bank, Melbourne Insititute)

The chart below shows HGL's share price against 2 Australian retailers, Harvey Norman and Myer. (Harvey Norman is comparable to Best Buy in US. I'm not too sure what the US equivalence of Myer is. Maybe JC Penney?) You can see the dramatic recovery of HVN and MYR in the last 3-6 months, coinciding with the improvement of consumer sentiment. You can see HGL is lagging behind because improvement of its profitability is not yet in sight.

(source: Google Finance)

After deducted the minority interests, HGL has a net tangible asset (NTA) value of $0.41 and a net current asset value (NACV) of $0.35 per share. While the current share price is very close to NTA, HGL is definitely not a net-net. We have some safety from the value of the assets, but it's not bullet proof.

The opportunity here is the possibility of a quick turnaround. We are relying on its operating leverage to propel its profit (and share price) quickly when sales volume picks up.

Make no mistake. Turnarounds are risky businesses. Besides, there are few things I don't like about HGL:

• Since each subsidiary operates independently with its own CEO, HGL has effectively 2 layers of management. It made sense when Eley was still around acting the capital allocator. But it's no longer the case. I think it's redundant and wasteful. (The corollary is: HGL will be worth more if it's broken up. The main it'll lose is the access of the capital market.)
• The non-controlling interests act like preference shares: always standing in the front of the queue to take a cut before the equity owners.
• Mahoney stepped down as the CEO because of "ill health" a few months ago. One got to wonder if HGL's poor result took a toll on his health.

On a balance, my view is the potential of a swift realisation of the upside is enough to compensate for the negatives. And I think HGL is qualified as a "cigarbutt". You quickly take your puff and then move on.

(Disclosure: Long HNG.AX)

Ships, hogs, dirts and the shipbuilder called Conrad

Ships, hogs, dirts and shipbuilders. What do they have in common?

Their economics.

Ships

A while back, the dry bulk shipping industry caught my attention. You can see why from the 3-year BDI index chart below. The BDI index is the barometer of the charter rates for dry bulks. The industry has been in recession since GFC.  It is severe. Besides, I remembered one of my role models, Mohnish Pabrai, described in his book how he scored a multi-bagger win in his bet on the oil shipping company Frontline when the industry was in recession in 2001.

Source: Bloomberg

Were there values among the dry bulk shippers? 

The initial look looked promising. Listed dry bulk operators like DSX and GNK spotted attractive ROAs, profit margins and P/B ratios. However, the more time I spent to understand the industry and its economics, the less sure this was a game I was capable to play.

Take a look at the supply/demand curve I reproduce from Martin Stopford's book Maritime Economics :

Source: Maritime Economics, by Martin Stopford

Let me point out the important bits:

• Shipping is essentially a commodity business. (You generally don't care too much who is shipping you stuff as long as your goods arrives in one piece.)
   
• In short term, demand is inelastic. (If you need to buy steel beams to build your Olympics stadiums, high shipping cost won't easily deter you.)
   
• At the same time, worldwide shipping capacity is finite, because it takes years to build a new ship. Thus, supply becomes inelastic once you reach a certain point. Hence, the "hockey stick" shape supply curve. Freight rates can go from $6,000 to $44,000 in the space of a few months.
   
• When freight rates skyrocket, shippers will decide to invest to expand their capacity. It takes 1-3 years to build a new ship. By the time the shipbuilders expand their shipyards and new ships are built, the demand is no longer there. We now have an oversupply of ships and freight rates tumble.

So, here we go. Boom and bust cycles. Because of the above structural reasons, the magnitude of boom and bust cycles is extreme. Consider this: BDI was at its highest 11,000 in mid-2008 before the GFC, tumbled to 700 in Dec 2008, recovered to 4,600 in Nov 2009 and is now hovering around 1,000. To get a sense of what this means in real life, just imagine bus fare tumbles from $110 to $7 and then climbed back to $40 in the space of months.

This means the usual metrics like ROA, P/E and P/B are all meaningless. Earnings and asset values are quick sand. They are extremely unstable. You can't rely on them to value dry bulk shippers.

I ended up not investing in any of them because I just had no particular insight into individual shippers. Nor had I any insight into the cycles and the macro environment surrounding them.

Hogs and Dirts

I've omitted a lot of details about maritime economics which contribute to the "hockey stick" supply curve. (e.g. Ship owners can slow down their voyage or lengthen their maintenance time in response to low demand.) But the above supply/demand captures the essence. Furthermore, there are 2 key factors underscoring this extreme economics: (1) The decisions to expand the supply (i.e. the fleet) take years to materalise. (2) Each player in the industry is making rational decisions, but only considers themselves in isolation. Some kind of prisoner's dilemma is at work here.

This pattern shows up in another industry that I'm been worried about for some time: the mining sector in Australia.

Professor Steve Keen at University of Western Sydney explained it the best in this Business Sepctator piece. He pointed out this is nothing new. This was long recognised in hog cycle, the volatile 4-year cyclical pattern of prices for pigs in the US. And there is a neat economic theory, the cobweb model, explaining it.

(This is a good example that knowledge is accumulative. You builds up your circle of competence organically over time. From time to time, Things I learned from one place would show up in another place in a slightly disguised form. Things learned from one domain are never wasted if they didn't lead to any investment idea.)

Conrad Industries

This brings us to CNRD, the shipbuilder that I'm investing in.

My original conservative estimation of CNRD's intrinsic value was $18-20 per share. The current share price has now fallen into this range. Isn't it time to take the money off the table? This is the question I've constantly had in my mind in the recent weeks.

The original investment thesis was essentially based on a single event, the oil spill, or the recovery from it. But I have since realised there is more with CNRD. CNRD's management is more competent than I initially thought. CNRD has also become less sensitive to the exploration activities in the Gulf region than it used to be as the management has diversified its client base. CNRD may not have any structural advantage, but it is a very efficient business. It has the appearance of a "hidden champion". It's more like Buffett's Nebraska Furniture Mart than his Coca-Cola.

The difficult question is: how to value it now?

CNRD isn't exactly Nebraska Furniture Mart. Even though CNRD's client base is more diversified now, the products it makes are still commodities. It is still at the mercy of boom and bust cycles. "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." More importantly, the longer I hold CNRD, the more important the cycles will become.

For a cyclical business, the concept of intrinsic value as in Ben Graham's way of thinking may not even be applicable. Even if it exists, it's close to unknowable. There is no stable earning. It will be dangerous to normalise CNRD's earning over many years to arrive at an artificial figure. If we do so, we will be like having one foot in a bucket of ice water and another foot in a bucket of boiling water and claim we feel good on average.

And it is equally dangerous to time the cycles. Stopford says in his book the average length of boom and bust cycles in the shipping industries is about 7-8 years. This is, again, just an average. These cycles don't come in as clock work. The constant changing macro environment has significant influences on the supply-and-demand.

Where does this leave us? Without an estimation of the intrinsic value, I don't have a rational basis to judge when to sell. And forcing an estimation may easily give me a precisely wrong figure.

I'll follow Keynes' doctrine: "it's better to be vaguely right than precisely wrong". Here is how I will approach it:

• I mentioned in a previous post there are a few catalysts surrounding CNRD: the BP settlement, full recovery of its repairing/maintenance segment and a small possibility of some kind of corporate action. So, instead of getting obsessed with figuring out a valuation, I will wait for one or more of events to play out.
   
• I will add one more event to my list above. There is an important observation from the discussion of the boom and bust cycles of the shipping industries: The length of the cycles is a directly consequence of the duration it takes to materialise the investment/expansion decisions made by the players. It is not precise and will never be precise because unpredictable macro events will push things around. But the general cause and effect is there. If it takes only one week to add capacities in an industry, you will  expect to see the length of cycles in the order of weeks, not years. And here, we see CNRD is also buying land and getting government grants to expand its capacities. We can reasonably expect other players in the industry are doing the same within a similar time frame. (This will be a good place to do more scuttlebutt.) When all of these new capacities come online, we have to be worried. So, if we work backwards from here, the completion of CNRD's expansion program will be a signal the industry has passed its peak.
   
• I will err on the side of being over-cautious. I will rather leaving too much money on the table than being caught in the downturn of the industry.

I mentioned in my previous post the Credit Bubble Stocks blog is an excellent source of intelligence on CNRD's industry. Credit Bubble has linked to an informative research piece Good Year for the Barges. Being a contrarian, I'm becoming more cautious, treading with my eyes wide eye...

(Disclosure: Long CNRD)

CNRD 2012Q3 Results - Many things are going right

When I initially invested in CNRD 20 months ago, the investment thesis was a simple one: CNRD, a well-run shipyard located at the Gulf of Mexico, was adversely affected by the Deepwater Horizon oil spill. I reasoned it would only be a matter of time oil/gas exploration in the region would return to normal and CNRD's business would recover. This is a classic case where investment opportunities are created by temporary industry-wide downturns.

Since then, instead of passively waiting for tide to turn, CNRD has proactively replaced its revenues from the energy sector with revenues from other commercial and government clients. Now, from their third-quarter filing, we can see a few tailwinds are in play:

• Backlog is growing healthily. If we assume the run rate of first 9 months continues, annual earnings will come in at about $3/share. Shipbuilding is a cyclical business. Anecdotal evidence suggests we are now entering the up-cycle in inland water transport. CNRD is now riding this high tide. (For anyone interested in intels in the barge industry related to CNRD's operations, check out the Credit Bubble Stocks blog.)
  
  
• CRND is preparing to submit claims to the BP Settlement Fund. The claim amount is expected to be around $22-23m. Remember that CNRD's market cap is about $110m. So, we are looking at an potential one-off 20% (pre-tax?) boost to its intrinsic value.
  
  
• Oil/gas exploration at the Gulf is recovering but not in full swing yet. While revenues from oil/gass industry has improved to 12% of its total revenues, it's still far below the 27% before the oil spill or 40%+ before the GFC. Gross margin from its repairing and maintenance segment has improved to 15%, but is not yet back to long-term average of 20-25%. When oil/gas operations in the region are back in full force, there will be a continuous supply of repairing/maintenance work. But vessels which have just been moved into the Gulf won't need maintenance immediately. There will be a time lag.
  
  
• The company has repurchased about 2.5% of its shares in 2012 so far.
  
  
• Since Jr Conard took over the CEO role in 2004, this is the first time the company has engaged a financial adviser "to assist in its evaluation of strategic initiatives in order to determine potential alternatives that will enhance shareholder value and provides us with flexibility to respond to potential future business opportunities and risks." This can mean anything. It can also mean nothing. One possibility: Senior Conrad is in his 90's, well past his retirement age. The likelihood that CNRD will put itself up for sale is higher than ever. 

I am patiently waiting for the plots to unfold.

(Disclosure: Long CNRD)

Value of the century - the Aussie edition

I spent some time last month combing through the bottom end of the ASX market, looking at companies with market cap less than A$300m. I haven't found anything worth investing so far. Then, last night I saw Whopper's post ACGX: value of century? I just couldn't resist and decided to write this up for your amusement.

Details at a glance:

• Company: Richfield International Limited (ASX: RIS)
• Market Cap:A$1.6m
• NACV: A$6.3m, mostly cash!!
• Business: It operates shipping services in Singapore. It used to operate trucking services years ago.
• Profitability: Mildly profitable or break-even most of the years.
• Dividends: Never in the last 8 years.
• Insider ownership: 72% controlled by the directors

So, here you are. A crazy pile of cash. Buying a share of RIS is buying 25 cents dollar. Or, to flip it around, you are getting an instant 4 bagger. While the value isn't as extreme as Whopper's ACGX, RIS is a listed company with audited accounts and regular filings.  

What's the catch?  

I have serious doubt the company exists mainly for the purpose of running a business. It looks more like the directors' tax shelter. It's basically their family's piggy bank. The most likely end-game I can foresee is, when the business dries out, they will shut down the operations and gradually draws down the cash pile as salaries until it reaches zero. Well, there is no certainty. They may declare a surprise special dividend or announce someone tendering for the company. But I won't bet on it.


(Disclosure: No position)

Will PGNT become a mini replica of BRK?

No, Paragon Technologies isn't Berkshire Hathaway. But the current situation shares some interesting aspects of the old BRK when Buffett bought it in 1960s.

PGNT is a $4.3m microcap. It provides conveyor systems for assembly lines and order fulfillment operations. It lost money 7 out of 10 years between 2001-2010. Current share price is ~$2.8 while it has a NCAV of $3.25 which consists mainly of cash.

Normally I would quickly dismiss companies without a track record of making money. However, I noticed Sham Gad, a value investor, was involved. I took a closer look.

Downside protection

Gad was elected to the board in 2010. He subsequently built up his position to 25% throughout 2011. In March this year, he didn't only take over the chairmanship, he also got the 2 directors elected. These are the 2 directors that he originally recommended in the proxy fight back in 2010. So, effectively, Gad has the complete control of the company.

Why is this important? This is important because it puts a very solid floor on our downside. Gad intends to bring the business back to profitability. After he gained a seat at the board, he managed to reduce cost and steer the business to break even in 2011. What will happen if he senses he can't achieve it? As a value investor, he won't have any emotional baggage. He will immediately liquidate the business. The liquidation process may not be smooth. But since the bulk of the assets is in cash, we should get back most of the $2.8 invested. The presence of a value investor collapses the range of possible outcomes to almost a single point if the business fails to deliver. This wouldn't be the case if it were the founder controlling the company.

Valuation

And what is our upside? We should consider this a turnaround and handicap it. I take a stab at this in the spreadsheet below:

(If your rss reader doesn't show the spreadsheet, you need to visit my blog directly.) 





Under the "turned around" scenario, I assume it requires a 1.0x quick ratio to keep the business running. Hence $2.75 cash can be distributed. I assume it can double its revenue, back to the level before GFC. I assume it can earn a generic 5% net margin. And I give it a conservative 8.5 P/E multiple. This gives us a valuation of $7.13 per share.

Next, we need to guess how likely the business can turnaround. Again, this is a wild guess and a pretty aggressive one. But one thing that helps is the recovery of the US economy is on our side. I put down a one-fifth chance. The rest of the calculation in the table is self-explanatory. We end up with an expected return of 42%. You can try to plug in different numbers in different places. But the general risk/reward profile doesn't change much.

(Another thing to be aware of is, the 42% return or the $3.99 value won't exist in the real world. We will either end up with one of the possible scenarios. There is nothing in between. The expected value is only indicative.)

Capital allocation

Why did I make reference to BRK at the start? This has to do with how Gad intends to use the cash in PGNT. I don't believe Gad will actually distribute the cash if the turnaround fails. Gad has lay down his intent in his chairman letter published in March:

Through a disciplined capital allocation process, we will examine ways to utilize the Company's assets to increase the intrinsic value of the Company.

This is how I see it. He will try to keep the business breakeven and plow any operational cashflow back into the business (e.g. in R&D) while waiting for recovery of revenue. At the same time, he will invest the cash pile in any opportunities he can find. If you are familiar with the history of BRK, this is effective what Buffett did to BRK.

Gad is a Buffett disciple. Investing in PGNT will feel like investing in BRK in its old days. You need to be comfortable to be Gad's junior partner to invest in PGNT.

Final thoughts


So, we can look at the investment case this way: At $2.8, we are basically taking a stake in Gad's managed fund and at the same time getting a free option on the PGNT's business.


The asymmetric risk/reward profile here is a classic "tail I win, head I don't lose much" case. This is "high uncertainty, but low risk". I think the market misprices it because everyone focuses on the middle scenario. I imagine many value investors don't dare to dream wildly on the turnaround possibility because this is not usually how one will reason a net-net.

p.s. I have no position because my capital is deployed and locked up in other places.

(Disclosure: No position)

SODI shareholders

If you are a SODI shareholder, please look at this post at Oddball stocks.

(Disclosure: Long SODI)

Gulf of Mexico oil drilling activities

(If you can't see the chart in your rss reader, you have to visit the blog directly.)

Looks like the region is back in business. e.g. See this report in Washington Post.



I am holding onto my CNRD. Repairing work should pick up.

A followup post on Conrad Industries

Two days ago I wrote about Conrad Industries (CNRD). Nate at Oddball Stocks later jotted down his thoughts on Conrad in his recent post. Nate raised two important questions:

1. Why is Conrad cheap?
2. Is Conrad a cyclical business currently at the peak of its cycles?

These are important questions. These are excellent questions. I will try to address them here.

(I have to be carefully here not to do this for the sake of merely defending own investment decision. Otherwise, all sorts of nasty psychological biases will surface and cloud my judgments. But everyone has blindspots. "I am the easiest person to fool." It's always good to have a second opinion, particulary when the view is an opposite one. While investing by a committee is a dumb idea, having a sounding board forces one to examine and re-examine one's assumptions. "Always invert." Always in the outlook of contrarian views. That's why Warren Buffett and Charlie Munger make such a lethal team. A dialogue is beneficial to the participants.)

Knowing the History is Crucial

I believe to come up with an educated judgment of CNRD's value, it is instrumental to understand CNRD's history.

CNRD has been in the industry for very long time. It was founded in 1948 by Conrad Snr. It was listed in 1998 on NASDAQ and subsequently delisted in 2005. But the most important period for our discussion is from around the time it was delisted to now. I see 3 phases in this period:

• 2002-2004: Tough business environment. Lost money every year. Loan covenants were breached and renegotiated many times. Solvency was at risk. The management decided to delist the company in order to save $800k annual expense.
• 2005-2008: Management was replaced. Conrad Jr. took over as the CEO. Profitability improved every year. The client base was broadened.
• 2009-now: General economy was hit by GFC. Exploration activities were suspended in the Gulf because of the oil spill. Profitability took a hit. The management made efforts to reduce its dependency on the exploration activities in the Gulf. 

Keep this in mind. This will set the backdrop of the ongoing discussion.

Is CNRD is a cyclical business? 

We shouldn't have any delusion that CNRD is a defensive business like Coca-Cola or even ADVC which can maintain very consistent profits even in recessions. Instead, I would ask how cyclical CNRD is. CNRD's revenue used to be very dependent on oil/gas exploration activities. That was very cyclical. That was a key factor why CNRD got into trouble in 2002-2004. But the current management has successfully moved away from this. Offshore oil/gas industry used to account for 47% of CNRD's revenue in 2006. It has been falling in a linear fashion to 7% in 2011.

My take is, CNRD has become less cyclical over the years.

Were the turnarounds flukes?

Apparently, I've placed significant weight on the prudence of current management. In actual fact, my current investment thesis rests on the quality of the management. Ultimately, CNRD has no structural competitive advantage. (e.g. It doesn't have the kind of network effort Facebook enjoys. And it doesn't have the kind of brand loyalty Apple or Coca-Cola has.)

So, the improvements and turnarounds could just be luck but not skills, couldn't it?

One evidence that tells us the current management has indeed been a positive factor in CNRD's performance is the trend of its selling , general and administrative (SGA) expenses over the years. SGA was $4.8m in 2002. SGA was still $4.8m in 2010. It isn't that it hasn't moved. It did go up to $6.2m in 2009 and it was $5.4m in 2011. But this gives me the confidence that the management has been taking a very active role in lookinag after the business in tough times and successfully adjusting its cost structure.

What if I am wrong?

I agree with Nate 100% it's important to answer oneself why a company is cheap. Another question that I ask myself all the time is "What can go wrong?"

What if I am wrong? What if CNRD is still a cyclical business? What if the current high volume of non-exploration related revenues was a pure coincident, coinciding with the recovery of the US economy?

How bad is our downside?

The current management turned around the business in 2005. It was a breakeven in that year. Since then, it has been profitable every year in the last 6 years. In these 6 years, the lowest ROE was 13% in 2010. So, even if CNRD is indeed a cylical business, at the lowest point of it cycles it still managed a 13% ROE. And it was acheived with "negative leverage" (i.e. not only without debt, but with non-operational cash on the book). With that, I will think it deserves more than 1x BV, even for a cylical business.

Besides, as I already mentioned in my original post, I still expect exploration activities in the Gulf will recover. This gives us another wildcard of another up cycle.

(In actual fact, when talking about "what can go wrong", I am more worried about the possibility that the Jones Act will be abolished. Hence, I'm mindful of the size of my position. I'm managing this risk by position sizing.)

Why is CNRD cheap?

I can't be sure. What I have is a guess.

I think CNRD is cheap because investors were burnt twice in a row. The adverse period in 2002-2004 and the subsequent delisting must have left a sour taste in the investors mouth. Then, while seeing the business was picking up again in 2006-2008, it was hit hard again by both GFC and the oil spill. Investors must have concluded CNRD is so cyclical and dependent on gas/oil exploration activites in the Gulf that it shouldn't be worth more than its book value. Investors must also be skeptic of CNRD's pursuing of non-exploration related revenues.


One last thing. I do think the current high volume of non-exploration related revenues was a coincident, coinciding with the recovery of the US economy. Given the trend of its backlogs, I also expect revenue in 2012 will be lower. But I take a longer term view. When the management with a good tracking record thinks it's now good time to expand, I give them my trust.

A watershed moment for Conrad Industries (CNRD)

(PINK:CNRD)

CNRD is a shipbuilder which makes and repairs small to medium size boats (barges, tugs, ferries) operating at the Gulf of Mexico. It's not listed and is traded over the counter (OTC). It has a market cap of $106m and is controlled by the Conrad family. 

A reasonably run business in an industry-wide recession?

I initially invested in CNRD about a year ago. At the time, the CNRD's business environment was very gloom because of the Deep Horizon oil spill incident. CNRD's business was heavily dependent on the oil/gas exploration activities in the region. My original investment thesis was: exploration activities were destined to recover, it was just a matter of time; the headwind CRND facing was temporary. And there was evidence that the management was prudent: they had been gradually replacing their revenues from the energy sector with revenue from the public sector and the commercial sector. This is I wrote in my then private investment journal that I shared with a couple of close friends:

CNRD doesn't have much structural competitive advantage. What we have is a reasonably run business which is mispriced.  In 2010, ROE is 12%, op margin is 11%. (6 years averages are 24% and 12%) It looks like the management has been keeping the operation pretty efficient even in the bad years with price pressure from over capacity in the industry in the region.

I estimated CNRD's pre-tax earning power was about $17m in a more normal business environment and its intrinsic value would be about $19-20 per share. And I told myself I would sell it once it reached that price range.

Yesterday, CNRD released its 2011 annual report. Headline net profit was $19m, almost double the figure in 2010. Its share price briefly shot past $19 in the first trading hour. So now I need to decide what I want to do about my holding.

Or is it a growing business?

Events didn't unfold as expected, but in a good way. My original investment thesis hasn't played out as expected yet. Exploration activities in the region are still very muted. However, The performance of CNRD's management has far exceeded my expectation. They were growing revenue while completely moving away from the energy sector.

The more I look at it, the more I think CNRD is a high quality growing business which excels in its operation. It has been traded at its book value for some time. It should deserve much higher valuation. Look at its average ROE again. It's 24%. So we are talking about buying a business at 1x BV which is internally compounding at 24%. But that still doesn't fully justify CNRD's profitability. CNRD virtually doesn't use any debt and it  has ~$7 cash per share on the book. Both penalize CNRD's headline ROE. In other words, CNRD's real ROE is actually much higher. While CNRD has never paid any dividend, it has spent $3.6m in 2011 to buy back shares. That's equivalent to a 3.4% yield.

What to do now? Now comes the watershed moment.

CNRD has decided to spent $20.8m for 2012 to expand its shipyard. (See page 3 of the annual report.) Considered that it spent only $49m in total in capital expenditures in the last 11 years, this is a giant expansion program. If I consider CNRD an average business recovering from an industry-wide recession, I won't be happy with such expansion. I'd rather getting some kind of special dividends. However, if I consider CNRD a growing company and that they can main their mid-twenty ROE on this new investment, this is an excellent news. Many high quality businesses with high ROE's have hard time to reinvest capital back into the business. (Just ask Buffett about See's Candy or observe how Microsoft has struggled to put its pile of cash into good use.)

I'm leaning towards to the latter. The question I have to ask myself is: Do I trust them they can compound the $20m better than me? The current management has been prudent in their capital allocation and operation. It's highly likely their decision on the expansion is opportunistic. The expansion includes buying a piece of land right next to one of their existing shipyard. How often can you buy your neighbour's house? Also, don't forget the ROE we have been talking about includes this $20m in the denominator. Regardless what they are doing to the cash (e.g. flush it down the toilet), it shouldn't damage its ROE a bit.

On the top of that, I still believe it's a matter of time the exploration activities will eventually resume. At the moment, CNRD is at $16.8. It's still 15% below my original no-growth EPV of $20.

By the way, the senior Conrad is now 96. I am wondering what will change when he finally passes the full control of the company to his son who is currently the co-CEO.... (If I haven't mistaken the history, the son was originally brought in at CNRD's most difficulty moment in 2004 to turnaround the business. And he did.)

p.s. One has to be aware of the risk that US shipbuilder industry is protected by Jones Act (1920) that boats going from US port to US port have to be owned by US companies and built in US. This is protectionism. There are arguments that companies choose to import stuff from overseas instead of cheaper local alternatives because of the artificial high local shipment costs caused by the Jones Act. What's strange is, this Jones Act has survived for 90 years and through many rounds of deregulations (e.g. rails and air). It's still here. It looks like it's unlikely it'll change. But politicians brought it up once again in 2010 after the oil spill. There is still a risk. What I can't be sure is how much shipbuilding and repair work will lose to overseas competitors if the Act is abolished. Apparently, proximity is a factor that counteracts this threat. e.g. Oil companies in Gulf doesn't engage shipyards in Seattle (west coast) to do their repairing.

(Disclosure: Long CNRD)

UPDATE: Followup post can be found here. 

GLG Corp, a case study of (not) doing proper due diligence

GLE (ASX)

GLG Corp (GLE) is a Singapore-based company listed on ASX in Australia which provides apparel/knitwear supply chain management services. GLE's major customers are clothes retailers in the United States. It acts as a middleman between the retailers and the clothes manufacturers in China and other Asian countries. GLE is recognized in the industry locally as an established player. It's a micro-cap with a market cap of $18.50m.

GLE's share price has been hovering around $0.25 for quite some time. I originally looked at this company in mid-2011. Its value has improved substantially since then. NACV is now $0.34 per share and with the improvement in US economy its operation risks have subsided significantly. GLE has never lost any money since it was listed in late 2005. Both its margins and ROE before GFC look good. Average earning in the last 6 years comes to $0.085 per share. With a conservative 6.5x multiple, it will be worth $0.55. (GLE reported earnings in USD. But since exchange rate is close to 1, the difference isn't material in this discussion.)

So, we are looking at a 50%-100% upside. What did I do? I quickly bought a stake, of course. But the fun starts now.

Because the value looks so good, I actually wanted to buy more. But before committing more money, I decided to do more due diligence. There were 2 things in its financial statements that I initially grossed over. First is an "Amounts advanced to other parties" appeared in the financing activities section of the cash flow statements in 2012H1, 2011 and 2010. What the heck are they? I couldn't reconcile them to the balance sheets.

The other one is how GLE accounted for its trade receivables. It disclosed in the Notes that it did some kind of "offsetting" which seems to be related to how GLE accounted for its trust receipts. I re-read those few paragraphs a few times but was still not sure how the offsets worked. Besides, an entity called GLIT was mentioned here. GLIT was the spin-off from GLE when it was initially listed. It is a clothes manufacturer. In other words, it's GLE's supplier. It's actually GLE's main supplier. I'm not an expert in trade financing. So if I draw the wrong conclusion, someone please correct me. But why did a supplier have anything to do with receivables? On the top of that, GLE has also provided some $16m loan to GLIT since 2010.

With some google searches and through some Singaporean contacts, I tracked down 2 other public companies operating in the same industry in Singapore with comparable size: Ocean Sky and FJ Benjamin. Comparing their balance sheets to GLE's, I noticed a few things straight away. GLE holds far less cash, inventories and account payables than its competitors. GLE essentially has a very different capital structure than its fellow competitors. How so? Also, I didn't see the kind of trust receipt offsetting that GLE used.

If GLE is not a outright fraud, the only explanation I can think of is GLE doesn't do its own manufacturing while the other two competitors do. GLE outsources its manufacturing to GLIT. But, is it truly outsourcing?

By piecing together all these observations, I come up with a theory: Legally GLIT is an independent company. But it isn't, both commercially and financially. It's still part of GLE. As one can imagine, their operation is more capital intensive and they has probably lost money in the last few years. GLE has been shuffling money down the pipe to keep GLIT alive. Beyond the $16m loan shown up in the balance sheets, I guess GLE swept the transaction details all under those "trade receivables". Beyond that, nothing else about GLIT appears in GLE's book. The operation is basically off balance sheet. How profitability is the combined entity, GLE and GLIT together? What is the overall ROE? No one knows.

These are not facts. It's a guess.

But I was uncomfortable enough that I got rid of my stake at a small lost.

p.s. I was fully aware of Steve Johnson's post about a mistake in their financial statements. That alone didn't deter me from buying GLE. Stupidity? Greed? Maybe. But now with other supporting evidence, it fits the theory. It also fits the theory why GLE used a big name accounting firm in a small town.

(Disclosure: No Position... now)

Lesson learnt from my mistake with Lakeland

LAKE (NASDAQ)

Not buying LAKE was one of my biggest mistakes in 2011. This has led me to rethink how to judge risk/reward balance in net-net investments.

Lakeland (LAKE) is a protective clothing manufacturer. It's a microcap with a current market cap of  $54m. I looked at on and off for nine months with a passing interest. In November last year, it traded below $7.00, that was 20% below its net current asset value (NCAV) and 50% below its book value. That got me very interested and I took closer look. Whopper Investments has a nice writeup of the investment thesis on his blog. I'm not going to repeat the analysis here.

To cut the story short, I was troubled by their Brazil VAT liabilities. I couldn't reconcile the figures disclosed in the cashflow statements with the details else where in the 10-K. Together with a few circumstantial facts*, I started wondering if there was fraud at LAKE. After some email exchanges with Whopper and some more thoughts, I dismissed the fraud idea because there wasn't much incentive for the management to do so. But I did conclude their VAT mess (resulted from an acquisition) was a result of bad management. I concluded their incompetency would destroy value and their good ROE in past years was pure luck. Later in their fourth quarter result, they shuffled the India money losing operation into "discontined operation". That further enforced my thinking. With no catalyst in sight, I was worried that they would bleed money in foreseeable future.

Fast forward to today. LAKE is now trading at $10.50. That's 40% return in less than 3 months. What has happened? In December before Christmas, Ansell, an Australian protective clothing company, took a 9.7% stake in LAKE.

What's gone wrong in my reasoning?

I always wanted an exit strategy or catalyst in place but there wasn't one. I forgot a net-net is a net-net because it has a few warts and no obvious resolution in sight. Otherwise it won't be a net-net. Buying a net-net is basically a calculated bet on some "positive black-swan" event, if you wish, that some positive event you have no way to anticipate or foresee will happen. At the same time, the backing of the assets gives you the staying power and downside protection.

p.s. If you don't know what a black swan is in the context of investing, read Nassim Taleb's Black Swan or Fooled by Randomless.

----

*  Other circumstantial facts I found: (1) the proxy-advisory firm Institutional Shareholder Services (ISS) has advised sharesholders to vote against director John Kreft (sitting on the audit committee) and Lakeland's audit WAKM in its Jun 2011 AGM, objecting the high non-auditing fee paid to WAKM. Kreft nearly lost his seat.  (2) Lakeland only switched to WAKM it the last couple of years. Switching accounting firm always raises concern. (3) WAKM was being sued for negligence in auditing of a bankrupt furniture maker.

Advant-e: A rare kind of microcap

ADVC (OTC)

Most of the investment opportunities in the microcap space are net-nets. Not Advant-e. It is a company with moats with consistent ROE in the 25-35% range.

Advant-e is a pink-sheet microcap with a market cap of $15M. It has 2 subsidaries: Edict and Merkur. Edict provides EDI web services. Merkur is an integrator specialised in providing e-document connectivity for enterprise-level CRMs and ERPs like Oracle and Peoplesoft. 80% of ADVC's revenue is derived from Edict.

History

Edict was founded by the current CEO Jason Wadzinski. It has been in EDI business for 20 years and in web-based EDI for 10 years. In late 1990s, when the internet started taking over everything, Edict struggled to survive with its desktop-based EDI connector business. Wadzinski bet on web-based EDI and spent all the money to implement its own web-based EDI solution. When he ran out of money, he backlisted Edict in 2000 to raise capital via shares, unsecured notes and bank loans. The listing vehicle is now Advant-e. 
 
Edict's Business Model

Edict has found a niche in the grocery EDI market. 80-90% of Edict's revenue comes from grocery EDI. It is trying to grow in the automotive EDI market and also other vertical markets like chemicals.

What's special about Edict is its business model, what Wadzinski called the "hub-and-spoke". ADVC basically gives away EDI services (with direct system integration) to big grocery retailers for free. Revenues come from the small grocery suppliers who need to trade with the retailers. Because they are small, they don't have the IT resource nor budget to do full-blown integrated automated systems. And also because they are small, the market is ignored by bigger players like IBM and Sterling Commerce. So, Edict is able to run a profitable business by providing them a web-based solution -- or in the current lingo, "cloud-based". They are charged by trade volumes. Grocery suppliers on average pay $100 per month. The amount isn't really that material with respect to their business expenses. An electricity bill can easily eclipse it.

(Evidence it patchy here. But I believe ADVC runs Kroger's backbone. And Wal-Mart is directly connected on ADVC's EDI. It appears Wal-Mart ditched VAN and implemented their own internet-based EDI using iSoft in early 2000's and ADVC has partnered with iSoft. I suppose what it mean is Wal-Mart's EDI is connected to ADVC's EDI. By doing so, small suppliers can trade with Wal-Mart via ADVC's webapp interface and Wal-Mart doesn't need to spend any money on getting them connected.)

It's as good as an electronic toll booth! ADVC is clipping toll tickets whenever the grocery suppliers are trading. As far as I can see, this business has pretty strong moats. Big retailers have no incentive to leave. It's free. Small suppliers also have no incentive to leave because the costs aren't substantial and there is a degree of lock-in. It's the same kind of pain you have when you want to move from, say, Yahoo Mail to GMail. It can be done. But there is a huge baggage of stuff (i.e. your archive) on the server which is tedious to migrate. Not to mention you have your practices and processes that you've adopted for that particular service.

Due to the nature of grocery, revenue is very stable and pretty much recession proof. As in 2009, Edict has 4000 grocery suppliers. (This is the most recent data I could find.) So, there isn't much concentration risk. And it is very profitable. Operating profit margin is at mid-20% and ROA is mid-60%. Edict has been growing its revenue and profit since it became profitable in 2003.  

EDI is an entrenched technology. It may evolve slowly but is unlikely to become obsolete. One risk I can think of is what if a grocery retailer goes bankrupt. In 2003 (I think), Edict reported they had over 100 grocery retailers on board and majority of the revenue came from 25 of them. That was long time ago. So again, the concentration isn't high enough to by worrying.

Merkur

Merkur is a different story. A large portion of Merkur's revenue comes from maintenance contracts. Merkur's business is cyclical, sensitive to IT spending, of  lower margin, and with much less moats. Wadzinski acquired Merkur in 2007 from his brother. This fact alone isn't very comforting. But it appears there is some synergy between the 2 subsidiaries. In the past years, Merkur provided software to connect mainstream ERPs and CRMs to Edict's EDI backbone. Also, it seems Wadzinski is able to bring its operating profit margin from 8% in 2007 to a respectable 22% last year by cost control.

Since Merkur constitutes only 20% of ADVC, it's not too critical. It's a mild distraction to the management, I would say.

Management

Wadzinski owns 54% of the company. There is no doubt it's his company. My impression is he knows the industry and he knows how to manage software projects. 

More importantly he seems to be shareholder friendly. He draws a lowly $160,000 salary in 2010, which is actually less than his 2009 pay. Substantial dividends have been paid in the past 3 years yielding around 8-10%. Although future dividends aren't guaranteed, this at least shows he's willing share half of the fortune built up in the company with his fellow shareholders. In 2009 he also did a 10 for 1 split in order to increase the liquidity of the shares. 

The company also bought back $270k worth of shares between 2007-2009. Not very material. But again, all these are shareholder friendly and helps to release the value.


Valuation and Growth

ADVC has $4M cash and no debt. Like most software business, it's not capital intensive. Valuing the balance sheet doesn't tell you much. Its most valuable asset isn't on the balance sheet -- its customer relationship. So it's only meaningful to value it on earning basis.

Since it's not capital intensive and the requirement on working capitals is very stable, its earnings track  its free cashflows pretty closely. A pure cash business. Business can't be any simpler than this. At the current price of $0.23, P/E is at 9.5x That translates to a cash earning yield of 10.5%. This by itself looks cheap for a quality business. No growth is priced in. Given its stable business and moats, it's like receiving a bond coupon at 10.5%. 

But ADVC does grow. In the last 5 years, its revenue grows 5.5% p.a. and profit 15%. And ADVC has been improving its operating margin in the last 5 years.  

Profit growth comes in many areas:

• Steady increase in trade volume on grocery EDI
• New suppliers signed on
• Expansion in automotive EDI and other vertical markets; both are still a very smaller part of Edict. (Edict signed up Honda in 2009. I won't be surprised this is their only client at the moment.)
• Cost cutting
• Price increase. (They increased price in 2010, when US was still considered to be in recession. That shows it has some pricing power.)

I have to be frank here. I don't have high hope ADVC's success in grocery can be related in other vertical markets. For one thing, the automotive supplier world looks less fragmented than grocery suppliers. That said, it's hard to see profit won't grow at least 5% p.a. in foreseeable future. With that, we're getting a 15% annual return. If I am more aggressive and use the 5-year profit growth rate of 10%, you will get a 20% annual return.  

So here we are looking at a 10-20% p.a. return and minimal downside. ADVC is a cash machine. Each time when I researched another company, I would ask myself why not buy more ADVC. 


(Long ADVC)