George Risk Industries Resembles Buffett’s Dempster Mill But Lacks a Catalyst

One of Warren Buffett’s early investments during his partnership years was a small Nebraska company that  manufactured windmills and farm equipment.  The story of Dempster Mill Manufacturing in Beatrice, Nebraska is documented in great detail in Andrew Kilpatrick’s massive three volume set, Of Permanent Value:  The Story of Warren Buffett. Mr. Buffett began acquiring shares of Dempster in 1956 and had a controlling interest by mid 1961.  After gaining control, Mr. Buffett installed new management and dramatically improved the performance of the business.  By 1963, performance had improved and the business was significantly overcapitalized with only 60 percent of assets utilized in the manufacturing operations.  Through a reorganization that involved the sale of the operating business, excess capital was effectively returned to shareholders.

Revisiting George Risk Industries

We first profiled George Risk Industries in early January and noted that the company was massively overcapitalized and represented a potential bargain for investors.  George Risk designs, manufactures, and sells a variety of products with 87 percent of revenue in the last fiscal year coming from security alarm related products. Please refer to the original profile for more background on the business along with a spreadsheet with several years of financial results.

Not much has changed since the original profile based on the company’s recently released 10-K report covering the fiscal year ending on April 30, 2010.  Book value per share has increased to $5.42 per share at April 30 from $5.16 per share as of October 31, 2009 – the latest data available at the time of our original analysis.  The company earned $0.30 per share for the fiscal year ended April 30, 2010 compared to $0.10 per share for the prior year which was depressed due to large investment losses. Net-net current assets (current assets minus all liabilities) was $5.22 per share compared to a recent market price of $4.50.

Swimming in Cash and Securities

Most notably, the company had cash and investments of $23.2 million on the balance sheet as of April 30 which exceeds the company’s current market capitalization of $22.8 million.  The company has no long term debt.  Based on the nature of the company’s operating business, it is doubtful that more than $3 million of cash should be required to run the business and provide for foreseeable contingencies.  This would allow for a distribution of at least $20 million, or $3.95 per share, to be returned to shareholders.

The company earned $1.1 million in pre-tax operating income in fiscal 2010, which does not include income derived from investments.  This income level is still depressed due to the sensitivity of the company’s alarm business to housing starts.  While exact precision is not possible, it seems likely that the ongoing operating business might be worth $10 million, or approximately $2.00 per share.

Based on conservative assumptions, it seems reasonable to believe that George Risk could be worth approximately $6.00 per share from the combined value of the excess cash and securities on the balance sheet and the value of the ongoing business.  This compares very favorably to recent trading levels between $4.25 and $4.50.

But George Risk Industries Isn’t Exactly Like Dempster Mill …

All of our analysis regarding a potential distribution of the excess cash and securities is merely academic because Ken R. Risk, Chairman and CEO, owns 58 percent of the company and has not shown any interest in distributing excess cash.  Without the ability to take control of the company, could a minority shareholder benefit from this excess cash?

If the company continues to pile up cash and securities on the balance sheet, minority shareholders may never realize much value.  This is because the company has no competitive advantage in the field of investing, as demonstrated by the fact that they have outsourced this function to a “money management” firm with authority to trade for the account.  Furthermore, the company has not managed cash balances particularly well.  The 10-K reveals that large amounts are “sitting in cash at this time” because the company has not found a “worthy place” to invest the proceeds from several matured CDs.

Furthermore, the company maintains very large uninsured cash balances in a small financial institution in Kimball, Nebraska run by one of the company’s directors.  As of April 30, 2010, the company had an uninsured balance of $3.1 million with this financial institution.  According to the related party transaction table, the company earned interest of less than one percent on this cash during fiscal 2010.

Another warning sign documented in the 10-K involves the company’s statement regarding acquisitions.  Management indicates an interest in acquisitions and states that no financing is likely to be required — meaning that available cash and securities could be liquidated to fund expansion.  Could such expansion enrich shareholders?  Possibly, but this is not part of an investment thesis based on distributing excess cash to shareholders.

No Catalyst In Sight

Even if an investor is willing to overlook the lack of a catalyst, shares trade in such low volume that it would be very difficult to accumulate a meaningful position without impacting the price of the stock.  Apparently the company sees value in the shares and has been repurchasing stock in recent years.  This will further increase Ken Risk’s entrenched position as controlling shareholder.

Examining opportunities like George Risk Industries illustrates the importance of carefully reviewing the details of a business rather than simply buying shares based on simple filters like price to book value.  There are occasions when a stock can be cheap and remain cheap for an indeterminate period of time.  In such situations, one must be able to trust management to build value or at least refrain from destroying value.

While management at George Risk Industries appears perfectly competent to run a security alarm business, we are not reassured that excess cash or securities will ultimately benefit the minority shareholder.

Disclosure:  No Position in George Risk Industries.

Marty Whitman Reflects on Value Investing and Net-Nets

Despite a snowstorm that caused the absence of several speakers, the Columbia Investment Management Conference in New York today included many interesting presentations and panel discussions.  The highlight of the day was the conversation between Columbia Professor Bruce Greenwald and Martin Whitman, Founder and Portfolio Manager of Third Avenue Management.

Mr. Whitman has a sixty year history in the investment management field and represents a distinguished voice of experience we can all learn from.  This article includes several topics that were included in the discussion between Prof. Greenwald and Mr. Whitman but it is not a complete transcript and, unless otherwise noted, is based on the authors notes and recollection of the conversation rather than a presentation of direct quotes.

The Evolution of a Value Investor

Most investors who have arrived at a “value oriented” strategy moved toward the approach over a period of time.  Many of us know the story of Warren Buffett reading every book on investing in the Omaha library but not reaching the conclusion that value investing represents the best strategy until reading Ben Graham’s The Intelligent Investor in 1950.  A similar “evolution” was the case for Mr. Whitman who entered the business as a security analyst at Shearson, Hammil in 1950.  For the first four years, Mr. Whitman focused on many of the traditional benchmarks that security analysts today still concentrate on such as earnings per share growth and predicting near term price movements.

In 1955, Mr. Whitman read Between the Sheets by William J. Hudson which is a book (currently out of print) regarding the importance of paying particular attention to the balance sheet.  This book combined with several real life examples at the time convinced Mr. Whitman that emphasizing balance sheet quality should be more heavily considered in the field of security analysis.  Mr. Whitman also gained a great deal of experience working as a portfolio analyst for William Rosenwald starting in 1956. Experience in stockholder litigation and bankruptcy, fields that were shunned at the time, also provided important lessons regarding analyzing the capital structure of distressed firms.

“Cheap is Not Sufficient”

At several points in the discussion with Prof. Greenwald, Mr. Whitman came back to a central theme:  It is not sufficient for a security to be “cheap”.  It must also possess a margin of safety as demonstrated by a strong balance sheet and overall credit worthiness.   In other words, there are many securities that may appear cheap statistically based on a number of common criteria investors use to judge “cheapness”.  This might include current year earnings compared to the stock price, current year cash flow, and many others.  However, if the business does not have a durable balance sheet, adverse situations that are either of the company’s own making or due to macroeconomic factors can determine the ultimate fate of the company.  A durable balance sheet demonstrates the credit worthiness a business needs to manage through periodic adversity.

A New Take on Graham’s “Net-Nets”

Mr. Whitman believes that it is a “myth” that there are no “net-net” opportunities available in the market today.  We discussed Graham’s concept of net-nets in a prior article and came up with some examples of such opportunities over the past year (for example, see the articles on Hurco and George Risk Industries).  However, such opportunities are very rare and often exist only in the most thinly traded stocks and therefore are rarely actionable.

Rather than adhering to Ben Graham’s original concept of “net-nets”, Mr. Whitman has made a few modifications.  Instead of using current assets as the store of value, he looks at “readily ascertainable asset value” and tries to buy at a large discount to that value.  Assets that can be readily convertible to cash may include high quality real estate, for example.  In certain situations, assets such as real estate may be more valuable in a liquidation than inventories which are part of current assets but often highly impaired in distressed situations.

One other point that Mr. Whitman made while discussing corporate governance also applies to many net-net situations.  The true value of a company may never come out if there is no threat of a change in control.  This obviously makes intuitive sense because the presence of a very cheap company alone will not result in realization of value unless management is willing to act in the interests of shareholders either by liquidating a business that has no future prospects but a very liquid balance sheet or taking steps to improve the business.

When asked if the management of a typical public company is overpaid, Mr. Whitman said “you’d better believe it” due partly to the fact that most Boards of Directors are “a bunch of wimps, including me.”  This serves as a reminder that there is one other characteristic that many value investors share:  Humility and a willingness to admit errors.

Reader Questions on George Risk

Yesterday’s article on George Risk Industries generated quite a bit of reader interest but due to the recent removal of the comment and forum features, the questions were not posted directly.  This article consolidates the reader questions on George Risk and highlights a few additional points of interest.

Related Party Transactions

Question: There seem to be a number of related party transactions documented in the 10-K including the lease of an airplane that is co-owned by CEO Ken Risk.  Is this a warning sign that the family is trying to extract value from the company at the expense of other shareholders?

Answer: There are in fact a number of related party transactions including the lease of the airplane at a cost of $27,000 per year.  The plane is co-owned by the company and by Ken Risk and the company pays the cost of the lease for its portion of the plane to Ken Risk.  While it is not clear why a small Nebraska manufacturer with two locations that are less than fifty miles apart requires a private plane, the cost does not appear to be material to the investment thesis.

The company also leased a duplex from Eileen Risk, the CEO’s mother, until the end of 2008.  The lease required total payments of $7,000 per year.  In December 2008, the company purchased the building from Eileen Risk for $15,000.

The company also leases a building from the CEO requiring a $1,535 monthly payment.

While the presence of related party transactions is a legitimate concern, such transactions are common in companies that are majority controlled by the founding family.  In the case of George Risk, the transactions do not appear material to the investment thesis.

Marketable Securities

Question: The company has delegated responsibility for investment of the marketable securities portfolio to a “money manager” firm that has the permission to buy and sell stocks at will.  The company pays a quarterly service fee based on the value of the investments.  We know very little regarding the amount of the fee or the nature of the investments.

Answer: This is a legitimate concern given the amount of intrinsic value locked up the securities and prior results of the money manager which seem to be less than inspiring.  The company does disclose more regarding the allocation of assets within broad categories such as municipal bonds, corporate bonds, and equity securities.  As of October 31, 2009, 49.9 percent of the $19.1 million was invested in municipal bonds, 31.4 percent in equity securities, and 16.9 percent in money markets and CDs with the small remainder in corporate bonds and Federal agency securities.

While the most shareholder friendly move would be to distribute the excess capital to shareholders, this appears to be unlikely given management’s majority ownership of the company.  One of the main risks to the investment thesis is that the funds may be diminished by poor investment decisions or the company may choose to liquidate securities and pursue an acquisition that destroys shareholder value.

Preferred Stock

Question: Please comment on the preferred stock.

Answer: The company has 4,100 shares of preferred stock outstanding.  Each share of preferred stock is convertible into five shares of common stock.  The analysis has assumed the conversion of the preferred stock and this has been assumed as well by the company in the calculation of diluted earnings per share.  The amount of preferred stock does not seem material to the investment thesis.

Customer Base Concentration

Question: How does revenue break down across the company’s client base?

Answer: The security segment accounts for the vast majority of revenues as discussed in the article yesterday.  Most of the customers are distributors who sell to the end customer.  One distributor in the security segment accounted for approximately 42 percent of sales.  Loss of the distributor would have a material impact on the company.  However, management notes that the customer has purchased from the company for many years and is expected to continue.

Disclosure:  No position in George Risk Industries.