The Rational Walk
Intelligent Investing is not a "Random Walk"

George Risk Industries Resembles Buffett’s Dempster Mill But Lacks a Catalyst July 30, 2010

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 February 26, 2010

Marty Whitman

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 January 22, 2010

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.

George Risk Industries: A Potential Bargain With Limited Downside Risk January 21, 2010

George Risk

In a recent lecture on value investing, Columbia Business School Professor Bruce Greenwald perfectly captured the essence of what value investors are looking for in the following quote:

“You are looking for things that are ugly, cheap, boring, out of fashion, small and obscure, or otherwise on the other side of the existing finance industry mania.  If it’s on the recommended list of one of the big retail brokerages, my advice to you is to watch out.”

Few publicly traded companies are more obscure than George Risk Industries, a small Nebraska manufacturer of security alarm products.  With a market capitalization of $21 million and very low trading volume, the company is far too small to attract attention on Wall Street.

Background

George Risk designs, manufactures, and sells a variety of products with nearly 90% of revenue in the last fiscal year coming from security alarm related products.  While the company claims to compete well based on price, product design, and quality, George Risk has also built competitive advantages by specializing in small custom orders that larger competitors often decline.  The security products range from burglar alarms, pool alarms, and advanced sensors to detect incursions in unusual places such as skylights.

George Risk has been solidly profitable over the past decade although business has slowed considerably since demand for the company’s products are highly correlated to activity in residential construction.  The fact that the company has managed to remain profitable in this environment is a positive sign and an indication of good management, a competitive moat, or a combination of these factors.

Management

The company was founded by George Risk and has been run by President and CEO Ken Risk for the past two decades since the death of his father in 1989.  Mr. Risk owns a majority interest in the company with 56.8% of shares outstanding.  The presence of a CEO with a controlling interest in a company is often a mixed bag.  While minority shareholders have limited influence, the CEO’s incentives  are theoretically aligned with maximizing shareholder wealth (of course, provided that he does not pay himself unreasonable compensation).  In the case of George Risk, management appears to have reasonable policies on executive compensation and non executive Directors were only paid $150 each in the last fiscal year.  However, allocation of free cash flow has been questionable as we discuss below.

Classic Graham Situation

From a valuation standpoint, George Risk Industries is a classic Graham net current asset value situation with NCAV (current assets minus all liabilities) of $4.93 per share as of 10/31/2009 compared to a current market quote of $4.25.  What makes the company particularly interesting is the fact that management has chosen to retain a significant portion of earnings over the past decade and invest the proceeds in marketable securities.  As of 10/31/2009, the company had $4.28/share of cash and marketable securities on the balance sheet. Investments and securities accounted for $19.1 million as of October 31.

Excess Cash and Investments

In order to properly value George Risk, it is necessary to determine how much excess capital is on the balance sheet.  With a current ratio of 38.6 and no long term debt, the company is significantly overcapitalized.  A current ratio of 2 or more is normally considered adequate for an industrial business.  However, taking a conservative approach would make sense in light of current economic conditions in the housing industry.  Let us assume that George Risk requires a current ratio of 10 to safely navigate the recession.  This would imply the presence of approximately $19 million of excess investments and securities which represents $3.73/share of value.

Valuation of Business

George Risk has a strong operating record over the past decade.  Prior to the recession, operating margins averaged close to 25%.  Earnings per share averaged $0.43 per share for the ten year period ending on April 30, 2008 (which in fact could be an understated indication of the business earning power due to cumulative losses in investments that have depressed net income).  Since the recession began, sales have declined significantly and margins have been compressed.  Earnings per share came in at $0.10 for fiscal 2009 (ending 4/30/2009) and $0.09 for the first half of fiscal 2010 (ending 10/31/2009). The company has remained profitable and is still generating free cash flow.

While the quote on George Risk shares has varied quite a bit over the past decade, it was not unusual for the market to assign a price-earnings ratio of 10 or more prior to the recession.  This type of valuation does not seem unreasonable given the strong track record of the company and healthy profit margins.  Assuming that George Risk can earn $0.30 by the 2012 to 2014 time frame, the value of the business should be in the neighborhood of $3.00 per share. Discounting a $3.00 in 2012 to today’s present value at approximately 10% would result in a business valuation of around $2.50.

Intrinsic Value = Excess Cash & Investments + Valuation of Business

The combination of the excess cash and marketable securities on the balance sheet, which we have estimated at $3.73 per share, plus the valuation of the ongoing business of $2.50 results in an intrinsic value estimate of approximately $6.25 compared to today’s market quotation of $4.25.  This represents a potential upside of close to 50 percent. The stock currently yields 4 percent which should provide some income as well.

Potential Risks

There are a number of potential risks that could reduce the upside potential of an investment in George Risk Industries:

  1. The company is majority controlled by CEO Ken Risk and there is no indication that the company plans to distribute the excess cash and marketable securities or to change their long standing policy of building up a portfolio of marketable securities far in excess of requirements to support the business.
  2. The investments in marketable securities have failed to produce value for shareholders over the past decade.  The company has delegated responsibility for management of the portfolio to an outside manager who has the ability to make trading decisions.  It appears that there has been quite a bit of turnover in the portfolio and there is limited disclosure regarding what securities are held.
  3. The downturn in housing could continue for an extended period (think of a Japan style “lost decade”) and eventually cause George Risk to operate at a loss, thereby reducing the intrinsic value of the ongoing business.
  4. The company has indicated that it is interested in acquisitions and marketable securities could be liquidated to pursue such acquisitions which may or may not result in the creation of shareholder value.
  5. Management has been late in filing a number of SEC reports over the past few years and this could indicate that they are having difficulty keeping up with the requirements of being a public company.

Despite these risks to upside potential, it does appear that the risk of a permanent loss of capital is significantly reduced by the value of a well established operating company along with the excess assets on the balance sheet.

Limited Liquidity

George Risk Industries is very illiquid and there are many days when no shares trade.  On days when it does trade, the typical volume may be a few thousand shares.  As the saying goes, it “trades by appointment”. The bid/ask on the stock is unusually wide with a typical spread of fifty cents or more.  Therefore, any orders for the stock must be made using limit orders.

I should note that so far I have found it impossible to purchase this stock anywhere near the prevailing bid despite daily limit orders over the past two weeks.  I am viewing this more as an interesting case study in a Graham style investment than an opportunity to put any meaningful amount of funds to work.  It is better not to obtain any shares than to offer too much and lose the margin of safety.  Perhaps some of my readers will have better luck.

Resources

Historical Data and Analysis – Excel 2007 (Source:  Rational Walk Analysis)
Historical Data and Analysis – Excel 2003 (Source:  Rational Walk Analysis)
George Risk Industries Website
George Risk Industries SEC Filings

Reader Questions

A number of readers have asked questions about this article.  A new post was written to address the questions.  Click on this link for the Q&A.

Disclosure:  No position.

Hurco Companies 10-Q: Warranty Provision Concerns Revisited June 5, 2009

hurcowarrantyprovision

Hurco Companies, Inc. released a 10-Q report today which covers the company’s fiscal second quarter ending on April 30, 2009. I covered the initial release of Hurco’s earnings for the quarter in an article last week. In that article, I mentioned some concerns about an unexplained drop in Hurco’s warranty provision in Q1 and the need to closely examine the warranty provisions once the 10-Q for the second quarter is released. Now that we have the 10-Q, let’s take a look at the warranty provision concern.

Calculation of Warranty Provisions

The company does not provide much in the way of details regarding how warranty provisions are estimated for any given period.  In the latest 10-Q, the following explanation is provided:

We provide warranties on our products with respect to defects in material and workmanship. The terms of these warranties are generally one year for machine labor and service parts. We recognize a reserve with respect to this obligation at the time of product sale, with subsequent warranty claims recorded against the reserve. The amount of the warranty reserve is determined based on historical trend experience and any known warranty issues that could cause future warranty costs to differ from historical experience. The warranty reserve may vary due to changes in sales volume, product mix and sales by region.

The final line in the explanation appears to be an addition compared to the language used in the 10-Q for the first quarter.  I contacted Hurco’s management and received a response stating that they would consider adding more detail. Unfortunately, the additional detail merely states the obvious and does not add much that is useful to the analyst, particularly in light of the apparent change in management’s methodology for recent quarters.

Warranty Provision History

Let’s examine the history of Hurco’s practices when it comes to warranty reserves and provisions over the past five years.  The exhibit below shows data for the last five full years as well as the first two quarters of the current fiscal year:

Hurco Warranty Provision (2004 to Q2 2009)

In my opinion, the appropriate metric to use when evaluating warranty provisions for a particular period is the ratio of the provision to cost of goods sold.  The alternative would be to take the ratio of the provision to sales.  However, since the company’s cost of sales is a more accurate reflection of what it would cost to provide warranty services and parts, I have selected that metric for this analysis.

For the five full fiscal years from 2004 to 2008, warranty provisions as a percentage of cost of sales ranged from 2.06% to 3.23%, with a drop between 2004 and 2005 followed by relative stability in the low 2% range over the past four years.  During the five year period, aggregate provisions totaled $11,488,000 and warranty charges totaled $10,013,000.  Based on historical precedent, it would appear that management reserved properly for warranty provisions during this time frame.

In the first fiscal quarter of 2009, warranty provisions as a percentage of cost of sales dropped to 0.29%.  For the latest quarter, the measure came in at 1.25%.  For the first half, warranty provisions as a percentage of cost of sales measured 0.71%.  This appears to be a precipitous drop from the reserves taken in prior periods.  Either a change in methodology has been adopted or management believes that the product mix or regional sales mix will materially impact warranty charges in the future.

If one takes the average warranty provision as a percentage of cost of sales for the last five full years (2.34%) and applies this number to cost of sales in Q1 and Q2 2009, we can infer that warranty provisions should have been far higher than recorded.  In aggregate, there would appear to be a shortfall of $573K for the first half of fiscal 2009.

What Does This “Prove”?

This analysis, taken in isolation, does not in any way “prove” that earnings are being managed or that the warranty provision is not correct.  Management could well have solid reasons for the change in approach between prior years and the first half of the current year.  However, we are not told of any such reasons for such a dramatic change which leaves the suspicion that earnings are being managed during a particularly rough period for Hurco from  a business perspective.

In the absence of convincing reasoning to the contrary, I will assume that warranty provisions should be adjusted to reflect prior historical averages and assume that earnings were actually smaller than reported in the financial statements (or more accurately, net loss for the first half should be higher than reported). My view is that a change in methodology of this magnitude requires additional disclosure if we are to accept the figures in the financial statements without making appropriate adjustments for historical experience.

Position Liquidated

We have liquidated our position in Hurco this morning at an average price of $14.75.  The decision was not made based on the warranty provision issue alone.  There are two additional primary factors that have changed the equation enough to warrant a sale of the position:

First, as I mentioned in the article last week, I have growing concerns about the fact that management has not trimmed inventory aggressively to reflect the precipitous drop in sales so far this year.  The probability that inventory will be written down has increased significantly.  If this occurs, the drop will be reflected in Hurco’s current assets and obviously would have an impact on metrics such as tangible book value per share.  The discount to Hurco’s reported tangible book value per share was one of the primary factors leading to the initial purchase decision.

Second, I am growing less comfortable with Hurco’s regional sales mix based on the condition of Europe’s overall economy.  Hurco is heavily exposed to Europe with over 63% of sales coming from that region in the first half of the current fiscal year.  Europe has generally been less aggressive in terms of monetary and fiscal stimulus compared to the United States and this will have an impact on economic growth going forward.  While I never make investment decisions based on macroeconomic factors alone, Hurco’s exposure to Europe is a contributing factor in the decision.

It is possible, and perhaps even likely, that Hurco will enjoy a rebound in business and share price over the next several years.  However, my initial purchase rationale for the position was based on the company’s apparent discount to net current assets and tangible book value.  With my suspicion that the company’s balance sheet is now more impaired that the reported numbers show, I can either exit the position or change my rationale for  holding the shares from a net current asset play to a call on the eventual growth in the global economy in general and Europe in particular.  In my experience, changing the investment rationale for a position is nearly always a bad idea in the long run.

Investment Performance

The position in Hurco advanced 11.07% from the purchase on April 7 while the S&P 500 advanced around 14% in the same period.  I normally do not consider investments in special situations (such as net current asset plays) unless I believe that there is at least a 50% upside, so the result is disappointing from that perspective.  In addition, underperforming the S&P 500 is always disappointing.  Nevertheless, all things considered, there are worse things than exiting a position with gains that probably should not have been acquired in the first place had a more thorough review of all factors been considered initially.  Should Hurco’s stock price return to the lows of March, it may well be worth looking at again even considering the potential concerns brought up here; however, at the current quotation, the margin of safety is not sufficient.