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.