Thursday, October 30, 2014

Hanover Foods 2014 Results

Price$ 110.000
Market Cap$ 82.08 M
P/E TTM12.0 x
Div yield1.0 %
ROE3.1 %
LT Debt/Equity0.003
Hanover Foods just released its 2014 year-end results. Revenue was $429.0 M versus $443.8 M the previous year. Income was $6.9 M versus $12.1 M the previous year. Gross margins fell to 10.5% from 11.6%. Management did not make a single comment to explain the drop.

However the report did clarify the matter of the total outstanding shares. Apparently, the internet and blogsphere has been confused what that number is. It is a total of 746k A and B shares. A and B shares have same economic value but only B shares have voting rights. The company also gave hints as to the value of the shares. The company has a small amount of outstanding B shares in its employee incentive plan. The company at times buys back these shares when vested from the employees at $155. This is a $45 premium over the most recently traded A share price. The company does this probably because there is no real market for the B shares. I own the A shares, which are much more commonly traded on OTC.

The company made progress to reduce long-term debt to virtually zero. It also increased cash by $3M. So at least management isn't squandering earnings. But there is no getting around the fact that this is a low-return business. A 3.1% return on equity means that this business is no better than 10-year treasuries. Despite this I own this stock because it trades at less than 1/2 book. This is the classic cigar butt. I think and hope that this company can be acquired for twice the market value. But I have no idea whether the Warehime family want to sell. But while we all wait for some kind of an exit scenario, the company must work on improving operations. I have yearly data going back 4 years and it shows a distributing pattern. See below (all numbers are millions).

2014 2013 2012 2011
Revenues 428.9 443.8 439.0 425.1
COGS 383.9 392.3 380.2 371.6
Gross margin 10.5% 11.6% 13.4% 12.6%
Operating margin 2.4% 3.8% 4.8% 4.3%
Net income 6.9 12.1 13.6 12.3
Equity 221.1 213.3 200.9 188.8

Again, I don't know the reason(s) for the decline. I can only speculate that commodity prices may have played a major role over the last 4 years. But commodities prices are coming down worldwide. I will closely watch the results in the coming quarters. I certainly hope and expect it to improve.

Saturday, October 25, 2014

My Trip to the IEHC Annual Meeting

IEHC just held their annual shareholder meeting on Thursday and I was there. I decided to trek 3000 miles to attend because IEHC is a tiny company with a $12M marketcap and, not surprisingly, has little coverage in media. The company went up 75% in the 1 1/2 years that I owned it, and I needed more information to decide what to do next. So, I went mainly to see the company and its people in the flesh. Besides, I badly needed a vacation, even if it was for just 4 days.

So on the day of the meeting, I found myself in a busy business area of Brooklyn with a huge prison or military type building on one side. As I walked towards the company address in the rain, I found that prison or military building is the company's location! And the building is huge, the lobby has a 10-story high ceiling that makes you feel like you are in a train station. As I entered, I paid careful attention to my surroundings, because every impression can be a clue about the company. Next I had to ask someone where is the IEHC suite in this mammoth building. The person told me to go through an atrium which evidently used to be a railway platform because there is still the railroad tracks on each side, and there is even a WW2 era train car on one of the tracks! I even took pictures just in case anyone doesn't believe me. See below. If you look closely you can see weeds on the tracks. Look even closer and you can see that the surroundings were wet. That is because the atrium ceiling was leaking!

Entrance to IEHC; the office is on the 8th floor on the left

Now I will move on to the meeting. It was in a small partitioned conference room. I was one of three shareholders present, the other two being local to the area. The CEO Michael Offerman and his son David were there, as well as Robert Knoth, the CFO, the legal counsel and Jerome Rosenberg the long-time auditor. We started the meeting with the boilerplate legalese and voting formalities, then we spent about an hour on questions and discussions. I didn't expect to get any material nonpublic information, and I didn't. But it was extremely informative at the same time. I saw the interaction between the David and Michael, which was harmonious. Michael was a sharp, hands-on and knowledgeable for a 73 year old CEO. David, who is the marketing VP, also was passionate and knowledgeable. He appeared to be a person who deserves his position and I would gladly see him take over from the elder Offerman someday.

In the meeting us shareholders raised the issue of dividends and Michael Offerman said he has considered it but he was non-committal. But I learned that the IRS apparently pressures companies to have a clear path to either use retained earnings for capex or to distribute it. I got the impression management is still developing the growth strategy for the next few years as the company builds up more and more cash. The company increased equity by $1.8M last fiscal year but spent only $0.35 M in capex. If the company continues to perform well as it has done in the last few years, I think the company will accelerate capex spending. But it will still be in the same ballpark as it is now, maybe $0.5M. So then, given the about $2 M dollar expected cash flow in the coming years, management will have no choice but to give out at least a token dividend. I think 2% will make investors very happy. It will make me very happy.

After the meeting David gave us a brief tour of the factory. At this point, I just wanted reassurance that this small company really makes what it says it makes, and that it does employ over 100 employees as stated on its 10K. But it was during this tour that I met a most interesting 90 year old woman. This petite woman has been an IEH employee for 67 years! She originally worked for David's grandfather in the 1940's and not only has she worked for IEH for her entire life, but she has also brought her children and grandchildren into the company. This woman's presence told me more about the company management than anything I learned so far that day. As a shareholder in a company where the CEO owns more than 50% of the company, my biggest worry besides the health of the company is whether the insiders are treating the minority shareholders fairly. I know that Michael Offerman is paid $240,000 per year. And the company has a stock option plan but that plan is totally untapped. So I know the management compensation is very reasonable. And, after I met this lady, I am sure that the insiders will not take advantage of minority shareholders. A boss who can get that kind of loyalty from employees will not be out to screw the minority shareholders!

So, when I left the company, I felt very good about my IEH investment. I met the management and liked them. I saw the operation and it appeared efficient, well managed and low-cost, which leads me back to the company's building. This building I found later was the Brooklyn Army Terminal used in WW1 and WW2 to supply ships bound for Europe. The building now belongs to the City of New York who rents it out to businesses. And while it sure doesn't look impressive for an office building, I like it because it must be cheap. To me a company's premises should be as cheap as possible so long as it doesn't scare the customers and potential employees away. Below is a picture of the Brooklyn Army Terminal from the outside.

Wednesday, October 1, 2014

Why I Bought Sears Holdings and Promptly Sold It

Sears Holdings (SHLD) and I go back to late 2007, when I read the famous bullish Barron's article. After I read the article, I got the stock at $135 per share. Later, I managed to average down in the following year. I sold out the last of my position last year, and overall probably broke even. Last week, the stock hit a recent low when CEO Eddie Lampert announced he would lend Sears $400M for a short term through entities that he controls. That piqued my interest in the company again. The stock reached a low of $24.50 last week. From the time when I first bought seven years ago to now, they have spun off Sears Hometown, OSH, Sears Canada and Lands End to shareholders. I have heard people estimate these spinoffs at $23 per share. That means the stock has dropped 64% from when I first bought.

As the original Barron's article suggested, it is the real estate and other assets that makes SHLD attractive to investors. SHLD owns or leases about 2000 locations in the US. Sears also owns the Kenmore, Craftsman and Diehard brands. The company also operates the Sears Auto Centers. But in the last seven years we have not really seen any large-scale monetization of the real estate. The company has closed hundreds of stores because of underperformance. In the process, the company may make a gain on the sale of the real estate or on the sale of the lease if the store is not owned. Right now, the company's equity is less than $1 B and it has lost more than $5 B in the last 3 years alone!

So the company's income and balance sheet steadily declined over the last 7 years. No wonder then that the company stock has dropped 64%. Even if investors believed in the real estate story, it is very unclear how long it takes. And many gave up, myself included. But in investing, I can like any security at the right price. And I like SHLD at $24.

In my analysis, I am trying to be objective. Bad mouthing Eddie Lampert or being hysterical doesn't serve much purpose in making the correct decision. As I mentioned earlier, Sears has shed several businesses that it owns. Sears is still left with its main assets which has the most optionality. The following summarizes Sears' real estate associated with their full-line stores only and shows their change over the last two years.

Date No. of Stores Total Sq ft (mil) Owned vs. Leased
Sears Domestic 2012 867116 60%
Kmart 20121305 125 16%
Sears Canada 2012122 16 11%
Sears Domestic 2014 798109 60%
Kmart 20141221 115 16%
Sears Canada 2014 (prorated 51%)59 8 11%

The company has gradually been downsizing. In the process it had gains of $0.67 B and $0.47 B and $0.06 B in 2013 2012 and 2011, respectively, from property sales or sale of leases. The company also closed 145, 60 and 247 stores in 2013, 2012 and 2011 respectively, at a cost of $0.14 B, $0.16B and $0.34 B respectively.

Because Sears is bleeding money so badly the company is openly discussing harvesting the real estate value. The consensus view is that the company will have negative operating cash flows between $1B - $2B per year. The CEO resorted to lending the company $400M because of this urgent need for cash. Whatever the CEO was trying for the last seven years to revive the company has proven to be a failure. The is no other out for the company but liquidation or major downsizing of the Sears' retail business. The following lists Sears' financial position and how I estimate it would fare in a liquidation.

Value (bil) Total value (bil)
Market cap2.6 Total EV: 18.3
Long-term debt 2.8
Pension and other liability 4.7
Current liability 8.2
Inventory and current assets 8.4 Liquidation value: 20.7
Sears Canada
Trademarks 1.8
Store Real Estate 8.5
Other Property 0.5
Auto Center 0.5
Home Warranty & Repair 0.5
Difference 2.4

I used $8.5 B for the store real estate because that is a number I've heard floating around. That means the company can realize a gain of about $4 M a store or $40 per square feet. The above also does not put any value on Sears online though Sears is the third biggest online retailer today! So the reader may argue that I am being too conservative, but that's my nature. And to me the overall $2.4 B potential gain is too small a margin considering it is bleeding so much cash everyday. Also there is just so much unknown regarding value of the company's real estate. Are the remaining store locations more or less valuable on average versus the hundreds that were closed before? A retail investor like me simply does not have the resources to research the answer.

With that in mind, who is backing the company becomes a major consideration for me. The company is owned by three of my most respected value investors: Eddie Lampert, Bruce Berkhowitz of the Faireholm Fund and David Chou of the Chou Funds. Berkowitz and Chou have two of the best track records over the last two decades in the USA and Canada. And both of them have a sizeable 10% position in their funds.

So, there I was on Friday, thinking about the issues with SHLD. I also reminded myself that I spent more money at Sears than any other retailer in recent years — mostly for appliances and at the Sears Auto Center. I then decided to reopen a position. However, I hadn't completed this blog entry and I didn't have the entire analysis clearly in mind. When I completed this entry during the weekend, I reconsidered my purchase and thought that the problems outweighed the potential upside. By Monday, I decided to put SHLD in the too-hard pile and sold my position.

This was a small mistake that didn't harm me, thankfully.