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)

How much research is enough?

Nate Tobik wrote an excellent piece on his Oddball Stocks blog about scuttlebutt. Scuttlebutt is important. That's what Phil Fisher advocated. And that's what gives Warren Buffett the confidence to put a quarter of his partnership money into American Express in 1960's in the middle of the salad oil scandal (he sat at restaurant tables and counted how many people were still using Amex card) and invest in IBM last year (he talked to his managers who used IBM's services and products).

This leads to an important question: how much scuttlebutt is enough? Or more generally, beyond analysing the financial statements, how much extra research is enough?

Financial statements tell us a lot. The quality of the products, the operation and the management will eventually be reflected in the numbers. But many times, there are delays. The impacts are not immediately visible in the financial performance. Getting the information firsthand before the impact finally surfaces in the numbers gives us an edge. Surely more information is better. So, where do we stop?

I think this all comes down to what Bill Ackman half-jokingly called "Return on invested brain damage":

“One of the things I learned a lot earlier in my career is to do a calculation which I call return on invested brain damage, which is before I make an investment which requires brain damage, or a lot of work and energy, I figure out how much money I can make.  The higher the brain damage, the higher the profit has to be to justify it.”

In short, it's a judgement of "cost vs. benefit" of the your research effort.

As Nate has already mentioned, the bigger your stake is, the more effort you want to put in. Your stake can be big because you have a large pool of money to manage. Your stake can also be big because you run a concentrated portfolio.

Besides, I also believe scuttlebutt is more important in investing in quality businesses than in net-nets. Why? The value of a net-net comes from its current assets, which are (usually) concretely shown in the balance sheet. You don't need to talk to a customer to find out. On the other hand, the value of a quality business comes from things like brand loyalty, quality of services and excellence in execution etc. These are intangibles. You won't find them in the balance sheet. To know you are getting what you pay for, you need to verify the company's brand loyalty, its quality of services, its execution, etc. How? Scuttlebutt.

If you look at it this way, it becomes clear why people like Benjamin Graham and Walter Schloss didn't emphasize scuttlebutt as much as people like Warren Buffett and Phil Fisher. Investors in the first group tended to hold a hundred positions, each taking up only 1-2% of the portfolio; investors in the second group took large stakes in their positions. Investors in the first group invested mainly in net-nets; investors in the second group invested in quality businesses.

One more thought. Early on I said more information was surely better. But is that always the case? Michael Mauboussin in his excellent More More Than You Know argues, with the support of researches, that beyond certain point, acquiring more information doesn't improve the quality of your decision-making. Instead, it will only increase your confidence which may turn out to be wrongly placed. I think this is a form of confirmation bias.

At the end of the day, I agree with Nate. I definitely think I have to do more scuttlebutt than I was. 

p.s. If you want to find out some "think outside the box" scuttlebutt techniques, check out hedged fund manager John Hempton's blog. For example, how to find out a supermarket's supply chain is more efficient than the others? You can do an apple freshness test. How to find out a hi-tech company is likely a lie? Check out what kind of car the CEO's son is driving.

Corning: the (Gorilla) Glass company - $GLW

(I did this analysis a few months ago. The price has been volatile but ends up not much higher than where it was. While my view has altered slightly since they released their November quarter numbers, the main thesis is intact. I'll give an update towards the end of post.)

GLW (NYSE)

Chances are you have some Corning ceramic cookware at home. And chances are you have LCD TVs, smart phones and laptops. And chances are you don't know the same Corning making the cookware is the same company which commands 50% of the world market of the glass substrates used in LCD/LED panels.



Valuation

Corning (GLW) consists of 3 main business entities:

• The parent company Corning: 
• involves in LCD panel, Environmental (car exhaust converter), optical fibre in telecom, Life Science (e.g Pyrex) and the most sexy Gorilla Glass (the tough glass used on Android phones).
• In dot.com days, it nearly went bankrupt because of over expanding in fibre optics.
• Dow Corning: 
• 50% non-controlling join venture with Dow Chemical. Make silicon products. 
• It went bankrupt in 1995 because of law suit on its silicon breast implants
• Samsung Corning Precision (SCP):
• 50% non-controlling join venture with Samsung.
• It makes LCD glasses

GLW accounts SCP using the equity accounting method. A great deal of SCP's operation/financial details are not visible in GLW's own financial statements. GLW does include SCP's book in its 10-K's. You just need to look for it.

I believe the best way to value GLW is to do a sum-of-parts valuation of its 3 business entities:

(figures in millions)

Here are a few observations worth mentioning:

• The income before tax figures are normalised, baised towards more conservative figures. See details below.
• SCP which makes the glass panels for LCD screens is the actual gem. So, it should command a higher multiple. And since its earning and revenue grow consistent over the years, I use its 2010's earning figure instead of multi-year average when I calculate its normalised EPV.
• Tax rate is a key factor. SCP's foreign earning is on average taxed at only 15%. But after capex, the cash needs to be brought onshore in order to realise the value and will incur tax liability. 
• Corning is sitting on some $3B worth of deferred tax credit.
• Capex is huge across all 3 entities. They are 2-4x average depreciation. There is no way to work out which portion is maintenance capex and which portion is growth capex. (When a factory is retooled to make Gen10 LCD glass panel instead of Gen8, that's as much maintenance -- maintaining profitability -- as growth.) Again, SCP looks best here as its ROA over the years stays pretty consistent. That implies it can maintain its incremental ROE. On the other hand, Dow Corning itself has bumpy ROA. Anyway, I factor in a "cash conversion rate", basically a FCF/accrual earning factor, to cater for the capex.
• Interestingly, Dow Corning has relatively high ROE. It is achieved with gearing, but it's not debt. Instead, it has customer pre-paid deposit sitting on the book. That's interest free loan from the customers.
• GLW is also low in debt and has truckload of cash on its book. (50% of its cash are offshore.)

Refer to the table above of the 3 different scenarios. So here we have a range of earning-based valuation between $10-20. (EPV = earning power value)

A quality business

On the qualitative side, without doubt, the world will have more flat panels and touch screens in 10 years time. This is high margin business (gross margin ~60%). GLW currently commands 50% of the worldwide market share. There are a couple Japanese competitors which have comparable technologies. Can GLW maintain its profitability? Apart from the its proprietary know-hows and patents, both supply-chain management and scale matter in this business. It appears GLW excels in both. Its cash conversion cycles are pretty consistent even through the 2008 recession.

GLW is a Buffett/Fisher kind of business. It spends 10%+ on R&D.

I reckon my valuation is conservative. I haven't factored in the huge growing potential of Gorilla Glass and GLW's environmental products in Europe, both have no material contribution to GLW's bottom-line at the moment. And I discount heavily of the growth potential from its capex. I read other analysts gave it a target price of ~$25. It's aggressive but achievable.

Talking about Gorilla Glass. Gorilla Glass is currently used on smart phones. Since GLW sells glass by sq metres, it needs to sell a lot of them to move the needle. The bright future comes from the next generation of LCD/LED TVs which will have full glass cover edge-to-edge for pure aesthetic reason. We know Steve Jobs loves glasses. (Just look at the Apple Stores.) Apple TV is around the corner.

Limited Downside

Wait, there is more.

In the height of GFC in Nov 2008 when a few of GLW's insiders (including the CFO) bought the shares, the price was at around $10. At the time, GLW's book value was $8.50. They were paying 1.25x book value. First forward to Aug 2011. The CFO bought at $13.50. (A much smaller stake. Granted.) Guess what the book value was? It was $13.40. The book value hasn't change much since then. We are now paying ~1.0x book value. Besides, in October last year, GLW instituted share buyback. That instantly put a floor on the share price.

We are talking about a company with ROE in the range of 17-25%, not under any business threat, with low debt and with many future potentials. It's nonsense it's trading at 1.0x book value.

* * *

Update 

I was wrong that GLW wasn't under any business threat.

It was revealed in the fourth quarter a "big customer" walked away from their contract. Although no name was given, it has been reported elsewhere LG had been working with a German company in partnership to produce LCD glasses. In the conference call, GLW management said there would be a "reset in the margins" in the industry, whatever it means.

The LCD glass market has been an oligopoly. Profitability is maintained when the players don't get into a price war in order to grab market share. That's the win-win situation. The risk here is the LG venture tries to fight for market share at any cost and flood the market with supplies. That doesn't just put pressure on the margins. It'll destroy the industry.



Where does this leave us?

I think this doesn't change the main value proposition. However, it does increase the risk.


(Long GLW)

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.

China and the Australian Dollar

I follow Michael Pettis' writings. Michael Pettis is a finance professor at Peking University’s Guanghua School of Management. His analyses of China's financial market are always insightful and thought provoking.

Last month, he published a piece titled "When will China emerge from the global crisis?" It follows up on an argument that he has made in the previous years: The impact of the GFC will affect United States first. It will spread to Europe, and eventually Asian countries and China, but with a delay. The States will also be the first economy recovering from the crisis. The delay is the result of different fiscal policies and monetary policies adapted by different countries

(Pettis' piece worths reading even if you are not interested in Australia's economy.)

We haven't seen the impact on China yet. But it appears we are now at the point of inflexion. China has just  reported their largest trade deficit in two decades. It also announced last week it would lower the growth target to 7.5% which is more symbolic than anything. Besides, there are more and more accounts reported in the Western media in the recent months about China's shaky financial status. (Examples are here and here and here.)

Even if there is no hard landing, a slowed down China will hurt Australia's economy. It looks like many people in Australia, including the politicians, pay no attention to it. They either pretend that won't happen or don't know that will happen. Australia has suffered from the Dutch Disease for some time. The economy has been buttressed solely by the resource and mining exports. Excluding the resource sector, all other industries have lost their competitiveness because of the high Australian dollar and are deteriorating fast. Since the GFC, China has accelerated their infrastructure investments. They've brought forward many of their infrastructure projects in order to keep the economy going. That's what keeping the resource sector strong. But such acceleration must come to an end at some point. By that time, it will be a major slowdown (recession?) in Australia.


One way to "short" the Australia economy is to bet against its currency. And the simplest way to do so is to buy USD. When resource exports slow down, AUD has to come down. The Economist's not-too-scientific Big Mac Index says it's about currently ~20% overvalued with respect to USD.


You got to wonder what Forex has to do on a value blog. I'm wondering that too. :-) There are so many factors influencing a currency. Macro economics, carry trades, geopolitical factors, to name a few. There is no way to predict its short term and medium term movements. However, I just can't help but think the underlying fundamentals is pointing to only one direction in long term. Given the pace how the impact of GFC unfolds around the world, when I say long term, the time scale I'm thinking of is 1-3 years. 


Probably the relative high 6% interest rate one can easily get in AUD$ bank accounts is the biggest hurdle. The way I see it, when I have a significant portion of my assets in Australia, moving some money into USD is a reasonable hedging strategy and the 6% is one has to pay for such hedge.


By the way, for Australian readers, I found one can get the best exchange rates at HSBC. The buy/sell spreads at the major banks like Westpac are just ridiculous.

First Anniversary of Japan 311 Disaster

I've just heard on the radio yesterday was the first anniversary of Japan's "311" earthquake and tsunami. And I found this entry I wrote in my own investment journal on 29th March 2011,

It's really scary. Really really scary.

After the Japan nuclear incident, most of my holdings went down and some went up. When I looked at those which went up, I found my confidence in their analyses went up and wanted to buy more. When I looked at those gone down, my confidence in them dropped and wondered when I could unload them.

My emotion is my biggest enemy.

If I can keep my head cool and be rational and methodological all the time, 80% of the work is done.

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)

First Post

Portfolio 14 starts today.