PGNT is a $4.3m microcap. It provides conveyor systems for assembly lines and order fulfillment operations. It lost money 7 out of 10 years between 2001-2010. Current share price is ~$2.8 while it has a NCAV of $3.25 which consists mainly of cash.
Normally I would quickly dismiss companies without a track record of making money. However, I noticed Sham Gad, a value investor, was involved. I took a closer look.
Downside protection
Gad was elected to the board in 2010. He subsequently built up his position to 25% throughout 2011. In March this year, he didn't only take over the chairmanship, he also got the 2 directors elected. These are the 2 directors that he originally recommended in the proxy fight back in 2010. So, effectively, Gad has the complete control of the company.
Why is this important? This is important because it puts a very solid floor on our downside. Gad intends to bring the business back to profitability. After he gained a seat at the board, he managed to reduce cost and steer the business to break even in 2011. What will happen if he senses he can't achieve it? As a value investor, he won't have any emotional baggage. He will immediately liquidate the business. The liquidation process may not be smooth. But since the bulk of the assets is in cash, we should get back most of the $2.8 invested. The presence of a value investor collapses the range of possible outcomes to almost a single point if the business fails to deliver. This wouldn't be the case if it were the founder controlling the company.
Valuation
And what is our upside? We should consider this a turnaround and handicap it. I take a stab at this in the spreadsheet below:
(If your rss reader doesn't show the spreadsheet, you need to visit my blog directly.)
Under the "turned around" scenario, I assume it requires a 1.0x quick ratio to keep the business running. Hence $2.75 cash can be distributed. I assume it can double its revenue, back to the level before GFC. I assume it can earn a generic 5% net margin. And I give it a conservative 8.5 P/E multiple. This gives us a valuation of $7.13 per share.
Next, we need to guess how likely the business can turnaround. Again, this is a wild guess and a pretty aggressive one. But one thing that helps is the recovery of the US economy is on our side. I put down a one-fifth chance. The rest of the calculation in the table is self-explanatory. We end up with an expected return of 42%. You can try to plug in different numbers in different places. But the general risk/reward profile doesn't change much.
(Another thing to be aware of is, the 42% return or the $3.99 value won't exist in the real world. We will either end up with one of the possible scenarios. There is nothing in between. The expected value is only indicative.)
Capital allocation
Why did I make reference to BRK at the start? This has to do with how Gad intends to use the cash in PGNT. I don't believe Gad will actually distribute the cash if the turnaround fails. Gad has lay down his intent in his chairman letter published in March:
Through a disciplined capital allocation process, we will examine ways to utilize the Company's assets to increase the intrinsic value of the Company.This is how I see it. He will try to keep the business breakeven and plow any operational cashflow back into the business (e.g. in R&D) while waiting for recovery of revenue. At the same time, he will invest the cash pile in any opportunities he can find. If you are familiar with the history of BRK, this is effective what Buffett did to BRK.
Gad is a Buffett disciple. Investing in PGNT will feel like investing in BRK in its old days. You need to be comfortable to be Gad's junior partner to invest in PGNT.
Final thoughts
So, we can look at the investment case this way: At $2.8, we are basically taking a stake in Gad's managed fund and at the same time getting a free option on the PGNT's business.
The asymmetric risk/reward profile here is a classic "tail I win, head I don't lose much" case. This is "high uncertainty, but low risk". I think the market misprices it because everyone focuses on the middle scenario. I imagine many value investors don't dare to dream wildly on the turnaround possibility because this is not usually how one will reason a net-net.
p.s. I have no position because my capital is deployed and locked up in other places.
(Disclosure: No position)
Seems like a very interesting find, thanks for the work and for sharing.
ReplyDeleteReading the letters is interesting. It seems like he's hit choppy waters. I like the investment in Meritage Preferred, and the fact he's acquiring a stake in an insurance company is interesting. Beyond that, SI & Sed seem to be a little on the ropes.
ReplyDelete