Occasionally, we have guest authors contribute to this blog. The following post was written by Stephen Stewart, C.A., M.B.A. (Richard Ivey School of Business).
Benjamin Graham frequently refers to ‘net-net’s in his writing as a prized investment opportunity. A ‘net-net’ is a company where the combined value of its current assets less all of its liabilities is greater than the market capitalization of the company. From a value investing standpoint, these companies are perceived to have minimal risk.
In today’s investing world it is hard to find companies that meet this criteria. If an investor screens stocks carefully some can be found. One such example is Glendale International (GIN-T), which is listed on the Toronto Stock Exchange. Glendale International is a holding company that owns two recreational vehicle (RV) businesses and has a large stake in a publicly listed technology firm, Firan Technology Group (FTG-T).
Using some basic value investing stock filter for a low BV/MV will quickly identify Glendale as a potential value investment. Some quick calculations on the May 31, 2008 statements indicate that the shares are trading substantially below the book value of equity (BV of equity of $35.5 million versus a market capitalization of $17.0 million). There is also a substantial amount of cash on the balance sheet, accounting for almost a third of the equity. Overall this looks like a promising candidate for a net-net. On the negative side, Glendale is losing money.
Buying into a net-net is founded on the belief that the value can be realized from the resources of the company. This is because net-nets are almost always companies that are failing to achieve an acceptable return on invested capital or are unprofitable altogether (as is the case with Glendale). Resource realization can take many forms: liquidation, sale of the assets or a change industry characteristic that will allow for a higher return on capital. This analysis will focus on the first two, under the assumption that an investor can create the conditions for a catalyst event to occur through shareholder activism, board influence or takeover.
Performing a net-net analysis requires a careful read of the financial statements and accompanying notes to understand the nature of the assets and liabilities of a company. Glendale is a perfect case of this. The goal of this process is to unlock value from the balance sheet.
The first issue that emerges from the financial statements is that the balance sheet is really a combination of two separate businesses, the 100% controlled RV business and the consolidated 43.6% interest in Firan. Firan is a publicly listed company with a market capitalization of $14.0 million. This interest could be distributed directly to shareholders or sold to a third party. This would allow for approximately $6.0 million in value realization. Doing this though means that Firan needs to be carved out from the balance sheet:
This leaves the Glendale portion of the business with total balance sheet liabilities of $4.0 million (the minority interest and deferred gain are not real liabilities). Cash totals $10.8 million. Non cash liquid assets (inventory and accounts receivable) total $16.6 million.
The remaining assets likely have little liquidation value with the exception of the Note Receivable. Per notes to financial statements this is a mortgage. Upon liquidation or sale, a value of $1.9 million could be realized from this financial instrument.
The ‘Investment’ is peculiar as it is an ownership interest of 11% in the management buy-out (MBO) company that owns 3,620,000 shares on Glendale (29% interest). The MBO currently owes Glendale $4.4 Million, which is secured by the shares of Glendale. For purposes of this analysis the loan will be treated as an asset and the shares will be included in the total outstanding (12,487,017). However of this amount Glendale effectively owns 398,200 of itself, thereby reducing the total to 12,088,817.
As a sale of the business will generate higher proceeds than liquidation, it is important to determine the liquidation value to establish a value floor.
To determine the liquidation value of current assets some industry knowledge is required. A read of the MD&A indicates that the RV business is in decline due to a myriad of factors. This reduces the amount we can expect to realize on inventory and receivables. To be conservative lets assume that receivables will be recoverable at 80% and inventory at 40%. This will provide $7.8 million in cash.
Liquidating a business will result in significant closure and severance costs, so a provision of $2.0 million will be added. This leaves us with a liquidation value of:
The stock is currently trading between $1.20 and $1.35. This would imply an upside on liquidation of over 50%. If the RV business could be sold in its entirety for more than $1.7 million then the gain would be higher.
Overall this is a good example of where a catalyst event can result in substantial gains on resource conversion.