A reader recently brought our attention to Protective Products of America (TSE: PPA), a micro-cap that provides ballistic protection to military and law-enforcement. On the surface, this appears to be a company that could offer some value. However, too many red flags pop-up upon further review. By themselves, each of the items discussed below don't necessarily disqualify an investment, but PPA has so many of these issues that its just not worth the risk (as we prefer to buy companies that look like sure things: examples here).
First of all, its debt to equity ratio of about 55% seems a little bit higher than what we're usually comfortable with for this type of company. But throw in the fact that most of the equity is made up of Goodwill, part of which was just written down last quarter, and you quickly realize that this company is funded mostly by debt.
And much of this debt has been called, thanks to the company's poor performance in the last year. As such, the company must refinance, either by issuing shares or replacement debt, at terms which are not likely to be favourable to shareholders.
So how did management get into this mess? They overpaid for an acquisition, resulting in a write down last quarter of about 1/3 of shareholder's equity! Perhaps the economic climate blindsided management, so maybe they deserve a free pass on this one?
Unfortunately, this doesn't even scratch the surface in terms of signs of weak management. The company has had issues with revenue recognition (they were recognizing revenue before they had officially made a sale, thus moving earnings forward, making earnings appear higher than they were), and were forced to restate results by independent auditors. Even if the statements are correct now, it's not a good sign that management is not being conservative with its accounting.
Finally, there are a slew of transactions the company has undertaken whereby corporate officers have personally benefited! For example, the company has leased property that is owned by an executive! Such conflicts of interest result in shareholder interests not being aligned with those of management. After all, this manager might be tempted to increase company investment at the property which he owns, whether it benefits shareholders or not! That's not to say that management is dishonest. Nevertheless, as discussed in Security Analysis, such a situation is detrimental to shareholders, through no fault of management.
Although many of these factors are qualitative, they paint a picture that suggest an investment in this company is not protected on the downside. For all I know, management is perfectly honest. Unfortunately, the circumstantial evidence is enough to prevent a "swing" at this company.