Thursday, December 4, 2008

H Paulin: Safety First

The first rule of value investing is to never lose money. An investment in H Paulin (PAP.A), a manufacturer and distributor of nuts, bolts and 75,000 other stock keeping units, appears to offer investors such an opportunity. The company's inventory and accounts receivable add up to $82 million, while all of its liabilities total just under $39 million, for a difference of $43 million. Meanwhile, the company trades for just $20 million on the market.

Therefore, even in a liquidation situation, investors are protected to a great extent. As a going-concern, one can look at this situation as akin to buying the inventory and receivables of this company for half price while still getting all the fixed assets and customer relationships for free!

A couple of days ago, we saw a similar situation to this when we looked at Shermag, which was burning through cash. However, this is not the case for Paulin: its operating income continues to be positive as its distribution business profits make up for its manufacturing losses.

As such, the fixed assets of this company may not be worth much (but remember, you're getting them free!), as the auto industry customers the company serves are going through a tremendous downturn. On the other hand, the customer relationships (another freebee!) appear very valuable: Paulin has managed to position itself as a supplier of choice to The Home Depot (HD).

As The Home Depot concentrates on consolidating its suppliers, Paulin has been a clear winner, having secured valuable sales contracts with this customer until at least 2011. As a result, despite slowing sales at Home Depot, Paulin's sales to Home Depot have increased year over year in the double digits thanks to market share gains within the stores.

As such, a big component of Paulin's sales and accounts receivable are from The Home Depot. Therefore, it's worthwhile ensuring HD is financially stable and able to pay its debts. As we looked at here, despite the exceptional downturn in HD's industry, it is in no danger of going away: interest coverage, cash flow, and liquidity appear strong enough to outlast even the most severe downturn.

There's no such thing as guarantees. H Paulin may make mistakes causing HD to cancel its contracts, or it may blow its profits on what turns out to be unprofitable ventures. But a portfolio of companies made up of "Paulins", trading at discounts to liquid assets and having positive earnings and cash flow, is sure to offer investors outstanding returns over the long term.

Disclosure: The author owns long positions in both PAP.A and HD.

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