Thursday, May 24, 2012

Running Into A Duckwall

About a year ago, Duckwall-ALCO (DUCK) was discussed on this site as a high-risk, turn-around situation. Since then, the company's value has stabilized while it's price has fallen some 30%. As a result, it trades at a 50% discount to its net current assets and is therefore much more compelling from a value standpoint.

DUCK operates 200+ stores in small towns throughout the central US. It appears as though previous management ran this company into the ground, as new management that came in about two years ago had to start from scratch with a deeply indebted, cash-burning situation. But as a reader recently pointed out, things appear to have turned around. The company earned $1.6 million in its most recent fiscal year, compared to a loss of $4.6 million in the year before.

But try selling DUCK's improved situation to Mr. Market. While the company has net current assets above $60 million, DUCK trades for just over $30 million! To be sure, the company's return on capital and return on equity is still weak (the latter coming in at about 1.5%), but there are reasons to believe the new management team has potential to continue to improve the company's financial situation.

First, DUCK management finally believes it has systems in place to be able to reduce inventory meaningfully. Inventory is expected to drop by $15 million this year (half of the company's market cap!), with some of it going towards paying down debt and some going towards share repurchases.

Management also believes there are a few million dollars to be saved annually by re-organizing the company's distribution routes. Furthermore, the company is able to negotiate better lease terms on stores that come up for renewal (operating lease obligations have dropped by $10 million y/y while store counts are essentially flat).

DUCK has also begun to participate in the e-commerce world, offering a number of items to customers online. Management is also in the process of instituting regional pricing and merchandising, which provides an opportunity to increase margins without capital investment.

Finally, shrink also remains an opportunity. Though management has been touting this issue since last year, it has not yet been able to make meaningful progress. Recent software upgrades may help in this regard; if the company can get back to DUCK's shrink average, about a $2 million increase in annual operating income is possible. If DUCK can get to industry shrink levels, about a $4 million increase in operating income is possible.

There are risks to this investment, however. The company carries almost $200 million of debt and operating lease obligations combined. DUCK does have working capital of $150 million, which is what allows it to borrow the $65 million in balance sheet debt that it carries. In addition, the company has land and buildings carried on the books for $12 million.

But management's bonuses are calculated based on the company's ROE, which means you can expect the company to continue to carry heavy debt obligations. This financial leverage magnifies the gains and losses for you as an investor. You can do very well if the trend of managements' improvements continue, but if things turn south again you can also fare very poorly.

Further adding to the risk is that rather than shrink down until it generates decent returns on capital, the company continues to add stores even as it closes unprofitable ones. These require cash investments in equipment and inventory that could otherwise be used to pay down debt or buy back shares.

Shareholders may also want to be aware of some potential financial shenanigans as well. The company has changed its inventory accounting method in each of the last two years, both of which have served to improve the income statement. For example, its most recent change (from the retail inventory method to the weighted average cost method) resulted in a GAAP net income increase of $2.6 million, though there was no cash flow impact.

Overall, however, DUCK does look like a bargain at its current price. This is a profitable company trading at a 50% discount to its net current assets. As mentioned, however, there is a remarkable amount of operating and financial leverage built into DUCK, which may scare some value investors away. Incidentally, if you were to buy shares in this company you would be joining value investor Michael Price.

Disclosure: No position


Anonymous said...

Everything being said here was essentially said almost exactly a little over a year ago. You can pull up that post.

But the tone of this post is about 30% more pessimistic and cautionary than last year.

This is a perfect example of getting a little more fearful when you should be getting a lot greedier.

Saj Karsan said...

Tone is obviously hard to measure. I actually do like the company a lot more than I did last year; I think if you compare the intro and concluding paragraphs from the two articles, that becomes more clear.

Anonymous said...

how do you get the $200M figure? where are you getting this data from?

Saj Karsan said...

Hi Anon,

The debt figure is from the balance sheet, and the operating lease figure is from the notes to the financials statements on the company's latest annual report.

Ray said...

Now, buyout at less than 50% of the book value