Thursday, September 10, 2020

ADF Group

ADF Group is engaged in "the design and engineering of connections, fabrication, including industrial coating, and installation of complex steel structures, heavy steel built-ups, as well as miscellaneous and architectural metalwork", having been originally founded as a blacksmith in 1956. It trades under the ticker symbol DRX in Toronto.

The company has a book value of $97 million, with a net debt position of about $17 million (including all lease liabilities as debt). But it trades for just $36 million, despite earnings of $2 million in its most recently reported quarter and a healthy backlog of $315 million. Last quarter's revenue came in at $42 million, to give you an idea of how many quarters worth of backlog the company has.

The signing of large contracts is invariably volatile not just from quarter to quarter but also from year to year, so the company's current backlog can give investors peace of mind that during what could be a difficult period, the company has work in hand to avoid large losses. Furthermore, the healthy backlog also reduces pressure on management to accept price concessions in times of industry overcapacity just to keep the lights on.

While the company is headquartered in Canada, most of its work is done in the US through its subsidiaries. The company hedges its foreign exchange risk to avoid unanticipated losses due to currency fluctuations.

More than $5 million of the company's long-term debt is through the US government loan program put together to ease the burden of the pandemic. Some or all of this debt is likely to be forgiven, which is a significant amount for a company with a market cap of just $36 million.

While the strong balance sheet and tangible assets provide some downside risk protection, there are some negative elements to this investment. Fixed costs are high, and while the current backlog provides enough work for now, that may not always be the case. Comments on the company's latest conference call suggest that while bidding activity remains strong, customers are taking their time signing commitments considering the economic/pandemic environment.

Furthermore, the company is controlled by its management through a dual-class share structure. This makes it possible for management to abuse their positions by doing things that benefit them at the expense of shareholders. In this case, however, the benefits the managers make relative to their stakes suggests their interests are more aligned with shareholders than not; the company's CEO makes about $500 thousand per year in compensation while owning more than $5 million worth of stock.

The three siblings that control the company are also all over 60 and so eventually there may be a liquidity event where they sell out, at a price much higher than the current price as the "dual-class discount" will likely disappear.

Overall, I view this situation as an asymmetric bet. There is upside here thanks to the low price to book and enterprise value to current earnings. But there is also downside protection in the form of tangible assets and a safe capital structure.

Disclosure: Author has a long position in shares of DRX

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