Tuesday, August 19, 2008

Potential Value Trap: Craftmade International

I showed here that Craftmade International Inc. seemed interesting to value further according to some preliminary screening tests. If a company looks undervalued, the next step could be to value the earnings power and assets of the company. Valuing these components properly requires a deeper look at the business, the industry and the management to better understand and reflect the risks of the business.

There are a few things about Craftmade which make investing in the stock fairly risky. First, the company is heavily reliant on sales from Lowe's. Second, Craftmade does not have long term contracts with their customers and on Nov. 2006, Lowe's cancelled 14 of the lighting SKUs previously supplied by Craftmade. This had material impact to the company's overall sales. Lowe's had decided to start sourcing these products directly from overseas manufacturers. Third, the company has a new CEO and CFO as of June and Aug of this year, but the reasons for the change are not clear (imho). Additionally, the suspension the dividend, as was announced in May of this year, could be an indication that additional problems are brewing.

Companies like Craftmade depend heavily on being able to come up with new product designs, get overseas manufacturers to make the products and then market them to their customers (largely big box retailers). The problem is that the industry is increasingly moving towards big box retailers going direct to manufacturers and squeezing out the "middle-man" companies like Craftmade. With this business model, Craftmade can survive as long as they continually add value to the relationship with their customers by introducing new, innovative designs and products that are one-step ahead of the competition and are well received by the end consumers. I believe there are a lot of things that could go wrong with Craftmade's existing business model.

One way to value this company would be to use a higher discount rate for future cash flows reflecting the risks inherent with the business model. Another approach would be to calculate a liquidation value (as demonstrated here for another company) to estimate what shareholders might expect if the company decides to liquidate. Or, you can do as Buffett suggests, and just not "swing" at the company and continue looking for better situations.


Anonymous said...

Reyer, great writeup as usual. Please note that Buffett is spelled with a double 't' at the end...

Saj Karsan said...

Fixed! My fault, missed it during editing. Thanks for pointing it out