Wednesday, May 11, 2011

Duckwall-ALCO: Turnaround In Progress

Turnarounds can be a great source of returns for investors. When the market counts a company out, its shares can trade at extremely low levels, allowing investors the opportunity for tremendous upside potential. The shares may also trade at large discounts to book value, allowing the value investor some downside protection in the form of assets. Duckwall-ALCO (DUCK) may be just such an opportunity.

Duckwall-ALCO operates a chain of 200+ retail stores throughout the central US. The company attempts to avoid competition by operating in small towns with populations under 5,000 where no broad line retailers exist.

But the company has had a rough go of it in the last few years. Profits have fallen as the company has struggled with its merchandising, causing management to believe many customers are driving some distances away to make their purchases at competitor stores. As a result, the company trades at a price-to-sales ratio of just 0.1 and a price-to-book ratio under 0.5.

But things appear to be turning around. A new management team took the helm in early 2010, and they implemented a number of new measures to improve the company. Merchandising was re-organized, technology systems were implemented to better track inventory, distribution centre flow was re-designed, and a line of unprofitable stores was closed.

As a result, the numbers have started to improve. Over the last few months, same-store sales are actually increasing, the company's shrink ratio has fallen (and there is still room for significant improvement to the bottom line if the company can eventually achieve industry average shrink ratio levels) and costs have been cut. Investors who buy now may be on the cusp of a turnaround story that drives up the stock price significantly.

However, this investment is not for the conservative investor. Downside protection is not as strong as it may appear to be because of the company's debt level. DUCK's recovery is still in its nascent stages, and if it doesn't gain traction, the company's debts will start to pull the company under.

Against a book value of just over $100 million, the company has debt and operating leases approaching $200 million. Unfortunately, these aren't short-term leases either, so if things don't go well, the company is still obligated to pay tens of million of dollars per year for the next ten years. Considering the company has had positive free cash flow only once in the last four years, the risk of financial trouble is certainly present.

Furthermore, the cash flow that does come out of this business appears earmarked for expansion. Though management has said it may pay down debt with free cash flow, which would make the company safer, it appears clear from their actions that management would rather open more ALCO stores with any money that's freed up from the business. You can't really blame management for this viewpoint, considering their bonuses are based on DUCK's return-on-equity (ROE). The bonuses can be as much as 150% of salaries if certain ROE targets are hit, and nothing increases ROE like a ton of leverage. Unfortunately, it is shareholders who bear the risks of leverage.

If DUCK's turnaround proceeds on its present course, shareholders will likely be rewarded enormously. However, there isn't a whole lot of leeway if things turn south. The company's financial position is such that a premature expansion or an economic downturn could raise doubts about the company's future.

Disclosure: None


Taylor said...

The debt was the main thing that worried me here, especially given the fact that it hasn't been decreasing.

What do you think about the NOL carry forwards the company has accumulated?

As per 10-K:

"At January 30, 2011, the Company has total federal and state net operating loss carryforwards of $10.1 million and $20.2 million, respectively, which are available to offset future taxable income. The federal net operating loss will expire in fiscal 2031. The state net operating losses will begin expiring in fiscal 2020. Due to the history of earnings and projected future results, the Company believes it is more likely than not those future operations will generate sufficient taxable income to realize the deferred tax assets. As such, at January 30, 2011 and January 30, 2010, there is no valuation allowance on the net operating losses."

Saj Karsan said...

Hi Taylor,

The NOLs are nice to have, but obviously they are worthless if the company can't stay profitable. So they can help with upside but they don't protect the downside at all, and it's the downside which is what I'm worried about here.

Taylor said...

Understandable. I just found it strange that management applied absolutely no valuation allowance against the NOLs. From my experience (which is very limited), I have generally seen management apply a valuation allowance.

This tells me that DUCK's mgmt may have some degree of certainty in regard to future profitability; however, on the flip side, they may just be using overly optimistic projections, rendering the projections worthless. It's probably safer to be skeptical of their projections.

Anonymous said...

Here we are. Exactly one year removed. The stock has fallen about 35% from when you made this post. We've reported three successive profitable quarters.

The market cap is $30M, about 50% of its net current asset value which hovers around $60M.

What next? Buy more?

Saj Karsan said...

Hi Anon,

I do find it a lot more interesting this time around. My latest thoughts are here: