Keeping what the market throws away (Key Tronic)

October 18, 2009

Warren Buffett once wrote that in financial analysis, having an IQ above 125 is wasted and that success in investing is largely a matter of temperament. This tells us two things, one, that the world’s greatest investor thinks that dispassionate adherence to investing principles is more important than fancy quantitative models, and two, that Warren Buffett’s IQ is 126.

01netfull01_jpg_jpgThe most dispassionate method is the “net-nets” recommended by Ben Graham. These are firms whose working capital (cash and short term investments, receivables, and inventory) exceeds their total debts, and which are selling to a discount even to that. In other words, the current assets of the firm will pay for the purchase of the entire firm, and the firm’s longer-term assets and the future earning power they represent are available for free, or in fact, the current shareholders are paying you to buy them. The Snowball, Warren Buffett’s biography speaks of Benjamin Graham’s employees wearing lab coats and filling out forms to calculate whether a net-net existed. Nowadays, with SEC filings available online and the Excel spreadsheet having been invented, one would expect that these opportunities are harder to find, and indeed they are, and upon seeing them one might be curious as to why.

In theory, a diverse portfolio of these investments could be purchased without any further analysis, but as I’ve stated there may be something other than a depressed market at work. USEC Inc., for example, sold at less than its net working capital for a long period, but it was actually stockpiling cash in order to build its centrifuge plant, and we all know how that worked out.

Anyway, some kind person on the Internet has a screener to identify these opportunities. Most of them are over the counter or penny stocks, which are difficult to trade and subject to liquidity issues, which does suggest that neglect by the market is still a significant cause of these net-nets appearing. Some of them are in danger of delisting, which in theory does nothing to a firm’s operations, but usually does adversely affect its share price and also its access to capital markets. More troubling than trading difficulties, though, are operational difficulties; if the firm has a negative operating cash flow, it is quite conceivable that it will burn through the discount it sells for, thus robbing these issues of their apparent safety. Another issue is firms that reclassify their long-term investments to short-term, as with Asta Funding, a debt recycler on the list, has reclassified all of its portfolio of debts as receivables, when in reality they hold the debts for multiple years. Other firms may have inventories that need writing down.

But a firm that can avoid these troubles is almost by definition an attractive investment. Key Tronic Corporation (KTCC), manufactures circuit boards and other electronics. They have positive operating earnings, although they are a bit low in terms of return on capital, but more importantly they have 61 million in current assets, 27 million in debts, and 24 million in market cap, leaving a discount to current assets of $10 million, producing a 42% discount which makes a very decent margin of safety. Hence, this firm is worth more liquidated than it is valued at as a going concern, and when the economy improves and they have more orders, their return on assets should dramatically improve.

So, clearly fine returns can be made off what the market overlooks, if you do a little homework to make sure the market isn’t actually right.

13 Responses to “Keeping what the market throws away (Key Tronic)”

  1. According to a very quick calculation, KTCC has a net-net value of $1.06 per share. It has a market price of $2.40 p/s currently. Not exactly what I’d classify as a Benjamin Graham investment opportunity. Other than that, I enjoyed your article.

  2. I’m not sure if you’re making alterations to the reported figures, but taking receivables, inventory, and “other” at face value, they have 61 million in current assets against 27 million in total liabilities, leaving 34 million in net-net current assets. Out of 10 million or so shares currently outstanding that is about $3.40 per share. I’m glad you enjoyed the article. Please do keep visiting.

  3. I am indeed making alterations to the Current Asset just as Ben Graham did and every other true value investor I know of. Since when has a value investor ever took the information that was stated on their books at face value? I know of no value investor who has enjoyed any long term success by doing so.

    Just as Ben Graham did, Current Assets must be discounted as well before arriving at a net-net figure. Furthermore, items such as prepaid expenses and ‘other assets’ have no value and are not accounted for during this process.

    Accounts Receivable: No company in the history of business has ever been 100% successful in receiving 100% of the amount that is owed to them. If they were, debt collection companies would not be in existence. The value investor uses a ration between .75 and .85 to value receivables, .75 being the most conservative. Without knowing the complete history of the business, we’ll give KTCC the benefit of the doubt and presume they are very efficient in collecting what is owed to them and discount the $24.87 Million they have on the books at a factor of .85 coming to the discounted value, for margin of safety purposes, of $21.14 Million.

    Recievables Value = $21.14

    Total Inventory: During a liquidation sale a company who operates in the Computer Peripherals business will NEVER be able to collect full face value for their inventories; especially any company that has anything to do with technology. Technology is the most rapidly changing field there is. Prices and value change on a daily basis and most often times devalue in price. I have yet to see a technology related to this industry that increased in price. Could KTCC be the first to ever experience an increase? Anythings possible. Does a value investor speculate? NO. For this reason, Ben Graham valued Inventories at a factor of .50. The only exception to this rule was that if they were durable goods and he had direct knowledge of what those goods were. The only absolute knowledge we have regarding technology is that it never has increased in value and has done the exact opposite for a long period of time. Anything technology is not considered a durable good because new superior technology is often created in this sector on a monthly basis.

    Total Inventory: $32.29 Million at a factor of .50 = $16.15 Million.

    The ONLY item that we know to be accurate on a balance sheet is the amount the company owes the banker and the amount of cash & ST Investments the company has on hand. In this case, they owe the banker $26.64 Million and they have $730,000 of cash in the bank.

    Adding it up:

    Cash & ST Investments: $730K
    Total Receivables: $21.14M
    Total Inventory: $16.15M
    Total Liabilities: $26.64
    Outstanding Shares: 10.07M

    Final Result (Ben Grahams way): $1.13 Per Share

    There is NO margin of safety available in this purchase.

    Conclusion: KTCC is not a Net-Net stock as defined by Benjamin Graham or any other reputable value investor I know of.

    Other than that, I enjoyed your article. Visit my site sometime when you get the chance. ValueInvestorToday.com

  4. I take your point about receivables, but with regards to their inventory, KTCC is a contract manufacturer, meaning that the vast majority of their inventory is, as it were, “sold” before they even start producing it. Of course, customers do try to back out of contracts or declare bankruptcy, but I think a blanket haircut of 50% is excessive given the nature of their business and I would deem it more accurate to have a small (15%) discount for inventory (in the last three years they have had to write off a total of about $1 million, or less than 1% of current inventory levels and, as stated, 1/4 of that was due to the bankruptcy of a single customer), and a full 25% discount for their receivables. Of course, this view assumes that they are making an orderly liquidation, finishing up or outsourcing their existing contracts, and not having a fire-sale liquidation.

    Using those figures, and not throwing out the “other,” I get a value of $2.31 per share, which admittedly is a dime under the current share price. And, properly speaking, I’m not calling for the liquidation of the company; it has profitable operations as well, so I view the current asset position as more of an insurance policy or floor than anything. So, even if Graham would not approve of it as a canonical example I consider KTCC an attractive purchase.

    Thank you for the detailed reply. Do visit again soon.

  5. Inventories are items that have not been sold yet. That is the definition of an inventory. If an inventory item is sold, it moves to the receivables category of a balance sheet. The inventories they have marked down have not been sold yet, if they were, they wouldn’t be classified as an inventory. Now, they may have had orders for those inventories, but no actual exchange of money for those inventories have taken place yet. When a monetary exchange does take place, they are moved to the receivables category.

    A 50% discount may be excessive in KTCC’s situation, it is a general net-net discount though. Even if were were to take KTCC’s inventories at full value and not discounting them, and since you already agree with the point I made concerning receivables, we’d come to a not-so-conservative net-net value of $2.73 per share. Since KTCC is trading for $2.44 per share currently, there still is no margin of safety to justify the purchase. Ben Graham used a 66% margin of safety. Today’s modern value investor uses at least a 50% margin of safety. There’s only a 10.73% margin of safety from the NON-CONSERVATIVE valuation I’ve just presented. That’s not enough justification to call this a net-net investment opportunity.

    If you want to classify it as a “insurance policy or floor”, then that’s quite a different scenario all together and your article should reflect that information instead.

    Looking at this company as a going concern business, they’ve generated a 1.18% increase in revenue’s over the last 10 years. Their gross profit has decreased over the last 10 years from 12.7% to 8%. Their Liabilities have remained steady over the last 10 years with the exception of the current year. Their equity value has increased 0.93% over the last 10 years. Their net income has diminished significantly over the last 7 years, and the three years before that they produced a negative net income.

    As a going concern, this company has very little to offer an investor.

  6. Technically speaking, when inventory is sold, it does not turn into a receivable; a receivable is created and the inventory disappears since the company of course no longer owns it. However, this company’s inventory, like most manufacturers’, consists of raw materials, work in progress, and finished product, and only the last can actually be delivered in satisfaction of their contracts. The value represented by the other two still has to go somewhere, and where would it go if not inventory? I described their inventory as already sold because there is already a buyer who has signed a contract binding them to purchase it before Key Tronic even buys the raw materials, which is not the case that Graham’s 50% rule of thumb comprehends.

    As a going concern, shareholder equity has in fact increased every year for the last seven, and the net-net position has done likewise. Since 10 years ago was a dramatically high point in the business cycle and now is definitely a low point, it seems a bit unfair to compare the two. There is also the small matter of a $20+ million lawsuit in 2002.

    And given the net-net position, anyone who buys it effectively has a permanent put option at the net current asset value, so effectively the buyer is paying for the put option and any future earnings come free, or the buyer is paying for the future earnings and the put option is free (apart from the current 10 cent gap, and any opportunity costs of course). If I call it insurance or floor, well, Graham himself wrote that the net current asset test is an effort to determine whether the firm’s current price is for less than can be taken out of the company.

    As my article stated, the results of the screen do require further investigation, since they are more likely than not to arise from something other than the market overlooking something, now that data on companies is so easy to find, unlike in Graham’s day. Based on my investigation, I find this company safe and attractive, which is the net resulted intended by the net-net test to begin with.

  7. I appreciate your remarks even though I disagree with nearly all of it. Just as Buffett has stated many times, I too don’t believe there is any security in a company who’s industry changes at a rapid rate. Even if we looked at the last 7 years rather than 10 for equity growth, we’d come to a growth rate of 12.01%. It wouldn’t meet the requirements of Buffett or Fisher. I can’t find one fundamental measurement that this company passes for either a Buffett or Graham stock. Appreciate your blog nonetheless. Take care.

  8. When a bill of sale is created and the transaction of money hasn’t occurred, it is classified as a receivable. A receivable is obviously something that was agreed by both parties involved; one that promised to sell and the other that promised to buy. Any money that is collected goes on the books as revenue. If I agree to purchase a computer chip from you, for example, and you agree to sell it to me and you send me the chip I ordered and are waiting to collect the money from the transaction, then we’ve just created a receivable. Therefore, the product has been shipped but not collected on and it is no longer an inventory item. On the other hand, if you collect the money per the agreement, then you’ve created a revenue. I’m sure you know this information, I’m just being clear for you that I know it without a doubt as well.

    Especially in regards to the technology sector where rapid change occurs, how a business handles its inventory needs to be addressed. Last In First Out (LIFO) First In First Out (FIFO).

    If I am the company and my inventory consists of raw material, for example, that cost my business $1 for that inventory and 6 months later my competitor can purchase that same inventory for $0.50 and therefore sells his finished product for $1, I need to sell my product for $1 just to compete with him and the $1 I spent to make my product doesn’t allow me to profit from it now.

    This is a very real situation in the Tech business and that is why technology businesses do not often times provide for a sound and risk free investment opportunity.

    Now, if you were to tell me that KTCC owned 25% of company A and 10% of Company B and by owning those percentages in those two companies, they have a claim to let’s say $100 Million extra per year in revenue, well, then we’ve got an entirely different situation on our hands then. Then, we’ve found an opportunity; But on its own merits, we haven’t limited the risk factor with the information that is provided to us in KTCC. For me, risk is more important than the reward.

  9. A receivable can only be created once the product is completed and shipped and the seller has a legal right to payment. That is KTCC’s accounting policy, and the rule followed by every accountant. But where KTCC differs from your example is that for their contract manufacturing services, they have already received a price, projected volume, and more importantly an agreement to buy back unused inventory purchased by KTCC within a certain lead time, before they start buying the materials, so there is less risk of inventory of obsolescence, although they can lose out during the contract bidding process to begin with.

    As to your other comment, I’ve never been terribly obsessed with growth because it’s too easy to overpay for, but the fact that the price floor for this stock itself has risen, indicating that the firm is still earning and retaining profits in excess of its cost of capital is a promising sign in my view

  10. “But where KTCC differs from your example is that for their contract manufacturing services, they have already received a price, projected volume, and more importantly an agreement to buy back unused inventory purchased by KTCC within a certain lead time, before they start buying the materials, so there is less risk of inventory of obsolescence, although they can lose out during the contract bidding process to begin with.”

    If that is the case, then a .50 factor for its inventory is too conservative. In my example, I also produced a number in which I didn’t discount their inventory at all. Even after doing that, I couldn’t find a margin of safety. Do you believe in the importance of a margin of safety?

    Over the last 10 years:

    Median Free Cash Flow = 0%
    Median CROIC = 10.10%
    Median Revenue Growth = 0.20%
    Median Return on Equity = 13%

    Growth is everything in my opinion. The simplest way not to overpay for growth is to not do it :) In any event, we can debate this until we’re blue in face. We don’t see eye to eye and that’s ok. I’ve produced an 850.62% annual return thus far for 2009 so I’m a bit stubborn :) I’m sure you’ve done well also. All the best and I look forward to reading more of your blog.

  11. I do believe in a margin of safety, and I think that for a firm with profitable operations, by buying something is worth at minimum a dime less than what I pay for it, in a liquidation that is unnecessary to realize any profits, there is one.present in this stock. And I”m not sure that the median is appropriate for measuring revenue growth or return on equity, but we can leave it at that. Best of luck on your investing too.

  12. Out of the last 10 years, there were 3 years of negative revenue growth and 7 years of slightly positive. In order to find any sustainability and insight of what the future may hold, the median is the correct way to measure growth in order to smooth out the numbers from cyclicality. This is the same concept when determining Capital Expenditures when calculating Warren Buffett’s Owner Earnings.

    Same situation with ROE. Matter of fact, you’re the first value investor I’ve ever run across that challenged the median calculation. Everyone from Columbia University to the self educated value investor uses median because its smooth the cyclical nature of a business and allows an asset to be valued correctly rather than exaggerated.

  13. My recommendations generally do not depend on growth; you can get return on assets without it and sustainability is enough when the price is cheap. But it seems to me you can also smooth out cyclicality by annualizing results from various points in the business cycle. With a small number of data points, even the median can jump around a lot. Of course, using that method this particular company still is not growing at any impressive rate, but my investing thesis never called for it to grow.

    Actually, some quick googling of “+median” and “Warren Buffett,” “value investing,” or “owner earnings” does reveal one blogger, http://rcrawford.wordpress.com/ceradyne-inc-crdn/ , who uses median (actually, the median of a set of rolling several-year medians), but I don’t see that its use is that ubiquitous. I don’t recall Graham, Klarman or even Damodaran mentioning its use.

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