Fructivore Investments

One of the more famous places to look for value is the net-net company, which has a market capitalization that is less than it could be liquidated for, meaning that the company could never earn another cent and investors would still get more than they paid for. Surprisingly, even in the age of the database such companies still exist here and there. Nowadays, however, many of these companies have money-losing operations that will suck up the excess liquidation value before the shareholders can get to it, so the criteria for purchase should further be limited to firms that have a free cash flow that is positive, or at least zero.

One such company is Richardson Electronics, an internationally leading distributor of vacuum tubes, which you may recognize as a technology that was replaced by the transistor about fifty or sixty years ago. Nonetheless, vacuum tubes still have their uses, as they are more resilient to electromagnetic pulses and are useful in some high energy, high frequency operations such as broadcasting, but on the whole the tube remains a specialized market. Richardson also produces customized display units for products such as medical devices. The source of Richardson’s excess asset position is from a large asset sale in 2011, which has left the company with a lot of cash that it has been slowly deploying into share repurchases as well as a few small acquisitions of other tube companies.

The balance sheet, where all the action is, shows $130.5 million in cash and investments, $1.8 million in noncurrent investments, $20 million in receivables, and $35 million in inventories, total $189.3 million. The company also owns a 242,000 square foot headquarters on a 96-acre lot in La Fox, Illinois, which is probably worth a non-trivial amount of money but I don’t include it as part of the net-net value. The company shows liabilities of $26.4 million, leaving $162.9 million in net asset value. The company has 11.8 million class A shares outstanding and 2.2 million class B shares. The class A shares are publicly traded; the class B shares have ten votes each and are not publicly traded, but are entitled to 90% of the dividends on the class A shares. In fact, most of them are in the hands of Mr. Richardson, the CEO.

If we assume that the class B shares are entitled to a premium of, say, 30%, over the class A shares because of their voting control, we have a total of 14.683 million effective shares. If no premium is applied, the total is 14.026 million. Dividing these figures into the net asset position of $162.9 million, we have a per-share value of $11.10 applying the premium, or $11.62 without it. As the company’s share price as of this writing is $10.31, this represents a discount to liquidation value of 7.66% or 12.71%, respectively. I would add the caveat, though, that inventory obsolescence is a problem in the tube business, so it might be prudent not to take these discounts as set in stone.

As is wisely stated by Aswath Damodaran in his book, The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses, the decision of whether to apply a control premium depends on how good a job management is doing. If the entrenched management is running the company as well as any other outside manager could be expected to, then there is no control premium. If, however, the current management in place is incompetent or looting the place though excessive compensation, then the value of control can be significant because the minority shareholders would be better off with the ability to throw them out. For legal reasons I will not state an opinion on Mr. Richardson’s competence, but I am pleased that the company is engaging in share repurchases, since spending a dollar to purchase more than a dollar’s worth of liquidated assets earns the company at least 7.66% without actually having to do anything. On the other hand, given the company’s almost nonexistent free cash flow, I think tying up $162 million in assets to produce it is a little excessive, so I would submit that the repurchases should be accelerated at least until the discount is erased.

In terms of free cash flow from operations, in fiscal year 2013 (ended in June), net sales were $141 million and operating income was $11 thousand (note, thousand, not million). Also, capital expenditures exceeded depreciation by $583 thousand, so the company’s free cash flow would have been negative that year if not for the interest income, which I am not taking into account because the bulk of them are non-operating assets that again should be returned to the shareholders via repurchases. For the first 9 months of fiscal year 2014, net sales were $103 million as compared to $106 million in the same period for the previous year, which is in line with the ongoing trend at Richardson. The operating loss over that period was $229 thousand, although the company did allocate $800 thousand for evaluating potential acquisitions to operating expenses. This compares to $1.6 million in operating earnings for the same period in the previous year. And, again, capital expenditures exceeded depreciation over this period, this time by $1 million, making for another period of negative free cash flow.

So, where does that leave us? It’s fairly clear from the slightly negative free cash flow that tubes is not the place to be right now, but the drain the company’s operations is producing on its asset position is for the moment almost negligible at roughly $1 million a year. Therefore, it would be prudent to purchase the company to take advantage of its discount to its liquidating value, but to watch the discount like a hawk. Also, as inventory obsolescence is a risk factor in the tube business (but not so much for the customized displays as the company makes them to order), it might be advisable not to wring out the last penny of the discount either.

I should also point out that Richardson will release its 4th quarter and fiscal year 2014 earnings very soon, on July 24th. Forecasting what those results will be in any great detail would be a fool’s errand, but here is my forecast. Free cash flow will, barring a miracle, be disappointing relative to the amount of capital tied up in the business, and there may or may not be share repurchases; there were none in the third quarter, but Richardson’s share price has been lower on average in the fourth quarter.

So, with the above caveats in mind, I can recommend Richardson as a candidate for portfolio inclusion, if you believe as I do that purchasing at a discount to liquidation value is a viable strategy.

Disclosure: At the time of this writing, I was long shares of Richardson Electronics.

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Investing by grocca