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The Street has an article Companies That Serve as Buyout Targets advocating a Darwin’s Darlings / Endangered Species-type strategy for buying stock:

When evaluating small-cap stocks, individual investors would do well to emulate private-equity professionals.

Focusing on balance sheets and private-market valuations of small companies cuts through the noise sounded by volatile stock markets like today’s. After all, price isn’t always indicative of value. The difference between the two can mean big profits for discerning investors, says Mark Travis, chief executive officer of Intrepid Capital Funds.

Travis uses such a strategy to determine the price that a rational buyer, paying cash, would offer for a company. Many companies he follows are growing fast and generating a lot of cash, but retail investors know very little about them because they fly under Wall Street’s radar.

Travis says companies that generate cash consistently attract suitors, either larger companies in their industry or private-equity firms. If neither comes forward, Travis is happy knowing the investment will continue to grow as the company’s cash builds up.

Stable businesses with little debt tend to be winners, Travis says.

“That makes them durable when you go through some of the bumps we’ve been through in the last three to five years,” he says. “We’re not trying to front-run Steve Schwarzman at Blackstone (BX). We just happen to like the characteristics of cash generators.”

Three of the companies on Travis’s list are as follows:

  • Tekelec (TKLC):

Travis’ Take: “This is an off-the-radar pick. It’s an example of a company that has a really beautiful balance sheet and a share price trading at a low multiple. This trades at 12 times earnings. There’s no debt and there’s $226 million in cash. Almost a quarter of the market cap is in cash. You’re able to buy it at a little over five times pretax cash flow. We think those shares are worth in the high teens.”

  • Aaron’s (AAN)

Travis’ Take: “People don’t realize with the financial-regulation bill that credit won’t be more available; it’ll be less available. This company has 1,700 stores with about 1,000 of those franchised and about 700 corporately owned. At $16, it has a 12 multiple and a beautiful balance sheet. It has $54 million in debt but $85 million in cash, so they have net cash on their books. It’s a good business and could trade in the mid-20s.”

  • Tidewater (TDW)

Travis’ Take: “They service offshore oil rigs, which certainly have gotten a lot of negative press. But they have a clean balance sheet, with $300 million in debt and cash of $122 million. Less than 10% of revenue comes from servicing rigs in the Gulf of Mexico. It trades at less than 10 times earnings and you get a dividend of 2.4%. We think the shares are probably worth $53 or $54.”

Read the rest of the article.

Long TDW.

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One of my favorite strategies is the Endangered Species / Darwin’s Darlings strategy I discussed in some detail earlier this year (see Hunting endangered species and Endangered Species 2001). The strategy is based on a Spring 1999 Piper Jaffray research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy. The premise of the report was that undervalued small capitalization stocks (those with a market capitalization between $50M and $250M) lacked a competitive auction for their shares and required the emergence of a catalyst in the form of a merger or buy-out to close the value gap.

The NYTimes.com has an article, Accretive Uses “Take Private” Tactic In Equities, discussing hedge fund Accretive Capital Partners, which uses a strategy described thus:

Accretive Capital’s strategy is to buy long-only stakes in small- and micro-cap stocks that [founder Rick] Fearon believes would be attractive “take private” companies. The benefits of being public just don’t add up for such companies, he said.

Years ago when Fearon was a principal at private equity firm Allied Capital, he was struck by the wide gap in value the public and private equity markets assigned companies.

In private equity, companies were valued at six to seven times their cash flow, while public companies, especially the smallest businesses, were valued at almost half that, he said.

Fearon believes that market inefficiency, where prices often fail to reflect a company’s intrinsic value, and the $400 billion or so that pension funds and endowments currently have committed to private equity, will help spur returns.

Fearon is fishing in waters where, because the market capitalization of the smallest companies is less than $100 million, Wall Street research fails to adequately cover their operations. In addition to helping create an inefficient market, it has eroded the benefits of being a public company.

With an undervalued stock, stock options are never in the money, erasing the use of stock as a motivator for management and employees; cash becomes preferable to stock for acquisitions, and management holds on to undervalued shares.

“Management teams that have a strategy of A, B, C and D for creating shareholder value may in the back of their minds be thinking, ‘Well, maybe strategy E is the take private transaction, or we sell the company to a strategic buyer, because we’re not recognizing any of the benefits of being public,'” Fearon said.

In essence, the strategy is Endangered Species / Darwin’s Darlings. How has Accretive Capital performed?

Accretive Capital has been involved in 19 take-private transactions, or about one-third of the positions it has closed over the past decade.

Fearon has managed to take the $2 million in capital he started with from mostly high-net worth friends and family to about $20 million on his own. His fund plunged in 2008, but returned 132 percent last year and is up about 20 percent as of July.

Assuming no additional outside capital, turning $2M into $20M in ten years is a compound return of around 25%, which is impressive. [Update: As Charles points out in the comments, the article clearly says he’s returned 4x, not 10x, which is a compound return of around 15%, which is still impressive in a flat market, but not as amazing as 25%.]

Says Fearon of the investment landscape right now:

“We’re not lacking investment ideas or opportunities, our primary restraint is capital right now.”

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In the Spring 1999 Piper Jaffray produced a research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy (see also Performance of Darwin’s Darlings). The premise of the report was that undervalued small capitalization stocks (those with a market capitalization between $50M and $250M) lacked a competitive auction for their shares and required the emergence of a catalyst in the form of a merger or buy-out to close the value gap.

In the first follow-up, Endangered species update: The extinct, the survivors, and the new watch list, from Summer 2000, Murphy and Buckley (Donoghue is not listed on the 2000 paper as an author) tested their original thesis and provided the “Darwin’s Darlings Class of 2000,” which was a list of what they viewed as “the most undervalued, yet profitable and growing small cap public companies” in 2000.

In the Fall of 2001, Donoghue, Murphy, Buckley and Danielle C. Kramer produced a further follow-up to the original report called Endangered Species 2001 (.pdf). Their thesis in the further follow up should be of particular interest to we value folk. Putting aside for one moment the purpose of the report (M&A research aimed at boards and management of Darwin’s darlings stocks to generate deal flow for the investment bank), it speaks to the very fertile environment for small capitalization value investing then in existence:

In the last few of years, many small public companies identified this [secular, small capitalization undervaluation] trend and agreed with the implications. Executives responded accordingly, and the number of strategic mergers and going-private transactions for small companies reached all-time highs. Shareholders of these companies were handsomely rewarded. The remaining companies, however, have watched their share prices stagnate.

Since the onset of the recent economic slowdown and the technology market correction, there has been much talk about a return to “value investing.” Many of our clients and industry contacts have even suggested that as investors search for more stable investments, they will uncover previously ignored small cap companies and these shareholders will finally be rewarded. We disagree and the data supports us:

Any recent increase in small-cap indices is misleading. Most of the smallest companies are still experiencing share price weakness and valuations continue to be well below their larger peers. We strongly believe that when the overall market rebounds, small-cap shareholders will experience significant underperformance unless their boards effect a change-of-control transaction.

In this report we review and refresh some of our original analyses from our previous publications. We also follow the actions and performance of companies that we identified over the past two years as some of the most attractive yet undervalued small-cap companies. Our findings confirm that companies that pursued a sale rewarded their shareholders with above-average returns, while the remaining companies continue to be largely ignored by the market. Finally, we conclude with our third annual list of the most attractive small-cap companies: Darwin’s Darlings Class of 2001.

Piper Jaffray’s data in support of their contention is as follows:

Looking back further than just the last 12 months, one finds that small-cap companies have severely lagged larger company indices for most periods. Exhibit II illustrates just how poorly the Russell 2000 compares to the S&P 500 during the longest bull market in history. In fact over the past five, seven and ten years, the Russell 2000 has underperformed the S&P 500. For the five, seven and 10 year periods, the S&P 500 rose 82.6 percent, 175.6 percent and 229.9 percent, respectively, while the Russell 2000 rose 47.9 percent, 113.4 percent, and 206.3 percent for the same periods.

The poor performance turned in by the Russell 2000 can be attributed to the share price performance of the smallest companies in the index. Our previous analysis has shown that the smallest companies in the index have generally underperformed the larger companies (see “Wall Streets Endangered Species,” Spring 1999). To understand the reasons for this differential, one must appreciate the breadth of the index. There is a tremendous gap in the market cap between the top 10 percent of the companies in the index, as ranked by market cap (“the first decile”) and the last 10 percent (“the bottom decile”). The median market capitalization of the first decile is $1.7 billion versus just $201.0 million for the bottom decile. There is almost an 8.0x difference between what can be considered a small cap company.

This distinction in size is important, because it is the smallest companies in the Russell 2000, and in the market as a whole, that have experienced the weakest share price performance and are the most undervalued. Exhibit III illustrates the valuation gap between the S&P 500 and the Russell 2000 indices. Even more noticeable is the discount experienced by the smallest companies. The bottom two deciles of the index are trading at nearly a 25 percent discount to the EBIT multiple of the S&P 500 and at nearly 40 percent below the PIE multiple on a trailing 12-month basis.

This valuation gap has been consistently present for the last several years, and we fully expect it to continue regardless of the direction of the overall market. This differential is being driven by a secular trend that is impacting the entire investing landscape. These changes are the result of:

• The increasing concentration of funds in the hands of institutional investors

• Institutional investors’ demand for companies with greater market capitalization and liquidity

• The shift by investment banks away from small cap-companies with respect to research coverage and trading

The authors concluded that the trends identified were “secular” and would continue, leading small capitalization stocks to face a future of chronic undervaluation:

Removing this discount and reviving shareholder value require a fundamental change in ownership structure. Equity must be transferred out of the hands of an unadoring and disinterested public and into those of either: 1) managers backed by private capital, or 2) larger companies that can capture strategic benefits. Either remedy breathes new life into these companies by providing cheaper sources of equity capital and shifting the focus away from quarterly EPS to long-term growth.

They recognized the implications for secular undervaluation which lead them to make an impressive early identification of the re-emergence of modern shareholder activism:

Unfortunately, many corporate executives continue to believe that if they stick to their business plan they will eventually be discovered by the financial community. Given the recent trends, this outcome is not likely. In fact, there is a growing trend toward shareholder activism to force these companies to seek strategic alternatives to unlock shareholder value. Corporate management is now facing a new peril – the dreaded proxy fight. Bouncing back from their lowest level in more than a decade, proxy fights have increased dramatically thus far in 2001 and are running at nearly twice the pace as they were last year, according to Institutional Shareholder Services. In fact, not since the late 1980s has there been such attention devoted to the shareholder activism movement.

As shown in our Darwin’s Darlings list in Exhibit XX, page 23, management ownership varies widely among the typical undervalued small cap. For those that were IPOs of family-held businesses, management stakes are generally high. In these instances in which a group effectively controls the company, there will be little noise from activist shareholders. However, companies with broad ownership (i.e., a spinoff from a larger parent) are more susceptible to unfriendly actions. In fact, widely held small caps frequently have blocks held by the growing number of small-cap investment funds focused on likely takeover targets.

Regardless of ownership structure, these companies typically have the customary defensive mechanisms in place. They are also protected because they are so thinly traded. In most cases it can take more than six months to accumulate a 5 percent position in the stock without impacting the share price. While we expect most of the successful acquisitions in this sector to be friendly, small-cap companies will have to increasingly worry about these unfriendly suitors.

There are several consistent factors that are driving the increased frustration among shareholders and, consequently, the increased pressure on Management and Boards. These factors include the aforementioned depressed share prices, lack of trading liquidity, and research coverage. But also included are bloated executive compensation packages that are not tied to share price performance and a feeling that corporate boards are staffed with management allies rather than independent-minded executives. Given the continuing malaise in the public markets, we believe this heightened proxy activity will continue into the foreseeable future. Companies with less than $250 million in market capitalization in low growth or cyclical markets are the most vulnerable to a potential proxy battle, particularly those companies whose shares are trading near their 52-week lows.

Here they describe what was a novelty at the time, but has since become the standard operating procedure for activist investors:

Given the growing acceptance of an aggressive strategy, we have noticed an increase in the number of groups willing to pursue a “non-friendly” investment strategy for small caps. Several funds have been formed to specifically identify a takeover target, invest significantly in the company, and force action by its own board. If an undervalued small cap chooses to ignore this possibility, it may soon find itself rushed into a defensive mode. Thwarting an unwanted takeover, answering to shareholders, and facing the distractions of the press may take precedence from the day-to-day actions of running the business.

So how did the companies perform? Here’s the chart:

Almost 90 percent of the 1999 class and about half of the 2000 class pursued some significant strategic alternative during the year. The results for the class of 1999 represent a two-year period so it is not surprising that this list generated significantly more activity than the 2000 list. This would indicate that we should see additional action from the class of 2000 in the coming year.

A significant percentage (23 percent of the total) pursued a sale or going-private transaction to provide immediate value to their shareholders. Others are attempting to “grow out of” their predicament by pursuing acquisitions and many are repurchasing shares. However, many of Darwin’s Darlings have yet to take any significant action. Presumably, these companies are ignoring their current share price and assuming that patient shareholders will eventually be rewarded through a reversal in institutional investing trends, or perhaps, in a liquidity event at some later date.

The actual activity was, in fact, even greater than our data suggests as there were many transactions that were announced but failed to be consummated, particularly in light of the current difficult financing market. Chase Industries, Lodgian, Mesaba Holdings, and Chromcraft Revington all had announced transactions fall through. In addition, a large number of companies announced a decision to evaluate strategic alternatives, including Royal Appliance, Coastcast, and Play by Play ‘Toys.

The authors make an interesting observation about the utility of buy-backs:

For many of Darwin’s Darlings and other small-cap companies, the share repurchase may still have been an astute move. While share price support may not be permanent, the ownership of the company was consolidated as a result of buying in shares. The remaining shareholders were, in effect, “accreted up” in their percentage ownership. When a future event occurs to unlock value, these shareholders will reap the benefits of the repurchase program. Furthermore, the Company may have accommodated sellers desiring to exit their investment, thereby eliminating potentially troublesome, dissenting shareholders. There are circumstances when a repurchase makes good sense, but it should not be considered a mechanism to permanently boost share prices.

Piper Jaffray’s Darwin’s Darlings Class of 2001, the third annual list of the most attractive small-cap companies, makes for compelling reading. Net net investors will recognize several of the names (for example, DITC, DRAM,  PMRY and VOXX) from Greenbackd and general lists of net nets in 2008 and 2009. It’s worth considering that these stocks were, in 2001, the most attractive small-capitalization firms identified by Piper Jaffray.

See the full Endangered Species 2001 (.pdf) report.

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In March I highlighted an investment strategy I first read about in a Spring 1999 research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy (see also Performance of Darwin’s Darlings). The premise, simply stated, is to identify undervalued small capitalization stocks lacking a competitive auction for their shares where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’ve been exploring it over the last month.

Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recalled were each called “Endangered Species Update” and discussed the returns from the strategy. While I initially believed that those follow-up reports were lost to the sands of time, I’ve been excavating my hard-copy files and found them, yellowed, and printed on papyrus with a dot matrix 9-pin stylus. I’ve now resurrected both, and I’ll be running them today and tomorrow.

In the first follow-up, Endangered species update: The extinct, the survivors, and the new watch list (.pdf), from Summer 2000, Murphy and Buckley (Donoghue is not listed on the 2000 paper as an author) tested their original thesis and provided the “Darwin’s Darlings Class of 2000,” which was a list of what they viewed as “the most undervalued, yet profitable and growing small cap public companies” in 2000.

As for the original class of 1999, the authors concluded:

About half of the Darwin’s Darlings pursued some significant strategic alternative during the year. A significant percentage (19 of the companies) pursued a sale or going-private transaction to provide immediate value to their shareholders. Others are attempting to “grow out of” their predicament by pursuing acquisitions, and many are repurchasing shares. However, about half of the Darlings have yet to take any significant action. Presumably, these companies are ignoring their current share price and assuming that patient shareholders will eventually be rewarded through a reversal in institutional investing trends or, more likely, a liquidity event at some later date. The path chosen clearly had a significant impact on shareholder value.

Here’s the summary table:

There are several fascinating aspects to their analysis. First, they looked at the outstanding performance of the sellers:

The 19 companies that pursued a sale easily outperformed the Russell 2000 and achieved an average premium of 51.4% to their 4-week prior share price. The vast majority of transactions were sales to strategic buyers who were able to pay a handsome premium to the selling shareholders. In general, the acquirers were large cap public companies. By simply valuing the profits of a Darwin’s Darling at their own market multiple, these buyers delivered a valuation to selling shareholders that far exceeded any share price the company might have independently achieved. Note in the summary statistics below that the average deal was at an EBIT multiple greater than 10x.

Here’s the table:

Second, they considered the low proportion of sellers who went private, rather than sold out to a strategic acquirer, and likely causes:

Only three of the Darwin’s Darlings announced a going-private transaction. At first glance, this is a surprisingly small number given the group’s low trading multiples and ample debt capacity. With private equity firms expressing a very high level of interest in these transactions, one might have expected more activity.

Why isn’t the percentage higher? In our opinion, it is a mix of economic reality and an ironic impact of corporate governance requirements. The financial sponsors typically involved in taking a company private are constrained with respect to the price they can pay for a company. With limits on prudent debt levels and minimum hurdle rates for equity investments, the typical financial engineer quickly reaches a limit on the price he can pay for a company. As a result, several factors come into play:

• A Board will typically assume that if a “financial” buyer is willing to pay a certain price, a “strategic” buyer must exist that can pay more.

• Corporate governance rules are usually interpreted to mean that a Board must pursue the highest price possible if a transaction is being evaluated.

• Management is reluctant to initiate a going-private opportunity for fear of putting the Company “in play.”

• Financial buyers and management worry that an unwanted, strategic “interloper” can steal a transaction away from them when the Board fulfills its fiduciary duty.

In light of the final two considerations, which benefit only management, it’s not difficult to understand why activists considered this sector of the market ripe for picking, but I digress.

Third, they analyzed the performance of companies repurchasing shares:

To many of the Darwin’s Darlings, their undervaluation was perceived as a buying opportunity. Twenty companies announced a share repurchase, either through the open market, or through more formalized programs such as Dutch Auction tender offers (see our M&A Insights: “What About a Dutch Auction?” April 2000).

As we expected, these repurchases had little to no impact on the companies’ share prices. The signaling impact of their announcement was minimal, since few analysts or investors were listening, and the buying support to the share price was typically insignificant. Furthermore, the decrease in shares outstanding served only to exacerbate trading liquidity challenges. From announcement date to present, these 20 companies as a group have underperformed the Russell 2000 by 17.5%.

For many of the Darlings and other small cap companies the share repurchase may still have been an astute move. While share prices may not have increased, the ownership of the company was consolidated as a result of buying-in shares. ‘The remaining shareholders were, in effect, “accreted up” in their percentage ownership. When a future event occurs to unlock value, these shareholders should reap the benefit of the repurchase program. Furthermore, the Company may have accommodated sellers desiring to exit their investment, thereby eliminating potentially troublesome, dissenting shareholders.

One such company repurchasing shares will be familiar to anyone who has followed Greenbackd for a while: Chromcraft Revington, Inc., (CRC:AMEX), which I entered as a sickly net net and exited right before it went up five-fold. (It’s worth noting that Jon Heller of Cheap Stocks got CRC right, buying just after I sold and making out like a bandit. I guess you can’t win ’em all.) Murphy and Buckley cite CRC as an abject lesson in why buy-backs don’t work for Darwin’s Darlings:

I’m not entirely sure that the broader conclusion is a fair one. Companies shouldn’t repurchase shares to goose share prices, but to enhance underlying intrinsic value in the hands of the remaining shareholders. That said, in CRC’s case, the fact that it went on to raise capital at a share price of ~$0.50 in 2009 probably means that their conclusion in CRC’s case was the correct one.

And what of the remainder:

About half of the Darwin’s Darlings stayed the course and did not announce any significant event over the past year. Another 18 sought and consummated an acquisition of some significant size. While surely these acquisitions had several strategic reasons, they were presumably pursued in part to help these companies grow out of their small cap valuation problems. Larger firms will, in theory, gain more recognition, additional liquidity, and higher valuations. However, for both the acquirers and the firms without any deal activity, the result was largely the same: little benefit for shareholders was provided.

Management teams and directors of many small cap companies have viewed the last few years as an aberration in the markets. “Interest in small caps will return” is a common refrain. We disagree, and our statistics prove us right thus far. Without a major change, we believe the shares of these companies will continue to meander. For the 53 Darwin’s Darlings that did not pursue any major activity in the last year, 80% are still below their 1998 high and 60% have underperformed the Russell 2000 over the last year. These are results, keep in mind, for some of the most attractive small cap firms.

This is the fabled “two-tier” market beloved by value investors. While everyone else was chasing dot coms and large caps, small cap companies with excellent fundamentals were lying around waiting to be snapped up. The authors concluded:

The public markets continue to ignore companies with a market capitalization below $250 million. Most institutional investors have large amounts of capital to invest and manage, and small caps have become problematic due to their lack of analyst coverage and minimal public float. As a result, these “orphans” of the public markets are valued at a significant discount to the remainder of the market. We do not see this trend reversing, and therefore recommend an active approach to the directors and management teams at most small cap companies. Without serious consideration of a sale to a strategic or financial buyer, we believe these companies, despite their sound operating performance, will not be able to deliver value to their shareholders.

Tomorrow, the 2001 Endangered species update.

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