Buhler Industries (TSE:BUI): Inventorying this Net-Net

I have to admit, Buhler Industries (TSE:BUI) calls to me like a siren’s song.  What can I say, I have a weakness for net-net stocks.  And in many ways, BUI is my ideal net-net:

• It’s in an industry I (sort of) understand: Farm Equipment Manufacturing.
• It has a long history of profitability: EPS have been positive in every single fiscal year going back to at least 1993.
• Its foray into 4WD tractors has been initially successful based on reviews of its Versatile DeltaTrack models.
• Best of all, it trades at a discount to net current asset value (NCAV). As of December 31, 2014, NCAV was $5.56 per share, compared to the current quote of $5.20.

A historically profitable company trading at a discount to liquidation value - a rare find in this market.

Now, admittedly, there are issues surrounding BUI that give one pause, not the least of which is the ownership structure:

• Despite having a market cap of C$130,000,000, BUI has a very low float.
• In 2007, Combine Factory Rostselmash Ltd, a Russian manufacturer of combines, bought 80% of Buhler. The company remains headquartered and operated in Canada (with some U.S. manufacturing facilities), but the new owners have provided a potential growth avenue into Russia and Eastern Europe through co-marketing with Rostselmash.
• John Buhler (the retired CEO, current Board member and namesake of the company) still owns 14.5% of outstanding shares as of the most recent proxy. 
• The company’s deferred profit sharing plan owns another ~1%.

All told, BUI has a float of only ~4.5% of shares outstanding. This is 1,125,000 shares, or less than C$6 million at current prices. To say we would be minority shareholders in this stock seems like an understatement. 

While these issues certainly play into any purchase analysis, more concerning to me is the growing imbalance between revenues and inventories. In fact, many short sellers will use slowing sales and continued additions to inventory as a textbook screen for short ideas.

Now, arguably, some of this growing disparity is likely priced into shares considering they are trading for slightly less than NCAV. Yet, when we compare BUI’s numbers to peers, it is staggering how large its stockpiles of inventory and accounts receivable have become:

Among peers it has (usually by a wide margin):

• The longest receivables collection period
• The most days inventory on hand
• The highest inventory per employee
• And, despite a slowing ag economy, saw both its accounts receivables and inventory grow over the past twelve months.

In other words, I have some doubt that BUI could liquidate itself for NCAV. Additionally, BUI is having trouble converting working capital assets into cash (it has virtually no cash on hand), as evidenced by the receivables aging trends shown below:

As the above table from the 2014 annual report (year ended 9/30/14) shows, there has been a dramatic spike not just in accounts receivable, but particularly in the accounts receivable delinquent. In total, 17.2% of receivables are past due, with 10.1% of the total over 30 days delinquent. Comparatively, 6.4% of receivables were past due at the end of fiscal 2013, and a more manageable 3.5% were over 30 days delinquent.

Finally, due to balance sheet leverage, the margin of safety associated with this net-net could quickly disappear. Current Assets / Total Liabilities come to only 1.89 as of Dec. 31, 2014.  Although not a hard and fast rule, I use the rule of thumb that a net-net should have CA/TL of  at least 2.0 to lessen the impact of financial leverage on my margin of safety.  At a reading of 1.89, even a small receivables write-off and/or inventory discount could significantly impact Buhler's book value and NCAV:

So all this leads me to the question: what is Buhler Industries worth?

Over the past 10 years, BUI has averaged annual EPS of $0.43. Assign a 13x multiple to this (not sure why I chose 13, but it seems right given minority shareholder status) and we get an intrinsic value of $5.59.

Backing into valuation a slightly different way, over the last decade ROE has averaged 9.0%. To get a 10% annual return on a 9.0% ROE stock we should pay 0.9x book value.  Again, assume we take a discount for minority status, and we could in theory pay 0.8x book value for shares. At a recent book value of $7.79, this comes to $6.23 (and assumes there will be NO write-downs in accounts receivable or inventory, which I’d be surprised to see happen).

If we feel intrinsic value is somewhere between $5.50 and $6.00 per share, and since I like to buy at a discount, I’m not going to get too interested in Buhler until I see a price in the low $4 range (and even then, I’ll still need to get comfortable with my standing as a minority shareholder and who is the marginal buyer of BUI).

Ironically, a price in the low $4's would be pretty close to the old Benjamin Graham rule of buying a net-net at 2/3rds of NCAV.  So all that work I just did in the preceding paragraphs could be summed up by a very simple quantitative rule developed over 80 years ago.  Maybe there's a lesson for me there?

Full Disclosure: I own a handful of BUI shares (mainly for tracking purposes). I do not consider BUI a position in my portfolio.

Harvest Investor © 2015. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

P&C Insurers and Net Investment Per Share: The 1 Column Approach to Valuation

A recent post by The Brooklyn Investor on Markel (MKL) got me thinking about the two column approach to valuing hybrid insurance / capital allocation companies like Berkshire Hathaway or Markel.

The two column approach says that an insurance company with a history of profitable underwriting (i.e. a combined ratio consistently below 100%) has two sources of valuation (actually three, but the third is an intangible aspect difficult to estimate):

• The value of net investments per share (since investments are funded with “float,” which at a well underwrote insurer is a perpetual negative cost source of funding and therefore not a true liability).
• Earnings (at an appropriate multiple) from non-insurance operations.

As you would expect, Warren Buffett does an immensely better job of explaining this valuation method. See the 2010 Berkshire Annual Report, page 6.

For almost all insurers, #2 above can be ignored since very few have non-insurance operations. Even Markel, which is considered a “mini-Berkshire” by many investors, earns such a small amount (at least currently) from its “Markel Ventures” subsidiary that non-insurance operations can be thought of as a rounding error (The Brooklyn Investor addressed this in a subsequent post).

So, for most insurers out there, this leaves us with 1 column: net investment per share. Many analysts feel comfortable using this metric for Markel, but it is hardly ever used when looking at the run of the mill P&C insurer. I've often wondered why that is, so I decided to run the “1 column” valuation for a group of large P&C insurers.  Net investments per share = ((cash + total investments - short-term debt - long-term debt) / shares outstanding). (Please Note: Net Investments in the table below do not adjust for deferred acquisition charges, reinsurance agreements, and other line items that may distort comparisons among companies).

The results show that Markel is not cheaper than peer P&C companies. In fact, it is above average (higher priced) when we look at the price/investments column (i.e. you’re paying $0.68 for every dollar of net investments at MKL, and only $0.575 at the average peer).

Is it justified to pay more for MKL? Many would argue yes. It has a history of solid investment portfolio performance, book value growth, and underwriting. Yet, at least over the past decade, its peers also have a history of solid underwriting (average combined ratio of 92.1% although, admittedly, many insurers have higher volatility in their combined ratio than MKL and the last decade has been somewhat benign in terms of catastrophic losses).

Will Markel's management be able to continue growing book value at double digit rates and finding attractive investment opportunities? That is the $64,000 question isn't it? While valuation relative to net investments per share can give us a feel for how richly priced shares are, like almost all Financial companies with no competitive advantage outside of people/culture, it all comes down to our faith in management.

And that brings me to the main point of thinking about this. Why don’t more large P&C insurers follow the hybrid / capital allocation model? The benefits of negative cost “float,” the inherent leverage in using unearned insurance premiums, and the virtuous cycle of reinvesting cash flows from high quality investments are all well documented. Wouldn't the entire insurance industry benefit from skewing in this direction?

Of course, this is a little bit like asking why don’t more people buy stocks when they’re cheap (or as Will Rogers once wrote: “Buy stocks that go up; if they don’t go up, don’t buy them”). Finding a really good capital allocator (like Warren Buffett or Tom Gaynor) is beyond needle in a haystack difficult. On top of this, finding an insurance organization with the discipline to consistently underwrite profitable policies (and more importantly walk away from unprofitable policies) is just as difficult.

But still, there is room for improvement. Couldn't an activists target Allstate to capture some of the value of its investment portfolio? I see hedge funds going to the trouble of starting their own reinsurance companies to get “permanent funding” . . . isn't W.R. Berkley a ready made target for permanent capital (I do realize there would be plenty of conflicts of interest in being an activist in a P&C insurer and then inserting yourself into the management of said insurers investment portfolio). Conversely, why hasn't a large insurer scooped up MKL in an effort to capture its hybrid business model on a larger asset base? (obvious answer: why would you buy a smaller company just to replace yourself and your entire executive team?).

Maybe I’m just way off base and don’t understand insurance accounting well enough. Maybe the hybrid model only works when its built from the ground up (Warren Buffett does spend a lot of time discussing culture and partnership in his writings). Or, Maybe I've been brainwashed by the value investing communities infatuation with all things Buffett. 

Whatever the answer, the “1 column” valuation approach seems to show that MKL already has some premium built in (compared to peers) for its capital allocation and underwriting skills. Is the premium high or low? Time will tell.


Disclosure: Long MKL


Harvest Investor © 2015. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.