New Rules: Net-Nets & Leases

Net-net investing has always been mostly foolproof. It still is. But the implementation of a new reporting standard in the past year has had a big under-the-hood impact on the calculation of what is a net-net. The changes raise some questions and provides opportunities for enterprising investors like us. We examine the implications below.

ASC 842 is a financial reporting standard that provides guidance on accounting for leases (IFRS 16 is the international version). The key update is that leases will now be recognized on the balance sheet as a liability instead of just expensed on the income statement. There is a corresponding “right-of-use” asset entry to offset the new liability. On the income statement, leases will be depreciated with an interest charge.

Effectively, these new reporting standards bring off-balance sheet liabilities onto the balance sheet. It treats leases more like debt. And since total liabilities are increased with no change to current assets, net-current-asset value is lowered.

Off-balance liabilities were always true liabilities, even if they were not reported. These obligations are especially real in a liquidation scenario. Many of us accounted for them in our analysis by factoring in the contractual obligations of the company listed in the 10-K.

Adding incremental liabilities to the balance sheet means that far fewer companies will qualify for net-net status. Take, for instance, Tuesday Morning’s latest 10-Q:

TUES 10-Q Snippet

As of June 30th, Tuesday Morning’s net-current-asset-value was $57 million. By December, the net-current-asset-value dropped to -$286 million and was no longer a net-net. Yikes. The red circles above show the difference. In the December quarter, operating lease liabilities increased to a total of $382 million compared to $0 two quarters ago. Bringing these liabilities onto the balance sheet completely changed the equation. Under this new accounting, it is not surprising they recently filed for bankruptcy.

Tuesday Morning had quite a bit more leverage than their June balance sheet indicated. IFRS 16 helps identify this. It levels the playing field accounting-wise for those who rent vs. buy property & equipment. It also helps shed light on leverage that an unscrupulous manager may have tried to hide off the the balance sheet.

One implication for us is that in making the financials more conservative several former net-nets may no longer qualify by traditional screening. It was already difficult to find net-nets, and now its even harder.

My general view is that the accounting change is a positive. I always do my own work on whether a lease liability is real or not. I generally include them. And the accountants have done the work for me.

But for certain going concerns, I think it’s important to be flexible. Many times, if sales decline, businesses will right-size their footprint by exiting leases over time. The leases were real but the liability was reduced over time. And in a true liquidation, it’s not clear the lessor is going to get everything they are contractually required to get. So in certain situations, that lease liability is overstated.

And because net-nets are harder to find, there may be companies that do not qualify today, but could have qualified under the old accounting methodology. I would happily consider these as potential investments if I felt the businesses would be going concerns and had limited other risks.

On the other hand, one potential downside implication is that by excluding the riskiest of the net-nets, you invalidate the prior studies which showed strong historical performance. For example, in March 2009, the share price of Tuesday Morning dropped to $0.53. About twelve months later the shares had increased more than 10x. If you held your nose and bought a broad basket of these net-nets, you did well. There were some bankruptcies, but also some spectacular winners. By ignoring the hidden liabilities, you effectively took much more risk and could have benefited from it. Would net-nets have performed as well historically under the new accounting methodology?

I don’t have studies to prove it, but my personal experience is yes. Most net-nets did well despite (or because of) the leverage on the balance sheet. And the few that went bankrupt were usually those with hidden off-balance sheet liabilities, or had some other issues associated with it. Net-nets did well across the board.

Overall, I view the changes as a huge positive. It makes net-net financials more conservative. There are fewer of them, but they are higher quality. And if some net-nets are a little harder to discover, I’m okay with that too.

FLXS: A Furniture Net-Net

There are few industries worse than the furniture business right now. Retailers are closed. There is massive unemployment. Who is thinking, “Let’s make a large, highly discretionary, easily postponable expense!”

Hence the opportunity in Flexsteel, a 126 year-old furniture manufacturer based in Iowa. Sales are probably down 80-90% right now, and they will be burning cash until demand returns.

The company had already been burning cash through 2019 due to a series of restructurings. They rationalized SKUs and shut down facilities with low utilization. Inventory was written down. Flexsteel has also been fixing a disastrous SAP implementation which burned close to $100 million (yes, the market cap is currently $70 million).

The old management team rode a few product winners to new heights in the 2012-2016 period but left the pipeline dry. They compounded this with the flubbed the ERP implementation. The result of these miscues is the stock is down about 85% from the peak and is trading at 2009 levels.

On the bright side, the company hired a new management team. The new CEO’s primary experience is from a rival furniture manufacturer called HNI. He wrote an annual letter which outlined some ambitious goals. And insiders are even buying some stock.

The only fear: Are they moving too fast? I’m all for moving fast but it came at a large cash cost. Was it necessary to hire Alix Partners? Perhaps I’m just too cheap and short-sighted (I am a net-net investor after all). Regardless, after all the restructuring and cash costs, the core business was on the cusp of profitability.

And then the pandemic struck. Now the question is how much cash will they burn this year before demand comes back? The company is hunkering down. My estimate is that they could burn $30 million this year if demand comes back slowly. So by the end of the year, it goes from a 60% net-net to a 100% net-net. Still cheap, but then we’ll have to worry about 2021.

However, it seems like a company that will last. It’s been around forever. People talk about Flexsteel on BIFL forums on Reddit. It’s not the highest end, but they are known for making decent furniture.

When the dust settles, they should have a leaner operation. They will have flexible sourcing, manufacturing, and distribution. They will have an omni-channel presence. At their goal of 7% margins, this company is trading at about 3x earnings.

With that said, this one is not without risk. It could be down a decent amount in 1-2 years. But it’s a net-net. The odds are good it will be worth more, perhaps much more.

KTCC: An EMS Net-Net

Electronic manufacturing service companies like Key Tronic are frequent guests on Net-Net lists. They have razor thin margins, are asset heavy, and have all the hallmarks of a terrible business.

But things aren’t quite as bad as they seem. EMS companies add value by enabling customers to outsource their manufacturing. Because manufacturing is a core competency and they have scale, they can manufacture at lower costs than the customer can themselves. The key for the EMS companies is to turn the assets fast enough, keep costs low, and not do any bone-headed projects. If following the above rules, companies can churn out relatively consistent profits and even a decent ROIC.

Their balance sheets are usually quite good. They don’t typically have inventory risk due to price-protection or other agreements with suppliers. These agreements enable the company to sell the inventory back to the manufacturer should end demand for the product go awry. The receivables are usually safe since they are working with larger customers.

Key Tronic fits the model of a typical EMS player. It is on the smaller side so doesn’t have the scale to compete with the larger players for the big programs. But it does have the capability of manufacturing a wide range of products from consumer electronics to industrial equipment to fitness equipment.

Key Tronic has missed numbers the past few years and underperformed due to various reasons including program losses and China tariffs. Earnings recently haven’t been good and are there will be puts and takes with the recent pandemic. One customer represents 17% of sales per their last 10-K. As a result, KTCC currently trades at roughly 90% of net-current-asset-value and 42% of tangible book.

It’s not all terrible. The company has diversified facilities in China, Vietnam, and Mexico. When the company normalizes, it could achieve its stated ROE goal of 10%+, a number it has hit in the past. This upside case would imply a P/E of about 4x.

The main risk appears to be management. Craig Gates has been with the company for 25 years and CEO for 11. He owns a relatively modest 2% of the company. Under his tenure, operating results have been mixed, with plenty of disappointing quarters relative to guidance.

Capital allocation has been questionable. They don’t pay a dividend or repurchase shares. In 2014, the company paid $48 million in cash for an acquisition yet the total market cap of Key Tronic is about $47 million today. These decisions appear terrible in retrospect. While it may not be fair to assess total blame on management, this may be enough to pass on the investment here.

On the positive side regarding management, the key metric they are compensated on is ROIC relative to peers. This is a lot better than most alternatives.

Overall, I believe tangible book should be relatively steady, and should be increasing over time. It’s not crazy for this business to earn a decent ROIC over time (as it has in the past), and if there is some normalization, the stock should be worth at least it’s tangible book value.

This stock is relatively low risk, and might be worth trying to squeeze a puff. But I’d sleep better if I felt better about management.