Hunting: An Oil Net-Net

When scrounging around for cigar butts, it is rare to find one that is covered by Wall Street. Hunting PLC, a supplier to the oil & gas industry, is one of these companies. Despite the research coverage, Hunting still trades below net working capital. Such is the revulsion to oil stocks today.

Hunting is headquartered in London, but has operations primarily in the US. It has a 100+ year history in industries such as shipping and transportation, and still has significant equity ownership by the Hunting family. Its primary focus today is making products for the upstream oil & gas industry. The majority of Hunting’s revenues are derived from US shale, though they also sell into offshore and subsea markets. Hunting’s exposure to shale has made it ground zero for the current oil downturn.

Hunting makes a variety of products such as premium pipes and perforating guns. They have a good reputation in the market, but essentially, they are levered to drilling & completing oil wells. Given the depletion curve in typical shale wells, shale requires a lot of drilling. And Hunting has benefited from this activity the past decade.

At this point, US rig counts and frac spreads are at very low levels. They are only slightly above the multi-decade lows hit earlier this year.

Will shale come back to a reasonable level? That’s the key question for Hunting. It depends on oil prices, as shale is the marginal producer. I have a constructive view on oil as discussed previously (Musings on Oil). I also believe that shale drilling has a future, in the US and abroad, though probably at lower levels than in the past.

The last cyclical low for the oil industry was 2015-2016. During that period, Hunting posted significant operating losses and took impairments on inventory and goodwill.

The 2020 cycle low is even lower. Hunting has already taken another round of impairments and write-offs. But they posted a trading update with “underlying” EBITDA results that were breakeven. This is a significant improvement from the 2016 level. They made the tough decisions on their business early and are not bleeding cash. Should EBITDA results stay breakeven, they should preserve their net current asset value and survive a long time.

Hunting holds a fair amount of inventory and should generate a significant amount of cash as the business contracts. In this way, the business is counter cyclical. Working capital will unwind as revenues decline.

Management seems capable and properly incentivized. They will continue to do tuck-in acquisitions. And most likely, they will stay focused on upstream oil and gas.

One potential risk for Hunting is actually the family ownership. They still own stock but aren’t really involved in the company other than being reliant on a dividend. In 2016, they raised a decent amount of equity to fund a dividend (at a price 3x higher than today). The quote from the annual letter was that the canceling of the dividend “caused grief to some of our loyal shareholders.” I’m assuming the descendants of Charles Hunting don’t see the same investment merit in the business as he did.

Given the strength of the balance sheet today, the funding of the dividend should not be an issue. But going forward, the family will more likely to be focused on receiving a dividend rather than more accretive uses for their cash. This may not be optimal for capital allocation.

I don’t know when shale drilling will recover. But if the environment reverts to some reasonable historical level (say 500 rigs in the US), Hunting should be solidly profitable and trade at a low multiple to its earnings.

For what it’s worth, Goldman Sachs thinks Hunting is worth about double the current price and rates it a “Buy.” Might be worth swimming with the vampire squid on this one.

Musings on Oil

It hasn’t been a great year for oil stocks. The XLE is off 50% this year while the S&P 500 is close to record highs. COVID-19 has crushed transportation demand, which comprises the majority of oil consumption. The price war instigated by Saudi/Russia also made things a lot worse for producers.

Oil stocks have already had a rough decade. From the 2010-2014 period, oil prices ranged from $80-100. From 2015-2019, it averaged around $40-60. Oil companies, not surprisingly, made a lot more money in the first half the decade.

Hydraulic fracturing and horizontal drilling have helped access shale oil, increasing US production by a few million barrels a day. It helped the US achieve a greater degree of energy independence. But the increasing supply put additional pressure on oil prices.

The return on finding new oil remains low. For the past several years, it seemed like oil companies generated net income and paid dividends, but earned relatively little free cash flow.

On top of that, ESG mandates are encouraging oil companies to invest less in oil and more in sustainable technologies like wind and solar. This is particularly true in Europe. Emissions are the biggest downside to fossil fuels. They release a lot of CO2.

Finally, and potentially most devastating, the outlook for long-term demand has turned south. Just take a look at all the Teslas in any big city and you’ll get a glimpse of the future. BP has recently reported that oil demand will permanently decline from here. Peak oil? Yes, but due to demand, not supply. Other oil companies seem oblivious to the change.

Is it worth prospecting for investments here? There are net-nets among oil producers and services companies. Even the majors trade at or below tangible book value. I think the risk/reward on oil stocks is favorable.

Let’s first talk about oil’s fundamental advantages. First, it’s energy dense and relatively affordable. It is highly available with a global distribution infrastructure already in place. Oil is its own store of energy. It can be stored in tanks, in pipes, and even in tankers. It doesn’t require costly batteries for storage.

Oil is still highly strategic. Global trade depends on it. Militaries depend on it. The same is true for agriculture and air travel. There are a multitude of industrial and medical uses. There is currently no acceptable substitute for these applications.

But ultimately, it comes down to supply and demand.

On the supply side, capex levels are down. Rig counts are at record lows. Global capex for E&P companies will be in the $300-400 billion range this year. This is down from the $800-900 billion range earlier in the decade.

Negative prices earlier this year caused well shut-ins. Some of these won’t reopen. Those that do will resume production on their normal depletion curve. Shale wells typically have much higher depletion rates.

Overall, supply is down and capex is being cut. There is an extensive industry rationalization underway right now. That’s usually a good time to be buying any commodity.

The big question, of course, is demand. There are cyclical and secular factors at play. Roughly 50% of oil used is gasoline for cars. Another 8% or so is used for air travel. Vehicle miles are currently down by about 10% in the US. Air travel is down 60%.

Perhaps both will recover in the next couple years. But if air does not recover and people drive more, what will happen to oil demand? Both situations imply a fairly healthy recovery. I’m generally in the camp that things will return to normal.

And what about the long-term? Electric vehicles are the big threat. But oil has always had to contend with these threats. Vehicle emissions have been improving for decades, impacting oil demand. Vehicle emissions will continue to improve, and electric vehicles will accelerate that.

It will happen, but it will take time. There are 1.2 billion vehicles on the globe and 2.2 million electric vehicles were sold in 2019. But electric vehicle growth is accelerating, and small reductions in demand can have major impacts on price.

On the other hand, emerging market demand is still growing. Oil consumption per capita in the United States is ~900 gallons a year. This compares to ~150 gallons in China and ~50 in India.

Though the future is cloudy, it will take some time for long-term demand to be impacted. There is a reasonable case that oil demand will continue to rise for a while.

In the near-term, however, supply is down and demand could be coming back. If you believe that the post-COVID world could be anything like the the past, there could be a snap-back in oil prices. Investing in some of these oil net-nets could turn out to be a gusher.

USAP: Another Steel Net-Net

Mark Twain said, “History doesn’t repeat itself, but it often rhymes.” In the case of Universal Stainless, a Pennsylvania-based steel company, history has rhymed four times in the past twenty years. During each of those times, Universal Stainless’s stock, after a stupendous rise, crashed by at least 70%.

Mohnish Pabrai owned it during one of those interludes, from 2002-2006. He wrote a case study about it in his great book, The Dhandho Investor.

In the book, Mohnish discusses why he purchased the stock for about $14 or $15 per share in 2002. At that point, the company had recently purchased its Dunkirk facility for peanuts. The company was losing money and its end markets of aerospace, heavy machinery, and oil & gas, were weak. But the company was employing a “Dhandho” philosophy: i.e., they were making smart moves that cost little, but had optionality for huge upside.

This investment was a testament to Mohnish’s patience and investment skill. The stock had a wild ride. Mohnish survived a 65% drawdown. He doubled-down on the investment after a couple years when business started to improve, and ultimately sold much higher.

Fifteen years later, with a different CEO and a few crises later, Universal Stainless is down again.

One change over the past decade is that the company bet big on aerospace. In 2010, aerospace represented 35% of company sales. By 2019, it had doubled to 70% of sales. Aerospace seemed like a good bet. It requires more specialty alloys which command higher margins. It also has long product cycles and better visibility. But it required expensive investment.

Now the company’s aerospace business is facing a double whammy. First, the FAA grounded the 737-MAX, which had a huge impact on the supply chain. Then, COVID-19 decimated global travel.

Their other end markets, such as oil & gas, also aren’t doing well.

The situation is bleak. The company expects revenues to decline further throughout the end of the year before turning up next year. They said they will try to maintain a positive gross margin. Yikes.

Universal Stainless is trading only a point or two above the level where it bottomed in 2003. Since then book value has grown from around $10 per share to $27, most of it invested (wasted?) in PP&E.

The good news? Universal Stainless has faced these crises before and knows how to survive. They are cutting expenses and capex to the bone. They will generate cash as inventory gets worked down. And despite the haranguing on their $10 million PPP loan, it will probably be forgiven.

And there could be some improvement on the horizon. Street estimates for Boeing and Airbus are not so terrible. It appears 2020 will be the bottom. Industry revenue for 2021 is currently estimated to recover to 2019 levels. The return to service of the 737 MAX alone will have a big impact on the industry. The defense business should be steady. And there should be growth from 2021 onwards.

And what could go right? People could fly again. Recent news suggested that China’s domestic flights are approaching pre-COVID levels. Perhaps there is light at the end of the tunnel for the aerospace supply chain.

Given the amount of PP&E at this company, there is lots of operating leverage if things go right. If history does rhyme again, Universal Stainless could be a multi-bagger.

With that said, the company continues to invest in itself with no apparent return. The current management is a lot less Dhandho than the prior management. Unless things change, you might be a sap to own this long-term. But downside is probably limited below net-net value.

It’s a painful time again for Universal Stainless. But to quote Mohnish’s mother from his book, “Time is the best healer.”

The Pitfalls of Net-Net Investing

Net-Net investing can be very rewarding. The academic backtests show strong annual returns that trounce the market. But in the real world, investing is messy.

Take a look at Key Tronic Corporation for example. We had written about them earlier this year (KTCC). The stock has recently rebounded after the company posted improved results.

This chart shows the stock price over the past 12+ years compared to its Net-Net value per share. Because Key Tronic has not returned capital via a dividend or share repurchase, this is a pretty good indicator of the value the company has built over a decade.

The goal is to buy as far below the orange line as possible.

Overall we see steady improvement in the company. The falloff in the 2015 period was due to an expensive acquisition. The recent decline in net-net value was due to the lease accounting change. Net-net value has grown about 6% annually since 2008 excluding the accounting change.

Imagine if you had bought the stock around $3 in mid-2008. You might have thought, “Sure, the economy is rough. But the stock is down 50%+ from its recent peak. And it’s a decent business.” So you dive in.

And ultimately it was a good deal. A short two years later, you are sitting on 100% gains.

But the drawdown you faced while holding the stock over that two years was epic. The stock dropped to below $1 in early 2009. Within six months of your investment, you had lost over 2/3 of your money. The economy was in a crisis. Given Key Tronic’s debt outstanding, you may have worried about insolvency. It was not a fun time to own small, levered companies.

It worked out. But it was painful to hold.

A similar situation happened in early 2019. After the stock went nowhere for years, it dipped below Net-Net value in early 2019. Let’s say you bought around there. After twelve months, and in the middle of the COVID selloff, you were down 50%. The news was not good: demand was uncertain and plant were being shut down.

At today’s mark you are up 40-50% in eighteen months.

All of this agony is for a reasonably successful Net-Net investment. Others in your portfolio will be duds in that you lose money or the stock goes nowhere for years. It will feel worse to own these. And you’ll have the occasional name that’s a disaster.

To be a successful Net-Net investor, you have to be comfortable owning non-sexy stocks. Most people will think you’re crazy if you explain why you own the stocks that you do.

You have to do your own research. You need to believe the company will be around and sustain it’s Net-Net value. You’ll need to have faith that the strategy will continue to work, despite the drawdowns.

For this reason, I suggest you stay reasonably diversified if you choose to invest in Net-Nets. And once you do the work and make your investment, it’s best not to look too closely.

Any style of investment is difficult. It requires commitment to the strategy, and discipline in executing it. Following a Net-Net strategy is no different.

US Banks and Margins

Banks have been troubled investments since 2007. The housing crisis and resulting aftermath destroyed the equity value for most banks. A few didn’t survive or were absorbed by others.

After the crisis, banks had new difficulties: increased capital requirements, limitations on business activities, accounting changes, and increased oversight.

Additionally, fintechs with better technology and customer acquisition capabilities have entered the space.

Stock performance has been weak. Many US banks trade at single digit earnings multiples, or even below tangible book value. Some banks could even be considered net-nets, depending on how generous you are on asset liquidity and debt levels.

Banks also currently have limits on their dividend payouts and are restricted from repurchasing shares. The Fed has reserved the right to evaluate this policy on a quarterly basis.

Finally, and perhaps most importantly, net interest margins (NIMs), at US banks have been on a 10+ year slide. Net Interest Margin is the spread of what the bank earns on its assets (i.e. loans) against its costs (i.e. deposits). This metric is the key driver which determines their profitability.

One theory for this reduction in NIM the past decade has been the decline in interest rates themselves. One of the bear cases on US banks is that NIMs will continue to decline as interest rates go lower, similar to what happened in Japan.

But is there a relationship between interest rates and NIM? In the below chart, we compare net interest margins for US banks compared to 10 year government rates since 1984.

Source: FRED

Interest rates have been declining throughout the entire 35 year period. The ten year government rates dropped by over 1000 basis points. Meanwhile the decline in US NIMs was about 70 basis points.

Not exactly a 1-1 move.

Source: FRED

In Japan, NIMs are indeed much lower. In the late 1990s, they averaged around 1.2% and are currently around 0.8%. We only have data through 2017, but NIMs dropped about 40 basis points since the mid-1990s. At the same time, 10 year interest rates dropped by 300 basis to go negative. Again, not a 1-1 move.

NIMs in Japan have always been lower than the US. This is similar to how returns on equity in Japan have just always been lower. Japan is a fundamentally different place in terms of business culture. For example, Japanese banks return far less capital via share repurchases.

From this analysis, it seems that NIMs have moved down about 10-15% of the move in the rates themselves. And while the absolute levels may vary between countries, there is no obvious reason why NIMs in the US should drop to Japanese levels.

All of this data occurred in periods of falling interest rates. At this point, you are probably wondering what happens to NIMs when interest rates rise?

Fortunately Wells Fargo has annual reports from all way back to 1969 posted on their website. Here is their NIM compared to the US 10 year:

Source: Wells Fargo annual reports, FRED

Just as before, there is little correlation between NIM and interest rates. Wells Fargo increased its net interest margin through the mid 1990s, before embarking the slow slide to today’s lower levels. From the early 1980s through the 1990s, its NIMs were increasing as rates were falling.

Overall, the correlation between government rates and bank NIMs is weak. If anything, the direction of NIM appears to be more correlated to economic activity.

So will NIMs in the US continue to go down? Possibly. There is increased competition from fintechs and regulatory oversight is not lessening. If they do continue their decline, the decline will take a long time.

Future stock returns of US banks will depend on your view of competition and the US economy longer-term. Given the way banks are currently priced, it seems like a decent bet to me.

FRD: A Steel Net-Net (Update)

Normally I wouldn’t write an update so soon after my first post, but Friedman announced some interesting news last week along with its fourth quarter earnings.

The results for the quarter itself were mixed, with a $4 million impairment charge hitting their tubular segment. The investment they had made in a tubular facility a few years ago never really worked out. Excluding that charge, net income was modestly positive in the quarter.

For the year, the company posted their worst earnings year in over over a decade, losing about $5 million. The impairment write-off drove the majority of the loss.

While the coil segment is performing fine, I’d expect the tubular segment to struggle for a while. This segment is levered to the struggling energy sector. And they have a good amount of tubular inventory which will take some time to work through. The company also noted that COVID will have an impact across both segments, and they expect to lose money for the June quarter.

On the positive side, it appears that there are operational improvements underway. In my last note, one source of hope for the company was that new CEO Mike Taylor could make long-needed operational changes at the company.

It seems like he is making some of those changes. The company completed a strategic review last year with a few tangible improvements underway.

The first improvement is that they are making capital expenditures to boost capacity where they have been constrained. Overall they will spend $5.8 million, of which $3.8 million has already been spent. Given their last big capex project was just written off with a large impairment charge, we should be a little skeptical. But I also appreciate the initiative to try to grow.

The second improvement is Friedman will start to use price-risk actions to hedge their steel exposure. This hedging will lower their earnings volatility. This makes a lot of sense. As I said before, there is no reason a company like this should not consistently earn money.

The last major improvement is that the company announced a share repurchase authorization of 1 million shares or so, or about 15% of the company over the next three years. This is meaningful–if they actually follow through. Repurchasing shares at 55% of tangible book will be highly accretive.

The company is still in a black-out period. So it wouldn’t be able to purchase shares until mid-August or so after they report their next quarter. Just for reference, the company traded about 2.7 million shares last year. So it would require a daily purchase of 12% of daily volume to complete the buyback.

After the quarter, the company took in a PPP loan for $1.7 million, which will probably be forgiven. This will help offset the loss from the June quarter.

What does all this mean for earnings? It’s hard to triangulate given the information we have. In the past decade the company has earned about $25 million in total, or $2.5 million per year. Most of that occurred in the 2011-2015 period, with virtually nothing earned from 2016-2020.

If we assume 7% gross margins on $150 million of sales less $5 million of opex, we can get a $5 million earnings figure. This could be reasonable given what they have done in the past.

Earning $2.5 million relative to a market cap of $36 million is not particularly enticing value. Earning $5 million would change the equation. And if they return capital via buybacks along the way, the earnings yield would ramp up even more.

Will any of this happen? I can’t say for sure. But the downside does seem limited. As I said two weeks ago, it’s a heads I win, tails I don’t lose much situation. But maybe the odds on the coin flip are no longer less than 50%? As a net-net investor, I can only hope.

FRD: A Steel Net-Net

Steel used to be an industry people cared about. Lost among that disinterest is Friedman Industries, a processor and distributor of coil and tubular steel products. It’s a business that was founded in 1965 and seems to have been built for that era.

What is coil? It is flat sheets of steel rolled up and used for applications like rail cars, truck frames, construction, and containers. The tubular products are essentially pipes.

Friedman buys inventory from the steel mill in bulk, does some processing, and keeps inventory on hand for their customers. Their largest customer is Trinity Industries, a rail-car manufacturer.

Their coil products are made out of hot-rolled steel. Hot-rolled steel is less precise and requires less processing than cold-rolled steel. You can Google the price history of hot-rolled steel which is volatile like any commodity.

Historically this company has done well when they buy inventory at low prices, and prices subsequently increase. In the opposite scenario they don’t do as well. This past year, they had quarters where gross margin was negative. On the other hand, 2017 and 2018 were decent years based on a 60% or so increase in prices.

Right now prices are at lower levels and many of their core end markets are struggling.

On the positive side, Friedman has very little in operating expenses. Opex runs at $4 million per year.

This should be a decent little business. They distribute steel and keep their costs low. And looking over the past ten full years of earnings, their returns look pretty good on average.

But only on average. Here is the earnings history:

Year Ended MarchNet Income (in millions)
2011$8.2
20128.2
20136.1
20141.7
20150.4
20160.3
2017-2.7
20182.8
20195.1
2020 year-to-date (through 12/31/2019)-2.2

The trend is not good.

It not clear to me why a somewhat commodity distributor can’t make a decent ROI. According to the CFO, “It’s a relationship business.” They don’t want to antagonize customers by selling at anything other than current prices.

So their suppliers are big, and the customers are big. They have to have relationships to make this work. This doesn’t seem like a great business.

But everything has a price. So how cheap is it? The company is trading at a $35 million market cap. It currently has $55 million of net-current-asset-value. Of this $22 million is net cash. Friedman owns its facilities and land which is another $15 million. It’s cheap on assets. Less so on earnings.

Also, they have a new CEO. Michael J. Taylor was hired in September of 2019 with solid credentials. He ran Cargill’s Metal Supply Chain business for 10+ years. Could there be operational improvements? It’s too early to tell but there is certainly a possibility.

In a downside case, assume gross margins are 0%. They will burn $4 million per year. It would take a long time to burn net-net value.

But this business should have a higher gross margin (is higher than 0% too much to ask?). And there is always a chance the new CEO can get things going. Or prices spike for some reason. Both of those scenarios could see earnings go up. Tangible book will grow. And there is no reason why Friedman couldn’t trade at tangible book which is 100% higher.

It’s a “head I win, tails I don’t lose too much” situation. But the chance of flipping a heads may be less than 50%.

Charlie Munger & Quality

As the legend goes, Charlie Munger was the one who convinced Warren Buffett to buy quality companies. Up until that point, Buffett has been managing his partnership by investing in cigar butts. By the early 1970s, Buffett had turned Berkshire around and had a high-class problem: too much money with too few opportunities.

In 1972, Buffett had the opportunity to buy See’s Candy for $30 million. See’s was an exceptional business. A candy business with untapped pricing power. Graham’s principles would never have allowed it. Buffett wrestled with it. Finally he was able to negotiate the price down to $25 million. Buffett paid a nosebleed ~12x after-tax earnings and 3x tangible book. The acquisition turned out to be a success.

Finally, Buffett saw the light and proclaimed, “IT’S FAR BETTER TO BUY A WONDERFUL COMPANY AT A FAIR PRICE THAN A FAIR COMPANY AT A WONDERFUL PRICE!” And the rest was history.

Since then, much has been said on returns on invested capital and returns on incremental invested capital. It turns out to be very important for future returns.

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

Charlie Munger

This, of course, is mathematically true. But investors, armed with this information and Microsoft Excel, have been justifying paying crazy prices for businesses they are certain will maintain high ROEs over time. And it will work if you’re right on the ROEs. While some investors will have the conviction to hold forever and get it right, it’s not easy. And most people can’t hold a stock for 2 years, let alone 20.

It’s also instructive to look at Charlie’s actual investments the past 30 years. Here’s the list:

  • Costco: High-quality business for which he paid 12-13x
  • Tenneco: Over-leveraged business bought at cyclical lows
  • Li Lu’s Hedge Fund (incl. BYD): Net-nets and cheap stocks in Asia
  • Posco: Low-cost steel business trading below tangible book
  • US Banks: Decent businesses bought below tangible book

Wonderful businesses at fair prices? Some of them are wonderful. But what constitutes a “fair” price? It’s certainly a lot lower than prices people currently pay for quality businesses.

My takeaway: Quality is great, but price matters too. A multiple of 12-13x might be their rule of thumb for a wonderful business.

But, in looking at Charlie, there doesn’t seem to be anything wrong with investing in a fair businesses at a wonderful price either.

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.