Frank Voisin is the author of the popular value focused website Frankly Speaking, found at http://www.FrankVoisin.com.
Update: Like many of the companies I analyze, I wrote this post a few weeks in advance and then scheduled it for publication. Yesterday the company shot up more than 40% on no news. I now believe the company to be fairly valued.
Charlie Munger: Invert And Use “Disconfirming Evidence”
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Detrex Corporation (PINK: DTRX) is a small Southfield, MI based company that trades in the pink sheets. Many investors are fearful of companies that trade over the counter, but as we’ve seen there can be great opportunities in these under the radar companies. A reader emailed me about DTRX (email me your investment ideas here), calling it a hidden gem. Let’s investigate!
Until recently, Detrex had two operating subsidiaries, Elco which manufactures specialty chemicals such as additives used in petroleum products and hydrochloric acid for use in the semiconductor industry, and Harvel Plastics which produces PVC piping and ducts. Traditionally, Harvel comprised the bulk of DTRX’s sales but Elco provided the lion’s share of operating earnings.
On November 30, 2011, the company agreed to sell its Harvel subsidiary to Georg Fischer AG for $50 million in cash, for an after-tax gain of $17 million. This was big news, as DTRX was trading for just over $15 million at the time of the announcement. This sale was completed on January 6th, subsequent to the end of the period covered in the annual report. With the $30 million received after taxes, the company used $15 million to repay all of its outstanding debt, which is great for shareholders as the company previously had a relatively high debt load (D/E of 1.29x). With the remaining $15 million, the company spent $3.8 million on dividends (this seems like a bad use of capital to me; a share repurchase would have been more effective). The company also initiated a quarterly dividend of $0.25 which currently yields around 6.5%. After all of this, the company’s book value is now essentially equal to its market cap ($26 million).
Before the transaction, the company was trading at a premium to its book value of about a third. Then the company sold off its least profitable (and slowest growth) division, paid off all of its debt, built a stockpile of cash, initiated a dividend, and the end result is… the premium was eliminated. This seems strange to me, so maybe there’s more, related to the operations.
Detrex is now left solely with Elco, which has been experiencing rapid growth recently. Here are Elco’s revenues and operating earnings for the last six years:
Note however that these figures do not remove corporate overhead (a large portion of which I would expect to be related to Harvel), or one-time special charges related to the company’s pension plan and environmental liabilities. The company has $2 – $2.3 million per year in corporate overhead. I used a normalized operating margin which is less than the peak levels from the past two years, made assumptions about what portion of corporate overhead is attributable to Elco, subtracted a normalized annual charge for environmental remediation and pension charges (more on these below) and worked through to free cash flow. The result, and I think you’ll find the same if you go through this exercise, shows that DTRX is significantly undervalued. Given the company’s extremely low enterprise value (no debt, lots of cash), there appears to be a very low hurdle to make this investment profitable, and if management is able to maintain revenues and/or margins similar to the last two years (let alone grow either), the upside is just that much greater.
What about negatives? There are a few. First, Elco’s derives about 1/3 of its sales from its top five customers. The ideal investment would be in a company that is not reliant on any single customer for a large portion of its sales. This isn’t excessively high, but it is worth noting as a risk.
Secondly, the company has sizable environmental remediation liabilities related to a business it sold in 2002. The nature of these liabilities is such that new study of the polluted area often leads to sudden sharp increases in expected remediation costs. The company is currently in the midst of another study, which will likely lead to further negotiations with regulators and more expenses in the future. This is why I chose to treat the environmental remediation charges as ongoing. If they successfully clean up these areas (it has been almost a decade of effort), this adds some pleasant upside.
Third, the company has an underfunded pension plan which, despite recently adjusting assumptions to be more conservative, still appears to be aggressive. For example, the company recently reduced its expected return on plan assets to 7.5%, which might seem reasonable but when looking at the return of plan assets historically, we see that it has averaged just 4.56% over the last six years. Note that this is not an issue unique to DTRX; indeed, this is a concern many analysts have raised with respect to both private and public pension plan assumptions. For DTRX the concern might be more relevant, since the level of underfunding (about $9 million) is quite large relative to the company’s size.
Fourth, executive compensation is somewhat high given Elco’s earnings. The top two executives earned aggregate total compensation of slightly under $1 million last year, and the top three executives earned about $1.1 million in the previous year. This may not seem like a lot today but keep in mind how small this company is; relative to its size, this is high compensation. Perhaps executive compensation is somewhat inflated due to the sale of Harvel, but I would strongly hope that these packages would fall in line with the new size of the organization and its earnings.
Fifth, the company has a Shareholder Rights Plan (a.k.a. a Poison Pills). Quite simply, I can’t stand these. They exist solely to entrench insiders and almost universally act counter to shareholder interests. Unfortunately, I’ve featured on this site many great companies with these and sometimes they just have to be overlooked.
To leave on a positive note, insiders own just over 9% of the company. Additionally a value-oriented investment firm, Summit Capital, owns slightly under 36% (source: page 8 here).
What do you think of DTRX?
Author Disclosure: None, but may initiate within 72 hours.