O.J. Simpson’s parole hearing stole headlines from much bigger news stories over the last few weeks. While not yet a free man, he is scheduled to be released soon. What many had forgotten was that his nearly nine-year prison term was a result of his forcible seizure of sports memorabilia he claimed was stolen. If only he had some way to authenticate his claims! In fact, Collectors Universe, Inc. (CLCT) is in just this business!
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The Juice is Loose (Almost)
According to the company’s description “We provide authentication and grading services to dealers and collectors of coins, trading cards, event tickets, autographs and historical and sports memorabilia (“collectibles”). We believe that our authentication and grading services add value to these collectibles by enhancing their marketability and thereby providing increased liquidity to the dealers, collectors and consumers that own and buy and sell them.“
CLCT operates in a relatively small niche, which is enticing as it attracts little competition. In its three key businesses, it has strong market share, and the company essentially created the autograph authentication market. Anyone think Amazon’s drones are going to start authenticating collectibles?
If The Dividend Fits, You Must Acquit!
During O.J.’s recent parole hearing, the Nevada Parole Board carefully dodged the elephant in the room, avoiding the reason why all of the cable news channels were there and why this 70-year-old ex-athlete, ex-huckster, ex-actor still captivated the nation. Like this hearing, CLCT also has an elephant in the room, though not a famous murder trial, but something that can be considered the kiss of death in the investing world; the sustainability of its dividend. In a key moment during his trial, O.J. Simpson appears to struggle to put on bloodied gloves that were recovered from the crime scene, leading Johnnie Cochran, one of O.J.’s lawyers, to famously quip in closing arguments, “If it doesn’t fit, you must acquit”. At first glance, CLCT’s 5.9% dividend appears to not fit, as the company’s dividend payout ratio (DPR) consistently resides above 100%, causing concern for shareholders. Though if investors look deeper into the financials, they may in fact realize, that the glove really does fit.
CLCT’s business of authentication and grading is one that is not capital intensive. The company does not take ownership of the memorabilia, allowing it to generate substantial amounts of cash. Furthermore, CLCT is not an active acquirer, providing free cash flow to return large amounts of capital to shareholders. While it pays an attractive dividend, a closer look shows that it not only exceeds earnings, but it is barely covered the company’s current cash flow. Normally, this causes concern for shareholders, but if one digs further, not only does management consistently state that they are committed to the dividend, but the company also has a large cash pile that is able to cover the dividend for years. Going forward, CLCT has strong growth prospects that will lead to growth in EPS and free cash flow, while stabilizing and then growing their large cash balance back to previous levels.
Investors should have faith in CLCT’s comments about its dividend, as they have a strong balance sheet with no debt, along with a hefty cash balance to cover the current commitments. For years, CLCT had more cash on the books than net income coming in, thus this sizeable cash pile grew. With this, the board decided to start returning capital to shareholders and, more recently, the cash has been used to help cover the dividend, decreasing the overall balance.
At the end of 2016, the cash balance stood just over $10.1M, down from levels twice of that, and barely above the level at which management stated that they may revisit the dividend policy. Also at this time, management announced a $10M line of credit. Historically, the company has never elected to use debt as a way to finance dividend payments, but since the company tends to grow organically, this was seen as a way to insulate the sustainability of the dividend payment. Since this announcement, the cash pile did trough and has grown to $10.8M. If the company is able to grow, as they have stated, the company will be able to cover the dividend with cash flow as they “don’t see any large capital investments developing in order to keep the company growing.”
With insiders owning over 12% of the company, one has some sense of comfort that there is commitment to the continued payment of the dividend - authenticate that!
Life After Jail - What Comes Next?
CLCT’s business strategy hinges on organic growth, which may appear difficult as it already has substantial market share in each of its lines of business. Thus, the company has taken a different approach to grow. After successfully navigating expansion into Europe, Collectors is pursuing another impressive runway for expansion by moving into China.
With this U.S. industry starting to pick up steam, the company appears to be quite confident in future growth, as China provides an added kicker to earnings growth in the future. Though small in terms of contribution, China only accounts for 13% of total revenues. But when it pertains to growth, China attributed to 85% of the revenue growth over the last nine months. Management states that they have a long runway here as they expect to triple the number of coins authenticated in China by 2018.
When looking at CLCT’s historical earnings, it appears that there was a lack of growth from FY 2012 until FY 2016, as it stayed around $0.85 per share. Now, with growth in China materializing, CLCT has reported earnings over the last twelve months of $1.10. Even with the recent strength of U.S. growth, China remains the key determinant to growing earnings and free cash flow in the future, reassuring investors that the dividend remains safe and sustainable.
If I Did It
Though not convicted of the crime of the century (or at least the 1990s) O.J. Simpson wrote a “hypothetical” account of the infamous events surrounding the murder of his ex-wife and her companion titled If I Did It. In thinking about CLCT, we offer our own hypothetical scenario to look at how CLCT could unlock value for shareholders.
As mentioned, the company has no debt. We understand that some companies take a matter of pride with an unencumbered balance sheet. However, in the case of CLCT, it is creating a sub-optimal situation both for the company and its investors. Given the aforementioned line of credit with a variable rate of LIBOR + 225 bps, the company has an opportunity to add value in multiple ways. First, being a service company, CLCT pays full taxation on income. With the use of this debt, the company will be able to use interest payments as a tax shield, decreasing its overall tax rate.
More importantly, how should CLCT spend the proceeds from its debt? We believe that share buybacks would unlock additional value. The company is fully aware that there has been a recent overhang on the stock due to the perceived sustainability of its dividend. If the company truly believes that we are in a trough for the cash balance, as they have stated, and that strong growth lays ahead in the U.S. and China, then it would be a great time to use this cheap debt to finance share repurchases. This would immediately be accretive to shareholders as the company is currently paying over 5.9% in dividend yield to investors, while financing the buybacks would be much cheaper for the company. Not only would this minimize the cash paid in total dividends, but it would boost the company’s EPS, which has been stagnant over the past few years.
When used correctly, share repurchases can be materially accretive to shareholders, and a great financial lever for companies that prefer to grow organically. Share repurchases are not a new phenomenon, as it was revolutionized by Henry Singleton, CEO of Teledyne Technologies Corp., back in the 1960s. A common misconception is that this tactic hasn’t worked since O.J.’s football playing days, or that it is a cowardly way to say that a company has no better ways of deploying capital. We would disagree with this assumption as we continue to see this strategy working today. For example, Chemed Corp. (ticker: CHE), led by Kevin McNamara, has repurchased almost 40% of company shares over the last ten years, while seeing their stock price appreciate a staggering 250%! Though their business is much different than CLCT’s, they both have a strong foothold in their respective industries, and have historically grown organically. In fact, CHE took debt on to finance a majority of these share repurchases.
Now that we know what the company should do, the next question begs, when should this plan be implemented?
Well, last week, CLCT’s CEO, Robert G. Deuster, announced his retirement, but will remain in his position until the company announces his replacement. Robert’s successor should be a fresh set of eyes to re-evaluate the company’s capital allocation strategy. Even with a new commander in town, we expect the dividend to be considered safe, as the previous CEO had minimal insider ownership (0.36%), and the mostly independent board, which own a large portion of the company, has routinely stated to investors that the dividend is an integral part of their long-term strategy of returning capital to shareholders, i.e., themselves.
Closing Arguments
While it has already been announced that O.J. Simpson will be released this fall, it appears that the verdict remains out on Collectors Universe, Inc. (CLCT). For years, investors have shied away from this company, assuming that its large dividend payment was unsustainable and ripe to be cut. These investors, or may I say algo factor loading passivists, arbitrarily cut this high-quality company from their universe solely because “the machine” does not have the ability to dig into the weeds and authenticate the legitimacy of the dividend. All these machines see is a DPR above 100%. CLCT has a simple intrinsic growth formula that continues to be well-executed resulting in long-term growth. This organic growth strategy is not only being driven by its domestic business, but it also has incremental growth in untapped markets, such as its largest incremental growth driver, China.
Opus’ strategies, both domestic and international, find lower valued, higher-quality companies that have superior growth prospects. It is apparent where future growth will come from for CLCT, but some investors may argue that it is not cheap. We would disagree, as CLCT only trades at a slight premium to the Russell 2000 Index, which is relatively cheap when you consider that the company has a strong moat with competitive barriers to entry that will deter competition from entering the market. Not only is there an unlikely chance of increased competition, but CLCT’s customers have very few alternatives to consider. With this, we believe the market has discounted the valuation of CLCT due to the aforementioned misconceptions.
In our closing arguments, it is with-out-a-reasonable doubt that we believe management’s commentary that the dividend is safe. With the large amount of insider ownership coupled with a hefty cash pile, we trust management when they state that its capital allocation strategy “is a long-term policy”. Much like Johnnie Cochran in his closing arguments of the famed 1995 murder case, we are yelling “if the dividend fits - you must acquit”!
Article by David W. Wagner III & Adam T. Eagleston, CFA - Opus Capital Management
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