Continental Materials Corp based in Chicago, Illinois, was founded in 1954. The parent company owns six manufacturing companies in the building and industrial products markets in North America. The companies operate primarily in two industry groups; Heating, Ventilation and Air Conditioning (HVAC) and Construction Products. Continental Materials Corp is listed in the United States (American Stock Exchange) under the ticker CUO.
Background
CUO was one of my latest additions to the Liquidation Oxymoron’s portfolio for Q2 2019. The position was purchased at an average price of $15,25. Compared to many of the other ideas in the Q2 Liquidation Almanack, the pitch for CUO is a bit less straightforward. Still, I would argue that CUO is one of my most interesting positions because of the multiple catalysts in play and several favorable factors and characteristics that go along with the idea.
Margin of safety
1) Selling below liquidation value?
Looking at the latest financial report, it’s perfectly obvious that the CUO has a liquidation value that well exceeds the current market cap of $26M. For example, the company’s net-current-asset-value (NCAV) equals $43M. However, because of events that took place since the Q1 report that view is more debatable as of current date.
Here is the deal. During 2019 CUO got a favorable outcome from a legal situation which resulted in a settlement agreement of $15M. On top of that, the company recently sold one of their wholly-owned businesses for $27M. In total, that $42M would equal $25 per share in cash alone. As a result, per the last quarterly report, CUO had an NCAV of $43M with about half of the current assets in cash and cash equivalents. In relation to the market cap of $26M, we would here be talking about a company that is selling at a 0,6x multiple in relation to NCAV. However, what is not reflected in the last quarterly report and the numbers mentioned above is the fact that CUO made three acquisitions during May and June 2019. In other words, a large portion of the cash as stated on the latest balance sheet is most likely gone when the next quarterly report is published. How much is as of current date unknown as they have only released a few details about the transactions made. There is one exception. One of the three transactions was In-O-Vate Technologies, Inc. which CUO acquired in June for $12,3M.
Although the amount of cash will be lower in the next quarterly report and we, therefore, don’t know the liquidation value as of current date, I still think it’s reasonable to assume that CUO is selling well below its liquidation value as of today. I base that belief on a three-part argument that: 1) the businesses that CUO did not sell are profitable and should be worth something as they managed to sell the one that was not profitable for $27M. 2) The businesses that they have acquired should also be profitable assuming that they have followed their stated acquisition profile (more about that below when I discuss the second margin of safety criteria). In other words, the value of the $42M in cash should at least somewhat be carried over going forward. And finally, 3) apart from what I have already mentioned as it relates to the NCAV it should be noted that there is $15M of PP&E that already sits on CUOs books. Arguably that amount adds to the margin of safety of CUOs liquidation value as of today. That is, the company currently has a net tangible asset value of $62M which currently translates into a price-to-net-tangible-asset-value multiple of 0,4x.
2) Proven business model?
Looking at the earnings record for CUO one realizes that the company has both struggled and prospered historically. For the last ten years, CUO has reported more years (six) with negative net income numbers than positive. However, stepping beyond the last ten years by looking at the company’s retained earnings one gets a more favorable impression of CUOs business model. Retained earnings amount to $74M at the end of Q1 2019. On a similarly positive note, the accumulated amount of free cash flow over the last ten years is positive. The difference between earnings and free cash flow has to do with the fact that CUO made two quite major write-offs related to investments in the mining industry during the last ten years. Although what I have just stated is important to note, the previously mentioned changes in the company’s corporate structure make this information less valuable when one is to evaluate the whether CUO has a proven business model or not. Furthermore, because we know so little about the businesses that were acquired we are dealing with a few unknowns as it relates to that evaluation.
Here is what we do know though that leads me to believe that CUO has a proven business model going forward as well. First of all, the businesses that were not sold off were profitable per last quarter and what was sold was unprofitable. Secondly, going forward they are focusing on acquiring family-owned manufacturing companies and thereby moving away from their historical bad investments in the mining industry. Also, although we know little about the companies acquired (American Wheatley and Global Flow Products – price unknown, In-O-Vate Technologies Inc – price $12,3M, and Serenity Sliding Door Systems and Fastrac Building Supply – price unknown) we do know something about the CUOs acquisition profile that led to these specific acquisitions. Specifically, CUOs acquisition profile state that CUO is looking for companies with “Profitability – 5% operating margin minimum” but also companies with “Risk profile – Stable returns”. Although I don’t know for sure, I give CUOs management the benefit of the doubt here and believe that the businesses they have acquired follow their stated profile. In sum, on a consolidated basis, I believe CUO should be profitable going forward and therefore to be considered to have a proven business model.
3) Sound financial position?
CUO had $0,8M of debt on the books per the last quarterly report. One should here note that ten years ago the amount of debt was $13M. With such a small portion of debt together with what I have just stated about the company’s profitability history, it should come as no surprise that CUOs current Z-score amount to 4,2. In other words, a Z-score that is well above the cut-off for what could otherwise be an indication that troubles lie ahead (i.e. risk of bankruptcy). The only question one has to think about as it relates to this margin of safety criteria is; will CUOs levels of debt change as a result of the recent acquisitions? My answer is, I don’t’ have any reason to believe that a major increase in debt will be seen going forward given the amount of cash at hand when CUO made these acquisitions. At least, not an increase that would jeopardize or change my current view about CUOs financial position.
4) Responsible management?
I think there are a few positive things to say about CUOs management from a capital allocation perspective although they have made some mistakes historically (e.g. the investment in the mining industry as discussed previously). Looking at the last ten years CUO have been net buyers of their own shares. Going forward that seems to be the case as well given the fact that a stock repurchase plan for $1M is in place for the next 36 months (starting 6 of March 2019). The $1M might first seem like an insignificant amount for a $26M company. In absolute terms that is true. However, given the fact that CUOs free-float consists of only 397K shares (there are 1,72M shares outstanding in total), that is not so. In numerical terms, at the current share price of $15,25 the $1M share buyback plan would equal about 17% of CUOs free-float.
The low liquidity is related to one of the main reasons why I have confidence in the responsibility of CUOs management. That is, the CUO is both founded and majority-owned by the Gidwitz family. Insiders together own 73% of the shares outstanding. Management has arguably considerable skin-in-the-game both financially and emotionally which should at least somewhat align them with outside shareholders. On a negative note though, one should note that CUO has never paid a dividend to its shareholders (not during the last ten years at least). In sum, my view is that CUOs management is neither fraudulent nor shareholder unfriendly.
Other factors and characteristics
Using some of the information from CUOs acquisition profile mentioned previously we can make an educated guess about the added profitability from the three acquisitions they have made. CUO state in their acquisition profile that “Size – from $10m to $100m in Revenue” is one of their target criteria. Using their stated “Profitability – 5% operating margin minimum” criteria on top of that we can calculate potential amounts of added profitability:
- Assuming an average revenue of $10M for each of the three acquisition would result in an increase of $1,5M in operating income for CUO.
- Assuming an average revenue of $50M for each of the three acquisition would result in an increase of $7,5M in operating income for CUO.
- Assuming an average revenue of $100M for each of the three acquisition would result in an increase of $15M in operating income for CUO.
If any of these amounts turn out to be anywhere close to reality we are here talking about a considerable increase in CUOs overall profitability. I would argue that given the company’s current market capitalization of $26M the market as of current date gives no or little credit for any of these alternatives to be true. This could potentially be a catalyst when the next financial reports are published. For example, using the second alternative of $7,5M in operating income would imply a price-to-operating-income multiple of 3x for CUO (without taking into account any of CUOs current profitability) as of today.
Disclosure: The author is long Continental Materials Corp (NYSE:CUO)
Liquidation Almanack 