Thursday, July 30, 2020

Stephan Company: A Very Interesting Nano-Cap Moving (farther) up the Quality Curve

Author's Note: This article was originally published on Seeking Alpha in January of 2018. I wrote it over the Christmas break in 2017.  Many of the steps have been small and a few required some charges and also cash conservation.

However, the latest quarterly results have largely proven the thesis, I believe. 

I have been meaning to publish this on this blog for some time, but for a long time, the article was exclusive to SA and afterwards I thought I might want to submit it for publication elsewhere. It deserves a revisit, as much has changed - there is a new CEO, there are many new brands, and of course, COVID has limited options for barber shops.

As a prelude to an updated article, I thought it was time to publish it here.

There's plenty wrong with many of the details (capital policy has changed significantly), but I want to be honest with myself and with you. I hope you enjoy it.

The Stephan Company: A very interesting nano-cap moving up the quality curve.

-          The Stephan Co is a nano-cap company with a recent history of poor performance

-          Recent BOD and management changes have come with a smart restructuring

-          Management and board are disciplined in capital allocation and very shareholder friendly

-          Business has moved from bloated and loss making to lean and profitable

-          Focus is now on growth which is happening organically and inorganically

 

The Stephan Company (PK:SPCO) has had articles written about it on SA before, in 2007 and 2011.  Given the long gap and significant recent changes to its operations, I thought it was time that a new article be published.

The Stephan Company is a nano-cap stock with a market capitalization of about $10mn (3.993mn shares out as of latest Q)[1] [i]and a recent history of operating challenges, but in spite of its size, it is quite an old company that is moving back up the quality curve.  Founded in 1897[2], the company is focused on the beauty segment, particularly the barber shop distribution segment.

The business is now run by some very smart people who are incredibly disciplined in their use of capital and also very shareholder friendly.  Indeed, much of the BOD is made of up financial investors who are making sure that the business uses its excess cash (substantially all of its operating cash flow, as required CapEx is negligible) to return capital to shareholders.  This is the sort of high return on capital business that you can be comfortable holding for very long periods which offers some effectively no cost (negative cost, perhaps) real options on growth and capital gains, and which pays you to wait while you sit on those options.  As such, for the non-institutional investor, this might be interesting.  This assumes that you can get shares; they are quite illiquid.

Risks:

Before we explore the business any further, I think I should point out that SPCO is a very small business with control shareholders who already possess over 50% of the 4mn shares outstanding.  Acquiring shares is very difficult to do, selling them no less so (though helpfully, management is committed to repurchases, so there is some liquidity in that regard).

As a small business in the distribution segment the business competes with many other businesses some of which have greater resources.   It is also a business that until recently had significant losses, though that was before the restructuring.  This is a very interesting business but Coca-Cola it is not.

Given the high level of Board / insider ownership, you have to recognize and be comfortable with the control team as stewards of the enterprise and capital.  Moreover, there is a risk that this business will be taken entirely private and stop reporting altogether.  Efforts to do just that have been made before (by other shareholders and management) and the closely held nature and size of the business could make this attractive to insiders.  Somewhat mitigating this risk, I believe, are the DTAs, the fact that at least one major shareholder is an RIA with separate client accounts, which accounts would be harmed by a go private transaction, and the fact that being a public company offers SPCO some unique benefits in doing deals.

Investors should consider this a PE sort of investment with a very long lockup.  In return, the business generates nice cash and high returns on equity, but typical strategies for avoiding losses (eg. stops) will not work with such a business.

Background:

As you can imagine with a 120 year old company, they have had multiple operating approaches over the years, but what matters are some recent changes, starting about five years ago.  At that time, the then CEO who had controlled the company since the early 2000s (and attempted, unsuccessfully, to take the company private in 2004, but who did delist the company in 2010) died suddenly.  At the same time, the performance of the branded product part of the company headed down quite rapidly, resulting in millions in losses.  The successor management team tried multiple strategies to preserve the business in tact, cutting expenses and staff, moving production to reduce costs, but could not align costs with revenue.  Revenue mostly declined but even investments in improved marketing that did stem the decline negated through the incremental costs the benefit of stable sales.

CEO compensation was out of line and there were multiple lawsuits with companies and brands that SPCO had acquired.  These lawsuits consistently resulted in unfavorable outcomes for the company.  (Most of the issues had occurred under previous management, but the road on these litigations only ended in 2012-2014). 

The challenges in the branded products segment masked a profitable distribution business.  This is surprising, most investors tend to expect the branded part of the business to carry the intellectual property and the high returns on capital with low reinvestment required.  But in this case, the distribution business, specialized on a small customer segment as it is, actually has quite high margins for a distribution business (30%) and requires almost no capital expenditure, whereas production in branded products had low margins and significant capital outlays required to fend off new entrants.

Restructuring:

As a result, the BOD took the strategic decision in 2015 to exit the branded segment to focus on the distribution business exclusively.  They sold off the brands, liquidated inventory, liquidated excess real estate and separated from about 20 employees.  Among those were the CEO and CFO who were earning significant salaries for a struggling small business.  Instead the COO was promoted to the top job and finance was outsourced to an accounting firm with one of its partners functioning as a part time controller and CFO.  With a smaller firm, the scope of audit was reduced and the audit contract rebid and won by a smaller audit firm, presumably at better rates.  Old outstanding litigation was settled and the company was able to make a fresh start with much lower operating costs and therefore a realistic breakeven point, stable sales, good margins, minimal investment required and lots of deferred tax assets (DTAs) from the $18mn in losses the previous management incurred trying to rescue the branded products business.

And look what resulted!  The figures for 2013 and 2014 left the business in a state which raised doubts about the company’s ability to continue as a going concern.   

Then, in 2015, the business was successfully restructured.  Revenues declined, but costs declined much more rapidly and therefore net loss narrowed.  Exiting 2015, structural costs were so much improved that in 2016 the company earned a profit for the first time in years.[3]

Moreover, a smaller operation required less capital, so that the balance sheet could be shortened and shareholders rewarded with cash dividends from asset sales and liquidation.  Returns on capital soared, with ROA at 16.5%.  ROE at 20% and RONE (effectively equity less cash) went to 26.5%. 

If you could invest at book value, most investors would be happy to have 20%-28% passive returns indefinitely.  Alas, at today’s prices, an investor is paying a multiple of book, and so trailing returns are somewhere in the 10-12% range.  Except, what if there were growth?  Might return on capital get even better?

 

Market opportunity:

To have a sense of what kind of growth might be possible, let’s get a sense of how big the end market is.  We estimate that Stephen Co has about 8% +/-2% of the market in which it competes.[4]  4Q results are trending to about $2.4mn, which would give the company an annual run rate of $10mn in revenue.  I believe that the addressable market is somewhere between $100-$230mn. 

We make the following estimates of the market opportunity:[5]

Topic

Low

 

High

[1] Men in America

 

150,000,000

 

[2] Men who go to the barber (vs. salon, or DIY grooming)

60%

 

65%

[3] Barber visits per year for those who go

6

 

12

[4] Product usage (shop cost) per visit

 

$0.20

 

[5] Estimated Market

$108,000,000

 

$234,000,000

 

This makes Stephen Co, a tiny company you never heard of, a meaningful player in its market, but one that has plenty of scope for growth within its category.

Barber shops, I hasten to add, are not like salons.  When women go to the salon, they tend to spend much, much more money, not just on styling but also on product like coloring and product is a significant cost of a haircut.  Barber shop haircuts are almost entirely labor costs.  Mostly you get a cut, and there are some creams, powders, gels and disinfectants.  They come in the same jars and bottles we see everywhere, many of which are distributed by Stephen Co.  But in the end, it is a negligible cost of a haircut at the barber.  (Interestingly, this means that if you have a good distribution system, you can increase prices, because product costs do not drive customer spend barbers can more easily pass along those costs).

Growth:

As part of its 3Q17 quarterly report, management revealed several interesting things about 4Q in its discussion and analysis of the business.  An MDA that is so revealing about events after the date of the report is quite unusual.  I cannot recall ever seeing such a strong amount of color in Q, but the forthrightness is consistent with a BOD and management that want to be open and honest with minority shareholders.

To understand the impact let’s first understand the business through 3Q17.  Nearby you find the as reported figures for 2017

and adjusted figures that net the acquisition back out and then annualize figures for the year based on the “going concern” – ie. pre-acquisition - structure of the business. [6]  Returns on capital, assets and equity remain very strong.  In fact, 2017 looks like a near repeat of 2016.  But there have been some significant changes starting at the end of Q3, with the acquisition of MD Barber. 

MD Barber provides some attractive assets.  First off, it has some successful products, particularly LXIV (Louis XIV) Pomade, and it also has a successful website and online sales and distribution arm through which SPCO can market its products, so the business brings revenue, new products and new capabilities in going to market that make the existing business better.  Not only that, the acquisition involved no goodwill, suggesting that the price is quite fair.

What about the impact on the financials?  MD Barber is a business that had about $800k in revenue in 2016 (10% of SPCO).  It seems 2017 might have been similar through the first 9 months.  We can figure this as follows: given the relative size, we would expect MD Barber to increase revenue by 10%, in fact, it has increased it by 11% and management indicated this is an increase over last year.  Interestingly, it is in line with the organic SPCO business, which is also growing 9% YoY in 4Q, for a combined growth in revenue of 20%, with both units growing something like 10%.

What does this mean from a profitability standpoint?

One reason that SPCO earns strong returns on capital are the high gross margins available in the barber shop distribution business.  It is unusual for FMCG distribution companies to earn 30% gross margins, and yet SPCO manages.  I suspect that the high margins are available because barber shop distribution is expensive; each customer account is pretty small and not really eligible for a volume discount.  This means that larger distribution players who might be able to drive out cost mostly ignore the segment and the customers don’t expect to have pricing power, so discounting is minimal.  Also, if you look at the size of businesses that set themselves up as local distributors of barber shop products, you can see that they are themselves small (MD Barber looks pretty professional within its segment and it has less than $1mn in revenue), which means that each of them likely has considerable fixed costs that have to be amortized and limited reach, such that there simply is not much scope to cut prices and still make it worthwhile to stay in business.  Of course, if you could develop a platform that reduced fixed costs to serve and were able to go on adding revenue at or near historical margins, your operating margins could rise significantly towards your gross margins.

We assume that MD Barber, as an internet distributor, has lower gross margins (there have been no details on this yet).  We construct two scenarios, in both scenarios, we carry through the 9% organic growth with constant gross margins.  In scenario 1, we assume MD Barber has 20% margins.  For illustration, we then project a second scenario in which MD Barber has 30% margins, nearly those achieved by SPCO.  The impacts are to add $98 - $119k to gross profit.  But in both cases, there should be some incremental SGA, which offsets some of this benefit.  Still, due to other efforts by management, we believe this can be held to a much smaller increase.  We assume a small increase in D&A over the 20k per quarter that was running through 3Q as some of the intangible assets acquired get written off.  We then annualize this effect (straight-line multiplication as the quarters are pretty even) and get profits of $835-$921 per year.


In the lower scenario, the higher intangibles and increased balance sheet size keep ROA at a quite steady level, although in the more favorable scenario, they increase ROA by a few percentage points.  Returns on equity are higher in both cases.  What is really impressive, quite frankly, is that the organic growth was achieved with only $12k in CapEx into the legacy business OVER TWO YEARS.  That means that, to the extent that the organic growth is independent of the MD Barber business, the business was able to grow gross profit by about $200k (annualized) with just $12k of investment.  Long may it continue as it means that D&A costs will fall over time further enhancing profitability in the meantime, they shelter taxes.

Now, the question is, where will this money go?  We have seen already that very little needs to be reinvested, even if the past two years are a bit of an extreme example, likely no more than 30-80k need to be reinvested.  This leaves money for acquisitions on a similar scale and setup.  Assuming just maintenance capex and no further deals, the business could have $800-$900k for distribution.  With 4mn shares out, this would be a dividend of $0.20-0.225 per share.  If growth on the scale of the 4th quarter could be sustained annually, good for about a 1-2% share pickup per year, half from organic and half from inorganic, and a deal required some $200k in cash, there would still be enough cash for a $0.15-$0.18 dividend, before counting the incremental sales and gross profit effects.

 

Now for a fun exercise – note that management also mentioned that they are working on a deal to monetize some of the trademark portfolio.  What if they struck a royalty deal for 4% of sales on their trademarks with a company that specializes in the retail channel?  Say those products could earn $5-$10mn in the retail channel.  This would generate $200-$400k in gross profit with substantially no incremental cost at all.  The impact would be to lift Net Profit by an equivalent amount and push it to $1-$1.3m against shares outstanding of 4mn, good for $0.25-$0.325 cents per share.  Moreover, margins would shoot might higher since the new revenue would have effectively 100% margin.  In such a case, we could expect a very nice incremental payout, likely an amount offering a 10% yield at today’s price, not to mention a revaluation of the entire business upward.  With ROE of 40% and solid growth it would not be unreasonable to see the stock trade at 6-10x book value.  At current prices, it would also offer shareholders something on the scale of 12-15% returns annually, plus the appreciation in the shares, which might be significant.  In a market environment with 2% yields and 4-5% expected returns on equities in general, you are being paid reasonably for the risks assumed.

Conclusion:

SPCO is a business that generates fantastic returns on capital.  The business is very well run by smart allocators who are pursuing a variety of strategies to grow the business and further improve company economics.  Prices have risen some, reflecting those improved economics, and yet, the company still yields attractive payouts and offers the potential for further growth in what is mostly a mature category.

Obtaining shares is difficult, but not impossible, and while current prices are not a “slam dunk” they offer considerably higher potential returns that the overall market while simultaneously avoiding the risks associated with herding into index products.

This management team has been quite intelligent in allocating capital and has required minimal reinvestment to nevertheless grow the top line and margins.  There are some hidden assets that might be able to be monetized in interesting ways.

We believe that a fair price is likely between $3-$5 and possibly as much as $6-$8 in the right circumstances, plus a decent yield and little risk of capital loss.



[3] Data from Annual reports from 2016 and 2014.  Calculations are author’s own work.

[4] This is the products market, although it supplies barber shops, it is not selling capital goods, like swivel chairs or other furniture.

[5] Source: author’s own estimates.

[6] Source: 3Q17 10-Q, pages 3, 5. 7 for the financials, and page 8 and 9 for the purchase accounting.  Adjustments and ratios, author’s own analysis. 

Adjustments reverse the purchase accounting and the $56 that was paid subsequent to close to reduce loans available.  These loans were acquired, but as of 30 September were only showing $70 as management already partially paid down the loans.  Walking through the adjustments:

-          Adjustments to Equity:

a.  Reverse out stock issued reducing common stock by $2

b. Reverse out paid in capital by $392

c. Reduce Accumulated Deficit by $33 for the costs associated with the acquisition

-          Adjustments to Liabilities:

d.       Reduce A/P by $50 for payables assumed and by $35 in purchase credit for inventory

e.       Reduce Loans payable by $70

-          Adjustments to Assets other than Cash

f.         Reverse Intangible Assets acquired by $645

g.       Reverse Inventories Acquired of $132

h.       Reverse Receivables Acquired by $21

-          Adjustments to Cash (i)

o   Reverse Cash received of $38,

o   Reverse Cash Paid to Seller of $231

o   Reverse Cash Paid to Loan Holder of $56

o   Reverse SGA Costs incurred for acquisition of $33

-          Adjustments to P&L

j.         Reverse $19 in SGA costs associated with acquisition

k.        Reverse $14 in Other Expense associated with one time acquisition costs

 



[i]