The Stephan Company: A
very interesting nano-cap moving up the quality curve.
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The
Stephan Co is a nano-cap company with a recent history of poor performance
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Recent BOD
and management changes have come with a smart restructuring
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Management
and board are disciplined in capital allocation and very shareholder friendly
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Business
has moved from bloated and loss making to lean and profitable
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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.
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
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.
[1] https://www.otcmarkets.com/financialReportViewer?symbol=SPCO&id=184637; Balance Sheet, pg 3.
[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:
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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
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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
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