I take many different approaches to valuing stocks. Depending on the situation, liquidation value, sum of the parts, discounted cash flows, or private party value may be useful. Sometimes, I take a bond-like approach to equity valuation. In the case of Crown Crafts (CRWS), the "equity coupon" is yielding a junk bond interest rate, despite being investment grade.
Crown Crafts is a little company ($38 million market cap). From yahoo finance,
Crown Crafts, Inc., through its subsidiaries, engages in the design, marketing, and distribution of infant and toddler products in the United States and internationally. Its infant products include crib bedding, blankets, nursery accessories, room decor, bibs, burp cloths, bathing accessories, and other infant soft goods.
Their balance sheet is sound. They have an open credit line with CIT Group (CIT) in case they ever need liquidity. How profitable are they? A glance at their earnings would turn a lot of investors away.
Net Income/Free Cash Flow (In millions)
Year ending March 2007: $7.6/ $11
Year ending March 2008: $4.3/ $2.5
Year ending March 2009: $-17/ $8
TTM: $-8.1/ $9.8
Not very consistent. I have never been that keen on focusing on net income. Not only is it easy to fake, but it rarely represents the economic reality of a business for various reasons. In the case of CRWS, goodwill write downs have skewed earnings. However, free cash flow isn't very consistent either. Infant and Toddler bedding and soft goods is a fairly non-cyclical business. People don't stop having kids during a recession (although the birth rate does slow), and when somebody has a baby they will probably buy that baby a bib or a blanket. If CRWS sells such a non-cyclical product, then why are their profits so erratic? This question can be better answered when we look at Owner's Earnings (a measure Buffett introduced in his 1986 letter to shareholders)
Owner's Earnings (In Millions)
Year ending March 2007: $7
Year ending March 2008: $7.2
Year ending March 2009: $6.5
Much more consistent, isn't it? This is because free cash flow measures the cash left over for owners, but owner's earnings measures a company's true profitability. Owner Earnings takes out capital expenditures made for growth but keeps capital expenditures made for maintenance, while free cash flow makes no distinction between the two. CRWS doesn't have large CapEx, so that was not the reason for the big difference between owner earnings and FCF. Owner Earnings also ignores working capital charges if the business doesn't require further unit growth, free cash flow includes these working capital fluctuations no matter what. This skewed the consistency of CRWS's profitability, as they have no unit growth. Once you take out these fluctuations in working capital, you can see just really how consistently profitable CRWS is. As you can see, Crown Crafts has generated about $7 million in profits over the last 4 years. I expect this to continue.
How do I value CRWS off of those numbers? The company isn't growing owner earnings very much, so I assume no growth. Consistent cash earned with no growth is similar to what you get when you buy a bond, so I value CRWS as I would a bond. When you divide the $7 million that CRWS earns each year by their market cap ($38 million), you get an "equity coupon" of about 18.5%. This is the return you can expect out of an investment in CRWS if you bought the whole company and operated it as normally, but took out profits for yourself after each year. Obviously, an 18-19% return is very attractive. I plan to hold until that equity coupon falls below 10% (historical rate of return on equities). Therefore, I think CRWS intrinsic value lies somewhere between 65-80 million dollars (market cap), about a double from here.
Unlike a bond, I don't get that coupon payment in cash. Instead, management chooses what to do with it. Therefore, quality of management extremely important. Crown Crafts has excellent management, headed by CEO Randall Chestnut. He has been instrumental in Crown Crafts success. In addition to being a great operator, Chestnut has done a good job of allocating cash flow. When he took over a while ago, CRWS was heavily indebted and not very efficient (operationally). Over the years he has paid down debt to the point where it is now almost completely gone, he has slashed costs and outsourced manufacturing overseas, moves that may have saved the company. He has also made acquisitions over the years at very low prices, recently he bought a bib company that will diversify CRWS's product line. It is very refreshing to see such smart, realistic management in a small company. Too many CEOs of these microcap companies are focused on becoming the next Wal-Mart (WMT) or Microsoft (MSFT). They forget that you don't have to increase sales to produce profits, you can also cut expenses.
There are some risks to CRWS. Ironically, the risks are also CRWS's advantages. A large percentage of their revenue comes from their license with Disney (DIS), nearly half. This is a large advantage over competitors, who don't have access to such a powerful brand. However, loss of this would obviously be bad, but I think the company would recover. CRWS has a very low financial and operating leverage, meaning they can scale down easily. In the unlikely event that they do lose the license, I wouldn't expect losses, but profits would be cut in half. That wouldn't necessarily produce losses for the long term investor, however. If CRWS was generating half the profits it does now, then I'd consider the company fairly priced.
The company also has some customer concentration. Wal-Mart makes up the largest percentage, Target (TGT) and Toys-R-Us are also big customers. This is an advantage over competitors, as those three retailers are the biggest baby goods retailers in the world. It's a lot easier to sell crib bedding when you're doing it through Wal-Mart than if you're selling through some small mom and pop operation. A loss of Wal-Mart would be akin to what would happen if they lost the Disney license, the profits would probably be cut in half. CRWS's lean cost structure makes their relationship with Wal-Mart a natural one, so I don't think loss of this customer is a huge worry.
In the extremely unlikely event that they lose Wal-Mart, Target, and Toys-R-Us as customers and the Disney license, then liquidation value would probably be around $15 million.
CRWS presents the kind of low-risk high reward opportunity that I look for, and I believe it is a good investment at these levels.
Disclosure: Long CRWS