Craftmade: A Value Play for a Housing Rebound

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 |  Includes: COST, CRFT, LOW
by: Whopper Investments

Note- Craftmade recently delisted voluntarily, and now trades as OTC:CRFT over the counter

Thesis

Craftmade is selling for a discount to book value. In addition, it has an asset light business model with a history of strong earnings power. The decline in the housing market has hurt Craftmade, but a recovery in the housing market, a hostile takeover attempt, and a significant decrease in costs due to delisting could provide catalysts for realizing substantial value.

What does the company do?

The company designs and sources ceiling fans, ooutdoor patio furniture, and other home related furniture. Craftmade sells the furniture to both specialty and mass merchant retailers (revenue is split about evenly between specialty and mass sales) mainly under two brand names, Craftmade for fans and other indoor products, and Woodard for outdoor products. It also owns 50% of the lighting and lamp design company Design Trends by Patrick Dolan and sell products for mass merchants private label brands.

Does the company have a moat?

I consider it a small one, but it could be large depending on how you look at it. The company designs lamps and then sources them from China, making them a middle man. However, Craftmade adds value to retailers by supplying them with its design expertise. As long as the company continually introduces new, creative designs and keep costs and overhead low, it adds lots of value to the system. I view them as having a small moat because, all else being equal, current customers will stick with their current designer and sourcer instead of giving their business to a new customer. This makes customers VERY slightly sticky, provided the company keeps doing its job. However, if the company starts letting costs run amuck or fails to keep up with current designs, it will fall behind and get dropped. The reason I say the company could have a larger moat is you could say the company has demonstrated a consistent ability to design products consumers want. If you view their designers as superior, you could see them as having a decent moat (like a clothing retailer who has a consistent ability to forecast/create fashion trends).

Also, in the specialty segment, it does have some brand recognition, though I don’t think it’s a tremendous amount.

Operational Risks

The biggest risk here is customer concentration. Lowe’s (NYSE:LOW) account for 24% of sales, and Costco (NASDAQ:COST) accounts for 5%. Losing Lowe’s would be devastating. Indeed, in 2006, Lowe’s stopped sourcing some lighting products (about 14 SKUs) from one of CRFT’s subsidiaries to directly import the products. There is a serious risk that Lowe’s could decide to start directly importing more products, but both the company and I believe this will not happen as long as the company continues to add value, and management has stated it expects sales to Lowe’s will increase in the upcoming year.

Today’s investor might also worry about CRFT’s significant leverage- it has a net debt to equity ratio of 1.11, though some of that is due to seasonal increases in leverage. However, if you look at the company's historical leverage ratios, today’s leverage is actually on the lower end. Also, Craftmade recently extended its revolving loan agreement until July 2012, so it hsa sometime before the debt is due.

Valuation

(Note- Craftmade reported on Friday, May 14, and I am using those numbers in my valuation)

CRFT currently trades for a price to book of about 0.74. The company experienced losses in the past year because its sales are significantly levered to the housing market, but Craftmade is now on the verge of returning to profitability. It was basically breakeven on a EBIT basis, and costs were elevated due to integration costs associated with the Woodard acquisition.

What makes the company interesting is that it has demonstrated an ability to generate significant earning and ROIC in the past. Craftmade has averaged 9% ROA and 22.6% ROE per year for the ten years ending 2009. Its average annual EPS for the time period was $0.91. Additionally, it purchased Woodard for about $20,000,000 at the beginning of 2008. While the recession and certain restructuring charges associated with the acquisition have masked the company’s earnings power, the company thinks the Woodard acquisition will significantly increase earnings power going forward. The company will also save $500k to $700k per year from its recent delisting and says it has realized about $1.2 million in synergies from the Woodard acquisition. In sum, the potential earnings power of the company today is much greater, and costs are much lower than they were for the company in the middle of the 2000s. At the time, Craftmade consistently earned over $1.25 per share.

Catalysts

The thing that attracted me to CRFT is that there is a strong catalyst in place.

Litex, a privately-owned competitor, made a tender offer for CRFT’s shares at $5.25 per share. The board of CRFT has maintained the offer is inadequate and advised shareholders not to tender their shares. The offer expired on May 6 because only 18% or so of shares were tendered, and Litex returned the shares tendered, resulting in a significant drop in share price. However, Litex noted that it is still very interested in acquiring the company, and it has a history of trying to take over CRFT. In 2007, CRFT pursued strategic options and ended up rejecting a takeover offer from Litex to pursue growth options. The 2007 offer was at a substantially higher price, but Litex offered a price that was below the prevailing market price. I think it’s likely Litex comes back with another hostile takeover offer at a higher price to try to take the company over.

However, even if Litex doesn’t come back, a return to normalized earnings should significantly increase share prices. Revenues and earnings plunged due to the decline in the housing market (sales of ceilings fans and related products are strongly correlated with new housing starts). However, the company notes it has significantly increased dollars per housing start and should see significant earnings growth as the housing market improves. With the acquisition of Woodard, the company also has significantly increased potential earnings power as the economy improves.

Finally, while the recent stock delisting will decrease trading volume and liquidity, the company expects to realize savings of $500k to $700k per year. With a market cap of around $26 million, that’s a significant amount. Additionally, the company notes it spent $503,000 in the past quarter related to the Litex tender offer and delisting costs. These two costs combined will result in at least a $1,000,000 decrease in SG&A over the next year. Combined with an improving housing market, the company should be significantly more profitable in the upcoming year.

Price Target

I have a price target of $9.50 on Craftmade. This applies a 10 multiple to CRFT’s 10 year average earnings. With the catalysts mentioned above, and significant increased earnings power from the Woodard acquisition and cost cutting, this price could be too conservative, but a conservative valuation is in order due to the risks involved with losing Lowe’s or other mass merchants.

Disclosure: Long CRFT