Investing is a lot like shopping for movies. Check out the new releases or best sellers section and you'll have to pay full price. You might not get a good movie but you'll definitely get something new or exciting.
Value investors skip right by these movies and mosey on over to the bargain bin. These movies are all cheap and most of them aren't worth your time, but once in a while you'll come across a really great one that someone accidentally stuck in the bargain bin. Or maybe the case is cracked, but on further inspection the dvd inside is in great condition. It's up the movie shopper to figure out which are the real bargains, just like the value investor.
With this in mind, let's talk about Hallwood Group (HWG). Hopefully we can decide whether or not it deserves to be in the bargain bin, where it currently resides.
HWG has two subsidiaries, Kenyon and Brookwood. Kenyon creates woven synthetic products used in a variety of areas: military, luggage, backpacks, etc. Brookwood provides fabric laminating services for military clothing and equipment, sailcloth, medical equipment, etc. Military-related sales accounted for 72.5% of sales last year, up from 52.8% in FY2007.
Business is strong, with revenues growing by 70% since FY2006 (they fell from $130MM to $112MM from 2005 to 2006, however). Gross margin is at almost 30% on a TTM basis and operating margin is up to 15% from 0.7% in FY2006; clearly business is good. However, I prefer to look at owner earnings (which I define as NI+D/A+non cash items-capex). For the last four years owner earnings were:
- 2009: $18.4 million (10% margin)
- 2008: $13.7 million (8% margin)
- 2007: $20 million (15% margin)
- 2006: $.1 million
As I said, clearly business is good.
- P/E: 2.64
- P/Owner Earnings: 2.77
- P/B: 0.8
- P/S 0.3
I should emphasize that these numbers are not a mirage. Clearly if the business checks out, it is selling for pennies on the dollar.
P/E is 2.64?!
You bet it is. Up until recently, HWG was a minority owner (20%) in a company called Hallwood Energy, in which some of HWG's officers and directors were investors as well, and in which its CEO was Chairman. HWG was taking huge equity losses on its investments in Hallwood Energy, which was depressing earnings. Well, luckily for us on March 1, 2009, Hallwood Energy filed for bankruptcy, and HWG's interests were extinguished. HWG took a $12MM writedown in FY2008 and a $55MM writedown in FY2007 related to these investments, killing its earnings. With Hallwood Energy gone, HWG's net income went from $1.4MM in FY2008 to $17MM in FY2009! HWG was also contributing significant amounts of investment money to Hallwood Energy. With Hallwood Energy gone, this weight is no longer weighing on HWG (though it has created other potential problems, discussed later).
The balance sheet is sterling. HWG has about $9MM in cash and no long term debt. Long term debt that they did have was in the form of a revolving credit facility that expires in 2011, so they could conceivably draw on this again, but debt has been quite reasonable for this company. Accounts receivable took a huge jump from FY2008 to FY2009, but from reading the filings, this looks to be related to two things: restructuring of a factoring agreement with CIT Group and payment withheld from a client due to some of the material in a shipment of HWG's products being made partially with foreign supplies (US military products must be made with domestic supplies; this was a mistake of HWG's supplier, not HWG). The CIT Group bankruptcy caused HWG to diversify its factors and to rework its agreement with CIT. HWG reports that all factors are in compliance but that this had the effect of increasing accounts receivable. HWG believes that the issue with its client and the faulty merchandise will be resolved this year with no material impact.
Lawsuits (disclaimer: I do not have any inside information on these lawsuits and any speculation I make on the outcome is just that).
Things get much bleaker here. HWG is currently being sued for patent infringement by a company called Nextec Applications. HWG is also being sued by former investors in Hallwood Energy for damages of up to $200MM.
HWG has obtained favorable rulings recently in both of these lawsuits, but risks remain. In the patent litigation, the judge has dismissed seven of the ten patent infringement claims. If the judge does not side with HWG in the remaining three claims, HWG could be forced to cease use of these patents, pay back royalties to Nextec, or pay lost profits to Nextec. Back (and future) royalties are obviously the best case scenario if the claims are not dismissed. I think the chances are highest that HWG will have to pay back royalties or will have the claims dismissed, but chances of something worse remain. Nextec is a competitor of HWG, so might pursue this with more vigor than if it was merely a patent troll. I am less worried about the Energy lawsuit. I work in the litigation industry and the plaintiffs never get all that they are asking for (and usually much less). The judge in that case has recently dismissed claims that HWG abused the bankruptcy process with Energy.
In summary, these two lawsuits present a huge obstacle for HWG, and are likely the bulk of the reason for the company's valuation.
Another strike for HWG here. Anthony Gumbiner has been Chairman of HWG since 1981 and CEO since 1984. This is good. The downside is that Gumbiner owns about two-thirds of the company. This is another reason for the company's low valuation (company's with majority owners tend to trade for lower prices). This also increases the probability for abuse and general shadyness on the part of management. Additionally, HWG pays Hallwood Investments Limited (HIL), a company "associated" with Gumbiner, $1MM per year to provide consulting and advisory services. Though this seems fishy to me, and I don't like it, Gumbiner's annual compensation otherwise is only about $1MM, so one could think about this as augmenting his salary, assuming that the fee paid to HIL is paid to Gumbiner. Gumbiner has also tried to both liquidate HWG and return the capital to shareholders, and to buy the shares he did not currently own for $12/share. Another proposal like these could potentially rob HWG shareholders of the operations of a very profitable company.
As mentioned, the company derives almost 3/4 of its revenues from the military. Though concentration this high is obviously a risk, the military seems like kind of a sure thing. The company states that any decrease in military activity could affect its revenues; I find this to be unlikely. Even after the eventual pullouts from Iraq and Afghanistan, the military will likely continue to be active in the world, be it in Iran, Pakistan, Mexico, etc. Also, these sales are indirect. HWG's top three direct customers account for about 58% of its total revenues, with the largest accounting for 34%. It is unlikely that the military would stop purchasing from all three of these companies at once, giving HWG some diversification.
Despite my belief that the lawsuits won't work out as badly as some may think, they scare me. Anytime the whims of a judge can potentially take out a lot of your business or cost you a lot of money, or worse, shut you down, it's something to be concerned about. And I just don't know what's going to happen, The other risks are not as important as the valuation is so low, or at least they wouldn't be if the lawsuits weren't hanging like an axe over this company. I will be monitoring the situation closely. If the lawsuits clear up and the valuation stays low, I would definitely consider making this a small part (4-6%) of my portfolio. For now, HWG belongs in the bargain bin.
(Hat Tip to stocki711 for recommending I look into this stock.)
Disclosure: No positions.