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In my post on Posco, Berkshire, and Buffett, I mentioned that I had published a quarterly newsletter when I began this blog, but discontinued it during the second half of 2006, when I found bargains had become too scarce to reliably provide enough material to fill a newsletter each quarter.

In the first issue of the newsletter, back in April of 2006, I wrote about a company called Rex Stores (RSC). Theoretically, Rex Stores is a chain of electronics retail stores. In reality, a considerable amount of the corporate assets an investor acquires an interest in when he buys the company's common stock has little or nothing to do with selling electronics.

Some of you may remember how Bill Rempel answered the last of his twenty questions on January 24th, 2006:

20. What's the most interesting company we haven't heard of?

Rex Stores (RSC). I looked at them in mid-2005 as a possible value play. This little electronics store in the heartland, sitting on a bunch of real estate, with an extremely low effective income tax rate. Huh? Turns out the company had a big hand in these synthetic fuel plants that were getting oodles of tax credits, and the IRS was investigating several of these things because they were throwing off tax credits but the fuel they were producing synthetically was costing more than normal fuel, something along those lines. I can't remember if the synfuel plant they owned a part of was in the investigation or not, but I decided I didn't like the notion of buying a small cap retailer that was into quite that diverse an investment. It pays to read the fine print.

Bill's intriguing description of Rex Stores is essentially correct (note: the IRS audit was concluded favorably). This is how the company is described in its most recent 10-Q:

We are a specialty retailer in the consumer electronics/appliance industry. As of October 31, 2006 we operated 207 stores in 36 states, predominantly in small to medium-sized markets under the trade name "REX". Over the past eight years, we have also been active in several synthetic fuel investments and as of October 31, 2006, we had funded two ethanol producing entities and had contingent agreements to fund three additional ethanol producing entities.

The synthetic fuel partnerships are separate from (and older than) the recent funding of ethanol producing entities. The production of synfuel generates tax credits; synfuel production is only economical because of these tax credits. The credits are phased out once the price of oil exceeds a certain level.

As you can imagine, the historically high oil prices of the recent past threatened to impair the value of Rex's synfuel investments, because such high prices would effectively cause synfuel production to cease.

On October 31st, 2006 Rex made the following announcement:

REX recently received confirmation that all synthetic fuel plants for which it receives income are in operation. As such, the Company expects to record higher levels of income from the sales of its synthetic fuel interests than previously indicated through December 31, 2007 at which time the Section 29/45K tax credit program is currently legislated to end.

Stuart Rose, REX's Chairman and Chief Executive Officer, commented, "We are pleased that all the synthetic fuel plants are open and operating. We believe our ethanol interests represent ideal opportunities for REX to extend our presence in the energy sector and further diversify our earnings mix."

You may have noticed that Mr. Rose said:

higher levels of income from the sales of its synthetic fuel interests.

This is the sort of thing you really won't be able to fully understand until you dig into the filings yourself. I'm simplifying matters a bit here; for now, it isn't terribly important that you know the specifics of the agreements Rex made when it sold its synthetic fuel interests. All you need to know is that Rex has sold its interests in the synfuel partnerships and will receive quarterly cash payments through 2007 subject to production levels.

Real Estate

On October 31st, 2006 Rex's balance sheet showed net property, plant, and equipment of $121.85 million and mortgage debt of $23.81 million. On February 13, 2007 Rex announced a major real estate transaction:

On February 8, 2007, REX Stores…entered into a Purchase and Sale Agreement…with Coventry Real Estate Investments…Pursuant to the Agreement, the Company has agreed to sell to the Purchaser 94 of its current and former store locations for approximately $84.0 million, before selling expenses, and to leaseback a minimum of 40 of the properties for an initial lease term expiring January 31, 2010. The leases will contain renewal options for up to 15 additional years. Either party may terminate a lease after the initial six months of the initial lease term on 23 to 30 of the sites as selected by the Company.

The Company is in the process of analyzing the allocation of the purchase price to individual properties which have a carrying value of approximately $66.5 million. Since the Company has not identified all of the properties it intends to lease back from the Purchaser, the resulting gain to be recognized cannot currently be determined. The Company intends to use the proceeds from the sale to pay off approximately $17 to $19 million in mortgage debt related to these properties, to fund its alternative energy projects and for other general corporate purposes.

As a result of this deal, Rex will eliminate nearly all of its mortgage debt (which was already low relative to the value of the company's real estate holdings). The deal will also provide more cash for Rex to deploy in alternative energy investments. I expect those investments will be in ethanol producing entities. Rex has been very active in that area over the last year or so.

The total sale price of $84 million against the carrying value of $66.5 million seems to support the basic premise that made Rex an intriguing story in the first place – the company's assets are not carried at highly inflated values and the stock trades below book value.

When Rex sells at a considerable discount to book value, it may also be selling at a considerable discount to the economic value of its assets. Of course, as an electronics retailer, a large portion of Rex's book value consists of inventory. On October 31st, 2006 the company's inventory had a book value of $116.07 million. This inventory is essentially worthless from an investor's perspective – at least insofar as it is considered separately from ongoing operations.

In other words, whatever value is present in the inventory, shouldn't be assigned on the basis of the book value of the inventory itself, but rather on the basis of an appraisal of the retail operations as a whole. So, investors should ignore the book value of the inventory and simply assign a (conservative) estimate to the retail operations based on some percentage of total sales.

What is needed here is a sum of the parts analysis. I'll leave that to each of you to perform individually. This isn't the sort of investment opportunity you can get comfortable with unless you have spent a reasonable amount of time going through the filings yourself.

My interest in this stock has nothing whatsoever to do with ethanol (Rex Stores is a simple asset play. The specific nature of the asset is a secondary concern; its value relative to the market price is the primary concern). However, if you do have an interest in ethanol, you should obviously look at Rex Stores before you look at other ethanol stocks.

Rex Stores will release its 2006 annual report on Wednesday, March 28th.

Bill Rempel deserves a special thanks here.

Source: Rex Stores: Electronics, Ethanol and Real Estate