Universal Security Instruments Is Very Cheap

| About: Universal Security (UUU)
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Universal Security Instruments (NYSEMKT:UUU) does not look like a great business of late. Its operating income has been negative for four consecutive years. But as a result of what appears to be distressed selling, the company's stock price has been in free fall relative to the firm's equity, which is stable. As such, the stock now trades at a massive discount to book value, offering an extraordinary risk/reward opportunity for deep-value investors with a long-term outlook.

The Business

Universal designs and markets smoke alarms and related products. The company's products are manufactured in Asia, and sold here. The company has a 50% stake in its Asian supplier. For more on the company's business, see the description on its website.

Universal hit a speed-bump in 2010 when The Home Depot, which was a major customer at the time, stopped buying its products. The company has struggled since then; when it has generated positive earnings, it has only been because of its joint venture, which is accounted for on the balance sheet using the equity method.

The company currently anticipates introducing new products "later in the fiscal year." Housing starts continue to increase (though they remain well below their historical averages), which may provide a tailwind for the company in the coming years.

Management

Harvey Grossblatt has been the company's CEO since 2004. Though the company has struggled to revive sales and earnings since the loss of The Home Depot as a customer, Universal's book value per share has increased at an average annual compounded rate of over 10% since Grossblatt took over.

This can likely be attributed to the fact that the company's managers and directors own a combined 18% of the company. In Grossblatt's communications with shareholders, he often highlights the company's book value per share, suggesting he considers this an important metric.

The company has shown a propensity to buy back a small number of shares when the discount to book value is particularly wide.

Recent Sales

Since Universal's earnings release six weeks ago, where it was announced that the company had essentially broken-even, the company has not released any news. But over the last month and a bit, the shares have fallen by some 20% on heavier-than-normal volume. Since there have been no disclosures of insider sales and there has been no company news of late, it is quite possible that an outside investor has moved the price in an attempt to raise cash quickly.

Other Investors

At least one other value investor has noticed. The North Star Micro Cap Fund recently increased its position in UUU by 14% as per this filing from two days ago. This fund has compounded its capital at 11% per year since its inception in 1998, versus the S&P 500's return (with dividends reinvested) of just over 5% over the same period. The fund now owns just under 10% of the entire company.

Valuation

Universal trades for just over $9 million; however, the company has current assets of $10 million and total liabilities of just $1 million. As such, investors at the current price are getting the company's joint venture, carried at $15 million, absolutely free. (Last year, Universal's share of the joint venture's earnings was $722 thousand. Last quarter, Universal's share of earnings was $272 thousand.)

In addition, the company has deferred tax assets and property and equipment carried at a total of $2.5 million.

Considering Grossblatt's track record growing book value, this stock is an unlikely candidate for trading at the massive 60%+ discount to book value at which it trades. If the stock were to trade at book value, investors at the current price would see a 150%+ return. Even if the company were to trade within 20% of its book value, investors at the current price would still see a return of greater than 100%.

Of course, since the company is not making any money, this return could take many years. This investment is only appropriate for the long-term oriented, deep-value investor.

Risks

The main risk is that the company will continue to languish, and that its book value will begin to decline as a result. The company competes with two companies that are much larger, in First Alert and Walter Kidde. As such, Grossblatt has to figure out how to do more with less in terms of designing and marketing competitive products.

The other risk is that the joint venture fails to maintain its earnings. This would result in a severe write-down to its carrying value, resulting in large losses relative to book value.

Both of these risks are mitigated to a large extent by the enormous discount to book value at which Universal is trading. For example, since the joint venture is essentially thrown in for "free" at the current price, any write-downs to its value are essentially protected to the downside.

It's also worth noting here that Universal is a significant customer of the joint venture. As such, a nightmare scenario whereby Universal loses sales, which cascades losses all the way to the joint venture, is possible.

Were such a scenario to come about, one would hope that the company would put itself or its joint venture up for sale, allowing shareholders the opportunity to receive something close to book value. The fact that insiders own almost 20% of the company's shares would suggest that management is likely to protect the firm's capital.

Conclusion

This formerly high-flying company (it had a P/B ratio of more than 3x for most of 2007!) has been brought down to earth by the double-whammy of a collapse in housing starts and the loss of a major customer. Its incentivized management remains intact, however, providing investors the opportunity to buy into a team that has compounded book value at a double-digit rate, at an enormous discount to book value. As a result, for patient investors the reward here appears favorable compared to the downside risk.

Disclosure: I am long UUU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.