In a depressed yield environment, it is rare that you find a fixed income instrument yielding 7%. It's even more rare to find an equity that yields 7%, particularly when the company has a great business model with little competition. However, that is currently the case for coin, card, and autograph grader Collectors Universe (NASDAQ:CLCT). Let's take a quick look at the business, where it's going, and if that fat dividend yield is sustainable.
Collectors Universe currently sports a market cap of $162 million, and it occupies a unique portion of the collectibles space. The firm owns a few businesses, PCGS (Professional Coin Grading Services), PSA (Professional Sports Authentication), and PSA/DNA Authentication Services. These businesses grade coins, trading cards, and autographs, respectively. Not only does Collectors Universe determine legitimacy/authenticity (there are plenty of counterfeits), but the firm also provides a grade or rating to objectively define quality. Each business is the pre-eminent of its kind in its respective niche and adds a tremendous amount of value.
With the prevalence of Internet marketplaces, there are more collectible transactions than ever. Without being able to see a coin or trading card in person, buyers (and sellers) have come to rely upon Collectors Universe to grade and authenticate collectibles and ensure transaction safety. Though the novice collector may not know or care about the difference between a "Very Good" 7 rated trading card and a "Gem Mint" 10, sophisticated buyers that spend thousands of dollars highly value these ratings.
The CLCT management team always provides some interesting anecdotes highlighting the value of the firm's services to show the remarkable difference grading can have on value. CEO Robert Deuster provided an excellent example on the firm's FY14Q1 conference call, saying:
"A 1967 Topps Mickey Mantle #150 sport card, this card in ungraded form is valued at round $250, as a PSA Gem Mint 10 which is an excellent specimen by the way, this card just sold at auction for $68,676, another example, a 1972 Topps Hank Aaron #299 card, this card in ungraded form is valued at $40, as a PSA Gem Mint 10, this card just sold for $20,654."
For arbitrageurs, you may want to speculate on ungraded cards and hope that a graded unlocks some value. Regardless, the example highlights why getting an item graded is a value-add proposition.
During the firm's FY13, coins accounted for 53% of total units processed and 92% of declared value, trading cards accounted for 35% of all units processed and 6% of declared value, and autographs accounted for 12% of all units processed and 2% of declared value. These figures are relatively stable from year-to-year, though high gold prices drove higher coin unit grading in FY11 and FY12. Even raw figures have remained relatively stable, though there has been some additional strength in cards and autographs as the economy recovers and collectible markets heat up.
How Does Collectors Universe Make Money?
Collectors Universe earns fees for authenticating/grading items. Fees are determined based on turnaround and product mix. Because the company has a high fixed-cost base, marginal revenue tends to flow through well to the bottom line. Margin can also be impacted by turnaround time requests. Higher turnaround request times also lead to superior gross margins because Collectors charges a higher fee.
Unlike dealers, Collectors Universe takes on no inventory risk, as it is not in the business of buying and selling collectibles. While it would be naïve to suggest that strong collectibles markets do not boost the company since its primary revenue driver is volume, it should be noted that swings in value probably do not have as much of an impact as swings in volume. As long as a grading service can add value, Collectors Universe should be able to generate decent profitability.
The Big Question: The Dividend
Collectors Universe is a great business that requires low-to-negative working capital, relatively light advertising costs, and developing skilled graders whose skills cannot be easily replicated. The company has posted an operating margin of 17.8% year-to-date, up 700 basis points versus the same time last year. As a result, the company has generated $2.8 million in free cash flow.
Sustaining a 7% dividend is not cheap. The company has spent $5.4 million on dividends thus far in FY14, compared to $2.8m in free cash flow generation.
Source: Company filings
As we can see in the above chart, the company has not been able to cover its dividend via free cash flow since FY10, when its dividend rate was much lower. While I think some of the current year deficit may diminish when the company generates more cash in the second half of the year, there is no doubt that the company cannot pay its dividend organically.
But does that matter yet? Management noted on its FY14Q2 conference call that it targets a cash balance of $10 million at the minimum. As of the most recent quarter, Collectors Universe had roughly $16.2 million at cash. If the company is able to slow its annual cash burn to roughly $2 million, then shareholders can be assured of a safe dividend for another 3 years. A new Shanghai grading business is generating terrific momentum, and although management does not provide a geographical breakdown, there is reason to believe the office is performing well and can help alleviate the cash burn.
A $1 million annual burn rate creates dividend safety for ~ 6 years, and any sustained free cash flow generation should keep the dividend safe for the future. As conservative income investor, the decision comes down to how easy or hard it is to conceive that Collectors Universe is earning more money in 3-6 years than it is today. In my view, that is not very clear; certainly not with the visibility that Warren Buffett would require.
Collectors Universe tends to do relatively well during prosperous times, but, like other assets, collectibles lose value when the economy sputters. The firm lost money in 2008 and 2009, on a free cash basis, and lost money from 2007-2009 on a GAAP net income basis. However, since the Great Recession, the company has exited the diamond and gem authentication business, as well as the stamp grading business, leaving it with businesses that are consistently profitable.
Thus, to answer the dividend question, yes it is safe for at least three years. More importantly, investors will have ample time to determine if Collectors Universe is able to generate ample cash to start covering dividends. If free cash flow generation does not improve by FY16, it is time to consider the dividend unsafe.
Is Collectors Universe a Buy?
With a 7% dividend yield, shares of Collectors Universe look awfully tempting. Shares do, however, trade at a rich multiple of roughly 20x my estimate for FY14 earnings. In my view, investors should not expect terrific capital appreciation, though a relatively safe 7% return is within reach. A pullback to the mid-teens might make me consider a purchase, but for now, I cannot say Collectors Universe is a buy from a total return perspective.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.