Collectors Universe: Operating Leverage Machine Remains Cheap

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About: Collectors Universe, Inc. (CLCT)
by: Detroit Bear
Summary

CLCT generated incremental margins of 99% in its most recent quarter, underscoring the firm's inherent operating leverage.

Strong cost management and revenue growth drove operating income up more than 140%.

Shares look cheap as the market continues to underappreciate CLCT's moat and high ROICs.

Shares of Collectors Universe (CLCT) ascended to a new 52-week high after posting fantastic revenue growth for its third quarter. With strong cost control, more measured capital spending, and high operating leverage, CLCT drove impressive growth in earnings and cash flow. I am increasing my fair value range to $24-28 per share given a new focus on cost containment. Let’s take a look at how Q3 demonstrates the qualities that make CLCT an excellent business.

Revenue Growth Returns

The most obvious place to begin when looking at CLCT’s Q3 results is at top-line, which grew an impressive 11% y/y to $19.5 million. Context is important here – during Q3 '18, CLCT suffered a 6% decline in revenue driven by a 24% decline in US coin revenue. CLCT thus had a relatively easy quarter to compare against. Interestingly, the US coin submissions contributed just $0.9 million in growth, with the business up 10% y/y. In fact, total number of coins graded fell 7% y/y to 605,600 units. Total coin revenue was up only 7% y/y, though management hinted that a show held in Shanghai at the end of Q3 should help boost revenue from China as it gets recognized in Q4.

PSA/DNA, the autograph and trading card segment, remains the star performer, with 24% growth y/y to $6.7 million. The business is growing so fast that management admitted they have added capacity and still have unsatiated demand, leading to a record backlog. I like the underlying dynamics of the business, as investors (speculators) pay ever-increasing amounts for unconventional assets. Additionally, CLCT is slowly growing the business overseas, leveraging its strong brand and competitive advantage to become a leading grading and authentication platform in new markets.

Operating Leverage Outstanding

Of the $1.96 million in incremental revenue in Q3, 99.5% converted directly to gross margin dollars, which increased by $1.95 million. The CLCT business model has relatively low marginal costs, thus any increase in revenue is highly accretive, and I think this quarter exemplified the dynamic better than any in recent memory. In fact, the growth in revenue in Q3 is responsible for all of the increase in gross margin dollars YTD in FY19, and one of the primary drivers behind the surge in operating profits.

In addition to gross margin leverage, relatively new CEO Joe Orlando delivered on his promise to reduce opex. Sales & marketing expense was flat y/y at $2.5 million and down 150 basis points y/y as a percentage of sales at 12.9%. G&A spending declined by $0.8 million y/y, leading to a dramatic fall from 29.7% of sales to 22.4% of sales. About 25% of this reduction was from lower payroll costs, while the other two drivers were one-off events.

Combining all of these positive dynamics led operating margin to more than double to 24.5% of sales, driving operating income up 140% y/y to $4.8 million. CLCT’s business model has inherent operating leverage, and its operating leverage dynamic is only getting stronger as the company contains below the cost of sales line.

Balance Sheet Cash Soars

Impressively, CLCT generated over $10 million in free cash flow through the first 9 months of fiscal year 2019, which compares favorably to the $3.9 million generated through the first 9 months of FY18. As a result, CLCT holds about $15.7 million. In the past, the CLCT team paid a more aggressive dividend, and we have yet to see Orlando experiment with capital allocation. Buying back stock may not make much sense with the low float, but it would be my preferred use of capital as long as the share price languishes under $20.

Overall, Shares Look Undervalued

While CLCT’s business can be volatile, the company’s Q3 results and ability to generate robust free cash flow due to its capital light business model underscore why I like the CLCT business model. CLCT’s intangible brand value creates an economic moat that can persist throughout the market cycle and leave the company well positioned to generate excess returns on invested capital.

With the strength displayed in Q3 and additional balance sheet cash, I am raising my fair value range to $24-28. The stock has truly traded all over the place in the last few years, but I think ultimately the market underestimates the company’s competitive advantages and operating leverage. I continue to own shares.

Disclosure: I am/we are long CLCT. 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.