The Hour Between the Dog and Wolf is originally a French saying (Entre chien et loup) which is multi-layered. It is used to describe a specific time of day, just before night, when the light is so dim you can't distinguish a dog from a wolf, however, it also expresses that limit between the familiar, the comfortable versus the unknown and the dangerous (or between the domestic and the wild). It is an uncertain threshold between hope and fear.
This is very much the feeling I have when I contemplate the latest developments at Emerson radio (you can reference my original investment memo on my blog if you are not familiar with the name). As a quick summary refresher the Emerson Radio long thesis can be boiled down into the following salient points:
- Ugly company, in an ugly situation and with very ugly corporate governance issues
- Company has two US businesses: (NYSE:I) low grade white goods distribution (micro waves & fridges), and; (ii) license / royalty business for the Emerson TV brand in the US
- The white goods business is roughly cash flow breakeven whilst the royalty business generates between $7.5 and 8.7m of cash flow a year which on the market cap net of cash is a monster free cash flow yield
- The controlling shareholder, Grande Holdings, has been in bankruptcy in Hong Kong since June 2011 and its owner has a history of bad acts both at Emerson and elsewhere. It has been working on an emergence from bankruptcy but has been rolling delays since June 2014
- The company has contingent liabilities totalling $20.1m in the form of three pieces of unpaid US tax claimed by the IRS which the company is disputing. At least one of the IRS' claims which is a liability of $4.8m seems to be a strong case for the IRS in my opinion
- At the time of investment I had a low / high recovery of $1.96 - $3.19 per share assuming no value for the US white goods business
- I initiated a 5.0% my position on the 27th April 2015 at $1.35 per share
Since then it has been a bit of a rollercoaster as described below
Delayed Filing of Annual Report (WOLF!)
On the 29th June 2015 the company filed a NT 10-K which stated that:
"Emerson Radio Corp. (the "Company") is unable to file its annual report on Form 10-K for the year ended March 31, 2015 (the "2015 Form 10-K"), within the time period prescribed for such report without unreasonable effort or expense. The delay in filing is principally attributable to the Company's need to analyze certain transactions and additional information relating to income taxes and potential income tax liability resulting from the U.S. Internal Revenue Service assessments and the Company's appeal thereof in order to complete the disclosure in the Registrant's financial statements and the 2015 Form 10-K. Please refer to the Company's periodic reports filed with the Securities and Exchange Commission for additional detail regarding such tax assessments. The Registrant anticipates that it will file its 2015 Form 10-K no later than the fifteenth calendar day following the prescribed filing date."
The stock duly tumbled from a trading range of $1.30 - $1.40 to $1.12 and ultimately a low of $1.07 per share. As discussed in my original investment memo I was not able to get any colour or edge on the tax claims save that they were historic in nature and the company was confident that they would be defeated. Given the track record of the company and the fact that they had not changed their auditors from the bad old days their statements gave me no confidence. Ultimately I was not in a position to add to my holdings post the drop due to a lack of conviction around the tax outcome which is never a good place to be. However, I was confident that even if everything went against Emerson the intrinsic value was still 40% above where I acquired the security.
The Published Annual Report (DOG!)
Emerson published their annual report on the 14th July 2015 and it was a beat to worst case expectations.
As a reminder the tax issues were two disputes related to income tax issues concerning overseas income (NOPA 1 & 2) totalling $15.3m of maximum liability, and; (ii) one dispute regarding withholding tax on dividends totalling $4.8m. On the NOPA 1 & 2 claims Emerson has reached a settlement with the IRS where it estimates that it is subject to additional federal and state income tax of $3.0m. The IRS has also agreed to not impose any penalties, a substantial beat to the $15.3m worst case (pre penalties).
What is really unclear to me based on the reporting is whether the $3.0m has already been paid by the company, eaten up by their NOLs, or is still a cash outflow to come. In the 10K Note 5 they make reference to the total $3.0m being recorded as income tax expense in Q4 2013-2015 (Q4 2015 being March 2015, i.e. their 10K). Further on in the note it suggests that they have provisioned the full $3.0m of tax for 2015 but also show a tax benefit of c. $1.5m for 2014. Finally on the balance sheet I cannot find either the $3.0m provision or the net provision of $1.5m. The only item that definitely captures the tax liability is $847k of Income Tax Payable. There are also new liabilities of $500k due to affiliates and $481k long term liabilities. It is a totally mystery to me so if anyone has cracked it or got an answer from the company it would be grate to connect.
Turning to the operating results the big negative announcement was that company expects that its customers (basically Target & Walmart) will cancel further product offerings during fiscal 2016 which will account for c. 15.0% of gross revenue. This comes off the back of Walmart cancelling two microwave oven products commencing in Spring 2013 which knocked off c. 30% of Emerson's revenue (2014 revenue declined by 42% vs 2013) and pushed them from $5.2m of EBITDA in the US business to $(655)k of EBITDA. Stripping out exceptional legal and tax advisory related to the IRS dispute the US retail business was roughly flat in terms of EBITDA. The business has a positive working capital position so the decline in revenues will release some cash.
Licensing revenue was basically flat YoY, however, 2013 licensing revenue was inflated
unreported licensing revenues from one of the Emerson's licensees of $1.2m meaning that the actual like for like increase in revenue was 15.2% which will have partially been driven by the new licensing agreement with Funai which lasts until 2018.
See below for a updated net creation value on a high and low case as well as an summary of the historical results of the business which should provide some colour (apologies I have not included the balance sheet and cash flow as they are v. vanilla).
Emerson Radio Creation Value
Emerson Radio Summary Financial Results
Given the developments and a trading price of $1.15 per share the business is now trading below cash despite a healthy cash flow generation from the royalty stream net of the losses on the US retail business. My biggest worry around the business is the fixed cost nature of the Emerson's US white goods business. Conceptually I would have thought that what is effectively a pure play distributor and brand owner would be able to adjust their cost base to declines in revenue in order to maintain a similar margin but the 2014 EBITDA decline suggests otherwise. The only reason I could think for this not being the case is either: a reduction in product units ordered means that the manufacturers have increased their unit prices cutting into margins, or (ii) insufficient cost cutting by Emerson management. We will have to watch the quarterly results closely to see how they deal with a further 15% reduction in revenues.
Grande Restructuring Update (DOG OR WOLF?????)
As a reminder Grande is the ultimate holding company of the entity that owns c. 56% of the Emerson shares. It went into liquidation in June 2011 and originally the liquidators had envisaged selling Emerson as part of the process, however, in May 2014 they reached an agreement with Grande's main creditor Sino Bright (later revealed as an entity controlled by Mr Ho the controlling shareholder of Grande before it filed for liquidation) which envisaged a restructuring and resumption of trading on the Hong Kong exchange. Since May 2014 there has been an almost comical string of announcements declaring the delay in the publication of the restructuring circular and resumption proposal due to further scrutiny from the stock exchange regulator and promising a resolution 2/3 months after the date of the update.
It seems there has finally been a breakthrough on the 1st June 2015 when Grande announced that "the Stock Exchange has decided to allow the Company to proceed with the Updated Resumption Proposal subject to satisfying its conditions by the 21 December 2015." The conditions are effectively the release of the shareholder circular and implementation of all the restructuring steps. This is clearly the next catalyst in the Emerson story with the Circular due on or before the 31 August 2015 (it must have happened at least 5 times).
Unfortunately only time will tell whether Grande and Mr Ho are a dog or wolf. In my mind shareholder bad acts remain the biggest risk to this investment with the performance of the US white goods business coming in a distant second. I think there is a good chance that a dividend of a significant portion of Emerson's cash balance may be part of the Grande restructuring proposal in order to ensure the company is well capitalised and also to fund the takeout of non-consenting creditors which hopefully will lead to a re-rating in the stock as the market is forced to consider the cash flow generation of the combined Emerson business vs the market cap.
A combination of the revised upside/downside metrics and my evolving thoughts on portfolio concentration I am adding an additional 2.5% to upsize my Emerson position to 7.5% of my portfolio.
As an aside the Hour Between the Dog and Wolf is also an excellent book by John Coates who was a successful wall street derivatives trader turned Cambridge neuroscientist which examines the body's chemical influence on risk in men. In short there is a feedback loop between testosterone and success that dramatically lowers the fear of risk in men and similarly a loop between intense failure and a rise in levels of cortisol the anti-testosterone hormone that lowers the appetite for risk across an entire spectrum of decisions.
Disclosure: I am/we are long MSN.