Northamber appears to qualify as a Net Current Asset Value, NCAV, share. However, Benjamin Graham and I both like(d) an NCAV company to also have ‘good prospects for the business’. This is where the doubts creep in. Any help would be appreciated.
Market capitalisation is £7.7m. Based on the last (interim) balance sheet to 31 December 2012 the company has current assets of £22.4m including £3.2m of cash (no debt). To calculate NCAV we deduct current liabilities (£7.4m) and non-current liabilities (£0.05) to give an NCAV of just under £15m – almost double the current market cap. Of course, we cannot take the receivables and inventory at face value but need to reduce them to build in a margin of safety. Even taking an ultra-pessimistic approach NCAV is greater than market cap.
A further consideration is the shift in the balance sheet over the past two years. Whereas it used to have over £11m of cash (resulting in the net cash being greater than NCAV) the directors decided to stop paying rent on its warehouse. They had been trying for years to buy the freehold and they finally got a chance to do so. They paid £6.7m. Rent expense will now fall to zero from £0.6m (a 9% return on the spare cash rather than virtually zero). The company also owns its office building. In total there are around £9m of property assets. These have a reasonably stable market value.
So, if worst came to the worst the company could run down its inventory (£6.6m) and its trade receivables (£12.7m). The proceeds, after paying off creditors (£7.4m), could be added to the cash of over £3m to provide a very nice cash pile (even if the amounts received for inventory and receivables are much less than the BS value). On top it could sell or rent out its £9m of property. There could be a company consisting of property plus cash of £3m? £10m? or £15m? Thus, there is reasonable hope that market capitalisation is covered by either (a) NCAV, or (b) property assets. If both turn out to be as valuable as the BS makes out we have a potential trebling in market price.
The fly in the ointment
Northamber trades in an industry with some of the worst economic characteristics I have come across. It is a medium sized player in an industry in which entry is wide open (there is little customer captivity/loyalty). Suppliers hold a great deal of power. Customers can quickly obtain alternative prices from competing wholesalers. Substitute methods of getting the product (e.g. computer) to the end-user are viable (e.g. manufacturer selling direct). Furthermore, the year on year product price falls and manufacturers on wafer thin margins expect wholesalers to also operate with low gross profits (in Northamber’s case 7.7%).
So what can save this company from cash burn and continuous slide?
NCAV shares have serious problems but they usually improve their positions in one or more of the following ways:
(1) Industry economics change as result of competitors exiting the industry. The last man (men) standing gains in pricing power to return to reasonable profitability. This is possible with Northamber, but unlikely. It will be one of last standing because of its strong BS and its ability to reduce overheads as sales fall to remain close to breakeven, but I cannot rely on there being a sufficient number of competitors exiting to make a material difference to profitability. There is a good chance that new competitors will emerge.
(2) Earnings power will be lifted. Management will stop the slide by returning the company to fair ROCE through excellence in operations or by stopping the head-against-brick-wallbanging and reallocating assets to areas of business with better returns. Here we have some hope. The senior team are very experienced and have shown a willingness to drop low margin products.
(3) Liquidation. This is a possibility. It seems to be happening to some degree by stealth: Over the past 6 years turnover has declined from around £200m to around £80m, and with that there has been the release of cash from working capital and quite high dividends and share buy backs.
(4) Takeover. Perhaps another industry player will bid for it, but how valuable is the client list when buyer switching cost is so low.
Managerial quality and commitment
Directors have sensibly withdrawn from the most unprofitable activities rather than chase after sales in a highly competitive industry. There is always a worry that majority share controlling directors will behave dishonourably and suck money out of the company while it is in decline. However here is evidence of a sense of responsibility and duty to fellow shareholders and workers: Chairman and CEO, David Phillips, again waived a large portion of his salary in 2012. It was reduced to only £15,000. The annual reductions in workforce shows grit, but has also resulted in reported low morale on the shop floor. The sound financial position is used as a competitive weapon in negotiating with both customers and suppliers.
Lost vendors such as IBM, Fujitsu and Allied Telesis in the past 2 years, often due to failure to push through enough volume. High degree of realism in assessing the business and the industry economics, e.g. ‘it is not possible to be positive about the immediate future’. (Interim Statement 2012)
Over the last five years profits average out at just above zero. However, this must be seen in the context of very poor sales in the industry and a halving of sales for this company. There seems to be an ability to stabilise the roughly breakeven position by improved overhead control (down by £0.6m in 2012), improved stock turnover ratios (9.9 times in 2011 and 13.8 times in 2012 resulting in £4.7m of cash being released), shift to higher gross margin product lines (gross margin in 2010: 6.69%, 2011: 6.8%, 2012: 7.7%) and directors waiving of salary. The saving of £0.6m rent each year will again help stabilise. Solvency is not an issue, nor is pension fund obligations (there are none) nor rent obligations (none).
Dividend yield is currently 4.5% (1.3p/29p). Given the BS strength, this should be sustainable. Despite the high dividends (2008: 2.2p, 2009: 1.6p, 2010: 1.6p, 2011: 2p) NAV has declined only a small amount: 2008: 90.1p, 2009: 89.4p, 2010: 88.5p, 2012: 85.7p December 2012: 82.7p. It is thus treading water rather than collapsing in a heap.
David Phillips, the founder and 61.47% shareholder, is now 68 years old and has shown some signs of wishing to hand over responsibility to others. The transition phase may lead to some instability. Peter Hammett was brought in as a senior operations manager (not on Board) in 2013, but left after just 6 months ‘to save costs’. He is on ‘holiday’ – classed as a consultant.
(1) Will they get swamped by the competitive pressure in this industry, resulting in perennially low profits but continued high capital commitments? Or will the industry economics improve sufficiently to allow acceptable ROCE?
(2) Alternatively, will they increasingly see themselves as ‘property plus cash firm’ with an irritating appendage of a wholesaling business draining managerial attention and other resources for little reward? If so will ROCE potential outside of wholesaling become the guiding light? Or will outright liquidation or liquidation by stealth be attractive options? If so will the directors treat the minority shareholders decently?
(3) Are they capable of weighing up the alternative uses of the capital at their disposal rather than automatically stick with what the activities they know and love regardless? Is there sufficient clarity on the future industry economics for them to work out the best uses of shareholder capital? Are they true to the fundamental meaning of the statement in the Dec 2012 interims: ‘we are best placed to benefit from any commercial viable opportunity that becomes available that do not overly risk our custodianship of our shareholder asset base’.