Mallet a net current asset value investment 15th november 2013

I would value your comments on the following ideas. Earlier this year I analysed Mallett, the antique dealer, after a numerical‐only screen showed it to have a market capitalisation lower than the value of the current assets minus all liabilities on the balance sheet – at first glance a NCAV investment. However NCAV requires more than a superficial analysis.

We also need to be:
(a) reassured that the prospects for the business are good
(b) that the managers are both competent and act with integrity, particularly with regard to shareholder interests
(c) the business is financially stable.

It was put on the rejection pile because it had produced years of losses on a turnover of £14m to £10m (declined over 5 years) combined with a management that thinks sucking £750,000 or more out of the firm each year is suitable reward for a job well done. I was also nervous about placing so much weight on an inventory of antiques valued either by cost/net realisable value or by ‘external independent valuation’ subsequently adjusted by the directors based on ‘market movements’ (which is used is not entirely clear to me). But the facts have changed over the last nine months and so the strength of the case for investment has improved. I’m grateful to ‘Rainmaker’ (posts on ADVFN) for his well‐reasoned arguments which encouraged me to take a second look at the company.

Mallett has a market capitalisation of £10.7m at 80p. Based on the accounts for the six months to the end of June 2013 it has inventory of £11.46m, receivables of £5.2m and cash of £0.95m. Current liabilities are £6m and non‐current liabilities (all pension deficit) are £1.5m. Thus NCAV is £10m, which is less than MCap. However one of the facts that has changed is that a freehold building has been sold with planning permission for flats. When the receipts come in, the cash on the BS will be boosted by around £2.5m. This helps alleviate worries over the ‘flexibility’ in valuing such slippery items as furniture. Furthermore Mallett holds a 23.75% stake in a prestigious annual antique fair, Masterpiece, which had a successful fourth year with visitor numbers rising by 20% to 34,000 this year spread over 8 days. While Mallett’s share of the profits is a mere £85,000 (2011: £82,000) this business has potential to provide a low‐capital‐input‐with‐high‐upfront‐receipt‐of‐cash income for many years to come (Rainmaker points to high operational leverage given the fixed cost nature of the business; negative cash conversion cycle; absence of bad debt risk; and ‘toll‐gate’ characteristics). Once established as an annual fixture there are good reasons to think that a business like this has a quality franchise (If it is well managed).

Which brings me to reasons for cautious optimism concerning managerial competence and shareholder orientation. Peter Gyllenhammar, the activist investor, has taken more than 29% of the equity and has entered discussions with the managers on matters of importance to shareholders (he withdrew an attempt to get elected to the Board in March 2013). Whether his suggestions/pressure have stimulated pro‐shareholder action or whether the senior team woke from their five year slumber (while asleep they draw millions in remuneration and blamed the economic climate for costs exceeding revenue) and decided spontaneously to take action we do not know. But action has been taken:

(a) Director remuneration totalled £0.58m in 2012, down from £759,000 in 2011 (It was over £1m in 2008 when large losses were made!). No executive is receiving more than £160,000.

(b) The expensive showroom in New Bond Street has been vacated after a sale of the lease. By moving to Ely House the company saves £0.7m in costs per year and increases square footage by 50%. Given that losses last year were only around £0.3m a rental saving of £0.7m is highly significant. Note also that turnover appears to be unaffected by the lowered property costs.

(c) A plan is under way (or is it? – the latest interims suggest that the plan may be ‘reviewed’) to ‘reduce substantially fixed costs in New York by subletting two floors of the Madison Avenue showroom’. The sublet rental income is expected to equal the rent currently being paid on the whole building. Background: the USA operations lost £1.2m in 2011 and £275,000 in 2012

(d) The FD is in the process of leaving (the date has recently been put back to December 2013. He will not be replaced. This should save over £100,000 per year ‐ significant for such a small company. I agree that company of this size needs merely a competent accountant rather than a finance director.

(e) Over the past five years staff costs have fallen from £2.4m to £1.8m while numbers have decreased from 53 to 35. Turnover has dropped as well, but the staff reduction remains an indicator of managers cutting cloth according to their means.

(f) The loss‐making JHBA subsidiary has been sold off. More recognition that unprofitable activities should not be allowed to continue?

(g) I’m led to believe that the recent liquidation of major competitors has left Mallett as the ‘go‐to’ place to deal in high‐value antiques. Perhaps they can develop an economic franchise on the back of this to allow acceptable ROCE?

(h) In the last three years they have built up the showroom offering by displaying antiques held on assignment rather than owned by Mallett. This is smart: low cash requirements but exploiting extraordinary resources of name, retail position and expertise.

(i) An innovation: a website for selling antiques.

(j) Peter Gyllenhammar says that the company has “superb reputation, skills and infrastructure”. Respected in the market place but managers promoted beyond their competence to run a business for shareholder wealth maximisation?

(k) Managers have made efforts to establish the company in China, Brazil and other developing economies.

Where might share returns come from?

The four possible areas of improvement for NCAV firms are:

1. Earning power is lifted due either the industry economics improving, e.g. exit by competitors improves the returns for the survivors, or due to managerial change when a spirit of revival emerges or they are replaced. In the case of Mallett we have some evidence of both these effects being underway. Competitors have gone to the wall and (under pressure) the directors are cutting costs.

2. A sale or merger. A possibility that is in the wings, but I cannot see it yet.

3. Complete or partial liquidation. Highly unlikely given the potential recovery in antiques, the strong balance sheet and the potential of Masterpiece.

Questions

1. Is the managerial conversion to shareholder wealth pursuit real, imagined or put on for show?

2. How valuable is Masterpiece?

3. Will Gyllenhammar encourage a greater proportion of professional managers (rather than antique experts) in the Boardroom?

4. How cyclical is the antiques business? Will the economic upturn result in significantly greater sales?

5. Director shareholdings are at laughable levels – are their interests really aligned with shareholders?

6. Very high levels of receivables outstanding, for example at year end 2012 those outstanding for more than 120 days were over £1m. Do these well‐heeled customers not pay on time? If not, why not? Is there a danger of high bad debt?