Evaluating mediocre management / owner operators

[Jurgis]

Mostly copy-pasting from PSSR thread since the general discussion might be better fit here.

 

 

The question for me is how to evaluate management/owner-operators of small companies that have done nothing and gone nowhere for a long time.

 

In case of PSSR, the Chairman has been around for almost 20 years, CEO has been CEO for over 10 years, and yet the company is at 27M market cap (11M sales, 350K income if we don't want to talk about market cap and would rather talk about sales/income). So basically management succeeded of going nowhere in terms of size/sales/income for 10-20 years.

 

Is this an issue and if it is, how do you deal with it?

 

I understand that this might not be an issue for people who buy shares cheap to sell them soon at higher value. It is also not an issue for activist investors who would like to replace the management. It also might not be an issue for people who believe in growth story independent of management: they see an inflection point and go for it.

 

I just look at it from management evaluation point of view. And from that POV, I don't see how suddenly management goes from lousy to great.

 

This came up as I was looking at PSSR and PM.v (same issue) and RSSS (somewhat same issue though shorter time period) and some other companies mentioned on CoBF and elsewhere.

 

As a positive example of this situation, there's PFHO, which had huge insider ownership by CEO, went nowhere for ages and then went up 50x ( http://finance.yahoo.com/echarts?s=PFHO+Basic+Tech.+Analysis&t=my#{%22range%22:%22max%22,%22allowChartStacking%22:true} ). So perhaps sometimes the business becomes good by itself even though management does not get new brains or new Wizard of Oz...

 

Is the approach here that if you want to buy only companies with good/great management, you simply move on. You only buy something like this if you don't care about the management quality and buy on cheap price and/or general business outlook?

 

What people think?

[Guest Schwab711]

I think you can assume bad management will remain bad. PFHO had their turnaround because they shifted their business to take advantage of a recent CA law. They were one of the first companies to jump on it and grew substantially. Their growth has pretty much halted in the last couple quarters and some major contracts are at risk. Once the larger insurance companies/servicers jump in, I think PFHO will fall back considerably.

 

It's rare in the microcap world to find a product or niche service that is unlikely to face competition AND has growth runway. A lot of the turnaround stories I've seen occur because the business economics changed and not because management suddenly changed their decision patterns. I like to estimate the replacement cost or new competition cost for all my investments. I look for businesses where it costs substantially more to compete with my investment opportunity then to buy them for a 100% premium. This also gives you a rough idea of whether they have the ability to raise prices or if they provide better substitute value. ELDO has the only non-farming senior water rights in a state with frequent droughts and has consistently won the best tasting water in NA award at the biggest water tasting competition in WV (if you aren't a water snob, you would be if you tried their water!). They are also the lowest cost producer because of their densely located sales and water source. I estimate that it would cost ~4x their EV to steal their business (and it would have to be at lower margins with out-of-state spring water... good luck). In ELDO's case, their business started to grow at 10%+ after 2009 (from 4%-5% for the first 20 years) because consumers in Denver are more willing to pay higher prices for local spring water vs. store-brand purified water. Their average customer is a regular Whole Foods shopper and follows an "organic" diet. This is extremely popular in Denver (relative to the rest of the country) and growth has accelerated in the past few years. The economics of selling bottled water have shifted incredibly since ELDO was listed in 1986. I'm a huge fan of the CEO, but the demand for spring water is the major driver of their growth.

 

That's the only example I have that I've already written about.

[jawn619]

I think you can assume bad management will remain bad. PFHO had their turnaround because they shifted their business to take advantage of a recent CA law. They were one of the first companies to jump on it and grew substantially. Their growth has pretty much halted in the last couple quarters and some major contracts are at risk. Once the larger insurance companies/servicers jump in, I think PFHO will fall back considerably.

 

It's rare in the microcap world to find a product or niche service that is unlikely to face competition AND has growth runway. A lot of the turnaround stories I've seen occur because the business economics changed and not because management suddenly changed their decision patterns. I like to estimate the replacement cost or new competition cost for all my investments. I look for businesses where it costs substantially more to compete with my investment opportunity then to buy them for a 100% premium. This also gives you a rough idea of whether they have the ability to raise prices or if they provide better substitute value. ELDO has the only non-farming senior water rights in a state with frequent droughts and has consistently won the best tasting water in NA award at the biggest water tasting competition in WV (if you aren't a water snob, you would be if you tried their water!). They are also the lowest cost producer because of their densely located sales and water source. I estimate that it would cost ~4x their EV to steal their business (and it would have to be at lower margins with out-of-state spring water... good luck). In ELDO's case, their business started to grow at 10%+ after 2009 (from 4%-5% for the first 20 years) because consumers in Denver are more willing to pay higher prices for local spring water vs. store-brand purified water. Their average customer is a regular Whole Foods shopper and follows an "organic" diet. This is extremely popular in Denver (relative to the rest of the country) and growth has accelerated in the past few years. The economics of selling bottled water have shifted incredibly since ELDO was listed in 1986. I'm a huge fan of the CEO, but the demand for spring water is the major driver of their growth.

 

That's the only example I have that I've already written about.

 

Just wondering, does PFHO have bad management? Stock looks pretty cheap right now and business has high ROIC at first glance. Also the fact that Eldo just took out a large amount debt and went dark doesn't bother you?

[SharperDingaan]

With small firms you need to reframe your thinking.

 

Do you want the firm to grow, so that you can sell later at a higher multiple and EPS. Or, do you want the firm to pay out its earnings and forsake growth, so that you can invest the cash flow elsewhere. In private firms, the latter option is almost always better. 

 

Start getting big, and the money disappears into machinery and price wars. Stay small and you are no threat to anyone. You are also mall enough for most to consider taking you out via a buyout versus starting a price war.

 

SD

 

[Guest Schwab711]

I think you can assume bad management will remain bad. PFHO had their turnaround because they shifted their business to take advantage of a recent CA law. They were one of the first companies to jump on it and grew substantially. Their growth has pretty much halted in the last couple quarters and some major contracts are at risk. Once the larger insurance companies/servicers jump in, I think PFHO will fall back considerably.

 

It's rare in the microcap world to find a product or niche service that is unlikely to face new competition AND has growth runway. A lot of the turnaround stories I've seen occur because the business economics changed and not because management suddenly changed their decision patterns. I like to estimate the replacement cost or new competition cost for all my investments. I look for businesses where it costs substantially more to compete with my investment opportunity then to buy them for a 100% premium. This also gives you a rough idea of whether they have the ability to raise prices or if they provide better substitute value. ELDO has the only non-farming senior water rights in a state with frequent droughts and has consistently won the best tasting water in NA award at the biggest water tasting competition in WV (if you aren't a water snob, you would be if you tried their water!). They are also the lowest cost producer because of their densely located sales and water source. I estimate that it would cost ~4x their EV to steal their business (and it would have to be at lower margins with out-of-state spring water... good luck). In ELDO's case, their business started to grow at 10%+ after 2009 (from 4%-5% for the first 20 years) because consumers in Denver are more willing to pay higher prices for local spring water vs. store-brand purified water. Their average customer is a regular Whole Foods shopper and follows an "organic" diet. This is extremely popular in Denver (relative to the rest of the country) and growth has accelerated in the past few years. The economics of selling bottled water have shifted incredibly since ELDO was listed in 1986. I'm a huge fan of the CEO, but the demand for spring water is the major driver of their growth.

 

That's the only example I have that I've already written about.

 

Just wondering, does PFHO have bad management? Stock looks pretty cheap right now and business has high ROIC at first glance. Also the fact that Eldo just took out a large amount debt and went dark doesn't bother you?

 

Where do you see the debt for ELDO? They restructured their debt ~18 months ago and it's no split 50/50 (or close enough) between maturity dates of 2022 and 2032. They could pay off the debt in 2-3 years if they really wanted to (biz requires little additional $ since they are currently at ~20% capacity in their current facility). They could do $30m-$50m in revenue out of the current facility. I see ELDO's revenue potential as ~1/6 Dasani/Aquafina and ~1/4 Fiji (~$100m-$200m currently). There's limits to how much they can extract from their well (since it's in a narrow canyon), but if they ran trucks to the source 24/7 they have potential to be at least 10x-15x their current size. $150m is a realistic revenue cap. They could reach this if they took 2-3% market share in CA or ~0.5-1% of the west coast and kept their current share in CO (6%?).

 

I don't understand PFHO to be honest. They do look cheap (because liquidity vanished?). I was scared off by the 12 SA articles in 4 months so I really haven't looked at them but they are on a small watchlist. Their ROTA is incredible, 89%! How are they pulling that off? If the business is sustainable for at least the next 5 years then it's an obvious multi-bagger. I have to think barriers to entry are low. A lot of SA articles talked highly of CEO (a lot of the articles are written by the same person; wouldn't be surprised if PFHO paid for them). I'm surprised no one ever posted PFHO.

[Travis Wiedower]

A lot of SA articles talked highly of CEO (a lot of the articles are written by the same person; wouldn't be surprised if PFHO paid for them).

 

Glad I'm not the only person who is highly suspicious of many SA (and a couple VIC) articles out there.

[Jurgis]

PFHO - They lost 13% client in June last year and then they lost 30% client in December:

 

http://yahoo.brand.edgar-online.com/displayfilinginfo.aspx?FilingID=11289552-883-212659&type=sect&TabIndex=2&dcn=0001185185-16-004075&nav=1&src=Yahoo

 

As previously reported, effective June 1, 2015, Companion ceased using our MBR services following its acquisition by a third party and the decision to take its business in-house.  As a result, we realized no MBR fee revenues from Companion during the six-month period ended December 31, 2015.

 

...

As previously reported, during the fourth quarter 2015, AmTrust, the Company’s largest customer, notified the Company it would be terminating the services provided by the Company in December 2015.

 

So much for the greatness of PFHO management that pushed it up 50x.

 

I guess that's a great example of risk in doing concentrated nanocap portfolio and/or buy-holding nanocaps. The stock may look cheap even through most of 50x rise and then it blows a huge hole into almost complete roundtrip.

 

Maybe deep DD on the ground can avoid this. Maybe.

 

Will there be act II of this show? :)