Gencor Industries - Interesting Net Net. An in depth view.

Gencor Industries (GENC US) $9.41

This is a follow up to my initial piece on Net Nets (http://www.stockopedia.com/content/on-ben-grahams-...) where I mentioned Gencor (GENC US) and follows on from Rupert Hargraves's analysis of “Three Buffet Style Cigar Butt Bargains" on 14/11/2014.

Gencor is a net net for the following reason:

Net Current Asset Value (NCAV)

Cash on B/S: $87.1m

Accounts Receivable minus creditors & customer deposits & Accrued expenses : -$1.5m

Inventories: $13.7m (but lets discount these by 30% for safety = $9.5m)

Long term and short term debt: $0m

Net Current Asset Value (NCAV) $95m

Net Asset Value

Same as above, but add on value of property which is owned : $7.1m (this is for 2 offices / manufacturing facilities in Marquette, Iowa for a 137k sq ft facility and 72 acres and in Orlando, Florida for 215k sq ft facility and 27 acres of land).

Total Net Asset Value: $103m

Shares in Issue: 8m (plus a few options)

Share Price: $9.4

Mkt Cap: $75m

Valuation

0.78x NCAV

0.72x NAV

0.64x stated Tangible Book Value

Thoughts on the valuation
Cash on the balance sheet accounts for more than the current market cap alone, before we factor in the value of inventories. But the Group also has a breakeven(ish) design / manufacturing operation for asphalt plants. This is definitely worth something in my view

Lets dig into this further

The Operating Business
Gencor Industries “designs, manufactures and sells machinery and related equipment used primarily for the production of asphalt and highway construction materials. The Company's principal core products include asphalt plants, combustion systems and fluid heat transfer systems." (Annual Report, 2014)

First off lets be very clear. Gencor Industries is NOT a good business as defined by most classical definitions of good businesses eg High return on Capital Employed (ROCE). ROCE is poor and inconsistent. Looking back over the last 10 years the Gross Margins have oscillated between a low of 15.8% in 2011 and a high of 26.4% in 2007. These are low GMs and give little protection if trading disappoints. Its an unfair comparison but look at Aggreko which designs and assembles generators: Gross margins >60%. A high quality business.

My first observation is that this implies that Gencor operates in a highly competitive, fragmented industry, with low barriers to entry. Consequently I assume it has little or no pricing power, which is why GMS are low and show considerable variability. Steel is a major raw material and the volatility in the GM implies to me that GENC struggles, when steel prices rise, to pass on cost increases to the customers. Operating margins are also rubbish with a 10yr average of around 1% but a high of 8.4% in 2007 and a low of -8.4% in 2009.

But the Group has a turnover (revenue) of $40m, which is down over 50% from a high of $88m in 2008. This would be worth something to a consolidator. Especially as the Group has SG&A costs of $6.5m. If we assume that 70% are sales related eg sales people, commissions etc, then a consolidator could save back office costs of 30% * $6.5m = $2m.

But as its family owned lets assume they don't want to sell and the Group can cut costs then it may be possible to earn a 5% margin on its sales.

Assume it can earn a 5% margin = $40m * 5% = $2m EBIT

Assume the market now values that on 10x PAT = $2m * (1-30%) * 10 = $14m (which equates to 0.35x sales, so looks roughly right)

Add this back to our NAV of $103m = $103 + 14m = $117m. Upside = 55%

The outlook for Sales?

Right now it doesn't look great as Rupert Hargreaves pointed out. “All road projects within the U.S. are funded by the Federal Highway Trust Fund, which narrowly avoided bankruptcy this summer and is already in trouble again"

From the 2014 Annual Report: “On July 6, 2012, President Obama signed a $118 billion transportation bill, Moving Ahead for Progress in the 21st Century Act (“MAP-21"). MAP-21 included a final three-month extension of the previous SAFETEA-LU bill at then current spending levels combined with a new two-year, $105 billion authorization of the federal highway, transit, and safety programs effective October 1, 2012. The bill provided states with two years of funding to build roads, bridges, and transit systems. On August 8, 2014, President Obama signed a $10.8 billion short-term bill to fund Federal highway and mass-transit programs through May 31, 2015. The level of future domestic highway construction funding is uncertain. “ (my emphasis added)

The Canadian government enacted major infrastructure stimulus programs, which benefitted the Company in prior years. In 2007, the Building Canada Plan provided $33 billion in infrastructure funding through 2014. As part of the Building Canada Plan, the Gas Tax Fund was approved in 2009, providing $2 billion in annual infrastructure spending.

Nominal domestic economic growth and the lack of a fully funded, multi-year federal highway bill have resulted in reduced capital equipment purchases within the Company's served markets. This continues to have an adverse impact on sales and pricing pressures on the Company's products, resulting in lower revenues and margins

Also looking at the backlog it has halved in the last 12 months from $10m to $5m. In 2007 the back log was $29m. How times have changed.

BUT the company also flags this as a risk……

From 2014 Annual Report: “In addition to government funding and the overall economic conditions, fluctuations in the price of oil, which is a major component of asphalt mix, may affect the Company's financial performance. An increase in the price of oil increases the cost of liquid asphalt and could, therefore, decrease demand for asphalt and certain of the Company's products. Increases in oil prices also drive up the cost of gasoline, which results in increased freight costs. Where possible, the Company will pass increased freight costs on to its customers. However, the Company may not be able to recapture all of the increased costs and thus could have a negative impact on the Company's financial performance."

Errr hello, have you seen the price of WTI recently ?

So net net a falling oil price could positively impact this business.

“I Have a dream"….

The US is recovering, of this there is little doubt. Lets dream a 3 year dream here.

Sales bottom in 2015 and start to recover in 2016, 17 and 18.

They reach $60m, the same level as 2011. The company has cut costs, of this we know so margins should recover strongly into an upturn. Assume a 6.5% margin (crazy, I know). The market goes utterly mad and applies a 12x taxed multiple to the earnings…

Revs $60m* 6.5% * (1-30%) * 12 = $33m

New Corporate Value: $103m + 33m = 136m

Suddenly those inventories don't need to be discounted, and the property is money good and you are close I would say to $150m vs current mkt cap $75m, ie upside of 100%

Stranger things have happened…

The Risks?

The family own the majority of the voting B Shares. They can appoint 75% of the board members. As an investor here you are very much the minority.

Also the company wants to do an acquisition. Tough times bring out silly desperate acquisitions in even sensible companies. Having said that family run companies tend to stick to their knitting better than say GEC / Marconi…..

Trading is likely to be weak in 2015 especially is using the backlog as an indicator, but this company has low visibility so this could change quite quickly. The oil price falling may be a boost to activity levels this summer.

My View?

I must admit I find the risk reward very interesting. In my mind this is definitely an undervalued situation with considerable upside. I think Rupert Hargreaves is exactly right when he says this is a situation in need of a catalyst. Catalysts by their nature can be unpredictable. But i would hazard a guess that good catalysts tend to happen more frequently to undervalued companies than to overvalued companies. Why? Because there is already a lot of good news incorporated into overvalued share prices. Therefore you may have to wait a while for this to play out. This goes back to my original conclusion that it is probably better to have a portfolio of net nets and counterbalance them with some undervalued compounders that generate cash day in day out like Imperial Tobacco. With one you may just be waiting for a long time, and then the management goes and does something stupid.

I must state I am NOT long of this company, I just wanted to put a few thoughts on paper. However I may buy some having done the work !