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Andrew Kuhn August 28, 2018

KLX Inc/KLX Energy Services Spinoff

Member Write-up by Yuvraj Jatania

Spinoff Background 

In May 2018, KLX Inc. (KLXI) announced an agreement to sell their Aerospace Solutions Group (ASG) to Boeing for $63/share in an all cash deal. 

The deal was based on a successful spinoff of KLXI’s Energy Services Group (KLXE) because Boeing had no interest in buying this part of KLX’s business. 

The management team led by founder, Chairman and CEO, Amin Khoury, initially tried to market the energy business for sale to trade and financial buyers. Bids were received from a mixture of competitors and PE houses in the range of $250-$400m but management felt very strongly that these valuations undervalued the potential of the business based on the rapidly improving market conditions, the higher market value of comparable companies and strong forecasted financial performance of the business. 

Instead they decided to initiate a spin off which would allow them to run the energy business as a standalone, publicly traded entity. 

Our investment opportunity lies in the spinoff of the energy business which will trade on the NYSE under ‘KLXE’. 

The spinoff is expected to take place before the end of Q3 2018. Not long. 

KLX Inc 

KLXI is a US listed company which used to be part of BE Aerospace (BEAV). 

BE Aerospace was founded by Amin Khoury in 1987 through an acquisition of an aerospace interiors parts manufacturing and services business with only $3m in revenue at the time. Khoury grew the business and sold the manufacturing side to Rockwell Collins in April 2017 for $8.6bn and retained and managed the services business which became known as ‘KLX Inc’. 

KLXI operates through two distinct and unrelated businesses: 

1. KLX ASG – Aerospace after-market services and parts/consumables for commercial and private aircrafts 

2. KLXE – Onshore oil and gas field services – focused only on serving North American onshore Exploration and Production (E&P) companies 

KLX Energy Services Group 

The energy business was founded through a quick succession of acquisitions in 2013-14 of seven regional oilfield services companies which each operated in the major shale basins in North America – the Southwest, Rocky Mountains and the Northeast. The execution and integration of the acquisitions was managed by Khoury and his executive team. 

The business provides well completion, intervention and production services and equipment to major oil and gas E&P companies. Their customers include Conco Phillips, Chesapeake Energy and Great Western amongst others. These companies drill and create wells in the shale basins looking for oil and natural gas. When they have a pump issue, equipment gets stuck or loss, a valve becomes faulty or loose, or any other well-related issues they call in technicians or equipment and tools from a company like KLXE. Historically, some of these players would resolve these issues by having an in-house team but now a majority of them outsource the support services to companies like KLXE as the work is considered non-core to their daily activities. 

One of the very attractive features of this type of business is …

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Andrew Kuhn August 24, 2018

BUKS follow-up: A catalyst could emerge within a month

Member write-up by VETLE FORSLAND

I wrote up BUKS on the website earlier this month. After discussions with Geoff, we agreed that a follow-up article was relevant, as there were important parts of the thesis that I left out in the original write-up (which you can read here if you missed it).

https://focusedcompounding.com/butler-national-corp-buks-an-illiquid-ben-graham-style-mini-conglomerate-in-aerospace-and-casinos/

This article will focus on a real estate deal that could act as a drastic catalyst for the stock, which is desperately needed.

BUKS’ real estate deal, and why it’s a bargain

BUKS has a buyout option on the Boot Hill Casino, which they have been renting since 2009. They are paying $4.8 million in leases annually on the property right now. If we cap this at an aggressive rate like 8%, we get a valuation on the property of $60 million. BUKS has the option to buy the very same property for $45 million – or $16 million below what we can expect is a conservatively fair price.

That difference alone is worth BUKS’s entire market capitalization.

And, that $60 million valuation isn’t just from a lease cap assumption. The CEO himself, Craig Stewart, said in an earnings call that the official appraisal is «significantly higher» than the $45 million price tag, which he again claimed was «definitely substantially under» appraised values. Understandably, an analyst on the call asked for specifics on the appraisal value. He didn’t get a clear answer on his question, as it’s confidential, but Stewart claimed $55 million was «close» to the fair value presented by the bank they’re working with, when he was pressed on the subject. Stewart also revealed that it will cost $1 million to get the deal financed. So, what does this mean?

I got the impression that the leasing contract expires in 2034, as they agreed on a 25-year lease in 2009 (2009+25=2034). Therefore, if they don’t buy out the casino, BUKS is stuck with $77 million in leasing costs over a 16-year period. Instead, they can buy a property for $45 million, when it’s worth 30% above that figure, and then finance it with a one-time expense of $1 million – sound good yet?

If BUKS wanted to, they could buy the casino, and instantly look for a buyer, and potentially make 70% of their market cap in one transaction. However, there is probably more value for the company if they keep the real estate for themselves and cut lease expenses.

What does this mean for the stock?

Obviously, this is a good deal for the company, and the value added to the firm should be reflected in the stock price. However, there is clearly a lot of value in BUKS already that the market is either not seeing, or blatantly ignoring. It might very well be the latter, and I explained why in my original write-up. In a nutshell, the executives, represented by the CEO and his brother, his cousin and his son-in-law, are using BUKS to get generous salaries year in and year …

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Geoff Gannon August 19, 2018

Outperformance Anxiety

To Focused Compounding members:

I spend a surprising amount of time talking with members about other investors – investors who are doing better than them. The truth is: returns much beyond 20% a year aren’t even worth thinking about. Sure, you can find investors who have done better than 30% a year for a ten year stretch. I have a copy of Joel Greenblatt’s “You Can Be a Stock Market Genius” sitting here on my desk. And if I flip to the back of that book, I’ll find a performance table that goes like this: 70% (1985), 54% (’86), 30% (’87), 64% (’88), 32% (’89), 32% (’90), 29% (’91), 31% (’92), 115% (’93), and 49% (’94). The works out to a 10-year compound annual return of 50%. Then there’s Warren Buffett’s partnership record which reads: 10% (1957), 41% (’58), 26% (’59), 23% (’60), 46% (’61), 14% (’62), 39% (’63), 28% (’64), 47% (’65), 20% (’66), 36% (’67), 59% (’68), and 7% (’69). That works out to a 13-year compound annual return of 30%. One member wanted to talk to me about the performance of a fund manager – better than 30% a year for longer than 5 years – who followed a concentrated portfolio. For the managed accounts, Andrew and I target six equally weighted positions. So, I’m always interested in seeing what a concentrated portfolio looks like. This fund manager had most of his portfolio in 4 stocks: Herbalife, Cimpress, Credit Acceptance, and World Acceptance. A portfolio like that is taking risks very different from the ones you’re taking. They may be right about all those risks. But, they have to have opinions about subprime credit risks, pyramid schemes, tax avoidance strategies, etc. It isn’t just that those stocks are often shorted, controversial, etc. as stocks. The actual businesses are doing riskier things than the businesses you likely own. You don’t have to take big risks to get rich. But, you often do have to take big risks to get rich quick. I mentioned Joel Greenblatt’s record at Gotham Capital. It was 50% a year over 10 years. Charlie Munger’s record was just 20% a year over 14 years. Warren Buffett’s record at Berkshire – not his partnership – has been 22% a year over 53 years (and Walter Schloss did 15% a year over something like 45 years managing smaller sums). During the time Berkshire did 22% a year, the S&P 500 did 10% a year. Those are the two yardsticks you should look at: 10% a year and 20% a year. In every year where you manage to do 10% a year, you are on pace to match or beat the long-term rate for the S&P 500. In ever year where you manage to do 20% a year, you are on pace to match or beat the long-term rate for some of the very best investors in the world. People mention the performance of investors like Joel Greenblatt and Peter Lynch a lot. But those performances are …

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Geoff Gannon August 12, 2018

Pre-Judging a Stock

To Focused Compounding members:
This week, a Focused Compounding member sent me a link to a blog post about Brighthouse Financial (BHF). Brighthouse Financial is the spun-off retail business of MetLife. Although websites often list Brighthouse Financial under the industry group “Life Insurers”, the stock is really a seller of annuities. Many of these annuities are tied to the performance of the S&P 500 or other stock indexes. So, the company’s investor presentation includes a slide where it shows how badly affected the company would be by various percentage declines in the S&P 500. Based on that slide, the writer of that blog post eliminated the stock from consideration. He had spent – perhaps – an hour or less looking at this company. That was enough to tell him no to invest. Should it be? What we are talking about here is literally prejudice. It is judging a business before you fully understand it. It is making a snap judgment based purely on your initial impressions. And especially on this stock’s resemblance to other such stocks you’ve seen before. You think back to all the stocks you know that have some similarities to this one and you make a snap judgment – assigning this stock to the same group as those stocks. It’s definitely a time saver. And for those who believe in Peter Lynch’s motto that he who turns over the most rocks wins – it’s an efficient approach. If you can quickly glance at a thousand stocks and find ten that really excite you on your first impression and buy those – maybe that’s enough. A lot of investors follow the pre-judging approach. I tweeted about the KLX Energy Services business. This is technically going to be a spin-off. However, what is really happening is that Boeing is buying KLXI’s aerospace business for cash and leaving KLX Energy Services for KLXI’s current shareholders. This is the spin-off I’ve most been looking forward to this year. Someone on Twitter mentioned that “…if I recall ESG is a collection of absolutely garbage businesses.” KLX Energy Services was formed as a super fast roll-up of a bunch of
U.S. energy service providers that served “tight oil / tight gas” (shale oil) producers in the U.S. The price of oil dropped quickly around the time of KLX’s acquisition spree (late 2013 through 2014). Some of these acquisitions were made when oil was around $100 a barrel. So, KLX paid high multiples of EBITDA for businesses where the EBITDA completely vanished in the oil price crash. This collection of businesses may be garbage. But, it’s impossible to know they really are if you only have data going back about 5 years and those 5 years don’t include anywhere near a full cycle in oil.
Brighthouse Financial and KLX Energy Services are both tempting stocks to pre-judge, because if you don’t pre-judge them you have to do some heavy lifting. Brighthouse Financial is complicated. KLX Energy Services doesn’t have the past financial performance data …

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hiddenvalue August 7, 2018

CountPlus (CUP)

 

CountPlus Investment Thesis

Market data

Ticker:                         ASX:CUP

Price:                            $0.66

Net debt:                    ~$0m

Market cap:               AU$74m

 

Elevator pitch

After years of poor performance, a revolving door at the C suite and ongoing restructuring charges/impairments, recent insider buying gives us confidence that CountPlus has reached an inflection point in its turnaround. Looking through the one-off charges to cash profitability and assuming no improvement in operating margins (~10% vs. peers >20%) we believe the shares are selling for a pre-tax free cash flow yield of 14%. As the turnaround begins to show up in the reported financials and the company re-instates a dividend policy, we believe the market will wake up to this emerging growth story.

 

Investment thesis

  • New CEO who co-founded one of the best performing groups within the network, and who has a non-monetary vested interest in the success of the business due to relationships with many of the employees he mentored, is implementing a strategy he successfully employed while managing Hood Sweeney and recently acquired ~$400k of stock on market
  • Sticky, diversified, annuity like revenues provide downside protection. Operating margins of 10% due to a loss-making division and poor incentivisation under old model vs. peer group margins 20%+. Every 1% improvement in profitability adds $0.08 in value per share (if capitalised at 8x)
  • Increased regulatory pressure on the back of a Royal Commission should drive consolidation as sub-scale firms look to partner with a well-capitalised competitor to scale fixed compliance overheads, providing an attractive backdrop in a highly fragmented industry
  • Current valuation implies extremely low expectations. Assuming no improvement, it should currently be generating $10-12m in pre-tax owner earnings (14%+ earnings yield). Given the low capital requirements of the business, the majority of this cash flow can be used to pay dividends or make acquisitions. As the CEO has a track record of finding and executing value accretive acquisitions, combined with a board rich in M&A experience, and a consolidating industry backdrop, we believe CUP is in a prime position to increase value for shareholders
  • The convergence of cash profits and reported financials, together with the dividend returning, should provide a hard catalyst for the Aussie small cap community to take another look at the business

 

History

CountPlus (CUP) was born within Count Financial (Count), one of Australia’s largest network of advisory firms. Count, which is now owned by The Commonwealth Bank of Australia (ASX:CBA) spun CUP off into its own publicly traded entity in 2010 and still retains a 36% shareholding. CUP generates revenues through a network of ~17 firms (wholly and partially owned) with a fairly even split between accounting and financial advice fees.

After an initially successful IPO, CUP began to get into trouble when Count Financial went from a stand-alone public entity, to being acquired by CBA. While this had little impact on the underlying operations of CUP member firms, because of the unique relationship between CUP and Count, CBA began making “loyalty payments” …

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Geoff Gannon August 7, 2018

Northfield Precision Instruments Corporation (NFPC) – A Dark, Illiquid Nanocap at an Unlevered P/E of 6

Member write-up by LUKE ELLIOTT

Northfield Precision Instruments (OTC: NFPC)
Quote: $15.00

Let’s go ahead and get one thing out of the way. When I say nanocap and illiquid, I really mean it. Northfield has a market cap of 3.6 Million USD (234,237 shares x $15/share) and its 10/90 day volumes are 0 and 102 respectively. This is a tiny company and the largest daily volume (by far) of shares trading over the last year was 6,400 (around $95,000 USD). For some of you it probably doesn’t make sense to continue reading.

For some background, Northfield Precision was founded in 1952 by three men in Long Island, NY. The first products manufactured by the company were micro spin bearings, precision gear blanks, precision shafting, precision limit stops and miniature slip clutches for the electronic industry. The company went public in 1959. I was unable to determine what year the company stopped filing with the SEC, which probably means it was a very long time ago.

The company looks quite different now. None of the original founders are still at the company and they now manufacture air and diaphragm chucks. A chuck is just a specialized type of clamp. They’re typically used to hold or clamp a rotating workpiece that is being machined. Northfield supplies chucks to part manufacturers in a variety of sectors including automotive, aerospace, electrical/electronic, robotics, medical/optical, and machine tooling. It’s likely that their largest customers are in the aerospace and auto parts industries and in a nutshell, Northfield provides parts that are necessary to manufacture specific metal components for these industries (Examples include transfer case components, water pump components, crankshaft and driveshaft components). Depending on the complexity, one chuck is in the ballpark of between $2,000-6,000 which is typically less than 1% of the cost of the CNC (Computer Numerical Control) Mill or Lathe and typically a small percentage (thought not insignificant) of setting up a new process to produce an auto/aerospace component.

Because the company is dark and does not file with the SEC, I had to request the financials from the company directly and was provided with only the last 5 years. The company was unwilling to send financials further back than 2013. Based on 5 year numbers, durability can be difficult to determine from a quantitative perspective. Focusing on what we do know, we can say that the company certainty ticks the box from a longevity perspective since they’ve been around for 60 years. The company is certainly run conservatively, and like many small businesses (typically family owned), they carry no debt (besides some equipment leases) with a large amount of cash on hand.

Because the products the company sells are both competitively priced and such a small percentage of the total “new part” start-up cost for their customers, keeping the continuity of their customer relationships, timely delivery, and high product quality are what matter most for a company like this. Most customers are unlikely to switch from a supplier they’ve been using for …

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Geoff Gannon August 6, 2018

Butler National Corp. (BUKS) : An Illiquid Ben Graham Style Mini-Conglomerate in Aerospace and Casinos

Member write-up by VETLE FORSLAND

 

Butler National Corp (BUKS) is a $14 million OTC stock that operates in the Aerospace Products industry and manages two casinos. The two unrelated businesses split revenues 40/60, respectively. It trades at an EV/EBITDA of 2.30 (while peers trade at around 10 times) and the company has net cash. While all this sounds attractive, it only gets better; a simple sum-of-the-parts calculation shows that the stock is trading at 29% of its intrinsic value.

 

The stock trades around $0.20 per share. It’s illiquid. And their assets shows great unrealized value for shareholders. However, the management has done a poor job at utilizing these assets. So, an activist investor or an acquisition may be necessary for the stock to reach its fair value.

 

About the business – Aerospace

BUKS was formed in 1960. It maintained electronic aircraft parts like switching equipment, navigation instruments, radios and transponders. It has since expanded its Aerospace Products segment. Today, Butler gets revenue from: system design, engineering, manufacturing, integration, installation, services and repairing products for business-sized aircraft. This part of the business has three subsidiaries, namely Butler Avionics, Avcon Industries and Butler National Tempe. The former subsidiary – Butler Avionics – sells, installs, and repairs avionics equipment (the electronic systems used in aircrafts) like airplane radio equipment and flight control systems. Avcon Industries modifies business aircraft mostly by modifying passenger-to-freighter configurations, adding aerial photography products to aircraft, and providing stability enhancing modifications. All of these are crucial parts of airplanes. Butler National Tempe is the defense-contracting part of the business. They focus on electronics upgrades for weapon control systems used by militaries. They also manufacture transient suppression devices and switching units for Boeing aircraft.

 

About the business – Casinos

In the early 1990s, the management at BUKS decided that they wanted to diversify their revenue away from the cyclical aerospace business. The Board of Directors at the time had contacts with American Indian tribes, so they went into the gambling business by managing two casinos: Boot Hill Casino (a state-owned Kansas casino) and the Stables (a Modoc tribe-owned casino in Oklahoma).

 

The management agreement with the Stables expires on September 30th, 2018 (less than two months from today). The company’s latest 10-K says ‘negotiations are underway to renew this contract’.

 

This segment, called Professional Services, is divided into two subsidiaries: Butler National Services (which provides management services to the two casinos) and BCS Design (which provides architectural services on commercial and industrial building designs). While the Aerospace part of the company originated three decades before professional services, 61% of the company’s revenue came from the professional part of the business in 2017, and 67% in 2016. Before then, the 6-year average had been 66%, while assets are always split 50/50 between the two segments.

 

Quality

There’s not much to say about the quality of the business, because it’s not as necessary as with other companies I write about. This is a value play. …

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