Tuesday, February 22, 2005

Getting Around Sarbanes Oxley:
Follow up to 12/22/04 report
Hanover Foods

Since our first report on this subject, in which we discussed the growing trend of smaller companies opting out of filing with the SEC, and avoiding Sarbanes-Oxley compliance in the process, more companies have taken the same road, and this report will focus on one of them.

As our 12/22/04 column stated, due to the relatively high costs of filing documents with the SEC (including sending reports to shareholders), as well as the additional costs associated with Sarbanes-Oxley compliance, small companies are making good use of a loophole. To avoid filing, and complying with Sarbanes, they need to have less than 300 shareholders. Those that are below that level simply need to file form 15-12G with the SEC, and no longer need to report. Those that are nominally above 300 have found interesting ways to reduce their shareholder rolls (namely through the combination of reverse stock splits, and buying odd-lot shareholders out. Whether you own 100,000 share or 1 share, you are still just one shareholder.)

Hanover Foods Corp
Price: $90.50 (Class A)
Market Cap: $97.3
Shares Out: Class A non-voting: 288,000(actual)
Class B voting: 781,600(actual)
Average daily volume: 59 (actual, Class A)
No recent trades (Class B)
Book Value per Share: $99.09
Dividend Yield: 1.21%

Hanover Foods Corp is a small Pennsylvania based processor of and distributor of vegetables, founded in 1924. Still, the company ranks as the largest independently owned food processor in the eastern US. Fiscal year 2004 sales were $318 million, up 10 percent from 2003 ($290 million). Net income was $11.4 million in 2004, up 13 percent from 2003 ($9.9 million).

The company had about $3 million in cash, and $21 million in long term debt as of its last reported quarter (Aug, 2004). Currently, the company trades below its most recently reported book value of $99.09.

Admittedly, this is not the most exciting company, but by now avid readers of this site are used to that. It is, however, a consistently profitable one-17 straight profitable quarters-and that’s as far back as the data goes, (that I can find, anyway), so the run may extend far beyond that.

What is interesting about this company, though, is how they went about achieving the sub 300 shareholder plateau. In December, 2004, the company announced its intention to ultimately end filing with the SEC, commencing a tender offer to any shareholders holding 15 shares or less. At a time when the stock was trading around $84, the company offered $131.00 per share, a 55 percent premium! Although, this was not going to make anyone rich, as it only applied to shareholders owning 15 or fewer shares, it was still a nice premium.

The company was very clear about its reasons for the tender offer, and intentions to terminate registration of its stock, and with that, end SEC filing responsibility. It was also clear about the associated cost savings of doing so: The following is from the company’s SC 13E3, dated 12/6/04:

"We estimate that the costs of compliance have been at least $80,000
annually, in addition to onetime increased costs to document and test our system
of internal control over financial reporting, estimated to be approximately
between $344,000 to $961,000 in fiscal years 2005 and 2006 and ongoing increased
annual costs to document and test internal controls estimated to be
approximately $198,000 on an annual ongoing basis. Our management (in particular, Gary Knisely and Pietro Giraffa) has periodically and informally discussed with members of our board of directors the relative advantages and
disadvantages of being a reporting company for a number of years. The estimated
one-time costs to document and test our system of internal control over
financial reporting, the estimated ongoing costs to document and test our system
of internal controls and our estimated expenses of compliance as a reporting
company are as follows:"

Estimates from Consultants to Establish Internal
Controls and Documentation Procedures(1) ............. $ 174,000 - $561,000
Hanover Staff(2) ..................................... $ 120,000 - $200,000
Additional Audit Fees(3) ............................. $ 50,000 - $200,000
TOTAL INCREMENTAL COSTS .............................. $ 344,000 - $961,000
Hanover Internal Staff Time and Expenses ............... $ 133,000
Internal Controls Audit Fees ........................... 65,000
TOTAL ESTIMATED ONGOING COSTS .......................... $ 198,000

Annual Audit Fees ......................... 45,000
Annual Legal Fees ......................... 25,000
SEC EDGAR Printer Costs ................... 10,000
TOTAL ESTIMATED ANNUAL COSTS .............. $ 80,000

In summary, this move saves the company $278,000 per year pretax, plus one-time costs from between $344,000 and $961,000-not insignificant amounts for a company which earned $11.4 million last year. The filing goes on to mention other savings, specifically management’s time and attention:

“In addition, management devotes a significant amount of time and
attention to the preparation of the periodic and current reports required under
the Exchange Act and to compliance with the SEC rules and regulations
promulgated under the Sarbanes-Oxley Act. We estimate the time devoted to tasks
associated with public reporting as approximately 10% for the Chief Executive
Officer, 28% for the Chief Financial Officer, 37% for the Chief Accounting
Officer and 10% for the Treasurer. Management believes this time could be spent
more efficiently on operating our business and evaluating business

Finally, the company cited cost reduction of no longer having to administer small shareholder accounts:

“The expense of administering the accounts of small shareholders is
disproportionate to their ownership interest in us. As of the record date, we
had 287,996 shares of our Class A common stock outstanding. We had approximate
101 shareholders of record that held 15 or fewer shares of our Class A common
stock, holding an aggregate of approximately 718 shares. As of the same date,
estimated 265 shareholders of record held 16 or more shares, holding an
aggregate of approximately 287,334 shares of our Class A common stock. As a
result, approximately 33% of the administrative expense relating to our
shareholder accounts relates to the administration of shareholder accounts
constituting .2% percent of our outstanding shares.”

The Offer itself
Perhaps the most interesting part of this entire story is the tender offer price, and how it was derived. The company hired Gocial Gerstein LLC to calculate a fair market value for Hanover’s Class A shares. In summary, based on Hanover’s EBITDA(earnings before interest, taxes, depreciation, and amortization), sales, book value and operating cash flow, as applied to selected multiples, total equity value was placed at $138.9 million. A 25 percent marketability discount factor was then applied, to arrive at $104.17 million. Then, Gocial Gerstein made some further adjustments to arrive at $100.12 million. That figure was divided by shares outstanding, to arrive at $138.00 per share. Finally, a 5 percent discount was applied to account for the fact that Class A shares do not have voting rights. The result? $131.00.

What are the shares really worth? Well the market says $90.50, the current trading price. But these shares trade on the pink sheets, and trade infrequently. Does the market have it all wrong? Are the shares really worth $131.00, the price Hanover was willing to pay to small shareholders? Are they worth more? Time will tell.

The end result of this story is that after the tender offer, Hanover was able to reduce its number of shareholders to 289, filing its Form 15-12G on January 10th, 2005. This is a story we’ll no doubt be following.

You probably won’t read about this company, or this story, anywhere else. Analysts have no reason to cover this stock, and for the most part, institutions are not interested because of the company’s size, and small float. But we here at Cheap Stocks see the potential opportunity in situations such as this. It is our purpose to educate our readers about “off the beaten path” investment concepts and ideas, such as this.

That being said, please understand the risks of investing in illiquid securities such as Hanover. Only a small portion of your portfolio should be dedicated to such investments. Such companies may be difficult and expensive to buy, and sell. When investing, be careful not to place a market order for illiquid stocks, as the bid/ask spreads tend to be wide.

*The author does not have a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.

Thursday, February 10, 2005

Real Estate: Part 4
California here we come: Tejon Ranch

Ticker: TRC
Price: $46.81

My good friend Jim e-mailed me this morning (Monday 2/7) after noticing real estate related stocks heading higher. Tejon Ranch, he said, among others, was up strongly today (4 points early in the day, settled to finish the day up$.76). Funny, I said, Tejon Ranch is the subject of this week’s report, Part IV in our real estate series. No, really.

Never heard of this company either? Just like previous companies in past real estate reports such as JG Boswell, St. Joes, and PICO Holdings? Not surprising to me, or probably to you either. You are probably getting used to the off the beaten path topics and companies we research here at Cheap Stocks.

Tejon Ranch is primarily a real estate development company, with some agricultural operations as well. Total Revenue for 2003 was $18.3 million, down from $21.7 million in 2003. Net loss was $2.9 million in 2003, down from net income of $243 thousand in 2002. Nothing spectacular on that front. But, it’s not about sales and earnings with this company. It’s about the underlying assets.

The underlying assets are a nice piece of California land. Tejon Ranch owns 270,000 acres, which includes land in the San Joaquin Valley, Tehachapi Mountains, and Antelope Valley, 60 miles northwest of Los Angeles, California. According to the company’s 2003 10K, 247,000 of the acres are in Kern County, the other 23,000 in Los Angeles County. To put 270,000 acres into perspective, it’s the equivalent of 422 square miles, an area 20.5 miles by 20.5 miles. That’s about one third the size of Rhode Island in terms of square miles.

As we discussed in prior real estate reports on PICO holdings, JG Boswell, and St. Joes Corp, quantity of land is not always the most important factor, it’s location that really matters. In Tejon’s case, Interstate 5, considered to be one of the nation’s most heavily traveled highways, runs through company owned land. In fact, the company owns 16 miles of frontage on both sides of the freeway. Sixteen miles!

The company’s general strategy is best described by the following, from the 2003 10 K:

“We are a diversified, growth oriented land development and agribusiness company whose strategy is to increase the value of our real estate and resource holdings in order to increase stockholders’ value. Operations consist primarily of land planning and entitlement, land development, commercial sales and leasing, income portfolio management, and farming. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield.

Over the last several years, we have been implementing a strategy that has led to our transformation from an agricultural operations based company to a real estate development company. In order to implement our strategy we began to pursue joint venture agreements for the development of portions of our land, began conceptual planning and land entitlement projects, and undertook a program of divesting non-strategic assets. “

Tejon, which has just 10 full-time employees, currently has no analyst coverage. It does, however, have significant institutional ownership. Third Avenue Management (as in Marty Whitman, who also holds St. Joe’s) owns 27 percent. Several other institutions own smaller stakes, including Fidelity (7 percent), Highbridge Capital (3 percent), and Wellington Management (2.7 percent), to name a few.

With just 16.2 million shares outstanding, and a float of 12.8 million, volume averages less than 25,000 shares per day. Current market cap is around $775 million, while Enterprise Value is about $719 million (the company has $55 million in cash, with no debt).

If you read our prior real estate pieces, you’ve heard us wax on about the calculation of enterprise value/acres. In Tejon’s case, that amounts to $2610, and is calculated as follows:

Enterprise Value: (in millions)
Market Cap: $759
Debt: $.6
Cash: $54.8
Enterprise Value: $704.8
Acres: 270,000

Your editor picked up shares of Tejon within the past year at around $35 per share. At its current price of $46.81, the story is still very interesting. I’d urge you to do your own research. Check out the company’s 10 q and 10k filings, as well as the company website. The website does an excellent job of putting the company land holdings into perspective.

This marks the fourth and final piece in our real estate series. Each of these reports featured companies that are part of my portfolio. There are several others that I’ve been following, and we’ll publish research on some of these in the coming months.

Friday, February 04, 2005

2nd Anniversary of Cheap Stocks

This week marked our second anniversary. To mark this occasion, we are republishing our initial research piece. The content is timeless. Thanks for reading, and keep that feedback, and questions coming. CM

Ben Graham is considered to be the father of value investing, and although his principals seemed antiquated during the bubble, they still have application in today's market. Graham's focus on having a margin of safety in investments is as meaningful today, as when he first put pen to paper.

One of Graham's strategies focused on identifying companies trading below their "Net Current Asset Value", which is defined as:
Current Assets minus (Current Liabilities+Preferred Equity+Long Term Debt + Other Long Term Liabilities)

The product of this equation is then compared to a company's market capitalization. In cases where market cap is less than net current assets, you may (the operative word is may) have found a bargain. Why? Because net current asset value does not even consider the value of long-term (or non-current assets) such as property plant and equipment, land, long term investments. Therefore, buying a company trading below its NCAV is like getting the rest of the assets for free.

Graham preferred companies trading at less than 2/3 of their NCAV, which allowed a greater margin of safety. Word of warning though, companies may be trading at these levels for good reason. They may be in trouble, and Graham was very clear on this point in his writings. Howevever, the analysis of such companies is still well worth the effort.

In building this web page, the intent is to educate readers about this investment technique, the ins and outs, what to look for in NCAV companies, and why. As the concept is further explained in the coming weeks, short research reports on companies meeting the criteria will be also be posted.

Unfortunately there have not been many studies (outside of Graham's research, that is) on the success or lack thereof of buying companies trading at less than their NCAV. One, by Professor Joseph Vu of Depaul University from (1988) found that buying these companies, then selling two years later beat the market by 24 percent.

Tweedy Browne, an investment management firm (these guys are the real deal, excellent value managers), publishes a booklet titled "What Has Worked In Investing", which also references the NCAV strategy, saying that it's research "indicated that companies satisfying the net asset value criterion have not only enjoyed superior common stock performance over time, but also have often been priced at significant discounts to "real world" estimates of the specific value that stockholders would probably receive in an actual sale or liquidation of the entire corporation."

The bottom line is that you will not find many well known companies meeting the criteria. The large majority will be small companies, with market caps below $100 million. Analysts typically don't follow these companies, institutions don't own them, so they don't generate much press. Some are fallen technology companies, chock with cash, but unfortunately, that cash is being burned very quickly, and the companies are not profitable. You can also find companies that are making money, have great balance sheets, and a potentially positive future. This is where the analysis comes in.

The composition and quality of a company's current assets is an important factor as to whether you are truly getting a bargain. All else being equal, the greater the amount of cash and marketable securities as a percentage of current assets, the better. In terms of true value, it goes down hill quickly for the other current asset accounts. Accounts receivable, for instance, must be collected in order for value to be realized, and there are no guarantees this will happen. Inventories may be worth pennies on the dollar if they needed to be quickly converted into cash, plus there are storage and maintenance costs. Cash, on the other hand, has a fixed value. What you see is what you get.

Thats exactly what this strategy demands. Even if you uncover a true gem, it may take a long time for the market to realize a company's true value. You may find a company with tremendously undervalued assets (remember, if you buy a company below it;s NCAV, you essentially get the long term assets for free), but you should also look for a potential catalyst. Look for companies who have positive earnings (many NCAV companies do not), who have the potential to increase earnings in the future. Loads of cash, along with in-demand products will buy these companies time to make their strategies work. While, those that are bleeding red ink, and have little cash may be headed to bankruptcy.

Since most NCAV companies are small, and have relatively low trading volume, the bid/ask spreads can be huge. Always use limit orders when buying or selling. A market order placed for a thinly traded issue can really hurt when buying or selling.

Read the 10K, know what business the company is in, know its financials, and don't be afraid to call the company for more information. Don't buy if you can't explain the business in one sentence. This strategy is risky, so do your homework.