EnviroStar (EVI) (current price: $1.06; price target: $1.90+) primarily distributes commercial and industrial laundry and dry cleaning equipment, including a proprietary line of dry cleaning machines (98% of revenue) with a focus on environmentally friendly dry cleaning methods and equipment. There is even a “green” angle here for environmentalists.
Overall prospects for this business are not great but not terrible. Much of their dry cleaning products sales are to hotels, hospitals etc, all of which are obviously very weak. They do have some good growth into international and Latin America though, which is ~20% of their sales and growing. Not exactly the most “sexy” industry but any investment is interesting at the right price.
EVI has a market cap of $7.8m, yet has $6.94m in cash, $1.75m in inventory, $1m in AR, with no debt and less than $3m in AP and customer deposits. This valuation would make sense if the company was burning cash, but it is free cash flow positive, insiders own >60% of shares, and company has had respectable ROE, ROIC and EPS growth over last few years. Furthermore, revenue actually grew 23% last quarter.
I believe valuation for this company is ridiculous and that there are some potential catalysts to unlock value in the next two years with minimal risk of permanent loss of capital. The only way I would believe EVI is fairly valued at current price is if extended cash burn occurs and I think that is very unlikely.
The company used to pay out 50-100% of cash flow in dividends but cut that dividend when the economy really started coming unwound to be conservative. This dividend was never reinstated and as a result they have been building cash on the balance sheet. Considering that they were cash flow positive even in 2009, and that cash flow approximates earnings, they really don't need much, if any, cash on the balance sheet considering the $2.2m revolver they have (that has to be renewed annually in October).
Note that cash + inventory + AR (at balance sheet value) exceeds current market cap. When discussing the large cash balance with the CFO, he justified their cash levels by saying they are looking out for acquisitions. However, he also says they are not interested in most acquisitions because it is hard to find quality companies in this industry at this size with reliable accounting.
VALUATION
Market cap minus cash ~$1m. Assuming a mild rebound in end markets I get 2011 net income of $680k meaning the core company trades for <2x earnings. Even if you adjust for customer deposits of $1.38m you still get a core P/E of <3.5x This is despite low teens ROIC, strong cash flow and high ROE while growing eps by ~10% a year since 2001. Note that even in the depths of the collapse they were free cash flow positive and kept ROE and ROIC at respectable levels with decent profit margins. Liquidation value is approximately $7.5m, so downside is protected.
I think there are a few likely outcomes and catalysts:
1. Management takes the company private.
It makes no sense to me for a company this small to even be public, and management apparently agrees since they attempted to take the company private last year (at an absurd price). The costs of being public far outweigh the benefits and since insiders own 60% of shares, the float is ridiculously small. If they do take the company private, I would imagine they pay out at least half the cash on the balance sheet sometime later this year in a one time dividend, giving us >$0.50 in cash in the process. Management could then use this cash they now have as equity in a very low leverage LBO that could largely be done with their line of credit and their own capital.
Valuing the core company at 11x 2012 earnings (well below historical valuation), I get ~$1.25 per share for the company. Add back the $0.50 we got in cash from the dividend, and this scenario gives us a total return of around $1.75. From today's prices that is more than 60% upside and makes a lot of sense from management’s perspective.
In this outcome, management could give themselves millions of dollars, take complete ownership of the company at low valuation on trough earnings, and save at least $350k annually in annual cost for being public and hassle. Note that for a company with <$1M in net income that $350k in annual savings from being a private company is enormous.
**By comparing current working capital levels and marketing spending with past levels, it looks like the company could be “preparing” the company for a bid.
2. They payout 65% of current cash balance and reinstate the old dividend
Assuming the company pays out cash flow at the low end of their historical pay out rate of 50-100%, and pay out 50% of 2011 cash flow, that would give us an annual yield of 4%. This would then allow them to hold and compound the rest of their cash at ~12% and payout 65% of current cash holdings ($0.65 per share) as a one time dividend. So we would get half of our cost basis back in cash and be left with ownership of a small but well run company with 60%+ inside ownership at a 4 P/E and 4%+ dividend yield. This probably gives us at least 50% return depending on how the core company is valued post payout.
3. Nothing.
If nothing happens at least they will be building cash on the balance sheet and compounding returns at 10%+. Since the company is well run and generating cash, I am happy to wait and I'd rather have capital invested in this idea than sitting in cash. I believe that at some point that cash will be paid out or put to work somehow given management ownership and incentive to do something good for shareholders (them).
Given stabilization in their end markets, something will probably happen sooner rather than later. While recent top line declines have occurred more quickly than I expected it also raises the question of how long they will continue to allow the company to burn half of its “potential net income” in costs just to be public? If they took the company private it would increase net income by over 40% and then they could pay that money to themselves.
Downside. Primary downside is liquidity as EVI has basically no bankruptcy risk, no litigation outstanding or union issues, no pension liabilities, and no off balance sheet liabilities. If the market implodes again it could trade down to ~$0.85. In 2009 it traded down to $.80 but EVI has also grown cash on the balance sheet by 20%+ since then so I would be very surprised if the stock traded down to less $.85 and if it did I would be a buyer.
Risks. The Steiner family owns an enormous amount of EVI shares. The Steiner’s lowball takeout attempt last year worries me that they aren't the most shareholder friendly. This company also rents property from the Steiner’s with guaranteed increases. The cost is not huge but they get 3% guaranteed increases which obviously don't make sense in the current real estate market. The history on this is that EVI rented this property from the Steiner’s (the founders) before the company went public and it just didn’t make sense to change this relationship given that the rents are not excessive
While management salary is high, they don't pay themselves a truly ridiculous salary, which they could. EVI has no plans or arrangements with any officers which provide for the payment of retirement benefits, or benefits that would be paid primarily following retirement, other than the company’s 401k which is a deferred compensation plan under which the company matches employee contributions up to 2% of an eligible employee’s yearly compensation. The past dividend also indicates to me that EVI are somewhat shareholder friendly.
Also, the company has no arrangements that pay any company executive following or in connection with resignation, other termination of employment or change in control of the company. The company’s five directors each receive a modest fee of $5,000 per annum. The chairman receives $10,000 per annum and is an independent officer.
If not for the huge inside ownership in these shares I would be less bullish on this stock. The excessive executive compensation and real estate deal bothers me but given other signs of management honesty, I think there is low risk of management doing something dishonest or destructive for shareholders. Some insider dealings are pretty common in micro cap land so the real estate relationship is not as unusual as you might expect.
Another potential risk is the volatility of a stock this small and illiquid. If we get another market melt down this stock could easily fall 50%+ for no fundamental reason. Investors should only own this stock if they are comfortable with that and can afford to have at least a 2 year time frame. The way I think about this is “would I be comfortable buying this company if it was private and I could not sell for 2-3 years?” For me, if someone proposed selling me a growing free cash flow positive company with no debt for less than the value of inventory and cash on hand with a motivated management team, I would find that extremely attractive.
Summary: So you essentially have 25% downside and 70%+ upside using relatively conservative estimates, for a 2.5x return/risk ratio with very little risk of permanent loss of capital. It is impossible to know exactly what could happen but it seems under almost any scenario the company is under valued. Any stock could do anything in the short term but over the next two years I have a hard time coming up with any scenario that has less than a 50% return. I am a buyer at anything <$1.20.
If the company starts having multiple quarters of negative net income indicating likely extended cash burn or if management shows me reason not to trust them, then I will likely exit the investment.
Be cautious.
Disclosure: I am long EVI. We reserve the right to sell or change our opinion at any time without notification.
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