Description

This is my VIC application idea.  The stock has moved up substantially from the level when the idea was originally submitted (about a month ago). I'm reposting it and providing some updated thought on valuation in the end, as I believe there's still about 20% upside from here and a possibility of privatization of the company.

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Summary: Currently at $5.50, Collectors Universe (CLCT) common stock represents an opportunity to buy a profitable, non-capital intensive service business at 4-5x FCF with good downside protection from a cash-rich, debt free balance sheet, ongoing cash generation and a shareholder friendly board & mgmt.  My target price represents a 45-60% upside with several possible catalysts.

Description

CLCT is the leader in the business of authentication, grading and certification of high-value collectibles, such as rare coins, sports cards, autograph and stamps. The collectible market is an extremely fragmented and inefficient marketplace, characterized by a large number of local dealers' shops, trade shows, auction houses etc. Before the 3^rd party authentication service came, most buyers lacked the information needed to determine the authenticity and quality of the collectibles being sold and had to rely on the opinions or representations made by the dealers/sellers, who are definitely not "disinterested". The development of virtual marketplaces like Ebay have even heightened the concerns of the authenticity of items being sold.  Having an independent party like CLCT providing an extra level of certification gives the collectors and buyers the confidence to purchase high priced items at Ebay or even higher value assets offered at places like Sotheby's, knowing that they are authentic and that quality is as represented by the sellers..  CLCT essentially serves a similar function to the one of rating agencies in credit markets.  The two barriers to entry in this business are reputation and the limited number of specialized experts available.  Our channel check shows that CLCT has brands with strong recognition among the collectible dealers and process/grade significantly more items under categories than any of its competitors.  The majority of their experts have 20+ or even 30+ years of experience in grading the respective collectibles.  The company has significant market share and has graded twice as many coins and sports cards than its nearest competitors.  Its market position is even stronger in newer stamps/autograph categories.

How it works: CLCT receives the collectible and removes any packaging that identifies the submitter.  The rating is a "double blind check" process requires that two of their experts evaluate the item independently; the authenticity opinion is issued and a quality grade is assigned only if two experts have the same conclusion. The opinion and grade are then verified by a senior expert, who has the authority to resubmit the coin for further review if deemed to be necessary.  This procedure is aimed at keeping the process independent of the identity of the owner and the history of the coin. !3C/p>

The collectible grading biz generates revenue primarily from service fees, and to a lesser extent, subscription fees from its internally operated virtual dealer-to-dealer marketplace and from the sale of ads on its websites.  It collects a fee of $5-$200 per unit (which is a small price to pay, especially compared to the 200k+ rare coin or sports card you're buying). The rating price depends on the level of turn-around time.  For example, the fee revenue from the service provided at coin trade shows with same day turn-around carries the highest fee and margin.  After paying the experts, the company gets gross margins of 60%+ and EBITDA margins in the neighborhood of 20-25%.  Return on tangible capital invested is usually in excess of 100%.  There's minimal Capex and little requirement for working capital so FCF is fairly close to EBITDA.  In terms of growth, the current market's expectation has been rationalized to a quite reasonable level and no one thinks the core business is going to have unit-growth in excess of 20%  - as Wall Street thought 5 years ago. We think, this is, at best, a GDP or inflation type of growth. Although some people may argue there's still chance for unit growth from increasing service penetration at places like Ebay, some new product initiatives and more collectible buying activities,  none of these factors have been included in my investment thesis. 

Some background & development

CLCT went into its core coin-grading business in 1986 and launched sportscard, autograph and stamps grading in the 1990s.  In November 2005, they entered a business of providing authentication services to the much larger but more competitive markets of jewelries (diamond and colored gemstones).  To make a long story short, they took a high margin, capital-light, cash generating core collectible biz and did a secondary stock offering to do the acquisitions in order to enter the jewelry biz.  The venture has not only been unsuccessful but also became a money hole and drain on the company's cash resources.  Overall, the company's EBITDA went down from close to +$8m in FY05 to a $3.5m loss in FY08.  The overall P&L is dragged down by the substantial added expenses and investments to grow the jewelry biz.  The good thing is, earlier this year they decided to exit this loss generating business.  The former CEO, Michael Haynes, who was the original architect of this strategy, left the company soon after this event.  The board has conducted a strategic review of its business and capital structure and they decided to do a "Dutch Auction" offering to buy back 20% or about 1.75m of its O/S shares in June 2009.

Why is the stock attractive now?

Dutch Auction and insider buying:

At the time that the Dutch auction was announced, CLCT had $23m net cash and a market cap of only $42m, with 9.14m O/S shares and $4.55 price (down from a high of $19 in 2005).  For the 6 months before the offer was announced, there has been a consistent history of open market buying activities of insiders with significant stock holdings.  There were 2 important insiders here, David Hall, the founder, President and current board member of CLCT and Kenneth Duncan, who happens to be one of the biggest coin dealers in the country.  Both had significant buying during the past several months at prices ranging from $2.80-$4.15.  The offer was to repurchase 1.75m of the shares at a price range of $5-$5.40, the midpoint of which was a 14% premium of the market price.  It also comes with an over-allotment option to buy an additional 2%.  All of these are signals that the stock price was a bargain.  Shareholders, however, are fatigued after a long, disappointing wait and my guess was a lot of them just wanted to get out of this thinly traded micro-cap stock.  The evidence?  A total of 4.69m shares, 260%+ of the offered amount, were submitted in response to the tender. Out of this, 3.95m shares were submitted at the low end of the price range at $5.  Excluding the some 30% of shares held by the insiders & Mr. Duncan, the 4.69m represent over 70% of the float!  In fact, before the tender was announced and right after CLCT announced the intention to exit the jewelry biz, there was a letter sent to the board from Shamrock Capital Advisors, known as an activist investor and a long time shareholder of the company, agitating for an immediate sale of the company.  A quick look at the current shareholder list shows that the majority of the shareholders have held CLCT for quite some time and, therefore, suffered a large loss of their capital.  Since final proportionate ratio of the auction was a mere 42%, the stock should continue to be under some selling pressure.  The company CFO phoned large shareholders after the tender and offered to buy large blocks of shares back at a small discount to market price.  Even after a good 4^th quarter result was released in August, the stock still traded below $5.  Subsequent to the earnings release, another insider, interim CEO Mike McConnell, bought 38,250 shares at prices just below $5.  The key here is if the company is right in believing its stock is undervalued, the buyback of shares at prices under intrinsic value should have enhanced the value of shares not being sold back to the company.  None of the insiders seem to have submitted their shares so their % ownership in CLCT have all increased after the transaction (see below).

* Shares held by David Hall are included in the Board & Mgmt group, but not the ones held by Duncan.

Shareholder oriented Board and Mgmt:

Despite a failed venture overseen by this board, it has been quite friendly to the shareholders in the past and is committed to maximize the value of their investments.  CLCT was paying a $1 annual dividend (about the same amount the core biz is earning in CF) while the investors waited for them to make the jewelry biz work, and had always been a net buyer of its own shares.   They've decided to shut down the money losing jewelry unit to refocus on the core collectible biz, and launched an aggressive cost reduction plan to bring the overall company back to profitability.  The interim CEO Mike McConnell was on the board as a representative for Shamrock Capital Advisors, before taking over to fix the biz and manage the transition.  Although he's no longer with Shamrock, he surely understands the needs of shareholders and is intelligent about capital allocation with his background as an investor.   I suspect the Dutch auction had been a result of much of his input.  As investors demanded an exit from this thinly traded security, the tender was an effective, trading cost-free way for them to get out.   On the other hand, it's a great way to enhance the value for the shareholders who decided to stay in.  Last but not the least, this board and management as a group currently hold a substantial amount of shares (see table below).

Core biz trading at low valuation:

The most recent fiscal 4Q earnings was most indicative of future earning power of the company, as previous numbers were full of distortion from costs associated with the jewelry biz and some corporate fat.  CLCT reported $9.7m in revenue and $1.9m EBIT in Q4, excluding the asset impairment charge.  Given the loss from the jewelry biz and discontinued ops, they've accumulated about $17-$20m in NOL tax losses and pay minimal cash tax, so almost all EBITDA falls directly to the bottom line earnings.  Maintenance capex is usually less than $500k and D&A (including some amortization of intangibles from earlier acquisitions) is in excess of $1m+ annually.  As a result, FCF is currently about the same as the annual EBIT run-rate of at least about $7m+ (The co is on a June 30 FYE.  Dec qtr is usually seasonally weaker and the March qtr is strongest, so my conservative annual run rate is lower than the annualized June quarter number).  At current $5.50 stock price and with 7.41m in shares, the company has a market cap of $41m, net cash of about $12m ($15.1m cash less $3.3m liability associated with a lease from the discontinued jewelry biz), so EV is about $29m.  Based on these numbers, the ongoing biz trades at about 4.1x untaxed earnings or FCF ex. any interest income. The other way to look at this is, once NOL runs out and their earnings get fully taxed in 2-3 years, the company will have about $26m cash on a market cap of $41m and will have earnings of about $4.2m per year. So the EV to FCF multiple is still less than 4x, an extremely cheap multiple for even a mature, but profitable, cash generating biz.

Target price & upside:

The target price depends on what kind of multiple you think the public market is willing to pay for a mature business like this.  I'd like to think an 8-10x multiple on FCF is appropriate given the attractive ROIC and the cash flow characteristics of CLCT.   This range gives us a $9-$11 value per share.  On the conservative side, a 10% discount for the illiquidity brings the fair value to about $8-$9, still a 45-63% upside from current price of $5.50.  At this price, we're only paying a slight 10% premium over CEO's purchase prices and the price at which company repurchased the 1.75m shares.

So what are other possible scenarios, upside and catalysts?  As it stands now, the mgmt is only looking to grow the core biz with initiatives that requires minimal amount of incremental investments in S&GA and capex.  The CEO has made it clear to us that they're not looking to do any acquisition (this is apparent because no shareholder is willing to do another venture after the losses they've suffered).  The only other upside would be some margin expansion or return to historical EBITDA margin of 25%ish through product mix changes.  So what could happen to such a mature, boring, cash cow company with a $41m market cap?  The most logical (although not the most possible) scenario is for them to go private.  CLCT incurs an annual cost of $1.5-2m of being a public company, a huge amount for a company with only some $36m rev and $7-8m EBIT.  We've heard some shareholders speculating that David Hall and Kenneth Duncan might push to privatize the company, thus taking away the public company expenses.  I do not have any insight whether this could materialize, but we have to admit there's always a possibility that the company will find a buyer for itself given a significant shareholder base is still demanding to get out.   It'll be quite difficult for the company and the board to consider investing in a new venture without a change in majority of its shareholder base.  The CEO Mike McConnell has also stated to us that he's not looking to stay beyond this calendar year. This means, in order for the company to stay public, a replacement needs to be found for him, someone with an operational background who will be effective at running the business.

IMO, the most likely and somewhat unfortunate scenario for current shareholders is, the company stays public, continue to operate but reinitiate a cash dividend.  The previous $1 dividend was suspended due to liquidity concerns from the large cash drain in jewelry biz, prior to the exit from it.  In order to justify being a publicly traded company with the large reporting costs, they have to give something back to the shareholders.  A $0.50 per share annual dividend will get to stock to yield close to 10% and should be well covered by the FCF from the core biz.  The CEO told us they definitely have no problem of paying out that CF as dividend, like they did in the past.  Assuming a 5% yield is reasonable for this biz, the stock should trade up to $10 upon the declaration of such dividend.

Risks:

• 1) The buyout scenario does not happen - One argument against the privatization is the impairment of NOL assets upon a change of control. This is one reason for the company not to go private until they burn out the tax loss in 2 years. After all, the scenario of a buyout happening is, at best, a speculation.  There's also a poison pill at 20% ownership, but the board will have to put it up for a shareholder vote at the next annual meeting.
• 2) Conflict of interests b/w the insiders and public shareholders - As the President, founder and a large shareholder of the co, David Hall (and other some insiders) may not want the company to be sold. It is even harder to figure out Kenneth Duncan's motive in the stock. We've never spoken to him. As someone who's in the collectible business and uses CLCT's services as a customer, his intention could be different from what investors wanted, although the mgmt and board claims Duncan's sole intention is to make money on this financial investment. Nevertheless, I think it will be extremely hard for them to keep the company public w/o giving something to the public shareholders. Judging from the past record of this board, it doesn't look like this will happen.
• 3) Thin trading volume - 3-month avg trading volume 30k per day, and sometimes volumes were usually as low as 5k. Continued liquidation of shares by previous shareholders could weigh on the share price, although this can also be the opportunity to build a position.
• 4) Core business started to deteriorate - a possibility but unlikely to happen. The absolute downside in the stock now is $1.62, the value of cash per share, and this number should increase to $2.50 next FYE in June 2010 based on my conservative estimates. It will be a crazy scenario for the stock price to get to cash level w/o giving any value to the underlying business with good cash flow and strong brands. The stock did trade as low as $2.80 during the market low in March and that was when David Hall and Mike McConnell started buying shares.

Recent updates:

On Oct 26th, the company resumed a $1 annual dividend, making the stock yielding 18% at the price of $5.50.  Even at current price of $8.37, the dividend yield is still about 12% and stock trades at 7.1x EV to untaxed FCF.  Because the company is paying out all of its FCF as dividend, once the NOL runs out in 3 years, it'll be earnings $0.60 fully taxed FCF and have a dividend yield of 7%.  Plus, by the time the earnings get taxed, anyone who gets in here will get 40% of their initial investment back with the 12% yield and end up with a stock paying 7% dividend.  Last but not the least, it really does not make sense for the company to stay public given the small revenue/earnings base and minimal growth prospect.  I believe there's still a possibility that the company will be privatized.  The company will not be able to enter another venture for growth without a change of its current shareholder base.

 Disclosure: Long position in the stock.

Catalyst

- Seveal continued quarters of clean results for the core business
- Market realizes the value in the core business
- Re-initiation of a dividend
- Buyout of the company