Description

Crown Crafts is an average business run by decent management that is valued like a bad business run by below average management.  Currently valued at an EV of 8x after tax run rate free cash flow (the business does not actually pay taxes currently), I believe downside is limited and the potential for a double or more is unusually high in this picked over market.

 

Our Average Business:

Crown Crafts designs, markets and distributes products for kids.  It is the largest distributor of infant bedding, bath items, and bibs in the US and it sells under branded, licensed (especially Disney – 41% of revenue), and private labels.  Its biggest competitor is Russ Berrie (a VIC write-up from 2.5 years ago that has struggled as a business since then), though this is not Russ Berrie’s primary business (ticker: RUS).  The industry itself is not particularly cyclical as babies continue to be born at a steady clip (kind of the opposite end of the deathcare industry).  Being in a stable demand industry, of course, does not mean that the business is inherently stable.  .

 

Distinct from the industry, the business has gone through clear ups and downs.  Here’s a snapshot of our average business over the past several years:

 

Fiscal Year (3/31)                    2003    2004    2005    2006    1H06   1H07

Sales:                                       $94.7   $86.2   $83.9   $72.7   $34.9   $37.7  

Gross Profit:                             $21.4   $19.6   $17.0   $17.1   $7.6     $10.3

EBIT*:                                     $8.7     $7.4     $6.2     $7.0     $2.5     $5.2

EBITDA:                                  $7.7     $8.0     $6.7     $7.5     $2.7     $5.4

Adj. Net Income**:                  $2.7     $2.0     $1.5     $2.4     $0.6     $2.6

Net Debt:                                 $31      $28      $24      $20      $20      $11                             

Interest Expense:                      $4.5     $4.1     $3.8     $3.0     $1.5     $1.0

 

* FY2003 EBIT is grossed up for $1.8 million of restructuring charges associated with shutting down manufacturing.

**Assumes 40% tax rate and excludes one time gains/losses.  Also, CapEx has approximated D&A, so net income and FCF tend to be close.

 

I only go back to FY2003, because prior to that the company was involved in a woven products business and in adult bedding.  Those were shutdown or sold in the first few years of the decade.  It also moved from an insourced manufacturing solution to complete outsourcing.  That transition took several years and concluded in the first half of FY 2004.  Throughout 2005, CRWS reallocated its Asian sourcing to incrementally lower cost producers and it consolidated its distribution centers from two to one.  These decisions have improved margins (discussed later).

 

A hugely important event happened to the company earlier this year; it restructured and refinanced an onerous outstanding loan while simultaneously reducing its debt lode from about $23 million to $10 million.  Associated with the debt were penny stock warrants for a majority of the company.  In one of the greatest refinancings I have ever seen, CRWS paid off existing lenders, canceled the outstanding warrants, and reduced the cost of financing in one fell swoop.  This effectively saved the company over $2 million in interest per year and saved existing shareholders from massive dilution.  A quick glance at the stock price chart from July through today will provide an indication of how valuable the market perceived these actions (for the lazy among us, shares traded for $0.65 on July 11 and $2.00 two days later).  After reporting the June 30^th quarter in mid August, shares traded up over the $3.00 level and have basically stayed there and crept incrementally higher.  A 6x move in the share price in five months often indicates that we have missed the bus, but in this case I believe Mr. Market still does not fully appreciate the value of this business. 

 

One of the interesting things about the table of financials that I included above is a remarkable resiliency to the gross profit line, despite top line pressure.  This results from increasingly disciplined pricing and sourcing.  At the same time, SG&A has settled into the $10.2 - $10.5 million range.  During the early part of this year, the very modest bump in SG&A toward that $10.5 million annualized range has been more than offset by improved top line and gross margin, thus providing operating leverage.

 

Valuation:

So, for now, times are good.  The question of sustainability is natural.  Management believes that the first half’s after tax profit margin of 7% is a reasonably sustainable level and can still be improved upon.  However, let us assume that gross margins return to the 21.5% level of a few years ago (average of 2004/2005) down from the 25% average gross margin of the past 18 months (27.3% so far in FY07, but part of that was due to a one time blip, so let’s call it about 26% so far in FY07). 

 

Current annualized sales of about $78 million x 21.5% gross margin = $16.8 million gross profit.  Subtract $10.5 million of SG&A = $6.3 million EBIT.  Take out the government’s 40% vig and our depressed unlevered net income is $3.8 million (just under a 5% net income margin or a 10% ROE).  10x depressed net income gets us today’s $38 million fully diluted market cap.  That ignores the $10 million of net debt but it also ignores the fact that we will not be paying taxes for a few years.  Not quite an equal trade, but applying trough multiples is an imprecise science.

 

I view 10x (or even 12x) an artificially depressed net income as an attractive implied return.  It is my general view that Mr. Market does not allow 10% coupons to click along perpetually unnoticed in an environment of BBB rated yields at 5.6%.  Of course, our little business is not generating 10% coupons; it is generating 16% coupons.  Every day that passes is our friend.

 

I don’t really use price targets, rather I focus on implied discount rates/yields.  However, I noticed that people on VIC seem to like specific targets, so here is a quick and dirty sensitivity first using a handful of multiples on a fixed FCF level then the opposite (using a handful of FCF levels on a fixed multiple). 

 

The business is currently generating $2.5-$3 million of EBIT per quarter.  Call that $10 million of run-rate EBIT.  CapEx and D&A approximate each other, so FCF and after tax EBIT are about the same.  So, annualized FCF is about $6 million (assuming 40% tax rate).  A reasonable range of values is probably 10-15x FCF.

 

Sensitivity to valuation multiples at FCF current run rate:

10x $6mm = $60mm - $10mm of debt = $50mm equity value = $5.00/share

11x $6mm = $66mm - $10mm of debt = $56mm equity value = $5.70/share

12x $6mm = $72mm - $10mm of debt = $62mm equity value = $6.30/share

15x $6mm = $90mm - $10mm of debt = $80mm equity value = $8.00/share

 

Sensitivity to various normalized FCF levels at 12.5x multiple:

12.5x $3.5mm = $44mm - $10mm of debt = $34mm equity value = $3.40/share

12.5x $4.0mm  = $50mm - $10mm of debt = $40mm equity value = $4.00/share

12.5x $4.5mm = $56mm - $10mm of debt = $46mm equity value = $4.60/share

 

My view is that a reasonable range of $3.40 to $8.00 is a good range to have on a $3.80 stock.  10% down vs. 110% upside (and our upside does not assume any growth in earnings power).  Growth is a free option as is attractive redeployment of capital.

 

Management:

Randall Chestnut is the Chairman, CEO, and President.  In a business this small, he is clearly the key man.  He was promoted from EVP to his current position in 2001 and has skillfully managed the business through the changes of the past several years (focusing on higher margin products, taking cost out of the system, outsourcing manufacturing, etc.).  Randall believes he has an eye for attractive acquisitions and it would not surprise me to see him make occasional small acquisitions.  He owns 5% of the business.  He is paid a fair compensation level, in cash.  His base salary is about $400,000 and his bonuses for the last three years have been $221,000 is FY2004, $0 in FY2005, and $166,000 in FY2006.

 

Other Things Worth Noting:

It is worth noting that Wynnefield Capital owns 15% of the business.  Wynnefield is a noted small cap investor that has been occasionally activist (compounding at around 20% p.a. net for the past 13 years).  I view them as the guard dog at the door; someone who will fight to protect value (and, hopefully, create value) if the need arises, but otherwise merely serves as a deterrent.

 

Risks:

The primary risk is the loss of the Disney license, which represents 41% of sales.

Bad acquisitions are another risk.

 

Catalysts:

If the business continues to operate at or near current levels, the implied return will be too great for the market to ignore.

 

Continued growth.

 

Attractive redeployment of capital via share buybacks or acquisitions.

 

Sale of the business.

 

Catalyst

- If the business continues to operate at or near current levels, the implied return will be too great for the market to ignore.
- Continued growth.
- Attractive redeployment of capital via share buybacks or acquisitions.
- Sale of the business.