Description
We are recommending the purchase of the Jan '08 in-the-money LEAPs on DHB Industries.
Business Background:
DHB Industries, Inc., the eponymous company of David H. Brooks, consists of two lines of business. DHB Armor Group makes bullet resistant plating used in bullet-proof vests, armor for vehicles, aircraft, shields, and other defense applications. DHB Sports Group makes protective athletic equipment like knee and wrist braces, shin guards, and back supports. DHB Sports Group accounts for less than 3% of sales and profits, and is therefore immaterial to this thesis. In DHB Armor Group, 90% of sales come from the premium-priced Point Blank brand of body armor, while the remaining 10% comes from their value brand, P.A.C.A.
The company’s success is attributable to a number of factors. The number of military and law enforcement personnel is increasing. Furthermore, the percentage of law enforcement personnel wearing body armor has increased from 30% in 1992 to almost 80% today. Purchasing a $400 vest simply makes sense to save the life of a soldier or police officer. DHB benefits from a short replacement cycle resulting from changes in technology and body shape changes of its end users. If a cop eats too many donuts, he needs a bigger vest. Finally, the federal government has provided grants to assist law enforcement agencies with their body armor purchases.
Why the stock has gone from $20 to $4:
Shareholders have two major reasons to be upset with DHB management. First, David H. Brooks is not shy about getting rich off shareholders. Late last year when the stock was trading around $20/share, David sold stock in amounts equivalent to the current market cap of the company. After the stock tanked, he got warrants for 5 million more shares at $1. He also appears to be a spendthrift in his personal life. The Motley Fool reports that he threw his daughter a Bat Mitzvah that only someone like Dennis Kozlowski could appreciate. The Rainbow Room extravaganza reportedly included 50 cent, Don Henley, Aerosmith, and Tom Petty. The total tab was rumored to be in excess of $10 million. As a result of his opulence, he has been crucified in various newspapers as a war profiteering party-boy. There is currently an SEC investigation into transactions between Mr. Brooks and the company.
The second tidbit germane to the story is that the company took a $60 million charge to replace its bulletproof vests. The company and most of its competitors used a material called Zylon in their vests, which has been proven to have its ballistic-resistant capabilities diminish over time. The National Institute of Justice did a study that confirmed this and a rapid decline in stock price ensued. Class action lawsuits followed from both shareholders and customers of the company. The $60 million charge includes the cost of obsolete inventory, estimated settlement negotiations with customers, and the cost of replacements. The company has stopped producing vests with Zylon and is currently getting a replacement product approved. The securities class action is still an unknown.
More information on the Zylon issue can be found here:
http://www.nlectc.org/testing/bodyarmor.html
So why purchase the Jan ’08 LEAPs?
Joel Greenblatt illustrated in his first book that LEAP purchases could be lucrative by exploiting their inherently skewed payoff profile. He used the example of the purchase of Wells Fargo LEAPs during the writeoffs in CA real estate. Ironically, they are most appropriate where there is risk of large economic loss. Why buy DHB common with risk of the stock going to 0 when you could buy the ’08 LEAPs with the same risk of loss but instead get a 10:1 payoff on the upside?
On an EV of almost $200 million, DHB trades at 4x trailing EBITDA with little capex. The primary reason, as described above, is the $60 million in warranty expense (called vest replacement program on the P&L). The company has over $50 million in credit availability to cushion the blow of an adverse settlement with customers (its currently has recorded a $36.7mm reserve for this purpose). The financials indicate that the company should be able to generate in excess of $25mm in FCF on a normalized basis, but the uncertainty surrounding the cost structure of the new vests cast a shadow on this number. But so long as the company can continue to operate with profitability somewhere near historical levels, the short term costs related to Zylon replacement should be digested without devastating consequences.
Clearly the gambit here is that between now and the end of 2007 the company works out the dual issues of the Zylon vest replacement and a change in upper management. The latter issue has begun to be addressed through the hiring of Retired General Larry Ellis as president. While the new executive hires have been given generous compensation packages, we believe it is a step in the right direction. The Zylon issue may have dented, but not destroyed, the relationships with customers. The company recently announced a $30 million order from the U.S. army giving confidence that this may be a short-term problem for the company. Given that many other vest manufacturers used Zylon in their vests, we predict that aggressively maintaining customer relationships and getting to market with new product can minimize share losses.
Because of the unique risks associated with the Zylon issue, we believe the Jan ’08 LEAPs provide a better risk-reward opportunity than owning the common outright. Open interest is low, but the 2.50 and 5 strikes are your best bet.
* Disclaimer: This recommendation is not suitable for some accounts. We may own securities mentioned in this report and are under no obligation to update any information related to this recommendation. We may buy or sell securities mentioned in this report at any time.
Catalyst
Settlement of the Zylon issue