Description
With the beating the market has taken, I think that this idea would suit the
mood for the week.
Company and Industry Overview:
Liquidation World is a Canadian-based company (Calgary, Alberta) that
specializes in marketing merchandise from distress situations, such as
bankruptcies, receiverships, close-outs, inventory overruns, and insurance
claims. They have over 90 retail outlets located in Alberta, British
Columbia, Ontario, Saskatchewan, Manitoba, Washington, Idaho, Alaska, and
Texas. They also provide asset recovery services such as on-site auction
services and store closure management services. The stock is listed both on
the Toronto stock exchange (LQW) and Nasdaq (LIQWF). From this point on, all financial figures are in Canadian dollars, unless otherwise indicated.
The current CEO, Dale Gillepsie, founded the company in 1986. The company
currently has over 1700 employees, $185 million in sales, and $6.96 million
in earnings. Over the last sixteen years, the company has always been
profitable - 62 consecutive quarters! During this time, LIQWF's return on
equity has averaged about 17%; over the last five years, it has averaged
16%. Low points for ROE have been around 10%.
The company operates in a niche market. To date, their main business
involves acquiring acquire inventory from distressed situations -
bankruptcies, closeout, inventory or production overruns - at extremely low
prices and reselling it through a variety of retail outlets over a wide
geographical area. LIQWF does not break down their sales, but they will tell you that over 90% of their revenues comes from this business. The
inventories they acquire are primarily "hard" lines such as furniture,
hardware, electronics, paints, and surplus food ("soft" lines are items such as clothing). Their main value proposition to their customers is good
products at a great price - their inventory does not consist of "cheap"
merchandise.
In this business, they do not believe that they have any pure competitors.
At the retail level, they compete mainly against the deep discounters such
as Big Lots, Mazels, and Value City, but those chains acquire their
inventory by more traditional means. There also many mom-and-pop operations
that sell cheap and discount merchandise obtained from liquidations.
About 18 months ago, LIQWF also entered the going-out-of-business (GOB)
services market of the liquidation industry. This business involves services such as managing store shutdowns, on-site auctions, re-packaging, and inventory appraisals. In this business, LIQWF mainly acts as a middleman, facilitating transactions between sellers and companies or individuals willing to buy distressed merchandise. Here, their main competitors are Gordon Brothers, Hilco/Great American, Ozer Group, and Nassi Group. Although these competitors will occasionally warehouse inventory, none of them operate retail stores (although Gordon Brothers started an online store called SmartBargains.com in 2001).
By its nature, the liquidation industry is a tough business. Many operators
have poor reputations for activities such as renegotiating or backing out of deals at the last minute and other variants of not keeping a promise. LIQWF is quick to point out that it does have competitors with good reputations. However, the company considers its reputation for integrity,
professionalism, and discretion to be its primary competitive advantage
because distressed situations require delicate handling to avoid alerting
competitors and customers of the client company.
Here is one example the company cited. When a certain major supplier of name brand TV's has a production over run and needs to liquidate these TV's, it will request that the TV's not be sold in certain markets and that any advertising of low price TV's should not contain the name brand of the company to preserve pricing and relationships with its customers. LIQWF will honor this promise and only advertise that its stores have low price TV's and let the customer discover in the store that the TV's are name brand. Keeping this promise has led to a lot of repeat business from this client because other liquidators have not honored their promises. LIQWF believes that their reputation alone exposes them to many deals, especially from Fortune 500 companies.
The company's website lists many other competitive advantages. I consider
the main ones to be
1. Size: The company has the financial resources to handle many deals
that smaller operators cannot. Their size also provides them with leverage
to obtain better pricing and higher quality inventories. The company still
has plenty of room to grow since they still encounter deals that they cannot handle, and they only operate in a total of nine US states and Canadian provinces.
2. International distribution: The company has over 90 outlets in
Canada and the US. This distribution makes it easier for them to sell excess inventory in a different markets without "rocking the boat" of the local markets of their clients.
3. A one-stop shop: With the addition of the GOB services, LIQWF now
offers a full range of liquidation services. The company is no longer just a buyer of liquidated inventory and is exposed to better deals.
4. The lowest price retailer in an area: The company has a consistent
retail policy of offering the best price for comparable value in a
geographic area to customers. They try to price their goods below all
competitors (discounters, warehouse clubs, specials, or sales etc) in the
market. Despite this policy, they still achieve a gross margin of around 38% and profit margins of 3% to 4%. Their accounting is conservative because they expense all the costs of opening new stores and moving stores as they occur. This policy also leads to a loyal customer base (the website claims 700,000 transactions a month in their outlets - which I calculate is about $22 a transaction).
I will add one other advantage that I consider important. They are
liquidators. They have seen all the ways that businesses fail.
I think it is important to understand that LIQWF is not a typical retailer.
They buy their inventory at such a low price and run such a low cost
operation that inventory makes up a significant part of their shareholder
equity. Their strategy is to build shareholder equity by, at the lowest cost possible, acquiring the best inventory available (what will sell at the highest margins) and opening new stores. They will occasionally sacrifice margin to raise the cash to exchange lower quality inventory for higher quality inventory when it becomes available (something that they are
currently doing). Using Marty Whitman's vocabulary, I consider LIQWF more a
wealth building company that an earnings company (although they have always
had positive earnings). My model of the company is better-organized,
well-managed, multi-location, international, upscale junkyard - a view they
probably would not appreciate.
Because inventory is such a large part of shareholder equity, it is
important to understand how LIQWF accounts for it. They carry inventory at
the lower of cost or the price they can sell it at minus profit margin.
There is no history of inventory write-offs with the company because they
are always adjusting the value of their inventory on the fly. They tend to
be conservative during the year because the gross margin numbers always seem to jump at the end of the year - the inventory sold at a higher price than they estimated.
Another item to understand about LIQWF is that inventory turns are
meaningless. In the liquidation industry, you have to buy when the deals are available, in the quantities that are available.
Other Issues:
The company recently acquired a turnaround consulting practice - Clear
Thinking Group by issuing 18,000 shares at a price of $9.68. However, LIQWF
agreed to issue an additional 912,684 shares (about 11% of the company) over the next three and a half years if Clear Thinking Group achieved certain goals. The company will not reveal what those performance goals are, but they state that Clearing Thinking Group will have to add significant value to the company to earn its share of the company. I do not believe that management is giving away the company because insiders own around 12% of the company (16% diluted). The Gillepsie family owns about 10% of the 12%. Many of the insiders have purchased shares in the past few years at much higher prices than the current market price.
There was a major drop in share price during 1999 and 2000. I believe this
drop was partially due to a slowdown in the growth of the business. From
1995 to 1998, LIQWF grew sales, earnings, and earnings per share at annual
rates of 33%, 34%, and 23%. From 1998 to 2001, these growth rates were 11%,
6%, and 4%. The main cause of this slowdown seems to be one transaction: an
unprofitable contract that the company entered with a major US retailer. The contract had significant start up costs, and due to events beyond their
control, the arrangement did not work out as expected. They had to terminate the contract early and close the operations involved with it. This process ended in 2000, and they claim to have learned from the experience.
Valuation:
The valuation case is simple. Pay about book value for a good, founder
operated business that has always been profitable (62 consecutive quarters), operates with zero debt, has consistently provided an ROE around 16%, and has plenty of room to grow. The business is also one that happens to do well in tough economic times.
My estimate of LIQWF's current intrinsic value results in around $7.80 (in
US dollars), so its current price represents a 40% margin of safety. My
estimate of expected annual return over the next five years ranges from 12%
to 21%.
Risks:
I do not see many risks with this company. Possibilities include:
1. The market takes a long time or never realizes the value of the
company;
2. The economy tanks to the point that LIQWF is not able to sell it
extremely low-priced merchandise; and
3. Management makes a big mistake.
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Catalyst
There is no catalyst. In fact, I think the price will probably drop with the market in the near term. However, it is a good business at a good price.