Description

Peerless (PRLS) is a microcap stock with significant downside protection and substantial upside from a recent bargain purchase. Unfortunately, this is a true microcap with a market cap of just $12m and a free float of ~$8m, so it’s really only appropriate for PAs and very small funds, but I think the risk reward is so outsized at these prices that it’s very much worth a look. It’s been written up twice on VIC, most recently in 2009. While that write up is useful for some background, I certainly hope no one will accuse me of “recycling” old ideas because of that!

Again, that write up is useful for background, but the basic story is Peerless sold most of their assets in 2008; however, they retained the rights to sublicense certain pieces of the technology they sold as well as some products from Novell and Adobe. Following the asset sales and with a push from a few activists (this filing by current CEO / Chair Tim Brog gives some extra background), Peerless was basically a big cash shell with a small licensing business that generated relatively consistent, if declining, revenues at very high margins. The company dabbled a bit in activism to mixed results and eventually decided to milk the core business for cash while looking for an acquisition they could take control of.

That acquisition came in mid-September, when Peerless announced the acquisition of 80% of Deer Valley for $3.682m. The stock responded well to the news, shooting up from the mid $3s to the mid $4s, where it sits today. However, as the rest of this article will show, external factors likely led the acquisition to be done at a bargain basement price, and the combined company is likely worth significantly more. In addition, some recent changes to the Deer Valley business model should generate significant amounts of cash which could be used as a catalyst to unlock further value.

Let’s start with a discussion of Deer Valley. The company makes factory built homes and is actually traded OTC (DVLY). This is by no means a great business, but it is a relatively steady one with some interesting tail winds.

The first thing that suggests Peerless may have gotten a deal on their DVLY stock is the purchase price. Peerless acquired their share by acquiring 12.3m DVLY shares from Vicis for $3.6m, and then to push them over the 80% ownership threshold they acquired an additional 126k shares directly from Deer Valley for $81.9k. The quick math shows that Peerless bought the shares from Vicis for around $0.29 per share, but directly from the company for $0.65 per share. The stock’s traded pretty much range bound between $0.65-$0.75 per share for the past 2 years (many of Vicis shares were acquired through warrants, but Vicis bought ~15% of these shares for $0.6667 per share on March 9^th, 2009), so the Vicis purchase price obviously stands out as strange, especially since generally a control premium would be paid for a block that big and the price of shares in the open market would generally be treated as trading with a discount due to the illiquidity and controlling shareholder.

Peerless’s purchase of 80% of DVLY for $3.682m values the equity at ~$4.6m (enterprise value is a bit lower given a slight net cash position). Trailing twelve months EBITDA is >$1.3m and book value is $9.7m, and that EBITDA isn’t a one-time flash in the pan: ignoring goodwill impairments and other non-cash charges, EBITDA has consistently been >$1m since 2008 (it was actually higher than that previously, though a lot of that was caused by contracts awarded in the wake of Hurricane Katrina).

However you cut it, it seems like Peerless acquired their DVLY stake for a very low multiple, which begs the question of why Vicis would sell at such a low price? The fund is winding down (here’s a bit more) under an SEC order. I would imagine a 79.9% stake in an OTC company is not exactly easy to sell in a liquidation for a few reasons. First, there aren’t exactly a ton of buyers for companies doing ~$1m in EBITDA, and the pool of potential buyers for $1m EBITDA companies with a “stub” publicly traded minority shareholder base? I doubt there are any natural buyers for that. Add to those issues that Deer Valley seems to have been a rounding error compared to the size of the rest of Vicis’ holdings (the article linked above says it used to be a $5B fund, and their old 13F’s confirm they were pretty sizable), and it’s easy to see a path to Peerless picking the shares up with a “liquidation” discount.

So it seems like Peerless stepped into a value investor’s dream: a stable asset with some upside being unloaded by a forced seller who viewed the asset as a rounding error.

I think it’s easy to look at Deer Valley and the relatively stability of their income statement and assume that it’s just a stable FCF generator, but I actually think there’s some potential hidden upside to Deer Valley. If you read through their financial statements, they mention that since the financial crisis banks have been unwilling to lend to dealers to finance their homes, so the company has been providing inventory-secured financing so their dealers could continue to operate. In 2013, a bank stepped in and started providing financing again, and inventory secured financing has dropped from 47% of sales in 2012 to 36% of sales in 2013 to 14% of sales in their last quarter. This drop is releasing a massive amount of cash onto Deer Valley’s balance sheet: in 2012, the company had ~$8m in inventory finance notes, which is not insignificant against a book value of $9.1m! The inventory finance number dropped to $5.9m at year end 2013 and $4.2m at their last quarter end. This massive drop has allowed the company to significantly pay down debt, and total debt now stands at ~$1.7m versus over $5.8m at the end of 2012. The inventory-secured contracts were for 24 month terms, so the majority of the rest of the contracts should wind down pretty quickly. If the % of inventory-financed sales continue dropping at the same rate they currently are, it’s not hard to see the contracts running down to ~$1.5m or so by the end of next year, which would generate an incremental $2.7m in cash. Add to that another $900k or so in after tax FCF generation between now and then (just assuming $1m in annual EBITDA, taxed at 35%-ish and with $100k in annual capex) and Deer Valley would have around $4m in net cash by the end of 2015, or ~$0.26 per share, which would almost cover Peerless’s cost basis. Deer Valley also has $2m in tax assets that will lead EBITDA to more closely equal FCF in the short term (the tax assets are on the books, so already incorporated in book value).

There are a few other interesting things about Deer Valley. They’ve been operating at ~50% capacity for several years, so we’d likely see some operating leverage if the company grows. They also went gangbusters after Hurricane Katrina when the south was rebuilding, so they’d serve as something of “disaster” insurance in that they’d probably mint cash if there was some form of disaster in the south, though I’d prefer not to be paid on that particular “policy”!

Anyway, looking back to Peerless, their value basically nets out to four things: (1) cash on their balance sheet + (2) value of Deer Valley holding + (3) value of their license business – (4) holding company / overhead costs. They had $10.8m in cash at their last balance sheet and paid $3.7m for Deer Valley, so net cash comes out to $7.1m, or ~$2.60 per share. I generally net #3 and #4 out; in total, the licensing business less the holdco overhead will do ~$800k in operating income this year. The license business is lumpy and likely declining, I value that profit stream at 4x for a total value of $3.2m for a per share value of ~$1.15. That gives us a value of $3.75 per share before factoring in Deer Valley value. At cost, the Deer Valley shares are worth $1.35 per PRLS share. At book value of ~$0.63 per share, Deer Valley shares are worth ~$2.85 per PRLS share. Finally, as an upside target, if you assume DVLY is worth 8x annual EBITDA of $1.3m plus my pretty conservative estimate of year end 2015 net cash ($4m), DVLY is worth over $0.90 per share and the value to PRLS is worth $5.25 per share. Add it up, and my low end (DVLY cost basis) yields a NAV of $5.10 per PRLS share, my middle case (DVLY = book value) a value of $6.60 per share, and my high end (8x EBITDA plus 2015 net cash) a value of $9.00 per share.

There are, of course, some risks. Insider pay is high for what I consider something of a cash shell before this transaction, and insiders own ~30% of shares so an activist coming in and lowering pay is unlikely, but if they can keep pulling off deals like the Deer Valley one then the pay will prove a bargain. In addition, the company still has a significant amount of excess cash, and there is the question of how future acquisitions will play out and what Peerless will do with the Deer Valley minority shareholders. Peerless has also dabbled in investing and activism to mixed results (though there appear to have been some external circumstances in those), so it’s also possible they return to those. Finally, the Chairman is somewhat of a mystery as there’s not much out on him, though anecdotally I have heard positive views on him from mutual contacts.

However, investors are more than compensated for those risks at today’s prices, and as Deer Valley throws off cash and blends onto Peerless’s financial statements, the stock should go significantly higher.

Disclosure- I own shares of PRLS.

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