Description

The Stephan Company (SPCO) is a cash flow-generating, illiquid ~$11.5 million nanocap barber supply distributor without much sex appeal.  It won’t give you the lottery induced fantasies of a biotech CVR, but it also won’t let you down so devastatingly either.  SPCO shares have traded an average of 12,000 shares/day over the last five years.  The distribution business is stable and profitable.  Value investors on the Board recognize the significant returns generated by acquisitions in the space and have redirected annual dividend cash flows towards acquiring businesses and brands at reasonable prices.  The company hopes to increase deal volume and to do larger deals than it has in the past. SPCO’s Board and CEO are patient and value-conscious.

The Business | website

SPCO is a distributor of hair care and personal care products in the United States.  The company recently consolidated its operations to Williamsport, Pennsylvania, and stands to benefit from significant cost reductions.  Today, the company operates efficiently, with 28% fewer employees than it had in 2018 and a single warehouse that allows them to turn around most orders within a day.

The barber supply distribution business is fragmented, and companies compete on price, quality, and customer service. SPCO owns an insignificant portion of the US market.  Most of the operations are “mom and pop” family-run businesses that cater to clients in their geographic region.  Each player is small, and when an operator decides to exit, private equity firms don’t exactly line up.  SPCO is effectively becoming a nanocap company rolling up nano-nanocap barber supply distributors.

Aside from M&A activities, SPCO also has significant room for organic growth via increasing brand awareness and tapping its social media and online channels that remain somewhat antiquated.  SPCO’s online presence has improved drastically over the last ten years, but it still has a long way to go.  As young barbers enter the industry, they will be more tech-savvy than those who are nearing retirement.  SPCO hopes to improve its online platform and increase its industry presence through online ad campaigns and “barber influencers.”  

Furthermore, there is significant white space in the local area.  Management had planned to make an effort to increase brand awareness through trade shows and networking events in 2020.  Unfortunately, the pandemic put these plans on hold.  As the world reopens in 2021 and beyond, the company will start to execute its organic growth strategy.

Today, SPCO operates three distinct segments: Williamsport Bowman, Morris Flamingo, and MD Barber.

Williamsport Bowman Barber Supply | website

Bowman is the primary driver of SPCO’s financial results.  Bowman is a wholesale distributor that distributes barber supplies directly to barbers.  The business is “old school,” and the company still mails out its annual catalog to roughly 90,000 barbers and takes orders over the phone.  Customer service is one of SPCO’s strong suits, and Bowman has barbers on staff who serve as customer service representatives.  Furthermore, the relationship between Bowman and its customers is “sticky” as the business is relationship-based and SPCO’s sales representatives know their customers well.  

Morris Flamingo | website

Morris Flamingo (“MF”) is a two-step wholesale distributor that supplies other barber supply distributors with its proprietary products.  Morris Flamingo plays a part in the acquisition pipeline because MF’s customers are small barber supply distribution businesses that are the exact type of companies that SPCO is looking to acquire.

MD Barber Supply, LLC | website

SPCO acquired MD Barber in September 2017 for a total consideration of $675,000. In 2018, MD Barber did $637,000 in revenues and, in the first twelve months, exceeded its earn-out thresholds of $840,000 in revenues and $250,000 in gross profit.  SPCO suggests the business stands to generate revenues above $1MM in 2021.  Furthermore, MD Barber had a robust online presence, something SPCO was lacking.

Brands

SPCO owns several brands and is looking to acquire others.  Proprietary brands are attractive as they offer higher margins and require other distributors to come to SPCO if they want to redistribute them.  Some of SPCO’s brands include: 

LatherKing | youtube

The LatherKing is a popular shaving cream dispenser that creates a hot lather. Initially patented in the 1940s, the LatherKing has been a barber staple for decades.

StixFix | youtube

StixFix is a styling stick intended to replace hair gel that provides a superior hold.  SPCO purchased the brand for $40,000 in 2019 and relaunched the popular product in the same year.

BarberMate | youtube

BarberMate is a clipper and barber tool rack that allows barbers to keep their tools untangled and organized. SPCO purchased the assets of BarberMate for $76,000 in 2018.

Why Is SPCO a Buy Today?

1. SPCO Generates High Returns on Invested Capital, Income Sheltered From Tax

2. SPCO Has Successfully Weathered COVID-19

3. SPCO Is Heading in a New Direction: Capital Allocation Strategy Update

4. SPCO’s Past Acquisitions Have Generated Significant Returns

5. SPCO’s Pandemic Performance Has Been Impressive

6. SPCO Trades at a Reasonable Valuation Today, Cheap Relative to Growth Potential

7. SPCO Is Run by Value Investors for Value Investors

1. SPCO Generates High Returns on Invested Capital

[Source: SPCO annual and quarterly reports][link]

SPCO’s business is profitable and generates an attractive return on invested capital.  The above returns are presented pre-tax given that SPCO had roughly $17 million in net operating loss carryforwards as of year-end 2019.  The losses were generated before the recent tax cut act and will expire after 20 years.  Although SPCO’s NOLs will begin to expire in 2025, it appears that roughly 78% or ~$15M will not begin to expire until 2032, which provides SPCO with the ability to offset significant taxable income for the next 11 years.  EPS and multiples in this report assume no taxes during the forecast period and a conservative terminal growth rate.

Furthermore, SPCO has been able to pass cost increases on to its customers via price increases.  Though somewhat surprising, this pricing power stems from the significant markups on barber services and the small amounts of product used in performing a given service.

[Source: Author calculation based on SEC and OTC filings]

Given the attractive returns, it is pertinent that SPCO begins to put more capital to work. Before 2019, SPCO paid out a significant portion of its free cash flow as dividends.  In 2019, the company redirected its strategy towards growth via strategic acquisition. While acquisition opportunities come at irregular intervals, SPCO’s leadership focuses on networking to organically source acquisition targets. With a liquid balance sheet, insignificant balance sheet debt (aside from a forgivable PPP loan and a couple of thirty-year low-interest Economic Injury Disaster Loans), and a cash flow generative business, SPCO can wait patiently for attractive opportunities. The long-term holder of SPCO stands to earn a healthy return on both their invested capital and, perhaps more rewardingly, their patience.

2.  SPCO Has Weathered COVID-19 Well

SPCO has been in survival mode for the past year as the world has dealt with the COVID-19 pandemic.

Before the pandemic hit the US, through the first two months of 2020, SPCO generated stable revenues and saw an 11% increase in gross profit dollars. 

With barbershops shut down in March, revenues took a hit, particularly in the Morris Flamingo wholesale business.  However, MD Barber and other online channels saw an increase in revenues year over year.

Sales continued to be affected in the first half of April but reversed course as re-opening began to seem more likely.

Manufacturers halted the production and distribution of many of SPCO’s products. Still, given SPCO’s strong cash position, it could carry higher inventory levels and fulfill higher demand in areas such as clippers, which became popular with end-users seeking to cut their hair at home.  SPCO even pivoted somewhat into offering personal protective equipment, home barber products, and disinfectants.  

Furthermore, SPCO received a forgivable PPP loan of $215,000 and took out SBA EIDL loans of $382,000.  These loan programs were designed for small businesses like Stephan.

3. New Direction: Capital Allocation Strategy

In July 2015, the Board shuttered an unprofitable segment, disposed of non-core assets, and reinstated the semi-annual dividend.  SPCO promised that its continuing distribution operation was poised to generate a run-rate of $0.20/share in FCF with right-sized corporate overhead. At the time of the announcement, this represented a 20% FCF yield (excluding corporate overhead). 

Since the strategic review, SPCO’s share price has risen, fallen, and risen again:

[Source: Nasdaq.com]

Between 2015 and 2019, SPCO paid out nearly all of its cash flows, representing a cumulative $0.60/share in dividends.  In 2019, the company replaced its President and installed board member Ben Large as CEO.  The company consolidated its operations and moved its headquarters to Williamsport, PA. Notably, the company also announced that it would redirect cash flows from dividends to strategic acquisitions of brands and distributors.  Today, SPCO is looking to grow via acquisition and to do larger deals.  With a board of value investors who own a significant portion of the company, we anticipate that acquisition activity will be disciplined.

4. Past Acquisitions Have Had Attractive Returns

Home Run: Norva Barber Supply in 2020 | | website

In 2020, SPCO acquired Norva Barber Supply’s assets for $150,000 plus $150,000 for inventory.  Historically, Norva had generated $1 million in annual sales but revenues declined before its acquisition.  Although SPCO acquired Norva in June 2020, Norva generated roughly $42,000 in revenues for the second quarter.  The purchase brought along with it Norva’s loyal barber and institutional customers.  SPCO folded Norva into the existing distribution business without the need to increase headcount.  At the end of Q3 2020, SPCO said they had already earned back a significant percentage of the purchase price and has indicated a payback period of around twelve months from acquisition.

5. Performance During the Pandemic Has Been Impressive

Looking at the first nine months of 2020, during the pandemic no less, SPCO has grown revenues 5% over the prior years period, increased gross profit dollars by ~12%, and both operating income and EBITDA by 42%. Furthermore, SPCO acquired Norva without needing to marginally increase operating expenses, allowing added revenues to fall directly to the bottom line.  Naively annualizing the first three quarters leads to EBITDA of more than $1 million.  Adjusting those numbers to assume the full year 2021 does not see complete shutdowns (as 2020 saw for roughly 1.5 months) leaves us with a little less than $1.2 million in EBITDA.  Given that the first three quarters of 2020 only included one-quarter of Norva revenues and was during a decreased demand environment, these estimates are likely conservative.

6. Valuation

SPCO is cheap relative to its intrinsic value calculated using conservative assumptions.  But, ultimately, enormous upside potential resides in its growth through acquisition. 

No Growth Scenario

Aggregate adjusted EBITDA for the years from 2016 to 2019 was $2.28 million.  Over that period, SPCO paid out a total of $2.08 million in dividends.  Supposing SPCO reversed course, gave up its acquisition strategy, and resumed paying out most of its cash flows to shareholders, the downside from today’s share price is small.  Given that 2020 EBITDA is trending to roughly $1 million or (~$0.25/share), if we assume a 100% perpetual payout ratio and a 10% discount rate, the fair value should be around $2.50/share or just ~12% below current levels.

Scenario Implied by Today’s Share Price

Today’s share price of $2.85/share implies a low 4.5% annual growth rate (growth of revenues to ~$12.5M/year) over five years and zero growth beyond the forecast period.

Conservative Growth Scenario

Assuming that SPCO only grows revenues by $5 million over the next five years with a 1% terminal growth rate, we begin to see a picture of the upside that even a moderately successful acquisition program might bring.

Sensitivity Analysis

Revenue Growth Rate and Terminal Growth Rate

Given the operating leverage built into the business and the minimal need for capital expenditures, strategic fold-in acquisitions will likely lead to significantly higher revenue growth and margins.  The Norva acquisition appears to have a payback period of roughly twelve months, adding an incremental $300,000 to revenues in the first year with minimal, if any, additional operating expense.  As SPCO begins to target larger businesses, it is reasonable to assume a more aggressive acquisition program will increase revenues much higher than $15M over the next five years.  Growth may be lumpy as timing is uncertain, but the downside from $2.85 appears small given SPCO’s pandemic performance, value-oriented managers, and the attractive IRRs generated on recent acquisitions.

7. Run by Value Investors

At year-end 2019, most of the company was owned (by a slim margin) by two value investors serving on the board.  SPCO’s Board is properly incentivized and shareholder-friendly.

[Source: SPCO 2019 Annual Report][link]

Furthermore, between April 2016 and year-end December 2019, SPCO repurchased 305,685 shares for $404,000 or $1.32/share. SPCO intends to benefit shareholders through acquisitions, special dividends, or share buybacks.

Litigation Risk / Insurance Discussion

Recently, The Gori Law Firm [link] has named SPCO in several asbestos-related lawsuits stemming from its legacy operations.  The cases are related to talc products that SPCO’s legacy Old 97 business manufactured under contract for larger companies.  SPCO appears to have been swept up in a scorched earth litigation strategy to sue anyone and anything potentially related to the talc products.  SPCO has said that they have begun to be dismissed from some of these lawsuits, and we believe that it is reasonable that this will continue. 

SPCO is also named in a case in New Jersey in which the plaintiff is suing mega-corporation Johnson and Johnson.  In that case, SPCO has filed a motion to dismiss, arguing that the New Jersey court does not have jurisdiction over SPCO.  Furthermore, SPCO contends that the plaintiff has not provided a shred of evidence that SPCO’s legacy business manufactured the products in question, that the products manufactured by SPCO were in any way linked to the state of New Jersey, or that the plaintiff purchased products produced by SPCO.  A ruling on that motion to dismiss should come in early February.

In place tail-risk insurance policies have covered SPCO’s legal costs thus far.  SPCO has additional coverage and seems to have already completed much of the upfront and time-consuming (read, expensive) legal work associated with getting their attorneys up to speed.  While the cases’ legal merits are suspect, as with any form of litigation, there are no guarantees except that the lawyers’ meter will continue to run.

Risks

• Adverse asbestos litigation result

• Insurance coverage is overwhelmed by ultimate legal expenses

• The company makes poor investment decisions and begins to destroy value

Conclusion

SPCO is a small company with a stable business and value investors at the helm.  SPCO is embarking on a growth-by-acquisition plan to increase revenues with a minimal amount of additional operating expense.  While we wait for the strategy to show results, the current business continues to generate free cash flow.  Although SPCO is working through some difficult-to-quantify legal issues associated with its legacy businesses, we are encouraged by recent dismissals, that insurance has covered expenses so far, and that further coverage remains.  We believe SPCO is an attractive long-term investment for the patient investor.

Catalyst

Catalysts

• Larger acquisitions

• Increase in deal volume

• Organic growth through online channels and brand awareness

• Removal of legal overhang