Automodular Corporation

Automodular Corporation
TSE:AM

Automodular Corporation is a small-cap ($40.75 million market cap) Canadian company based out of Ontario. Automodular’s business operations are extremely simple and straight forward: they sequence and sub-assemble parts used by other manufacturers.

Currently the company’s largest client is Ford Motors, and they have an agreement extending to June of 2014: Automodular located its plant right next to Ford’s geographically so that it can sequence, sub-assemble, and deliver the parts to Ford right as they are about to be installed, on call. Outsourcing is always a possibility, though the timeliness that Ford requires makes that unlikely: there’s a strong advantage to being able to order parts, and, in a matter of hours, have them delivered to you and ready to go. Insourcing is the real threat to the company because small companies like AM are very nimble and efficient, but due to relaxing regulations it is becoming more and more feasible for auto companies to sub-assemble and sequence the intermediate products themselves at similar margins, which could lead to them avoiding this kind of business with external companies like AM altogether. Ford is currently studying the feasibility of insourcing their own components. Perhaps AM will be able to secure another contract with Ford after June of 2014, but if they want to survive and thrive in the long run they will have to diversify (preferably) to multiple different avenues. Automodular typically does around $20 million in sales to Ford each quarter.

Just last year the company also expanded into Ontario’s renewable energy industry. Seeing as these projects currently rely on subsidies, I do not consider them to be a viable business venture (being a Darwinian, I would much prefer to invest in companies that can survive and thrive on their own accord). Having said that, there is a strong liberal presence in Ontario, and the issue of clean energy is very important to many people, this fact shouldn’t be underestimated. So important was the issue that in 2009 Ontario enacted the “Green Energy Act” which in large part is directed at pumping capital into the local renewable energy industry. In 2010 alone, the Ontario government invested approximately $270 million into green energy and created about 20,000 jobs. The riding of Brant (which is where Automodular’s facility to sub-assemble parts for the windmills is located) declared itself the “Green Energy Hub” and the Ontario Minister of Energy had this to say about Green Energy, and also about Automodular in particular:

“The creation and expansion of the clean energy industry supply chain was a major part of the vision for the Green Energy Act,” Bentley said. “Companies like Automodular are great examples of how Ontario’s clean energy industry is strengthening our economy, creating jobs across the province and ensuring cleaner air and a healthier environment.”

Perhaps more interesting for Automodular, he also had this to say about small local companies who are involved in the green energy industry:

“The more you develop your local expertise, the more you are able to cement the industry here in Ontario,” Bentley said. “It is good to be a leader in an industry like this, that the world is going to be turning to increasingly for years to come.”

So despite the fact that Automodular’s windmill contract is up by the end of 2012, and despite the fact that I will write this business venture off as zero going forward, it would be wise to recognize that this could be the start of a very good thing for the company, especially since in the third quarter of 2012 AM did about $16 million in sales, or about 45% of the company’s total revenue through these windmill projects. AM is currently in talks with many of the companies in the renewable energy space to attempt to find more contracts.

An interesting wild card: After GM reneged on its contract with Automodular in 2010, due to finding a company that offered to sub-assemble parts for GM at much lower rates, AM filed a lawsuit for $20-$25 million against GM (I haven’t looked too deeply into it, I write this off as zero, but it’s still a point of interest). A quick look on Google finance at the company that GM switched to, Inteva, reveals a $100 million company by market cap which has been losing money for the past 2 years at least, has a profit margin of close to -50% and returns of around -15% (on equity and assets). Inteva’s stock price went from a high of around $15.75 in 2010, to $4.39 currently, a long and protracted continual decline – during the same time period Automodular’s stock more than doubled while maintaining very solid returns and margins. Needless to say, the competition that this Inteva company poses to Automodular does not frighten me.

Now let’s take a peek at why I think Automodular is a great investment, despite the fact that it has such a high risk of bankruptcy if it cannot renew some sort of renewable energy contract, its Ford contract, or further diversify its operations by the end of its Ford contract in June of 2014:

The Downside (Bankruptcy: Liquidation)

Current Net Tangible Assets

As per the third quarter 2012 report, on September 30th the company had $23.541 million in cash and cash equivalents, $20.787 million in accounts receivables (which I will briefly elaborate on soon), $2.578 million in inventory, and $1.555 million in prepaid expenses.

Now, since the company’s contract with Ford expires in June of 2014 I will continually refer to this as the hypothetical liquidation date – this is for purposes of looking at what the downside to the investment looks like between now and that date.

I count the receivables to be as good as cash during a so-called liquidation since the majority of A/R are currently owed to Automodular by Ford (which is apparently too important to fail), and since less than 1% of the A/R are passed 30 days due. Around $20 million in A/R is a perfectly normal level for Automodular – given its sales of over 4 times that per year.

I also count inventory to be as good as cash since Automodular has contracts with both the windmill component and the automotive component – this clearly does not represent a buildup of excessive inventory – it’s a normal level of raw material to have on hand to run regular business operations (and all of it will be used up due to the nature of the contracts).

The company also has $11.949 million listed on its balance sheet as long-term assets such as property and equipment.

What I’m going to do now to build a margin of safety, because quite frankly I have no idea what their long-term assets are/will be worth (in the event of a fire sale), is write the entirety of the $11.949 million (of long term assets: plant/property/equipment) off as being worth zero. This means that I’m saying the company wouldn’t even be able to obtain one penny for these assets in a liquidation fire sale. Clearly this is an absurd estimate, which therefore provides me with an equally “absurd” margin of error in this respect.

Next I will write off the prepaid expenses as zero – not counting at all as current assets.

So what would I say the assets of AM would, at the bare minimum, go for in a fire sale?

Well the cash could just be immediately distributed to the shareholders as the long-term assets are set on sale. Therefore since cash and cash equivalents is currently $23.541 million, and the current A/R is $20.787 million, which will be cash 18 months from now at the time of the hypothetical liquidation date, and the current inventory of $2.578 million, which will be cash 18 months from now at the time of the hypothetical liquidation date, gives us a grand total of $46.906 million in cash and cash equivalents at the time of the liquidation (based on the near-future pay-out of their current assets).

If anything, the inclusion of inventory as a cash equivalent is an underestimate – since the company produces a solid profit margin of over 10% by taking its raw inventory and producing something with it, the raw materials must be worth more than, or bring the company more than, the $2.578 million accounting value of them (if the company wasn’t able to turn its inventory of raw materials into something net-net more valuable, factoring in costs of production etc, it wouldn’t be making profits, it would be making losses, like our friend Inteva). Therefore this figure, since it takes inventory at accounting value and not economic value, and since it writes off prepaid expenses and a large amount of long-term assets as being literally worthless, is extremely low. There is a ton of margin of safety in this analysis.

The total liabilities of the company are $18.786 million.

Therefore, the current liquidation value would be $(46.906 – 18.786) million, or $28.12 million. I’m not discounting this because it will all be cash within the next 2-3 quarters. And the risk free rate of return (what could I earn lending my money to the government?) in the next quarter or 2, based on where interests rates are and will be (they won’t be substantially higher a few months from now based on current economic conditions – it will take quite some time for interest rates to rise significantly, as well as improvement in the overall economic outlook and state), is completely insignificant in this instance.

So without making any stunning predictions on future earnings, just by looking at the balance sheet in a highly conservative manner, we have a minimum net of $28.12 million in what I will call liquidation value (I don’t know most proper terms as I’m largely self-taught at the moment), and a maximum of over $40 million if long-term assets could actually be sold for what the company claims they’re worth.

I want to point out at the moment that Automodular has 20,377,167 shares outstanding (diluted), and the stock price is sitting at $2.00 per share. This gives the company a market value of $40.75 million.

If the bare minimum the company would go for in this hypothetical liquidation event in June of 2014, based on current assets, is $28.12 million, then the market cap ($40.75 million) less the $28.12 million in current liquidation value, or $12.63 million, tells us what we’re really paying for the earnings power of the entire business going forward.

*I will factor in the recent dividend paid in a few paragraphs to take account of the fact that around $4 million is no longer on the balance sheet*

A first glance will tell us that Automodular had a net income of $4.243 million this quarter alone (of which over $2 million is from Ford, which still has another 6 quarters to go on the contract with Automodular). Over the past 9 months Automodular has averaged $2.55 million in free cash flow each quarter, paying about half of this out in dividends). And despite the storm that the company could potentially be sailing into regarding future contracts, the company has had continual and substantial increases in revenues quarter over quarter for the past 5 quarters in a row, and given a current P/E ratio of 2.50, and the fact that it’s is trading right around book value is cause for a second look in and of itself.

Future Projections

Is this justified?

Once again, let’s be conservative, let’s say that starting next quarter, until the following 6 quarters with Ford are up, the windmill component of the company disappears entirely. This would lead to free cash flows of just over half of what they are at present, assuming they aren’t able to grow their business with Ford or diversify elsewhere or renew their green energy contracts – which is a free cash flow (on average) of just over $1.275 million per quarter. This prediction that free cash flows will roughly halve should be a safe one because there are (next-to) no costs associated with closing the windmill factory because the company planned to shut it down at this date from the get-go and therefore entered into a short-term facility lease and hired hourly workers. Since this would be going on for another 6 quarters we have a sum of free cash flows equal to $7.65 million. For reasons already stated I will not discount this at all (with interests rates where they’re at, and markets as volatile as they are – I really don’t consider there to be much of any opportunity cost associated with parking my capital here for the next 18 months, other than a small cost associated with the advantages of cash).

Even if this was discounted at 15% annually, that wouldn’t change my attraction to this company.

To further justify this free cash flow estimate of one half the current cash flows as being conservative, note that due to an apparent rebound in the auto industry (near-record Canadian/American sales), and an agreement with the autoworkers union, Ford announced that it will be adding a third shift to its Oakville facility, which is the one that Automodular is located near-to and services with sub-assembly parts and components. This will likely lead to a strong increase in demand from Ford, and better sales for Automodular.

Note that just like on the current liquidation value portion of this analysis, I am likely grossly underestimating what the actual figures will be. A pick up in the economy or auto industry would likely lead to further increases in sales to Ford, Ontario’s renewable energy industry very well may come back to Automodular with a new proposal which could easily double or triple this figure of free cash flow 18 months out, or a new diversification could arise as well.

I am trying to build a large margin of safety here by continually underestimating everything. If at the margins everything is grossly underestimated, then the sum of all underestimations must itself be a gross underestimate. Therefore if I am going to be wrong about the liquidation value, I want to be grossly on the low side, and I likely will be due to the nature of my analysis.

So now let’s add this conservative figure of $7.65 million in free cash flow to the current liquidation value, or subtract it from the current market price less the current liquidation value, meaning we are, in effect, paying $4.98 million for the company. Put another way, this means that we are paying $40.75 million for a company that will have an absolute minimum liquidation value of around $35.77 million at the time the contract with Ford expires (June of 2014).

*Factoring in the special dividend*

As of November 16th the company paid a special 20 cent dividend, or slightly more than $4 million to the shareholders. Seeing as how I’m going based off numbers from 2 months ago it is likely that the company has generated at least $1.5 million in free cash flow since then, but I will go ahead and add the $4 million directly to the purchase price since it is no longer on the balance sheet: we are therefore effectively paying $8.98 million for the entire future earnings of Automodular. Put a different way, we are paying $40.75 million for a company that, should it face bankruptcy 18 months from now, would return a bare minimum of $31.77 million in distributions to shareholders. Therefore the true current P/E ratio is not 2.5, it’s closer to 0.5 (it would only take the company 6 months to have a net income of what you’re paying for the company), and if we don’t count the windmill earnings, as they are not secure over the next 18 months, the true P/E is still close to 1.

Absurdly cheap.

I’d like to once again remind the reader that this is not including about $12 million in long term assets (which I wrote off as being worth zero), not factoring in about $1.5 million in prepaid expenses, not factoring in a possible $20- to $25 million lawsuit win over GM for reneging on a contract with AM in 2010, not factoring in any growth (indeed it’s factoring in negative growth), not factoring in any diversification or re-signing of any contracts/agreements, etc. The true liquidation value of the company 18 months out could very well be double what I have set as the minimum. Even if just the long term assets are counted in we’re paying $40.75 million for a current liquidation value of around $43.75 million.

All I have been doing so far is building a picture of the possible downside.

Since the net liquidation value 18 months out is likely to be in the range of $35 and $70 million (with $40 million a safe lower figure), I believe my downside risk is effectively $0.

I paid $40.75 million for something that 18 months from now would be able to distribute to shareholders an easy $35-$40 million at the reasonable minimum (and with share buybacks and a dividend yield of over 12% at the moment with not-so-infrequent special dividends, much of the money will be returned to shareholders before the 18 months is up I suspect – management is VERY shareholder friendly).

So despite the high odds of bankruptcy, and therefore perceived risk in the company, based on the price and liquidation value (essentially the market has 100% priced in bankruptcy for Automodular), there doesn’t appear to be much risk associated with purchasing the company at this particular price.

Essentially, if the company goes bankrupt I still stand to get my original investment back (safety of principal), based on the liquidation value alone – or, as I have shown, an absolute bare minimum of over 75% of my investment back. I therefore view the total possible downside as being -25%, and the probable downside of being 0 to 25% or more (a positive return, therefore).

The Upside

What is the upside?

The upside is that the company can manage to re-sign the contract with Ford and lock in another multi-year deal. The same could be said about the renewable energy component of AM. Or perhaps they’ll be able to diversify somewhere else. Perhaps our pals over at Inteva will wind up regretting setting their prices so low and GM will come running back to us. Perhaps the economy takes an unexpected upswing and new business avenues present themselves. At any rate, the upside is collecting a 10%+ dividend for the next 3-5 years, a return to a more normalized earnings multiple of, say, 7.5 (we could even bring this down to 5 for increased safety in reasoning). Net present value calculations moving past the 18 months I’ve projected, giving the company a vastly greater intrinsic value.

The upside is therefore an easy 150-250% or more. If they can find further avenues of growth, a little $40.75 million company could quintuple itself (500% return…) and still only have a market cap of just under $204 million. If we take what I call the “true” P/E ratio of 0.5 to 1 (figuring out what you’re truly paying for the earnings) the company could easily quintuple and still be fairly priced based on just the earnings power derived from the Ford contract.

Therefore I see in this little company, with a high propensity for bankruptcy, close to zero downside, and upwards of 150-250% in upside. Needless to say this is a statistical opportunity that I cannot pass up, so I bought 2,425 shares at $2.00 each. I believe that even if the company earns no money between now and the hypothetical liquidation date it would still be a fantastic investment.

Now, I cannot say for certain what the stock price will do despite what I believe to be a very rational analysis. The fact that this opportunity exists in the first place is evidence enough that markets aren’t always rational. The key, however, is that I do not really care about stock price fluctuations, I care about liquidation value and future value.

Seeing as how only about 25% of this stock’s outstanding shares are held by institutional fat cats, and how it’s followed by not a single analyst, and how its tiny market cap of $40.75 million would preclude it from the vast majority of investment funds out there anyways – I believe that if there are any inefficiencies out there in the marketplace, that this is exactly the kind of place they would be hiding.

A possible reason explaining part of the undervaluation is that the CEO who owned approximately 20% of the company retired last year and has (understandably) been liquidating a good chunk of his position. When someone owns nearly 4 million shares, and wants to liquidate some of the shares in a relatively illiquid market with less than 100 thousand shares trading (on average) every day, it can produce substantial downward pressure on the stock price, even if the company continues to deliver great results.