If you've ever read Peter Lynch, you'll probably remember the section in Beating the Street where he writes about the easy money that can be made when a credit union or mutual savings bank converts from a mutually owned enterprise to a publicly traded company. For years, there was probably no other little corner of the market where investors could make such great returns with so little risk.
Lynch likened this experience to buying a house and then finding the down payment in an envelope in the kitchen drawer with a note that reads "Keep this, it belonged to you in the first place." Here's an excerpt from Beating the Street that describes how the process works:
Traditionally, the local S&L or mutual savings bank has no shareholders. It is owned cooperatively by all the depositors, in the same way that rural electric utilities are organized as co-ops and owned by all the customers. The net worth of a mutual savings bank, which may have been built up over 100 years, belongs to everyone who has a savings account or a checking account in one of the branches.
As long as the mutual form of ownership is maintained, the thousands of depositors get nothing for their stake in the enterprise. That and $1.50 will get them a bottle of mineral water.
When the mutual savings bank comes to Wall Street and sells stock in a public offering, a fascinating thing happens. First of all, the S&L directors who put the deal together and the buyers of the stock are on the same side of the table. The directors themselves will buy shares. You can find out how many in the offering circular that accompanies the deal. How do directors price a stock that they themselves are going to buy? Low.
Whether those deals really exist anymore now that Lynch has let the cat out of the bag, I don't know. What I do know is that the investing world is full of Lynch disciples, many of whom harbor secret fantasies of finding one of these "cash in the kitchen drawer" investments. I'm one of them, in fact. So you can understand my enthusiasm when I got a call out of the blue from a friend with whom I occasionally swap investment ideas. This friend, who shall remain nameless to protect the guilty, breathlessly related to me how he had discovered just such an investment, and in a place where you'd imagine such deals are still to be had � rural Texas. Since I live in Texas, he naturally thought to run the idea by me.
Cap Rock Energy (AMEX: RKE) is a former cooperatively owned energy distribution company based in Midland, Texas, that recently went public at $10 a share. At first glance, Cap Rock looked like it might just be one of the classic Peter Lynch cash-in-the-kitchen-drawer investments. The company, formerly known as Cap Rock Cooperative, was originally founded in 1939 to provide electric service to rural West Texas customers, and now serves some 34,000 customers in that area.
My friend can be excused for initially thinking that Cap Rock Energy might be easy money. It had a lot of the telltale signs that Lynch described in Beating the Street. First of all, the company committed to purchasing from the cooperative owners their shares in the enterprise one year after issuance at $10. So, how would you price the shares that you were going to be purchasing yourself? Low, that's how.
Secondly, the company conducted an auction in which they offered to purchase a certain number of shares immediately from the cooperative owners -- the catch was that the maximum bid that Cap Rock would accept would be 70 cents on the dollar � or $7.00 per share. The actual average price Cap Rock paid for these shares turned out to be 63 cents on the dollar. This is essentially a share buyback at a discount rate -- which is a good deal if you can get it. Some shareholders also agreed to future reductions in their energy bills, to be spread out over the next year, in return for giving up their shares.
Third, at $10 per share, the company was only valued at about $10 million, and, according to my friend, was in the process of selling some energy assets for $70 million. Now that would have been cash in the kitchen drawer -- enough to buy seven houses!
If your mouth is watering at the thought of getting $70 million in assets for $10 million, I'm afraid I'm going to have to disappoint you. After getting off the phone with my friend, I did what I have trained myself to always do: I printed out the company's most recent SEC filings -- in this case, the quarterly 10-Qs and the S-1 filing that every company must make prior to going public. I adopted this rule about a year ago -- I absolutely, positively will not make an investment decision about any company unless I have read the most recent annual and quarterly filings. I can't tell you how much heartache this has saved me.
What I discovered is that the company had more than $150 million in debt. And it's all variable-rate debt, which means if interest rates go up, this company's debt payments will go up. The company has lost money each year over the past five years, and had blown some $8 million of its cooperatively owned capital in ill-fated investments in oil exploration and other ventures. The company's stated strategy is to become a major player by consolidating other energy cooperatives (Cap Rock has acquired three other co-ops and is in the process of buying another one.) But with almost no cash on the balance sheet, and $156 million in debt, there is no way that this company will be getting any more loans to finance further acquisitions any time soon.
Oh, and that $70 million asset sale turned out to be, on further inspection, a sale and leaseback transaction that would net $40 million in cash but would still require the company to pay to use the assets. Finally, if this isn't enough, the company is very sensitive to the price of energy -- not only in terms of the prices it can charge consumers, but also in its consumer base itself.
According to the S-1, a large chunk of the company's customers are oil field operators. These operators are also sensitive to the price of energy -- if the price gets too low, they don't drill, which means they don't use Cap Rock's energy services. To sum it up, Cap Rock Energy is an exceptionally risky, highly leveraged enterprise that could easily go under if any of a number of potentially adverse events were to occur. After reviewing this with my friend, we both had a good laugh about it and quickly decided to move on to the next idea.
There are three takeaways from all this. First, it is easy to fool yourself into thinking that a new investment idea is a classic example of a "Peter Lynch company" or a "Warren Buffett idea." Usually, it just isn't so. Second, it's critical to print out and read the SEC filings on any company you are considering for investment. As I did in the case of Cap Rock Energy, you'll almost always find some new information that materially changes your opinion on the investment, for better or worse. Third, you should always do your own research, no matter how good or trusted your source may be. In the end, it's your money on the line.
As for the "cash in the kitchen drawer" investments: I haven't found one yet, though I suppose I will always be looking -- after all, the searching is half the fun.
Zeke Ashton re-reads Peter Lynch's great books, One Up on Wall Street and Beating the Street, at least once a year. Zeke is also working on that classic Andy Warhol-style hair -- the true secret to Peter Lynch's success. At the time of publication, Zeke didn't own shares of Cap Rock Energy. The Motley Fool is investors writing for investors.
