When is "too much cash" a corporate problem? The answer is never -- with one distinct exception: when it's the symptom of a management team that hoards cash, reluctant to put it to use for shareholders' benefit.
Today, I want to discuss a company that presents exactly this dilemma, and how I'm choosing to approach the situation as an investor. The company in question generates consistent free cash flow; its stock appears to be undervalued and ripe for a buyback. But management, while honest and operationally competent, has a Scrooge-like capital allocation policy. Except for this last point, I genuinely respect this company.
I'm talking about Deb Shops (NASDAQ:DEBS), a 327-store teen-fashion retailer. Over the past six years, Deb has generated 9% annual sales growth and strong free cash flow, resulting in a war chest of $152.6 million or $11.15 per share in net cash. At a recent stock price of $18.92 (after rising 6.7% yesterday), cash accounts for 59% of Deb's market value, implying that the business itself is only being valued at $7.77 ($18.92-$11.15). With earnings per share this year, ending January '04, expected at $1.25 to $1.30, Deb's business trades for a low six times forward earnings.
Teen apparel isn't the greatest business under the sun, but this is cheap. Especially considering that Deb typically generates free cash flow equal to, if not slightly greater than, net income. In addition, we're talking about six times depressed earnings -- this year's EPS is expected to come in well below that of the past several years (average of $1.81 since 1999). The anticipated drop in earnings this year is based on the weak outlook for consumer spending, in addition to what's probably a conservative forecast by management.
Scrooge McDuck?
So with all that cash sitting around and such a low valuation, Deb is attracting value investors like moths to a flame. On the company's most recent conference call (March 6), a good portion of the Q&A was devoted to investors asking management about the possibility of a share buyback. But despite several callers' protests, management wasn't biting on the idea. The frustration on both sides, management and callers, was palpable.
Here's a brief excerpt from the tail end of the call that I think sums up the debate (transcript provided by Fair Disclosure Financial Network):
Caller:
As you pointed out a few times, you have an extremely strong balance sheet and excellent free cash flow generation based on the capex numbers you gave. At this kind of rate we'll probably have net cash on the balance sheet between $12 and $13 a share by the end of this fiscal year. The stock price right now is in the $17s. While we agree it is important to have a strong balance sheet, that seems extreme to me. You're almost a bank at this point. Is there any way or any plan or any potential for you to try to move some of that cash back to your shareholders this year through higher dividends or share repurchases?Company representative:
At the Board meeting which takes place in May, the Board will certainly be discussing the dividend policy. If this Board meeting is anything like any of the past six or eight or 10 then share repurchase will certainly be a subject of discussion. But in spite of the fact it's been a subject of discussion for many years, as you well know, the Board has yet to authorize a share buyback.Caller:
You're earning maybe 50 basis points on that cash. You could do something for shareholders here where you continue to maintain an incredibly strong balance sheet. However, you can do something that's extremely accretive to both earnings and your return on equity.Company representative [CEO Marvin Rounick steps in at this point]:
As a one-third shareholder [meaning Rounick himself], we're paying very nice dividends at the moment. Like we said, it will be reviewed at the Board meeting.Caller:
You're totally comfortable with the capital structure? You do not think it's a little bit extreme?CEO Marvin Rounick:
No, I believe in Scrooge McDuck so I do not think it's extreme.Caller:
I find that hard to believe, but OK, thank you.
I find it hard to believe, as well. And what's this business about Scrooge McDuck? To get some answers, I called the company last week and had the opportunity to speak with its Sr. V.P. of Finance, Lewis Lyons. Mr. Lyons was very candid and helpful in explaining their rationale for conserving cash.
Defensively opportunistic spirit
Apparently, there are two main reasons, one offensive and the other defensive.
First, on the offensive side, Deb seems to be saving up for some unnamed opportunity. My impression is they're probably hoping for a competitor to go bankrupt, providing a fire sale on real estate assets. This idea was supported on the conference call when Mr. Rounick spoke against the idea of an outright acquisition, saying he'd rather pick up assets on the cheap.
To paraphrase, Mr. Rounick said that a distressed retailer typically finds itself in financial hardship because in the pursuit of growth it paid too much for its leases. Better, then, to let that competitor go bankrupt and get its real estate at a bargain than to acquire a struggling company and pick up the tab for its expensive leases. Makes sense.
Second, on the defensive side, Deb intends to maintain a strong enough balance sheet so that it will always be a survivor no matter how tough the retail business becomes. This probably goes a bit beyond healthy paranoia, but I do respect Mr. Rounick's longevity in this business -- 41 years at Deb Shops, including 23 years as CEO.
Mr. Rounick's logic, as stated on the conference call, is that, "The [retail apparel] business is a series of roller coaster rides. . The question is, can you keep your downs shorter than your ups? . When they keep asking me why do you keep that balance sheet, the answer is because if everybody goes, we will still be here, we will be back on top, and we will be growing our business -- but we will be doing it in an intelligent manner."
To these two points, I applaud the company for what I would call a defensively opportunistic spirit. But does this preclude Deb from allocating at least some of its $152 million to buying back its own cheap stock? I put this question to Mr. Lyons, and he explained that Deb's board of directors has always felt that the positives of buying back undervalued stock are offset by the negatives of reduced liquidity.
These successes tell a different story
Hmmm, I'm not persuaded. Deb has 4.3 million shares of publicly traded float, according to Yahoo! Finance. That's a thin float, but not nearly as thin as Koss Corp. (NASDAQ:KOSS), a maker of stereo headphones, which for the past seven years has generated annual returns in excess of 25% due almost exclusively to significant share repurchases at undervalued prices. Since 1995, Koss has bought back 4.9 million of its own shares, reducing its publicly traded float to only 0.8 million. If Koss can effectively repurchase shares down to that level, then so can Deb.
And Koss isn't the only example. Recently, Zeke Ashton presentedUtah Medical Devices (NASDAQ:UTMD), a company that has been buying back its stock hand over fist for the past three years. Even though the stock is thinly traded (current float of 4.8 million shares), Utah Medical was able to effectively repurchase large amounts of stock by making self-tender offers above the prevailing market price. Through this type of structured buyback, the company has been able to repurchase substantial amounts of stock without being impeded by illiquidity. The result for those who held on to their Utah Medical shares has been annual returns over the past three years in excess of 34%.
Reinvest cash or give it back
Let's hope that when Deb's board meets in May it will consider some of these other companies' success stories. The lesson is clear: Buying back undervalued stock is the lowest-risk means to creating shareholder value, and the market will reward it! With more than $150 million in the bank, Deb has plenty of cash to meet its offensive and defensive objectives while still funding a major share repurchase. (Arguably, a one-time dividend could be a beneficial alternative, but given the stock's low valuation, a share buyback would be much better.)
In the meantime, though, it's necessary for investors to evaluate Deb as it exists today. That means there can be no assumption that management will ever change its stingy ways. I've struggled over this question because, by all appearances, Deb is wildly undervalued. And yet, the value becomes questionable if management can't be trusted to return excess cash to shareholders. Here's the crux: I don't buy a company for its latent asset value; I want cash flow to either be reinvested in the business or returned to me through dividends or share buybacks, whichever makes more sense.
So as for Deb, I'm choosing to put it on the back burner and will only consider it for my portfolio after I've exhausted all other similarly undervalued stock ideas. That logic dictated Deb's removal from my port about three weeks ago (after having owned it for about six weeks). Essentially, Deb got crowded out -- not a hard thing to happen given that I run a concentrated portfolio. So be it. Until Deb's board shows some willingness to get serious about creating shareholder value, why should I be in any hurry to own their stock?
And to Deb's board, I hope you change my mind in May.
Matt Richey ([email protected]) is a senior analyst for The Motley Fool. At time of publication, he had no position in any of the companies mentioned in this article. For Matt's best stock ideas and exclusive in-depth analysis each month, check out our newsletter, The Motley Fool Select . The Motley Fool is investors writing for investors.
