Investing in Turnarounds

by Geoff Gannon

A reader sent me this email:

Do you invest in turnarounds / cyclicals?

I came across Furniture Brands (FBN). Avg. FCF over 10 years is $75 million. Current EV is $280 million. Of course, last two years were horrible from an earnings perspective...However, FCF was not bad in those years...Trades at 1.2x tangible book value and 0.2x sales...The low ROE even in good years tells me this is not a great business...thoughts appreciated.

I wouldn't pay a dime more than tangible book for any company involved in making furniture. In fact, I'd want about a 33% discount to tangible book to even get interested in that sort of thing. I think invested assets in the furniture industry are worth far less than book. The more likely capital is to stay invested in the furniture industry, the less likely I am to value that capital at anywhere near book value.

I don't think of myself as investing in turnarounds or cyclicals. But others might disagree. Was Barnes & Noble (BKS) a turnaround? I don't think so. It was more the expectation of horrible things happening in the future than the present that was weighing on that stock.

However, I will invest in stocks that are temporarily unloved because of the state their industry is in. So I would buy something like Masco (MAS) or Mohawk (MHK) at the right price. I bought Omnicom (OMC) when the advertising industry looked bad (early 2009). And it's only because I have a pretty high hurdle rate - and a micro cap bias - that I don't own Fair Isaac (FICO) right now. I'd say each of those companies at one point had a low stock price mainly - though not exclusively - because it was the wrong time in the cycle for their industry. But I want a good long-term record and good operations relative to peers. I don't want to invest in something that's gone downhill compared to competitors. But, if I think their competitive position is strong - it's just the industry that's weak - I would definitely consider buying something like that.

The thing with Furniture Brands is that all the stocks in the furniture industry are really, really cheap. I mean, I posted Mason's report on Stanley (STLY) on the blog and Chromcraft Revington (CRC) shows up in Ben Graham net/net screens. My problem is that furniture looks a bit like textiles when Buffett bought Berkshire Hathaway (BRK.B). Textile production was moving from New England to the South back then. And there were very good, very permanent reasons for that happening. Not permanent for the South keeping the mills but permanent for the North losing them.

Furniture - unlike textiles - is a consumer product. But furniture is tricky because like appliances, computers, flat screen TVs, etc. it's a product where the customer often does an exhaustive search. I don't like businesses where the customer rationally considers alternatives. Furniture isn't a repeat purchase business. Brand loyalty is low. Credit can be involved. It's like someone combined every negative economic aspect a consumer product can have and built a capitalist's nightmare.

If it's between owning a company that makes furniture and a company that makes underwear, I'm buying the underwear company. If they're one of the two leaders today they'll probably be one of the two leaders in 20 years. And if they have 10% operating margins today, as long as they run things right, they've got a shot at 10% margins in 10 or 20 years whether they make the stuff in North Carolina, the Dominican Republic, or Vietnam. It'll fluctuate. But over decades I kind of know what the return on capital and sales in the underwear business will be for Fruit of the Loom and Hanes (HBI). The furniture business is the polar opposite of the underwear business from the customer's perspective - always the most important perspective - and so I have no clue what the return on capital or sales in furniture will be in 2020.

It sounds silly to talk about 2020. But my problem is that I don’t believe I have a much better insight into 2012 than 2020. The future of some businesses is very unclear. The future of other businesses is roughly clear. Not in the sense that I know what they will make in any one year, but in the sense I know they will produce free cash flow and earn a decent return on capital. As long as you buy into a business like that at a low price, the risk of a catastrophic loss on your investment is very low. Eventually, your purchase will work out.

I don’t think an investment in a furniture company is like that. I think there are real risks even at low prices, because I think it’s hard to tell if they’ll be clear skies at any point in the future.

If I was looking at the furniture industry I think I would look hardest at retailers (and you know how little I know about them) and especially distributors. The advantages one distributor has over another should stay intact better than the advantages of companies on the production side. I usually prefer the distribution side to production side of most industries anyway. Enduring, intangible competitive advantages tend to accrue more to distribution than production in non-integrated industries. So, if I was looking at a stock that would rebound with the furniture industry, I would look hardest at the distribution side. I would look for a distributor that had been consistently profitable up until the economy crashed.

The first stock that comes to mind is Craftmade (CRFT).

There are two strikes against this one. One, it doesn't file with the SEC anymore (you just get the press releases via the pink sheets website). And two, it doesn't have a sparkling balance sheet (an understatement). But the business itself is almost certainly worth more than it sells for if it had the right balance sheet. A competitor has been sniffing around the company for years now. I think they bought 15% of the company in a kind of creeping, kind of hostile way.

Since Craftmade is an off the radar micro cap stock that doesn't file with the SEC, don't expect to get timely updates on that situation.

And if you want to read a blogger who actually knows something about turnarounds, take a look at Variant Perceptions.

Talk to Geoff About Investing in Turnarounds