Sunday, 16 March 2008

Being a Net/Net is Nothing to be Proud of...

Companies don’t typically become net/nets mysteriously. They aren’t designed that way, and it’s no badge of honor to trade at such a shockingly low valuation, (assuming your assets are real, that is) below the value of the difference between current assets and all liabilities. You get there for reasons that typically are not positive. No CFO worth his salt would be proud that his company found itself on any of our net/net lists, or as a constituent of the recently launched Cheap Stocks 21 Net/Net Index.

To become a net/net, typically much has gone wrong. Perhaps it’s been one bad quarter after another, you are sinking in debt, your products are becoming obsolete, and the market has given up on you. Perhaps its all of those reasons and more. But once you get there, there are few typical paths: Your situation improves, you become profitable again, and the market wakes up and pulls you out of the doldrums, or an acquirer sees some real value at a distressed price, and takes you out of the game. Another path may be a slow road that ultimately leads to bankruptcy. Still others remain net/nets for years, and Mr. Market, in his ultimate wisdom, has determined that your true value is already being reflected. We’ve seen companies such as Audiovoxx and Zapata perennially on the list. Interestingly, Ben Graham referred to National Presto Corp, which met his definition of a net/net, in one of his great masterpieces. National Presto was still a net/net many years later, one which we wrote about 25 years after Graham’s death!

Net/Nets are referred to as “cigar butts” for good reason. Sometimes they recover, and sometimes they don’t. Handleman (HDL), a member of the Cheap Stocks 21 Net/Net Index may just be the latest example of a net/net that does not recover. The company has fallen to $.35, a sure sign that the market believes that bankruptcy is in the future. At that level, and with deteriorating fundamentals and business conditions, the fact that such a company trades below its NCAV is of little comfort or relevance. Net/Net status is only relevant if the company is viable, or the assets are worth more than all claims (including equity) in fire sale type conditions. Stay tuned in the Handleman situation.

On another note, as markets decline, we continue to see new and potentially interesting names appear among the roles of the downtrodden net/nets. These include novelty sneaker maker Heely’s (HLYS), and small retailer and former net/net Duckwall Alco (DUCK)(search our archives for DUCK research).

As market volatility continues, we expect to see more interesting opportunities in the land of the forgotten.

*The author does not have positions in any of the companies mentioned. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this post.

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