By Deep Value Analyst :
Calloway's Nursery (OTC: [[CLWY]]) is the rare under the radar micro-cap stock that is trading below liquidation value that could be worth 3x more as its experienced management team and board continue to make operational improvements and unlock value.
Calloway's is an 18 store chain of high margin plant and garden related stores in Dallas Ft Worth with an additional store in Houston. 3K, a family office run by Peter Kamin, co-founding partner of Value Act Capital became the controlling shareholder and lead director of the Company in January 2016 after winning a proxy vote. Year to date operating cash flow has improved 68% and EBITDA has grown 36% as the company continues to find ways to make operational improvements to the business.
Given the business operates with near 50% gross margins, we believe the business has the ability to achieve double digit operating margins over the next couple of years as the new management team makes improvements in purchasing, inventory management, marketing automation and proper staffing at the store level. In addition, given the continued strength in the Dallas and Houston economies (see here , here , and here ), which rank 1 and 2 in the entire country, we expect to see continued sales growth. Over the last 2 years, same store sales have averaged mid-single digits and the company added 2 new stores in 2016, which increased the store base by over 10 percent.
What makes Calloway's unique is its ability to offer a more unique and specialized plant selection than Home Depot and Lowe's, but also superior customer service. Calloway's employees are certified nursery experts that have taken credentialed coursework, which provides employees with a far deeper knowledge base than that of general retail employees. Having visited all of Calloway's stores and multiple Home Depot and Lowe's, the difference is significant. If you want to buy a generic house plant or fertilizer and you are an accomplished do it yourself gardener then shopping at Home Depot will save you a little money, which is not the Calloway's customer.
In order to determine the value of CLWY's real estate holdings, we used satellite images to individually map out the size of each retail location. Our analysis indicates that CLWY owns approximately 900,000 sq. ft. of land across its 11 fully owned stores, with an average size of roughly 80,000 sq. ft. per location (including parking space.)
To support our analysis, we have not only spoken with commercial brokers in Texas, but when one analyzes Calloway's financials, one will notice that Calloway's sold a store in Houston in December 2014 for a gain of $9.9m. Unfortunately, no purchase price was disclosed. If we assume, however, that CLWY obtained the land for free and sold the 3.0 acre lot for $9.9M, this equates to approximately $75 per sq. ft. If you were to value the remaining properties at $50 per square foot, the properties would be worth $6 per share. Since 2015, real estate in Calloway's markets is up 15-25%. Calloway's real estate is currently being valued at roughly $3 per share on its balance sheet and most of the real estate is held at cost or hasn't been appraised in at least 5 years. We believe that valuing the real estate portfolio at $50 per square foot is conservative and could present significant upside potential, as seen below.
CLWY's new management team is aware of the value of these holdings and will look to monetize the assets in the near future. 3K discussed potentially repurposing some of the company's valuable locations in their 2013 proxy filing, stating: " 3K believes that CLWY should not only evaluate the performance and strategic location of each retail operation, but that the company should consider the market value of each retail location to determine whether some operations should be repurposed to a more valuable use." (Emphasis ours.) Given Dallas' limited housing market, Calloway's sizable (on average, +80k sq. ft.) locations in premium residential neighborhoods should attract healthy interest from real estate developers and push prices even higher, as was the case with the 200 N. Dairy Ashford location that was sold by management to be converted into condominiums.
Shareholders who invest alongside 3K are getting a superior capital allocator to make investment decisions for the good of all investors. 3K is only investing its own capital and owns roughly 4.3m shares or roughly 60% of the company. When they sold the Houston store for a gain of $9.9m they used the majority of the proceeds to buy 2 new stores and thus avoid paying capital gains. The Board also wisely bought back 1m shares at $2.52 and has paid down almost all the debt on the balance sheet, all decisions which have been highly beneficial to shareholders.
We believe the reason why the mispricing exists and why Calloway's currently trades at $3.80 instead of closer to $8-$10 is for the following reasons:
1. Management and the Board have a very long-term view and are not promotional
a. Company does not have an investor relations department and does not engage with shareholders or Wall Street
i. This strategy is no different than from that of the Board or management teams of other extraordinarily successful microcap companies such as Atrion, Winmark, Investors Title Corp, Rockford Corporation, Rand Worldwide or ELXS Corporation.
2. Company trades on the OTC market and therefore has less financial disclosure requirements.
a. With less than 300 shareholders since the tender offer, CLWY can avoid most of the SEC's reporting requirements. Limited disclosure, however, presents an opportunity for diligent investors.
3. Stock is very illiquid
4. Stock price is below $5
5. No sell side research coverage and company's small market cap limits most firms on the buy-side from investing.
6. Requires independent research and primary due diligence visiting stores, reading financial statements, talking to real estate brokers, talking to employees to understand value of the business and the land
As awareness of the company and the current mispricing becomes better known, we believe the shares of Calloway's will move substantially higher and be valued more in line with the value of the business and its real estate. We have seen this countless times occur with other undiscovered microcap companies including the examples we listed above many of which are worth 5-25x more than they were many years ago and they still have no research coverage.
Secondly, as awareness increases, demand for the shares should become greater than the supply. Once supply is absorbed in an illiquid stock with improving fundamentals, stocks can move higher and re-price extremely quickly given scarcity of shares. We believe there has been a long time large holder of CLWY that did not sell shares in the dutch tender at $2.52 that has been selling at $3.85. We believe the seller is close to being done with his sale and once this supply dries up, the stock will move materially higher as there are no other sellers at these prices and the remaining long-term holders aside 3K amount for over 80% of the float.
Unlike other funds, what makes 3K unique and a very valuable shareholder is that it only invests its own money from its personal family office. As a result, it has no incentive to be promotional and spend money on IR and attending conferences. Its time is best spent running the business and allocating the capital of the company. As can be seen from the filings, company bought back stock in 2016 so it has no incentive to bid up the price as the largest shareholder.
We believe that Calloway's nursery business should be valued at least at $5.80 today based on an ~$0.90 per share EBITDA value in 2017 and a 7x EBITDA multiple, both assumptions we view as conservative. Our $0.90 per share EBITDA assumes same stores sales growth continues at 5.5% (achieved in 2015) as well as improving productivity for the two stores added in 2016. We believe a 7x multiple is fair given that the company has traded at an average of ~7x in the past 10 years. The difference, however, is that the company has significantly improved operations in the last couple of years by shutting down unprofitable stores, cutting costs, and refocusing on core markets.
In our model, we have the company generating $1.10 in EBITDA per share in 2018 and we apply an 8x multiple. If we want to be conservative, we could value the business at 6x on $0.80 and come up with $4.20. Net debt is ~$5m including $2M in deferred taxes. If the company were to stop rolling out new stores, we believe CLWY could generate at least $3.5M in free cash flow (+10% yield on a FCF/EV basis) which could be used to buy back more shares or pay down debt. Both options would be highly accretive to shareholders.
We believe the real opportunity for upside lies in additional margin expansion. Given CLWY's industry-leading gross margins of +50% (vs. mid 30s for Home Depot, Lowe's, etc.) we think there should be plenty of room for CLWY to improve EBITDA margins from the ~7.6% achieved in 2015 (vs. midteens for competitors.) On a trailing twelve month basis, CLWY already has made significant improvements, driving margins to +10% and we see no structural reason why CLWY should not be able to achieve mid-teens EBITDA margins in the next 3-4 years as the company benefits from a bigger shift into private label products and continues to cut operational expenses. We estimate that CLWY is on track to achieve an EBITDA margin of 11.5% in 2016. For our model, we forecast 100bps of expansion per year, which we believe to be easily achievable. This get us to a 13.5% EBITDA margin by 2018.
Either way you look at it, the company's real estate is worth ~$4 even on an after tax basis (or $30M gross) and you are getting the operating business for free. Over time, we believe the Board will continue to unlock shareholder value by opportunistically selling off stores as they did in late 2014 and either redeploying the cash into other stores, buying stock or paying special dividends. This means that the combined worth of the business and the land should be at least $12, which signifies +200% upside.
Additional Source of Upside / Catalysts
1. Multiple expansion over our 8x EBITDA figure as the company continues to improve operations.
2. Additional margin expansion as the company gains operating leverage in overhead, advertising, etc.
3. CLWY monetizes its real estate holdings at a greater price than $50/sq. ft.
4. CLWY continues expanding in the strong Texas market more rapidly than anticipated. Particularly given the company's attractive store economics and high ROIC of ~18%.
5. 3K LP offering a good price for remaining shares and taking the company private.
See also Trade War Or Bust? on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.