By Jim Roumell :
Liquidity Services ( LQDT ) operates a leading online auction marketplace for surplus and salvage assets. It enables buyers and sellers to transact in an online auction environment. The company's marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with digital images and other relevant product information. An easy to understand way to view the company's business is to think of it as an industrial strength eBay ( EBAY ). The company offers clients several engagement options: purchase model (pay a guaranteed price for assets); profit share model (share sales proceeds with customer); consignment (company can technically send back unsold goods); and a straight commission model. William "Bill" Angrick is the Chairman and CEO of LQDT. Mr. Angrick co-founded the company in 1999. The Department of Defense (( DOD )) was the company's first client. As of the January 2015 proxy statement, Mr. Angrick owned approximately 5.3 million shares (17.6% of total outstanding). LQDT fits nicely in RAM's wheelhouse of finding value in well-capitalized out-of-favor, overlooked and misunderstood securities possessing unique, if under-earning, assets. The immediate outlook stinks, but the price trumps the outlook.
The company recently announced the sale of its Jacobs division which will bring in roughly $50 million ($35 million in a tax refund plus a $13 million, 5-year amortizing note; we ascribe no value to the $4 million earn out). Accounting for these proceeds, adjusted cash/note to market capitalization is nearly 70% with a market capitalization of $210 million (at $7/share) and cash/note of about $143 million ($95 million cash + $35 million tax refund + $13 million note). The resultant EV is $70 million.
What asset do we now own at our effective purchase price of $70 million? The company owns the leading online auction platform and transacts GMV (gross market value) sales of roughly $800 million (revenue is roughly 50% of GMV) and has been widely recognized by leading industry sources as the premier liquidation platform. To wit, the company was recently named "Asset Disposal Firm of the Year" for the second consecutive year by ACG Magazine's Global Awards 2015. The earnings power of this platform had been very impressive, although that is clearly not currently the case with operating margins falling from nearly 13% in 2012 to 7% in 2014 and to 4.1% in 2015. In 2012, the company generated over $100 million in EBITDA, $1.50/share in GAAP earnings and traded at $60/share. To be clear, the company is not going back to its heyday margins and hugely profitable DOD contracts. However, it doesn't need to for the investment to work. To wit, at today's price, if the company can generate a 4% EBITDA margin (one-third of peak), the investment should work out just fine.
Three things have collided to undermine the company's earnings power. First, the DOD business has become less profitable. The company lost the DOD's rolling stock (things with wheels) contracts, arguing that it was unwilling to bid at unprofitable levels. The company continues to perform non-rolling stock asset and scrap liquidation for the DOD, but its current contracts are materially less profitable than earlier ones. Second, the company lost a major piece of business with Wal-Mart ( WMT ) after determining that Wal-Mart was not adhering to the terms of its agreement. After not backing down on this particular contract, Wal-Mart paid an early termination fee of $7.5 million. Wal-Mart continues to be a LQDT client, notwithstanding the loss of this particular contract. Third, the energy industry bear market has significantly reduced activity in that industry vertical as buyers and sellers have not yet agreed upon clearing prices.
We believe the company has admirably diversified away from DOD (once 100% of its business and now one-third). Further, despite the Wal-Mart setback, the company's retail business is well positioned with other major retailers like Costco ( COST ). The company believes that Wal-Mart is receiving less than 50% of the recovery values on the associated merchandise on the specific contracts lost, underscoring the value proposition of LQDT's buyer network of nearly 3 million. In the energy sector, current business activity is anemic, but liquidations are assuredly coming before too long as smaller E&P companies are forced to liquidate assets to keep their lights on. Finally, the company has a very nice growing business in its GovDeals division (state and local government marketplace), having signed up roughly 6,000 of the over 60,000 municipalities in the country. The company estimates the next player in this space has likely less than 500 municipal contracts. GovDeals' revenue continues to grow nicely and is now about 25% of overall revenue, and offers attractive straight commission revenue.
Our investment thesis is threefold: 1) we believe there are identifiable, non-existential, reasons for the margin erosion noted above; 2) sophisticated online liquidation offering secure, authenticated high-quality service to customers is likely to continue to take share from onsite auctions and "Mom and Pop" liquidators; and 3) not a lot has to go right for our investment to be successful at the current price. It should be noted as well that the lost Wal-Mart contract did not contribute to 2015 earnings. Finally, the company's new Liquidity One platform is roughly one-third completed. Upon completion in early 2017, Liquidity One will meaningfully reduce operating expenses and will further differentiate the company's industry competitiveness.
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