Liquidity Services: A Case Of An Illusory Network-Type Moat

One of the things that are permanently on my to-do list is to constantly look for companies with a durable competitive advantage (aka “moat”) to add to my watch-list or even better to my portfolio if I’m lucky and find one on the cheap.

One company that looked quite promising was Liquidity Services Inc which trades on NASDAQ under the symbol “LQDT“. Here what LQDT does as it was reported in its 2013 10-K:

“We operate leading online auction marketplaces for surplus and salvage assets. We enable buyers and sellers to transact in an efficient, online auction environment offering over 500 product categories. Our marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with customer focused information including digital images and other relevant product information along with services to efficiently complete the transaction. Additionally, we enable our corporate and government sellers to enhance their financial return on excess assets by providing liquid marketplaces and value-added services that integrate sales and marketing, logistics and transaction settlement into a single offering. We organize our products into categories across major industry verticals such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware, energy equipment, industrial capital assets, fleet and transportation equipment, and specialty equipment. Our online auction marketplaces are  http://www.liquidation.com, http://www.govliquidation.com, http://www.govdeals.com, http://www.networkintl.com, http://www.truckcenter.com, http://www.secondipity.com, and http://www.go-dove.com.”

What essentially LQDT does is being a “market maker” in the surplus & salvage assets market. It makes it easy for big companies that neither have nor want to operate a reverse supply chain for their surplus & salvage assets. LQDT does it for them. It picks up the goods, stores them and makes sure to find a willing buyer to sell them to.

At first glance LQDT seems to benefit from a classic network-type moat. The more asset sellers it serves the more asset buyers it attracts and the more asset buyers it attracts the more asset sellers are attracted to its services. And the virtual cycle goes on and on..

Furthermore this qualitative analysis seems to be backed by the company’s extraordinary performance. It has compounded its revenue at 24% for the last decade and its net income at 31%. It has no debt and has negative working capital (excluding cash) that suggest the existence of float, and thus a competitive advantage.

(For more on the relation between moats and floats read this excellent series by Sanjay Bakshi at the “Fundoo Professor“)

However, the image of a big sturdy moat around LQDT’s business collapsed when I reached the Management discussion segment, where the company clarifies how it makes its money. LQDT generates income from three transaction models. Asset sellers are free to choose which one they want:

  • The profit-sharing model: Under this model LQDT buys inventory from the asset sellers and sells it, sharing a portion of the profit with the original seller. This model accounts for 13.5% of the company’s revenue and 7% of its gross merchandise volume or GMV.
  • The consignment model (fee revenue): Under this model LQDT receives a commission fee for matching asset sellers with the buyers of the surplus & salvage goods. The fee is a percentage of the price the assets are sold. This model accounts for just 20.1% of the company’s revenue despite the fact it covers 59.1% of the company’s GMV.
  • The purchase model: Under this model LQDT offers asset sellers a fixed amount for their assets or the option to share a portion of the revenue generated by the assets’ sale. This model accounts for 66.5% of the company’s revenue although it covers only 33.9% of its GMV.

The only part of LQDT’s business that has a network-type moat is the consignment segment where LQDT is the facilitator of the transactions in a model similar to eBay’s. However under the other two models, LQDT is nothing more than a wholesaler/reseller of surplus and salvage assets. It may have some cost advantages due to its scale but nothing more.

The way I arrived at this conclusion was by trying to answer the following question:

“What would happen if Amazon and/or eBay (which are the eventual selling places of many surplus and salvage goods) decide that they want a piece of LQDT’s business?”

Well they would probably try to steal asset sellers from LQDT by offering a bigger portion of sales profits/revenue or by buying their assets for a higher price. And thus they would target LQDT’s most profitable models. Would they succeed? Probably yes, because they both have the necessary distribution networks to sell the surplus/salvage assets and they can afford to do it with smaller profit margins compared to LQDT. And they would satisfy both asset sellers (with greater profit/revenue returns) and asset buyers (with lower selling prices).

“Would LQDT’s customers have any trouble or hesitation to abandon LQDT or to split their business between LQDT and LQDT’s competitors?”

And the answer here is… no. LQDT’s clients on both sides of the transaction are mostly businesses who are targeting consumers one way or another and that constantly working on razor-thin margins. They wouldn’t miss an opportunity to be the low-cost seller or increase their margins for a tiny-bit even if it’s temporary.

So it seems perfectly clear that LQDT faces a big catastrophe risk down the road. Competition from the likes of Amazon or eBay has the potential to wipe out 80% of the company’s revenue and thus putting it in existential risk.

HOWEVER, what I’m not saying above is that if LQDT continues to operate competitor-free as it has so far, I believe that it will continue to grow at a breakneck pace and would probably be a multi-bagger for the next decade or so.

Nevertheless, I’m a hard-core Buffett fan and cloner and I can’t bring myself to violate the first step in Buffett’s investment process. And the first step is (as it was artfully demonstrated by Alice Schroeder in the video below) to always check every potential investment for catastrophe risk, which is the possibility of the investment going to zero. If the investment has even a small chance of catastrophe risk the investor should stop thinking and just reject the idea.

And (at least in my eyes) LQDT certainly seems to face some degree of catastrophe risk…

Disclosure: I have no position in LQDT and as of this writing I don’t plan to initiate any long or short position on the company.

FTD Companies: A fairly valued company with a strong moat but low growth potential.

Overview

FTD (NASDAQ: FTD) is a floral and gifting company. It connects consumers with local florists and gift shops from all over the world. A typical order for FTD goes like this:

A customer orders some flowers of his choosing, online or over the phone, to be delivered at a specific address. FTD redirects the order to one of the florists that belong to its network and is closest to the delivery address. The florist prepares the order and delivers it to the specified address either the same day or the day that the customer specified.

From this transaction FTD gains two-fold. It receives a part of the order as a fee for connecting the customer and the florist, and it receives an annual subscription fee from the florist in order to include his business in its network.

FTD - Brands

FTD’s Brands

FTD is a recent spinoff from United Online (NASDAQ: UNTD) and is again a public company since November 1, 2013. I say “again” because FTD has entered and exited the stock market many times over the last 14 years, as you can see below.

FTD's History


A slide with FTD’s history as shown in its investor presentation on December 3, 2013.

Moat

This company is interesting because it seems to have a very wide moat. The moat is its network of 40,000 floral shops worldwide, which is a huge network if we consider that the US floral market consists of approximately 15,000 retail florists. In the floral network business the more locations a network covers the more orders it gets, and the more orders it gets the more florists want to join in adding new locations.

This virtuous cycle is a huge barrier of entry which keeps potential entrants out and limits the competition between the incumbent companies such as 1-800-FLOWERS, Proflowers and Teleflora. FTD also faces indirect competition from mass retailers like ASDA, Marks & Spencer and Amazon that sell and ship boxed flowers to customers.

Besides the qualitative evidence of a moat FTD’s numbers tell a similar story as well. The company operates on a negative working capital basis (excluding cash and short-term debt) which implies some short of float.  Furthermore it has a stable 37% gross profit margin indicating some pricing power.

Unfortunately FTD’s tumultuous history of takeovers and IPOs seems to have created big amounts of long-term debt and goodwill that heavily distort the business’s performance and we can’t use ROE or ROA to evaluate the business.

However the business’ strength becomes evident when we examine it on a free cash flow basis. It has generated $50 million of FCF on average over the last 3 years and is expected to generate about $60 million in 2013. This is a 20% cash return on equity and a 10% cash return on assets, with both numbers being strong enough to indicate a potential moat.

Valuation

Given that the company historically had a very slow growth rate of about 5% over the past 15 years or so, the company is currently worth at best 10x its FCF or about $500 to $600 million or about $27 to $32 per share (the company has 18.5 million share outstanding). And this is the base case scenario.

However in this case capital allocation can change the company’s value by a wide margin.

Scenario 1: Reducing share count by 2% to 3% annually.

If management pursues such a strategy we can essentially increase the company’s future EPS growth rate from 5% to 7% or 8%. At these rates the company would worth between 11x and 12x its FCF or between $30 (11x $50 mil FCF) and $39 (12x $60 mil FCF) per share.

Scenario 2: Paying a 50% to 80% of free cash flow as dividend.

In this case the company would become a pure dividend play and it could pay a dividend somewhere between $25 million (50% x $50 mln FCF) to $48 million (80% x $60 mln FCF). This is a $1.35 – $2.60 per share dividend. So, assuming a fair value at a 4% dividend yield the company could trade from $34 to $65 per share.

Scenario 3: Extinguishing debt by December 31, 2018 and then one of the other options.

If FTD used all its free cash flow to pay down debt it would be debt free in 3 years time, and at that point its free cash flow would rise to $70 million or about $3.8/share annually.

At 10x FCF the company would worth $38 or about 20% higher than its current price. Furthermore the company could also decide to annually return some of its FCF to shareholders, boosting its value even more.

Scenario 4: Using cash to make acquisitions

The company could use its FCF to acquire other companies and thus boost its revenue growth going forward.

In this case I believe the company could worth about 9x to 10x FCF or about $24 to $32/share. The reason I’m so pessimistic in this case is that management’s tend to overpay when acquire new revenue. Thus, I prefer to err on the side of caution than to assume a superb management team and be disappointed.

Scenario 5: Piling up cash

The company could just hoard the cash and wait for some extraordinary opportunity down the road. In this case the company’s value would just increase every year by $2.7-$3.2 per share depending how much cash it generated that year.

In this case I would still value the company not more than 11x FCF or $30 – $35.

Conclusion – Calculating Probabilities

Concluding I’ll try to roughly estimate the odds of each scenario happening. We aren’t completely blind in this process as there are some hints on management’s attitude for investors.

The first hint is the following question and answer from the investor relations Q&A page.

FTD - Dividend Question

The second hint comes from the framework for management incentives insiders currently own insignificant amounts of the companies shares. If they want to maximize their compensation they should give themselves plenty of options and simultaneously decrease the number of shares outstanding in order to give themselves as big a piece of the company as possible.

FTD - Shareholders

So without further delay here are the odds (as I see them of course) of each scenario materializing:

Scenario 1: FTD just buys back shares. Fair value $30 to $39. – 15% probability.

Scenario 2: FTD pays a hefty dividend. Fair value $34 to $65. – 5% probability.

Scenario 3: FTD extinguishes debt immediately. Fair value $38 or more. – 5% probability.

Scenario 4: FTD grows through acquisitions. Fair value $24 to $32. – 20% probability.

Scenario 5: FTD simply hoards its cash. Fair value $30 to $35. - 5% probability.

Combination of scenarios 1,3 and 4. – 35% probability.

Some other combination of outcomes or something else completely - 15% probability.

Given that most probabilities are for a fair value between $30 and $40, the stock isn’t a buy at its currents price of $32. However I added it in my watch-list and I will probably act on one of the following conditions:

-The company clarifies its plans for the future and decides to return some cash to shareholders. In this case I will reevaluate the company and if the price is favorable I’ll buy.

-The company’s shares fall to $20 or lower. At this price I would be a strong buyer (up to 25% of my portfolio) because the stock would have a big margin of safety and big potential returns (up to 100%).

Collectors Universe: A Low Risk, High Uncertainty Investment

Recently I came across a write-up of Collectors universe (NASDAQ: CLCT) on Investing Sidekick.com, an excellent value investing blog I follow. Collectors Universe is a wide-moat business that pays an 8% dividend yield because Mr. Market is expecting the dividend to be cut sooner or later. I disagree strongly with Mr. Market’s view and below I’ll try to explain why.

I won’t talk a lot about the business and the company’s financials as they were thoroughly discussed on the Investment Sidekick. However here are some basics.

Business Overview

Collector’s business is a simple and straightforward one. They provide authenticity certification for collectible items like coins, cards, autographs and others. The company gets 65% of its revenues and 73% of its operating income from its coin authentication segment, which is not only its main business, but also the one with the most growth potential.

It is the second biggest coin grading company and has graded cumulatively 27 million coins over its history. Its main competitor is NGC (Numismatic Guaranty Corporation) which has cumulatively graded 28 million coins. Both of these companies are the most trusted coin graders by a wide margin. However, Collectors is constantly closing the gap with NGC and sooner or later will be the one with the greater number of authenticated coins in the market.

In case you’re wondering, I’m using the “cumulative” number of coins graded to compare these companies for a reason. This number represents not only the market share of these companies but also the strength of their moats. You see the coin grading business is a business build in reputation. The more graded coins one has in the market the more trusted his name becomes attracting more customers.

Furthermore the collectibles that are graded by such a trusted grader (like Collectors) get premium pricing in the market over non-graded ones or ones graded by less trusted companies. This is because fraud is rampant in the market for coins and other collectibles. Verification of authenticity is extremely important for collectors, especially nowadays where a large part of the collectibles market has migrated online.

Finally, despite the great economics of the grading business, it is virtually impossible for any new or existing grading business to compete with either Collectors Universe or NGC. This is because their brands are so widespread and so entrenched in their markets that a competitor would have to struggle for decades before experiencing any significant market share gain.

Financials

The economics of the grading business are really wonderful. Collectors Universe operates with a 63% gross profit margin and a net income margin of 11.5%. Furthermore since Collectors’ customers usually pay in advance for the grading of their collectibles the company has negative working capital, which means that it’s operations are mostly funded by the cost-free float customers are providing.

It doesn’t come as a surprise then, that the company generates returns on assets (excluding surplus cash) north of 30%. It has also increased its FCF at an average 20% over the past three years.

Furthermore according to the company only 10% of the US collectable coins market has been graded leaving enormous potential for the future. Moreover CLCT has just opened offices in mainland China which is the oldest and bigger coin market on the planet.

Mr. Market’s Take

The opportunity in this stock exists in the form of its $1.30/share dividend which at its current $16.2 price represents an annual yield of 8%.

The reason this opportunity exists is that the dividend surpasses both the company’s income and its free cash flow. As a result Mr. Market believes that it will be cut sooner or later. This opinion is reinforced by the fact that some income tax reliefs the company enjoyed over the last few years (due to losses carried forward) have come to an end.

Possible Outcomes

I believe that Mr. Market is overwhelmed by the uncertainty surrounding the dividend and has gone too low in pricing CLCT. Let’s take a look at the potential outcomes for this situation to figure out if Mr. Market is right or wrong:

Outcome 1: Collectors Universe decides to keep this $11 mil dividend for as long as possible and subsequently cut it to 80% of its $8 mil free cash flow. I assume no material change in current business.

In this scenario Collectors has enough money ($17.5 million as of Sep 30, 2013) to fund its $3 million cash flow deficit for at least five years. After that the dividend will fall from $11 mil to $6.4 mil or from $1.3/share to $0.75/share.

So we will receive $6.5 of cumulative payments over the next five years and after the dividend is cut an annual payment of $0.75. The discounted cash flows (I use a 5% discount rate) over the next ten years will have a present value of $8.58 and we will still own the stock which will trade around $19 (assuming CLCT trades at a 4% yield on its $0.75 dividend).

Concluding, in scenario 1 we pay $16.2 for an asset that’s worth $27.58 or 70% more.

Outcome 2: In this scenario let’s assume that CLCT cuts its dividend immediately to 80% of its $8 mil free cash flow.

In this case CLCT will pay out a $0.75 and will probably trade around a 4% yield or $19/share. It will also have a cash hoard of $17.5 million or $2 per share and thus it will ultimately worth around $21/share.

In scenario 2 we pay $16.2  for an asset worth $21 or 30% more.

Outcome 3: In this scenario let’s assume that Collectors Universe China investment goes well and the company continues to grow its FCF at 20% at least for the next two or three years.

In this scenario CLCT’s free cash flow will exceed its dividend needs within the next two years and thus the $1.3 dividend will be fully funded. And the company will have at least $10 million left in its coffins. In this case CLCT will probably trade around a 4% dividend valuation or $32.5/share.

In scenario 3 we pay $16.2 for an asset worth $32.5 or 100% more.

Outcome 4: The company blows it, China is a complete failure, domestic cash flow falls 30% to $5.6 million and the company cuts its dividend by 50% to $0.65/share.

In this scenario CLCT will have a fully funded dividend of $0.65 and will probably trade around a 4% yield valuation or around $16. The cash hoard of $2/share though, will remain intact and thus the whole company will worth around $18.

In scenario 4 we pay $16.2 for an asset worth $18 or 12% more.

Conclusion

Some notes before we calculate the odds for the four outcomes:

  1. The CEO has stated in the Q4, 2013 earnings call that they intend to keep paying the dividend for the foreseeable future.
  2. The first signs from the Chinese market are pretty good.
  3. For my calculations I use the latest number of shares outstanding which is 8.5 mil.
  4. I assume that a 4% dividend yield is a reasonable return for investors given the current economic environment and the quality of the business (wide moat).

Now let’s put some approximate odds on our 4 scenarios.

  • Outcome 1: 40% probability
  • Outcome 2: 10% probability
  • Outcome 3: 30% probability
  • Outcome 4: 20% probability

So, we’ve got an investment that has a 70% probability for a 70% to 100% return, and a 30% probability for a 12% to 30% return. The possibility for a permanent  loss of capital if we buy at these prices is essentially zero!

For me this is the perfect investment opportunity. What do you think?

Disclosure: I am long CLCT for my personal account