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

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11 thoughts on “Collectors Universe: A Low Risk, High Uncertainty Investment

  1. Will you elaborate on Outcome 4? The company “blows it,” domestic cash flow take a big hit, yet you projected the stock to be flat in that scenario? You’ve got to be joking.

    • I don’t now what the stock will do in the short-run. It may fall below current levels or it may stay the same or it may even rise. Who knows?

      However, I believe that the company’s intrinsic value will be at least $18. That means no *permanent* impairment of capital for those buying below that level. And this is my primary investing goal, avoiding permanent capital losses.

      Thanks for posting,
      Greg

      • Fair enough, I can’t argue with a long term approach. But my point is that if you don’t have a realistic framework regarding pretty obvious near-term cause/effect, then why should readers be convinced of your estimates regarding long-term value, which are much more sensitive to small changes in inputs?

  2. My only experience in this area is with another previously “wildy high” dividend and currently “high” dividend stock, CTL. I too expected that the stock would maintain value even if dividend was cut to just “high”. Unfortunately, the stock fell dramatically. What is the difference in the two scenarios? I’m sorry for my inexperience, and I know these companies are hard to compare, but I admire your reflections, and may learn something from your response if you would be so kind.

    • I can’t compare CLT with CLCT because I haven’t studied CLT’s situation and business.
      However I’d like to point out a couple of things:

      1. I intent to hold my position in CLCT for as long as it takes for it to realize its true value. There is of course the possibility of selling because I found an even better opportunity (unlikely but it may happen).

      2. Volatility is inevitable. As Warren Buffett says, “In the short-term the market is a voting machine, but in the long-term it is a weighing machine.”. This means that the market will overreact from time to time but it will recognize value, EVENTUALLY. Markets can stay irrational for quite some time.

      3. One should NEVER invest without doing his own due diligence no-matter how thorough or well-thought a write-up may seem. This is for two reasons. First the author (in this case me) could me wrong, missing something or have an agenda. Second, if an investor don’t do his own research, he won’t have the necessary conviction and will likely sell when he should be probably buying.

      Thank you for your nice words, I hope this helps.

      Thanks for posting,
      Greg

  3. comparing NGC to PCGS and using coins graded totals is like comparing Motorola phone sales to Apple. Moto sells more of the lower cost stuff, same as NGC. Most of the low margin Modern stuff flows to NGC. The high value, high margin stuff flows to PCGS. Look at revenue. PCGS revenue is probably 50% more than NGC. Profits are higher. If I had to guess, PCGS has 50% of the market, NGC 40%, and other the remaining 10%

    • I fully agree that NGC has probably the low-margin part of the market.

      However, I don’t believe that the cellphone parallel is accurate. In the coin grading market collectors want their coins graded by the most reliable and trustworthy company. As the aggregate number of PCGS-certified coins increases PCGS’s reputation grows and becomes more and more entrenched.

      I think of it like this: As collectors see PCGS graded coins outnumber other graders coins crowd mentality will “push” them to use and respect PCGS even more than its competitors.

      That’s why I used the aggregate number of certified coins. I believe it’s a proxy (although a crude one) for each company’s reputation.

      Thanks for the comment,
      Greg

      • I m not sure if pure numbers of coins graded is the thing to be tracked. If that was the case all the Modern junk graded by Anacs and ICG and hawked on HSN/QVC would outnumber the coins graded by NGC/PCGS. I think a better gauge is resale value. If you look at closed auctions on Ebay, Heritage, etc of equivalent coins, you will find that PCGS graded coins tend to get a 10%-20% premium over NGC. Coins then certified by CAC also tend to have higher resale values as well. Follow the money.

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