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George Risk Industries Resembles Buffett’s Dempster Mill But Lacks a Catalyst

July 30, 2010 | About:
One of Warren Buffett’s early investments during his partnership years was a small Nebraska company that manufactured windmills and farm equipment. The story of Dempster Mill Manufacturing in Beatrice, Nebraska is documented in great detail in Andrew Kilpatrick’s massive three volume set, Of Permanent Value: The Story of Warren Buffett. Mr. Buffett began acquiring shares of Dempster in 1956 and had a controlling interest by mid 1961. After gaining control, Mr. Buffett installed new management and dramatically improved the performance of the business. By 1963, performance had improved and the business was significantly overcapitalized with only 60 percent of assets utilized in the manufacturing operations. Through a reorganization that involved the sale of the operating business, excess capital was effectively returned to shareholders.

Revisiting George Risk Industries

We first profiled George Risk Industries in early January and noted that the company was massively overcapitalized and represented a potential bargain for investors. George Risk designs, manufactures, and sells a variety of products with 87 percent of revenue in the last fiscal year coming from security alarm related products. Please refer to the original profile for more background on the business along with a spreadsheet with several years of financial results.

Not much has changed since the original profile based on the company’s recently released 10-K report covering the fiscal year ending on April 30, 2010. Book value per share has increased to $5.42 per share at April 30 from $5.16 per share as of October 31, 2009 – the latest data available at the time of our original analysis. The company earned $0.30 per share for the fiscal year ended April 30, 2010 compared to $0.10 per share for the prior year which was depressed due to large investment losses. Net-net current assets (current assets minus all liabilities) was $5.22 per share compared to a recent market price of $4.50.

Swimming in Cash and Securities

Most notably, the company had cash and investments of $23.2 million on the balance sheet as of April 30 which exceeds the company’s current market capitalization of $22.8 million. The company has no long term debt. Based on the nature of the company’s operating business, it is doubtful that more than $3 million of cash should be required to run the business and provide for foreseeable contingencies. This would allow for a distribution of at least $20 million, or $3.95 per share, to be returned to shareholders.

The company earned $1.1 million in pre-tax operating income in fiscal 2010, which does not include income derived from investments. This income level is still depressed due to the sensitivity of the company’s alarm business to housing starts. While exact precision is not possible, it seems likely that the ongoing operating business might be worth $10 million, or approximately $2.00 per share.

Based on conservative assumptions, it seems reasonable to believe that George Risk could be worth approximately $6.00 per share from the combined value of the excess cash and securities on the balance sheet and the value of the ongoing business. This compares very favorably to recent trading levels between $4.25 and $4.50.

But George Risk Industries Isn’t Exactly Like Dempster Mill …

All of our analysis regarding a potential distribution of the excess cash and securities is merely academic because Ken R. Risk, Chairman and CEO, owns 58 percent of the company and has not shown any interest in distributing excess cash. Without the ability to take control of the company, could a minority shareholder benefit from this excess cash?

If the company continues to pile up cash and securities on the balance sheet, minority shareholders may never realize much value. This is because the company has no competitive advantage in the field of investing, as demonstrated by the fact that they have outsourced this function to a “money management” firm with authority to trade for the account. Furthermore, the company has not managed cash balances particularly well. The 10-K reveals that large amounts are “sitting in cash at this time” because the company has not found a “worthy place” to invest the proceeds from several matured CDs.

Furthermore, the company maintains very large uninsured cash balances in a small financial institution in Kimball, Nebraska run by one of the company’s directors. As of April 30, 2010, the company had an uninsured balance of $3.1 million with this financial institution. According to the related party transaction table, the company earned interest of less than one percent on this cash during fiscal 2010.

Another warning sign documented in the 10-K involves the company’s statement regarding acquisitions. Management indicates an interest in acquisitions and states that no financing is likely to be required — meaning that available cash and securities could be liquidated to fund expansion. Could such expansion enrich shareholders? Possibly, but this is not part of an investment thesis based on distributing excess cash to shareholders.

No Catalyst In Sight

Even if an investor is willing to overlook the lack of a catalyst, shares trade in such low volume that it would be very difficult to accumulate a meaningful position without impacting the price of the stock. Apparently the company sees value in the shares and has been repurchasing stock in recent years. This will further increase Ken Risk’s entrenched position as controlling shareholder.

Examining opportunities like George Risk Industries illustrates the importance of carefully reviewing the details of a business rather than simply buying shares based on simple filters like price to book value. There are occasions when a stock can be cheap and remain cheap for an indeterminate period of time. In such situations, one must be able to trust management to build value or at least refrain from destroying value.

While management at George Risk Industries appears perfectly competent to run a security alarm business, we are not reassured that excess cash or securities will ultimately benefit the minority shareholder.

Disclosure: No Position in George Risk Industries.


Ravi Nagarajan

http://www.rationalwalk.com

About the author:

Ravi Nagarajan
StreetAuthority, LLC is a research-intensive financial publishing firm that aims to level the playing field for small investors by giving them access to the ideas and insights of some of the country's top investment researchers, analysts and writers. Although we specialize in income and international investment research, we publish a wide variety of newsletters that are geared towards helping EVERY kind of investor profit from today's volatile marketplace. Visit StreetAuthority.

Visit Ravi Nagarajan's Website


Rating: 4.3/5 (10 votes)

Comments

softdude2000
Softdude2000 - 4 years ago
Thanks Ravi for good articles.

It is selling at cash value for a reason. Only unattractive can sell at that price. Having said that, I think we can trust management to do right thing, at least to have good intentions: (1) If they want to do some careless acquisition, they would n't have this large pile of cash in first place. So they are looking for a good fit.(2) Ken and others have big share in the company. So it is in their best interest too.(3) They managed tough times with some positive earnings.

I have 1% of my portfolio in this company.

My goal of this posting is to ask a question. Is it possible to find durable moat businesses in micro caps at cash value? Most have durable moat because of economies of scale along with some other characteristic.

WEB said if he had small cash, he would do exactly like what he did before. So I took it meant he wont look for durable moat and just value. Am I wrong?

Thanks.
rnagarajan
Rnagarajan - 4 years ago
As you say, companies that are selling at depressed valuations usually do so for a reason. In the case of George Risk, there is no earthly reason that I can think of that justifies management's stubborn retention of the excess cash. Do they have any competitive advantage managing investments? Clearly not. They outsource this function and results have not been great in recent years. Management seems unable to prudently manage the cash, concentrating funds in a small Nebraska bank without benefit of deposit insurance on the majority of funds.

I see no reason to doubt management's ability to run the business but they really have no business retaining this amount of cash merely to have the option to make an acquisition at some indeterminate future date. In the meantime, we can expect mediocre investment results, at best, and there is a risk of a bad acquisition.

Regarding moats, yes this is important if you want to own an operating business for long periods of time. It is less important in a liquidation scenario in which your investment rationale involves unlocking the value sitting in cash. I don't know if George Risk's security alarm business has much of a moat, but it is a decent little business that throws off cash. They just don't need $20m+ in excess cash to run it.
Hester1
Hester1 - 4 years ago


I think Rskia doesn't distribute the excess cash/investments because of reported earnings. If they distribute the cash, total earnings would be cut in half. I cannot think of any other logical reason not to distribute. It would benefit everybody, including Ken Risk. If he wants to invest money or use a money manager, why not distribute the cash and do invest in his personal portfolio? He owns half the company if memory serves me, so he would retain half the distributions anyway. It is truly puzzling.

Ravi, have you ever tried to call or email the company and discuss this? Probably not because you don't own shares, but I wonder if management could ever be convinced.
rnagarajan
Rnagarajan - 4 years ago
I think Rskia doesn't distribute the excess cash/investments because of reported earnings. If they distribute the cash, total earnings would be cut in half.

But the market obviously sees through this and assigns little value to the business anyway.

I've never tried to contact management but it might be something an activist investor who manages to buy up blocks of shares could attempt. Probably the only viable way to get a position is to find sellers privately since the shares barely trade.
batbeer2
Batbeer2 premium member - 4 years ago
I think Rskia doesn't distribute the excess cash/investments because of reported earnings.

IMO that is an unlikely motive. Maximising reported earnings is not an end but a means. If they intended to bolster the price of the shares they have better alternatives. These guys are not dumb !

Paying out a dividend is costly, you pay taxes. The Risks deal with the company as if it were their own, including the cash balance. It makes no sense for them to transfer it to their private bank account minus taxes when they can do what they want with that cash now. Parking some of that cash with a friend at 1% is typical. Who knows, they could very well have their personal savings in that very bank yielding 8% interest.

I like the business but the way management treats minority shareholders is outrageous.

I compare it to Solitron and Gencor and I think these are better investments. GENC too is not very shareholder friendly, but it's not this bad. At some point, the Risk family might want to take RISKIA out; posibly ahead of an acquisition.
batbeer2
Batbeer2 premium member - 4 years ago
If they want to do some careless acquisition, they would n't have this large pile of cash in first place. So they are looking for a good fit.

I agree; they sure are patient and that is a good thing. I have some doubt they are using that patience in the best interest of minority shareholders though.
Geoff Gannon
Geoff Gannon - 4 years ago
Just to add to Batbeer's comments on other stocks that trade at a similar prices, like Gencor (GENC) and Solitron (SODI), each situation has its own little peculiarities.

For example, Solitron is cheaper relative to NCAV (or was a couple days ago). However, Solitron's business is not as good in terms of returns on operating assets. Risk earns very high returns on the assets actually employed in the business. That makes it unusual. Solitron earns decent returns over a full-cycle for a semiconductor company. But that's about it.

More importantly, they each have different reasons for dividend payments, stock buybacks, or lack thereof. As we all know (from Ravi's excellent article), Risk actually pays one annual dividend and buys back what stock it can find (which isn't much).

However, unlike Risk, Solitron is legally prohibited from paying a dividend - for now. The company went through an unusual bankruptcy 17 years ago which requires it to pay a portion of its earnings to creditors. At the rate things are going, Solitron may be out from under those obligations in a few years and free to pay out a dividend if it wants to.

So Solitron's cash hoard and stock price come from the long shadow of the agreement that brought it out of bankruptcy. While Risk's cash hoard and stock price comes from more than a decade of very large free cash flows (relative to assets) that the CEO just let build up.

Oddly though, Risk does pay a small dividend. The stock yields 3.78%.

I say odd, because even a dividend that small must mean an additional $350,000+ in taxes for Mr. Risk.

Disclosure: I own 11,000 shares of George Risk Industries (RSKIA).

Geoff Gannon
Geoff Gannon - 4 years ago
Sorry: meant to say the 17 cent a share dividend must mean an additional $75,000+ in taxes for Mr. Risk. Don't know what I was thinking.
rnagarajan
Rnagarajan - 4 years ago
Risk's salary is low at just $156K salary+bonus for the last fiscal year. He is the only employee earning over $100K according to the latest filing. So I assume he's paying the dividend to fund his personal expenses while benefiting from the lower tax rate on dividends. His take on the annual dividend is roughly $500K. If he took this as salary, he would owe an incremental 21.65% to the Feds due to income tax and medicare so he's saving around $108K/year in this manner.

I am not convinced that he would pay a dividend if the tax rate between dividends and income is equalized in the future, as it may be if Congress fails to take any action on taxes and simply lets the Bush tax cuts expire.

I'll have to look up GENC and SODI - never looked at them before.

Geoff Gannon
Geoff Gannon - 4 years ago
Ravi,

I don't know Mr. Risk. I've only read the 10-Ks and his past interviews with The Wall Street Transcript. However, my impression based on review of financials going back to 1997 (that's as far as EDGAR takes it), is that the CEO just never did anything with the free cash flow. It was his father's business. He's been there a long time. It's a small, simple business. It's hard to see how they could ever put that cash to work in the business. So they just let it pile up.

Will they ever do anything with it? It's hard to say. But even if it takes 10 years for them to do anything, if you add expected free cash flows to current cash and put a multiple on continuing business in 2020, you don't get an insanely low CAGR. The downside of having to hold this stock for a full 10 years and then seeing a distribution is like an 8% CAGR at worst.

Do I really think there's a chance I'll wait 10 years and still nothing will happen? No. They will distribute assets, buyout minority shareholders, or the stock will go up for some other combination of reasons during the next decade. The value gap is so big here, you can trade away a lot of time and still end up with a pretty decent downside.

Unless they buy something. That would be very bad. Especially since they have enough cash to buy a business much bigger than their own operations and thereby turn a good, narrow moat with a cash hoard into a mediocre, no moat business with no cash.

Regarding Solitron (SODI), you want to take into account the fact that they aren't paying taxes yet but will have to in the future when they get out from under the bankruptcy obligations and the tax losses expire. It's all covered in the 10-K. Also, CEO of Solitron has also done interviews with The Wall Street Transcript. He seems...taciturn.

Hester1
Hester1 - 4 years ago
"I compare it to Solitron and Gencor and I think these are better investments. GENC too is not very shareholder friendly, but it's not this bad. At some point, the Risk family might want to take RISKIA out; posibly ahead of an acquisition."Sodi looks similiar to RSKIA, but not Gencor. Yes, they both trade below NCAV, but the whole attraction to RSKIA is that you get a steady, profitable business for free. Gencor is hardly a steady profitable business. If you strip out interest/dividend income and fluctuations in working capital, their operating cash flow has been negative for as far as the eye can see.

ly motive. Maximising reported earnings is not an end but a means. If they intended to bolster the price of the shares they have better alternatives. These guys are not dumb ! aying out a dividend is costly, you pay taxes. Fiscal year ended: (000's ommitted)

2008 dividends paid: $829 interest/dividends recieved: $845

2009 dividends paid: $802 interest/dividends recieved: $768

2010 dividends paid: $785 interest/dividends recieved: $712

So basically they are just passing along the dividend/interest they recieve from investments on to shareholders. They aren't really paying any dividends from the core business's cash flow.

However, they are doing this in the most tax INEFFICIENT way possible. The interest they recieve is taxed (although muni bonds interest isn't) and then they take that interest and pay almost all that out as a dividend to shareholders, which is taxed yet again. If you distributed, future interest would only be taxed once. In addition, the company has a large uninsured cash balance at a bank, and a money manager manages a large portion of the investments. The shareholders no nothing about this manager. Distributing cash to shareholders would reduce these risks, and allow the shareholders to actually do what they want to do with the cash. And Ken would recieve the same dividend income to supplement his salary. It would also force the market to only focus on valuing the core business, so a huge deal of value would be realized. I doubt the market would put a negative value RSKIA's core business, as they are doing now.

It makes NO SENSE whatsoever, for all parties involved, not to distribute investments. These guys are either dumb or have alternate motives.

Geoff Gannon, why not give Ken Risk a call or email and discuss this? I would, but I don't own any shares and cannot make this a meaningful position due to liquidity, so its not worth my time.
batbeer2
Batbeer2 premium member - 4 years ago
Gencor is hardly a steady profitable business. If you strip out interest/dividend income and fluctuations in working capital, their operating cash flow has been negative for as far as the eye can see.

Fair enough, these are not all apples. Then again, I hate comparing only apples ;-)

I believe operating cash flow of GENC is understated due to the way they account for their investments; but yes, earnings are lumpier.

It makes NO SENSE whatsoever, for all parties involved, not to distribute investments. These guys are either dumb or have alternate motives.

I agree, I just don't think they are dumb.
Geoff Gannon
Geoff Gannon - 4 years ago
Geoff Gannon, why not give Ken Risk a call or email and discuss this? I would, but I don't own any shares and cannot make this a meaningful position due to liquidity, so its not worth my time.



Hester,

I guess I might. But I'm not sure I'm done buying forever. And I would never talk to management before I was done buying.

As for not making it a meaningful position due to lack of liquidity, it really depends how big your portfolio is, how you buy, and how long you are willing to be bidding for stock. George Risk is definitely less liquid than most stocks with this much float. I don't know the company's story decades back. But it kind of feels like this stock was distributed oddly at some point. Is it regionally concentrated or something? I've only seen this little liquidity in things like local banks that never sold their initial shares very far afield.

Having said that, it's not impossible to get shares. It's just impossible to know when and at what price you will get shares. It's a totally different experience trying to buy something like George Risk than it is trying to buy 99% of the stocks out there.

You can leave out good-till-canceled limit orders like a penny below the last trade and hope for something to go off eventually. Or, you can try placing very large bids near the ask. In these kinds of stocks, sellers will sometimes suddenly appear when they realize you are bidding for a big block, because they know they have no hope of unloading this kind of stock in a steady drip. When you bid for a big block, you kind of fill the role of a market maker for them. Because no one else is going to help them sell - say 10,000 shares in one trade.

Warren Buffett bought some things like this - in terms of liquidity - back in the very early partnership days. It can take months to build your desired position this way. And some times there are no trades for weeks. I understand why people don't want to go through this kind of buying, or lock themselves in. But it isn't as impossible as it looks when you just watch the quote staying the same on no volume day after day.

Generally, you get your position through just a couple trades. It's never a steady flow. You get a complete drought for weeks and then suddenly you get what you want. You have to wait for the guy on the other side to make up his mind, which isn't really necessary with most stocks.

hpmst3
Hpmst3 - 4 years ago
e
Geoff Gannon
Geoff Gannon - 4 years ago
Hugh,

Even easier than that: I was just talking things like Operating Income / Total Assets - Cash & Securities, Cash Flow From Operations divided by ditto, and Free Cash Flow divided by ditto.

Comparing George Risk to Solitron, there are two specific issues to think about, one is taxes and the other cash conversion. Solitron is untaxed for now. George Risk is not. Eventually, they will both be taxed. Also, Solitron's cash conversion is usually not as good. But it's a cyclical business, so sometimes the cash conversion is strong and other times it isn't. Usually, the changes to working capital are the culprit.

In this case, you don't even need to dig into those details to see the difference, Solitron is a low ROA business. George Risk is a high ROA business. The only issue obscuring that is Risk's investment portfolio and how that skews the balance sheet and net income.

Never look at net income. That's the headline number everyone cites in the media. But for the kind of companies value investors like Ben Graham and early Warren Buffett liked, net income is not a useful number. Either look at operating income or come at it from the cash flow side of things.

The exact approach isn't important. The overall idea is. Some people think you should keep a little of the cash as necessary for operations. Technically, yes, a business normally has a little cash on hand. But, really its easier to just level the playing field and remove cash and securities from every stock's balance sheet when you look at the returns on assets employed in the actual business.
hpmst3
Hpmst3 - 4 years ago
e
Hester1
Hester1 - 4 years ago
Geoff,

ROA doesn't really matter here. ROA, ROE, ROIC all only matter if the company is capital intensive and/or reinvesting heavily in their business. RSKIA and SODI do not posses either of those traits. Return on assets isn't relevant when there are never any new assets for there to be a return on.
batbeer2
Batbeer2 premium member - 4 years ago
In this case, you don't even need to dig into those details to see the difference, Solitron is a low ROA business. George Risk is a high ROA business.

Hmmm.... I'm a bit more optimistic about Solitrons business. I believe they keep a lot of inventory to smooth out their operations. They make two types of product. "Specials" are made to order. If business is slow in that department, they just keep working, producing their standard "commodities". These are the items they keep in stock.

The margins on the standard products are decent; but it's heavy on assets; you need a big inventory. On the "specials" the margins are indecent, also it's light on the assets. While they are busy making special orders, customers can still rely on their stock of standard (shelf) products.

This is not to say that it is better than George Risk.... just to say that Solitron is too good to be free.

I agree on the taxes, but if memory serves, the NOL will be good for at least another five years of operations. Another reason for them to accumulate cash. The interest earned is tax sheltered.

Geoff Gannon
Geoff Gannon - 4 years ago
Batbeer,

I agree Solitron (SODI) is too good a business to be free. Mostly because it is profitable over the whole cycle. It may have one down year here or there. But it's a profitable company.

However, Solitron's margins and returns on capital are much lower than at George Risk (RSKIA).

Hester,

I agree with you in principle.

However, ROA always matter insofar as it is an indicator of the kind of business the company is in. Is George Risk in an intensively competitive business that will turn cash flow negative for good in the future? Maybe. But the fact that the company says it is not a price leader and yet often has double-digit margins suggests there is some small moat here.

Also, ROA matters in these cases, because we are getting the operating assets for free - these stocks basically trade for just the cash. So, yes, what really matters is not the ROA itself, but the operating profit, free cash flow, etc. we expect those "free" inventories and receivables to produce.

In these two cases, Solitron and Risk, the important idea is that the assets other than cash seem to be worth something in operations rather than just in liquidation. In Solitron's case I think that number is not terribly higher in operations than in liquidation. That is no slight to Solitron, a lot of businesses in that industry do not return much above what they could be liquidated for. In Risk's case, I actually think assets aside from cash - like inventories and receivables - tend to return more inside the actual business of George Risk than they would if they were simply liquidated.

So, all I'm trying to do here is value the "freebie" we're getting in each case after we back out the cash. I think the Solitron "freebie" is real, but it's not much more than you can see on the balance sheet for yourself. The George Risk "freebie", the actual business assets, are really more valuable than carried on books. So, in both cases, we want to look past just NCAV and also think about the value of the business when separated into two buckets; bucket #1 cash and securities + bucket #2 expected long-term cash flows that come from returns on operating assets.
rnagarajan
Rnagarajan - 4 years ago
OK ... who here got irrationally exuberant with that 500 share trade @ 5.25 today? :-) Please tell me it wasn't someone who put in a market order ...
Hester1
Hester1 - 4 years ago


LOL. I am sure it was a market order.

On second thought, maybe Berkshire Hathaway is loading up.
Geoff Gannon
Geoff Gannon - 4 years ago
Might have been a market order in George Risk (RSKIA). I certainly hope it wasn't anywhere here. But I did notice more shares (like 2,500) on offer around that price. And the seller isn't masking the ask size. So it could be something else. But I doubt it. 500 shares is a really small stake to pay up for. It does sound like someone made a mistake and moved the price up on themselves with a market order.

Disclosure: I own 19,000 shares of George Risk (RSKIA)

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