Precision Auto Care: Size Matters

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Aug 23, 2011
Precision Auto Care (PACI) is a franchisor and operator of auto repair centers, with 262 locations in the United States and 79 international locations. Many investors are scared of the pink sheets, which means that these companies often provide great and overlooked value opportunities (like Conrad Industries — one of the best value opportunities I have found yet). That said, it is important to be cautious with these companies, since they are subject to less oversight.


When dealing with companies that has deregistered, I look to see why this occurred. PACI voluntarily deregistered in February 2008 and provided this rationale:
The Company’s Board of Directors decided to take this action because it believes that the burdens associated with operating as a registered public company currently outweigh any advantage to PACI and its stockholders. Among the factors that the Board considered were the costs of preparing and filing periodic reports with the SEC; the elimination of the substantial legal, audit and other costs associated with being a reporting company including the substantial increase in costs associated with the requirements of the Sarbanes-Oxley Act of 2002 and the related SEC rules; the limited nature and extent of current trade in the Company’s common stock; and the lack of analysis’ coverage and minimal liquidity for the Company’s common stock.
I have come across this reasoning when looking at many companies in the pink sheets. The financial costs and time burden of remaining a registered public company are outweighed by the benefits for many small companies with low demands for raising capital (especially a company like PACI which has strong free cash flows, as we’ll see).


Getting back to the company’s fundamentals, it is worth noting that the company trades (as of August 3) for $6.09 million, but has a book value of $17.97 million. Unfortunately, $10.64 million of this is goodwill which resulted in part from the company’s acquisition of company-owned locations. Stripping this out, the tangible book value is $7.33 million, or about 20% above the current market cap.


There are good reasons why some companies trade below tangible book value. The main reason is that the assets comprising book value are generating sub-par (possibly negative) returns. Let’s look at PACI’s returns:


PACI-returns-1024x736.jpgPrecision Auto Care - Returns, 2003 - 3Q 2011


These returns have been fairly unimpressive throughout the recession, though performance looks like it is reverting toward its longer-term mean (a good thing in this case).


PACI-margins-1024x741.jpgPrecision Auto Care - Margins, 2002 - 3Q 2011


This chart shows that the company’s margins have been unstable. This is somewhat to be expected for such a small company, where a $50,000 one-time charge can swing margins by 7%. The growth in revenue is a positive, in that the company isn’t in decline (another reason why a company might trade below book).


PACI-free-cash-flows-1024x741.jpgPrecision Auto Care - Free Cash Flows, 2002 - 3Q 2011


I did not include as capital expenditures the company’s purchase of company-owned stores. Instead, I used CFO – additions to PP&E, using additions to PP&E as a proxy for maintenance capital expenditures. I think this is somewhat more conservative method of estimating, since maintenance capex should be less than actual capex in the long run (especially for a growing company). (Learn more about maintenance capex (and different ways of calculating it) in Bruce Greenwald’s "Value Investing: From Graham to Buffett and Beyond").


The figures in the above chart need to be put in context. At first, $1 million in free cash flow doesn’t seem like very much. But keep in mind that the company has a market cap of $6.09 million! In fact, PACI has generated net free cash flow over the last five years of $3.5 million, or more than half its market cap (and over eight years, 100% of its current market cap has been generated in free cash flow).


So what is the company doing with its free cash flow? It initially reduced debt to an extremely conservative level, then split the money between expanding its business and building an increasing cash balance… until this last quarter.


PACI-capital-structure-1024x737.jpgPrecision Auto Care - Capital Structure, 2002 - 3Q 2011


As you can see, the company’s cash balance dropped substantially this last quarter. Why? A massive share repurchase. From this press release:
[PACI] announced it completed the repurchase of 6,449,757 shares of its common stock from Desarrollo Integrado, S.A. de C.V. (Desarrollo), one of the company’s largest shareholders.


The Company’s President and CEO, Robert Falconi, stated, “Desarrollo came to us with a unique opportunity at the right time. The Company had the financial resources to purchase these shares in a single cash transaction. The repurchased shares will be cancelled and retired.”


Lou Brown, Chairman of PACI, said, “While the Company has not established a formal share repurchase program, the Board of Directors was pleased Desarrollo offered the Company this opportunity to purchase a large block of shares in one, simple transaction.
6.45 million shares doesn’t sound like much, until you realize that it represented 22.2% of shares outstanding, in a single transaction, and at a large discount to book value (though, not tangible book value).


Here’s something interesting: Desarrollo owns these 6.45 million shares evidently without disclosing this to the company prior to the transaction. On an annual basis, the company would state all known beneficial shareholders, but Desarrollo was never mentioned (I am guessing because SC 13 filings aren’t completed once a company delists, and so the company was unaware of Desarrollo). This is pure speculation, but the purchase of Desarrollo’s shares could have been greenmail to make an activist go away. The purchase price ($0.40 per share) on Jan. 12, 2011, despite being far below book value, was actually a substantial premium to the company’s traded share price from as far back as January 2008! Why the premium purchase price? Your guess is as good as mine.


While on the topic of shares, it is worth noting that the chairman and president/CEO jointly own approximately 22.5% of the company, which should translate to an alignment of interests with other shareholders (however, this is mitigated by the fact that the value of these holdings is quite small).


In valuing the company, I made a number of assumptions relating to long-term margins and revenues. Given the size of the company, it is important to note that small events have disproportionately large effects on the company’s operations, which makes valuations that much less reliable in the short term. For long-term investors, there does appear to be a sizable margin of safety.


However, it is unclear whether the margin of safety is the market’s way of compensating for perceived riskiness of the fact that the company trades in the pink sheets. To that, I point to the company’s consistent filings and transparent disclosures (they go so far as to disclose different slip-and-fall lawsuits which are almost certainly inconsequential!).


To summarize, PACI operates in a stable industry unlikely to be disrupted by technological innovation. It has low capital demands (a characteristic of most franchise models) which translates to strong free cash flows that the company has used effectively in the past. The company has a conservative capital structure and significant opportunities for future growth throughout the United States and abroad.


What do you think of Precision Auto Care?


Author Disclosure: None