Precision Tune Auto Care: A Microcap Opportunity
Precision Tune Auto Care is a small microcap stock that, as you may have guessed, operates and franchises auto care centers in the U.S. and abroad. At current prices, the stock offers an extremely favorable risk/reward based on a variety of metrics.
As per the Yahoo Finance company profile:
Precision Auto Care Inc. (PINK:PACI), through its subsidiaries, owns, operates, and franchises auto care service centers in the United States and internationally. The company’s auto care service centers provide automotive care services, and fast oil change and lube services. Its services also include the diagnosis, maintenance, and repair of ignition systems, fuel systems, computerized engine control systems, cooling systems, starting/charging systems, emissions control systems, engine drive train systems, electrical systems, air conditioning systems, oil and other fluid systems, and brake systems. In addition, Precision Auto Care provides various services, such as brake services and repair, cooling system service, fluid maintenance service, car repair, tune up, fleet services, and warning lights/diagnostic services; and involves in the sale of tires and offers tire-related services. As of June 30, 2011, it owned 26 Company Centers; and franchised 234 domestic centers and 80 international centers under the Precision Tune Auto Care brand name.
Notes on the Company Structure:
As of June 30, 2011, the company was comprised of 26 Company Centers, owned and operated by PTAC Operating Centers Inc. (POC), a Virginia corporation and subsidiary of the company. Precision Franchising LLC (PFL), a Virginia limited liability company and also a subsidiary of the company, was the franchisor for the 234 domestic Franchised Centers, and 80 international Franchised Centers. A third subsidiary of the company, Precision Tune Auto Care Inc., a Virginia corporation, manages the operations of these entities.
The company was originally founded in 1976. The next year, the company began implementing their franchise model. Under the present franchise model, the company’s standard franchise agreement requires payment of an initial franchise fee of $25,000 and a continuing royalty of 6.0% to 7.5% of weekly gross receipts. In addition, the franchisee is required to contribute to or expend up to 9% of weekly gross receipts on advertising.
In some areas of the United States, the company also employs an area-development system to facilitate expansion of the system. PFL grants Area Developers the right and obligation to develop centers within specific geographic regions for stated periods of time. The area developer typically receives up to one-half of the initial franchise fee, one-half of the subsequent royalty revenues and one-half of franchise renewal and transfer fees. After execution of a franchise agreement, the area developer performs many of PFL’s franchise support obligations. As of June 30, 2011, seven area developers had an ownership interest in approximately 27% of the total number of domestic franchised centers.
As U.S. franchise growth has slowed in the last five years, the benefits of being an area developer have greatly diminished (due to the lack of collection of the one-half initial franchise fees). Therefore, PFL has aggressively enforced its agreements with area developers, and has either terminated or repurchased rights to areas that were previously developed and supported by area developers. This slowing in franchise growth not only caused changes in the area developer arrangements within the company, but also spurred management to begin to buy back stores from franchisees. During fiscal year 2008, the company began operating five stores, while adding 3, 8 and 10 company-operated stores during fiscal years 2009, 2010 and 2011, respectively. As we will see, the initiation of company-operated stores, along with the area developer agreement repurchases, have had a significant impact on the direction of the company. The market seems to currently be discounting the positive long-term benefits that these moves will provide.
Move to the Pink Sheets:
One reason for the company’s current lack of investor interest could be due to its listing on the pink sheets. While many companies that delist have some hair on them, Precision Tune did so on their own accord, and for reasons that would seem to be in the best interest of a value investor. In 2008, in an effort to save costs, the company voluntarily delisted, and thereby avoided the continuing fiduciary requirements of filing periodic reports with the SEC. Fortunately, this delisting has not materially affected the company’s financial reporting standards. They still issue comprehensive quarterly and reports, as well as press releases regarding any relevant company events. Furthermore, their financials are fully audited by Yount, Hyde, and Barbour, P.C, a respected accounting firm in the Virginia area.
Before discussing specific valuations, I think that we first need to discuss one of the significant events in the company’s recent history, which originally initiated my interest in the company. Due to Precision Tune’s historically conservative balance sheet, the company was recently able to repurchase 22.2% of the company’s outstanding common shares, as well as about 40% of their outstanding preferred shares. In one day. At a substantial discount to book value (albeit not tangible book value). Here is an excerpt from the company’s press release:
LEESBURG, VA – January 12, 2011, Precision Auto Care, Inc. (Pink OTC Markets, Inc: PACI.PK) 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. Desarrollo, which initiated the sale, sold its common shares for an aggregate purchase price of $2,579,902.80 ($0.40 per common share). The Company also redeemed 4,507 Series A Cumulative Redeemable Preferred stock held by Desarrollo for $46,692.52 ($10.36 per preferred share).
Although the company does not have an official stock repurchase program in place, this repurchase was quite accretive to shareholders, and was made possible by the company’s conservative nature. At the time of the purchase in January, the company had approximately $3.5 million in cash on the balance sheet, with virtually no debt and only $1.9 million in liabilities, against over $20.3 million in equity. So, this repurchase did not really put any unnecessary financial strain on the company. Despite the purchase at a discount to book value, the $0.40 per share purchase price represented a significant premium to the market price for common shares at the time. CFO Mark Francis has noted that, while the shares were bought at a premium, negotiations did take place and the final purchase price was less than the asking price.
Fundamentals and Valuing the Company:
At the current market price of $0.247 per share, Precision Tune shares appear to be significantly undervalued based on a variety of metrics. Let’s take a look.
The book value of the company’s shares, as of June 30, 2011, was $18,061,663 which equates to a book value of $0.795 per share. This means that the stock current trades at 28% of book value. Sounds cheap, what’s the catch, you say? Unfortunately, Precision Tune carries a significant amount of goodwill on its balance sheet, totaling $10.8 million as of June 30, due to its repurchases of franchise locations to operate as company stores. According to the company, goodwill is evaluated for impairment at least annually. The company engages a valuation expert to assist in estimating the fair value of operations utilizing a discounted future cash flow approach that estimates revenue, driven by assumed market growth rates and appropriate discount rates. Based upon the current year analysis, management concluded that the $10.8 million carrying value of goodwill at June 30, 2010, was not impaired.
Even if we ignore the goodwill, which the market seems to be doing anyway, we still get a book value of $0.318 per share, meaning the company is trading at roughly 78% of tangible book. If the company were to trade at its tangible book value (ignoring all goodwill), we would be looking at a gain of almost 29%.
As the company has bought back stores to operate on their own, we can see that revenues have grown at an average five-year growth rate of about 18%. Unfortunately, much of this revenue growth comes from the lower margin company-operated stores. As the number of company-operated stores continues to grow, however, the company is confident that they will be able to achieve some level of margin expansion due to the increased scale of their company-operated stores.
In valuing the company on an EV/EBIT basis, we can see that performance appears to have been quite inconsistent over the past five years:
Year: EBIT (in thousands)
This gives the company a 2011 EV/EBIT multiple of 5.34x, and a five-year average EV/EBIT multiple of 7.57x (based on closing price on October 28). In looking a little bit deeper, however, we see that the company actually performed better than it first appears in the down years of 2009 and 2011. This is due to the manner in which the repurchase of some of the previously mentioned Area Developer agreements were accounted for. As per the 2009 end-of-year press release:
The Company's President and CEO, Robert Falconi, stated, “I am pleased with the Company’s performance this past year. Although the bottom line is negative for the first time in seven years,
the reason for the loss is not because the Company’s day-to-day franchise operations were not
profitable. It is due to the fact that the Company spent approximately $813,000 to purchase back
the rights to the Austin, Las Vegas and Baltimore markets from Area Developers within the
PTAC system who were ready to relinquish their role as Area Developers. Although this buy back is
expensed in the year that the buyback is executed, the fact is that the Company should recoup its
investment in 2 ½ -3 ½ years and will continue earning money on the investment for many years
beyond that. The bottom line is that those purchases make enormous long-term sense for the
These repurchases were included as a franchise support direct cost on the income statement. The same type of repurchase occurred in 2011, when the company repurchased the area developer rights to the Seattle market for more than $200,000. As Falconi noted in the 2011 year-end press release:
“The results for the 4th quarter are skewed downward because the company purchased the rights back from the Seattle market which was an unusual, one-time event. Over the long haul, this will be a very good use of capital despite the short term impact on P&L.”
In a recent email correspondence, CFO Mark Francis reiterated that these area developer repurchases are generating a 25-33% annual ROI, and the same is expected for the 2011 Seattle repurchase. If we were to consider these Area Developer repurchases as a type of capital expenditure, as opposed to a direct cost, we would see that the company operations have been a lot more stable than it first appears. Our five-year EBIT would look something like this:
Year: EBIT: (in thousands)
2011 1,200 (conservative estimate)
Using these adjusted figures, we would get a 2011 EV/EBIT of 4.45x, and a five-year average EV/EBIT of 5.88x. Taking the Area Developer repurchases into consideration, the stock starts to look pretty cheap. It is also important to keep in mind that the company currently has a lot more earning assets than it did five years ago. The company currently has 26 company-operated stores, vs. 0 in 2007, while the number of franchisees contributing revenue has remained relatively stable. Therefore, it is unlikely that EBIT will revert towards the 2007-2009 figures.
Free Cash Flows:
Precision Tune has proven adept at producing substantial free cash flows over the past five years. When determining company free cash flows, I felt it prudent to exclude the cash used to repurchase company-owned stores as capital expenditures. Rather, for our purposes, we will use CFO – additions to PP&E. Here are the adjusted free cash flow figures for the past five years:
As we can see, the company has demonstrated the ability to produce significant free cash flows (aside from 2009, which was discussed above). Although 2010’s $1 million in free cash flow does not sound all that significant, we need to consider that the company’s market cap sits at $5.61 million, which gives the company a very respectable 2010 free cash flow yield of about 19%, based on current prices. What happened in 2011, you ask? Well, the company spent nearly $1.2 million updating and renovating its company-operated stores. The company made a significant investment in stores that were purchased prior to fiscal year 2011, along with stores that were purchased in fiscal 2011. By improving the interior and exterior of the stores and making sure that they were completely outfitted with the proper equipment, the company realized significant increases in same store sales. As the 2011 10-K notes:
The same store sales increased by approximately $1.6 million, or 24.7%, for the sixteen company-operated stores during the year ended June 30, 2011.
Obviously, this additional investment in PP&E is already having a positive effect on sales. In communications with CFO Mark Francis, Mr. Francis noted that the company does not anticipate an equivalent level of investment in fiscal 2012, meaning that the company should once again generate significant amounts of free cash flow going forward.
Trailing P/E and Forward P/E:
As we pointed out at the start, one of the events that make this investment so intriguing was the share repurchase earlier this year. This repurchase will prove to be quite accretive to EPS in the coming year. For fiscal 2011, EPS were calculated based on net income of $570,000, divided by the average number of diluted shares outstanding throughout the year (about 26 million), giving the company EPS of $0.022. However, if we use the current number of shares outstanding, EPS rises to $0.025, giving the company a trailing P/E of just under 10.
When we look at the P/E going forward, things look a lot more exciting. Even if we assume zero growth in earnings, the company should once again earn about $570,000 (assuming that increased depreciation and amortization expenses are offset by the increasing same store sales and operational synergies with the increased number of company-owned stores). If we then add back the one-time $200,000 franchise support cost from repurchasing the Seattle area developer agreement in fiscal 2011, we should expect to see net income of $770,000 (this assumes zero value added from the area developer agreement repurchase, despite the fact that management has already guided for a 25-33% annual ROI on that $200,000). Also, the company will not be responsible for hosting the bi-annual franchisee conference in fiscal 2012, which cost the company about $130,000 in 2011. Adding this $130,000 back to our fiscal 2011 net income, we arrive at a conservative FY´12 expected net income of about $785,000 ($570K + $200K + $130K – 35% income tax rate on the additional $330K of assumed income). This would give us fiscal 2012 EPS of about $0.035, which gives the stock a forward P/E of 7. This estimate also assumes zero additional income from having a full year of operations from their (newly renovated) fiscal 2011 company-operated store purchases. Not too shabby for a company trading at 78% of tangible book value.
Management currently has significant skin in the game here, as current Chairman of the Board Louis Brown and CEO Robert Falconi collectively own over 22% of the shares outstanding, while all directors and executives currently own about 27% of all shares. Both Brown and Falconi have been with Precision Tune for over 10 years, and are proving adept at continuing to grow the top and bottom line as traditional U.S. growth opportunities have slowed during the recession. Judging by the 2011 share repurchase, creating value for shareholders is a priority for them. Another interesting note about management is that 58% of the shares outstanding are currently voted and/or beneficially owned by Avenir Corporation, which is a Washington D.C.-based investment firm. According to their website:
We are long-term, value oriented investors and seek to invest in good businesses with excellent management selling at a significant discount to our appraisal of intrinsic value. We do our own research and conduct a thorough “bottom-up” analysis of each potential holding. We strive to remain disciplined on price, and invest with a margin of safety in order to protect against unforeseen outcomes. We only purchase securities for clients that we would own ourselves. In short, “we eat our own cooking.”
We are patient, long-term investors and work very hard to achieve an attractive return without taking unnecessary risk. In other words, we seek to invest with a margin of safety in order to protect ourselves against what we do not know. Derived from the philosophy of Benjamin Graham, our idea of a good investment is simply to buy a dollar of value for fifty cents.
Avenir Corp. President Peter Keefe sits on the board of Precision Tune (without collecting a fee for his services, I might add), adding an additional level of comfort that a Benjamin Graham-style investor is looking out for shareholders from the inside.
1) The company does operate in a competitive environment, and national franchising growth opportunities have been hard to come by. While the company has been growing internationally in recent years, there is no guarantee that franchising growth opportunities in the U.S. will pick up anytime soon.
2) In 2011, the top three executives of the company (chairman, CEO and legal counsel) earned a total of $903,000, which seems high for a company trading at a market cap of $5.61 million. Executive salaries were determined by the independent compensation committee according to the following:
Compensation Philosophy: The Company's philosophy with respect to executive compensation is based on the principle that the compensation of its executive officers should be competitive with compensation of senior executives at comparable companies, and that a meaningful portion of the compensation received should be closely tied to the performance of the Company and, in certain instances, to the achievement of individual goals.
Salaries for these three executives have not increased significantly over the past three years, although CEO Falconi did take home a $33,000 bonus this past year (included in the $903,000 calculation). Despite this, they did not issue stock options in 2011, so shareholders are not currently facing further dilution from new options.
3) There is also no guarantee that the company will be able to expand margins on their company-operated stores as expected, meaning that the company’s current growth will come from this lower margin source. While profit margins are fairly unimpressive, the company’s overall revenue growth should offer investors additional profit growth going forward.
4) Furthermore, this is an extremely illiquid pink sheets stock that does not provide larger investors with ample opportunities to enter and exit a trade.
Considering the fact that the average age of a vehicle in the U.S. is the highest that it has been in 16 years (at 10.2 years old), a company such as Precision Tune should stand to benefit from the increased maintenance required to keep these vehicles on the road. Precision Tune Auto Care stock certainly appears to be undervalued and unloved by investors. While it may be fair to apply some discount to a stock that trades on the pink sheets, Precision Tune’s discount is certainly unwarranted considering its recent operating performance and potential for continued growth through its company-operated stores. Even if the stock were to trade at a conservative P/E ratio of 10 going forward, that would value the stock at $0.35, giving us a one-year expected return of 42% (which is entirely reasonable, considering the stock was trading at these levels as recently as this past July).
Disclosure: Long PACI.PK