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Ben Graham Net-Net Newsletter: TSR (TSRI) One Year Later

April 09, 2012 | About:
Geoff Gannon

Geoff Gannon

407 followers
Last month, I wrote the first of what will be a regular series of monthly articles on net-nets owned by the Ben Graham: Net-Net Newsletter’s model portfolio. Just as a reminder, the Ben Graham: Net-Net Newsletter is a monthly newsletter available to GuruFocus Premium Members.

I write the newsletter. I pick the net-nets in the newsletter’s model portfolio. In fact, the model portfolio is actually one of my brokerage accounts. It uses a small amount of money – a little over $9,100 as I write this – to build a real net-net portfolio. I add $650 a month to the account. And that money is used to buy the latest monthly pick.

For example, the April issue of the Ben Graham: Net-Net Newsletter came out on Friday. And I put in a buy order for the stock picked in that issue this morning.

We’ve been doing this for a little over a year now. The Ben Graham: Net-Net Newsletter’s model portfolio now has 13 net-nets in it. Last month, we talked about the first-ever net-net bought by the model portfolio. That stock was Gencor (GENC).

We bought Gencor on March 7, 2011. And I wrote about it on Feb. 29, 2012. This is the pattern we’ll be following. I’ll write about the stock the newsletter bought 12 months earlier. So, you’re kind of getting a free look at the newsletter’s stock picks a full one year later.

This month we’ll be talking about TSR (TSRI). Let’s start with when the Ben Graham: Net-Net Newsletter’s model portfolio bought TSR.

The Ben Graham: Net-Net Newsletter bought 123 shares of TSRI at $5.09 a share on April 4, 2011. We also paid a $7 broker fee. So, the newsletter’s total cost was $5.15 a share. TSR opened today at $4.59 a share. So, the stock is down 11% since we bought it. That’s a one-year loss of 11%. During that same time, the S&P 500 rose about 4% in price (and paid some dividends).

So, both the absolute and relative performance of TSR has been poor.

Original Idea

Before we look at whether the Ben Graham: Net-Net Newsletter should keep its shares of TSR for another year, let’s talk about why we bought TSR in the first place.

This is what I wrote about TSR back on April 1, 2011 (remember, the Ben Graham: Net-Net Newsletter comes out the Friday before the model portfolio buys its shares):

TSR (TSRI) isn’t a great business. But it is a safe, cheap stock. TSR sells for a 21% discount to its book value. If that book value was made up of property and equipment that wouldn’t mean much. But TSR’s book value is made up of two super liquid assets: cash and receivables.

Receivables are considered a quick asset, because they can quickly be converted into cash at close to their stated book value. Receivables are generally pretty safe. And TSR’s receivables are definitely safe. The company’s clients are Fortune 1000 companies like McGraw-Hill.

The stock last traded at $4.99. And TSR has $3.65 in cash. So, you’re paying $1.34 a share for the ongoing business. That $1.34 is completely covered by TSR’s receivables. But, receivables—unlike cash—are invested assets.

So, TSR isn’t quite as cheap as Gencor. Gencor was literally a free business. TSR is just a nearly free business. You are taking very little risk when you buy TSR, because the purchase price is easily covered by the excess of cash and receivables over total liabilities.

That wouldn’t be enough protection in a money losing business. But TSR has been profitable in each of the last 10 years. And TSR’s costs can easily be adjusted to match lower sales.

TSR provides computer programmers to big American companies. It’s not a good business. A lot of these companies are now looking to India for the same service. But because TSR’s costs are mostly just what it has to pay its programmers, the company is unlikely to lose buckets of money in the future.

TSR is a company with liquid assets and adjustable costs. Ben Graham would buy TSR because buying TSR means almost getting a historically profitable business for free.

I also presented – very Ben Franklin-like – a series of pros and cons regarding an investment in TSR. Remember, this was written in April 2011:

Pros:

· $6.15 a share in net quick assets. $3.65 in cash. $4.16 in receivables. And just $1.66 in total liabilities.

· No losses in the last 10 years.

· 10 straight years of positive free cash flow.

· Easy to cut costs in line with falling sales.

· Paid dividends from 2004-2009.

· Stock outperformed S&P 500 over last 10 and 15 years. Returned 11% a year since 1996.

· No history of value destruction. Business value—and stock price—has grown over the long-term.

· Financed entirely with retained earnings. Market price is about 50% less than total retained earnings.

· Most net-nets have history of substantial losses and little/no free cash flow. TSR has a solid cash flow history.

· All the year over year numbers are improving. Business is rebounding from the depths of the Great Recession.

· Company stayed profitable even in the very bad economy we’ve seen over the last 2 years.

· Almost zero need for any capital expenditures. The most asset light business you’ll ever find.

Cons:

· Controlled company. CEO owns 45%.

· Will probably go cash flow negative this year as rebound from Great Recession will cause receivables to build up.

· Stopped paying dividends.

· Doesn’t buy back much stock at all. Has the authority, but hasn’t really used it since the stock market crash.

· Competitive position is getting worse.

· Clients have switched to using vendor managers who hire outside companies like TSR mostly on the basis of cost.

· Customer relationships are undermined by this middleman. So are profit margins. It’s a permanent, irreversible trend.

· A lot of TSR’s business is tied to mainframes. These will become obsolete.

· Customers want to outsource their programming to India. TSR’s offices are in New York and New Jersey — not India.

· Industry is in permanent decline.

Management

Personally, I do not find the controlled company part to be much of a con. But most investors do. So I included it there. Investors see controlled companies as investments that lack a catalyst. That may be true. Although, even control owners do sometimes sell their companies. When they do, issues like control and lack of liquidity disappear. And shareholders are paid according to the economic value of the business to a 100% buyer.

Could TSR be sold? The company is controlled by Joseph Hughes. He is the CEO and chairman. He owns 46% of the company. Hughes founded TSR in 1969. He is now 80 years old.

I have no idea if he would ever sell the company.

Top executives at TSR now make considerably more in salary than the company reports in earnings. Christopher Hughes has a base salary of $300,000 per year. Joseph Hughes has a base salary of $500,000 a year. And John Sharkey has a base salary of $200,000 a year. So, you have three executives getting $1 million in salary versus operating income of $482,000 in 2011, $317,000 in 2010 and $998,000 in 2009. You have to go back to 2007 and 2008 – when TSR had operating income of around $2 million a year – to find a time when the company was earning comfortably more than it was paying its top executives.

Does high pay relative to net income discourage a company’s management from selling the company?

Probably. The capitalized value of $482,000 in pre-tax income is less impressive when you realize the CEO is already making $500,000 year by not selling his company. On the other hand, these controlled companies almost always have managers who benefit much more on a purely pecuniary basis from a sale of the company than is true at most large, professionally managed companies. After all, even in this high-pay/low-net income situation, the CEO owns 46% of the company – and would obviously receive millions of dollars in cash if he ever chose to sell the company.

Is the CEO’s pay too high? Possibly. I know of similarly controlled companies – the founding family owns about 50% of shares, has multiple family members in top positions, etc. – where the CEO makes well under $200,000 a year despite operating income of over $2 million a year.

So, top executives can be paid more than 100% of operating income. And they can be paid less than 10% of operating income. You’ll come across both extremes when looking at small, controlled companies. Part of the issue is obviously the stickiness of salaries versus the variability of income. A lot of times when you see highly paid CEOs at low-earning companies – the companies were once earning a lot more and the CEO’s pay was set at a high level back then.

What are the CEOs of companies like this usually paid?

It varies a lot. But somewhere between $200,000 and $300,000 is not uncommon. Half a million dollars is pretty unusual for a controlled company this small. Generally, the CEO’s pay at a (small) controlled company tends to be set by how much the most senior non-family member is getting paid. For this kind of company, that will usually be about $200,000 and the guy making that $200,000 will very likely be the CFO.

That is almost exactly the situation here. The “Vice President, Finance” does make $200,000 a year. He’s been with the company for about 22 years. That part of the situation is very similar to what you find at most controlled companies like this. The only odd part is the big gap – $500,000 versus $200,000 – between the CEO and this vice president. Unlike at big, professionally managed public companies it is fairly common for the gap between such a vice president’s pay and the CEO’s pay to be very small. In fact, the CEO may be paid just a token amount above the most senior non-family member. So, if the going price of a non-family top executive at a company like this is about $200,000 (which it is) the CEO might make as little as $225,000 or $250,000.

That’s not the case here. Which may be concerning. I’m sure it’s annoying for shareholders who can see that the difference between the CEO’s pay of $500,000 a year and the $200,000 paid to the top finance guy is more than the entire company reported in net income last year.

Today’s Balance Sheet

However...

The Ben Graham: Net-Net Newsletter didn’t buy TSR for the management team. We bought it for the balance sheet. So, what does TSRI’s balance sheet look like today?

· Cash: $3.93

· Receivables: $4.58

· Other Current Assets: $0.10

· Non-Current Assets: $0.06

· Liabilities: $2.31

Like a year ago, the balance sheet is basically just cash and receivables on the asset side. TSR’s net cash value – cash minus total liabilities – is $1.63 a share. The company’s net current asset value is $6.30 a share. And its book value is $6.36 a share.

What matters here is the $6.30 a share in net current asset value. This still compares favorably to the company’s stock price of $4.59 a share. In fact, the company’s net current assets exceed its stock price by about 37%.

Last year’s net income was still positive. And TSR had $184,000 in operating income over the last six months. That’s down 50% from the same period a year ago. And it reinforces the constant decline in this company’s business.

The major risk here is obsolescence. This is a dying business. The founder started this company in 1969 after working at IBM. IBM has changed. It is no longer in a dying business. TSR still is.

As expected, free cash flow turned negative this past year. Changes in working capital caused cash flow from operations to drop below zero.

Overall, TSR is still a marginally profitable company trading for less than its net current asset value. TSR’s net current assets are all quick assets – cash and receivables. The company has no inventory.

If the company stays on its current path it will continue to decline, start losing money and eventually end up bankrupt.

Will the company stay on its current path?

That is always the question with net-nets.

There is enough value in TSR to more than cover the stock price simply by liquidating the business. Usually, net-nets don’t liquidate. Something else happens. They go under. Or they get bought out.

Capital Allocation

TSR’s capital allocation hasn’t been horrendous. They used to pay a dividend. They’ve continued to buy back stock. Not enough. They haven’t made any special effort in that area. But they keep cutting the share count over time.

Also, they haven’t added assets over the last decade. In fact, they’ve cut total assets by about 4% a year. This is something to watch. Whenever a bad business is willing to invest less in itself – it’s something shareholders should pay attention to. Most companies will refuse to reduce reinvestment in the business below zero no matter how bad things get.

But TSR has actually cut its total assets over time. They’ve shrunk the balance sheet.

This was achieved in part through dividends they paid over a period of about six years in the back half of last decade. TSR has stopped paying these dividends. They hardly earn anything today, so it’s not like they will be increasing their assets by not paying dividends.

This raises the possibility that TSR will produce really awful returns on capital, not pay out any capital and then start losing money fairly soon.

How likely is this?

It’s a very real possibility. Just look at TSR’s 10-year record. Pay special attention to revenue, EBITDA and free cash flow. It’s an ugly trend.

There’s a huge risk this business won’t last.

But it’s a risk at most net-nets. TSR’s balance sheet still qualifies the stock as a net-net. NCAV is much higher than the current stock price of $4.59 a share. If the stock just rose to its net current asset value, investors who buy the stock today would have a return of close to 40%.

Obviously, we’ll keep TSR for another year.

Right now, the Ben Graham: Net-Net Newsletter is down 11% on its investment in TSR. We’ll check-in again with TSR in April 2013.

Read Geoff’s Other Articles

Ask Geoff a Question about TSR(TSRI)

Check out the Buffett/Munger: Bargain Newsletter

Check out the Ben Graham: Net-Net Newsletter

About the author:

Geoff Gannon
Geoff Gannon


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