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George Risk Industries: A Potential Bargain With Limited Downside Risk

January 21, 2010 | About:
In a recent lecture on value investing, Columbia Business School Professor Bruce Greenwald perfectly captured the essence of what value investors are looking for in the following quote:
“You are looking for things that are ugly, cheap, boring, out of fashion, small and obscure, or otherwise on the other side of the existing finance industry mania. If it’s on the recommended list of one of the big retail brokerages, my advice to you is to watch out.”
Few publicly traded companies are more obscure thanGeorge Risk Industries, a small Nebraska manufacturer of security alarm products. With a market capitalization of $21 million and very low trading volume, the company is far too small to attract attention on Wall Street.

Background

George Risk designs, manufactures, and sells a variety of products with nearly 90% of revenue in the last fiscal year coming from security alarm related products. While the company claims to complete well based on price, product design, and quality, George Risk has also built competitive advantages by specializing in small custom orders that larger competitors often decline. The security products range from burglar alarms, pool alarms, and advanced sensors to detect incursions in unusual places such as skylights.

George Risk has been solidly profitable over the past decade although business has slowed considerably since demand for the company’s products are highly correlated to activity in residential construction. The fact that the company has managed to remain profitable in this environment is a positive sign and an indication of good management, a competitive moat, or a combination of these factors.

Management

The company was founded by George Risk and has been run by President and CEO Ken Risk for the past two decades since the death of his father in 1989. Mr. Risk owns a majority interest in the company with 56.8% of shares outstanding. The presence of a CEO with a controlling interest in a company is often a mixed bag. While minority shareholders have limited influence, the CEO’s incentives are theoretically aligned with maximizing shareholder wealth (of course, provided that he does not pay himself unreasonable compensation). In the case of George Risk, management appears to have reasonable policies on executive compensation and non executive Directors were only paid $150 each in the last fiscal year. However, allocation of free cash flow has been questionable as we discuss below.

Classic Graham Situation

From a valuation standpoint, George Risk Industries is a classic Graham net current asset value situation with NCAV (current assets minus all liabilities) of $4.93 per share as of 10/31/2009 compared to a current market quote of $4.25. What makes the company particularly interesting is the fact that management has chosen to retain a significant portion of earnings over the past decade and invest the proceeds in marketable securities. As of 10/31/2009, the company had $4.28/share of cash and marketable securities on the balance sheet. Investments and securities accounted for $19.1 million as of October 31.

Excess Cash and Investments

In order to properly value George Risk, it is necessary to determine how much excess capital is on the balance sheet. With a current ratio of 38.6 and no long term debt, the company is significantly overcapitalized. A current ratio of 2 or more is normally considered adequate for an industrial business. However, taking a conservative approach would make sense in light of current economic conditions in the housing industry. Let us assume that George Risk requires a current ratio of 10 to safely navigate the recession. This would imply the presence of approximately $19 million of excess investments and securities which represents $3.73/share of value.

Valuation of Business

George Risk has a strong operating record over the past decade. Prior to the recession, operating margins averaged close to 25%. Earnings per share averaged $0.43 per share for the ten year period ending on April 30, 2008 (which in fact could be an understated indication of the business earning power due to cumulative losses in investments that have depressed net income). Since the recession began, sales have declined significantly and margins have been compressed. Earnings per share came in at $0.10 for fiscal 2009 (ending 4/30/2009) and $0.09 for the first half of fiscal 2010 (ending 10/31/2009). The company has remained profitable and is still generating free cash flow.

While the quote on George Risk shares has varied quite a bit over the past decade, it was not unusual for the market to assign a price-earnings ratio of 10 or more prior to the recession. This type of valuation does not seem unreasonable given the strong track record of the company and healthy profit margins. Assuming that George Risk can earn $0.30 by the 2012 to 2014 time frame, the value of the business should be in the neighborhood of $3.00 per share. Discounting a $3.00 in 2012 to today’s present value at approximately 10% would result in a business valuation of around $2.50.

Intrinsic Value = Excess Cash & Investments + Valuation of Business

The combination of the excess cash and marketable securities on the balance sheet, which we have estimated at $3.73 per share, plus the valuation of the ongoing business of $2.50 results in an intrinsic value estimate of approximately $6.25 compared to today’s market quotation of $4.25. This represents a potential upside of close to 50 percent. The stock currently yields 4 percent which should provide some income as well.

Potential Risks

There are a number of potential risks that could reduce the upside potential of an investment in George Risk Industries:

  1. The company is majority controlled by CEO Ken Risk and there is no indication that the company plans to distribute the excess cash and marketable securities or to change their long standing policy of building up a portfolio of marketable securities far in excess of requirements to support the business.
  2. The investments in marketable securities have failed to produce value for shareholders over the past decade. The company has delegated responsibility for management of the portfolio to an outside manager who has the ability to make trading decisions. It appears that there has been quite a bit of turnover in the portfolio and there is limited disclosure regarding what securities are held.
  3. The downturn in housing could continue for an extended period (think of a Japan style “lost decade”) and eventually cause George Risk to operate at a loss, thereby reducing the intrinsic value of the ongoing business.
  4. The company has indicated that it is interested in acquisitions and marketable securities could be liquidated to pursue such acquisitions which may or may not result in the creation of shareholder value.
  5. Management has been late in filing a number of SEC reports over the past few years and this could indicate that they are having difficulty keeping up with the requirements of being a public company.
Despite these risks to upside potential, it does appear that the risk of a permanent loss of capital is significantly reduced by the value of a well established operating company along with the excess assets on the balance sheet.

Limited Liquidity

George Risk Industries is very illiquid and there are many days when no shares trade. On days when it does trade, the typical volume may be a few thousand shares. As the saying goes, it “trades by appointment”. The bid/ask on the stock is unusually wide with a typical spread of fifty cents or more. Therefore, any orders for the stock must be made using limit orders.

I should note that so far I have found it impossible to purchase this stock anywhere near the prevailing bid despite daily limit orders over the past two weeks. I am viewing this more as an interesting case study in a Graham style investment than an opportunity to put any meaningful amount of funds to work. It is better not to obtain any shares than to offer too much and lose the margin of safety. Perhaps some of my readers will have better luck.

Resources

Historical Data and Analysis – Excel 2007 (Source: Rational Walk Analysis)

Historical Data and Analysis – Excel 2003 (Source: Rational Walk Analysis)

George Risk Industries Website

George Risk Industries SEC Filings

Ravi Nagarajan

http://www.rationalwalk.com/

About the author:

Ravi Nagarajan
Ravi Nagarajan is a private investor and Editor of The Rational Walk website. Ravi focuses on applying value investing techniques to find securities trading well below intrinsic business value. Ravi has over 15 years of experience in the financial markets and started investing on a full time basis in 2009. From 1996 to 2009, Ravi held a number of technical and executive level positions in the commercial software industry. Ravi graduated Summa Cum Laude from Santa Clara University with a degree in finance. Visit his website The Rational Walk

Visit Ravi Nagarajan's Website


Rating: 4.1/5 (15 votes)

Comments

kfh227
Kfh227 premium member - 4 years ago
For such a small company, it has some very nice FCF numbers!
kfh227
Kfh227 premium member - 4 years ago
I jsut did a DCF on this one.

Let's just say that it is a no brainer to think this is worth more than $7. This is arrived at by looking at nothing but free cash flow.

A more honest valuation puts this one well north of $10 in my opinion.

Mr Nagarajan, I am going to research this a bit more tonight. This is simply an awesome idea! Good work!
kfh227
Kfh227 premium member - 4 years ago
For those looking for the reports like me .....

Here:

http://www.sec.gov/cgi-bin/browse-edgar?company=&match=&CIK=84112&filenum=&State=&Country=&SIC=&owner=exclude&Find=Find+Companies&action=getcompany

I had to look it up by the correct CIK number. Which is 84112.
rnagarajan
Rnagarajan - 4 years ago
All - the ticker for George Risk is RSKIA. It looks like it got filed under an invalid ticker.

KFh227 - thanks for the comments. Unless I'm overlooking something significant, the biggest issue I see here is lack of liquidity - this thing is an exercise in frustration to trade, although that's true of most microcaps I suppose.
kfh227
Kfh227 premium member - 4 years ago
I find the fact that the CEO owns an airplane which is leased to the company as a bit odd. Also, some buildings are rented from family members. I think the airplane is $210K and leased for something like $27K each year.

Also, I sent them an e-mail about this:

From the 10-K:

"Additionally, the Company continues to purchase marketable securities, which include municipal bonds and quality stocks."

"We are continuing the use of "money manager" accounts for most stock transactions. By doing this, the Company gives an independent third party firm, who are experts in this field, permission to buy and sell stocks at will. The Company pays a quarterly service fee based on the value of the investments."

What is the quarterly fee? It should be under 2% per year (0.5% per quarter) and closer to 1% a year. If it is 5%, that is horrible. I also asked about the stocks that are being held.
kfh227
Kfh227 premium member - 4 years ago
heck, I might as well ask. Do you know anything about hte preferred stock? There apparently is some but I don't know where to find it. It might be for execs only. I just don't know.

I am curious because it is convertible to 5 shares of common stock. I want to know since there is a possible arbitrage here. Or I am just wrong. I figured that it is worth pursuing for 10 minutes. I gave it 10 minutes and gave up.
batbeer2
Batbeer2 premium member - 4 years ago
Thanks for the idea.

A question, how does revenue break down accross their client base ? Are there one or two major clients like Home Depot ?
rnagarajan
Rnagarajan - 4 years ago
"heck, I might as well ask. Do you know anything about hte preferred stock? There apparently is some but I don't know where to find it. It might be for execs only. I just don't know."

Conversion of the preferred stock to common is assumed in the diluted share figures. It seems like a marginal factor driving value so I did not highlight it. However, to avoid confusion I probably should have broken this down. I don't think it is a factor. Conversion of all preferred shares would only result in an addition 20,500 shares of common which is not that material w/over 5 m common outstanding.

rnagarajan
Rnagarajan - 4 years ago
"I find the fact that the CEO owns an airplane which is leased to the company as a bit odd. Also, some buildings are rented from family members. I think the airplane is $210K and leased for something like $27K each year."

Agreed - it was a red flag for me as well but didn't view it as a deal breaker. If the CEO really wanted to milk the company for excessive compensation, there would be easier ways to do so ... although I really don't understand why a small Nebraska manufacturer with two locations 40 miles apart requires a private plane.

Related party transactions are pretty common with small family owned businesses - I've seen much worse than the modest related party issues here.

rnagarajan
Rnagarajan - 4 years ago
"A question, how does revenue break down accross their client base ? Are there one or two major clients like Home Depot ?"

They sell mainly to distributors and there is one customer that accounts for a large amount of sales. From 10-K:

"The security segment has approximately 4,000 customers. One of the distributors

accounts for approximately 42 percent of the company's sales of these products.

Loss of this distributor would be significant to the company. However, this

customer has purchased from the company for many years and is expected to

continue."

rnagarajan
Rnagarajan - 4 years ago
All - I've consolidated the questions asked here and elsewhere in a new post on my site:

http://www.rationalwalk.com/?p=4494
batbeer2
Batbeer2 premium member - 4 years ago
Thanks for the folow-up.

I'll share my thoughts here after I look into it this weekend.
kfh227
Kfh227 premium member - 4 years ago
My limit order is in!
batbeer2
Batbeer2 premium member - 4 years ago
After reading up on this one, I have three things to add:

1) The cost basis of their investments changes continuously. This suggests a high turnover. It could be an accounting issue though. Given that they have not lost a lot of money in the past 24 months, I guess it's not too bad. If you can conserve capital in this environment, then you have not forgotten rule #1.

2) The #1 in this business is GE security. This has been the case since 2001 when GE purchased Interlogix for 1.2 x sales (750m).

3) The dividend is higher than current earnings, yet they are sticking to their dividend policy. With a mountain of cash, I would be unpleasantly surprised to see them cut the dividend, but I have seen stranger things happen.

GRI meets my main test; If it drops by 50% how will I feel ? Answer..... "more greedy".
rnagarajan
Rnagarajan - 4 years ago
I agree on the question of turnover. I would like to see management disclose more about the investment manager as well as the securities that are held.

I suspect that the CEO relies on the dividend for his personal income - given his ownership, he receives the majority of the cash. So a dividend cut given the huge cash pile is hard to envision.

This company seems to fly under the radar and specializes in niches that the larger players in the industry don't really care about. At least given the operating track record, that's what I would conclude although obviously there are situations where past characteristics of a business may suddenly change. Fortunately, even if the operating business was worth zero, which seems very unlikely, you have the investments as a form of protection.
kfh227
Kfh227 premium member - 4 years ago


I get a kick out of volume on this. Today there was 100 shares that sold at $4.25. Then I saw the price jump to $4.50. All 20 shares are $4.50. Less than $100 was used to buy it.

Sadly, my limit order has not been hit yet.
kfh227
Kfh227 premium member - 4 years ago


The lack of liquidity is maddening. I've been tryign to buy this one for a month now. The limit order is in so it's jsut waiting I guess.

The good news is that I have some cash in case somethign else comes up prior to my RSKIA order being filled.

rnagarajan
Rnagarajan - 4 years ago
LOL ... I guess now you know why I let everyone in on this gem a while back ! It is more of an intellectual curiosity in valuation than anything that you can profit from. Still, I keep an eye on it.
rnagarajan
Rnagarajan - 4 years ago
I was looking at this in more detail today ... it's crazy how low the volume is. Here are the trades for February that I can see via Google Finance:

February 23: 150 Shares

February 22: 187 Shares

February 16: 300 Shares

February 12: 2400 Shares

February 9: 120 Shares

February 8: 100 Shares

February 5: 500 Shares

February 1: 300 Shares

That's a grand total of 4057 shares which amounts to something like $18K based on typical prices during the month!

It is quite odd. There are many other 20M +- market cap companies that have much more volume.

Anyway, my frustration with this led me to give up on trying to buy it but I still watch it.
kfh227
Kfh227 premium member - 4 years ago


Ravi,

Do what I did. Put a limit order in for what you want to pay and keep doing research. If a better idea come up in the meantime, cancel the order and buy something else.

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