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Praveen Chawla
Praveen Chawla
Articles (84) 

Investment Note: SPAR Group

Spar Group is an interesting Cigar Butt opportunity, but like most 'cheap' stocks, it's got some hair on it

September 28, 2020 | About:

While researching using the Gurufocus All-in-One screener, I came across an unusual company, SPAR Group Inc. (NASDAQ:SGRP).

SPAR is a Nano-cap stock with a market cap of only $15 million and an enterprise value of $26.4 million. What caught my eye was the high Business Predictability Score (4.5 out of 5 stars), the Earnings Yield (Greenblatt) and the Forward Rate of Return (Yacktman). The Profitability and Financial Strength scores are also decent. The Gurufocus valuation score is 10 out of 10.

SPAR generated $15 million of free cash flow in the last 12 months, yet the stock price appears to be struggling. So what is going on?

The company provides merchandising and other marketing services to manufacturers, distributors, and retailers worldwide and coordinates the operations through the use of a multi-lingual proprietary technology that drives the logistics, communication and reporting for global operations and customers. SPAR works primarily with mass merchandisers, office supply, value, grocery, drug, independent, convenience, home improvement and electronics stores, as well as providing furniture and other product assembly services, audit services, in-store events, technology services and marketing research.

Gurufocus has an old bullish article on the stock by Shadow Stock written in 2014: Spar Group SGRP : Forgotten Nano Cap Value with Strong Growth. It looks like six years after this article was written, the stock still remains forgotten and is actually much cheaper than it was in 2014. This is in spite of the fact that the company is growing by double digits and is generating a large cash flow. The price-to-free-cash-flow ratio is 1.03.

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SPAR's clients include some of the largest and most well-respected companies in the world, like Amazon (AMZN), PepsiCo (PEP), Electronic Arts (EA), and many others. The company currently does business in ten countries: the United States, Canada, Japan, South Africa, India, China, Australia, Mexico, Brazil and Turkey.

Growth has been fairly robust over the last six years. Revenue has grown at a 15% CAGR and Ebitda has grown at an 11% CAGR.

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Looking at the balance sheet diagram shows that while the company has no long-term debt, it does have a large minority interest in the equity section. Of the 30 million equity, 12 million (40%) belongs to the minority.

The 2019 Income statement diagram below shows that $1.284 million (46%) of the net income flowed to the minority and $1.523 million (54%) flowed to the shareholders. So in essence, based on the review of the balance sheet and income statement, about half the company does not belong to the shareholders. The minority interest is as a result of the company forming joint ventures with business groups outside the U.S. These joint ventures are recorded on the balance sheet using the equity method.

Declining profit margins are another issue the company has to contend with. Even though the company has posted good top-line growth numbers, gross margins remain under pressure due to the highly competitive nature of the marketing services industry.

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The minority interest solves the mystery of why Gurufocus metrics like the Earnings Yield (Greenblatt) and Forward Rate of Return (Yacktman) are so high. They are based on EBIT and Free Cash Flow, respectively, and do not capture ownership of or payment to minority interests. The valuation scores also do not capture minority interest.

Another large issue with SPAR is that its profit margins are quite small. The merchandising outsourcing business is very competitive.

That being said, Spar is likely selling at a very depressed price. Even if you were to apply a 50% haircut to the forward rate of return of 46%, it would still be very good. The same is true for the Greenblatt Earnings yield of 29%.

The stock was over $1 before the Covid-19 crisis. I think it should regain that price point in the next year or so, as brick and mortar retailers are likely to need a lot of merchandising help, though there could be issues with the solvency of some retailers.

Interestingly the company's working capital is more than its market cap. There is also litigation going on between the majority shareholders and founders of the company and the company's current management. The fight is over control of the board, as well as a dispute regarding related party transactions with affiliates controlled by the majority shareholders. This litigation is likely depressing the share price.

If the litigation gets settled this will provide a further catalyst to the stock price. Logic would dictate that this litigation would get settled and the litigants go back to building the business.

Given the slim profit margins and the lack of moat, SPAR is not a high quality, buy and hold business. However, the company generates a lot of cash for its size. Spar appears to be an interesting little "cigar butt" with quite a few puffs left:

"My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs, I obtained in the 1950's made the decade by far the best of my life for both relative and absolute performance."
Warren Buffett (Trades, Portfolio) - Berkshire Hathaway Letter, 2014

Disclosure: The author does not own Spar stock at the time of writing.

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About the author:

Praveen Chawla
I am a full-time investor now, investing my own money. I spent most of my working life in the pharmaceutical industry.

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