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TSRI- dividend gone, but shares still cheap

December 21, 2012 | About:

One of the reasons I’ve found special dividends caused by the fiscal cliff so interesting is they serve as a catalyst for value realization. My focus on these special dividends as catalyst may have confused some readers, as I’ve said several times on this blog that dividends really don’t matter in terms of valuing a stock.

There’s a pretty simple reason for that: the value of the business is the NPV of it’s cash flows. It technically shouldn’t matter how those cash flows are reinvested (dividends, repurchases, or investment in the business). Of course, in practice, it does matter: you’d rather a young Warren Buffett retain all those earnings than pay dividends, and you’d rather HP pay out dividends than make acquisitions. In fact, if you read all of Buffett’s shareholder letters, you’ll see he repeats the sentiment just expressed several times throughout the years.

So do I think special dividends are so value creative?

Let’s do a little thought experiment. Suppose you had a company that you though was worth book value. It’s book value was $10 per share. If it was selling for $5, you’d have a pretty interesting bargain- that’s a 50% margin of safety.

Now take the same company and add $90 of excess cash to it’s balance sheet. Maybe it’s an investment portfolio, maybe it’s just cash in the bank. The business is now worth book value + excess cash = $100. Unfortunately, if the market values the cash at 100%, the stock will now trade for $95. What was a 50% margin of safety before is now only a 5% margin of safety.

Even if the market doesn’t value the cash at 100%, but say 90%, you still don’t get a huge margin. In this case, the market would value the company at $90 * 90% + $5 = $86. Sure, it’s trading below cash, but it’s only a 14% margin of safety.

Sure, it’s a business trading below net cash. Incredibly safe. But it can also be a killer. If the business can’t compound it’s value (very few net-nets can actually compound value), and it takes 3 years for the company to sell out or realize value, then you’re going to be looking at a pretty horrific compound return. Even if the business can earn a decent ROE, having all that cash earning nothing and doing nothing will kill you over the long term in most net nets.

Obviously, every situation is unique… but that’s why many of these cash boxes are so difficult to invest in. They’re safe, for sure, but if the cash balance is too great relative to the business value and the catalyst isn’t present, your compound annual returns could be horrendous.

Ok, so what does all that have to do w/ special dividends? And, while you’re asking questions, isn’t this post supposed to be about TSRI????

Don’t worry, we’re getting there!

Suppose that same business with $90 worth of excess cash decides to pay 90% ($81 per share) of their excess cash balance as a dividend. Well, if the stock was trading at $86 and drops by the amount of dividend, you’ve suddenly got a really interesting looking stock again. Now it’s trading for $5 per share despite a business worth $10 and $9 of cash. Even if the stock rises on the div announcement (as most do), you could be looking at a big margin of safety now.

Let’s take the first scenario as an example. If the stock was getting 100% credit for the cash and trading at $95 dollars, post dividend it will drift down to $5 per share. What was a 5% margin of safety ($95 stock price vs $100 value) has suddenly mushroomed to a 50% margin of safety ($5 stock price versus $10 value).

Which takes us to TSRI. I had held shares for a while and was excited by the announcement of a special dividend. The stock was trading at $3.80-ish before the dividend (the div was $1.50 per share). It shot up on the div announcement, but since paying it out has drifted down to $2.80 per share.

Obviously, people who bought in at $3.80 are happy. $2.80 + $1.50 = $4.30, a very healthy return from that $3.80 per share. But I think the case can be made that the company is actually cheaper today than it was at $3.80 a few months ago.

Let’s do some quick math. At their last balance sheet, TSRI had ~$6.25 per share in book value. That consisted of just under $4.15 in excess cash per share and $2.10 in “business” book value per share (almost all of which was current assets”. Trading at $3.80 per share, that represents a price to book of just over 60%. If you considered it as a pile of cash and a business, you could say you were paying full price for the business and getting the cash for $0.40 cents on the dollar.

But then consider what happens after you adjust their balance sheet for the dividend. TSRI now has a book value of $4.75 per share. They still have $2.10 in “business” book value per share, but only $2.65 per share in excess cash. At $2.80 per share, they’re trading for under 60% of book. If you consider it as a pile of cash and a business, you can say you’re getting the business for full price (assuming, of course, it’s worth book) and getting that cash pile for just 25 cents on the dollar.

Obviously, I’m teasing the numbers just a bit. But I think these examples really illustrate why these special dividends can be so important- even though you might be paying more than the adjusted stock price before the dividend announcement, you actually might be creating the company cheaper once the excess cash has been stripped out!

And I think it ignores one other key component- management teams with large equity stakes in the business get a lot of cash from these dividends.

Consider TSRI’s management. They own just under 50% of the shares outstanding. and now have (assuming a 15% tax rate on dividends) roughly $1.275 for each share of TSRI that they don’t already own.

The CEO is over 80 years old. He’s got investors complaining about his compensation levels. He has absolutely no reason to be public… in fact, DGTC (which I mentioned is going private via reverse split) estimates public costs at $300k per year, which means TSRI could increase pretax ROE by 2% and pretax margin by 0.7% (not a small number, for a business which has run at breakeven-ish levels for the past two years) simply by going public. Don’t laugh at that- that $300k is more than his son makes in base salary, which he’s getting complaints for (you could consider “public costs” TSRI’s 3rd highest paid executive!!!). And the fact he paid out a special div means he’s worried about future tax rates…. think he might want to sell this business or use that cash to take it private, turn it over to his son (also the VP), and have the two of them milk it???

I do.

And that special div gives him the cash to do it.

Disclosure- Long TSRI

Rating: 3.7/5 (6 votes)


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