Description

ALJ Regional Holdings (ALJJ)

1. Executive Summary

1. ALJ Regional Holdings (“ALJJ”) is a jockey stock.

2. While cheap (~13x our bear case FCFE and ~9x our base case FCFE), we think that smart capital allocation decisions (acquiring stable businesses at 4x – 5x unlevered FCF) would create tremendous shareholder value.

3. We view ALJJ as a compounder with a wrong runway of small accretive acquisitions.  

4. ALJJ’s history, its organizational design, and Mr. Ravich (Chairman and 42% shareholder) behavior remind us of Outsider CEO playbook.  

5. ALJJ had been an OTC stock for year but it complete an uplisting in May 2016 which would expand its investors base and, more importantly, provide it with an acquisition currency (other than cash).  

2. What is ALJ?

ALJ is a holding company that consists of three operating business:

1. Faneuil

2. Carpets

3. Phoenix Color

We would profile all three businesses in more detail later.  At this point we want to point out that ALJJ strikes us as a company with many features of holding companies led by outsider type CEOs.  Let’s look at them one by one.  

1. Decentralized operations of divisions + very high degree of autonomy of division managers

ALJJ CEO Jess Ravich runs ALJJ in a extremely decentralized manner, and division managers have lots of autonomy in how they run their business.

2. Centralized capital allocation decisions

While operations are very decentralized, capital allocation is very centralized.  It is our impression that all important capital allocation decisions are made personally by Mr. Ravich.  

3. High Insider Ownership

CEO Jess Ravich owns ~42% of shares outstanding.

4. Small headquarters

ALJ’s headquarters personnel is very small.  As of September 30, 2014 (the last date when such was disclosed), the full headcount was two employees – Executive Chairman and CFO.  It has not grown much since then.  

5. Proper, clear and aligned incentives for divisional managers

Divisional managers not only enjoy benefits of almost fully autonomy but also can reap lucrative financials awards if they perform well.  We think the existing incentives system should be quite motivating for divisional managers.  

For example, Faneuil’s CEO Anna Van Buren “receives an annual salary of $520K and is eligible to earn an annual bonus equal to ten percent (10%) of the Company’s defined EBITDA [reference is made to Faneuil’s EBITDA and not ALJ’s EBITDA], before any bonus amount owed to MS. Van Buren, in excess of $5,000,000”.  (Source: 2014 Annual Report, p. 27).]  Faneuil had FY 2014 EBITDA of ~$18.5M and FY 2015 EBIDA of $14.45M after CEO’s compensation.  It means that in FY 2014 and FY 2015 Faneuil’s CEO take home pay (pre-tax) was in the range of $1.5M - $2M.  

We think that the total compensation here is quite high given that Faneuil is a relatively small business with revenue of ~$133M and ~$150M in FY 2014 and FY 2015 and EBITDA of ~$18.5M and ~$14.45M in FY 2014 and FY 2015.  However, we also think that Ms. Anna Van Buren mostly likely deserves such high compensation.  We need to keep in mind that every dollar paid to Ms. Van Buren consists of about 42 cents that is effectively paid directly by Mr. Ravich himself.  When we see such arrangement in a public company where CEO owns few shares, we would call it egregious; however, given extremely high insider ownership we think that such compensation arrangements make sense since it allows ALJ to have extremely lean headquarters instead of having several more reporting layers and allows Faneuil to produce best possible results.  

In a similar fashion Mr. Reisch, the Chairman of Phoenix Color Corp., will “be paid as $200K annual base salary and is eligible for an annual bonus equal to 5% of the excess of EBITDA over $20M”.  (Source: 2015 Financials, p. 29, Footnote 18 “Related Party Transactions”).  In our view, such compensation arrangement also incentivizes Mr. Reisch to perform to the best of his abilities since financial rewards can be quite lucrative.  

Interestingly, Phoenix Color Adjusted EBITDA (net of write offs) was ~$26.8, ~$19M, and ~$20.1 in calendar years 2012, 2013, and 2014 (Phoenix Color was a part of Visant at that time).  We would think that Mr. Reisch believes that he can grow EBITDA nicely, otherwise he would probably not sign up for the job under these compensation terms.  

6. Jess Ravich’s Compensation

At the same time, Mr. Ravich’s compensation is quite modest and very cash light ($125K of base salary + $35K of director compensation in 2015 = $160K).  

Source: 2016-05-31 ALJJ DEF 14A.  

3. Who Is Mr. Ravich?  What Is ALJJ History?

1. Who Is Mr. Ravich?

What is Mr. Ravich background?  He is a professional financier and investor.  He started his career as a bond trader at Drexel Burnham in the 1980s where many big profile current investors and financiers started his careers as well.  He founded Libra Securities, a boutique investment bank, in the early 1990s which was later bought by Houlihan Lokey in 2009.  He joined HL for a few years as an MD and then moved to an MD position with TCW Group, an asset management firm (he is still there).  

While his background explains his deal making skills and capital allocation acumen, one can wonder how he can run operating companies.  Mr. Ravich does not run operating companies as we discussed above.  He selects management teams and almost always keeps the management of companies when ALJJ buys them.  However, he puts the right incentives in place.  For example, he would link bonuses of managers to operating income.  

As we would show later, ALJJ pays 4x – 5x unlevered FCF and does not buy businesses through competitive bidding.  How does it achieve that?  We believe that the answer to his is Mr. Ravich’s vast proprietary network of contacts many of which go back to his Drexel days.  

2. What Is the History of ALJJ?

Here is a bit of history of ALJJ (we will try to keep it brief).

ALJJ was a failed technology company with no business and massive NOLs when Mr. Ravich took effective control in 2006.  At that time shares were trading below $0.20; now they trade ~$4.80.  

ALJJ subsequently acquired a steel mill in Kentucky out of bankruptcy.  ALJJ fixed the mill and returned it to profitability.  In early 2013 ALJJ sold the mill making profit of more than 140%.  

With cash received, Mr. Ravich did something unusual.  Most corporate managers under these circumstances will take entire proceeds and buy another business(es) and then will run it.  The bigger the better.  Not Jess Ravich.  He announced a tender offer for ALJJ shares while disclosing that he will not tender any of his own shares.  This way ALJJ retired ~50% of its shares.  

Why is this move unusual?  This is a rare behavioral pattern because most CEOs care about the size of the company while shareholders care about intrinsic value per share.  Given Mr. Ravich’s high ownership (more than 40%), he tends to act more as a shareholder rather than a hired CEO.  

After that ALJJ became just a corporate shell with cash and net operating losses (NOLs).  In the hands of a smart and finance savvy manager, NOLs can be a tool of tremendous value creation because such NOLs can offset any taxable income earned by the company in many years to come.  Given our background in tax law, we feel quite capable of analyzing such companies.  Then ALJJ completed acquisitions of three businesses: (1) Faneuil, (2) Floors N’ More, (3) Phoenix Color.  

4. Operating Business #1: Faneuil

1. What Does Faneuil Do?

Faneuil is “a provider of outsourcing and co-sourced services to both commercial and government entities in the healthcare, utility, toll and transportation industries.”  

Sounds quite boring and unsexy.  Let’s see whether acquiring and running a boring and non-sexy business can be financially attractive.  

2. History: Acquisition of Faneuil Is a Stellar Example of Value Creation

ALJ acquired Faneuil on October 18, 2013.  

“The aggregate consideration for the acquisition of all of Faneuil’s outstanding stock was $53 million, consisting of $25 million in cash, a contribution of $500,000 in cash for working capital purposes, 3,000,000 shares of ALJ common stock valued at $2,500,000 and a seller note for $25 million (the “Harland Clarke Note”).  ALJ acquired 96.43% of Faneuil’s outstanding capital stock and the remaining 3.57% was acquired by Ms. Van Buren.  Following the closing of ALJ’s acquisition of Faneuil on October 18, 2013, ALJ sold 3,286 shares of Faneuil’s common stock to Tarsha Leherr, Faneuil’s Vice President of Operations.  As a result, as of the date of this Report, ALJ, Ms. Van Buren and Ms. Leherr respectively hold 883,857, 32,857 and 3,286 shares of Faneuil’s common stock, for a total of 920,000 shares of Faneuil’s common stock issued and outstanding”.  (Source: FY 2014 Annual Report, p. 7).  

We would point out that in 2015 Ms. Anna Van Buren and Ms. Leherr exchanged their shares of Faneuil for shares of ALJ and ALJ now owns 100% of Faneuil.  

So $53M for 96.42% of Faneuil equates to EV of ~$55M.  Based on changes in balance sheet between FY 4Q 2013 and FY 1Q 2014 ALJJ did not assume any debt of Faneuil as part of the transaction.  

As mentioned above, in FY 2014 and FY 2015 Faneuil generated EBITDA of  ~$18.5M and ~$14.45M.  This equates to multiples of ~3x and ~3.8x.  Not bad!  

But what’s about maintenance CapEx and conversion of EBITDA to actual free cash flow?  In FY 2014 Faneuil had total CapEx of ~$4.3M.  We believe that some of it was expansion CapEx while some was MCX.  We do not know the breakdown and, therefore, would consider the entire CapEx to be MCX, which we believe is draconian.  Even in this draconian case Faneuil had EBITDA minus MCX of $14.2M.  This is 3.9x multiple of the purchase price.  

Given that ALJ had substantial NOLs, the cash tax expense is de minimis ($450K in FY 2014).   Even we assume that the entire amount of cash taxes in FY 2014 was attributable to Faneuil, then free cash flow to enterprise (i.e., before interest expense) was ~$13.75M which translates into cash flow multiple to enterprise of 4x or 25% free cash flow yield to enterprise.  Given that a large portion of the acquisition was financed by debt with coupon of 7.5% and was subsequently refinanced even at a lower rate, the cash on cash return from the perspective of equity tranche is truly astonishing.

We take it that boring and non-sexy businesses can be quite sexy if you look at free cash flow after all…

3. Faneuil Acquisition: ALJJ’s Playbook

We would like to point out several elements of ALJJ’s M&A playbook:

1. Seller for whom the division / company being is relatively small / unimportant.

2. Management stays with the acquired company and Mr. Ravich / ALJJ does not need to recruit new management team.

3. Management invests their own money in the acquisition and has skin in the game.

4. No auction / bidding process and no bankers pitching the company and showing it around.

We will see these elements again in other ALJJ transactions.

4. Faneuil: Verticals and Industry Exposure

In terms of industries and verticals that Faneuil services, it has the largest exposure to toll collection: 56.8% as of 3Q 2015.  Those are almost equally split between manual toll collection and electronic toll collection.  

Healthcare vertical is the 2nd in terms of its importance and exhibits strong seasonality because many contracts that Faneuil has are contracts with various state healthcare exchanges pursuant to The Affordable Care Act.  Needless to say Faneuil performs under such contracts for no more than 6 months (for example, Faneuil worked as a call service center for Covered California).  For example, in FY 2Q 2015 the share of healthcare was 37.2% while in FY 3Q 2015 it was only 24.4% of total revenue.  

ALJJ stopped breaking down Faneuil’s revenue by vertical after FY 3Q 2015.  

5. Faneuil: Customer and Contract Concentration

The most troubling thing about Faneuil’s business is high customer and contract concentration.  

1. Customer Concentration

Faneuil has high customer concentration.

Needless to say, customer concentration is dangerous.  Furthermore, Faneuil lost a large contract in Florida which accounted for a very large part of revenue decrease in 4Q 2015, 1Q 2016, and 2Q 2016.  Here is an article on the matter:

http://www.orlandosentinel.com/business/os-xway-tolls-engineering-20150813-story.html

2. Contract Concentration

Faneuil also has high concentration in terms of contracts.  

“For the year ended September 30, 2015, Faneuil had eight contracts in which each contract independently contributed to more than 5% of total revenue.  In the aggregate, these contracts accounted for $119.9 million, or 80.1% of total revenue.  Three of these contracts independently contributed to more than 10% of Faneuil revenue, at 19.7%, 12.6%, and 11.4% for each contract.”  (Source: 2016-04-22 Form 10-12B/A, p. 26).  

“For the year ended September 30, 2014, Faneuil had seven contracts in which each contract independently contributed to more than 5% of total revenue.  In the aggregate, these contracts accounted for $110.7 million, or 83.3% of total Faneuil revenue. Two of these contracts independently contributed to more than 10% of revenue, at 23.0% and 16.6% for each contract.”  (Source: 2016-04-22 Form 10-12B/A, p. 26).  

ALJJ stopped disclosing this data and we do not have relevant information for 1Q 2016 and 2Q 2016.  

Similarly to the customer concentration, Faneuil’s high contract concentration is worrisome.

3. Faneuil: Contract Disclosure

The right way to analyze Faneuil’s business would be to look at all or at least major contracts, analyze their duration and revenue, figure out EBITDA margin, working capital needs (if any), CapEx (if any), and then do a DCF for existing contracts.  Then we can assume some re-bid success rate and do a DCF on those.  Finally, if one wants to be optimistic, we can also think about potential future new contracts wins.  

That would be really great in theory.  However, “in theory there is no difference between theory and practice; in practice there is” (c) (attributed to Yogi Berra).  The problem which we are facing here is that Faneuil and ALJ do not provide a very detailed disclosure of Faneuil’s contracts and we cannot really perform an exercise that we outlined above.  

4. Faneuil: What Gives Us Comfort?

So the key question is what gives us comfort given that we cannot perform a perfect valuation exercise, especially given significant year-over-year revenue decreases in 4Q 2015, 1Q 2016, and 2Q 2016.  Well, we derive comfort from a few things.  

1. Management Commentary

Our first source of comfort is management’s commentary.  

FY 2Q 2015

“We continue to stay focused on growing our revenue base for both Faneuil and Carpets. We are very happy with the added verticals at both companies.  Such vertical expansion reduces our exposure to any particular industry or counterparty.” (Source: FY 2Q 2015 Press Release quoting Mr. Jess Ravich).

"We are excited to see our continued diversification and growth within the healthcare sector.  We have experienced, and will continue to experience, seasonality in the healthcare sector as enrollments require higher staffing levels at the beginning of each calendar year.  However, we have invested resources into expanding into other vertical markets and expect to see returns later in the year." (Source: FY 2Q 2015 Press Release quoting Ms. Anna Van Buren).

FY 3Q 2015:

“The increase in net revenue was attributable to $4.4 million related to two new contracts and revenue from existing customers during the period, primarily within the healthcare vertical, partially offset by a reduction in one-time implementation revenue of $1.8 million within the healthcare vertical and a reduction in revenue of $1.4 million from a customer contract that concluded in early 2015.”  (Source: FY 3Q 2015 Press Release).

“We continue to stay focused on growing our revenue base for both F and Carpets.  As we mentioned during our annual shareholder’s meeting, we will be investing in additional vertical for both Faneuil and Carpets during 2015 which will increase our SG&A at both subsidiaries … We expect to see the results of such expenditures in 2016 and beyond.” (Source: FY 3Q 2015 Press Release quoting Mr. Jess Ravich).

"Our large investment in our infrastructure this year, especially in our sales division, is starting to return dividends, as we are beginning to receive contract awards in numerous verticals and have the strongest pipeline in the Company's history.”  (Source: FY 3Q 2015 Press Release quoting Ms. Anna Van Buren).

FY 4Q 2015

“Fiscal 2015 was a transitional year for ALJ," said Jess Ravich, ALJ's Executive Chairman.  While Faneuil's revenues were up by over 10%, its adjusted EBITDA was lower by $3.4 million.  This was in part due to its need to compete for a large number of multiyear contracts that were rebid in 2015 as well as staff increases that allow Faneuil to bid for additional contracts.  Our record backlog of $290 million is a testament to Faneuil's quality of product and should position Faneuil well for Fiscal 2016 and beyond.” Source: FY 4Q 2015 Press Release quoting Mr. Jess Ravich).

“We have worked hard to expand our product offerings and the geographies we service over the past few years, and I believe we are well positioned for a strong upcoming year” (Source: FY 4Q 2015 Press Release quoting Ms. Anna Van Buren).

FY 2Q 2016

“While revenue growth presented some challenges for us in the second quarter due to the planned expiration of a few large customer contracts, I am pleased to report that we are ramping up operations on several new contracts.  I expect these new customer contracts to replace the lost revenue in the near term.” said Anna Van Buren, CEO of Faneuil.  (Source: FY 2Q 2016 Press Release quoting Ms. Anna Van Buren).  

“Faneuil net revenue for the three months ended March 31, 2016, was $33.9 million, a decrease of $8.4 million, or 19.9%, over net revenue of $42.4 million for the three months ended March 31, 2015.  The decrease in net revenue was attributable to a $4.7 million reduction in operational revenues from existing customers during the period, primarily within two healthcare contracts and a $3.8 million reduction in revenue from customer contracts that concluded in 2015.  During the remainder of fiscal 2016, Faneuil will begin to ramp up operations on several contracts, including a large multiyear contract with a utility provider which will contribute to additional revenues in the near term.  In connection with such ramp up, Faneuil incurred expenses during the three months ended March 31, 2016 with no corresponding revenue.” (Source: FY 2Q 2016 10-Q).  

We view the last quote as particularly informative not only due to its recency but also due to the fact that it coming from 10-Q as opposed to a press release.  A Form 10-Q is a legal document and we would think that a lot of thinking (and legal review) went into the first 10-Q ever issued by ALJJ.  

Summary

Management sounds optimistic and is sending a clear message that there is lots of work being done behind the scenes in terms of (1) rebidding for “old” contracts, (2) sourcing new contracts, and (3) diversifying customer and contract base.  

2. Management Incentives

Upbeat commentary by management is of course encouraging but it does not really show up in financials statements and does not generate free cash flow.  So can we trust management’s ability to execute (i.e., successfully rebid for “old” contracts and win new contracts)?  

We believe so because management is highly incentivized to reach goals and execute: Mr. Jess Ravich owns roughly 42% of shares outstanding.  Ms. Anna Van Buren owns [NTD] ALJ shares and her bonus is clearly dependent on ability to generate EBITDA which is of course dependent on ability to re-win “old” and win new contracts.  

Long story short, we believe that management will be working hard.  

3. Signs of Early Success

Most importantly, we see some signs of early success which we believe would continue.  

In the press release that accompanied FY 4Q 2015 financial results ALJ disclosed that “Faneuil’s contract backlog as of September 30, 2015 was $290.2 million as compared to $110.1 million as of September 30, 2014”.  (Source: FY 4Q 2015 Press).  This is more than 2.6x increase.  

We definitely do not want to overemphasize and get overexcited about this impressive increase because it is attributable to a large extent to some of contracts approaching expiration as of September 30, 2014.  

Let’s put these numbers into perspective.  Faneuil’s revenue was $132.9M in FY 2014 and $149.6M in FY 2015.  It means that theoretically Faneuil would have exhausted its backlog of $110.2M by the end of the first eight months of FY 2015.  This is of course a highly theoretical exercise because most likely some of that backlog had maturity / duration of more than one year.  In a similar fashion, using FY 2015 revenue and backlog at the end of FY 2015, we would expect that the backlog would last almost two years.  

Is this analysis accurate?  Definitely not.  Qualitatively, we know that contracts typically have duration of 2 to 5 years.  We would think that a 5 year duration is very rare.  At the same time we also know that many contracts with state healthcare exchanges are no longer than six months.  The key question is where the weighted average duration falls in this spectrum.  However, we do not have such data.  Still replenishing the backlog is very encouraging and shows that management’s commentary over the past few quarters about their hard work to win new contracts and rebid for old contracts were not just words; they have been actually backed up by results.  

4. Guidance for FY 3Q 2016

Faneuil provided guidance for FY 3Q 2016 (ending June 30, 2016) in the range of $30.3M to $33.5M.  While this compares unfavorably with FY 3Q 2015 revenue of $36.2M, it appears that Faneuil’s revenue decrease is likely to decelerate.  

5. Recent Uplisting

Given that ALJ just did uplisting in May 2016, we tend to think that Faneuil is on track to deliver solid operating and financial results.  This is not granted but given Mr. Jess Ravich’s financial acumen and aligned incentives, we think that he would not be pursuing uplisting if Faneuil was going to deliver poor results.

6. Faneuil: Margin Profile

Faneuil’s gross margin has been very stable and fluctuated between 19.4% (FY 2Q 2016) and 23.8% (FY 3Q 2014).  Gross margins vary depending on the contract mix.  In addition, gross margins can be temporarily elevated when Faneuil has implementation revenues.  For example the press release for FY 2Q 2015 quoted Ms. Anna Van Buren saying "We experienced higher margins last year due to onetime implementation revenues that were not repeated this year."

EBITDA margins show greater fluctuations because new business development expenses and expenses associated with re-bids flow through SG&A.  EBITDA margins fluctuated between as low as 6.3% (FY 4Q 2015) and as high as 15.5% (FY 2Q 2014).  

Below is a table with more information about Faneuil’s EBITDA margins.  

We are not particularly worried about drop in EBITDA margin since we attribute it not to operating challenges or inefficiencies but mostly to high SG&A expenses associated with re-bids and bidding for new contracts.  

Here is relevant commentary from management:

“While Faneuil's revenues were up by over 10%, its adjusted EBITDA was lower by $3.4 million.  This was in part due to its need to compete for a large number of multiyear contracts that were rebid in 2015 as well as staff increases that allow Faneuil to bid for additional contracts.  Our record backlog of $290 million is a testament to Faneuil's quality of product and should position Faneuil well for Fiscal 2016 and beyond”. (Source: FY 4Q 2015 Press Release quoting Mr. Jess Ravich).  

“We have worked hard to expand our product offerings and the geographies we service over the past few years, and I believe we are well positioned for a strong upcoming year”. (Source: FY 4Q 2015 Press Release quoting Mr. Jess Ravich).

7. Faneuil: CapEx Needs

As we pointed out in the section about Faneuil’s acquisition, MCX needs are quite modest.  CapEx tends to go up temporarily when Faneuil wins a new contract but proper MCX is quite low.  

We do not have a CapEx breakdown between various segments which makes our analysis more complicated.  

CapEx that includes both Growth CapEx and MCX for both Faneuil and Carpets was ~$7.1M and ~$4.3M in FY 2015 and FY 2014 respectively.  

Based on these admittedly limited data points, we tend to think that Faneuil MCX is unlikely to be above ~$3M.  

8. Faneuil: Valuation

Figuring out Faneuil’s normalized earnings is not an easy task.  So let’s start with data that we already have.

This table summarizes EBITDA for the past 10 quarters.  

Two full years that we have provide us a historical range of Faneuil’s EBITDA: ~$14.5M to $18.5M.  2016 is likely to be below that range due to heavy investments in winning new contracts (please refer to our discussion of these issues above).  

So what is normalized EBITDA of Faneuil?  We would estimate it to be ~$15M - $16M in the base case and ~$18M - $20M in the bull case.  In the bear case, we would estimate it to be ~$12M.  

Due to large NOLs ALJJ and Faneuil are not large cash taxpayers.  However, we will address taxes and use of NOLs on the operating level.  

5. Operating Business #2: Carpets

1. What Does Carpets Do?

Floors N’ More provides various floor coverings to home builders, commercial and retail customers including carpet, hardwood, laminate, tile, ceramic, porcelain, natural stone, vinyl plan, vinyl tile, area rugs and specialty flooring including bamboo, leather, cork and large format tile.  

2. Carpets History and Acquisition by ALJJ

ALJ acquired Faneuil effective October 19, 2013, Carpets effective April 1, 2014.

This is relevant information about Carpets acquisition:

“On April 1, 2014, ALJ acquired 100 percent of the membership interest of the Company under a purchase and sales agreement.  The aggregate purchase price was approximately $5,250,000.  ALJ acquired Carpets since it was in a growth sector at the time.  Concurrent with the closing, ALJ invested $240,000 in Carpets.  Mr. Chesin, the Chief Executive Officer of Carpets, was issued 40,000 Equity Award Units, 10,000 which vested on each of June 30, 2015, 2016 and 2017.  On July 1, 2014, each of the Limited Liability Company Operating Agreement and the Members’ Agreement of Carpets were amended and restated to provide Mr. Chesin with an allocation of 750,000 Class B Preferred Units and 75,000 Common Units.  On July 10, 2015, Mr. Chesin exchanged his 750,000 Class B Preferred Units with a preference amount equal to $750,000, 75,000 Common Units and 40,000 Equity Award Units of Carpets for 150,000 shares of common stock of ALJ.  ALJ funded the Carpets acquisition through existing cash, the sale of 1.4 million shares of its common stock in two separate private placements at a price of $1.60 per share, totaling $2.2 million, and the incurrence of $2.0 million in debt from Libra Securities Holdings, LLC, a related party, by issuance of a promissory note.”  (Source: 2015 Annual Report).  

We would note that the related party note (from Libra) was subsequently repaid with proceeds from a 3rd party (unrelated) loan.  

So the total purchase price and investment in the business shortly after the acquisition constituted ~$5.5M.  

The seller was a private equity firm Levine Leichtman Capital that paid multiples of $5.5M in 2007 – at least ~$46M – please see the link below:

(https://www.turnaround.org/cmaextras/TMAMASTERJan2008.pdf).  

Let’s put things into historical perspective here.  2007 was a peak in the housing bubble and Las Vegas residential sector was booming.  Carpets was (and still is) one of the largest flooring and cabinets retailer in LV area that serves several end markets (residential, homebuilder, and commercial).  To put it mildly, that was a poorly timed private equity acquisition.  

Based on our research, Carpets had become a neglected, small private equity holding.  This status coupled with Mr. Ravich’s proprietary deal flow allowed ALJJ to buy Carpets at an attractive price.  

Similar to Faneuil, we would point the following four elements of ALJJ acquisition:

1. A private equity firm as a seller for whom Carpets was a neglected (failed) holding and who likely did not want to invest managerial (private equity) time and resources due to a small size of the business.

2. Management stayed with Carpets and Mr. Ravich / ALJJ does not need to recruit new management team.

3. Carpets CEO invested his own money in the acquisition and has skin in the game.

4. No auction / bidding process and no bankers pitching the company and showing it around.

3. Carpets: Revenue Breakdown by End Market

Carpets serves three end markets: home building, commercial, and retail.  Below is the breakdown of revenue by segment.  Please note that after 3Q 2015 Carpets stopped reporting this breakdown.  

4. Carpets: Business Quality

We consider Carpet’s business quality low due to cyclicality, high customer, and significant supplier concentration.  

1. Cyclicality

We have already addressed it when we discussed Carpets history.  

2. High Customer Concentration

Carpets has a very high customer concentration with top 2 – 4 customers accounting for at least 50% of revenue (and often more).  

Please note that reference to each customer (for example, Customer #1) does not mean a reference to the same customer over the years.  

3. Significant Supplier Concentration

Carpets also has significant supplier concentration based on the percentage of inventory purchases from significant suppliers.  Please see data below.

4. Carpets: Intermediary Role

Given that Carpets has high customer concentration and significant supplier concentration, a reasonable question to ask is why Carpets even exists.  This is a great question and we do not have a very compelling answer as we could not grasp why suppliers and customers cannot talk to each other directly and use direct sales.  

However, Carpets has been in business for a long time so it seems that there is a need for this business.  Again, we do not feel very comfortable and view Carpets as a low quality business.  

5. Carpets Performance Post Acquisition and Future Outlook

After ALJJ acquired Carpets, ALJJ’s management and Carpet’s management focus was on growing sales and increasing scale (adding more products and more verticals).  Such growth did not allow to generate consistently positive EBITDA.  This was by design.  

Here is data about Carpets revenue growth since ALJJ acquired Carpets.

Revenue growth was very-very strong.  It looks like in 2Q 2016 it reached “maturity” / steady state growth.  

LTM Carpets revenues are ~$47.7M.  Assuming a 5% growth, NTM revenue would be ~$50M.  

Based on our research, this business can achieve EBITDA margin of 5% to 8%.  

We are assuming 3% EBITDA margin in our bear case, 5% in our base case, and 7% in our bull case.  We think it is quite possible that EBITDA margin can exceed 7%.  

Thus, EBITDA would be ~$1.5M, $2.5M, and $3.5M in our bear, base, and bull cases.  

6. Carpets: Steady State Free Cash Flow Generation

Below are our projections for the steady state FCF for Carpets.  

Please note that we are ignoring changes in working capital here since once the steady state (i.e., stable revenue) is achieved, normalized changes in working capital should be around zero.  

6. Operating Business #3: Phoenix Color

1. What Does Phoenix Color Do?

Using ALJJ’s own language, “Phoenix is a leading manufacturer of book components, educational materials and related products producing value-added components, heavily illustrated books and specialty commercial products using a broad spectrum of materials and decorative technologies”.

2. Customer and Supplier Concentration => Low Business Quality

We evaluate Phoenix Color business quality as relatively low due to high customer and supplier concentration.  

1. Phoenix Color: Customer Concentration

Below is the data for Phoenix Color customer concentration which is very high: top 3 customer account for ~47% to ~56% of revenue.  

2. Phoenix Color: Supplier Concentration

Below is the data for Phoenix Color supplier concentration which is very high: top 3 customer account for ~43% to ~59% of inventory purchases from significant suppliers.  

3. Phoenix Color History and Acquisition by ALJJ

ALJJ acquired Phoenix Color on August 9, 2015,

The seller was Visant Corporation, an overleveraged LBO done by KKR.  Phoenix Color was the least important division among all units of Visant.  As far as we know, ALJJ again bought with no auction and no competitive bidding.  Not surprisingly, ALJJ got a great deal on this acquisition: 4.5x EV/EBITDA (see more on this below).

The total acquisition price was ~$90M.  

Here are pre-acquisition Phoenix Color financials based on Visant’s segment disclosure.  

Here are some observations based on this pre-acquisition data.  

1. Phoenix Color: Pre-Acquisition Revenue

The first reaction when someone hears about components for physical books is to think about rapidly declining revenue.  

However, here is data re: sales of books in various formats.

As you can see, revenue from sale of physical books has remained quite stable.  

2. Phoenix Color: Pre-Acquisition Profitability Metrics

While Operating Income and EBITDA numbers look horrible, they were affected by massive non-cash charges / write offs.  

Adjusted EBITDA showed a large decrease from 2012 to 2013 (from $26.8M to $19M).  However, since then Adjusted EBITDA showed an impressive stability since then.  

Based on 2014 Adjusted EBITDA of $20.1M and the acquisition price of ~$90M, the EV/EBITDA acquisition multiple was ~4.5x (as mentioned above).

3. Phoenix Color: Pre-Acquisition CapEx

Phoenix Color CapEx was running between $2.0M to $3.9M.  As far as we understand, 2012 CapEx was impacted by facility upgrades that have been described to us as “state of the art”.  While we do not want to put too much emphasis on this, we believe that 2012 CapEx was elevated compared to the normal run rate.  

4. Phoenix Color: Post-Acquisition Performance

Below we present Phoenix Color financial performance post acquisition.

Please note that references above are to fiscal quarters of ALJJ (while prior references to Phoenix Color performance pre-acquisition were to calendar quarters of Visant).  

Please note further that Fiscal 4Q 2015 above included only 52 days due to the closing of Phoenix Color acquisition on August 9, 2015.  Management specifically cautioned in ALJJ’s 4Q 2015 press release against extrapolating this performance over the entire quarter using revenue per day or EBITDA per day.  

So Phoenix Color LMT EBITDA is ~$16.8M though it ignores those “missed” days in Fiscal 4Q 2015.  So let’s round it to $18M for now though this is admittedly just an estimate.  

5. Phoenix Color Free Cash Flow Generation

Assuming zero to very modest growth which results in no changes in working capital, this is how unlevered cash flow generation would look like for Phoenix Color:

So we have not even increased LTM EBITDA here for those missed days in 4Q 2015.  

7. Holding Company Expenses

While ALJJ has de minimis headcount at the holding company level and generally very frugal nature of ALJJ, it still has holding company costs.  Those costs would also increase compared to, for example, 2014 fiscal year due to uplisting.  

ALJJ parent company costs were ~$1M in FY 2014 and ~$3.2M in FY 2015.  

We believe that some expenses in FY 2015 were one-off caused by ALJJ uplisting.  So we would expect the company costs after uplisting to be around $2M (double of the pre-uplisting level).

8. Debt and Interest Expense

1. Debt

ALJJ has ~$101.6M of debt.  The debt has amortization feature built in: every quarter ALJJ repays $2M.  On top of this, a cash flow sweep will kick in starting the quarter ending September 30, 2016.  Under the cash flow sweep 75% of ALJJ’s excess cash flow must be used to pay down debt.  The remaining balance is due on August 14, 2020.  

2. Interest Expense

The interest rate is 7.5%.  So the interest expense is ~$7.6M.  

9. Net Operating Losses

As we mentioned before, ALJJ has very sizable NOLs.  

In its Annual Report for FY 2015 ALJJ disclosed:

“At September 30, 2015, the Company had a net operating loss carryforward for federal income tax purposes of approximately $162 million that expires from 2020 through 2028.  Approximately $140 million of the carryforward expires in 2022”.  

One value NOLs tax shield separately or include NOLs into FCF/FCFE valuation.  We would use the latter approach.  

10. ALJJ FCFE Generation

Putting together all components and moving pieces, we are arriving to the following FCFE.

Below we present the valuation of ALJJ based on FCFE yield / multiple.

Is ALJJ cheap?  On the one hand, quality of ALJJ’s businesses is low.  On the other hand, superb capital allocation skills and outstanding track record of Mr. Jess Ravich deserve a very significant premium.  

So where do we end up in terms of the multiple?  It is everyone’s call and this is what makes the market.  We think 13x – 14x FCFE multiple is what ALJJ should trade at.  If these multiples are about right, then currently Mr. Market prices our bear case for ALJJ.  If our base case plays out, then ALJJ has ~40% upside.  

However, we expect that FCFE would be significantly enhanced by future capital allocation decisions.  

11. Future Capital Allocation Decisions

FCFE generated by ALJJ would be used for debt repayment, share buybacks, and, more importantly, future acquisitions.  

1. Debt Repayments

As we outlined above, ALJJ has $8M of debt repayments per year.

On top of that, very soon ALJJ would be subject to the excess cash flow cash sweep (75% of the excess cash).  

We expect debt repayments to result in accretion to equity.  

Even we assume no debt repayments out of the excess cash flow, $8M of mandatory debt amortization payments would mean 4.65% of accretion to equity.  

2. Share Buybacks

We do not expect massive share buybacks due to loan covenants: ALJJ can buy back only $2M worth of shares per year.  [NTD: is this correct?  Reference?]

3. M&A

We expect ALJJ to engage in more M&A transactions over the next 3-5 years.  Specifically, this is our set of expectations:

1. Acquisition rate would be one M&A transaction per 12 – 18 months which is in line with the acquisition history of Faneuil, Carpets, and Phoenix Color.

2. Given that for the first time in its history ALJJ has an acquisition currency other than cash (i.e., its shares), we can see even faster acquisition pace.  

3. ALJJ would acquire businesses at 4-5x FCF to Enterprise.

1. Note: while we typically do not like issuance of shares to finance an acquisition, we feel comfortable here due to a multiple arbitrage.  ALJJ trades at 13.8x FCFE (levered after tax) in our bear case and 9.2x (levered after tax) in our base case.  It means that any acquisition at 4x – 5x unlevered FCF would be hugely accretive to FCF per share.  

12. Additional Upside from Capital Allocation

We view ALJJ as a compounding machine.  Acquiring businesses at 4x – 5x unlevered FCF is extremely attractive.  

While ALJJ is cheap, in our view, in its current form and shape, we think additional acquisitions would create an Outsider CEO type return (15%+ per year over the next 5-7 years).  The returns can be bumpy and we have no idea what return will be in any particular year.  But we believe in the bright future of ALJJ if an investor takes patience.

13. Catalysts

1. More M&A transactions.

2. Increased investor awareness and interest due to uplisting.

3. Debt repayment.

DISCLOSURE: We and / or our affiliates are long ALJJ, and may buy additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of ALJJ.  This is not a recommendation to buy or sell shares.

We do not hold a position with the issuer such as employment, directorship, or consultancy.

Catalyst

1. More M&A transactions.

2. Increased investor awareness and interest due to uplisting.

3. Debt repayment.