Description

Arrow-Magnolia is an undervalued micro-cap company that is willing to sell itself at the right price. In 2000, the company had an agreement to sell itself to BioShield for $5.00 a share ($4.41 in cash and 0.05221 shares of BioShield common). The deal fell apart, however, due to financial problems at BioShield, which is now close to bankruptcy.

What this failed deal showed was that Arrow-Magnolia?s management is willing to sell the company. I intent to show is that the stock is currently priced significantly below its intrinsic ?earnings power? value. As well, I will also show that the company?s market value approximates the company?s liquidation value, which supports the idea of how safe of an investment this is.

Description of Company

Formed in 1937, Arrow-Magnolia makes and distributes hundreds of chemicals and products used for cleaning, coating, general maintenance, and sanitation (e.g., industrial solvents, disinfectants, cleaners, lubricants, degreasers, herbicides, and pesticides). The products are sold through 80 sales representatives and outside distributor to large-scale users, such as hospitals, manufactures, and golf courses.

Earnings Analysis

From 1996 to 2001, the company?s annual earnings varied between $0.26 and $0.35 a year. Although sales and gross profits were rising steadily until 2002, higher SG&A expenses have kept earnings from yet surpassing their 1997 peak. The very strong economy in 1998-2000 caused high turnover of the company?s sales representatives, which have hindered both the company?s profits and expansion plans.

In 2002, ARWM will earn about $0.12 (first three quarters eps = 12 cents; my Q4 estimate is Nil compared to 01Q4 of d$0.01 ? 01Q4 had some non-recurring costs associated with the failed buyout). The causes for the shortfall in 2002 are attributable to three reasons: (1) temporarily higher shipping costs; (2) still relatively tight labor market; (3) a slight sales decline; and (4) a $125K settlement of a lawsuit.

The lawsuit amounted to $0.03 per share. The shipping costs and labor problem, which caused SG&A to jump about 10% this year. Had these cost only increase by half of that, earnings would be about $0.07 higher for the year. Furthermore, the tight labor market has required management to find new sales representatives. This explains why sales are down 3% this year. Without these issues, which directly accounted for at least $0.17 per share in 2002, earnings would likely have reached $0.30.

In 2003, I expect the company should be able to post earnings of or exceeding $0.30 a share. This estimate is based on the absence of the aforementioned difficulties, along with the likelihood of resumption in sales growth (sales had grown every year from 1993 to 2000 at an annual rate of 9.5%). A weaker labor market (compared to the 1998-2001 period) should help the company keep turnover of its sales reps low, thereby lowering G&A expanses and letting management focus on growth. The company has much room to expand ever since it double the square footage of its facility in 2000.

A proper P/E ratio for a company like this should be at least in the 10 to 12 range, in my opinion. Using the $0.30 normalized earnings figure, (and adding back the company?s $2.5 million, or $0.65 per share, of excess cash, but subtracting $650,000, or $0.20 a share, for the after-tax cost of the environmental remediation) yields a valuation of $3.45 to $4.05. That?s an upside of 70% to 200% over the current share price. Plus, keep in mind that this is a stand-alone valuation. The company's acquisition value is undoubtedly higher considering that combining this company with an similar one would likely produce both cost and operational synergies.

The two key attractions to an investment in ARWM are the limited downside (see Balance Sheet Analysis below) and the likelihood of an eventual sale of the company. I think it?s pretty obvious that management is a willing selling at the right price, given their willingness to be bought out by BioShield.

Current management, which holds 61% of common, took control of the company in 1985. Morris Shwiff and Mark Kenner, who together own 53% of common, are 79 and 69 years old, respectively. Their ownership stakes probably represent nearly all of thier wealth since there salaries are nothing special. Both of them have been making about $200K a year in salary and bonus.

Balance Sheet Valuation and Analysis
(as of September 30, 2001)

Current Assets $7.3 million
Net Property $2.3 million
Intangibles/other $0.2 million
Total Assets $9.8 million

Total Liabilities $1.2 million
Shareholder Equity $8.6 million

Net-Net Working Capital: $6.1 million

Market Capitalization: $6.5 million / $7.3 million (including diluted shares)

The company owns its only property, a 70,000 sq. ft. building in Dallas, TX. The main use of it is a warehouse, but 10,000 sq. ft. is used as administrative and executive offices. The cost basis for the land and the building is $1.5 million. The company?s 2001 tax appraisal was $1.3 million. Any way you slice it, though, either valuation seems low consider that at $1.5 million the building?s value is only $21 per sq. ft. (My own guesstimate is that the property is likely worth at least $30 per foot given its good location. Note: The company spent about $700,000 adding 30,000 sq ft in 2000.)

Taking the net-net working capital figure of $6.1 million and adding the value of the property you get $7.6 million. That works out to just above the market value of the company (including diluted shares)

But, the company has one potential off-balance sheet liability. In 2000, the company found that soil and groundwater underlying its facility have to be decontaminated due to the presence of chemicals. The company has yet to determine how much this will cost. Through my conversations with management I believe this won?t be a serious issue ? almost certainly less than $1 million. Obviously, however, this reduces the company?s valuation.

All told, barring a horrible outcome of the environmental issue, the company?s market value approximates its true asset value. This factor, combined with a likely sale of the company within a couple of years, makes this a very appealing investment.

Catalyst

- Potential sale in the next couple years
- Aging management
- A resumption in sales and earnings growth