ALJ Regional Holdings Inc. (ALJJ, Financial) is a strange business that is difficult to research, which is good news for value investors. Due to the company’s lack of publicity, it is undervalued and underappreciated despite its enormous opportunity.
ALJ is a mini Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) in more ways than one. The company was born out of the bankruptcy of Kentucky Electric Steel. After the assets of this business were wound down, ALJ was born as a cash shell with over a hundred million dollars of net operating losses to make use of. The company has over $150 million in federal NOLs that do not begin to expire until 2022, so it is currently not a federal taxpayer and can generate higher cash flows as a result.
Building the business
The tax shield is just one part of the investment case. Management has used the company’s cash pile to acquire a string of businesses that are highly cash generative and benefit from the tax shield but are growing slowly.
Capital outlays are low for these businesses as well. Since the company took its present form in 2014, annual capital expenditures have averaged 2.5% of revenues. ALJ’s most significant segments are Faneuil, a call center and customer service provider, and Phoenix, a high-specification printing business. Both segments have substantial backlogs and produce substantial cash flows. ALJ’s third division is Carpets. This business sells flooring and other interior components to homebuilders and retail customers in the Las Vegas, Nevada area. This business is currently not profitable, but it is multiplying.
During the first nine months of fiscal 2017, ALJ generated just under $17 million in operating cash flows, up 21% year over year. Over the long term, it is estimated the two profitable divisions can produce free cash flow of $19 million minus corporate costs and interest ($3 million p.a. and interest charges) -- this against a current market value of $127 million.
ALJ’s cash generation coupled with the tax shield are only attractive assets in the right hands. Fortunately, the business is run by the highly accomplished Jess Ravich, who owns 35% of the outstanding stock (If you are curious about Ravich’s ambitions for the company, check out this podcast).
Why does the opportunity exist?
So why does the opportunity exist here? Three factors stand out.
First, the company flies under the radar. It is too small to be picked up by many funds and there is no real effort by management to market the stock or get the word out. Trying to find financial data requires investigating SEC filings.
Second, the business is highly leveraged. In some respects, Ravich is using the private equity model of buying unloved companies at low prices with debt and then extracting value by using the cash flows from these companies to pay down debt. Gearing was around 120% at the end of June, down from 134% in the prior-year period. The company’s free cash flow is helping it pay down debt rapidly at the rate of around $10 million per annum. Debt to free cash flow is approximately eight times.
Finally, ALJ records large amortization expenses due to the accounting treatment of certain intangible assets like customer relationships and trade names. These amortization charges significantly reduce reported earnings.
Of these three factors holding the stock back, the high level of debt is the most concerning. Regardless, it appears the company has this under control and over the next two years or so, the problem should rectify itself.
Conclusion
Overall, ALJ is an undervalued, unloved stock that is managed by a motivated owner-operator. As the business continues to expand, debt paydown should accelerate, which should drive a re-rating. This whole scenario reminds me of the early days of Berkshire Hathaway when Warren Buffett (Trades, Portfolio) was using the cash generated from the failing textiles business to invest in other companies.
Of course, ALJ is not identical to Berkshire, but over the next several years, as the company’s balance sheet improves and cash flow grows, investors could be well rewarded.
I welcome any comments or criticism from readers.
Disclosure: The author owns shares of ALJ Regional Holdings.
