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Steven Wood was one of three finalists in the first Value Investing Challenge in 2012, which had more than 110 submissions that were judged by a panel of top money managers. Here's an update on his thesis on Fiat.

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THIS MONTH'S ISSUE

Building Value, Brick by Brick
By Guy Gottfried

The Brick Ltd. (TSX: BRK) is a Canadian retailer of furniture, appliances, mattresses and electronics. The stock presently trades at $2.85 and has a market cap of $400 million. (All dollar figures in this write-up are in Canadian dollars.) It is a high-quality and extremely well-run business that trades at an undeservedly cheap price.

The Brick traded for $9-plus per share as recently as 2008 but was undercapitalized entering the financial crisis due to years of excessive dividends by prior management. It nearly went bankrupt before being recapitalized in mid-2009 in a transaction led by Fairfax Financial. It then recruited turnaround specialist Bill Gregson as CEO, and under his leadership has staged a dramatic recovery in its operations and financial condition.

However, these improvements are not reflected in The Brick’s valuation. This business trades at just over seven times trailing free cash flow (FCF). Moreover, trailing FCF significantly understates normalized results given operational and capital allocation initiatives that are already underway, making the stock substantially cheaper than it appears.

The Brick is extremely well run. Fairfax remains the lead shareholder and owns 33% of the company. Well known in value investing circles, Fairfax is an insurance company in the Berkshire Hathaway mold, which has compounded book value per share by 25% annually over 25 years. Meanwhile, CEO Bill Gregson is a great operator with a penchant for reviving troubled retailers. He has already achieved major progress at The Brick in his short tenure; for instance, the company has improved gross margins by 300 basis points (bps) and generated the best same-store sales in its space by a wide margin this year.

Capital allocation under Fairfax and Gregson has been excellent. In late 2010, as soon as the The Brick’s financial strength had been restored, it began aggressively retiring shares. The company has cut its diluted share count by an impressive 25% in just the past 14 months. It is presently engaged in another repurchase program for 5% of its shares and warrants, which it is on track to complete by mid-2012.

The Brick has also seen heavy insider buying, with 13 senior executives and directors, including Fairfax and Gregson, purchasing a combined 6.1 million shares and warrants since May 2010. It is a strong signal that these shrewd capital allocators are committing their personal capital to the company through open market purchases.

Notwithstanding its past challenges, The Brick is actually a good business. It has substantial economies of scale – it is the second-largest retailer of furniture and appliances (its two main product categories) in Canada – and one of the most recognized brands in the country. It also operates a highly profitable and cash flow generative financial services segment and rapidly growing, high return on capital franchising business, whose excellent economics are masked by the larger corporate retail chain.

Operationally, despite Gregson’s progress to date, there remain significant opportunities for additional improvements due to mismanagement by the prior leadership. The Brick’s operating costs as a percent of sales are some 350 bps above those of Leon’s Furniture, its closest competitor. For every 100 bp improvement in this operating cost percentage that the company can achieve, its trailing FCF will rise by 18%.

On the capital allocation front, the company will likely end this year with over $130 million in cash and is generating $55 million in annual FCF. Given its financial strength, by early 2012 The Brick will be able to comfortably repurchase a boatload of stock. To illustrate, if it executed a self-tender at a 20% premium to the current stock price, it could retire 18% of its shares and grow FCF per share by 22% while leaving $50 million of cash in the bank. Importantly, The Brick not only possesses the balance sheet to take such actions, but also an ownership and management team that is actually willing to take them.

The Brick presently trades at seven times trailing FCF. This is already an attractive multiple for such a well-run business. However, it is even more appealing considering the firm’s significant growth prospects stemming from the initiatives described above. By 2014, The Brick will have been able to: 1. improve its operating cost structure by at least 100 bps; 2. buy back 20% of its shares; and 3. redeem its costly 12% debentures issued as part of the recapitalization, which mature that May.

This would translate into nearly 70% cumulative growth in FCF per share within two-and-a-half years, yielding a FCF multiple of just four. And our assumptions are hardly Herculean – the foregoing scenario assumes zero sales growth and actually leaves The Brick with a sizeable cash balance due to ongoing cash flow generation.

What sort of multiple will The Brick merit at that time – ten, twelve, or perhaps higher? The answer is irrelevant: in any of these cases, the stock is worth significantly more than its trading price. Ultimately, with The Brick, you are investing in a good business, with terrific management and capital allocation and a rock-solid balance sheet, at a bargain valuation.



 
Guy Gottfried
 
Guy Gottfried
Guy Gottfried is the founder and manager of Rational Investment Group, a value-oriented investment fund. Rational employs a risk-averse, research-intensive value methodology to uncover securities exhibiting material upside potential along with minimal risk of capital impairment. Prior to launching Rational, Mr. Gottfried was an analyst at Fairholme Capital Management. Mr. Gottfried is a graduate of York University in Toronto, where he was a President's Scholarship recipient.
 
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