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INDUSTRY RESOURCES - VALUE INVESTING LETTER LIBRARY

Hardwoods Distribution: A Nice Fixer-Upper
Guy Gottfried, Rational Investment Group • February, 2012

Hardwoods Distribution Inc. (TSX: HWD) is a Canadian distributor of hardwood products primarily to the home construction and renovation industries. The stock currently trades at $3.70 and has a market cap of approximately $60 million. (All dollar amounts throughout this article are in Canadian dollars.) Hardwoods trades at a single-digit free cash flow (FCF) multiple based on depressed results, is strongly capitalized and has a catalyst to boot.

The company has a history of steady profitability, which for years enabled it to support a large dividend. However, approximately 70% of its sales traditionally came from the US, leaving it vulnerable to the housing collapse and overall economic slowdown that occurred late last decade. Hardwoods’ results were hit hard and it was forced to suspend its dividend, causing its stock price to plummet. Nonetheless, operationally the company managed to withstand this difficult environment, nearly breaking even during a brutal 2009. By the following year, it was back to being solidly profitable. Hardwoods continued to rebound in 2011, with sales in the US climbing 17% year-over-year on a constant-currency basis (excluding the effect of acquisitions).

Hardwoods just completed a highly accretive transaction with the purchase of Frank Paxton Lumber Company, a US competitor. Paxton expands the company’s geographic reach and product offering at a bargain price. Hardwoods bought Paxton for just the cost of its working capital and machinery and equipment. Moreover, the deal valued Paxton at just eight times trailing FCF, which we believe is far below normal levels.

Presently, Hardwoods trades at nine times trailing FCF; however, trailing figures do not do the company justice since its results continue to suffer from an American housing market that remains in a severe slump. Indeed, trailing FCF is approximately half of the FCF that Hardwoods generated in every year but one between 1999 (which is as far back as financials are available) and 2007 (prior to the onset of the housing crash and financial crisis). In other words, once industry conditions normalize in the US, earnings and cash flow will soar. Therefore, Hardwoods’ true multiple in a normalized environment is dramatically lower than the already inexpensive trailing figure. And, of course, that multiple will be lower still if management can execute more intelligent acquisitions like Paxton.

The stock possesses several other attractive attributes. In addition to being cheap on an earnings and cash flow basis, Hardwoods trades at a 20% discount to tangible equity. It also has a solid balance sheet: cash, receivables and inventory exceed long-term debt by a factor of four to one, and in the last twelve months, FCF has covered interest expense by more than eight times. Further, the company has seen steady insider buying since late 2011. Most recently, its largest shareholder, Peter Bull, has singlehandedly accounted for roughly half the total volume in the stock since the start of December. His purchases have averaged $3.45 per share and have been as high as $3.80.

Lastly, after two-and-a-half years, Hardwoods reinstated dividends in mid-2011. The resumed quarterly rate of $0.02 per share equates to a payout ratio of only 20% of trailing FCF, which, again, is on the rise. The company will almost surely boost dividends substantially over time as its performance continues to recover, which we expect to serve as a catalyst for the stock. Note that Hardwoods used to pay out as much as $1-plus per share, and while we do not expect a return to anywhere near that level, even at 75% below that amount the stock would yield 7% at the current price.

In conclusion, Hardwoods trades at a cheap multiple despite 70% of its business being near a cyclical trough, has a strong balance sheet and has a catalyst in the form of a material increase in dividends in the near-to-medium term.



 
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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