Monday, October 11, 2010

Hardwoods Income Fund - A bargain?

Lets kick things off with a case study, Hardwoods Distribution Income Fund (TSX-HWD.un).  According to Buffett your investment idea should be very simple and should be explained without any difficult math, discounted cash flow analysis, etc.  I will give the short Buffett version, and a much longer explanation of this investment.  So here goes:

The Short Version

Hardwoods has fallen on hard times through the recession.  Despite the losses from bad debts (customers who didn’t pay) and writing off of goodwill, the company's core business hasn't changed at all.  Sales have fallen from $360 million per year in 2006 to $200 million in 2010.  The company's Net Profit margin as percent of sales historically has ranged from between 3.2% to 4.9% in normal times, with 3.8% being the most common.  Once operating conditions return to some level of normalcy, probably next year, the company will earn around $6.4 - $7.8 million.  If we divide this by number of shares outstanding (14.4 million), the company will earn between $0.44-$0.54 per share. 

Now we go look at the share price and it currently trades at $2.06.  That means the company is selling for around 4 times it's annual profit in a year.  I should add that this multiple is based on the new lower level of sales and assuming the lower end of the profit margin, conservative yet reasonable assumptions. 

Clearly buying this company with an earnings yield of 25% you will do just fine in the long term.  If we apply a conservative earnings multiple of 8.5 times, Hardwoods is easily worth approximately $4.25/sh.

Long Version

Hardwoods Inc is a Vancouver based wholesale lumber distributor.  Their many areas of focus is Western Canada, and Western US states.  It has been in business for something like 70 years.  The former owners (Sauder family) have a long history in the lumber industry.  The business is amazingly simple, they buy hardwood lumber and sheet goods and resell them for a profit.  Looking back over their filings since 2004 their gross margins have ranged between 18-19% (percent of sales).  So basically that is their markup on the products they sell.  Out of the gross profit they have to pay all of their overhead, salaries, and other cost such as bad debts.  The company requires very little maintenance capital and it leases much of there facilities. 

Looking back to the period from 2004 to 2007 the company, at the end of the day, earned a Net Profit (percent of sales) of between 3.2% and 4.9%.  In 2005 & 2007 the company's net profit was 3.8%. 

During the period that followed 2007 the company has struggled with debt covenants, and bad debts.  Obviously being tied to the housing market caused a dramatic drop in sales and bad debts.  The company was loaded with debt before going public in 2004.  Beside this, the company has written off all the goodwill it had on its books creating large losses in the process. 

Despite tough operating conditions the company has paid off substantially all of their debt during this period and the losses associated with bad debts are subsiding.

Sales have fallen from $360 million in 2006 to around $200 million in 2010.  The bad debts of the recession are nearly behind them and once again this company will be a cash cow.  Applying the conservative net profit margin of 3.2% and 3.8%, the company will earn somewhere between $0.44/sh and $0.54/sh.  At the current share price of $2.06 the shares are trading at roughly 4 times normalized earnings. 

As above, applying a conservative valuation of 8.5 times normal earning this company is easily worth somewhere around $4.25/sh.  It's trading for approximately 50% of it intrinsic value.  It's like getting a dollar bill for 50 cents. 

No catalyst required, the company just isn't followed by analysts, is small and thinly traded.  It is a pure Graham-Buffett investment. 

Is Hardwoods a bargain?  You bet.

I should add that the company is currently an income trust and will likely convert back to a corporation before the end of the year.  The company is thinly traded however volume seems to be picking up as of late.  This makes it opportune for individual investors.  You will have to be patient but even paying $3 would be a fair price. 

So in summary, this is simple value investing case study.  It is a simple company trading at a steep discount to intrinsic value.  The odd are heavily stacked in your favor that this no-brainer will be an investment success.  This won't make you money tomorrow, but two years from now it will be trading higher than today. 

Price is what you pay, value is what you get - Charlie Munger

Disclosure - long HWD.un at time of writing


  1. Why don't you include the Class B shares in the share count? The Class B shares increase the share count by 30%, resulting in an equivalent adjustment to the valuation: $0.35 EPS * 8.5 = $3 per share.

    Also, how do you get the 8.5 P/E? What kind of multiple has it traded at in the past?

  2. Thanks for your comments.

    All earnings discussed above are net of the Class B shares. Thus the earninga above are only attributable to the Class A shareholders.

    I use the 8.5 P/E as prescribed by Ben Graham in his book Security Analysis as a base case for a company assuming no growth.

    The company has sold at a higher multiple when it went public. It's a good conservative number and gives an earnings yield of just shy of 12%.

    Company has historically grown slowly at 3-4%.

    Thanks for stoping by,

  3. Thanks for the reply.

    I guess that means you're expecting margins to expand from current 1.2% to above 3.2%, without an increase in sales.

    Have you looked into how much further they can cut their overhead expenses? They've already trimmed about 20%. You might need a recovery in sales to get to your target margins. Nice leverage to sales though...

  4. You are absolutely correct. If you read either the last quarterly or the 2009 annual report they have already cut overhead and staff level inline with sales.

    The margins will expand as the bad debts(cost of sales) decrease.

    Gross margins have been unchanged throughout the recession.

    I will post again after the next quarterly. I expect a decent increase to net profit margin.


  5. Do they pay a distribution or dividend, and what does that look like going forward a year?

  6. Hi Persistentone,

    The don't pay anything currently and haven't since they had some bad debts in the USA due to recession. They have paid off nearly all of their debt in the meantime and have been profitable for last several quarters. They should earn $0.21/share in 2010 at 1.5% profit margin. Going forward they should be able to pay $0.30-$0.40/share in dividends based on normal net profit margins. Based on historical profit margins the company could earn anywhere between $0.44-$0.71/share at current sales levels.

    The Q3 results. due any day, should shed some light.

    The Government of Canada is phasing out income trusts at the end of this year, 2010. I'm sure they will convert to a corporation by the end of the year. Most are converting back.


  7. H Kevin,

    Thanks for your write-up on Hardwoods. This does look very cheap based on past results. After reading some of their filings, your thesis still looks pretty solid to me. I have some questions about the company, however.

    1) What do you think of the long-term incentive plan that was passed in 2010? It allows for a maximum of 10% of outstanding units to be granted as incentives. In Q3 2010, over 460K units were granted, which works out to over 3% of outstanding units. I guess 3% per year is not too bad, but if they are planning on doing something similar each quarter, that does sound like bad news for current unitholders.

    2) From reading the financials, it does not seem to me that the numbers you quote above are adjusted for the class B units. But looking at the subordination arrangement that is in place, I don't think we need to be concerned about the class B units until the per-unit distribution reaches $1 or so. I am not convinced that I understand the subordination arrangement that well though. What is your take on it?

    3) Do you have any pre-2004 numbers for Hardwoods? It would be nice to see a longer historical trend.

    Thanks again.


  8. Hi Veejar,

    Thanks for your comments. I will answer in order. To start, hardwoods has run up quite a bit since that post from sub $2 to over $3 and now at around $2.75. You will have to make your own assumptions as to whether it still has a margin of safety. Also, all of my assumptions are conservative.

    1) I don't like the long term incentive plan, however it isn't the end of the world. The company is slow growing and this won't amount to much. Hardwoods is a classic value play and I wouldn't own this company over the long term. The only strength of the company is it's long track record and ties to the Sauder Group, but after that they have no competitive advantage.

    I should add this note. Whenever a option grants are made a depressed stock prices, below intrinsic value it makes the existing shareholders poorer.

    2) The number I quoted above are adjusted for the Class B units. They are the earnings attributed to the Class A only.

    The subordination agreement basically says that the b shares will be converted after a certain amount has been distributed to the class A. Given the sharp drop in sales and the disaster in the USA, the class B shareholders (Lawrence Sauder) will be in subordination hell for a long time.

    3) Pre-2004 numbers can be found in the IPO prospectus. I'm sure it is on sedar. I read it a few years ago. I'm quite sure it had historical data on sales.

    Best Regards,

  9. Hi Kevin,

    It is very interesting to know what you think about the stock currently? Is it overvalued?