Avalon Holdings | Cash Flow Illusion

When I began focusing on value investing I started out using a Discounted Cash Flow method (DFC) to determine the future value of a security. However, the problem with DCF is that it forces you to predict and if you have a long time horizon (say ten years) only a fractional difference in growth rates or risk-free rates can move valuations at light year distances.

Discounted Cash Flow Analysis

Consider for example a cash flow stream that you would like to discount over ten years with 10-year treasury bonds (3,72% in this example) as a risk-free return. Let’s assume that the investment is returning $1 in the first year, with a (gu)estimated growth rate of 4%.

With these assumptions, the Net Present Value (NPV) of the investment is $13,17. Now, suppose that the growth rate is 5%. The Net Present Value changes with this increase of one per cent to $52,02, an astronomical difference. After tinkering with this method for some time I came to the conclusion that this forced predicting was leading me astray from finding value. I needed an alternative approach.

Cash Flow Yield

Enter cash flow yield. The likes of Henry Singleton set themselves a benchmark of not investing in a project unless it had an expected rate of return of at least 15%. With this in mind, I started focusing on price-to-free-cash-flow yields. My assumptions were as follows:

1. A company that creates wealth by generating free cash flows (as opposed to the other three ways hypothesised by Marty Whitman) can be measured in terms of quality with relative ease by looking at the free cash flow that it returns on its equity.
2. However, the market price of that equity is also a source of potential value. So if a given security is returning a 4% free cash flow yield on its equity, but I can buy that equity at ¼ of its book value, then I’m getting a 16% cash flow return on the capital I used.

Avalon Holdings Corp

This conjecture was central to my reasoning for buying shares of Avalon Holdings Corp (AWX). In my Avalon Thesis, I took the following possibilities for the market’s apparent undervaluation to be valid (thus making it a Value Trap):

• Slow growth rate (5Y annual avg. sales growth is 4.24% compared to 12.5% industry average)
• Low profitability (note: the main source of losses comes from the golf operations)
• The stock is very small and illiquid
• Chairman and former CEO Ron Klingle has total voting power and therefore control over the company
• Gross margin is very low (18.4%) compared to the industry average (60.7%)

I was also optimistic about the fact that Mr Klingle was stepping aside as CEO (but remaining as Chairman) and Steven Berry would take over. My thoughts were that Berry had incentives to perform (and increase shareholder value) as Klingle had been under scrutiny for using the company (and its treasury) as a means to improve his social status as a golf club owner. When Berry resigned in less than a year after taking over, I saw it as a sign that the company is completely in the hands of Klingle and he simply is not returning value to shareholders.

Value Trap

At current prices, you can get AWX’s cash flow on very favourable terms, a hefty 16% yield on market price. But, this is a trap. The bottom line is that Klingle controls the company and as he is retaining all earnings and investing them, the quality of those reinvestments is what matters in terms of creation or destruction of value. To demonstrate I want to borrow the back of the hand calculations of a one ThomasCapital on the Yahoo! AWX message board:

I recently came across this company through a value screen, and I was fairly interested until I ran some back of the envelope calculations on how management has allocated capital, relative to what that capital has earned shareholders:

Capex spending, sum of prior five years:
Golf segment & other operations: $16.3 mil.
Waste management $.145 mil.

Total earnings before taxes, sum of prior five years:
Golf segment & other operations: -$2.1 mil.
Waste management $15.7 mil.

Thus far, I’m inclined to think the numbers speak for themselves – management has been investing in the wrong business! On the other hand, does anyone have an idea what level of earnings the golf segment could eventually earn?

To sum up the lesson I learned from Avalon: The free cash flow yield is meaningless if the cash flow is being reinvested by management to project of lower rates of return.