Sunday, December 23, 2007

New Position: Finishmaster

This idea begins courtesy of Tweedy Browne:
For instance, in our Value Fund, we recently purchased shares in a small company called FinishMaster, Inc., which is the largest independent distributor of aftermarket automotive paints, coatings and related accessories to the collision repair industry with an estimated market share of 18%. The company buys automotive paint and paint-related accessories from a concentrated group of suppliers (BASF, Dupont, PPG, and 3M) and distributes the products to a highly fragmented customer base of collision repair shops, auto dealerships and organizations that maintain their own automotive fleet. Size in this industry is an important competitive advantage for FinishMaster, because it allows for price discounts and rebates only available via volume purchases from the original equipment manufacturers (“OEMs”). As the only national distributor, they have a cost advantage versus their competitors. They have an excellent long-term operating record, having compounded their intrinsic value at nearly 13% annually. Margins have been stable, and the company generates significant free cash flow, which has been used primarily to pay down debt, and secondarily, to make modest tuck-in acquisitions.

At the time of our initial purchase, the company was trading at 6.8 times trailing twelve-month earnings before interest, tax, and amortization (“EBITA”), and approximately 11 to 12 times earnings per share. At this valuation, FinishMaster provides us—as investor/owners—with an
underlying pre-tax yield on our investment of 14.7% and an after-tax earnings yield of 8.3% to 9.1%. It also appeared to be trading at roughly a 40% to 50% discount from valuations paid in observable acquisitions (buyouts) of comparable companies. This company may sound somewhat boring, but it is cheap, growing, and has what appears to be a sustainable competitive advantage. We’d love to own 100 bargains like this. One caveat is in order. This company is small, and was de-listed in 2003, so it currently trades in the Pink Sheets, and has a publicly available float of only $50 million, so the Value Fund has a very modest position.
For Fiscal 2006, Finishmaster had income from operations of $35,015,000. Assuming a 35% tax rate, that leaves $22,760,000 in after-tax income. But there is also a bonus: Finishmaster's net income understates their true free cash flow.

Depreciation and Amortization over the last 3 years has been:
9,038,000 .... 7,777,000 .... 6,114,000

And Capital Expenditures has been:
2,072,000 .... 3,753,000 .... 3,205,000

So if you assume a run-rate capital expenditure of 3 million, thats an additional 6 million in income, bringing free cash flow up to about $28,760,000 for 2006.

As for the valuation of the company, the most recent quarter had 7,834,000 diluted shares outstanding. Adding the recent special dividend to the stock price brings it up to $32.50. And adding debt brings Enterprise Value to $302,259,000. That means 2006 cash flow yield is at 9.5%. For the three quarters up to this year, net income is down 2.3 million, yet Depreciation and Amortization is also up 2.76 million and the run-rate capital expenditure rate hasn't changed. So free cash flow is about even so far this year, but growth has stalled.

Which brings us to the second factor: Moats. It was already mentioned by Tweedy Browne that they are the largest distributors in their field and have an advantage in terms of volume discounts. But there is also some other things we can perceive from a look at the historical data on Finishmaster:

The chart is not complete, but we see:
1) The company has shown phenomenal and consistent growth over the last 12 years. Part of that has been organic, and part has been because of tuck-in acquisitions.
2) Because their industry has had stable revenues over the years, their growth has been largely due to expanding market share.
3) Inventory Turnover in 1995 was 3.37. In 2005 it was 6.75.
4) The company has been able to reduce operating costs as a percent of sales and gain efficiencies as they've expanded their business. As a result, they have a competitive advantage against smaller competitors and they have been able to reduce gross margins and increase sales, while still expanding their net margins.

Overall, Finishmaster is a pretty simple business, and it provides a necessary service that doesn't appear to be going anywhere. It has possibilities for continued growth by stealing more market share and by using its distribution for expanding into similar products. It has a low cost/market-share advantage over competitors. And as a distribution business, it requires very little in capital expenditures, so the free cash flow is really free. Management appears to be focused on the right things, and is incentivized appropriately with about 73% of the outstanding shares. They have chosen the shareholder-friendly rather than abusive route and their wages are very reasonable. And finally, you can buy a piece of this business at a current yield of 10%.


Anonymous said...

"Independent" meaning Finishmaster competes against its suppliers? Do BASF et al. have their own distribution divisions? Or do they compete against Oreilly and Autozone?

Nnejad said...

Here's what they have to say about it from their 10-K:

Nevertheless, some paint manufacturers have
elected to operate company-owned distribution facilities in selected markets,
including markets in which we operate. We believe, however, that the largest
automotive paint manufacturers have generally avoided the cost of operating
their own distribution network due to their inability to offer multiple lines of
paint which prevents them from spreading distribution expenses across the
market's entire potential customer base. Consequently, we believe that
independent distributors like us, which can sell the products of several paint
manufacturers, are better situated to service the end users' needs than the
company owned distribution facilities of automotive paint manufacturers.....

Although the largest automotive paint manufacturers have
generally not operated their own distributors, or have done so only on a limited
basis, they may decide to expand such activity in the future. For example,
Sherwin-Williams distributes its own automotive paints through its sales
outlets. In addition, BASF, one of our principal suppliers, also distributes in
certain markets through its own outlets in North America. While we do not
believe that current direct distribution efforts by automotive paint
manufacturers have significantly affected our sales, there can be no assurance
that we will not encounter increased competition in the future. We may also
compete with our suppliers in selling to certain large volume end users such as
van converters, small manufacturers and large fleet operators.