Danier Leather, a retrospective on a cheap stock.

Almost three years ago to the day I looked at Danier Leather -a Canadian leather retailer- and walked away because I couldn't identify a margin of safety. The company was cheap at 2x EV/EBIT, earned an ROE of 12% and traded for slightly more than NCAV. After passing on the investment I mostly forgot about them until recently when I came across a post on a message board mentioning they were pursuing strategic alternatives. This news grabbed my attention although as you'll see in this post my interest faded quickly once I realized what had happened to the company in the years since I looked at them.

Danier Leather (DL.Toronto) is a Canadian leather retailer. They sell leather handbags, coats, belts and most anything that can be made out of leather. The company has a large sales presence in malls throughout the country.

Common sense would dictate that a leather company would be seasonal with most sales coming in the colder months. This is partly due to weather (winter coats) but also due to holidays and the fashion calendar. It was certainly true for Danier Leather up until a few years ago. The company made an incredible claim for a winter coat company in a recent report, they stated that last year's winter was too cold and sales were down as a result. Maybe sometimes there really is too much of a good thing. Danier Leather hoped to sell warmer winter coats this year to compensate for last year's cold and long winter.

I believe Danier Leather illustrates a number of different points regarding potential value investments: cheapness alone isn't a thesis, buybacks aren't always good, and that a margin of safety is essential for any investment.

Cheapness Alone Isn't a Thesis

Most people prefer to pay less for something verses paying more for the exact same thing. But just because something is cheap doesn't make it good. On weekends, neighborhoods near us are littered with garage sales and estate sales in the spring and summer. Shoppers can browse through items sellers have determined aren't necessary anymore. Most things for sale are cheap, almost astounding cheap, but not much is worth purchasing.

At a garage sale, an object needs to be both cheap and useful. An old lampshade for $.50 is cheap, but if you don't have a lamp to put it on, the shade is money wasted. The same is true for investments. A company can only have a low EV/EBIT (or EBITDA) ratio by having a lot of cash, or abnormally high earnings. Companies with a lot of cash might be cheap, but if the cash is squandered or the market never values it, what's the point? Likewise a stock trading below book value could own valuable assets the market doesn't recognize, or it could own a bunch of worthless assets and IOU's in the form of uncollectable receivables.

When a company re-rates higher it's due to business improvement, market awareness about an asset or earnings, or from a management action. If a cheap stock remains obscure and management continues with a faulty business plan it's likely the price will remain depressed.

At the time of my first writeup Danier Leather was trading with an EV/EBIT of 2, an extremely low valuation. And at barely above NCAV the stock was clearly cheap. The problem was the outcome for the stock rested on what management did with the cash, and how the business performed. In the ensuing years management mismanaged both the company's operations and their pile of cash.

Buybacks Aren't Always Good

There is a piece of common wisdom passed around amongst investors that stock buybacks are always a good thing if the stock trades below intrinsic value. This is mostly true. When a company buys shares below their intrinsic value buybacks are value Accretive. If buybacks happen when a company trades below book value the buybacks increase book value per share. Both of these scenarios are good for investors.

Investors prefer buybacks over dividends because they're tax efficient. But buybacks make an assumption that isn't always true for value type companies. Stock buybacks presume that the company conducting the buybacks is stable or growing. If the company is losing money and the stock price continues an unrelenting fall buybacks are merely throwing money into the wind. The list of companies that have purchased their shares at high levels only to see them trade lower on a semi-permanent basis is long.

Danier Leather has been buying back their shares since I last wrote about them. The company has also been incurring losses as revenue has declined. The company's net loss decreased book value, and while the company repurchased shares it wasn't enough to counteract their losses. To make matters worse the company repurchased shares at a value about 3x higher than where shares trade today. Investors have realized nothing from the buybacks whereas if the company paid out the cash used for buybacks as a dividend it would have helped investors reduce their losses, or reinvest elsewhere.

If a company is growing or stable, I appreciate buybacks. If the company is very small, has illiquid shares, or the future is uncertain I'd prefer a cash dividend. With cash I can make the decision myself to reinvest back into the company or invest elsewhere. Of course it's never possible to know what the future holds and sometimes it's better to have one bird in the hand (dividends) verses two in the bush (buybacks).

A Margin of Safety Is Essential

A cheap company with a future of losses is akin to a melting ice cube. At the time of my post I couldn't foresee their losses. The problem with a retailing company is they run with a high level of operating leverage. Operating leverage cuts both ways, once fixed costs are paid income increases rapidly as sales volume increases. On the downside losses accelerate on slight sales declines. Danier Leather's sales have been on a decreasing trend for years. They finally hit the tipping point and revenue declines have finally led to losses.

A retailer can be caught in a vicious cycle where in an effort to increase sales they incur even larger losses with investments in sales and deeper product discounts. Danier Leather has finally unveiled a way for potential customers to order online. This is astounding to me, outside of a few luxury brands the inability to purchase something online is a hindrance to the brand. They touted their online marketplace as a replacement for their phone ordering system. An order by phone system is reminiscent of the 80s and 90s. With telephone ordering I wonder who their target market is?

If there was a margin of safety in the shares it has been eroded with the operating losses. The company's cash pile shrunk with their share buybacks and now the company is in a defensive position. Their products appear to be out of fashion and they're caught in a deep discount loop.

What's Next?

The biggest question shareholders are asking at this point is what's next for Danier Leather? If the company can't stop the sales decline this ice cube will melt fast. Management finally decided to take action and issued a press release stating they are looking at strategic alternatives. This should be encouraging, with a book value north of $10 per share shareholders stand to benefit if management were to liquidate or sell. I'm not sure of the likelihood of that happening. The press release mentioned that management will consider raising debt, issuing equity or selling the company. I'd presume the strategic alternatives were in the order that management might attempt to act. They will issue debt first then issue equity and finally when all hope is lost sell or liquidate.

Maybe there is a play here for savvy investors. I've learned a lot reviewing the company and where they've been the last three years. I'll end this post the same way I ended the last one. There still isn't a margin of safety in Danier Leather for me to consider investing, I'll continue to watch from the sidelines.

Disclosure: No position