TTA Holdings, a very cheap Australian net-net

A few years ago I ran a screen for Australia and came back with less than five companies selling below NCAV.  Things change quickly of the 1,905 companies listed in Australia 622 are now trading below 80% of book value.  Of course when that much of the market is selling below book there are bound to be stocks trading below NCAV as well, TTA Holdings (TTA.Australia) is one of them.

TTA Holdings is the Australian subsidiary of TEAC, a Japanese technology company.  TEAC manufactures and sells everything from LED TV's to audio recording equipment to CD-ROM drives. TTA Holdings is the regional distributor of TEAC's products in Australia.

The company fits a common net-net stereotype, a company struggling with revenue declines.  TTA Holdings has seen their revenue shrink from $62m in 2010 to a recent $51m.  As revenue has declined the company's earnings and dividend have fallen as well as seen in the table below:

Even with declining sales and earnings TTA Holdings could be interesting from an investment perspective.  The company has a market cap of $5.8m against a NCAV of $9.8m, and equity of $18m.

From a pure numbers stand point this seems like a decent enough investment.  Buy $9.8m of current assets, and $18m of equity for $5.8m and wait for the company to turn things around.  Management is of course telling investors that they're working to turn things around, although the results tell a different story.

There's a line in the company's annual report and their most recent trading statement that triggered the first red flag for me.  The company attributed losses to incentives offered to dealers to clear out older inventory.  A statement like that seems innocuous, and maybe it is, but I have a reason to believe it's otherwise.

Sometimes with an investment we can gain insight from unusual sources.  In the case of TTA Holdings I have a very close relative who was in sales at a US TEAC subsidiary.  The stories he told were legendary, channel stuffing, tricks to make quarterly numbers, pressure tactics, and others.  If you can imagine a terrible sales tactic they were encouraged to use it.  Not only by the local US branch, but by their Japanese parent.  Their parent company had a culture that cared about the numbers and not much else.  Whereas most investors praise companies that are focused on the numbers it's cultures like this that worry me as an investor.  

What are the incentives offered to customers to clear their old inventory?  Are they simply rebates, or are they more aggressive tactics?  The problem with a company whose sales forces does whatever it takes to get the job done is that they can burn relationships with clients.  A company can get away with this for a while if they're in a market leading position.  Comcast can ignore customers without fear of customer attrition.  If a smaller company ignores or alienates their customers they'll find themselves without any customers.  Reputations travel fast in the business world.

Besides the company's sales tactics there are a few issues with their financial statements that make me hesitant to invest in TTA Holdings.  The first is that the company is deriving a significant amount of their earnings from foreign currency gains.  If one only looks at their bottom line then TTA Holdings earned a profit last year.  But on further inspection they incurred an operating loss and had a currency translation gain for a profit.  Currencies are very volatile and shouldn't be relied on for continued profits.  It's better to invest in a business who can price their products for more than their cost and sell at that price.

The company has also begun to incur debt to fund their operations.  While they had a $464k profit on their income statement they consumed $6.7m according to their cash flow statement.  I don't make a big deal about cash flow on this site because in most cases the companies I look at have cash flow that mirrors earnings.  When those two values diverge it's a warning flag to research further.

In the case of TTA Holdings the company is paying out more to suppliers and employees than they're bringing in from receipts.  They're funding the shortfall with short term debt to the tune of $7m.  The bank borrowing is due in less than a year, which indicates the company expects things to turn around quickly from a cash flow perspective.

Unfortunately their latest press release is more bad news.  In the first four months of the latest year the company lost $3.2m that they again attribute to inventory issues.  The press release didn't include financial information but with a loss this size it's possible much of the margin of safety provided by the company's assets has been eroded.

While the company initially appeared cheap after a much closer inspection the investment case began to fall apart.  In the most recent annual meeting transcript for FRMO Murray Stahl has an insightful point.  He said if a fund manager were tracking the S&P and wanted to outperform instead of looking for stocks that would do better they should purchase the index and not invest in the worst constitution.  Buying 499 S&P companies and avoiding the worst would result in the index being beat.

Many times investors are so blinded to potential gains that they forget to look at what could be lost.  When I looked at TTA Holdings I see a very cheap company at a low valuation.  But I also see a situation where the potential for a loss is very significant, potentially greater than the potential for a gain.  This stock could shoot higher, but if I think of Stahl's statement I merely need to avoid the losers to do well.