Recommendation: BUY, target price $1.40
Share Price: $1.37
Market Cap: $37.2m
Free Float: 43.9%
Ave. Daily Traded Volume: $58,454
Emerson Radio is an ugly company, in an ugly situation and with very ugly corporate governance issues which peaked my interest. My attention was drawn to the stock whilst trawling through The Corner of Berkshire & Fairfax (great investment board if you are not already aware). Unfortunately by the time I got round to doing my analysis I was a month too late to capture the ridiculously low valuation at c. $1.0 per share but I still think it represents good value at these levels and as a result I am adding it as a 5.0% position to the HIPS portfolio.
Emerson Radio is a well-known brand in the US which started life in 1912. The last c. 20 years have not been very kind to the company and it filed for bankruptcy 1993 emerging a year later retaining its listing. In 2006 Grande Holdings, a listed Chinese electronics company, acquired over 50% of the business and started to flout almost all the corporate governance rules in the book. There has been a long history of related party loans and dealings which resulted in various independent board members resigning from the company including the chairman of the audit committee. Grande Holdings filed for provisional liquidation in Hong Kong in June 2011 and is still mired in the process. FTI Consulting were appointed provisional liquidators and up until Feb 2014 had communicated that they would look to monetise Grande’s assets for the benefit of creditors including their c. 60% stake in Emerson Radio. What has transpired as the insolvency has matured is that (i) the vast majority of Grande’s creditors (specifically Sino Bright) have been revealed as related party entities controlled by Mr Ho, the controlling shareholder pre insolvency, and; (ii) the current plan supported by the liquidators is a debt for equity swap and resumption of Grande’s trading on the Hong Kong exchange (more detail on this situation is provided below).
As it stands today there is unfortunately nothing to show that things have changed for Emerson from the bad old days as (a) their effective owner remains the same, (b) Emerson management remains Grande appointees, the board governance is somewhat bolstered by the presence of FTI employees, and; (c) they have retained their auditors despite public censorship of the firm and their relations with Chinese reverse mergers etc. In short “the leopard has not changed its spots.”
Today the company has two key business lines:
- Low grade white goods
- Their main product lines are micro waves and small fridges which they sell almost exclusively through Walmart & Target who represent c. 90% of their sales
- They outsource all manufacturing of the items to c. 3-4 factories in China
- License / royalty business for Emerson TV brand
- They license the Emerson brand and IP to Funai (listed Japenses net net) who sells flat screen LCD TVs into the US market
I looked that the valuation in two different ways both using low / high cases due to the inherent uncertainty around the tax liabilities. The first was to look at the premium to current market value assuming in one case all the tax liabilities and the other wins on NOPA 1 & 2 and a loss of the dividend claim. As a sense check I looked at the implied net creation price of the Funai royalty stream if all the tax liabilities are all realised and if they are not. My lowest value for the royalty stream is a multiple if 4.0x, in reality given that EBITDA converts 100% into EFCF I imagine the market will value this higher by demanding less than a 25% running cash yield on the market cap. It is worth pointing out that I have not given Emerson credit for its strong positive working capital position which I have detailed above. Even using a liquidation value where you assume they (i) do not recover 100% of receivables due from Walmart, Target and Funai (unlikely), (ii) the inventory & prepaid purchases are fire sold in a car parking lot, and; (iii) any money remitted to the Chinese factories is not recoverable the positive net working capital balance still represents c. 20% of today’s market cap. If the two parts of Emerson were sold on a solvent basis my exclusion of working capital is likely to under value the company. Finally one criticism you could lay at this valuation is that it does not apply a negative value to the white good business which is currently losing $400k of cash on an annual basis. I assume that any buyer of the business would be able to generate significant synergies which could allow them to take it for at least $1 as opposed to being required to be paid a dowry to take the subsidiary which would represent a downside to valuation.
Getting comfortable underwriting the above assumptions you need to diligence three key areas (i) the tax liabilities, (ii) the licensing revenue, and; (iii) the US white goods business. In addition you have to ask yourself whether you can get comfortable with the controlling shareholder risk particularly given the lack of minority protections in the articles of association and their past track record.
The company has three different tax liabilities that it is fighting with the IRS over.
The first, referred to by the company as NOPA 1 and raised by the IRS in April 2013, relates to the way Emerson’s controlled foreign corporation (“CFC”) in Macao recorded its product sales during FY 2010 & 11 where the IRS is arguing for an increase in taxable income of $5.0m and $5.7m respectively. The company is disputing this claim and has pegged the total liability at $14.9m on the basis that if the IRS is successful they will apply this to the period FY 2012 – 2014 as well. This liability is not recorded on their balance sheet as the company thinks the probability of losing the case is low (will come back to how much reliance you can place on this later).
The second, referred to by the company as NOPA 2 and raised by the IRS in June 2013, relates to the IRS challenging the position Emerson took with respect to the fact that they considered the service fee paid to their Macao CFC to be non-taxable in the US. In this case the company agrees with the position of the IRS but disputes the IRS’s figures, to date they have paid $0.9m out of an estimated $1.3m liability.
The final tax issue relates to a $1.10 dividend paid in 2010 and was raised by the IRS in August 2012. In determining withholding tax payable the company determined that only 4.9% of the dividend was taxable due a “stock-for-debt” exception. The IRS has outright challenged this position claiming that 100% of the dividend is taxable. The company is defending the claim but should they loose then the IRS will look to claw back tax from parties that received the dividend. This is where it gets really murky as the company originally withheld tax from the dividend paid to foreign shareholders but on request from S&T (controlling shareholder and subsidiary of Grande Holdings) they paid out the full amount in return for an indemnification from future claims in the form of S&T stock in Emerson. In Feb 2011 the company agreed that the collateral arrangement was no longer required. It is unclear why they agreed this as (i) they clearly thought it was required at the time of the dividend, and; (ii) it was way too short a period to be certain the IRS was fine with the interpretation they had taken, usually tax indemnities last of the statue of limitation e.g. 6 years in the UK. If Emerson looses the case and the IRS cannot make recovery from S&T (unlikely as it is in liquidation in Hong Kong and the IRS would be an unsecured creditor) then Emerson could be liable for $4.7m of tax due by S&T. Obviously all of this happened under the watch of pre-insolvency Grande so perhaps to be expected but what is even more galling is that Emerson paid an extraordinary dividend in Sep 2014 and only negotiated a $400k holdback for S&T’s portion of the dividend. Now the optimists would say that this shows that they are confident of their case but in my mind how FTI could have not reserved the full amount when there is an open challenge from the IRS particularly given how complex and uncertain tax issues inherently are is (i) beyond me, and; (ii) shows that even today the majority shareholder, controlled by FTI, is not aligned with the minority holders at Emerson.
Aside from the controlling shareholder I think the tax liabilities are the most tricky part of the Emerson underwrite. I take absolutely no comfort in the company believing that NOPA 1 has no merit as I imagine they are taking advice from their auditors MSPC which have a chequered history at best see (i) (http://pcaobus.org/Inspections/Repor…e_Stephens.pdf, and; (ii) http://www.thefinancialinvestigator.com/?p=166 . That said time has passed since the IRS originally raised the claim and Emerson’s disclosure has stayed the same. The company is spending money defending the claims. In my mind the $4.8m dividend withholding tax claim appears to be a realistic probably as the company originally withheld the dividend and the entity is in liquidation in Hong Kong and unlikely to be able to repay the claim and hence I have showed it in both my upside and downside valuation. The NOPA 1 & 2 claims are much more difficult and therefore I can only “bookend” the outcomes and buy the security at a discount to the worst case underwrite.
Emerson has a licensing deal with Funai Electric Co (6839 JT) to use the Emerson brand name to manufacture and distribute products in the United States. Looking at Funai’s website (http://www.emersonaudiovideo.com/product/index.php) and financial reports their Emerson branded products appear to be exclusively LED / LCD HDTV flat screen TVs.
Emerson’s relationship with Funai is a long standing dating back to 2001 and has been revised a number of times with the latest agreement being inked in Dec 2013. The current form of the agreement stipulates that Funai will pay a non-refundable royalty of $3.75m and a license fee on sales of product in excess of the minimum annual royalties. As it stands the royalty fees on an LTM Dec 2014 basis are $8.7m and have trended up on an LTM basis over the last three quarters from a low of $7.5m.
Funai’s investor disclosures do not provide any breakdown or insight into their Emerson line, however, the vast majority of their sales are TVs (65% of sales) and their key market is the US (82% of total sales). Their total sales have been declining with the best performing category being TV equipment (1.9% decline vs consolidated 6.4% for 9M 2014) and the company is very marginally EBITDA positive. The one good thing offsetting the lack of profitability is that they are extremely cash rich $400m of cash vs $430m market cap.
The authority on US TV sales appears to be IHS which tracks data on a quarterly basis. From their press releases it appears that the US TV market has taken a tumble following robust sales from 2009-11 as people upgraded to flat panel TVs. Peak TV sales were 38m in 2011 with 2012 dropping to 37m (2.6% decline) and 2013 dropping to 34m (8.1% decline). I do not have access to IHS data (it would be great if anyone did) but I imagine you could track the quarterly sales of Emerson branded TVs and work out whether Funai is gaining or losing market share and the general trends in the US TV market which would be very helpful data to accurately value this asset.
I find valuing royalty streams particularly difficult as you could look at them simply as EBITDA which should trade at the same multiple as the company / industry they relate to or as priority revenue streams (such as rent) on income generating assets which should trade at a substantial premium to the underlying industry multiples. A good real life example of the royalty premium is Anglo Pacific Plc (APF LN) which has royalties on 6 producing mining assets, 1 in development and 3 in early stage development. I do not know the company very well but it has traded in the 10-15x EBITDA multiple range over a number of years which is a significant premium to where the miners trade (e.g. Rio Tinto at 5.0 – 7.0x)
For my valuation I am putting a 4.0 – 6.0x multiple on the Emerson royalty stream reflecting (i) the difficult market outlook for US TVs, and; (ii) the lack of buyers (realistically only Funai is going to buy this stream) and using a low and high royalty revenues of $7.5 – 8.7m. If you believe Funai is realistically the only buyer of this stream then you would imagine they would look to pay a discount to their trading price to ensure it was an accretive transaction. Unfortunately as Funai is a net net so multiples are meaningless but looking at peers such as Sony a 4.0 – 6.0x multiple range seems fair.
US Retail Business
Away from the licensing revenue Emerson runs its own electronic wholesale business focused on the US market. A list of their products can be found on (http://www.emersonradio.com/) and are best described and high volume low grade household white goods.
Their two main customers are Wal Mart and Target who account for c. 90% of their sales. Wal Mart has been slowly drawing business away from Emerson most recently cancelling a line of microwaves which accounted for $36.1m (29.7% of total sales) effective from Mar 2013.
As of LTM 2014 this segment had sales of $68.4m and a gross margin of 9.5%. Normalising SG&A for the various one-off items (e.g. legal costs to defend litigation, the majority of which are now finished) the business was EBITDA negative at $417k.
The business is deeply unattractive and has a little to no moat around it with Emerson simply being a middleman for Chinese manufacturers and at the mercy of two very large and powerful price setting customers. I am not ascribing any value to this part of the investment but am also not viewing it as a liability.
Shareholders / Future of the Business
Frankly this is the biggest issue in the trade. The main shareholder S&T Holdings is a subsidiary of Grande Holdings which has been in insolvency in Hong Kong since June 2011. Reading the detailed release on the agreed restructuring plan (http://www.grandeholdings.com/english/investor_announ/20140512_-_ew_00186Ann-(change_of_auditor,_Scheme_of_Arrangement,_etc).pdf) it would appear that the vast majority of creditor claims into Grande Holdings are owned by entities controlled by Mr Ho who was the mastermind behind the previous bad acts (in fact Grande itself has a history of shady transactions in the Hong Kong market dating back to 1999).
The restructuring of Grande had previously envisaged a sale of Emerson which would have been great as the sooner they monetise the royalties, find someone to buy the US white goods business for $1 or greater, and return the proceeds to shareholders the better.
As it currently stands the liquidators of Grande Holdings, FTI consulting, have received a restructuring proposal from Sino Bright on the 2 Dec 2013 and on May 2014 they entered into an agreement with Sino Bright under which all the operations of Emerson (and other divisions) would be retained. Bizarrely in June 2014 the company received a summons to remove the provisional liquidators from Sino Bright which they are challenging. The hearing of these summons have been delayed to the 16 November 2015 and it is not clear whether the liquidators have fallen out with Mr. Ho or whether the application to remove FTI was bad faith or general negotiating tactics.
Interestingly as part of the restructuring proposal the Ho connected entities have offered a 60 cents cash alternative to independent third party creditors equitising their debt into new shares which will resume trading on the Hong Kong exchange. As part the disclosure the total claims pool is HK$ 3,177m which will equitise into 90% of the post dilution share capital. As a result the Sino Bright cash out offer values the group at HK$ 2,118m or $273m at today’s exchange rate.
Taking the Dec 14 results of Grande Holdings (http://www.grandeholdings.com/english/investor_announ/ew_00186ann-31032015.pdf) you can do some work to try and backsolve the value of the group and see if there is any read through to Grande’s view of Emerson’s value. Today Grande consists of two business lines (i) Emerson, and; (ii) a licensing business focused on the Akai, Sansui and Nakamichi brands. Leaving Emerson to one side the licensing business has revenues of HK$ 55m and segment results of $39m.
There is HK$472m of cash and I am assuming all other assets on the balance sheet represent working capital or other non monetisable assets. I am also assuming all liabilities are wiped clean in the debt for equity swap.
Subtracting the HK$ 472m of cash from the implied “market cap” of Grande leaves you with a value of HK$ 1,646m. If you value the royalty business at a high multiple of 8.0x (HK$ 312m) you are left with a value for Emerson in the mind of Mr Ho of HK $1,334m or US$ 172m which is substantially higher than today’s trading price and implies a EBITDA multiple on the royalty stream of 15.6x assuming all the tax liabilities are defeated. Another way to look at this is that Mr Ho is paying an implied HK$ 1,646m for HK$ 74m of EBITDA or c. 22x (in reality it is likely that Grande normalised EBITDA is higher as their administrative expenses are likely bloated by liquidators and legal fees). I am not taking a huge amount of comfort from this but spent time on it as it is both interesting and also directional that Mr Ho is willing to offer $25m of his cash to clean out Grande creditors at a 60c on the dollar price.
Reading the disclosure it seems that the next hurdle is getting approval from the Hong Kong listing authority for a resumption of trading on the exchange and then a full release of a shareholder circular detailing the plan. Timetables in liquidations are always tricky and the release of the circular has been delayed now for over c.12 months vs the original estimated delivery time.
Getting full details of this restructuring and also seeing the plans for Emerson is clearly the next major catalyst for the stock with the currently deadline announced by Grande as the 30 April 2015.
Emerson is not for the faint hearted. However, I think you are being paid for the risks particularly as in a liquidation scenario assuming (i) no value for the royalty stream, (ii) full tax liabilities, and; (iii) the liquidation value of the working capital you would recovery 75% of the current market valuation. As is so often the way when the stock was trading at the lows of $1.0 it was disgustingly cheap and I would have made it a 10% position in the HIPS portfolio but today I still think there is a lot value to be had and am willing to add at these prices and hope that the share price goes lower. The clear catalyst for price action is progress to the relisting of Grande’s equity and settlement on the outstanding tax claims.
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