Calloway’s Nursery, Inc.

Disclosure:

I own CLWY. I do not own any other securities mentioned in the below article.

Idea generated from DTEJD1997 via cornerofberkshireandfairfax.ca.

Hypothesis

Calloway’s Nursery, Inc. (CLWY) is a retail gardening company that has 19 stores in the Dallas-Fort Worth area and 1 store (Cornelius Nurseries) in Houston, TX. They provide a large variety of plants and flowers that are not found in the big box stores while also giving their customers expert opinions via their knowledgeable employees. The plants and flowers are purchased from a wholesale distributor.

Calloway’s has experienced a significant turnaround due to activist investor Peter Kamin. CLWY is currently undervalued due to the fact that they are not very transparent when making financial disclosures. But, a business is a business… and if Calloway’s keeps performing as it has under the leadership of the new board of directors, I believe that there is significant upside potential with limited downside. A major catalyst is the sale of shares from major shareholder, Peter Kamin. Kamin owned 56.7% in February of 2016. According to the 3K website, they are still a holder of Calloway’s and I have no reason to believe that their percentage ownership in the company has changed since 2016. In my opinion, Kamin will try to find an exit strategy within 3 to 5 years. In doing so, he may do one of two things:

  1. Generate more liquidity by re-listing on a major financial exchange – this will require much more financial statement transparency due to SEC requirements.
    1. In my opinion, by listing on an exchange while filing more transparent financial reports, CLWY will see new types of investor clientele investing in its shares, which will substantially increase liquidity. This will allow Kamin to exit his investment and deploy capital where he sees fit for 3K.
  2. Sell the company to a third party.
    1. Shares will be bought at a premium due to controlling interest.

The Story

Calloway’s board of directors recently went through a massive transformation due to activist investor, Peter Kamin, of 3K. In May of 2013, Kamin proposed to have a shareholder vote to replace the current board of directors with a new slate of directors, as determined by Kamin and 3K. Calloway’s current board obviously did not appreciate this move and actually filed a lawsuit against Kamin and 3K, stating he had no authority to propose such a thing (as he only had 18.4% ownership of the company at the time). The thing is, Kamin had good reason to suggest the board should be replaced. The agency issues were out of control. The board of directors was comprised of executive management, so there was no incentive for the board to act in the best interest of shareholders. Management/the board lined their own pockets by giving themselves excessive stock options and bloated salaries. Something needed to change.

In July of 2013, Calloway’s and 3K reached a settlement. Calloway’s agreed to change the number of members on the board from five to eight. The board added Kamin, Alan Howe (a 3K elected member), and David Straus to the board… this was just the start.

In 2016, Calloway’s and 3K announced a joint tender. Under the terms, they would both buy back a significant amount of stock from existing shareholders. Following the expiration and completion of the tender, 3K offered to purchase nearly all the shares of common stock held by then CEO James Estill and John Cosby (former Co-Founder). Kamin was not messing around. By purchasing these shares from both Estill and Cosby, on top of the tender offer, Kamin would own over 50% of the business.

Estill and Cosby agreed to the terms offered by Kamin, giving Kamin a 56.7% ownership of CLWY on February 19th, 2016. After Kamin obtained control of the company, a number of board members (James Estill (CEO and chairman of the board), Dan Feehan, Alan Howe, Daniel Reynolds, and David Straus) resigned from the board, giving Kamin and shareholders the opportunity to elect a new board that would act in their best interest. I believe that the 56.7% ownership that Kamin has works to keep shareholders’ interests aligned with the board of directors. The post-recapitalization board of directors consisted of Peter Kamin, David Alexander, Marce Ward, David Schneider (a 3K recommendation), and Terry Shaver (a 3K recommendation). Marce Ward was then appointed as president and CEO.

The company has experienced a significant turnaround since these changes have occurred, and most changes are in line with what Kamin said he would do when he first proposed that the board of directors should change in 2013. The company is currently undervalued due to lack of transparency in financial reports, which I believe will be remedied when Peter Kamin seeks an exit strategy.

How has the company done since Kamin has taken over?

Let us now take a look at what Kamin said he would do in 2013[1] to change the business around versus what he has done with the new board (2016). Kamin doing as he said is indicative of whether or not he will be acting in the shareholder’s best interest in the future.

“…if 3K is successful in obtaining control of the CLWY board, we plan to take the following actions:

  1. Elect a new chairman of the board an implement best corporate governance practices for the operation of the board going forward.

Kamin successfully took control of the board in 2016 after the recapitalization and elected several independent board members after the resignation of James Estill (CEO and chairman of the board), Dan Feehan, Alan Howe, Daniel Reynolds, and David Straus.

  1. Undertake performance reviews for each senior manager of the company and review their performance against industry benchmarks; attract new talent to the company where necessary.”

Since Kamin’s arrival, senior management has changed drastically. This was highlighted when Kamin bought most of the shares from former CEO/Chairman James Estill and Co-founder/Executive John Cosby.

  1. “Review and adjust compensation arrangements for senior managers so that their incentives are clearly aligned with the interests of shareholders.”

As stated in the last paragraph, many former executives resigned from the company when Kamin gained control over the board. The results since Kamin first proposed this action in 2013 can be seen in the decrease in the amount of SG&A as a percentage of sales (implying that excessive salaries were cut) and in the decrease in the amount of diluted shares outstanding:

SGA Diluted SA

  1. “Consider the strategic value of each asset of the company; analyze direct store profitability and results for each location; consider strategic alternatives for underperforming retail location.”

Since this statement (July 10th, 2013), Calloway’s has closed several stores and properties that it owned and leased:

  • 1200 North Dairy Ashford (Cornelius), Houston, TX – Sold in December, 2014
  • Undeveloped land in Southlake, TX – Sold in December, 2014
  • Undeveloped land in Frisco, TX – Sold in January, 2015
  • 723 South Cockrell, Duncanville, TX – Closed in Mid 2015

It is especially important to consider the present value of each property as a going concern versus what Calloway’s could get in return if they sold it, as the market value of property in Northern Texas has significantly increased over the last few years.

  1. “Review and develop the growth pipeline for potential new retail locations in the core Dallas-Fort Worth market.”

Since this statement (July 10th, 2013), there have been several stores that have opened up within the Dallas-Fort Worth market:

  • 1801 F.M. 423, Little Elm, TX – Opened in late 2013
  • 311 East Debbie Lane, Mansfield, TX – Opened in early 2016
  • 3936 N. Tarrant Parkway, Fort Worth
  • 2415 West Parker Rd., Hebron, TX – Opened April 6th, 2018

I believe that they will focus more on opening stores in the Dallas-Fort Worth market, rather than other markets, due to brand recognition and the failure of past ventures in San Antonio, Houston, and Austin markets. This isn’t a bad thing though, because the Dallas-Fort Worth market is one of the fastest growing areas in the country… plus they always have the real option of expanding their geographic presence if they wanted to try again.

  1. Undertake a best practices study to set goals for the organization against benchmarks developed for leading operators in the industry. 3K believes that CLWY has operated for far too long under a non-independent board of directors with a significant lack of focus on profitability and returns for shareholders.”

Profitability has increased significantly since Kamin has gained over 50% ownership (February, 2016). I list normalized net income below… this figure takes out the effects of non-normal items, such as recapitalization expenses, gains/losses on the sale of property, gains/losses on the prepayment of debt, proxy contest expenses, and impairment of property held for sale:

Margins

It is worth noting that 2017 was an exceptionally strong year for profitability, and also the first full year Kamin had control of the company (his board was in place for all of 2017).

The balance sheet has also improved significantly, which I believe is extremely important for future growth. I believe that the excessive amounts of debt and low interest coverage ratios significantly hindered growth in the past. The financial health of the company has improved as Kamin’s involvement has increased:

Solvency

Everything that Kamin said he would do in 2013, he has done… and has succeeded fantastically. For this reason, I believe that he will continue to be a good steward of capital in the future and act to increase value for shareholders. Although this turnaround has been extremely impressive, there are significant risks within the business that one must be aware of.

Risks

Although Calloway’s is well positioned for growth, there are certain risks that may significantly impact the business. These risks include an increase in competition, recession, and weather. It is also worth noting that there is significant risk in regard to the current financial statements, which plays into why I believe the company is undervalued.

Competition

The Dallas-Fort Worth area population growth is one of the fastest growing in the country. Although more population growth is generally a positive for Calloway’s due to increased demand for gardening items, this should also lead to more competition, which could put downward pressure on profits. Although competition may increase, Calloway’s already has a strong presence within the Dallas-Fort Worth area and has for over 32 years. On top of their brand name recognition, their superior product line and service expertise should set them apart from their competitors.

According to Google, there are 210 nurseries, Home Depots, Wal-Marts and Lowe’s in the greater Dallas-Fort Worth area that are in competition with Calloway’s. In this same area, there are 19 Calloway’s stores… which is 9% of the greater Dallas-Fort Worth retail gardening market. Their plan is to continue to increase their presence within this market, which will help them capture the massive growth this area has experienced over the past few years. In my opinion, Calloway’s will be able to capture more market share in this market due to the size and scale of their operations when compared to many of the small “mom-and-pop” stores that will struggle to compete with Calloway’s, Home Depot, Lowe’s, and Wal-Mart.

But who’s to say that Calloway’s can compete with Home Depot, Lowe’s and Wal Mart? In my opinion, they differentiate themselves by providing more gardening options while providing excellent customer service. Each store is employed with at least one Texas Master Certified Nursery Professional. This is said to be the highest level of recognition in this field of business. In my opinion, the knowledge and expertise that these employees have will give customers a better experience than employees working at the big box stores. This is easily shown by the ratings and reviews of each store:

Stores

Customers love Calloway’s. They attribute this love to Calloway’s vast selection of flowers and plants, as well as the help and expertise they are given when looking to satisfy their gardening needs. This is their competitive advantage versus the big box stores.

Recession Risk

It seems that we have heard that another recession is right around the corner for the past 10 years. Recessions are almost impossible to predict, but there will inevitably be one. It is the economy’s way of liquidating malinvestments that occur within the economy due to poor allocation of resources.

Discretionary spending usually takes a hit during a recession. People will spend more money on what they need and then save the rest as a buffer in case of any catastrophic event.

In my opinion, sales will significantly fall for Calloway’s when a recession does eventually rear its ugly head. Spending money on making one’s landscape look nice will take a back seat to more important aspects in one’s life (food, shelter… etc.).

Weather

Bad weather is a significant risk to the margins of Calloway’s, in particular their gross margin. If there is a significant drought, suppliers and wholesalers of healthy gardening products will be able to charge higher prices due to there being less supply. It may be hard to pass these prices along to customers because they have a simple choice of foregoing gardening if it is too expensive to do so.

Financial Statements

The disclosures have been extremely limited since the Q1 2016 financial statement. The company simply gives the balance sheet, financial statement, and cash flow statement, with no disclosures about accounting policies, MD&A, and other significant factors found in 10-Qs and 10-Ks. Calloway’s was delisted from the NASDAQ in 2004 and suspended its duty to file public reports with the SEC at this time as well. In my opinion, this is one of the main reasons for the undervaluation, as I believe Peter Kamin will look to increase liquidity when he eventually sells out of his position. One way he could do this would be to list the company on an exchange and provide SEC required reports that are much more transparent than current reporting.

Valuation

I believe that the price per share for CLWY is somewhere between $10.71 and $13.06, representing a 33% minimum upside potential from the current price (8/7/18) of $8.00 per share. To obtain this appraisal, I used three measures.

The first measure was a simple EBITDA comp between HD and LOW. The average EBITDA multiple between LOW and HD, when applied to the EBITDA of Calloway’s, give an implied share price of $11.88. CLWY is obviously much more illiquid than HD and LOW, but it also has more growth potential in my opinion. For these reasons, I determined that discount for lack of liquidity and premium for growth on the share price for CLWYs when compared to HD and LOW would offset each other.

The next two methods of appraisal were done by discounting the future cash flows of the firm using two different scenarios with various costs of equity. The present value of the future cash flows was then added to the net property value + cash. In this context, net property value is defined as market value of property minus total liabilities. This figure came out to be $9,007,270.00, or $1.22 per share. Market value of property was obtained from several county central appraisal districts websites for tax purposes, which I believe to be a conservative valuation.

The first scenario was if CLWY’s sales continued to grow at its 5-year same store sale growth figure. By my calculations, same store sales have increased 2.94% over five years. The terminal value was found using the Gordon Growth model. I believe this scenario to be extremely conservative due to the fact that one of Kamin’s plans was to increase Calloway’s presence in the Dallas-Fort Worth market. This is one of the fastest growing markets in the entire United States. I obtained a base price of $10.91 for this scenario, representing a 36% margin of safety from the current price (8/7/18) of $8.00 per share:

No Stores Pessimistic

No Stores Optimistic

No Stores Base

*Optimistic, base, pessimistic refers to the discount rate, not projections.

In the next scenario, sales growth was projected at the rate of growth as displayed by the Dallas business cycle index, which is around 5%[2]. As sales grew, I determined that Calloway’s would probably have to open more stores to keep up with the demand, which were included in the CAPEX projections. The terminal value was found using an H-Model, whereby sales growth declined from 5% to 3% over a 10 year period. The base price obtained from this scenario was $13.50, representing a 69% margin of safety from the current price (8/7/18) of $8.00 per share:

Dallas Pess

Dallas Optim

*Optimistic, base, pessimistic refers to the discount rate, not projections.

One major obstacle I ran into was determining the cost of equity for CLWY. To do this, I found the unlevered beta of Lowe’s and Home Depot, then re-levered this beta to reflect the capital structure of CLWY. The base cost of equity I used in my analysis was 11.41%. The cost of equity I obtained for CLWY using the private equity method of finding cost of equity was 7.60%. I then increased this figure by an arbitrary 50% to reflect liquidity issues. Please inquire for more detailed projections and analysis. I then ran two other scenarios where the cost of equity was decreased and increased by 100 basis points to reflect a different liquidity premium and found that even in the most conservative situation, Calloway’s was still undervalued by 14%.

Catalysts

Other than continued sales and margin growth, there are several large catalysts that relate to Peter Kamin’s exit strategy. Kamin runs a middle-market-esque private equity type firm. Typically, the holding period for this type of firm is 3-5 years.

As a large shareholder (56.7%[3]), Kamin will need to draw a substantial amount of liquidity to sell his shares, otherwise he’ll be taking a liquidity haircut. This can be done by becoming more transparent through re-listing on one of the US exchanges and providing more transparent quarterly and annual reports. Calloway’s is no stranger to the big exchanges, as they were listed on the NASDAQ for several years[4]. By listing on an exchange, they will provide shareholders more information through their reported 10-Ks and other filings, which will bring in a slew of different investing clientele. This should significantly increase the liquidity of the stock, which will decrease the liquidity premium that was added to the cost of equity, leading to a higher share price (all else equal).

Another exit strategy Kamin could undertake would be a sale to a strategic buyer, where a premium would be placed on the shares to represent control.

One other short-term catalyst could be another dividend payment. Calloway’s paid a $.50 dividend with an ex-date of 12/14/2017. Perhaps Kamin needed some holiday money for loved ones. Perhaps he will need some more this year.

Summary

Calloway’s has experienced a significant turnaround over the past few years under new leadership. I believe the stock is currently undervalued about at least 33% when compared to the current share price of $8.00 with several catalysts in place. These catalysts include relisting on a major exchange, a sale to a third party, continued sales and margin growth, and continued dividend payments.

– Eddie

[1] https://www.businesswire.com/news/home/20130710005900/en/3K-Discusses-Opportunity-Calloway%E2%80%99s-Nursery

[2] https://www.dallasfed.org/research/econdata/dalcoini.aspx

[3] https://www.prnewswire.com/news-releases/calloways-nursery-and-3k-limited-partnership-announce-final-results-of-joint-tender-offer-and-closing-of-recapitalization-300223175.html

[4] https://www.bizjournals.com/dallas/stories/2004/01/19/daily48.html

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