May 29, 2017 - 6:47pm EST by
2017 2018
Price: 5.10 EPS 0.63 0.74
Shares Out. (in M): 7 P/E 15 15
Market Cap (in $M): 38 P/FCF 0 0
Net Debt (in $M): 5 EBIT 7 8
TEV ($): 39 TEV/EBIT 9.5 9.5

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Calloway's Nursery (OTCPK:CLWY) is the rare, under-the-radar, micro-cap stock that is trading below liquidation value that could be worth up to 3x more as its experienced management team and board continue to make operational improvements and unlock value. After spending the last year on realigning the cost structure, Calloway’s is set for explosive growth in 2017, where Q1 was 21.3% and our projections for 2017 revenue are 13.1%. Alongside 2017 sales growth, we are forecasting year-over-year 39% EBITDA growth, 142% EPS growth to $0.63, and 109% free cash flow growth.


Calloway's is an 18-store chain of high-margin plant and garden related stores in Dallas Ft. Worth with an additional store in Houston. 3K, a family office run by Peter Kamin, co-founding partner of Value Act Capital, became the controlling shareholder and lead director of the company in January 2016 after winning a proxy vote. Year-to-date EBITDA has grown 69% as the company continues to find ways to make operational improvements to the business.


Given the business operates with over 50% gross margins and the recent great quarter to start off 2017, we believe the business should achieve low-to-mid-teens operating margins over the next couple of years as the new management team makes improvements in purchasing, inventory management, marketing automation and proper staffing at the store level. In addition, given the continued strength in the Dallas and Houston economies (see here, here, and here), which rank 1 and 2, respectively, in the entire country, we expect to see continued sales growth. Over the last two years, same-store sales have averaged mid-single digits, and the company added two new stores in 2016, which increased the store base by over 10 percent.


With the recent first quarter of 2017 results, the board and management have skillfully lowered the fixed cost structure of the business and operating leverage was witnessed given the organic sales growth. Not only did Sales grow 21% year-over-year, but the net margins jumped to 11.63% from 1.62% and debt has been consistently paid down over the past year to under $5M from $8M a year prior. With the spring planting season ahead, we should see strong sequential growth as well as solid year over year growth in Q2.


What makes Calloway's unique is its ability to offer a more unique and specialized plant selection than Home Depot (NYSE:HD) and Lowe's (NYSE:LOW), but also superior customer service. Calloway's employees are certified nursery experts who have taken credentialed coursework, which provides employees with a far deeper knowledge base than that of general retail employees. Having visited all of Calloway's stores and multiple Home Depot and Lowe's, the difference is significant. If you want to buy a generic house plant or fertilizer and you are an accomplished do-it-yourself gardener, then shopping at Home Depot will save you a little money, which is not the Calloway's customer.  What Calloway’s also does really well is that they have developed a strong customer database that they utilize to customize promotions, pricing and in store activities and events, which are useful tools for driving engagement, maximizing inventory turnover and targeting their customers.


What makes Calloway's attractive to us is that you're able to buy a leading pure-play nursery company in the best economic micro climate in the United States for 5.7-6.7x EBITDA with fundamentals that continue to improve. In addition, you are getting a land portfolio (Calloway's owns 11 of its stores) that we believe is worth a minimum of $6.00 per share.


In order to determine the value of CLWY's real estate holdings, we used satellite images to individually map out the size of each retail location. Our analysis indicates that CLWY owns approximately 900,000 sq. ft. of land across its 11 fully-owned stores, with an average size of roughly 80,000 sq. ft. per location (including parking space.)


To support our analysis, we have not only spoken with commercial brokers in Texas, but also when one analyzes Calloway's financials, they will notice that the company sold a store in Houston in December 2014 for a gain of $9.9M. Unfortunately, no purchase price was disclosed. If we assume, however, that CLWY obtained the land for free and sold the 3.0 acre lot for $9.9M, this equates to approximately $75 per sq. ft. If you were to value the remaining properties at $50 per square foot, the properties would be worth $6 per share. Since 2015, real estate in Calloway's markets is up 15-25%. Calloway's real estate is currently being valued at approximately $3.20 per share on its balance sheet and most of the real estate is held at cost or hasn't been appraised in at least five years. We believe that valuing the real estate portfolio at $50 per square foot is conservative and could present significant upside potential, as seen below:




CLWY's new management team is aware of the value of these holdings and will look to monetize the assets in the near future. 3K discussed potentially repurposing some of the company's valuable locations in its 2013 proxy filing, stating:


"3K believes that CLWY should not only evaluate the performance and strategic location of each retail operation, but that the company should consider the market value of each retail location to determine whether some operations should be repurposed to a more valuable use." (Emphasis ours)


Given Dallas' limited housing market, Calloway's sizable (on average, +80k sq. ft.) locations in premium residential neighborhoods should attract healthy interest from real estate developers and push prices even higher, as was the case with the 200 N. Dairy Ashford location that was sold by management to be converted into condominiums.


Shareholders who invest alongside 3K are getting a superior capital allocator to make investment decisions for the good of all investors. 3K is only investing its own capital and owns roughly 4.3m shares or roughly 60% of the company. When it sold the Houston store for a gain of $9.9m, it used the majority of the proceeds to buy two new stores and thus avoid paying capital gains. The Board also wisely bought back 1m shares at $2.52 and has paid down almost all the debt on the balance sheet, all decisions which have been highly beneficial to shareholders.


We believe the reason why the mispricing exists and why Calloway's currently trades at $4.60 instead of closer to $8-10 is for the following reasons:


1. Management and the Board have a very long-term view and are not promotional.


a. Company does not have an investor relations department and does not engage with shareholders or Wall Street.


i. This strategy is no different than from that of the board or management teams of other extraordinarily successful microcap companies such as Atrion (NASDAQ:ATRI), Winmark (NASDAQ:WINA),  Rockford Corporation (OTCPK:ROFO),  or ELXSI Corporation (OTCPK:ELXS).


2. Company trades on the OTC market and therefore has less financial disclosure requirements.


a. With less than 300 shareholders since the tender offer, CLWY can avoid most of the SEC's reporting requirements. Limited disclosure, however, presents an opportunity for diligent investors.


3. Stock is very illiquid.


4. Stock price is below $5.


5. No sell-side research coverage, and company's small market cap limits most firms on the buy-side from investing.


6. Requires independent research and primary due diligence visiting stores, reading financial statements, talking to real estate brokers, talking to employees to understand value of the business and the land.


As awareness of the company and the current mispricing becomes better known, which continues to take place since the publicity in January, we believe the shares of Calloway's will move substantially higher and be valued more in line with the value of the business and its real estate. We have seen this countless times occur with other undiscovered microcap companies including the examples we listed above, many of which are worth 5-25x more than they were many years ago and they still have no research coverage.


Secondly, as awareness increases, demand for the shares should become greater than the supply. Once supply is absorbed in an illiquid stock with improving fundamentals, stocks can move higher and re-price extremely quickly given scarcity of shares.


Unlike other funds, what makes 3K unique and a very valuable shareholder is that it only invests its own money from its personal family office. As a result, it has no incentive to be promotional and spend money on IR and attending conferences. Its time is best spent running the business and allocating the capital of the company. As can be seen from the filings, the company bought back stock in 2016, so it has no incentive to bid up the price as the largest shareholder.


We believe that Calloway's nursery business should be valued at a minimum of $10.50 today based on a ~$1.10 per share EBITDA value in 2017 (which we view as conservative) and a 9.5x EBITDA multiple (where it is currently trading at a 4.9x EV/EBITDA NTM multiple), both assumptions we view as conservative. Our $1.10 per share EBITDA assumes same-store sales growth continues at 5.5% (achieved in 2015) as well as improving productivity for the two stores added in 2016. We believe an 9.5x multiple is conservative given that the company has a high teens ROIC and comps all trade with double digit multiples and lower margins. For 2018, we see a minimum of $1.25 per share EBITDA and afforded with the same multiple, the stock is valued upwards of $12.00. This is also supported by a 15x P/E multiple off of a projected EPS of $0.63, which leads to a conservative $9.45 valuation. Furthermore, the company has significantly improved operations in the last couple of years by shutting down unprofitable stores, cutting costs, and refocusing on core markets. CLWY with a 9.5x EV/EBITDA NTM multiple and a 15x P/E multiple is still below comparable companies yet witnesses better growth and return on invested capital, alongside with a double-digit FCF yield of 10.1% as of a current share price of $4.95.



In our model, we have the company generating $1.15 in EBITDA per share in 2018 and we apply an 8.5x multiple. If we want to be conservative, we could value the business at 6x on $0.90 and come up with $5.40. Net debt is $5M including $2M in deferred taxes. If the company were to stop rolling out new stores, we believe CLWY could generate at least $3.5M in free cash flow (+10% yield on a FCF/EV basis) which could be used to buy back more shares or pay down debt. Both options would be highly accretive to shareholders.


We believe the real opportunity for upside lies in additional margin expansion. Given CLWY's industry-leading gross margins of +50% (vs. mid-30s for Home Depot, Lowe's, etc.), we think there should be plenty of room for CLWY to improve EBITDA margins from the ~7.6% achieved in 2015 (vs. mid-teens for competitors) to mid-teens. On a trailing 12-month basis, CLWY already has made significant improvements, driving margins to ~11.3% for 2016, and we see no structural reason why it should not be able to achieve mid-teens EBITDA margins in the next 3-4 years as the company benefits from a bigger shift into private label products and continues to cut operational expenses. We estimate that the company is on track to achieve an EBITDA margin of 14.0% in 2017. For our model, we forecast 50bps of expansion per year, which we believe to be easily achievable.


Either way you look at it, the company's real estate is worth ~$4 even on an after-tax basis (or $30M gross) and you are getting the operating business for free. Over time, we believe the Board will continue to unlock shareholder value by opportunistically selling off stores as it did in late 2014 and either redeploying the cash into other stores, buying stock, or paying special dividends. This means that the combined worth of the business and the land should be at least $12, which signifies +200% upside.


When you get the opportunity to own a company trading below liquidation value that is generating free cash flow with good fundamentals (we estimate high teens ROIC) with a long-term capital allocator that is highly incentivized to make good decisions in a stock that has a diminishing amount of supply, we believe that is a risk reward that is worth acting upon.



Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.


I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.




I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Additional Source of Upside / Catalysts:


1. Multiple expansion over our 9.5x EBITDA figure as the company continues to improve operations.


2. Additional margin expansion as the company gains operating leverage in overhead, advertising, etc.


3. CLWY monetizes its real estate holdings at a greater price than $50/sq. ft.


4. The company continues expanding in the strong Dallas/Ft. Worth Texas market more rapidly than anticipated. Particularly given its attractive store economics and high ROIC of ~18%.


5. 3K LP offering a good price for remaining shares and taking the company private.

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