When you buy a share of Gencor Industries (GENC) you are purchasing a free option (Actually, to be accurate, it’s a negatively priced option!) on the recovery of the highway construction industry in the US. If you believe that Congress will never pass another highway bill and will allow the country’s infrastructure to deteriorate further, then an investment in GENC is not warranted.
GENC shares sell for $6.85 per share and the company has $7.38 per share of net-net cash, Yes, that’s the cash balance net of all liabilities! One might consider Gencor to be essentially a large pile of cash ($78 million or $8.20 per share), but there is much more to this company as it is the dominant player in the US asphalt equipment manufacturing industry. This has not been an exciting industry over the past few years as highway spending has been kept to a minimum, but this cannot continue indefinitely as our roads and bridges cannot be neglected for much longer without leading to national paralysis. We strongly believe that it is just a question of when and not a question of if. With its huge cash hoard and small operating losses, GENC is extremely well positioned to wait stoically for the inevitable. We think GENC is one of the few compelling opportunities in the currently fully-valued small capitalization market.
Gencor is a leading manufacturer of heavy machinery used in the production of highway construction materials, synthetic fuels, and environmental control equipment. The company’s products are manufactured in two facilities in the United States. The company designs, manufactures and sells machinery and related equipment used primarily for the production of asphalt and highway construction materials. The company’s principal core products include asphalt plants, combustion systems and fluid heat transfer systems. The company believes it has the largest installed base of asphalt production plants in the United States.
Because the company’s products are sold primarily to the highway construction industry, the business is seasonal in nature. Traditionally, the company’s customers do not purchase new equipment for shipment during the summer and fall months to avoid disrupting their peak season for highway construction and repair work. The majority of orders for the company’s products are typically received between October and February, with a significant volume of shipments occurring prior to May.
How did Gencor accumulate its large cash balance? In 1998, the company entered into agreements with Carbontronics pursuant to which the company designed, manufactured, sold and installed four synthetic fuel production plants. In addition to payment for the plants, the company received membership interests in two synthetic fuel entities. These entities derived significant cash flow from the sale of synthetic fuel and tax credits and consequently distributed significant cash to the company beginning in 2001 and through 2010. The tax credit legislation expired at the end of calendar year 2007. As a result, the four synthetic fuel plants were decommissioned. The plants were sold or transferred to site owners in exchange for a release of all contracted obligations related to the removal of plants from the sites. The administrative partner informed the company that there were no operations in calendar 2008 and almost all of the partnership affairs were finalized in 2008. The company received $163,000 of final distributions in fiscal 2010. Gencor no longer has any position in these entities or business.
Highway Funding and Company Performance
Company performance slightly improved in fiscal 2011 (ending September 2011) with net revenues increasing by 7.4% while operating costs decreased as result of improved efficiencies and cost cuts. The revenue increase came both from market share gain and market growth. However, the overall road building construction and manufacturing sectors continue to operate in a state of uncertainty and, the company asserts, without a fully funded Highway Bill of at least $40 billion a year the industry is expected to atrophy and the deterioration of our country’s infrastructure will accelerate.
Over the last three or four years there has been some highway funding under a variety of bills with strange acronyms, all intended to be “unemployment-reducers” and economic stimulants. Unfortunately, the impact of these various bills has varied dramatically among different states. The absence of adequate oversight and inconsistent discipline in the use of the funds has resulted in much of these funds going to various non-infrastructure applications, neither contributing to fixing our roads nor to job creation. These various bills have provided little benefit to the company. While some road builders in a few states have had good years, without any visibility into the future which only a traditional six year highway bill provides, they unfortunately have cautiously abstained from purchasing any new capital equipment.
The company believes 2012 will bring more of the same with conditions not expected to improve until after the fall election. The company has adjusted its expense base for these conditions but is prepared to ramp up production if conditions improve faster than anticipated.
First quarter 2012 (December 2011) revenue was down 12% versus the same quarter last year, but the decline was due to the timing of orders, which are expected in the second quarter. The company stated in its press release, “Our two factories are currently operating under full capacity. As we enter the second quarter of fiscal 2012 we are enjoying a significantly improved sales backlog. However, we continue to remain cautious about the growth of the U.S. economy and the absence of a long term highway Bill.”
The company’s financial position is pristine. It has a book value of $10.35 per share with $8.20 of it made up of cash. Net current assets stand at $9.46 per share and, as mentioned previously, net-net cash is $7.38 per share. The fiscal 2011 operating loss was about $.18 per share which gives the company ample time to wait for the inevitable Highway Bill with minimal impact on its financial position.
What is Gencor worth? What is a reasonable proxy for its value? Should it be valued at its $9.46 liquidation value or at its preposterous $7.38 net-net cash value? Is its dominant asphalt business with the largest installed base in the country worth zilch? It would be difficult to rationally support these estimates of value even if you believed that we will never have a highway bill and our incompetent legislators will let our roads and bridges atrophy bringing the country to a state of complete gridlock. Even at the current depressed levels the business has some value as the company could reduce the size of the operation to make it profitable.
As for us, we think it’s totally rational to assert that the company’s business and market position is extremely valuable and will ultimately be recognized. With the stock trading at $6.85, would it be unreasonable to state that the stock is conservatively worth $12? This would give a value of about $4 (I am netting out the $8 of cash from the $12 value.) to a business that could easily earn a $1 per share once the rebuilding begins. One can argue what the level of earnings will be once the recovery occurs, but one cannot reasonably argue that the company is worth less than it cash position. The margin of safety here is solid.
The bottom line is that the company is worth substantially more than its current $7 per share market price, unless you believe management is suicidal and will burn the cash in an ill-advised acquisition or other imprudent action. We see little evidence of this and find the current valuation compelling.
1) The Company uses its cash in an imprudent manner. Management has a 30% economic interest in the business and we believe is adequately incentivized to act in the best interest of shareholders. But, imprudent management actions are always a possibility and we do not totally discount this risk. We simply have seen no evidence of this tendency, at this point.
2) The Highway Bill does not happen for several more years. This is a possibility and, given the gridlock in Congress, we should expect a continued delay. But, again, we think GENC is well-prepared for this with its fortress balance sheet and cash.
3) Management acts in a non-outside shareholder friendly manner. Management owns 96% of the B shares, which allows management to elect five out of six directors. Corporate governance is not strength of this situation, but we do think that outside shareholder interests are aligned with those of management.
4) Management’s strategy for utilizing the cash is unclear. We have not received from management a well delineated plan for the use of its large cash position. They have been very restrained in employing the cash.
1) The passage of a Federal Highway Bill
2) Discovery by the market of the undervaluation
3) Implementation of a share buy-back program or dividend