Calloway’s Nursery: Undervalued with Aligned Ownership

Calloway’s Nursery is undervalued on an earnings basis, owns valuable property in addition to that, and is run by a very successful investor. Calloway’s runs 19 nurseries and garden centers mostly in the Dallas-Ft. Worth area (with one in Houston). These nurseries are more specialized, have more variety, and are more expensive than the garden centers at Lowe’s or Home Depot.

I’ve followed Calloway’s (CLWY, $4.00) for years, but what pushed me to take a closer look last year was Peter Kamin taking control. Kamin co-founded ValueAct in 2000 with Jeffrey Ubben. ValueAct was immensely successfully while Kamin was there, but he stepped away and started 3K LP in 2012. 3K has no outside investors and they focus on micro-cap companies, both public and private. Kamin seems to be following a similar script at Calloway’s that he’s done at other public companies. That script includes: gradually build a position over several years, eventually take control, repurchase shares, pay down debt, and decrease public company expenses (by down-listing or de-listing). In the case of Abatix Corp (formerly ABIX), Kamin went through the aforementioned steps and eventually took them private at a 39% premium to the market price. Knowing Kamin has taken a controlled company private at a reasonably fair price gives me comfort in him being a majority shareholder at Calloway’s.

At Calloway’s, the game plan looks similar to the above.  3K started buying shares in 2012 and Kamin got a board seat in 2013 after a proxy fight. From 2013 to 2015 Calloway’s paid back roughly half their debt. In February 2016, 3K bought out two major shareholders (including the founder/former CEO). In the year since Kamin took over, operating margin increased from 6.5% in 2015 to 9.6% in 2016. Calloway’s also decreased shares outstanding by almost 25% in 2016. Finally, public company expenses have been decreased as they are now listed on the Pink Limited OTC marketplace and their quarterly releases consists of the three financial statements and nothing else.

Industry overview

Calloway’s was founded in 1986 so they benefit from brand name recognition and local scale in the Dallas-Ft. Worth markets. There are plenty of other nurseries around Dallas and Fort Worth, but a new one generally isn’t going to open up across the street from where an incumbent is. Calloway’s should also have some local scale advantages when it comes to marketing. All things being equal, $1 spent on Calloway’s advertising will go further than $1 spent on a competitor that only has one or two locations. In the Dallas-Ft. Worth area, I’ve counted one company that owns four nurseries (Ruibal’s Plants of Texas), four companies that own two nurseries, and the rest are individual stores. This dynamic should also give Calloway’s a purchasing power advantage. Purchasing for 19 nurseries is a significant difference vs all their competitors who buy far less volume.

With that being said, Calloway’s doesn’t appear to be as well-liked as their competitors. Over their 19 stores, Calloway’s has a weighted average Yelp rating of 3.6 compared to 3.9 for all the other nurseries around Dallas-Ft. Worth. While this isn’t good to see, I’m not sure it’s that significant. Yelp is far more popular for restaurants that often have hundreds of reviews per location, but most nurseries have fewer than ten reviews (some even have zero). So it’s hard to draw too many conclusions from a small sample size. One final note, all their competitors are private.

Bear case

I see a few ways this investment could go bad. First, Kamin might screw over minority shareholders. This is always a risk in majority owned companies. I only know what I can find online about Kamin, but I like everything I’ve read. He’s obviously a successful investor, but seeing him take out Abatix shareholders at a nice premium makes me feel good about his attitude toward minority shareholders. He’s taken significant positions in several other public companies and, judging by the share prices, he has succeeded in each one. I haven’t found evidence of him screwing minority owners in any of those companies. Also, 3K’s pitch book aligns very well with my own investing principles.

The second thing I’m most concerned about is a downturn. Discretionary spending (like fancy plants for your yard) is probably one of the first things to be hurt in a downturn. I’ve tried to mitigate this in my discounted cash flow by only assuming 2% revenue growth from now into perpetuity. So while they would certainly see some years of negative comp store sales during a downturn, I think assuming GDP-like growth in the long-term is very reasonable.

Finally, this is retail. I generally avoid retail like the plague, but I think nurseries and garden centers are one thing that should remain resistant to Internet domination. Even when looking at the same type of plant, each one is different—they have color variations, height/width variations, some have more dead leaves than others, etc. Ordering a “Blue Boa Hyssop” (random plant from Calloway’s website) from the Internet is likely to get you a plant that isn’t exactly what you would have picked out if you went into an actual store. I despise shopping in person as much as anybody, but I doubt nurseries are going online in the near future.

Valuation

The most simple valuation method is by multiples. My preferred multiple is comparing enterprise value to what many would call owner earnings (though I prefer saying NOPAT because acronyms are cooler). When I calculate NOPAT I remove one-time expenses, subtract interest, apply the full statutory tax rate, add back D&A, and subtract a normalized number for capex. Using this method, I get trailing twelve month earnings of $2.1 million vs an enterprise value of $30.6 million (at $4.00 per share) for an EV/NOPAT of 14.5x. Multiples aren’t my favorite valuation method, but I think they’re a good sanity check. At the very least I think we can say Calloway’s isn’t expensive.

I think a better way to value most companies is a discounted cash flow with conservative assumptions. Calloway’s is a very simple, mature business so there really aren’t that many assumptions to make compared to a lot of companies. I think the following assumptions make for a fair DCF:

1. GDP-like revenue growth of 2% per year.
2. Operating margins gradually scale up to 11% (from 9.6% in 2016).
3. 2% of shares repurchased per year.
4. Corporate tax rates don’t change.
5. 11% discount rate.
6. 12.5x terminal multiple.

This spits out a value of $5.93 per share. Given the historical cash flow generation and capex intensity, they can easily afford buying back 2% of shares and paying down 10% of debt each year (assuming the stock appreciates 10% per year). We also get what I would consider a free option on tax reform. Punching in a 25% corporate tax rate raises the value to $7.00.

But wait, there’s more!

Of the 19 nurseries they run, they own 11 of them. The quickest way to get an estimate on what these properties are worth is looking at the tax assessed values of each. The total tax assessed value for these properties in 2016 was $22.8 million. While that number looks great (especially compared to an enterprise value of $32.7 million), what matters more is how much of that value we’ll actually see turn into cold hard cash. If a nursery sits on a plot of land for another 50 years before it’s sold, well, that’s not worth very much to me today.

One option is to do sale-leasebacks. I think this is the least likely option for two reasons. First, they haven’t done any previously (at least in the recent past). Second, some of these locations would clearly be better suited as something other than a nursery. If that’s the case, Calloway’s would get a lot more value by selling the property to a developer who’s going to turn it into an apartment complex or a grocery store or whatever. Buying the land only to lease it back to a nursery isn’t going to be as profitable.

Calloway’s has sold one property that got redeveloped since Kamin got involved and that was the 1200 North Dairy Ashford location in Houston that was sold in 2014. The gain on sale was announced (not the gross sale price), but I estimate it was sold for around $13.4 million (with a gain of $9.9 million). What’s amazing is that Dairy Ashford’s tax assessed value in 2013 was only $1.2 million. Thus, it’s possible I’m undervaluing some of their locations by using the tax assessed numbers. The Dairy Ashford nursery was torn down and a nice apartment complex was built in its place. The area surrounding the apartment complex isn’t anything special, but it’s right off the highway between Katy, Texas and downtown Houston, which is probably great for commuters. Of the $9.9 million gain on Dairy Ashford, $7.1 million was used as a 1031 like-kind exchange to buy two other locations and the rest was returned to the company and subject to taxes.

Theoretically, if they sold all 11 properties for $22.8 million and didn’t 1031 any of them, those proceeds would be subject to the 35% corporate tax rate. So the net benefit to shareholders would be $14.8 million, or $1.96 per share. But that windfall wouldn’t all be at once so the $1.96 most likely needs to be discounted over several years. It probably goes without saying that a tax rate cut would also increase the value of these properties.

The most valuable property they own is 2233 South Voss Rd in Houston. It has a tax assessed value of $6.8 million and is located in a nice suburb. The nursery is near lots of shopping, restaurants, and neighborhoods. The neighborhoods are all mid to high end with plenty of gated mansions and almost every house has a nice yard. Long way of saying: I’m sure this location kills it. It’s pretty much an ideal location for a nursery. With that being said, the property is worth a lot and it could almost certainly be redeveloped into a shopping complex or high end apartments/condos (there are several of those along the same strip).

Bottom line, I have no idea how much value shareholders will ever see from the land assets, but I view it as a free option. I wouldn’t have invested if I didn’t think the core business wasn’t undervalued by itself. Beyond that, I trust Kamin to know what the best thing to do with the owned properties is. I’m invested to see the core business accrete to fair value, but I also expect a few “bonuses” along the way as some land is sold off. Finally, a corporate tax cut would immediately add one or two dollars of value to the company.