Collectors Universe: The Poor Man’s Moody’s

April 15, 2016 Moats 21 Comments

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Collector’s Universe (CLCT) is the kind of company value investors profess to love.  After all, it ticks most of the boxes on a value investor’s checklist.  It is a microcap[1] with years and years of reliable cash flow.  It has a wide moat and provides a mission-critical service.  It has extremely high returns on capital, no debt and requires little cash to operate.

Over 19% of the company is owned by insiders.  Management has an extremely cautious approach to growth investments.  When no attractive investment opportunities present themselves, management distributes excess cash to the owners.

Yet the enterprise value of the company is just 10x FY2015 EBIT and the company lingers in obscurity.  It is followed by no sell-side analysts.  It was written up once on VIC – an incredibly tepid buy recommendation back in 2009.  What’s going on here?

As I was researching CLCT, an article came out by Josh Brown entitled “Simple vs Complex.”  It certainly struck a nerve.  I think most of the reasons he describes for the interest in complicated stories like Ocwen or Valeant or SunEdison instead of CLCT are exactly right.

I certainly understand the appeal of the complex.  To name one example, peeling back the onion and understanding all the moving parts that make the Live Nation business model work was great fun.  And, perhaps not coincidentally, it is my most popular article to date.  But, Buffett did not make his fortune buying the complex.  He bought candy makers, soda makers and auto insurance companies.  Even at this late stage in his career, he is buying ketchup bottlers.  Buffett made a lot of money buying “companies making cookies for a nickel and selling them for a dime,” as Brown describes them.  But, simple lacks sex appeal.

What Does Collectors Universe Do?

CLCT is the leader in the business of authentication, grading and certification of high-value collectibles, such as rare coins, sports cards, autograph and stamps.

This is not sexy but CLCT serves a clear need.  CLCT solves the problem of information asymmetry.  Asymmetric information is a situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. This disparity leaves the less knowledgeable party vulnerable to fraud.

There are numerous potential solutions to the problem of asymmetric information. These include:

  1. Caveat Emptor
    The ancient rule of caveat emptor or “let the buyer beware” is the most basic solution to information asymmetry. It is a warning that notifies a buyer that the goods he or she is buying are “as is,” or subject to all defects.  Accordingly, the burden is on the buyer to close the knowledge gap.
  2. Reputation
    Another simple solution is to rely on the reputation of the seller. If the seller has been in business for a long time and has developed a reputation as an honest dealer, the risk that the buyer will be fooled is greatly reduced.
  3. Guarantees and Warranties
    Guarantees and warranties benefit both the firm, by attracting customers with an assurance of higher quality goods and services, as well as consumers who, in the case of receiving a faulty product, can return the item or have it replaced. Almost all electronic device makers, for example, offer warranties.
  4. External Product Certification
    Similar to creating industry standards, firms may attain external product certification so that consumers can rely on expert verification of the quality of their goods and services.  For example, Moody’s and S&P place this role in assessing the credit worthiness of debtors in the bond market.
  5. Consumer Protection Regulation
    In many industries and governments act to address asymmetric information by implementing consumer protection laws designed to set a standard by which all firms must legally comply. For example, credit card issuers are subject to consumer protection laws set forth by the government.
  6. Torts and Other Laws
    Buyers who think they have been wronged by a vendor can seek redress via the courts through reliance on torts and other laws regulating seller behavior. This solution is typically expensive, time-consuming and risky.
  7. Licensing
    Licensing falls under consumer protection regulations as well. Certain professions, such as law, medicine and hair-dressing, require a license by the government to sell certain goods and services.

In the market for high value collectibles, until recently buyers primarily relied on reputation.  A dealer with a reputation for honesty could earn more business at a higher price.

Other than that, buyers tried to close the knowledge gap by insisting on physically examining high-priced collectibles before consummating transactions.  This reliance on physical inspection caused two inefficiencies in the collectibles market.

First, physical inspection was hardly a perfect mechanism for detecting fraud.  Unlike professionals in the trade, most purchasers and collectors lacked the experience and knowledge needed to determine, with confidence, the authenticity, quality or rarity, and hence the value, of high-priced collectibles, even when they had the opportunity to examine them physically.

Second, physical inspection of goods is slow and inefficient.  Because of a lack of trust, goods could not be bought on a “sight unseen” basis and all dealings had to be localized.  Accordingly, the collectibles market was extremely fragmented and not particularly transparent.  Instead of a central clearinghouse, the market was made up of a large number of local dealers’ shops, trade shows, auction houses etc.

To solve the information asymmetry problem and increase efficiency, market participants turned to trusted third parties.  Independent appraisers are able to make information more symmetric.  CLCT, as the largest appraiser, has the standing and the authority to certify as authentic hard to authenticate items.  In short, CLCT is able to provide solution #3 above.

The ability to get certification from CLCT ended the need for buyers to physically inspect goods.  In turn, this ended the need for all transactions to be localized and allowed the collectibles market to move online, particularly to eBay.  As a result, the market thrived.  As CLCT describes it:  “The shift to Internet transactions has enabled more efficient long-distance trading.  The advent of the Internet and, in particular, eBay’s development of an Internet or ‘virtual’ marketplace, has overcome many of the inefficiencies that had characterized the traditional collectibles markets.  eBay and other online marketplaces (i) offer enhanced interaction between and greater convenience for sellers and buyers of high-value collectibles; (ii) eliminate or reduce the involvement of dealers and other ‘middlemen;’ (iii) reduce transaction costs; (iv) allow trading at all hours; and (v) continually provide updated information. “[2]

CLCT’s services offer a clear value proposition for all three parties involved in an Internet transaction,  the buyer, the seller and the virtual marketplace.

  • A CLCT certification allows vendors to sell at a higher value and increases liquidity. A certified good fetches a premium because buyers are willing to pay a higher price to reduce the risk of being defrauded.
  • Buyers are assured that they are buying the genuine article and not being ripped off.
  • The Internet platform company has an interest in ensuring that buyers on their site have a positive experience and are not subject to fraud. Companies like eBay realize that if someone buys a counterfeit via their marketplace, it ruins the relationship with that customer and they are unlikely to become a repeat buyer.

In this way, CLCT provides a mission-critical service for many in the trade.  As a result, in this narrow context, it is no exaggeration to call CLCT a poor man’s Moody’s.

The Power of a Niche

I have written before about the attractiveness of businesses that focus on dominating a niche.  The benefits are two- fold.  First, as a matter of simple mathematics, if the minimum efficient scale in a business requires, say, a 33% market share, only 3 companies can get to scale.  Assuming a the market has three participants each with equal market shares, a fourth entrant will either be deterred from entering the market altogether or will engage in self-defeating price competition to seize market share.  Second, a tight focus on a niche keeps management from making value-destroying investments outside their circle of competence.  I admire managements that stick to things they understand.

CLCT is a superb example of this.  In the mid-2000s they made a disastrous move into grading jewelry which they later had to exit.  Since then, they have focused exclusively on their niche, grading and authenticating coins, trading cards and other collectibles.   Management describe themselves as “very focused” on growth within their core market.[3]

This niche focus leads in turn to the creation of two large barriers to entry.

Sustainable Competitive Advantage through Brand and Reputation for Integrity

In basic terms, barriers to entry into the authentication and grading market are low.  You or I could set up a website and advertise ourselves as coin or baseball card graders in an hour or two.  There are no licensing requirements or educational requirements.  There are no significant capital requirements.

But to thrive, the authenticator must have a reputation for integrity and professionalism.  The brand must be recognized as an honest arbiter.

CLCT has brands with strong recognition among the collectible dealers and process/grade significantly more items than any of its competitors.  Brand name recognition and a reputation for integrity, independence and consistency in the application of grading standards can take several years to develop.   A company has to grade millions of coins and deal with hundreds of satisfied customers before a reputation takes hold in the marketplace.

This creates a large obstacle for anyone hoping to compete with CLCT.  Accordingly, CLCT has a ~50% market share in coins, a ~90% market share in trading cards, and a ~75% share in autographs and other memorabilia.[4]

Assembled Workforce Creates a Significant Barrier to Entry

Getting to scale as an appraiser requires assembling a team of qualified experts.  This is no easy task.

The majority of CLCT’s experts have many years of experience in grading the respective collectibles.  As of June 30, 2015, CLCT employed 46 experts who have from 7 to 54 years, and an overall average of 28 years, of experience.

However, talented collectibles authentication and grading experts are in short supply, and there is considerable competition among collectibles authentication and grading companies for their services. There is also no school aspiring authenticators can go to.  As a result, CLCT must train  collectibles experts in-house.

An aspiring competitor would have to hire away experts in grading collectibles from a firmly-entrenched leader or begin an expensive and time-consuming training process.  Incentives to do so would be limited in a niche market.

 CLTC is a Highly Profitable Business, with Strong Organic Growth Funded  Entirely  by its Own Generated Cash Earnings

CLCT has strong top-line growth that’s entirely organic.  Revenues have grown at a CAGR of 6% from 2006 to 2015.  Except for a misguided series of acquisitions in 2006 and 2007 (which they subsequently sold), CLCT had one this without the benefit of any acquired sales.  CLCT spent just $753,000 on acquisitions from 2008 to 2015.

Instead, because it offers a mission-critical service, CLCT has ample pricing power:  The average price CLCT charges per item graded has increased at a 7% CAGR over the last five years.

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Source:  Company reports via Sentieo.com

CLCT has not raised any external capital, debt or equity ,since its IPO. It funds its capital expenditures and investments entirely with generated cash. CLCT converts an average of 14% of sales to FCF.  Further, it has extremely low capital needs.   On average over the last 10 years, less than 2% of sales has been spent on capital expenditures.  As you would expect, ROIC is very high – averaging 36% over the past 10 years.

This allows CLCT to pay out an extremely high dividend.  Over the last 10 years, CLCT has distributed in excess of 100% of free cash flow to owners.  The stock is currently yielding 8.37% .

Collectors Universe, Free Cash Flow & Dividends, 2006-205

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Source:  Company reports via Sentieo.com

CLTC’s Growth Runway Underappreciated

We believe that the market is under-estimating CLCT’s ability to increase FCF over the next 10 years.  There are several growth drivers out there.

Most simply, CLCT has ample opportunities to grow as global penetration rates for collectible grading are still quite low.  CLCT believes that it serves less than 20%of the available market for coin grading worldwide.[5]

There is also ample and pending growth outside North America.  In recent years, CLCT expanded their geographical reach by opening offices in Paris (2010), Hong Kong (2012) and Shanghai (2013).  International is now approximately 7% of total revenues and growing.

What Could Go Wrong?

The biggest threat to the company is the slow death of coin collecting due to aging population in the US.  The demographics are not favorable.  The American Numismatic Association estimates that the average age of coin collectors is over 50, which could be a headwind for the industry if retired coin collectors begin cashing in and younger collectors don’t step up to absorb the additional supply.

The stamp collecting industry, for instance, has struggled with this in recent years as interest from young collectors has waned. Coin collecting may be a different story, however, given the gold and silver content of many coins and their perception as currency.

The question then becomes whether overseas growth offset sluggish demand in the US.  International revenue grew 7X from 2011 to 2015.  I do not expect it to keep increasing at this rate but it should still make up for a drop in the US.

In the shorter term, sales are subject to fluctuation.  CLCT has identified the following factors which can cause sales drops:(i) economic downturns which can result in a decline in consumer and business confidence and disposable income and, therefore, the willingness of dealers and collectors to buy collectible coins, (ii) the performance of the stock and bond markets, the level of interest rates and fluctuations in the value of the U.S. Dollar and in the value of precious metals, which can lead investors to shift some of their investments between stocks and bonds, on the one hand, and precious metals, on the other; (iii) in the case of modern coin submissions, increases or reductions in the marketing activities or the popularity of programs that are conducted by the U.S. Mint and by dealers who specialize in selling modern coins and (iv) short-term changes in the value of gold around the time of trade shows.

Fortunately, the conservative nature of management keeps them prepared for dark times.  As of December 31, 2015, the company had $12.7 million of cash, roughly equal to two years of net income, and no debt.  This should serve as a nice buttress against a short term decline in sales.

Conclusion

So there you have it:  a mature, boring, cash cow where management is smart enough to pay out over 100% of FCF in dividends.  I readily admit that writing this post was not as much fun as putting together the pieces of the LYV puzzle.  But, the goal of investing is not to have a stimulating intellectual exercise.  For that, play chess.  Instead, the goal is to make money with reduced risk.  CLCT fulfills that goal.

CLCT provides a unique opportunity to buy a stable old franchise at just 10X trailing EBIT with an ~8% dividend.

Shares out          8,898,104
Price                  16.87 (4/15/2016)
Market Cap     150,111,014
Debt                         –
Cash        12,794,000
EV     137,317,014
EV/EBIT                  11.34

 

[1] Market capitalization of $148 million as of April 15, 2016.

[2] Page 4, 2015 Form 10-K.

[3] 2015 Investor Presentation

[4] 2015 Investor Presentation

[5] 2015 Investor Presentation