April’s Pick of the Month isn’t especially “contrarian” in comparison to many of my other picks, which often involve substantial amount of leverage, depressed multiples and unfair bias surrounding the businesses. The only (slightly) displeasing characteristic to this pick is the high earnings multiple of 17x and a low free cash flow yield of sub-3%.
Envela Corp (NYSE: ELA) is a regional company (headquartered in Texas) that you’ve likely never heard of. With a lowly market cap of $120m and a unique operating model, there’s good reason for that. However, in the last five years, the stock has watched its market cap rise tremendously, gaining about 1000% (admittedly, though, this is partly due to the favourable conditions that the pandemic brought to the luxury goods market). Initially attracted by the reasonable valuation highlighted by an Enterprise Value-to-EBITDA ratio just shy of 10x and a 15% return on equity in FY 2023, it made sense to me to look slightly harder.
Really, there are two segments to Envela’s business but at their heart is the wider “re-commerce” industry. Re-commerce involves taking used products and extending their lives through reselling and recycling parts in the secondary marketplace. It is important to recognise that the most critical part of the business is not the selling but the acquisition of the right “stuff.”
The two segments to Envela’s business are the consumer services and the commercial services, described in more detail below:
The commercial services model is the segment you probably will be less familiar with. When a large corporate/governmental entity (Microsoft, Tesla and Walmart are examples of the corporations that Envela work with) decides to upgrade their IT, Envela swoop in and buy the obsolete stuff that nobody cares for. The old IT can then be sold (if it’s decent quality), harvested (for components that may be needed in the future), or recycled for a profit. On top of this, Envela have programmes with retailers and OEMs to offer their consumers ways to trade in their items. Envela also repair/refurbish such electronic devices. The brands offering these solutions include ITAD USA (IT equipment disposition), Echo Environmental (end of life electronics recycling), Teladvance and Avail Recovery Solutions (both value-added resellers).
The consumer business model is primarily involved in the reselling/purchasing of luxury hard assets (jewellery, diamonds…) and you are probably familiar with the brick-and-mortar store concept where you can trade in your items and/or buy refurbished products. (Envela also run similar online marketplaces but selling must be done in person!) Less commonly, Envela also recycle these products to third-party refiners when reconditioning is not possible, but there is some substantial salvage value. This business is more simple to understand but you must realise that this differs from the standard retailer because the authentication is the most important aspect to it and the employees at the till dictate the success of the company. Consumer brands include Dallas Gold & Silver Exchange, Charleston Gold & Diamond and Bullion Express.
Both the commercial and consumer segments can be divided once more – into resale revenues and recycling revenues. In the consumer segment, recycling isn’t as important, accounting for less than 9% of the revenues. However, in the commercial segment, recycling revenues account for one quarter of commercial revenues.
Out of the two business segments, the commercial services model seems to be more profitable with a gross margin of 61.5% against 12.1% in the consumer model. Revenues, however, are much smaller for the commercial services segment totalling $42m against $129m in the consumer segment. Operating margins for the consumer segment settled around 3.6% and at 9.7% for the commercial services model. Note that the thin margins in the consumer segment aren’t a terrible disadvantage, effectively working as a deterrent to new firms trying to enter the market.
Overall net profits for Envela totalled $7.1m and cash flows from operations were lower than that (at about $5.8m) due to a large increase in inventories. To be clear, such increases in working capital should be cheered as the company grows, even if the cash flows appear weaker. For those concerned about reinvesting profits too quickly, there is little risk of any liquidity concerns with the company sitting on close to $18m of cash and $8m in current liabilities. Net working capital also totals $24.2m. (And, even then, Envela continued to generate free cash flow of $3.6m!)
Of course, the bulk of the inventory is related to the consumer segment (95%) with a much smaller inventory reserve for the commercial segment totalling $1.2m. It is important to note that the consumer inventory is recorded at the lower of cost or net realisable value. If the price of the underlying commodities were to deteriorate sharply, impairments would take place. Fortunately, at the moment, we’re not currently in such an environment.
If we look at the resale consumer inventory in more depth, you will realise that days inventory was about 66 days in 2023. Of course, resale consumer inventory increased more than 30% in the year. By comparison, in the smaller resale commercial segment, days inventory was about 44 days. It’s important to remember that Envela are a small company that are growing – therefore, such numbers should be taken with a pinch of salt. Compared to previous years, these numbers are worse and in the future, these numbers should also be watched. You definitely don’t want to be involved in a situation where a company expands too fast and struggles to generate sufficient cash flows.
Speaking of a component of the balance sheet, let’s look at the balance sheet. My opinion is that it’s really healthy and set up for more growth. We have a net-net situation on our hands where there are $50m worth of current assets against $25m in long-term liabilities. Unfortunately, the market cap isn’t sub-$25m else this would be a complete steal! It’s also worth mentioning that there is about $9.5m in real estate sitting on the balance sheet (at cost).
Yes, there is $13.5m in long-term debt (in the form of eight notes: four involving real properties and two involving acquisitions), but the interest on such notes is super low (under 4%!) and maturities are spread out between now (2024) and 2030. Cash in the bank literally earns more than interest on debt! Assuming Envela continue to operate the way that they have, the debt can be serviced pretty comfortably – to the point where refinancing may not need to occur!
What is also really appealing is the fact that management are now buying back stock ($2m in 2023) at an average price ($5.18) higher than the current price. Whilst we’ve certainly missed the big “run” between 2019 to 2021, long-term investors still have lots to benefit from and management are showing that.
If we briefly talk about management, it’s a really interesting situation with John Loftus, CEO, owning about 70% of the stock. He was only appointed as CEO at year-end 2016 and made large purchases at that time when the stock was stock well under $1. When asked about why he chose to join Envela, his answer was simple – NOLs on the balance sheet. Unfortunately, at this point in time, there are no NOLs left to offset future taxable income, but that is even more testament to Mr Loftus’s business ingenuity! Furthermore, since becoming CEO, Mr Loftus has taken no compensation in the form of stock/cash – and SBC hasn’t been a killer for investors, either, with no SBC taking place since Mr Loftus took his position. To further highlight the extent of this turnaround, it is also worth mentioning that in 2016, S&P Global Market Intelligence ranked Envela as the second most likely company to go bankrupt, behind Sears Holdings. How wrong they were!
In a brief interview with the New York Stock Exchange, Mr Loftus mentioned his desire to “double our number of stores“, “expand our marketplace into new markets“, and “grow by double by the end of 2024.” Perhaps an element of management schmooze? But his money really is where his mouth is and such management is rare to find today.
Unfortunately, there is no real catalyst here. We have to wait for profits to be realised, management to continue to spend money on growth and revenues to pick up. It is of use to note that precious metal prices have skyrocketed in recent weeks, so if such price levels are sustained for a substantial amount of time, it may result in higher margins (resulting in larger profits) on inventory acquired at lower prices.
As for a recession (if it occurs), Envela benefits from it. If consumers feel the strain, they will come to Envela’s stores to get quick cash on their goods. Such irrational mentality benefits Envela and investors can probably learn a lesson from it.
Frankly, this is also an obvious sum-of-the-parts play. With the information I’ve provided you with above, it would be wiser to split the company into two and then value them independently.
The commercial segment is leaner, higher margin and seemingly more steady. Assuming revenues stay around $50m and operating profits average $5m for the life of the company, we can use discounting to try and work out a value. If we work out what the company will earn at a 10% discount rate (much higher than the current WACC of sub-5%), the commercial segment is valued at $50m.
The consumer segment is slightly tougher to value with all of the forecasted growth, commodity risk and wage increases. From here, I think it’s conservative to assume operating profits to grow by 7%/annum for the next decade as more stores open across the US and precious metal continue to stay popular as inflation becomes tough to extinguish. From there, we assume operating profits stabilise until the demise of the company. In a decade, the consumer segment should be doing operating profits of about $7.7m. If we discount those results fully (at a 10% discount rate again), the discounted value of operating profits total about $110m.
If we add both values together, we get a value of $160m – a value 42% higher than the current market price. It is important to also realise that these numbers are severely undercooked and I’m very much erring on the side of caution. I’m assuming no growth for the commercial segment and am assuming very slow, conservative growth in the consumer segment. In fact, based on the last five years it is possible that Envela attain this level of earnings growth in the next three years!
However, despite these conservative growth assumptions, it is also important to note that this rough forecast doesn’t factor in either effects of interest or taxes – the reason for this was because I didn’t want to (mis)calculate how much debt would be used to finance future growth (if any). Nor does this account for capital expenditures which I figured would be too “lumpy” to properly account for. Therefore, in this regard, you must also realise this method of valuation overstates reality.
Inconclusion, don’t be misguided by the high P/E ratio of 17x. This business is growing sustainably (no pun intended!), with high quality management and beginning to really create value for shareholders! I finally reiterate the point that this cannot be held for just a few quarters. The stock is illiquid and there is little-to-no analyst coverage. This unusual situation where the CEO also owns 71% of the shares, leaving a float of 6.7m, further enhances the opportunity for smaller investors.
Feel free to let me know if you have any questions.
Best investing,
HV
