May 24, 2007

Crown Crafts

From Seeking Alpha:

A week ago, one of my contrarian stock screens picked up a jewel, namely Crown Crafts (Nasdaq: CRWS), which, at $4, is ridiculously cheap by almost any fundamental measure. Crown Crafts is a manufacturer of quality infant and juvenile products, and owns or licenses many valuable brands, including Disney Baby, Sesame Street, Classic Pooh, Eddie Bauer Baby, and more. The company aggressively defends its reputation as a maker of quality products, and is thus able to convince many brand-holders to license their brands to Crown Crafts. Meanwhile, parents are willing to pay a premium for brand-name products for their babies.

CRWS once had a terrible capital structure, with lots of outstanding stock warrants. However, its solid cash flow allowed it to do a massive refinancing in the middle of 2006, which in one fell swoop eliminated all those stock warrants (thus abolishing the threat of massive stock dilution) and paid down debt, resulting in dramatic drop in interest payments. This caused the stock to jump from $0.65 to $2 in a couple of days. At the same time, the company shifted its manufacturing to Asia, and consolidated its distribution centers from two to one. Revenues dropped from $83 million in 2005 to $72 million in 2006, presumably because management was too preoccupied with the momentous restructuring in 2006, but operating income actually increased from $6 million to $7 million, a testament to the huge increase in operating efficiency and profit margin brought about by the restructuring.

In 2007, Crown Crafts has fully emerged from its restructuring as a much stronger company. The stock price has trended upwards from $2 in 2006 to $4 today. It has spun off its Churchill Weavers furniture business to focus on its core infant and juvenile product business, and has bought the Kimberly Grant brand of infant products to further strengthen its core business. In March 2007, Crown Crafts graduated from an OTC stock to a Nasdaq listing.

At this point in 2007, Crown Crafts is on track to achieve a net income of $7 million for 2007, and a free cash flow of $10 to $12 million. Assuming a conservative $6 million net income for 2007, with an EPS of $0.60, this implies a PE of 6.7. With a quality company in a safe steady industry, a discount rate of 10% is appropriate. With a 10% discount rate, a company experiencing zero growth should have a PE of 10, and a company experiencing a very modest 5% growth should have a PE of 14. In other words, CRWS should be worth at least $6 per share, and probably is worth around $10 per share.

Of course, no investment is completely safe. A batch of baby bibs produced by Crown Crafts was recently found to contain high levels of lead, although the lead was in an non-absorbable form and does not place babies at risk. Nonetheless, to defend its reputation, Crown Crafts initiated a voluntary recall of the product. Management believes that the recall will be limited in scale and will not materially affect the earnings in 2007. Nevertheless, this episode illustrates the danger of outsourcing production to Asian countries, a danger which management will have to consider and mitigate in the future. In addition, the company derives 35% of revenues from Walmart, 15% from Target, and 30% from Toys R. Us, and sales of the Disney Baby brand makes up 41% of its revenue.

The extraordinary concentration of customers and licensees means that the loss of one of these key relationships will materially affect results. Lastly, CRWS has attracted very little attention thus far, and trading volumes is only around $100k a day, which makes it difficult for large institutional buyers to acquire any meaningful amounts of stock.

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