Dorel Industries, Inc (TSX: DII.A and DII.B) is a Canadian company that designs, manufactures and distributes a range of branded products, including juvenile products (e.g. child card seats, strollers), bicycles (and accessories such as helmets) and home furnishings (e.g. futons). I first learned of Dorel from reading Saj Karsan’s articles on the company stretching back as far as 2009. Unfortunately, in 2009 I did not pull the trigger on Dorel and my hesitancy (really, my focus on other companies) caused me to miss out on a gain that ultimately exceeded 100%. Luckily, Mr Market is fickle and DII has suffered a precipitous decline in its share price over recent months, down 32% this year. I thought it was time to take a closer look.
Here we see that the company has generated positive returns for more than a decade, with only minor declines throughout the recession.
The company has experienced growing revenues. Part of this is related to acquisitions (which explain the large 2004 and 2008 increases). Though the company’s gross margin has declined over the last two years, it is still very close to its long-run average. However, in the last few quarters, gross margins have contracted further, in part due to unfavourable product mixes, but also as a result of increases in resin costs (one of the company’s key inputs). I was unable to find the exact form of resin the company is using, but ThePlasticsExchange.com helpfully provides information on the pricing of a wide range of resigns on a bi-monthly basis for the last year. By heading over to that site, you’ll see that resin prices have come down dramatically in the last six weeks, which should translate into gross margin expansion in coming quarters.
While on the topic of revenues, it is worth noting that one scary aspect of Dorel is that its sales are somewhat concentrated. From its 2010 10-K [PDF]:
For the year ended December 30, 2010, one customer accounted for over 10% of the Company’s revenues, at 31.0% of Dorel’s total. In 2009, this customer accounted for 31.4% of revenues. Dorel does not have long-term contracts with its customers, and as such revenues are dependent upon Dorel’s continued ability to deliver attractive products at a reasonable price, combined with high levels of service.
This adds a degree of risk, as reliance on a single customer that has no long-term commitment can spell disaster should that customer switch suppliers (a potential problem we’ve noted elsewhere).
Here we see that the company has traditionally enjoyed strong free cash flows, with relatively low capital demands (as evidenced by the small spread between FCFs and CFOs). The company’s cash flows from operations fell quite dramatically in both 2008 and 2010. In both cases, this was largely the result of inventory builds. This can sometimes be a cause for concern, so we’ll take a quick look at the company’s Cash Conversion Cycle.
Here we see that the company’s Days of Inventory have increased fairly consistently since 2004. In the last two quarters, the company has worked to reduce its inventory levels, and the company appears committed to continuing this in the future. From the company’s recent quarterly earnings conference call:
As has been stated in the past, the company estimates the appropriate level of inventory to support the business to be 450 to 470 million, and this remains the expectation for the second half of the year.
The company currently has $504 million of inventory, so a reduction of $30 – $50 million will flow through to free cash flow in the coming quarters, which will go a long way toward moving back to levels of historical free cash flows.
Of interest is the fact that the company self-insures against product liability exposure. This is an important area to focus on, as incorrect assumptions can create large unrecognized liabilities. At the end of 2010, the company had reserved approximately $24 million under Accrued Liabilities. Unfortunately, the company does not break out actual claims, so there is no way to tell how accurate its estimates have been over time. It is shocking that the Canadian securities regulators allow companies to not provide details on major reserve accounts that are formed largely on managerial assumptions.
Here we see the scariest part of Dorel. Its debt levels are far higher than I would prefer. Mitigating the increased risk of this debt level is that fact that the company’s free cash flows far exceed its interest payments, and the bulk of its debt comes due not until 2013, leaving plenty of time to find alternative funding sources or repay the balance owing. Unfortunately, there is no indication that the company is interested in paying down this debt as they have not made meaningful progress in nearly two years.
While on the topic of capital structure, it is worth noting that the company has two share classes, A and B. Class A shares carry ten votes each, and given the relative proportion of each Class, represent nearly 60% of total votes eligible to be made across all voting securities. The Schwartz family owns a fairly significant chunk of the Class A shares, which gives them disproportionate control, leading to the potential for corporate governance problems.
Ok, on to the valuation. Dorel appears significantly undervalued in all of my scenarios. Though there are some risks which I have noted, but I do not believe they justify the current discount. I see a lot of value in Dorel, especially as the company frees up inventory and margins improve due to declining resin costs.
What do you think of Dorel?
Author Disclosure: None, but may purchase within 72 hours.