About 11 months and 16 days ago ( but who’s counting), news broke of the first Covid-19 cases in British Columbia, Canada. At the time I was working part-time at a local grocery store on the Simon Fraser University campus. Most people in the store were confused, and at times like this we looked to our supervisors for guidance, but they had no answers.

Being the rational economist that I am, I rushed to pick up the essentials. You know like chips, cookies, my favorite energy drink ( Monster: Ticker Symbol MNST), and toilet paper.

I got home that night and thought to myself, “perfect, I’m fully prepared for everything this short-term problem is going to throw at me .” Oh boy was I wrong. Little did I know, out of all the essentials I had gathered for my short-term hibernation, the one that would run out in stores would be toilet paper.

Like lemmings, we had all jumped off a cliff and stockpiled hundreds of tissue rolls. At that time, you had to do what you needed to survive. But we had no idea that with each dollar we used to purchase toilet paper; we all took part in a voting machine that would allocate capital to an industry that seemed ‘dead’ at the time.

As a corporate manager, there’s nothing better than announcing to the public that revenues are up by +200% and our stock is up +100%. Of course, this sure sounds like something a certain CEO of an infamously high growth electric vehicle company would say. But this is exactly what the management team at WestBond Enterprises (“WBE”) a Vancouver-based firm that manufactures disposable paper products had to say in their last quarterly report.

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It would be easy for me to just go right into an analysis of how profitable the business is over time and see if there’s any value left for potential shareholders. This would be very beneficial and a waste of time. Paradoxical I know, I’m the first to admit that due diligence can be boring, but investing is an art better served by compounding knowledge.

So, to save us time I’m just going to give you the valuation that I came up with, and the key assumptions that I used to come up with this value.

The fair value of the entire business was just above CAD$ 17,000,000. I used a dividend discount model over a 10-year period and grew the dividends by the company’s historical growth rate. At the end of the 10-years, I assumed that like a bond at maturity, the company would be sold for its historical price to earnings ratio of 10 times. Currently, the company is being sold for just below CAD$30,000,000. In terms of per-share measures, the fair value was $0.48 per share and the current stock price is $0.82 per share. This implies an overvaluation.

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I know it seems rough and usually, I spend more time digging deep into the valuation, but I thought this would be a great opportunity to focus on working capital management instead of stock valuation.

Working capital is important to the underlying economics of a business that depends on the sale of manufactured goods to generate revenues. This sort of analysis is not common in today’s market because most technology firms are in a working capital deficit.

But before I get ahead of myself, I think it’s best I define working capital in a clear and concise way. Working capital (also known as net current assets ) is the money invested in assets or held as liabilities that the business needs to run its day-to-day operations. In accounting, this would be the current assets minus the current liabilities.

Working capital is a measure of a company’s short-term financial health, liquidity, and operational efficiency. Usually, if a company has a substantial working capital surplus this indicates a higher liquidity position than a company with a working capital deficit. Of course, this is not always the case and there are companies that run a working capital deficit to their advantage.

In WBEs’ case, they are in an industry that demands a working capital surplus. Management explicitly states that :

“We have suspended payment of our quarterly dividend effective June 2020 in order to ensure sufficient funds are available to invest in our new disinfecting wet wipe production equipment and inventory. We intend to spend around 1 million over the next year, which we will finance from operating cash flows, supplemented with our revolving bank loan facility.”

“We use the revolving bank load facility primarily to finance operating working capital. Inventory and accounts receivable levels normally fluctuate by as much as 300,000 and account payable by an additional 300,000. We purchase all pulp and paper supplies in relatively large quantities and often have large shipments to customers on credit, which are the main reasons for these fluctuations.”

To be completely honest, although they explicitly state their day to day mandate, it does take better judgment by the investor to see the implicit goal. But all in all, it is pretty obvious that working capital is a big factor for WBE and its potential profitability. So, a quick analysis of the working capital trend will shed light on how management was able to weather the storm.

Working Capital and Profitability

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I have collected all the working capital data that we will need above. I took data from December 2019 till September 2020. This gives us a birds-eye view of management’s working capital plan over four quarters. These four quarters include three distinct events:

  1. the COVID-19 pandemic in early February,
  2. the stock market correction in March,
  3. and the business recovery of some industries during the COVID-19 pandemic in September.

Those with a deeper understanding of accounting would find it beneficial to replace the quarterly numbers with a full year trend from 2010 till 2020. But for our short analysis, this should be enough.

For context, in the last few quarters WBE increased its earnings by +258% during this period. And in the three months ended September 2020, they made CAD$ 3,268,000 in revenue, compared to the CAD$ 1,955,000 in June 2020.

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The first thing that stands out is the large holdings in inventory and accounts receivable. This could be because of the management team’s business model of buying up the pulp and other raw materials in large quantities and converting them into paper products. Once they have the finished goods, they sell some of them on credit creating an accounts receivable balance, or through direct sales generating instant cash.

Once accounts receivable books are open, they rely on the financial health of their customers to make good on their payments. This doesn’t always happen, and sometimes smaller accounts can default on their payments creating an impairment expense. This is what happened to them in the quarter ending June 2020, rapidly reducing earnings and their current assets.

Since then, they have generated enough business with their new trademark ViroBan Plus product. For lack of a better terming, management capitalized on the pandemic and created a new brand that would boost profitability.

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The other current assets that they hold are cash and prepaid expenses. Cash is usually cash held in a bank or invested in the very short term and liquid assets (think 90-day Treasury bonds or Canadian bonds )for high liquidity. Prepaid expenses can be anything from insurance premiums, early rent payments, or other fees that have been paid in advance, and services that have yet to be ‘used’.

The ones we can’t ignore would be cash and cash equivalents. At the end of 2019, they had CAD$ 243,882 in the bank and CAD$ 170,050 in September 2020. This likely reflects a combination of the following three things:

  1. Management has been using cash to invest in projects that will hopefully generate revenues in the future like the trademark Viroban Plus disinfectant wipes.
  2. They have invested heavily in equipment and inventory to meet consumer demand
  3. The cash drain could stem from the fact that they’re making more sales utilizing accounts receivables, meaning they are not receiving cash immediately.

So, if most of the cash is being used to invest in product lines with higher gross margins, one would ask where are they getting the money to fund these projects?

Leverage is the key here. The business doesn’t have bonds trading in the open market like most companies. This is mainly because of how small the company is and how difficult it would be to sell a bond offering to the secondary market. Management has opted for term loans and bank credit. They have historically had a revolving credit facility of CAD$ 1.5 million with a Canadian financial institution for the last few years.

However, due to the high demand and the lack of investable cash in their coffers, management had to find an alternative way to raise cash. Instead of increasing the facility, they got a revolving bank loan. The difference between a revolving credit facility and a revolving bank loan is important, but for now, the details will be left out. This cash injection brought in CAD$ 150,000 that was used to buy working capital. Management expects to pay as of today a 2.5% variable interest rate, which can be thought of as the cost of capital.

Debt is not the only way that they were able to generate these earnings. With the management teams’ experience, they were able to negotiate favorable contracts with their suppliers to get raw materials early before making any payments. For WBE this creates a trade payable, and for their suppliers, it creates an accounts receivable entry.

Having accounts payable increase overtime is not always a bad thing, it theoretically means that reasonable management has contracted for services payable through their bank account to reinvest into projects and inventory – which implies they expect enough money to pay off these new contracts. But it must be remembered that these accounts payable still have to be paid. But it must be remembered that these accounts payable still have to be paid. Defaulting on these payments would cause them to have a worsened relationship with their suppliers making it difficult to renegotiate contracts, especially at beneficial terms. That said, they seem to have enough cash and enough revenue to continue to make the payments, and we know because?

Say it with me now, working capital surplus! They have consistently been able to have above $1,000,000 in working capital surplus for the last four quarters, excluding the one where they experienced a 100% decrease in their sales and earnings.

This kind of corporate efficiency in working capital is ignored today. Most executives of publicly traded companies only have three goals these days :

  1. Sell the stock at the highest price possible in secondary offerings
  2. Buyback stock no matter what the price is
  3. Use accounting magic to inflate quarterly numbers

Having said that, it’s also important to take a step back and look at what the current price is telling you about the future of WBE.

Earlier I came up with a valuation, rough valuation, of about $17,000,000 for the entire company. I assumed for the first five years they would be able to grow earnings at about a 10% clip, and then after that growth rates would decrease gradually to match the Canadian GDP growth rate of about 2% (standard valuation practice). The market is currently trading at above $30,000,000,  indicating an expectation of growing earnings by 15% constantly for the next 10 years.

This is a classic situation of a mediocre business that was selling at an attractive price and has been bid up by speculators. Great investors have referred to this as the cigar butt investment style.

“A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

But again, this is merely a guess. The reality of the beauty contest that is the stock market is that if every stock is somebody’s favorite, then every price should be viewed with skepticism even those that may seem like risk-free investments.


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Taku Ndachena

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