In this edition of Investing chronicles, Lockstep CEO Paul Farah explores how understanding a company’s liquidation value can act as a safety net to cushion your investments.
In previous editions, we’ve discussed the importance of having a margin of safety to reduce investment risk. If you haven’t read it, please check out Reducing risk when buying shares in a company to better understand the margin of safety and its significance.
This week, let’s explore one of the greatest safety nets you can have when investing – the liquidation value of a business – using a real-life example to illustrate its potential.
What is the liquidation value?
The liquidation value measures the minimum value of a company if it is forced to sell all its assets in a distressed situation, such as bankruptcy.
It represents the amount shareholders would receive after all the company’s assets were sold and the proceeds used to pay off the company’s debts and other obligations. Whatever remains is then distributed to shareholders.
How to calculate liquidation value
The calculation is straightforward on paper:
Liquidation value = Total assets less total liabilities.
Steps to calculate the liquidation value
Identify total assets: This includes everything the company owns that could be sold, such as cash, inventory, equipment, and property.
Estimate sale value: Determine how much money each asset could bring in if sold quickly. This might be less than their book value, but sometimes it could be more.
Sum of assets: Add up the estimated sale value of all the assets.
Identify total liabilities: This includes everything the company owes, like loans, bills, and other debts.
Subtract liabilities from assets: Finally, subtract the total liabilities from the sum of the assets to get the liquidation value.
While this theoretical application is straightforward, it’s more challenging in reality, but therein lies the opportunity – most people don’t want to do the work.
But let’s look at a real-life scenario to see how this is done in reality.
The liquidation value of Legacy Housing Corporation
Background
Legacy Housing Corporation (LEGH) builds, sells, and finances manufactured homes and “tiny houses” distributed through a network of independent retailers and company-owned stores.
Established in 2005, LEGH is the sixth-largest producer of manufactured homes in the United States, primarily operating in the southern US. Over 50% of its sales come from Texas, 12% from Georgia, and 9% from Louisiana.
Targeting customers with household incomes below $75 000 per year, representing over 50% of all US households, LEGH constructs homes in its three factories, sells them through independent retailers and company-owned outlets, and offers customised financing solutions.
How the company earns its money
LEGH generates revenue primarily from product sales (manufactured homes) and its financing business. As of full-year 2023, 76% of its revenue came from product sales, 20% from financing, and 4% from “other” sources.
Source: LEGH’s 10-K Reports
Trading at liquidation value
During the first quarter 2024 investor call, the CEO mentioned that after the poor Q4 2023 results, the company’s share price traded around its liquidation value.
“There was confusion with our fourth quarter numbers and the stock traded down to liquidation value.”
Duncan Bates, CEO of LEGH
What a comment!
It is pure gold to hear a CEO publicly state the company is trading at its liquidation value. Consequently, the board of directors implemented a share buyback programme to take advantage.
But it’s essential to conduct our research. So, what is the liquidation value of the business?
Calculating LEGH’s liquidation value
1. Identify total assets
We turn to the balance sheet to find the total assets:
Source: LEGH’s March 2024 10-Q
Don’t let the above intimidate you. We’re going to work through this together.
Note: I have marked various assets on the balance sheet as these can be grouped to form a single line item as they are similar. All items marked in red are essentially “loans” the company has made to buyers of their homes.
2. Estimate sale value
While the balance sheet provides us with the book value, this might not be accurate. In a distressed situation, the company might not be able to sell the item for that amount, while sometimes the item might be worth more than what is on the books.
Our job is to go through each item and estimate its actual value. Below, I have done just that and added my comments to show my thinking:
Property, plant, and equipment
As per note 8 of the March 2024 10-Q, we can see what the property, plant and equipment consist of: land, buildings, vehicles, etc.
Source: LEGH’s March 2024 10-Q
But here is where it gets interesting.
LEGH purchased raw land years ago, which it has been developing to sell to Mobile Home Park (MHP). The land is sitting on the books at cost – the price LEGH originally paid for it – but because it has developed the land and property prices in Texas have soared, that land is now worth considerably more.
From my conversations with the CEO, they have had independent valuations of up to $400 million for that land; however, the CEO and I believe that land could easily fetch $75 million if they had to sell it quickly.
Therefore, I valued the land at $75 million and the rest of the property, plant and equipment assets at 75% of their book value, for a total value of $115.5 million.
Loans
LEGH lends money to MHP owners and individuals to purchase homes. In a distressed situation, these loans would likely go bad and be worth zero.
However, LEGH has collateral on all the loans, and the collateral is the homes itself. Given these are manufactured homes, they can be transported and resold reasonably quickly. So they are worth something.
Again, based on conversations with the CEO, LEGH has 100% collateral on the loans, meaning they should be able to recover 100% of the loan value should the lender default.
Furthermore, in the case of MHP loans, they have third-party guarantors that would have to step in should the lender default and often the collateral is the entire park itself, meaning 1) the probability of these loans defaulting is very low and 2) if they did, often the collateral is more than what is on the balance sheet.
I am, therefore, confident they could recover the total $403 million in loans should all go bad, which is very unlikely.
3. Sum of assets
As per the table above, the estimated liquidation value of assets = $538.8 million.
Easy!
4. Identify total liabilities
As with the assets, we now have to do the same thing on the liability side, calculating the actual value of the liability vs what is on the books.
Source: LEGH’s March 2024 10-Q
Fortunately, this is easy as we simply assume LEGH pays off everything it owns (it can’t pay more), which is the value on the balance sheet.
5. Subtract liabilities from assets
Finally, subtract the total liabilities from the sum of the assets to get the liquidation value.
Liquidation value = Total assets less total liabilities
Liquidation value = $538.8 million - $59.6 million
Estimated liquidation value = $479.2 million
So, after LEGH has paid off all its debt, there will be $479.2 million left for equity owners of the company.
This is where one needs to be careful because that equity might not all be available to the company’s shareholders. If there are preferred shares or separate classes of shares, they might get paid before the common shareholder (you and me).
In LEGH’s case, however, there are no preferred shares or complex equity structures, so the $479.2 million would be distributed equally to all existing shareholders.
Liquidation value per share
To determine what we get paid, we still need to calculate the liquidation value per share.
As per the March 2024 10-Q there are 24,316,488 shares outstanding. So the $479.2 million would be distributed equally among these shares, meaning each shareholder would receive $19.71 per share.
Conclusion
The liquidation value gives us a fantastic safety net as it’s the worst-case scenario. In LEGH’s case, we should expect to receive around $20 per share.
LEGH is currently valued at $23.61 per share (at the time of writing), so if you bought the share today, in a worst-case scenario, you should expect to lose -16.5% on your investment. That is not bad considering the potential of this business (see When should you sell a stock for profit).
That doesn’t mean the share price cannot go below $20 or even $17 or more. But it does mean that if the share price drops to $15 per share, there is a high probability that I will be buying a lot more of LEGH.
There’s plenty more to discover with Lockstep.
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* Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and are for informational purposes only, it is not intended to serve as investment advice and it does not represent the view or opinion of Standard Bank. This information should be used as a starting point for generating investment ideas, and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.
