Monday, December 11, 2006

CRFT - How a drop in the dollar can kill it

I like this little company Craftmade International INC (CRFT) which makes ceiling fans and outdoor lighting accesories. They make good returns on equity (fairly steady ROE= 25%). They have been growing earnings at about 20% over the last 10 years. They are still tiny (market cap $96M) so have plenty of room to grow.

I even called around and and asked all kinds of people about their fans. Apparantly they are top notch. Based on the usual valuations they are quite cheap EBIT/EV = 17%. They even have an 8% Free cash flow yield (on EV). On top of that thet have a dividend yield of 2.6%.

So what is wrong with this company? Two things.

First of all they sell half of their product to the new home market. Housing starts are down 20% and will probably fall another 20%. So they may see a 20% revenue drop from that. But that is simply a cyclical phenomenon, not a problem with the business. Starts will rise again someday and the market will improve.

What will kill their business? A dollar decline could. To see this, we need to understand how this business works. Basically they are very light on assets. They design the fans, outsource manufacturing to China and Taiwan and sell them to US new home builders and home refurbishers. This company has fairly steady 6% net margins. This means that any change in their cost of goods and sales (CG&S) is magnified by a factor of 100/6=16.7 in net income.

They are very up front about this in their annual report

They say that a 1% drop in the dollar will decrease annual net income by $1.15M. Net income is $7.1M so this is 16.2% which agrees with my 1/(Net Margin) calculation for the degree of magnification. In other words a 6.2% decline in the dollar versus these currencies will result in the entire loss of income. In fact a 26.3% decline in the dollar wipes out all $30.3M of stockholder equity.

Here is the dollar versus the Taiwanese dollar and the Yuan.

The USD to TWD has lots of flucuation but has declined about 3% in a two months (this is Dec 11 2006). The dollar has been falling versus the Yuan since they unpegged it a little over a year ago. It is down almost 6%. If this continues then CRFT is history. It's entire business model is based cheap goods and sales from Asia and sold to the insatiable US consumer. How could it survive? It would have to raise prices to compensate. Can CRFT raise prices on ceiling fans amid a severe housing contraction? No way. In fact their will probably be a supply glut and prices will probably fall. CRFT may in fact be a good short opportunity.

I think this is an excellent micro example of a larger macro phenomenon. Most people think that if the dollar declines by 5% it means that their trip to Europe becomes 5% more expensive. They wouldn't think about a company going bankrupt because of it. The concept of leverage is clearly displayed here. However the dollar might not decline. Maybe globalization has created so much foreign labor that companies like CRFT will be able to keep lowering labor prices by shopping around. In fact I think this is why they have been moving away from Taiwan to China. Maybe they will be OK after all? Or maybe not. I think they began this move before the Yuan was unpegged and before the Secretary of the Treasury was going around asking the Chinese to lower their currency.

The moral of the story is (I think) to stick to companies with much higher net profit margins like JNJ (20%), KO (21%) and MSFT (28.5%) and stay away from little speculative companies that are highly leveraged to things like exchange rates. This is another reason to prefer old companies who have survived many such currency/economic cycles.