Rockford Corp. - ROFO

Rockford Corp. manufactures and distributes car audio systems, both under its own brand names and under licenses from other companies. Rockford Fosgate is the company's flagship product line. The company's products can be found in new Nissan, Suzuki and Mitsubishi automobiles. Despite continuing sales and earnings growth, the company trades at a trailing P/E ratio of 6.3.

Rockford is a great example of a firm that was once highly profitable, then made serious errors that lead to years and years of losses. Rockford made money hand over fist through the late 90s, peaking in 2000 at $8.01 million in earnings. However, in each annual report from 1999 to 2003, the company makes mention of weak or declining sales in its core Fosgate product line. Rather than investing in revamping its core line of business, the company proceeded to acquire businesses and brands including Lightning Audio, Q-Logic, MB Quart, NHT and SimpleDevices. In the process, the company took on substantial debt. Unfortunately, the acquired assets failed to live up to expectations and the company was forced to either write off or sell most of them in the mid '00s.

In 2005, the company took significant steps to reduce costs and eliminate low margin products. Though revenue fell 15.7% from 2004, gross profit actually increased by 24% as gross margins rose from 19.75% to 29.08%. In 2006, the company appointed William R. Jackson as the company's new CEO, which he remains. Over the next few years, Rockford fought to reduce costs and improve gross margins as sales continued to fall. The company also concentrated on repairing its balance sheet and succeeded in eliminating all its debt in 2010.

2010 brought a resurgence for Rockford, as Fosgate audio products finally showed a sales increase. Cost reductions made in previous years allowed the company to produce a record operating margin of 11.01%. Accumulated losses allowed the company to shield virtually all income from taxation and record a profit of $2.71 million, the highest since 2002. Since then, Rockford's revenues have continued to increase and earnings have leaped to $7.38 million in the twelve trailing months, or $0.86 per share.

Rockford CEO William R. Jackson continues to express optimism in the company's quarterly reports, noting that the company has recently signed an exclusive agreement to distribute Blaupunkt mobile electronics in the US.

Despite its successful turnaround, Rockford's shares trade at $5.45 (+/- $0.05), only 6.3 times trailing earnings. The company's management is aware of the discounted valuation and has announced a tender offer for up to $8.4 million at up to $5.60 per share. Rockford's largest shareholder group owns 2.9 million shares and has agreed to tender 1.5 million of them. Because of this, the tender offer is guaranteed to be fully subscribed. After the transaction, Rockford will have about 7.06 million fully-diluted shares outstanding.

The company is funding its $8.4 million tender through its existing asset-based credit facility with Wells Fargo. The interest rate is currently around 4.5%. Because the spread between the interest rate and the earnings yield on the shares to be repurchased is so large, the transaction will be highly accretive to remaining shareholders. 1.5 million shares, each yielding $0.86 in annual earnings per share amounts to $1.29 million. The interest expense on $8.4 million in debt at 4.5% is $0.38 million. (The tax shield created by interest expense will not apply for several more years, as the the company works through its net operating losses.) After deducting interest expense, the tender offer results in an additional $910,000 or 13 cents per share in annual earnings for remaining shareholders. This might not seem like much, but it increases earnings yield from an already generous 15.8% to 18.2%.

I submit that a modestly indebted, growing company should not trade at an earnings yield of 18.2%.

Another important effect of the tender offer is the resulting changes in the shareholder base. 3K Limited Partnership, lead by Peter Kamin, is currently the second-largest shareholder and will become the largest by purchasing shares from another board member and seeing 1.5 million shares extinguished by the tender offer. Mr. Kamin is a respected value investor who has a long career with ValueAct Capital and now 3K. 3K describes its investment approach here. After the tender offer is complete, 80% of shares outstanding will be held by the three largest shareholders.

Risks to Rockford's future success include the state of the economy and the popularity of custom care audio systems. As a highly discretionary item, audio system sales can be strongly affected by factors like wages, unemployment and consumer confidence. Additionally, the allure of vehicle ownership has diminished among the younger adults who make up the core of the car audio system market.

From an investment perspective, Rockford is exclusively a growth and multiple expansion thesis. The company's market value is several times its book value, so investors should not look to the company's physical assets to limit downside.

If the company can successfully maintain sales momentum, it seems likely that the market will eventually grant a higher P/E multiple. Even an increase to 8 times trailing earnings after accounting for the tender offer would yield a stock price of $7.92, a 45% increase from current levels.

Disclosure: No position. May add.