The Brick: A Deep Value Stock With Catalysts

I do not typically write up the same idea twice, but given The Brick’s (BRKQF.PK) favorable recent developments, I believe it is necessary. These include the following items largely introduced in last Thursday’s earnings call:

• Announced a plan to repurchase high cost 12% notes with $175M in excess cash
• Adding 10-11 franchise stores and likely new corporate stores in 2012
• Repurchase program for 5% of shares outstanding, only 10% complete so far
• HSBC credit card program expansion to capture $50M-80M in additional organic sales in 2012 while not adding any incremental balance sheet risk as the credits are held by HSBC
• Former CEO of Wal-Mart (WMT) Canada taking over CEO role January 1 (has been COO since February 2010)
• New IT/ distribution platform to reduce SG&A and potentially increase operating margins by 1-1.5%

Bottom line: The Brick reported a strong third quarter with 17% EBITDA growth, 1.3% comparable store sales increase with over 1% EBITDA margin expansion and a number of near-term catalysts. Yet it still trades below 5x EBITDA with a mid-20s FCF yield. Even if none of the aforementioned catalysts are realized, the stock still has +75% upside.

Valuation

The Brick has an appealing FCF profile with limited capex, strong margins and no cash taxes due until at least 2013. At $3.02 a share with 131M FD shares outstanding and $92M of net debt, the market capitalization is $395M and the EV is $485M. The Brick trades at an EV/ EBITDA multiple of 4.8x versus 8.4x for its peers BMTC Group and Leon’s Furniture. It trades at 4.9x EBITDA-capex versus 9.3x for the peers. If you apply these peer multiples to BRK, the implied price is $5.00 - $5.50 per share.

One could also argue that The Brick should be valued at a premium to its competitors because of its higher margins and scale. The Brick trades at a 25% 2011E FCF yield. No matter w! hat metr ic you look at, this is a very inexpensive price for a growing, high return business with a top rate management team. In addition to the previously noted catalysts, cash generation and the delivering of the balance sheet alone increase equity value meaningfully.

Overview

For those that are new to the story, The Brick is the largest furniture retailer in Canada with 292 stores and a very strong regional brand. Back in 2009 the former management team pursued a growth at all cost approach and consequently brought The Brick to the verge of insolvency. The Board responded by replacing management and recapping the balance sheet. The new team consists of the former CEO of Wal-Mart Canada and the former CFO of Sears (SHLD) Canada, among others. The recap was sponsored by the Chairman and the large Canadian insurance company Fairfax Financial. This saved the company, but also massively diluted shareholders and saddled it with costly debt.

The new management team significantly improved operations, shuddered weaker stores, refocused the business on higher margin products, rationalized inventory and re-struck vendor terms. The Brick’s gross margin of 44% is now 4% higher than it was at pre-crisis levels, inventory turns have almost doubled and annual cash flows is over $100M. The company continues to gain market share while also improving margins. The Brick derives a competitive advantage through purchasing power, regional economies of scale, management strength and customer loyalty from it brand and card rewards program. As noted, The Brick still trades at half the price of its peers.

With the recap came 121M warrants that acted as a weight on the share price. However, these warrants have almost completely been extinguished through a cashless tender in late June. The fully-diluted share count consequently declined from 170M to 129M. On January 1, the company also converted from an income trust to a c-corp. As a result, the shareholder base turned over as yield-cent! ric hold ers sold. This pressured the stock in a structurally similar way as a spin-off. Though both RBC (RY) and BMO both have strong buys on The Brick, institutional following of the company is somewhat limited. The Brick was recently pitched as a buy the Value Investing Congress.

The stock plunged from $9 prior to the downturn to $2 and has remained a neglected orphan around that level since. But now the dilutive warrant overhang is gone, selling pressure from the conversion has subsided and performance has been demonstrably strong and is improving.

Disclosure: I am long BRK.