A Special-Situation With 286% Upside
A business trading below net-cash with a positive FCF for the foreseeable future.
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It’s 1952.
Rockwood & Company were famous for their massive chocolate factory in New York and a legendary 1919 ‘chocolate flood’.
Apparently, there was a fire in the factory and melted chocolate was literally pouring down the street.
The sticky mess attracted excited school kids from miles around, and went down in folklore.
The business had quite the history.
At one point, it was the second largest chocolate manufacturer in the US (after Hershey’s).
But then, a young Warren Buffett was entering the picture.
He’d been compounding his own capital, using Ben Graham’s principles for a couple of years, and stumbled upon a fascinating situation.
A special-situation.
Rockwood had accumulated a large inventory of cocoa beans, under the LIFO accounting rule.
The price had skyrocketed and tens of millions of pounds of cocoa was sitting there with huge paper-profits.
The company wanted to tap into that cash, but the tax laws at the time meant that 50% of the cash would be lost to the IRS.
Wanting to avoid that situation the management at Rockwood came up with an interesting idea…
Instead of selling the cocoa and incurring the tax liability, they would offer shareholders a fixed-amount of cocoa for each share tendered.
The value of the shares were less than the value of the cocoa, therefore the shareholder could sell the cocoa for a profit.
They wouldn’t literally swap their shares for barrels of cocoa of course. They would receive warehouse-receipts instead.
This allowed the company to cash in on the cocoa, return value to shareholders and avoid the 50% tax rate.
Buffett along with Graham took part in the tender.
Graham took his $2 per share profit by selling the receipts via a broker, Buffett, however, held onto his stock.
He realised that the value of the cocoa was far higher than the market cap.
Sure enough, the stock soared from $15 to $100 and was a 6-bagger for Buffett.
A 22-year old Buffett made around $160K (in today’s money) from that one trade.
It’s one of my favourite special-situation stories.
Joel Greenblatt also loved this type of stuff, with his particular favourite involving spin-offs.
In fact, when I was buying businesses in the real-world, I used to come across them constantly.
For example, we once met a guy that had built a large waste-management business, but was a little ‘forgetful’ with his tax payments.
Over the years, as the business grew, so did the stress of operating ‘cash-only’ and dodging the taxes.
He wanted to get rid of the business to retire, but no sane, respectable person would buy it.
This special-situation allowed us to do a deal.
We took control of the business immediately, sold some unused equipment owned by the business, and made an initial payment using that cash.
We then cleaned the business up, made it respectable and honest, and paid the guy out over several years.
We essentially got a multi-million pound business for free (if you don’t count all the stress and hard work cleaning it up).
I love special-situations.
Today’s business looks pretty interesting.
I first found it a couple of years ago, but there was a recent development that I believe could lead to a re-rating.
In other words, the catalyst has already started.
If everything works out the way I believe it will, the upside from today’s stock price is almost 300%.
Let’s take a look…