Real Industry’s (NasdaqGS: RELY) mishmash business of selling face cream and recycling aluminum is unreal in and of itself. Then mix in its price-to-earnings ratio…
Stocks trading at extremely high P/E ratios are great stocks to avoid. Overvalued stocks are more likely to suffer future losses than stocks trading at lower P/Es.
Add the enormous P/E ratio to recent insider selling and investors can begin to glimpse the downside risks that suggest Real can't turn recycled aluminum, net operating losses and face cream into gold.
Investors may find other viewpoints here. Meanwhile, let's consider those ramping risks:
*1. Net Carry Forward: Not Real Revenue
A couple of promotional pieces, here, have apparently been misinterpreted, resulting in support for Real’s stock price. The piece comments that the company operates on a plan of taking tax advantages based on net operating losses (NOLs).
An NOL is not the way to build a business.
Only a truly troubled company would try to build a reputation on taking a tax advantage based on losing millions of dollars.
Yet someone holding shares of the stock has gone out and promoted that effort on the Seeking Alpha financial website.
The author wrote: "We are happy with the performance so far. We didn't buy the stock only for its aluminum business, we bought it because of the NOLs, and the management's disciplined capital allocation."
Racking up losses and calling them tax benefits - and then having someone crow about it - may work for a little while.
But to take advantage of those losses, the company has to have a positive operating income - something Real has missed in three of the last four years.
The overarching issue is this: Organic growth is the lifeblood of solid companies. Any growth – and all planned growth for Real – depends on acquisitions and NOLs. That's not a great growth plan.
*2. The Foundation: Rollup Company
At its very foundation, Sherman Oaks, California-based Real is a rollup company.
And Wall Street is strewn with battered remnants of rollup companies much like Real. Studies show that 70 percent to 90 percent of mergers and acquisitions fail. Failures are undoubtedly even greater for rollup companies with acquisition after acquisition after acquisition.
What happens is that all too often, companies simply choose the wrong candidate, pay too much and don’t know how to integrate the new business, suggests Harvard Business Review.
Unfortunate mergers include Daimler-Benz and Chrysler, which culminated with Daimler-Benz spending hundreds of millions to sever the deal after management realized lower-income folks didn’t fit with the luxury car business; and Kmart and Sears, a mishmash of poor inventory investment and sub-par locations that has left the retailer's stock price whimpering to an all-time low.
*3. Former Subprime Lender: Business Operating Losses Grow
Since emerging from bankruptcy proceedings initiated in 2010 under the legacy business called Fremont – a subprime loan lender - the company has reported significant losses from continuing business operations:
(Source: Company SEC filings; Nasdaq)
Finances have continued to be difficult ever since Real sold the circuit breaker division in 2015 and shifted to recycling metals.
“(T)he nature of our operations and our operating costs have changed significantly,” Real noted in the recent annual report in regard to the switch to the current business of aluminum recycling.
“Therefore, we may experience operating losses and net losses in the future, which could make it difficult to fund our operations, finance acquisitions and achieve our business plan, any of which could cause the market price of our common stock to decline,” filings state.
As the chart above shows, operating losses have accelerated. Even though revenue through acquisition reached $1 billion, operational losses are the biggest in five years and gross margins have dropped to 6.54 percent versus 30.19 percent year-over-year.
But surely losses won’t go on and on, right? Read on …
*4. Stock Dilution Looms
The business plan comes down to two key components.
- Buy companies
- Use net operating losses
We’ve already discussed the wrong-headed use of net operating losses. That portion of the business plan fails to generate what investors want … real money.
Additionally, the tax benefit surrounding NOLs is uncertain due to tax law changes and whether the company generates sufficient revenues so that the NOLs can even be applied (see page 12 ).
Now, if Real follows through as planned on acquisitions, it has to pay for them somehow.
Ah-ha! Diligent investors will find the funding options - and looming stock dilution potential - staring out at them under “Shelf Registration Statement.”
Yes, Real has $700 million worth of stock, registered and just begging to be sold.
Another 9.235 million shares of blank check preferred stock await, too (page 13).
As Real explains in filings, its stock offerings “could result in dilution to our stockholders.”
Generally unprofitable companies require stock offerings and big debt just to keep the doors open. At the end of last year, Real held a monumental debt load exceeding $331 million with overall liabilities over $536 million. Filings explain that debt interest costs will be “substantial.”
*5. More Uncertainties: Environmental Issues, Lawsuits
And the expenses just keep coming. An unknown level of costs await Real through threatened, previous and pending litigation.
Through its legacy Fremont subprime mortgage business, Real may face additional costly litigation (page F-50).
On the environmental front, too, potential costs related to litigation and remediation could escalate. Two states have already placed consent orders on Real over environmental issues.
Recently released US Environmental Protection Agency data shows that in Illinois, Real’s facility was one of the top 50 worst polluters among 1,180 facilities.
In fact, environmental liabilities have escalated for Real to a whopping $11.7 million.
*6. Insiders Yell, “Sell!”
Meanwhile, insiders have recently begun selling stock in their company. After setting up his automatic selling plan, chief financial officer Kyle Ross began unloading shares in late February. Mr. Ross dumped 6,722 shares in three weeks.
Mr. Ross sold the shares for just $6.05 to $6.77 apiece – close to one-third cheaper than where the stock trades now. And at today’s extremely inflated price - who would be shocked to see more insider selling very soon?
*7. Low Commodity Price
Finally, let's look at the price structure surrounding Real's aluminum segment.
We expect diligent investors will be hesitant to include in their portfolios a company dealing with aluminum - a boring commodity which has dropped ~7 percent in the past month to the lowest levels in five years.
This former sub-prime mortgage company with a 1,037 P/E actually wants investors to believe it can turn recycled aluminum, anti-aging cream and net operating losses into gold. We're not buying it. In fact, we fully expect the stock to fade to $4.50 per share, a valuation far more reasonable than Real's business plan.
* Important Disclosure: The owners of TheStreetSweeper hold a short position in RELY and stand to profit on any future declines in the stock price.
* Editor's Note: As a matter of policy, TheStreetSweeper prohibits members of its editorial team from taking financial positions in the companies that they cover. To contact Sonya Colberg, the author of this story, please send an email to [email protected].