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A Scratch ‘n Dent Stock Suitable for a Frothy Market

By Michael Brush
Exclusively for InvestorIdeas.com
December 08, 2006

It’s been a couple of good months for Insiders Corner.

Since October 5 almost every pick in this column has advanced much more that the 5% S&P 500 gain in the same timeframe -- barring the November 30 column which is too recent to count. Here’s a look at some highlights.

Earlier this week the clothing retailer dELiA*s (DLIA) surprised investors by reporting exceptionally strong sales growth in brick-and-mortar stores, as we suggested it might in this October 19 column (http://investorideas.com/insiderscorner/Articles/101906.asp). The stock is up over 30% since then.
My two best picks are up 40% and 30% since October 5 -- the natural gas play Goodrich Petroleum (GDP) and a Ghana gold mining play called Golden Star Resources (GSS). (For the original columns, check here: http://www.investorideas.com/insiderscorner/.)
Abraxas Petroleum (ABP) and the brand manager Cherokee (CHKE) have each advanced around 16% since we recommended them in October.
Even my mediocre performers -- stocks like Eagle Materials (EXP), Owens Corning (OC), Macquarie Infrastructure (MIC) and Heico (HEI) -- are up 10% since they appeared here in late October and November.

The 5 Stocks to Own in 2010 -- Free Report!

Only two of the thirteen picks has under-performed the market. One, Cogdell Spencer (CSA), is up 3% since October 16. The other, NeoPharm (NEOL), is down 6%.

Look for beaten up names

I’m not selling any of these winners that I own. But for new positions, I’m not chasing strong performers like these either -- even where insiders are buying significant positions. There’s too much bullishness in the market right now – suggesting we’ll see pullbacks that will allow us to get better entries on the superior performers.

Instead, for new positions I’m sticking with insider-buy stocks that have been beaten up -- preferably savaged -- by the market, but unfairly so. I believe these will have more bounce if the overall rally continues. And they should see less downside in any reversal since they’ve already been pounded.

This kind of stock is hard to find. But the market handed us a prime example this week in Industrial Enterprises of America (IEAM), a tiny New York-based vendor of chemicals, additives and fluids used in cars and air conditioning systems.

A week to remember

Industrial Enterprises may be in some pretty dull businesses -- but management and investors have had an electrifying week.

A combination of delayed filings, disappointing earnings, surprise expenses and flubbed communications sent the stock tumbling nearly 70% to nearly $3 on huge volume.

But it doesn’t seem that anything has really changed in the underlying businesses – except that they continue to get better. Cost cutting and sales growth should lead to a tripling of revenue by the second quarter of next year, over the year before. For act two, a plant in China is expected to help bring down costs in 2008.

A matter of trust

Management credibility is another matter. It took a severe hit along with the stock this week as investors griped openly in conference calls of a need to revamp communications with Wall Street. Chief executive John Mazzuto – in conference calls and in interviews with me – pulled no punches in offering a mea culpa. “We screwed up, there is no excuse,” he says.

One of the biggest surprises for investors was a $1.6 million non-cash charge for expenses associated with warrant financing – an expense that should continue for about another year. Another no-no – delays in filings covering the last quarter – was linked to those financing expenses. Industrial Enterprises auditors held up the filings at the last moment to rework calculations on the warrant expenses, contributing to the delay.

Another problem was that Industrial Enterprises reported operating earnings below what investors expected – in part because the company took longer to do an overhaul of operations last quarter than it expected.

All of this means that Mazzuto and Industrial Enterprises have lost a lot of trust with investors – many of whom preferred to exit and move on to companies where managers cook up fewer surprises.

A matter of time

But management credibility has a way of coming back over the course of a several quarters especially when you have two conditions in place.

Managers who face the problem head on at the outset and admit fault -- rather than hide out or pass the buck -- and take steps to resolve the problems. Mazzuto is taking over as finance chief and the firm is hiring a new auditor, among other changes.
A decent underlying business that is seeing healthy growth.

I believe you have both with Industrial Enterprises, which makes the stock a buy right here. Insiders seem to agree. They’ve purchased over $730,000 in the carnage this week. That’s a lot for a small company like this. There are still disgruntled investors who want out. So the weakness isn’t over. But on Thursday, at least, big buyers seemed to step in every time the stock fell to around $3.10. Be patient and purchase shares with limit orders.

What lies ahead

Here’s a quick look at what the company does, and why what went wrong this week might not matter in the long run.

Industrial Enterprises has a division called EMC Packaging that repackages hydrofluorocarbon gases for use as a refrigerant, and in aerosol cans that shoot air as a way to clean things – like your computer keyboard. A division called Unifide Industries sells fluids used on cars like deicer, wind shield wiper fluid and tire cleaner. Pitt Penn Oil distributes discount motor oil, transmission oil, brake fluid, antifreeze and other fluids.

Here’s what may bring decent gains in a year if you buy the stock now.

Chief executive Mazzuto likes to say he is in the business of buying “mediocre companies.” Then he puts in new managers to fix them up, selling off non-core assets. Through a combination of things like cost cutting and cross-selling of products, the company expects to see $35 million in revenue in the June-ending quarter of next year.

Industrial Enterprises is opening up a plant in China that should start shipping in March. It could double profit margins in the aerosol business. “It will have an enormous impact in 2008,” says Mazzuto. The company is also expanding distribution of aerosol products to get a national reach.
Investors panicked in part this week because of apparently low cash levels. But Industrial Enterprises has $2.5 million in cash, and it expects monthly free cash flow of $700,000 to $1 million. Money from warrants – over $10 million – may be used to buy back stock in the coming months.
Mazzuto takes no salary. Instead he plans to reap his reward through a big position of around 350,000 shares purchased before the problems this week at an average price of about $5. His children also have large positions. Insiders, mainly Mazzuto, bought another $730,000 worth in the current sell off for prices ranging from $3.40 to $4.60. In short, he has a big incentive to do things that make the stock go higher.
By my calculation, Industrial Enterprises looks like its trading for a miniscule .25 or so times expected sales. That’s cheap.

The bottom line: It can take a long time for management credibility to come back, so don’t buy this stock unless you are ready to wait a year or more for decent gains.

Disclaimer

At the time of publication, Michael Brush owned shares of dELiA*s, Golden Star Resources, Heico, Cogdell Spencer and Industrial Enterprises of America. Mr. Brush is an independent columnist for this web site.

For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorI deas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp . InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.

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