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Cedar Creek Partners – Queen City Investments: Royally Bad Capital Allocation

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The following segment was excerpted from this fund letter.

Queen City Investments (OTCPK:QUCT)

Queen City Investments was spun off from Farmers & Merchants Bank of Long Beach (OTCQB:FMBL) in 1973. FMBL itself was founded in 1907 by C.J. Walker and as far as we know, has been controlled by the Walker family ever since. It is a conservatively run bank. Total assets are nearly $11.7 billion. The bank has always had a very conservative balance sheet. Historically it has kept nearly half of the assets on its balance sheet in government securities. Equity to assets was in the 20% range for decades, which is more than twice what the typical bank kept. Despite the drag of lower earning securities, and excess equity, the bank still managed to earn just under double digit returns on equity. Its earnings are due to a low-cost deposit base. In other words, Queen City has a very conservative parent, and it shows.

Queen City has 47,739 shares outstanding with a last trade of $1,300 per share. It is described as an investment company. It initially held securities in FMBL and a 27,000-acre cattle ranch in Arroyo Grande, California (Central coast, inland from Pismo Beach, near San Luis Obispo). We are not sure when it occurred, but it no longer owns shares in FMBL. Today, it really is a trust company. As of the end of 2021 it managed $6.17 billion in assets for 1,391 trust accounts, a solid increase from the $4.34 billion in assets for 1,304 accounts at the end of 2020. In addition to the ranch, it owns some real estate, including one of FMBL’s branches.

Queen City also owns a large pile of treasury bills. Roughly $29 million, or over $600 per share of QUCT. That is the problem. The trust business is fabulous, with a return on equity of approximately 90%. What QUCT’s management has done is paired this fabulous, capital light, high ROE business with a portfolio of T-bills – an asset that is the opposite – poor performing, capital intensive, miniscule ROE “business.” The end result is that all the earnings of the fabulous business are being reinvested at 1.5%, a rate that not only historically very low, but is now well below inflation. To put it another way, every dollar they retain is worthless a year later. (See the next page for our segment analysis).

There is absolutely no reason that we can think of for QUCT to do this. It does not relate the trust business. The annual report notes that the pledged assets to ensure faithful performance of fiduciary duties is less than $1 million. We should also point out, the same poor capital allocation applies to it owning a 27,000 cattle ranch that appears marginally profitable, yet could likely be sold for more than $20 million. Management even borrowed $4 million for a real estate investment at prime (3.25%), which is a great rate, but really makes no sense while perpetually sitting on nearly $30 million of lower yielding treasury bills.

Some may ask, why own it then? Fair question. Last summer, after nearly fifteen years of a stagnant share price, and twenty-five years with no dividend increase, we believed that shares at just over $1,000 were an attractive low-risk opportunity. We knew cash and securities were roughly $700 per share and that the business was earning in excess of $80 per share. In other words, we were paying less than four times earnings net of cash, which was attributing nothing to the 27,000-acre ranch. With 47,739 shares, each share “owns” 0.57 acres. If the ranch at the time of our purchase was only worth $14 million, or $300 per share, we were getting the trust business for “free” ($700 per share of T-bills and $300+ per share for the ranch).

We haven’t even delved into the rental properties. Our segment analysis shows the rental properties as earning $900,000 and that is after accounting for $754,000 of depreciation. Rental properties are typically valued on FFO (funds from operations) which is basically cash flow or net income plus depreciation.

Source: Google Finance

Assuming a 15x multiple, the $1.65 million in cash flows would be worth around $25 million, or nearly $520 per share. Note 5 of the annual report notes a basis of $25.5 million, so we think we are being conservative. Based on a sum of the parts analysis, which admittedly can be dangerous, the non-trust company segments are conservatively worth $1,400 per share. We are up 25-30% since we purchased last year and know if QUCT management ever got serious about creating shareholder value we could do significantly better.

Even if it doesn’t happen soon, we think eventually family members, who are shareholders, will catch on over time, and push for change. It seems doubtful the trust business would ever be sold due to its connections to the bank, but the other three segments are not essential. One last point on the trust business that got our attention was that revenue rose $1.1 million in 2021 versus 2020 while personnel compensation declined by $10,000. The prior year, revenue had risen by nearly $700,000 and personnel costs had only risen by $40,000. That is excellent operating leverage, and important since sometimes the profits from these kinds of securities are siphoned off via salaries.

We would propose that Queen City liquidate most of the treasury bills and either pay a $500 per share special dividend or allocate the $500 per share to a tender offer, which would allow them to reduce shares by up to one-third. Either would show that management is serious about capital allocation and would improve shareholders’ view of the company. After that they could look at either selling the ranch or spinning it off, possibly with real estate. Lastly, with the trust business not needing additional capital, Queen City could increase the dividend to a more meaningful percentage of net income.

Queen City Investments Inc.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.