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THE ODDBALL STOCKS NEWSLETTER 6

Avalon Holdings
Ticker: AWX Price: $2.60

I worked in a factory one summer break during college. I never set out to
work in a factory, but my parents believed that I needed factory experience
to balance out growing up in an upper middle class area and to learn the
value of a dollar. While friends were busy with internships that involved
filing papers and getting coffee, I worked in an auto parts factory. Perhaps I
should consider myself fortunate as my brothers worked construction and
welded.

I’m not sure if this experience taught me the value of a dollar or not, but I
did learn some useful trade skills. But one thing I do remember from my
factory days was getting stuck taking out the trash. Some workers liked this
job because there was a wooded area by the dumpster they could take a nap
in (apparently lengthy trash trips were expected). I hated it because the
dumpsters were filled with metal, oil, and other industrial waste.

One afternoon while on trash duty with a co-worker a giant tank truck
pulled up. Like any good factory worker we proceeded to shoot the breeze
with the driver for a half hour just killing time. Little did I know that that
conversation would provide enlightenment with respect to an investment a
mere 16 years later.

The driver worked for a specialty waste company located in the Youngstown,
Ohio area. He said entry-level drivers started at $60,000, a good salary in
2001, especially for driving a truck. The drivers had routes through the rust
belt stopping at different industrial facilities draining the sludge out of
dumpsters and waste tanks. Industrial sludge is toxic and requires special
handling. Factories pay a lot of money to remove this stuff before their
trash can be recycled.

The auto parts factory I worked at was a metal stamping plant. Steel came
to the factory in rolls and was fed into stamping machines. The machines
pushed thousands of pounds of weight down on to metal dies that then
formed the sheet metal. Think of it like stamping out Christmas cookies
with a Rudolph stamp, except with metal. When you stamp out cookies you
never use all of the dough, there’s always scrap pieces left. It’s the same
with stamping out metal. The question is how do you dispose of dumpsters
full of discarded metal pieces? Most of it is melted down and recycled, but
along with the metal scraps there is a lot of oil and other heavy chemical
lubricants mixed in. These fluids sink to the bottom of the dumpsters and
can leak onto the ground.

Copyright Red River Research Inc. 2017
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The waste hauler who I spoke with that day specialized in transporting and
disposing of these heavy chemicals. So I was very intrigued when I found an
Ohio-based company called Avalon Holdings in which the primary business is
specialty waste disposal.

In 2016 the company generated $44.3m of revenue (up from $38m in 2015)
from waste hauling and related brokerage services. First quarter 2017
revenue was on track with 2016’s pace. A portion of the company’s revenue
is produced by project-based work. For example, there might be a
construction site that needs waste removed until a building is completed.
Other waste revenue comes from continuing sources, such as the factory I
worked at in college.

One area of potential growth for the company is disposing of salt water and
fracking fluid from the natural gas fracking activity in Ohio. This looked like
a promising business venture for Avalon Holdings until August of 2014 when
a seismic “event” occurred potentially as a result of their waste disposal.
The way companies dispose of drilling waste is to pump it back into the
ground to fill the hole that natural gas or oil left when it was extracted. In
theory this makes perfect sense, but geologists aren’t quite sure of the actual
impact of doing so.

Following the seismic “event,” Avalon Holdings was ordered by the Ohio
Department of Natural Resources to stop their saltwater waste injections
and this decision is now tied up in the Ohio courts. In February of 2017, the
court issued their final order stating that they didn’t believe the company
had caused this situation and that other seismic activity of a similar nature
had been observed in the same area. In theory this judgment opened the
door for the company to continue their salt water injections, however the
regulators filed a Motion to Stay the next day. In a separate action the
company filed suit against the Ohio Department of Natural Resources
alleging an illegal taking and unclear rules and regulations.

For those who love court dramas this could become quite a show. But, for
investors it will probably just mean years of legal bills before there is a
definitive outcome. In fact, the company may decide to move on from
saltwater wells regardless of the litigation outcome. They mention in their
2016 annual report that they weren’t even sure if they would re-open their
wells if permitted.

Out of the $44.3m in revenue the waste business produced in 2016, it
generated $2.7m in pre-tax income. In 2015 it generated $1.7m in pre-tax
income from $38m in revenue. If Avalon Holdings were simply a waste
manager we could look at their assets, slap a multiple on their income and
call it a day.

Copyright Red River Research Inc. 2017
THE ODDBALL STOCKS NEWSLETTER 8

Let’s stop here for a quick minute and review some basic facts about the
company. They have a market cap of $9.8m, which is tiny, and seemingly
very strange when looking just at the waste management company. At
current prices, the market is saying that $2.7m in pre-tax waste hauling
income is only worth $9.8m, a 3.63x multiple.

So what’s dragging down the price? In addition to the waste management
business, there is another half to the company that I haven’t mentioned yet.
This would be Avalon Clubs and Resorts, which is a combination of three golf
courses and the Avalon Inn, a newly remodeled hotel abutting the Avalon
Golf and Country Club property.

It seems crazy that a profitable waste company would acquire money-losing
golf courses and then pile on with a hotel. But is it? I have a small
confession to make. If I ever came into silly money, or had funds to spend
on fun purchases, I’d probably consider buying uneconomical things like ski
resorts. Why? Because I like to ski and from what I understand there’s
nothing like skiing at your very own resort. I view golf course ownership in
the same way. The executives at Avalon Holdings enjoy golf, and these are
status purchases. The problem is they’re using shareholder money, not their
own funds, for these purchases.

The primary reason golf courses are a problem is because less people are
playing golf. According to a recent Bloomberg article, the number of people
who played golf in 2016 was 20 million, down from 30 million in 2001.
That’s a big drop. The sport is in decline. The average age of a golfer is 44
and younger people have less and less desire to play golf.

Personally, I have a few anecdotal observations regarding this. When I was
growing up my father was a salesman, and in sales playing golf was
mandatory. Beyond playing for work he played in leagues, along with
playing a night a week and the occasional weekend. It was pounded into our
heads as little kids that success in business meant being able to play golf.

My brothers took lessons as kids and enjoyed it, but that didn’t translate into
them playing when they were older. I took lessons in my late 20’s, which
coincided with the birth of my first son. I struggled to find time to play a
game that required up to six hours on a weekend day with a young child at
home. As it turned out, I didn’t need to play golf to do well in business. The
generation that believed it was necessary to succeed has passed into the next
world known as retirement (or they’re close to it).

It’s not that golf is a bad game, in fact it’s very enjoyable! It’s just that
times have changed. Joining a country club isn’t something that’s important
to the younger generation. This struck me as so odd that for a while I
specifically asked any successful person under 40 if they knew anyone who
was a member of a country club. The answer was crickets.

Copyright Red River Research Inc. 2017
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We experienced a golf glut in this country with overbuilding and lofty
aspirations that met a different reality. Courses are closing, especially in
rural areas that don’t have the population to support them.

Avalon Clubs and Resorts is experiencing these same problems. They cite
that country club memberships are stable, but aren’t at the level needed for
their desired profitability.

The company’s Clubs and Resorts division reported revenue of $17.1m in
2016 compared to $14.9m in 2015. The increase in revenue is likely due to
increased occupancy in their hotel, as well as from country club related fees.
By that I mean dining revenue, banquet revenue, and non-golf revenue. The
golf courses themselves generated $4.7m in revenue from 4,615 members.

Their Clubs and Resorts division reported $300,000 in operating income in
2016, almost all of it from their hotel. Let’s take a moment to talk about the
company’s hotel. While the golf courses are a drag on income, the hotel is
an interesting acquisition that’s showing potential.

In 2014 the company purchased the Avalon Inn, which is adjacent to one of
their country clubs. They envisioned offering a complete vacation
experience where visitors could relax at the hotel, eat at on-site dining
facilities and play golf. A stay at the hotel entitles a visitor to play at any of
the three golf courses, eat at one of 12 restaurants, play tennis, swim at the
pool and use the spa. It’s actually quite a package.

The resort is located in Warren, Ohio, which is near Youngstown, Ohio and
Sharon, Pennsylvania. Youngstown has a bad reputation as a dilapidated
steel town. It deserves the reputation, but Warren is nice. Historically, the
steel money of Youngstown lived in Warren. Warren is also close to
Cleveland and Pittsburgh, both of which are roughly an hour drive away.

These little resorts are popular in this area. As a side note, I live in
Pittsburgh and have been to and through Warren in the past, although I
haven’t been to this resort.

Pennsylvania has a number of resorts similar to the Avalon Inn, such as
Nemacolin Woodlands Resort, Bedford Springs Resort, and in West Virginia,
Oglebay Resort. The resorts are a destination for company outings, or
couples and families looking to get away for a few days. This isn’t the type
of place you’d fly in from New York City or Los Angeles to visit, but it would
be a nice weekend away from the kids, or a weekend away from the wife
(husband) with golfing buddies.

Copyright Red River Research Inc. 2017
THE ODDBALL STOCKS NEWSLETTER 10

The point being that what Avalon Holdings has built isn’t unique. Rather,
it’s a popular business model that has stood the test of time (many of the
resorts I named have been around for years).

The Avalon Inn looks very nice from pictures on the Internet. They have a
4.7 star review on Google from 181 reviews. On TripAdvisor they have 85
reviews and an average rating of 4.5. I know employees are probably on
there giving themselves five star reviews, but with almost 300 reviews
online I’m not sure how much sway employees have at this point. The resort
is seemingly nice and well received.

The company has been updating the hotel since it acquired it and expects to
spend another $4-6m to complete the transformation. What’s encouraging
for shareholders is that the hotel is pulling its weight financially even
though it isn’t completely remodeled and is in the midst of a complete
renovation. The good news is that once the renovations are complete
occupancy and customer satisfaction should be higher, which in turn should
translate into higher revenue and profits.

Hotels and golf courses have a high break-even point due to operating costs.
There is a lot involved in keeping the doors of a hotel, or the greens of a golf
course, open. But, once the break-even point has been hit almost any
additional revenue falls straight to the bottom line. The hotel appears to be
operating slightly north of this break-even point, while the golf courses are
hovering near it. Even a slight uptick in business could be substantial.

Well, here we are with almost four pages of text and no discussion of
valuation yet! Let’s dive in. The company’s market cap is $9.8m, which as
noted is tiny. It’s even tinier compared to their book value and earnings (ex-
Clubs and Resorts).

The company’s book value is $37.8m, meaning they trade for 25.9% of such
amount. Many investors, considering the declines discussed above, would
argue that golf is dead. Of course, any sector that isn’t “hot” is by definition
dead. In addition, these same investors might argue that waste management
isn’t a compounding machine or scalable, or an asset-light company. All of
these things are true, but I’d argue that 25% of book value is unreasonably
low, especially when the company has some considerable tangible assets.

Let’s look at those assets. The company breaks them down as follows:

Copyright Red River Research Inc. 2017
THE ODDBALL STOCKS NEWSLETTER 11

They have $14m in land, $34m in buildings, another $9m in machinery,
$445k worth of vehicles and $6m worth of office furniture.

Let’s suppose that their land is junk and only worth 75% of what it was
acquired for years ago. So now our new land value is $10m. Let’s further
haircut their buildings by 50% giving them a new value of $17m. Let’s go
further and assume the machinery could only be sold for 50% of its purchase
price, which would be $4.5m. Finally, let’s say that everything else they own
is completely worthless. Add all of this up, net out their $11m in debt, and
the value is $20m, still double their current market cap.

I’m not implying that the company is going to liquidate or advocating that
they should liquidate. But, the point is that even with draconian cuts to the
value of their assets it’s still possible to come up with a value that far
exceeds the current value assessed by the market. However, the problem
with assets is that unless they’re readily salable it’s hard to value them if
they don’t generate some sort of return.

The most easily valuable segment is the company’s waste business. As
discussed above, it earned $2.7m pre-tax in 2016 and $1.7m pre-tax in 2015.
At a very reasonable 10x multiple the waste segment alone could be worth
$17m-27m. The company’s waste income fluctuates, but is substantial. In
2011, for point of reference, they earned $3.5m pre-tax from waste, while in
2010 they did $2.5m. I mention these older results to show that the last year
or two wasn’t a flash in the pan. Avalon Holding’s waste operations have
been consistent cash generators.

On their own it’s pretty easy to say the waste operations are worth at least
$20m, or more than double the current market cap. The big question mark is
their resort operations which have masked the profitability of the waste
operations. The open issue is whether this portion of the business has any
actual value, or whether it should be written off as worthless.

In my view one of the better moves the company made was to acquire the
hotel adjacent to one of their golf properties. By acquiring and remodeling
the hotel they’re working to add value to their entire set of properties.
Initial indications seem to show that this is working. Last year while their
golf courses lost money the hotel made up for the loss and generated a tiny
bit of profit.

Someone is probably reading this and saying to themselves, “I bet an activist
could come in and ‘encourage’ management to sell the resorts to unlock
value.” The problem with this line of thinking is there are two classes of
stock: the A shares that elect two directors, and the B shares that elect three
directors. The CEO of the company, Ronald Klingle, owns 99% of the B
shares, effectively warding off any potential activist. In addition to the CEO

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control, the top three executives earn a combined $844k, which is a
considerable amount for such a small company.

Even with the insider majority control and the executive salaries, I would
argue that this company is worth much more than 25% of book value. We
can come up with all sorts of dire scenarios in which the company’s assets
are impaired. Maybe their land isn’t worth all that much, or maybe the
resort is worthless.

The question is whether what they own is worth more than 25 cents on the
dollar. I would argue that the results of the waste division alone give these
assets a value in the range of 50 cents on the dollar, if not more. Beyond
that, the hotel and golf courses are a bit of a wildcard. Maybe things turn
out well and the company gets a boost. But, even in the worst-case scenario
it’s hard to argue that Avalon Holdings is worth so little. The company
might not be worth book value, but even at 50% or 75% of book value this
provides investors the opportunity for an outsized gain.

Copyright Red River Research Inc. 2017
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