I do not want to appear as a genius or sly investor. I was reading an article on thestreet.com that highlighted National Presto Industries (ticker:NPK) and felt it was a company that I would be interested in analyzing and potentially adding to my portfolio one day. Investing in these names offers huge upside as they may continue to grow (higher price and higher dividends) and may be undervalued leading to be a potential buyout target. NPK did not appear on those screeners since the regular dividend it pays is low and yields less than 1%.
Note: I have changed the DCF model I have used to value NPK slightly. I do not believe it would have a material impact on other companies I have highlighted on this blog. I feel this new methodology is cleaner and more transparent. As always, if you feel an investment idea is worth pursuing, please do additional research and/or contact a financial advisor.
Firm overview
National Presto Industries (ticker: NPK) is a diversified manufacturing company. The company operates in three key segments: housewares/small applianes, defense products, and absorbent products. Housewares/small appliances include the wide variety of Presto products, which can be found at Wal-Mart; Wal-Mart is a major customer. Defense products sell products to the U.S. Department of Defense. Absorbent products include the sale and manufacture of adult diapers.
Investment rationale
Key reasons to initially look at this company include the low valuation and high dividend yield (after factoring in the annual special dividend). Once an investor digs deeper in the company, an investor finds a company that has solid management who generates cash effectively and effective re-invests cash in the business. This is proven by increasing returns on common equity.
But, like most manufacturers, NPK is highly tied to the recovery of the U.S. economy. Most of its products are sold through Wal-Mart and most of household items they sell are discretionary. As consumers become more confident, they will begin to purchase discretionary items like small appliances. If Wal-Mart’s sales increase, so should NPK’s. One interesting sidenote is although NPK’s household appliances are primarily sold through Wal-Mart, the firm has found a way to increase margins over the past ten years. As a potential investor, this indicates to me the firm has effective costs controls and/or can pass on higher costs to consumers (both are pluses).
Key risks NPK include the concentration of customers. Like the Wal-Mart scenario stated above, NPK also heavily relies on the U.S. Department of Defense. If U.S. defense spending is materially reduced or NPK loses any contracts for whatever reason, this may have a material impact on the earnings power in the future.
Sales & profitability
Total sales have grown from $119.1 million to $479.0 million in the years 2001 to 2010. When compounded, this is 16.7% per year. The firm only had one year of negative profitability; the year was 2001.
In addition, the firm has increased gross margins, operating margins, and net margins during this time. Gross margins increased from 21.0% to 23.7%. Operating margins have increased from -1.9% to 20.3%. Net profit margins increased from 5.3% to 13.3%. Net profit increased from $6.3 million to $63.5 million. When compounded, this is 29.3% per year.
Sales | Net profit | |
2001 | $119.1 | $6.3 |
2002 | $124.8 | $8.7 |
2003 | $125.7 | $15.5 |
2004 | $159.0 | $15.4 |
2005 | $184.6 | $16.4 |
2006 | $304.7 | $28.0 |
2007 | $420.7 | $38.6 |
2008 | $448.3 | $44.2 |
2009 | $478.5 | $62.6 |
2010 | $479.0 | $63.5 |
Do these trends indicate NPK has a durable competitive advantage? Sales are increasing; which is positive. A firm with a d.c.a. typically has a gross margin of 40% or greater. At year-end 2010, NPK had a gross margin of 23.7%; over the ten years analyzed, this ratio was consistent, which is a plus.
Capital structure
The firm does not have any outstanding debt. In addition, the firm typically holds plenty of cash on balance sheet, in addition to investments in marketable securities. Per the Form 10-K, municipal bonds make up a majority of the investments in “marketable securities.” Per the Form 10-K, marketable securities are sold in order to meet short-term liquidity needs.
Do these trends indicate NPK has a durable competitive advantage? Yes. Firms with a d.c.a. typically do not hold any debt, or little debt in general. NPK does not hold any debt, in addition to being cash rich. At year-end 2010, NPK had a current ratio of 5.2; in other words, NPK had 5.2x more current assets than current liabilities.
Capital efficiency
Since the firm does not have any debt, leverage should not play a huge role in capital efficiency. The most common metric for capital efficiency is return on common equity (ROCE). ROCE for NPK has increased since 2001; ROCE increased from 2.7% to 18.5%. Long-term investors typically like to see high, consistent ROCE. The fact ROCE has been increasing each year indicates NPK’s management is making productive use out of retained earnings; this should continue to increase in the future.
Return on common equity | |
2001 | 2.7% |
2002 | 3.6% |
2003 | 6.3% |
2004 | 6.0% |
2005 | 6.2% |
2006 | 10.0% |
2007 | 13.1% |
2008 | 14.2% |
2009 | 18.6% |
2010 | 18.5% |
A favorite metric of Warren Buffett is return on unlevered net tangible assets. Mr. Buffett has said a “great” company has a return of 25% or greater; this ratio can exceed 100%. Return on unlevered net tangible assets has increased from -1.5% to 34.3%.
Dividends and share repurchase
NPK does pay a dividend, but does not engage in a share repurchase program. Annually, the firm pays a regular dividend of $1 once a year. Given the current closing price of around $111 per share, this equates to a dividend yield of less than 1%. In addition, the firm pays a special dividend based on the previous year’s profitability once a year.
NPK paid a total dividend of $8.25 per share earlier this year; this is a $0.10 increase from the previous year. Since 2001, the dividend grew approximately at a rate of 16.9% per year. The dividend growth rate is slower than rate in growth of net income; net income increased 26.9% during the same time.
Dividend | |
2001 | $2.00 |
2002 | $0.92 |
2003 | $0.92 |
2004 | $1.17 |
2005 | $1.67 |
2006 | $2.12 |
2007 | $3.80 |
2008 | $4.25 |
2009 | $5.55 |
2010 | $8.15 |
Since the situation is different for NPK as most of the yield is from the special dividend, it is important to look at previous years to spot a trend. The payout ratio, when using net income, has varied fro m 40.6% to 218.8%. The payout ratio, when using free cash flow, has varied from being negative to 138.7%. In 2010, when using net income, the dividend payout ratio was 88%. This payout ratio is high, but should not be considered alarming; the firm elects to return cash to shareholders through this special dividend versus share repurchase. When combined, both dividends and share repurchase frequently exceed either 100% of net income of free cash flow.
Dividend payout ratio | |
2001 | 218.8% |
2002 | 72.4% |
2003 | 40.6% |
2004 | 51.7% |
2005 | 69.4% |
2006 | 51.8% |
2007 | 67.2% |
2008 | 65.8% |
2009 | 60.7% |
2010 | 88.0% |
If an investor is specifically looking at NPK as a dividend play, it is important to invest with a higher margin of safety. When using the methodology I used to value this stock, I considered only the $1 regular dividend in my analysis (please see valuation section below).
In the valuation section below, I make some assumptions for the valuation. If those assumptions hold true and the firm pays out 70% of earnings to shareholders, NPK should pay a dividend of approximately $7.00 in 2012. The dividend yield would be 4.9% on the intrinsic value calculated or would have a yield-on-cost of 6.34% if the investor were to buy shares at the most recent closing price. Given a payout ratio of 80%, the firm should pay a dividend of approximately $8.00 in 2012.
Valuation
Using a DCF valuation model, I calculate the intrinsic value of NPK to be $144.20 per share. This value is approximately $32.85 higher than the most recent closing price, giving an investor an actual margin of safety of 22.8%.
Key inputs into this model include 6% annual growth and a 19% EBITDA margin. As for most investments, I like to use a 15% risk-adjusted discount rate. In my opinion, since NPK has no short-term or long-term debt, the firm has approximately 80% the financial risk of the average company. Due to broad product line, reliance on government contracts, and the impact of commodity prices, the firm has around 110% the risk of the average company. When combined, this equates to a 13.2% discount rate. Thus, given these inputs, the model produced an intrinsic value of $144.20 per share.
In addition, the price an investor should purchase NPK at given the level of risk is $112.21, or a 20.3% margin of safety to the intrinsic value. The 20.3% margin of safety was calculated as I would like a 30% initial return for any stock. After adjusting for 6% growth, the 0.9% dividend yield from the regular $1 dividend, and the business and financial risks mentioned above, the risk-adjusted margin of safety is 20.3%.
At current trading levels, the stock appears to be an attractive buy.
This information is for educational purposes only, and the opinions expressed do not constitute a recommendation to buy or sell. Author may have a position in the companies discussed, subject to change at any time. Information on this website obtained from reliable sources, but there is no guarantee of accuracy. Please consult your financial advisor before making investment decisions. Past performance is not indicative of future success.
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